"The mere existence of a “service agreement” will not mean “service charges” are deductible".

The Administrative Appeals Tribunal (AAT) has recently held in Case 4/2016 [2016] AATA681 that a service charge provided pursuant to a Services Agreement between related entities was not of the type contemplated in Taxation Ruling TR 2006/2, which discusses the deductibility of service fees paid to associated entities. As the taxpayer was unable to produce evidence that it had incurred the service charge in carrying on its business, the AAT upheld the Commissioner’s decision to deny a deduction for the relevant charges under section 8-1(1)(b) of the Income Tax Assessment Act 1997.

The taxpayer, referred to as “Service Recipient Pty Ltd” (Service Recipient) for the purposes of the AAT hearing, was part of a corporate group comprising itself and “Service Provider Pty Ltd” (Service Provider). Both companies had a common single shareholder and director, “Mr Smith”, a certified practising accountant (CPA) who provided both public accounting and contract accounting services to clients.

In order to mitigate the risk of Service Provider not complying with CPA public practice certification requirements, Mr Smith decided that Service Provider would undertake contract accounting work and Service Recipient would continue to undertake public accounting work. The companies subsequently executed a Services Agreement pursuant to which Service Provider would directly manage the relationship with clients and invoice Service Recipient for all reasonable costs incurred in providing services, such as office accommodation, billing, and customer administration, hiring of professional staff, marketing and promotional services and client management services. In turn, Service Recipient would invoice Service Provider for all services performed on behalf of Service Provider clients.

The Commissioner objected to Service Recipient’s deduction for workers’ compensation expenses and client entertainment expenses included in the “Service Charge” for the 2012 income year, on the basis that the former could not be substantiated and the latter was not deductible.

Mr Smith argued that the test in section 8-1(1)(b) of whether a loss or outgoing is “necessarily incurred” in carrying on a business for the purpose of gaining or producing assessable income was to be seen through “the eyes” of Service Recipient as the taxpayer and not from the perspective of Service Provider, and as there was a commercial explanation for the service arrangement, the Service Charge was deductible to Service Recipient, even to the extent that it comprised expenses that would not have been deductible if Service Recipient had directly incurred those expenses.

The AAT upheld the Commissioner’s decision on the basis that there was insufficient evidence to show that the taxpayer incurred the Service Charge in carrying on its business - there was no evidence to prove that the services were provided, or that any Service Charge was charged by Service Provider and incurred by Service Recipient in adherence to the terms of the Services Agreement, as no invoices had been issued and “payment” had been effected via journal entries only. In the reasons for decision the Member noted:

“…the evidence of Mr Smith was that the parties did not prepare estimates or statements or issue any invoices (or at least none with respect to the disputed Service Charge the subject of this proceeding). Instead, any amounts that were claimed to be owing by Service Recipient Pty Ltd to Service Provider Pty Ltd were by reference to general ledger statements which were then “settled” (using the terminology adopted by Mr Smith) by other journal entries in the loan accounts maintained by each entity.”

Further, there was insufficient evidence about the activities of Service Recipient and the relevance of the “Service Charge” to its business and income producing activities for section 8-1 purposes. Consequently, the Services Agreement was found to have little probative value.

The AAT also held that the imposition of an administrative penalty of 75% was reasonable in the circumstances.

The decision highlights the importance of following the terms of a Services Agreement and ensuring that relevant documentation and the actions of the parties reflect the reality of any service arrangement between the parties. As the Commissioner has noted in TR 2006/2: “6. While the Commissioner accepts the correctness of the decision in Phillips, the case is not authority for the proposition that expenditure… under a service arrangement… will always be deductible under section 8-1….  The question of whether expenditure…. is deductible depends on what the expenditure was calculated to achieve from a practical and business point of view. This is a question of fact.”

To discuss this further or for more information please contact:

Renuka Somers
Special Counsel
Sladen Legal
M +61 407 478 592|  T +61 3 9611 0110
rsomers@sladen.com.au

or

Daniel Smedley
Principal | Accredited Specialist in Tax Law
Sladen Legal
M +61 411 319 327|  T +61 3 9611 0105
dsmedley@sladen.com.au

or 

Patricia Martins
Legal Executive / Project Manager
Sladen Legal
T +61 3 9611 0138
pmartins@sladen.com.au

Sladen Legal

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