CURRENT CIRCULATION: DATE: ISSUE NO:
7017 2nd April 2007 141
Welcome to Health & Life’s free email newsletter service. Tell a friend that we would be happy to add their email address to the distribution list. This service is to provide Health and Life’s clients and those who attended our presentations with up to date information on key financial and practice management issues that may affect your practice. Please do not use this as a substitute to seeking professional advice. Writer in charge: Mr David Dahm CPA, BA Acc, FTIA, FFin, FAAPM,GLF.
Service Trust Deadline 30th April 2007 – Has Your Adviser Got It Right?
Service Trusts they are still worth it if you get it right. In fact the ruling creates more business and tax planning opportunities. We have received many calls nationally from doctors who have requested a second opinion on service fees they charge their doctors. Time is starting to run out so it is important practices finally assess how effectively they have restructured their service trust arrangements. The following are some of their comments in response to the Tax Office Rulings recommendations and our concerns. A GP complained… “My non-owner doctors get paid more than I do. If my overheads are 50% of gross fees I will go broke if I run my practice at the Tax Office rate of 40% of gross practice fees”. Another doctor questioned her accountant about the Tax Office Ruling Guidelines …. “Why if the maximum service fee she could charge was 40% of gross fees, how can her radiologist friend survive when his overheads are at 75% isn’t he breaking the law?”. The answer is advisers should not and cannot follow the Ruling’s indicative benchmarks literally and to the exclusion of the rest of the Ruling. There is flexibility and it is a good illustration that the Tax Office’s one size fits all approach rarely works. Even if you do follow the ATO’s minimum service fee guidelines your arrangements can still be struck down as a sham. Many accountants are using the ATO’s minimum rates without considering the impact it has on a practice. Inadvertently it can significantly starve it of investment dollars and make the repayment of practice loans difficult to impossible. Of more concern, an unprofitable practice that runs at a low profit, break even or at a loss is impossible to sell and would put off any potential providers seeking to join your practice. This can significantly devalue your practice and destroy any succession plans you may have. Accountants commonly struggle with this question because they do not know or appreciate what is the commercial purpose (other than income splitting) for a service entity and the commercial rate for the healthcare industry. Furthermore they do not have a strong basis for their opinion other than relying on the Ruling, which is problematic in itself as it leads to lower rates set by the Ruling which are not sustainable in the long term. We use our exclusively developed benchmarking software program and form opinions from our national database of over 1200 practices over a 14 year period. Our arguments are provable.
This edition covers the most common mistakes we see advisers and practices are making in th response to the Tax Office’s new service trust ruling where compliance comes into effect on 30 April 2007. We are ardent critics of the Ruling and how advisers have approached this issue. Our position was published in the influential Business Review Weekly in January 2007. Email us at pa@healthandlife.com.au for a copy of the article or see attachment. 1. What is a service trust? Do you really have peace of mind? 1.1
Just because you charge service fees of 40% to 45% does not mean you are compliant with the law.
2. What should have you done by now? Common Pitfalls and Mistakes! 2.1
Do You Really Have A Commercially Justifiable Business Case? 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.1.6
3.
Medico-legally group practices really have no choice but to use service trusts. Incorrect Business Structure – don’t use a discretionary trust! The asset protection argument is not a good defence if your trust does not own the building. Owners can have a higher service fee percentage than non-owners Carefully apply the percentage approach - watch out for profit sharing disputes! So what is a commercial rate?
2.2
Practice Documentation Service Agreements – are not commercial
2.3
Systems Timely tracking and banking of service fees So where do you go to from here?
Service Trust Deadline 30th April 2007 – Has Your Adviser Got It Right?
1. What is a service trust? Do you really have peace of mind? Service trusts are run by professionals such as doctors, accountants and lawyers. They operate as independent businesses owned by a company or trust. The entity usually owns most of the practice assets and employs staff, while the practice entity meets professional standards. The trust is usually owned by practice principals and charges for practice management services, equipments hire, branding rights, debt collection and premises. This is called a service fee. For medical practices it can be expressed as a percentage of gross receipts, for example 50%. Where the rates are excessively charged to the owner practitioners (because they are not arms length and are considered related) the Tax Office is scrutinizing the tax deduction to the extent that all or part of the service fee will be denied a tax deduction to the extent it is “deemed” excessive.
This controversial issue of what is excessive or what is a “commercial rate” has led to the Tax th Office issuing guidelines that need to be complied with by 30 April 2007. In broad terms high tax audit risk cases are those that meet ALL of the following criteria. • • •
service fees higher than $1m service fees greater than 50% of gross practice fees service entity net profit higher than 50% of combined net profits
If they cannot be justified the arrangement may be struck down. Like INR’s there is a safe range if you can justify your service fee. As reported in the Medical th Observer on 30 March 2007 urban practices that set fees at 40% of gross practice fees and rural practices 45% will be “safe” from scrutiny. These are called the “indicative rates”. 1.1
Just because you charge service fees of 40% to 45% does not mean you are compliant with the law
The suggested rates are not “safe harbour” rates. Furthermore they are not in accordance with Federal Court Rulings. Specifically the Courts have provided a service fee established must be “commercial” for it to be legal to avoid allegations of tax avoidance. Even if your rate is at 40% it could be still be held as tax avoidance because your structure is not commercial, for example there are no assets your trust protects. To the other extreme a service fee of 46% could be deemed a “high” audit risk which seems as a ridiculous assertion for the Tax Office to investigate. The one size fit all rule is cold comfort. Like the introduction of the GST, reviewing your arrangements properly should provide more opportunities (including tax savings and better succession planning and asset protection) than draw backs if you want to successfully defend your service entity. So the real question arises “what is a commercial rate and what is the basis for such a rate”. 2.
What Should have you done by now? Common Pitfalls and Mistakes
Below are what we believe are the key issues commonly overlooked in service entity reviews by professional advisers and practices. 2.1
Do You Really Have A Commercially Justifiable Business Case? Our key concern there is no business case for a practice to use a service trust. This would render the whole arrangement a sham whether or not you use the ATO indicative rates or “safe harbour rates”. 2.1.1
Medico-legally group practices really have no choice but to use service trusts
For asset protection purposes group practices (i.e. with greater than one owner), have no choice but to use a service trust as a common entity that owns and runs the practice. The main reason is because the alternative structures, such as a partnership or company, unnecessarily make the owners/partners/directors personally vicariously liable (i.e. responsible for each others malpractice mistakes). To use a practice company or partnership in conjunction with a service trust only undermines the key commercial purpose and benefit of using a trust as no risk has been eliminated or reduced. Alternatively, the use of an associateship effectively carves out and/or reduces this responsibility and risk.
2.1.2
Incorrect Business Structure – don’t use a discretionary trust!
At the end of the day, the main commercial purpose of a service trust is so the practice can be sold in whole or in part. Commonly discretionary trusts do not have an equity base like shares in a company or units in a trust that can be readily sold. Accordingly the key commercial argument that your discretionary service trust is used for succession planning purposes would be futile as there is no instrument like shares or units that could be sold to another person or entity. This only brings into question the legitimacy of the structure whereby the profits of the trust cannot be legally sold due to the discretionary nature of the trust. The use of a discretionary unit trust structure (not a fixed unit trust) would overcome this problem. Contact us for further information. 2.1.3
The asset protection argument is not a good defence if your trust does not own the building.
Traditional asset protection is a reason referred to in the Ruling and the original Federal Court Phillips case. In this landmark case it was noted the accounting practice’s building was owned by the service trust, which provided the partners greater asset protection rather than holding the building in the partnership name. These days, many practices own their property in a property trust separate to the service trust. Clearly this old argument no longer holds water. To this extent it is interesting to note that under the new Bankruptcy Laws passed in 2006 income earned that is not based on personal exertion is less accessible by the Bankruptcy trustee. This in itself appears to be a new defence for using a service entity. if income earned can be sheltered from allegations that it is not from personal exertion, such as Practice Incentive Payments, the sale of consumables etc., this would make a service trust more attractive. 2.1.4
Owners can legitimately have a higher service fee percentage than nonowners
A common question is can you justify owner practitioner’s say having a 60% service fee, when the arms length non-owners have a service fee of 40%? The simple answer is yes, but you will need to financially benchmark your practice, which is a useful exercise in itself. We can assist with our national benchmark series. This study investigates practice costs and the impact it has on ownership returns, pricing strategies and recruitment and retention. One of the many rationales we use for this is that the owners are subsidizing the nonowners with a view to selling an interest in the practice. Rental holidays and rent discounting is common place in shopping malls to attract tenants. A medical practice is no different if you have the correct business model. Many do not realize this is a legitimate argument and can be a primary motive for service fee discounting. Practices should consult us before using this argument, as this needs to be reflected in practice agreements and in your practice business plan. 2.1.5
Carefully apply the percentage approach - watch out for profit sharing disputes!
Due to the new ruling many practices are moving away from the cost plus mark up approach. An example is when wages are marked up by 50% and on charged to the
provider. The ruling now permits a percentage approach, which is easier to calculate. However watch the pitfalls. Base all formulas on practice receipts and not billings or you will have a major tax and cash flow problem. Make sure the practice charges GST on all service fees however, remember GST collected on behalf of the practitioner must be 100% paid back to the provider. Conceptually this is a simple methodology to understand, however, the biggest pitfall is if you have a fixed unit trust (which many practices have due to the Phillips case) and different doctors have different workloads. This will lead to large ownership profit sharing disputes. The most common one is that the harder working doctors are paying more in service fees into the trust and the passive or slower working doctors are receiving a higher profit share based on the fixed profit sharing arrangements of the trust for doing less work. The impact of such a rigid structure results in doctors insisting on different services fees within the group so it remains equitable, however this becomes quite messy and inconsistent with the ruling. In some instances, we have seen practices abandon the service trust structure altogether for a single partnership structure. This problem can be avoided by using a discretionary unit trust. Please contact us for further information. 2.1.6 So what is a commercial rate? It is interesting to note the Tax Office’s main concern is doctors who excessively income split their personal exertion income by setting excessive service fees. Another common mistake accountants/practices make is to include the Practice Incentive Payment and other non-personal exertion receipts in their percentage calculation. 40% of total receipts including PIP’s (which should go directly in the trust because it is not based on personal exertion) increases the amount of service fees that can be charged. Why – because the overheads to personal exertion gross receipts is legitimately higher. We have outlined in our BRW article that an appropriate commercial service fee must be based on the costs of running the practice plus an operating profit margin. The operating profit margins will vary from 11% to 49.5% depending on the nature and size of the practice. Using our exclusive national benchmark database we can compare your practice to practices similar to you. It is not difficult to prove commercial service fees of up to 60% for general practices by validating your business model. We can provide written opinions and perform benchmark studies if requested or assist with a private ruling. This will make it very hard for the Tax Office to argue your fees are excessive. 2.2 Practice Documentation The practice should ensure Service Agreements are commercial and go beyond the taxation issues. They should address Privacy Laws, Malpractice Liability, patient’s records etc. There should be a difference between owner and non-owner service agreements in relation to commercial risks. Every doctor must have a signed agreement. Group practice owners must have an up to date practice agreement that actually refers to the service entity in terms of ownership rights and benefits and practice valuations, which are consistent with the practices business model. This is the most commonly overlooked issue. This should clearly distinguish the owner responsibilities and risks from the nonowners, which supports the profit sharing (income splitting) approach. Read your agreements carefully.
2.3
Timely tracking and banking of service fees Using the percentage approach is the simplest way to calculate service fees. It is much easier than the cost plus mark up approach. In practice however, with SIP’s and medical reports that may or may not attract GST, it is hard to keep track of using spreadsheets and re-issuing tax invoices when there is a bad debt or error. Practices must ensure every month that they are tracking service fees and making sure they are banked or transferred in the right accounts. Most importantly 100% of the GST collected on behalf of providers is paid to them. It is important at least monthly transfers are correctly calculated and made to the service trust. Health and Life has developed a database service fee calculator that tracks and prepares tax invoices, BAS and Income Tax Extracts for providers and the practice. It is 100% accurate and simplifies your payroll problems. Due to the nature of these transactions they cannot be done on Quick Books or MYOB as they will mess up you quarterly BAS. Instead of using complicated spreadsheets that do not reconcile, consider using Health and Life’s Service Fee Calculator to do the same and save time and make no mistakes with your providers pays. This will keep the taxman away by keeping a solid audit trail. Click here for more information: Service Fee Calculator download.
3.1
So where do you go to from here? 1. Make sure your practice legal structure and business case is correct and you understand it. Consult your adviser or call us on 1800 077 222 for a brief no obligation consult if you are not sure. 2. Consider benchmarking your practice and getting a written opinion. Contact us about accessing our exclusive national database with over 1200 practices benchmarked nationally over a 14 year period. We can assist with tailored written opinions if you think your practice needs to justify its service fee. Or you may simply want to know if your practice is running efficiently. There are good succession planning and tax benefits for going down this path. 3. Put in writing all legal arrangements and contracts. We have template service and practice agreements. Visit www.healthandlife.com.au under “Products & Services”; Ensure your administration or paperwork reflect the arrangements agreed to by all parties e.g. the practice issues regular service trust tax invoices. See our Service Fee Calculator Program at www.healthandlife.com.au or Service Fee Calculator download. We can email example templates. 4. At no charge we provide to accounting clients only an Annual Best Practice Benchmark and a Practice Overview and Strategy commentary which addresses the tax ruling requirements and any practice inefficiencies or missed opportunities. This simple to read “practice dashboard report” and expert commentary is why practices use us rather than a traditional accounting firm. This is a peace of mind solution. You will instantly notice the difference and feel more confident about how well your practice is running. Email us for a sample of our annual financial statements at pa@healthandlife.com.au and compare this to your current accountants reports.
The bottom line is, should your practice experience an audit, legal or tax problem, it is hard to backtrack your arrangements (we would not advise it). An audit is not the right time to restructure your affairs. Auditors will require proof the arrangements that you say are actually in place, are in place. The less evidence you have i.e. written documentation and administrative audit trails, the
more questions they ask and the more suspicious they become. Unfortunately there are no short cuts. The burden of proof is always on the taxpayer and where there is no proof then your arrangements are left open to challenge no matter how good your intentions are. Make sure your accountant/advisers have addressed these issues for you or contact us for assistance on 1800 077 222. Which topics would you like to be covered? If there is a particular topic that you would like covered in one of our future News Alerts, please email pa@healthandlife.com.au and let us know what it is. We will then endeavor to cover your requested topic. Do we have your email address? It is apparent feedback we are receiving that there are persons receiving this regular email who are not on our email list. If you are receiving this email ‘second-hand’ from another source, we would be delighted to receive your email address and we will add you to our list so that you can receive it first-hand on the day that it is sent. This invitation is open to all medical practices. Please send your email address to pa@healthandlife.com.au Do you wish to unsubscribe from our list? Please email pa@healthandlife.com.au if you wish to be removed from out distribution list Copyright Notice This email, including any attachments, is for the personal use of the recipient(s) only. Republication and re-dissemination, including posting to news groups or web pages, is strictly prohibited without the express prior consent of Health & Life Pty Ltd. Disclaimer Notice Health & Life Pty Ltd’s Best Practice News Alert is designed as a comprehensive and upto-date Accounting and Practice Management news service to alert readers to the latest in practice and related developments affecting the medical, dental and allied profession as they happen. It is published when there is news to report. No responsibility can be accepted for those who act on its content without first consulting us or obtaining specific advice.
Health and Life Pty Ltd (formerly acpm.com.au) Accounting & Practice Management Services. “Looking after your future” PO Box 8145 Station Arcade, ADELAIDE SA 5000 Telephone
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