2.1 This review has looked at how the Tax Office handled service entity arrangements. It was prompted by concerns that the Tax Office took too long to identify and resolve the tax issues associated with these arrangements and that this delay led to considerable uncertainty and (in some cases) unnecessary costs for affected taxpayers.

2.2 There is no doubt that there were compliance issues associated with the operation of service entity arrangements by a number of taxpayers and that these have persisted for a number of years. These issues included taxpayers charging service entity fees that were well in excess of commercial rates and failing to ensure that these arrangements were properly established and operated (for example, by ensuring that expenses claimed by the service entity were in fact incurred by that entity).

2.3 However, in the Inspector-General's view, the Tax Office bears some responsibility for the development of this state of affairs and its persistence during the period from 1978 until at least the middle of 2005. This is because of various actions and inactions by the Tax Office over this time period.

2.4 Service entity arrangements are commonly used within a number of professional firms. They are present in a wide range of industries (including the legal, accounting and health industries) and are present within a wide variety of different business structures (ranging from sole practitioners through to partnerships, companies and trusts).

2.5 Under these arrangements, service entities, which are usually trusts, employ staff and acquire other services, premises, plant and equipment which they on-supply to a related-party professional firm. The fee charged for these services is usually set at a mark-up to the amounts paid by the service entities for the relevant staff, services and equipment. This mark-up allows the service entity to make a profit which can be distributed to the parties who have a membership interest in the relevant service entity (usually the principals in the relevant professional firm and/or their families).

2.6 The Tax Office first challenged the deductibility of fees paid under a service entity arrangement in the 1978 case of Phillips.1 However, this case upheld the validity of these types of arrangements for a professional firm where the amount charged by the service entity to the firm involved mark-ups of 50 per cent on the direct costs of staff and 6 to 8 per cent on the cost of plant and equipment.

2.7 Following this decision, the Tax Office issued a short ruling (IT 276), which it later made publicly available, where it indicated that it accepted the result in this case. This Tax Office ruling contained no comment on the specific mark-ups used in that case. The ruling noted only that the court found that the charges were not in excess of commercial rates and that this must be accepted as reasonable. It appears to have been widely believed by taxpayers and their advisers (with some justification) that mark-ups at the kinds of levels considered in the Phillips case would henceforth be acceptable to the Tax Office.

2.8 The Tax Office's internal assessing manual for trusts which was released to the public in 1985 appeared to confirm this understanding by taxpayers and advisers. This manual expressly stated that the Phillips case 'established guidelines for net fees with mark-ups approximating 50% on wages claimed in providing the service and 15% of other expenses'.2

2.9 During the 1990s service fees charged by the service entities of accounting firms rose considerably due to a change in the professional practice rules issued by the professional accounting bodies. This rule change permitted the service entities of accounting firms to now employ professional accounting staff as well as other staff. This rule change did not affect legal firms and their service entities continued to only employ non-legal staff.

2.10 During the 1990s a number of Tax Office staff made speeches to private audiences of tax professionals where they acknowledged that it was a common practice amongst taxpayers to apply a 50 per cent mark-up on wages and 15 per cent on other expenses in setting the fees charged by a service entity. In these speeches, the relevant officers stated that the Tax Office did not endorse any particular percentages as a suitable level for mark-ups. They also drew attention to a number of compliance issues that the Tax Office were concerned about with these arrangements.

2.11 However, the comments made in these speeches were not embodied in any formal public guidance material on service entities at this time.

2.12 Also, although these speeches in the early 1990s flagged that there were compliance issues with service entity arrangements at this time (which included the charging of possibly excessive service fees) the Tax Office did not commence any audit activity on these arrangements until late in 1999. This audit activity followed on from a project that was formally begun in 1996 to investigate the tax affairs of large accounting and legal firms. When this audit activity did begin it was confined to two large accounting firms only.

2.13 In 2001 the Commissioner flagged in his Annual Report that there were compliance concerns with service entities. These concerns were repeated in subsequent speeches and liaison group minutes but were not embodied in any formal guidance material issued to taxpayers at this time.

2.14 Following the conclusion of the audits of the service entities of two accounting firms in 2002, the Tax Office made a formal decision to address the compliance issues associated with the amount of service entities fees being claimed as deductions by issuing public guidance to taxpayers on these issues. This guidance was not however issued to the public in draft form until the middle of 2005 and in final form until early 2006. This final guidance took the form of a Tax Office Ruling TR 2006/2 and an accompanying service entities guidance booklet.

2.15 When this guidance was issued in final form the Tax Office changed the mark-ups referred to in Phillips case and the trusts assessing manual (and seemingly endorsed in IT 276) quite significantly. These rates were now to be a maximum of 30 per cent on labour costs and 10 per cent on equipment and were to be subject to an overriding cap of being not more than 30 per cent of the total combined net profit of the service entity and associated firm. The guidance also set out other methods of calculating service entity fees for tax purposes which did not involve the application of mark-ups to specific expenses.

2.16 When releasing the final version of the ruling and booklet the Tax Office announced that most taxpayers who might be adversely affected by the terms of the final ruling and booklet were to be given a 12 months period of grace in which to review their existing service arrangements and implement any necessary changes. This period would end on 30 April 2007.

2.17 In the final booklet, the Tax Office also stated that audits of service entity arrangements for prior year periods would be conducted (and the above 12 months period of grace would therefore not apply) where there were serious questions as to whether the services were in fact provided by the service entity and also in cases where the following three conditions were satisfied:

  • the service fees were over $1 million;
  • the service fees represented over 50 per cent of the gross fees or business income earned by the professional firm; and
  • the net profit of the service entity represented over 50 per cent of the combined net profit of the entities involved.

2.18 Normally, when the Tax Office issues public guidance to taxpayers on the operation of the tax laws which differs from that which it has previously provided it accepts that this new guidance will operate only prospectively. This practice is embodied in various administrative and legislative guidelines concerning the effect of a change in the Tax Office's general administrative practice.

2.19 However, in the case of service entity arrangements, the Tax Office has denied that any of these rules concerning the prospective application of a change in general administrative practice apply. The Tax Office contends that its view of how the law applies to service entity arrangements as set out in its draft and final guidance on service entity arrangements that were issued in 2005 and 2006 respectively has not changed from the view on these arrangements which it initially expressed in IT 276.

2.20 The Inspector-General considers that this view is not supported by the evidence which his office has gathered during the course of this review. He considers that the changes the Tax Office has announced in setting new and lower mark-up rates that can be used to calculate service entity fees and in establishing other methods for calculating these fees amount to changes in how it is administering the law on service entity arrangements.

2.21 In this review the Inspector-General therefore finds that the Tax Office did change its view on how to calculate the amount of a service entity fee that will be deductible.

2.22 Put simply, the Inspector-General considers that the 'safe harbour' rates in the recent Tax Office booklet are essentially a proxy for what is acceptable as being 'commercial', and that the earlier rates specified in the Tax Office assessing manuals and in advice to some taxpayers were essentially the same thing. The new rates are different to the old ones and give a different result. Therefore, a change has occurred. The old assessing manuals were publicly available and, in the absence of any other guidance, used by tax advisers and tax staff, even if they were not binding on the Tax Office nor endorsed as a basis for making claims.

2.23 The review recommends (Key Recommendation 4) that the Tax Office accept and publicly acknowledge that it has changed its view and outline the consequential implications for affected taxpayers.

2.24 The Tax Office has dismissed the review's evidence and conclusions on this important point and it has disagreed with Key Recommendation 4.

2.25 The Inspector-General believes that the Tax Office's disagreement with Key Recommendation 4 reinforces the Inspector-General's Key Recommendation 6 which deals with the need for the Tax Office to provide detailed guidance, which is publicly available, of its view of when a 'general administrative practice' of the Tax Office will arise and the implications that arise when that practice has changed. The Inspector-General notes that the Tax Office has agreed with Key Recommendation 6.

2.26 Furthermore, the Inspector-General considers that the Tax Office's conduct in not clarifying its views on service entity arrangements via any announced change to IT 276 and/or to the material set out in its assessing manual until mid-2005 and in undertaking only limited and belated audit action on this issue provide further reasons for the Tax Office adopting an approach of applying its new guidelines in TR 2006/2 and its accompanying booklet on a prospective basis only.

2.27 In the light of the above comments, the Inspector General considers that the Tax Office should not be making tax adjustments for service entity arrangements conducted prior to the 12 months period of grace which is referred to in TR 2006/2 (which ends in April 2007) in cases where the only significant issue is that service fees were calculated in accordance with the 50/15 per cent method set out in the Tax Office's previous trusts assessing manual, rather than any of the methods flagged either in the draft or final version of the service entity ruling and booklet.

2.28 The view set out above would not preclude the Tax Office from investigating and making tax adjustments for service entity arrangements conducted prior to April 2007 in cases where the fees are considered to be grossly excessive, in cases of fraud or evasion, or in other cases where there are features of the arrangements which raise issues as to the genuineness of the service entity's operations during the relevant period. Examples of such features would include cases where the service entity has no staff of its own who carry out its business or where the entity has no legal entitlement to property which it allegedly supplies to the professional firm.

2.29 A prospective approach would provide important protection for service entity arrangements which are audited by the Tax Office after its current period of grace for these arrangements ends in April 2007. If such an approach is not implemented, audited entities could face retrospective adjustments, penalties and interest going back as far as 2003. This is a time before the new approaches being taken by the Tax Office were known.

2.30 The review has also found that there are issues with how and when the Tax Office pursues the payment of primary tax for previous years in cases where the Tax Office has changed a previous general administrative practice. New laws relevant to this issue were enacted following The Review of Aspects of Income Tax Self Assessment (the RoSA review) that was conducted by Treasury in 2004.

2.31 The Tax Office does not consider that this new law gives taxpayers protection against the payment of primary tax where, as in the case of service entity arrangements, a new Tax Office practice is set out in a guidance booklet rather than a public ruling. The Tax Office also does not consider that this new law gives taxpayers protection where a public ruling which sets out the change is issued but that change has been made previously and the ruling simply confirms the previous change.

2.32 The Inspector-General believes that it is a fundamental principle of good tax administration that the Tax Office should not, as a general rule, pursue the payment of primary tax in situations where it has changed a general administrative practice. In his view, this principle operates regardless of the means by which the relevant change is made (that is, it does not matter whether or not the relevant change has been made by a formal public ruling).

2.33 This principle is founded on the view that in a self assessment environment it is not fair to require taxpayers to retrospectively pay tax for a previous year where they originally calculated their tax liability for the relevant year in accordance with a general Tax Office practice which existed and was widely known at the relevant time.

2.34 In the case of service entities, the Tax Office has effectively sidestepped the application of this principle. It has done so by asserting that it has not in fact made any change in its general administrative practice. It continues to make this assertion despite the overwhelming evidence which has been gathered during the course of this review that it has changed its general administrative practice in this area.

2.35 The Tax Office has then further sidestepped this principle of good administration by contending that, in any event, it only legally needs to consider this principle in the case where it has made a change in its general administrative practice by issuing a public ruling.

2.36 This principle and the overall concepts and protections of general administrative practice are only available if the Tax Office agrees that the practice existed and that it has been changed. The application and effectiveness of the general administrative practice provisions therefore rely on the Tax Office behaving fairly, objectively and being willing to admit that it has contributed to a behaviour that it seeks to change. However, the Inspector-General has noted in other reports that the Tax Office can be reluctant to admit fault, can have a tendency to defensiveness, and on occasion displays a 'win at all costs' mentality.

2.37 The Inspector-General therefore concludes that there is a systemic weakness in relying on Tax Office fairness and objectivity to provide access to the principles, protections and provisions of a changed general administrative practice.

2.38 The Inspector-General will consider this systemic issue further in the course of his final report on all three case studies which form part of his overall review of the Tax Office's ability to deal with complex tax issues. However, as a first step towards addressing this systemic issue, the Inspector-General has, in this review, made two recommendations. The first is that before any compliance enforcement activity, the Tax Office should test how well it has met its obligations to provide adequate and contemporary guidance to taxpayers on the relevant issue (Key Recommendation 1). The second is that the Tax Office should produce a practice statement giving a clear indication (with examples) of how it will consider if a general administrative practice exists and if it has been changed (Key Recommendation 6). The Tax Office has not agreed with Key Recommendation 1, but has agreed with Key Recommendation 6.

2.39 The review also found that the greater part of the final ruling as well as the booklet on service entities arrangements have been issued in the form of advice which is only administratively, not legally, binding on the Tax Office. The review notes that this does not seem to be giving full effect to the principle which underlies a number of recommendations from the previous RoSA review. This principle is that the Tax Office should provide its guidance wherever possible in the form of a legally binding ruling in the interests of providing taxpayers with greater certainty in a self assessment environment.

2.40 From this review, there is no doubt that the compliance issues associated with service entities could have been resolved much more quickly. In the Inspector-General's view public guidance on this issue could have been issued by as early as 2001 rather than in 2006. The Inspector-General notes that the Tax Office has agreed that there could have been an improvement in the timeliness of publishing the ruling and booklet for service entities.

2.41 The review has examined in some detail the reasons for the seven year delay between the Tax Office formally identifying that there were compliance issues with service entities in 1999 and the issue of the final ruling and booklet on these arrangements in 2006.

2.42 The review found that one significant cause of the Tax Office's tardiness in issuing detailed guidance on service entities during this period was that the senior Tax Office personnel who were responsible for handling service entity arrangements held an underlying belief that these arrangements were not acceptable per se. While the former Commissioner took action to quell the effect that this belief was having on the timely and objective resolution of the service entities issue in mid-2004, in the Inspector-General's view this action should have been taken much earlier.

2.43 Another reason for the Tax Office's tardiness on service entity arrangements during this period was that the Tax Office personnel who were managing this issue did not give sufficient weight to the need for taxpayers in a self assessment environment to be provided as early as possible with sufficient guidance to help them comply with the law.

2.44 A further factor which contributed to the Tax Office's tardiness in resolving this issue was that the Tax Office's existing timeliness standards for public rulings did not operate effectively.

2.45 The Tax Office has sought to defend its failure to issue final detailed public guidance on service entities any earlier than 2006 on the basis that its approach of issuing this guidance in the form of a compliance booklet setting out fact-based guidance on how to calculate the amount of service fees that would be deductible is an 'innovation'. It further asserts that this level of guidance represents a development that is 'unsurpassed by any other national tax administration in the world'.

2.46 In the Inspector-General's view, these comments ignore the vast amount of guidance material on facts based and quantum issues that the Tax Office has issued since its very early days. Furthermore, these comments suggest that senior management within the Tax Office may not wholeheartedly endorse the view that part of the Tax Office's role in a self assessment environment is to provide detailed guidance to taxpayers on how to apply the law. This is despite the fact that the provision of such guidance has been referred to in a number of key Tax Office documents as being one of its core values.

2.47 The review also found that the Tax Office's processes of communicating with the community on the service entities issue were deficient in a number of respects. It recommends the following improvements.

2.48 Firstly, the Tax Office should ensure that it is living out its core value of providing sufficient guidance to taxpayers on how to comply with the law in a self assessment system. To be effective, this guidance needs to be provided on a timely basis.

2.49 Secondly, the Tax Office should ensure that it employs appropriate communication processes to let taxpayers know its view of the application of the law to significant issues. These views should be set out in material that is accessible to all taxpayers and which is recognised by taxpayers as being a source of guidance on such issues. These views should not, as occurred in the case of service entity arrangements, only be set out in media releases, speeches given to private audiences or in minutes of liaison group meetings.

2.50 Thirdly, the Tax Office should ensure that, if its view of the law on a significant issue is made in the form of draft guidance, this draft guidance always contains a very clear statement of its intended date of effect.

2.51 The report has also found deficiencies in aspects of the Tax Office's performance standards for public rulings.

2.52 Under these standards, 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, while final public rulings are to be issued within six months of the draft ruling being issued.

2.53 The review found that the Tax Office has not been monitoring its adherence to these standards in accordance with a previous recommendation of the Auditor-General that it do so. Monitoring of the Tax Office's performance against these standards was only recommenced during this review after the Inspector-General drew attention to this lapse. This monitoring revealed that for the last two financial years only 50 per cent of public rulings have met either of these existing Tax Office standards for public rulings.

2.54 The review has recommended that the existence of these standards and the degree to which they have been met by the Tax Office should be publicised by the Tax Office in the same manner as it publicises and reports on its other performance standards.

2.55 The review also recommends that the content of these standards should be changed to better deal with complex issues that are addressed by the issue of public rulings, such as service entity arrangements.

2.56 Firstly, the Inspector-General considers that these standards should operate from when a compliance issue is first identified, rather than when the matter is first referred to a certain internal unit within the Tax Office.

2.57 Secondly, they should be altered so that if a ruling is to be accompanied by detailed practical guidance which contains commercial benchmark rates for a number of industries, such as occurred in the case of service entities, both documents are issued within a maximum period of 24 months of the relevant compliance issue being identified.

2.58 Thirdly, they should stipulate that if a ruling and any accompanying guidance material are issued more than two years after any relevant compliance issue is identified, the date of effect of both the ruling and any accompanying guidance should be prospective only.

2.59 The report also makes recommendations which address certain undesirable audit practices which came to light during the review. These recommendations seek to address the following matters:

  • In a number of service entity audits, the Tax Office did not appear to be considering the individual circumstances of the relevant taxpayer.
  • In some cases, these individual circumstances included the fact that the relevant taxpayer had been issued with a prior private ruling or opinion in relation to how their service entity fees should be calculated. However, the Tax Office sought to argue that these opinions were no longer valid as they had been withdrawn by subsequent speeches.

2.60 Finally, the report notes that ATO consultation processes on the service entity ruling and booklet were conducted secretly for a considerable period of time and that this led to perceptions that members of the private sector who were engaged in these consultations processes had obtained an unfair advantage for themselves and their clients over other taxpayers with service entities. The report recommends that, to prevent such perceptions arising, Tax Office consultation processes on key documents should be conducted openly at all times.

2.61 The Inspector-General's key and subsidiary recommendations from this review, together with the Tax Office's responses, are set out below.

Key Recommendations

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.

Tax Office response

2.62 The Tax Office does not agree with this recommendation. Providing guidance is not appropriate for every compliance issue, for example, where deliberate fraud or evasion is uncovered. In other situations where lack of understanding is a major contributor to non-compliance, an educative approach is appropriate. This approach is summarised in the compliance model applied by the Tax Office.

2.63 In relation to service entity arrangements, 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 National Tax Liaison Group (NTLG). The people represented by members at 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.

2.64 The Tax Office's current compliance approach to service entity arrangements is consistent with the established and widely understood principles on the relevant issues involved. The central tax issue is that fees under a related-party service entity arrangement must be commercial. This has at all times been identified by the Tax Office as the tax compliance issue on which appropriate advice has been published. The answer to this issue is a question of fact which means that the correct amount deductible under the law can only be determined in relation to the circumstances of each particular arrangement. Whether a particular arrangement is commercial is a business issue and is not a tax issue.

2.65 Nevertheless, the Tax Office has responded to uncertainty on these matters of ordinary business judgment and indicated what, in its opinion, would reflect commercial conditions in the type of conventional service entity arrangements described in the booklet. Taxpayers can choose to adopt these arrangements and manage the risk of audit of their tax affairs. The degree of compliance risk borne by Tax Office in offering this approach has been subject to careful management.

2.66 We have adopted a compliance strategy that has regard to our existing advice, and most arrangements are not subject to audit under our current audit program. Only the highest risk cases are currently subject to potential audit. The selection of these cases had regard to the degree of potential non-compliance and the circumstances in which taxpayers could reasonably have complied with the law on the basis of existing guidance in case law, IT 276, and other information available at the time, without the need for the additional guidance material now in the booklet.

2.67 The Tax Office does not accept that there is any evidence of an internal culture that ignored the need for adequate and contemporary guidance. We note that reasonable views can differ on the sufficiency and appropriateness of guidance on issues. Discussion of different views in the course of developing compliance approaches are an important part of good administration and good decision making.

Inspector-General's comments on Tax Office response

2.68 The Tax Office asserts that its interpretation of the law and expectations regarding compliance were widely known and well understood in the community. However, this assertion is not supported by any of the evidence gathered during this review. It is also not supported by the community concerns which led to this review being conducted. Furthermore, this assertion is also inconsistent with the Tax Office's other statement in this response that there was uncertainty on the relevant issues.

2.69 In its more detailed response (see Appendix 2) the Tax Office cites a number of articles and speeches by practitioners as evidence that the Tax Office position was widely known. The Inspector-General notes that the vast majority of these occurred after the Commissioner had made public his concerns in his Annual Report of 2001 (tabled in November 2001).

2.70 The Tax Office's response confirms that, in the case of service entities, the Tax Office has adopted an internal culture of ignoring the need for adequate and contemporary guidance.

2.71 The Inspector-General agrees that providing guidance is not appropriate for every compliance issue (for example those involving fraud or evasion). The recommendation does not expressly deal with such cases because, as confirmed by the Tax Office elsewhere in its comments on this report (see for example its comments on paragraph 6.73), in most service entity cases there was no evidence of fraud or evasion.

2.72 In any event, Recommendation 1 is not about providing guidance on all compliance issues. It simply suggests that the Tax Office, before embarking on a compliance strategy, should check if it has contributed to non-compliance through not having provided adequate (clear and contemporary) information to enable taxpayers to comply. Evidence gathered during the course of this review indicates that the Tax Office may rush to an aggressive enforcement without fully appraising why the situation has occurred.

Key Recommendation 2

The Tax Office's timeliness standards for public rulings should be made public in the same manner as its other service standards.

The content of these standards should be altered as follows.

Where a compliance issue arises which gives rise to the possible need to issue a ruling, the Tax Office should reach a decision to issue a ruling and then should actually issue the relevant ruling in final form no later than 12 months after the compliance issue is identified. If the ruling is to be accompanied by detailed practical guidance which contains commercial benchmark rates for a number of industries, such as occurred in the case of service entities, both documents should be issued within a maximum period of 24 months of the relevant compliance issue being identified.

If a ruling and any accompanying guidance material are issued more than two years after any relevant compliance issue is identified, the date of effect of both the ruling and any accompanying guidance should be prospective only.

Tax Office response

2.73 Agree in part, as part in existence prior to commencement of review. Timeliness standards for public rulings are already published on the ATO website. However, we do not agree with the rest of the recommendation.

2.74 First, it is not clear at what point a 'compliance issue' may be said to have arisen, making the measurement of time from that point problematic. Further, the setting of the time period to apply to such 'issues' which gives rise to the 'possible need' to issue a ruling makes the recommendation so vague as to be unadministerable.

2.75 More fundamentally, giving rulings only prospective application where the time limits suggested are not met would deny taxpayers the protection that public rulings offer. Public rulings give the Commissioner's opinion as to what the correct interpretation of the law has always been, and so generally have both a past and future application, which taxpayers may then rely upon.

2.76 The Commissioner recognises that there may be situations where, for the proper administration of the relevant provisions, giving a public ruling both a past and future application would, on an objective consideration of all the factors, produce an unfair, absurd or unjustifiable result. This could be, for example, where the ruling departs from an earlier ruling or general practice. This was not the case in relation to service trusts.

Inspector-General's comments on Tax Office response

2.77 The Inspector-General welcomes the Tax Office's decision to publish service standards for public rulings in the same manner as it publishes its other service standards and notes that, once this recommendation is implemented, these service standards will be located in the same place as all its other service standards.

2.78 The Inspector-General also welcomes the Tax Office's confirmation that its general practice is to give a public ruling a prospective application where a failure to do so will produce an unfair, absurd or unjustifiable result.

2.79 The Tax Office's assertion that part of the recommendation is unadministerable has been made without engaging in any dialogue with the Inspector-General on the reasons for this assertion. The Inspector-General believes that the principles which underlie this recommendation can be given effect to and suggests that the Tax Office should engage in a wider dialogue with interested parties (including the Inspector-General) on this issue. The aim of these discussions should be to achieve an outcome which ensures that its timeliness standards for rulings actually achieve the result of ensuring that these rulings are issued in a timely manner.

2.80 The Inspector-General also notes that in its response to paragraph 5.85 of the review the Tax Office has agreed that for service entities 'the timeliness of publishing the ruling and booklet could have been improved on', and that two years was a reasonable time within which to have finalised its guidance on service entities.

Key Recommendation 3

The Tax Office should monitor and assess the degree to which public rulings are meeting its internal service standards on timeliness for these rulings on at least an annual basis. The results of this monitoring and assessment process should be publicly reported in the same way as its performance against other service standards is reported.

Tax Office response

2.81 Agree, as existing prior to commencement of review.

2.82 The Tax Office already monitors and assesses the timeliness of public rulings. This information is available on the Tax Office's website.

Inspector-General's comments on Tax Office response

2.83 The Inspector-General welcomes the Tax Office's agreement with this recommendation, but notes that the Tax Office needs to remain vigilant to ensure that this monitoring is not suspended for any significant period of time, particularly if this monitoring indicates that a significant breach of these standards is occurring. As discussed in the report, prior to this review the Tax Office had last monitored its performance against these standards for the 2003/04 year and had not taken steps to review its performance against these standards for subsequent years. The monitoring process for the 2003/04 year indicated that two-thirds of public rulings sampled under this process had not met relevant timeliness standards.

Key Recommendation 4

The Tax Office should acknowledge, in a public statement, that it has changed its view on how to calculate the amount of a service entity fee that will be deductible with effect from the date of issue of TR 2006/2 and its accompanying booklet on 12 April 2006. It should confirm that this change will be applied prospectively from that date and that this prospective application will include a 12 months period of grace for taxpayers to adjust their service entity arrangements.

The Tax Office should, in this public statement, outline the consequences (including those relating to the remission of penalties, interest and prior year tax adjustments) that this change in view has for all taxpayers with service entities, including:

  • taxpayers who are currently subject to prior year audits of service entity arrangements;
  • taxpayers who have entered into prior settlement arrangements with the Tax Office in relation to their service entities; and
  • taxpayers whose service entity arrangements will be subject to audit after 30 April 2007.

Tax Office response

2.84 Disagree.

2.85 The Tax Office's view on how to calculate service fees has not changed. IT 276 refers to the need for commercial reasons and realistic charges not in excess of commercial rates. IT 276 did not specify particular allowable rates, and this approach is consistent with the law in this area. Handbooks used by assessors in 1987 are therefore irrelevant to the calculation of commercial rates almost 20 years later. In any case, internal assessing guidelines identified rates to guide Tax Office staff in the performance of their assessing duties. The use of these rates for the purpose of making claims for service fees was not endorsed by the Tax Office, and could not be endorsed as deductible rates in terms of legal principles. The Tax Office's assessing manuals did not contain public guidance. This position was further explained in TD 1994/45 and in an addendum to TR 1992/20. Other public statements by the Tax Office consistently identified the overriding requirement for fees to be commercially realistic. Particular rates were never endorsed in public advice. This position was well understood by the tax profession, and is consistently reflected in publications and presentations by members of the tax profession.

2.86 The booklet provides additional material covering:

  • the steps that can be taken to establish the commerciality of a service entity arrangement,
  • information on rates that the Tax Office uses in relation to comparable fees,
  • information on how the Tax Office reviews arrangements for compliance risk purposes.

2.87 The guidance material published in the booklet is not contrary to any existing general public advice, and is of a kind not previously published. Also, as commerciality is a question of fact, and commercial circumstances change over time, direct reliance on any information regarding commerciality of fees that is out of date is patently unreasonable. Such information fails to provide any support or evidence on the question whether a particular contemporary arrangement is commercially realistic.

2.88 The Tax Office has based its administration of this issue on a risk assessment approach to the compliance risks and issues involved and decisions about priorities and the application of resources available. This approach provides support for the Tax Office to meet its obligations to collect tax payable under the law and its obligations under the Financial Management and Accountability Act 1997.

2.89 Under this approach, a small number of service entity cases are subject to our current audit program. These cases are dealt with in accordance with the law. Our approach in these cases reflects ordinary principles on commercial dealings.

Inspector-General's comments on Tax Office response

2.90 The Tax Office's assertions that it has not changed its view on how to calculate service entity fees is not supported by any of the evidence gathered during this review.

2.91 The Inspector-General considers that the 'safe harbour' rates in the recent Tax Office booklet are essentially a proxy for what is acceptable as being 'commercial', and that the earlier rates specified in the Tax Office assessing manuals and in advice to some taxpayers were essentially the same thing. The new rates are different to the old ones and give a different result, therefore a change has occurred. The old assessing manuals were publicly available and, in the absence of any other guidance, these were used by tax advisers and tax staff, even if they were not binding on the Tax Office nor endorsed as a basis for making claims.

2.92 The Inspector-General believes that the Tax Office's disagreement with this recommendation reinforces the Inspector-General's Key Recommendation 6 which deals with the need for the Tax Office to provide detailed guidance, which is publicly available, of its view of when a 'general administrative practice' of the Tax Office will arise and the implications that arise when that practice has changed. The Inspector-General notes that the Tax Office has agreed with Key Recommendation 6.

Key Recommendation 5

When conducting audits of any taxpayer (including any audits of prior year service entity arrangements), the Tax Office should ensure that it fully considers all the relevant taxpayer's individual circumstances. It should also, as part of the audit process, clearly demonstrate to the taxpayer that it has done so, for example, by addressing these circumstances specifically if the taxpayer has raised these circumstances in a written submission.

Tax Office response

2.93 Agreed.

2.94 The Tax Office has consistently adopted this approach in relation to its active compliance activities on service entity arrangements.

Inspector-General's comments on Tax Office response

2.95 The Inspector-General welcomes the Tax Office's agreement with this recommendation. The Inspector-General notes that evidence gathered during this review (discussed in detail in chapter 6) indicates that an approach of fully considering all the relevant taxpayer's individual circumstances was not always applied in the Tax Office's compliance activities in respect of some taxpayers. The evidence also indicates that some taxpayers perceived that the Tax Office had not considered their individual circumstances.

Key Recommendation 6

The Tax Office should issue comprehensive guidance to its staff, in the form of a practice statement which is made publicly available, on the meaning of the term 'general administrative practice' and on the implications with regard to penalties, interest and primary tax which arise if the Tax Office has changed such a practice. This guidance should also provide practical examples and should be subject to public consultation prior to being issued.

Tax Office response

2.96 Agree.

2.97 Taxation Ruling TR 2006/10 issued on 4 October 2006 deals with this issue.

Inspector-General's comments on Tax Office response

2.98 The Inspector-General welcomes the Tax Office's agreement with this recommendation. He also notes that by agreeing to produce a practice statement on this issue the Tax Office has agreed to provide further guidance material than is currently set out in TR 2006/10.

2.99 As noted in the report, the Inspector-General considers that the comments in PS LA 2006/2, PS LA 2006/8 and TR 2006/10 are a positive first step towards providing further guidance on the meaning and application of the term 'general administrative practice'. However, as also noted in the report, he considers that more needs to be done to provide Tax Office staff with guidance on this issue in the context of both the application of penalties, the remission of interest and the imposition of primary tax. The Inspector-General considers that comments in all three documents are too brief. They do not contain any practical examples of cases where a general administrative practice may exist but has not been set out in an ATO Practice Statement.

2.100 The Inspector-General also considers that, in the proposed practice statement, the Tax Office should explain how it will administer the law whose effect is to protect taxpayers against the payment of primary tax for previous years in cases where there has been a change in general administrative practice. In the Inspector-General's view this new law should have the effect of giving taxpayers protection against the payment of primary tax for previous years regardless of the means by which the a change in administrative practice is made (that is, it should not matter whether or not the relevant change has been made by a formal public ruling).

Key Recommendation 7

The Tax Office should ensure that when it is dealing with a compliance issue that affects a significant segment of the taxpayer population it employs appropriate communication processes to ensure that its concerns on this compliance issue are made known to that population directly and as soon as possible. The Tax Office should not seek to rely on communicating these concerns only in publications or speeches to limited audiences.

Tax Office response

2.101 Agreed in part, and that part met in this case.

2.102 The Tax Office identified potential compliance risks with the use of service entity arrangements in the legal and accounting sector in the course of reviewing tax performance in these industries. The Tax Office considers that a correct leverage point was used for the communication of our concerns with members of these professions. Speeches and articles by practitioners in these professions demonstrates a wide awareness of the issue and that our concerns were well understood.

2.103 The Tax Office does not agree that direct communication to the taxpayer population will be an effective or efficient means of communicating compliance information. Members of professional bodies involved with these speeches and articles provide advice, including tax advice, to over 95 per cent of businesses. It is also our experience that communication with this group of professionals is highly effective as a communication strategy to reach the broader business community on tax related issues. The taxpayer population affected will, in many cases not be able to be individually identified by the Tax Office and many will not be in a position to fully understand the issues involved. Communication via their agents is what they and their agents would expect.

Inspector-General's comments on Tax Office response

2.104 The Inspector-General welcomes the Tax Office's agreement in part with this recommendation. However, he notes the Tax Office's assertion that direct communication to the taxpayer population is not an effective or efficient means of communicating compliance information. This assertion strongly implies that the Tax Office does not fully appreciate that communicating with tax advisers does not equate to communicating with taxpayers.

2.105 The Inspector-General notes that the Tax Office has previously been strongly criticised (for example in Senate inquiries3) for a failure to communicate compliance issues directly to affected taxpayers.

Key Recommendation 8

The Tax Office should, in the interest of providing maximum certainty to taxpayers in a self assessment environment, ensure that all guidance which is of a significant nature and which applies to a substantial segment of the taxpayer population is, to the maximum extent possible, embodied in the form of guidance which is legally binding on the Tax Office.

Tax Office response

2.106 The Tax Office agrees with this in principle. The Tax Office considers material in the booklet to be inappropriate for inclusion in a public ruling. For example, indicative rates set out the Tax Office's approach to auditing arrangements and the risk of being audited.

Inspector-General's comments on Tax Office response

2.107 The Inspector-General welcomes the Tax Office's in principle agreement with this recommendation. However, he notes that the Tax Office's response does not indicate why it considers that the material it has listed in its response is not appropriate for inclusion in a public ruling.

2.108 The Inspector-General notes that one of the principles underlying the RoSA review is that all guidance which is of a significant nature and which applies to a substantial segment of the taxpayer population is, to the maximum extent possible, embodied in the form of guidance which is legally binding. This principle provides taxpayers with greater certainty in a self assessment system.

2.109 The Inspector-General also notes that the Tax Office's guidance material on service entities was one of the first guidance materials to be issued in final form after the date of effect of the changes to the rulings regime made as a result of the RoSA review. However, only a small portion of this guidance material has taken the form of a binding ruling.

Key Recommendation 9

The Tax Office should ensure that when any form of draft guidance is issued to taxpayers, that draft always contains a very clear statement of the intended date of effect of that guidance. This requirement should be set out in a Tax Office practice statement or other internal document which provides guidance to its staff.

Tax Office response

2.110 The Tax Office agrees.

Subsidiary recommendations

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.

Tax Office response

2.111 Agreed in part, and during the time of this review announced changes to the consultation process that are in line with this. There may continue to be situations where a public ruling is being developed to address a particular issue in a particular industry and where the development process is enhanced by consultation with a targeted group both before the draft ruling is publicly released for comment and after. In some situations, early consultation can also be effective in allowing the Tax Office to form a view on the extent of compliance and to consider the most appropriate resolution strategy in situations where the law is not being complied with.

2.112 Service entity arrangements were added to the public rulings program in January 2004. This followed the decision made in December 2003 to prepare a public ruling on the issue. The program is publicly available. Consultation with NTLG members commenced after this time.

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

2.113 This recommendation is consistent with Tax Office's management processes for priority technical issues which may lead to the preparation of a public ruling.

2.114 The NTLG serves a role in providing the tax community's perspective on the importance and merits of particular issues, including those on the public rulings program. This perspective assists the Tax Office in providing commensurate resources and leadership on issues. Feedback from this consultation resulted in escalation of the issue with direct leadership provided at Deputy Commissioner level.

Subsidiary recommendation 3

The Tax Office should state in a practice statement or other guidance document that is issued to its staff that prior year advices given to taxpayers will not be considered to have been withdrawn unless the withdrawal is specifically brought to the attention of affected taxpayers.

Tax Office response

2.115 The Tax Office will give consideration to providing guidance to staff on the circumstances in which taxpayers are entitled to rely on prior year advice.

2.116 The Tax Office notes that the application of private rulings is covered by law under which they apply for the particular years to which a ruling relates.

2.117 Tax Office publications include a commitment statement on the protection that taxpayers have when following advice in a Tax Office publication. This protection is explained on the inside front cover of the booklet on service entity arrangements.

2.118 The booklet also provides the following explanations on page 4 about specific advice that taxpayers may have acted on:

If you have acted on specific advice from the Tax Office you would generally be excluded from our current audit program, but you may need to review your arrangements for the future. In any examination of these cases we would need to consider the terms of the specific advice and whether there are material factors relevant to the operation of the service arrangements that were not disclosed in connection with the advice.


1 F C of T v Phillips (1978) 8 ATR 783.

2 Australian Taxation Office, Trusts Assessing Manual, Chapter 13 at paragraph 14.13.2, reproduced in Appendix 4 to this report.

3 See, for example, Parliament of the Commonwealth of Australia, Senate Economics Reference Committee, Inquiry into Mass Marketed Tax Effective Schemes and Investor Protection, Final report, February 2002 at paragraphs 1.38 to 1.59.