Around March 2006, the ATO announced that it was allowing a 12 month period for people to review their Service Arrangements to ensure that the service entity was not charging fees in excess of commercial rates. This period ended on 30 April 2007. Any businesses that have not reviewed their Service Arrangement to address the ATO's concerns may face income tax adjustments and penalties.
A typical Service Arrangement involves:
- the owners of a professional services business setting up a wholly-owned service entity;
- the service entity providing the business with a service (for example: labour hire of support staff, lease of premises, provision of office equipment) at increased prices; and
- the business claiming the fees paid to the service entity as a tax deduction
Periods to review has ended
For many years professional service businesses have commonly had a service entity arrangement in place - also known as a 'Phillips' arrangement (Service Arrangement). These arrangements govern how support services are provided to the business.
If a Service Arrangement complied at the end of this period, then the parties to that arrangement have a reduced chance of being audited on this basis.
How to assess whether a Service Arrangement measures up?
Reviews of Service Arrangements had to consider whether the service fees and charges were reasonable in the circumstances. For instance:
- Could it be explained how the Service Arrangement helps run the business?
- Were the service fees and charges correctly calculated?
- Were there sufficient records that explain transactions between the business and the service entity for tax purposes?
These questions continue to be relevant to persons entering into new Service Arrangements, as does the ATO's Guide on this topic.
The ATO's Guide released in April 2006, 'Your service entity arrangements', outlines the market rates that the ATO considers are commercial benchmarks for typical Service Arrangements. These rates are based on standard market rates: but they also include higher rates that the ATO considers indicate a degree of divergence from comparable market rates. If a Service Arrangement involves these rates (or higher rates), then they could prompt an audit.
One example of these acceptable rates is set out in the following table:
|Arrangement||Characteristics||Acceptable fees and charges|
Labour hire - temporary staff
| || |
If a Service Arrangement has an objective commercial connection with a business and its activities, and the business is confident that the service fees and charges are correctly calculated, then those fees and charges may well be deductible and less likely to prompt an ATO audit. However, parties to existing and new Service Arrangements need to consider reviewing these matters to ensure compliance with the ATO's standards.
For further information, you can go to the ATO website at www.ato.gov.au and see the Guide. For advice concerning Service Arrangements, call Maddocks on 03 9288 0555 (Melbourne) and ask for a member of the Tax & Revenue team.