Tax Office Crack Down on Service Trusts - Best Practice News Alert 107

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

6781

DATE: ISSUE NO:

9 May 2005 107

Welcome to Health & Life’s (formerly acpm.com.au) 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 & 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

NEWS ALERT BROADCAST

Tax Office Crack Down on Service Trusts – is this the Death of Service Trusts?

Problem On the 5th May 2005, the front page of the Australian Financial Review reported about a crackdown by the Tax Office on service trusts. This has received an enormous amount of national press coverage, causing unnecessary angst amongst taxpayers, because it has been noted many accountants and lawyers had got it wrong.

The bottom line is many doctors and dentists may be denied tax deductions for their service fees if their arrangements are not commercial. This means they could risk losing their income splitting benefits and be forced to pay back a lot of GST. There is nothing to fear, other than to check you have the right systems and procedures in place before 30th June 2005. However if you have not been following our advice in past news alerts, be warned the Ruling will apply retrospectively.

A Draft Taxation Ruling has been released by the Australian Taxation Office in relation to payments made to associated service entities: The Tax Office seeks to clarify its position of how service trusts can be used by professionals. We have already had discussions with the Tax Office and they are satisfied our approach and methodology is consistent with the Ruling.

For those that have been following our past broadcasts, we are not stating anything new other than the ATO Ruling has only confirmed our long held approach.

The solution to protecting your practice from scrutiny is based on the Ruling and is provided below.

Key Points: The ruling affects practices that incur a tax deduction for fees and charges in the conduct of its business for the acquisition of staff, clerical and administrative services, premises, plant and/or equipment from an associated entity. Any non-commercial structures or arrangements will be struck down by the Tax Office.

The key areas under review are: 1. Non-commercial service fees 2. Non-commercial structures 3. No paper evidence supporting arrangements 4. Retrospective Application These key areas will now be discussed in detail.

1. Non-commercial service fees exist?

1. Disproportionate, Inconsistent or Excessive Service Fees Some doctors charged cost plus mark and others on a percentage approach in the same practice.

2. Service Fees are calculated using arbitrary or fixed mark-ups (“Cost plus mark up”) e.g. 50% wages and 15% other costs.

For medical and dental practitioners we do not believe this method is commercial or permissible. This is consistent with the Ruling.

Common mistakes made by practices ……

Practices are should source quotes from independent external providers of administration services e.g. human resource companies, serviced office providers etc… and then charge a service fee consistent with the industry standard.

The Cost plus Mark up method is not a medical or dental industry standard.

Many practitioners are not aware this is a common methodology used by accountants. This practice was based on an old Court case called the Phillips case which was about a group of accountants and not health professionals who had set up a service trust for its accounting partnership. They had won this case against the ATO. The ATO still upholds the principles of this decision.

However, many accountants have blindly followed this methodology without regard for the actual case findings nor what is common practice in the healthcare industry in Australia. This is why it is under scrutiny.

The Solution A common industry arrangement and rate is between 40% to 60% of gross fees generated by a practitioner. Interestingly this methodology, provides greater income splitting opportunities and a simpler way to calculate service fees without complicated and un-reconcilable monthly spreadsheets.

Practices must be able to prove this is a commercial arrangement. We have been able to prove this arrangement is correct. We have submitted this proof to the Tax Office – they have indicated our approach is correct. Contact our office for more information about receiving a written professional opinion and assessment.

2. Non –commercial structures No real commercial purpose other than to gain income splitting benefits or entity.

No real assets are owned by the trust e.g. a building The ATO accepted the primary commercial purpose for utilizing a service trust was for asset protection. In the Phillips case the partners had transferred their practice building into this structure to avoid exposing the building to legal claims.

To the contrary, due to a lack of medical indemnity insurance for nonprofessional staff, plant and equipment, systems and processes we have been advising clients not to put their buildings into the trust.

The ATO are questioning that if this the case what is the primary purpose other than income splitting.

Common mistakes made by practices ……

Practices and their advisers have made the mistake in assuming the main role of their service trust is for income splitting purposes.

They fail to realize that the main purpose for setting up a service trust, is to raise capital for the infrastructure required to run a practice, for casting votes when group business decisions need to be made and to ultimately sell your practice.

A sale of an interest such as units in the service trust like shares in a company is the simplest way to dispose a partial or full interest in a practice.

Underwriting staff wages, signing a 5 year property and/or plant and equipment lease, with personal guarantees comes with risks that owners of infrastructure should be rewarded for. This is commonly overlooked by accountants and has not been argued with the ATO.

Unfortunately a grave error is made by not focusing on the site goodwill and the commonly owned infrastructure owned by a trust.

Accordingly this approach fails to realize the dominant commercial purpose of the practice and more importantly the need to establish an infrastructure entity such as a service trust.

A service trust rewards its owners for their efforts in establishing systems and procedures, practice branding, human capital and physical infrastructure. These are the non-clinical functions and tasks of a practice which is quite separate and distinct from a clinical practice.

Listed companies like Primary Healthcare are just publicly owned service entities.

There is a very strong precedence for this type of business. This demonstrates such entities do have a dominant commercial purpose other than income splitting.

Furthermore a discretionary trust should not be used. This type of structure does not encourage investment for legal, accounting or commercial purposes.

Finally, for medico-legal reasons always avoid partnerships or incorporated medical practice company arrangements. Associateships are the preferred structure, where each treating doctor is a tenant doctor, not a employee or contractor.

The Solution Our view, contrary to the commonly held view, the dominant purpose of a service trust or service entity is for attracting capital to fund practice infrastructure and succession planning.

We have put this argument to the ATO and it is consistent with their argument that the need to establish a commercial purpose for the structure is critical.

A unit or hybrid trust (preferably) trust structure, should be used so voting rights and capital raisings can occur. This makes commercial not just tax sense. This in itself will overcome the key concerns the ATO has with service trust structures.

The key features the structure should include: 1. Use a Discretionary Unit Trust 2. Written and signed Unit holders Practice Agreement 1. Stipulates Voting Rights 2. How profits are shared – provide a 25% to 30% pre-tax return with any purchase of the units. Never use it to share costs only.

3. Practice Valuation upon death and disability is based on the value of the service trust and not the individual practitioner.

4. No paper evidence supporting the arrangements Service fees are charged without clear evidence that the service trust added value or performed any substantive functions. Where is the REGULAR paper trail. Does it reconcile to your bank accounts!

Common mistakes made by practices ‌‌ Owners must check their systems properly record all service fees charged and actual cash is transferred regularly to the service trust.

Common errors include: 1. No regular tax invoices are issued to doctors when service fees are paid 2. Tax documentation does to reconcile to bank accounts.

3. One bank account is used to deposit practice fees and service fees. It is impossible to reconcile accounts and to detect fraud or error.

4. No signed service agreements or they are out of date.

5. Service agreements have been drafted for taxation purposes only 6. Administration systems are not consistent with the terms and conditions of executed service agreement.

7. In appropriate accounting for minimum guarantees that are not commercially consistent with the audit trail.

8. The practice BAS does not show the same service fee claimed by the providers BAS. 9. Complicated spreadsheets do not account for payments and adjustments and are not in the required Tax Adjustment Invoice format.

The Solution 1. Establish Fool Proof Systems At Health and Life we can supply examples from our software program called the Doctors Pay Calculator which illustrates the correct Taxation Documentation including individual Tax Invoices, individual BAS Extracts and Annual Income Tax Summaries that reconcile to the practice accounts.

Contact David Dahm at pa@healthandlife.com.au. for our Doctors Pay Calculator software overview. We can email this to you.

2. Service Agreements Written and signed service agreements should be executed for all owner and non-owner providers. These agreements should cover the types of services provided, the basis for charging services including applicable GST, and medical indemnity exemptions and exclusions. The contract should not be drafted just for taxation purposes. It should be a real contract.

The administrative systems should reflect the terms and conditions of the service agreements.

Contact David Dahm to purchase template service agreements (08) 8415 5400 or email us at pa@healthandlife.com.au.

4. Retrospective Application The controversial part of this Ruling is that it is intended to operate retrospectively. There may be some opportunity for practices to avoid tax penalties if they volunteer breaches.

Practices who have a problem have only till 30.06.2005 to fix up any issues for the current year.

The bottom line is if you are not prepared to make the above changes (if required) to your structure you are running a risky arrangement.

For many group practices there is no other alternative for medico-legal reasons group partnerships and medical practice companies are too risky as professional indemnity for group structures may not be available or too expensive.

The biggest problem is for solo practitioners. Solo practitioners may need to consider allowing other providers use their facilities so their arrangements are justified as commercial.

Some attempt should be made to emulate the activities of group practices.

Health & Life ‘on the move’!!

IS HEALTH & LIFE COMING TO A PLACE NEAR YOU? Throughout the year, David 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 him if you have any issues to discuss.

If you want to catch up, call us on 1800 077 222. Fees may apply.

Future places/dates are: Late May 2005 Late June 2005 Early July 2005

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