7.1 This chapter sets out the Inspector-General's findings in relation to the Tax Office's communication processes for service entity arrangements.
Absence of a comprehensive statement or set of statements of the Tax Office's view on service entity arrangements for the period from 1978 to 2005
7.2 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.
7.3 This review has confirmed that until mid 2005 the Tax Office's view of service entity arrangements could only be gleaned by referring to a number of different Tax Office statements. These statements included:
- a short non-binding tax ruling (IT 276);
- an assessing manual;
- speeches made by tax officers in 1994 and 1998;
- the Commissioner's 2001 Annual Report;
- a number of speeches made by the Commissioner since 2002;
- minutes of various liaison group meetings (such as the National Tax Liaison Group); and
- the Commissioner's Annual Compliance Program.
7.4 Three of these statements (being the three tax officer speeches in 1994 and 1998) were not made public by the Tax Office.
7.5 The issue and subsequent finalisation of the ruling and accompanying booklet on service entities has largely addressed this concern about the absence of a set of consolidated statements by the Tax Office on service entity arrangements.
7.6 These comments lead to the following key finding.
Key finding 7.1
The Tax Office did not express a complete view on service entity arrangements in any formal detailed consolidated statement or set of statements until mid 2005. A finalised, detailed and consolidated set of statements on these arrangements was issued in April 2006.
Should the Tax Office have issued a Taxpayer Alert on service entity arrangements prior to the issue of the draft ruling and booklet?
7.7 A number of submissions have suggested that the Tax Office, rather than referring to its concerns on service entity arrangements in the period from 2001 to 2005 via speeches, liaison group minutes and annual reports should have made those concerns known to taxpayers generally via the issue of a specific Taxpayer Alert on this topic. These submissions state that this alert should have been issued as soon as these concerns were known.
7.8 The Inspector-General's fieldwork for this review has confirmed that the Tax Office did consider the issue of such an alert as early as 2002. However, no such alert was issued. The Tax Office has advised the Inspector-General that preparation of such an alert was not considered a priority because the Tax Office already had a view on service arrangements (as set out in IT 276). Furthermore, the Tax Office has advised that it considers that such an alert would have served little or no purpose as the use of service arrangements was widespread and the Tax Office's concerns with non-commercial arrangements had already been well published.
7.9 These Tax Office comments ignore the fact that the communication mechanisms which the Tax Office used to make its concerns on service arrangements known to the community (that is, its annual report, speeches and liaison group minutes) are principally directed to an audience which consist of tax advisers or those with a professional interest in tax matters rather than taxpayers generally. Taxpayer Alerts, by contrast, are a communication mechanism which the Tax Office specifically employs to reach a taxpayer market. When drafted, there are internal Tax Office requirements that they be accompanied by both a draft ATO media release and a briefing for Federal Parliamentarians.45
7.10 The process of publishing a Taxpayer Alert also gives rise to a formal internal Tax Office requirement to publish an ATO view on the relevant matter as a high priority.46 Had this requirement been activated, it is possible that the draft ruling and booklet on service entity arrangements could have been issued far sooner than they were.
7.11 The Inspector-General considers that, in view of the widespread use of service entity arrangements by taxpayers, the Tax Office should have issued a Taxpayer Alert or a similar document47 on its concerns with these arrangements and that this document should have been issued by no later than May 1999, which is one month after it produced an analysis of the results of its 1998 survey of a number of legal and accounting firms.
7.12 The Tax Office's response as to why it failed to issue this alert strongly suggests that it does not fully appreciate that communicating with tax advisers does not equate to communicating with taxpayers.
7.13 The above comments lead to the following key finding and key recommendation.
Key finding 7.2
The Tax Office did not issue a Taxpayer Alert or a similar document on its concerns with service entity arrangements at the time when in 1999 it first identified concerns with these arrangements.
Key Recommendation 7
The Tax Office should ensure that when it is dealing with a compliance issue that affects a significant segment of the taxpayer population it employs appropriate communication processes to ensure that its concerns on this compliance issue are made known to that population directly and as soon as possible. The Tax Office should not seek to rely on communicating these concerns only in publications or speeches to limited audiences.
Concerns about the content, completeness and clarity of the final service entities ruling and booklet
Content of final ruling and booklet
7.14 A number of submissions to this review raised concerns about the content of the final ruling and booklet in the sense that neither document was said to reflect an accurate statement of the relevant law. As indicated previously, the Inspector-General is not empowered to comments on these concerns.
7.15 However, submissions also raised concerns on:
- whether these documents had been developed on an objective basis;
- whether these documents were needed at all;
- whether these documents were sufficiently complete and clear; and
- the extent to which taxpayers would be protected against retrospective taxation in the future if they follow these documents.
7.16 These matters are all administrative in nature and are matters which can be the subject of review and comment by the Inspector-General.
7.17 Each of these matters is examined below.
Objectivity of the Tax Office's view on service entity arrangements as expressed in the final ruling and booklet
7.18 As noted in a previous chapter, the Tax Office has stated that the final ruling and booklet are together its principal strategy for combating the compliance issues it has found in relation to service entity arrangements.
7.19 The Inspector-General notes that this kind of strategy runs the risk that the terms of the ruling and guidance will not represent an objective Tax Office view of the relevant law, but rather a view of what the Tax Office would like the revenue law to be for revenue collection purposes.
7.20 A number of submissions to this review asserted that the draft booklet on service entities was revenue-biased. Public comments on the final ruling and booklet have not focussed on this aspect, however. At least one professional body that was involved in the consultation processes for the ruling has even been quoted as saying that the new rates for service fees set out in the final booklet are 'quite reasonable and easy to live with'.48
7.21 From the Inspector-General's fieldwork for this review, there appears to be at least one feature of possible revenue-bias in the final ruling and booklet on service entities. This is that these documents do not deal with the situation where all or part of the professional firm's practice is conducted not by a partnership but by a practice trust. The Inspector-General notes that the Tax Office has audited at least one firm which employed such a structure and that the result was that no tax adjustments were made in relation to the service fees charged in prior years. This was principally because most of the service fees were being paid from one trust to another trust with the same beneficiaries. In this situation, no additional tax payment arose because if the deduction for the fee in one trust was adjusted to a lower amount a corresponding amount of income would need to be removed from the second trust. This meant that any additional tax payable by the first trust as a result of this adjustment would be matched by and cancelled by a corresponding decrease in the tax payable on the relevant fee by the second trust.
7.22 The Inspector-General notes that in some public rulings (especially those which deal with GST49) the Tax Office does include examples of structures which prevent an adverse tax result. The Inspector-General considers that the practice trust structure for professional firm should therefore have been the subject of comment by the Tax Office in its final guidance on service entities.
7.23 During the course of this review, the Tax Office has stated that it did not provide comments on this kind of practice structure in its guidance material on service entities because it is not in the business of providing advice to taxpayers about how to structure their affairs. The Inspector-General notes that this comment raises issues about how the Tax Office defines its role of providing advice to taxpayers on the application of the law. This matter may be the subject of further examination in future reviews by the Inspector-General.
7.24 Subject to the above comment, the Inspector-General believes that the statements made by tax advisers and professional bodies on the final ruling and booklet suggest that the Tax Office has not compromised the objectivity of the view it has expressed in these final documents.
Should the ruling and booklet have been issued at all?
7.25 Some stakeholders argued that there was no need for the Tax Office to have issued either a new ruling and/or booklet. Stakeholders who held this view mainly argued that a new ruling was not necessary as IT 276 was a sufficient statement of the Tax Office's view.
7.26 Other submissions were not concerned about the Tax Office communicating its view on service entities via a new ruling but did not think that the issue of the accompanying booklet with comparable and indicative mark-up rates was warranted. This was because each service entity arrangement needs to be judged in the light of its own facts and it is not therefore appropriate to formulate rules of general application in this area.
7.27 A number of submissions also asserted that the issue of a booklet which sets out maximum mark-up rates for service entity fees and a maximum amount of 30 per cent of the firm's profit that can be made by a service entity may actually hinder taxpayer compliance with the law on service entities. This is because these mark-up rates may encourage taxpayers to use these rates or to ensure that 30 per cent of their firm's profits are derived by their service entity even though their individual firm's circumstances do not justify such results.
7.28 The Inspector-General notes that the majority of submissions were in favour of the Tax Office updating its view on service entity arrangements and setting out 'safe harbour' mark-up rates for such arrangements. He therefore believes that it was appropriate for the Tax Office to have issued these documents and for these documents to have contained 'safe harbour' rates.
7.29 These comments lead to the following key finding.
Key finding 7.3
It was appropriate for the Tax Office to have issued a ruling and detailed guidance booklet for service entities.
Concerns about the completeness and clarity of the final ruling and booklet
7.30 Other concerns raised by stakeholders about the completeness, clarity or appropriateness of the final ruling and booklet on service entities, include the following:
- The examples provided in the final booklet (other than those provided for the medical profession) are simplistic as they deal with situations where an entity provides only one type of service (for example, labour hire, the provision of property or recruitment services) while in reality most service entities provide a complete package of services to the main business. A number of submissions suggested that the Tax Office should have used as a case study the actual facts of the Phillips case as this was still a common form of service entity arrangement.
- The final booklet does not adequately explain the manner in which the Tax Office will apply the 30 per cent profit cap for the purposes of determining whether a service arrangement will be audited. The booklet does not indicate, for example, whether this cap will apply to medical practitioners, does not indicate how the 30 per cent cap will apply in a year when the professional firm operates at a loss and does not fully indicate how the profit is to be determined (for example, whether it is to be before or after interest).
- The final booklet does not adequately explain how the 30 per cent indicative gross mark-up rate for labour hire is equivalent to a 10 per cent net mark-up method and how the minimum 18 per cent of operating costs requirement applies. Some taxpayers consider that the wording of the booklet suggests that the 30 per cent gross mark-up on costs method coupled with a requirement for 18 per cent of operating costs being in the service entity equates to a 12 per cent (not 10 per cent) net mark-up.
- The final booklet provides detailed guidance on service arrangements only for lawyers, accountants and medical practitioners. Other taxpayer groups which have service arrangements (such as dentists and pharmacists) have not been dealt with in detail in the ruling and booklet50 and these taxpayers are not certain how the Tax Office's view will affect their circumstances.
- The documentation requirements in the final booklet are too onerous and impractical.
- The ruling and booklet do not deal with a situation where the current partners in a professional firm have inherited a service entity arrangement which they themselves did not establish (this being a common occurrence, particularly with larger accounting practices).
- The final ruling and booklet keep IT 276 on foot and 'supplement' it with the new final ruling. Submissions assert that IT 276 should have been amalgamated with the final ruling so that taxpayers do not have to consult three separate Tax Office documents to gain a complete understanding of the Tax Office's view on service entities. These submissions note that such an amalgamation would be in accordance with the ease of access and clarity criteria for rulings that were set out in Treasury's 2004 report on Review of Aspects of the Income Tax Self Assessment51(the RoSA review).
7.31 The Inspector-General considers that the above concerns are valid. During the course of this review he advised the Tax Office that the first six of these concerns could be addressed by the Tax Office developing a process for capturing these concerns.
7.32 The Inspector-General notes in this regard that during this review at the NTLG meeting held on 21 June 2006 the Tax Office invited feedback on the booklet from the professional bodies and advised that is has now set up a dedicated email address to receive such feedback.
7.33 Furthermore, in response to the Inspector-General's concerns about the lack of an overall feedback process on all final public rulings, the Tax Office has now established a web-based electronic feedback process for all public rulings and determinations it has issued since 1 January 2006. This process is therefore available for the service entities ruling.
7.34 The Inspector-General considers that the concern about the continuing existence of IT 276 should be addressed by the Tax Office simply withdrawing this ruling.
7.35 These comments lead to the following key findings.
Key finding 7.4
In response to the Inspector-General's concerns about the lack of an overall feedback process on all final public rulings the Tax Office has now established a web-based electronic feedback process for all public rulings and determinations it has issued since 1 January 2006. This process is therefore available for the service entities ruling.
Key finding 7.5
The Tax Office should withdraw IT 276.
Concerns about whether the final ruling and booklet provide adequate protection for taxpayers who follow them
7.36 Submissions have noted that the final form of the ruling and booklet on service entities contain only a relatively small portion which is in the form of legally binding advice. Legally binding advice will protect taxpayers against the payment of tax, penalties and interest if they follow it.
7.37 These submissions note that the greater part of the ruling and booklet (including those parts which contain the Tax Office's comparable and indicative mark-up rates and the Tax Office's technical analysis of the law on service entities) only takes the form of advice which is administratively binding on the Tax Office. In material provided to the Inspector-General during this review the Tax Office has confirmed that such advice will only protect taxpayers against the payment of penalties and interest (but not against the payment of additional tax) if they follow it. Furthermore, these protections only arise as a result of the Tax Office's administrative practice. They are not protections which the Tax Office is legally bound to grant.
7.38 These submissions note that the principles underlying the RoSA review (especially those which extend the kinds of matters which can be the subject of a ruling to matters involving ultimate conclusions of fact) appear to suggest that the Tax Office should, wherever possible, provide its advice in the form of a legally binding ruling, in the interests of providing taxpayers with greater certainty in a self assessment system.
7.39 Submissions have further noted that the binding part of the final ruling on service trusts does not contain any examples, which appears to conflict with a recommendation made in the RoSA report.
7.40 The Inspector-General agrees with these submissions and considers that the Tax Office should give effect to the principles underlying the RoSA review by ensuring that all guidance which is of a significant nature and which applies to a substantial segment of the taxpayer population is, to the maximum extent possible, embodied in the form of guidance which is legally binding.
7.41 These comments lead to the following key finding and key recommendation:
Key finding 7.6
The greater part of the ruling and booklet on service entities (including those parts which contain the Tax Office's comparable and indicative mark-up rates and the Tax Office's technical analysis of the law on service entities) only takes the form of advice which is administratively binding on the Tax Office.
Key Recommendation 8
The Tax Office should, in the interest of providing maximum certainty to taxpayers in a self assessment environment, ensure that all guidance which is of a significant nature and which applies to a substantial segment of the taxpayer population is, to the maximum extent possible, embodied in the form of guidance which is legally binding on the Tax Office.
Other communication issues
Lack of clear and /or timely communication by the Tax Office of key aspects of its approaches to service entities
7.42 Submissions have also asserted that the Tax Office did not properly communicate two key aspects of its approach to service trusts at, or prior to, the time of issue of the draft ruling and booklet on service entity arrangements. These submissions assert that the failure to properly notify affected taxpayers of these key features of its approach at this time caused unnecessary angst, uncertainty and, in some cases, unnecessary additional costs.
7.43 The first of these key features concerns the criteria the Tax Office decided to employ to identify high risk audit cases.
7.44 In the draft booklet issued in June 2005, the Tax Office said that a taxpayer had to meet only two criteria to be considered a high risk audit case that was to be subject to retrospective audit action. The two criteria were that the service fees had to be over $1 million and that those fees had to represent more than 50 per cent of the gross income of the professional firm. This statement in the booklet confirmed a statement which the Commissioner had made to a Senate Committee about four weeks prior to the booklet being issued.52
7.45 However, on 3 November 2005, the Commissioner announced at another Senate Committee hearing that a third requirement would be added for a case to be considered a high risk case. This new requirement was that the profit of the service entity had to be more than 50 per cent of the combined profits of the service entity and professional firm.53 The Tax Office did not communicate this new key criterion to taxpayers until it confirmed the change in the final version of the service entity booklet. This booklet was however issued some months after this statement to the Senate Committee.
7.46 Submissions assert that this new third criterion that would be used to identify high risk cases should have been settled by the Tax Office prior to both the issue of the draft booklet on service arrangements and the Commissioner's June 2005 statement on this issue. These submissions further claim that even if this criterion was not settled by this time it should have been communicated to taxpayers as soon as it was settled and that this communication should have taken the form of either a media release and/or by way of an erratum to the draft booklet. An immediate communication of this change at least in the form of a media release was considered to be appropriate in view of the significance of this new criterion to the relevant taxpayer population and the fact that the initial two criteria for high risk audit cases had originally been firstly referred to by the Commissioner at a Senate Committee hearing and then subsequently announced in a media release.54
7.47 The second key feature of the Tax Office's approach to service entities which submissions claim was not clearly communicated to taxpayers concerns the date of effect of the Tax Office's new approaches to service entities.
7.48 This 'date of effect' involved the granting of a 12 months period of grace to taxpayers before the Tax Office would commence audits of their service arrangements.
7.49 Submissions assert that by the time when the draft booklet was issued in June 2005 the Tax Office did not make it clear when this 12 months period would commence. As a result many taxpayers assumed that it would commence on the date of issue of issue of the draft booklet. As the booklet was issued on 29 June 2005 that is, just prior to the end of the financial year, these submissions assert that many taxpayers assumed that the 12 months rule meant that audits would first apply for the year ended 30 June 2006. This meant that taxpayers had only one day (that is, until 30 June 2005) to ensure that their service arrangements complied with the Tax Office's stated view.
7.50 Submissions assert that the Tax Office only first made it clear to a group of tax professionals that its 12 months rule would apply from the date of issue of the final ruling and booklet and that taxpayers would have the benefit of a full 12 months to restructure their affairs in comments provided to a liaison group meeting held on 26 August 2005.55 The comments of the 26 August 2005 meeting were subsequently published on the Tax Office's website in February 2006 as part of the minutes of the relevant meeting. The comments were not embodied in a formal Tax Office communication document directed to all affected taxpayers until they were embodied in the final booklet that was published in April 2006.
7.51 Submissions assert that the precise terms of the Commissioner's intended date of effect of his new approaches to service entities should have been settled by the time of issue of the draft ruling and draft booklet on service entities and should have been clearly spelt out in those documents.
7.52 These submissions also note that as soon as the Tax Office determined the actual terms of this 12 months period of grace it should have immediately taken steps to notify taxpayers of these terms by way of a press release. An immediate communication in this manner was considered to be appropriate in view of the significance of this 12 months period to all taxpayers with service entities and because this 12 months period had originally been referred to by the Commissioner in a Senate Committee hearing56 and then subsequently announced in a media release.57
7.53 The Inspector-General agrees with these submissions. He further notes that the Tax Office's failure to clarify the terms of its proposed 12 months period of grace leaves it open to the accusation that it was deliberately creating uncertainty so as to exert compliance pressures on taxpayers with service entity arrangements.
7.54 The Inspector-General considers that taxpayers are entitled to receive, at the time of issue of any draft Tax Office guidance, a very clear indication from the Tax Office of the intended date of effect of that guidance. Clear statements of intended dates of effect provide taxpayers with greater certainty as to the likely effect of the guidance on their past, present and future activity so that they may fully consider what steps they need to take in respect of that guidance and when they should take those steps. Unclear statements of dates of effect can cause taxpayers unnecessary anxiety and can lead them to incurring additional costs (such as seeking professional advice and/or restructuring their arrangements) which may either not be necessary or which may not be necessary until a future date.
7.55 The Inspector-General notes that the Tax Office's internal Rulings Manual specifically states that all draft public rulings (including determinations) are to contain a date of effect. However this manual is silent on the need for this date of effect to be absolutely clear and on whether Tax Office guidance which does not take the form of a ruling is to contain a date of effect clause.
7.56 The above comments leads to the following key finding and recommendation:
Key finding 7.7
The Tax Office did not properly communicate at, or prior to, the time of issue of the draft ruling and booklet on service entity arrangements either:
- the criteria it would employ to identify high risk service entity cases that were to be subject to audit; and
- the date of effect of its proposed approach to service entities.
Key Recommendation 9
The Tax Office should ensure that when any form of draft guidance is issued to taxpayers, that draft always contains a very clear statement of the intended date of effect of that guidance. This requirement should be set out in a Tax Office practice statement or other internal document which provides guidance to its staff.
45 These requirements are contained in ATO Practice Statement Law Administration PS LA 2005/13 at paragraph 22(ii).
46 ibid at paragraph 22 (iv).
47 The formal Taxpayer Alert system was not introduced until December 2001.
48 See The Australian Financial Review of 21 April 2006 at page 15.
49 See, for example, the going concern ruling GSTR 2002/5 at paragraphs 137 to 140.
50 It is noted that one example in the booklet refers to an arrangements conduced by a chemist but this example, which relates to rental arrangements for commercial premises, is not specific to chemists only.
51 The Treasury, Report on Aspects of Income Tax Self Assessment, August 2004, Commonwealth of Australia.
52 The statement was made at the Senate Economics Legislation Committee hearing of 2 June 2005 (see page E165 of the hearing transcript).
53 Senate Estimates Committee hearing, transcript of 3 November 2005 at page E51.
54 Australian Taxation Office, Draft Guidance on Service Trusts, Media Release Nat 2005-42, 29 June 2005.
55 The meeting was that of the Small to Medium Enterprises Sub-committee of the National Tax Liaison Group, held on 26 August, 2005. The minutes of this meeting are available on the Tax Office's website at www.ato.gov.au.
56 The 12 months period was referred to by the Commissioner at the Senate Economics Legislation Committee hearing of 2 June 2005 (see page E165 of the hearing transcript).
57 Australian Taxation Office, Draft Guidance on Service Trusts, Media Release Nat 2005-42, 29 June 2005.