ascendia Rough Guide: Service Entities

what are they and why use them?

Service Entities include things like companies and trusts that are used by a business to provide services to the main business.

They are useful because they allow a businessperson to:

Separate their business liabilities from some of the assets of the business – which are placed in the service entity that is designed so as to have far lesser liabilities and risks of liability.

Obtain some incidental tax advantages as a result of the flexibility or range of options in respect of the business structure that can be used for service entities in particular industries – which is often greater than the choice of business structure available for the main part of the business.

Obtain a clear focus on the part of the business that creates the wealth - business generating aspect of the business - by structuring it separately from the factor inputs – which after all do not generate the business. This can result in better management and improved business outcomes because the business manager is not managing the service entity – the factor inputs and services for the ‘back office’ are simply supplied in a manner required by the ‘front office’ of the business. The business manager’s attention can focus solely on the business generating aspects once the service agreement is in place.

The problems with using a service entity are that the ATO have endeavoured to govern such use with more controls and rules recently than they have in the past.

The utility of a service entity in a specific business depends on the cost / benefit analysis – as applied to the specific circumstances. One cannot determine whether a service entity is appropriate in a given industry or business type, a close inspection of the business is required. The requirements for the use of a service entity should not put a businessperson off from investigating the option. Both sides of the analysis should be considered – the usefulness and benefit of a service trust in your circumstances, and of course the costs of compliance. Bear in mind that all methods of providing the factor inputs or resources that a business uses needs to be done in a compliant manner.

The ATO have given Service Entities consideration over the last 30 years or so because of the second major usefulness of them as outlined above. In addition they can be misused and exploited to profit shift in an illegitimate manner.

This does not mean that the use of a service entity is illegitimate or not allowed; they are in widespread use and in the main are quite lawful. It is how one is used that is the issue – not the use of one per se.

There are a lot of tax ruling and case law and general articles and discussion available on the web that relates to this area – service entities or service trusts as the topic is sometimes narrowly referred to. We have provided a rough guide to the topic in this discussion to enable a lay / businessperson to make sense and use of these more specialised and technical resources. We have also provide a few links to most fruitful resources. Any search of the web however will show a host of resources.
This article will help you sift through the area of the topic you are most interested in.

compliance with australian law

There is a recent tax ruling (TR 2006 / 2) that represents that ATO’s effort to have the last say on Service Entities. It is also an effort in the view of some in the tax and legal profession to somewhat reframe the compliance situation with regard to Service Entities. However the legal and professional community do not think the ruling will be successful in this regard and will not stand up to legal challenge.

Nevertheless the vast majority of tax payers will not be interested in a legal dispute and court ruling as part of their compliance process and will acquiesce to the ATO view – a fact obviously well understood by the ATO.

Consequently we have below outlined the major guidelines for compliance as the ATO sees it – and also where this differs from the situation as the lawyers and professional tax community see it.

In addition we have provided a basic commercial analysis of the issues that should be considered when deciding whether to maintain or discontinue use of a Service Entity, and some of the alternative approaches.

This is a general “Rough Guide” for non-professionals in the area. It is intended to assist business people to understand the commercial context of the ATO guidelines and the use generally of a Service Entity.

the ATO perspective

The ATO is allowing until 30 April 2007 for taxpayers to make changes to their service entity arrangements.

The Service arrangement will not be examined by the ATO where

“The contractual benefits conferred by a service arrangement provide an objective commercial explanation for the whole of the expenditure made under the service arrangement alone will suffice to characterise the expenditure as expenditure that satisfies the positive limbs of s8-1 ITAA 1997.” (TR 2006/2 in 570, Taxation in Australia, 40,11, June 2006, Tax Institute).

An example where the objective commercial explanation does not exist is: where there is no clear separation between the service entity and the business – in which case the service arrangement may be seen as a sham.

Another example is where the amount of fees to the Service Entity and expenditure by the main business is grossly excessive in relation to the service provided, or where there is no real service actually provided.

In these examples according to TR 2006/2 the ATO would undertake an examination. Under a number of other scenarios they would too.

Once the ATO decide to undertake a broader examination of “all the circumstances surrounding the expenditure” a service arrangement will be regarded as non compliant where:

The fees are ‘disproportionate or grossly excessive in relation to the benefits conferred on the main business by the service arrangement”
The fees “guarantee the service entity a certain profit (guaranteed) profit outcome without commercial explanation, or,
The fees generate profits in the service entity with no evidence that there is any “value added (to the main business) or substantive functions performed” by the service entity”.

In considering these factors the ATO uses a “commonsense or practical weighing of the whole set of objectives and advantages which the taxpayer sought in making the outgoing”.

In relation to item a. above the ATO has published guidelines regarding what it considers excessive fee levels to be paid to service entities.

compliance with the ATO guidelines

Basically the ATO will not trigger an audit initially in respect of a service arrangement where the fees are within these benchmark mark up rates and the overall profit of the service entity is no greater than 30% of the combined profit of the main business and the service entity.

However, the ATO Guidelines and compliance thereof does not confer a “safe harbour” nevertheless. Adopting the indicative mark up benchmarks will mean that the level of fees will not trigger an ATO audit of themselves. However if there is alternative basis for an audit, them while they are there the ATO can decide to take a broader investigation of the Service arrangement, in this situation, regardless of the compliance with the rates the ATO may conclude that part or all of the expenses to the main business are not deductible.

Hence the broader reference to the Tax Rulings and the case law, and understanding the general principles is still important.

the broader legal and compliance context

It is useful to identify some basics as best as can be discerned from a non-legalistic analysis.

A. Identifiers of whether your business has a high risk of ATO Audit (doesn’t mean you’ll fail the audit!)

Three tests are identified:

Service expense are greater than 1 million
Service fee expense are greater than 50% of the gross income of the combined main business and the service entity
Net profit of the service entity(s) represents greater than 50% of the combined net profit of the entities involved (including the main business). (This is a restatement of item 11 for more complicated arrangements).

B. Identifiers of whether your busienss has a Medium risk of an ATO audit targeting service arrangements (again – you can still pass the audit of course)

An arrangement that does not adopt the ATO Guidelines regarding the benchmark, mark up rates (as discussed above).

The review process of the ATO is 2 step:

Are the fees excessive (refer guidelines)
Can the taxpayer explain how the service arrangement helps them ruin their business

Guidance as to the way this second factor in the review process is determined is provided by reference to the broader legal and tax ruling context. In a nutshell, the asset protection benefit seems to be a satisfactory explanation.

Useful references are:

Phillips Case
BCD Technologies Ruling
Mochkins Case

So if the guideless are followed and Asset Protection is reasonable the Service Arrangement should be a low audit risk and a low risk of failing an audit.

Asset Protection as an Acceptable Explanation of the benefit the Service Arrangement provides the business.

Useful references are:

Phillips Case
BCD Technologies Ruling
Mochkins Case

1. Phillips Case

If the taxpayer explains to the ATO that the service arrangement is beneficial to them for asset protection reasons – the Phillips case is no help. In this case the justices considered the reasons for the set up of the arrangement and not a lot of credence was give to the asset protection reason by the justices. However 2006 is a very different litigation culture to the 1970’s as indicated by subsequent landmark findings.

If the taxpayer explains the purpose as the acquiring of assessable income by the service entity and the carrying on of business for that reason, they would have support from Philips case. The justices agreed with this explanation and held that there was no secondary purpose of benefiting the families of the partners, rather the benefits which accrued to these families were the incentive for the acquisition of the services from the management company rather than elsewhere.

2. BCD Technologies Ruling

Asset Protection benefit is considered a sufficient reason. Senior Member McCabe held that:
“ I also accept the explanation …that a desire to protect assets was the taxpayers principal motivation in agreeing to establish of a service company arrangement. The Taxation Institute of Australia says, “the decision in the BCD technologies case suggests that despite what is said in the tax ruling of the same name – asset protection may be enough t satisfy step one of the booklet “Can you explain how the service arrangement helps you run your business?).

3. Mochkins Case

The decision in Mochkins case (full bench of the Federal Court) provide some indication of a bone fide explanation that would be OK: The justices held that: “ The tax payer achieved the objective of immunising himself from personal liability for the conduct of the stockbroking business”. So the objective of the arangement, the dominant purpose that woudl be Ok is Asset Protection.

a rough guide to keeping your service arrangement compliant

To implement an approach generally compliant you need to:

Talk to your business tax consultant and business accountant
Obtain a chart of accounts for the service entity and the main business that includes the correct items for each entity
Establish a pricing policy for the services operating out of the Service Entity that ensures the mark up guidelines and the overall net profit benchmark are complied with. This can be done by making an expense budget (within the Service Entity) and using a spreadsheet to mark up the process by the benchmark, and then sum to a total service fee to be charged to the main business.
Still using your spreadsheet: establish the overall service fee to be charged to the main business so as not to be above 30% of the expected profit of the combined enterprise for the current financial year. (Reducing the charge identified by the mark up modelling if necessary).
Talk to your lawyer (get a formal Service Agreement in place between the entities).
Ensure the Service Agreement is a commercially binding contract and that is specifies the prices and services to be provided including a description of the services to be provided, the terms and conditions under which these are to be provided, the risks and responsibilities assumed by the respective parties, the resources utilised by the service entity.
Establish a separate set of electronic book keeping records for the service entity and the main business.
Have different controllers and managers of each of the service entity and the main business – structure the operation to provide reasonable asset protection benefits.
Ensure the Service Entity is not in an exclusive arrangement with the main business – that if the opportunity were available and commercial etc that you would be able to offer the same service to third parties.
Maintain proper business documentation including, a separate office, office equipment and infrastructure to enable the operation of the business.
Be able to substantiate the operation of a substantive business practice, for instance by documents such as a business plan, cost documents, budgets, staff appraisals, governance records and registers, minutes of meetings, etc.

cost / benefit: should I use a service agreement?

There are other approaches that you may consider to provide similar benefits. This is not the topic of discussion:

Licensing and License Agreements
Incorporation
Use of Mum & Dad Partnerships and recent changes to their regulation.

We are in the process of developing more in our ascendia rough guide series to these areas of discussion.