Many businesses operate through multiple entities, with each entity holding different parts of the business, such as intellectual property, premises, or other assets. In businesses structured this way, it is common for one entity to charge another a fee for the use of these assets.
Since the same people often control the entities, it might seem that everyone “understands the deal.” However, the Federal Court has made it clear that informal understandings are not enough to support tax deductions in these situations.
For example, in a recent case involving a real estate group, intellectual property and rent rolls were held by separate trusts, which charged service fees to operating entities for their use. From 2005 to 2015, all parties had formal written licence agreements. However, when the contracts expired, they were not renewed, and the parties relied on verbal agreements. Service fees continued to be charged, but the Australian Taxation Office (ATO) later disallowed the deductions for the 2016–2019 years.
The Full Federal Court found that there was insufficient evidence of an agreed contract or clear terms outlining what constituted a fair and reasonable fee. The argument that fees “up to 8% of the value of the business” were reasonable, based on external accountant advice, was not supported by consistent calculations or documentation. Additionally, the court noted a lack of communication between directors about any liability and that no tax invoices had been issued, meaning the recorded service fees did not reflect an actual contractual transaction. Consequently, the ATO’s appeal succeeded, and the service fee deductions were denied.
This decision reinforces the importance of proper documentation for inter-entity arrangements. Written agreements, clear calculation methods for fees, and adherence to the contract are essential to substantiate deductions. Informal or oral arrangements carry little weight in related-party dealings and may lead to denied claims.
For businesses with multiple entities, now is a good time to review all inter-entity arrangements. Ensure contracts are up-to-date, that service fees are reasonable and supported by evidence, and that the entities are acting in accordance with the agreements. Taking these steps can help reduce the risk of unexpected tax issues and ensure deductions are defensible if reviewed by the ATO.