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In recent times, management fees and other inter-entity charges have been attracting a higher level of scrutiny from the Australian Taxation Office (“ATO”) and NSW Office of State Revenue (“OSR”). One alarming aspect is the fact that genuine arrangements are being challenged by the revenue authorities.
Multiple entities are commonly used within group structures for reasons such as segregating business activities, increasing asset protection (by separating passive assets into different entities), or to maximise tax opportunities (by holding capital assets in trusts). However, the separation of assets and activities commonly results in the need to pay fees between those entities.
In two recent cases, the ATO has been successful in challenging the deductibility of ‘management fees’ (Fitzroy Services Pty Ltd v Commissioner of Taxation [2013] FCA 471 and Kelly’s Office Furniture Pty Ltd and Anor v Commissioner of Taxation [2013] AATA 9).
In both cases, deductions for the management fees were disallowed because the taxpayer was unable to show that the expenses were necessarily incurred in carrying on their business. Importantly, in the Fitzroy case, the tax deduction was disallowed even though fees were actually paid on a recurring basis during the relevant income year (i.e. the fees were not merely recorded by way of journal entry).
What needs to be shown?
In the event of an ATO audit, it will be necessary to demonstrate how the inter-entity charges have been incurred by the entity in carrying on its business (or, for passive entities, how the expenses have been incurred in gaining or producing assessable income).
In practice, a taxpayer is likely to be required to show:
- That the expense has been incurred (regular payments are preferable to journal entries);
- The nature of the service that has been provided;
- How the service was needed by the entity paying the expense, and how it relates to its business or income producing activity;
- The regularity at which the services are provided;
- That the relevant entity had the capacity and capability to provide the service. For example, if ‘management fees’ are paid to an entity that does not have ‘salaries and wages’ showing as an expense in its income statement, the ATO would be likely to question how those management services were provided;
- The commerciality of the methodology used to calculate the fees (for example, identification of particular employees who have been engaged in the provision of services); and
- Consistency in the fee calculation on a year-by-year basis.
We recommend that the above issues be considered, documented and updated on an ongoing basis, and not merely following the notification of any review or audit by the ATO. In addition, the existence of a written agreement is often looked upon favourably by the ATO and may add weight to the acceptability of the arrangement in the eyes of the ATO.
It’s not just about tax deductions
Whilst the deductibility of expenses appears to be the main area of scrutiny for inter-entity charges, a number of other issues also need to be considered, including:
- GST and tax invoices;
- Payroll tax grouping (if the entities are not already grouped by common ownership or control); and
- Whether the payments could be subject to payroll tax under the ‘contractor’ provisions, or the ‘third party payment’ provisions in the payroll tax laws. Under these provisions, the fees themselves are deemed to be wages for payroll tax purposes, rather than the wages paid to the employees of the service entity.
In our experience, the OSR is placing a greater focus on the contractor and third party payment provisions as part of their payroll tax reviews in recent times. During these reviews, the OSR seem to be imposing a very high burden on the taxpayer to provide evidence regarding the nature of the payment, and written agreements are expected by the OSR even when the payments are between related parties.
Detailed supporting documentation will be necessary in the event of a review by the OSR. This documentation should be prepared prior to the commencement of an audit or review.
A solution for income tax purposes
The compliance burden of inter-entity charges may be reduced if the entities are ‘consolidated’ for income tax purposes. This is because:
- The profits and losses of members of the consolidated group are aggregated for the purpose of determining the taxable income of the group (i.e. losses from one entity can be deducted against the profits of another entity); and
- Transactions between members of the same consolidated group are ignored for income tax purposes. Therefore, from an income tax perspective, it is not necessary to substantiate transactions between entities.
A consolidated group can be formed where a company owns 100% of the shares in one or more other companies (or where a company owns 100% of the units in unit trusts).
Whilst the consolidation provisions can be quite complex, most of the complexities are around the formation of the group, the entry of new entities to the group and the exit of entities from the group. In many cases, once the group has been established, the ongoing compliance obligations are minimal. The benefits gained from consolidating (including, but not limited to, the impact on inter-entity charges) may substantially outweigh the initial costs associated with entering the consolidations regime.
Even if consolidation is not the answer for a particular client, it is advisable to think outside the square with structuring and restructuring, rather than merely relying on management fees that may be challenged by the revenue authorities.
Should you require further information regarding structuring or inter-entity transactions, please contact your local William Buck advisor.
