A Service Entity Checklist - Best Practice News Alert 108

HEALTH & LIFE’s BEST PRACTICE NEWS ALERT Current circulation:

6912

DATE: ISSUE NO:

14th June 2005 108

Welcome to Health & Life’s free email newsletter service. Tell a friend that we would be happy to add their email address to the distribution list. This service is to provide Health and Life’s clients and those who attended our presentations with up to date information on key financial and practice management issues that may affect your practice. Please do not use this as a substitute to seeking professional advice.

Writer in charge: Mr David Dahm CPA, BA Acc, FTIA, ASIA, FAAPM

*SPECIAL BROADCAST*

Service Trust Under the Microscope – A Service Entity Checklist th

After reading the recent ATO tax update from 4 May 2005 on service trusts and the recent press commentary, we thought the following service trust checklist would be useful (if you have a service entity) before you sign this years tax return. Should you have any concerns feel free to contact David Dahm on 1800 077 222 or 0407 620 120 for a no obligation confidential chat.

Problem – the latest ATO tax update on service trusts: 1.

2.

3.

4.

5.

Service fees are not commercial. Email us to review your rates for commerciality.

Failure to document. Email us for free template documentation.

Solo practitioners will have a harder time justifying their arrangements.

Asset protection is no longer a good enough defence for using a service trust.

12 month grace period announced for practices to fix up their affairs and resubmit their BAS’s

Solution Service Entity Checklist - they are still worth it!

Service trusts are still worth it, saving between $6000 to $20,000 p.a. in tax. If structured correctly, they provide a valuable succession planning vehicle for practices who have senior owner doctors wishing to sell down their interest.

While this is not an exhaustive checklist, we suggest that these points be covered in a review of a service entity engagement: (a) Were the arrangements established at arms-length? Arms-length parties as the manager of the service entity may be useful. Medical Corporates charge management fees of between 40% to 60% of gross fees. This is a useful starting point. However practices need actual proof or independent consultants to attest the fees charged are commercial. Contact our office for more information. (b) Are the arrangements documented, so as to show the service to be provided and the cost of such services? Without such documentation, the Commissioner will have a field day in cross-examination. More importantly, the taxpayer will be hard put to establish that an assessment is excessive – it is the taxpayers onus. Signed service agreements with all Doctors is a solution. Contact us to find out more about our template service agreements. (c) Has the arrangement been implemented In a way consistent with the documentation?

Details matter. You should assume that you will be cross-examined from your own documents. You can assume that this will not be pleasant where those documents are inconsistent with your overt acts. This means are you calculating Doctors pays correctly and issuing the correct tax invoices or adjustment notes where errors occur on a timely basis. We have a program that can simplify this time consuming process.

If you are paying Doctors on a percentage of gross fees see point (j). (d) Review the service agreement from time to time. Specifically, update the list of services to be supplied, and the prices at which they are to be supplied. See point (b) as a starting point. (e) Review the commerciality of the service costs from time to time. Do not simply rely on the mark-ups sued in Philips’ case i.e. mark up wages by 50% and all other expenses by 15% or variation thereof. This methodology was not specifically ruled as correct.

The judge ruled all management fees charged must be commercial. Once again refer to point (a) as a starting point. (f) Take great care to avoid doubling up on charges. How can a substantial mark-up be applied to something like electricity, where a substantial mark-up for the staff involved in processing such charges has already been claimed? Point (a) is a solution to this problem. (g) In the same vein, charges for labour should be inclusive of labour on-costs, and charges for premises and equipment should cover the economic risk of ownership (i.e. of the chance that repairs will need to be effected by the service entity). Once again, point (a) should be considered as a possible solution. (h) Where the service agreement leaves matters of mark-up and cost in the realm of generalities, at least settle the amount of the service fees for the tax year during the tax year. There must be a risk that a liability will be incurred, in terms of s8-1 of the Tax Act. The service fee should not bear minimal risk - the pricing structure should not guarantee all of its costs together with a fixed profit mark-up. A service fee based on a percentage of gross fees better reflects the risk and a justification for a higher mark-up. (i) In light of the above, bill periodically, which is normally monthly. This is not only more commercial than annual billing, but also focuses the minds of the managers of both

the medical practice and the service entity on the on-going costs. Actual bank transfers should provide evidence of these arrangements. (j) Get the on-going paper work right! For example, issue tax invoices (where required) contemporaneously with the transaction (or on the agreed periodical basis). Actually see to payment, or arrange arms’-length terms for amounts outstanding to attract interest. We have software called Doctors Pay Calculator that can simplify this process, which reconciles doctor’s payments to their Annual Tax Return and periodic Business Activity Statement. Contact us for an overview of this software program. It does more than your Excel spreadsheet. (k) Review the suitability of the service entity in terms of stamp duty, especially if it is a trust or owns any significant interests in land. Consider whether the way the service agreement causes a liability for rental business duty or lease duty. (l) In the process of such a review, consider whether it is desirable to bring the service entity within the GST provisions. (m) Asset protection is no longer a good enough reason to justify the existence of a Service Trust. The ATO have noticed many service trust arrangements do not hold the practice building in the trust and are in fact leased to the trust. More importantly most assets are leased and very few assets are held in the trust. Furthermore, the ATO has found: o service trusts also bore minimal risk - the pricing structure guaranteed it all of its costs together with a fixed profit mark-up. o Service trusts do not contribute any tangible or intangible assets (such as knowhow or brand name). o Practitioners continue to carry out all of the management functions associated with the recruitment and personnel functions.

We have always held an alternate view in relation to the role and purpose of a service trust which does justify a commercial existence beyond the common view held. The service trust should be a hybrid unit trust (not a fixed unit trust, discretionary or family trust), so check your current trust deed. We suggest a hybrid trust for the following commercial reasons: 1. Units can be bought and sold in part or as a whole to potential practitioners seeking to purchase an interest in the practices infrastructure; 2. All units must provide a deemed 25% to 30% return on investment. This allows doctors to purchase an interest by borrowing at a lower rate say 7%. This means owners can earn an income stream not based on a percentage of gross fees otherwise known as an “eat what you kill” basis.

3. Ownership is encouraged as it “locks in” practitioners. Employment and contractor arrangements can be terminated within a short period of time, say two weeks. This provides much uncertainty to owners of a practice. Ownership legally binds all owners to the debts of the practice in form of personal guarantees to underwrite loans and property leases and staff leave commitments etc.

4. The establishment of an investment vehicle where units can be traded allows for the valuation of practice branding, systems know how and location – site goodwill (as distinct from personal goodwill). A practice agreement should provide a clear formula on how the practice is valued based on the death or termination of a principal and how profits and liabilities are shared.

5.

A written Practice Agreement amongst the owners should provide clear commercial evidence. Contact our office to discuss our template Practice Agreement.

IS HEALTH & LIFE COMING TO A PLACE NEAR YOU? Throughout the year, David and the other consultants will be traveling regularly intrastate and interstate. This section will keep you up to date with these movements so that it gives you the opportunity to arrange to see them if you have any issues to discuss. Please contact our office to arrange a possible appointment. Future places/dates are:

15th to 18th June 2005 Late July 2005 August 2005 September 2005

David Dahm

Sydney Brisbane Melbourne Perth

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*** End of Issue 108 ***

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