It can be a rare thing to have all the assets of a business held by one entity. Often the business structure contains various entities that own different elements of the business such as the intellectual property or the business premises. The use of service entities has waned in recent years however many still exist.
Invariably one group entity will charge a fee to another group entity for the use of its assets. The controllers of those entities are generally the same people, so everyone understands what the deal is, right? Is that enough to claim a tax deduction for the fee though?
There were muted celebrations when a case last year found that the documentation requirements for related party dealings, particularly for small and medium enterprises, should not be as onerous as the requirements for large enterprises. The Federal Court recognised informal arrangements and accounting practices could be sufficient to underscore a genuine commercial arrangement, with some suggestion that the ATO should understand the commercial realities of SMEs.
The celebrations were muted due to the expectation that the ATO would appeal the decision, and the appeal findings have now been made in the Full Federal Court.
The case involved a group involved in real estate where intellectual property such as trademarks and the rent rolls were held by different trusts. These trusts would charge service fees to the operating real estate entities for the use of those assets. From 2005-2015 all parties had written licence agreements in place, however due to an apparent oversight, they were not renewed when the contracts ended, and instead an oral agreement was entered into.
Service fees continued to be charged, and the ATO disallowed them as deductions in the 2016-2019 years. The Court does not provide any weightings, but of great interest is that the calculation of the service fees post-contract differed significantly from the expired contracts. The taxpayer argued that the new service fees, of “up to 8% of the value of the business”, was based on the advice of an external accountant. The actual amount of the service fees differed greatly from year to year without any coherent reasoning as to why.
The Court found there was not enough evidence that the entities had agreed to form a contract with terms outlining what a fair and reasonable fee for the services were.
The concept of a service fee being worth “up to 8% of the value of the business” being reasonable could not be backed up with any evidence.
The Court found no evidence of communication between the directors of the relevant entities that there would be a liability in relation to service fees, and the directors could not explain how the service fees were calculated. In addition, the service fees entered into the accounts of the entities appeared to not reflect an actual transaction that may occur under a contract, as there were no tax invoices issued in relation to the service fees as one might expect there to be.
The Court accepted the ATO’s appeal and the service fee deductions were denied.
Where does this leave deductions from inter-entity arrangements? Well, right where they were. The best form of proof is a written contract, where the reasonableness of any service fees can be backed up with evidence, and the entities actually act in accordance with the contract. Removing any of these elements means replacing written evidence with oral evidence, which will have a lot less weight considering these are related party dealings.
Now would be a great time to review any inter-entity arrangements you have, ensure they are documented, are still part of a valid contract, and consider whether the terms are reasonable.
Please contact Ross Prosper if you have any queries.