Tax is ever changing, but some things never change. The concern with alienation of personal exertion income through trusts is one of those things, Late last year, the ATO issued Taxpayer Alert 2013/3 dealing with this issue in the context of partnerships of discretionary trusts as structures for professional practices.
History
The ATO’s concern goes back decades. Anti-avoidance provisions were found to apply in the famous doctors’ cases and the insurance agent’s case; in response, the ATO issued IT 2330 and IT 2121 in the mid-1980s. The personal services income rules were introduced in 2000. In 2006 there was an attack on service entity arrangements by the ATO, leading to the issue of TR 2006/2. In 2009 the ATO again foreshadowed concerns about alienation of personal exertion income and noted this
concern in the ATO 2012 compliance program.
What is alienation of personal exertion income?
TA 2013/3 describes alienation as follows: “In this context, ‘alienation’ refers to a situation where income that would otherwise be assessable to an individual is the income of a different entity. This may occur as the result of the assignment of an existing partnership interest, or by the creation of a new interest.”
Restructure arrangements
A typical restructure involves individual partners in a professional practice generating relatively high taxable incomes, restructuring to a partnership of discretionary trusts, and their personal taxable income being significantly reduced, with most of the income going to family members and related entities.
Why the concern?
Simply put, the ATO’s concerns are:
. the alienation of income is ineffective;
. CGT consequences of restructures are not correctly reported; and
. part VA (general anti-avoidance provisions) may apply to the restructure.
All these concerns point to a leakage in revenue. Understandably, the ATO will show interest and concern.
Specific features of concern
TA 2013/3 lists many issues that may be of interest to the ATO, These include:
. after restructuring, the income of a professional partner falls significantly, with most of the income distributed to family members and associated entities;
. the day-to-day activities do not correspond to the agreements entered into (eg the individual is represented as a partner in the firm), and
. agreements often attempt to provide employee entitlements to a corporate entity.
What should be done?
The Taxpayer Alert is essential reading for professionals operating through a partnership of discretionary trusts. The key issue to conside is whether the partnership income comes from a business or is a result of the efforts of the individuals representing the discretionary trust partners. The size of the professional practice, the number of professional employees and the investment in plant and equipment are all relevant factors in determining whether the income is business income or personal exertior income. Passing the personal services income (PSI) rules is not the end of the matter.
The remuneration for professionals, whether paid as salary and wages or as trust distributions, should be commensurate with work performed and set according to market rates. A clear distinction must be drawn between reward for services and return on equity investment.
Partnership agreements should be carefully drafted to ensure there is power to make variable distributions of partnership income, and that provisions relating to partners (trustees) and professionals (key persons) are clear and set out the rights and responsibilities of each of the trustees and key persons.
