PROPER COMMERCIAL USE OF SERVICE TRUST ARRANGEMENT
SERVICE TRUST ARRANGEMENT IN MELBOURNE
Commercial use of Service Trust Arrangements with the Australian Taxation Office
COMMERCIAL USE OF SERVICE TRUST ARRANGEMENTS WITH THE AUSTRALIAN TAXATION OFFICE
Most business professionals cannot involve their families or use companies or trusts as their business organisation due to various licensing requirements for their particular profession, or due to structuring for asset protection. This prohibition or asset protection limitation has given rise to the interposing of a service entity that provides external administrative and support services in return for the payment of fees and charges by the business professional service provider.
Traditionally, the narrow utilisation of the service entity has been to divert income from the business professional to another entity by paying for administrative and support services over and above the usual operational costs expended by the business professional.
Consequently, the business professional could transfer funds to the service entity and split income with the family through a discretionary trust, or by dividend if a trust was not in place. Unfortunately, this narrow approach focused merely on tax minimisation and not on pertinent strategies such as asset protection and the creation of value to clients as part of the service entity’s value proposition.
Although the Australian Taxation Office does not agree with this narrow approach it has allowed service entities to continue, however, it has earmarked service arrangements for scrutiny and attack. The Australian Taxation Office has allowed service arrangements with the service entity where the business professional could prove:
The services were connected with the taxpayer’s income earning activities, and
The service fees charged were not grossly excessive.
The Australian Taxation Office published its guidelines in June 2005, which it hopes, will underpin these service arrangements. The Australian Taxation Office will now look at whether the service arrangement is commerciality realistic assessing both the purpose for the arrangement and the level of the service fees charged.
Business professionals who operate service arrangements now have an opportunity to revise their strategy and decide if they can convert the service entity that provides little or no value to the value proposition into a business that actually creates a product or service adding value to the owner and clients. The wider approach this article espouses can easily overcome the objections of the Australian Taxation Office and avoid the wrath of an unfavourable determination.
According to Behan Legal’s Managing Director, Francis Ruggiero,
“… Those business professionals who carry the risk, or are about to enter the business market will have the most to lose.”
Recent taxation audits have uncovered major defects in service arrangements, and not even one of Australia’s larger accounting firms was immune from scrutiny, attack, and liability to repay substantial fines and taxes. Frankly, if an accounting firm could not correctly set up a service arrangement that could stand up to the rigours of the Australian Taxation Office, then there is little hope for the business professional who has not obtained the correct legal advice.
The solution is simple-change the paradigm of doing business. Business professionals should consider making the business more commercially realistic and provide real goods and services to the public and not merely to the particular individual that is primarily running a professional service.
The business professional should create strategies that protect personal and business assets in the organisational structure and avoid the traditional narrow approach espoused by tax advisers who seek to minimise or avoid taxation. One can avoid an unfavourable determination during an audit by the Australian Taxation Office if one can:
a) Identify the commercial benefits of the service entity;
b) Explain how the service arrangement helps the business;
c) Show the existence of commercially realistic rates; and
d) Ensure there is adequate documentation.
As part of the audit, the Australian Taxation Office examines:
e) The service arrangement to determine whether the payments are commercially realistic and if there is a reasonable connection between the service entity and the business professional;
f) The business or corporate structure;
i) Invoicing, and
j) Distributions under the service trust to determine whether the arrangement is commercially realistic
The preceding aspects highlight the need to cover thoroughly each issue in strict compliance with the taxation legislation. It is fatal to a service arrangement if the business professional does not have a service agreement or the pricing schedule that fully complies with the taxation legislation.
Failure to adhere strictly to the requirements will lead the Australian Taxation Office to make a negative determination. This will result in it denying the claim for deductions by the business professional of some or all service fees under the service arrangement. It is likely that some business owners do not have proper service agreements that have been prepared in accordance with the strict requirements of the taxation legislation, or some do not have any agreements in place at all.
Business professionals had a 12-month grace period (until June 2006) to review their service arrangements and meet these conditions to avoid the negative determination:
The service entity does not derive fees in excess of AUD$1M, and
The service fees represent less than 50% of the gross income of the professional practice.
PROPOSED ACTION & IMPLEMENTATION
This is the critical time to review:
The actual need for a service arrangement
Whether it is possible to change the business paradigm whilst utilising the arrangement
The use of the wider rather than the narrow business approach
The strategies necessary to protect business and personal assets
Whether there is correct compliance of the service arrangement
It is essential that the business professional carry out a systematic legal analysis of the current service arrangement to determine whether there is strict compliance with the requirements of the Australian Taxation Office. This analysis may uncover gaps in the structure, which need rectification before the gaps become financial liabilities. In conjunction with the business professional, Behan Legal can outline the necessary preventative legal steps to put a stop to costly taxation disputes.
NEED MORE INFORMATION
Behan Legal assists and advises on these important issues. For an appointment, call 03 9646 0344