Using service arrangements
We understand that it is common for accountants, lawyers and other professionals (particularly those who are required to operate their businesses as individuals or as partnerships) to engage associated entities to provide them with labour hire, recruitment, clerical, administrative and other services (also known as service arrangements). These arrangements can also be used in the broader business community.
We also understand that it is common for professionals to view service arrangements as an effective means of protecting their assets from professional negligence actions and other claims.
Our concern is whether the service fees being claimed are deductible under the income tax law.
If you have a conventional service arrangement where your payments are correctly calculated and the services are reasonably connected to the conduct of your business, then the presumption will be that your service fees and charges are a real and genuine cost of your business and deductible in full.
If your payments are grossly excessive or the services are not reasonably connected to the conduct of your business, then the purpose, and the deductibility, of some or all of your service fees is open to question. We may ask you to explain your entitlement to the deduction claimed. If we are not satisfied with your explanation, we may disallow some or all of your deduction.
For an authoritative explanation of why this is the case, you should consult taxation rulings IT 276 Payments to service companies: splitting of professional income and TR 2006/2 Income tax: deductibility of service fees paid to associated service entities: Phillips arrangements.
Tax Office compliance activities
Our concerns about practices being adopted in some service arrangements arose from audits conducted in the legal and accounting sector. These concerns were raised publicly in the Commissioner of Taxation's Annual Report to Parliament for 2000-01, and subsequently in speeches by the Commissioner. After consulting with industry, Taxation Ruling TR 2006/2 was issued to supplement Taxation Ruling IT 276 and provides a more detailed explanation of our views in light of these practices.
Our approach for existing arrangements
We will allow a period of 12 months after the release of this guide for people to review their service arrangements if their circumstances warrant a review. This period ends on 30 April 2007.
In such cases, we recommend that you commence a review of your arrangements as soon as possible as the implementation of changes can take some time. Reviews that have not been finalised by 30 April 2007 will only be given additional time to comply in exceptional circumstances.
If at the end of this period your service arrangement is generally in line with the information provided in this guide there is little risk that we would audit your arrangements. If at the end of this period your service arrangement is not in line with the information in this guide, and we do commence an audit, our review may include earlier income years.
This guide provides:
- Case studies assessing the risk of audit for service arrangements in place at the end of this review period. It also includes case studies that deal with service arrangements entered into by general medical practitioners.
- Our general indicative rates above which your arrangement may be audited.
- Specific indicative rates relevant to the medical profession.
We will also continue with our current audit program for the highest risk cases. We consider these highest risk cases meet all of the following three tests for a given income year:
- Service fee expenses are over $1 million.
- Service fee expenses represent over 50% of the gross fees or business income earned.
- Net profit of the service entity (or service entities) represents over 50% of the combined net profit of the entities involved.
These tests look at the size of deduction claimed, the materiality of the arrangement to the business, and the potential extent to which the arrangement may be a sign of unacceptable tax planning.
The highest risk cases with the features listed above will not be given 12 months to review their arrangements. We believe businesses that make claims of this size and materiality could reasonably be expected to comply with the law without the need to rely on the additional information in Taxation Ruling 2006/2 and this guide. If we do commence an audit in these cases, our review may include earlier income years.
We will also look at cases under our current audit program where there are serious questions as to whether the services were in fact provided by the service entity.
In terms of our current audit program, when we do start an audit of your service arrangement, it does not mean we think you are dishonest. We acknowledge there may be cases selected for audit based on risk assessment which on further examination turn out to be acceptable.
If you have acted on specific advice from the Tax Office you would generally be excluded from our current audit program, but you may need to review your arrangements for the future. In any examination of these cases we would need to consider the terms of the specific advice and whether there are material factors relevant to the operation of the service arrangements that were not disclosed in connection with the advice.
Our approach after the review period
After the review period, we will manage ongoing tax compliance for service arrangements in accordance with our general risk assessment approaches. Depending on what we see as the ongoing risk, we may include service arrangements in our general compliance program, and conduct market or industry based projects. Our view on tax compliance risk for service arrangements is explained in this guide.
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If we do start an audit of your service arrangement, it does not mean we think you are dishonest. We acknowledge there may be cases selected for audit based on risk assessment which on further examination turn out to be acceptable.
All or part of the fees may still be deductible even if the fees charged exceed market rates. The greater the divergence from those rates, the greater the likelihood becomes that other benefits which do not support a deduction may explain the purpose of the arrangement. In these cases, all or part of the fees will be non-deductible.
Depending on the overall level of risk we see, we would not ordinarily commence an audit unless there is substantial divergence. We provide indicative rates that reflect this divergence.
In this guide we provide data on the level of commercial returns seen for some of the more common functions performed under service arrangements. This represents the best information currently available to the Commissioner. This data would be used by the Commissioner if amendments to assessments are required to adjust excessive expense claims back to economically justifiable amounts. Over time, commercial returns can change for services and the Commissioner will consider up-to-date information in making adjustments.
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If we conclude that an income tax adjustment and penalties are required, our usual practice is to issue a position paper that gives you the opportunity to comment before any tax and penalties are assessed. Further, where the audit results in an income tax adjustment and/or the imposition of penalties, any such adjustments would be subject to the normal review and appeal processes.