APSI Rulings regarding Commission based contractors

[razorback]

Dear forum,

I know this is primarily a property forum, but I have been so impressed with the depth of taxation knowledge present on these forums that I would throw out a question that has baffled me and my colleagues for a while.

The whole purpose of working this out is to get to trade as a company for taxation and deduction purposes.

I am a newly practicing medical professional. Most professionals in this industry basically work for a commission/percentage of fees billed. So say $100 is billed, the "contracting professional" gets $30. The professional is servicing hundreds of "clients" but usually gets paid by the principal medical professional (who owns the practice).

My question relates to the APSI rules. I have been trying to decipher the wording of all the clauses.

1) The "agents and principal ruling" states that a agent (the contracting professional) cant use the premises of the prinicple except on the basis of an arms length rental. What does this term mean? Can the 70% the contractor pays to the principle be considered rental at arms length for both leasing premises and plant/equipment?

2) The 80/20 ruling: If I work two part time jobs, does this bypass the 80/20 ruling. (By the nature of having 2 part time jobs I would also meet the unrelated clients test, as one of three of these other tests must to self assess)

3) The results test: This test states that the payment must be for producing a result, must supply plant and equipment and must be liable for rectifying faults in work.
Can an "contract" be worded such that the "contractor" meets such requirements? ie 1) The contractor shall be payed according to item numbers billed, 2) The contractor will lease plant and equipment from the practice at a rate of 70% billed fees, 3) The contractor is financially liable for correcting any faulty work.

Complex issue. All help is appreciated as most accountants have been unable to help.

Steve

[coastymike]

Steve,

Firstly when you do establish an entity make sure it is a trust and not a company. You might have been using the term interchangeably but just wanted to make sure you get your structure right.

Lots of tax opportunities for you as a medical professional and I trust that your accountant is assisting in these matters. If you ever get to the stage when you have your own medical practice you will also have the joy of creating a service trust and some of the wonderful things that can be done from a tax perspective (provided the service trust complies with the Phillips case).

Anyway I digress and should address your concerns. You have obviously looked at the flowchart provided by the ATO and I will endeavour to address the questions raised by the flowchart and see whether the personal services income rules apply. You can then take this to your accountant for further discussions.

PERSONAL SERVICES INCOME

The measure contained in Divisions 84 to 87 of the Income Tax Assessment Act 1997 (ITAA 1997) only applies if a taxpayer has income that is personal services income (of an individual). The definition of personal services income is contained in subsection 84-5(1) of the ITAA 1997 which states:

Your ordinary income or statutory income, or the ordinary income or statutory income of any other entity, is your personal services income if the income is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income).

The definition refers to income (including ordinary income or statutory income of any entity) that is mainly a reward for an individual’s personal efforts or skills. Subsection 84-5(3) of the ITAA 1997 extends the definition of personal services income to income that is for doing work or for producing a result. The result must be produced from the individual's personal efforts or skills.

Based on your description of your activities then this is personal services income. The the question is do the personal services income tax rules apply ?

RESULTS TEST

In order to answer this question you would need to provide further information such as contracts between you and the medical centre (what does it say about your responsibility regarding disputes re patients results). This would be used to determine whether you are responsible for rectifying any defects (i.e. if a patient complains about a drug not working who is responsible for that - you or the medical centre). Given that you have professional indemnity insurance then all doctors will generally be responsible for the end result and so this part of the test is fairly easy to meet. Do you supply the equipment necessary to undertake your trade (under arrangements such as yours it is common for the medical centre to provide all the tools of the trade - some contracts however charge you for the use of ALL services). Is it also services provided as a direct result of your skills and labour (yes - you have answered that component)

If you meet the results test (you would need to supply your accountant with further information) then you dont need to go any further. The PSI rules do not apply for you.

If you do not meet the results then you need to go further and then ask if 80% or more of your income comes from one client. I would argue that this is not the case as the medical centre is merely billing patients on your behalf and then remitting the fees to you. They are simply acting as an agent on your behalf. In this case 80% of your income would NOT come from one client and therefore the PSI rules would not apply.

However even if you wanted to go one step further you would meet the unrelated clients test.

UNRELATED CLIENTS TEST

Section 87-20 of the ITAA 1997 which provides:

(1) An individual or a personal services entity meets the unrelated clients test in an income year if:

(a) during the year, the individual or personal services entity gains or produces income from providing services to 2 or more entities that are not associates of each other, and are not associates of the individual or of the personal services entity; and

(b) the services are provided as a direct result of the individual or the personal services entity making offers or invitations (for example, by advertising), to the public at large or to a section of the public, to provide the services.

(2) The individual or personal services entity is not treated, for the purposes of paragraph (1)(b), as having made offers or invitations to provide services merely by being available to provide the services through an entity that conducts a business of arranging for persons to provide services directly for clients of the entity.

It would be reasonable to hold that the medical centre is merely invoicing the patient and collecting the fees on behalf of the patient. Also, no one patient would provide more than 80% of the total personal services income to you. Based on the facts you have provided it would therefore seem that you meet the unrelated clients test (even if you were working for just one medical practice). Therefore, your income from this source is not caught by the personal services income provisions and your deductions will not be limited by this legislation. However, it is necessary to consider the general anti-avoidance provisions.

So even if you dont meet the results tests you will still ultimately meet the unrelated clients test. I hope this helps. It's a shame you haven't found an accountant helpful in these matters.

[razorback]

Coastymike,

Thanks for such a well read and thorough response! You could be my accountant anyday. I have a couple of questions to ask to clarify some matters raised.

1) For a trading entity why do you suggest using a trust structure over a company. (I assume the type of trust you refer to is a HDT with a corp trustee). Isnt it simpler to have the PTY LTD just be the trading company as it will not hold capital appreciating assets?

2) Regarding the results test: The employment contract states that; a) I get paid for the work i bill, b) I am financially liable for any faulty "work" c) Regarding the supply of equipment - I "lease" this for a rate of 70% of billed $.

So it can only be concluded that I may meet this test. But the rental of equipment bit is a bit sketchy and isnt defined under the legislation.

3) Unrelated clients test. This all hinges on who the client is. For the client to be my patients and not the medical centre the PRINCIPAL AND AGENTS TEST must be met.

This test basically says your patients are you clients if you meet all the conditions of this test (5 of them). I meet all of them. However number 5 is tricky. It states "you do not provide any services to the customers, on the principles behalf, using premises that the principle owns or has leasehold interest in, unless you use the premises entered into at arms length."

Now if I am leasing the premises at a rate of 70% of billings, which would be around $700 per day, would this be considered an arms length rental and thus would I meet this test? (Otherwise my client is deemed to be the medical centre and I must get 2 non associated jobs to meet the 80/20+unrel clients test.)

I have an appointment with one of the fabulous accountants from this forum tommorrow morning. Hope we can nut this one out. The ATO make it hard to even work out where you stand.

Thanks again forum members.

Steve

[coastymike]

Steve,

I'll let you discuss these issues at your appointment with our fellow forumite. It's great you have someone that will help you through these issues. Have fun.

[razorback]

Thanks anyway mate. Appreciate the help.

I will inform the forum of the results of my findings tommorrow.

If anyone else can throw in some thoughts on the matter you are more than welcome.

Steve

[Mry]

For a trading entity why do you suggest using a trust structure over a company. (I assume the type of trust you refer to is a HDT with a corp trustee). Isnt it simpler to have the PTY LTD just be the trading company as it will not hold capital appreciating assets?

There are very few reasons nowadays for a small business to operate in a corporate structure. Loans to shareholders, justifying payments to non working family members, lack of CGT concessions and rigid operating structure leave little room for saving on tax.

Worst of all is that working professionals operating through companies will not have asset protection benefits. I asked a barrister about this some time ago and he said that if you operate through a company and you provide services to clients, you can be sued directly for negligence in your own name successfully. Have no assets in your name razorback!

2) Regarding the results test: The employment contract states that; a) I get paid for the work i bill, b) I am financially liable for any faulty "work" c) Regarding the supply of equipment - I "lease" this for a rate of 70% of billed $.

So it can only be concluded that I may meet this test. But the rental of equipment bit is a bit sketchy and isnt defined under the legislation.

Contractual details are helpful, but actual facts of how you are operating matter more. This is a grey area I'm afraid. Unless you and your accountant feel comfortable in making a decision, I'd get a private ruling.

Now if I am leasing the premises at a rate of 70% of billings, which would be around $700 per day, would this be considered an arms length rental and thus would I meet this test? (Otherwise my client is deemed to be the medical centre and I must get 2 non associated jobs to meet the 80/20+unrel clients test.)

I believe the 70% is a service fee that covers a variety of services you receive (am I right?). As long as the fee can be separated out into its individual service components which can be justified, there should be no problem. You just need to prove that there is a justifiable and commercial reason for the charge. Showing that it is similar to other surgery's charges is also helpful

I have a number of clients in the same situation you describe who have adjusted to "the associate way" and while it does provide good benefits to the medical practice manager, unless all the paperwork and activities comply precisely, there could be tax trouble.

[Apocalypse]

Lots of tax opportunities for you as a medical professional and I trust that your accountant is assisting in these matters. If you ever get to the stage when you have your own medical practice you will also have the joy of creating a service trust and some of the wonderful things that can be done from a tax perspective (provided the service trust complies with the Phillips case).


coastymike - what is a service trust?

[coastymike]

A service trust is essentially a separate entity which employs the administrative staff, employs service personnel, provides administrative support and services (including property) to the trading entity (a hybrid trust). Provided that the service trust complies with the FCT v Phillips case then the service trust can apply a mark-up to these services and they can be charged to the trading entity.

It is important that the service trust is a commercially realistic one otherwise the ATO will come down hard on it.

I would talk to your accountant about this one as there are a lot of things to consider and it is critical that you establish a service trust to comply with Phillips. It was either PriceWaterhouseCoopers or Ernst & Young which recently settled with the ATO for having the wrong sort of service trust. The other one got it right. Can't remember which one but anyway it demonstrates how critical it is to get the structure right.

[Apocalypse]

So what happened as a result of your meeting, razorback?

[razorback]

Basically I seem to be ok considering I have 2 different jobs so I meet the 80/20 rules.

Regarding the trusts. We worked out it was best to have a discretionary trust as the trading entity and a separate HDT for investments.

Cheers,

Steve

[coastymike]

Razorback,

Why don't you establish two HDT. They cost the same as a straight Discretionary Trust but provide you with much more flexibility for the future and in case circumstances change.

[razorback]

Coastymike,

Thanks for the suggestion. I was thinking the same thing after the appointment with my accountant. However the HDT was about $1200 and the normal DT around $800.

Steve

[Mry]

Why don't you establish two HDT. They cost the same as a straight Discretionary Trust but provide you with much more flexibility for the future and in case circumstances change.

As said, the DT is much cheaper.

Also I don't see much reason for setting up a medico business HDT. It won't be investing in assets and there's no asset protection for medical practioners in running in a HDT anyway.

Reason 2
Oh yeah, even if the medical business within the trust ceased, there would also be a chance of having an action against the trust later on. If the trust stopped running the medical business and bought a rental, and a former patient sued the practioner and the trust for negligent medical treatment within statuory limits and won, goodbye rental.

Once a business within a trust/company ceases, the trust/company is usually gotten rid of.

[coastymike]

Mry,

Well the tax lawyer I get the HDT from is the same price as the DT but those can always vary so if one is more expensive than the other then yes I would agree the less costly one would be a better option. Personally I think it gives you more options for the future, and in my case, at the same price.

Regarding litigation it is the corporate trustee that is sued, not the trust. You need to look at a whole heap of things to determine whether the property is the property of the trust or the defendant but the nature of the transaction, timing, etc. needs to be evaluated. (You could purchase a rental property in a new discretionary trust 6 mths after closing the medical practice - the practice then goes bankrupt a further 6 mths later and they then go after the medical practitioner - as the asset purchased was within a 2 year time frame from the bankruptcy the solvency provisions are going to come into play so goodbye rental property anyway). So if you have a company as the trustee then the litigation is against the company (which should have no assets) and ultimately the directors (who again should have minimal assets). -(Again note the bankruptcy provisions)

Most medical practitioners also have professional indemnity insurance so the suit will be against the practitioner not the trust. Even if they win against the practitioner, and they don't have adequate insurance, then you start to look at their assets. In this case the medical practitioner would own units (either special income or capital units) in a hybrid discretionary trust. They don't own the property directly, it is held on trust. So the courts will ask for the units to be redeemed but this is where your asset protection comes into play.

For example you hold 500,000 $1 units in a trust (HDT). You have borrowed the $500,000 from the bank to purchase the special income units. The trust then uses that $500,000 to purchase the rental property. This is to get your negative gearing benefits. Let's then say 10 years later the property is worth $1M and you get sued.

Then you get sued and the courts hold you owe the creditor $500,000. So you sell your units back to the unit trust for $500,000 (the trust will need to borrow the $500,000 to redeem the units but this debt will then be deductible to the trust). That means you now have $500,000 in your pockets BUT you owe the bank (as a secured creditor) $500,000. So your net worth is zero and the creditor gets nothing.

The trust still owns the property worth $1M and it owes the bank $500,000. The trust owns the assets and the debt now. So you the bankrupt have been protected. The creditors cant then go after the trust as the claim is not against the trust. It is against the medical practitioner. Even if they do go after the trust (claiming the company - not the medical practitioner - was negligent) then they come up against the corporate trustee (it doesn't own anything it only has a single director (well I hope its a single director company). So you are in the same position.

It is also my understanding that a beneficiary of a trust only has a mere right to the income or capital of the trust and therefore will only be assessed on the actual distributions made to that beneficiary. Basically if the person was bankrupt no distributions would be made to them and the value would be nominal.

Correct me if im wrong but this is the whole point of using such structures. To obtain adequate asset protection both now and in the future.

[Mry]

Regarding litigation it is the corporate trustee that is sued, not the trust.

Yes I know. But "trust" is a lot easier to say than "the trustee in the execution of their duties towards the trust." The trustee is sued pursuant to their duties, which means that they can indemnify themselves from such actions out of the assets of the trust.

Most medical practitioners also have professional indemnity insurance so the suit will be against the practitioner not the trust.

Lawyers sue everything. Too many of them have spent thousands pursuing legal claims to have been told in court that they are suing the wrong thing. So they include as much as possible in the suit, and if they could include the kitchen sink they would. The trust would surely be in there.

Insurance isn't all its cracked up to be. Insurers are quite happy to take your money for the premiums but some become as wiggly as a snake when you come to make a claim. Besides, remember HIH and the recent problem with that medical insurance company that went down the gurgler. You can rely on your insurance most of the time though, but don't rely on it 100% to see you through. I go straight to Lloyds of London myself.

Then you get sued and the courts hold you owe the creditor $500,000. So you sell your units back to the unit trust for $500,000 (the trust will need to borrow the $500,000 to redeem the units but this debt will then be deductible to the trust). That means you now have $500,000 in your pockets BUT you owe the bank (as a secured creditor) $500,000. So your net worth is zero and the creditor gets nothing.

Is there any case law on this point? I can see the plaintiff arguing that the units were redeemed at below market value and go after the asset trust.

[Apocalypse]

As I can envisage a similar opportunity as razorback's arising for myself, I'd like to pursue some of the more basic points...

If the best structure for razorback is to operate a business within a trust - exactly how does that work? Does razorback work for himself, or does the trust/trustee "employ" him? If he is an employee - does the trust therefore have to pay workcover levies, super, etc, etc? And if he's not an employee, how is the trust anything more than a shell for distributing profit to others?

On the matter of corporate trustees: if razorback (for example) formed a company to actly solely as trustee for his (business) trust, and the sole director of that company is razorback - how is this anymore protective than if he were trustee in person? If the trustee is the one to get sued - if it was the company, aren't directors ultimately held responsible - so his personal assets are still vulnerable? Still would just mean one needs to keep personal assets minimised...

Or is the extra layer of red-tape the basis of the improved asset protection?

[Apocalypse]

Further searching has yielded this thread (http://www.somersoft.com/forums/showthread.php?t=6346)

The second post in it:

Hi John!

It is virtually impossible for a doctor to operate their practice through a trust.

Even so, it is very much a standard within the profession for the buisness to be in the doctors own names as a sole trader, but, with a family trust running parallel to the business and invoicing the practice for administration services. This parallel entity usally owns the computers, phones, fax machine etc and hires the secretarial and nursing staff.

The practice pays a fee for the hire of the equipment and staff (plus a margin) from the trust.

It is also common for the doctor to have a 2nd trust which is used to own IP's and other investments.

I hope that this helps

Dale

I was wondering how this relates to razorback's situation? Dale only really talks of service trusts...

[Mry]

Apocalypse,

Some professions have rules for membership and trading structure. For example, accountants in professional bodies can only trade as a sole trader or in partnership with other accountants if they want their business to be referred to in partnership with their professional body.

The AMA allows only sole traders, partnerships and companies to operate a practice. Hence Dale's comment rings true.

[coastymike]

Seems as though I deleted my message. Anyway Pam Burton, Legal Counsel from the AMA, informed me a while ago that there are no restrictions on the structure that a medical practitioner can trade through. There used to be restrictions a while ago but this has changed and the advice is left up to the accountant, lawyer or financial advisor and they don't interfere.

The reason why most medical practitioners would find it difficult to trade through a trust is due to the PSI rules. The ATO is aware that there is the mistaken belief that income earned by a personal services business is income from a business structure.

If you are really interested in reading about PSI (personally I would rather be reading a decent Patricia Cornwell novel but hey each to their own) then IT 2121 - FAMILY COMPANIES AND TRUSTS IN RELATION TO INCOME FROM PERSONAL EXERTION, IT 2330 - INCOME SPLITTING and IT 2503 - INCORPORATION OF MEDICAL PRACTICES might make some interesting reading.

Essentially these rulings help in determining the distinction between income from a business structure and personal services income. Factors that need to be considered include

- the number of arm’s length employees or others engaged by your business to perform work and the efforts of those employees (also see paragraph 10 of Taxation Ruling IT 2639)
- the extent to which the income depends on your own personal skills, efforts or expertise
- the extent to which income-producing assets such as plant and equipment or machinery, or intellectual or other property are used to derive the income
- the presence of goodwill
- the nature of the activities carried out, and
- the size of the operation.

Well I think I'll leave the PSI discussion for the others. Discussing property taxation is much more interesting than discussing alienation of personal services income.

Just thought I would also add that at present, although this is being changed for the future, under the Pharmacists Registration Act a pharmacist can only operate as a sole trader.

[Mry]

The reason why most medical practitioners would find it difficult to trade through a trust is due to the PSI rules. The ATO is aware that there is the mistaken belief that income earned by a personal services business is income from a business structure.

Uh, don't PSI rules apply to trusts, companies and partnerships? Would that not mean that the same PSI problems that trusts have also apply to companies?

Anyway, if you want to know why non sole trading doctors working in practices get out of PSI rules, best speak to your accountant about "associate" arrangements. There isn't enough space here to describe how it works.

[coastymike]

Mry,

The PSI rules most certainly do apply to other structures. The ATO has held that if the personal services business is also earning personal services income then as long as the profit is paid out as a wage to the medical practitioner (in the case of a company) or the net income is wholly distributed to the medical practitioner (if a trust) then Part IVA will be deemed not to apply. A lot of people think that just because you meet the personal services business tests that you can then establish a structure such as a company or trust and stream income. There are essentially two tests.

1, Is the business earning personal services income ? (the infamous flowchart) and
2. Is the income derived mainly from the business structure or as a result of personal services income ? (based on the Income Tax Rulings)

That is why the ATO is concerned because people have just been applying the first test and not looking at whether income is earned from the business structure or not.

Number 2 is appropriate in determining whether Part IVA will apply. However I will qualify this by saying that as long as you have distributed all the profits to the sole practitiner then the ATO has held that these structures can be used to obtain the superannuation benefits from such structures.

I agree that a service trust will still provide some wonderful tax planning opportunities even to a sole practitioner provided that it complies with Phillips Case. However in this case the sole practitioner would also have to be paying the administrative staff, own the equipment, etc.

Corporatisation of the medical sector has meant that a lot of doctors now work on a commission basis and this is paid back to the centre. In these cases I think it is going to be extremely difficult for a doctor working through a trust not to claim that this isn't personal services income.

Agreed that we are only discussing sole practitioner doctors. Doctors who aren't working as sole practitioners are in a different boat.

Gee they made the PSI rules difficult for the average person to understand. I get confused about it all the time.

[Apocalypse]

coastymike, I've read the Rulings you've referred to and get the impression that the ATO don't care what you do as long as all the money is distributed to the practitioner - so that from a taxation perspective they're not losing out. Although there is mention of super benefits that they don't mind in a corporate structure.

Your original recommendation was to operate within a trust structure. If there is no real financial benefit, is it mainly for the asset protection angle? And if so, if it is the trustee that is sued, ultimately if it is a corporate trustee of which the practitioner is a director, isn't he as a director still responsible for the company? In which case he is well served to have minimal personal assets...

Where is the benefit over being a sole trader with no complex structure, but just minimal personal assets?