The claiming of deductions by taxpayers of amounts necessarily incurred in gaining or producing their assessable income has become second nature, due in part to section 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 97). However sometimes it is not that simple. Partner Justin Byrne and Law Clerk Felicity Dunstone consider the traps of deducting service charges following the decision in Case 5/2016 before the Administrative Appeals Tribunal.
As the parties' names were not published in the Tribunal's judgment, pseudonyms for the parties will be used for the purposes of this alert. Mr Smith (Smith) was a certified practising Accountant who established Service Provider Pty Ltd (SP) to provide professional services to small-medium enterprises. Following a review by CPA Australia, concerns arose over provision of lengthy contracted accounting services where SP would work almost as an "in-house" accountant. As a result, Smith established Service Recipient Pty Ltd (SR) to mitigate this risk, with the intention that SR would undertake any contractual accounting work and SP would provide public accounting services. The allocated type of work was rarely carried out by the desired company in the group, and subsequently a Services Agreement was entered into between SP and SR, whereby SP would manage all client relationships and invoice SR for all reasonable costs incurred in providing the services.
Deductibility of the Service Charge
The Tribunal authorised the description provided by the High Court in Spriggs v Commissioner of Taxation; Riddell v Commissioner of Taxation (2009) 239 CLR 1:
"... It is well established that "in" gaining or producing means incurred "in the course of" gaining or producing assessable income...
The essential question... is: "Is the occasion of the outgoing found in whatever is productive of actual or expected income?...
It was held [in Ronpibon Tin] that a loss or outgoing will be "necessarily incurred in carrying on" a business if it is "clearly appropriate" or "adapted" for the carrying on of the business. Restating the test another way, the loss or outgoing will be "necessarily incurred" if it is "reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business."
Smith contended that in the "eyes" of SR, SP had charged SR for services and SR had necessarily incurred the charge in carrying on its business, therefore making the Service Charge deductible under section 8-1(1)(b) of the ITAA 97. Smith gleaned support for his position from Taxation Ruling TR 2006/2 and FC of T v Phillips 78 ACT 4361, believing the expense in the hands of the taxpayer was the Service Charge, and it was charged in accordance with the terms of the Service Agreement.
The evidence of Mr Smith was that the parties did not prepare estimates or statements or issue any invoices. Instead, any amounts that were claimed to be owing by SR to SP were by reference to general ledger statements which were then "settled" (using Mr Smith's terminology) by other journal entries in the loan accounts maintained by each entity.
The Tribunal disagreed, considering Smith presented insufficient probative evidence to demonstrate that SR had "incurred" the Service Charge. In particular, the Tribunal referred to the following points:
- There was no evidence to prove services were provided by SP to SR, that any Service Charge was charged by SP, nor that any Service Charge was incurred by SR. In particular, the Tribunal commented at paragraph : "Journal entries are not of themselves evidence of payment, let alone of expenses having been incurred... [Therefore] in all the circumstances, I find that not Service Charge was incurred by SR and so it is not entitled to claim a deduction under section 8-1 of the ITAA 97".
- There was insufficient evidence about the activities of SR and the relevance of the Service Charge (so called) to its business and income producing activities. Smith's case rested heavily on the description of "Services" and the Service Charge provisions in the Services Agreement, yet no supporting probative evidence of this was led.
- Further, the oral evidence of Smith suggested there was no Service Charge because invoices were never issued nor were any payments made between the related entities. Such a testimony indicated a tendency of SP not to adhere to the terms of the Services Agreement.
The AAT found the taxpayer had incorrectly relied on Taxation Ruling TR 2006/1 and was not entitled to claim a deduction for any Service Charge under section 8-1 of the ITAA 97.
Considerations for Taxpayers
- Identifiable services need to in fact be provided from one company to another to warrant a Service Charge. Where there is a written agreement or contract in place, the terms should reflect the activities undertaken.
- Costs may only be deducted under section 8-1 of the ITAA 97 where it can be shown that incurrence of those costs was necessarily related to business activities, in that they are "reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business". Taxation Ruling TR 2006/2 (paragraphs 6-7) confirms that expenditure made under a service arrangement will not always be deductible under section 8-1 of the ITAA 97. Deductibility of this expenditure depends on what the expenditure was calculated to achieve from a practical and business point of view.
- Proper documentation is critical to prove the existence of the outgoing, thereby grounding the claim for the tax deduction. Journal entries in the accounts are insufficient.
- The Commissioner may impose administrative or other penalties for failure of a taxpayer to take reasonable care under the Tax Acts in respect of claiming deduction for losses/expenditure.
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