It is common for asset protection purposes to establish a service entity to provide for a commercial service fee administrative services, staff, plant and equipment and premises to a trading entity. Service entities may also provide income splitting advantages.
Since 2006, the Australian Taxation Office (ATO) has administratively restricted the service fee tax deduction to benchmark rates. While many will voluntarily comply with the benchmark rates or restructure out of service entities, there remains uncertainty regarding the tax consequences of service entities.
The Victorian State Revenue Office (VSRO) groups the service entity with the trading entity for payroll tax. Recent cases challenge the VSRO approach.
Legislative references are to the Corporations Act 2001 (CA 2001), the Income Tax Assessment Act 1997 (ITAA 1997) and the Payroll Tax Act 2007 (Vic) (PTAV 2007).
Service entities may provide asset protection purposes by quarantining the liabilities of the trading entity from the business assets and resources owned by the service entity.
Service entities may also provide income splitting advantages (FCT v Phillips  FCA 28).
The contentious issue is the extent to which a service fee which exceeds a commercial rate is not incurred for the purpose of gaining assessable income or is of a capital nature (sec. 8-1 ITAA 1997).
On 20 April 2006, the ATO released TR 2006/2 and Your service entity arrangements Guide (NAT 130086-04.2006) which provides for indicative net mark-ups of 3.5% to 7.5% (Net Mark-ups) or gross mark-ups of 10% to 30% (Gross Mark-ups) on certain costs depending on the type of service provided.
As a crosscheck, the use of the Mark-ups must not result in greater than 30% of the combined profits of the Firm and the service trust being earned by the service trust due to the service arrangement (Profit Ceiling). The Guide provides a 40% to 45% Profit Ceiling for medical practitioners and rural and sole medical practitioners respectively.
Modelling indicates that the Mark-ups and Profit Ceilings are generally consistent. The 30% Profit Ceiling may not result in sufficient net profits for the service trust arrangement to be viable. However, a 45% Profit Ceiling is likely produce an acceptable net-profit for the service trust (depending on the size of the Firm and the extent of the services provided).
Importantly, the Guide does not provide an exhaustive list of services Mark-ups, the Profit Ceilings are not themselves a safe-harbor and rates can be exceeded if supported by sophisticated and robust benchmarking.
Payroll tax is levied on the Victorian wages (or deemed wages) payable by an employer (or group employer) to the employees, directors, certain former directors and designated contractors, if the total taxable Australian wages exceeds $500,000 per annum (sec. 7 PTAV 2007).
Grouped employers include related bodies corporate under CA 2001 (sec. 70 PTAV 2007), employers using common employees (sec. 71 PTAV 2007), commonly controlled businesses (sec. 72 PTAV 2007), a person or persons controlling the businesses or a person or persons directly or indirectly or in aggregate controlling the company or companies (sec. 73 PTAV 2007), unless de-grouped by the CSR (sec. 79 PTAV 2007).
Assuming that the trading entity and the service entity have sufficiently different ownership and directors to not be otherwise grouped, the VSRO will generally apply the common employee grouping provision (sec. 71 PTAV 2007) to group a captive service trust with the serviced trading entity. The VSRO is unlikely to de-group the service trust (sec. 79 PTAV 2007).
The VSRO website provides that were a separate entity is established to provide administrative services to the main operating business, the entities may be grouped because only minimal services provided by the employee of one business to another business is required for these provisions to apply.
Examples of grouping of service entities includes:
- an administration service entity providing services to two commonly owned businesses (Network Clothing Company v CSR (Vic)  VCAT 2492);
- a management and administrative staff service entity providing services to an engineering business entity (Seovic Civil Engineering P/L v CSR (NSW)  NSWCATAD 94 at ); and
- a management and administrative staff services entity providing services to a related manufacturing business and transport business (Tasty Chicks P/L v CSR (NSW)  NSWSC 1007 at ;  HCA 41).
Examples of not grouping service entities includes:
- a management and administrative staff service entity providing services to multiple medical practices (CSR (SA) v Garrett F Hunter P/L (1977) 69 SASR 275 at 282);
- a franchisee providing management and administrative services to the franchisor (Bank of Queensland Ltd v CSR (Vic)  VCAT 1966 at ); and
- an estimating entity providing staff to a captive builder (Liquid Rock Construction P/L  VCAT 2164 at ;  VSC 329).
The orthodox view was that the service entity and the trading entity would be grouped where substantially or wholly interdependent on each other.
Recent decisions in Victoria may have limited the provision to circumstances where the trading entity has an employment relationship in respect of the service entity’s staff.
Accordingly, there is uncertainty regarding the payroll tax liability for service trusts.