In a recent address to the Tax Institute of Australia, the Deputy Commissioner of Taxation reiterated his concerns about service trust arrangements. According to the Deputy Commissioner, preliminary risk evaluation work had led the ATO to conclude that:
- '.... there may have been widespread use of service trust arrangements which involved payments that were grossly excessive in relation to the benefit conferred by the service arrangement.'
This article reviews service trust arrangements and the characteristics that the ATO is likely to focus on.
Service trust arrangements — What?
In a typical service trust arrangement:
- a service trust is used to hold certain assets; and
- those assets are provided to a separate operating entity for a fee.
Service trust structures have been widely used to facilitate the provision of non-professional services in a professional practice environment, including:
- clerical, secretarial, accounting, personnel management, administration and copying services; and
- premises, furniture and equipment.
Service trust arrangements — Why?
Service trusts are used for two primary reasons:
- Income splitting — Service trust arrangements facilitate income splitting as the stakeholders in the service trust which is being paid for the services can be different from the stakeholders in the entity receiving the services; and
- Asset protection — Service trust arrangements allow assets to be efficiently quarantined outside a business entity, thereby safeguarding those assets from litigation or other liability claims against that business entity.
Cleardocs provides Service Agreements for use in service trust arrangements here
Why doesn't the Commissioner like service trust arrangements?
Although the use of service entities was accepted as valid on commercial grounds in the 1978 case FCT v Phillips, the ATO has concerns about the size of the mark-up some service entities charge.
In Phillips' case, the Commissioner unsuccessfully challenged the deductibility of fees paid by a partnership to a service trust under the former general anti-avoidance provisions.
The Commissioner's views
According to the Commissioner, whether expenditure made under a service arrangement is deductible under section 8-1 of the Income Tax Assessment Act 1997 (Cth) depends on the objective the expenditure was calculated to achieve. This is to be determined from a practical and business point of view — which is a question of fact to be considered on a case-by-case basis.
In effect, the Commissioner is targeting the size of the mark-up on the services provided by the service entity. If the benefits conferred by a service arrangement:
- provide an "objective commercial explanation" for the whole of the expenditure made under the service trust arrangement then, generally, the arrangement alone will suffice to characterise the expenditure as expenditure that is deductible under section 8-1;
- do not provide an "objective commercial explanation" for the whole of the expenditure, then the service arrangement alone will not suffice, without more, to characterise the expenditure as deductible in that way.
Essentially what this means in practice is that unless a taxpayer can justify (on objective commercial terms) the amount of the mark-up on services acquired, then the Commissioner will seek to deny a deduction under section 8-1 to the entity acquiring the services.
Determining what is an "acceptable commercial mark-up"
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The Commissioner does not set out any parameters for determining what is an acceptable commercial mark-up. However, he does state that factors working against deductibility are:
- the service fees and charges are disproportionate or grossly excessive in relation to the benefits conferred;
- the service fees and charges guarantee the service entity a certain profit outcome without reasonable commercial explanation;
- the service fees and charges generate profits in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions; or
- there is no clear separation between the service entity's business activities and those of the taxpayer.
If the service trust arrangement provides no commercial benefit and the service fees and charges are not correctly calculated, then the deductibility of the service fees and charges may depend on a range of other factors, including:
- the nature of the taxpayer's relationship with the service entity;
- the reasons the taxpayer's business had for entering into the service trust arrangement; and
- the reasonableness of the fees relative to the benefits provided.
Review of service trust arrangements — the ATO's Guidelines
The Tax Office has published guidelines to help taxpayers decide whether or not to review their service arrangements in light of TR 2006/2. You can read the guidelines 'Your Service Entity Arrangements - NAT 13086' (Guidelines) here
In broad terms, the service fees charged will probably be deductible under section 8-1 if:
- a taxpayer can identify how the benefits passing to a business under a service trust arrangement assist the business; and
- the service fees and charges are correctly calculated.
The Guidelines set indicative rates the use of which is likely to reduce the chance of a tax audit. There are comparative economic rates for various services for people who do not to use the conventional arrangements in the guide. (An example is contained in a previous ClearLaw article on this topic which you can view here.)
It is important to review arrangements for which:
- Fees are excessive or disproportionate The ATO's interest will be aroused by:
- fees that are disproportionate or grossly excessive in relation to the benefits conferred on the taxpayer's business; or
- a taxpayer that has agreed to pay service fees calculated without regard to the value of the services provided by the service entity. For example, where partners in professional practices are returning incomes which are very low compared to partnership profits.
- Businesses are not clearly separated The ATO's interest will be aroused if the business being conducted by the taxpayer is not clearly separated from the business being carried on by the service entity. This is because profits may be generated in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions.
- Lack of appropriate records The ATO's interest will be aroused if there is a failure to maintain adequate records evidencing the service trust arrangement and its benefits to the taxpayer.
A final note — general anti-avoidance rules are still relevant
Even after all that, it is worth noting that this issue is not necessarily confined to sec.8-1 of ITAA97.
The Commissioner has confirmed that the general anti-avoidance rule in Part IVA of ITAA36 may apply to service arrangements. It will do so if a proper weighing of features would cause a reasonable person to conclude that the service trust arrangement exists for the dominant purpose of enabling a taxpayer to obtain a tax benefit.
Essential estate planning resources
Stay on top of issues affecting estate planning with the following resources from Thomson Reuters: Australian Financial Planning Handbook, Death and Taxes and Family Business Succession Guide. Available in book, ebook and online.
Questions & more information
For questions or more information about the above article, please call Maddocks in Melbourne (03 9288 0555) and ask for a member of the Maddocks Tax and Revenue Team.