Review of Tax Office’s management of complex issues – Case study on service entity arrangements

Chapter 5: Inspector-General’s findings — timeframes and consultation processes

5.1 This chapter deals with the Inspector-General’s findings and recommendations on the Tax Office’s timeframes and consultation processes for dealing with service entity arrangements.

Timeframes for the Tax Office to complete its activities in relation to service entities

5.2 A timeline which summarises the key events in the Tax Office’s handling of service entity arrangements in the period from 1978 to date is in Appendix 5.

5.3 This timeline indicates that the Tax Office’s investigative or compliance-based activities with respect to service entity arrangements first obtained a project status within the Tax Office in June 1996. From that year it then took approximately 10 years for the Tax Office to settle additional details of its view of the law on service entities beyond that which it had set out in IT 276. It provided these additional details in TR 2006/2 and the accompanying booklet both of which were issued in April 2006.

5.4 This 10-year timeline can be broken down into the following three time periods:

the time taken to reach a decision to issue public guidance;
the time from when a decision to issue public guidance was made to the date when the guidance was issued to the public in draft form; and
the time from when the guidance was issued to the public in draft form to when it was issued in final form.

Time taken to reach a decision to issue public guidance on service entity arrangements

5.5 The Inspector-General has gathered evidence which indicates that the Tax Office made an internal decision to issue further details of its view on service entity arrangements in the form of either a ruling or a practice statement in December 2002. This evidence consists of internal Tax Office material together with the published minutes of the National Tax Liaison Group meetings held in September 2002 and March 2003. At the September 2002 meeting the Tax Office indicated that a ruling on this topic was not in planning. However, by the time of the March 2003 meeting the Tax Office advised that it anticipated issuing either a discussion paper or ruling on this matter.

5.6 During the course of this review the Tax Office has rejected this evidence and asserted that a decision to issue a ruling on service entities was not made until late in 2003.

5.7 Regardless of whether the date of decision to issue a ruling was made in December 2002 or a year later, the Inspector-General considers that a decision to issue public guidance on service entities should have been made after the Tax Office formed the view (via the survey it conducted in 1998) that this matter was a significant issue for members of the legal and accounting profession and that there was an issue about the commerciality of service entity fees that were being charged by members of those professions.

5.8 As indicated in the timeline in Appendix 5, the Tax Office reacted to the findings of its 1998 survey of legal and accounting firms by commencing an audit program on service entities. No public announcement was made of this decision at this time, nor was there any public announcement of the results of the 1998 survey. A number of taxpayers, including two large accounting firms, were notified they would be audited under this program in 1999. In November 2001, two years after these audits commenced, the Commissioner first publicly flagged that the Tax Office was auditing the service entity arrangements of some accounting and legal firms and that it had concerns with some of these arrangements. One year later, in December 2002, came the decision to issue detailed guidance to the public on these arrangements. This decision to issue further public guidance was made at about the same time as position papers were issued to the two major accounting firms whose service entity arrangements had been subject to audit since late 1999.

5.9 The Inspector-General considers that it was appropriate for the Tax Office to have commenced an audit program following the 1998 survey. However, he considers that it was not appropriate for the Tax Office to have waited until the issue of position papers to the two firms who were subject to this program to make a decision to issue detailed public guidance for the benefit of all taxpayers generally on how they should be calculating fees paid to service entities.

5.10 The Tax Office’s failure to make a decision to issue this further guidance following the analysis of its 1998 survey results (which was completed by April 1999) effectively meant that for a considerable period of time the only two taxpayers that were actually aware of the Tax Office’s detailed views on service entities were those that were being subject to audit.

5.11 The Inspector-General considers that the Tax Office’s failure to start work on providing detailed public guidance on this matter immediately after analysing the 1998 survey results is particularly unacceptable given the very significant role which the large accounting and legal firms that were the subject of this survey play in providing advice on tax matters to taxpayers generally and to other smaller professional accounting and legal firms. This advisory role should have led the Tax Office to conclude from its 1998 survey results that it was potentially dealing with a tax risk that was far greater than that which was directly attributable to the service entity arrangements being conducted by the surveyed firms. This risk could have been as large as the risk that taxpayers as a whole did not properly understand or apply the tax law or as small as the risk that other taxpayers with service entities did not properly understand or apply the tax law relating to these entities.

5.12 The Inspector-General considers that the Tax Office should have identified these potential risks at the time of its 1998 survey and then have properly evaluated them. The Tax Office has provided no evidence to the Inspector-General which indicates any such risk identification and assessment process was properly carried out. The Tax Office did not, for example, at this time assess either the extent of the operation of service entity arrangements in sectors other than the legal and accounting industry or the scale of tax that may be being underpaid as a result of these arrangements in other industries. The failure to carry out an adequate risk assessment of this nature is evidenced by the manner in which the Tax Office conducted an assessment of the total possible revenue at risk from these arrangements after the 1998 survey. This assessment did not include firms that were not in the legal and accounting industry.²¹

5.13 The Inspector-General considers that, had the Tax Office conducted an adequate risk assessment process at this time, it would have become aware of the prevalence of these arrangements in other industries such as the medical profession and gained an appreciation of the potential minimum level of the tax risk associated with these arrangements.

5.14 The Inspector-General believes that, had this been done, a need to issue detailed guidance to the public on this matter would have immediately become obvious.

5.15 The above comments lead to the following key finding.

Key finding 5.1

The Inspector-General considers that a decision to issue public guidance on service entities should have been made at least by April 1999, or within a very short time thereafter (such as by no later than the following month that is, by May 1999). This is three years six months before the Tax Office actually reached a decision to issue such guidance, which occurred in December 2002.

5.16 During this review, the Tax Office has indicated that it needed to complete the audits of the service entities of two large accounting firms so that it had sufficient material to commence preparing a ruling and detailed guidance on service entities.

5.17 However, the Inspector-General considers that all of the major material that was eventually embodied in the first draft versions of both the ruling and booklet that were issued to the public in May/June 2005 was either available by April/May 1999 or could have been obtained within a reasonable time thereafter (say, within six months) so as to allow that material to be embodied in the first drafts of these documents that were issued to parties outside the Tax Office. The major material that was already available by April/May 1999 was:

detailed guidelines for calculating service entity fees. These were contained in the 1994 paper on service entities that was authored by a tax officer and presented at a Taxation Institute of Australia convention;²² and
detailed guidelines for using either a ‘cost plus’ or ‘net profit’ approach to determine an arms length fee (for example, for internal management fees paid within a multinational corporate group). These were contained in Taxation Ruling TR 99/1 that was issued in January 1999.

5.18 The major material that could have been obtained within a further six month period was the comparable profits achieved by labour hire firms. The Inspector-General notes that during the audits of the service entities of the two major accounting firms the Tax Office’s Economists Unit was able to obtain this material within six months of being requested to do so.²³

5.19 In any event, the Inspector-General considers that the nature of public guidance material on any matter is that it is not specific to any individual taxpayer or group of taxpayers. In the Inspector-General’s view, it is therefore not appropriate for the Tax Office to assert that the preparation of any such material is or was dependent on the outcome of specific taxpayer audits.

Time from the date of the Tax Office’s actual decision to issue guidance to the date of issue of this guidance in draft form

5.20 After reaching a decision to issue public guidance on service entities in December 2002 the Tax Office issued a draft form of this guidance in May and June 2005. This is two and a half years after its decision to issue such guidance.

5.21 This two and a half year time period involves a breach of the Tax Office’s internal standard for the time by which a draft ruling is to be issued. This standard states that draft public rulings are to be issued within six months from the date of notification of the proposed ruling to the Public Rulings Branch for inclusion on the Public Rulings Program. The date of notification of the proposed ruling on service entities to the Public Rulings branch was 31 January 2004, while the date of issue of the draft ruling was May 2005. This time period is 15 months and exceeds the relevant Tax Office internal timeliness standard by nine months.

Time from the date of the Tax Office’s actual decision to issue guidance to the date of issue of this guidance in final form

5.22 The Tax Office issued final guidance on service entities in April 2006. This date is 10 months after the date it issued draft guidance, three years and four months after it decided to issue such guidance and four and a half years after the Commissioner first publicly flagged that he had concerns with service entities in his 2001 Annual Report.

5.23 This date is also seven years from the May 1999 time when the Inspector-General considers it should have reached a decision to issue such guidance.

5.24 The 10 month period to issue a final ruling following the issue of a draft form of that ruling involves a breach of the Tax Office timeliness standard for final rulings. This standard states that a final public ruling is to be issued within six months of the draft ruling being issued.²⁴ The date of issue of the final ruling was April 2006 while the date of issue of the draft ruling was May 2005. This time period is 11 months and exceeds the relevant Tax Office’s internal timeliness standard by five months.

Causes of delays

5.25 The Inspector-General considers that an appropriate period over which to examine the causes of any delay in the Tax Office issuing its final guidance on service entities is the seven years that lapsed between May 1999 and April 2006. This seven year period commences at the time when the Tax Office first identified internally that there were concerns about service entities and ends when finalised guidance was issued to the public on these entities.

5.26 The Inspector-General’s review has found that there are several factors which led to unnecessary delay during this seven year period. These factors differ according to the various time periods which make up this time period.

April 1999 to December 2002

5.27 The period from April 1999 to December 2002 starts at the time when the Tax Office had internally identified that there were concerns about service entities and ends when it decided to issue public guidance on this matter. It is a period of three years and seven months.

5.28 The Inspector-General considers that the first reason for this three year seven month time lapse is that the Tax Office did not conduct a proper risk assessment of the service entity issue by May 1999 which would have immediately prompted a decision to issue public guidance on this issue. This cause of delay was entirely within the Tax Office’s control and is unacceptable.

5.29 A second reason for this three year seven month time lapse was internal dissent within the Tax Office between its Tax Counsel Network (TCN) area and the Large Business (LB) area as to the content of any public guidance on service entity arrangements.

5.30 The TCN area became involved in the service entity issue from at least March 2000. From this date, it maintained that the existing IT 276 should remain on foot and that the appropriate strategy to address the compliance issues discovered in respect of service entity arrangements was to finalise any relevant audits and, if necessary, proceed to litigation.

5.31 The LB area’s view from the beginning of its involvement with service entities was that the Commissioner should announce by way of press release that service entity arrangements were no longer acceptable and that IT 276 was to be withdrawn.

5.32 The Inspector-General considers that this second cause of delay in reaching a decision to issue public guidance was also entirely within the control of the Tax Office and is unacceptable. He considers that a decision should have been made at an appropriate senior level within the Tax Office to resolve any actual or potential internal dissent within at least one month of the service entity issue being identified as a compliance issue in April/May 1999.

December 2002 to October 2003

5.33 The period from December 2002 to October 2003 marks the time between the date when the Tax Office made a decision to issue its public guidance on service entities and the date when it commenced drafting this public guidance. It is a period of 10 months.

5.34 This decision took 10 months because TCN wanted the guidance to issue as a practice statement while the LB area wanted it to issue as a ruling.

5.35 The Inspector-General considers that this internal dissent factor is an unacceptable cause of delay. The Inspector-General considers that internal dissent on the nature of the proposed public guidance should have seen resolved at an appropriate senior level within the Tax Office within at least one month of the decision to issue public guidance being made.

5.36 These comments lead to the following key finding.

Key finding 5.2

The Inspector-General believes that the Tax Office should have reached a decision to issue public guidance on service entities in the form of a ruling rather than as a practice statement within a period of one month. The Tax Office actually took a 10 month period to reach this decision because there were competing internal views inside the Tax Office as to whether this guidance should take the form of a ruling or a practice statement. There was therefore an unnecessary delay of nine months in reaching this decision.

October 2003 to May/June 2005

5.37 The period from October 2003 to May/June 2005 marks the time between the date when the Tax Office commenced drafting public guidance on service entities and the time when this guidance was issued in draft form to the public. It is a period of one year and eight months.

5.38 The factors which may have unnecessarily prolonged this time period were as follows:

the process of actually preparing the draft ruling;
the review of the draft ruling which occurred via a number of meetings of the Tax Office’s internal Public Rulings Panel. These meetings were held in December 2003, February 2004 , March 2004, September 2004 and March 2005;
confidential consultation processes that were conducted with members of a NTLG subgroup on the draft ruling between May 2004 and May/June 2005;
the process of drafting the practical guidance booklet; and
the involvement of very senior ATO executives in the drafting process for both the final ruling and booklet from at least October 2004.

5.39 Each of these factors is discussed below.

Drafting of the ruling

5.40 The Appendix 5 timeline indicates that it took two to three months for the TCN area of the Tax Office to prepare an initial draft of the ruling on service entities. This time period appears to be reasonable.

Review of the ruling by the Public Rulings Panel

5.41 During the next six months after the three month period of drafting of the ruling the ruling was reviewed by the Public Rulings Panel (Rulings Panel). The Inspector-General considers that this six months time period is excessive for the following reasons.

5.42 Firstly, this time period is prima facie excessive in view of the Tax Office’s current internal timeliness standard for public rulings. This standard states that the entire period of time between the date of decision to issue a ruling being notified on the rulings program and its date of release in draft form should be a maximum of six months. This standard therefore suggests that the panel should have taken no more than three months to review the ruling.

5.43 Secondly, the Inspector-General’s review of the changes made to the ruling as a result of going through this initial six months of consideration by the Rulings Panel were not as significant as the changes made to the ruling firstly during the 12 months confidential consultation process with NTLG members and then during the subsequent 10 month public consultation process. The Inspector-General therefore believes that, in hindsight, the extent of the changes that arose as a result of the process of being reviewed by the Rulings Panel did not justify that panel taking any longer than three months to consider the first version of the ruling.

5.44 The Inspector-General has been advised that members of the Rulings Panel were not aware until around April 2004 that the ruling would be subject to confidential scrutiny by members of the NTLG prior to its public release. It therefore appears that the Rulings Panel, for at least part of the six months that they were considering the ruling, were operating under the belief that they would be the only group that would be scrutinising the ruling prior to its public release.

5.45 Nevertheless, the Inspector-General notes that the end result of the Tax Office’s confidential consultation processes on the ruling involved a degree of duplicated effort, in that the ruling was first scrutinised for six months by one group of tax experts comprising tax professionals that were both internal and external to the Tax Office and then for a further 12 months by another group that consisted only of tax professionals who were external to the Tax Office. The Inspector-General notes that this duplication would not have occurred had the ruling been released to the public for consultation immediately after being considered by the Rulings Panel.

5.46 The above comments lead to the following key finding.

Key finding 5.3

The Tax Office’s Rulings Panel spent a period of six months reviewing the service entities ruling. This is three months more than the standard time period it should have spent on this task.

NTLG confidential consultation processes

5.47 The final 12 months prior to the date of issue of a draft ruling to the public was taken up by the Tax Office engaging in a confidential consultation process with a special subgroup of the NLTG on the terms of the proposed ruling and (from December 2004) a proposed guidance booklet. The decision to engage in this confidential consultation process was made by the Commissioner at the NTLG meeting of December 2003. These processes led to the Tax Office deciding to issue a practical guidance booklet to accompany the draft ruling on service entities.

Preparation of the guidance booklet and involvement of senior Tax Office staff in the drafting of the ruling and booklet

5.48 The detailed practical guidance booklet on service entities was first prepared by the Tax Office’s Small Business area in conjunction with its Large Business area in the three month period between September 2004 and December 2004.

5.49 This three month period to actually draft this booklet appears to be reasonable. However, the Inspector-General considers that this three month period should have been commenced and concluded much earlier. He considers that it should have commenced by no later than the time when the related ruling was first made available for consultation with NTLG members, and possibly earlier.

5.50 Starting the drafting of the booklet at the time when NTLG consultation on the ruling commenced would have shifted both the three month period of the drafting of the booklet from September to December 2004 as well as the subsequent three month consultation period on this document with NTLG members that occurred between January and March 2005. This is a six month period in total. The Inspector-General considers that, had the process operated in this way, the total 12 months confidential consultation period with NTLG members that actually occurred on both documents would have been reduced to, at the very least, a period of six months only.

Reasons why the Tax Office did not commence work on the booklet until September 2004

5.51 As explained further below, the principal reason why the Tax Office did not commence drafting of the booklet until September 2004 was because the personnel who were involved in the service entities issue, and those who managed them, did not consider that such a booklet was either appropriate or necessary. These personnel considered that the Tax Office should not be issuing detailed guidance which set out any level of ‘safe harbour’ service fees. This was because of a fear that any levels set by the Tax Office in such a document could be too high and therefore could lead to revenue leakage.

5.52 This view is reflected in one internal Tax Office document which states:

To provide safe harbours would be to facilitate the behaviour the ATO is trying to discourage; safe harbours would be open to manipulation and would encourage creeping functionality in the service entities; safe harbours would distract attention from the central mischief which in most of these arrangements is a fundamental mischaracterisation of the commercial benefits, if any, flowing to the taxpayer.

5.53 As so stated, this view appears to be based on an underlying belief that service entity arrangements are unacceptable per se. As noted earlier²⁵, this was the view which the Large Business area held at the beginning of its involvement in service entities.

5.54 In September 2004, during the period of confidential consultation, members of the NTLG subgroup wrote a joint letter to the Commissioner which raised a number of concerns about the manner in which the Tax Office was dealing with service entities. These concerns included the following:

The Tax Office personnel who were engaged in the confidential consultation on the ruling did not appear to accept the legitimacy of service entities, contrary to the previously publicly expressed views of the Commissioner; and
The draft ruling did not provide any form of assistance to the community by the omission of guidance in areas where the Commissioner would accept levels of charges.

5.55 The Commissioner immediately took steps to address both these concerns.

5.56 Firstly, responsibility for the service entities issue was transferred to the Tax Office’s Small Business area.

5.57 Secondly, over the following six to eight months, he took steps to ensure that the Tax Office issued a booklet on service entities which included ‘safe harbours’ and that both the existing ruling and this new booklet reflected the Tax Office’s corporate view on these arrangements. As discussed later in this chapter, he did so by becoming personally involved in the drafting of these documents.

5.58 As indicated earlier, the Inspector-General considers that these additional months of work, while necessary to ensure that these documents reflected the Tax Office’s actual corporate views on service entities, should have occurred earlier in the process of drafting the ruling. If this had occurred the Inspector-General considers that at the very least the NTLG consultation processes on the ruling could have been reduced from 12 months to six.

5.59 The Inspector-General considers that it should not have required external representations being made to the Commissioner for him to either:

become aware that the members of his staff who were preparing the public guidance on service entities had a fundamental belief that these arrangements were not legitimate which was contrary to the Tax Office’s corporate view on this issue; or
reach a decision to issue detailed public guidance to taxpayers on how they could calculate their service entity fees.

5.60 The above comments lead to the following key findings.

Key finding 5.4

The Tax Office did not commence drafting of a detailed practical guidance booklet on service entities until September 2004 because the staff who were involved in the service entities issue, and those who managed them, did not consider that such a booklet was either appropriate or necessary. This view was based on an underlying belief held by the relevant staff and/or those who managed them that service entity arrangements were unacceptable. This was a view which these staff and/or their managers had held since the beginning of their involvement in service entities. It was not the Commissioner’s view on these entities.

Once the Commissioner became aware that these staff still held this view he:

changed management responsibility for the service entities issue;
authorised a decision to issue a detailed practical guidance booklet which contained ‘safe harbour’ mark-up rates for service entities; and
took steps to ensure that this booklet and the related ruling reflected the Tax Office’s corporate view on these arrangements by becoming personally involved in the drafting of these documents.

These management changes better facilitated resolution of the service entities issue. The culture and strategies employed by the Large Business and Aggressive Tax Planning areas of the Tax Office on this issue prior to this management change were not conducive to the objective progression and resolution of this issue.

Key finding 5.5

The Tax Office spent six months preparing its detailed practical guidance booklet and having this booklet reviewed by a NTLG subgroup. This six month period should have occurred earlier in the process of drafting the proposed guidance on service entities. If this had occurred, the NTLG consultation processes on the proposed guidance for service entities, which took place over a one year period, could have been reduced to at most six months.

5.61 The Inspector-General also notes that the conduct of the Large Business area in not preparing any detailed practical guidance on service entities indicates that there may be a serious misunderstanding within this area of the nature of the current self assessment system and of the Tax Office’s obligations under this system with regard to the issue of detailed public guidance to taxpayers which will enable them to voluntarily comply with the law.

5.62 Under this system, the Tax Office is obligated to issue such detailed public guidance on how to apply the law to taxpayers in all possible cases (including those which may be considered not to be legitimate), subject only to resource constraints and risk management and other prioritisation processes.

5.63 This obligation is reflected in some key Tax Office documents. For example, the Tax Office’s Public Rulings Manual states:

the Tax Office must provide sufficient education, assistance and information to facilitate self-regulation.

5.64 The Inspector-General notes that by at least September 2004 the Tax Office’s Large Business area was aware, from the audit work which had been conducted on two large accounting firms and from other activities that it had conducted by this time (such as its 2003 survey of other legal and accounting firms) that the issue of the level of service fees that were deductible for tax purposes had all of the following characteristics:

it involved a matter that was not clearly set out in the law;
it involved large numbers of taxpayers at least in the legal and accounting industry;
it had led to widely divergent claims by taxpayers; and
it involved large amounts claimed as tax deductions.

5.65 It therefore was clearly an issue for which detailed public guidance was both appropriate and necessary in a self assessment environment, even if the terms of the ultimate guidance on this issue accorded with the Large Business area’s view that these arrangements were not legitimate.

5.66 These comments lead to the following key finding and recommendation.

Key finding 5.6

The senior Tax Office personnel who were responsible for handling service entity arrangements did not consider the adequacy of the Tax Office’s existing detailed practical guidance to taxpayers in this area, particularly in relation to the manner in which service entity fees were to be calculated. These personnel did not act to update or correct any previous practical guidance material that taxpayers may have been relying on. This issue was only addressed when the Commissioner made a decision to issue such practical guidance in September 2004.

Key Recommendation 1

Before it decides on an approach to any compliance issue, the Tax Office should test how well it has met its obligations, in a self assessment system, to provide adequate and contemporary guidance to taxpayers on the relevant issue. The Tax Office should introduce formal processes and procedures to ensure that it tests itself against this obligation before finalising the approaches that it will adopt to the relevant issue. It should not tolerate any internal culture which ignores the need to provide such adequate and contemporary guidance to taxpayers.

May/June 2005 to April 2006

5.67 The period from May/June 2005 to April 2006 starts from the date when draft guidance was issued and ends when final guidance was issued. It amounts to a total of 10 months.

5.68 The Inspector-General’s review has established that there were at least four factors which contributed to this 10 month time period. They were as follows:

the continued involvement of very senior Tax Office executives in the drafting process for the final ruling;
the need for the final ruling to be further considered by the Public Rulings Panel;
revised international benchmarking work conducted by the Tax Office; and
the need for the Tax Office to consider submissions received from the public generally on the draft ruling. These submissions included submissions from the legal and accounting bodies who had previously been consulted on the ruling via the NTLG subgroup process. However, these submissions also now included submissions from other industries whose members operated service entity arrangements. These other industries (which included the medical profession) had not been a party to the confidential consultations previously held on the ruling and booklet.

5.69 All of these factors are capable of being fully or partly controlled by the Tax Office.

5.70 The Inspector-General considers that the 10 month period of community consultation on the ruling and booklet was not excessive. This is because of the following factors:

the Tax Office did not, prior to the issue of the ruling and booklet, consult with any industry that would be affected by the ruling other than the legal and accounting profession;
consultation with the legal and accounting profession was confined to a select group from those industries; and
the booklet contained commercial benchmark rates for all industries who have service entity arrangements. The Inspector-General considers that it is appropriate for the Tax Office to set such rates only after extensive consultation with industries who conduct such arrangements.

However, as discussed further below, the Inspector-General considers that this 10 month consultation period should have commenced at the same time as NTLG members became involved with these documents. He also considers that, if this had been done, it is possible that the total time period between the date of release of the ruling to NTLG members and the date of its publication in final form could have been truncated from the 22 months years this process did take to perhaps as short as 12 months.

5.71 These comments lead to the following key finding.

Key finding 5.7

The Inspector-General considers that the 10 month period of community consultation on the service entities ruling and booklet was not excessive.

Inspector-General’s overall comments and conclusions on timeframes

Periods of Tax Office-generated delay

5.72 The Inspector-General has concluded that the seven years that lapsed between the Tax Office identifying the existence of a potential compliance issue for service entities and issuing a final ruling to address this issue involved at least four significant time periods that could have been reduced by appropriate Tax Office action.

5.73 The first of these time periods was the three years and seven months which lapsed while the Tax Office reached a decision to issue public guidance. The Inspector-General considers this time period should have taken no more than one month.

5.74 The second of these significant time periods was the 10 months it took the Tax Office to reach to a decision on whether to issue the guidance on service entities in the form of a ruling or a practice statement. Again, the Inspector-General considers that this decision should have taken no longer than a month to reach.

5.75 The third significant time period was the three months of additional time spent by the Rulings Panel on reviewing the ruling that was beyond the standard time period it should have spent.

5.76 The fourth significant time lapse was the six month period the Tax Office spent on firstly preparing and then conducting consultation on the draft practice booklet with NTLG members. The Inspector-General considers that this six month period should have taken place over a period that was no later than, and coincided with, the first six months of the ruling’s actual 22 month external consultation processes.

5.77 The total of the above time periods (ignoring the two one month periods that are considered to be reasonable) is five years.

5.78 The Inspector-General considers that better project and/or risk management processes within the Tax Office could have reduced all the above time periods.

What would have been a reasonable total time period for the issue of final guidance on service entities?

5.79 The Inspector-General considers that a reasonable maximum time period for the preparation and finalisation of both the ruling and booklet on service entities would have been two years. This is the sum of the following time periods:

two months (being a one month period to reach a decision to issue guidance once the compliance issue had been identified plus a further one month period to decide on the form of this guidance);
three months (being a reasonable time to draft the ruling);
three months (being a reasonable period for the ruling to be reviewed by the Tax Office’s internal Public Rulings Panel);
three months (being a reasonable period for the guidance booklet to have been prepared). During this time the ruling itself could have been released for consultation; and
thirteen months (being a reasonable time for subsequent consultation on both documents).

5.80 The last two components of this time period give rises to a total of 16 months of consultation. This time period is equal to the six month period the Inspector-General considers was a reasonable period for the Tax Office to have consulted with NLTG members to reach the version of the ruling and booklet which was released to the public in May and June 2005, followed by the additional 10 month period of consultation with other taxpayer groups which then in fact occurred to reach the final version of the ruling and booklet that was released in April 2006.

5.81 The Inspector-General considers that this period is reasonable, given that the guidance that was issued on service entities incorporated commercial benchmark rates for a number of industries. The Inspector-General considers that it is appropriate for the Tax Office to set such rates only after extensive consultation with the relevant industries. The Inspector-General further notes that where the Commissioner determines benchmark commercial rates in other contexts (such as when he determines the effective life of assets that are subject to capital allowances) the practice is to consult extensively with relevant industries and that this period of consultation is generally expected to take up to a year.

5.82 Had the ruling process started in April/May 1999 and taken the two year benchmark period referred to above, final guidance on service entities could have been issued as early as April 2001. Instead, final guidance on this matter was only issued some five years later.

5.83 The Inspector-General therefore considers that there has been at least an unnecessary delay of five years in producing the final versions of the service entity ruling and booklet.

5.84 The Inspector-General notes that the Tax Office has not itself conducted an internal examination of whether the service entities ruling and booklet may have been unnecessarily delayed for any period. This is despite the fact that the time periods involved breaches of firstly, the Tax Office’s benchmark time for issuing a draft public ruling and secondly, its benchmark time for converting a public ruling into a final ruling.

5.85 The above comments lead to the following key findings.

Key finding 5.8

The seven years that lapsed between the Tax Office identifying the existence of a potential compliance issue for service entities and issuing a final ruling to address this issue involved a total period of unnecessary delay of five years.

Key finding 5.9

The Inspector-General considers that a reasonable maximum time period for the preparation and finalisation of both the ruling and booklet on service entities would have been two years. Had this period commenced when the Tax Office first identified a potential compliance issue for service entities, the service entities ruling and booklet could have been issued by April 2001.

Other recommendations relating to timeframes

5.86 The Tax Office aspires to provide excellent service when providing guidance to taxpayers and has internal service standards relating to the timeliness of public rulings to help it meet this aspiration. However, the Inspector-General’s review of the manner in which the Tax Office has handled the issue of public guidance on service entities indicates that there is a need for changes to be made to the manner in which these standards are communicated to the public, to how the Tax Office is assessing the extent to which they are being met and to the content of these timeliness standards. The changes that he believes need to be made in all these areas are discussed below.

Manner in which the Tax Office’s timeliness standards for public rulings are published

5.87 The Tax Office does not publicise its timeliness standards for public rulings in the same manner as it notifies the public of its timeliness standards for other activities. The principal reference to the Tax Office’s timeliness standards for public rulings is at the beginning of the Tax Office’s Public Rulings Register which is published on its website. This reference, while it states that the Tax Office should meet timeframes of six month for issuing both draft and final rulings, does not actually state that these timeframes are internal Tax Office service standards. The Inspector-General believes that the Tax Office should notify the public that these timeframes are standards and should publicise both the existence of these standards and the degree to which they are met in the same manner as it deals with other service standards.²⁶

Assessing the Tax Office’s adherence to timeliness standards for public rulings

5.88 The Inspector-General considers that the Tax Office should ensure that it is assessing the timeliness of all its public rulings on at least a once a year basis.

5.89 The ANAO in its 2001 review of the ATO’s administration of rulings recommended that the Tax Office should introduce a process to periodically self assess the timeliness of its public rulings. In its follow up review in 2004 the ANAO considered that this recommendation was in the process of being addressed because the Tax Office was at that time conducting an internal review of the timeliness of public rulings.

5.90 The Inspector-General has obtained a copy of the report from the internal review that was referred to in the ANAO’s 2004 report. This report, which was completed for the 2003/04 year, concluded that, during that year, two thirds of the 21 rulings that were reviewed for the purposes of the report had not meet internal ATO timeliness standards.

5.91 Despite the negative findings of this report, the Tax Office only conducted subsequent reviews of the timeliness of its public rulings for each of the years ended 30 June 2005 and 2006 during the course of this current review. These reviews occurred after the Inspector-General drew the Tax Office’s attention to this matter.

5.92 The reviews by the Tax Office found that, for each of the years ended 30 June 2005 and 2006, only 50 per cent of all draft public rulings and 50 per cent of all final public rulings met the relevant internal ATO timeliness standards.

5.93 The Tax Office has therefore not been consistently monitoring and assessing the timeliness of public rulings on an annual basis, despite the ANAO’s earlier recommendation that it establish a periodic process of this nature. The Inspector-General believes that the Tax Office should take steps to ensure that such a process is conducted at least annually and that its results should be published.

5.94 These comments lead to the following key finding.

Key finding 5.10

The Tax Office has not been consistently monitoring and assessing the timeliness of public rulings on an annual basis, despite the ANAO’s earlier recommendation that it establish a periodic process of this nature.

5.126 The above comments lead to the following key findings.

Key finding 5.13

The Inspector-General considers that the process of consulting with members of the NTLG which took place before the release of the draft ruling and booklet was beneficial in the sense that it allowed the Tax Office to produce a ruling and booklet on service entities for presentation to the public as a draft with knowledge of the views of these stakeholders on these documents.

However, he considers that this process should not have been conducted with a select group and that any detailed consultation with this group should only have commenced after the draft ruling was issued to the public.

Key finding 5.14

The Inspector-General considers that at most a 16 month period of public consultation should have occurred on the service entities ruling and/or booklet. This period is six months shorter than the total period of 22 months of consultation which actually occurred on these documents.

Tax Office conduct during the consultation processes

5.127 A number of positive comments were made in submissions from participants in that the consultation processes on the ruling and booklet had been conducted by the Tax Office in a professional manner.

5.128 The concerns that were raised in submissions about the Tax Office’s conduct during these processes were as follows.

5.129 Firstly, a number of submissions asserted that these processes took too long.

5.130 Secondly, a number of submissions stated that public consultation processes commenced too late in the drafting process.

5.131 Thirdly, submissions asserted that key Tax Office decision makers were not engaged early in these consultation processes.

5.132 Fourthly, submissions asserted that the Tax Office took a ‘negotiation’ style approach during these consultation processes which was inappropriate, given that the Tax Office should have been endeavouring to reach an objective view of how the relevant law should be applied.

5.133 Finally, some stakeholders asserted that during these consultation processes they were led to believe that the Tax Office agreed with certain contentions (and that as a result the Tax Office would change the ruling or booklet to reflect this agreement) when in fact the Tax Office had not accepted the relevant contentions.

5.134 The Inspector-General’s comments on these concerns are as follows:

Consultation processes were too long and commenced too late

5.135 The timeline contained in Appendix 5 indicates that consultations on the content of the proposed service entity ruling with members of the NTLG subgroup commenced six months after a discussion paper/initial version of the ruling was first prepared. These confidential NTLG consultations then took place over a further one year period. Public consultation on the ruling and an accompanying booklet then commenced at the end of this confidential consultation and this took an additional 10 month period.

5.136 As discussed earlier in this chapter, the Inspector-General considers that all these time periods, other than the 10 month period of public consultation, were too long. Also as discussed earlier, he considers that the public consultation processes on these documents commenced too late in the drafting process.

Key decision-makers were not involved early in the drafting process

5.137 The Inspector-General has established, through his fieldwork for this review that during the time the ruling and booklet were being drafted by the Tax Office there were a number of different areas of the Tax Office with different responsibilities in relation to these documents. The corporate management arrangements for these documents were as follows:

until September 2004, responsibility for these documents resided with the Large Business area of the Tax Office (with a senior executive from the Aggressive Tax Planning area having executive oversight). Thereafter this responsibility was transferred to the Small Business area of the Tax Office;
throughout the entire period of the drafting of the ruling, this drafting was the responsibility of the Tax Counsel Network (TCN). This area reported at all relevant times to a Second Commissioner. Under the usual Tax Office procedures for rulings, as set out in the Tax Office’s internal Rulings Manual, the TCN area is not usually responsible for the drafting of rulings. Usually their role is to approve and review rulings. The usual author of a ruling is a member of the relevant Centre of Expertise (COE) for the subject matter of the ruling.
preparation of the booklet was initially the responsibility of the Large Business area of the Tax Office but was subsequently transferred to the Small Business area of the Tax Office. From September 2004, this area reported to the Commissioner directly on this matter.

5.138 As a result of these managerial arrangements, there was from September 2004, one key ATO decision-maker in relation to the ruling (the Second Commissioner) and two key decision makers in relation to the booklet (the then Commissioner and the head of the ATO’s Small Business area). The second group of key decision-makers were not involved in the processes of preparing the ruling which had taken place prior to the decision to create the booklet.

5.139 These arrangements therefore meant that two key members of the Tax Office whose decisions on content issues were ultimately crucial to the final form of guidance that was issued to the public on service entities were not in fact involved in the Tax Office’s processes for drafting this guidance until one year after drafting processes for this guidance commenced and four months after the confidential consultations with NTLG members on this guidance commenced.

5.140 The Inspector-General therefore agrees with the concerns raised in submissions that key Tax Office decision-makers were not involved in the processes for drafting the ruling (including the consultation processes that were used for the ruling) until some time after these processes had commenced.

5.141 The Inspector-General considers that it is desirable for the Tax Office to ensure that all key decision-makers on a high priority issue such as the guidance that was prepared on service entities are involved as early as possible in the process. Their involvement should begin at least from the time when this issue is subject to consultation with parties that are external to the ATO or shortly thereafter.

5.142 During the course of this review the Tax Office has advised that its current processes normally result in the engagement of key decision-makers at the time when a Priority Technical Issue which may give rise to the issue for a ruling is formally registered as an issue on the Tax Office’s Priority Technical issues register. However, these processes do not appear to have operated effectively in the case of the service entities ruling. As noted earlier, the service entities issue was designated as a ‘priority technical issue’. This designation was however made well before the time when the ultimate key decision-makers on the ruling and booklet were engaged in the development of these documents.

5.143 A failure to engage key decision-makers early in such consultation processes can, as in the case of service entities, have a number of undesirable consequences. One of these consequences is that this failure will prolong these processes. A second undesirable feature is that the guidance may be being prepared in a way which does not accord with the key decision-maker’s view of the relevant subject matter. As discussed earlier, this adverse consequence did arise in the case of service entities, although the Commissioner did take steps to address this once he became aware that it was occurring. A third undesirable feature is that external stakeholders who are involved in these processes may be unwilling to participate further in those processes or in subsequent similar processes because of a belief that their time and energies (which are often being given for no remuneration) are being wasted because they are not dealing directly with parties who are making the key relevant decisions.

5.144 The identity of the key decision-makers is also a matter which should be carefully considered by the Tax Office when it is allocating managerial responsibility for key issues, such as service entities. The Inspector-General notes that in this case the key decision-makers were all at the very top of the ATO’s managerial structure and all had other significant tax administration responsibilities.

Other practices adopted by the Tax Office during consultation processes

5.145 The Inspector-General considers that the consultation processes employed for the service entities ruling booklet were not adversely affected by the Tax Office adopting a negotiation style during these consultations. The Inspector-General notes that this can be a feature of any process which involves the discussion of issues where not all parties to the discussion are in agreement. The Inspector-General also notes that during his review the Tax Office confirmed that there was one instance where a junior officer represented to a professional body that was involved in the consultation that the ATO had accepted an important contention made by that body when in fact the relevant key decision-maker had not accepted this contention. The Tax Office has indicated that it has subsequently apologised to the professional body concerned.

5.146 The above comments lead to the following key findings and recommendations.

Key finding 5.15

Key Tax Office decision makers were not involved in the processes for drafting the service entities ruling (including the consultation processes that were used for the ruling) until some time after these processes had commenced.

Subsidiary recommendation 1

The Tax Office’s consultation processes with the community for public rulings should be conducted openly at all times and should commence as soon as possible during the drafting process. These processes should not involve, to any significant degree, consultation with only a select group of taxpayers that may be affected by the ruling.

Subsidiary recommendation 2

The Tax Office’s key decision makers on any proposed public ruling (or any proposed ruling which is to be accompanied by detailed practical guidance) should be engaged in the process of developing the ruling no later than the time when that ruling and any accompanying guidance is subject to public consultation processes.

Tax Office response during the review

5.147 During the course of this review, the Tax Office has stated that the consultation processes employed to deal with the service entities issue were appropriate because the group that was involved in secret consultations with the Tax Office represented more than 95 per cent of all businesses across every industry in Australia. The Tax Office also asserts that it was through this consultation that issues with service entities in the medical industry were identified.

5.148 These comments ignore the fact that, unlike most other consultation arrangements held with members of the NTLG, the service entities issue involved a matter which directly affected these NTLG members as taxpayers and they were therefore not in the usual position of acting as disinterested parties who advise affected taxpayers.

5.149 The Tax Office’s comments that the NTLG consultation processes led to service entities issue for the medical profession being identified is not correct. Evidence gathered during the course of this review clearly indicates that the industry association which represents this industry was not aware of the effect of the proposed ruling on this industry until it was issued publicly in draft form.

²¹ In a briefing paper prepared on 27 April 1999 following the 1998 survey, the Tax Office estimated that $150 million was being underpaid through a number of activities being conducted by accounting partners (including the alienation of income through service entities). It estimated a similar level of revenue was at risk from the activities of legal partners.

²² O’Donohue, P, The ATO perspective on Phillips, paper given to SA Annual Convention of the Taxation Institute of Australia, March 1994.

²³ The request was made in March 2002 and responded to by September 2002.

²⁴ This timeliness standard as well as that for draft rulings are referred in Australian National Audit Office, Administration of Taxation Rulings Follow up Audit, Audit Report No. 7 of 2004-05, dated 9 August 2004 at paragraph 2.34. They are also documented in the Tax Office’s Public Rulings Manual. These standards differ from those that were in place when the ANAO conducted its original 2001 review of the Tax Office’s administration of tax rulings. During that review, the Tax Office’s Rulings Manual set an ideal of six months from commencement of drafting to finalisation of a public ruling, including a period of three months between the draft and final ruling for public rulings which are relatively complex (see Australian National Audit Office, The Australian Taxation Office’s Administration of Taxation Rulings, Audit Report No. 3 of 2001-01, dated 17 July 2001 at para 3.23). The ANAO concluded that this review period was, however, unrealistic and that a more realistic target might be six months between the date of draft and final public ruling.

²⁵ See paragraph 5.31.

²⁶ The service standards for 2005/06 for a number of Tax Office activities, and the degree to which they have been met in the year to date are available on its website at www.ato.gov.au.

Previous: Chapter 4: Comments made and concerns raised by stakeholders on Tax Office’s approach to service entity arrangements

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