A.2.1 The Tax Office's response to the review consists of three letters, an attachment to one of these letters which contains responses to the recommendations of the review and a second attachment which contains detailed comments on certain paragraphs in the review.
A.2.2 The first of the Tax Office's letters contains its comments on Appendix 1. This letter is reproduced at the end of Appendix 1.
A.2.3 The Tax Office's responses to the recommendations of the review are set out in Chapter 2.
A.2.4 The other two letters and the attachment which contains the Tax Office's detailed comments on certain paragraphs of the review are set out below.
A.2.5 Detailed Tax Office comments on matters raised by the Inspector-General are:
A.2.6 The Commissioner argued that the whole of the fees were incurred for purposes that were not deductible. In particular, they were incurred to make the unit trust viable to achieve income splitting with family members. Alternatively, the Commissioner argued that the fee to the extent it represented a profit to the unit trust was not incurred for a deductible purpose. The amount not allowable was argued to fail the statutory requirement of having been necessarily incurred in gaining or producing assessable income.
A.2.7 A vital aspect of the decision by Justice Waddell was a finding of fact that the evidence led by the taxpayer established that the rates were realistic and not in excess of commercial rates.
A.2.8 In 1981, at a joint seminar, Deputy Commissioner Brian Nolan stated that the anti-avoidance rules in the newly enacted Part IVA would not apply to a service trust arrangement if the mark up was commercially realistic: Justinian (20) November 1981 pp 10-13.
A.2.9 Assessing manuals were instructions to staff. The manual did not specify the circumstances in which fees were or were not considered deductible. In circumstances identified in the manual, staff were instructed to refer returns to a specialist assessor.
A.2.10 In addition to referring to particular threshold rates, the manual also provided that arrangements should not be inconsistent with ordinary business dealings, for example the fees should not be demonstrably out of line with the commercial value of the services rendered. Arrangements that were inconsistent with such ordinary business dealings were also to be referred to a specialist assessor.
Paragraph 3.24 – dot point 2
A.2.11 The paper also noted there was in fact no rule of thumb and mark ups had to be determined on a case by case basis. Individual arrangements may be challenged if they were not commercially realistic or where there was inadequate or inappropriate documentation.
A.2.12 Michael Fox from Hall Chadwick Accountants also presented at this conference. Referring to Peter O'Donohue's prior presentation, he said:
The other observations he has passed on, together with the Tax Office views in published rulings can only emphasise the need to calculate the service entity charges properly. Quotes should be obtained from an 'alternate supplier' to help justify the actual charges.
A.2.13 Michael Fox also published an article on this theme entitled 'Fracturing a Fairy Tale' in the February 1995 TIA journal.
A.2.14 This external recognition of the ATO position should have been reflected in the report.
A.2.15 Taxation Determination TD 94/45 further explained that taxpayers who wish to know the current ATO position should refer to Tax Office documents such as Taxation Rulings and Determinations or seek a private binding ruling. A Ruling or Determination that is less favourable to taxpayers than the position adopted in an Assessing Handbook need not, in terms of the date of effect guidelines in TR 92/20, have only a future application.
A.2.16 These opinions also stated that service trust arrangements are only acceptable for income tax purposes provided that the activities of these trusts are considered commercially realistic and the mark-up on the cost of providing the services is reasonable.
A.2.17 At the same conference, Michael McLaren from William Buck accountants also presented a paper in which he reviewed the history and state of the service trust issue and concluded that: 'The key message is: Check the mark-ups in the market place.' This external recognition of the ATO position should have been reflected in the report.
A.2.18 The paper further explained that acceptance of service entity arrangements is on the basis that there is a commercial arrangement in place. Individual cases may be subject to scrutiny and will be challenged if they are not commercially realistic. What is commercially realistic will depend on the facts and circumstances of each case and it will be on the basis of evidence presented as to prevailing market rates that decisions will be made as to whether a particular charge is commercial or not. The reference to 'Phillips case guidelines' does not mean a blanket acceptance of the actual rates that were adopted by the taxpayer in that case, but refers to a more general concept that the arrangement be commercially realistic.
A.2.19 No comments or feedback were provided by NTLG members in response to this request for input.
A.2.20 Tax Office activity had also been widely communicated across the tax profession. The views expressed by the Tax Office, and Tax Office activity relating to service entity arrangements, were the subject of a number of presentations and articles by tax practitioners over many years. These comments reflected the Tax Office's messages that there were no standard mark-ups, and that commerciality was the important touchstone.
A.2.21 A paper was presented to the TIA's 2002 North Queensland conference by David Marks, Barrister, which urged delegates 'Do not simply rely on the mark-ups used in the Phillips case'. This theme was reprised in Mr Marks's paper in the April 2002 TIA journal entitled 'Service Arrangements: everything has its season'.
A.2.22 In October 2002 Ken Schurgott from Thomson-Playford Solicitors presented to the TIA's Sydney conference and stated: 'The question must always be asked whether the mark-up is commercially realistic. There is no standard mark-up.'
A.2.23 In March 2003 David Marks, Barrister also addressed the TIA's South Australian conference and advised them: 'Review the commerciality of the service costs from time to time. Do not simply rely on the mark-ups used in the Phillips case.' Mr Marks reprised this theme in his article in the TIA journal in August 2003.
A.2.24 Robert Richards advised the readers of the Law Society Journal in April 2003 that the charges need to be 'commercially realistic'.
A.2.25 Gil Levy, the President of the TIA cautioned his members to 'have a fresh look at their service trusts' in May 2003.
A.2.26 Tony Greco advised Taxpayers Australia members in August 2003 that 'The ATO requires that the charges be commercially realistic and up-to-date'.
A.2.27 Also in August 2003, the Weekly Tax Bulletin reminded subscribers that: 'Amounts above 'realistic commercial rates' for a comparable service from an unrelated party are likely to be denied deductibility'.
A.2.28 Law Institute members were advised in September 2003 by Dr Srechko Kontelj that: 'it does not follow that cost plus 50 per cent will be accepted by the commissioner in every instance. The commissioner will adopt a case-by-case basis to assess the commerciality of particular arrangements.'
A.2.29 In November 2003, the ICAA Tax Manager advised members in her column in the CA Charter magazine that they should 'Also bear in mind that the commerciality of an arrangement can change over time in accordance with market forces, and a periodic review might be appropriate.'
A.2.30 Law Society members were advised by Wayne Lonegan and Julie Planinic in the December 2003 Law Society Journal that 'commercial rates (that is, consistent with those charged by unrelated parties providing similar services)' were required to avoid ATO scrutiny.
A.2.31 CPA Australia's magazine 'In the Black' advised members in November 2004 that 'The Commissioner's approach to this issue inevitably involves benchmarking service entity profits against profits generated by organisations providing labour on an arms' length basis to the market generally.' It also set out four general health indicators for compliant service trusts.
A.2.32 This period of audit activity provided material for a subsequent review of the Tax Office's position on service arrangements. The methodology decided on was consistent with general budgeting and planning approaches to cost setting. It is a standard business analysis tool. Also, the approach taken did not adopt the full functional analysis and arm's length methodologies that apply for transfer pricing purposes. The methodologies had also been used by taxpayers in supporting the commerciality of their arrangements.
A.2.33 At the September 2002 meeting of the NTLG, the professional bodies suggested that Tax Office guidelines or opinions on service entity arrangements would benefit from being developed in consultation with the professional bodies. The Tax Office explained that it did not have an understanding at that time of how widespread features of the kind that were of concern were evident in contemporary service entity arrangements. The Tax Office welcomed the professional bodies' views about whether there has been a shift from the typical Phillips case service trust arrangement and, if so, what has driven such a shift. In seeking to identify service trust arrangements which vary from the arrangement reflected in the Phillips case, the Tax Office would likewise welcome the professional bodies' input to assist in developing appropriate strategies. The help of the professional bodies was sought to identify what particular features may be relevant, and to what extent arrangements were commercial. The Commissioner noted that a small number of cases have been identified to date. The Tax Office would form an opinion on particular cases and publish its views.
A.2.34 At the March 2003 meeting of the NTLG, the professional bodies requested the Tax Office to clearly outline what arrangements are acceptable to provide a safe harbour for taxpayers who follow them. The questionnaires were developed over several months and suggestions were invited from key NTLG members. A number of professional bodies further requested that they publish the draft questionnaires for comment by members before being finalised and sent. The information gathered through this survey was essential in meeting this request.
A.2.35 No decision was made in December 2002 to issue additional guidance. The idea of publishing further material was at this stage only being canvassed in a paper prepared by Tax Office staff for consideration in the development of an appropriate Tax Office response to developments with service entity arrangements.
Paragraph 3.50 – dot point 1
A.2.36 The Tax Office does not consider that there is any evidence in support of this assertion.
A.2.37 The draft figures were based on preliminary statistical extrapolation from samples. Extrapolation techniques were later refined to take into account statistical bias in the original samples.
A.2.38 Public rulings provide the ATO view on an interpretative issue and provide a date of effect for the ruling and statement regarding the nature of the protection that it provides. A public ruling is an expression of the Commissioner's opinion about the way in which a relevant provision applies, or would apply, to entities generally or to a class of entities in relation to a particular scheme or a class of schemes.
A.2.39 If a taxpayer relies on a ruling, the Tax Office must apply the law to that taxpayer in the way set out in the ruling (or in a way that is more favourable for the taxpayer if the Tax Office is satisfied that the ruling is incorrect and disadvantages the taxpayer, and the Tax Office is not prevented from doing so by a time limit imposed by the law). A taxpayer will be protected from having to pay any under-paid tax, penalty or interest in respect of the matters covered by this ruling if it turns out that it does not correctly state how the relevant provision applies to the taxpayer. The service entity arrangement is not exceptional in this regard. It states that the ruling applies to years of income commencing both before and after its date of issue, and that it does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the final Ruling. Material dealing with other aspects of our administration, including audits, are dealt with in the accompanying guide.
A.2.40 Rulings do not deal generally with matters relating to audit and other administrative, compliance or educational activities because they are not issues of interpretation.
A.2.41 The draft guide did not make the use of any particular approach mandatory. Discussion of these approaches was to provide taxpayers practical information on how they can review their arrangements. The approaches are consistent with common business practices used when budgeting and pricing decisions are made.
A.2.42 The conclusion is incorrect and contrary to the considerable evidence available which demonstrates that both the Tax Office and tax practitioner assessments of what the Tax Office required was current and commercially benchmarked mark-up rates.
A.2.43 The guide explains that if the indicative rates are used, and no greater than 30 per cent of the combined profits of the professional firm and service entity (or service entities) is earned by the service entity (or service entities), there is little risk of an audit being commenced because of the amount of the deduction claimed. There may be other reasons for a case to be selected for review or audit.
A.2.44 If a deduction claimed for service fees is adjusted following an audit, we will allow a deduction based on what we consider the appropriate commercial benchmark rate in the circumstances to be.
A.2.45 This chapter sets out submissions that have been made to the Inspector-General by parties other than the Tax Office. We do not propose to comment on these submissions. However, it should be noted that the Tax Office does not agree with many of the assertions made in these submissions, and this is reflected in our comments in other parts of the report.
A.2.46 Service entity arrangements did not have project status in 1996. In 1996, the Legal and Accounting Project started with preliminary sampling of 1996 income tax returns. The objectives of the project included:
- gaining greater understanding, knowledge, information and intelligence about the larger accounting and legal firms and their partners,
- identifying any tax avoidance arrangements,
- identifying firms which may be high risk.
A.2.47 There was no mention of service entity arrangements in 1996, and they had not been identified as a distinct compliance issue by then.
A.2.48 Officers in the Large Business Line canvassed the possibility of a public ruling or practice statement in December 2002 when reporting the results of the Phillips Scan and in a treatment strategy that was drafted in March 2003. No decision was made on a ruling at this time as audit and TCN resources were still focused on completing the two lead audits. Instead, Large Business was asked to proceed with another recommendation in the treatment strategy to undertake a wider industry survey to better define the risk. Questionnaires were issued to 56 firms in June 2003. The questionnaires were developed over several months and suggestions were invited from key NTLG members. Results from this survey were not available until December 2003.
A.2.49 The Tax Office stated at the September 2002 NTLG meeting that it had not planned to issue a ruling, but that it was interested to know whether the NTLG believed a ruling was necessary and, if so, what areas the Tax Office should address. Given the limited understanding of how widespread the undesirable features of service arrangements were, the Commissioner welcomed the professional bodies' input to assist the Tax Office in developing appropriate strategies to deal with its concerns. By the NTLG meeting in March 2003 no input had been received from NTLG members as to the merits or otherwise of a ruling, nor what areas should be addressed
A.2.50 The NTLG Minutes of the March 2003 meeting explain that after completion of audits and enquiries across a range of the Phillips type vehicles used by professional firms, the Tax Office said it anticipated issuing a discussion paper and/or a public ruling setting out the Tax Office view on the way forward. The internal Tax Office material does not provide any evidence of a decision having been made at that time.
A.2.51 Tax Office records show that a decision was made in late 2003 to issue a public ruling. Public notification of that decision was given in the Tax Office's public rulings program in January 2004.
A.2.52 The 1998 survey was sent to 10 firms in the Large Business market. It was broad ranging in nature and the analysis was necessarily at a high level. The focus of the survey was to understand the reasons for the tax performance of the firms involved. It was not a survey specifically about service entity arrangements or to provide any detailed analysis of these arrangements. Examination of the financial results for the firms indicated that profit levels were lower than expected and that income splitting via Everett assignments and Phillips arrangements could be a potential cause for concern. There was a potential risk around the pricing in service entity arrangements. The survey did not provide any basis on which to conclude that either the use of service entity arrangements was a significant issue, or that there was an issue about the commerciality of service entity fees. At this stage, concern regarding the commerciality of pricing in these arrangements was purely speculative.
A.2.53 The survey helped the Tax Office target issues (for example, work in progress, Everett assignments, Phillips arrangements) and high risk taxpayers. However, it could not have provided the Tax Office with enough detailed information needed to determine whether arrangements were subject to reasonable challenge and that IT 276 needed to be revisited. Further inquiries were required to ascertain this. There was no reasonable basis upon which to review IT 276 at this stage or on which to provide general advice on the commerciality or otherwise of contemporary arrangements. Any questions regarding the commerciality of arrangements were not able to be answered until the results of the leading audits and the June 2003 questionnaires were available.
A.2.54 The Tax Office was relying on a number of audits to test its ability to challenge unacceptable service entity arrangements. The work carried out and the results achieved gave confidence that service entity arrangements could be legitimately challenged. At this stage, a broad public education campaign became appropriate. Until then, there was no basis on which the Tax Office could make a justifiable decision that any public guidance beyond that already provided in IT 276 could be given on how service fees should be calculated.
A.2.55 The Tax Office has limited resources and constantly makes business decisions on the most efficient and effective application of its resources. We must balance our resources across the entirety of the tax system. Appropriate administration depends on factors that include the nature and extent of observed and potential risk, tax law issues involved, and strategies for their effective treatment and resolution.
A.2.56 The Tax Office must make choices on a daily basis on which issues to pursue and in which way to pursue them. These decisions are made having regard to information available at the time. Reasonable judgments can differ on these decisions, especially with the benefit of hindsight. Decisions on the Tax Office's program are also made having regard to matters including the Commissioner's statutory obligations and sound risk management practices.
A.2.57 Concerns with service entity arrangements emerged only out of work focussing more broadly on compliance risks in the legal and accounting professions. There was no evidence, and no reasonable basis on which to believe, that significant compliance risks existed in other professions. The appropriateness of investing additional time and resources on extending the scope of the review is open to question.
A.2.58 Having decided to test compliance issues with service entity arrangements in the legal and accounting professions, undertaking additional analysis in other professions at this stage was not a sensible use of Tax Office time or resources. This risk in the identified professions already established the need to undertake targeted audit activity to establish whether or not deductions claimed in contemporary related party arrangements were in compliance with law. Moreover, the underlying compliance risk under review was the tax performance of the legal and accounting professions, rather than tax compliance of service entity arrangements as such.
A.2.59 The merits of judgments made, and the correctness of administrative decisions and agency business choices that the Tax Office makes, are matters within the statutory responsibility and competence of the Commissioner. The Tax Office will work with the Inspector-General on any improvements that can be made on our risk identification and assessment processes leading up to these decisions in light of any systemic tax administration issues that relate to the concerns identified.
A.2.60 The use or prevalence of these arrangements in other industries does not indicate the extent to which these arrangements may involve a potential compliance risk if at all. Such an association would be speculative and inappropriate. The legal and accounting profession were selected because of concerns regarding industry tax performance, and not because of the use of service entity arrangements as such. Industry tax performance in other professions was not under review. The Inspector-General's approach presupposes that service entity arrangements were the identified compliance risk at the time. There was no reasonable basis at the time to expand compliance focus on arrangements outside of the legal and accounting professions. Addressing technical and compliance issues with service entity arrangements, including the commerciality of fees, was part of the treatment strategy for risk in the legal and accounting profession, rather than the underlying risk itself.
A.2.61 By April 1999, the Tax Office had no reliable information on which a finding could be made about the extent or prevalence of arrangements that were considered to involve unacceptable features or to represent significant compliance risks in the legal and accounting professions, or more generally. The 1998 survey provided some support that a potential compliance risk may exist. However, the analysis was high level and focussed on economic results. It did not identify any information in support of whether contemporary service entity arrangements were reasonably exposed to legal challenge or the basis of such a challenge. There was no reasonable or defensible basis on which to responsibly assert or act on a premise that there was widespread or significant degree of non-compliance with the law in claiming deductions for fees incurred in related-party service entity arrangements.
A.2.62 The Tax Office has responded in a measured way to the nature of concerns being raised about service entity arrangements. On relevant occasions, especially in presentations and articles widely circulated in the tax profession, Tax Office staff explained that arrangements had to be commercially realistic and that there were no acceptable generic levels for mark ups. This was consistent with the Tax Office's existing position set out in IT 276, which material from the accounting and legal profession shows was well understood.
A.2.63 Based on early intelligence, several arrangements were selected for audit. Findings made in the course of audit activity contributed significantly to our understanding of the nature of contemporary arrangements and their associated compliance risks. The conduct and results of these audits, together with additional intelligence work undertaken, allowed the Tax Office to supplement its existing views in a manner relevant to contemporary arrangements. The work also allowed the Tax Office to form a view on the basis in law on which these arrangements were open to question.
A.2.64 Without an understanding of this kind and at this level of detail, the Tax Office was not in a position to provide any additional detailed public guidance beyond the advice already provided in IT 276. Moreover, the Tax Office would have been open to criticism for overplaying its hand in questioning contemporary arrangements without having either understanding of the circumstances of these arrangements or satisfying itself of the legal grounds for doing so.
A.2.65 As noted in earlier comments, the decision to issue additional guidance had not been made in December 2002.
Paragraph 5.17 — dot point 1
A.2.66 This paper did not provide detailed guidelines of the kind or extent now contained in the booklet. It did not provide guidelines on actual mark-ups, or acceptable levels of fees more generally. The paper referred to the underlying requirement that fees be commercially realistic, and identified a number of issues and practical points to consider.
Paragraph 5.17 — dot point 2
A.2.67 Taxation Ruling TR 1999/1 addresses the operation of the international transfer pricing rules contained Division 13 of Part III of the Income Tax Assessment Act 1936, and the Associated Enterprises Articles in Australia's various double taxation agreements. Where the transfer pricing rules apply, consideration paid or received is taken to be an arm's length amount. The ruling deals with various approaches to the calculation of arm's length amounts for these purposes.
A.2.68 The deductibility of fees under domestic service entity arrangements is not covered by transfer pricing rules. Before the Tax Office was in a position to refer to methodologies also used for transfer pricing purposes, contemporary arrangements needed to first be shown to involve fees and charges that were grossly excessive, disproportionate to the services provided or that the arrangements were not commercially realistic. Until this is first established, a deduction under a service entity arrangement is not subject to adjustment. This matter is not dealt with in TR 1999/1. Moreover, the amount to which a deduction will be adjusted requires a determination of the purpose or purposes for which the expense was incurred and the extent to which it was incurred for deductible purposes. This does not require a determination of the arm's length amount. Fees paid under comparable commercial arrangements are relevant but not determinative of this issue.
A.2.69 A decision to rely on commonly used business analysis methods like comparable prices and comparable profits for working out acceptable service entity arrangements, as well as the subsequent question of the level of acceptable fees, were not able to be made without considerable further legal and practical analysis of contemporary arrangements and extensive consultation.
A.2.70 It was only in the course of these audits that the precise nature of the issue, and the necessary supporting economic data emerged. This had not been established by 1999. The mere existence of the material identified does not indicate its applicability or suitability for the purposes currently in issue, or the degree of modification that may be required for its use on service entity arrangement issues.
A.2.71 The characterisation of contemporary arrangements as labour-hire arrangements followed from detailed active compliance work. Moreover, this characterisation departed from the types of arrangements dealt with in TR 1999/1. Further survey work identified that contemporary service entities arrangements also covered other services including equipment hire, expenses payments, rent, and debt collection. Without developing this understanding first, any public guidance would have been premature and at risk of being irrelevant to arrangements actually in place.
A.2.72 The Tax Office issued public guidance material of general application in IT 276 which was publicly released in 1983. The nature of that advice was not specific to the circumstances of any particular arrangement. The extent to which generic advice could be given on such questions of fact, and the nature and detail of such advice, required a detailed understanding of contemporary arrangements. More detailed guidance, covering matters including the actual level of acceptable fees and charges, requires consideration of the circumstances of contemporary arrangements and the formation of a view on questions of fact. It has been customary practice in tax administration to give administratively or legally binding advice on questions of fact only in respect of particular arrangements. General public advice has been limited to the principles on which such questions are decided. In recognition of the community's need for this kind of detailed advice for service entity arrangements, because of the unusual nature of the legal and compliance issues involved, the Tax Office decided on the innovative approach of providing guidance which included advice on comparable market rates for certain set arrangement types and internal indicative rates used for audit selection purposes.
A.2.73 The ability of the Tax Office to challenge service entity arrangements in terms of their commerciality was tested and validated in the course of audit work. The release of additional public guidance was unwarranted until we were in a position to be satisfied that such challenges were reasonable, administrable, and could withstand legal dispute.
A.2.74 In the absence of the work undertaken in the course of these audits, any public statements going further than IT 276 would have attracted serious criticism by tax professionals as unwarranted and unsupportable which we would have had difficulty in responding to.
A.2.75 It is also our experience that service entity arrangements are extremely varied, including in terms of their structure, conduct and the scope and type of services and benefits provided. The further guidance provided by the Tax Office in the ruling and booklet is modelled on conventional service entity arrangements, with some additional discussion of an alternative type of medical practice arrangement in response to requests made during consultation. Detailed public guidance has been correlated with the features and services prevalent in contemporary arrangements. This focus and understanding came in part from the detailed work carried out in the course of leading audits and detailed surveys. Our understanding will continue to be revised as commercial considerations evolve.
A.2.76 We also note the Inspector-General's concern at paragraph 5.120 of this report that consultation with individual industries should have occurred earlier in the drafting process and that any public advice was a work in progress until specific industry circumstances were taken into account.
A.2.77 The decision to issue further public guidance was made in late 2003: see earlier comments.
A.2.78 It does not follow that undertaking further risk assessment would have prompted a decision at that time to issue further public guidance on the issue. The risk assessment that had been undertaken had already identified the potential compliance risk and a treatment strategy was already being worked on. The decision to issue further public guidance followed from further work undertaken in the course of audit activity and required the formation of administrative and technical views. This work had been decided on as the next necessary step and this decision was made without the need for further risk assessment. Also, the original compliance risk which was under review was the tax performance of the legal and accounting professions, and was not service entity arrangements as such.
A.2.79 The Inspector-General seems to refer to comments made by individual officers which were not concluded views of the Large Business Line. The sharing of views, and developing proposals, is an ordinary and essential element in the development of the Tax Office's position on compliance issues. The Tax Office does not accept that there was any dissent that delayed the issue of public guidance. No decision had been made to issue further public guidance by this time, let alone whether such further guidance was appropriate and the content of any such guidance. It is inappropriate to regard such discussions as a cause of delay in issuing further public guidance. During this period, the appropriate treatment strategy for the potential compliance risks associated with service entity arrangements were being developed. This is not in the nature of dissent. The issue was subsequently discussed between senior officers in 2001, and instructions were given to Large Business to proceed with individual audits on the most serious cases.
A.2.80 The Tax Office does not accept that there was a delay in the process for the reason identified. The decision to issue further public guidance was made in late 2003. Before that time, project resources were applied on the individual audits being undertaken. The decision to issue further public guidance followed from the work undertaken in the course of these audits. Consideration followed on the most appropriate form for such guidance. The matter was immediately escalated to the Public Rulings Panel for consideration.
A.2.81 The Public Rulings Panel, which comprises both Tax Office and external members, first considered an early version of the draft ruling in December 2003. Further versions of the draft ruling were considered by the Panel in February and March 2004 taking into account comments and feedback by Panel members. As drafting of the ruling commenced in November 2003, and as it was first considered by the Panel in December 2003, Panel consideration of the draft ruling in February and March 2004 is not considered to represent any period of unreasonable delay. After that time, further review and development of the draft ruling and booklet was driven through the NTLG consultation process. The Panel process was not a cause of delay during this further time.
A.2.82 Work on the draft booklet commenced in the Large Business Line. It was transferred to the Small Business Line when general responsibility for the issue was transferred to Small Business. Suitable material for wider NTLG consultation was not available until an acceptable version of the draft ruling was prepared with advice from the Public Rulings Panel. An iterative process is likely to be more efficient and effective in garnering feedback from the various review processes adopted for this product.
A.2.83 The decision to issue additional guidance in the form of a booklet followed from feedback received during the NTLG consultation process. As the booklet was prepared in response to this feedback, work on the booklet could not have commenced at the start of the NTLG consultation process. At the commencement of the process, the Tax Office had only intended to publish further public guidance to the extent contained in the draft ruling. Some of the material had been originally prepared in early versions of the draft ruling. However, it was removed on advice from the Public Rulings Panel.
A.2.84 The inference drawn here does not follow from the statement extracted above. The view quoted reflects concerns about the impact that safe-harbours could have on compliance behaviour rather than a view that service arrangements are unacceptable per se. These concerns are consistent with those raised in the external submissions outlined at paragraph 7.27 of this report. The extract also refers to the compliance issue being the characterisation of the commercial benefits in those arrangements that are unacceptable, not to the arrangements being unacceptable per se. The characterisation of the commercial benefits, their relationship with the fee charged and the deductible/non-deductible purposes remain the key considerations.
A.2.85 The Tax Office considers this assertion to be unfounded. Disagreement between Tax Office staff and NTLG members was on the issue of appropriate pricing, and not on the legitimacy of service entity arrangements as such.
A.2.86 On this point, the letter actually stated:
'the draft ruling fails to recognise the importance of service entity arrangements as a legitimate commercial structure in this highly litigious environment.'
A.2.87 Responsibility was transferred to the Small Business Line because the bulk of affected taxpayers were in the Small Business market. It was not transferred because of the alleged concerns about the management of the project.
Paragraph 5.60 – Key finding 5.4
A.2.88 This finding is not accepted in light of the material set out in earlier Tax Office comments.
Paragraph 5.60 – Key finding 5.5
A.2.89 The Tax Office accepts that it is possible for decisions to involve other consultative groups like the NTLG, in addition to the Public Rulings Panel, can be made in a more timely manner. Such additional consultation is unusual, and its use for the service entity arrangements ruling reflects the unusual nature of the issues involved and the compliance treatment strategy relied on. The need for additional practical guidance in the form of the booklet emerged after NTLG consultation commenced on the draft ruling: see further Tax Office comment at paragraph 5.50. This additional practical guidance dealt with questions of ordinary business judgment rather than questions of tax law and its application.
A.2.90 The provision of public guidance is well understood to be a core task for the Tax Office, one to which the Tax Office, including Large Business, devote a considerable amount of resources.
A.2.91 However, at the time available resources were focussed on the conduct of audits to validate the nature and extent of the risk. Our experience from these audits informed the development of the ruling. When consultation processes indicated the demand for more detailed practical guidance, this was not opposed by Large Business or any other part of the Tax Office. We do not consider that Large Business acted in a way that displays any serious misunderstanding about the Tax Office's obligations.
Paragraph 5.66 – Key finding 5.6
A.2.92 Senior Tax Office personnel had regard to the adequacy of the Tax Office's existing guidance on service entity arrangements. This guidance was principally contained in IT 276. A decision was made in late 2003 to supplement this ruling which resulted in the publication of TR 2006/2. In light of concerns raised over the adequacy of the material, and the need for additional practical guidance, the Tax Office decided to also produce the booklet. The Tax Office was responsive to feedback which identified the need for this additional advice. The booklet was an innovative approach to providing practical guidance dealing with matters well beyond interpretative advice.
A.2.93 The Tax Office agreed to allow additional time for comments to be received on aspects of the ruling and booklet. The release of the final ruling was also delayed at the request of professional bodies which preferred that the ruling and booklet be published together. The ruling itself was ready for publication in December 2005.
A.2.94 The Tax Office does not accept that the period has been correctly identified: see previous comment at paragraph 3.47.
A.2.95 The Tax Office does not accept that the period has been correctly identified: see previous comment at paragraph 5.36.
A.2.96 The Tax Office does not accept that the period was caused by or reflects additional time spent by the Public Rulings Panel on reviewing the ruling: see previous comment after paragraph 5.46.
A.2.97 The Tax Office has already revised its consultation processes and has announced that future consultation will generally not involve confidential processes. There may be instances where confidential consultation will still be necessary or where preliminary consultation with select groups may be required before the Tax Office is in a confident position to publish material suitable for broader public consultation.
A.2.98 For the reasons explained in earlier comments, the Tax Office does not consider that there has been a five year delay. The Tax Office does not consider that the content of the ruling and booklet could have been developed based on a sound and effective approach within two years of April 1999, in part because the Tax Office does not agree that the compliance risk could be clearly identified at that time. However, the Tax Office agree that the timeliness of publishing the ruling and booklet could have been improved on, and that a two year period from December 2003 would have been reasonable.
A.2.99 The Tax Office does not accept that the circumstances existed in April 1999 to warrant the development of the ruling or booklet at that time. IT 276 was in place throughout the period under review. The Tax Office's strategy, arrived at early in 2002, was first of all to take with audit action and thereafter to conduct a review of the ruling and, if warranted, to undertake a public education campaign, of which the public guidance and especially the booklet is a major part.
A.2.100 For the two years in question, comparable percentages for taxation determinations, which are a shorter form of public ruling, were 80 per cent and 40 per cent respectively. The percentages mentioned above represent the aggregate result for the 2005 and 2006 income years rather than for each year.
A.2.101 The Tax Office has had established processes in place for at least the past seven years to continually review (usually monthly) the timeliness of rulings.
A.2.102 The preparation of a public ruling may be decided on as a suitable product for the purposes of responding to a compliance issue. However, not all issues are addressed by the preparation of a public ruling. The period prior to a decision to prepare a public ruling is relevant in the context of the holistic resolution of a compliance issue. Once the matter is classified as a priority technical issue (PTI), time spent is monitored as part of PTI reporting processes. However, it is not appropriate to include that time as part of the measurement of the public ruling process itself. It would not provide relevant management information for the purpose of monitoring performance of that particular process which commences with the decision to prepare a public ruling and including the topic on the public rulings program.
A.2.103 Tax Office standards on public rulings are explained in detail on our website at www.ato.gov.au as well as being published each month as part of the introduction to the ATO's Public Rulings Program which is also published on the website. While relevant to the timeliness of resolution of compliance issues, the time before a decision to issue a public ruling is made is not relevant to the measurement of timeliness of the public ruling process itself.
A.2.104 In many cases, the retrospective application of Tax Office advice provides taxpayers with administrative or legal protection. For example, in relation to service entity arrangements, retrospective application of the guidance will provide taxpayers with certain protections where they fall within the terms of the guidance, even though the arrangement might otherwise be subject to audit adjustment on the basis of IT 276.
A.2.105 In any event, we do not consider that the ruling and booklet are a departure from the views expressed in IT 276; they are merely expanding on the guidance already available.
A.2.106 In the view of the Tax Office there were some unique features about the service entities issue which meant that it cannot be regarded as a good example of how the PTI/public ruling process usually works. The requirements in reaching a robust compliance outcome on service entity arrangements are considered to be unique in nature and do not provide any indication of systemic problems with prioritisation of public rulings. The treatment of service entity arrangements is an exception to the ordinary conduct of the public rulings program. This is because of the nature of the particular issue involving questions of identifying and quantifying commercially realistic fees.
A.2.107 The resolution of the technical issues, and the preparation of the supplemental ruling on service entity arrangements was not the cause of any delay. These matters were resolved in a reasonable timeframe. Moreover, the Tax Office had already published IT 276 which dealt with the tax law issues. The acute issue in relation to service entity arrangements was stakeholder expectations that the Tax Office provide additional detailed practical guidance on commercial questions.
A.2.108 As noted earlier, the Tax Office's interpretation of the law, and expectations regarding compliance, were widely known and well understood in the tax community. This is evidenced by the number of articles written by tax practitioners in widely distributed professional journals and presentations given at major tax industry conferences. The matter was also raised at the NTLG. The people represented by members of the NTLG, and the professional associations who published and conducted conferences which dealt with the Tax Office's position on service entity arrangements, account for over 95 per cent of all businesses across every industry in Australia. We observe that taxpayers do take the advice of their tax practitioners in matters like service entity arrangements. It is considered an appropriate strategy to raise systemic tax issues through consultative forums of representative tax professionals.
A.2.109 The approach on the acceptability of particular rates has been to identify the most common types of services provided in conventional service entity arrangements and to provide comparable and indicative rates for each of these types of services. These rates are attributable to the type of service provided rather than the particular industry of a taxpayer's main business.
A.2.110 The booklet explains that higher rates can be acceptable, and the commerciality of an arrangement can be demonstrated on any reasonable basis. Arrangements other than conventional service entity arrangements were outside of the scope of the identified compliance risk and were outside of the scope of the draft booklet.
A.2.111 Conventional service entity arrangements in the medical and other professions were already covered by the booklet. Representatives of the medical profession sought additional advice on service entity arrangements which were comparable to a different commercial service model used in the medical profession and which were outside of the scope of the booklet.
A.2.112 It is reasonable to expect that there are a multitude of arrangements across the community that are not in the nature of conventional service entity arrangements. To provide detailed guidance, as the booklet has done for conventional service entity arrangements, on all these possible arrangements in a single product or project is demonstrably impractical and unmanageable, especially in the absence of an identified compliance risk relating to these other arrangements and industries.
A.2.113 Nevertheless, the Tax Office was responsive to stakeholder concerns that emerged in the course of consultation and undertook further work to provide advice on medical practice arrangements. This advice confirms that medical practice arrangements comparable to arm's length commercial arrangements in the medical profession are at a low risk of audit. This follows from the general approach in the booklet on reviewing the commerciality of arrangements.
A.2.114 Given that commercial arrangements change over time, it misunderstands the nature of the issue to expect that there is a 'final' position in relation to commercial rates. An assessment of the commerciality of an arrangement will require consideration of contemporary comparable arm's lengths dealings. This changes over time. The same is true of industry specific commercial arrangements. The Tax Office has provided detailed practical guidance for conventional service arrangements, applicable to all taxpayers and industries, as it is based on the service being provided. The commerciality of other arrangements can be established with evidence of contemporary comparable arm's lengths dealings. Other professions did not approach the Tax Office during the public consultation period with requests for other industry models to be dealt with in the booklet.
A.2.115 The Tax Office has during the time of this review announced changes to its consultation processes that attend to these concerns.
A.2.116 The Tax Office notes that commercially sensitive information about particular acceptable rates was only made available late in the confidential consultation period shortly before the public release of the draft booklet. The shortness of this time, together with the draft nature of the booklet being released, and the 12 months review period provided, makes it unlikely for any substantial advantage to have arisen.
A.2.117 The Tax Office has already revised its consultation processes and has announced that future consultation will generally not involve confidential processes. There may be instances where confidential consultation will still be necessary or where preliminary consultation with select groups may be required before the Tax Office is in a confident position to publish material suitable for broader public consultation.
A.2.118 The Tax Office accepts the consultation with tax specialists could have occurred at the same time as public consultation and this could have shortened the overall period of review.
A.2.119 The Deputy Commissioner Small Business signed off on the second version of the draft ruling.
A.2.120 The decision to prepare the booklet was not caused by a change in key decision makers on the issue. It was prompted by feedback received during consultation on the proposed draft ruling. Drafting of the booklet was commenced by staff in Large Business with Tax Counsel Network assistance.
A.2.121 The level of key decision makers and degree of direct involvement of senior staff depends on the degree and nature of the risk, technical issues and treatment strategy involved. Senior officer involvement on the issue was commensurate with these factors.
A.2.122 In the course of discussions, a number of contentions were put to the Tax Office, which were accepted at face value for the purpose of discussion, and to develop the form and nature of the Tax Office's treatment of the issue. Further information gathering was carried out which raised concerns about the acceptability of the original contention. The Tax Office has apologised for the misunderstanding caused.
A.2.123 A high level meeting with one of the professional bodies involved in the NTLG consultation process took place on 21 September 2005, following the September 2005 NTLG meeting. At this 21 September meeting safe harbour rates were discussed, including discussion of a percentage of practitioner billings method for the medical profession. Details on this were contained in a subsequent letter from the professional body dated 5 October 2005. Our initial enquiries with representatives of the medical profession in October 2005 were designed to corroborate this data, in addition to addressing issues raised in their submissions on the drafts and subsequent documentation.
Paragraph 6.2 – dot point 1
A.2.124 Ruling IT 276 relevantly states the Tax Office position to be:
4. Given the view of the facts which the court adopted, that is, a re-arrangement of business affairs for commercial reasons and realistic charges not in excess of commercial rates, the decision to allow a deduction must be accepted as reasonable. Accordingly, the decision is not seen as requiring any alteration to existing policy concerning payments of this nature.
5. The case demonstrates the practical difficulties, of reducing or disallowing claims for deductions where the payments are marginally above commercial rates. Fisher J. in his judgment commented that, if a payment allegedly for services was grossly excessive, the presumption would arise that it was made for some other purpose. He also referred to the necessity to be able to identify and quantify the consideration applicable to any advantage unconnected with business activity. The decision indicates the need for a close examination of all relevant facts before deductions are allowed in cases of this kind.
A.2.125 Meeting this commerciality requirement does not of itself make the expenses deductible. All other requirements for deductibility will also have to be meet in addition to the specific issue about the fees being realistic and not in excess of commercial rates. For example, the services must be relevant and incidental to the conduct of the business, they must be on revenue account, and must not be capital, private or domestic in nature. Other provisions of the law may also be pertinent in particular cases, for example, the application of prepayment rules.
Paragraph 6.2 – dot point 2
A.2.126 The position was that arrangements in excess of those particular mark up rates would be open to scrutiny. However, they would also be open to scrutiny if the arrangements were not commercially realistic.
A.2.127 The administrative question of how the law will be applied involves the circumstances in which a deduction is likely to be questioned by the Tax Office, rather than how the deductible amount of service fees will be calculated.
A.2.128 This is not correct. The Tax Office always has accepted, and continues to accept the principles set out in Phillips and IT 276. The second statement can be correct in individual cases, as it is a question of fact. It was never accepted as a statement applicable in all cases. It is our experience that contemporary arrangements tend to involve materially different circumstances. It has always been possible for taxpayers to make claims in excess of the guidelines, depending on their particular circumstances.
A.2.129 It should also be noted that these documents released as drafts for comment and were not final views of the Tax Office.
A.2.130 The following material shows that the Tax Office did not hold the view ascribed to it above:
A.2.131 Draft Taxation Ruling TR 2005/D5 stated:
7. Whilst the Commissioner accepts the correctness of the decision in Phillips, the case is not authority for the proposition that service fees calculated using the particular mark-ups adopted in that case will always be deductible under section 8-1 of the ITAA 1997.
8. If the benefits passing to the taxpayer under a Phillips service arrangement are connected to the conduct of the taxpayer's income earning activities or business and, having regard to the benefits delivered, the service fees and charges are commercially realistic then the presumption will be that the service fees and charges are a real and genuine cost of earning the taxpayer's income and the cost of that alone (Phillips at ATR 791; at ATC 4368).
9. Where, however, the benefits passing to the taxpayer under a service arrangement do not reveal an obvious connection with the conduct of the taxpayer's income earning activities or business and/or where the service fees and charges do not constitute a commercially realistic charge for the benefits delivered, then the service arrangement alone may not suffice, without more, to characterise the expenditure. In these circumstances there is no objective commercial connection between the outgoing and the taxpayer's income earning activities or business. Consequently it may be necessary to undertake a broader examination of all of the circumstances surrounding the expenditure to determine what the expenditure was for ('a broader examination'). Depending on the circumstances of the particular case, this may include an examination of the taxpayer's subjective purpose, motive or intention in incurring the expenditure.
A.2.132 Statements on the Tax Office's view of the law are contained in the ruling (and a preliminary view for consultative purposes was in the draft ruling). The draft booklet and final booklet deal with practical administration and are not the source for a view on the law.
A.2.133 The draft booklet in fact stated:
The fact that the fees charged exceed commercially realistic rates is not of itself conclusive that all or part of the fees are not deductible. However, the greater the divergence is, the greater the likelihood becomes of a conclusion that other benefits are being sought, for example, the diversion of income. In this case, all or part of the fees will be non-deductible.
A good rule of thumb for determining whether the service fees and charges are commercially realistic is to ask yourself whether an independent person in your circumstances would engage the service entity to provide the same or similar property or services on the same (or substantially similar) terms to those you have entered into with the service entity. The law does not require exact equivalence provided the charges are commercially reasonable.
A.2.134 The booklet explained that service fees charged at the rates mentioned would be accepted as being commercially realistic. As explained in the previous Tax Office comment, higher fees can also be deductible.
A.2.135 The draft booklet dealt with rates for service fees below which they would be accepted as commercially realistic. This did not mean that only fees which matched an arm's length price would be accepted as being deductible. What it meant was that there might not be an objective connection between the expenditure and the income earning activity, and a broader inquiry into the purpose of the expenditure may be required. The material extracted above shows this position. Higher service fees could be deductible, but could be open to question. This is consistent with Phillips and IT 276.
A.2.136 Also, the methodology used applies standard business analysis methods that are used for ordinary business budgeting and pricing purposes.
A.2.137 The position adopted in active compliance activity and decisions made during this time are also consistent with the decision in Phillips, IT 276, and the final ruling and booklet. Differences between the draft and final ruling are limited to style, choice expression, and would not have led to different results. Some more detailed guidance was included on interpretative matters about the circumstances in which service fees would be open to question. These differences are not points of distinction which would have led to different decisions and results in these cases.
A.2.138 Taxation Ruling TR 2006/2 relevantly states:
6. While the Commissioner accepts the correctness of the decision in Phillips, the case is not authority for the proposition that expenditure made under a service arrangement and calculated using the particular mark-ups adopted in that case will always be deductible under section 8-1 of the ITAA 1997.
7. The question of whether expenditure made under a service arrangement is deductible depends on what the expenditure was calculated to achieve from a practical and business point of view. This is a question of fact.
Where the service arrangement provides an objective commercial explanation for the expenditure
8. Ordinarily, expenditure incurred in obtaining the supply of goods or services from another party under a contract will be characterised by reference to the contractual benefits passing to the taxpayer under the contract and the relationship that those benefits have to the taxpayer's income earning activities or business.
9. This means that where the benefits conferred by a service arrangement provide an objective commercial explanation for the whole of the expenditure made under the service arrangement, then the service arrangement alone will suffice to characterise the expenditure as expenditure that satisfies the positive limbs of section 8-1 of the ITAA 1997. (See paragraph 12 for situations where there may not be an objective commercial explanation for the whole of the expenditure.)
Where the service arrangement does not provide an objective commercial explanation for the expenditure
10.Where, however, the benefits passing to the taxpayer under a service arrangement do not provide an objective commercial explanation for the whole of the expenditure then the service arrangement alone will not suffice, without more, to characterise the expenditure. In that case a broader examination of all of the circumstances surrounding the expenditure will be required to determine what the expenditure was for ('a broader examination'). Depending on the circumstances of the particular case, this may include an examination of the relationship between the taxpayer and the service entity, the manner in which the taxpayer and the service entity have dealt with each other and the taxpayer's subjective purpose, motive or intention in incurring the expenditure.
11. A service arrangement may not suffice to provide an objective commercial explanation for the whole of the expenditure if:
(a) the service fees and charges are disproportionate or grossly excessive  in relation to the benefits conferred by the service arrangement;
(b) the service fees and charges guarantee the service entity a certain profit outcome without reasonable commercial explanation; or
(c) the service fees and charges generate profits in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions. For example, this might occur where there is no clear separation between the service entity's business activities and those of the taxpayer. 
 It should be noted that whether a payment is grossly excessive will depend on the circumstances of the service arrangement. The nature of the connection between the parties is of particular relevance in this context.
 This should not be taken to be an exhaustive list, nor are the situations described necessarily separate or distinct from each other.
A.2.139 As explained by the Inspector-General in the following paragraph, statements in the booklet provide practical guidance on comparable market rates, and indicative rates below which an arrangement will be at little risk of audit. The rates in the booklet do not represent rates that are or are not deductible as such.
A.2.140 The booklet explains that service fees not disproportionate or grossly in excess of these rates will be accepted (if the arrangement has the characteristics described, and the services have a relevant connection with your business). The comparable market rate is not identified as the low audit risk threshold.
A.2.141 IT 276 has consistently represented the Commissioner's view of the law and has been applied consistently throughout this period. Whilst a draft ruling was issued for comment, there is no evidence that the Tax Office 'did in practice' adopt a new view of the law. All audits were conducted in accordance with IT 276.
A.2.142 As explained in earlier Tax Office comments, we do not agree with this finding.
A.2.143 The Tax Office does not accept that the material contained in the Assessing Manuals could be reasonably used or relied on in the way identified by the Inspector-General. In addition to the reasons set out above for this view, the Tax Office considers that:
- Selective reference to the rates given in the Assessing Manual disregards material that arrangements would also be open to review if they were inconsistent with ordinary business dealings, for example, the consideration paid for the services is demonstrably out of line with the commercial value of the services rendered.
- It is patently unreasonable to rely on grossly outdated information for the purposes of satisfying the relevant issue whether services fees grossly exceed commercial comparable rates. Setting prices by adopting outdated information is also uncommercial conduct.
A.2.144 These materials were not inconsistent with the Tax Office's position in IT 276 (and was also not inconsistent with the material in the assessing manuals). They provide additional information about our concerns and attention to the issue. They consistently referred to the requirement that arrangements be commercially realistic, and signalled that we were seeing arrangements where this was questionable.
A.2.145 As identified in Chapter 5, speeches and articles by tax professional establish that the Tax Office's position was well understood and based on IT 276.
A.2.146 Awareness and conformance with IT 276 is considered to have been a reasonable expectation of taxpayers who chose to enter into service entity arrangements. Moreover, selective reliance on outdated material contained on the Tax Office's internal Assessing Manual, and which had been publicly advised as not able to be relied on, is considered to be patently inappropriate. This is especially so in circumstances where the deductibility of fees was open to question in accordance with IT 276.
A.2.147 The period of consultation reflects the nature of the issue involved. The length of time this took is no indication whether or not there was a change of view. Rather, it reflects the work and extensive consultation undertaken in providing practical guidance at a level of detail not previously provided on how taxpayers should work out whether their arrangements involves commercially realistic or grossly excessive fees. As this advice has been provided for the first time, it does not involve a change in view. The Inspector-General has already noted that the final ruling does not display a change in the Tax Office's position.
A.2.148 As explained in comments made in earlier chapters of the report, the Tax Office does not agree that there has been a delay in issuing advice. The Tax Office is obliged to administer the law and taxpayers are obliged to comply with the law. The Tax Office's view on the law was set out in IT 276. Deductions could be claimed in accordance with the requirements of the law, and taxpayers could have regard to the Tax Office's advice in IT 276 in doing so. The law, and the principles applicable to the application of the law have not changed. The Tax Office's administration of the law has been consistent with case law, and IT 276.
A.2.149 In our compliance work, on having formed a view that service fees were grossly excessive, based on the principles in Phillips and IT 276, the next question is to work out what amount would be deductible. This is established on ordinary commercial principles and is not a question on the interpretation or application peculiar to tax law. The booklet is based on these ordinary business principles. The Tax Office does not accept that this situation can be construed as applying the booklet retrospectively. The booklet simply sets out these principles in response to feedback during the consultation period that taxpayers who used service trusts needed detailed advice on commercial pricing of services that they provide.
A.2.150 The ruling and booklet do not require service fees to be calculated using any particular method. Our approach to reviewing arrangements is to look at the result of the method used, rather than to challenge the use of any particular method.
A.2.151 Our compliance approach has been to allow most taxpayers 12 months, to 30 April 2007, to review their arrangements. They will be at little risk of audit if their arrangements are in line with the information provided in booklet by the end of the review period. We have limited our current audit program to the highest risk cases, based on the size of the deduction, the materiality of the arrangement to the business, and the potential extent to which the arrangement may be a sign of unacceptable tax planning. It is only these cases which have not been given the benefit of the review period. We believe businesses that make claims of this size and materiality could reasonably be expected to comply with the law without the need to rely on the additional information in Taxation Ruling TR 2006/2 and the booklet. We consider this approach is based on sound risk assessment principles and, contrary to completely disregarding earlier non-compliance, satisfies the Tax Office's obligations under the tax law and the Financial Management and Accountability Act 1997.
A.2.152 Our current active compliance work involves a review of the conduct of the arrangement, which looks at factors going beyond the particular mark up rates used for labour hire. In cases where an adjustment has been made, there have been features in addition to the level, or commerciality, of the mark up used including:
- the cost base used for mark up purposes;
- the absence of staff, premises or equipment for the service entity to conducts its own business;
- activities and costs of the conduct of the service entity's own business being carried out by staff of the professional firm, or who had been on-hired and charged to the professional firm;
- provision of services other than labour hire and equipment hire;
- mark ups and profits made on back to back arrangements between third party service providers and the professional firm where the service entity is merely a conduit, for example equipment hire, rental of premises, and payment of third party invoices;
- inadequate documentation or records;
- conduct and pricing not consistent with service agreements; and
- dealing between the service entity and firm reflected only in year end journal entries.
These concerns are in addition to questions about the commerciality of the mark ups involved, and these factors also raise serious issues about the applicability of the rates used in these arrangements.
A.2.153 The Tax Office considers that the cases where an adjustment has been made involve arrangements where the fees are considered to be grossly excessive or otherwise meet the conditions identified above. Whether fees are grossly excessive depends on the facts of the arrangement, and regard is not limited to the particular mark ups used.
A.2.154 The Tax Office notes that the situations described above deal with a reassessment of an effective life or change in commercial rate. The law specifically provides for the Tax Office to statutorily provide a determination of effective life which taxpayers may choose to adopt. This is not comparable with the law on service entity arrangements which is covered by the general deductions rules and the body of law applicable to these rules.
A.2.155 The Tax Office is of the view that there was no prevailing advice on commercially comparable rates for service entity arrangements prior to the release of the booklet. Any misconception about the applicability of the rates set out in the Assessing Manual was conclusively dealt with in 1994 with the release of TR 1994/45 and the release of an addendum to TR 1992/20. In any event, the Assessing Manuals were not issued as advice on deductible service fees. The information is also outdated and it cannot be reasonably asserted to remain relevant or applicable to the question of commerciality.
A.2.156 The media release for the draft booklet explained that the Tax Office would look at cases where fees were over $1 million and represented over 50 per cent of the gross fees earned by the professional firm. The media release explained that our analysis showed that over 90 per cent of cases were below this threshold. This was the effect of the test. The media release does not state that the threshold was set in order to limit the number of cases to a maximum of 10 per cent of legal and accounting firms.
A.2.157 The media release dealt with the draft booklet which did not include the third condition referred to. The net profit condition was included in the final booklet following further consultation.
A.2.158 It follows from other Tax Office comments made in this report that we do not agree with these assertions.
A.2.159 The criteria are based on reasonable, objective and appropriate grounds that have regard to fair and effective treatment of compliance risk and non compliant behaviour.
A.2.160 The targeting of serious compliance issues that involve questions of whether the services were in fact provided is not conditional on the size of the service fee. Fees below $1 million can be assessed as a compliance risk where the arrangement is non-genuine and such arrangements remains subject to our current audit program. The threshold based test does not apply to these cases. In any event, the size of the deduction claimed is a legitimate factor in risk assessment and compliance treatment. Cases with service fees below $1 million other than these non-genuine arrangements are not considered to represent highest risk in terms of the commerciality of the arrangement.
A.2.161 The Tax Office considers that the three-step test provides a suitably targeted approach to identify the range of cases that would remain subject to our current audit program. As explained in the booklet, the tests look at the size of the deduction, the materiality of the arrangement to the business, and the potential extent to which the arrangement may be a sign of unacceptable tax planning. We believe businesses that make claims of this size and materiality could reasonably be expected to comply with the law without the need to rely on the additional information in Taxation Ruling TR 2006/2 and this guide.
A.2.162 The Tax Office considers that this would not provide taxpayers with any clarity or certainty whether their arrangement was at risk of being audited or whether they had until 30 April 2007 to review their arrangement and bring it in line with the information provided in the booklet. Providing taxpayers with certainty that they were covered by the review period requires the nomination of fixed thresholds as we have done.
A.2.163 Also, breaching the thresholds does not necessarily result in the commencement of an audit. The threshold test identifies a pool of cases that remain subject to our current audit program, and which are therefore at risk of being audited. Before commencing an audit we confirm whether or not the threshold test has been breached, and we undertake a review of the circumstances of the arrangement.
A.2.164 The work undertaken during this review allows the Tax Office to form a view whether or not an audit should be commenced on the taxpayer. The matters identified above are of the kind that the Tax Office has regard to in deciding whether or not to commence an audit. The collection of information that addresses these points is carried out in the course of a review. An overall assessment is made, having regard to the information gathered during the review, and the individual facts and circumstances of the particular case, whether or not an audit should be commenced.
A.2.165 The threshold test in the booklet, and the factors that this test takes into account, are used for the purpose of establishing the pool of cases subject to our current audit program. The threshold test in the booklet is not the basis on which a decision to commence an audit is made.
A.2.166 In fact, the Tax Office was asking for more information about which aspects of a taxpayer's compliance history the Inspector-General would regard as relevant. On this point, the Tax Office noted that the compliance risk covered more that non-genuine arrangements that the Inspector-General considered to be the only risk to be targeted.
A.2.167 As explained in earlier comments, we do not agree with this finding.
A.2.168 As explained in earlier comments, work carried out in the initial stages focuses on whether the taxpayer is within scope of the current audit program or has the benefit of the Tax Office's undertaking on giving a period for arrangements to be reviewed.
A.2.169 Also, the information gathered at this stage, as identified by the Inspector-General in the above paragraph, is not limited to obtaining material relating to the size of the fee. The financial statements allow a preliminary view to be formed on the application of the threshold test, together with a preliminary financial analysis of the operations of the professional firm and service entity. Information requested at this preliminary stage is kept at a minimum needed in order to minimise disruption and cost to the taxpayer.
A.2.170 The additional material referred to is of the kind requested if the preliminary review proceeds any further.
A.2.171 In most cases, there is adequate prima facie evidence that the arrangement exists. At issue is the entitlement to the deduction to the extent claimed.
A.2.172 Because of the administrative and compliance costs associated with the conduct of an audit, we conduct preliminary reviews for the purpose of identifying potential risks. Information is gathered to the extent considered appropriate for this purpose.
A.2.173 The Tax Office is willing to consider such issues and has considered, and responded to, matters of this kind when they have been raised. However, we may not necessarily agree with the taxpayer on the consequence of these factors. In cases where further compliance action is taken, even after taking these factors into account, we may consider that the circumstances still indicate grossly excessive fees.
A.2.174 The circumstances were considered, and it was determined that it did not provide an adequate explanation of the commerciality of the fees claimed. The circumstances would be considered in the course of the review as part of the overall circumstances of this case. The circumstance alone was not appropriate grounds on which to decide to not even commence a review.
A.2.175 The Tax Office does not accept that our conduct has been in breach of the Taxpayers' Charter. The individual circumstances of arrangements have always been taken into account, and our approach in each case is modified to reflect these circumstances.
A.2.176 The Tax Office does not agree. Advice is not simply ignored but it is true that the applicability of advice to an arrangement may be considered during an audit. In doing so the Commissioner considers a number of factors including:
- the advice was non-binding;
- the advice was not given to that partnership or firm;
- details of activities had been given to support the request of the Commissioner for the very general advice provided; and
- the advice applied only in respect of commercially realistic activities.
A.2.177 (The next two paragraphs of Tax Office's comments on this paragraph have not been published owing to concerns about taxpayers' privacy. The Tax Office has however previously communicated, in a general fashion, a number of the assertions which it makes in these paragraphs. A number of these general assertions have been set out elsewhere in this report — see for example the assertions referred to in paragraph 3.35 in the body of the Inspector-General's report).
A.2.178 More generally, the appropriateness of a particular level of mark-up depends on the circumstances of the case. Mark ups in reliance on Phillips '50/15 rates' need to reflect the facts in that case that supported the commerciality of those mark ups. At no time have we 'walked away' from the rates. We have always said it is a question of fact and the arrangement had to be commercially realistic. Cases where we have not allowed '50/15' claims have involved cases were we were satisfied that the mark ups was patently inappropriate in the individual circumstances of the case, and the circumstances were materially different from those in Phillips.
A.2.179 (The next paragraph of the Tax Office's comments on this paragraph have not been published owing to concerns about taxpayers' privacy.)
A.2.180 The Tax Office does not accept that it has 'walked away' from the previous advice. These advices, which were not in the form of rulings or other binding advice, were isolated in nature and could not be taken to represent an administrative practice on the part of the Tax Office. (The remainder of this paragraph has not been published owing to concerns about taxpayer's privacy).
A.2.181 The Tax Office does not accept there is a contradiction between the comments on the term 'general administrative practice' in both TR 2006/10 and the explanatory memorandum to TLAB (No. 2).
A.2.182 More specifically, it involves determining question of facts about what is commercial in the circumstances of a particular arrangement.
A.2.183 The Tax Office also considers that, if there was a previous general administrative practice (which is not accepted), that practice was withdrawn with the release of TD 1994/45 and the associated addendum to TR 1992/20.
A.2.184 Material in the assessing manuals from 1985 about a question of fact patently has no validity or relevance to that question of fact decades later. Especially since reliance on the material was officially rejected in 1994. The material has to be understood in the context of what the material addresses, ie the question of fact whether fees are commercially realistic. It is patently clear that the material in the assessing manuals can have no relevance to that question in recent years.
A.2.185 The Tax Office is concerned by the view that internal Tax Office risk assessment methodologies could be taken to constitute general administrative practices concerning the interpretation and application of the taxation laws. The Tax Office is of the view that general administrative practices relate to matters affecting the determination of tax liability and does not relate to Tax Office audit practices. As presently relevant, a tax shortfall must arise because of reasonable reliance in good faith on such a practice. This does not cover practices concerning the way in which the Tax Office goes about auditing cases. Whether or not a case will or will not be audited, or its risk of being audited, are not matters that can cause the tax shortfall to arise.
A.2.186 This accords with the Tax Office's understanding of general administrative practices. However, the Tax Office does not accept that there was a prevailing general administrative practice accepting the calculation of tax using a particular method or particular rate for service fees prior to the release of the booklet.
A.2.187 The Tax Office is unclear what the source of any such general administrative practice would be, other than potentially the comments made in the 2001 Annual Report. These comments are consistent with previous public comments made by the Tax Office.
A.2.188 The Tax Office submits that each of these factors referred to above has an explanation which does not require a view to be formed that there has been a change in general administrative practice.
A.2.189 As explained in earlier Tax Office comments, we do not accept that there has been a change in a general administrative practice.
A.2.190 We note the Inspector-General's view in paragraph 6.12 that the Tax Office's view on the law on service entities is the same view of the law which it had in 1978. The change that the Inspector-General asserts is not set out in two sets of documents, being TR 2006/2 and the booklet. The change that the Inspector-General asserts, which is not accepted by the Tax Office as having occurred, only related to the practical guidance material in the booklet.
A.2.191 Although the Tax Office does not accept that it has changed a general administrative practice, prior advices were taken into account in arriving at penalties in appropriate cases. Moreover, as the Tax Office is of the view that there has been no change in general administrative practice, it follows that the existence of such a change would not be taken into account, and cannot be evidence of a systemic issue that there has been a failure to take this into account.
A.2.192 The Tax Office does not consider that is accurate to describe the circumstance that arises in relation to service entity arrangements as the imposition of double taxation. The law, and the Tax Office's administration of the law, does not operate to assess income from service fees twice.
A.2.193 In an unacceptable service entity arrangement, fees are claimed as deductions by a professional firm or other business in excess of the amount deductible at law. Nevertheless, the fee charged by the service entity remains assessable income at law. The assessability of income to a recipient is not dependant on the deductibility of the expense to the payer.
A.2.194 Nevertheless, the Tax Office understands the economic mismatch that arises in cases where excessive fees have been charged and has taken steps available to it to provide relief. This has been achieved through the exercise of Tax Office's general administrative power in the course of reaching settlements of the issue with taxpayers, by giving recognition in the settled amount for tax already paid by associates of the partner in a professional firm in respect of the partners' tax adjustment due to the non deductible fee.
A.2.195 The Tax Office does not accept that the settlement of these cases has forced taxpayers to either 'actually' or 'practically' admit that their arrangement is struck down by Part IVA. While Part IVA may have potential application in individual cases, the non-deductibility of service fee essentially involves the application of the ordinary deduction rules.
A.2.196 The Commissioner does not have power to make 'compensating adjustments' under the general deduction provision in section 8-1 although he does under Part IVA. Accordingly, when negotiating settlements, the Commissioner may have regard to the possibility that Part IVA might apply and that compensating adjustments might be available to parties other than the taxpayer. This approach is beneficial to taxpayers.
A.2.197 However, that is not what ordinarily happens in relation to service fees.
A.2.198 We note first that the Tax Office does not consider that it is accurate to say that there is the imposition of double taxation in these cases. The law, and the Tax Office's administration of the law, does not operate to assess income from service fees twice.
A.2.199 In an unacceptable service entity arrangement, deductions are reduced or denied in the hands of the firm or business, but the fee charged by the service entity remains assessable income at law for the service entity. The assessability of income to a recipient is not dependant on the deductibility of the expense to the payer.
A.2.200 Nevertheless, the Tax Office understands the economic mismatch that arises in cases where excessive fees have been charged and has taken steps available to it to provide relief. This has been achieved through the exercise of Tax Office's general administrative power, by giving recognition in a settlement for tax already paid by a shareholder or beneficiary of the relevant service entity in respect of the partner's tax adjustment due to the deduction for service fees being disallowed.
A.2.201 The suggestion that taxpayers have been 'forced to admit' to the application of Part IVA is not an accurately reflect what has occurred.
A.2.202 The prevailing Tax Office view was published in IT 276. This ruling was exhaustive of our interpretative views on the issue. The ruling emphasised the factual nature of the issue and that cases needed to be looked at on their own facts. Additional communication on the issue reflected the emerging nature of the risks and issues in relation to service entity arrangements.
A.2.203 There was no document similar to a Taxpayer Alert in 1999 which could have been used to publish concerns about the use of service entity arrangements.
A.2.204 The criteria which were proposed in the draft booklet reflected the Tax Office's tentative positions at the time. These were released for the purposes of public consultation, and changes were made in response to feedback and submissions received, and the time spent in the consultation process.