Pay No More Tax - Best Practice News Alert 120

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

6962

DATE: ISSUE NO:

12th April 2006 120

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, FFin, FAAPM,GLF.

H&L Update Happy Easter We hope everyone has a safe and happy Easter break with their families and friends!

Want to Pay Less Tax (max rate 30%) and have 100% Asset protection? – new Tax Ruling creates new opportunities The Problem – New Federal Court Case opens new income splitting opportunities?

We are sure this title will always raise a few eyebrows. My father who is a doctor once said to me that he only worked 50% of the time because the other 50% went to the government to pay taxes.

We wonder if he had arranged his affairs like the person below whether he may have seen a few more patients! This could be the answer to the doctor shortage in private practice.

We have been following this case for the last 5 years and were surprised with the final outcome.

The bottom line is a provider can bill $500,000 p.a. then claim a $500,000 tax deduction by transferring this money to a family related company which can then legally income split to family trusts and corporate beneficiaries who pay tax at the lowest marginal rates. Tax savings can range upwards from $12,000 p.a. for somebody earning $120,000 p.a. This would apply whether you were married with kids or single.

Could you benefit from such an arrangement?

1. Who Does this affect?

Anyone working private practice or at a public hospital who pays more than 30c in the dollar in income tax and who also directly bills patients on a fee for service basis could utilise this arrangement.

• • • • •

Solo practitioners Employee practitioners in private practice and public hospitals private practice arrangements Associates Partnerships Contractors

2. So where is the tax break?

The case is Service v Federal Commissioner of Taxation [2000] FCA 188 Don’t confuse the name with “service trusts”!! This is totally unrelated.

The arrangement is quite simple. The taxpayer was a property developer, professional director and consultant. He entered into an arrangement with his own family company. The company was owned by his wife and children. The agreement was that any earnings from himself such as Director Fees or consulting fees must be paid to the family company. He was employed and paid an $80,000 wage from the family company.

It was held, the taxpayer was allowed to claim a tax deduction for all his Director and Consulting Fees generated in his name that were transferred to the family company. It is noted a company pays tax at a maximum rate of 30%.

Another recent example is the Tax Office class ruling CR 2004/121 ACT it states in relation to private practice arrangements at public hospitals in the ACTB Para 25.“The billings are paid over, as a condition of employment and this creates the connection with the activities which more directly gain or produce the assessable income. Therefore, the deduction for the amount paid over is a 'work related expense'”.

So for example, if Dr Good billed Medicare $100 then Dr Good could claim a deduction against this amount for $100 and transfer $100 to a related family company.

These arrangements appear to good to be true.

This all sounds a bit dodgy and we thought so too, until we heard the Tax Office appeals were heard and rejected multiple times. The Tax Office initially objected to the Service arrangement in the Administrative Appeals Tribunal. The judge had found in favour of the taxpayer. The Tax Office appealed the judgement before the Full Bench of the Federal Court. The full Federal Court found in favour of the taxpayer once again. The Tax Office was still not happy and appealed to the High Court. The High Court refused to hear its appeal! Talk about never giving up.

Then in an about face the Tax Office has recently endorsed the case as a number of private sector hospital rulings in the Eastern States have been issued. These relate to doctors involved in private practice arrangements employed in public hospitals.

We have had face to face meetings and contact with the Tax Office since 2003 to clarify their position as we still find it hard to believe the position the Tax Office had taken, although we agree with the letter of the law could be severely curtailed.

In 2006, our investigations have led us to conclude there may be a legitimate tax planning opportunity available. We are the first to publicly comment or express this view. We do not believe they are definitive in this news alert and all readers should seek independent professional

advice to ensure this is applicable to their own arrangements before embarking on such an arrangement.

3. Can the tax loop hole be closed?

The Tax Office have tried many times and have not been successful yet in closing this loop hole. They are in a catch 22 position. Their recent support for the case will only contradict their position with the public hospitals. The following explains further problems they will have.

This case is similar to the Phillips V FCT 1977 case on service trusts. The Tax Office had failed to attack or legislate against them for over two decades. Recent audit activity shows if they can’t challenge the law they will attempt to challenge your paperwork – regardless this remains good law.

Another example includes Everett Assignments, where a taxpayer was legally allowed to gift his share of partnership income to his wife each year.

This is what makes this ruling compelling. It has been challenged in the highest Courts in Australia and appears to be another landmark test case like the Phillips case.

Can this arrangement be challenged by the Tax Office?

1. Personal Service Income (“PSI”)Legislation After the Service case in 2000 the Tax Office has attempted to close this loophole.

Alienation of Personal Service Income law was introduced in 2001. This stops “Friday secretaries” resigning and becoming “Monday morning company contractors”. This law denies various tax deductions to the taxpayer who provides predominantly personal services for labour through a company or business.

Where a single customer represents greater than 80% of the total income of the taxpayer in a given tax year they are caught by this legislation.

Various exemptions apply if a taxpayer can show this is not the case.

To access the exemption, many doctors operate as associates and not as contractors specific to a practice. Under such an arrangement the patient is the customer and not the practice and therefore the PSI rules do not apply even though the personal services are rendered. This arrangement is perfectly legal and specific tax rulings exist exempting providers.

Providers do not appear to be caught under the PSI rules if structured correctly.

2. My accountant does not like it!

Part 4A was not applied to the Service case. On special leave to the High Court they said Part 4A is “irrelevant” and did not apply!

Part 4A is the most feared piece of legislation by lawyers and accountants. This gives the Tax Office enormous powers to strike down an arrangement as a sham and deny a tax deduction or void a scheme or arrangement. This law was introduced in the 1990’s and replaced the old s.260 laws. The main defence is the arrangement must have a basis where the sole and dominant purpose is not to obtain a tax benefit.

We believe the Tax Office failed in its case, because the taxpayer was a property developer and his personal directorships were stated to be in the interests of the company (as he could influence property deals) where he was also employed. This appears to legitimise the relationship and the transfer of income to the company

because it was made on commercial grounds, other than for tax reasons. This is a Part 4A defence.

To avoid Part 4A the taxpayer must have a reasonably arguable position that the dominant position for such an arrangement is not to obtain a tax benefit.

If a tax break happens to coincidently occur this is not a breach of Part 4A. It would need to be seen as incidental and not a dominant outcome for entering into the scheme or arrangement.

The Service court case would be an extremely strong legal precedent for a taxpayer to enter into such an arrangement.

As far as a strong commercial argument goes, asset protection for professionals could be seen as a dominant reason for entering into such an arrangement. We shall discuss this below.

3. Asset Protection!

One of the main commercial reasons for entering such an arrangement is for asset protection purposes. There are ongoing professional indemnity insurance problems and uncertainty over cover provided to practitioners.

Specifically numerous insurance exception clauses exist that do not cover practitioners such as performing unauthorized procedures, employing doctors, locums, practice staff, contractors, directorships and partnership arrangements.

For taxation purposes, the Service arrangement appears to be an appropriate solution and commercial argument in itself.

By adopting such an arrangement as referred to in the Service case this would result in a NIL taxable earnings or NIL net profit each year based on a providers fee for service income. Therefore a provider would not and could not LEGALLY accumulate income or assets in their own name. This is perfect for asset protection, but the bank manager may have a few issues.

The number one rule about asset protection – DO NOT HOLD ASSETS IN YOUR OWN NAME! Keep it in a trust or a superfund. An ability to re-direct income into an entity outside of a liquidators hands or bankruptcy trustees hands could be seen as a dominant motive. There is no legal precedent to suggest in the event of a medical claim how this would hold up, we will comment on this in a later edition of the Best Practice News Alert. All we can say for now, it is making it harder for claims to be brought against providers if they have no money on the balance sheet. Lawyers do not like subpoenaing empty balance sheets. There is a bigger chance they will not be paid.

Some other points of interest •

Mr James Service who was the taxpayer named in the Service Case was on the James Packer Family Board of Directors and was awarded an “AM”.

•

The Tax Office has issued a public class ruling in the private sector that relates to public hospital private practice arrangement that supports this arrangement.

4. What if we are wrong?

An industrial backlash?!?

Should we be wrong, then many enterprise agreements signed off between the State Government and public hospital employees who have access to private practice arrangements could go into dispute. This is because these tax deductions would not be allowable and all income from private practice arrangements would be fully assessable at the highest marginal rate of tax in a doctors hands. This is despite the fact the hospital is in possession of the income.

This would lead to very large industrial disputes, large scale tax audits and possibly resignations by doctors in the States public hospital system. Private practice arrangements currently underpin doctors employment conditions in the public hospital.

If we are right whether you are earning $110,000 or $2m p.a. this is worth careful consideration!

5. Where to from here?

1. Don’t get rid of your service trust. Practitioners in group practice still need them for practical and commercial reasons;

2. Consider restructuring into an associateship arrangement. The provider needs to put themselves in a position of self employment. Avoid practice company, sub contractor and employee doctor arrangements; and

3. Contact your professional adviser about obtaining a private ruling from the Tax Office to address any concerns. This is the safest option as it is binding on the Tax Office.

This will provide you additional protection and comfort from such an arrangement, if you want to be 100% sure. Ensure your application presents the correct structure and features that is consistent with the Ruling. Let us know if you require any assistance.

We are happy to receive any feed back.

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