The ATO renews its scrutiny of 'service trust' arrangements

In a recent address to the Tax Institute of Australia, the Deputy Commissioner of Taxation reiterated his concerns about service trust arrangements and their effectiveness as a vehicle to minimize tax and to protect assets. This ClearLaw articles reminds practitioners and their clients about the ATO's views on legitimate, and illegitimate, service trust arrangements. Tina Savona - Maddocks Tax & Revenue Team

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Background

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[1], 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.[2]

The Commissioner's views

According to the Commissioner[3], 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;[4]
• 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.[5]

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"

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.

[1](1978) 8 ATR 783
[2]Sections. 51(1) and 260 of the Income Tax Assessment Act 1936 (Cth)
[3]The Commissioner's views on service trusts are now in Taxation Ruling TR 2006/2. That ruling supplements Taxation Ruling IT 276 which was issued in response to Phillip's case.
[4]Para 9 of TR 2006/2.
[5]Para 10 of TR 2006/2.