Private ruling: Service entity arrangement
Published: October 2013
Ruling period: Financial year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Are service fees paid by medical practitioners to the service trust calculated on a basis of a flat rate percentage of gross professional medical fees, allowable deductions under section 8-1 of the Income Tax Assessment Act 1997 ? | A1: Yes.

Relevant facts and circumstances: X Pty Ltd as trustee for the Services Unit Trust (the service trust) provides administrative services to a number of independent medical practitioners (associates). Each associate is a director of X Ltd Pty Ltd. Each associate holds an equal number of ordinary shares in X Pty Ltd. Each associate's independent practices are operated under a related discretionary trust. Each associate's discretionary trust is a Unitholder of the service trust, owning an equal number of ordinary units and special income units. The associates all work from the same business premises (the premises). Each associate's discretionary trust owns an equal interest in the premises as tenants in common. The service trust is granted an exclusive right to use and occupy the premises for a licence fee. The associates have registered a business name for group recognition purposes. Each associate conducts their own separate practice from the premises under their own Medicare provider number. You have stated that the associates do not conduct their business activities in partnership. From time to time, non-associate practitioners, or locums, practise from the premises using their own Medicare provider number. The service arrangement has been documented in a service agreement contract which incorporates a service agreement and a license to use the premises. The associates' discretionary trusts engaged the service trust to provide the services in consideration for the payment of a service fee. The associate's discretionary trusts claim deductions for the service fees as expenditure incurred by it in the conduct of its business. The service trust returns the service fees as assessable income. The profits derived by the service trust may be distributed to the Unitholders in proportion to the number and class of units held and/or retained for future distribution. Historically, the service trust has distributed profits to the Unitholders. No related parties of the associates work for the service trust. The current structure has been in place for over X years. The service trust provides administrative services to non-associates for a percentage of gross patient billings at a negotiated rate, or service fee. Each associate maintains continuous membership of a union or association at their own costs and expense. Each associate maintains at all times indemnity insurance at the associate's own cost and expense. Each associate maintains at all times medical practitioner registration with the Medical Board of Australia at the associate's own cost and expense. The associates maintain at all times appropriate insurance so that in the event of the termination of an associate, the continuing associates are able to fund purchase of the terminating associate's interest. Each associate personally pays premiums in respect of the insurance policy. SERVICE FEES PRIOR TO THE PUBLICATION OF Taxation Ruling TR 2006/2 Historically, the trustee of the service trust has endeavoured to use genuine arms length commercial rates based on periodic investigation of fully independent like service providers' rates. As a result, service fee charges prior to the publication of Taxation Ruling TR 2006/2 did not vary significantly from fees post TR 2006/2. SERVICE FEES AFTER THE PUBLICATION OF Taxation Ruling TR 2006/2 Service fees have been calculated and charged on the following basis: Associates - service fees have been calculated on the basis of gross mark-up on costs as outlined on page 15 of the ATO publication Your service arrangements (NAT 13086-04.2006). Non-associates - service fee is a fixed rate charged on the basis of a percentage of the non-associate's gross patient fees. The rate is based on common market rates for specialist medical practices determined by the service trust from its inquiries of several such practitioners and, arms length negotiations between the associates and non-associates prior to their commencement to practice. Internal administrative fees of the service trust are excluded from the service fees charged. SERVICE FEES SINCE 1 JULY 2012 Non-associates - flat rate of X% of non-associate's gross patient fees. Associates - unchanged PROPOSED SERVICE FEES Service fee rate of X% of gross professional fees for both associates and non-associates is proposed. REASONS FOR X% SERVICE FEE Due to the complexities and resource-intensive process involved in calculating associate's service fees involving several components (labour-hire, expenses and equipment hire), a flat service fee of X% is proposed. You expect this will substantially reduce the time and effort involved in administration of service fees and improve efficiency. The effective rate in the current service fee system approximates a X% service fee rate and not being materially different to charging a flat rate of X% service fee. Associates consider a X% service fee accurately reflects arms length rates charged by similar medical practices in the region. In determining this rate, the associates made inquiries and observations of other such practitioners. These inquiries and observations indicated rates varying between X% to X% are commonly charged, and in the case of substantial corporate medical service enterprises, rate of not less than X% are charged. Rates of up to X% are commonly charged in a variety of other kinds of specialist medical practices in urban centres in the region. Other income of the service trust (apart from service fees) includes insurance recoveries, interest income, and registrar fees. The service trust has incurred expenses in excess of $X since the 20XX financial year. The increase in revenue and expenses are due to an increase in size and scale of the service trust's operations, which has required additional administrative staff. The net profit of the service trust has never exceeded X% of the combined net profit of all entities involved in the arrangement. The service fees charged by the service trust have never exceeded X% of the gross fees or income derived by the associates from patients.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any losses or outgoings to the extent they are: · incurred in gaining or producing your assessable income, or · are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income ( the positive limbs ) However, no deduction is allowed under section 8-1 of the ITAA 1997 for expenses to the extent they are: · of a capital nature · of a private or domestic nature · incurred in relation to gaining or producing your exempt or non-assessable non-exempt income · a provision of this Act prevents you from deducting it (the negative limbs). Expenditure will satisfy the positive limbs of section 8-1 of the ITAA 1997 if its essential character is that of expenditure that has a sufficient connection with the operations or activities undertaken that produce a taxpayer's assessable income. Taxation Ruling TR 2006/2 provides the Commissioner's view regarding the deductibility of service fees paid to associated service entities, typically dubbed Phillips arrangements. Phillips arrangements involve a taxpayer incurring a 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. These service arrangements are typically dubbed Phillips arrangements following the highlighting of related issues in Phillips v. Federal Commissioner of Taxation (1978) 8 ATR 783; 78 ATC 4361 ( Phillips Case ). In Phillips Case , the service entity charged service fees to a related individual who was carrying on a business. The quantum of fee was calculated using mark-ups on expenses. Problems arise where parties are not dealing with each other at arm's length and the charges are grossly excessive which is indicative of another purpose for making the payment. The Commissioner's concern was that the service arrangement affected the splitting and/or diversion of professional income for the purpose of tax avoidance. However, despite the substantial transfer of income, the court found that the rates charged by the service trust were realistic and not in excess of commercial rates and that there were sound commercial reasons for the arrangement quite apart from tax savings. In response to Phillips Case , the Commissioner issued Taxation Ruling IT 276 stating that: Given the view of the facts which the court adopted, that is, a re-arrangement of business affairs for commercial reasons and realistic charges not in excess of commercial rates, the decision to allow a deduction must be accepted as reasonable… … the decision indicates the need for a close examination of all relevant facts before deductions are allowed… IT 276 also noted that Fisher J. in his judgment commented that, if a payment allegedly for services was grossly excessive, the presumption would arise that is was made for some other purpose. He also referred to the necessity to be able to identify and quantify the consideration applicable to any advantage unconnected with business activity. TR 2006/2 explains that ordinarily, expenditure incurred in obtaining the supply of goods services from another party under a contract will be characterised by reference to the contractual benefits passing to the taxpayer under the contract and the relationship those benefits have to the taxpayer's income earning activities or business. This means that where the benefits conferred by a service arrangement provide an objective commercial explanation for the whole of the expenditure made under the service arrangement, then the service arrangement alone will suffice to characterise the expenditure as satisfying the positive limbs of section 8-1 of the ITAA 1997. However, where the benefits passing to the taxpayer under the service arrangement do not provide an objective commercial explanation for the whole of the expenditure, then a broader examination of all circumstances surrounding the expenditure in addition to the service arrangement contract will be necessary to characterise the expenditure. This will include a practical weighing of the whole set of objects and advantages which the taxpayer sought in making the outgoing. If the broader inquiry finds that the expenditure was incurred partly or wholly in pursuit of an advantage independent of the taxpayer's income earning activities or business, to that extent, the expenditure will not be deductible. Paragraph 11 of TR 2006/2 provides the following circumstances in which a service arrangement may not suffice to provide an objective commercial explanation for the whole of the expenditure: · the service fees generate profits in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions. · the service fees are disproportionate or grossly excessive in relation to the benefits passing to the taxpayer under the service contract · the service fees guarantee the service entity a certain profit outcome without reasonable commercial explanation A consideration of each of these circumstances given your facts is below. | Detailed Reasoning - Value added: You have pointed to the following commercial benefits arising from the service arrangement that is supported by documentation provided: · it gives you access to staff, skills and know-how that is relevant to the conduct of your business and which is provided by the service entity including nursing aids, a practice manager, clerical and accounts staff · relieves you of the responsibility for conducting and managing certain functions including staff recruitment, payroll services, accounting services, clerical and administration services, debt management, cleaning services, repair and maintenance of plant and equipment, marketing and advertising · relieves you of financial and legal obligations including employer obligations relating to worker's compensation, payroll tax, superannuation, statutory holidays, staff leave entitlements, unfair dismissal, insurance · provision of business premises, equipment, specialised medical equipment, plants, furniture, fixtures and fittings, stationery, linen, accounting and administrative software systems We consider the service trust provides substantive functions and services for your business, effectively conducting the business of the medical practice. | Detailed Reasoning - Grossly excessive service fees: The Australian Taxation Office's publication Your service entity arrangements (NAT 13086-04.2006) provide the Commissioner's view on appropriate service fee rates, and thus an indication of their commerciality. For example, the comparable rates reflect the Commissioner's understanding of market rates for typical services. Specifically, service fee market rates for a medical practice service arrangement 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. The Commissioner has stated that service fees up to 40% for these medical practice arrangements are likely to be appropriate regardless of the context and circumstances of a particular arrangement. In your circumstances, you have used the comparable market prices approach and have compared like with like by making appropriate inquiries and observations of other similar practices. These inquiries and observations indicated rates varying between 40% to 50% are commonly charged, and in the case of substantial corporate medical service enterprises, rate of not less than 40% are charged. Rates of up to 60% are commonly charged in a variety of other kinds of specialist medical practices in urban centres in the region. You consider X% service fee accurately reflects arms length rates charged by similar medical practices in the region. Further evidence of comparable independent market evidence has been provided in that non-associates currently pay up to X% of their gross patient fees as a service fee to the service trust. We acknowledge that you have stated that the associates do not conduct their business activities in partnership. However, for the purposes of considering the commerciality of the service fees paid to the service trust, the nature of the relationship between the practitioners is not considered material. The profit outcomes achieved by the service trust are not unrealistic given the relative risks it has assumed and functions performed as indicated in the Value added section above. The service fees are unlikely to be materially disproportionate compared with the benefits conferred to the practitioners as described above. We consider you have taken reasonable steps and provided sufficient evidence indicative that the service fees proposed are comparable and are not grossly excessive. Therefore, your proposed X% service fee rate will be accepted as long as your arrangement is sufficiently similar to that of the medical practice arrangement described in Your service entity arrangements in its range of services and that you also have an objective commercial explanation for the arrangement. | Detailed Reasoning - Objective commercial explanation: Due to the complexities and resource-intensive process involved in calculating associate's service fees involving several components (labour-hire, expenses and equipment hire), you have proposed a flat service fee of x%. You expect this will substantially reduce the time and effort involved in administration of service fees and improve efficiency. The effective rate in the current service fee system approximates a x% service fee rate and is not materially different to charging a flat rate of x% service fee. | Detailed Reasoning - Conclusion: Given the range of services and other commercial benefits provided by the service trust, it is reasonable to conclude that benefits provided by the practice management service trust to the practitioners is reasonably connected to the business carried on by each practitioner, as it clearly supports their ability to provide medical services to patients and to earn income from clinical activities. You have provided sufficient evidence indicative of a comparable arm's length arrangement and therefore, a share of gross patient fees is an acceptable basis of charging for these services. We consider your arrangement is similar to that of a Medical Practice Arrangement business model described in Your service entity arrangements (NAT 13086-04.2006) and that your proposed x% service fee is in line with commercial rates identified by the Commissioner and is not grossly excessive. You have provided an objective commercial explanation for the whole of the expenditure made under the service arrangement, and have appropriately documented the arrangement. Accordingly, service fees paid by specific specialists to the service trust calculated on a basis of a flat rate of x% of gross professional medical fees, will be allowable deductions under section 8-1 of the ITAA 1997.