4.1 Stakeholders have made a number of comments and raised a number of concerns in submissions to this review about the manner in which the Tax Office has dealt with service entity arrangements.
4.2 These comments and concerns can be divided into comments and concerns with respect to the processes the Tax Office has employed to resolve this issue (that is, concerns over the Tax Office's administration of this issue) and comments and concerns over the validity of the view which the Tax Office has reached on these arrangements (that is, concerns on whether this view is either legally correct or appropriate).
4.3 The Inspector-General is not empowered to conduct reviews into matters involving the validity of the Tax Office's view of the law on a particular matter. This report therefore does not deal with the comments and concerns raised in submissions that related to this issue.
4.4 However, this report notes that most submissions did raise strong concerns as to the validity of the Tax Office's view. These concerns particularly centred on whether the Tax Office has the power to determine what is a reasonable amount that professional firms should be entitled to deduct for fees paid to service entities where the relevant fee is not subject to any of the specific provisions of the income tax law (such as the transfer pricing provisions) which grant the Commissioner such a power.
Comments and concerns with respect to Tax Office processes applied to service entity arrangements
4.5 The comments and concerns which relate to the processes which the Tax Office has used in relation to the service entity issue which were raised in submissions fall into the following five headings:
- concerns regarding the length of time the Tax Office has taken to resolve the service entity issue;
- comments and concerns on whether the Tax Office was using the rulings and advice process as a way of altering the law to ensure that its own view prevails;
- comments and concerns relating to the Tax Office's audit approaches with respect to service entity arrangements, including whether the Tax Office was changing its prior general administrative practice on these arrangements;
- comments and concerns with respect to the consultation processes which the Tax Office employed for service entities; and
- concerns with respect to the manner in which the Tax Office has communicated its approach to service entity arrangements.
The Tax Office has taken too long to reach a final position on service arrangements
4.6 Most submissions to this review have asserted that the Tax Office has taken too long to reach a final position on service trusts. Submissions gave differing views on the length of this time period. The length of this period was regarded as being either:
- 28 years (being the time between the decision in the Phillips case and the issue of TR 2006/2);
- 23 years (being the time between the decision in the Phillips case and the date of the Commissioner's statement about his concerns on service entity arrangements in his 2001 Annual Report);
- 10 years (being the time between the Tax Office's commencement of a project on legal and accounting firms in 1996 and the date of issue of TR 2006/2);
- 8 years (being the time between the Tax Office's survey of accounting firms on the service entity issues in 1998 and the date of issue of TR 2006/2);
- 4½ years (being the time between the date of the Commissioner's statement about his concerns on service entity arrangements in his 2001 Annual Report and the date of issue of TR 2006/2);
- 2 years (being the length of time between the provision of a draft ruling on service entities to certain parties that were external to the ATO who were invited to provide their comments on that document and the date when the final ruling and booklet was issued); or
- 10 months (being the length of time between the issue of the draft and final versions of TR 2006/2 and accompanying booklet.)
4.7 An associated concern was that any delay in issuing detailed Tax Office advice on Phillips may indicate a systemic failure in the processes for determining what matters are to be given priority status for the Tax Office's Public Rulings program. These submissions argued that the failure of this topic to emerge on this program earlier was because the processes for giving priority status to certain topics were too heavily skewed in favour of issues that were of concern to the Tax Office (for examples issues involving revenue leakage) rather than issues of concern to taxpayers (such as how to apply Phillips).
Has the Tax Office used the rulings and ATO advice process to alter the law on service trusts?
4.8 A number of submissions have asserted that the Tax Office is using the ruling and booklet it has issued on service entities as a disguised and inappropriate means of challenging the decision reached in the Phillips case.
4.9 The Taxation Institute of Australia noted that the draft ruling contained a statement (which remains in the final ruling) that the Phillips case:
… is not authority for the proposition that service fees calculated using the particular mark-ups adopted in that case will always be deductible under section 8-1 of the ITAA 1996.19
4.10 The submission then states that:
It is hard to see what the case is authority for, if not authority for these very rates. It is a case determined by its facts.
4.11 The Taxation Institute's submission later states:
Clearly the Commissioner is not bound forever by decisions against him. Law changes and Courts' attitudes shift. If the Commissioner is dissatisfied with the result in a prior case, such as Phillips case, and feels that its outcome is no longer appropriate, the way to challenge the existing position is either by running a test case, or else by securing the passage of amending legislation. Until either of these things occur, the Commissioner should administer the law as it stands. The appropriate means of challenging Phillips case is for the Commissioner to fund a test case or for him to secure a legislative amendment, not simply to announce contradictory views.
4.12 In a similar vein, some submissions have argued that the ruling has been used as an ambit claim by the Tax Office to generate more tax and that it is biased towards the Tax Office's view of the law.
4.13 On the other hand, some submissions have asserted that the ruling and booklet do not embody any change to the law on service entities and in some cases have queried whether it was necessary to issue these documents at all.
Comments and concerns on the practices which the Tax Office is adopting in service entity audits
4.14 Submissions have made a number of comments and raised a number of concerns under this broad heading.
Should the Tax Office be conducting audits on service entity arrangements for periods prior to the date of issue of the final ruling and booklet?
4.15 Submissions have generally supported the Tax Office conducting audits of service arrangements for years prior to the date of the final ruling and booklet in cases where those arrangements exhibited features of fraud or evasion. An example of such a case mentioned in submissions was where there was a serious question as to whether any services were provided by the relevant service entity.
4.16 Submissions however have varied in their support for the Tax Office conducting prior year audits of service entity arrangements which do not involve fraud or evasion. A number of submissions strongly argued that, absent fraud or evasion, no such audits should be conducted. Other submissions acknowledged that the Tax Office should audit prior years in cases where it could be said that the Phillips case principles were being abused. However, submissions offered different views on the circumstances in which this abuse would be present. For example, some argued that an example of a case where Phillips principles were being abused could be where the service entity was deriving a substantial portion of the combined profits of the professional firm and service entity. However, submissions offered different views on what level of 'substantial' profits in the service entity should give rise to the result of being subject to prior year audits.
The Tax Office has altered its general administrative practice on service entity arrangements
4.17 A number of submissions have asserted that the final Tax Office view on service entities as stated in TR 2006/2 and the accompanying booklet represents a change in the Tax Office's general administrative practice on service entity arrangements. They asserted that the Tax Office has falsely represented that there has been no such change in its practice so as to maximise the extent to which it can levy additional tax, penalties and interest on taxpayers whose service arrangements for prior years are audited.
4.18 If the Tax Office has changed a general administrative practice for service entities the Tax Office would be legally bound to consider the application of section 284-215 of the Taxation Administration Act 1953 (TAA 1953)20 in any service entity audit. This section would prevent it from levying an administrative penalty on a taxpayer where they have followed the Tax Office's previous practice in prior years of income.
4.19 Such a change in practice would also mean that for things done on or after 1 January 2006 the Tax Office would be legally unable to charge interest on underpaid tax to such a taxpayer under section 361-5 of the TAA 1953.
4.20 Furthermore, such a change in practice would mean that the Tax Office would need to consider whether its own rulings, other internal guidelines (such as TR 92/20 and its replacement TR 2006/10) or section 358-10 of the TAA 1953 prevented it from collecting tax underpaid by such a taxpayer.
The Tax Office has walked away from previous advice it has given
4.21 Submissions have asserted that, in audits the Tax Office has conducted on service arrangements for periods prior to the issue of the service entity ruling and booklet, the Tax Office has 'walked away' from previous advice it has given to specific taxpayers that a 50 per cent mark-up on labour costs and a 15 per cent mark-up on other expenses would be an acceptable way to determine the amount of service fee to be charged by the service entity.
Tax Office audit activity on service entities has been retrospective
4.22 Submissions have asserted that the Tax Office's approach to auditing certain service entities prior to the issue of the draft ruling and booklet has amounted to retrospective taxation. Submissions noted that a number of audits of service entity arrangements were initiated and/or completed prior to the date of either the release of the Tax Office's draft guidance on these arrangements or the release of its final guidance on such arrangements. A number of submissions also asserted that some of these audits involved questionnaires being issued to taxpayers which were based on the draft booklet at a time when that booklet was still the subject of confidential discussions and was not therefore publicly available.
Tax Office audit activity on service entities has been discriminatory
4.23 Submissions have also raised concerns that the Tax Office's approach to auditing service entities for years prior to the issue of the draft ruling only in cases where three specific criteria are met, one of which is that the relevant service fee is over $1 million, was discriminatory.
4.24 One group of submissions asserted that this approach was discriminatory because the $1 million threshold meant that only accounting and legal firms of a certain size would be subject to this audit activity.
4.25 A second group of submissions asserted that this approach was discriminatory because the $1 million threshold meant that the accountants and lawyers who did not meet this criterion for retrospective audit activity were being given preferential tax treatment when compared with certain other sectors of the taxpaying community. These submissions noted that the Tax Office does not generally exempt taxpayers from audit activity merely because a disputed deduction is less than $1 million. They noted that a de minimus exemption of this nature did not operate during the Tax Office's audit activity on mass marketed tax effective investments or on employee benefit arrangements.
4.26 A third set of submissions asserted that partners in professional firms as at June 2005 have effectively been discriminated against, when compared with partners who retired prior to that date or with partners who have joined a professional firm after that date. These submissions asserted that retired pre-June 2005 partners have enjoyed the tax benefits associated with the original Phillips mark-ups and were not generally affected by the Commissioner's new approach to service entities (unless they belong to a firm being retrospectively audited). These submissions further asserted that new (that is, post-June 2005) partners were able to structure their involvement in the partnership in the light of the Commissioner's announced approach. However, taxpayers who were partners in firms as at June 2005 face the costs of having to review and, if necessary, unwind structures associated with their involvement in the firm, a process that could entail numerous costs, including additional tax costs, depending on the method of unwinding that is chosen. These submissions also noted that the Commissioner's final published guidance on service entity arrangements does not deal with any restructuring issues.
4.27 Submissions have also stated that, in audits on service arrangements, the Tax Office is asserting that it is entitled to apply double taxation. This double taxation is said to arise because the Tax Office is asserting that the entity which has paid the fee is to be denied an income tax deduction for that fee and also that the same fee will be still be assessable as income in the hands of the service entity (or of the beneficiaries of that entity).
4.28 These submissions stated that the Tax Office claims that there is no specific power in the ITAA 1936 or elsewhere for it to make a compensating tax adjustment in these circumstances so as to reduce the tax on the fee income that has been paid by the beneficiaries of the service entity. These submissions however noted that the Tax Office accepts that if the service entity arrangement is struck down by the anti-avoidance provision (Part IVA) it does have the specific power to make such compensating adjustments.
4.29 Submissions to this review stated that by taking the stance that it only has the power to make compensating adjustments where Part IVA applies the Tax Office is effectively forcing taxpayers who wish to settle a service entity dispute to admit that the arrangement is struck down by Part IVA even where the circumstances may not warrant such a conclusion. These submissions asserted that the Tax Office should not be seeking to exert pressure on such taxpayers by relying on an ability to levy double tax in this situation. Instead the Tax Office should be seeking to penalise such taxpayers, where appropriate, only in accordance with either the administrative penalty regime or the regime that applies for tax prosecutions.
Taxpayers' ability to challenge Tax Office view on service entities
4.30 One set of submissions has also noted that the Tax Office has to date confined its auditing of service entity arrangements to those which exist in legal and accounting firms. By doing so, it is claimed, the Tax Office has effectively prevented any challenge to the view which it has adopted on service arrangements. This is because legal and accounting firms are unwilling to challenge the Tax Office's position because the nature of their business involves representing other taxpayers in dealings with the Tax Office and this business would be seriously jeopardised if the firm was itself in dispute with the Tax Office.
4.31 Submissions have also asserted that the Tax Office has effectively minimised the prospect of challenges to its view on service entity arrangements through its process of auditing arrangements for years of income that ended up to three to four years previously. These submissions noted that, where audits are conducted over such lengthy periods, the amount of tax payable will usually include both a penalty and a significant amount of interest. As a result, the final tax payable as a result of the audit will be much greater than just the additional tax arising from the audit itself. If a taxpayer challenges the Commissioner in respect of the audit, but is unsuccessful, they will have to pay this total tax amount. These submissions asserted that the prospect of paying a tax bill of this size at the end of such a challenge is sufficient, in many cases, to deter taxpayers from launching any such challenge.
4.32 Submissions have raised a number of comments and concerns under this broad heading.
4.33 A number of positive comments were made in submissions that the consultation processes on the ruling and booklet had been beneficial and had been conducted by the Tax Office in a professional manner.
4.34 The concerns that were raised in submissions about these consultation processes were as follows.
4.35 Firstly, a number of submissions stated that the consultation processes did not occur until late in the drafting process.
4.36 Second, submissions asserted that the parties that were involved in these processes did not represent all industries which have service arrangements.
4.37 Third, submissions asserted that the consultation processes on the ruling and booklet involving parties external to the Tax Office took a total time period of around two years which was too long.
4.38 Fourth, submissions asserted that key Tax Office decision makers were not engaged early in these consultation processes.
4.39 Fifth, submissions asserted that the Tax Office took a 'negotiation' style approach during these consultation processes which was inappropriate, given that the Tax Office should have been endeavouring to reach an objective view of how the relevant law should be applied.
4.40 Sixth, submissions asserted that these consultations should have been conducted in a completely open and transparent way from the time the Tax Office first became aware of the relevant issues.
4.41 Seventh, submissions asserted that certain accounting and legal firms that were involved in the confidential consultations which the Tax Office employed for the ruling and booklet gained knowledge of the Tax Office's proposed new approach to service entities earlier than other affected parties. The firms that were privy to this consultation were therefore able to adjust their tax affairs between 2002 and 2005 so that they would not be subject to retrospective audit action. Submissions claimed that this opportunity was not available to other parties that were not involved in these confidential consultations.
4.42 Finally, some stakeholders asserted that during these consultation processes they were led to believe that the Tax Office agreed with certain contentions (and that as a result the Tax Office would change the ruling or booklet to reflect this agreement) when in fact the Tax Office had not accepted the relevant contentions.
Manner in which the Tax Office has communicated its approach to service entity arrangements
4.43 Submissions have raised a number of concerns about the manner in which the Tax Office has sought to communicate its approach to service entity arrangements.
4.44 The principal concern raised in submissions to this review on the Tax Office's communication processes for service entities was that the Tax Office did not express it views on these arrangements in any formal detailed consolidated statement or set of statements until mid-2005.
4.45 A second concern was that the Tax Office's communication processes on service entity arrangements were, as a result of the confidential consultation processes it employed, carried out secretly and selectively for at least a one year period, if not longer.
4.46 Other communication concerns related to the content of the final service entities ruling and booklet. These concerns that were administrative in nature (and which are therefore matters which can be the subject of review and comment by the Inspector-General) were:
- whether the Tax Office's views as expressed in these two documents had been developed on an objective basis;
- whether these documents were needed at all;
- whether these documents were sufficiently complete and clear;
- whether the documentation requirements referred to in the booklet were too impractical and onerous; and
- whether taxpayers would be protected against retrospective taxation in the future if they followed these documents.
4.47 A number of other major concerns of an administrative nature raised in submissions which related to the content of the ruling and booklet on service entities referred specifically to the content of the draft service entity booklet. These concerns were:
- that the safe harbour mark-up rates in the draft booklet were unrealistically low and would lead to professional firms abandoning service entity arrangements;
- that no such safe harbour mark-up rates were given for cases where it was appropriate to apply a 'cost plus' methodology to determine a commercially realistic service fee; and
- that the draft booklet required all taxpayers (including small business taxpayers) to undergo a detailed benchmarking exercise to justify the size of their service entity fees that was in some respects more onerous than the benchmarking work which the Tax Office requires of multinational companies in a transfer pricing context.
The Inspector-General of Taxation notes that these major concerns have all been substantially addressed by the terms of final ruling and booklet.
4.48 Other communication-related concerns raised in submissions to this review dealt with the manner in which the Tax Office had communicated its proposed audit approaches to service entity arrangements both before the issue of the draft booklet and for the period between the date of issue of the draft booklet and the date of issue of the final booklet.
4.49 One submission asserted that the Tax Office never issued any Taxpayer Alert to highlight its concerns with service entities and should have done so at least by the time when the Commissioner first raised compliance concerns with these entities in his 2001 Annual Report.
4.50 Other submissions stated that the Tax Office failed to properly communicate its audit approaches to service entities for the period between the date of issue of the draft and final service entity booklet by:
- failing to communicate the addition of the third profits-related criterion for prior year audits at an appropriate time; and
- failing to make it clear that the 12-month period of grace to allow taxpayers to restructure their service entity arrangements referred to in the draft booklet would not end 12 months from the date of issue of that booklet but 12 months from the date of issue of the final booklet.
4.51 Submissions asserted that the failure of the Tax Office to properly communicate its views on, or approaches to, service entities in all the areas referred to above has caused unnecessary angst, uncertainty and, in some cases, unnecessary additional costs to taxpayers with service entities. They urged that the Tax Office should review its practices and procedures so that the speed, clarity, openness, impartiality, efficiency and effectiveness of the Tax Office's communication processes with taxpayers on complex matters such as service entities are all significantly improved.
19 TR 2006/2 at paragraph 6.
20 Section 226V of the ITAA 1936 for years of income prior to 2000/01.