Nature of service entity arrangements
3.1 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). 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).
3.2 Appendix 3 contains an extract from an April 2006 Tax Office publication on service arrangements which provides more detail on what the Tax Office considers to be the typical features of a service entity arrangement.
3.3 The deductibility of fees paid under a service entity arrangement was accepted by the Full Federal Court in the 1978 decision in the case of Phillips4 (provided a number of conditions were met). These conditions included a requirement that commercial rates were charged by the service entity.
History of Tax Office’s approaches to service entity arrangements
Tax Office approach up to Phillips case
3.4 In Phillips the Tax Office challenged the deductibility of fees paid under a service entity arrangement.
3.5 In Phillips the taxpayer was a partner in the chartered accounting firm of Fell & Starkey. In 1971 the firm set up a unit trust, with a trustee company and separate management company. Partners of the firm were to neither act as directors of these companies nor beneficially own shares. The unit holders were either the firm’s partners or (more usually) their spouses, children and other associated entities. The unit trust employed all the non-professional staff of the accounting practice together with certain professional staff who conducted the firm’s share registry business. It also purchased the firm’s office plant, furniture and equipment. It then supplied the staff and plant, furniture and equipment to the accounting firm for a service fee which involved the cost of direct salary paid to staff being marked up by 50 per cent and the cost of the plant and equipment being marked-up by between 6 to 8 per cent. The 50 per cent mark-up for salaries was the same rate of mark-up that was then being adopted by an office personnel hire company which was a client of the accounting firm. Unpaid service fees bore interest at between 8.5 to 10 per cent per annum.
3.6 Prior to the establishment of the trust, the firm wrote to the Commissioner of Taxation stating that the trust would sell its services to the business community. However, this did not in fact occur and its services were provided only to Fell & Starkey. In its letter to the Commissioner the firm also stated that the establishment of the trust was to meet a desire of the firm to diminish the assets held by the firm and its partners and increase the assets held for the benefit of their families so as to protect these assets against legal claims that might be made against the firm. At the time of the establishment of the trust a circular was sent to partners saying that the reasons for having a service organisation were to remove the assets from the ownership of partners and to reduce income tax and death duties.
3.7 The Commissioner disallowed deductions claimed by the firm for service fees paid to the unit trust for the years ended 30 June 1972 and 1973. The taxpayer appealed against the disallowance of these deductions. The Commissioner supported the assessments on the following two grounds.
3.8 The first ground was that the fees were either not wholly deductible or were only partly deductible under the general deduction provision of the income tax law. This provision was, at the time of the case, section 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936). The modern-day equivalent, which is in very similar terms, is section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)).
3.9 The second ground was that the service fee arrangement attracted the application of the anti-avoidance provision of the income tax law. This anti-avoidance provision was, at the time of the case, section 260 of the ITAA 1936. The modern-day equivalent of this provision is Part IVA of the ITAA 1936, which differs substantially from the former section 260.
3.10 The taxpayer appealed against the disallowance of a deduction for the service fee. The matter was heard by Justice Waddell of the Supreme Court of NSW who held that the fees were fully deductible under section 51 and that section 260 did not apply. His Honour held that the previous Privy Council case of Europa Oil5 supported the fee being fully deductible under section 51 and that the previous High Court case of Cecil Bros6 supported the view that section 260 did not apply.
3.11 The Tax Office appealed against Justice Waddell’s decision in respect of section 51 (but not in respect of section 260) to the Full Federal Court. The Full Federal Court upheld Justice Waddell’s decision and allowed the deduction. It relied on his finding (which had not been challenged in the appeal by the Tax Office) that the service fee charges were realistic and not in excess of commercial rates. The Court however noted that:
if the expenditure had been grossly excessive, it would raise a presumption that it not been wholly payable for the services and equipment provided, but was for some other purpose.7
By this comment, the Court appeared to infer that if the fees had been grossly excessive a deductibility issue would then arise.
Tax Office approach from 1978 to 1985
3.12 In September 1978, in a Head Office Memorandum, Tax Office staff were advised that the Commissioner would not seek special leave to appeal against the Full Federal Court’s decision in the Phillips case.
3.13 In the same month, the Commissioner issued a short taxation ruling to its staff on service entity arrangements. This ruling was IT 276.
3.14 In the preamble to this ruling, the Commissioner noted that a significant effect of the service entity arrangements in Phillips was, in his view, to divert income. However, the Commissioner stated that the taxpayer in the case was able to satisfy the trial judge that the rates charged for services by the service entity were realistic and not in excess of commercial rates and that this was a crucial finding that could not be effectively challenged on appeal.
3.15 In the preamble to IT 276, the Commissioner stated that additionally it was accepted that there were sound commercial reasons for the service entity arrangement quite apart from the tax saving. The sale of the plant and equipment by the firm to the trust released working capital and enabled accrued profits to be distributed; assets were moved away from the firm and thus protected against possible litigation based on professional negligence.
3.16 Following the preamble, the ruling itself stated that the decision to allow a deduction in Phillips must be accepted as reasonable but that the decision indicated the need for a close examination of all relevant facts before deductions were allowed in cases of this kind.
3.17 IT 276 was made publicly available in September 1983 in accordance with the terms of the Freedom of Information Act 1982.
3.18 In 1981, the Tax Office released Taxation Ruling IT 25. This ruling dealt with the tax issues associated with the incorporation of medical practices. Paragraph 12 of this ruling noted that in a considerable number of cases service arrangements had been entered into by medical practitioners and that these arrangements generally complied with the official guidelines in this area and had been approved by the Tax Office’s branch offices.
3.19 In 1985, further material on the Tax Office’s approach to the case of Phillips became publicly available when Butterworths and CCH Australia Ltd published edited versions of the Tax Office’s assessing manuals obtained under the Freedom of Information Act 1982. As at October 1985 these manuals were used within the Tax Office to give its assessors a guide to both the procedural and technical aspects of assessing income tax returns.8 This was a time when the Tax Office, rather than taxpayers, assessed the amount of tax that was payable by taxpayers.
3.20 Volume 4 of these assessing manuals deals with the assessment of trusts. The relevant extract from the Tax Office internal version of this manual is reproduced in Appendix 4. This appendix indicates, by way of footnote, the parts of this document which were not reproduced in the version of this manual that was published by CCH Australia Limited.
3.21 As can be seen from Appendix 4, the version of this document that was published by CCH Australia Limited 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’. The version of this manual that was published also contained two examples from the Perth branch of the Tax Office of how these guidelines on mark-ups were to be applied, one involving where rental income was not derived by the service entity and one where such rental income was derived. The examples noted that rental income and expenses are not taken into account when determining the allowable mark-up and that the commerciality of the rent charged should be reviewed if it was considered excessive.
3.22 The assessing manual’s statement that the Phillips case established guidelines of 15 per cent on other costs does not appear to be consistent with the facts of the case itself, which as noted above, involved mark-ups of between 6 to 8 per cent on plant and equipment.
Tax Office approach from 1985 to 1996
3.23 For the period from 1985 until 1996 the only additional guidance that was provided by the Tax Office to taxpayers generally on its approach to service entities was issued in 1988 and 1989. In these years the Tax Office issued Taxation Rulings IT 2494, 2503 and 2531 all of which contained paragraphs which referred to service entity arrangements. IT 2503 in particular confirmed that the comments in IT 25 which dealt with medical practices still applied.
3.24 During this period the Tax Office made the following comments on service entity arrangements in speeches made to groups of tax practitioners:
- In 1986 when addressing the Taxation Institute of Australia (TIA) Queensland Division’s Annual Tax Convention the then Commissioner stated that ‘the operation of a service company or trust where the charges are commercially realistic does not attract the operation of section 260’.
- In March 1994 an ATO officer presented a paper at a Taxation Institute of Australia Convention on service entity arrangements. This paper contained detailed comments on how to calculate service entity fees and indicated that the Commissioner was not specifically targeting service entity arrangements in its audit program at the time. It also referred to there being a common practice to apply a 50 per cent mark-up on wages in setting the fees charged by the service trust but noted that the Tax Office did not endorse any particular percentages as a suitable level for mark-ups.9
3.25 During this period the Tax Office also issued Taxation Determination TD 94/45, together with an addendum to Taxation Ruling TR 92/20 which stated that it considered that Taxation Office Assessing Handbooks that were issued during the period when the Tax Office itself assessed returns could not be relied on as evidence of the Tax Office’s position.
3.26 There was little other activity by the Tax Office in relation to service entity arrangements during this period. However, in 1990 and 1991 the Tax Office issued at least two opinions to a major accounting firm which confirmed that mark-ups of service fees that were consistent with those set out in its previous trust assessing manual were acceptable and that these mark-ups could be applied to clients of the firm as well as to the firm itself.
3.27 During this period the quantum of service fees charged by the service entities of accounting firms rose 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.
Tax Office approach from 1996 to mid-2005
Public statements provided by the Tax Office
3.28 From 1996 to mid-2005 statements by the Tax Office on its approach to service entity arrangements increased. However, the statements provided during this period did not take the form of a ruling or other public advice. Taxpayers not could rely on these statements either legally or under the Tax Office’s administrative practices for treating certain forms of its advice as being binding. The statements that were made were as follows.
3.29 In May 1998 a paper was presented at a Taxation Institute seminar by an ATO officer. This paper noted that some taxpayers believed that a rule of thumb existed that a 50 per cent mark-up on wages and a 15 per cent mark-up on all other costs would always be accepted by the Tax Office. However, the paper noted that all cases had to be determined on their own facts.10
3.30 In November 1998 another paper on service entities was delivered by an ATO officer at a TIA seminar.11 This paper noted that the Tax Office had accepted for some time that professional practitioners could establish service entities to provide non-professional and administrative duties. The paper discussed the potential application of Part IVA to these arrangements and concluded that such arrangements, where they were established on a commercial footing and where the rates payable were realistic, would not warrant the application of Part IVA. However, it did flag that where these arrangements involved the service entity employing professional staff to provide professional services rather than administrative staff then the Commissioner would examine the case to see if Part IVA might apply.
3.31 The paper also flagged that, although certain mark-up rates were accepted in the Phillips case it would be quite inappropriate for the Commissioner to say that those rates were acceptable in all cases.
3.32 The paper further stated that the Tax Office did not intend at that stage to challenge the validity of such arrangements by litigation. Neither this paper nor the previous May 1998 paper flagged that the Commissioner was investigating service entity arrangements as part of a legal and accounting project it had begun in 1996. This project is discussed further below.
3.33 In November 2001 the Commissioner in his 2000/2001 Annual Report, in the chapter dealing with ‘Aggressive Tax Planning’, noted that the Tax Office had reviewed the service entity arrangements of some legal and accounting firms and that in some cases under examination the Tax Office had concerns whether the arrangements were commercial and effective for tax purposes.
3.34 From 2001 to 2004 the Commissioner made general references to cases involving service entity arrangements in a number of speeches, documents (such as its Annual Compliance Program) and in published minutes of National Tax Liaison Group (NTLG) meetings. In this material the Tax Office noted that the arrangements it had seen varied significantly from those reflected in Phillips and that there was an issue as to whether the service fees charged were commercially realistic.
3.35 In one speech12 the Commissioner stated that the variances in arrangements that the Tax Office was seeing from those reflected in Phillips were as follows:
- In Phillips, only administrative staff were employed by the service entity, while in the arrangements seen by the Tax Office all staff of the firm (including the professional staff) were employed by the service trust.
- In Phillips, substantial assets such as premises and equipment were owned by the service trust, whereas in the arrangements seen by the Tax Office no such assets were held by the trust.
- In Phillips, the service trust was a fixed unit trust while in other arrangements seen by the Tax Office the service trusts were discretionary trusts, with distributions being based on the annual performance-based profit-sharing arrangements for the professionals who were principals or partners in the firm.
- In arrangements seen by the Tax Office the partnership was a beneficiary of the service trust.
- In these arrangements the great bulk of the partnership profit ended up in the trust.
3.36 In April 2002, an article written by a tax officer was published in the Institute of Chartered Accountants magazine. This article noted concerns that service arrangements were being used in a manner seemingly beyond the scope of the decision in the Phillips case.13
3.37 At a meeting of the NTLG held in September 2002 professional bodies raised the issue of service entity arrangements and in particular whether the Tax Office proposed to issue a ruling. The Tax Office indicated that it was not planning to issue a ruling. It sought input from the members of this group on this and other appropriate strategies to deal with concerns about service entity arrangements.
3.38 At the NTLG meeting of 26 March 2003, NTLG members sought an update from the Tax Office on the progress of the service trust issue and also sought to have the Tax Office clearly outline what arrangements were acceptable so as to provide a ‘safe harbour’ for taxpayers who follow them. The Tax Office advised that its review of service arrangements in the legal and accounting sectors would continue and that, on completion, it anticipated issuing a discussion paper and/or public ruling setting out the Tax Office view on the way forward. The Tax Office also stated that other features of service arrangements it was seeing which raised issues as to whether the service fees were commercially realistic were as follows:
- Net mark-ups for service fees were well in excess of market rates for the provision of equivalent services. For example, in some instances the service entity was more profitable than comparable labour hire firms or the professional firm itself.
- The professional firm remained responsible for the oversight of staff and services provided by the trusts. The firm was therefore not relieved of all the employment risk associated with staff nor of the economic costs typically associated with the employment of permanent staff.
- The service arrangements were not established and conducted on an arm’s length basis and documentation was poor.
- It was difficult to identify any service entity staff who were not on-hired to the professional firm and who were responsible for the operation and administration of the trust.
3.39 At the NTLG meeting of December 2003 the Tax Office invited members of the group to form a subgroup to assist with development of a ruling on service entity arrangements.
3.40 Details of other public comments made by the Commissioner during this period are provided in Appendix 5.
Other activities conducted by the Tax Office that were generally not made public
3.41 During the period from 1985 to 2005 the Commissioner also conducted certain other activities in relation to service entity arrangements. Some details of these activities were reported in the financial press. However, press reports on these activities were not based on any detailed information provided by the Tax Office, other than that which is listed above. These Tax Office activities are set out below.
3.42 In 1996 the Tax Office commenced a review which involved a data mining exercise of the accounting and legal profession. Service arrangements were one of a number of issues identified during the course of this review.
3.43 In 1998 the previous review was re-badged as an accounting and legal project which was conducted by the Tax Office’s Large Business Area. Senior leadership was provided by a senior executive from the Tax Office’s Aggressive Tax Planning area. This project involved sending out questionnaires covering a number of tax issues to 10 large legal and accounting firms and covered the income periods 1 July 1995 to 31 March 1998. From the responses to these questionnaires, service entity arrangements were identified as an issue which should be audited by the Tax Office to ascertain the commerciality of service fee pricing and the extent of the use of service entities for income alienation.
3.44 In 1999, a number of taxpayers, including two large accounting firms were notified that their activities would be audited, with service entity arrangements being one of the issues to be examined. In March 2002 the Tax Office decided to desist with other cases and focus its efforts on the audits of the two large accounting firms. At an internal ATO workshop held the same month to discuss the progress of these audits the Tax Office decided to look at the pricing structures of the two cases under audit to see if the service fees paid were commercially realistic. It engaged a Tax Office economist to establish the current commercial rates for independent businesses carrying on similar activities to service trusts. The methodology to be used to determine these rates was essentially the same kind of methodology the Tax Office was using for the purposes of its rules on international profit shifting by multinational companies. These rules are also known as ‘the transfer pricing rules’. Position papers on the service trust issue were presented to each firm in November 2002. The two audits were settled in 2003 and 2004.
3.45 In December 2002, the Tax Office commenced further work to identify cases where they considered there was a high risk that service trust arrangements were not being implemented in accordance with the law. Under this project, in June 2003 the Tax Office sent questionnaires to 56 accounting and legal firms to better understand their use of service entities.
3.46 During this review, the Tax Office has stated that this project was undertaken following a request to do so made by the NTLG group. The Inspector-General has not found any evidence which supports this statement and notes that the recorded minutes of 2003 NTLG meetings do not suggest that any such request was made.
3.47 In December 2002 the Tax Office decided to issue public guidance on service entity arrangements but was unsure at the time whether that guidance would be in the form of a public ruling or a practice statement. In October 2003, following advice from the Public Rulings Panel, the Tax Office decided to issue a public ruling. An embargo was then issued to Tax Office staff restricting the issue of advice in relation to the deductibility of expenses for any cases with similar features to Phillips service entity arrangements.
3.48 In May 2004 the Tax Office issued a preliminary version of a draft ruling on service entity arrangements to members of a special subgroup of the NTLG on a confidential basis.
3.49 In September 2004 the NTLG members involved in the confidential consultation process for the draft ruling wrote a joint letter to the Commissioner expressing concerns in relation to the project to date and seeking executive level intervention to set the project on a proper path.
3.50 The concerns expressed in this letter included the following:
- the Tax Office personnel who were engaged in the confidential consultation on the ruling did not appear to accept the legitimacy of service entities, contrary to the previously publicly expressed views of the Commissioner;
- assuming that these arrangements were legitimate, the draft ruling did not provide any form of assistance to the community by the omission of guidance in areas where the Commissioner would accept levels of charges;
- the ruling should operate prospectively; and
- the draft ruling neither addressed Phillips case in any detail nor accommodated the proper balance of authorities relevant to the question of deductibility.
3.51 In the same month, the Tax Office decided to issue a draft booklet alongside the proposed ruling that would provide practical guidance to taxpayers and their advisers on service entity arrangements. A first draft of this practical guidance booklet was provided to the special NTLG subgroup in December 2004, together with a further draft of the proposed ruling.
3.52 In late 2004, overall management of the service entity issue was transferred from the Large Business and Aggressive Tax Planning areas to the Small Business area of the Tax Office. The Large Business area of the Tax Office (but not the Aggressive Tax Planning area) remained involved in this issue via an internal Tax Office Steering committee. The aim of the committee was to ensure that the Tax Office approach to service entities was applied consistently, that appropriate risk analysis tools were used and that only those cases which required audit activity were targeted.
3.53 In May 2005, the Tax Office estimated that, based on figures for the 2000/01 year, the annual amount of tax that the Tax Office may not be collecting as a result of partnerships in the legal and accounting profession not correctly applying the law on service entity arrangements could be as high as $26 million (for the accounting profession) and $35 million (for the legal profession). These figures did not include any estimate of revenue leakage for service entities conducted by sole practitioners in the legal and accounting profession or by other groups of professionals. These figures were considerably less than earlier estimates made by the Tax Office of the potential revenue leakage which had ranged up to $215 million.
Tax Office approach in 2005/06
3.54 In May 2005, the Tax Office issued to the public a new draft ruling on service entities. The ruling made no mention of what the Tax Office’s approach would be to auditing service entity arrangements for periods prior to the date of issue of the ruling. The new draft ruling stated that once finalised it would not replace, but rather would supplement, the previous ruling IT 276.
3.55 In June 2005 this draft ruling was supplemented by the issue of an accompanying draft booklet which set out certain indicative mark-up rates (which may be described as ‘safe harbours’) which the Tax Office would accept for fees paid to service entities.
3.56 This booklet contained a statement that the Tax Office would continue with its existing audit program for periods prior to the date of release of the draft ruling and booklet and would be auditing cases where the following two conditions were satisfied:
- the service fees were over $1 million; and
- the service fees represented over 50 per cent of the gross fees or business income earned by the professional firm.
This statement in the booklet confirmed a statement which the Commissioner had made to a Senate Committee about four weeks prior to the booklet being issued.14
3.57 The booklet also stated that the Tax Office would look at cases under its audit program where there were serious questions as to whether the services were in fact provided by the service entity.
3.58 The draft booklet indicated that under this approach about 80 prior year audits would be conducted. At a subsequent liaison group meeting, the minutes of which were published in February 200615, the Tax Office stated that these audits would be conducted by staff of the Small Business area of the Tax Office.
3.59 The draft booklet outlined two approaches that taxpayers could choose in working out whether service fees were acceptable. The first approach was to determine comparable market prices for the relevant service provided by the service entity. The second approach was to determine comparable profits achieved by independent suppliers in respect of the same or similar services using one of two methods ─ either a ‘cost plus ‘approach or a ‘net profit’ approach.
3.60 The draft booklet gave ‘safe harbour’ mark-up rates for staff hire and equipment only for cases where a net profit approach was used. These safe harbour mark-up rates were as follows:
- for temporary staff hired by the service entity and on-hired to the practice entity: five per cent of the direct and indirect operating costs associated with the on-hiring;
- for permanent staff hire by the service entity and on-hired to the practice entity: three and a half per cent of the direct and indirect operating costs associated with the on-hiring; and
- for equipment owned by the service entity and on-hired to the practice entity: a rate which resulted in the service entity deriving a return on net assets of less than or equal to nine per cent of the written down value of the assets used in the hiring activity.
3.61 For real property leased by the service entity to the practice entity the draft booklet provided only a comparable price approach. This comparable price was stated to be equal to market rates for the relevant property plus finder fees where appropriate.
3.62 The safe harbour net profit mark-up rates for staff and equipment were calculated using a sophisticated net profit methodology of the kind that was and still is typically used by economists to determine what represents a reasonable level of profit that should be derived by a foreign owned entity from its Australian-based operations for the purposes of Australia’s transfer pricing rules.
3.63 The draft booklet did not provide any ‘safe harbour’ rates where professional firms wanted to employ a cost plus approach to setting service fees of the kind employed in the Phillips case and the Tax Office’s previous assessing manuals. This cost plus approach is generally perceived to be less complex and less costly than a net profit (transfer pricing) based approach.
3.64 The net profit mark-up rates provided in the booklet for staff and equipment could be converted to give approximate acceptable ‘cost plus’ mark-up rates. However, the booklet did not provide these conversions, not did it give any guidance on how to make them. It was therefore left to taxpayers with service entities to determine how to make these conversions and then to actually make them. Once these conversions were made, it became apparent to many of these taxpayers that the cost plus mark-ups that they had previously employed (such as the 50/15 per cent rates set out in the Tax Office’s assessing manuals, the rates referred to in previous Tax Office advice and the rates used in the Phillips case itself) were now no longer considered acceptable by the Tax Office. This had the result that these firms were put on notice that, in the Tax Office’s view, they may have incorrectly calculated the amount of service fees that should be charged by their service entity for previous years of income.
3.65 In April 2006 final versions of the ruling and booklet were issued. The final version of the ruling (TR 2006/2) and booklet differed from the original draft versions in a number of ways. The main differences were as follows.
3.66 Firstly, the ‘safe harbour’ mark-up rates set out in the original draft booklet were generally re-named in the final booklet as ‘comparable’ market rates. During this process one of the net profit rates set out in the draft booklet (being that for equipment) was lowered.16 The new booklet stated that these comparable rates would be the benchmark rates the Tax Office would generally apply if it conducted an audit of a service entity.17
3.67 Secondly, a new set of rates were provided which were higher than the safe harbour mark-up rates set out in the draft booklet. These new mark-up rates were described as ‘indicative rates’ and were the rates which, when applied by taxpayers, would mean that the arrangement was at little risk of being audited. However, the rates would only give this result provided they did not result in the relevant service fee being greater than 30 per cent of the combined profits of the professional firm and service entity.
3.68 These indicative mark-up rates were as follows:
- For labour hired by the service entity and on-hired to the practice entity:
- If the net mark-up on costs method was used: 10 per cent of the direct and indirect operating costs associated with the on-hiring;
- If the gross mark-up on costs method was used: 30 per cent of the salary and benefits of the on-hired staff, provided that all direct and indirect operating costs associated with the on-hiring were absorbed by the mark-up. Operating costs also needed to be a minimum of 18 per cent of salary and benefits.
- For expenses paid by the service entity:
- Here, the booklet only provided a net mark-up on costs rate for determining the relevant mark-up. This was to be a maximum of 10 per cent of the direct and indirect operating costs associated with the expense payment activities.
- For equipment owned by the service entity and on-hired to the practice entity:
- Here, the booklet only provided a gross mark-up on costs rate, which was 10 per cent of the cost to the service entity of the equipment (provided all relevant costs relating to the equipment were met by that service entity).
- For real property leased by the service entity to the practice entity: a mark-up (if any) which resulted in the rent being set at market rates plus finders fees where appropriate.
3.69 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.
3.70 In the final booklet, the Tax Office also stated that audits for prior year periods would still 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.
3.71 The third of these conditions was new. It had not been announced by the Tax Office in any previous publication on service entity arrangements, although it had been referred to by the Commissioner in a statement made to a Senate Committee in November 2005.18
3.72 The Tax Office did not publicly reveal the number of cases it expected would now be subject to prior year audits as a result of these three conditions.
3.73 The Tax Office has also not revealed its planned audit activities on service entity arrangements after the 12 months period of grace ends on 30 April 2007. At the NTLG meeting of 15 March 2006 (the minutes of which were released on the Tax Office’s website during May 2006) the Tax Office did indicate that two industries — the legal and accounting professions — were being monitored for service entity arrangements and that there were 1200 firms in the Tax Office’s data base. It also advised the meeting that, as at that date, there had been a moderation of service entity returns.
4 F C of T v Phillips (1978) 8 ATR 783.
5 Europa Oil (NZ) Ltd (No 2) v I R Comr (NZ) (1976) 5 ATR 744.
6 Cecil Bros Pty Ltd v F C of T (1964) 111 CLR 430; 9 AITR 246.
7 F C of T v Phillips (1978) 8 ATR 783 at page 792.
8 CCH Australia Limited, Australian Taxation Office Assessing Handbook — Trust Volume 4, Current at October 1985 at page 3.
9 O’Donohue, P, The ATO perspective on Phillips, paper given to SA Annual Convention of the Taxation Institute of Australia, March 1994.
10 Forsyth, S, Professional income structures and personal service income, paper given at Taxation Institute of Australia Queensland State Convention, May 1998.
11 Sharma, C, Service Entities (Trusts/ Companies): The Commissioner’s Perspective, paper given at Sunrise Seminar of the South Australian Division of the Taxation Institute of Australia, 4 November 1998.
12 Commissioner of Taxation, Issues confronting Australia’s tax system, speech given to Financial Review — Leaders’ Luncheon, 29 July 2002.
13 Fitzpatrick, K, ‘ATO plans aggressive attack’, Charter, Institute of Chartered Accountants, April 2002.
14 The statement was made at the Senate Economics Legislation Committee hearing of 2 June 2005 (see page E165 of the hearing transcript).
15 Minutes of the meeting of the Small to Medium Enterprises Sub-committee of the National Tax Liaison Group, 26 August, 2005 at page 6. These minutes are available on the Tax Office’s website at www.ato.gov.au.
16 In the final booklet, the rate for equipment was set out as being the rate which results in the service entity deriving a return on net assets of less than or equal to 7 ½ per cent of the opening written down value of the assets used in the hiring activity.
17 Australian Taxation Office, Your service entity arrangements, Guide Nat 13086-04.2006, April 2006 at page 14.
18 Senate Estimates Committee hearing, transcript of 3 November 2005 at page E51.