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Professional service trusts – are you covered?

Feature Articles

Cite as: (2003) 77(9) LIJ, p.40

Professional service trusts are the latest area of professional practice threatened with more intensive Australian Taxation Office scrutiny.

By Dr Srechko Kontelj

Service trusts have been part of the professional practice landscape for a number of decades especially since their status was clarified by the Full Federal Court in the landmark case of FCT v Phillips.[1] Today, it is estimated that tens of thousands of professional practices,[2] especially in the legal, accounting and architectural professions use professional service trusts as an adjunct to their businesses. The use of a professional service trust can offer protection to the personal assets of the principals of professional practices and can also provide the opportunity to save personal tax payable by such professionals. Their scrutiny comes at a time when professional practices are becoming increasingly aware of their vulnerability since the collapse of insurance companies HIH and FAI and the corresponding action against the auditors of those firms and the consequential difficulties that have arisen for professionals in obtaining effective indemnity insurance for their actions. This, against a backdrop of a more litigious society, makes the Australian Taxation Office’s (ATO) announcement of its intended increased scrutiny less than welcome by most in professional service practice.

The structure

The usual professional service trust structure involves a corporate entity acting as a trustee of the trust. The directors and shareholders of the corporate trustee entity are generally family members of the professional practice’s principals. These same individuals, together with other direct family members, are also usually the beneficiaries of the service trust.

The professional firm through its legal structure has a contract with the service trust for the provision of various administrative services for the professional practice. Office administration services, including the wages of associated staff, library services, reception services, office space and office related equipment are some of the more common services hived off to a professional service trust. The service trust charges a premium, up to 50 per cent plus costs, for the provision of such services. The income generated by the trust is distributed by the trust to family members or related entities of the professional practices principals to achieve a more favourable taxation position than if the principals had declared all the income in his or her own name. In this way, taxation payable by the “family” unit is minimised.

ATO’s proposed action

In the past, the ATO has accepted the existence and operation of professional service trusts without too much scrutiny. Recently, however, the ATO has indicated that it intends to take action against service trust arrangements that deviate or vary significantly from the arrangement in Phillips.

In response to concerns raised by the National Tax Liaison Group at meetings with the ATO in September 2002 and March 2003, the ATO advised that:

“During the next few weeks the ATO will be contacting a range of legal and accounting partnerships seeking information about the use of their service trusts and service entities. The information requested will be directed at the commerciality of the arrangements including details as to the fees paid, gross and net mark-ups used and entities employed. The information requests are intended to test compliance with IT 276. In IT 276, the ATO indicated that we would accept service trust arrangements that were entered into for commercial reasons and with realistic charges that are not in excess of commercial rates paid to unrelated parties for the provision of similar services. This requires a close examination of all relevant facts. In each case, the deductibility of any service fees including application of Part IVA will depend on the particular facts”.[3]

The ATO released the table below which “ ... summarises some of the differences between the service arrangement in Phillips and the arrangements more recently encountered by the ATO which taken together tip the scale beyond what seems to be explicable on commercial grounds. The differences are the result of the analysis of a number of factual circumstances and do not necessarily relate to any particular factual circumstance. Consequently, not all of these differences will necessarily exist in any one case. Nor will the absence of one or more of these differences necessarily mean that an arrangement is acceptable. Ultimately, the question for the commissioner is whether a particular arrangement is ‘commercial’”.[4]

Having been forewarned all legal firms who use a service trust should review their structure to ensure compliance with IT 276 and identify significant variations from the Phillips arrangement.

Professional practices must be able to establish to the commissioner’s satisfaction that the trust was set up for reasons other than to avoid taxation. If tax avoidance is the dominant purpose for establishing the trust the commissioner can argue that the arrangement falls foul of Part IVA of the Income Tax Assessment Act 1936 (as amended) and if so it will be struck out. The operation of the trust must reflect the fact that the trust was established to help protect assets, to improve business efficiency, to increase the wealth of the involved professionals and lastly to split income. The taxation benefits that flow from using the service trust can be one of the legitimate reasons for using the trust but it must not be dominant purpose for establishing and using the structure.

Checklist

To successfully answer the commissioner’s assertion that a service trust falls fouls of Part IVA, the professional practice must ensure that the rates charged by the trust are reasonable and commercial. While cost plus 50 per cent was used in Phillips to bill support staff, it does not follow that cost plus 50 per cent will be accepted by the commissioner in every instance. The commissioner will adopt a case-by-case basis to assess the commerciality of particular arrangements. Professional practices will need to be able to articulate how and on what basis the mark-up rate was set. In today’s market the commissioner will have ample opportunity to compare the rates charged by the market against the mark-ups used by professional service trusts. Any significant deviation in the mark-up rate from the market is likely to receive the commissioner’s attention and will need to be explained and substantiated.

The administration of the service trust must resemble that which one would expect from a business offering the services of the trust in the market. Documentation including the existence of appropriate contracts for the provision and payment of the professional services must exist. Other relevant documentation includes appropriate, up-to-date accounting and management records and minutes of meeting of directors that show a professional level of decision making and discourse commensurate with the business of the service trust.

Invoices should have been issued by the trust in the usual commercial manner and bank accounts, statements and records maintained. It is extremely important that the fees provided for under the professional service contract have been paid as and when they fell due. A paper trail of book entries without physical payment will not suffice and is likely to attract the adverse attention and reaction of the commissioner.

Conclusion

A professional service trust is and will continue to be a useful adjunct to a professional practice provided it is established, administered and run in a manner commensurate with a like service provider in the open market. The commissioner has indicated that he is not interested in re-opening Phillips. However, he is interested to ensure that those who use professional service trusts are doing so for legitimate commercial practice reasons and on commercial terms and conditions and not for the dominant purpose of taxation avoidance. Having been forewarned of the commissioner’s intention of increasing scrutiny of existing service trusts, professional practices who use such trusts should as a matter of urgency, carry out a due diligence of their service trust structure or better still, arrange for the structure to be reviewed by an objective third-party expert in this area of the law.

Phillips

  1. Phillips concerned a service arrangement between a partnership (Fell & Sharkey) and a unit trust (the FMT). The trustee and manager of the FMT were both companies. The directors and shareholders of the trustee and the manager were not members of the partnership.

    Variations The service trust is a discretionary trust, the trustee of which is a company owned and controlled by the partners.

  2. Income distributions from the FMT were fixed by the unit holdings.

    Variations The trust is discretionary in form. However, in substance the trust distributions are fixed by reference to the profit sharing arrangements in the partnership. In effect, this means that the partners have the ability to direct the distributions on an annual basis.

  3. In Phillips, the service arrangement was entered into and conducted in an arm’s length manner.

    Variations The service arrangements are not established and conducted on an arm’s length basis, documentation is poor.

  4. The service fees and charges in Phillips were found to be realistic and not in excess of the commercial rates.

    Variations The fees for the services provided are not commercially realistic and the net mark-ups are well in excess of market rates for the provision of equivalent services. For example, in some instances the service trust is more profitable than comparable labour hire firms or indeed the partnership itself.

  5. In return for the services fees, Fell & Sharkey was relieved from most problems of staff and office management and all financial obligations in respect of wages, sick leave, annual leave, long service leave etc.

    Variations The partners retain management responsibility for overseeing the staff and services provided by the trust. The partnership is not relieved of all of the employment risk associated with the staff, nor is it relieved of the economic costs typically associated with the employment of permanent staff.

  6. The service trust employed its own executive staff who were responsible for its operations, administration, staff supervision etc. It rented premises, held assets, bore a range of staff-related expenses and stood ready to sell its services direct to the business community.

    Variations The service trust does not rent or own premises or equipment, it has minimal assets and it does not solicit third party clients. It is difficult to identify any service trust staff who are not on-hired to the partnership and who are responsible for the operation and administration of the trust.

  7. In Phillips, only the administration and clerical staff were outsourced to the FMT.

    Variations All the permanent staff, including the professional staff, are hired via the service trust at substantial net mark-ups.

DR SRECHKO KONTELJ is a general counsel specialising in business law. He previously lectured in tax law at Deakin University and in 1999 was awarded that university’s first doctorate in juridical science. Dr Kontelj is also a specialist reserve legal officer with the RAAF.


[1] 78 ATC 4361.

[2] BRW, 8-14 May 2003, p80.

[3] Taxvine 2003, no 19, Taxation Institute of Australia.

[4] Note 3 above, at pp2-3.

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