A service arrangement generally has the following features:
- The taxpayer (and this could be a sole trader, trust, partnership or company) carries on a business or professional practice.
- There is a trust or company that is owned or controlled by the taxpayer or their associates.
- The taxpayer enters into an agreement with the service entity for the service for the taxpayer to pay certain fees in exchange for the service entity providing certain services. These services could include staff hire, premises, administration services, and plant or equipment.
- The service fees are calculated by way of a mark-up over all of the costs of the service entity.
- The taxpayer claims a deduction for service fees incurred as an expense in conducting its business.
- The service arrangement gives rise to profits in the service entity which are either retained by the service entity (if a company) or diverted to the taxpayer’s associates (if a trust).
Historically service entities have been used by professional persons (i.e. accountants, doctors, dentists, etc.) to divert part of their professional income away from themselves to an associated trust. The beneficiaries of the associated trust are usually family members in lower tax brackets, so overall tax savings are made.
To avoid the ATO challenging the service arrangement the mark-up charged by the service entity trust needs to be commercial and arms-length and comply with TR 2006/2.