6.1 This chapter deals with the Inspector-General's findings in relation to the Tax Office's legal and compliance approaches to service entity arrangements.
Issue of whether the Tax Office used the rulings and Tax Office advice process to alter the law on service entities
6.2 The history of the Tax Office's approach to service entity arrangements indicates that from 1978 (being the year of issue of IT 276) to at least the early 1990s (when the Tax Office issued two advices on these arrangements to a major accounting firm) the Tax Office accepted the following two statements:
- that deductions for fees paid by professional firms to service entities were, in accordance with Phillips case, were allowable for tax purposes if they were realistic and not grossly in excess of commercial rates; and
- that these deductions would be allowed if they were set using a 50 per cent mark-up on direct salary costs and a 15 per cent mark-up on other expenses.
6.3 The Inspector-General considers that the first of these statements is a statement of the law on service entity arrangements, while the second is a statement of how the law on service entity arrangements will be applied by the Commissioner, in the sense of how the deductible amount of a service fee will be calculated.
6.4 By the time the Tax Office issued its draft ruling and booklet on service entities in 2005, the Tax Office did not accept either of the above statements.
6.5 By this time, the Tax Office considered that a correct summary of the law on service entities was as follows:
- Deductions for fees paid by professional firms to service entities were allowable for tax purposes only if they were commercially realistic in the sense that they would be the same as the amounts which a party that was not related to the service entity would pay for the property or services provided.27
6.6 It considered that a correct statement of how to calculate the deductible amount of a service fee was as follows:
- Deductions would be allowed if service entity fees for professional firms were set with reference to comparable market rates and involved net mark-ups of no more than 3 ½ per cent (for the provision of permanent staff) and 5 per cent (for the provision of temporary staff and most other expense payments).28
6.7 These new 'draft' statements reflected a belief within the Tax Office that service entity fees were only deductible if their amount matched an arm's length price that would be paid to a service provider that was not related to the relevant professional firm. This arm's length pricing was to be calculated using the same kinds of economic methodologies that were used to calculate the level of arm's length pricing within a multinational corporate group for the purposes of the Australian Taxation Office's rules on cross-border profit shifting.
6.8 Based on the fieldwork for this review, the Inspector-General considers that the Tax Office's view of the law on service entities set out in TR 2005/D5 and its view on how to determine the level of deductible service fees, as set out in the booklet which accompanied TR 2005/D5, although labelled as 'draft' views of the Tax Office, were both actually adopted in practice by the Tax Office from at least March 2002 at least with respect to large accounting firms. This was the date when the Tax Office decided to engage an economist to determine a commercially realistic price for the service fees being paid by the two major accounting firms that were being audited between 1999 and 2003 or 2004.
6.9 By April 2006, when the Tax Office finalised its ruling and booklet on service entity arrangements, the Tax Office had changed its first summary statement of the law on service entities back to that which it had adopted from 1978 to the early 1990s that is, it stated that service fees would be deductible provided they were 'realistic and not grossly excessive'.
6.10 At this time the Tax Office also changed its statement on how to determine the amount of service fees involving labour-hire services that would be deductible.
6.11 This statement sets out the current circumstances in which deductions for service entity fees will either be at a low risk of audit or accepted. Service fees will be at a low risk of audit if the fees do not exceed 30 per cent of the combined profits of the service entity and either:
- labour costs are marked up by 30 per cent (with operating costs being at least 18 per cent of those labour costs) and other expenses are marked up by 10 per cent; or
- the service entity derives a net mark-up not exceeding more than 10 per cent of the direct and indirect costs associated with the on-hiring of staff or the payment of other expenses.
Service fees will be accepted as a deduction if the fees are set by reference to comparable market rates and involve net mark-ups of no more than 3 ½ per cent (for the provision of permanent staff) and 5 per cent (for the provision of temporary staff and most other expense payments) (although higher commercial benchmark rates may be acceptable if appropriate evidence is provided).
6.12 The above comments indicate that the Tax Office's view of the law on service entities, as stated in its final 2006 ruling and booklet, is essentially the same view of the law which it had on these arrangements in 1978. This view was that deductions for service entity fees would be allowable if they were realistic and not grossly in excess of commercial rates. This being the case, the Inspector-General does not consider that the final ruling and booklet on service entity arrangements evidences any change in the Tax Office's view of the law on these arrangements from the view which the Tax Office expressed on these arrangements in IT 276 in 1978.
6.13 However, the above comments do indicate that the Tax Office did in practice adopt a new view of the law on service entities between the dates of March 2002 and April 2006 and that this new view of the law was embodied in the draft version of the service entities ruling that was issued in May 2005.
6.14 The Inspector-General considers that the above comments also indicate that:
- between March 2002 and April 2006, the Tax Office was adopting a view on how to calculate the amount of service fee that would be deductible that was different from that which it had set out in previous public and private documents (such as its assessing manual and in earlier private rulings). This new view was made public in TR 2005/D5 and its accompanying draft booklet; and
- when it issued its final public ruling and booklet on service entities in April 2006, the Tax Office adopted another view of how to calculate these service fees. This new view was different to both the view on the pricing of fees which it had expressed in its draft ruling and booklet, and to its view on the pricing of these fees which it had expressed in its previous assessing manual and other documents.
6.15 These comments lead to the following key finding.
Key finding 6.1
The final ruling and booklet on service entity arrangements does not evidence any change in the Tax Office's view of the law on these arrangements from the view which it expressed on these arrangements in IT 276 in 1978.
However, the Tax Office did in practice adopt a new view of the tax law on service entities between the dates of March 2002 and April 2006.
When it issued its final public ruling and booklet on service entities in April 2006, the Tax Office adopted a view of how to calculate service entity fees which was different to all previous views it had expressed on the pricing of these fees.
Tax Office comments on whether it has altered its view of the law on service entity arrangements or how that law is to be applied
6.16 Throughout this review (and also the period of development of the final ruling and booklet on service entity arrangements) the Tax Office has denied that either it has ever altered its view of the law on service entity arrangements or how that law is being applied. Its reasons for these views are set out below.
6.17 Firstly, the Tax Office states that it has not altered its view of the law on service entities in TR 2006/2. It states that TR 2006/2 specifically confirms that it 'supplements' rather than replaces IT 276 and provides further guidance on service entity arrangements.29 It also points to various statements it has made during the life of the development of the ruling and booklet where it stated that it was not seeking to re-open or challenge the decision in the Phillips case.30
6.18 As discussed above, the Inspector-General agrees that the Tax Office's view of the law on service entity arrangements as stated in the final version of TR 2006/2 is essentially the same as that in Phillips case and IT 276. However, as also discussed above, the Inspector-General considers that the Tax Office did in practice change its view of the law in this area for the period between at least March 2002 and April 2006.
6.19 Secondly, the Tax Office considers that it has not changed its view on how the amount of deductible service fees is to be determined. This is mainly because neither the Tax Office itself nor any court has ever made a definitive statement on how this is to be done. In support of this argument it makes the following assertions.
6.20 Firstly, it asserts that Phillips case 'is not authority for the proposition that expenditure made under a service arrangement and calculated using the particular mark-ups in that case will always be deductible under section 8-1 of the ITAA 1997'31 and that that this statement applies to years of income commencing prior to the date of issue of TR 2006/2 and its accompanying booklet;32
6.21 Secondly, it asserts that the statements made in its 1985 trust assessing manual concerning the acceptability of 50 per cent and 15 per cent mark-ups do not amount to statements of Tax Office practice.
6.22 One reason for this, according to the Tax Office, is that its assessing manuals operated as risk assessment guidelines for assessment purposes rather than statements of the law itself, or even of the application of the law to particular circumstances.33
6.23 A second reason is that, according to the Tax Office, the trusts assessing manual contained other guidelines which indicated that any particular mark-ups used had to be consistent with ordinary business dealings and not be demonstrably out of line with the commercial value of the services rendered.
6.24 The Tax Office asserts that a third reason why its assessing manuals do not amount to a statement of Tax Office practice is that the statements in these manuals did not bind Tax Office staff on an Australia-wide basis. These statements, according to the Tax Office, represented only the views of particular branch offices of the Tax Office during a time when those branch offices could formulate their own views of the practical application of the tax law to taxpayers in their jurisdiction.
6.25 A fourth reason is that in 1994 the Tax Office issued TD 94/45 and an addendum to TR 92/20, both of which indicate that taxpayers should not rely on Tax Office assessing manuals as evidence of the Tax Office's interpretation, policy or practice.
6.26 The Tax Office's alternative argument is that, if it has changed its view on the way in which service fees are to be calculated, this changed view has been made known to the community from at least 2001 onwards (and arguably from the early 1990s) via numerous statements in various documents (such as annual reports, Commissioner's speeches and liaison group minutes).
6.27 In examining the above assertions by the Commissioner it is important to recognise that since both the decision in Phillips case and the date of the trust assessing manual Australia has adopted a self assessment system for income tax.
6.28 From 1986, this self assessment system meant that taxpayers, rather than the Tax Office, bore the responsibility of interpreting the tax law and applying it to their circumstances in order to self assess the amount of tax they had to pay. Under the new system, the Tax Office became obliged to provide taxpayers with sufficient information and support to ensure that taxpayers could correctly interpret and apply tax laws.
6.29 From 1986 until the dates of issue of draft versions of TR 2006/2 and its accompanying booklet the only official Tax Office publications which provided guidance to taxpayers on how to calculate their service entity fees were IT 276 and the Tax Office's 1985 assessing manual. The only court case on this issue was Phillips case. In the absence of any other material the Inspector-General believes that in a self assessment environment taxpayers (including those who provide tax advice for a living) should have been be entitled to rely on this material and this material only in setting the levels of deductible service entity fees for any period up to at least the date of issue of the draft version of TR 2006/2 and its accompanying booklet in May/June 2005. When determining the effect of taxpayers reliance on the draft guidance for the period between May 2005 and April 2006 the Tax Office should have also taken into account the fact that this guidance was clearly labelled as being of a 'draft' nature only.
6.30 The Inspector-General considers that the Tax Office should not expect taxpayers to be either aware of or bound by any comments made on how the tax law applies to service entities in documents such as speeches (whether by the Commissioner or by other tax officers), liaison group minutes, or annual reports. In a self assessment environment neither taxpayers nor their advisers perceive that these kinds of documents have a role in providing definitive guidance on the Tax Office's view of the application of any particular tax law. This is because these kinds of documents are prepared for other, quite different purposes. In a self assessment environment, taxpayers and their advisers rely for guidance on the Tax Office's view of an issue only on publications such as rulings, fact sheets and other materials which are expressly prepared by the Tax Office for the purpose of providing such guidance either to its own staff or to taxpayers generally.
6.31 Furthermore, the Inspector-General considers that it is unrealistic for the Tax Office to expect taxpayers and their advisers to have been aware of these other documents. A number of these documents were either not publicly available at all (as in the case of the four speeches by tax officers that were made to TIA conventions) or were only made publicly available some time after they had been originally prepared (as in the case of liaison group minutes).
6.32 The Inspector-General also notes that the Tax Office's assertions that it has not changed its view on how the law on service entities will be applied are incompatible with the lengthy confidential consultation processes which it engaged in prior to the issue of TR 2006/2 and its accompanying booklet to the public.
6.33 Furthermore, the Inspector-General notes that, as discussed in Chapter 3, there was a delay of seven years between the time when the Tax Office first identified that legal and accounting firms may not be correctly applying the laws on service entities and the date when the Tax Office settled and issued detailed guidance on how those laws should be applied.
6.34 The Inspector-General considers that the retrospective application of detailed Tax Office guidance is generally undesirable, particularly in a self assessment system. However, it is particularly inappropriate where, as in this case, it has taken the Tax Office seven years to issue that detailed guidance and throughout this period it was aware that the absence of this guidance was causing compliance problems. The Inspector-General believes that in such circumstances the Tax Office should not apply this guidance retrospectively.
6.35 As discussed in Chapter 3, the Inspector-General believes that the Tax Office should generally take no more than two years to issue detailed guidance on how particular tax laws are to be applied in cases where he becomes aware that the absence of this guidance is causing compliance problems and the form of that guidance consists of a public ruling accompanied by detailed practical guidance which contains commercial benchmark rates for a number of industries. The Inspector-General also believes that there should be an absolute time limit on the issue of any such guidance which is to take retrospective effect of no more than two years. A two year upper limit of this nature would be consistent with the maximum two year period which applies whenever the Tax Office is seeking to correct the amount of tax that has been paid by taxpayers in previous years under the current rules for amending assessments for individuals and many small businesses.
6.36 In 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 trust assessing manual, rather than any of the methods flagged either in the draft or final version of the service entity ruling and booklet.
6.37 The Inspector-General notes that, as at the date of this report, there appear to be a number of audits being conducted by the Tax Office on service arrangements for periods prior to April 2007 where this appears to be either the only matter or at least the principal matter at issue.
6.38 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 (and therefore are in breach of the law as originally stated in Phillips case), 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.
6.39 The above view would also be consistent with the way in which the Tax Office applies other changes it makes to how a tax law is to be applied, in the sense of how the quantum of a deduction is to be calculated.
6.40 One common example of a change which the Commissioner makes in the quantum of a deduction is the changes he makes to the amount of capital allowances that will be deductible where there has been a re-assessment of the effective life of the relevant capital assets. These changes are only ever applied prospectively by the Tax Office.
6.41 When the Commissioner re-assesses the effective life of a particular capital asset he makes a decision as to what is an acceptable commercial rate of write-off for that asset. This process involves a commercial assessment which is made in the light of various factors, including commercial conditions prevailing at the relevant time.
6.42 A change made by the Tax Office in the commercial rate of tax write off for a capital asset is similar to the change which the Tax Office has made in TR 2006/2 and its accompanying booklet to the amounts of service entity fees that will be considered to be commercially realistic (and therefore deductible). The Inspector-General believes that it is appropriate for both these kinds of changes to be applied only prospectively in a self assessment environment.
6.43 The above comments lead to the following key findings and recommendation:
Key finding 6.2
From 1986 until the dates of issue of draft versions of TR 2006/2 and its accompanying booklet the only official Tax Office publications which provided guidance to taxpayers on how to calculate their service entity fees were IT 276 and the Tax Office's 1985 assessing manual. The only court case on this issue was Phillips case.
In the absence of any other material the Inspector-General believes that in a self assessment environment taxpayers (including those who provide tax advice for a living) should have been be entitled to rely on this material and this material only in setting the levels of deductible service entity fees for any period up to at least the date of issue of the draft version of TR 2006/2 and its accompanying booklet in May/June 2005.
When determining the effect of taxpayers' reliance on its draft guidance for the period between May 2005 and April 2006 the Tax Office should also take into account the fact that this published guidance was clearly labelled as being of a 'draft' nature only.
Key finding 6.3
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 trust assessing manual.
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 audit practices as regards service entities
6.44 The Tax Office has advised the Inspector-General that the production of the final ruling and booklet is its principal strategy for addressing the compliance risks associated with service entity arrangements.
6.45 The Tax Office is expecting that the detailed guidance it has provided on service entity arrangements will result in accounting and legal firms ensuring that their own service entity arrangements meet Tax Office guidelines for the future. It should also assist with similar compliance being achieved by those firms' clients. The Tax Office has advised that this 'rulings based' approach to achieving compliance already appears to have had the result of moderating taxpayer behaviour with respect to service entities.
6.46 While the Tax Office's principal compliance activity in relation to service entities has been the production of the ruling and booklet it has, as indicated in the previous chapter and in timeline in Appendix 5, either completed or is currently conducting a small number of audits on the service entity arrangements of legal and accounting firms for periods prior to the date of release of TR 2006/2.
6.47 The Inspector-General has found, from his fieldwork on these audits, that these audits were largely carried out in accordance with internal Tax Office requirements in existence at the relevant time, and other legal and administrative guidelines. This was particularly the case for audits carried out by the Large Business area of the Tax Office. However, the following five areas of Tax Office activity or behaviour associated with these audits give rise to tax administration concerns:
- the criteria used by the Tax Office to select service entity cases for prior year audits;
- the practices adopted by the Tax Office in conducting service entity audits for small to medium size legal and accounting firms (SMEs);
- the Tax Office's conduct in cases involving prior specific taxpayer advice;
- the Tax Office's assertions that it has not changed any prior general administrative practice practices as regards service entities; and
- the Tax Office's requirements of taxpayers when setting the final level of tax payable as a result of a service entity audit.
6.48 Each of these five areas of concern in the Tax Office's audit practices for service entity arrangements is discussed in detail below.
Current Tax Office criteria for selecting prior year audit cases
6.49 The previous chapter indicates that the Tax Office is currently conducting prior year audits of service entity arrangements where all the following three conditions are 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.
6.50 In addition it is also looking at cases where there are serious questions as to whether the services were in fact provided by the service entity.
6.51 The Tax Office has stated that it established the $1 million and 50 per cent of gross income conditions to limit the number of potential prior year audit cases to a maximum of 10 per cent of legal and accounting firms.34
6.52 As noted in the previous chapter, submissions have asserted that these conditions are discriminatory in a number of respects. The Inspector-General agrees with most of these assertions. He also considers that these criteria apply retrospective conditions to service entity arrangements and fail to adequately target potential cases of fraudulent, non-genuine or grossly excessive service entity arrangements.
6.53 Although only a small number of taxpayers may be affected by these criteria, their existence, especially when coupled with the existence of similar criteria in other areas of current Tax Office audit activity, undermine community confidence in the extent to which the Tax Office is administering the tax system on an impartial, non-discriminatory and effective basis.
6.54 The first of these conditions eliminates from Tax Office audit scrutiny all prior year service entity arrangements where the relevant fee does not exceed a certain amount (other than in cases where there are serious questions as to whether the services were in fact provided). In effect this largely eliminates from prior year scrutiny professional firms with a turnover of less than $1 million and, depending on the taxpayer's circumstances, a number of taxpayers with turnovers of more than that amount.35
6.55 Anecdotal evidence suggests that serious compliance issues with service entities in these prior years may be more prevalent amongst taxpayers with less than $1 million in turnover. The Tax Office has advised the Inspector-General during the course of this review that this anecdotal evidence does not accord with the Tax Office's experiences. However, the Inspector-General notes that this Tax Office comment does not appear to be based on any significant audit activity that was conducted on these entities.
6.56 The first criterion, in the Inspector-General's view, is also discriminatory in that accountants, lawyers and others who do not meet this $1 million criterion for retrospective audit activity but who have conducted non-genuine service entity arrangements will be given preferential tax treatment for these activities. Retrospective audits for most other taxpayers (including large groups of taxpayers such as Mass Marketed Tax Effective Investment (MMTEI) and Employee Benefit Arrangement (EBA) taxpayers) have generally embraced all relevant taxpayers. These audits have not excluded taxpayers merely because their relevant activities were small.
6.57 The second and third conditions for selection as a high risk service entity audit case introduce two requirements for service entity arrangements in prior years which were not mentioned in any Tax Office guidance material on service entities that was issued prior to the draft versions of TR 2006/2 and its accompanying booklet.
6.58 The third condition for selection as a high risk prior year audit case — that the profits of the service entity exceed 50 per cent of the combined profits of both the service entity and professional firm — is also at odds with the much smaller 30 per cent profits cap which the Tax Office intends to apply when selecting service entity arrangements for audit after 30 April 2007.
6.59 The Tax Office has advised the Inspector-General that the reason for the different rates is because the 50 per cent test was applied for the purposes of case selection during a period when the Tax Office would only be auditing the highest risk cases. The 30 per cent test is for a different purpose and puts a cap on a taxpayer's ability to rely on the indicative rates approach.
6.60 The Inspector-General believes that the Tax Office should have developed far more refined and less discriminatory conditions for identifying cases of fraudulent, grossly excessive and non-genuine service entity arrangements for prior years. He considers that the Tax Office would have been able to do so quite easily, especially given the degree of information it collected on these types of arrangements over the 10 years prior to TR 2006/2 via its two surveys of accounting and legal firms and the audits it conducted on two major accounting firms.
6.61 The Inspector-General considers that a more refined and properly targeted set of conditions would have included criteria such as:
- the amount of the service fees (without setting any minimum level of fees which were to be excluded from consideration);
- the relative proportion those fees bore to the firm's total gross income (without setting any particular figure for what proportion would be acceptable or unacceptable);
- the level of the firm's profits versus those of its service entity (again without setting any figure on what level of profits in the service entity would be acceptable or unacceptable);
- the prior compliance history of the principals in the relevant business;
- the identity of the legal lessee or owner of the firm's premises; and
- for firms which had responded to the Tax Office's 2003 survey questionnaire, data supplied in that survey, such as:
- the existence of any written service agreement;
- the nature of expenses subject to mark-up;
- the evidence used to justify the commercial reality of those mark-ups and resulting profit of the service entity; and
- whether the firms had marked up or re-charged all of the costs of the service entity (thereby indicating there might have been no employees who were engaged in the service entity's own business operations or no other expenses incurred by that entity in conducting its own business).
6.62 Furthermore, all these selection criteria should have been considered together in selecting audit cases. The audit selection process should not have involved, as it has to date, the overly simplistic approach of considering the first three of these criteria in isolation from all other factors.
6.63 During the course of this review, the Tax Office has commented that it is unsure of what aspects of unacceptable taxpayer history would be relevant for such a case selection process and has also indicated that there would be difficulties obtaining any such material at the case selection phase. These comments raise broader questions as to the degree to which the Tax Office actually considers that a taxpayers' prior compliance history is relevant for an audit case selection process and the extent to which tax officers are able to actually access such a history. Further investigation of these matters is outside the scope of this review but may be the subject of future review by the Inspector-General.
6.64 These comments lead to the following key finding.
Key finding 6.4
The criteria which the Tax Office has used to select prior year audits of service entities are discriminatory, apply retrospective conditions to service entity arrangements and fail to adequately target potential cases of non-genuine service entity arrangements.
Tax Office's practices in conducting prior year audits on SME service entities
6.65 As stated above, the three selection criteria which the Tax Office is currently using to identify service entity arrangements for prior year audits all focus on aspects of the amount of the relevant service fees rather than the nature of the service entity arrangement as a whole.
6.66 This focus on the amount of the fee has carried through to the manner in which the Tax Office has conducted all of its recent audits on service entity arrangements.
6.67 The application of these criteria — in particular the $1 million criterion — has meant that the Tax Office is not currently conducting prior year audits of accounting and legal firms whose service fees are less than $1 million, except for cases where it obtains evidence that no service entity arrangements actually exist.
6.68 The application of these three current selection criteria has also meant that the Tax Office is not currently conducting any further audits on large accounting and legal firms beyond the two it commenced in 1999.
6.69 The Tax Office's current prior year audit activity is therefore focussed almost exclusively on small to medium size accounting and legal enterprises (SMEs).
6.70 The two audits of major accounting firms which were started by the Tax Office in 1999 and completed in 2003 and 2004 were conducted by the Large Business (LB) area of the Tax Office. This area is responsible for all taxpayers with a turnover of over $100 million. In both these audits, the Tax Office's focus was on gathering evidence not only on the amount of the fee but on all the surrounding circumstances. Extensive evidence gathering was a feature of these audits, with the Tax Office gathering as part of that process a detailed understanding of the nature of the service entity's operations, including relevant documentation (such as copies of all major contracts entered into by the service entity, including leases of equipment, employment contracts and the service agreement itself, details of all personnel who were involved in the service entity's operations and the extent to which their salaries were subject to mark-ups). The extent of this evidence gathering can be gauged from the fact that in one audit the Tax Office established an office inside the premises of the relevant firm being audited.
6.71 For audits of service entity arrangements conducted by SMEs, most of which were commenced after September 2004, the extent of the Tax Office's evidence gathering at the initial stages has been limited to obtaining material relating to the size of the service fee. This material consists of copies of the financial statements of the service entity and relevant professional firm together with a copy of the relevant service agreement (if one exists). Copies of relevant leases, employment contracts, details of the personnel actually involved in the service entity's operations and other documents going to the genuineness of the service entity arrangements have not been sought by the Tax Office at this initial stage of the audit. As a result, the Tax Office has not during this phase of the audit gained an understanding of the extent to which the service arrangements were genuine that is, properly implemented.
6.72 The Tax Office has then, based on this limited evidence, proceeded to settle an acceptable level of service fee with a number of these taxpayers being audited. These settlements have been based on the levels of service fees the Tax Office obtained in their settlements with the two major accounting firms where far more evidence of the relevant service entity operations had been gathered.
6.73 For taxpayers who have not settled with the Tax Office at this stage, evidence relating to the genuineness of the service entity arrangement has only started to be gathered once the taxpayers have made it clear that they will not settle without a full audit being conducted. In some cases, however (such as where the taxpayers appear to be willing to settle) this evidence has not been gathered even, in one case, as late as 21 months into the relevant audit.
6.74 The Inspector-General has also obtained other evidence that, in its prior years audits of service entities, the Tax Office is unwilling to consider that there may be factors that are specific to a particular professional firm (such as a significant downturn in its business) which provided a reasonable explanation for the relevant service entity fee exceeding Tax Office benchmarks. In this kind of case, the firm may still be committed to paying fees to its service entity to cover overhead expenses that are surplus to the firm's actual needs.
6.75 In one case of this kind that was examined by the Inspector-General the taxpayer made a written submission to the Tax Office which detailed both the effect of a business downturn on its service fees and its overall behaviour in attempting to comply with the published ATO guidelines on service trusts. The Tax Office's response to this submission did not address any of the points raised by the taxpayer. Rather, the response stated that the submission did not establish grounds for the Tax Office to depart from its 'general guidelines'.
6.76 The manner in which the Tax Office has approached these audits strongly suggests that it is attempting, in its current prior year audits, to use the audit results it has obtained from the two large accounting firm audits as a simplistic 'one size' solution to all service entity arrangements, without adequately considering the individual circumstances of other arrangements. This kind of an audit approach is in breach of Taxpayers' Charter principles which require the Tax Office to take into account individual taxpayer's circumstances in its compliance activities.
6.77 The approach adopted by the Tax Office in prior year service entity audits also involves attempts to apply audit results reached with large and influential firms to much smaller firms.
6.78 A failure by the Tax Office to consider taxpayer's individual circumstances has been the subject of adverse comment in previous reviews of Tax Office behaviour which have been conducted both by the Inspector-General and by other review bodies such as Senate Committees. The Tax Office's justification for this kind of behaviour is that it has limited resources, that this approach leverages off previous work that the Tax Office has done in the area and that this approach is efficient from an administrative viewpoint. The Inspector-General notes that these kinds of justifications have more validity in cases where thousands of taxpayers may be subject to the relevant audit activity, as in the case of MMTEIs and EBA arrangements. However, they have far less validity in cases such as the subject of this report where only a relatively small number of taxpayers are involved (a maximum of 80 in this case).
6.79 The above comments lead to the following key finding and recommendation:
Key finding 6.5
The manner in which the Tax Office has approached the prior year audits it is conducting of the service entity arrangements of small to medium size accounting and legal firms strongly suggests that it is attempting to use the audit results it has obtained from the two large accounting firm audits as a simplistic 'one size' solution to all service entity arrangements, without adequately considering the individual circumstances of other arrangements. This kind of an audit approach is in breach of Taxpayers' Charter principles.
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.
Other Tax Office behaviours evidenced in service entity audits
6.80 The Inspector-General's fieldwork on service entity audits has produced other evidence of other Tax Office behaviour which is in breach of Taxpayers' Charter principles and/or other relevant legal guidelines.
6.81 This behaviour, which is discussed below, includes the Tax Office walking away from previous advices it has given, refusing to accept that it has changed its prior general administrative practice for service entities and effectively forcing taxpayers to admit that they have engaged in anti-avoidance behaviour in order that they are able to receive a total tax bill which is fair and reasonable in the circumstances.
6.82 Apart from the behaviour discussed below, all other Tax Office conduct in relation to these audits that was the subject of examination for this review appears to have been conducted in accordance with Taxpayers' Charter principles.
The Tax Office has 'walked away' from previous advices
6.83 Submissions assert that in audits it has conducted on service entity arrangements for periods prior to the issue of the service trust 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 their service entity.
6.84 The Inspector-General's fieldwork has confirmed that these assertions are correct. In at least two of the audits the Tax Office has conducted the relevant taxpayers have been in receipt of specific advice that 50 per cent/15 per cent mark-ups were acceptable for their service entity arrangements. The relevant advice was given in the early 1990s and took the form of what the Tax Office considers to be non-binding advice. When the firms were subsequently audited the Tax Office asserted that it was entitled to ignore this advice because it has been rescinded in a 1994 speech that was given to the TIA by a tax officer. This speech was however not provided at the time specifically to the relevant taxpayers and has never been made available by the Tax Office to the public. It was and is now only accessible to members of the TIA.
6.85 The Inspector-General considers that it is unacceptable, particularly in a self assessment environment, for the Tax Office to assert that it has rescinded specific taxpayer advice by comments made in a speech which it has neither provided to that taxpayer nor made publicly available. This is the case, even if the speech was given at a forum where members of the firm who received the relevant advice may have been attendees. In a self assessment system taxpayers should be entitled to rely on specific advices given to them by the Tax Office, unless they receive notice directly from the Tax Office that those advices are no longer considered to be correct. In the two cases under consideration, the earliest time when both taxpayers would have received such direct notice was during the relevant audits.
6.86 In the Inspector-General's view, this advice should have resulted in the Tax Office accepting that, for periods prior to when the relevant advice was formally rescinded, the taxpayers were entitled to apply 50/15 per cent mark-ups in setting the level of their service entity fees. If the relevant arrangements exhibited no other significant tax issues, these taxpayers should not then have been subject to any prior year tax adjustments (including penalties and interest).36
6.87 The above comments lead to the following key finding and subsidiary recommendation:
Key finding 6.6
The Tax Office has 'walked away' from previous advice it has given to specific taxpayers for use by their clients and themselves 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 their service entity.
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.
The Tax Office has changed a prior general administrative practice but has failed to take this into account in determining the amount of tax, penalties and interest payable
6.88 As stated in a previous chapter, a number of submissions assert that the final Tax Office view on service entities as stated in TR 2006/2 and the accompanying booklet represent a change in the Tax Office's general administrative practice on service arrangements. They assert that the Tax Office has incorrectly represented that there has been no such change so that legal and administrative rules (which require it to refrain from levying additional tax, penalties and interest in cases where it has changed such a practice) do not apply.
6.89 Earlier in this chapter the Inspector-General has stated that he believes that the Tax Office has not changed its view of the law on service entity arrangements as stated in its final ruling and booklet on service trusts from that which it held in 1978. However, the Tax Office has, in these documents, changed its view on how this view of the law will be applied to such arrangements (in the sense of how to calculate the amount of service fees). These documents incorporate guidelines and tests for calculating the amount of service fees that are new.
6.90 The Inspector-General believes that the change the Tax Office has made in 2006 from the view it has in 1978 on how to calculate service entity fees amounts to a change in a prior 'general administrative practice', despite assertions to the contrary by the Tax Office.
What is a prior Tax Office 'general administrative practice'?
6.91 In examining the issue of whether the Tax Office has changed a prior general administrative practice it is first necessary to reach a view on the meaning of this term. The following matters need to be considered in this respect.
6.92 Firstly, there is limited public material on the meaning of this term. The only public statements on this term have been those made in one court case, in an Explanatory Memorandum and (from March 2006) in two Tax Office practice statements and one Tax Office ruling.
6.93 Secondly, the term is capable of being interpreted either widely or narrowly.
6.94 The court case where the term 'general administrative practice' was considered is Prebble v F C of T (2002) 51 ATR 459. In this case, at page 470 Justice Cooper noted that, although there was some evidence of a general administrative practice of the Commissioner in the circumstances of the case that practice must still exist at the time a taxpayer makes a statement in a tax return for it to be a ground for the non-application of any penalty.
6.95 The term was discussed in the Explanatory Memorandum which accompanied Tax Laws Amendment (Improvements to Self Assessment) Bill (No. 2) 2005 (TLAB (No. 2) 2005). This bill introduced a new legislative regime for Tax Office rulings and also introduced changes in the extent to which reliance by a taxpayer on a Tax Office general administrative practice would protect that taxpayer from the imposition of interest (and also possibly of primary tax). All these changes took effect from 1 January 2006.
6.96 The comments in this Explanatory Memorandum on the meaning of the term 'general administrative practice' may strictly only have relevance after 1 January 2006. However, the term was used in the tax law prior to this date.
6.97 The Explanatory Memorandum makes the following points on the meaning of the term 'general administrative practice':37
- 'General administrative practice' will usually be established by the Tax Office having communicated consistently to a wide range of taxpayers on a particular issue.
- It will often be documented in a Tax Office practice statement, a Tax Office policy document or other precedential material (such as an ATO interpretive decision).
- Where a draft public ruling represents the Commissioner's only public statement on an issue, the draft ruling will usually represent the Commissioner's general administrative practice.
- A 'general administrative practice' is not established merely because there are several similar private rulings on a matter, although evidence of a significant number of uncontradicted private rulings on a matter over time will tend to support such a conclusion.
- A bare failure by the Commissioner to take some action within his power does not establish a general administrative practice, but a repeated failure by the Commissioner to exercise that power after the issue is drawn to the Commissioner's attention will tend to do so.
- Mere silence or failure to issue a public ruling on a matter does not constitute general administrative practice but it will be established where, following identification of an issue, ATO officers have accepted it as the basis on which taxpayers should treat the issue in a range of situations.
6.98 The only guidance which the Tax Office has issued on the meaning of the term 'general administrative practice' is contained in:
- two practice statements that were issued after 1 January 2006 during the course of this review. These are PS LA 2006/2 (which deals with penalties for false and misleading statements) and PS LA 2006/8 (which deals with the remission of interest); and
- a Tax Office ruling — TR 2006/10— which was also released after 1 January 2006 and during the course of this review. This ruling contains comments on the non-application of primary tax to arrangements entered into prior to a change in the Commissioner's general administrative practice. It only applies however where a change in practice has been made by the issue of a binding public ruling and not where that change has been made by other means.
6.99 None of these Tax Office statements contain a comprehensive statement of the meaning of the term 'general administrative practice'.
6.100 TR 2006/10 contains the most comprehensive commentary on this term. This ruling essentially repeats what is already set out in the Explanatory Memorandum to TLAB (No. 2) 2005. However, it appears to contain an additional statement which contradicts what is in the Explanatory Memorandum. As noted above, the Explanatory Memorandum states that:
A general administrative practice … will often be documented. … in other precedential material (such as an ATO Interpretative Decision).
6.101 However, TR 2006/10 states that:
... not all precedential material (such as ATO Interpretative Decisions (ATO IDs)) indicate a general administrative practice. An ATO ID will only be accepted by the Tax Office as representing general administrative practice where the view contained therein is supported by other evidence of a pattern of Tax Office treatment of the issue consistent with the view expressed in the ATO ID (for example, a significant number of private rulings on the same matter which reach the same conclusion).
6.102 Neither this ruling, nor either of the two practice statements referred to above, contains any practical examples to guide tax officers and taxpayers on the meaning and application of this important term.
6.103 The Inspector-General considers the lack of comprehensive public guidance on the meaning of the term 'general administrative practice', especially prior to 1 January 2006, has caused the Tax Office to adopt an overly narrow view of this term and its application in the context of service entity arrangements.
Tax Office grounds for asserting there has been no change in a general administrative practice on service entities
6.104 The evidence and grounds that the Tax Office relies on for asserting that it has not made any change in its prior general administrative practice for service entities are essentially the same grounds the Tax Office relies on for its assertions that it has not changed the manner in which it applying the law on service entities. These grounds differ from those discussed earlier in this chapter only in that they deal specifically with the term 'general administrative practice'. They are as follows.
6.105 Firstly, the Tax Office argues that it has not changed a prior general administrative practice for service entity arrangements because there was no such practice to change.
6.106 Secondly, it argues that, if there was a practice on service entities evidenced in documents such as the 1985 trust assessing manual, this practice was not a 'general' one because its assessing manual only gave specific guidance to particular Tax Office branch offices in respect of particular years of income.
6.107 The Tax Office's third argument is that the term 'administrative practice' does not embrace situations where, as in service entity arrangements, the Tax Office changes its view of how a deductible amount is to be calculated. This is because this issue involves a question of the application of the law rather than an administrative matter.
6.108 The Tax Office's fourth argument is that even if it did have a general administrative practice on service entities as set out in its trust assessing manual that practice was changed before the date of issue of TR 2006/2 and its accompanying booklet via a number of Tax Office statements in annual reports, liaison group minutes and Commissioner's speeches.
6.109 A final argument is that even if there was a general administrative practice still in existence by 2006 it was not appropriate to apply any change in this practice that was made by TR 2006/2 and its accompanying booklet prospectively because this practice was being exploited by professional firms in an egregious manner to avoid tax.
6.110 The Inspector-General considers that none of the above Tax Office assertions should be fully accepted. He considers that the method for calculating service entity fees set out in the 1985 trust assessing manual represents a practice which existed at that time. This practice was not contradicted in any public guidance document issued by the Tax Office until the time when the draft versions of the service entities ruling and booklet were issued in 2005. This practice was also both 'general' (as it was made known to the public) and 'administrative' in nature, given that it was the method which the Tax Office stated was an acceptable means for determining the amount of a service fee deduction.
6.111 There are also difficulties with the Tax Office's assertion that a change in its general administrative practice will have no impact if the Tax Office considers that the practice has been exploited by taxpayers to avoid tax. This is because the legal provisions dealing with the consequences of a change in a general administrative practice (which are discussed further below) do not contain any express proviso that taxpayers will not be protected from paying tax for previous years in cases where the Tax Office considers that a previous practice has been exploited. However, the Inspector-General notes that there is a view that an implied proviso to this effect can be read at least into the provision which provides taxpayers with protection against the payment of interest for previous years as this protection only applies where the taxpayer was 'reasonably relying in good faith' on the relevant practice.38 The Inspector-General also notes that paragraph 3.132 of the Explanatory Memorandum to TLAB (No. 2) 2005 appears to contain a statement that the Commissioner would not apply a new practice prospectively where tax avoidance is involved or the previous practice has been exploited in an unintended way.
6.112 The Inspector-General further notes that, even if the Tax Office is correct and the term 'general administrative practice' does not apply to a case where it changes its view of how the amount of a deduction is to be calculated (because this is not an 'administrative' matter but rather a matter of law), this term almost certainly embraces a situation where the Tax Office has changed the administrative parameters it uses for determining whether particular arrangements will be subject to audit. It is clear from the Tax Office's own comments that the parameters for audit which are set out in its 2006 final booklet on service entity arrangements have been changed from those which it set out in its trust assessing manual in 1985. This change of itself therefore amounts to a change in a general administrative practice by the Tax Office.
6.113 The Inspector-General's view that the Tax Office has changed a general administrative practice in respect of service arrangements is also supported by the discussion of the meaning of this term in the Explanatory Memorandum to TLAB 2005 (No. 2).
6.114 As noted above, this Explanatory Memorandum states that a 'general administrative practice' can be embodied in a Tax Office interpretive decision. It therefore clearly supports the Inspector-General's view that a Tax Office statement on the application of a tax law to a set of circumstances can amount to a general administrative practice.
6.115 This Explanatory Memorandum also states that a failure by the Commissioner to take some action within his power after an issue is brought to his attention will tend to establish a general administrative practice. In this regard, it could be argued that the Tax Office's failure to issue any form of detailed practical guidance on how to calculate service entity fees for three and a half years after his 2001 Annual Report amounts to evidence of a general administrative practice in respect of those fees at least for this three and a half year period.
6.116 The Inspector-General's view that the Tax Office has changed a general administrative practice in respect of service arrangements is also supported by:
- a survey covering 1,000 service entities which the Institute of Chartered Accountants (ICAA) conducted of its members after the release of the draft ruling and booklet but prior to the release of the final ruling and booklet;39
- the fact that the Tax Office felt it was necessary to make consultations held with NTLG members on the ruling and booklet prior to their public release confidential;
- the fact that the Tax Office suspended most of its audit activity on service entities for roughly the period between the date of issue of the draft and final versions of the ruling and booklet. The Inspector-General queries why such a suspension was considered necessary by the Tax Office if neither the draft or final ruling and booklet had or would change the Tax Office's previous administrative practice on service trusts;
- evidence which has been obtained by the Inspector-General which shows that:
- 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; and
- prior to 1999, a number of taxpayers with service entity arrangements had been subject to audit by the Tax Office either in respect of their overall tax affairs or in relation to their service entity arrangement specifically and had received either written confirmation, oral confirmation or acquiescence from the Tax Office that they were entitled to deduct fees paid to their service entity where those fees were calculated using mark-ups that were the same as, or close to, those used in the Phillips case; and
- every submission to this review which dealt with this issue (other than those made by the Tax Office).
6.117 The above comments lead to the following key finding.
Key finding 6.7
The Inspector-General believes that the change the Tax Office made in 2006 to the view it had in 1978 on how to calculate service entity fees, which incorporates new tests, amounts to a change in a prior 'general administrative practice', despite assertions to the contrary by the Tax Office.
Legal implications of a change in a prior general administrative practice
6.118 As stated previously, 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 TAA 195340 in all the service entity audits it has conducted. This section (and its predecessor) have, since the early 1990s, prevented the Tax Office from levying an administrative penalty on a taxpayer where they have made a return which agrees with the Tax Office's previous general administrative practice.
6.119 Such a change in practice would also mean that, from 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. Section 361-5 gives this protection where a taxpayer has relied on the relevant practice.
6.120 The Inspector-General notes that, while these legislative protections for penalties and interest are not worded in exactly the same way, they have a similar effect.
6.121 From 1 January 2006, such a change in practice will not of itself mean that the Tax Office is legally obliged to forego the payment of primary tax for years preceding the change. From this date, section 358-10 of the TAA 1953 allows the Tax Office not to pursue the payment of primary tax for previous years (and therefore also has the effect of providing legal protection for taxpayers against the payment of this tax), but only where the change has been made by a public ruling. The Inspector-General notes that section 358-10 was enacted following the RoSA review which was conducted by Treasury in 2004. This review recommended that the law should be amended so that where the Tax Office changes a longstanding practice to the detriment of taxpayers that change should take effect from a future date. This was so as to allow affected taxpayers reasonable time to become aware of, and act upon, the change.41 Section 358-10 legally allows the Commissioner to confine the future application of a changed Tax Office practice to situations where that change is made by the issue of a public ruling.
6.122 There is a view that, when enacted, section 358-10 was not extended to cases where the change is made by means of something other than a public ruling because the RoSA changes to the laws on rulings were not designed to proscribe every aspect of tax administration, including the circumstances in which the Tax Office will raise amended assessments. Under this view, principles of good administration (particularly the principle of fairness) , rather than any express provision in the law, should bring about the result that the Tax Office does not pursue the payment of primary tax in situations where it has changed a general administrative practice by means other than the issue of a public ruling.
6.123 The Tax Office considers that section 358-10 gives legislative effect to a policy which it has had in effect since 1992. This policy was that where the ATO had contributed to taxpayers adopting a certain practice in lodging their tax returns any ruling less favourable to taxpayers which directly overruled that practice would usually only have a future application.42
6.124 The administrative consequences which the current wording of section 358-10 have given rise to are illustrated when considering what effect the section has if, as a result of this review, the Tax Office accepts that it has changed its prior general administrative practice on service entity arrangements. In this case, under current Tax Office practice, it appears that section 358-10 has no application. This is despite the fact that a public ruling (TR 2006/2) has been issued after the date of effect of section 358-10 (being 1 January 2006) and that this ruling has been accompanied by appendices to the ruling and a guidance booklet which appear to give effect to a change in a general administrative practice.
6.125 The reasons for this are as follows.
6.126 Firstly, the Commissioner's change in practice on service entity arrangements has actually been set out in two sets of documents — that is, in both a ruling and a booklet. Only the former of these documents partly takes the form of a binding ruling. Section 358-10 only gives protection against primary tax for previous years for changes made by a public ruling. Therefore the changes in ATO practice that are only referred to in the booklet and which are the most significant changes in practice which have occurred — being the changes to how the level of deductible service entity fees should be calculated — will not attract the operation of section 358-10. Similarly, the changes in administrative practice which are referred to in the non-binding appendices section of the ruling will also not attract the operation of section 358-10. Despite these changes in practice, taxpayers will therefore not be legally protected under section 358-10 for the payment of primary tax for previous years.
6.127 Secondly, it is arguable that the Commissioner's change in practice on service entities has occurred prior to the issue of TR 2006/2 and its accompanying booklet. The Tax Office has asserted that this change may have occurred earlier than the release of TR 2006/2 date as an alternative argument as to why any change in general administrative practice should not affect current service entity audits which it is conducting. If this view of the Tax Office is correct, then section 358-10 again does not operate. This is because section 358-10 only gives protection against primary tax where the change has been made by a public ruling. It would therefore not operate in a case such as this where the change in administrative practice has been made prior to the issue of the relevant ruling and/or any accompanying non–binding material and the ruling and/or accompanying material then simply confirms this change.43
6.128 These comments lead to the following key finding.
Key finding 6.8
Taxpayers only have express legislative protection against the payment of primary tax for previous years where a change in a longstanding practice of the Tax Office has been made by a public ruling. There is no express protection where the change has been made by other means (such as the issue of non-binding Tax Office guidance) or where the change has been made prior to the issue of a public ruling and the ruling confirms the relevant change.
In contrast, the legislative protection which is given to taxpayers for the application of penalties and interest for prior years in cases where a longstanding practice is changed does not depend on whether the change has been made by a public ruling. In the case of interest, taxpayers need only have relied on the relevant longstanding practice, while in the case of penalties taxpayers need only have made a return which agrees with the relevant practice.
Extent to which the Tax Office has considered the issue of a change in administrative practice in service entity audits
6.129 The Tax Office's view that it has not changed a general administrative practice with respect to service entity arrangements has meant that it has not taken this change into account in levying any of the penalties, interest and primary tax it has imposed in prior year audits of service entity arrangements.
6.130 The Inspector-General's fieldwork on these audits has established that this issue has not been referred to in any of the Tax Office's internal paperwork prepared for these audits, including that prepared for the internal technical committee which reviews the amount of any penalty. This is despite the fact that taxpayers in these audits raised this issue as being a ground for the legal remission of penalties and as a ground for the administrative remission of both primary tax and interest (in accordance with TR 92/20).
6.131 The Inspector-General considers that the failure to take this matter into account in setting either the level of penalties or the amount of additional tax and interest payable amounts to a serious systemic issue which should be immediately addressed by the Tax Office.
6.132 These comments lead to the following key finding.
Key finding 6.9
The Tax Office's view that it has not changed a general administrative practice with respect to service entity arrangements has meant that it has not taken this change into account in levying any of the penalties, interest and primary tax it has imposed in prior year audits of service entity arrangements.
Tax Office administrative practices and guidelines on the meaning of the term 'general administrative practice' and its effect on the determination of penalties, interest and primary tax
6.133 The only internal reference material or processes which the Tax Office has for its staff when they are considering whether primary tax should not be collected because the taxpayer has relied on a prior general administrative practice of the Tax Office is contained in TR 2006/10 which was issued in final form in October 2006. However, this ruling only deals with the situation where a change in a previous Tax Office practice has been made by the release of a binding public ruling. It does not cover the situation where a change in practice is made by other means, such as by the issue of a non-binding Tax Office publication.
6.134 Until March 2006, the Tax Office also had no such internal reference material for its staff to refer to when considering whether a penalty should not be applied because there has been a change in a general administrative practice. This was despite the fact that this ground for the non-application of any penalty has been part of the law since the early 1990s. This situation has been remedied by the issue of PS LA 2006/2 which was issued during the course of this review.
6.135 Furthermore, until 1 August 2006, the Tax Office had no such reference material for its staff to refer to when considering whether a change in a general administrative practice would lead to a remission of interest. This situation has also been remedied during the course of this review by the issue of PS LA 2006/8. This practice statement deals with shortfall interest (being the interest that accrues for the period between when tax should originally have been paid and when the Tax Office issues an amended assessment to the taxpayer in respect of that tax). It covers the situation where this shortfall interest has arisen as a result of a taxpayer relying on a general administrative practice of the Tax Office either before or after 1 January 2006 and contains a number of statements on the meaning of the term 'general administrative practice'.
6.136 The practice statement states that where a taxpayer has followed a general administrative practice of the Tax Office in good faith prior to 1 January 2006, that practice is incorrect or misleading and the taxpayer makes a mistake as a result, any shortfall interest charge that applies in the period up to 21 days after the Commissioner notifies the correct position to the taxpayer will be remitted in full.44
6.137 The Inspector-General considers that the comments in PS LA 2006/2, PS LA 2006/8 and TR 2006/10 are a positive step in the right direction. However, he considers that more needs to be done to provide Tax Office staff with guidance on the meaning and application of the term 'general administrative practice' 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. In the case of TR 2006/10 the Tax Office's comments are also too limited in that they do not cover the situation where a change in a prior Tax Office practice is made but not by means of the issue of a binding ruling.
6.138 The Inspector-General considers that the lack of overall comprehensive guidance for Tax Office staff on the meaning of the term 'general administrative practice' and the effect that a change in such a practice will have on the remission of penalties, primary tax and interest needs to be urgently addressed.
6.139 The Inspector-General also notes that the Tax Office's interpretation of the term 'general administrative practice' and the circumstances in which such a practice will have changed were also major themes of his previous review of the Tax Office's practices for the remission of the general interest charge (GIC) for groups of taxpayers. Despite the concerns raised by the Inspector-General, the Tax Office has still not promulgated sufficient guidance to its own officers on the meaning and effect of this term.
6.140 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).
6.141 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.
6.142 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.
6.143 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.
6.144 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.
6.145 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.
6.146 The Inspector-General will consider this systemic issue further in the course of his final report on all three cases 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 made two recommendations in this review on this issue. 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 recommendation is Key Recommendation 6 which is set out below.
6.147 The above comments lead to the following key finding and key recommendation:
Key finding 6.10
The Tax Office has no specific internal reference material for its staff to refer to or processes to follow when considering whether additional tax should not be applied because the Tax Office has changed a general administrative practice and the relevant change has been made in a way which does not involve the issue of a binding public ruling.
Until October 2006, the Tax Office also had no such reference material or processes for its staff to refer in the case where a change in a general administrative practice was made by the issue of a public ruling. The guidance it has now issued on this matter only applies however for periods after 1 January 2006.
The Tax Office had no reference material or processes for its staff to refer to when considering whether a change in a general administrative practice would lead to the non-application of a penalty until March 2006. In the case of the remission of interest, there was no such material or processes until August 2006. The guidance it has now issued on both these matters applies for periods both before and after 1 January 2006.
The guidance which the Tax Office has issued on all of the above matters is too brief and does 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.
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.
6.148 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 is still assessable as income in the hands of the service entity (or by the beneficiaries of that entity).
6.149 These submissions state that the Tax Office claims that there is no specific power in the ITAA 1936 or elsewhere for the Tax Office to make a compensating tax adjustment in these circumstances (that is, to reduce tax on the fee income that has been paid by the beneficiaries of the service entity.) These submissions however note 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.
6.150 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 forcing taxpayers who wish to settle a service entity dispute to effectively admit that the arrangement is struck down by Part IVA even where the circumstances may not warrant such a conclusion. These submissions assert 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.
6.151 The Tax Office has responded to these assertions by stating that settlements will generally give recognition for taxes already paid by associates without making any findings or inferences about Part IVA. These comments do not address the assertions made in submissions that the Tax Office's practices force taxpayers to effectively rather than to actually admit that their arrangement is struck down by Part IVA.
6.152 The Inspector-General notes that the subject of compensating adjustments is not addressed in either the final ruling or booklet on service entities.
6.153 The Inspector-General considers that taxpayers should not be effectively forced to admit that Part IVA applies to their tax situation solely for the purposes of obtaining a compensatory adjustment which is otherwise fair. If the Tax Office believes that it cannot adequately address this issue through its current general administrative power then it should recommend to the Government that the relevant law should be changed so that any such effective admissions no longer become necessary.
6.154 The above comments lead to the following key finding:
Key finding 6.11
The subject of compensating adjustments is not addressed in either the final ruling or booklet on service entities. The Tax Office is, in practice, forcing taxpayers who wish to settle a service entity dispute to effectively admit that the arrangement is struck down by Part IVA even where the circumstances may not warrant such a conclusion.
27 Draft booklet at page 7.
28 Draft booklet at page 11.
29 TR 2006/2 at paragraph 2.
30 See, for example the comments made in the following speech: Commissioner of Taxation, Future Directions in Tax Administration (A Relationship of Mutual Dependency), 17 June 2003 available on the Tax Office's website at www.ato.gov.au.
31 See TR 2006/2 at paragraph 6.
32 TR 2006/2 at paragraph 17.
33 ATO Minute No IGT 10-ST-2006, dated 10 July 2006 at attachment B.
34 Australian Taxation Office, Draft guidance on service arrangements, Media Release Nat-2005/42 dated 29 June 2005.
35 One commentator has estimated that the $1 million test will generally be failed by any firm that has more than four partners.
36 This would be in accordance with:
- for periods prior to 1 January 2006: the administrative rules contained in TR 92/1, TR 97/16 and PS LA 2001/4 (especially paragraphs 73 and 74) and the legal rules contained in section 284-215 of the TAA 1953; and
- for periods after 1 January 2006: the above legal and administrative rules (other than TR 92/1 and TR 97/16 which have been withdrawn with effect from 5 April 2006), TR 2006/10 and sections 358-10 and 361-5 of the TAA 1953.
37 Commonwealth of Australia, Explanatory Memorandum to Tax Laws Amendment (Improvements to Self Assessment) Bill (No. 2) 2005 at paragraph 3.130 to 3.132.
38 See section 361-5 of the TAA 1953.
39 According to the ICAA the results of this survey indicated that 80 per cent of ATO audit activity up until very recent times resulted in no adjustment to service entity arrangements or no challenge to the service arrangement, that 83 per cent of members participating in the survey considered that TR 2005/D5 represented 'a high to extremely high' shift in attitude by the ATO towards service entities and that most if not all such members would find that their own or their clients' arrangements would not satisfy the requirements of the draft ruling and booklet.
40 Section 226V of the ITAA 1936 for years of income prior to 2000/01.
41 The Treasury, Report on Aspects of Income Tax Self Assessment, August 2004, Commonwealth of Australia recommendation 2.6 at page 13.
42 This policy was stated in paragraph 16 of TR 92/20.
43 The Commissioner has confirmed this interpretation of section 358-10 publicly at a tax administration forum held in April 2006.
44 PS LA 2006/8 at paragraph 107.