• General

    1. Is the guide legally binding on the Tax Office?

    The guide gives practical guidance on the application of the law and the Tax Office approach to risk management of the issue. Material on risk management, which includes our indicative rates, is not legally binding.

    The correct application of the law is subject to individual circumstances, whereas the material in the guide on the application of the law is only general in nature, so cannot be made legally binding. It contains our commitment statement for publications that provide taxpayers with interest and penalty protection should the product contain incorrect or misleading statements that cause a taxpayer to make a mistake which results in a tax shortfall.

    2. Information in the guide suggests that my service entity arrangement is not acceptable to the Tax Office. Will I face audit action for prior years?

    The guide explains our transitional approach for service entity arrangements that were in existence on 20 April 2006 and our approach to all service entity arrangements after the 12 month review period, which ended on 30 April 2007.

    The guide explains how service entity arrangements can be conducted to minimise the risk of audit. The 12 month transitional review period was designed for taxpayers to review their existing service entity arrangements and bring them into line with our guidance material. If, following a review of your service entity arrangement, you found that changes needed to be made; such changes should have been implemented no later than 1 May 2007. This review process may have meant implementing changes that affected part of the 2006-07 income year, i.e. for May and June 2007.

    Now that the transitional review period has ended, you will be at a low risk of audit if you continue to follow our guidance material, which includes being able to demonstrate that your ongoing service entity arrangement helps you to run your business and that the service fees have been correctly calculated.

    There is no expectation that you will need to self-correct earlier years, nor will you face audit action, as long as your service entity arrangement remains in line with our guidance material after 30 April 2007

    There were some businesses that could reasonably have been expected to comply with the law and IT276 without the need to rely on the additional information in Taxation Ruling TR 2006/2 and the guide, given the size and materiality of their claims. These cases were regarded by us as high risk cases and were not given the transitional 12 months to review their service entity arrangements. They were the subject of our compliance program in recent years and those reviews included an examination of prior year service fee claims. As part of that compliance program, which has now been wound back, only a handful of taxpayers were looked at and only a small number faced adjustments. The cases adjusted all had unacceptable features that went beyond the particular level of fees or mark-ups used.

    3. How is the Tax Office currently managing compliance for service entity arrangements?

    Service entity arrangements in line with our guidance material will be at little risk of audit, especially about the amount of fees claimed, if:

    • they are within the rates in the guide and, importantly
    • the circumstances in which those rates can be used also apply.

    As foreshadowed in the guide, we will manage ongoing tax compliance for service entity arrangements in accordance with our general risk assessment approaches. Depending on what we see as the ongoing risk, we may include service entity arrangements in our general compliance program. For example, the Compliance Program 2007-08 states that service trusts will continue to be an area of focus in the small to medium enterprises taxpayer segment. The nature and extent of our ongoing review of such arrangements will be guided by tax return and other information which measures the effectiveness of our approaches to date. This will give an indication of the level of ongoing compliance risk associated with these arrangements.

    Uncommercial arrangements will continue to be at risk of audit, and such audits can include prior years.

    Following conclusion of the 12 month transitional review period on 30 April 2007, we have been monitoring the extent to which service entity arrangements have been reviewed in light of our guidance material and, for this purpose, have started conducting some visits. Most of the firms we have contacted have been quite happy to show how they have been following the guidance issued. We see the majority of the issues explained in our ruling and guide have been well understood and most firms appear willing to bring themselves within the terms of our guidance.

    The guide explains that, from 1 May 2007, if the Tax Office indicative rates are used, and no greater than 30% of the combined net profits of the professional firm and service entity are earned by the service entity (or service entities), there is little risk of an audit being commenced because of the amount of the deduction claimed.

    It is important to note that you may only rely on the indicative rates if no more than 30% of the combined net profits of the professional firm and service entity (or entities) involved is earned by the service entity (or entities). Above this profit level, we may ask you for a satisfactory explanation, whether or not your arrangement is above or below the indicative rates.

    In the case of general medical practitioners who operate their service entity arrangements under the 'percentage of gross practice fees' business model for a complete suite of services as outlined on page 25 of the guide, service fees of up to 40% of the general medical practitioner's gross practice fees (up to 45% in the case of rural and sole GPs) will generally be accepted by us as long as the circumstances in which those rates can be used also apply. The risk of being audited will increase according to the degree of divergence above those fee levels and where there are questions concerning adherence to the business model on which the rate has been determined.

    There may be other reasons for a case to be selected for review or audit. These reasons include:

    • concerns about whether the services were in fact provided (e.g. potential shams or where the service entity does not appear to have either the personnel or property to provide the services)
    • the service arrangements are not typical Phillips-type service entity arrangements (e.g. multiple entities involved or novel structures)
    • lack of supporting documentation
    • private expenses claimed by the service entity
    • possible application of the general anti-avoidance rules needs to be determined
    • other compliance risks are associated with the arrangement.

    If a deduction claimed for service fees is adjusted following an audit, we will allow a deduction based on what we consider the comparable rate would be for a particular service. This would be based on:

    • the individual facts and circumstances of the case
    • the findings of the audit for the relevant income years
    • the relevant market rates at that time; together with
    • consideration of the actual nature and extent of the services provided.

    This comparable rate would be used by us if amendments to assessments are required to adjust claimed excessive expenses under a service arrangement back to commercially justifiable claims.

    4. How will the 30% of combined profits test operate?

    We may ask you for a satisfactory explanation where more than 30% of the combined net profits of the professional firm and service entity is earned by the service entity, whether or not your arrangement is above or below the indicative rates in the guide.

    Profit for the purpose of this test will be accounting net profit pursuant to Australian accounting standards and generally accepted accounting principles, not taxable income, and will be calculated after any interest and amortisation of goodwill.

    In situations where the professional firm is incorporated, we will look at the combined position of both the company and the professional ( as the professional business) on the one side, and the service entity on the other side, when calculating the relevant profit split. This addresses the interaction of the net profit test and the application of IT 2503, and ensures that both operate as intended.

    In determining the net profit of the service entity, costs that are not genuinely incurred by that entity in carrying on its business should be disregarded. For example, payments made by a service entity to its associates or to associates of the taxpayer may be either excessive or inflated when compared with payments that would have been made to an independent party providing the same services. In such situations, the payments should be excluded from any calculations, at least to the extent of the excess.

    A genuine loss making service entity will satisfy the 30% profit test and can rely on the indicative rates in the guide. However, the general circumstances of the arrangement can still be subject to review. In particular, a loss making service entity will generally not be charging excessive rates for its services, so we would generally only look at such entities where there are other compliance issues.

    5. What is the difference between comparable rates and indicative rates?

    The guide provides rates which are applicable to typical service entity arrangements. It provides both comparable market rates and indicative rates.

    The comparable rates are generally lower than the indicative rates. The comparable rates reflect the Commissioner's current understanding of market rates for typical services. The indicative rates on the other hand, while above market rates, reflect the Commissioner's view that the potential compliance risk would generally not justify audit activity for service entity arrangements that rely upon rates up to that level.

    Use of rates higher than the indicative rates can be acceptable in individual circumstances, but we may ask you to explain those circumstances.

    If you are unable to support those higher rates with appropriate evidence, we may make an adjustment in relation to your arrangement. If amendments to assessments are required to adjust claimed excessive expenses under a service entity arrangement back to commercially justifiable claims, we will reduce the rate allowable to a comparable rate that is applicable in the circumstances, not the indicative rate.

    This commercially realistic rate would be based on:

    • the individual facts and circumstances of the case
    • the findings of the audit for the relevant income years
    • the relevant market rates at that time, and
    • consideration of the actual nature and extent of the services provided.

    6. What are comparable rates?

    In the guide we have provided economic data, generally in the form of net mark-ups on direct and indirect costs (referred to as net mark-ups), for functions typically performed under service entity arrangements As this data represents our current findings (commerciality of rates can change over time) on the commercial returns pertaining to these functions, you can use those net mark-up rates with little risk of being audited - provided your arrangements are operating as described in the guide.

    Those rates are:

     

    Labour Hire (temporary)

    5% net mark-up on direct and indirect operating costs

    Labour Hire (permanent)

    3.5% net mark-up on direct and indirect operating costs

    Recruitment

    5% net mark-up on direct and indirect operating costs

    Expense Payments

    5% net mark-up on direct and indirect costs of paying the expenses, but not the expense itself

    Equipment Hire

    Return on assets (ROA) of 7.5% of opening written down value (for accounting purposes) of assets owned and used in the hiring activity in addition to depreciation, direct and indirect hiring costs.

    Analysis of the accounts of independent equipment hire firms for comparable rate purposes has been undertaken on an EBIT basis. Accordingly, financing costs are excluded in any ROA calculation.

     

     

    Example for Equipment Hire

    Opening written down value
    of equipment:                            $10,000

    Return on assets @ 7.5%                                 $ 750

    Depreciation rate (@ 10%):      $ 1,000

    Insurance expense                      $ 1,000         $2000

    Service Fee for Equip Hire:                              $2,750

    For assets acquired and disposed of during the year, the charge can be calculated monthly, such that a return on assets could be obtained in respect of new asset additions, from the month immediately after the date of acquisition. Conversely, no return on assets could apply in the month immediately after an asset is disposed of and thereafter.

    Rental

    Commercial rates, plus finder fees where appropriate

    7. What are indicative rates?

    Indicative rates are above market rates and can be used by taxpayers to position their service entity arrangement into a low risk audit category. This does not mean that we are satisfied that the indicative rates are in fact commercial benchmark rates for typical services. They merely reflect the Commissioner's view that the potential compliance risk would generally not justify audit activity for service entity arrangements that rely upon rates up to that level, providing the arrangement has the relevant connection to the income earning activities of the business and supporting documentation exists.

    In applying the rates to expenses borne by the service entity, there should be due care given to the matter of apportionment. When a service entity provides a number of services, the direct and indirect costs involved in providing each service need to be properly identified and apportioned. This is to ensure that all these costs are counted, that no cost is counted twice and, in the case of gross mark-up methodologies, costs related to the service entity's own administration of the services are excluded, and that the applicable mark-up is calculated for each service type.

    The indicative rates are:

    Labour

    Provision of labour, comprising temporary and/or permanent staff, may be marked up by 30% of the salary and other direct remuneration costs of the employees involved in the arrangement, subject to the service entity paying all costs relevant to its labour hire business from this mark-up. The costs to be absorbed include its own rent, payroll tax, recruitment, training, supervision, personnel costs and other indirect overhead costs.

    When conducting a review we would look to ensure that such costs are being paid and absorbed by the service entity and that they are not being kept artificially low. We would expect that the costs to be absorbed would amount to approximately 18% of the salary and other direct remuneration costs of the staff on-hired. Where costs to be absorbed from the labour hire charge are less than 18% of salary and other direct remuneration costs, the gross mark up of 30% may need to be reduced on a 1% for 1% basis. The guide contains two case studies which explain how this works.

    Given some confusion on how the calculation operates, an abridged version of these case studies, as depicted by an article in the Law Institute Journal (Aug 2006), is provided below, accompanied by a brief narrative.

     

    Extract from the Law Institute Journal (Aug 2006) - Examples 1 and 2 - Operating Statements from two labour hire service entities.

    In the second example, while the gross mark-up rate is still 30 per cent, the operating costs met by the service entity out of the gross mark-up is only 9.67 per cent, well below the ATO benchmark of not less than 18 per cent. The net mark-up on costs of 18.54 per cent is also a buy of the ceiling rate of 10 per cent. This is service entity would be in the high-risk category of being audited by the ATO.

    Alternatively, the service entity can mark-up all the direct and indirect operating costs associated with the on-hiring by 10%. Adopting this method of calculating the appropriate labour hire charges under the service agreement relieves the professional firm and the service entity of the obligation to dissect certain costs. You should note that this alternative gives approximately the same return on total costs as the 30% gross mark-up with 18% costs method described above.

    Recruitment

    In providing recruitment services, the service entity can mark-up all the direct and indirect operating costs associated with its recruitment activities by 10%.

    Expense Payments

    The service entity charge for the costs of paying the professional firm's expenses must be limited to the costs associated with the payment of the expenses, marked-up by 10%, not the cost of the expense itself. For example, in the case of labour applied in administering expense payments, this would be the actual costs of the labour activity marked-up by 10% as described above.

    Equipment Hire

    Under our indicative rates, the hiring fee for equipment owned by the service entity on a hiring arrangement is expected to result in a gross mark-up not exceeding 10% on the cost to the service entity of the equipment with all relevant costs relating to the equipment being met by the service entity.

    This assumes, on an earnings before interest and tax (EBIT) basis (which excludes financing costs), that almost all attributable expenses would be gross costs and we would not expect to see any significant level of other operating costs relating to equipment. Accordingly, we would expect the net mark-up and gross mark-up result from the hiring activity to be close together. If other operating costs are significant, we may have some concerns and the arrangement would not be within the type intended to be covered by the indicative rate.

    For the purposes of the indicative rates, the cost of the equipment is defined as the purchase price of the equipment. Gross costs such as depreciation, repairs, maintenance, insurance and stamp duty are charged across at cost, with the service entity left to absorb other costs such as administrative staff time and office costs associated with the hiring activity. The following is an example of a hiring fee that would be at low risk of audit:

     

    Example for equipment hire (using indicative rate)

     
       

    Original purchase cost of equipment:

    $400,000

    10% Mark-up*

    $  40,000

     

     

    Depreciation rate (@ 17.5%):

    $  70,000

    Other gross costs

    $  95,000

    Gross costs

    $165,000

    Operating costs

    $     5,000

    Total costs

    $170,000

     

     

    Gross mark-up

    $  40,000

    Gross costs

    $165,000

    Service Fee for Equip Hire:

    $205,000

       

    Net income (before interest & tax)

     

    from hiring service

    $  35,000

    * The gross mark-up on the purchase cost of the equipment would only be available for those years where the asset is being depreciated, i.e. the effective life of the equipment over which the purchase cost is written off. Using this method, it would be inconsistent to continue to apply a mark up on purchase price after it has been fully depreciated.

    An arrangement which does not exceed the comparable rate for equipment hire would remain at a low risk of audit even if it exceeded this indicative rate.

    In either situation, the relevant mark-up or return on assets should have regard for whether the service entity is the owner of the equipment. Where the asset is not owned, which will be the case for operating leases, the indicative rates cannot be relied upon.

    Rental

    In providing property rental services, the service entity should be charging rent at market rates, plus finder fees where appropriate.

    The following additional material explains how to apply the approach in the guide for 'rental arrangements' and in particular, what we have regard to when reviewing particular rental arrangements.

    The following points are not exhaustive, as each case is determined on its particular facts and circumstances:

    • To the extent that any property rented by the service entity is used in the provision of a particular service such as labour hire or recruitment services, it is appropriate to allocate a proportion of the rental expense to the service entity's cost base for that activity. This would then be included in the net-cost mark-up cost base for that activity.
    • To the extent that the property rented by the service entity is provided to the professional firm, both the comparative and indicative rates state that the "rent is at market rates (plus finder fees where appropriate)." Determining the appropriate market rate will always depend on the facts and circumstances.
    • As with any service provided by the service entity, key considerations are the "value add" of the service entity in the particular transaction and the market price for the service or property provided. In relation to rental arrangements, the starting point is likely to be the market rent expense negotiated between the third party supplier and the service entity. Since this is an independent third party transaction, it represents a market price for the supply of that rental property.
    • If the supply of the property to the professional firm is on different terms and conditions than those of the head lease, leading to a mark-up claim that is higher than the relevant market rate at the time, and you are audited, you may be asked to explain why the service fee is higher. In particular, we will examine the commerciality of the terms and conditions between the service entity and the professional firm. An example of this would be if a premium is charged for the lease between the partnership and the service entity being on a short term basis.
    • If the service entity secured a discount to the market price, a mark up may be justified. This would need to be a real discount to the market price, rather than a discount to some other nominal amount. A further consideration would be if such discount could have also been obtained directly by the professional firm, or indeed if the discount was only available because the professional firm was seen as the real tenant.

    Example 10 of the guide provides an example of a low risk rental arrangement. A key consideration in this example is the ability of the service entity to gain a volume discount that the professional firm may not have been able to, since it only needs half the space. The rent charged to the professional firm, although it may be higher than that paid by the service entity, is at market rates for office space of the same or similar volume. The plan for the service entity to take on more space than needed by the professional firm would be able to be seen from the service entity's plans and forecasts.

    8. What about debt collection services?

    The guide does not deal specifically with pricing for debt collection services as it is not regarded as a function typically provided under a conventional service entity arrangement. However, appropriate prices can be worked out using the methodologies described in the guide or any other appropriate methodology.

    If there are bona fide external arrangements that price their fees on the basis of charging a percentage of fees collected and the service entity is providing the same level and type of service, then this pricing method may be appropriate. It is important to ensure that the services offered by the service entity are the same or similar to those offered by comparable third parties. In particular, we note that most state and territory jurisdictions require some kind of licensing in relation to debt collection activities. Any service entity using these third party arrangements as a comparable market price would need to ensure they comply with any relevant regulatory requirements.

    In addition, independent service providers generally price their fees on the basis of charging a percentage of outstanding debts collected, which have not been paid by the due date. We would have some concerns if the percentage applied was based on the total fees invoiced to clients, rather than on overdue and impeded debts.

    9. How are operating and finance leases treated?

    Both the indicative and comparable rates include rates for equipment hire when "the service entity owns the equipment". The following information provides guidance on the treatment of leases for the purposes of the guide. In deciding upon a particular treatment, we would expect that it be consistently applied for the equipment over the term of the lease.

    The issue of operating leases is relatively straight forward, and is covered by the examples in the guide, specifically case studies 8 & 9. In "operating lease in operating lease out" arrangements, the service entity does not own the equipment and is, at best, providing a facilitation service and the net mark-up on the costs of the staff providing this service is likely to provide a commercial profit for this service. Accordingly, the comparable and indicative rates for equipment hire cannot be relied upon. In these cases, the equipment hire service provided to the professional firm is primarily an expense payment service. Therefore, the entire lease payment would be passed on to the professional firm at cost (i.e. with no mark-up), with the appropriate expense payment comparable or indicative rate applied to any direct and indirect operating costs associated with the expense payment activity.

    In the case of finance leases, the legal form of the arrangement is that the lessee may acquire no legal title to the leased asset. However, for the purposes of the application of the comparable and indicative rates, our view is that, in substance, the lessee acquires the economic benefits of the use of the leased asset for the major part of its economic life. This accords with current treatment of finance leases under Australian Accounting Standard AASB 17. Accordingly, we accept that the reference to ownership for the purposes of the guide includes assets acquired under finance leases.

    Finance leases are akin to borrowing to finance the purchase of an asset. Analysis of the accounts of independent equipment hire firms shows that some assets are acquired through finance leases. For these comparable companies EBIT has been calculated to exclude interest costs on such assets.

    If using the comparable rate for equipment hire in the guide (per Question 6):

    The comparable market rate in the guide is a return on assets (ROA) set at 7.5% on the opening written down value of the asset. Consistent with outright ownership, the ROA component of the service fee is based on the written down value of the asset which excludes the finance cost component of the finance lease.

    In certain circumstances the application of the ROA comparable rate may lead to the service entity incurring an overall loss for the equipment hire activity. This may occur when the interest costs incurred by the service entity exceed the ROA profit from the activity, since the service entity must absorb interest costs from the ROA. When the level of interest expenses in a service entity is high enough to place the entity in a loss for the equipment hire activity, the following concessionary treatment can be applied:

    This concessionary treatment is to view the service entity as a conduit, so that the service it is providing to the professional firm is primarily expense payment. Therefore, the entire lease payment would be passed on to the professional firm at cost (i.e. with no mark-up), with the appropriate expense payment comparable or indicative rate applied to the direct and indirect operating costs associated with the expense payment activity. Using this approach it would also be necessary for the service entity to charge across, at cost, any costs applicable to the equipment such as depreciation, repairs or insurance.

    If using the indicative rate for equipment hire in the guide (per Question 7):

    For the purposes of the indicative rate, the cost of the equipment is defined as the purchase price of the equipment. For finance leases, this definition comprises the capital component of the lease.

    The related interest component of the lease can be treated as an operating cost to be absorbed by the service entity out of the 10% mark-up on the capital component. This is consistent with the position for the comparable rate calculation where financing costs are excluded.

    In certain circumstances the application of the indicative rate may lead to the service entity incurring an overall loss for the equipment hire activity. This may occur when the interest costs incurred by the service entity exceed the net profit from the activity, since the service entity must absorb interest costs from the 10% mark-up rate. When the level of interest expenses in a service entity is high enough to place the entity in a loss for the equipment hire activity, the following concessionary treatment can be applied:

    This concessionary treatment is to view the service entity as a conduit, so that the service it is providing to the professional firm is primarily expense payment. Therefore, the entire lease payment would be passed on to the professional firm at cost (i.e. with no mark-up), with the appropriate expense payment comparable or indicative rate applied to the direct and indirect operating costs associated with the expense payment activity. Using this approach it would also be necessary for the service entity to charge across, at cost, any costs applicable to the equipment such as depreciation, repairs or insurance.

    10. What are typical service entity arrangements?

    The guide provides comparable and indicative rates which are applicable to typical service entity arrangements.

    Features of typical service entity arrangements are explained in the guide and are typically entered into by lawyers and accountants, although we have seen such service entity arrangements involving other professionals such as medical practitioners and pharmacists.

    There are service entity arrangements that differ significantly from the conventional business model, such as some medical practice arrangements which charge for services on a percentage of gross practice fees basis, instead of using a mark-up on costs approach. The guide at pages 24 -25 allows for a separate set of rates to be used for general medical practitioners who operate under this business model.

    Other service entity arrangements that have been observed include multiple entities or novel structures.

    As indicated in the guide, we will continue to respond to any concerns we see with these other types of service entity arrangements as appropriate.

      Last modified: 15 May 2015QC 20302