The following steps will help you identify the commercial benefits of your service arrangement to your business and, given those benefits, judge whether the service fees and charges are correctly calculated.
Step 1: Can you explain how the service arrangement helps you run your business?
For expenses to be deductible, they need to have a connection to the income earning activities of your business.
A service arrangement is likely to enhance, assist or improve your ability to produce income or make profits if the service entity:
- gives you access to staff, skills or know-how that is relevant to the conduct of your business and which is in fact provided by the service entity
- relieves you of the responsibility for conducting and managing certain functions (for example, recruitment or payroll services)
- relieves you of certain risks (for example, provides you with a fixed or pre-determined cost structure for certain activities), or
- relieves you of certain financial or legal obligations (for example, employer obligations in relation to workers' compensation, payroll tax, superannuation, statutory holidays, long service leave or unfair dismissal).
Your service entity should be able to point to the personnel (for example, staff and management) and resources (for example, materials, equipment and premises) it employs to deliver the contracted services to you at the times and to the quality agreed under the service agreement.
If you conclude that you have not obtained any commercial benefits from the service arrangement and it is clear that there is no connection between the arrangement and the income earning activities of your business, the service fees and charges may not be wholly deductible (see taxation rulings IT 276 and TR 2006/2).
If you have identified the commercial benefits provided by the service arrangement and the necessary connection with the business, go to step 2.
End of further information
Once you have identified the necessary business connection and the commercial benefits to your business from the service arrangement, the next step is to review whether the level of service fees and charges are acceptable.
In cases where fees charged are grossly excessive, all or part of the fees may be non-deductible. The greater the divergence away from market rates, the greater the likelihood becomes that other benefits that are not deductible are being claimed.
The simplest method of review is to look at the indicative rates and the case studies. If you come within these, you have a low risk of audit.
However, if you want to carry out a more extensive review to determine a market benchmark from which you can consider whether your charges are correctly calculated, a number of approaches are described below.
Comparable market prices
Comparable market prices can provide a starting point to determine whether your charges are grossly excessive. You do this by comparing your service arrangement with arrangements entered into by independent parties to look at the prices charged for the same or similar property or services by independent suppliers in the open market.
For example, if the service entity is leasing you office space, you might compare the rent the service entity is charging you to the market rent charged between independent parties for similar office space (adjusted for any differences in the terms and conditions on which the respective leases are negotiated or for any other relevant factors).
Similarly, if you are hiring a staff member from the service entity on a long-term basis, you might compare the hire fee the service entity is charging you with either the salary, on-costs (such as superannuation and payroll tax) and administrative expenses you would be likely to incur if you employed the person directly, or the fee charged on comparable long-term commercial arrangements if these are available and ordinarily used in your industry.
If your service arrangement is not delivering you any commercial benefits above and beyond what you could have obtained direct from an unrelated supplier, but your service fees and charges are grossly excessive relative to the market price, then there is a high risk of audit and adjustment.
Another approach to determine a benchmark from which to see whether your charges are grossly excessive is to look at the profits achieved by independent suppliers who provide the same or similar property or services in the open market.
- Net mark-up on costs - under this approach, you might look at the net profit achieved by independent suppliers who provide the same or similar property or services in the open market, measured as a net mark-up on total costs.
The following table provides information about a number of publicly listed companies providing labour hire and recruitment services.
The financial results for these companies were publicly available from the Australian Securities and Investment Commission (ASIC) and from the companies themselves (via their websites). We were able to take the publicly available information and calculate the operating profits achieved by these companies' labour hire and recruitment activities.
We have considered this information in working out the comparable labour-hire and recruitment rates.
Net mark-up on costs (operating profit/total costs), 2003-05
3.1% to 4.3%
Note: In this table, operating profit was defined as the profits from labour hire and recruitment activities, before interest, income tax, and goodwill amortisation expenses. Non-labour hire/recruitment expenses were excluded from the calculations. Total cost was defined as the total cost of the labour hire activity, taking into account both direct and indirect costs. The interquartile range represents the middle 50% of the observations or data points.
- Gross mark-up on costs - under this approach, you might look at the gross profit margin that independent suppliers apply to particular operating costs in order to arrive at a benchmark rate for the particular property or services, measured as a gross mark-up on those costs.
Labour hire firms generally determine the charge for staff placed with clients by adding a mark-up to the salaries, and employment on-costs like superannuation, workers' compensation insurance and payroll tax costs incurred by the labour hire firm for those staff members.
Other operating costs incurred by the labour hire firm, such as its own staff costs, marketing, consumables, accommodation, administrative and recruitment costs, are not charged to the client but are instead absorbed by the gross fees earned from customers.
Usually, the gross mark-ups vary with the length of the placement. The mark-ups usually decrease the longer staff are placed with the client. This is because costs involved with the recruitment cycle are incurred less frequently.
An appropriate level of gross profit mark-up and the comparability of a particular arrangement depends on:
- the industry or service involved
- the detail of the pricing model used
- the extent to which expenses are included in the calculation of the service fees and charges compared to those expenses that are not
- the mix between fixed and variable costs, and
- the mix between gross costs and operating expenses.
These factors differ greatly from business to business. For example, a higher gross mark-up rate for labour hire services applied to a narrower base of direct salary only can be equivalent to a lower gross mark-up rate that is applied to a broader base covering salary and other direct and indirect employment costs.
A gross mark-up in a particular case can be shown to be correctly calculated in a number of ways. For example:
- it does not grossly exceed the mark-up in independent arrangements with comparable pricing factors
- it can be a mark-up consistent with business plans or budgets supporting a net profit outcome which does not grossly exceed benchmark net profits, or
- it can be a mark-up for the current year based on the previous year's results, or an average over a number of years, adjusted to provide a net profit outcome which does not grossly exceed benchmark net profits.
Using these methods
A labour-hire arrangement typically involves a labour-hire agency employing casual workers on a temporary basis to on-hire to clients on short-term to medium-term placements.1
Regular labour hire arrangements provide the client with an efficient and cost effective way of accessing a flexible pool of appropriately qualified staff, readily able to help the client cover staff absences and to respond to the fluctuating demands of its business. They may also provide the client with an opportunity to assess individuals before offering permanent employment.
The agency supplies the assets, staff and know-how required to recruit and match workers to clients and it retains the bulk of the employment risks and responsibilities for the workers. The client has control over how much time the worker is engaged and is able to employ additional labour only when required, resulting in lower overall wage costs compared with a strategy of hiring additional ongoing labour.2
Regular labour hire arrangements of the type described in the example above should be distinguished from labour hire arrangements in which the agency recruits permanent staff specifically for long-term placement with a client who assumes the long-term control and management of the staff.
The sharing of responsibilities, risks and benefits in a permanent recruitment arrangement is different to the regular labour hire arrangement. The fees that would be charged by independent labour hire firms for the particular type of services provided to you gives a reasonable benchmark from which to determine whether your charges are grossly excessive.
If you choose to use a comparable profit approach, you need to take care to be consistent about the cost structure you use to make the profit comparison and make sure the arrangement you use for comparison has the same types of expenses. You should also exclude any non-operating expenses that are not connected to the provision of the particular property or services (for example, interest and royalties).
Similarly, costs that are not genuinely incurred by the service entity in carrying on its business should be disregarded. In some cases, 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 these cases, the payments should be excluded from any calculations - at least to the extent of the excess.
You also need to be careful if the service entity provides more than one type of service. A common mistake is to take the same costs into account when making comparisons in relation to two or more types of service - this is often referred to as 'double counting' the costs.
A service entity is engaged to provide both marketing services and a labour hire service, and a comparable profit approach is used to compare the service arrangement with the same or similar marketing and labour hire arrangements entered into by independent persons. In this situation, the salary and on-costs incurred by the service entity for the marketing staff should only be taken into account in determining a comparable profit outcome for the marketing service. Their salary and on-costs should not be taken into account in determining a comparable profit outcome for the labour hire service.
Information about comparable profit approach
There are several public sources of information that can be used to undertake a comparable profit approach. One source of industry information is the Australian Bureau of Statistics catalogue that reports industry profitability outcomes. Alternatively, information about many companies is publicly available through a range of commercial databases of companies, such as IBISworld, Dunn and Bradstreet and Business Who's Who.
This information can be complemented by the financial results published by the companies themselves (for example, on their websites or as reported by ASIC).
Please carefully consider the reliability of the data and, where necessary, make adjustments to reflect any material differences between two factual situations so you are matching like with like.
If we ask you about your service arrangement, the way you have used such information can help explain the commerciality of your arrangement and the basis for any differences with the indicative rates we have provided.
Commercial arrangements and profits differ between industries and the nature of the services provided. This needs to be recognised in any comparison undertaken. Similarly, commercial arrangements in one industry may not be used in another industry and may not be suitable for comparison purposes.
Certain practice management arrangements that have come to be used in the medical profession may be appropriate for comparison purposes in the medical profession where a similar range of services is provided by the service entity. However, they are unlikely to serve as a suitable comparison for the purposes of more conventional service arrangements in other professions. This is because the features and circumstances of these arrangements are substantially different. Refer to case studies on the medical profession.
Step 3: What documentation do you need?
While there is no obligation on you to create specific business records about your dealings with an associated service entity, you must keep records that explain your transactions for tax purposes. The extent to which records are ordinarily kept can depend on factors like the significance and complexity and materiality of the transaction and the size of the business.
In large businesses a high standard of planning and governance is usual and consideration of commerciality can be expected to include an economic assessment of the various parts of the business and the value of all major contracts and arrangements. Documentation can also be expected to deal with a comprehensive business assessment including allocations of business profits to brand value and goodwill of the firm in working out a fair commercial return on each element of the business, including those elements provided by the service entity.
In our experience, arrangements with related parties generally involve a greater level of potential tax compliance risk. Our attention will be drawn to arrangements with related parties that are not well documented and that do not have the elements usually associated with a commercial activity.
End of attention
The key documentation that you may already have in relation to your arrangements and that may be relevant in supporting the way you have characterised and priced the benefits of your service arrangement includes:
- the service agreement
- documents showing how you and the service entity arrived at a pricing structure for the services provided
- tax invoices for the service fees charged, and evidence of payment
- calculation statements showing how the service fees were calculated from time to time, including details of how any mark-ups have been applied
- minutes of meetings concerning the service entity
- budgets, business plans, and organisational charts for both your business and the service entity - your service arrangement should be reflected in your planning and budgeting
- detailed profit and loss statements and balance sheets for both your business and the service entity for the current year and two prior years
- if you are a partner in a partnership, your partnership agreement, as varied
- the constituent documents for the service entity (such as the deed establishing the service trust)
- resolutions by the service entity about distributing profits
- a list of personnel employed by the service entities together with relevant duty statements
- employment contracts, timesheets, other personnel records and reporting guidelines for employees of the service entity
- relevant insurance contracts, and
- relevant lease and/or rental agreements.