Income Tax: Deductibility of service fees paid to associated service entities: Phillips arrangements

You may have read a good deal in the papers recently about the 'deductibility of service fees'. The reason is that the Australian Taxation Office (ATO) recently released a draft taxation ruling, TR 2005/D5 (Ruling), concerning the deductibility of service fees paid to associated service entities.

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The Ruling was issued in response to the ATO's concerns with the proliferation of service arrangements following the decision in Phillips v FC of T 8 ATR 783 (Phillips case) and the perceived lack of commerciality surrounding these arrangements.

The Ruling is supplementary to the ATO's previous taxation ruling, IT 276, which was issued in 1978 after the Federal Court's decision in Phillips case. It is proposed that when the final ruling is issued it will apply retrospectively.

The ATO has stated that "(T)he draft ruling reflects our long standing view that service arrangements are acceptable provided they are entered into for commercial reasons and at commercially realistic rates". However, the Ruling indicates an intention to place an increased compliance burden on taxpayers by effectively reducing the threshold level of service fees that will attract ATO review. The Ruling seeks to justify a 'broader examination' by the ATO of deductions for service fees where the fees are not considered commercially realistic on an objective basis.

Further, the ruling places emphasis not just on the level of service fees, but also on the commerciality of establishing the service arrangement.

Examples of arrangements that will attract ATO review are listed to include arrangements where:

• service fees are disproportionate orexcessive in relation to the benefits
• conferred; service fees and charges are calculatedusing arbitrary or fixed mark-ups; where there is no clear separation betweenthe service entity's and the taxpayer's
• business activities.

The ATO also sets out its position on the application of the anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 to service arrangements.

Importantly, while the ATO acknowledges the legitimacy of asset protection benefits in determining a taxpayer's dominant purpose, it states that it does not consider that separating business profits from the business entity is a legitimate form of asset protection.

If the ATO considers that the service trust constitutes a scheme for the dominant purpose of obtaining a tax benefit, it may disallow any otherwise allowable deductions.

Where a deduction is disallowed, the taxpayer may be liable for additional penalties and interest as well as tax on the disallowed deduction.

The Draft Ruling clearly indicates that the ATO intends to adopt a tough stance on service arrangements.

Given the proposed retrospective application of the final ruling by the ATO, taxpayers should review their service arrangements as a matter of urgency.