Service Trust Final Ruling - Best Practice News Alert 121

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

6965

DATE: ISSUE NO:

23 April 2006 121

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.

The ATO and Service Trusts – The Final Verdict !!! – The Good, Bad and Ugly We have been reviewing service trust arrangements over the last 14 years. In this latest broadcast the Tax Office latest Ruling (over 60 pages including booklet) on Service Trust arrangements vindicates our position at law and concerns we have expressed about their establishment and implementation in Australia. This is a very important Ruling for practices who have service arrangements in place. Practice Managers should take a keen interest on this issue as it affects their daily work. Practices need to seriously change their thinking on how they run and operate their present arrangements.

What is in this issue: 1. The Problem – The Tax Office has released its final ruling and it will impact your practice.

2. Who does this affect?

3. What is the Ruling About? – Background 4. When do I have to address this issue? – immediately!

5. Do I need to review my arrangements?– Brief Overview The Good – it is still worth it!

The Bad – Costs time and money to fix up The Ugly – Increased tax audit activity!

Is there an alternative? – Stop using a service entity.

6. The Devil is in the Detail - So where am I most at Risk?

You Need a Commercial Reason What Document Arrangements & Systems Do you need?

What is a Commercial Rate for Service Fees – be careful!!

7. Is Your Practice a Tax Office Target Audit!

High Risk Practices Practices that have Poor Documentation Where your Service Fees are greater than 40% of practice fees 8. Where to from here?

The New Ruling

1. The Problem – The Tax Office has released its final ruling and it will impact your practice.

Taxation Ruling TR 2006/2 and a booklet called “Your Service Entity Arrangements NAT 13086– th 04.2006” has been issued on 20 April 2006. The Ruling questions the tax deductibility of service fees charged by a practice to its providers that uses a service entity.

It has been reported 75% of practices may be affected by this Ruling. Unlike the draft Ruling, medical practices (General Practitioners) were referred to for the first time in the ruling. Similarly it recognised the medical industry is different and practices charge service fees based on a percentage of gross fees (e.g. 50%) which is an acceptable methodology. The traditional cost plus mark up method where wages are marked up by 50% is not the only way to calculate service fees and it may actually be an incorrect approach for the healthcare industry.

This creates new tax and commercial opportunities for practices who currently use the cost plus mark up method.

Important Notice for Health and Life “Annual Accounting” Clients.

Clients who have signed all our authorised service agreements, practice agreements, that are using the Doctors Pay Calculator, our annual national practice benchmarks and have been following our advice to the letter, should not be concerned about this Ruling. All of our advice and recommendations have been consistent with the final ruling. We will be issuing shortly for those that do not have a written service fee pricing explanation a commercial explanatory Memorandum. Please advise us if you have not received this to date.

The Ruling impact will vary from attending to simple one off costs such as documentation and systems that may vary from $1,000 to $2,000 to a full practice restructuring up to $25,000 depending on the size of your practice and what issues arise.

2. Who does this affect?

Any practices that use service entities such as service trusts, service companies or service partnerships. The Ruling addresses concerns about what is an appropriate commercial service fee that a service entity can charge.

• • •

Solo practitioners Associates Partnerships

• •

Contractors Practice Managers - will need to understand and implement the practices arrangements!!

3. What is the Ruling About? – Background

We have paraphrased (in blue bold italics) from the Tax Office Booklet “Your service entity

arrangements” published on 20.4.06 the following: It is common for providersI “(particularly those who are required to operate their practices as individuals or as partnerships) to engage associated entities to provide them with labour hire, recruitment, clerical, administrative and other services (also known as service arrangements). It is common for professionals to view service arrangements as an effective means of protecting their assets from professional negligence actions and other claims”.

The Tax Office’s concern is “whether the service fees being claimed are deductible under the income tax law”.

If a practice “…has a conventional service arrangement where payments are correctly calculated and the services are reasonably connected to the conduct of your business, then the presumption will be that your service fees and charges are a real and genuine cost of your business and deductible in full”.

“If payments are grossly excessive or the services are not reasonably connected to the conduct of a”.. practice,…” then the purpose, and the deductibility, of some or all of your service fees is open to question”.

“The Tax Office may ask you to explain your entitlement to the deduction claimed. If we are not satisfied with your explanation, we may disallow some or all of your deduction”.

4. When do I have to address this issue? – immediately! th

Practices have until 20 April 2007 to fix up their affairs. To keep accounting costs to a minimum st practices should restructure or attend to any changes before 1 July 2006 .The Ruling applies retrospectively.

5. Do I need to review my arrangements? – Brief Overview The Good – it is still worth it!

The bottom line, service trusts are very worthwhile structures to keep for medico-legal, succession planning and income splitting purposes.

Providers can still save in tax from $15,000 p.a. if they bill over $200,000 p.a. The benefits still out weigh the costs of running a service entity. We believe they are mandatory for group practices that have greater than 2 owners.

The Bad – Costs time and money to fix up If practices are concerned about a potential tax audit and are not prepared to invest the time and money in understanding their arrangements or using the right documentation and systems, then winding up your service entity is the only real alternative. The impact is much like the introduction of the GST. We all disliked it. It was expensive and time consuming, however after establishing proper accounting systems and procedures most of us would agree it was a good thing. It gave us a better understanding and more financial control over our affairs. The same can be said for the impact of this Ruling. The incidental tax benefits should cover the costs involved.

The Ugly – Increased tax audit activity!

The Tax Office is continuing to use “fear factor” tactics to stamp out the use of service trusts. This is despite their admission the arrangement is legal and the setting of service fees is a subjective process and dependent of the “facts of each case”. If you are still not certain about your service fee then obtain a private ruling. We believe they will have a hard time proving “excessive gross service fees”. The ruling has stated the “unprepared” practices will have most to risk who have not documented and or cannot explain their arrangements (including practice managers) or do not have the right systems in place.

Is there an alternative? – Stop using a service entity The only real alternative is to stop using service entities. It is important to assess the serious medico-legal implications, succession planning and tax planning issues arising from this. Please speak to your professional adviser before taking this course of action.

We had suggested in our Best Practice News Alert # 120 an alternate arrangement this may be a suitable solution. Please seek professional advice before acting on this information.

This broadcast analyses the practical impact of the ruling on practices and is split into three categories: 6. The Devil is in the Detail - So where am I most at Risk?

The following are relevant extracts from the Ruling and Service Entity Booklet and some solutions to the issues raised by the Tax Office.

1. You Need a Commercial Reason Problem 1: Asset protection is not a good enough reason “…The Commissioner does not accept, however, that asset protection alone can explain service arrangements” Solution1: From a medico-legal point of view due to vicarious liability laws, practices that are Associateships with a service trust will have an easier time explaining the commercial reason for this arrangement than those that continue to use a partnership with a service entity. The medico legal risk will shift significantly away from the joint and several liability nature of partnerships to specific individuals. A service trust would be a critical entity that is required to facilitate this approach.

Providers who pay a service fee based on a percentage of gross fees is to cover the service entities staffing, marketing and infrastructure costs for running the practice, demonstrates there is a legitimate “business model” behind the arrangement. Furthermore it should be designed to make a profit. This means it can be used for succession planning purposes.

This model has been identified by the Tax Office and not rejected as an inappropriate methodology. Many practices use this approach in the medical profession in Australia. Most importantly it is far more simpler and logical to use than the “cost plus mark up method”.

Problem 2: You Need to Show a Commercial Value “The service fees and charges generate profits in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions. For example, this might occur where there is no clear separation between the service entity's business activities and those of the taxpayer.”

Solution 2: In addition to the fundamental reason for establishing a service entity, ensure separate bank accounts are maintained between the service entity bank account and providers.

Set up a providers billings trust account outside the service entity. Ensure all business guarantees, non-provider employees, property and plant and equipment leases and supplier contracts are in the name of the service entity and not in the owner providers name.

Problem 3: What Document Arrangements & Systems do you need?

Problem 3.1: What practice agreements should you have?

Any documented arrangements need to provide the following: • • • •

a description of the services and the terms and conditions under which the services were to be provided by the Services Trust; the resources that were to be used by the Services Trust in providing the services; the way in which the gross services fee is to be calculated and/or reviewed vis-a-vis the individual services; and the risks and responsibilities that were to be assumed by the respective parties.

Solution 3.1: Consider purchasing Health and Life Service and Practice Agreements Health and Life provides template service and practice agreements that address all of the above issues raised by the Tax Office. This will need to be tailored to meet each practices needs.

Contact Health and Life for further information.

Ensure service agreement applies across the board to all providers on a consistent basis whether they are owners are not. This is a common mistake. Owners must have a signed practice agreement.

Make sure the practice has the correct type of trust which is a Hybrid Trust that complements the practice agreement. Contact us for more information.

Problem 3.2: Accounting systems and procedures that need to be in place The Tax Office have recommended the following documentation – if some of these arrangements are not complied with it does not necessarily mean the deduction will not be allowable: • • • • • • • • •

•

documents showing how you and the service entity arrived at a pricing structure for the services tax invoices for the service fees charged, and evidence of payment calculation statements showing how the service fees were calculated from time to time, including details of how any mark-ups have been applied minutes of meetings concerning the service entity budgets, business plans, and organisational charts for both your business and the service entity – your service arrangement should be reflected in your planning and budgeting detailed profit and loss statements and balance sheets for both your business and the service entity for the current year and two prior years the constituent documents for the service entity (such as the deed establishing the service trust) resolutions by the service entity about distributing profits a list of personnel employed by the service entities together with relevant duty statements employment contracts, timesheets, other personnel records and reporting guidelines for employees of the service entity relevant insurance contracts, and

•

relevant lease and/or rental agreements.

Solution 3.2: Implement Appropriate systems Practices must ensure there is “substance over form” that regular bank transfer and not just accounting book entries are made on a regular basis e.g. monthly.

In addition at Health and Life we have the following tools that help clients overcome many of these issues and they form part of our standard annual accounting services: 1. Doctors Pay Calculator accounting program that calculates service fees, tax/adjustment invoices, BAS and Income Extract summaries for providers on a database; 2. Template charts of account ledgers for MYOB and Quick Books to account for service fees; 3. Template staff employment contracts; Current Accounting Clients annually receive the following: 4. Service Fee Pricing Explanation Memorandum that links to the practice service agreements and Doctors Pay Calculator to ensure a commercial reason and prices are used to set service fees; 5. Annual national and client specific practice benchmarks. We have a database of 1200 practices we have been monitoring over 14 years; 6. The practice receives an annual legal and tax structure flow chart; 7. An annual practice benchmarking report with recommendations Problem 4: What is a Commercial Rate for Service Fees – be careful!!

“If payments are grossly excessive or the services are not reasonably connected to the conduct of a”.. practice,…” then the purpose, and the deductibility, of some or all of your service fees is open to question”.

“The Tax Office may ask you to explain your entitlement to the deduction claimed. If we are not satisfied with your explanation, we may disallow some or all of your deduction”.

What is an appropriate commercial rate that is legal? This has been the “holy grail” question for many accountants that have been asked by their clients over the last 12 months. Many believe the Tax Office recommendations are the only allowable rate. The Tax Office has responded to this issue and this is not the case at law. In fact this issue will greatly influence the viability of maintaining a service trust. Legally the actual rate can significantly vary from the Tax Office’s rates according to the law. The bottom line is that there is no set legal allowable rate.

All practices need to do is provide a sufficient commercial reason if they wish to use a rate higher than the Tax Offices “safe harbour” rates of greater than 40 and 45%. We believe such reasons are not difficult to establish nor substantiate as we shall see below.

It is bit like a patients “INR” practices need to be sure they remain in a safe range. The Tax office makes the following comments that support our position. “…the Ruling also notes the practical difficulties of reducing or disallowing claims for deductions where payments are marginally above commercial rates.

Nor is it for the Commissioner to tell a taxpayer 'how to run his business profitably or economically': Tweddle v. Federal Commissioner of Taxation (1942) 180 CLR 1; (1942) 7 ATD 186 at CLR 7; ATD 190. The Commissioner must take the results of the taxpayer's activities as he finds them, regardless of whether those activities give rise to good or bad commercial outcomes”.

“Higher Rates Can be Acceptable” Some reasons that higher rates may be acceptable include: • industry specific comparable data • specialised or highly skilled nature of the service provided the extent to which services are provided in excess of comparable third party arrangements • the economic contribution to profits of the main business that is attributable to the activities of the service entity (the activities of on-hired staff are not activities of the service entity), and • level of business risk associated with the activities of the service entity and the nature of the service model used.”

“We (the Tax Office) have observed that fees generally vary between 35% and 50% of gross practice fees depending on factors such as the location of the practice, cost structures and the relative bargaining position of the parties. Fees of up to 40% of gross practice fees will not generally be considered sufficient to warrant further examination.”

Solution 4: Setting a commercially realistic rate The following three options exist for setting practice service fees. Only where it is “grossly excessive” will a partial or full denial of a tax deduction will apply.

It is has not been defined what is a grossly excessive fee. It could be construed that anything greater than 10 to 20% above the commercial rates may be considered excessive in absence to a justifiable commercial reason.

Comparable market rates The Tax Office has indicated service fees for typical services provided to the medical profession can be used to determine the correct service fee. In the Ruling it has reported service fees of between 35% to 50% of gross fees are commonly charged by service trusts to medical practitioners in Australia.

Practices charging service fees at these rates are not considered high audit risks. Corporates such as Primary Health Care have reported management fees of between 40 to 60%. These can be used as test whether the rates are within commercial principles. Practice must compare their rates with practices of a similar size and nature. One would argue rates in excess of these amounts could be seen as excessive.

Indicative rates (“Safe Harbour rates”) The Tax Office have stated that no explanation is required for service fees charged if they are within the Tax Office recommended rates or the “safe harbour” rate. The rate for GP practices is 40% of gross receipts for city practices and 45% for rural practices. Fees charged in excess of this rate require a commercial explanation in order to avoid an audit.

Warning we believe this rate is too low and if a practice accepts this it may become insolvent and the service entity may become unviable. It is not a defence to blame the Tax Office service rates had caused your practice to become insolvent. See below for a possible explanation. It is critical that the practice remains actually profitable. See below for a further explanation.

Calculating the mark-up

The Tax Office allows service fees to be charged with a mark up priced by reference to comparable arm's length service providers (or industry standards) to be reviewed on a regular basis. This means it will allow a profit in the service entity. To what extent a profit can be made should be compared to similar service providers like the Corporates.

We have been monitoring the profit margins of medical practices and corporates over 14 years. The ranges are wide and varied. Practices need to ensure they are not outside these ranges.

Therefore one could consider if all costs were marked up by less than an arms length commercial provider than this amount the profit in the trust would not be seen excessive.

How are service fee percentage is calculated The mark-up as calculated in the service entity’s accounting records. Traditionally various expense lines are marked up such as wages by 50% and other expenses at 15%. This would then compared and adjusted according to market rates for similar service providers. When using a percentage approach the following example shows how a practice calculates its service fee.

Example Doctor Good is a solo GP and does not receive any grants. His practice service fee is calculated in the following way: Practice Fees (A)

$230,000

Practice Overheads (B)

$100,000

Practice Profit Margin say 40% (1.4 x $100,000 (B)) = (C)

$140,000

Service Fee as a percentage of Gross Fees is (C) divided by (A)

60%

It is important to note if a service entity does not make a profit it runs the risk of being insolvent, it cannot retire debt, it cannot invest in new infrastructure and services. Most importantly would you buy/invest in a business that never makes a profit or a small profit for the high medico-legal and commercial risks (e.g. doctor shortages)?

Always equate risk with return. Higher the risk the higher the return! Smaller practices are harder to sell. One will always would expect a higher return profit margin, because they are harder to sell. Higher profit margins should be expected.

7. Is Your Practice a Tax Office Target Audit!

Audits will continue after 20 April 2007. The Ruling applies retrospectively! The following audit categories apply.

1. High Risk Practices Tax audits can vary from a quick phone call from the Tax Office, to a desk audit where paperwork is sent into the Tax Office or a full scale audit. Being prepared to answer the Tax Office questions and providing good documentation is the best defence. If you can produce the right information on a timely basis they are less likely to ask more questions. More importantly they are more reluctant to prosecute a taxpayer that has a good or reasonable argument. They generally do not like to fight tax payers who have done their homework. The law is currently not in their favour despite their current position.

Higher risk cases will continue subject to all of the conditions below:

•

Service fee expenses are over $1 million

•

Service fee expenses represent over 50% of the gross fees or business income earned.

•

Net profit of the service entity (or service entities) represents over 50% of the combined net profit of the entities involved.

Practices should convert to an Associateship model to avoid application of the “combined” profit rule.

2. Practices that have Poor Documentation Poor documentation is a major issue and the following comments are noted in the Service Entity Booklet “In our experience, arrangements with related parties e.g. spouses or owners generally involve a greater level of potential tax compliance risk. Our attention will be drawn to arrangements with related parties that are not well documented and that do not have the elements usually associated with a commercial activity. Related parties more under scrutiny documentation needs to improve” 3. Where your Service Fees are greater than 40% of practice fees Just because your service fee is 5 or even 20 percentage points higher than the “safe harbour rates” does not make the service fee a non-allowable deduction or illegal. Practices just need to demonstrate why.

The following Tax Office comments are designed to discourage practices from using a service entity. There is an inherent flaw in their approach.

“However, for fees over 40% you will be expected to be able to explain the reasons for the higher fee.

The risk of being audited will increase according to the degree of divergence above 40%. For rural and sole medical practitioners, costs can represent a higher percentage of revenues and in these situations we would consider that service fees of up to 45% of gross practice fees would not warrant further examination. The firm would be at high risk of a tax audit.”

We believe their rates are unrealistic. The above service fees reflect the average costs of running a practice. If a practice follows these rates, there is no profit nor commercial advantage in running a service trust. This means the practice would never make a profit and it would make the practice impossible to sell.

Furthermore the practice runs the more serious risk of trading while insolvent. This is a Corporation Law breach and Directors can be personally sued and prosecuted for running a business on this basis. The Tax Office Ruling would not be a defence. As reported last month the Federal Court case prohibits a tax deduction for an expense where a business is not designed to make a profit Ell v. Commissioner of Taxation (10 February 2006).

8. Where to from here?

1. Don’t get rid of your service trust just yet. Practitioners in group practice still need them for practical and commercial reasons. No need to panic – it sounds worse than it is.

Consider improving practice systems and documentation – don’t throw the “baby out with the bath water”. Visit the Tax Office website at www.ato.org.au ; 2. Your advisers may feel a little outside their depth. If they are, contact us for specialist expertise in this area if you require service and practice agreements or require more

information about our Doctors Pay Calculator Tax Invoice program and/or our annual practice benchmarks; and 3. Alternatively contact your professional adviser about obtaining a private ruling from the Tax Office to address any further concerns. Ensure your application presents the correct structure and features that is consistent with the Ruling. Let us know if you require any assistance call us on 1800 077 222 or email David Dahm on pa@healthandlife.com.au .

We are happy to receive any feed back.

Which topics would you like to be covered?

If there is a particular topic that you would like covered in one of our future News Alerts, please email pa@healthandlife.com.au and let us know what it is. We will then endeavor to cover your requested topic.

Do we have your email address?

It is apparent feedback we are receiving that there are persons receiving this regular email who are not on our email list. If you are receiving this email ‘second-hand’ from another source, we would be delighted to receive your email address and we will add you to our list so that you can receive it first-hand on the day that it is sent. This invitation is open to all medical practices. Please send your email address to pa@healthandlife.com.au

Do you wish to unsubscribe from our list?

Please email pa@healthandlife.com.au if you wish to be removed from out distribution list

Copyright Notice This email, including any attachments, is for the personal use of the recipient(s) only. Republication and re-dissemination, including posting to news groups or web pages, is strictly prohibited without the express prior consent of Health & Life Pty Ltd. Disclaimer Notice Health & Life Pty Ltd’s Best Practice News Alert is designed as a comprehensive and up-to-date Accounting and Practice Management news service to alert readers to the latest in practice and related developments affecting the medical, dental and allied profession as they happen. It is published when there is news to report. No responsibility can be accepted for those who act on its content without first consulting us or obtaining specific advice.

Health and Life Pty Ltd (formerly acpm.com.au) Accounting & Practice Management Services.

“Looking after your future” PO Box 8145 Station Arcade, ADELAIDE SA 5000 Telephone:

(08) 8415 5400

Fax:

(08) 8231 6767

Email:

pa@healthandlife.com.au

Web Site

www.healthandlife.com.au