In private groups it is incredibly common for the parties to charge inter-entity management fees, or service fees. There are many reasons why this is necessary, usually because there is different ownership between valuable assets (such as plant and equipment, intellectual property or a rent roll), and the public facing trading entity. There are often sensible, asset protection reasons for the private groups separate entities between risk and value.
The ATO recently challenged one such arrangement for a real estate group, where asset holding trusts which held intellectual property and the rent roll charged service fees to the operating entities. The operating entities claimed deductions for the service fees, and the asset holding trusts earned assessable income.
There was no doubt that the arrangement was genuine, with real assets and commercial service fees. There was also an agreement in place until 2015, but that agreement had lapsed. Despite the director of all of the entities giving uncontested evidence that there was an agreement in place, the ATO argued that the absence of objective evidence in relation to that agreement meant the director’s evidence of his subjective intention was irrelevant.
The ATO issued amended assessments to the operating entities disallowing the deductions. The operating entities appealed to the Federal Court, and despite winning at first instance before Justice Logan, that decision was overturned on appeal.
The Full Federal Court decision has important implication for the enormous number of private groups that charge inter-entity service fees.
Facts
The case involved S.N.A Group Pty Ltd and ATPR Pty Ltd, operating companies within the Coronis Group. These companies used assets owned by two trusts: the Henry Trust (intellectual property, including the ‘Coronis’ trademark) and the Emily Trust (rent roll for property management). The operating companies made payments to the trustees, claiming these as deductible service fees under s 8-1 of the Income Tax Assessment Act 1997 (Cth).
The ATO disallowed these deductions, arguing that the payments were not losses or outgoings incurred in gaining or producing assessable income.
The taxpayers asserted that the payments were made pursuant to agreements (partly written, partly by conduct) for the use of trust assets, and thus deductible. The written agreements ended in 2015, but payments continued in subsequent years, with the taxpayers claiming deductions for these payments as service fees.
Outcome
The primary judge accepted that, although the taxpayers failed to prove the existence of the asserted agreements, there was an inferred contractual liability to pay service fees in each relevant year. This led to the conclusion that the ATO’s amended assessments were excessive.
However, the Full Court disagreed on appeal. The Full Court found there was insufficient evidence of an objective manifestation of mutual assent between the taxpayers and trustees to contract on terms requiring payment of a fair and reasonable fee for use of the trust assets. The Court held that establishing the existence of a contract necessitated objective communication (not just subjective intention) to establish a contract, especially where companies have common directors. The court allowed the appeal and reinstated the ATO’s amended assessments.
Practical implications: The importance of clear, contractual arrangements for related party dealings
This decision underscores the importance of clear, objective evidence of contractual arrangements when claiming deductions for payments between related entities. Taxpayers must ensure that any arrangements for the use of assets or services are documented and communicated in a manner that would be understood by reasonable people in the position of the parties—not merely based on internal or subjective intentions.
For tax lawyers and advisors, the case highlights:
- the need for written agreements or clear, documented communications to support deductions for inter-entity payments;
- the risk of relying on inferred contracts or informal arrangements, especially in groups with common directors or ownership; and
- the importance of consistency in financial records and the methodology used to determine fees, as mere arm’s-length pricing is not sufficient without evidence of a binding agreement.
Ultimately, the case serves as a cautionary tale: the ATO will closely scrutinise deductions for payments to related entities, and the courts may uphold the ATO’s decision to disallow such deductions if there is no clear contractual evidence.