Business of Medicine 2002

THE BUSINESS OF MEDICINE 2002
MEDICAL & DENTAL ACCOUNTING SERVICES PTY LTD
ACN 076 047 400 Public Accountants Specialists in Accounting and Consulting Services for Medical and Dental Practices
www.madas.com.au
Terry McMaster & Co Pty ACN 093 279 835 Solicitors &Consultants 144 Church Street, Brighton, Victoria 3186 PO Box 203, Brighton, Victoria 3186 Telephone: (03) 9592 9888 Facsimile: (03) 9592 9198 36 Dandenong Road West, Frankston Victoria 3199 Unit 13/828 High Street, Kew Victoria 3101 Level 5 203-233 New South Head Road, Edgecliff NSW 2027 Telephone: (02) 9328 6599 Email: terry@madas.com.au
MEDICAL & DENTAL ACCOUNTING SERVICES PTY LTD BUSINESS OF MEDICINE 2002 TABLE OF CONTENTS
1. INTRODUCTION 4 1.1 Why you should read this book ___________________________________________ 4 1.2 In a nutshell _______________________________________________________ 6 1.3 Now that we are ten ____________________________________________________ 9 1.4 About Medical & Dental Accounting Services _______________________________ 10 1.5 Medical & Dental Accounting Services Pty Ltds professional fees _______________ 12 2. HOW TO STRUCTURE YOUR PRACTICE 13 2.1 What should a medical practice look like? __________________________________ 13 2.2 What should a group practice look like? ____________________________________ 23 2.3 Incorporated Medical Practices ("IMPs") ___________________________________ 28 2.4 Service Trusts________________________________________________________ 35 2.5 Practice Trusts _______________________________________________________ 41 2.6 Partners or Associates?_________________________________________________ 48 2.7 What if you are married to a practitioner?___________________________________ 52 2.8 Case Study: The Story of John and Betty___________________________________ 54 2.9 Case Study: The Story of Gina and Guido__________________________________ 58 2.10 Letter regarding administration of legal structure _____________________________ 62 2.11 Hybrid Trusts________________________________________________________ 66 3. BUSINESS ISSUES 68 3.1 Practice goodwill and therefore profits_____________________________________ 68 3.2 The valuation of medical practice _________________________________________ 76 3.3 How to buy a practice _________________________________________________ 82 3.4 Checklist for buying a practice ___________________________________________ 89 3.5 Business Plans: Just where are you going? __________________________________ 92 3.6 Break-even analysis and cash budgeting ____________________________________ 96 3.7 Avoiding disputes with partners _________________________________________ 101 3.8 Debt collection for practitioners_________________________________________ 102 3.9 The move to a group practice___________________________________________ 104 4. TAXATION ISSUES FOR PRACTITIONERS 112 4.1 The taxation of practice companies: Fact or Fiction?_________________________ 112 4.2 The taxation of medical partnerships _____________________________________ 118 4.3 Family Trusts _______________________________________________________ 120 4.4 Ten top tax planning tips ______________________________________________ 135 4.5 Tax schemes and why you should not touch them ___________________________ 138 4.6 Why labor costs cannot be marked up by 50% ______________________________ 141 4.7 Common tax traps (or missed opportunities?) ______________________________ 144 4.8 Taxation and practitioners cars _________________________________________ 148 4.9 OMIGOD! Its tax time! _______________________________________________ 152 4.10 Lap top computers ___________________________________________________ 162 4.11 Practitioners' guide to year-end tax planning 2001 ___________________________ 164 4.12 Personal Services Income Rules _________________________________________ 171 4.13 Negative gearing_____________________________________________________ 173 4.14 ATO and Centrelink Websites __________________________________________ 176 5. TAXATION SOURCE MATERIALS OF INTEREST TO PRACTITIONERS 177 5.1 Income Tax Ruling 25 ________________________________________________ 177 5.2 Income Tax Ruling 2503 ______________________________________________ 180 5.3 Income Tax Ruling 2639 ______________________________________________ 186 5.4 Phillips Case________________________________________________________ 190 5.5 Janmoor Nominees Case: family home in a family trust ______________________ 201 5.6 Practitioners motor vehicle expenses_____________________________________ 214 January 2002 Page 1
5.7 Interest on amounts borrowed to pay income tax____________________________ 216 6. DEBT MANAGEMENT 218 6.1 Handy hints on borrowing money _______________________________________ 218 6.2 How to manage debt _________________________________________________ 221 6.3 Sources of debt: What are the options? ___________________________________ 223 6.4 One way to convert a non-deductible debt to a deductible debt _________________ 228 7. PRACTICE ISSUES 231 7.1 Marketing a medical practice ___________________________________________ 231 7.2 Bulk Billing ________________________________________________________ 232 7.3 Medical negligence and what to do about it ________________________________ 238 7.4 Staff selection procedures______________________________________________ 242 7.5 Dealing with an unsatisfactory employee __________________________________ 245 7.6 Time Management ___________________________________________________ 249 7.7 Leasing practice premises ______________________________________________ 257 7.8 The practice incentives program_________________________________________ 260 7.9 Dropping the local letterboxes __________________________________________ 263 7.10 The Reception Desk: The real front line __________________________________ 266 7.11 Change in the workplace ______________________________________________ 268 8. SMALL COMPANIES 271 8.1 What is a company? __________________________________________________ 271 8.2 One-practitioner companies ____________________________________________ 274 8.3 Company Directors What do you need to know ___________________________ 275 8.4 The taxation of private companies _______________________________________ 280 8.5 Common questions and answers ________________________________________ 283 8.6 New rules for distributions from private companies__________________________ 292 8.7 Use of the company seal_______________________________________________ 299 9. THE NEW TAX SYSTEM 301 9.1 Introduction________________________________________________________ 301 9.2 Some BAS basics ____________________________________________________ 301 9.3 Practitioners and the GST _____________________________________________ 304 9.4 Service Trusts and the BAS ____________________________________________ 309 9.5 The Pay As You Go Instalment System PAYGIS__________________________ 310 9.6 The Pay As You Go Withholding System (PAYGWS) ______________________ 318 9.7 The timing of tax payments ____________________________________________ 320 10. THE BUSINESS OF MEDICINE 324 10.1 Change, change and change ____________________________________________ 324 10.2 June 2000 __________________________________________________________ 326 10.3 Rising Goodwills ____________________________________________________ 328 10.4 An investment reality check ____________________________________________ 330 10.5 How can we help you? ________________________________________________ 331 10.6 An overview________________________________________________________ 335 11. AUSTRALIAN DOCTOR ARTICLES 337 11.1 Some Super Strategies ________________________________________________ 337 11.2 Dr Suzies Not So Super Super__________________________________________ 339 11.3 Is it time for some time?_______________________________________________ 340 11.4 This kid is foreman material! ___________________________________________ 341 11.5 Family Trusts: Better than ever _________________________________________ 343 11.6 Year end tax planning, for 2002 _________________________________________ 344 11.7 Five Ways To Increase Profits __________________________________________ 345 11.8 A child in every home_______________________________________________ 347 January 2002 Page 2
11.9 Service fees and service trusts___________________________________________ 348 11.10 Advanced gearing strategies ____________________________________________ 349 11.11 A Retiring Type _____________________________________________________ 350 11.12 Practitioners and investments___________________________________________ 351 11.13 A Valuable Employee_________________________________________________ 352 11.14 Some Super Strategies ________________________________________________ 354 11.15 New BAS rules______________________________________________________ 356 12 MADAS CLIENT NEWSLETTERS 357 12.1 Estate planning: do not leave it too late ___________________________________ 357 12.2 How to get wealthy, really _____________________________________________ 358 12.3 Trust Boon Uncovered Again __________________________________________ 360 12.4 FBT For Public Hospitals _____________________________________________ 360 12.5 When will the kids leave home? _________________________________________ 363 12.6 But before the kids leave home, put them to work ___________________________ 365 13. FURTHER COPIES OF THIS MANUAL 366
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MEDICAL & DENTAL ACCOUNTING SERVICES PTY LTD BUSINESS OF MEDICINE 2002
1. 1.1 INTRODUCTION Why you should read this book
"The best time to plant a tree is twenty years ago. The next best time is now."
The greatest investment you have is the time dedicated to yourself and your practice. Practitioners normally have the longest training period of all professionals: once through school and into university it takes at least six years to get out. Then the vocational training starts. Low pay and long hours. Once out and in full private practice it can take years to achieve professional independence and standing. Having made this great investment, you owe it to yourself to take time to reflect upon the business and investment structures and strategies that underpin your practice and your livelihood. This reflection requires you to examine the legal structure for operating your practice, your taxation profile, your superannuation and insurance profile, your business and practice development plan, your personal development plan, your investment strategy and, ultimately, (and this can never be done too early) your retirement and estate planning, including the contents of your will. This is easier said than done. We all know these issues are important, but how does one address them? First, in a busy practice how do you escape the patient pressures and the administration burdens so you have time to reflect on these issues? Second, where do you find the information and other resources necessary if this reflection is to be intelligent, informed and complete? Third, how do you find the professional expertise and assistance necessary to focus the reflection, to assist you in developing a plan and to then implement it for you? We help practitioners find the answers to these questions. This manual addresses each of the above issues in a practical and non-technical way. It has an easy to read style that distills complex thoughts into a series of digestible and intelligible propositions that can be built into your personal and business plans. This manual identifies techniques to maximize the rewards and minimize the risks associated with the business of medicine. It covers the major legal, accounting and business issues faced by practitioners. It has a strong taxation management and superannuation emphasises, as these are the keys to financial security for most practitioners. Specific topics of interest, such as "Why labor costs cannot be marked up by 50%" and "What if you are married to a practitioner" are included, along with practice management material on staff policy, the Practice Incentive Program, time management and similar issues. These materials have been prepared specifically for practitioners: they are not a rehash of other material stuck together quickly and flogged off to make a quick buck. Full details of who we are, where we are and what we do are set out at the end of the manual. The principals of Medical and Dental Accounting Services Pty Ltd and Terry McMaster, Barrister and Solicitor are public accountants and solicitors who deal almost exclusively with practitioners, dentists and allied health professionals. Each day we listen to practitioners, advise practitioners, prepare accounts and tax returns for practitioners, prepare legal documents for practitioners, set up legal structures for practitioners, set up partnerships, end partnerships, handle sales of practices and generally attend to the business accounting and commercial law requirements of practitioners. To our knowledge there is no other firm in Australia with this depth of background and variety of skills. January 2002 Page 4
We do not sell or advise insurances or investments. This is because we believe this is a major conflict of interest: you cannot be an advisor and a salesman at the same time. It is also an area where many practitioners have been badly betrayed and ripped off by their accountants in the past. Please feel free to contact us should you wish to discuss these materials or should you require further background materials, including precedent documents.
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1.2 In a nutshell (or what to do if you cant be bothered reading the rest of this manual)
In a nutshell, a practitioner who just cannot find the time to read the rest of this manual should: (i) run his or her medical practice through: (a) (b) an incorporated medical practice, (ie an IMP) and a service trust, or a practice trust; have all services not required to be provided by a registered medical practitioner (basically all services except payments to practitioners: these can only be made by a registered medical practitioner or an IMP) provided by the service trust; and contribute the maximum amount of superannuation for both directors of the IMP to a self-managed superannuation fund ("SMSF");
(c) (ii) (iii)
transfer all existing superannuation benefits to a SMSF. This minimizes the risk of losing your money to high commissions and other costs; if possible, trap taxable income in the IMP to limit the rate of income tax payable on that income (contrary to popular myth, the ATO does permit practitioners to do this and he has published a ruling saying how and why this may be done. Basically, if the income is business income it can be retained in an IMP. This is one of the most common mistakes made, particularly with general practitioners in group practices. See part 4 of the manual generally on this point); distribute the net income from the service trust each year to the family members and other beneficiaries, such as companies, who based on their particular tax profiles, will pay the least amount of income tax on it; dedicate the tax savings flowing from (i) to (iv) and the other recommendations and concepts outlined above to debt reduction, once debt is gone, to a properly constructed superannuation orientated investment plan that avoids commissions and management fees, high risk investments and excessive exposure to just a few different investments. Managed investments do not perform as well as direct investments in shares and property: the reason is simple: too many people get paid before you do, and none of them share the risk with you. A basic rule of investment is never listen to advice from someone who gets commissions or is not a good investor themselves (and if they really are good investors, why are they advising others?); ensure all investments are held by either the family trust or the SMSF, so they are in safe havens, and so you pay the least amount of tax on your investment income and capital gains each year; properly document the business structure. The required documents include an employment agreement, a management agreement, a trust deed, periodic invoices between the service trust and the practice company. If you are in practice with other practitioners you should review your associate agreement or your partnership agreement to make sure it covers all relevant issues including detailed rules on what happens if someone wants to leave the partnership or the associateship; if you can, and if it stacks up as an investment, take steps to own your premises; Page 6
(iv)
(v)
(vi)
(vii)
(viii)
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(ix) prepare a detailed business plan for the practice's future development. This plan should concentrate on improving the sustainable profits and, therefore, the goodwill of the practice. The trend to corporatisation shows that there is goodwill in a well-run medical practice. A policy of maximising goodwill you must maximize profits and to maximize profits you must maximize the quality of patient services as well. The three concepts complement each other and tend to go together; make sure your will is up to date, reflects your current wishes and protects your heirs from excessive income tax charges and from business creditors or potential litigants. Most wills do not do this: something more sophisticated than "everything to my spouse if he or she lives for more than 30 days after my death" is needed if the full potentials created by the law are to be achieved. Testamentary trusts are the way to go and we can easily arrange for these to be prepared for you; make sure you have adequate disability insurance, trauma insurance and life insurance. Your life insurance should be renewable term life insurance and should be conducted through a superannuation fund environment so all premiums are tax deductible. But do not have too much insurance: after all it's a bet you are most likely to lose. Older practitioners without dependants and with a reasonable level of wealth should be particularly vigilant about over-insuring; do not own your home in your own name. Instead own it through a spouse or, in some cases, through a family trust. This means it is safe if something goes wrong; own most of your other assets through a SMSF or a family trust so they are also safe if something goes wrong, and to minimize tax paid on your income; plan for the future. That is, put money away now, not later on under a disciplined investment program. Don't just spend all the cash you get. Consumption is a transitory pleasure, but investments and wealth are permanent pleasures. The best time to start an investment was ten years ago. The next best time is today. And the easiest way to do this is by speeding up your debt repayments and increasing your regular superannuation contributions; and sit down with an accountant and a solicitor to work out ways for the above concepts and the other concepts described in this book to be applied to your circumstances and to quantify the tax and other cash savings that flow if you do.
(x)
(xi)
(xii) (xiii) (xiv)
(xv)
Doing all of the above things will probably save you hundreds of thousands of dollars over the next ten to twenty years. We have seen examples for general practitioners where the savings have exceeded $35,000 cash a year. This sort of benefit sets the stage for some powerful investment and wealth accumulation strategies. A principle of investment is the power of compounded earnings: $10,000 a year each year for ten years adds up to more than $200,000 after ten years and more than $400,000 after fifteen years. But the accumulation of $10,000 each year must be deliberate: it does not happen just because you have read a book. To really get the benefits described in this manual you must actually implement its recommendations and then deliberately harness the cash savings by diversifying into quality investments so real benefits accrue over the long term.
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Perhaps you should find the time to read this manual cover to cover after all. This is a lot of money to save and it doesn't require any extra work on your part. Perhaps you should just give us a call: we can do it all for you.
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1.3 Now that we are ten
Terry McMasters legal practice started ten years ago and the accounting practice started not long afterwards. Its amazing how time flies when you enjoy what you do. Ten years down the road we are delighted to see our hard work bearing fruit. Its marvelous to hear clients tell us that the simple, low risk, common sense strategies have made a large difference to their lives. Our advice is (almost) always financially orientated. But we are very aware of the interaction between the financial aspects of our clients lives and the other aspects of our clients live. Nothing happens in a vacuum and there is definitely a positive relationship between the financial aspects of our clients lives and the other aspects of their lives. Getting the familys finances right certainly can reduce stress and make life more pleasant for all concerned. The important thing is to do something. You will not get ahead unless you do. Some things wont work, but most will, if you keep at it. Common suggestions include going into private practice, employing or engaging other practitioners and allied health professionals, starting another business, borrowing to buy a rental property, borrowing to buy shares, setting up your own SMSF, or moving your practice to a more profitable outer suburban or rural area. Over the last ten years most of these suggestions have worked most of the time. Everyday we now hear things like: your advice meant we could afford private schools for our children; your advice means we now have more than $500,000 in our SMSF; your advice means we could afford a better house, earlier than otherwise, and now its doubled in value; thanks for getting me out of that partnership. I did not realize how much I would enjoy running my own show; thanks for encouraging me into shares. Its made a big difference; I am glad I followed your advice. It means I am working fewer hours for more profit, and I will be able to retire before I am too old to enjoy it; it was a great idea to get the kids to buy their own homes first (ie in 1994). I am so glad they are not stuck with huge mortgages like all their friends; thanks for helping Dads with his will. It made things a lot simpler when he died; thanks for your common sense advice when we were getting divorced. Making sure the kids came first meant we did not fight and are still good friends; Moving my practice to the country was the best thing we ever did; I am glad I never touched a tax scheme. Friends did and they lost their shirts;
We look forward to more of the same over the next ten years.
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1.4 About Medical & Dental Accounting Services
Medical and Dental Accounting Services Pty Ltd is a public accountant and business consulting practice based at 144 Church Street Brighton and at Unit 13/828 High Street Kew in Victoria. It specialises in providing accounting and consulting services to the medical and dental professions and other health professionals. Medical and Dental Accounting Services Pty Ltd also has an office in Sydney. Senior Personnel Its consultants are Terry McMaster, Caroline Poon, Elaine Hinds, Michael Waycott. Terry has degrees in commerce and in law from the University of Melbourne and is a practising barrister and solicitor. Most practitioners have read his articles on taxation and related matters in Australian Practitioner and previously Medical Observer and monthly newsletters written for a number of Victorian general practice divisions. The consultants have been senior taxation consultants, business services managers or solicitors for Big 6 and medium sized accounting firms and legal firms, and have a broad base of professional and commercial experience beyond the big firm environment. Terry McMaster's Legal Practice Terry McMaster also conducts a legal practice focusing on the needs of practitioners and dentists. Terry is a regular speaker and writer on business matters impacting practitioners and dentists. Terry writes tax articles for Australian Practitioner and has presented papers on occasions such as the Royal College of Surgeons' Scientific Conference, ASTRA Zeneca conferences and has led seminars on a variety of topics at a variety of other venues. Staff and Clients Medical and Dental Accounting Services Pty Ltd has nearly thirty staff members and consultants. Medical and Dental Accounting Services Pty Ltd has a broad base of clients, including government authorities and public companies. However, it has deliberately specialized in providing accounting and consulting services to practitioners. Its practitioner clients range from large partnerships, to specialists and to smaller solo practitioners. This gives the directors a high level of understanding and experience of the problems that are encountered in the medical profession and has allowed them to develop specialized techniques to deal with these problems.
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The first contact When we meet a new client we often spend more than four or five hours reviewing a client's business and personal financial position and considering the options and opportunities that are available. If the appointment proceeds we concentrate on changing the legal structure of your practice so it is in line with the models explained in this manual and optimal for taxation and asset protection purposes. These changes are made as part of the agreed annual fee and are necessary to ensure the least amount of tax is payable by your practice. There is no charge for this service. The first meeting is charged at a maximum of two hours, which is usually about $400. This includes a written summary of the suggestions made at the meeting. Interstate Clients We have clients as far away as Darwin, Perth, Brisbane, Hobart and rural South Australia. Distance is not a problem. IMPORTANT DISCLAIMER The contents of this manual are not advice that applies to any particular client situation. There is no such thing as off the shelf advice and this is particularly so with the contents of this manual. While every care has been taken in preparing this manual readers should obtain specific advice regarding their own situation before proceeding with any suggestion or recommendation made in this manual. The parts of this manual, which deal with legal matters, have been prepared by Terry McMaster, Barrister and Solicitor, and have been reproduced with his permission. No responsibility is taken for the contents of this manual except where the reader is a client of Medical and Dental Accounting Services Pty Ltd or Terry McMaster, Barrister and Solicitor. In that case, every responsibility is taken. COPYRIGHT All materials included in this manual are subject to copyright and may not be reproduced in whole or in part without the written permission of Medical and Dental Accounting Services Pty Ltd and Terry McMaster, Barrister and Solicitor.
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1.5 Medical & Dental Accounting Services Pty Ltds professional fees
Medical and Dental Accounting Services Pty Ltds costs are time based and depend on the amount of work required to complete the accounts, tax returns and related tasks connected to a practitioners practice structure. All manuals and newsletters are provided free of charge. From time to time we attend to certain tasks connected to our clients affairs. The specific consent of the client is not always obtained, since this adds considerably to the time and costs connected to the task (although we usually write explaining what we propose to do). Clients are deemed to have consented to our completing these tasks for them, unless they instruct us otherwise in writing. In some cases we agree to a fixed annual fee for attending to certain tasks for clients and these are paid in 12 equal monthly instalments. They are not payments for services provided each month, but are instead monthly instalments of an annual fee and the obligation to pay this fee arises on 1 July each year. If for any reason a client elects to end the fixed annual fee before the end of the relevant year, the whole of the remaining annual fee is immediately payable unless we determine in writing otherwise. The most important variable is the completeness and correctness of the records and source documents provided to us. Costs will rise if records aren't kept properly, if there is an unusually large number of transactions, including investments, rollovers, sales or purchases, or an unexpected complexity arises or if we are asked to do extra work. We do not provide oral quotes to clients. All quotes must be in writing to be valid. Hourly rates range from $70.00 per hour for junior staff to $260 an hour for Caroline Poon and Terry McMaster. A schedule setting out the name of the staff member, their hourly rate, the number of hours (or part thereof) and the day the work was completed is attached to all fee notes. No other information is provided other than with the written consent of Medical and Dental Accounting Services Pty Ltd. Time expended in answering questions on fee notes and related matters including obtaining documents (except for immaterial amounts) will be charged to clients at normal charge out rates unless otherwise determined by Medical and Dental Accounting Services Pty Ltd. Fees are payable within seven days of invoice. Fees are rendered early in the month after the work is done. Typically this means two or three fees are rendered during the year, depending on the pattern of work and the nature of the tasks completed. Under the Institute of Chartered Accountants ethical rules we note that the above explanation of our fees is not intended to act as a quote or to create an expectation of a fee. Our fees are always time based and depend on the amount of time taken to complete the work to the required standard of care. The above guidelines also apply to legal tasks completed by Terry McMaster & Co Pty on the instructions of Medical and Dental Accounting Services Pty Ltd. Any disbursements paid on behalf of clients will be included in a following fee note and will be payable under the usual terms and conditions.
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2. 2.1 HOW TO STRUCTURE YOUR PRACTICE What should a medical practice look like?
Taking time to identify and implement the optimal legal format for your practice is essential if its long-term rewards are to be maximized. This is so for all practitioners, whether they are specialists, interns or general practitioners operating on their own or in partnership or associateship with other practitioners. Adopting the correct legal structure is one of the most important decisions a practitioner has to make and will have a significant impact on the after tax profit produced by the practitioners' practice. This decision is not as difficult as it sounds, as a lot of time has already been spent working out the best way to structure a medical practice. It is fair to say an optimum structure has emerged that is accepted by the ATO and the Courts. Despite this many practitioners do not use this structure and those that do often get its taxation implications wrong. This happens for a number of reasons: often the advice given to practitioners is inadequate and lacks a full understanding of the area (an example is the recent trend to advise some practitioners to de-incorporate: an astonishing phenomena which shows a huge ignorance on the part of the advisor). And a number of entrenched taxation myths exist that cloud the rationale behind medical practices. These taxation myths are considered in detail in part 4.1, which deals generally with the taxation of medical practice income. They are also covered in part 4.2, which deals with the taxation of medical partnerships. What is a well-structured medical practice? The exact details may vary but, generally, a well-structured practice will have at least three parts. These are (usually) an IMP, a service trust, and a practitioner. A self-managed superannuation fund is also highly recommended. A practice with each of these components will pay the least amount of income tax legally possible, having regard to its family profile, the nature of its income and its attitude to superannuation. We prefer clients to use this model because it means we can be more confident of making sure their tax bill is minimized. Since the start of the GST on 1 July 2001 we have set up new practices and modified old practices using a more simple structure involving a practice trust. This is discussed in more detail at Part 2.5 of this manual. IMPs and Service Trusts An Incorporated Medical Practice (IMP) is a proprietary limited company established to run a medical practice, whether as a sole proprietor or as a partner. The tax law says that unless the practices income is business income only a registered medical practitioner can beneficially owns shares in an IMP or derive income from an IMP. If the practices income is business income there is no legal limitation on who can own shares in the IMP, although practitioners who are AMA members may wish to consider its rules here. Advantages of IMPs January 2002 Page 13
IMPs are cheap and simple to set up and run. They have a number of advantages that, in our view, mean they are usually mandatory for any medical practice. Only some of these advantages are directly connected to taxation benefits attached to superannuation contributions. The advantages of incorporating include: (i) protection from legal liability issues. Practitioners remain personally liable for their own work but are probably not personally liable the work of staff and partners and are protected from other litigation, such as non-medical third party liabilities; the ability to cap tax at 30% rather than 47% if the practice's income is business income. This ability opens the door for some powerful tax deferral and minimization strategies; FBT opportunities connected to the status of the practitioner as an employee of the IMP. An example is reducing the after tax cut of running the family fleet by owning all cars through the IMP or a service trust. Remember, spouses and children are deemed to be employees under the Fringe Benefits Tax Assessment Act, which opens the door for multiple car fringe benefits. This simple strategy means the cost of all cars is tax deductible; certain income tax opportunities connected to the status of the practitioner as an employee. This includes, for example, the ability to take advantage of the rules for unsubstantiated travel costs when the practitioner travels for business purposes and the rules for employee meal costs. Another example relates to FBT free lap-top computers; (see Part 4.11 for a full explanation of how this works); by creating a separate legal person, greater commercial credibility and efficacy is conferred on the service trust arrangement. It is easier to show these dealings are real and not a sham (ie a legal faced hiding an alternative reality) and occur at an arm's length basis, which is critical in a tax audit.
(ii) (iii)
(iv)
(v)
The AMA's view of incorporation The AMA permits a medical practice to be conducted by a company provided certain conditions are met. These conditions include the use of an AMA approved constitution and a requirement that the sole beneficial ownership of the shares in the company be owned by practitioners. The AMA charges $250 for its members to use its standard constitution, and the AMA's consent to incorporate must be renewed each year. There is no legal or tax reason why the AMA rules need to be observed by practitioners. It is not uncommon to hear some accountants saying or implying that the AMAs constitution must be used if an IMP is to be effective. This is not correct. The arbitrary rules of a non-mandatory professional organization cannot have any effect on the legal status of a company or the tax consequences of a particular legal structure. Practitioners may choose to follow the AMAs incorporation rules if they wish to do so, and pay to use the AMAs constitution. But there is no legal or tax reason or advantage for doing so. What does the IMP do? A detailed analysis of the use of IMPs is set out at part 2.3 of this manual. In summary, the purpose of the IMP is to provide medical services direct to patients. This may be in a solo practice or an associateship or, in some cases, to enter into a partnership agreement January 2002 Page 14
with a number of other incorporated practitioners under which the partnership provides medical services to patients. The IMP will then provide medical services to patients and will contract with all other persons whose services and materials are required to conduct the medical practice. This includes the landlord, nursing, clerical and reception and other administrative staff, suppliers such as the electricity and gas utilities, financiers, and suppliers of pharmaceuticals, dressings and medical equipment. Gross practice income (ie patient fees and other fees) is derived and banked by the IMP. This cash is then used to pay the practitioners salary and superannuation contributions and, in some cases and provided the IMP is deriving business income, a fully franked dividend to the practitioner. If a service trust is not used the IMP will also pay all other practice costs. If a service trust is used a management fee will be paid to the service trust (which will be beneficially owned by the practitioner and/or the practitioner's family. These payments are made in return for the service trust providing certain administrative services and other services, such as the use of practice premises, to the IMP. Service trusts are discussed in detail in Part 2.4 of this manual. The important point is that under the service trust arrangement the service trust is responsible for all administrative costs. The IMP should only be paying the practitioners' salaries and fees (and any pay as you go withholdings tax or similar payments on those salaries), and a periodic service fee to the service trust. The service trust makes all other payments. These are then invoiced back to the IMP, and paid by the IMP, on a regular basis. The services typically provided by a service trust to an IMP will differ from case to case but will typically include: (i) (ii) (iii) the provision of non-medical staff, such as clerks, cleaners and bookkeepers; the use of computer systems and practice management systems; general office services such as telephones, computer equipment, photocopying, insurances, finances (including debt factoring and collections) facsimile machines, couriers and so on; and occupancy of the practice premises.
(iv)
Basically, the service trust should provide all services that are necessary to the practice and which are not required by law to be provided personally by a registered medical practitioner. The IMP's activities should be limited to those things that must be performed by a registered medical practitioner: treating patients and employing other practitioners. Management Contract A properly structured management agreement or contract should be in place between the IMP and the service trust. This agreement or contract should be reviewed and up-dated at least once a January 2002 Page 15
year. Invoices must be rendered periodically, preferably each month. These invoices should reflect services actually provided to the IMP by the service trust and should be based on current market prices, including profit margins. A properly constructed management agreement or contract and the implementation of commercially based invoicing methods will give a firm legal base to the arrangement. It also helps to ensure the ATO cannot disallow the management fees should he have cause to examine the arrangement. Employment Contracts An employment contract between the practice company (ie, the employer) and the practitioner (the employee) should be in place. This contract should specify the obligations of the practitioner as an employee of the IMP and should spell out all of the employment obligations of the medical practice. Like a management agreement, the use of a sound employment agreement gives a firm legal base to the arrangement. It also helps ensure the ATO cannot disallow the salary payments as tax deductions should he have cause to examine the arrangement. The employment agreement also has effect for non-taxation purposes, such as worker's compensation type insurances. An employment contract helps prove the relationship of employer and employee exists, and the benefit of this type of insurance is in place. Do all the practice's profits have to be paid out to the practitioner each year ? We are frequently asked whether the employment contract should contain a provision requiring all of the IMP's profits to be paid out to the practitioner as salary, superannuation contributions and fringe benefits, so the IMP breaks even each year. The answer to this question is normally "no", there is no need for such a provision. This is because there is no hard and fast rule that an IMP has to break even each year. It all depends on the type of income derived each year. Business income can be retained in an IMP. Under the rules set out in Income Tax Ruling IT 2639 dated 20 June 1991 the income of an IMP will be business income where the "rule of thumb" ratio of 1:1 between proprietor practitioners and non-proprietor practitioners is satisfied. Personal services income must be distributed out to practitioners each year. (IT 2639 should be read by all practitioners because it tells how to potentially save thousands in tax each year. This ruling is reproduced at Part 5.3 of the manual.) Generally speaking, a practitioner will be interested in making sure the practice's income is business income and is not personal services income. This is because its means the marginal rate of income tax faced by the practitioner is the corporate rate of tax, currently 30% rather than the top individual rate of tax, currently 47% plus Medicare. In most cases, a practitioner will be better off in cash terms by the difference between the two rates, ie., 17%, times the amount of income that is not distributed out each year. Further, some serious timing advantages can arise if a practitioner switches from a policy of full income distribution to a policy of full income retention. These add to the overall cash flow benefits connected to this strategy. Practitioners should realize, however, that the retention of profits is real and not just a paper entry. It means that you cannot use the cash for private purposes. If cash is used for private January 2002 Page 16
purposes then an equal amount must be treated as a dividend or similar taxable receipt in the practitioners hands. If this is not done serious penalties can arise. An example of the tax savings of an IMP If $40,000 of medical practice profit/taxable income was retained (ie not paid out to a practitioner (whether as salary, superannuation or a fully franked dividend) then the total tax payable by the group for that year would be $6,800 (ie. $40,000 times 17%) less than it otherwise would have been. Bearing in mind this cash flow saving represents "after tax dollars", this is economically speaking, the same as earning almost an extra $12,000 in "pre-tax dollars". After a couple of years a cash flow saving like this really starts to add up, particularly if it is used to retire debt or otherwise invested properly. Self-Managed Superannuation Funds Many practices will feature a SMSF. Setting up a SMSF means a practitioner can avoid the heavy commissions and fees typified the managed funds run by the large life offices and fund managers. It also means the practitioner has control over his or her investment destiny and does not face the risk of sub-standard investment performance by the investment manager. A SMSF sits comfortably with the other aspects of a well set up practice and is not expensive to create and to maintain each year. The costs of doing this will certainly be lower than the commissions and management fees charged by the life offices and fund managers, most of which you are not told about. Need extra information on SMSFs? We have prepared a separate 250-page manual dealing with SMSFs: as far as we know its the most extensive coverage led discussion of how and why SMSFs should be used. Contact us and we will send you a copy. Advantages of the service trust structure Service trusts are trusts set up to provide administrative services to medical practices. The service attracts a profit and this profit is distributed each year to the trusts beneficiaries, ie in most cases the practitioners spouse and children. Service trusts are discussed in detail in part 2.4 of this manual. Service trusts have a number of significant advantages. Each of these advantages is discussed in details in the other parts of this manual that deal specifically with the major components of the structure. In summary, these advantages include: (i) (ii) protection for the valuable assets and investments held in the trust; (probable) protection from any future death duties or probate duties. This topic is being brought up with increasing frequency. The growing probability of some form of taxation of wealth on death, particularly as the population ages and large amounts of wealth pass from one generation to another, should not be overlooked. Many commentators see the introduction of an estate or probate tax as inevitable; Page 17
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(iii) income tax flexibility and flexibility in the distribution of capital gains and any company imputation tax credits. The service trust ensures the legal minimum of income tax will be paid each year; capital gains tax advantages, particularly compared to a company based structure, and where there are beneficiaries with little other taxable income; more rapid wealth accumulation, as a result of achieving the taxation advantages and other advantages set out at sub-paragraphs (i) to (iv) above; and most importantly, greater peace of mind knowing your financial affairs are in good order and your wealth is protected.
(iv) (v) (vi)
The proposed new rules for taxing trusts as companies will make service trusts better than ever. The basic reason is that 30% is less than 47%. This basic reason and the secondary reasons for this are set out in Part 4.3 of this manual. The ATOs View The ATO accepts an IMP/service trust structure is effective for taxation purposes. Background material regarding this acceptance is set out at part 2.3 and part 2.4 of this manual. A copy of Phillip's case, where the full court of the Federal Court accepted the tax efficacy of a service trust arrangement, is set out at part 5.4 of this manual. A word of caution, contrary to popular myth the ATO does not accept 50% is a reasonable markup for labor costs incurred by the trustee of a service trust. This is covered in detail in part 4.12 of this manual. This is an important point to note for all practitioners using services trusts. Expert accounting and legal advice should be sought before setting up an IMP/service trust structure. Particular advice should be obtained on the effect of such a structure on your will: this can be a very complex area. Why is the least amount of income tax paid? The main reason why this is so relates to the proper use of service trusts. Under trust law generally and under the taxation law applying to trusts, and provided certain conditions are met, the taxable income of the trust (technically known as "net income") is taxed in the hands of the beneficiaries who are presently entitled to it, rather than in the hands of the trustee itself. The beneficiaries will typically be family members or controlled companies and trusts. The beneficiaries are described in the trust deed. This means the net income can be distributed to the beneficiaries who will pay the least tax. In most cases this will be relatives who have little or no other assessable income. In some cases the beneficiaries may include a company owned by the practitioner or by a family member, but if this is done it is critical that the distribution actually be paid to the company. The advantage is companies only pay tax at a rate of 30%, compared to a top individual rate of 47% plus Medicare Levy. (It is easier to introduce a new trust beneficiary by forming a new company than it is to have another child. It is a lot cheaper too.) As indicated above, the cost of accessing these professional and practical skills and experience will be minimal compared to the significant annual and recurring tax/cash flow savings they give rise to. In a typical case, we estimate the amount of these annual tax/cash flow savings would be about $10,000 per annum in cash, based on a taxable income of $120,000. This adds up to a lot of money in the long run, particularly if it is harnessed and applied to sensible practice January 2002 Page 18
development strategies and other wealth creation strategies. Bear in mind the effect of compounded earnings: $10,000 a year cash adds up to more than $200,000 after ten years and more than $400,000 after fifteen years. The amount of the annual tax/cash flow savings obviously will be higher where taxable income is higher or where a self managed superannuation fund is used. Worked Example This saving is shown in the following worked example based on a sole practitioner with a taxable income of about $120,000 in the year ended 30 June 1996. A taxable income of $120,000 per annum will give rise to income tax payable of $47,002 for the year ended 30 June 1996, plus provisional tax of about $50,762 for the year ending 30 June 1997.
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IMP/Service Trust Structure Medical Practitioner Service Trust: - Beneficiary One (non-working spouse) - Beneficiary Two (non-adult child) - Beneficiary Three (non-adult child) - Beneficiary Four (investment company) Total Cash Saving Taxable Income $70,000 $35,000 $643 $643 $13,714 $120,000 Tax Payable $23,502 $8,447 Nil Nil $4,937 $36,886 $10,116
The above example ignores the effect of any super contributions and ignores the effect of provisional tax timing advantages, including the possibility of a pay as you go instalments tax refund. These matters make the arrangement more attractive again. Obviously these matters, together with the specific tax and family profile of each particular practitioner have to be considered before a definitive computation of the advantages arising in a specific situation can be made. But $10,000 is a very realistic estimate of the average savings to be had by using an IMP and service trust structure. What does this mean? One way of looking at it is to try to relate the cash flow advantages to more personal (and generally more pleasant) concepts. This often makes more sense to clients (and to us) than just quoting a raw dollar figure. It also highlights the opportunity cost of not getting your practice structure right. Many times we have spoken to older practitioners who bemoan not setting things up right years earlier: they become acutely aware of the savings they have missed, and the money that's not in the bank account now as a result of this. The savings can be looked at in other ways too. For example, one could ask how many more weeks would a practitioner have to work each year to derive the same amount of cash from the practice, what effect this has on a loan to buy a family home or what does this mean in terms of the cost of educating children. How about two months off each year? For a practitioner who is facing the top marginal tax rate of 48%, additional gross income totaling about $19,000 must be earned to generate an additional $10,000 of cash each year. Assuming the practitioner has a taxable income of $120,000 per annum, an extra $10,000 cash per annum is the same as not having to work for another two months each year. We cannot think of any other way to get a two-month paid holiday each year. How about getting rid of your home loan? Another way of looking at this is to ask what would happen if this saving of $10,000 cash was invested in a safe and conservative investment. An example is paying off a bank loan used to buy the family home (which we recommend be done: debt reduction, particularly for non-deductible debt, is almost always the best investment). At the end of ten years, at a rate of 10% pa, an extra $10,000 per annum cash off a bank loan per annum would add up to about $175,000 calculated as follows: Opening January 2002 Amount Closing Page 20
Year 1 2 3 4 5 6 7 8 9 10 Balance $11,000 $23,100 $36,410 $51,051 $67,156 $84,872 $104,359 $125,795 $149,374 Invested $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 Interest $1,000 $2,100 $3,310 $4,641 $6,105 $7,716 $9,487 $11,436 $13,579 $15,937 Balance $11,000 $23,100 $36,410 $51,051 $67,156 $84,872 $104,359 $125,795 $149,374 $175,312
In other words, if a practitioner earning $120,000 a year adopted an IMP/service trust structure and dedicate the resultant cash saving/tax saving of $10,000pa to paying off a non-deductible home loan, the amount of the home loan will fall by about $175,000 by the end of the tenth year. It will fall by even more by the end of the twentieth year, or if interest rates on average are higher than 10% pa during the relevant period. In fact, by the end of the twentieth year the total compounded savings will easily exceed the cost of virtually all homes. How about paying the private school fees? Another way to look at this is to ask what is the cost of educating a child at a private school for a year. If you avoid some of the extreme options (such as educational ski trips to the French Alps) then an extra $10,000 cash per annum probably covers the cost of one child at private school (and hopefully leaves some change for a holiday each year). The beauty of this strategy is the benefits continue long after your children leave school (leaving plenty of spare cash for the cost of a university education). Hopefully it will also leave some spare cash for you too! This is shown in the following table based on a family with two children, one starting school next year and one starting in three years time:
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Opening Balance $0 $6,480 $13,478 $16,717 $19,134 $21,745 $22,404 $23,117 $21,726 $20,224 $16,442 $12,537 $5,786 -$1,311 -$336 Tax Saving $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 Closing Balance $6,480 $13,478 $16,717 $19,134 $21,745 $22,404 $23,117 $21,726 $20,224 $16,442 $12,357 $5,786 -$1,311 -$336 $717
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Child 1 $4,000 $4,000 $4,000 $5,000 $5,000 $6,000 $6,000 $7,000 $7,000 $8,000 $8,000 $9,000 $9,000 $0 $0
Child 2 $0 $0 $4,000 $4,000 $4,000 $5,000 $5,000 $6,000 $6,000 $7,000 $7,000 $8,000 $8,000 $9,000 $9,000
Interest $480 $998 $1,238 $1,417 $1,611 $1,660 $1,712 $1,609 $1,498 $1,218 $915 $429 -$97 -$25 $53
Of course, this analysis assumes the tax savings are used to reduce debt at 8% or are otherwise invested effectively. We invariably recommend the tax/cash savings achieved through sound tax planning practices be harnessed and used to create further wealth, rather than dissipated on consumption.
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2.2 What should a group practice look like?
Introduction In this section we consider the different ways of structuring a group practice. A number of issues are considered, including how to deal with disproportionate contributions by owners, goodwill and the question of whether owners should be equal owners. Part 2.6 of this manual, titled "Partners or associates" examines the idea of a partnership in more detail and compares it with the idea of an associateship. Readers should also refer to part 4.2 of this manual. This deals specifically with the taxation of medical practice partnerships and notes the advantages to practitioners of practising through partnerships. Readers should also refer to part 2.11, dealing with hybrid trusts; this can be a particularly attractive way of setting up a group practice. In this part of the manual we consider the business issues attached to being in a group practice. These concepts are equally applicable to practitioners who practice together as associates: this is because, as explained in part 2.6 of this manual, there is often little day to day difference between the concept of partnership and the concept of associateship except, for the name. There is also very little real difference between the legal liabilities of partners and associates, the concept of joint and several liability being an overstated risk. Different ways of structuring a medical practice partnership The word "partner" is commonly used to describe the various types of co-ownership of medical practices (and other businesses) that exist, as well as the concept of a "partner" in the strict legal sense of the word. For convenience, we will use the word "partner" and its derivatives as a general tag describing the various forms of co-ownership that are available. We will use the phrase "legal partner" and its derivatives as a tag describing "partner" in the strict legal sense of the word. How is a partnership different from a sole practice? The differences that exist relate to detail and reflect the nature of a partnership as opposed to a sole practice under the law. Typically these differences are that: (i) the shares in the IMP will be owned by each of the partners in their agreed partnership proportions ("Arrangement 1") or, alternatively, each of the partners will have their own IMP and each of these companies will be a party to a legal partnership agreement ("Arrangement 2"); and the service trust will be a unit trust and the individual partners will own the units in the unit trust family trusts in their agreed partnership proportions.
(ii)
A number of complications may arise with partnerships. These complications include: (i) (ii) in the case of Arrangement 1, the need for the rights and obligations of each of the partners as shareholders in an IMP to be set out in a shareholders' agreement; in the case of Arrangement 2, the need for each of the legal partner's rights and obligations to be set out in a legal partnership agreement; and
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(iii) in the case of each of Arrangement 1 and Arrangement 2, the need for each of the partners' family trust's rights and obligations as unitholders to be set out in a unitholders' agreement.
The partnership agreement, the shareholders' agreement and the unitholders' agreement should each contain terms and conditions dealing with changes in the ownership structure. These will include provisions for dealing with exiting partners and new partners and for valuing goodwill on a change of partners. Goodwill The general question of medical practice goodwill is dealt with in detail in Part 3.1 of this manual under the heading: "Practice goodwill, and therefore profits". We look at the general question of how to value a medical practice at Part 3.2 under the heading "The valuation of a medical practice". Part 3.4 comprises a valuable checklist of things to be thought about when buying a practice. The issue of valuing goodwill is probably the most problematic and emotional issue to be dealt with by a medical practice partnership. It comes up every time there is a change in the composition of the partnership. Any number of approaches are possible, but if the intention of the partnership agreement is to avoid a fight between the partners, the approach to valuing goodwill should be spelt out in detail in the partnership agreement and not left to chance upon a change occurring in the partnership. Very often partners agree to something that is not contemplated by their agreement, and this is fine: here the agreement works as a base for the discussion and a fall back position if an amicable alternative solution cannot be found. Unequal Contributions The question of how to deal with unequal contributions to partnership profit should also be dealt with. In some partnerships profits are shared in the partners' agreed proportions. This is regardless of who contributes what to the partnership each year: the idea is that, in the long run, the partners' contributions to the partnership will even out. If it seems the partners' contributions will not even out then changes to the structure of the partnership may need to be made. This can be easier said than done, and the partners should first consider alternative ways of equalizing the workload, particularly regarding who sees which patients and when. In other partnerships profits will be shared on a strict contribution basis. This means, for example, if partner A contributes 60% of the gross revenue of the partnership, then partner A receives 60% of the partnership's profits. Partner's returns will vary each year as their individual contributions vary.
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Which approach is best? There is no right or wrong answer to the question. Different approaches suit different practices. One thought though is whether gross fees produced are always a good measure of contribution. Sometimes a partner may contribute in other ways. For example, partner A may prefer tenminute consultations while partner B might prefer twenty-minute consultations. Both put in an equal amount of time each day. The practice manager or receptionist might structure the partners' appointments so the patients with more complex matters are seen by partner B and the patients with less complex matters are seen by partner A. This suits the partners best and also suits the patients best. Partner B might spend more time on practice management than partner A. Both sets of patients are valued by the practice, and the practice management tasks have to be attended to by someone. Partner A may end up with higher gross fees than partner B, but does this accurately reflect their respective contributions? The answer is clearly "no". If the partnership is to work properly, the partners must agree to a profit share arrangement which reflects this and which is not based on gross fees produced. One good compromise is to use gross fees as basis for profit sharing but to have profit distributed in the partners' agreed proportions within certain tolerance limits. For example, in a two-person partnership, profit might be shared in equal proportions unless the variance is greater than an agreed amount say, ten per cent. When the variance is greater than the agreed amount the partner who produced more fees receives an additional profit share equal to half of the variance. For example, if partner A contributed 55% of gross fees and partner B contributed 45% of gross fees, partner A would be entitled to 52.5% of partnership profit and partner B would be entitled to 47.5% of partnership profit. The advantage of this approach is it recognizes gross fees should not be the sole determinant of profit share arrangements because they are not the only measure of contribution. Yet it has a built in "pressure valve" so some compromise is made where gross fees are not equal. There is also an incentive for the partners to do their best to share the workload equally rather than compete internally for patients A "handball" clause in a partnership agreement is a good idea here: the receptionist is instructed to allocate unallocated patients to the least busy partner so overall efficiency is maximized. What about part-time partners? This is essentially a decision each partnership must make. Once equality of time contribution was viewed as being non-negotiable, each partner gave equally to the partnership and, in return, received equally. This view is probably too rigid and inflexible. In the long run, it is more likely to work against the partnership than for it. We have seen partnerships shoot themselves in the foot and lose valuable members when some compromise would have kept everyone on board and avoided an unpleasant increase in workload for the remaining practitioners. Not to mention the disruption to patient services. There is a growing tendency for partners to not be equal. For example, it can be a good idea to offer a female practitioner with young children a pro-rata partnership based on her working, say, January 2002 Page 25
half time. An option can be created to allow her to become a full partner later on. This means she can enjoy the economic benefits of partnership and the practice can secure her services for the long run as she makes an equity contribution. The female practitioner's long-term commitment to the partnership should mean this is a worthwhile option for all concerned. Examples of flexible profit share arrangements We have recently come across two different cases where inflexibility regarding the format of a medical partnership and a fixed mindset on how profits should be shared between the partners was causing a lot of stress within the partnership. In both cases workable solutions were identified that satisfied all partners. We stress these are not the only possible solutions, and they are not perfect, but they did do the job and show what can be done if all concerned are prepared to be flexible. In summary: (i) a large specialist practice has a number of older partners who, to be blunt, are tired and no longer wish to (and perhaps are not able to) work the long hours they once did. The younger partners are in a different mode and are anxious to crank up the hours even more and to increase partnership profit once again. Therein lay the seed for some serious conflict between the partners, and the eventual break down of the partnership, unless a compromise was found. The eventual solution was to introduce a two-tier profit distribution system that distinguishes between reward for time spent in the practice and reward for ownership of the practice. The first tier of the profit distribution system is based on agreed market value salaries. It means if an older partner wishes to work reduced hours he or she can do so, and the salary component of their profit share will be reduced accordingly. If a younger partner wishes to work longer hours he or she can do so and the salary component of their profit share will be increased accordingly. The second tier of the profit distribution system is based on funds invested in the practice and represents a return on investment made. As each partner has an equal dollar investment in the practice this will always result in an equal profit share no matter what hours they spend in the practice; and (ii) in a rural based five partner general practice two of the partners have young families and find the after hours work in particular to be very hard on their family lives. The solution was once again a two-tiered profit distribution system, but this time the first tier was based on the number of after hours shifts worked. Basically, the partner who works the after hours shift keeps almost all of the profits connected to that shift. The second tier of the distributions system deals with profit, less profit on the after hours shifts, and is based on five equal partner shares. (iii) in a suburban general practice the one (.8) female partner was earning only $80,000 pa, while her full time male partners were each earning about $180,000 pa. Page 26
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The reasons were: (a) (b) the male partners were on call for obstetrics at a local hospital which meant they often worked nights and weekends; and and that the female practitioner was doing more than her fair share of the administration and the training of younger practitioners, which did not feature at all in the profit share formula.
It was agreed that the male practitioners should get extra profit for the obstetrics work, since they were the ones at late at night and at weekends and it did ensure a constant stream of new patients that everyone benefited from, but the female practitioners extra administration and training time was a problem. The solution was amazingly simple: she got paid an extra $20,000 a year for this work. The payment was from the service trust, and because she beneficially owned one quarter of the service trust this meant that her overall profit share went up by $15,000, and each of the male practitioners profit share fell by $5,000. It was agreed that $95,000 a year profit share was reasonable for a .8 partner not involved in obstetrics. The point is lateral thinking, combined with flexible profit sharing arrangements, can contain the pressure and tension within a partnership. This can mean each partners' personal preferences and circumstances can be considered when determining who does what and who gets what in the partnership.
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2.3 Incorporated Medical Practices ("IMPs")
Introduction We usually recommend medical practices be carried on in the name of an IMP (ie IMP), although there can be exceptions. The advantages are often overwhelming, and more extensive than most commentators realize: over the years the practitioner will be much better off in this type of structure. This is particularly so when the IMP is used in conjunction with a service trust and a self-managed superannuation fund in the manner described in Part 2.1 of this manual. On this part of the manual we set out a brief history of the use of IMPs, look at their advantages, and consider practical issues in setting them up and operating them each year. A brief history Prior to 1981 IMP were not commonly encountered. Medical practices were almost always carried on by the individual practitioners, whether as solo practitioners or as partners. This is because the AMA rules did not permit incorporated practices and because the ATO did not accept them as being effective for taxation purposes. Other professional groups were in the same boat. At the time practitioners, along with a number of other professional groups, thought they were disadvantaged in respect of superannuation. This was because, under the rules as they then stood, self-employed practitioners got little tax relief for superannuation contributions. This meant superannuation was not an attractive investment medium (although spouses could be superannuated). By incorporating their medical practices practitioners became employees. They were then able to arrange for their employers (ie. the companies they owned) to make large deductible superannuation contributions for their benefit and for the benefit of spouses involved in the practice. The AMA was concerned practitioners were not adequately providing for their retirement and were being discriminated against relative to other occupational groups. It therefore commenced discussions with the ATO to develop guidelines for incorporating medical practices. These guidelines facilitated improved superannuation arrangements but did not give rise to any other income tax benefits and ensured ethical considerations regarding the conduct of medical practices, such as control and profit sharing, were maintained. A number of other groups had similar discussions with the ATO at the same time. In the end, a deal was done. In summary, the ATO accepted IMPs provided all practice income was passed out to the practitioner. This was also conditional upon the only income tax benefit attached to the arrangement was the benefit of a tax deduction for the extra superannuation contributions able to be made each year and the arrangement being commercially realistic. This position is outlined in income tax rulings IT 25 Incorporation of Medical Practices and IT 2503 Incorporation of Medical and other professional practices. Copies of these two rulings are set out in full at parts 5.1 and 5.2 of this manual. IMPs are now part and parcel of most medical practice structures and are well accepted by all parties. We are not aware of the ATO challenging such an arrangement provided the conditions set out in Income Tax Ruling IT 25 are followed. This is so notwithstanding the theoretical impossibility connected to a practitioner transferring personal exertion income to an IMP: its actually a legal impossibility. January 2002 Page 28
A correct summary of the law It is important to appreciate the position taken by the ATO in Income Tax Ruling IT 25 is just an administrative expedient and compromise. It is not an accurate view of the law. The correct view of the law is as follows: (i) (ii) where the income is personal services income an IMP will not be effective and the income will remain the income of the practitioner who earns it; and where the income comprises business income an IMP will be effective irrespective of any administrative guidelines laid down by the ATO.
This position is recognized by the ATO. Practitioners should refer to paragraph 10 of Income Tax Ruling IT 2639 dated 20 June 1991. This ruling is reproduced in full in part 5.3 of this manual and should be read carefully, particularly practitioners in group practices. Practitioners should be aware that if their income is business income, IMPs do not have to pass all income out each year. This will be for example, where the practitioners are in a partnership (subject to certain conditions), where they have full employee or associate practitioner working with them, or where they have a significant investment in their total business infrastructure. That is, an IMP deriving business income can make a profit and pay income tax on this profit at the corporate rate of income tax, which is currently 30%, rather than passing the profit out to the practitioner to face income tax at a rate of 48%. Advantages of Incorporation The incorporation of a medical practice has many advantages. Most of these are not found in the literature on this topic, but become quite obvious once you start to use an IMP. Most of these advantages are not connected to income tax. The advantages of incorporating a medical practice include: (i) protection from legal liability issues. The practitioner will still be responsible for his own negligence. However, for example, the practitioner will not be personally liable for the negligence of a locum or a staff member. The IMP will be so liable, whether as principal or under the common law doctrine of vicarious liability, but this liability normally cannot be passed on to a practitioner, even where the practitioner is a director and a shareholder. Provided assets are not allowed to accumulate in the IMP this provides a practical barrier to litigation: you are basically saying, "even if you win, you will not get anything because the company does not have anything". This is quite a disincentive to potential litigants and, even where litigation does start, it can be quite a spur to a quick and favorable settlement; This, of course, ignores the reality of medical indemnity insurance: there is no precedent yet for a practitioner losing significant personal assets in a medical negligence case. The real defendant is the insurer. But in a past-HIH world, there is no point in taking chances here.) (ii) enhanced deductions for superannuation contributions for each director (ie. not just the practitioner). For example, a self-employed practitioner is able to claim a tax deduction for superannuation contributions equal to the lesser of the amount paid or $3,000 plus 75% of the amount paid, up to his or her age based deduction limit. Unless a spouse is Page 29
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self employed or employed no tax deductions will be able to be claimed by the practice for contributions by or for the benefit of the spouse. However, in the case of an IMP contributions can be made for each director without the 75% adjustment. (Note each director is deemed to be an employee for superannuation purposes even if not an employee for other purposes.) Full details of superannuation benefits and planning techniques are set out in parts 11, 12 and 13 of this manual. Assuming $50,000 is contributed in a year, this creates a tax benefit of $3,878, calculated as follows: Self Employed Employee Amount Contributed $50,000 Amount Deductible $38,250 Effective Tax Rate 48% Tax Benefit $18,360 Difference Less: Reduction in Tax Paid by Superannuation Fund Total Tax Saving $50,000 $50,000 48% $24,000 $5,640 $1,762 * $3,878
*The superannuation fund would have to pay $1,762 less income tax on the contributions received from the self employed person because the $11,750 of non-deductible contributions will not be assessable income in its hands. This favorable superannuation profile accelerates the many planning possibilities connected to self-managed funds. These possibilities are very attractive and are explored in full in our Self-Managed Superannuation Manual. Please contact us if you would like to receive a copy of this manual; (iii) fringe benefits planning opportunities connected to the status of the practitioner and, possibly, a spouse, as employees of the IMP. A good example is the ability to reduce the after tax cost of running the family's fleet of cars by having all the cars owned and operated by the employer. This is normally at least two cars and may also include the cars of other family members. A self-employed practitioner will only be able to claim a deduction for the cost of running one car. Other fringe benefits may also be provided; (iv) certain income tax opportunities connected to the status of the practitioner as an employee. This includes, for example, the ability to take advantage of the rules for unsubstantiated travel costs when the practitioner travels for business purposes and meal allowances. Another example relates to FBT free lap-top computers; by creating a separate legal person, greater commercial credibility and efficacy is conferred on the service trust arrangement. It is easier to show these dealings are real and not a sham (ie a legal faced hiding an alternative reality) and occur at an arm's length basis, which is critical in a tax audit. This supports the tax planning aspects of service trusts; the opportunity to cap the rate of income tax at 30%, being the rate of income tax paid by companies, rather than the top income tax rate of 48% payable by the practitioner. This assumes the profit is actually retained in the IMP. This is discussed in detail at Part 4.1 of the manual; Page 30
(v)
(vi)
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(vii) in some cases, the opportunity to receive a refund of provisional tax or Pay As You Go Instalments paid as a result of transferring a practice to an IMP, as well as capping the rate of income tax payable on practice income at 30%. Where the practitioner is a partner in a partnership this can be particularly powerful because the practitioner may, in effect, transfer the whole of the year's net partnership income to the IMP irrespective of the time of the year this transfer is completed. The tax rate can then be capped at 30% on retained profits; (viii) new owners can be admitted without the existing owner(s) facing a CGT computation. Issuing shares to the new owners does this: the issue of a share is not a disposal of an asset for capital gains purposes. The entry of a new owner, the exit of an old owner or a change in proportions between owners can be complex and specific advice should be sought in each instance; the interest on amounts borrowed by the IMP to pay Pay As You Go Instalments are deductible whereas interest on any amounts borrowed to pay income tax by practitioners practising in their own names is often not tax deductible. This opens the door for strategies aimed at lowering the after tax cost of interest; and in conjunction with practice trusts (see part 2.5) can create cash flow timing advantages by shifting to and from the provisional tax system, and its successor, the Pay As You Go Instalments System, to get multiple tax-free "first years".
(ix)
(x)
The mechanics of incorporating a medical practice The first step is to retain a solicitor to incorporate the company that will run the medical practice. This normally costs about $1,500. It is usual for the name of company to include the name of the practitioner or the practice's business name, but this is not essential. Practitioners must own the IMPs shares unless the IMP derives business income. Once the IMP is set up, the practice, or the practitioner's interest in the practice in the case of a partnership, should be transferred to it. This is not complicated and solicitors normally use a simple form standard sale of business agreement to record the sale. The procedure is simple because the purchaser is owned by the vendor and, for obvious reasons, the purchaser will not sue the vendor if something goes wrong. The sale of business agreement should not cost more than about $300 for a solicitor to complete, unless unexpected complications arise. Capital gains roll over relief The transfer of a practice, or, in the case of a partner, an interest in a practice, to an IMP usually can be ignored for CGT purposes. This is provided appropriate declarations are completed at the time the transfer is made and certain other conditions are satisfied. In the case of a practice acquired before the start of the CGT rules (20 September 1985) this means the shares in the company will be deemed to be acquired by the practitioner before the start of the capital gains rules. The company will be deemed to have acquired the practice before the start of the CGT rules so any subsequent disposal will be outside of those rules. January 2002 Page 31
In the case of a practice acquired after the CGT rules the practice will be deemed to be disposed of for a consideration equal to its indexed cost base and the shares will be deemed to be acquired for the same amount. The practice will be deemed to be acquired for an amount equal to its indexed cost base in the hands of the practitioner. Assignment of an interest in a partnership Where the practitioner is in a partnership the practitioner should consider assigning all rights under the partnership agreement to the IMP. This means, in effect, all entitlements to partnership net income from 1 July in the current taxation year can be passed to the IMP, not just the rights to partnership net income for the remainder of the year. This can lead to powerful tax savings including large Pay As You Go Withholdings tax refunds. Other Agreements Other legal agreements, such as associate agreements and partnership agreements, leases and finance contracts (overdrafts etc) will need to be changed. A change in a partnership ends the old partnership and starts a new partnership. A new partnership agreement will normally need to be put in place after the incorporation of one of the partners, although in some cases this will be contemplated by the old agreement and the old agreement will apply to the new partnership.
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The day-to-day things Once the transfer is completed the IMP begins to run the day-to-day affairs of the practice. This means: (i) the practitioner must become an employee of the IMP. We recommend a formal employment agreement be prepared to record and control this employment: this is important because it provides a legal basis to all salary and other payments made to the practitioner as an employee and provides protection in the event of a tax audit; preferably, an administration agreement will be entered with the trustee of a service trust. The details of this agreement are discussed at part 2.4 of this manual. In summary, the service trust should provide all services to the IMP that are not required to be provided by a practitioner. This includes occupancy, insurances, telephone, power, administrative staff, equipment, medical supplies, accounting services, and so on. Regular invoices should be rendered to the IMP and these should be paid on a timely basis; if a service trust is not being used the responsibility for all of these administrative services should be transferred from the practitioner to the IMP; patients and others should be advised of the change. It can be a good idea to leave a notice in the surgery explaining the change and assuring patients this will not affect your services in any way. Something like this may be appropriate. "Dr John Smith advises that from 1 January 1999 his practice will be run by John Smith Pty Ltd. This change will not alter the nature of the services provided to you in any way. All cheques for payment should be made out to John Smith Pty Ltd."; practice signage and stationery should be changed; a bank account should be opened for the IMP. The bank manager will require a copy of the IMPs constitution to do this; once the new bank account is open make sure all practice income is banked into the IMPs bank account; remember if a service trust is used, payments by the IMP should be limited to salaries for practitioners, withholdings on those salaries, superannuation and the payment of the tax invoices rendered by the service trust (apart from minor matters such as annual ASC fees and so on). All other business costs should be paid by the service trust; and new Pay As You Go Withholdings, Work Cover and other registrations may need to be arranged in the name of the service trust.
(ii)
(iii) (iv)
(v) (vi) (vii) (viii)
(ix)
(A sample tax invoice for a service trust is reproduced in part 13.12) Can an IMP provide fringe benefits to the practitioner? Yes. For some unknown reason some people say "no" to this question. This is even though the ATO says "yes". IMPs can provide fringe benefits to the practitioner (and to associates of the practitioner, including relatives. However, since the July 1994 changes to the basis for calculating the amount of FBT payable, this question has been academic, as there is little advantage to be had in doing this, except for car fringe benefits and certain minor fringe benefits. One interesting minor fringe benefit relates to laptop computers, personal organizers and brief cases. This is discussed in more detail in Part 4.11 of this manual. When is an IMP not appropriate? IMPs are appropriate in most but not all cases. Two common exceptions are: January 2002 Page 33
(i) (ii) the practitioners practice is small, there is no business income and the employer type benefits (including more tax efficient superannuation contributions) can be achieved by the service trust; or the practitioner has non-deductible debt and wishes to convert the non-deductible debt to deductible debt.
Each case is different and should be considered on its own merit. In closing As indicated above, we often recommend a medical practice be carried on in the name of a company. It is difficult to identify any real disadvantage connected to do this. The costs of setting up and running an incorporated practice will almost certainly always be outweighed by the benefits of doing so. The incorporation of a practice should not be looked at in isolation from the other recommendations for structuring practices set out in this manual. It is just one, albeit essential, part of these structures. If these structures are set up we are able to guarantee an optimal result in terms of both asset protection and the after tax return on your investment in your practice.
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2.4 Service Trusts
Readers should also refer to box 4 of Part 4.12 and to Part 4.7. Introduction The purpose of this part of the manual is to consider practical issues regarding setting up and running a service trust. Before we do this we will briefly look at the legal background of service trusts and the relevant case law: this is required to give the practical issues their proper theoretical context. Discretionary trusts are discussed at Part 4.3 and the role of a service trust in a properly constructed medical practice, together with a practical example of the tax savings this can generate each year, is discussed at Part 2.1. Those materials should be read in conjunction with this part of the manual for a full coverage of the role of the service trust in an IMP. What is a "service trust"? A "service trust" is a trust that provides administrative services to an IMP. A service trust can be either a discretionary trust (ie. a family trust), a unit trust or a hybrid trust. The service trust of a solo practice will normally be a discretionary trust (ie the practitioner's family trust) and the service trust of a partnership or associateship will normally be a unit trust or a hybrid trust, with the units owned by the practitioners' family trusts in accordance with their partnership percentages. A brief look at the law The leading case in this area came before the Full Federal Court in 1978. The decision in FCT v Phillips 78 ATC 4361 is commonly known as "Phillips case" and involved a service trust set up some seven years earlier to provide non-professional services to a firm of accountants. This case is reproduced at Part 5.4 of this manual. Previously the accountants performed these tasks. The service trust was a unit trust and the units were owned by the partners' family trusts. There is nothing in Phillips case suggesting the decision is limited to unit trusts. We understand the Commissioner accepts the case has general application to all service trust arrangements. He certainly is not on the record as disputing this in any way and his public comments. The particular services provided by the service trust in Phillips case were: (i) (ii) (iii) (iv) (v) (vi) secretarial services and general clerical services; share registry services; insurance agency; internal training; office furniture and plant and equipment; and finance.
The partnership claimed a tax deduction for the amount of the management fees invoiced to it by the service trust. This management fee was calculated on a costs plus basis (for example, labor was charged at cost plus fifty per cent). This, in effect, resulted in an amount of taxable income equal to the mark-up amount being shifted out of the partners' hands into the hands of their family trusts.
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Generally the partner's family trusts had better profiles than the partners. This meant overall less tax was paid than would have been had the service trust not been set up and these management fees not been paid to it. The Commissioner of Taxation rejected the arrangement. He disallowed the deduction for management fees claimed by the partnership. The partnership objected and, eventually, the matter ended up in court. Once there, Phillips, one of the partners, stated the setting up of the service trust was intended to: (i) (ii) (iii) (iv) protect valuable assets from litigation; increase the amount of valuable assets owned by the partners' families; reduce the risk of death duties eroding partnership wealth; and reduce income tax.
The Full Federal Court's view The Full Federal Court accepted the re-structure for income tax purposes and allowed the partnership a deduction for the management fees paid. The court thought the amounts paid to the service trust by the partnership were commercially realistic and were not excessive. It found the main reason the partnership incurred the management fees was to secure the management services provided to it by the service trust. Subsequent cases have established that for management fees to be deductible a formal service agreement must be in place to give a legal basis for the provision of the services and the related payments. Further, invoices should be rendered on a regular basis and should be paid on a regular basis. Practical issue one: provide the services The first issue is the need to ensure the services are actually provided by the service trust to the IMP. This may sound obvious, but you would be surprised at how often this is not the case. For example (and these are two common errors): (i) the lease should be in the name of the service trust, and not in the name of the IMP. This may require a lease to be transferred to the service trust or the old lease surrendered (a stamp duty refund should be available) and a new lease taken up by the service trust; and non-medical staff should be paid by the service trust. This may mean employments need to be terminated and new employments started as the service trust is introduced into the practice's structure.
(ii)
It also means employment related amounts, such as superannuation, pay as you go withholdings and Work Cover premiums should be paid by the service trust. (As a digression, usually the service trust should not employ the practitioner to provide medical services to the IMP. The IMP should employ the practitioner.) Where employees are transferred, the service trust will need to assume liability for all accrued annual leave and long service leave entitlements. Practical issue two: get the name right As a second issue, the service trust should conduct its affairs in its own name (ie. the name of the trustee company.) This means, for example, stationery invoices received should be in the name of the service trust and the service trust should pay the account using its own funds, preferably by cheque. January 2002 Page 36
Practical issue three: keep an eye on things As a third issue, the relationship between the service trust and the IMP should be constantly monitored and be adjusted for changing commercial conditions. There is a natural tendency for office procedures to evolve over time as staff and principals (consciously and sub-consciously) search for easier ways to do things. Short cuts should not be taken with the service trust. The service trust should do everything that needs to be done to run the practice except the things that must be done by a practitioner and the IMP does the things that need to be done by a practitioner. Short cuts are hard to explain to a tax auditor and cast doubts on the whole arrangement. Practical issue four: monthly tax invoices As a fourth issue, it is critical that monthly tax invoices including GST be raised by the service trust and that these be paid for by the IMP on a timely basis. If this is not done the whole arrangement will be thrown open to question. We have seen cases where a year's management fees were charged each year by the practitioner's accountant some months after the end of the year. The amount of the charge was set to bring an IMP to a nil profit position each year and had nothing to do with the services actually provided (or claimed to be provided) by the service trust. If this practitioner were selected for audit it would have been a picnic: the management fees just weren't deductible. Full stop. The practitioner would have been up for tens of thousands of income tax and penalties and there would not have been much any one could do about it. Tax invoices must show the name of the supplier, the suppliers ABN, the pre-GST amount, the GST and the post GST amount. (A sample tax invoice for a service trust is reproduced in part 13.12) The biggest myth in this area is that a mark up of fifty per cent is accepted by the ATO for charging personal services provided by the service trust to the IMP. This was the mark up accepted by the Full Federal Court in Phillips case. Many advisors now take it as a hard and fast statement of the law, a legal truism that holds good in all similar cases. This is not correct. In Phillips case the taxpayer was able to prove fifty per cent was an appropriate commercial mark-up at that time for that type of service. But this does not mean fifty per cent is always an appropriate commercial mark up. In most cases the appropriate mark up is a lot less than fifty per cent, and to the extent it is, the excess payment will not be deductible to the IMP. The ATO is on record as saying where an IMP pays invoices computed on fifty per cent mark up he will require each component of the invoice to be dissected into its components. Third party evidence (such as quote obtained at the time the services were provided) will then be required for each component of the invoice before he will accept the payment is deductible. In strictness, the percentage mark up for each service provided by the service trust will need to be demonstrated to be a commercial arms length amount each year. This is quite a lot harder than it sounds: some commentators even go as far as saying there should be a constant process of obtaining third party quotes for these services and, where the third party quote is below the January 2002 Page 37
amount to be charged by the service trust, the service trust's charges should be reduced accordingly. This is a very time consuming and costly process. This aspect of Phillips case is discussed in detail in this manual under the heading "Why labor costs cannot be marked up by 50%". Is there a simpler way? There is a simpler way. This is to abandon the percentage mark-up method in favor of the fixed fee method. Here, the monthly tax invoice rendered by the service trust to the IMP will be for an amount equal to the actual costs incurred by the service trust each month plus an agreed monthly fee plus GST. This is a lot simpler than the mark-up method and does not need to be supported by an annual file full of third party quotes ready to be perused by the ATO. What is a commercial monthly fee? There is no one answer to this question. It depends on the extent of the management services provided by the service trust, which in turn depends on the overall profile of the practice. We suggest between $2,500 a month and $3,500 a month per equivalent full time practitioner will normally be sensible fee. What is appropriate in each case will depend on the overall circumstances of the practice and should be reviewed in detail by the practitioners at least once a year. Practical issue six: get the documents right The most important document is a service agreement. This document will set out the services to be provided and the method of charging for them. Without such a contract the ATO is likely to challenge the payments made by the IMP to the service trust. Regular monthly tax invoices should be rendered by the service trust to the IMP. These invoices should set out in detail the basis for the monthly fee, whether it is on a costs plus basis or a fixed monthly fee basis. These invoices should be paid on a timely basis. (A sample tax invoice for a service trust is reproduced in part 13.12) Minutes of a meeting of the directors of the IMP and the directors of the trustee of the service trust should be prepared authorizing each company to enter into the service agreement and do all things required to give effect to that agreement. Where the service trust is providing finance to the IMP, a loan agreement and, if appropriate, security documents giving the trust a charge over the assets of the incorporated practice should be executed. Working files and normal accounting records to substantiate all payments made by the IMP should it be called upon to do so by the ATO should be kept. These records have to be kept for five years under the income tax law, but they should be kept for at least seven years to comply with the Corporations Law.
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Appendix 1: Check list of things to do once a new service trust is set up Things that we do: Medical and Dental Accounting Services Pty Ltd will need to: (i) arrange for the solicitor, Terry McMaster and Co Pty, to set up the trustee company; draw a trust deed to create the trust; forward the documents to the client for signing, dating and sealing as indicated on the deeds and once the deed is signed and returned to us, arrange for it to be stamped at the relevant State Revenue Office and return a signed copy for you; apply for the trusts Australian Business Number and tax file number and the forward them on to you once they are issued; register the trust for GST and for pay as you go withholdings; arrange for the solicitor, Terry McMaster and Co Pty, to prepare a service agreement between the service trust and the medical practitioner; and generally advise and assist on the logistics of setting up and running the trust.
(ii) (iii) (iv) (v)
You will need to: (i) (ii) (iii) (iv) sign, date and seal all documents sent to you on a timely basis; register for any work cover type insurances that may be required; arrange for fresh employee declarations to be completed by staff and lodged with the Commissioner of Taxation; arrange for services provided to the practice to be invoiced to the trustee of the trust. For example, the gas, telephone and electricity accounts should all be changed to the name of the trust; arrange for any lease documents or similar legal documents including assistant practitioner agreements to be redrawn showing the trustee as a party to the agreement; open a bank account. You do not need to tell the bank that the trustee company is acting as a trustee. For example, it is quite OK to open the account in the name of Acme Medical Centre Pty Ltd, rather than Acme Medical Centre Pty Ltd as trustee for the Smith Family Trust. You may need to show the bank a copy of the companys constitution and/or its certificate of incorporation. Contact Terry McMaster & Co Pty if copies of these documents are required; deposit a cheque for say $10,000 in the bank account, as a working capital float (unless the bank has arranged an overdraft type facility); pay all practice costs out of the trusts bank account. Practice costs means all costs other than the owner practitioner(s) salaries and similar payments to owner practitioners; prepare regular tax invoices for the trust showing the name of the trustee, its ABN, the amount of practice costs paid during the period, the monthly fee, the GST and the total Page 39
(v) (vi)
(vii) (viii) (ix)
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GST inclusive price, and arrange for the practitioner(s) to pay these on a timely basis. (A sample tax invoice for a service trust is reproduced in part 13.12); (x) (xi) (xii) fill out all cheque butt details and keep copies of all invoices paid, all invoices rendered and all bank statements; prepare a quarterly or monthly Business Activity Statement and pay withholdings and GST as appropriate; and generally oversee the operations of the trust.
Obviously the above matters do not comprise an exhaustive list of the things that have to be done. But the main points are covered and they do provide a neat summary of the most common tasks that have to be completed on setting up a service trust.
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2.5 Practice Trusts
Prelude This part of the manual is based on an article that was originally published in the June 1997 edition of Medical Observer under the heading "Putting Your Trust In A Practice Trust". Since then we have become increasingly in favor of practice trusts, largely because of their commercial simplicity in a post GST world. This is so irrespective of the size of the practice and whether or not it is deriving business income (ie has more non-owner practitioners than owner practitioners, or otherwise passes the ATOs tests as to what comprises a business). A memorandum used for hybrid trust clients is attached as an appendix. This gives more insight into why we are in favor of practice trusts, and the logistics connected to converting to a practice trust. This memorandum has been used as a tool for a number of client advices over the last 12 months and reflects our current thinking in this area. Introduction A practice trust is quite different from a service trust. A service trust provides services to the practice under a service agreement for a fee, which includes a profit element. A practice trust actually runs the practice, that is, it sees the patients and derives fees for doing this. A service trust may be used to provide services to the practice trust, but this is not strictly required. A practice trust is like an Incorporated Medical Practice ("IMP") because it is an entity used by a practitioner to run a practice - except it is a trust, not a company. We expect practice trusts will become more common as practitioners become more aware of their advantages. They are simpler than IMPs, yet have all their commercial advantages. Practice trusts allow practitioners to pay tax under the PAYG instalments system rather than the PAYG withholdings system tax system, thereby creating significant tax deferral opportunities and, by replacing salary with profit, eliminate the need for work cover, mandatory superannuation, payroll tax and other employment on-costs. Taxation of trusts as companies The proposed new rules for taxing trusts as companies will make practice trusts, particularly practice trusts deriving business income more attractive again. This is because the practice trust will be able to retain profit, pay tax on the retained profit at 30%, and then re-invest it, or carry it forward to be distributed in a year when a beneficiary has a pre-distribution tax rate equal to or less than 30%. Group Practices Practice trusts have an important role to play in group practices: they are an attractive alternative to partnerships and multiple-practitioner IMPs. They allow practitioners to enter and leave the group more efficiently and easily cope with complicated profit-sharing formulas and different classes of equity participation. Larger practices are more likely to be subject to payroll tax remember, salaries and fringe benefits paid by the individual practitioner's IMPs will be grouped for payroll tax purposes - so practice trusts may achieve very significant cost advantages here. The practitioner may be aware of the cash flow advantage connected to de-incorporating: a significant timing benefit arises as the practitioner moves off the pay as you go withholdings system on to the pay as you go instalments system. January 2002 Page 41
Advantages of incorporation The difficulty is that incorporation has advantages besides superannuation benefits, and these are lost on de-incorporating. The advantages of incorporating are listed in detail at Part 2.3 of this manual. What's the problem? Many practitioners want to save money on work cover and compulsory superannuation (and for larger practices, payroll tax). Often practitioners just can't afford these imposts. It's not that they think super or work cover is a bad idea, they just don't have the money to pay the bill. In other cases, they want to make contributions for a spouse who is not subject to the 15 per cent superannuation surcharge rather than contributions for themselves. How can they avoid these costs but not give up the benefits of incorporation noted above? The solution One solution is to convert the IMP to a practice trust. This is quite simple to do: the IMP executes a deed and transfers the practice to a practice trust. The practice trust with effect from, say 1 July 1997. Thereafter the IMP runs the practice as trustee for the practice trust. The beauty of it is, apart from the ATO, the bank (if there are borrowings) and any partners or associates, no one else needs to be told of the change. Patients, Medicare and suppliers do not notice anything different and stationery, credit bank accounts, signage do not have to be changes. The traditional tax advantage of trusts - income splitting - is not available to a practice trust. This is because all beneficiaries must be practitioners. The advantages are found in reduced employment on-costs and deferred income tax payments. Net income from a practice trust is not salary. This means it does not attract work cover premiums or compulsory superannuation contributions and, in some cases, payroll tax. This means a practitioner can reduce employment on-costs equal to 78% of salary each year, and possibly as much as 13% if the salary is subject to payroll tax.
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Income tax deferral The deferred income tax aspect deserves special comment. Practice trusts do not have to pay withholding tax on net income: this means, for example, a practitioner converting from an IMP to a practice trust from 1 July 1997 need not pay withholding tax for the year ending 30 June 1998. In our example, this means a practitioner previously drawing a salary of $70,000 will not have to pay tax of about $2,000 a month starting on 7th August 1997. In fact the tax will not have to be paid until March 1999, some 21 months later. Taxable income and tax payable will, of course, be exactly the same, but the time for payment is deferred significantly. Capital gains tax can be a problem when converting to a practice trust but, with proper planning, this can normally be avoided. Like all legal matters, specific advice regarding your circumstances should be sought before setting up a practice trust.
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Appendix: Memorandum setting out background issues to practice trusts Introduction This memorandum summarizes our suggestions regarding the legal structure of the Clinics medical practice. This memorandum is in general form only and will need to be expanded in subsequent meetings before the recommendations are implemented. General Comments Since the start of the New Tax System and the GST on 1 July 2000 we have explored ways to improve the administrative efficiency of medical practices. This is for both medical practices that are not running businesses (ie where number of equivalent full time non-owner practitioners is less than the number of equivalent full time owner practitioners) and for medical practices that are running businesses (ie, where the number of equivalent full time non-owner practitioners exceeds the number of equivalent full time owner practitioners). We believe group practices are best served by a hybrid trust structure. A hybrid trust combines the best features of a unit trust with the best features of a discretionary trust. The owners entitlements to income and capital are preserved, but the trust deed allows the owners to share profit on any basis they wish. Once each owners share of profit is identified, the owner may distribute it to any related party they choose (such as spouses or children over the age of 18), in much the same way as a discretionary (ie a family) trust distributes income out to beneficiaries. The trustee runs the medical practice. It bills patients and banks all amounts received for patient services. It also banks all amounts received from assistant practitioners for providing services to their own practices. It pay all costs connected to the practice. Using a hybrid trust minimizes internal administration costs and reduces some external costs, such as bank charges, pay roll tax and accountants fees, compared to alternative legal structures, such a partnerships and associateships and service entities. Legal Structure We recommend the Clinics medical practice be structured through a hybrid trust owned by the practitioners or other related persons (eg a spouse or a trustee of a family trust. The Trusts profit will be distributed to the unitholders (ie the practitioners spouses or family trusts) or other related persons each year in the most tax efficient manner. The Trust may distribute net income to a company owned by a practitioner or a related person, and if this is done the company tax rate will apply to the distribution. The company tax rate is currently 30%. However, any distributions to companies must be paid in cash before, or as a second best, as soon as possible after, 30 June in the relevant year. If in a particular year the Trust has fewer non-owner practitioners than owner practitioners then it should pay each owner practitioner an arms length salary (say $75,000 per annum, including superannuation) as a reward for the work that practitioner does. The practitioners should be able to salary sacrifice this entitlement on a prospective basis into superannuation or fringe benefits, particularly car fringe benefits for themselves and related persons. The existing service trust
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In many cases an existing service trust may be used to run the practice. It is a straightforward task to convert the existing trust deed to a hybrid trust deed, and to attend to the other minor documentation requirements. The documents required to do this are: (i) (ii) (iii) an ASIC form 205 to change the trustee companys and a minute of a meeting of the directors of the company recording this change; documents to change the name of the trust; and an amending trust deed to convert the existing trust deed to a hybrid trust deed. (This document is required to allow more flexible income distributions from the Trust to the unitholders and related parties) and a minute of a meeting of the directors of the company recording the adoption of the amending deed; and possibly, a unitholders agreement.
(iv)
If a practice is not using a service trust it is necessary to set up a new trust to own the practice. This costs about $1,500. Capital gains tax issues CGT will not be an issue. This is because the ownership of the goodwill, which is the major asset connected to the practice does not change as the result of the change in the Clinics legal structure. The individual practitioners own the goodwill both before and after the change in the legal structure. Internal Logistics Regarding the practices internal logistics, the procedure is for the practice manager to: (i) (ii) (iii) change the banking arrangements so all income from all sources is banked into the bank account of the Trust from the date of change; pay all costs from the Trust from 1 July 2001 from the date of change; and change the name on the Trusts bank account and advise other interested persons (eg Work Cover) of the change of name.
We will advise the ATO of the change of name. Tax file numbers and ABNs will not change if the existing service trust is used as the practice trust.
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Banking Arrangements It is possible a particular receipt may be banked into another bank account after the date of change. This may be, for example, because an automatic payment could not be changed before then. This is not a problem. There are at least two possible solutions. These are: (i) (ii) leave the receipt in the bank account, but consider it when allocating income/profit to the owners from 1 July 2001 on; or transfer the receipt to the Trusts bank account.
Solution (ii) is the simplest: it creates extra work at the beginning but makes the subsequent work and the profit allocation calculations a lot easier. Profit Share Arrangements The hybrid trusts profit share rules allow you to distribute income to family members and related entities in any way you determine. There is no restriction on the distribution of the hybrid trusts income to these persons: the whole of the profit (after the payment of an arms length salary to John Smith) can go to related persons, including companies if you choose to do so. The hybrid trust structure takes away some inherent tax uncertainties of service trust structures, such as the appropriateness of the mark ups. Proposed new rules for taxing trusts as companies The new rules for taxing discretionary trusts as companies, now expected to start in July 2002, should not have any extra impact if this recommendation is accepted. These rules are expected to be good for practitioners since the proposed rate of tax is 30%, which is less than 48.5%, and trusts will be able to retain profit and pay tax on the retained profit. This means that the hybrid trust is the most tax efficient choice of structure and will result in the least amount of income tax being paid each year. Banking Arrangements All cash should be banked into the hybrid trusts bank account and all costs should be paid out of its bank account. The practice manager should set up the new banking arrangements. Sometimes it is not practical to start the new banking arrangements 100% on a single specified day. Instead, the arrangements are changed gradually, over a period of a month or even more. In this case it is more of a migration to the new arrangements rather than a sudden change. Even after a few months the occasional cheque may arrive payable to the old entity and if this happens it should be banked into the old entitys account and the transferred to the new trusts account by cheque transfer.
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Asset Protection One advantage of using a service trust based structure is that the assets of the service trust, ie plant and equipment, are outside the reach of patient litigation. We believe this is an overstated advantage. Professional insurance is real and the insurers stand behind the practitioners. We understand no practitioner has lost significant assets as a result of patient litigation. This is certainly the claim of the insurers when they speak at seminars and conferences. As far as we can tell it is true: we have asked hundreds of practitioners (at seminars) whether they know of practitioners losing significant assets (as compared to small legal costs) and the answer is always no. The hybrid trust structure means the one entity, ie the trustee of the hybrid trust, runs the medical practice and owns the plant and equipment. This means the plant and equipment is not protected from patient litigation. As explained above, we do not think this is a problem. But if for any reason you think it is a problem the recommended structure can be adjusted to have a service entity that does nothing but own the plant and equipment and which leased the plant and equipment to the hybrid trust which runs the practice. This will add about another $1,500 or so to the set up costs and create extra internal administration costs and external accounting costs each year.
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2.6 Partners or Associates?
Introduction Most practitioners contemplate grouping with others at some time during their professional careers. Many do so. Whether one should do so, and how, is something we are often asked to comment on. This part of the manual looks at the main legal issues involved in running a medical practice through each of a partnership structure and an associateship structure. Prelude - ACCC Rules As a prelude, the ACCC announced in early October 2001 that general practices will be exempted from the price fixing rules contained in the Trade Practices Act, and hence this aspect of the partnership versus associateship debate is not covered in this manual. Partnership A medical partnership involves two or more practitioners (or their IMPs) combining in a business to provide medical services to patients for a profit. Each partner is both principal and agent of each other partner and has the authority to bind the other partners in respect of the partnership's business. Each partner has a duty of trust, confidence and utmost good faith to each other partner: this is the highest duty imposed by the law. It means each partner must put the interests of the other partners ahead of his own interests. A partnership is not a separate legal entity. Each partner deals with patients on both his own account and the account of his partners and each partner is therefore equally responsible for the actions of the other partners. This responsibility is joint and several, which means a patient who complains of the actions of a partner may take action against any one or all of the practitioners in the partnership. Each practitioner in the partnership has unlimited responsibility for the actions of each other practitioner in the partnership. Up to fifty practitioners can be partners in a medical practice partnership. Partnerships are not a separate taxable entity for tax purposes. A partnership will be required to lodge a tax return each year but, normally, will not pay tax itself. Instead each partner is required to include a share of net partnership income (or loss) in the partner's own taxable income computation. The amount of tax paid will depend on each partner's overall tax profile. A partnership is required to pay GST as if it is a separate entity. Partnerships are easy to set up, although some complex capital gains issues can arise where one wishes to vary a partnership. Any name used by the partnership should be registered under the Business Names Act. Partnership profit sharing arrangements It sometimes seems practitioners are capable of inventing an infinite number of ways for profits to be shared between partners. These can be complex and sometimes you need to be a High Court judge, or an Excel spreadsheet expert, to understand how each mechanism works (although somehow the practitioners never seem to miss a cent!). Despite this complexity and diversity, two basic concepts can be identified. These are:
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(i) (ii) proportionate profit sharing, ie., each partner is entitled to a fixed percentage of the profit each year. If there are two partners they will get half each, and so on; cost sharing, ie., each partner gets share of the partnership's profit each year calculated by taking the partner's gross fees as a percentage of the partnerships gross fees and multiplying this proportion by the amount of partnership's profit.
A simple example may help to explain. This example assumes the partnership of Dr Jones and Dr Smith makes three hundred thousand dollars profit a year and Dr Jones bills $60,000 a year more than Dr Smith. The figures look like this: Dr Joness Fees Dr Smiths Fees Total Fees Expenses Profit $220,000 $160,000 $380,000 $180,000 $300,000 57% 43% 100%
Under the proportionate sharing arrangement each practitioner includes $150,000 in his assessable income for tax purposes. Under the cost sharing arrangement Dr Jones includes $171,000 in his assessable income for tax purposes and Dr Smith will be required to include $129,000 in his assessable income for tax purposes. Partnership Agreements The Partnership Act deems partners to have adopted a standard partnership agreement if they do not have a written agreement. This standard partnership agreement may not be the agreement the partners would choose for themselves. This is a very good reason to have a written partnership agreement that reflects the preferences of the practitioners who own the practice and not the preferences of a statutory draftsman. Most partnership agreements will provide rules concerning the following matters: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) procedures for sharing profits and losses; procedures for admitting new partners (normally all partners must agree); procedures for partners to retire; procedures for changing the proportions (normally all partners must agree); procedures for changing the partnership agreement; procedures for ending the partnership; procedures for the death or serious illness of a partner; procedures for owning business names and similar assets; restrictive covenants; bankruptcy of a partner; practice management and borrowings; dispute resolution and valuation procedures; and interest on partners' capital and current accounts.
Associate Agreements Associates run their own practices and do not combine with other practitioners in a business. The associates will share the cost of services and facilities used by their practices, such as rent, receptionists, telephones and so on, and will (normally) co-operate with each other and help each other professionally. But they will not run a business together. Associates do not owe each other January 2002 Page 49
a duty of trust, confidence and utmost good faith. Associates are not jointly and severally liable for each others actions, whether with patients or otherwise. Most associates regulate their relationship with a written agreement. These agreements tend to look like partnership agreements except the word "associate" is used in lieu of the word "partner" and there is a provision saying the practitioners are not partners, are not jointly and severally responsible for each other and can't bind each other in any way. Associates are entitled to their own billings. They do not share income. They just share costs. Often this will be on the basis of each associate's billings as a percentage of total billings. This means, the associates' profits will be pretty much the same as partners sharing profits on the basis of billings. Most associate agreements mimic partnership agreements, with the nomenclature changed as appropriate to avoid creating a partnership. The associates then act as if they are partners. As a result it is often very hard to see what the real difference is between an associateship and a partnership. Which is better, associateship or partnership? There is no easy answer to this question. It depends on the circumstances of each case and the preferences of the practitioners. Of course, in many cases the die is cast and it can be hard to change from one to the other without engendering an adverse capital gains tax result. Certainly advice regarding your specific circumstances should be sought before changing from one to the other. It is not what you call yourself that is important but how the practice(s) are conducted. Practitioners who call themselves associates may be held to be partners if they hold out in any way that they are in business together. This did happen recently to a group of practitioners in South Australia, with surprising results for all concerned. Associates should therefore take care with matters such as signage, stationery, accounts, banking procedures and advertising on to avoid creating an impression of partnership. Partnerships of incorporated practices have significant tax advantages. These can overwhelm any concerns about joint and several liability and similar issues. These advantages are discussed in detail in Part 4.2 under the heading "The Taxation of Medical Partnerships". Further, if proper asset protection strategies, including mutual indemnities and guarantees between the partners, are put in place the practical significance of joint and several liability can be minimized. Overall, we normally recommend partnerships over associateships. This is because of the taxation advantages connected to medical practice partnerships. The tax savings can be more than $10,000 per annum per partner. This logic can be very hard to argue against. A digression: one popular myth: you cannot be liable for your partners private debts Many advisors incorrectly tell practitioners that partners can be jointly and severally liable for each others actions in all areas, not just the partnership. They say, for example, partner A can be liable for partner Bs investment loan. This is not right. The partners can only be jointly and severally liable for actions of other partners within the partnership. This is a basic common law principle and is reinforced by the Partnership Act of each state. Partners are not liable for each others private debts. Corporate partner or individual partner? January 2002 Page 50
As a general comment, it is wise to use a company to hold your interest in a partnership. The advantages of IMPs are listed in detail elsewhere in this manual, and we specifically note here: (i) an IMP can shield the individual practitioner from legal liability connected to the negligent acts of the other practitioners engaged in the practice, (but from his or her own negligent acts); and as partnerships tend to be larger, it is more likely that the income derived through the partnership is business income and is able to be retained in the company and taxed at 30%, rather than at 47%, plus Medicare, in the hands of the practitioner.
(ii)
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2.7 What if you are married to a practitioner?
Married practitioners present a favorable tax profile. It is easy for married practitioners to structure their practices so the income derived from the practice is business income and is not personal services income. The same rules apply for other close relatives. The basic idea The basic idea is as follows: (i) (ii) (iii) set up an IMP with one spouse as the sole director and shareholder. It is better if the practitioner with the lowest hours per week is the shareholder and director; have the IMP employ each practitioner on a salary of, say $37,000 each. Above $37,000 the marginal rate of tax exceeds the corporate rate of tax; possibly, arrange for services to be provided to the IMP by a service trust under the rules set out in Part 2.4 of this manual. This shifts further income to a low tax environment; and arrange for the balance of the net income (ie gross patient fees less salaries, superannuation and service fees) to be retained in the IMP each year.
(iv)
Under the rules set out in Income Tax Ruling IT 2639 dated 20 June 1991 (reproduced at Part 5.3 of this manual), the income of the IMP will be business income and not personal services income. This is because the "rule of thumb" ratio of 1:1 between proprietor practitioners and non-proprietor practitioners is satisfied, particularly as the non-proprietor practitioner is the sole shareholder. How much tax does this save each year? The amount of tax saved each year depends on the practitioners' total net income. Let's take a typical example of a male specialist married to a female part-time general practitioner, and assume the specialist earns $200,000 a year and the part-time general practitioner earns $60,000 a year. Ignoring the deductible superannuation contributions and service trust fees this technique will save more than $23,000 a year in tax. This is shown as follows: Before Specialist Ms General Practitioner IMP Total Annual Cash Savings Income $200,000 $60,000 __Nil__ $260,000 Tax $80,800 $15,000 _Nil__ $95,800 Income $60,000 $60,000 $140,000 $260,000 After Tax $15,000 $15,000 $42,000 $72,000 $23,800
There is also a Medicare saving of more than $2,000 cash, a Work cover saving and a superannuation surcharge saving of perhaps $5,000 cash, or more, depending on age and the amount of contributions paid each year. There is also a timing advantage in the first year as the practitioners move off the Pay As You Go Withholding system and on to the Pay As You Go Instalments system: this amounts to a one January 2002 Page 52
year tax holiday. In this example this leads to a cash flow saving of more than $100,000 in the first year of the change. A word of caution Skill is needed to make sure the ATO cannot attack this sort of structure under the general tax avoidance rules contained in the Income Tax Assessment Act. Skill is also needed to make sure you do not end up with a company with significant retained profits, matched by significant assets, which are susceptible to patient litigation. There are a number of simple techniques to guard against this type of problem: how the techniques are applied depends on the facts of the case and it is beyond the scope of this part of the manual to discuss them in detail.
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2.8 Case Study: The Story of John and Betty
This part of the manual was originally published in Medical Observer in 1997. QUESTION FROM A PROPOSED FINAL YEAR MEDICAL SCHOOL COURSE IN TAX PLANNING (SUB TITLED "STRESS MANAGEMENT WITHOUT A BOTTLE" OR "THE MYTH OF THE WEALTHY PRACTITIONER") THE FACTS Dr John is 50. He is married to Betty and has three children. Betty, 45, helps in the practice ten hours a week and runs a busy household. Daughter Mandy turns 18 in June and wants to be a practitioner. Daughter Tracy is 13 and wants to be a rock star. John owns the medical practice. Two other practitioners work there. They get along well, although John is frustrated the others do not make after hours calls and do not touch the paperwork. John runs the practice in his name. A service trust administers the practice. John makes $150,000 a year, and, of this, $35,000 is paid to Betty as a "salary". The trust's income of $30,000 is distributed equally to John and Betty because there are no other adult beneficiaries. The $30,000 is largely attributable to a 50% mark up on salaries. Total tax is $54,000. Provisional tax instalments of $15,000 are due on 1/12/97 and 1//3/98. The practice is 15 kilometers north from home and the girls' expensive private school is about 20 kilometers south from home. This adds up to a lot of driving each day. The practice is in an area under-serviced by practitioners. The practice bulk bills. John has not applied for the BPP as a matter of principle. Demand for John's services is great and the HIC recently indicated he might be audited as a result of high patient visits. John and Betty are not wealthy. Their home is worth $350,000, but there is a $200,000 mortgage. Betty owns a home unit worth $150,000 left to her by her late father. The practice premises are owned through a unit trust /family trust structure. John and Betty have no other investments. The trust owes Betty $100,000 for unpaid distributions, but the accountant said this is not a real asset. John drives an old BMW and Betty drives a new Toyota. Both cars are leased. Home to work travel is not deductible, so John only claims 30% of car costs and Betty doesn't use her car for business, so there is no tax deduction for these costs, the accountant said. Each of John and Betty expect to inherit $200,000 from their parents. John and Betty are worried. They are going backwards. High tax bills ($54,000), school fees ($20,000) mortgage payments ($25,000) and car costs ($20,000) take most of their $150,000 a year. They haven't had a holiday for years. Betty is worried about John's health, and has developed her own theory on why men die young. Retirement is 15 years away. But there are still nearly 10 years of educating children (assuming Tracy abandons rock and roll and enrolls in medical school too). With modest assets and inheritances they will not have enough to live comfortably but will not get a pension. John and January 2002 Page 54
Betty recently visited their accountant looking for help. He told them life in general practice is tough and they should just work harder. QUESTION Advise John and Betty. Consider tax planning opportunities, asset protection strategies and retirement planning issues. Answers should be well supported by primary sources including case law, statute and the Commissioner's rulings. Answers should assume a 48% tax rate. Answers outside established law and practice will fail. MODEL ANSWER 1 Interest Deductibility Home loan interest is not deductible. This means John has to earn $2 for every $1 of interest. With repayments of $25,000 pa this means 1/3 of John's income is used to service debt. Consider: (a) (b) (c) borrowing in trust's name to pay out Betty's $100,000 loan, and then have Betty use the cash to pay off some of the home loan; John borrowing $150,000 to buy Betty's unit and Betty using the sale proceeds to pay off some of the home loan; or banking practice proceeds directly on to non-deductible debts until repaid, and using fresh deductible debt to fund practice outgoings.
Annual cash saving: $10,000. 2 2.1 Family Trust Family trust is not used properly. Use a fixed fee rather than a percentage mark up to shift more income to the trust, say, $40,000 a year. Mandy can receive a full distribution in the 1998-year as she will be 18 by 30 June 1998. Distribute $643 to Tracy to use her $416 tax-free threshold and the $100 low-income rebate. Stop marking up salary payments by 50%. The Commissioner doesn't accept they are deductible: mark ups cannot exceed arms length rates (Phillips case). Stop paying Betty an inflated salary. The excess salary is not tax deductible (section 65 Income Tax Assessment Act). Income can be distributed to Betty under the trust deed without regard to actual hours worked in the practice. Annual cash saving: $8,000. 3 Practice Company Set up a practice company and retain income in it, other than a $38,000 pa salary to John. This is permitted under the Commissioner's rulings so John's practice income is business income (IT 2639). Tip: use retained cash to pay off the trust's business loan: deemed dividend rules will not apply to this loan (IT 2637). January 2002 Page 55
2.2 2.3 2.4
Annual cash saving: $7,000, plus a timing advantage as the company will not pay tax until March 1999. 4 4.1 Cars Run a new logbook for John showing much of the home to work as business travel (refer Collings' case and Ballesty's case). Make availability of car, equipment and being on-call a condition of John's employment with the practice company. Logbook should show 90% or more business travel. Transfer Betty's car to the trust and take it as a fringe benefit using the statutory method. As total kilometers exceed 25,000 a year. FBT will be low even though there is no business travel. Annual cash saving $10,000. 5 Superannuation Transfer 40,000 units in the property trust to a DIY fund for Betty (to avoid the 15% surcharge). This creates a $40,000 deduction in the trust, which, under the service agreement, is shifted to the practice company. Annual cash saving $13,000. 6 Vary Provisional Tax Instalments to Nil As a result, John will have only a small provisional income and Betty's provisional income will be nil. The instalments of $15,000 due 1/12/97 and 1/3/98 can be varied to nil. 7 7.1 7.2 Asset Protection Transfer John's interest in the home to Betty, to protect it from any litigation risks not covered by John's insurance. Change wills to create testamentary trusts on death to protect the survivor and the children from the risk of divorce, litigation and business failure.
4.2
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8 8.1 Pension Planning/Retirement Planning Transfer Betty's unit (and any debt) to the family trust. Acquire all other assets in the family trust, particularly as age 60 approaches. Assets in family trusts do not count for assets test purposes. Getting the old age pension should be a key part of John and Betty's retirement strategy. Arrange for John and Betty's mothers to change their wills to leave the $200,000 inheritances to the family trust. Cash saved: $20,000 a year tax-free including fringe benefits once John retires. 9 9.1 Practice Management Issues Apply for the BPP. The BPP typically generates $12,000 per practitioner per year. Estimated benefit $36,000 a year. 9.2 Consider shifting away from bulk billing: if there is no competition from bulk billers and the practice is busy this will probably increase profits overall (nb lower patient numbers mean less work for John and less HIC pressure.) Estimated benefit $15,000 a year.
8.2
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2.9 Case Study: The Story of Gina and Guido This part of the manual originally appeared in the December 1997 edition of Medical Observer Business
SAMPLE QUESTION FROM A PROPOSED POST GRADUATE MEDICAL SCHOOL COURSE IN TAX PLANNING FOR SPECIALISTS AND SURGEONS TIME ALLOCATION: ONE HOUR PLUS READING TIME Gina, 33, is a specialist. She is married to Guido, 37. They have two children, Bill, 7, and Ben, 3. Ben has Downs Syndrome. Caring for Ben is the priority so Guido doesn't work except for eleven hours of practice administration each week, after hours. Gina grosses $350,000 but due to high costs, particularly interest costs, only makes $170,000. Of this, $10,000 goes to Guido as a salary and $20,000 is paid to a large super fund. The rest, ie, $140,000, stays with Gina as salary from her practice company. Guido also derives $28,000 a year from his dad's family trust. Gina's tax bill is $51,702 and Guido's tax bill is $9,000 a year, plus Medicare. Gina and Guido own their home through a family trust. The home is worth $800,000 and $200,000 is owed on the loan. The bank said they have to pay 2% more than the home loan rate, ie 9%, because the loan is to a trust. The trust does not act as a service trust and only owns the home. Gina is concerned the market will crash, but is reluctant to sell her shares as she will make a gain of more than $70,000, of which about half will go in tax. The shares cost $100,000. Gina has never had a capital gain before. Gina also owns shares costing $250,000 bought using a loan under a gearing facility from a wellknown boutique merchant bank. She wants to sell but is concerned the excessive penalties and vague fine print mean she will lose all of her profits, despite the promises of the smiling salesman when she was signed up. The 17% interest rate 17% includes a hedge premium to cover the risk of a fall in the portfolio. Gina borrowed $50,000 three years ago on a personal loan at 10% interest to pay a tax bill. Gina and Guido have no other debts except a $100,000 loan arranged by their accountant for a primary production scheme. This is at 13% interest. The farm units, which cost $200,000, were sold for $100,000 two years ago after a horror tax audit. Gina works with a group of five other practitioners and para-medics. A proposal has been put to them to buy the practice premises, which comprise six separate units in a strata title complex. One colleague wants to form a unit trust to own the six units. Another thinks they should each own one unit and not have common ownership. The cost of a unit is $200,000. Gina is currently paying $25,000 a year rent plus outgoings for her rooms. Guido recently had some bad news. His sister, Maria, was laid off. Because Maria's husband, Mario, is employed she cannot get any government assistance and prospects aren't good for a new job. The retrenchment has strained the marriage and Mario is threatening a divorce. Gina wants to buy a new car for Guido, who travels more than 100 kilometers a day taking Ben to an early intervention centre. The time and cost of caring for Ben is huge, and Guido deserves the "father of the year" award, three years running. January 2002 Page 58
INSTRUCTIONS TO CANDIDATES Advise Gina and Guido. Pay attention to improving their tax profile, managing cash flow and developing a sound investment and, ultimately, retirement strategy. Candidates should not cover issues dealt with in the undergraduate course in taxation and financial planning (See October 1997 Medical Observer Business.) AVAILABLE TIME: ONE HOUR Use of Family Trust The trust is not being used properly. It should be used as a service trust. This allows, say, $40,000 net income to be shifted from Gina to the trust. But which beneficiaries can receive trust distributions? Simple. Ben is disabled. Disabled children may receive trust income without the penalty taxes normally applying to un-earned income of minors. This means Ben has the benefit of the tax-free threshold and the ascending rates of tax up to $50,000 pa, even though he is only three years old. Distributing $40,000 a year to Ben and $643 to Bill will save Gina about $5,000 cash a year. This will take some of the sting out of the cost of caring for Ben. Gina could consider distributing trust income to her sister-in-law Maria, who is a general beneficiary of the trust. The risk is an unpaid distribution will be treated as a marriage asset for family law purposes should Mario divorce Maria. But if half the $40,000 net income is distributed to Maria the total saving from will be about $13,000 cash a year. Interest Rate Management The cost of funds is too high. Interest is a cocktail of 9%, 13% and 17%, with a weighted average cost of 13% on $600,000 of debt. Gina and Guido have plenty of equity in their home and they should be using this to get the lowest possible rate, say 7% pa. Refinancing the geared share scheme may take some time. This will save about $36,500 in interest each year. This is calculated as follows: Home Loan Geared Equity Loan Tax Loan Tax Scheme Loan Total Less: Interest at a sensible rate Annual Interest Saving $200,000 $250,000 $50,000 $100,000 $600,000 $600,000 at 9% at 17% at 10% at 13% at 7% $18,000 $42,500 $5,000 $13,000 $78,500 $42,000 $36,500
As an aside, the interest on the tax scheme loan is not deductible, as Gina no longer owns the income-producing asset. The interest on the loan to pay tax is not deductible either. Gina should think about ways of converting these loans to deductible loans. For example, these debts should be rolled up together and churned using a revolving credit facility (eg. an overdraft) so this problem disappears over time. Great care is needed when completing a procedure like this, but it can save a lot in tax. Capital Gain on Shares Gina has a capital loss of $100,000 from the sale of her farm units. This loss will more than offset the expected gain of $70,000 on the shares. This means Gina can sell the shares without triggering a taxable net capital gain. January 2002 Page 59
Gina should consider transferring the shares to the family trust, so any future dividends and capital gains occur in a lower tax environment, and the assets are safe from litigious patients. Migrating assets to the trust environment also sets the stage for some sound pension planning and estate planning techniques: Ben's circumstances complicate things here, but, in concept, the family trust offers maximum potential for Ben. Use of a Practice Trust Gina can move away from the group tax system and on to the provisional tax system by converting her practice company to a practice trust from, say, 1 July 1998. This means she will not have to pay group tax and will not have to pay any other tax until March 2000, being nine months after 30 June 1999. This does not change the amount of tax payable but defers it for up to 21 months. It also saves mandatory superannuation that is of limited value as it is subject to the 15% surcharge and heavy commissions and fees. The tax respite can be used to accumulate cash that can be used to pay back the non-deductible debt left over from the tax scheme. The practice trust also simplifies the administration of the practice and makes sure the practice does not have retained profits. Superannuation Planning Gina should stop contributing to a managed superannuation fund and should instead contribute to a DIY superannuation fund for Guido. This gives control over their investments. Maximum superannuation contributions for Guido, who is age 37, are about $28,000 a year compared to about $9,000 for Gina, who is only 33. Guido's contributions are not subject to the 15% surcharge, as his income is less than $70,000, but Gina's are. Guido is a director of the practice company, so he is deemed to be an employee, and as he is employed for more than ten hours a week, Gina can superannuate him. A DIY fund costs $200 to set up and about $800 a year to run, so it is much cheaper than managed funds. There are no hidden commissions and fees. The existing benefits should be rolled into the new DIY fund and used to help buy the premises (see below). This will save about $9,240 a year in tax, plus a small fortune in commissions and management fees.
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Practice Premises The proposal to buy the premises makes sense. Practice premises are generally good investments for practitioners. Saving $25,000 a year rent is a good return on $200,000: it is the same as getting 12.5% yield on rents. This proposal also helps shift income to the trust to save a bit more tax. The better proposal is for each practitioner to own his or her own strata title. Group ownership is just too messy. Gina should use the family trust, the DIY superannuation fund, or both to own the premises. Debt can introduced via a unit trust if need be: this does not breach the rule against superannuation funds borrowing. The Geared Share Facility This was a mistake. Never borrow from the seller. The fine print always has too many ifs and buts and getting out of these contracts early can cost up to 15% of the amount put in. But it's too late now, so let the contract run and get out at the end (and never do it again). Always borrow from main banks, at the lowest rate of interest. The Tax Scheme Sue the accountant for breach of duty of care, breach of contract and accepting a secret commission. This probably won't make any money but Gina may feel better. Guido's New Car Guido and Ben need a new car. Buying it though the family trust and taking it as a fringe benefit is the cheapest way to own a car, after tax. Eliminating the (very small) FBT charge via an employee contribution makes this even cheaper, if the resultant extra assessable income can be shifted to a low tax rate beneficiary. This will save about $5,000 a year cash.
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2.10 Letter regarding administration of legal structure
This letter is a useful guide to the practical issues connected to running a medical practice through a practice company and a service trust. Readers should also refer to the appendix at the end of Part 2.4, summarizing what need to be done on setting up a service trust. Date Name Address Dear ADMINISTRATION OF PRACTICE ENTITY AND SERVICE TRUST We are writing to set out some guidelines for using your practice entity and service trust. These guidelines are intended to save you time, money and effort by simplifying the administration of your practice entity and service trust and make our lives easier when preparing your accounts and tax returns. This is a general letter and it is possible some part of it may not apply completely to you. Please ring Caroline Poon or Terry McMaster if you are unsure about anything. This letter does not cover any of the commercial advantages of service trust structures. It is intended to cover the administration aspects and to answer common questions in this area. This letter also discusses Quicken, a common small business accounting software package that is very appropriate for practitioners to use. Please read this letter carefully. It is intended to make your life and our lives easier. We are more than happy to meet to discuss these matters and please do not hesitate to contact us should you wish to make a time to do this. Who banks practice income? Patient fees must be banked into the practice entity's bank account. This includes direct payments by patients, Medicare payments and payments by groups such as Veterans Affairs. If a cheque is made out in your name it should still be banked into the practice entity's bank account. You may need to arrange with your bank for personal cheques to be banked into the practice entity's bank account. Patient fees should not be banked into the service trust's bank account. Income other than patient fees can be banked into the service trust's bank account.
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Who pays practice expenses? The service trust pays all practice expenses, except payments to practitioners. Payments to practitioners must be paid by the practice entity. Every month the service trust should prepare a tax invoice and render it to the practice entity. The invoice amount should equal the sum of the expenses paid in the previous month plus the agreed monthly management fee or, in some cases, fifty per cent of patient billings in the previous month. GST of 10% should be added to each amount. The invoice should be paid by the practice entity promptly. A sample tax invoice for a service trust is reproduced in part 13.12. What costs does the practice entity pay? The practice entity should only pay: (i) (ii) the monthly invoice rendered by the service trust; the practitioner's salary and related payments, including super contributions and PAYG withholdings tax, (but PAYGW can be paid on the practice behalf by the service trust if this is more convenient: the ATO doesnt mind who writes the cheque provided it gets its money); and payments to other medical practitioners.
(iii)
If the practice entity pays some other business costs, it is not a mistake as such: a tax deduction will still be available, subject to the usual rules regarding deductibility of outgoings. But it is better for other business costs to be paid by the service entity as this is what the service agreement prescribes and is the justification for the management fee charged by the service trust to the practice entity each month. What about superannuation guarantee levy contributions? The superannuation guarantee levy contributions should be paid by the entity that pays the salary. In the case of salary payments to practitioners this means the practice entity. The Commissioner has been known to apply penalties if the SGL contributions are not paid by the right entity even if a related party has paid it. If for any reason the SGL contributions are paid by the service entity we will shift them over to the practice entity when preparing the final accounts. What if the service trust is short of cash? If the trust is short of cash you can write a cheque from the practice entity to the trust as a loan. If you do this just write "loan to service trust" on the practice entity's cheque butt. (The amount of the loan cannot be deemed to be a dividend or otherwise included in assessable income provided it is treated as a loan by all concerned.) What income does the service trust derive? As you may deduce from the above, the income derived by the service trust includes the monthly service fee from the practice entity and any non-patient income. Is an administration agreement required? An administration agreement between the practice trust and the service agreement is required. This agreement sets out the services to be provided by the service trust to the practice entity and creates a contractual basis for the payments made to the service trust by the practice entity.
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An administration agreement should have been put in place. If for any reason this has not yet been done please contact us and we will arrange one for you immediately. Can personal costs be paid for by the service trust? Yes, they can. Cash inside the trust can be accessed when required, for example, to pay school fees, home electricity bills, and holidays. When you do this simply write the name of the payee and a brief description of the payment on the cheque butt, and then add words like "loan account beneficiaries" or "private", to flag the payment as a personal cost. We will take these payments to a beneficiaries loan account when preparing the tax return each year. Personal costs paid by the service trust are not tax deductible. What bank accounts should you have? As few as possible. There should be one bank account for you (perhaps jointly with a spouse), one for the practice entity, one for the service trust, and one for a superannuation fund (if you have one). We recommend any surplus bank accounts be closed as soon as possible: they just complicate the accounting process and create unnecessary bank charges for you. It is a good idea to have two credit/debit cards. The first card operates off your personal bank account and should be used solely for private purposes. The second card operates off your practice trust's bank account and should be used solely for business purposes. This means there is no need to keep complicated records of your business costs, because they are automatically recorded on the business credit card and copies can be requested from the bank years later if the original records are lost or destroyed. It also means we do not have to spend large amounts of time dissecting your costs into private and business and the interest charge on your business credit card can be claimed as a tax deduction without difficulty. The private credit card should be paid off before the business credit card. Automatic transfers are very useful, particularly for salary payments. Consider having your salary paid by automatic transfer into your bank account and then using this cash to fund your day-today living costs. Cash in the service trust can be used to fund larger costs. Group Practices Group practices typically use a unit trust to provide services to the practitioners. The units in the unit trust are owned by the practitioners' family trusts. Net income accumulates in the unit trust as service fees paid by the practice entities are received and practice costs are paid out. The practitioners' family trusts derive a share of this net income and this is paid out regularly on an agreed basis. The rules set out above apply to service unit trusts, but typically the service unit trust will not pay any personal costs of the practitioners. The personal costs can be paid by the family trusts. Accounting Systems For smaller practices we recommend Quicken or MYOB, both of which are small business accounting software package, be used to record practice income and expenses. Larger practices may use more complex accounting systems. These should also be used for the service trusts or family trusts, and for superannuation funds. January 2002 Page 64
The great advantage of Quicken and MYOB is their simplicity and the speed users can generate functional management reports on a monthly or even weekly basis. This means you do not have to wait for months after 30 June to find out how you are going. It also allows personal costs to be tracked. This can be an intriguing report to view and can help identify areas of waste and help set family finance policy. If you are not using Quicken or MYOB now we can arrange for it to be installed for you. If you are using Quicken or MYOB we can discuss ways to improve its use, including reconciliations and crosschecks between entities and with the bank statement. We will also be forwarding details of external Quicken training sessions so you can get some extra background and expertise if required. We are also happy to visit to look at the details and suggest improvements. It is quite common for the "front desk" activities to be handled by specialist software set up specifically for medical practices, with a regular download to MYOB or Quicken. This works well too. We trust you find these comments of some help. Please do not hesitate to contact us should you wish to discuss them or should you have any concerns regarding the administrative procedures to follow in your practice. Yours faithfully Terry McMaster Consultant
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2.11 Hybrid Trusts
Hybrid trusts take the best features of a discretionary trust and the best features of a unit trust and blend them together in the one entity to create a very flexible and powerful tax planning solution. How does it do this? There are different approaches. One approach is to allocate units to unitholders. As for most unit trusts the units entitle the unitholder to a fixed proportion of the net income of the trust as at 30 June each year and to a fixed proportion of any capital distributions. However, the income and capital distribution rules also allow the trustee to: by written resolution before 30 June allocate net income between the unitholders other than in proportion to issued units as a percentage of total issued units; by written resolution before a capital distribution, whether on the vesting of the trust or beforehand, allocate capital amounts including net capital gains between the unitholders other than in proportion to issued units as a percentage of total issued units; by written resolution before 30 June allocate net income allocated to a unitholder to persons included in a class of discretionary beneficiaries connected to that unitholder (typically family members and related companies and trusts); and by written resolution before a capital distribution, allocate capital amounts including net capital gains allocated to a unitholder to persons included in a class of discretionary beneficiaries connected to that unitholder.
The attribution principle applies to hybrid trusts. This means specific taxation credits and rebates, and particular types of assessable income, including net capital gains, can be allocated between unitholders and, once so allocated, between individual discretionary beneficiaries connected to that unitholder. As a result there is less likelihood of too much tax being paid because of, say, wasted franking credits or a failure to allocate net capital gains to an individual who has capital losses. Why is this an advantage? The hybrid trust is a flexible commercial structure and is particularly suited to situations where two or more unrelated persons co-own a business or an investment and there is a potential to distribute income, capital gains, tax credits and rebates to related persons. Because there is only one entity, ie the hybrid trust (and a trustee company), hybrid trusts are simple and cheap to put in place. Hybrid trusts can achieve the same commercial results as a partnership of discretionary trusts, but with less legal costs and less accounting and administrative costs (although often the unitholder will be the trustee of a discretionary trust or other entity, and will not always be a natural person). More particularly, the advantages of a hybrid trust are: unitholders can claim a deduction for the interest incurred on the cost of their units. A beneficiary of a discretionary trust is not able to do this. This has an intrinsic tax planning value, but also means it is less likely for a trust to have quarantined interest losses that are Page 66
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locked up and cannot be readily accessed by related persons. This can happen, for example, if a trust borrows money to buy an investment property or if a trading trust incurs business losses; it is comparatively easy for new owners to join and for old owners to leave the structure. Because the class of discretionary beneficiaries are defined by reference to their relationship with the unitholder, a transfer of a unit or an issue of a unit to a new unitholder automatically introduces a new class of beneficiaries without the need to amend documents or, for example, end one partnership and start a new one, with the attendant tax consequences and extra costs; the interests of each owner are protected, and are not subject to a discretionary power on the part of the trustee. The resolutions to distribute net income other than proportionately must be signed by each unitholder to be effective and this protects each unitholder from unfair treatment. This means the units capital value is preserved and the units have a market value and can be bought and sold. This compares to the position of a beneficiary of a discretionary trust who only has a mere expectancy that the trustee may exercise a discretion in its favor, and does not have a separate asses recognized at law; and the difficulties experienced with section 160ZM of the Income Tax Assessment Act 1936 (the Act), where non-assessable income received in connection with units effectively erodes indexed cost base or even triggers a deemed capital gain, can be avoided by allocating this income to a discretionary beneficiary. This means, for example, problems with undercapitalized unit trusts realizing tax-exempt capital gains on the sale of business goodwill can be avoided.
The specific advantages and disadvantages of discretionary trusts and unit trusts are covered in other sections of this manual and do not need to be repeated here. Is it possible to convert an ordinary unit trust to a hybrid trust? Yes. It is possible to convert an ordinary unit trust to a hybrid trust. An amending deed is prepared to delete the income and capital distribution clauses and introduce new flexible income and capital distribution clauses. This deed should be approved by the trustee company and by a general meeting of unitholders, and should be sealed and stamped as required under the law. The capital gains and stamp duty impact of a conversion should always be considered before adopting the amending deed. We can arrange an amending deed for you if required. Readers should also refer to the appendix included at the end of Part 2.5 of this manual.
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3. 3.1 BUSINESS ISSUES Practice goodwill and therefore profits
Readers should also refer to Rising Goodwills at Part 10.3 of this manual. What is goodwill? Goodwill is something practitioners think about a lot. (They also tend to ask a lot of questions about it, which is why we have written this part of the manual.) A mark of a good medical practice is a demonstrable ability to produce an above average return on investment for its owners. Other practitioners will be prepared to pay a premium over the value of the practice's tangible assets in order to share in that above average rate of return on investment. This premium is generally called "goodwill". Goodwill is an intangible asset: it does not have a physical presence and may differ in amount and nature from practice to practice. Why is goodwill important? It is important to understand the basic relationship between a practice's profit and a practice's goodwill. As a practice's profit increases and begins to exceed the amount that a practitioner could earn working similar hours as an employee, practice goodwill is created. A practice that yields a sustainable net profit per principal of $100,000 a year may not have a great deal of goodwill. This is because $100,000 a year does not exceed the amount most prospective owners could earn as employees. A practice that yields a sustainable net profit per principal of $200,000 per year is a different proposition. This is because an amount of $200,000 exceeds the amount many prospective owners could earn as employees. Therefore, in most cases, a prospective purchaser will be prepared to pay a premium to acquire all or part of that practice. This premium represents goodwill. It is solely connected to the profitability of the practice; more particularly, to the expected long term sustainable profits of the practice. This relationship between practice profit and practice goodwill is fundamental and should be borne in mind at all times. It means any plan or strategy to improve a practice's goodwill must first increase its sustainable profit. But what is "goodwill?" More conventionally, and more technically, accountants define goodwill as the excess of the market value of a practice over the sum of the values of the individual tangible assets (office equipment and so on) that are used in that practice. The market value of a practice will only be greater than the sum of the value of the individual tangible assets used in that practice when practice profits are higher than the amount the prospective purchaser can earn as an employee practitioner.
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But what is "market value"? Market value has been defined as the price that a willing but not anxious buyer and a willing but not anxious seller will agree on as the price of a particular asset. This definition assumes the buyer and the seller each have the same information regarding the asset and each of them have other alternatives that they may pursue if the sale is not completed. That is, it assumes that, both the buyer and the seller come to the negotiation table with equal knowledge bargaining power. This basic definition is rooted in legal precedent and history. It is now used as a basis for defining "market value" in a number of other commercial disciplines, such as economics and accounting. In the context of a medical practice, goodwill exists when the expected future profits from a practice exceed the amount the practitioner can earn as an employee. Here, a willing but not anxious buyer will be prepared to pay a premium to acquire a right to receive or to share in the practice's profits. Typically this will occur when the practice has a special quality that cannot be easily replicated, which is not personal to the proprietor(s) and which can be passed on to a buyer with a reasonable level of certainty. There is no complete list of the qualities that may give rise to practice goodwill. An infinite number of possibilities exist depending on the circumstances of the individual practice. However, the qualities that typically reflect (or create?) goodwill in a medical practice include: (i) (ii) efficient support staff that enjoy a friendly rapport with patients; clean modern premises that are easily accessible, have adequate car parking space and, preferably, a play area for children and some form of entertainment for adults, so patients do not find visiting the practice an unpleasant experience; stable and personable assistants and associates who have their own lists of patients and who are able to operate at a maximum capacity with minimal supervision and control (and who do not intend to, or who are contractually prevented from, setting up an opposition practice in the same locality); relationships with allied health care professionals, such as physiotherapists, pathologists and chemists, so the practice attracts a continuous stream of new patients and is able to provide a broad range of medical and health services to its existing patients; increasingly, a market niche or practice specialty that attracts a particular type of patient, as well as the general practice patient. Examples of this include geriatrics, sports medicine, a language expertise and women's medicine; location, both within a particular suburb and as to the choice of suburb or region itself, and the related issue of a practice's physical presentation; and in some cases, specialist equipment that has a cost or rarity creates a barrier to entry for a particular type of procedure or service.
(iii)
(iv)
(v)
(vi) (vii)
These qualities distinguish a medical practice from its competitors and create a sustainable competitive advantage that can be passed on to a new owner. This creates goodwill. Others will be prepared to pay a premium over the value of the practice's tangible assets in order to acquire all or part of that practice. January 2002 Page 69
How can we improve the profitability and the goodwill of my practice? The best way to improve the profitability and goodwill is to pay close attention to each of the qualities described at sub-paragraphs (i) to (vii) above. Consider these qualities from the point of view of your practice and ask what can be done to improve them. The purpose of this exercise is to allow you to systematically put in place a process aimed at maximizing your practice's profitability and goodwill. Be honest. The practice that cannot be improved has not yet been created. (And if it has it should be patented.) As a suggestion, it may be a good idea to ask another practitioner whose views you value to prepare a critique of your practice and to list out ways your practice can be improved. The external objectivity provided by such a person can be a powerful prompt to action, and it could be someone else will think of things that wouldn't occur to you on your own. As a further suggestion, perhaps you could identify other practices in your locality (and elsewhere) and ask: (i) (ii) (iii) (iv) (v) (vi) (vii) what (if anything) about this practice would appeal to a patient? What (if anything) about this practice would appeal to different types of patients? what hours is this practice open? How does it deal with out of hours calls? what type of services does this practice offer its patients? Is there a special niche this practice fills creating a unique demand for its services? how many practitioners are involved? Are other services (for example, physiotherapy or a pharmacy) offered from the same premises or nearby? do the assistants and associates engaged by this practice have their own patient following and loyalties? are out of surgery visits available? how good are this practice's support staff? Do they have an efficient and personable rapport with the patients? How well do they complement the professional staff? do the practice's premises have easy access and good parking facilities? what type of patients does this practice have? Does it rely on repeat business and build up strong personal relationships or is it a high turnover practice? how are patients billed? What proportion are bulk billed? what is the average time spent with a patient? does the practice qualify for the PIP and other blended payments? what other advantages or disadvantages does this practice appear to have?
The answers to these questions may not describe your concept of an ideal practice. Personal preferences are important. But the process of reflecting on what others are doing can be a January 2002 Page 70
fruitful source of new ideas and of change and renewal for yourself. The answers to these questions should provide a ready-made guide to the question of how you can improve the profitability and the goodwill of your practice. Remember, the essence of goodwill is whether a practice has a sustainable competitive advantage that generates above average profits can be passed on to a new owner and for which other practitioners will be prepared to pay a premium. The potential purchaser has to be convinced it is worthwhile paying that premium rather than starting a new practice from scratch. The vendor should think about these matters years before to ensure his or her practice commands a premium for goodwill upon ultimate sale. An example If your practice is operating from premises that are not as good as the premises occupied by other practices in the locality it could pay you to up-grade them. This can be done either by renovating or by moving to better premises. If the cost of doing this is a problem consider sharing the premises with other practitioners or with an allied professional. Perhaps the renovation could create space for another assistant, whose fees you can thereafter share. Remember, the idea is not to just spend money, but to spend money to make more money. If the extra fees generated by attracting new patients do not exceed the cost of renovating or moving, then you should not do it. (But this is rare: generally we find practitioners spend too little money on their premises. Spending more will make more.) If your practice is overly reliant on you, it could be a good idea to engage someone to take over a group of patients. Ideally a practice will have a principal to staff ratio of at least 1:2. That is, for every proprietor practitioner there will be the equivalent of two employee practitioners. The professional staff should be encouraged to develop their own lists of patients and to remain with the practice for a long period of time. The profit leverage created by the smart use of professional staff will enhance practice goodwill. This is because of the obvious increase in profit but also because the practice is less dependent on the proprietor: personal goodwill, which is not worth much, has been traded for practice goodwill, which can be worth a lot.
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Practice premises Practice premises have a significant effect on practice goodwill. Modern, well-located premises with good access and parking and with appropriate facilities attract patients. Patients do not like visiting sub-standard practice premises. There can be a symbiotic relationship between a good practice and good practice premises. Certainly appropriately presented practice premises improve profitability and therefore increase goodwill. They can also be viable as stand alone investments. Practice premises and the relationship with the practice's goodwill should be given close and detailed study by each practitioner. Strategies for acquiring and holding practice premises are dealt with in detail in Part 6.2 under the heading "Should you own your practice premises. If so, how?". The valuation of practice goodwill The valuation of practice goodwill is a difficult area. Benchmarks and rules of thumb exist, but they should be used with some discretion because they may not be perfectly applicable to the particular practice under review. The essence of goodwill is whether the practice has a sustainable competitive advantage that is able to generate sustainable above average profits that can be passed on to a new owner. If it does, other practitioners will be prepared to pay a premium over the cost price of the practice's tangible assets in order to acquire the practice. Describing goodwill may be straightforward, but it leaves open the question of how to value goodwill. The AMA suggests a rule of thumb to follow is goodwill should be equal to one third of a practice's gross billings. A half share of a practice with gross billings of $600,000 would therefore be valued at $100,000 (ie., $600,000 times 50% times 33.3%). Plant and equipment will be purchased separately at market value. In some cases this may be an accurate approach that satisfies both the vendor and the purchaser, and any other interested person. But this approach should be used with care. For example, you should ask what happens if: (i) the practice is only grossing $100,000 and has costs of $50,000. Its profit is therefore only $50,000. Would you pay $30,000 for a practice that makes less than the market value of an owner's salary? the practice is relying predominantly on the bedside manner and personal qualities of a sixty five year old principal who has cared for most of the patients for years. His patients are his (old) friends. Should a thirty five year old practitioner take the plunge with this practice? the practice has gross fees of $500,000 and is based in rural Victoria. The local community could easily absorb another two or even three practices before the supply of medical services will begin to exceed demand. (Most locals now travel 30 kilometers to the nearest regional centre for medical treatment.) Would you pay $75,000 for a half share of this practice, or would you set up a practice next door? What happens if you do pay $75,000 and then someone else sets up next door?
(ii)
(iii)
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Clearly each of these examples is problematic. We would not advise a client to buy into any of the above three practices (unless the price was very low, say $20,000 to $25,000). We would be inclined to say "set up your own practice" as in each case it is just not worth paying anything for a share of the practice. The DIY option can be the best option. So use rough benchmarks and rules of thumb with care. They are meant to be rough guides to market value. They are not meant to take on a life of their own as immutable laws to apply to all situations regardless of the facts at hand. A detailed analysis of how to value a practice, including a worked example, is set out in Part 3.2 of this manual. Current Trends: corporatisation Up to about 2000 the trend was to downgrade a practice's goodwill on the basis of a trend to bulk billing, cost pressures, a trend away from fee for service arrangement, competition, a preference on the part of younger practitioners to stay as employees and so on. These are all things we read in valuations prepared by other firms around that time. The conclusions are goodwill has fallen as low as 15% of goodwill. We do not agree with this: valued more objectively medical practices represent sound investments for practitioners and returns as high as 50%, and sometimes much, much higher (on top of a labor reward) are common, and excellent. Where else is a practitioner going to get an investment that performs as well as this? Since 1999 the phenomena of corporatisation has changed the way general practices are valued. The corporates tend to value practices as per the methods described above, and using a valuation multiple of 5. This is a very high multiple, and no doubt it is justified by the hidden value of radiology and pathology business referrals. But practitioner-to-practitioner sales of practices are largely unaffected by this phenomena, and we do believe corporatisation is not generally relevant. This is because the average practitioner purchaser is unable to realize the hidden value of the radiology and pathology referrals, and hence this should be ignored in a practitioner-to-practitioner sale. A special note for specialists The position of specialists and practice goodwill is more difficult than it is for general practitioners. The stronger emphasis on a refined and focused body of knowledge and the greater need to rely on a body of referring practitioners means the specialist practitioner is less likely to be able to sell his or her practice at a price that shows goodwill. But there can be exceptions. For example, a medical-legal specialist could be able to gather together a small team of professionals to provide services under a common letterhead. Here it will be the letterhead that is important, and not the particular practitioner who signs that letterhead. Goodwill exists here. In certain specialties, such as radiology and pathology, the need for a wide distribution network and the need for a large amount of capital expenditure create almost insurmountable barriers of entry. A practitioner who wishes to practice in these areas has little choice but to join an established practice and, after having earned his or her stripes, buy in to the practice at a price which reflects (generally a serious amount of ) goodwill. We have seen ophthalmologists achieve large goodwill payments, particularly where laser techniques are used. We have also seen periodontal practices do very well. January 2002 Page 73
Generally specialists should forget about goodwill and look to maximizing their long-term wealth by maximizing profits and by directing excess cash into other investments. Goodwill and Solo General Practices A solo general practice can certainly have goodwill and is no different in principle from larger multi-practitioner partnerships. This is particularly when the practice engages several employees and is not dependent on the one person for its goodwill. In fact, the most valuable practices we have seen are solo practices that engage four or five full time assistants. Goodwill here can exceed $300,000 (and the solo practitioner owns all of it). Corporate sales can achieve even higher goodwills. Succession Planning There are many reasons for solo practitioners to put special arrangements in place with other practitioners in case the solo practitioner becomes unable to run the practice. These reasons also apply to partnerships, but are particularly relevant to solo practitioners. Without an appropriate succession plan services to patients will be disrupted. And this means that profits and goodwill will fall. Similarly, if there is an unexpected death, a succession plan helps ensure dependants receive an appropriate value for the practice. Remember, amounts borrowed to help acquire or establish the practice will not be reduced just because the practitioner has died or has fallen ill. Where there is debt a payment for goodwill may be required just to break even. Possible Solutions Some possible solutions to this problem are to: (i) enter into a reciprocal management agreement with a similar sized solo practice (or practices) under which each practitioner agrees to assist the other practitioner in the event of one practitioner falling ill or dying suddenly; enter into a reciprocal buy/sell agreement with another practitioner under which each practitioner agrees to buy the other practice in the event that other practitioner falls ill or dies suddenly, (a renewable term insurance policy and a trauma insurance policy on the life of each other practitioner is a good means of ensuring adequate funds are available for the surviving practitioner to pay for the other practice); or at a less formal level, locate your practice so it is physically close to the other practice similar to yours in terms of services offered and patient ethos. In the event of an unexpected sickness or death, your staff can simply direct patients to the other practice. Your goodwill may go with them, but at least you know your patients are looked after properly.
(ii)
(iii)
Each of these options may avoid the damage an unexpected illness or death can wreak on a solo practice. We recommend any agreement address each of the following issues in detail: (i) what responsibilities and authority will the managing practitioner have on matters such as staff, the payment of costs, the rendering of bills and other practice details;
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(ii) (iii) (vi) are the procedures, policies and patient ethos of the practitioners' sufficiently compatible?; do your staff and patients know the succession planning procedure?; and does the indemnity insurance policy contemplate the arrangement by ensuring that the same cover applies to the "manager" as applies to the practitioner?
The actual way these matters are addressed will differ from case to case. A further thought As a further thought, consider the effect that a good succession plan may have on your own practice's goodwill. The plan should apply to a purchaser too, so you are able to deliver a more certain stream of income to any proposed purchaser of the practice. This on its own should lift the value of your practice's goodwill.
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3.2 The valuation of a medical practice
We are frequently asked to comment on the value of a client's medical practice. The question can be asked for a variety of reasons: the client may be interested in selling all or part of his practice, the client may be interested in buying all or part of a practice, a divorce might be in the air or the client simply wants to know what his practice is worth. The question is asked more frequently in the case of a partnership than a sole proprietorship. For obvious reasons there are more changes in partnerships than there are in a sole proprietorship. Value needs to be calculated each time a partner leaves or joins the partnership or the fractional shares of the partners change. Whatever the motivation behind the question, it is one that is frequently on the minds of clients. The question of how to value a practice is closely related to the question of goodwill, which is often the most valuable asset in a practice. Goodwill is looked at in part 3.1 of this manual. In this part of the manual we look at the mechanics of valuing the goodwill of a practice and put forward a sample valuation to give you some idea of what to look for in a practice and, perhaps, some idea of what your advisors are talking about when this topic comes up. What type of value The first port of call is a brief consideration of what is meant by "value", and how valuers use this word. Broadly speaking there are at least three types of value referred to by valuers. These are "market value", going concern value" and "economic value". Ultimately there is only one value, being the amount a person is prepared to pay to acquire the business or part of it. Or, more hypothetically, the amount a willing but not anxious buyer and a willing but not anxious seller would agree on as the sale price of an asset provided all relevant information is available to each of them. However, these three terms help to shed light on how this amount may be computed depending on the relevant circumstances. "Market value" is a term that implies an identifiable market of buyers and sellers This allows the valuer to determine the price to be paid for the practice by reference to comparable sales. "Going concern value" is the price a buyer is prepared to pay on a walk-in walk-out basis. "Economic value" exists where a buyer is prepared to pay a premium above the price suggested by the market in order to access or obtain some special advantage connected to the practice. Such an advantage might be the opportunity to access a particular type of patient or to practice in a particular geographic area where barriers of entry are high and custom takes time to develop. It is possible, even likely, these three values will be different in any given situation. This is quite normal. The only real value will be the value a person is actually prepared to pay to acquire the practice under consideration or, more hypothetically, what a willing but not anxious purchaser and a willing but not anxious buyer would agree upon as the sale price in this situation. This is what a valuer has to estimate when a medical practice is being valued. Each of the above three concepts of value have some role to play in doing this but none of them on its own will be determinative of the final outcome of the valuation process. A real life example January 2002 Page 76
The example used in the following paragraphs is based on a client situation and the actual figures involved are realistic. They have been altered to simplify the presentation and to preserve client confidentiality. The first step: calculate future maintainable earnings The first step is quite straightforward. Historical accounting reports prepared by accountants and used for things such as income tax returns are used to estimate the "real earnings" of the practice. "Real earnings" is the actual reward from all sources accruing to the owners from the practice. To compute this amount one normally uses an average of at least three years and adjusts profit for the effect of: (i) (ii) transactions with the persons who own the practice or who are related to the practice; and transactions that will not be experienced by the new owners. 1998 55,000 6,000 20,000 5,000 24,000 15,000 125,000 20,000 Nil 105,000 1999 50,000 5,000 20,000 15,000 24,000 16,000 130,000 Nil 10,000 120,000 2000 45,000 5,000 20,000 25,000 18,000 20,000 133,000 Nil Nil 133,000
An example may help. Accounting Profit Adjust for related party transactions Second Car Spouse Salary Superannuation Management Fee paid to Management Trust (adjusted for actual costs) Interest on Rental Property Adjusted for non-recurring items that will not be experienced by a new owner Sessional Work Elsewhere Locum Fees Incurred True Earnings
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The average is then computed (this bit is pretty straight forward): 1998 133,000 1999 120,000 2000 105,000 Total 358,000 Average 119,333
So the amount of $119,333, being the mean average of the three years, is taken to be the best estimate of future maintainable earnings. This is thought to be the best measure of renewable profit connected to the practice. This amount is then used as a basis for all subsequent calculations. The second step: determine the value of the multiple The second step is less mechanical than the first step. It requires the valuer to determine an appropriate multiple to apply to true earnings in order to estimate value. The determination of the multiple requires the valuer to apply logic, business experience and intuition. It is more art than science. Any two valuers will probably come to a different multiple and this is quite acceptable: the difference would reflect their differing perceptions of the strength of each component included in the determination of the multiple. The higher the multiple, the lower the valuer's assessment of the risk attached to the business and the greater the value of the business. One method of determining the appropriate multiple for a medical practice is to identify each of the factors that are believed to be critical to a practice's success and to then allocate to each of these factors an optimum score reflecting the relative importance of that factor in the valuation process. Each factor is then scored and the sum of the scores compared to the sum of the optimum score to determine the strength of the multiple. This approach is very flexible. It allows the practitioner to weight each factor according to the practitioner's own view of their relative importance to a practice, and to add or delete factors as they think appropriate. This calculation might have looked like this: Attribute Patients Loyalty New Patients Activity Number Premises Parking Aesthetic Appeal Functional Appeal Tenure Optimum 10 10 10 10 10 20 20 20 Score 5 5 5 9 9 7 18 10
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Attribute Location Access Population Growth Socio Economic Factor Geographic Location Competition Distance Other Referral Sources Staff TOTAL Multiplier Equals 186/300 = .62 In this example the multiple has been determined to be .62. But it is important to stress this is a very subjective value and your value may be different to it and for good reasons. There is no reason why you should not create your own list of factors to be considered and give them an optimum score that reflects the relative importance of each factor to you. This is actually what we ask our valuation clients to do: this makes the valuation their valuation. We just guide them through the formal thought processes underpinning the valuation. There is every reason why different prospective purchasers would attach different relative importance on each factor and then score them differently. In fact, one would expect this to happen. This is the advantage of this approach: it is very flexible and can be adjusted to meet different circumstances. This multiple is then applied to the estimate of future maintainable earnings of $119,333 obtained earlier to determine an estimate of the value of goodwill of $73,986 (ie, $119,333 times .62). In other words, in the valuer's opinion a willing but not anxious buyer and a willing but not anxious seller would agree to a price of about $74,000 to acquire the goodwill of a practice with the above characteristics and that has produced an average earnings for its owners over each of the previous three years of $119,333. The third step: adjust for other factors You may have noticed true earnings declined over 1993 to 1995 (ie., $133,000 in 1993, $120,000 in 1994 and $105,000 in 1995.) This is so despite accounting profit increasing in each of those years (ie., $45,000 in 1993, $50,000 in 1994 and $55,000 in 1995). This highlights the reason for making adjustments for payments to related persons and for non-recurring incomes and expenditures. Accounting profit will not always tell the whole story regarding a medical practice's profits and profitability. In this case, the position got so bad the owner had to do after hours sessional work in a large clinic a few kilometers from his practice during 1995 to maintain cash flow. This extra $20,000 was, of course, recorded as income in the practice's accounts. The difficulty here is this extra $20,000 is not intrinsically connected to the practice. It has nothing to do with the practice. January 2002 Page 79 Optimum 20 30 20 20 30 20 20 30 300 Score 12 10 18 18 15 15 10 20 186
Clearly an adjustment is required to the proposed purchase price to reflect this. The purchaser has investigated the reason for the decline in true earnings and believes the old owner got tired and didn't keep his bedside manner up to what it should have been. The clinical standards were maintained but some patients were put off by an increasingly gruff and unfriendly manner. These problems can be fixed but the purchaser believes it will take some time to do so. Therefore the purchase price of the practice should be adjusted appropriately. The purchaser should not have to pay for goodwill he will have to create/win back himself. There is no hard and fast rule for making this adjustment, but the purchaser's accountant suggested it should be a dollar amount of $27,563 being the difference between 2000 true earnings of $105,000 and the average earnings for the three years of $119,333 adjusted for the effect of income tax at the top tax rate of 48%. This amount of $27,563 was calculated as follows: 2000 True Earnings Average for the Period Difference Adjustment for Taxation (ie divide by 1-48%) 105,000 119,333 14,333 27,563
This adjustment could also have been made by listing "upwards trend in earnings" as a factor and then giving a negative score. Either way the effect will be pretty much the same and this method has the advantage of highlighting the problem and perhaps focusing discussion on it more than otherwise would have been the case. The final result So the final valuation of the goodwill of this practice was agreed by the purchaser and the vendor, with just a little bit of assistance and advice from each of their accountants, to be $46,423, being $73,986 less $27,563. This figure represents the summed effect of the purchaser's impression and expectations of the practice and is to a very large extent arbitrary. It is within the range of values observed for comparable sales, is within common sense limits and does not defy logic in any way. Plant and equipment Plant and equipment, furniture and fittings and other tangibles assets would be each valued separately. A further payment will then be made by the purchaser based on the agreed market values of each of these assets. Are there alternative valuation methods? Yes, there are. For example, we understand the AMA suggest a reasonable valuation of a medical practice can be obtained by multiplying a factor of between 15% and 35% to gross fees generated. A typical factor for these valuations appears to be about 30%. This approach, as simple as it is, seems to be historical entrenched in the minds of practitioners and is often used in valuing medical practices without any real attempt to analyze the practice's profile in a more scientific way. The difficulty is it is too mechanical and does not deal with issues other than gross fees. These issues may well have an overwhelming influence on the valuation of the practice. For example: (i) it does not consider costs. Some practices will have a much more favorable costs profile than other practices. It seems sensible to take this into account by basing the valuation Page 80
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methodology on net earnings rather than gross fees. If you do not do so different practices will be valued similarly just because they happen to have similar gross fees, for example, taking on an associate who bills what he costs will increase value but will not increase net earnings. This is not sensible; and (ii) it does not consider non-financial matters. For example, it does not take into account expected future competition. A potential purchaser may well be cognizant of this but the valuation process will not highlight the problem.
If this approach had been used in the above example the client would have paid too much for the practice as average gross revenue (and revenues for 1995) was more than $260,000 a year. Based on a factor of 30% this would have valued the practice at $78,000. In our view that would have been too much. We believe this valuation approach is too simplistic, too rigid and fails to take into account all relevant matters that may affect value. We do not recommend it to our clients. The due diligence process The phrase "due diligence" is an American phrase that emerged in the late eighties as a convenient tag to describe the various procedures and processes that should be carried out in order to identify whether a proposed business acquisition is appropriate or whether it is suspect for any reason. Basically, if an advisor could not demonstrate due diligence had been applied in this situation then that advisor could be sued by the purchaser for its lost profits and the costs connected to the failure to exercise due diligence. The phrase is not a term of art and it is a useful and evocative way to describe the processes that should be carried out by a practitioner to prove what he is getting is really there. The range and type of questions asked will depend on the circumstances. But be careful. You can't ask for too much and we have seen situations where, after a few pertinent questions were asked, the practice was suddenly withdrawn from sale. Conclusion? The figures were rubbery and didn't stack up. Our client bought elsewhere.
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3.3 How to buy a practice
Introduction A practitioner entering practice is faced with the question of whether to start a new practice from scratch or whether to buy into an old practice. Both options have their advantages and disadvantages. Starting from scratch is probably the harder and more daunting option, but it has the advantage you do not have to pay for goodwill. It also has the advantage you can be the master of your own ship and are not restricted by what your predecessor did or what your new partners do. Location, staff and premises are an open book. You can write the story. You create your own goodwill so there is the possibility of selling it to another practitioner down the track: the fifty per cent exemption for capital gains on the sale of goodwill and the rollover rules for the rest of it (see part 4.9) can make this a very attractive option. On the other hand, buying into an established practice or buying into an established practice has more certainty, as you can be more confident the patients will be there. This lowers the risk factor and heightens the prospect of a good income from day one. Often the practitioner will have worked in the practice for a while so he or she knows what they are getting, and, where they have contributed to goodwill, this can be reflected in a discounted buy-in price. The downside to buying is, of course, you have to pay and there is no guarantee you will be able to get your money back in the future. There is no definite right or wrong here: some practitioners are better off starting their own practice and some are better off buying an established medical practice or buying into an established medical practice. It depends on the circumstances of the practitioner, the circumstances of the practices available for purchase and the type of practice the practitioner wants to be involved with. In this part of the manual we assume the decision is made, or is about to be made, to buy a practice. We then look at a number of practical things that should be done to help ensure all goes well. This part is written from the point of view of a prospective purchaser but also gives interested vendors some insight into the sale process. A checklist of things to consider when buying a practice is included at part 3.3. Things to consider when buying a practice The phrase "buying a medical practice" should be read as including buying a share in an existing practice whether as an associate buying a right to practice, a partner buying a share of a partnership's assets or as a shareholder buying shares in an IMP. We assume the purchaser will also take over any rights to provide management services to the practice, which are commonly owned by a separate service trust, and this is included in the assets being sold with the practice.
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What assets are being purchased? The first thing to consider is what assets are being bought. Typically they will include: (i) the practice's goodwill. This generally includes patient lists and records, the benefit of expected repeat business from those patients, the benefit of the reputation and name built up by the practice and the benefit of the relationships established by the practice's owners and staff with patients over the years; the practice's plant and equipment. A detailed schedule of plant and equipment should be prepared. The vendor should be asked to confirm he has good title to these items and they are not subject to any charge or other encumbrances that restricts his ability to deal with them. If such an encumbrance exists the vendor should be asked to arrange for it to be lifted as a condition of the sale proceeding. Be careful with leased equipment: if you are buying leased equipment then either: (a) (b) (iii) part of your purchase price should be forwarded directly to the lessor as payment of the amount owed on the lease; or the amount of the purchase price should be reduced by the amount of the lease liability you are assuming responsibility for; and
(ii)
medical supplies and other supplies. Usually these are not worth much and you can afford to be a bit brief here. But this may change if the practice is larger than usual.
Is the price right? This is looked at in detail in part 3.1 and part 3.2, which deal with "Practice goodwill, and therefore profits" and "The valuation of a medical practice" respectively. We assume here the valuation of the practice is reliable and all the normal enquiries and investigations into the practice's financial history have been completed. Suffice it to say here you should ask yourself whether it is cheaper to take the risk of setting up your own practice from scratch. If it isn't, you should then ask the question "Is it possible to get the purchase price down?" This is essentially a matter of negotiation. Bear in mind if you get the purchase price down by, say, $10,000 that is $20,000 of future profits you do not have to earn (and you have just completed an excellent day's work). On the other hand, the vendor may just turn around and sell it to someone else. Negotiations are a dynamic and we find backing your own intuition is typically the best thing to do. Get someone else to double-check your thinking and to make certain you are not rushing. But at the end of the day you will have to live with your own decision on the matter of price. Do not be shy to say you want more time to think things through. Do not let yourself be rushed. If you lack confidence in your ability to negotiate a deal think about getting someone to do it for you. Emotional indifference can be a wonderful thing in a negotiation and can put an objective analysis over the whole proposal. Once a price is agreed then you should forget it. Negotiations are difficult things and in most cases you will never know whether you could have gotten a better price. We find it is best to not think too much about it. Once the price is agreed you should just get on with making the practice work. Deferred payment January 2002 Page 83
One thought to bear in mind is the potential for some part of the purchase price to be deferred for, say, a year. If this is done, and for any reason you are not happy with the results from the practice, the door is at least open for you to withhold all or part of the final payment due to the vendor unless an appropriate adjustment is made. Whether this can be done will depend on the facts. But bear in mind adjustments are a lot harder to make when you have paid all of the purchase price up-front: doing this doesn't leave you much bargaining power later on. Apportionment of purchase price How to apportion purchase price is a frequent source of argument between the vendor and the purchaser, particularly if the plant and equipment is significant. The vendor will typically be interested in minimizing the amount of the total consideration apportioned to plant and equipment because, to the extent this amount exceeds written down value, it will be assessable income in the vendor's hands for taxation purposes. On the other hand, the purchaser will be interested in maximizing the amount of the total consideration apportioned to plant and equipment because this will maximize the depreciation expense able to be claimed by the vendor in subsequent years. There is no hard and fast rule as to what to do here: the matter is often settled by giving plant and equipment a value equal to the vendor's written down depreciation values for income tax purposes. Common sense comes into the settlement of this question. You should be wary of adopting values that are plainly unrealistic. These will be problematic in a tax audit: you could find some part of your depreciation claim being disallowed on the basis the original cost of the plant and equipment is artificially inflated. Council zoning permissions It might sound obvious, but you would be amazed how often this simple check is overlooked: a failure to check zoning permissions is one of the most common mistakes in a sale of business transaction. Don't just assume a practice can be run from the premises because one is run from there now. Get it in writing from both the vendor and the council (or any other relevant body). Assumption of responsibility for the vendor's debts Great care needs to be taken here. Few advisors recommend purchasers should buy the shares of a private company that carries on a small business such as a medical practice. Not only do you get the assets of the business but you also get the liabilities of the business. This include liabilities which are not shown in the balance sheet, such as litigation not yet commenced, guarantees not yet invoked, liabilities for undisclosed (or as yet unknown) income tax liabilities, and so on. For this reason it is unusual for one practitioner to buy the shares in a medical practice company owned by another practitioner. Do not do it unless you get specific professional advice and appropriate safeguards are put in place, such as written guarantees and indemnities from the company's directors. This is standard advice given by any solicitor or accountant who is experienced in helping clients buy businesses. It is not something peculiar to the purchase of a medical practice. January 2002 Page 84
(If you are buying into an existing practice company a better way to go is to roll over the assets of the old company to a new company and for you to then subscribe for fresh shares in the new company. Provided certain rules are observed this means the roll over will be ignored for tax purposes. You can be certain the shares will not be tainted by any latent liabilities that are not shown in the balance sheet, or of which the current shareholders may be unaware. Get specialist tax advice if you have any concerns here.) It can be sensible for the purchaser to assume responsibility for specified debts of the vendor. For example, the practice may be one year into a five-year lease on computers that cost $30,000. The lease is at a competitive interest rate and is with a reputable financier. Provided the financier consents to the transfer of the lease and there are no unpaid amounts. Taking over the lease can be a smart way to part pay for the practice. Of course, if this is done the sale price of the practice should be reduced by the amount of the liability assumed by the purchaser. In our example this means $30,000 will be knocked off the purchase price of the practice. Employee Liabilities A purchaser will normally be interested in keeping on the practice's staff. They can represent a good part of the goodwill of the practice and continuity of staff can be very important for practice systems and patient relationships. However, there can be many sensible reasons why a purchaser may choose not to keep staff on. The staff may not be good enough, there may be too many staff or the purchaser may have a preferred person in mind for the job, such as a spouse who is a qualified nurse or receptionist. The question of which staff to keep and which staff not to keep is an important question which should be answered (at least tentatively) before you agree to buy the practice. Purchasers need to know whether they will be liable for any employee liabilities such as annual leave, sick leave and long service leave. If there is doubt as to whether this will be so, for example, if there is an employee who has thirteen years employment and who will probably become entitled to three months' long service leave in two years time, then some adjustment to the purchase price needs to be worked out. This is a notoriously difficult area. One possible solution is to have an amount of the purchase price equal to thirteen fifteenth's of the expected long service leave paid into a special bank account and use it to help fund any long service leave payment. If for any reason the long service leave payment is not made then the amount in the bank account will be handed over to the vendor. But this will not be appropriate in all cases, particularly where there are a few employees and some have, say, five years to go before they are eligible for long service leave. Restraint of trade clauses A restraint of trade clause is an essential part of any agreement to purchase a medical practice. It helps to make sure you actually get the goodwill you have paid for and your patients do not suddenly disappear. This is because if there is no restraint of trade clause then it is possible for a practitioner who sells a practice to turn up a month later around the corner with a new shingle on the wall. The practitioner would not be able to directly approach the old patients, but it won't take long for January 2002 Page 85
them to realize he is there. The restraint of trade clause should put in place a reasonable restriction on the vendor of the medical practice regarding each of: (i) (ii) (iii) the type of activity restricted (ie., medicine and, perhaps, health care generally), whether as a principal, a partner, an associate, an employee or otherwise; the geographic area restricted. A reasonable geographic restriction is usually not more than, say, between five and ten kilometers from the practice premises; the time period restricted. A reasonable time restriction is usually three years. This period could be longer if an unusually large amount is paid for goodwill.
Deferring part of the purchase price for, say, one year, is a good way to add business efficacy to restraint of trade clauses. It gives the purchaser of the medical practice some bargaining power should anything go wrong. Sale of book debts It is common for the purchaser to pay an additional amount for the vendor's book debts, whether they are from private patients, Medicare, Veteran Affairs or whatever. This simplifies the cash collection process in the months following the change of ownership. The risk to the purchaser is a particular debt may in fact not be able to be collected and to guard against this a buy back rule should be put into the agreement under which the vendor is required to buy any uncollected debts off the vendor should the debt remain uncollected as at, say, three months from the sale date. The purchaser will be required to include the collected debts in its assessable income computation and a deduction should be available for the cost of the debts. Premises The right to use the premises, whether as an owner or as a tenant, is a critical part of purchase agreement. It would be a disaster if you paid, say, $100,000 goodwill for a practice only to find three months later the landlord is not willing to renew the lease. Unless there was a specific term in the agreement saying tenure was guaranteed then there is probably little that can be done to help you here. For this reason the purchase agreement should ensure you get reasonable tenure and, if for any reason this is not able to be given, the goodwill should be marked down heavily. Tenure can be provided to a purchaser in a number of ways. These include: (i) if the vendor leases the premises, assigning the vendor's rights as a tenant under the lease agreement to the purchaser. The landlord's consent is required and is normally given without too much trouble; and if the vendor owns the premises, arranging for a fresh lease to be granted to the purchaser for, say, five years with options to extend the lease, as required.
(ii)
Warranties and Guarantees It can be a good idea for a purchaser to obtain third party guarantees from the vendor. For example, if the vendor is an IMP a guarantee from the directors is appropriate. January 2002 Page 86
This guarantee can be obtained indirectly, for example, by having each of the directors' names on the purchase agreement. This can add some confidence to your decision to buy the medical practice. One reasonably common warranty is a clause to the effect that the vendor has disclosed to the purchaser all matters which are known to him and which are relevant to the valuation of the medical practice. If for any reason the vendor is reluctant to agree to such a clause then you should probably walk away from the deal: something is being hidden from you and it probably is not going to be good news. Notice to Patients Practitioners do not own patients. Patient relations must be managed properly as the practice changes hands. The purchaser will be particularly interested in making sure this is done properly because this is why he is being asked to pay goodwill. Appropriate written notice should be given to all patients and this notice should stress the skills, experience and other attributes of the incoming practitioner. At the least, a notice should be put up in the surgery, say, one month from the change in ownership. You should consider notices in the local paper and, perhaps, writing to each patient to advise them of the change. If the new practitioner is buying into a partnership it can be a good idea for the retiring practitioner's patients to be invited to see the remaining partners as well as the new practitioner. This gives them a choice, and should reflect in better retention rate for the partnership as a whole. In the case of a solo practice the need to manage patients through a change over is even more important. The purchaser should insist on a phase-in phase-out arrangement where the vendor fades out of the practice over an extended period, say a year. If this is done properly the patients may virtually not notice the change. A purchaser should be prepared to pay more for goodwill where this is a phase-in phase-out arrangement: there is a greater prospect of retaining the patients loyalty. Consider a deposit of, say, ten per cent and then twelve instalments of the price over the phase out year. If after a few weeks (or months) it is clear patients do not see you as a good replacement for the vendor you should discontinue the arrangement. Yes, you may lose your deposit. But it is better to lose 10% of your money than it is to 100% of your money. Patient relations throughout the changeover are the most important thing for the purchaser to consider. Mistakes can spell disaster. Some attrition is normal, but you should be interested in limiting it to no more than 10% of patients. You should be aiming to grow the practice by more in the first year, so this balances itself out. Potential of the practice When making a decision to buy, think about the potential of the practice. A new face can be a breath of fresh air in a medical practice. A new coat of paint can help too. Many people in the area may decide to give you a try to see what you are like. The matters dealt with in other parts of this manual can, if properly applied greatly enhance the value of the practice and hence the value of your investment in it, so we strongly recommend that these matter be taken on board and applied in your practice. January 2002 Page 87
Word of mouth is the strongest form of advertising. Positive word of mouth advertising is not as strong as negative word of mouth advertising, so be on your best behavior. Remember you paid for the patients, so you better look after them. A final word As a final word, if you are not already conducting your professional activities through an IMP and a service trust, now is the time to start. The after tax cash savings this will generate will take the sting out of the buy in price and will accelerate the pay back of any loans that may have been needed to fund the purchase. These savings can take tens of thousands a year off your tax bill and, after a few years, this will pay for the practice. Starting a new practice is the ideal time to get your business structure right.
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3.4 Checklist for buying a practice
It is not possible to cover all matters that should be considered by a practitioner before buying a practice. The list is endless and differs markedly from case to case. What is important in one case may not be important in another. In this part of the manual we have simply set out in question form a checklist of matters to be considered by a practitioner contemplating buying a practice or buying into a practice, whether as an associate or a partner. Buying into a practice can be a very big step that involves one of the largest cash outlays made by a practitioner. Unlike buying physical assets, such as a home, you do not get something you can lay your hands and eyes on. A practice, and the goodwill within a practice, is an intangible asset without a physical existence. It can also be a very transitory asset, that is here one day and gone the next. For this reason caution at the beginning cannot hurt and can help avoid problems further along the way. This checklist applies to solo practices and group practices. When buying into a group considering these matters can lay a firm basis for future dealings between the practitioners. Professional advice A solicitor or accountant who has experience on the sale and purchase of practices should be consulted as early as possible once a sale or a purchase is in contemplation. Before you start What are your reasons for going into practice as a principal? How does the practice compare with alternatives, either as an associate or an employee? Are you suited to being a principal? Do you have the financial stability to be a principal? What hours will be involved? Have you spoken to an accountant? Have you spoken to a solicitor? Have you spoken to your spouse? Have you spoken to a bank manager? How long have you known the vendor for? How long have you known the practice for?
Assessment of value of the practice Has an expert valuer been consulted? How has the practice performed over the last three years? How is the practice expected to perform over the next three years? Does the practice have a potential that is not yet being tapped? What accounting records, tax returns and source documents are available to support the financial performance of the practice? What is the value of the plant and equipment included in the sale? What is the value of the furniture and fittings include in the sale? Are comparative figures available for other practices? What is the existing and proposed competition? Are there any key employees or associates? Page 89
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How long has the practice been going for? How did the current owner acquire the practice? How has the practice grown under the current owner?
The premises Are the premises leased or owned? Who owns them? Who has security over them? How will you occupy them, as a tenant or an owner? What does the lease look like? Have you seen a title search? Have you had an architect or other building expert look at the premises? Who is or will be the tenant? Who will own the premises? Does a lease need to be assigned? Is a real estate conveyance involved? Is a caveat required? What covenants, easements or other restrictions apply? Are all rates and taxes and other outgoings paid up?
The documents Have you seen a proposed contract of sale? Have you seen a proposed partnership agreement? Have you seen a proposed associate agreement? Have you seen a proposed service contract? Have you seen a proposed unitholders' agreement? Have you seen a proposed lease? Have you seen a proposed licence agreement? Is there a buy-sell agreement? Is there a restrictive covenant/restraint of trade clause? When is the money paid? How? Does a lease need to be assigned? In Victoria, do the provisions of the Estate Agents Act regarding the sale of a business or part of a business need to be complied with? These rules apply to businesses with a total value including goodwill of $200,000 or less.
Generally Have you read the draft legal documents included in this manual, so you know what the documents should look like? Have you read the sections in this manual dealing with legal structures and tax planning, so you know you have an optimum position? Have you read the section in this manual on owning practice premises? Have you read the section in this manual on leasing practice premises? Is the vendor bankrupt? Have you signed a confidentiality agreement? Should the benefit of any other contracts pass to the purchaser? Page 90
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If the vendor is a company? Does it have the power to sell? Who are the directors? Who are the shareholders" Have any charges been given by the company? Does a bank have to consent to the sale? Have the company's other activities been taken out of the financial information? Is the company being wound up? Are you being asked to buy shares in a company? Will you be responsible for the debts of the company? Are the directors guaranteeing the performance of the company?
Other matters Does a business name need to be transferred? Do any trademarks or logos need to be transferred? Are staff needed? Who pays for long service leave, annual leave and sick leave? Should there be new employment agreements? Have you seen the patient files? How many patients has the practice seen this month? This week? Do telephones need to be changed? Do specialists and allied health professionals need to be advised of the change? What medical services (eg pathology and radiology) are used in the practice? How will patients be advised? Do leases on plant and equipment have to be adjusted against the purchase price? Do plant and equipment lessors need to be contacted? How can you be sure the vendor owns the practice: Should you place a caveat on the premises? Are any special licences or advices required? Who will collect patient debts? Have all legislative disclosure requirements been satisfied?
Some details Who is the vendor's solicitor? Who is the vendor's accountant? Who pays for the sale documents? is stamp duty payable? If so, who pays stamp duty?
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3.5 Business Plans: Just where are you going?
"Plan for the future because that's where you are going to spend the rest of your life." A successful medical practice doesn't just happen. It is the result of a good idea implemented in a systematic way over a period of time according to a pre-conceived plan or schedule. This is so whether the practice is being started from scratch or whether it is an older practice entering a new phase of activity and growth. This is so no matter where the practice is located and what its competition is. Sometimes that plan or schedule is in the practitioners' heads. They know what will work and they set about doing it in a deliberate and determined way. That's great, and we can all think of examples where this worked well and produced good results. The prospects of good results will be greatly increased and, perhaps more importantly, the prospect of bad results will be greatly decreased, if you put down on paper, in a disciplined and structured way, what should be done and what should not be done, who will do it, and why. This discipline will focus thoughts on why and how the practice should be conducted. It leads to a more rigorous pursuit of the practice's goals and aspirations. It provides a set framework for performance assessment for everyone involved in the practice. Where does it all start? Everything must first start off as an idea. Formalizing the process can help turn abstract concepts and ideas a practical reality. Successfully executed, a business plan should also ensure practice profit, and hence goodwill, is maximized and all viable options available to the practice are explored and exploited to their fullest extent. But what about the patients? Medical practices are different to other businesses. The profound emphasis on patient care and support doesn't occur in most other business: the dominant purpose of a medical practice is only rarely profit maximization. We would never suggest patient care and support should be given second place on the practice's list of priorities. The paradox is a properly constructed and implemented business plan will assist in achieving the goals of patient care and support and assist the practitioners to maximize their income and wealth. In a good practice the two concepts support each other and do not conflict with each other. The market rewards good service. An ethos of patient care and support should dominate the business plan in the same way client service or customer service should dominate the business plan of any other type of business. If this occurs the medical practice should flourish under all measures of success, including both patient service and practice profitability.
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But what about me? A good business plan reflects the personal preferences and ambitions of the practitioners. It accommodates private lives and, by anticipating problems, helps stress level fall. If you know what you are going to be doing, and why, the chances are you will do it better and with less angst. For example, a good business plan will identify peak workloads and allow for locums to be obtained to help cope with them. It will also identify when it is time to engage other practitioners (and should aim to do so asap). The process of preparing a business plan allows the practitioners to identify what is important to them. The needs of a young family may dictate the hours the practice is open. An assistant may be required to help out after hours or on weekends. The preferred location of a practice may need to be weighed against the availability of good schools in that area, and the living requirements of a spouse. Whatever. The important point is that the business plan should not be developed without regard to the other aspects of life. The business plan process often presents a good opportunity for reassessing one's life and for ensuring there is consistency between personal and professional goals. What does a business plan look like? There is no one answer to this question. A business plan is not a precise formula to be slavishly adhered to no matter what the circumstances of the practitioners are. It is a flexible document reflecting the needs of the people who create it and who use it. Nevertheless, some broad guidelines can be set out to assist in preparing business plans. Within common sense limits, a business plan can be as short or as long as one wishes it to be. It can be filled with detail or devoted solely to the big picture. The plan should reflect the unique needs of the practitioners and, since it is their document, should be written by the practitioners, using outside assistance if required. Using a template or a precedent can assist in developing a logical and consistent strategy for conducting the practice in both the short and long terms. This is particularly so if a third party, such as a potential partner or a bank is going to see the document. After all, if it's got your name on it you may as well try to make it look as good as it can. One suggestion for a medical practice's business plan is set out below. 1. 1.1 1.2 1.3 2. 2.1 2.2 3. 3.1 3.2 3.3 3.4 4. 4.1 Background Information Purpose of Report Structure of Plan History of Organisation and Organisation Profile Mission Mission Objectives Industry Position Market Overview Competitors Patients Summary Organisational Strength Marketing Page 93
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4.2 4.3 4.4 4.5 5. 5.1 5.2 5.3 5.4 5.5 6. 6.1 6.2 6.3 7. 7.1 7.2 7.3 7.4 7.5 7.6 8. 8.1 8.2 Management Control Human Resources Construction/Operation Technology Finance Strategic Audit Situation Analysis Summary Strengths Weaknesses Opportunities Threats Grand Strategy Mission Review Basis for Growth Sustainable Competitive Advantage Functional Strategies Alternative Strategies Available Recommended Strategy Operations Strategy Finance Strategy Marketing Strategy Resources Strategy Implementation Implementation Strategy Contingency Factors
It is fair to say this template is a very detailed business plan for a medical practice. You may prefer something less formal and rigid. But it is useful to use this model as a model for our subsequent discussions and explanations. Business plans we have been involved in have exceeded thirty A4 pages of single spaced typing: this may sound a lot but it's not, and it is surprising how much detail can go in if you wish it to. A good business plan will address the following basic themes: Where is the practice going? What is the vision of the practice? What sets it apart from other practices and what goals do we want to achieve? Where is the practice now? What is the practice's past record, strategy and focus. Has it done as well as it should have, having regard to the purpose or vision of the practice. If not, why not? Consider the key areas of any business, including: (i) (ii) (iii) (iv) (v) (vi) (vii) management, direction and control; marketing; operations; finance; human resources; quality of management; and other strengths and weaknesses.
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Where do you want the practice to be? What is your big picture or grand strategy? One can afford to be a little idealistic here. As we said earlier, everything must start off as an idea. Consider, as a minimum, the matters effecting goodwill set out at Part 3.1 of this manual. As these are the factors that impact practice goodwill, it makes sense to consider each of them when preparing your business plan. How is the practice going to get there? Given where we are, how will we get to where we want to be? This is the sharp end of the business plan. It is here the real detail sets in and actual plans and proposed actions are formulated setting out the key issues of whom, when, what and how. How will you know when you are there? What controls and assessment criteria are needed to measure the success of the practice, having regard to the objectives that have been set for it. These should include financial and non-financial criteria. A final thought Before you start your business plan, think about asking your patients what they desire from a medical practice and whether they are getting it from your practice. Perhaps a simple questionnaire could be circulated amongst a sample of patients. Remember, you're not the Government Actuary, so you can be selective about whom you ask. But make sure that the sample is fairly representative and sufficiently large for the results to be reliable and meaningful. These questions should reflect the matters that affect goodwill discussed in Part 3.1 of this manual.
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3.6 Break-even analysis and cash budgeting
In this part we look at two basic management tools used to improve the financial performance of a practice. These basic management tools are break-even analysis and cash budgeting. Their names may not sound interesting (except to some accountants) but, properly used, they provide a good insight into the financial structure of a practice. They identify ways of improving the financial performance of a practice. The aim of this part is not to turn a good practitioner into a bad management accountant. By setting out a basic overview of these two concepts we believe you will get more insight into how your practice works and how you can improve it. Break-even analysis Each business reflects a relationship between costs, volume and profits. Break-even analysis, which is also called "cost-volume-profit analysis", studies the relationships between these variables and, in particular, how changes in costs and volume can cause profit to change. Few practitioners bother with break-even analysis. This is a pity. The technique is simple to use and, as indicated above, provides valuable insight into the financial profile of the practice. The technique lends itself to a "what if" analysis and is particularly valuable for practitioners starting a new practice or those who are contemplating offering a new service to their patients. Two perspectives The concept of "break-even" can be approached from at least two perspectives. First, it can be viewed as the level of activity, or volume, necessary to have the practice break-even, in the sense of not making a profit or a loss. Second, and perhaps more usefully, it can be viewed as the level of activity, or volume, necessary for making a target profit representing a reasonable return on investment and a reasonable reward for labor. Assume a practitioner has $100,000 invested in a practice. She believes a fair return is 20% (ie., $20,000), and a fair reward for labor is $80,000. This means target profit will be $100,000. The first step in the analysis is to identify how costs vary with changes in volume. Broadly speaking, there are two types of costs: fixed costs and variable costs. Fixed costs remain the same regardless of the level of activity. Good examples of fixed costs are rent, interest on amounts borrowed to start the practice and depreciation of plant and equipment. If you see half the normal number of patients, these costs will stay the same, and if you see double the normal number of patients these costs will remain the same. They are fixed and do not vary with changes in volume. Variable costs are different. They do vary with changes in volume and, for simplicity, we assume they vary directly and proportionately with changes in volume, so if volume increases by 25%, variable costs will also increase by 25%. Good examples of variable costs are stationery expenses, locum fees, and medical supplies. Are the assumptions valid? The assumption all costs are either variable costs or fixed costs is open to criticism. More realistically, many costs are stepped, in that they remain constant within a particular range of volume and then increase (ie., step up) as volume increases beyond that range. Also, many costs have both fixed and variable components. For example, electricity costs may be both fixed, in that certain lights and appliances have to be used regardless of volume, and variable, in that January 2002 Page 96
certain appliances are used in proportion to the number of patients seen (for example, lights in a second consulting room). Nevertheless, the assumption all costs are either variable costs or fixed costs is useful because it shows the basic relationship between volume and costs and profits. The techniques can be adapted to reflect more sophisticated cost experiences as required. An example Variable costs total $50,149 and fixed costs total $73,268. Total costs are $123,417. Total fee income is $240,625. This means profit is $117,208. The a percentage of sales; this percentage is about 21%. This means, on average, and subject to our assumptions, it costs about $21 to earn each dollar of fee income. Another way of looking at this is to say the contribution margin is 79%, or that every hundred dollars of additional income adds $79 to the practice's fixed costs and target profit. The relationship can be described algebraically as follows: BEP = FC where: BEP is the break-even in dollars CM FC is fixed costs in dollars; and CM is the contribution margin In our example, the break-even point is calculated as follows: $92,558 = $73,268 .791589 If the average fee per patient is $25 and the practitioner works for 5 1/2 days a week for 50 weeks of the year, this means the practitioner has to see 3,703 patients in a year, 74 patients a week and 13.4 patients a day to break-even. This is because at this level fees equal fixed costs plus variable costs. Therefore the practice will break even. How can this approach be used to compute the average number of patients to be seen each day for the practitioner to make a target profit of, say, $100,000 a year, reflecting a notional salary of $80,000 and a return on investment of $20,000? This is easy. Just treat the target profit as another fixed cost and change the formula accordingly. This is shown as follows: TPF = FC + TP where: CM TPF is the target professional fees in dollars FC is the fixed costs in dollars CM is the contribution margin; and TP is the target profit
In our example the target professional fees is calculated as follows: TPF TPF TPF = = = $73,268 + $100,000 .791589 $173,268 .791589 $218,886
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If the average fee per patient is $25 and the practitioner works for 5 1/2 days a week for 50 weeks of the year, this means the practitioner has to see 8,755 patients in a year, 175 patients a week and 31.8 patients a day to make the target profit of $100,000 a year. This is a very useful piece of information for a practitioner to have. What happens if the practitioner decides a target profit should be, say, $130,000 a year? This is easy too. Increase the value of TP by the additional target profit of $30,000, and see what happens: TPF = FC + TP where: CM TPF is the target professional fees in dollars FC is the fixed costs in dollars CM is the contribution margin; and TP is the target profit
In our example the target professional fees is calculated as follows: TPF TPF TPF = = = $73,268 + $130,000 .791589 $203,268 .791589 $256,785
If the average fee per patient is $25 and the practitioner works for five and half days a week for fifty weeks of the year, this means that the practitioner has to see 10,271 patients in a year, 205 patients a week and 37.3 patients a day to make the target profit of $100,000 a year. This is also a valuable piece of information for a practitioner to have. How does this analysis help the practitioner? First, it establishes the minimum activity, in terms of patients, necessary to avoid making a loss. Second, and very similarly, it shows the activity, in terms of patients, necessary to make certain target profits. Third, it highlights the matters to be considered if the practitioner is going to be able to increase the profits of the medical practice. For example: (i) to increase patient numbers it may be necessary to decrease the average amount of time spent with a patient, increase the length of each session, increase the number of sessions in a week, or a combination of these options; it highlights the importance of patient numbers to the profitability of a practice. If patient numbers just don't extend to seeing thirty seven patients a day on average, and the practitioner still wants to increase the target profit from $100,000 a year to $130,000 a year, then something must be done. Options include: (a) (b) January 2002 reducing fixed costs (for example, by obtaining cheaper premises or by rationalizing support staff hours and numbers); attracting an associate or an allied health professional into the practice on a cost Page 98
(ii)
share basis. In many cases this will produce virtually no extra costs for the practice but can substantially alter the cost structure of the practice. (We have seen many examples where this has knocked a net amount of more than $30,000 off a practice's net fixed costs); and (c) doing something to attract more patients to the practice, for example, opening longer hours in the evening or on Sundays (see part 3.1 of this manual which deals generally with how to improve the goodwill and profits of a practice).
Cash Budgeting A cash budget is another important management tool. Being in business is in some ways like driving a car backwards. You can drive a car looking backwards in the rear vision mirror as long as the road ahead is straight and no other cars are coming. However, if the road turns unexpectedly, or if an obstacle pops up, you can find yourself in a lot of trouble. You can even crash. Being in business is much the same as driving a car. You can control your business by looking at historical information, such as last year's accounts, but if the road ahead turns unexpectedly or if an obstacle pops up, you can find yourself in a lot of trouble. You can even crash. Medical practices are more predictable than many businesses and changes do not come up so fast. Most practitioners are astute regarding future trends and have some idea of what their future holds, at least in the short term. Nevertheless, cash budgeting, even at a basic level and for a short time, can assist a practice. This is particularly so for new practices or practices that are in financial difficulty. Advantages of a cash budget The advantages of a cash budget include: (i) (ii) (iii) (iv) it allows cash flow problems to be identified allowing remedial action to be taken in advance; it is conducive to the setting of realistic goals for the practice; it provides a basis for controlling the costs connected to a practice; and in many cases, it can assist with banking relationships.
A real advantage of cash budgeting is that the effect of different business strategies on the cash position of the practice can be highlighted. For example, if the first cash budget shows a problem the practitioner can consider alternative strategies designed to improve the profitability and cash flow of the practice. Preparing a cash budget forces you to reconsider your practice goals and strategies, re-evaluate each part of your practice, and allows you to evaluate new ideas and opportunities in a disciplined and systematic way. Cash budgets for medical practices are relatively straightforward. Unlike most other businesses there is not a large difference between profit and net cash receipts each period. This is because there is only a short time lag between completing the patient service and being paid and because there are few non-cash expenses such as depreciation and so on. The hard bit is identifying when cash must be paid out on items such as income tax expense and other large outgoings. Care is needed in estimating the size of personal cash drawings, particularly when big-ticket items such as tax bills and school fees are involved. January 2002 Page 99
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3.7 Avoiding disputes with partners
The most important way to avoid disputes with your partners is to choose them well. Make certain the partners share the same general values and attitudes to professional life. Where significant points of genuine disagreement exist these should be identified and dealt with early so every partner is aware of and respects the other partners' points of view. This is not to say each partner should be a clone of the others. This is not a good idea. The best partners are different but complementary to each other, not clones. For example, in a three partner general practice the first partner may prefer geriatric medicine, the second partner may prefer young children and the third partner may prefer women's health. Overall the three partners are able to develop a more diverse set of skills and offer their patients a better set of services because they are different to each other and are not three clones with identical professional interests and skills. Diversity, in terms of ages, personalities, skills and attitude is, within natural parameters and common sense limits, a good thing for a practice to have. Have a clear understanding of how the partnership is regulated and where it is going. In terms of how the partnership is regulated, plain English partnership agreements, shareholder agreements and unitholder agreements are essential. Each document should deal specifically with profit sharing arrangements, partner entry and exit procedures and goodwill. In terms of where the partnership is going, a comprehensive and detailed business plan, including budgets and a regular review mechanism, is essential. Agree that any disputes should be dealt with by mediation and not by confrontation. The mediator should be skilled, impartial and understand the issues facing the partnership and each of the partners. The purpose of the mediation is to allow each party to put their story and to explain their point of view. The mediator encourages a search for common ground and possible solutions to the problems facing the partners. In some cases another practitioner who is known to each of the partners is an ideal mediator. In other cases a professional mediator may need to be engaged. The critical issues in selecting a mediator are impartiality and an open mind. The mediator should have the respect of each party and the personal skills to create a positive and problem solving dialogue between the parties. The mediator's role is to help parties to compromise their position and consider other possible solutions. Often the mere presence of a mediator can encourage the parties to be sensible and to acknowledge there are normally at least two sides to each story and the other side may have some merit. Mediation is controlled by the parties and is less expensive and quicker than the Courts. The range of possible solutions is wider. Mediation is informal and copes with technical issues. This is particularly so where the mediator has a background in the medical profession and is personally aware of and has empathy for the issues involved in the dispute. Mediation can be binding if this is agreed to by the parties or is provided for in the partnership agreement, the shareholders' agreement or the unitholders' agreement that governs the particular medical practice. One experience we are aware of involved a dispute between former partners. One party was intent on pushing the issue to court. In the end the matter was settled after one day in court. Total legal costs exceeded $100,000. An expensive day that could have been avoided by having agreements that provided for mediation before any litigation was commenced (and, we must say, some common sense between the parties themselves).
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3.8 Debt collection for practitioners
The ultimate purpose of most medical practices is to generate cash for the proprietors. To do this patients must pay as close as possible to the time the service is provided. The ideal is credit card or cash at the end of each consultation, or a Medicare card followed by a cheque fourteen days later. Simple. Cash up-front, or close thereto, minimizes the cost of funding the practice and eliminating the administrative cost of collecting fees. Specialists and non-bulk billing general practices will have more of a problem with patients who have not yet paid, otherwise known as "debtors". How debtors are managed will have a significant bearing on the cash flow produced by the practice and how patients view the overall efficiency of the practice. How can this area of a practice's management be improved without offending patients or involving practitioners in matters that, to be blunt, do not warrant their time? Following some simple rules can save a lot of time and a lot of money, both on interest foregone and administrative costs. Step 1: What's the state of play? What are debtors now? How old are they? What is the average time for payment? Are there any problem accounts? Have you told your patients what your terms of trade are? How this is done depends on the practice. At the least, a sign in the surgery area is required. Practice brochures are a good spot to repeat the message. Think about a letter to your patients, either a standard form letter for a larger practice or a semi-customized appointment letter for a smaller practice with a smaller number of larger cost patients, such as a general surgeon. This letter should go out after the initial consultation and should refer to an earlier oral explanation provided by the practitioner. Bear in mind contract law. The courts require specificity regarding price before allowing a debt to be collected: if the cost of the service is clearly spelt out in writing this can be hard to make out and you can be left with just "a reasonable amount", which is typically less than the amount of the original invoice. The letter of appointment creates this specificity and effectively becomes part of the contract between the practitioner and the patient. For practitioners whose practices do not lend themselves easily to letters of appointment, typically general practitioners, bear in mind common knowledge and prior dealings: everyone knows a short consultation costs between say, $21 and $30, and someone who has paid this price happily before cannot later argue they never agreed to this invoice. Step 2: What payment policy should we have? Once this is done the next step is to set a policy. For a general practice, this should be simple: payment at the time of consultation is certainly the cheaper and simplest option. In exceptional cases, within 14 days with a small administration fee (say $5) to cover costs and to compensate for interest foregone. You should be able to bill patients on their leaving the surgery. Once this policy is set, it should be observed: depending on the circumstances the last words the patient hears should be "you can pay out the counter" or something similar. The receptionist should be on her toes to receive the departing patients and their payments. "This will save you the administration fee" is a friendly way to do this. If you decide to change your policy make sure this is brought to your patients' attention as earlier as possible and, in any event, a reasonable time before the change date so January 2002 Page 102
embarrassment is avoided and exceptions can be identified. Of course, for bulk billing practices the procedure is a lot simpler. Specialists are in a harder position. For obvious reasons payment has to be deferred for some time at least. The shorter the better. Once you have a debtor, how can you accelerate payment? Reminder notices are a good idea. A systemized mailing of statements every second Friday is a good idea. Do not be afraid to follow up with a call from the receptionist or office manager: you did your side of the deal, so it is only fair the patients do heirs. It is the slow paying patient who should be embarrassed, not you. Imagine the reaction if you unilaterally decided to provide your services 14 days later than the agreed time. But distancing the practitioner from the call is a sensible way to go: the practitioner's time is more valuable and a debate on an invoice, and when it should be paid, is hardly conducive to a good patient practitioner relationship. If for some reason all else fails, let the patient know the matter will be referred to a solicitor for collection, plus costs. But tread carefully because a court attendance can cost a practitioner a lot more than what the account is worth and can tarnish reputation. Negative word of mouth, however unfair, is a potent damaging force. A threat of legal action is not something that should be made lightly: some times it can be better to let the matter slide. Any other practical tips? If you expect an invoice is genuinely above someone's ability to pay, suggest a repayment program. Discount the amount if necessary. It is better to get a little every month than nothing all at once. Once the repayment program is agreed confirm it in writing: this, plus payment under the program, is strong evidence and the courts do not smile at debtors who do a deal and then fail to follow through. Generally speaking, discounts for prompt payment are not a good idea. Simple maths shows why: if you offer a 5% discount for payment within 7 days, and the account would otherwise have been paid say at 37 days, you have effectively lost 60% simple interest each year on the average value of the debtors. If average debtors is, say, $50,000, this costs $30,000 a year. That's expensive money and a lot to pay for getting debts in on time: a practitioner would be better off borrowing $50,000 at 10% to supplement working capital and letting debtors pay "naturally" without the prompt of an early payment discount scheme. But then again, perhaps the debtor may not pay! Bear in mind the other aspect of collecting debt: administrative time costs money and can be better spent. A sound debt collection policy, properly implemented, saves time and saves interest expense for the practice. In this situation factoring arrangements should not be ignored. But these are expensive, with the effective interest cost often exceeding 15% with significant management time spent providing information and generally liaising with the financier. Banks do not like factoring arrangements and they breach most common lending agreements. Factoring debts is very much a last resort solution and is not recommended.
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3.9 The move to a group practice
Practitioners, particularly GPs, face a fixed income stream. In economic jargon, they are price takers, not price makers. Prices are set and, putting aside the question of whether to bulk bill or bill privately, there is not much one can do to increase gross income except work longer hours. There is a sure fire way for a practitioner to increase gross income by at least forty per cent. Its simple, just work seven days a week instead of five. Effective yes. But hardly conducive to better health and better family relationships. For all but the obsessed, quality of life, however measured, falls as hours worked goes up. For most this critical point is probably about 55 hours a week. After that, happiness, work efficiency and probably life expectancy fall away. It's an over quoted line, but no one on their death bed ever wished they spent more time on the office. At best increasing hours is a short-term solution that creates more problems than it solves. So whats the answer? What can be done to improve income without sacrificing quality of life by working ridiculous hours? One answer may be to join or create a group practice. There is no doubt practitioners in group practices have much lower cost experiences than one or two practitioner practices. We are aware of examples where costs can fall from as much as 55% of gross income to as little as 33% of gross income. Thats a drop of 40% of total costs. With billings of $250,000 a year it means net income has jumped by more than $50,000 a year. Its the equivalent to getting nearly an extra six months income each year. Or, if you prefer to look at life the other way around, the practitioner gets the same net income working three months fewer each year. There is also the prospect of higher gross income. Group practices are more likely to have nonowner practitioners who are paid on a percentage of their gross billings (often subject to a minimum payment per session). This creates a leverage effect: the owner practitioners gross income goes up without any more work, or any more costs. It is not unusual to see the owner practitioners net incomes jump by more than $40,000 a year as a result of taking on associate practitioners. There is also the prospect of introducing new services and accessing expensive equipment beyond the reach of the individual practitioners. Group practices have more difficult personal dynamics. There are more people so there are potentially more problems. Group practices have more complicated operational logistics: everything from the site of the practice to the staff roster becomes more difficult because the dollars are bigger and more people are involved. Egos can be a problem too. The advantages of peer support, more time off and improved profitability can be lost if the practitioners or the staff do not get on and do not work efficiently as a team. When considering amalgamations practitioners typically overstate the difficulties and understate the advantages. Like many things, it is all to do with attitude. Approached positively the move to a group practice will almost always work. But the cerebral must be supported by the practical. How does a practitioner make the move to a group practice? What must be considered and dealt with if the move is to have maximum prospects of success? The first step: have a cup of coffee Everything starts off as an idea and talk is cheap. These two clichs should be borne well in mind at this juncture. The first step is simple: think of which practitioners you would like to group with, ring them up and sit down and have a chat.
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You do not have to be best buddies with the other practitioners. The question is really one of day-to-day personal and professional compatibility. Can you work with these people? Do they have similar professional philosophies and standards? Are you happy with them seeing your patients if you are not able to? They do not have to be just like you, in fact, differences should be encouraged. There is a lot to be said for a diverse mix of personalities, ages, nationalities, sexes and professional interests and skills. Diversity means the practice is likely to attract a wider range of patients, makes internal competition less likely and external competition with other practices more vigorous. The other practitioners could be solo, in a small partnership or already be in a large group. The last option is the simplest. If all goes to plan it is just a question of packing up and moving into the group practice. In this example we assume the practitioners are in separate practices and there are at least five of them looking to group together. The second step: detailed discussions Once interest in the idea is established, the second step is to sit down and discuss the idea in detail. This is the hard part. It is critical for each practitioner to approach these discussions with a positive attitude and an open mind. The white board should be clean and any suggestion should be considered on its merit. Just because its not the way you have done it before, or it is not what you first had in mind does not mean its not a good idea. Everyone must compromise. This is not a one off transaction like buying a house or a car. Everyone has to be a winner. The relationship is long term and if anyone feels they have been ignored, beaten down or otherwise treated unreasonably the relationship is unlikely to work. Put yourself in the other persons shoes before you take a position. Is everyone treated fairly? Is everyone treated the same? Are reasonable differences accommodated? Can everyone live with the deal? If the discussions do not go well this is the time to back off. Remember, no deal is better than a bad deal. If in doubt do not proceed. Intuition is important and if your tummy tells you it is not right, it probably is not right. The third step: put it down on paper Once the broad idea has been thrashed out and agreed, put it down on paper. You do not have to be too specific. Statements of principal are fine. You cannot anticipate everything so leaving specifics out and phrasing things in general terms is a good idea. The window headed What does the solicitor do? includes a detailed checklist of things to be considered. This checklist can be a used as a template for the discussion document and can be provided to the solicitor later on when the contract is being drawn up. Someone should be nominated as the author of the discussion document. Once the first draft is created it should be circulated for comment and a further meeting convened. After discussion and any agreed changes the document should be finalized and adopted as a working document. It is quite possible the practitioners have by now reached a legally enforceable agreement. All the requirements of a contract may be present. This is fine, as long as each practitioner realizes that a real commitment has been made. The commitment is less of a legal commitment and more one of good faith and reputation. Its hard to see why one would want to go to court if afterwards a January 2002 Page 105
practitioner pulled out. What remedy would you seek? Specific performance is hardly a sensible solution and what damages are there? But this is about to change. The fourth step: implement the deal This is crunch time. Old relationships need to end and new ones start. This is where commitment comes in. Premises will have to be bought or leased, renovations or even a new building may be required, staff must be engaged and some staff must be let go. Patients have to be advised and the physical move made. The legal structure needs to be determined and implemented. A formal group contract needs to be finalized and signed. A host of other administrative matters need to be attended to, not the least is the set up of a practice accounting and patient record and billing system. No matter how efficient your manual system may be it will almost certainly not cope with five or more practitioners and this is the time to automate. It is a good idea to elect a nominee who is authorized to act for the group. This person is responsible for driving the project and must be invested with sufficient authority to do this. This may include serious authorities such as the power to buy or lease real estate, although obviously this should not happen without the specific written consent of each practitioner in the group. The nominee may delegate specific tasks to other practitioners in the group or to external advisors such as accountants, solicitors, property consultants and so on. But delegation does not take away responsibility and practitioners should not rely too much on external parties in a situation like this. Do it yourself if you want it done right. The last step: starting practice Best of luck! As a suggestion, do not start with a big bang and do not rush things. It can be a good idea for, say, two practitioners to start in the new premises at first and trial the systems and the staff. The other practitioners might join in over the next month or so. This means there is time to sort out any logistical problems that may arise, and Murphys Law dictates there will be quiet a few. The practitioners should each trial the software and any other new systems in their old practices over the few months before the move starts. This means all practitioners and staff will be familiar with the new systems before the move goes ahead. Evolution, albeit at a pace, is better than revolution. Costs will be greater over the first few months, due to excess capacity at the new premises and some duplication of services, but this is a temporary phenomena and will not last long. Once all the practitioners are on board costs per practitioner will fall. Obviously existing patients should be advised of the move well beforehand. But keep the general public announcements until later when all systems are working properly and you are confident any first time patients will be handled well. It is worthwhile contacting large removalists who specialize in commercial moves and can work at night or over a weekend to minimize down time. Partnership or associateship? January 2002 Page 106
Group practices are traditionally set up as partnerships or associateships. Partnerships involve the practitioners sharing income and sharing costs. The practitioners draw their share of profits from a common pool. Profit may be allocated on an equal basis, in accordance with the individual practitioners gross fees or on some other basis. Associateships involve a sharing of costs only. The practitioners bill their own patients and contribute to costs on an agreed basis. In either case a service unit trust is normally used to provide services to the group. Profit is shifted to the service trust via management fees and this profit is distributed out to the unitholders, typically the practitioners family trusts. Which is better, an associateship or a partnership? Amalgamating practitioners will have to make a decision on this matter before the new practice starts. The answer is you normally do not have a choice. Whether a relationship between a group of persons comprises a partnership under the general law is a question of fact. It does not matter what the practitioners call themselves. The simple truth is most group practices are partnerships, even if the practitioners do not think they are partners and do not want to be partners. The definition of a partnership at general law is a combination of persons carrying on a business together in common with a view to profit. This is a very wide definition and there is nothing elective about it. You are either partners or you are not. The intrinsic nature of group practices: shared resources and shared relationships with external parties, particularly patients, means most, if not virtually all, group general practices are partnerships and are not associateships. The concept of an associateship in general practice is in fact a very rare and infrequently encountered animal. Partners are joint and severally liable for each other actions, within the framework of the partnership. This means an aggrieved patient can sue all or any of the practitioners in the practice. Each practitioner is legally responsible for the other practitioners actions. The best protection against being embroiled in an action under the doctrine of joint and several liability is to: use IMPs to hold each practitioners interest in the partnership. This does not protect the practitioner from the consequences of his or her own actions, but does help protect the practitioner from the consequences of the other practitioners actions; use the same professional indemnity insurer, as this reduces the incentive for an aggrieved patient to join other practitioners in the group to the action, since the real defendant will be the same insurer no matter how many practitioners are joined to the action; and make sure the practitioners agreement sets professional standards and allows a practitioner who does not continue to meet those standards to be expelled from the group.
Taxation implications Each case will be different, and specific advice should always be sought before joining up with another practice. January 2002 Page 107
The income from a group practice is more likely to be business income than personal services income. This is particularly the case if profit is shared equally and not in accordance with the individual practitioners relative fees. This can open the door on using IMPs to retain profit and pay tax at the company rate of 36% rather than at the 48% rate usually applying to individual practitioners. The switch from a solo practice or a small partnership to a larger group may involve a disposal of one asset and the acquisition of another. This will have capital gains tax implications. Bear in mind the abandonment of an asset is deemed to be a disposal, so a practitioner can trigger a capital gains tax liability by leaving one practice and moving to another, particularly as the new practice is likely to be a partnership. Larger practices are more likely to pay pay-roll tax, since their pay-rolls will be larger. In most states pay-roll tax is paid at about 6% of pay-roll above a threshold, typically about $500,000 to $600,000. The problem can become acute if the practice has employee practitioners or if the corporate partners employ the owner practitioners: its not hard to beat the threshold if, say, 5 practitioners plus non-medical staff are all drawing salaries. Grouping rules apply to treat related entities as if they are the same employer. The solution to the pay-roll tax problem is to not remunerate practitioners using salary and wages. They get a share of profit or, if IMPs are used, fully franked dividends. Profit share and dividends are not subject to pay-roll tax. Practice trusts, discussed elsewhere in this manual, are particularly useful for avoiding pay-roll tax. The trust does not pay any owner practitioners a salary, and instead distributes net income to them, and without a salary there cannot be any pay-roll tax liability. Non-owner practitioners If non-owner practitioners are engaged at the practice do not pay them salaries. Let them bill their own patients and pay a management fee to the practice. This avoids pay-roll tax since they pay the practice not the other way around. It saves money on other employment related on-costs, such as superannuation and Work cover. It means the owner practitioners are not vicariously liable for the non-owner practitioners mistakes, provided some simple ground rules are observed. This normally also creates tax advantages for the non-owner practitioners, and this helps attract and retain good practitioners. There is a shortage of practitioners around Australia and flexibility with the legal structures used by non-owner practitioners can make all the difference.
Some common questions about amalgamations

If I move from where I am will someone else get my patients? Probably not. Patients generally choose a practitioner, not a location. While car parking, access and convenience are important, they are not determinative. The best approach is to make sure your new location has better car parking, access and convenience than your old location. And your competitors locations. What about my staff? Ideally one or two will have to go. This is how most of the costs savings are achieved. January 2002 Page 108
Good staff will find good employment elsewhere. You can help them do this with good references and even calls to other practices that may not have good staff. If your staff cannot get good employment elsewhere, why are they working for you? A cost saving of $30,000 a year will compound to more than $600,000 over ten years. Whose future are you working for anyway? What if I cannot get on with the other practitioners? Do not join up with them. This is a critical point that you must establish before making the move. Afterwards is too late. Professional and personal compatibilities are critical and their absence makes life miserable. Remember, no deal is better than a bad deal. Dont do it if it doesnt feel right.
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Should we use solicitors to reach a deal? No. If you cannot agree on basic issues without using solicitors it is highly unlikely the group practice will work. Each practitioner should discuss the issues with their own advisors and the final documents to record the deal should be prepared by a solicitor. A solicitor should also make sure all important matters have been considered by the group and can comment on what other groups do and what is standard industry practice and why. But it is critical that the practitioners, not solicitors, do the deal. You have to work with each other closely afterwards, so if you cannot agree to a deal now without solicitors the prospects for the future do not look good. What will happen to my goodwill? It will go up in value. This is particularly so where the group practice has a significant number of non-owner practitioners working in it. This financial leverage creates goodwill, since sustainable profit is produced without having to do any extra work. You are also positioning yourself to take advantage of the increasing trend for non-practitioners to buy into service entities. Larger goodwill payments are being observed here. The group agreement should contain rules regarding how goodwill is measured, how it can be dealt with and what happens to it as practitioners join or leave the group. Who will see my patients? You will. But when you cannot see them the other practitioners will. This means you can be sick, can take a holiday and do not have to be on call all the time. Who sees new patients? It is a good idea for the group documents to stipulate that unless a new patient nominates a particular practitioner the new patient should be allocated to the practitioner with the fewest patients. This equalizes incomes and cost contributions and reduces internal friction regarding unequal workloads. The management task is to improve patient numbers across the board and to equalize patient workloads. Remember, under the cost sharing rules each practitioner makes money from each new patient, no matter which practitioner does the work. Where should the new practice be? It will probably be somewhere near the existing practices. But why limit your options? Why not start a group practice in an area that is under-practitionered? In the city this boils down to anywhere other than the fashionable suburbs. Rural and semi-rural areas demand consideration too, particularly if close to a major regional centre. It makes a lot of sense to base your practice where there is high demand and low competition. High volume and high profits can be achieved without bulk billing. Practitioners incomes are as much as 100% higher in rural areas. What does the solicitor do? The relationship between the practitioners should be set out in a contract prepared by a solicitor. The contract should cover all the matters typically covered in a co-ownership agreement. This includes rules covering:
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hours of attendance; professional standards; the valuation of goodwill; who owns the patient files; what happens if a practitioner wants to leave the group; what happens if a practitioner wants to join the group; what happens if the group wants a practitioner to leave the group; sick leave and annual leave; serious illness and death; use of service entities; cost sharing or profit sharing arrangements; the purchase of equipment; borrowing money and incurring credit; hiring and firing staff; use of practice name; patient services; engagement of locums and assistants; non-competition and restrictive covenant; professional indemnity insurances; practice management and goals; premises; decision making; and arbitration and mediation of disputes.
This list is also a good checklist of the issues to be discussed when finalising the deal. A solicitor should be able to provide sample group contracts on request for no fee. These samples are invaluable guides to what should be considered and what other groups have agreed to. But sample documents are just that, samples. They are not carved in stone: what was good for someone else may not be good for you and you should not feel bound to follow them.
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4. 4.1 TAXATION ISSUES FOR PRACTITIONERS The taxation of practice companies: Fact or Fiction?
The taxation of medical practices is a complex area of law riddled with obscure and incorrect references to the ATO's supposed practices. Legal fictions dominate and the underlying basis for applying the tax law is often forgotten. Many practitioners slavishly follow out dated income tax rulings without ever considering the underlying rationale of those rulings or the reasons why they do or do not apply to their practice. They also often fail to consider the ATO's more recent income tax rulings regarding medical practices. We find the taxation bill of a medical practice usually can be lowered by applying the law correctly and by using common sense tax planning techniques. Savings of $5,000 to $10,000 a year each year are common. These techniques are well established and are accepted by the ATO. They do not create any risk for the practitioner. Practitioners need to bear in mind the taxation profile of their practice and should routinely consider whether there is any way of keeping their practice's taxation liability down. The major areas of concern are the use of incorporated practices and the use of service trusts. We deal with the taxation law applicable to each of these two areas in turn below. The use of an incorporated practice The use of IMPs is a frequently misunderstood area of the law. Putting the ATOs published income tax rulings and determinations aside for one moment, the correct position under the general taxation law is as follows: (i) where the practice's income is "personal exertion income" (ie., in general terms the income is predominantly connected to the personal efforts and labor of one practitioner rather than to a business infrastructure), it is not possible for the income of the practice to be derived by a company. Accordingly, in this situation an incorporated practice will not be effective for taxation purposes; and where the practice's income is "business income" (ie., in general terms the income is predominantly connected to the business infrastructure, rather that the personal efforts of one practitioner), it is possible for the income of the medical practice to be derived by a company. Accordingly, in this situation an IMP will be effective for taxation purposes.
(ii)
Where the income of a practice is characterized as personal exertion income and a practice company is used, the ATO will be able to strike the arrangement out at any time and instead tax the practitioner on the practice's underlying income stream.
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The Commissioner's published rulings As straight forward and as simple as this may seem, for a long time it was not what the ATOs published income tax rulings and determinations actually said. Income Tax Ruling IT 25 dated 24 May 1984 and IT 2503 dated 3 November 1988 each deals generally with the incorporation of medical practices. These are reproduced in full at Parts 5.1 and 5.2 of the manual. They stipulate a number of special conditions that must be observed if the ATO is to accept the incorporation of a medical practice. These special conditions are that: (i) IT 25 states the incorporation of a medical practice should do nothing more than reduce the practitioner's profit by the amount of superannuation contributions made on behalf of the practitioner. That is, all profits/taxable income has to be paid out to the practitioner as salary and as superannuation contributions if the incorporation is to be accepted for taxation purposes. (Presumably the ST($640 times 36 divided by ATO would accept that profit can also be paid out as a fringe benefit: see Income Tax Ruling IT 2494 dated 11 August 1994 regarding fringe benefits provided to employees of administration entities generally on this point); IT 2503 says the same thing as IT 25. It puts more of a gloss on it by adding there should be no diversion of income to related parties and sound business reasons and commercial reasons (other than reducing a tax bill) should exist before incorporating a medical practice; IT 2503 acknowledges the practical difficulty of ensuring the incorporated practice should break even. It "allows" the company to derive a small taxable income provided that a "bona fide attempt" is made to avoid this situation. This amount is paid out as a fully franked dividend soon after 30 June in the following year; IT 2503 states if the proviso noted at sub-paragraph (iii) above is not complied with, the ATO will apply the anti-tax avoidance rules to the arrangement; interest on moneys borrowed to purchase practice goodwill from a third party will be deductible to the IMP. Interest on moneys borrowed to purchase goodwill from the practitioner will not be deductible; incorporated practices cannot own income producing property or plant and equipment unless the property or equipment is connected to the medical practice; the basis of accounting for practice income generally will be cash (ie., debtors are ignored in computing taxable income and hence taxation payable); sessional fees from hospitals may be derived by an IMP; practice trusts may conduct a medical practice provided the practitioner beneficially derives all of the income from the practice; and services entities are acceptable provided the amount paid is reasonable.
(ii)
(iii)
(iv) (v)
(vi) (vii) (viii) (ix)
(x)
The majority of practitioners who practice through companies are normally at great pains to observe the fine print of IT 25 and IT 2503. This is particularly so regarding the paying out of January 2002 Page 113
profits/taxable income each year to the practitioner as salary, superannuation, fringe benefits and, in some cases, franked dividends. Are they correct in doing so? Should they take these pains? Is IT 2503 an accurate statement of the taxation law applying to IMPs? No, they are not correct in doing so. They shouldn't take these pains. It is wrong to regard IT 2503 as an accurate statement of the taxation law applying to IMPs. The better view The better view is there is nothing special about IMPs. These companies are taxed in exactly the same way as other companies are and there is nothing in the case law or the Income Tax Assessment Act that changes the taxation profile of an IMP in any way. The key to the taxation of practice income is to ask whether it is personal exertion income or is business income. If it is business income then an incorporated practice will be effective for tax purposes. Just as any taxpayer may elect to conduct a business through a company, so may a practitioner elect to conduct a medical business through a company. There is nothing special about a medical practice for tax purposes. The rules apply generally to other types of taxpayers apply equally to medical practices. Accordingly, where the practice's income is business income there is no need to comply with the ATOs arbitrary rules regarding profit remittance, as set out in IT 2503. The IMP may retain profits each year and pay income tax on those profits at the corporate tax rate of 36% if the directors of the practice so choose. Where the practice's income is personal services income there is a need to comply with the ATOs rulings. Practitioners face serious tax penalties of they do not. This position is in fact recognized by the ATO in Income Tax Ruling IT 2639 dated 20 June 1991. This ruling is reproduced in full at part 5.3 of this manual This ruling is recommended reading for all practitioners. It provides an accurate (if awkwardly worded) explanation of how medical practice income is taxed. Paragraphs 10, 11 and 12 of this ruling are particularly instructive and set out in detail the ATO's "rules of thumb" in determining the nature of a practice's income for taxation purposes. These paragraphs are reproduced here in full: "INCOME OF A PRACTICE COMPANY OR TRUST 10. For the purpose of determining whether a practice company or trust falls within the scope of IT 2503 (and only for that purpose), this Office will apply the following guidelines as a general rule of thumb: (a) If the practice company or trust has at least as many non-principal practitioners (see para 11) as principal practitioners, then income is considered to be derived from the business structure (and therefore does not fall within the scope of IT 2503). If the practice company or trust has fewer non-principal practitioners than principal practitioners, then whether it derives income from personal services will still need to be determined by considering the factors contained in para 8 of this Page 114
(b)
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Ruling and the guidelines in previous Rulings on this issue. If these factors indicate that the practice company or trust derives income from personal services, it will fall within the scope of IT 2503. If they indicate that the practice company or trust derives its income from the business structure, it will not fall within the scope of IT 2503. 11. In paragraph 10: a. "Practitioners" include both full time professional and non-professional staff whose function is to derive material fees for the practice. Part-time staff count proportionately. The term does not include administrative, clerical or support staff. For example, a nurse under the direction of a practitioner or a legal secretary under the direction of a solicitor are not "practitioners" unless they earn material fees in their own right. "Principal practitioners" are those practitioners who own or share in the ownership of the practice, whether directly or indirectly. "Non-principal practitioners" are those practitioners who are not "principal practitioners."
b. c. 12.
The para 10 rule of thumb applies to income derived in the income year commencing 1 July 1991 and later years of income."
The question of how to classify a particular type of income is always a question of fact. The ATO will accept that income is business income where the number of "non-principal practitioners" (ie., fee earners) exceeds the number of "principal practitioners" and where this is not the case income may still be business income having regard to: (i) (ii) (iii) (iv) the nature of the practice's activities; the extent to which the income depends on the taxpayer's own skill and judgement; the extent of the income producing assets used to derive the income; and the number of employees and others engaged in the practice.
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What about partnerships? Medical partnerships, particularly those involving IMPs, are a special case and are dealt with specifically in part 4.2 of this manual titled "The taxation of medical partnerships". In summary, partnership net income is always business income and therefore can be retained in an IMP and taxed at 30% rather than 48% in the hands of the practitioner. Many practitioners, and the accountants who advise them, get this area of the taxation law wrong. This normally costs practitioners a lot of money. If you are a partner in a medical practice we suggest you read Part 4.2 of this manual very carefully. The use of service trusts The use of service trusts is a more clear area of the law. Phillips case, the major decision in this area, is reproduced in full in part 5.4 of this manual. Phillips case, a 1978 court decision, involved the partners of an accounting firm setting up a unit trust. The units in that unit trust were beneficially owned by the partners' family trusts. The partners then entered into a contract with the unit trust under which administrative services were provided to the partnership by the unit trust. The Court found that the reduction of the partners' taxable incomes and tax liabilities was only a minor motive for doing all of this. The major motives were: (i) (ii) (iii) to put assets outside the reach of potential litigants; death duty planning; and to create wealth for family members.
The unit trust provided secretarial, insurance, training, administration, share registry and occupancy services to the partnership. (Since Phillips case it has become common for a wider range of services to be provided, to the extent that it is now common to find all non-professional services being handled by a service trust.) Once aware of the situation, the ATO assessed the partners on their fractional share of the amount charged to the partnership by the unit trust. The matter ended up in the Federal Court that found that the structure was acceptable for tax purposes because: "the agreed rates for the relevant services were realistic and not excessive" and that "the only purpose of the expenditure was the acquiring of assessable income or carrying on business for that purpose." Despite being a straightforward decision Phillips case has given rise to its own set of legal fictions. These are related to the "mark-ups" to be applied to the charges levied by the service trust to the practice. For example, the Court accepted a mark up of 50% on labor costs was acceptable as a basis for charging for labor type costs. However, it is wrong to slavishly apply 50% as a mark up. Regard must be had to the nature of the labor services performed and the charge levied for that service should be the market value for that particular service. The best evidence of "market value" will be found in the charges that would be faced by the partnership if a non-related party provided the labor service. This can be greater or lesser than cost plus 50%, and almost certainly will be. The fallacy of the 50% mark-up on labor costs is discussed in detail at part 4.9 under the heading "Why labor costs cannot be marked up by 50%". Practitioners using service trusts should always remember that: January 2002 Page 116
(i) the charges should be made on a monthly basis (at least) and that payment should be made some time thereafter. Book entries put through after June each year will often not pass muster should the ATO decide to challenge them; the basis of rendering charges should be reviewed regularly and that this review should be properly documented at the time it is completed; and a properly executed management contract should be put in place to provide a firm legal basis for the rendering of the services.
(ii) (iii)
Summary A properly structured practice means that income need not be taxed at a marginal income tax rate greater than the prevailing corporate tax rate, currently 30%. As advisors we frequently encounter medical practice income being taxed at the top individual rate, currently 48%. This is normally due to a failure to properly understand how practice income is taxed and a failure to organize the practice's affairs so that the amount of tax required to be paid under the law is payable.
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4.2 The taxation of medical partnerships
Introduction This part of the manual looks at the income tax profile of a medical practice partnership made up of two or more IMPs. This is an area where mistakes are frequently made. We often find that many practitioners, and the accountants who advise them, fundamentally misunderstand the basis on which medical practice partnerships are taxed. Some care and attention to the material explained in this part of the manual is essential for any practitioner who is a partner in a medical practice. The concepts outlined in Part 4.1 are essential to understanding this part of the manual. We suggest that you read Part 4.1 before you read this part of the manual. What is a partnership? At general law, and under the Partnership Act, a partnership exists where two or more persons are carrying on business in common to make a profit. Whether a partnership exists is a question of fact: it doesn't matter what you call it: the test is whether you are in fact carrying on a business in common in order to make a profit. For tax purposes the definition of a partnership is broader and includes persons who receive income jointly. For example, the co-owners of a property will be partners for tax purposes, since they receive income jointly, but will not be partners under the general law and or the Partnership Act. This is because they are not carrying on a business: the mere ownership of a property does not comprise the carrying on of a business. It is just a passive investment. But co-owners of a passive investment can be partners under the taxation law. How is a medical practice partnership taxed? The definition of a partnership for general law and Partnership Act purposes and the definition of a partnership for tax purposes are critical to understanding how medical partnerships are taxed. If the relationship is in fact one of partnership: that is, the practitioners are carrying on a business together with a view to making a profit, then the income of the partnership will be business income. This is a cut and dry issue. It is not interpretive or subjective. If a relationship is a partnership under the general law the income of the partnership is business income. Full stop. It is a definitional impossibility for this to be otherwise: a partnership just cannot derive personal exertion income. It can only derive business income. Any attempt to treat personal exertion income as partnership income will not be effective because it is just not possible for personal exertion income to be shared with another person. This type of income is personal to the person who produces it. This is a basic principle of taxation law and there are no exceptions to it. (But of course there may be some instances where practitioners who think they are partners are not, because their activities do not have the characteristics of a partnership under the general law.) Therefore, the income of a medical partnership comprised of IMPs does not need to be paid to the individual practitioners each year, whether as salary, superannuation contributions or as a fully franked dividend. The partners can retain profits each year and the tax rate payable on these profits will be 30% and not the higher rate of 48% normally applying to practitioner's incomes. January 2002 Page 118
This is because the partnership's income will always be business income. It has to be or else there is no partnership. Therefore, the ATO's ruling regarding incorporated practices not making profits and not having taxable incomes do not apply to IMPs that are members of bona fide partnerships. This is important so we will say it again: Income Tax Ruling IT 25 titled "Incorporation of Medical Practices", dated 24 May 1984, and Income Tax Ruling IT 2503 titled "Income Tax: Incorporation of Medical and Other Professional Practices", dated 3 November 1988 do not apply to incorporated practices that are members of bona fide partnerships. An incorporated practice that is a partner in a partnership does not have to pay all of its profits out to the shareholder practitioner each year. The incorporated practice may retain its profits each year and pay tax on those profits at a rate of 36%, and is not required to pay them out to the shareholder practitioner to be taxed at (typically) 48%. This means that partnerships of incorporated practices have significant tax advantages over other practice structures. This is normally to the tune of about $10,000 a year in cash savings, but it may be more or less depending on each practitioner's particular tax profile and family profile. This is a compelling reason for the incorporation of any medical practice partnership. A special note for two person partnerships In the case of smaller partnerships the above analysis may not apply. This is particularly where the partnership agreement allocates income between the partners in accordance with each practitioner's gross billings, the partnership does not employ any other practitioners and does not have a significant business infra-structure. Although the practitioners may regard themselves as partners, and they will be partners for income tax purposes since they are receiving income jointly, they may not be partners for general law and Partnership Act purposes. This is because, on the facts, they are not carrying on a business in common: they are carrying on two separate medical practices. Generally the characteristics of a partnership may be absent, even though this is what the practitioners call themselves. The income from each of those two practices is inherently personal exertion income. This is so irrespective of what the practitioners call themselves, how they account for their income and what banking procedures are followed for cash receipts. This probably will be the view of the ATO. The position will be less clear where the income is in fact shared fifty/fifty, where the partners employ other practitioners, or where there is otherwise a significant business infra-structure. Here the practitioners will probably be partners for general law and Partnership Act purposes. If you are a partner in a two-practitioner partnership it can be a good idea to cast your partnership agreement and relationship generally so you are treated as partners for income tax purposes. It is common for mistakes to be made regarding the taxation of medical practice partnerships. In fact, this is probably the area where most accountants simply get it wrong due to a lack of experience, thought and understanding of the field. We find that many practitioners are paying too much income tax because they or their advisors are not aware of this aspect of taxation law and do not understand the nature of a partnership. Expert advice should be sought in each case. It almost always leads to significant tax savings for each partner in the practice. These savings can easily exceed tens of thousands of dollars a year.
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4.3 Family Trusts
This part of the manual helps explain the commercial advantages and disadvantages of conducting an investment or a business through a family trust. The various planning opportunities and pitfalls are considered and consideration is given to how trusts may be used to create and protect wealth. The roles played by the various parties, ie the trustee, the beneficiaries, the appointor and the settlor are explained. The trustees duties are described, a sample trustee minute is provided and the life cycle of a typical family trust is explored, including the procedure for ending the trust. In summary, the income tax, capital gains tax and asset protection attached to trusts means that they are often the preferred method of structuring a business or investment activity. This is so even when the business or investment is only of modest size. Review of basis of taxing trust income Draft legislation is before the Federal Parliament to tax discretionary trusts as if they are companies. These rules were intended to apply from 1 July 2001 but were postponed due to their complexity, the number of other significant tax changes and insufficient lead-time. It is not clear when or if the draft legislation will be passed in the foreseeable future. If it is, this will be generally good for discretionary trusts, because for the first time they will be able to retain net income, pay tax at the company rate, i.e. 30%, and then carry the net income forward to a future year to be distributed as a franked dividend to an appropriate beneficiary, possibly generating franking credit refunds as this happens. Your trusts deed does not reflect the draft legislation and may need to be amended when and if the draft legislation is passed by the Parliament. The deed has been drafted this way because the draft legislation may change significantly before it becomes law. It is better to wait and see what happens than to try to draft clauses dealing with something that may never become law. Any questions regarding the taxation of trusts should be referred to your accountant. Appendix 4 includes an article published in the December 2000 edition of Personal Investor Magazine dealing with the taxation of trusts and explaining how the proposed new rules would make family trusts more attractive than ever. What is a family trust? A family trust is a discretionary trust where the beneficiaries are all or predominantly members of the same family. To differing degrees the beneficiaries see themselves as a common economic unit and are happy for trust income to be distributed in a way that satisfies their common interests and objectives. Frequently these common interests and objectives include minimizing the total tax paid on the trust's net income. But this just raises the question "What is a 'discretionary trust'?" Indeed, what is a "trust"? Trusts originated in England hundreds of years ago. Their original purpose was to avoid feudal dues payable on land transactions. A landowner would give a piece of land to a friend to "hold on trust" for his descendants thereafter. This arrangement avoided paying dues as the land passed from fathers to eldest sons, through the generations. Modern trusts are far more evolved and sophisticated than these early primitive trusts. Although, strangely, they have not lost their original tax planning advantages. January 2002 Page 120
A modern trust is a fiduciary relationship rather than a legal person. The relationship requires one person to legally own an asset for the benefit of another person or set of persons or, in some cases, a purpose (eg a charitable cause). The person who legally owns the asset is called the trustee, and the person or persons for whose benefit the asset is held is called a "beneficiary" or, collectively, and rather pompously but thankfully rarely, the "cestui que trust". A trust is defined in Underhill's Law Relating to Trusts and Trustees as follows: "A trust is an equitable obligation, binding on a person ("trustee") to deal with property over which he has control ("trust property") either for the benefit of persons ("beneficiaries") of whom he may be one, and any one of whom may enforce the obligation, or for the advancement of certain purposes." Most Australian businesses are carried on in trusts. Trusts can be small, for example, a family trust may own a small unit with a cost of less than $80,000, or they can be very large: some of the managed investment trusts have more than 20,000 unit holders or beneficiaries. A trust can be very short lived, as is the case, for example, when a deposit for a house is left with an estate agent; or a trust can be very long lived, as is the case, for example, for most family trusts which may last for up to eighty years. Most trusts are evidenced by a trust deed. This is a legal document prepared by a solicitor which sets out the purpose of the trust, the rights and obligations of the beneficiaries, the powers of the trustee, and the identity of the beneficiaries, the trustee and the appointor. A formal trust deed is not essential to create a trust. But it is highly recommended and in practice mandatory, for taxation purposes at least. Discretionary trusts The phrase "discretionary trust" deserves specific comment. Most family trusts are discretionary trusts. The word "discretionary" refers to the power or discretion the trustee has to decide which beneficiary or beneficiaries get the net income and the capital from the trust each year or on winding up the trust. These discretionary powers are the critical element in creating the income tax, capital gains tax, asset protection and social security advantages of a trust and these are discussed in detail below. So, in summary, a family trust usually involves a trustee (typically a shelf company) holding an asset on trust for the benefit of a group of family members known as the beneficiaries. Family members usually own the trustee companys shares, and therefore it is they, through the trustee company, who decide how the trusts assets and income are dealt with. The trustee is appointed by a person called the "appointor" (or in some older deeds the guardian). The appointor is usually nominated in the schedule to trust deed and is typically the person (or persons) who decides to set the trust up in the first place. An important point to note is the nature of the duty owed by the trustee to the beneficiaries. It is one of the "utmost good faith" and it requires the trustee to act in the best interests of all of the beneficiaries at all times. This is the highest duty recognized by the law and requires the trustee to put the interests of the beneficiaries above those of the trustee at all times. The duty of utmost good faith stops the trustee from using the assets for its own purposes and not for the benefit of the beneficiaries. Trustees duties are discussed in more detail below. The beneficiaries are the persons for whose benefit the trustee holds the trust property.
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In most trust deeds the primary beneficiaries will be specified, and will usually be the people setting up the trust, and perhaps their children or other close relatives. The general beneficiaries will be defined by reference to the primary beneficiaries. For example, the class of persons who are general beneficiaries will usually be the parents, grandparents, brothers, sisters, children, grandchildren, aunties, uncles, nephews, and nieces of the primary beneficiaries. It is common for the definition to also include any private company or trust in which any natural person general beneficiary has an interest or expectancy. Most of the advantages of family trusts stem from the trustee's discretion over which beneficiary receives net income distributions or capital distributions from the trust each year, or on the vesting of the trust. Because of this discretion the law does not recognize any property right in a beneficiary over the assets owned by the trust. This is because no single beneficiary owns the assets held in the trust. The trustee has legal ownership but not beneficial ownership of these assets, and is required to hold them for the benefit of the family members who are specified in the trust deed to be the beneficiaries of the trust. As a group the beneficiaries own the assets, but no one beneficiary owns them, or part of them. This means it is usually not possible for a beneficiary to unilaterally do something that places the trusts assets at risk. Therefore, if the beneficiary becomes bankrupt there is usually nothing the trustee in bankruptcy can do to get his hands on the trusts assets (unless of course the trust has mortgaged the assets or guaranteed the performance of the beneficiarys debts, or otherwise involved itself in the bankrupt beneficiarys affairs. Primary beneficiaries do not have any greater rights over the trust property than general beneficiaries. In fact, as indicated above, they do not have any rights at all: they only have an expectation that the trustee may exercise its discretion in their favor. The role of the appointor deserves comment. The appointor is the person who decides who will be the trustee of the trust. The appointor controls the trust, since if the trustee did not follow the appointor's directions, the appointor would simply sack the trustee and appoint a more compliant trustee in its place. The appointor is normally the person or persons who decided to set the trust up in the first place. This is normally the practitioner and, if the practitioner is married, the practitioner's spouse. The initial appointor is usually specified in the trust deed. The deed normally states that the initial appointor may resign as appointor and instead nominate in writing some other person(s) as appointor in his or her place. If an appointor dies without making such a nomination then the deceased appointors legal personal representative will become the appointor of the trust, subject to the trust deed. The trustee is normally a shelf company owned by the client and set up specifically to act as trustee of the trust. The shareholders and directors control the trustee. The trustee legally owns the trust property but does not beneficially own the trust property. Beneficial ownership of the trust property lies with the beneficiaries. The trustee can also be any competent natural person over the age of 18 who is not bankrupt or under some other legal disability. The appointor, of course, is the person who really controls the trust. This is because the appointor can end the trustees appointment and appoint an alternative person as trustee in its place. The role of the appointor is discussed in the preceding paragraphs. The advantages of using a company as a trustee are that: January 2002 Page 122
(i) having legal ownership of the trusts assets in the name of the company makes it very clear that they do not belong to the individuals, and this means they are less at risk, particularly if the individual is in a risky business or profession; the company may stay in existence virtually forever, and will not die or become unable to manage its own affairs. This means things are simpler and there is less bother with changing trustees and re-registering ownership with authorities such as the various state Titles Offices; the reach of the Family Law Court is reduced, in some circumstances; the directors or other persons who control the company can exercise defacto control without being personally involved in the trust.
(ii)
(iii) (iv)
The disadvantages of using a company as trustee are largely the extra cost of setting up and running a company each year. The settlor (or, sometimes, the grantor) is the person who the law treats as establishing the trust. This is really a legal fiction: the settlor is usually someone connected to the trustee and the beneficiaries such as a friend or an accountant who pays a nominal sum, say $10, to the trustee to formally establish the trust. Obviously the bulk of the trusts initial assets will be contributed later by the client and related persons, not the settlor. Most modern trust deeds will contain a clause saying that the settlor is not able to benefit under the trust deed. This is because of a tax rule that may create a tax charge for the trust if such a clause is not included in the deed. Sometimes clients are concerned that the name of a person such as their accountant appears in the trust deed, and query whether this creates rights in favor of that person. It does not. The role of the settlor is a mere formality once the trust starts and the settlor has no rights whatsoever in respect of the trust. Inserting the accountants name in the deed as the settlor is a convenient convention and is a simple way of setting the trust up. Advantages of a family trust The major advantages of a family trust are: (i) (ii) (iii) (iv) income tax advantages; capital gains tax advantages; asset protection advantages; and as retirement planning vehicles.
Each of these advantages is dealt with in turn in the following paragraphs. Income tax advantages A major advantage of a family trust is the ability of the trustee to select the person to whom the trust's net income will be distributed each year. Provided certain formalities are observed, which are discussed below, and subject to one qualification, which is also discussed below, trust net income may be distributed amongst the beneficiaries in a way which minimizes the total income tax payable on it. January 2002 Page 123
For example, a family trust controlled by a practitioner may have two beneficiaries who are over the age of eighteen and who have no other taxable income. The trust has net income of $10,000 attributable to administration services provided to the practitioner's medical practice. The trustee may resolve to distribute $5,000 to each of the two beneficiaries and, if it does so, no income tax will be paid on the $10,000 so distributed. Had the practitioner derived the $10,000 of income personally income tax of $4,800 would have been payable this year and provisional tax of about $5,200 would have been payable early in the following year (for offset against the following year's income tax). The family trust has therefore saved the practitioner $4,800 in tax each year forever. After ten years, at ten per cent interest, this accumulates to more than $100,000 in total cash savings. After twenty years this adds up to more than $300,000 in total cash savings. Family trusts have capital gains tax advantages compared to companies. This is because the 50% discount factor on capital gains disposed of within a year applies to trusts but does not apply to companies. Specific advice should be sought before deciding to acquire a specific asset in the name of a trustee of a family trust. Family trusts can be combined with private companies to get the benefit of the 30% tax rate currently applying to private companies. Arranging for the trust to distribute net income to the trust each year does this. The main rule here is that the cash must be actually paid over to the corporate beneficiary, and then retained in the corporate beneficiary. If this does not happen there is a risk that special anti-avoidance rules applying to private company loans may apply. Specific advice should be sought before deciding to distribute net income to a company. Another major advantage of a family trust is the ability to put valuable assets beyond the reach of potential creditors. We have seen family trusts save the day many times. In most cases assets transferred to a family trust may not be able to be accessed by creditors if the transferor gets into financial difficulty or even goes bankrupt. This is because the transferor has no interest in the transferred property and has no interest in the family trust which is recognized at law. For example, a practitioner acquired a home worth $300,000 through a family trust and rented it back off the trustee. The practitioner also acquired a share portfolio worth $200,000 as an inheritance from a grandparent: the practitioner's family trust was the beneficiary under the grandparent's will. Some years later the practitioner guaranteed a large business loan for his brother. The brother's business collapsed and the bank called up the guarantee. The bank could not touch the family home and the share portfolio. These assets simply did not belong to the practitioner. They belonged to the trust. As a result the bank could not do anything to get its hands on these assets. This asset protection can go on down through the generations. For example, if the practitioner dies and leaves the share portfolio and the family home to a daughter, these assets will be a marriage asset should the daughter's husband one day divorce her. If these assets remain in the family trust they will normally not be marriage assets in a divorce situation. This means that the (ex) son-in-law gets nothing. The same thing happens if a son gets into business difficulties or investment difficulties and is sued by creditors. If necessary, your family trusts deed can be amended to make it more restrictive and protective of the next generation once control passes to it. For example, special rules can be inserted to guard against spendthrift children, or children in law. January 2002 Page 124
Increasingly family trusts are being seen as retirement vehicles, either in conjunction with a selfmanaged superannuation fund or as an alternative to a self-managed superannuation fund. Family trusts have the advantages of being able to acquire assets from related parties, borrow money, hold lifestyle assets such as holiday homes and company cars and are not subject to heavy prudential regulation, and do not need to be audited each year. Careful tax planning can mean the effective tax rate on the trusts income is less than 15%, being the tax rate faced by most self-managed superannuation funds. The planning can be as simple as paying a deductible superannuation contribution to a self-managed superannuation fund each year, sufficient to reduce the trusts net income to a level where the effective tax rate is less than 15%. There are no death duties or similar imposts in Australia at present. However, if death duties are reintroduced then the ownership of assets through family trusts may have some advantages over the ownership of assets by individuals. Other advantages Other advantages of a family trust include: (i) confidentiality of information, particularly regarding the financial affairs of the trust. There are no statutory disclosure requirements for trusts in the way that there are for companies under the ASIC database. There is also no requirement for a trustee dealing with other persons to disclose that it is acting as a trustee of a trust and not in its own right. Thus bank accounts can be opened, leases signed, investments made etc for the benefit of the trust without other people needing to know this. In most cases we suggest that they should not know that the trustee is acting for a trust; there are no formal audit requirements. Accounts have to be prepared but this is only to facilitate the preparation of an annual income tax return; the absence of any formal legislative framework, such as the Corporations Law, to control the activities of the trustee. Trusts are of course subject to the various Trustee Acts and all other relevant law for example, the Trade Practices legislation and the Income Tax Assessment Act. This makes trusts very flexible entities to use for your business activities); the easy entry and exit of beneficiaries, particularly in terms of who gets income and capital each year and on the winding up of the trust; trusts are cheap to set up and run each year; and trusts are relatively simple to wind up.
(ii) (iii)
(iv) (v) (vi)
What are the disadvantages of a family trust? The major disadvantage of a family trust is that, like other trusts, it cannot distribute capital or revenue losses to its beneficiaries. As a result, should a trust incur a net loss its beneficiaries will not be able to offset that loss against any other assessable income that they may derive. Expert advice should be sought if it is expected that a trust may make a revenue loss or a capital loss for taxation purposes. January 2002 Page 125
Some tax concerns From time to time concerns are expressed as to whether the income splitting advantages really do exist and whether the tax avoidance rules apply to family trusts used for income splitting purposes. Traditionally advisors have found some comfort in the words of the Treasurer John Howard when the anti-tax avoidance rules were introduced. He said that the anti-tax avoidance rules would only apply to particularly blatant, artificial and contrived schemes and would not apply to ordinary commercial and family dealings. It is unlikely these rules will apply to a person organizing or re-organizing their business and investment activities to achieve all of the non-tax advantages attached to family trusts as well the tax advantages. It is even less likely that the ATO will try to apply them. Most tax advisors believe that family trust arrangements are outside the tax avoidance rules provided there are sound commercial reasons for their use, such as the protection of assets and estate planning. If you have any concerns here you should discuss them with your accountant. The 31 August "Deadline" Most family trust deeds require the trustee to distribute net income to the trust's beneficiaries prior to 30 June each year. In practice, however, this is rarely done. Most trustees (and, perhaps more importantly, their advisors) rely on the ATOs administrative practice of allowing trustees to distribute trust net income at any time up to 31 August. However, this leads to the strange position whereby most trust distributions are ineffective for income tax purposes, albeit with the indulgence of the ATO. Although the ATO will in most cases follow the 31 August administrative practice, tax lore (cf tax law) contains many examples of the ATO not doing so when it suits: for example, when confronted with a large distribution to a non-resident beneficiary, or some other unusual circumstance. For this reason clients should ensure that any trust distributions in which they are involved follow both the strict letter of the trust deed and the strict letter of the law. Care in this area may now avoid a lot of pain and angst in the future should the ATO decide to challenge the efficacy of a particular trust distribution. As an example of the ATO abandoning established practice to enforce the strict law, practitioners should note the AAT decision in Case X87. In this case the taxpayer relied on the statement made by the ATO in Taxation Ruling IT 2480 that if certain so called "variable income annuities" were terminated in a specified period then concessional tax treatment would be applied, notwithstanding that they were not strictly annuities. Nevertheless, the ATO later denied the taxpayer this concessional tax treatment. The Tribunal showed some sympathy for the taxpayer but in the end had to apply the strict law, not IT 2480. The taxpayer did not appeal from the Tribunal's decision (although he may have taken up the Tribunal's suggestion that he pursue the issue with the Ombudsman). In whose name should assets be held? The trustee is the legal owner of the trusts property. This means the trustees name should appear on all ownership documents, such as shares in private companies, units in private trusts, or title deeds for land ownership. You may add the tag as trustee for the (name) family trust if you wish, and this has the advantage of informing or reminding all concerned that the asset is held on trust and does not January 2002 Page 126
belong to the trustee personally. However, in some cases this will not be possible. For example, most Title Offices will only register a title in the trustees name, i.e. the legal owner, and will not allow the tag as trustee for the (name) family trust to be used. Estate planning: testamentary trusts Family trusts are useful tools for estate planning purposes. This means that their benefits may be available to subsequent generations as well, long after the founders have passed on. This means assets left to children and grandchildren via family trusts can be protected against divorce, business failure and litigation. It also means children under the age of 18 can get significant tax advantages: income derived from trusts created on death is excluded from the rules set out in Division 6AA of the Income Tax Assessment Act regarding the taxation of unearned income for minors. This means the penalty tax rate normally applying to unearned income of a minor does not apply to this type of trust. Any individual person does not own assets transferred to or acquired by a discretionary trust. This means they are not controlled by an individuals persons will. Setting up a family trust and transferring assets to it does not mean that a will is redundant. The role of the family trust and its relationship with your will should be properly understood, and the two should as far as possible be consistent, both with each other and your general wishes and intentions. Specific estate planning advice should be sought from your accountant if this is of concern to you. FEEST Company Services consultant solicitors can assist here if needed.
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APPENDIX 1: THE DUTIES OF A TRUSTEE The dominant duty of a trustee of a discretionary trust is to exercise the utmost good faith towards the beneficiaries at all times. This means the trustee must put the interests of the beneficiaries ahead of his or her or its interests at all times and generally act in a competent and responsible manner. More particularly, the duties of a trustee include: (i) (ii) (iii) (iv) to be familiar with the terms of the trust. The best way to do this is to read the trust deed and to ask your accountant questions if the meanings of the various clauses are not clear; to hold and manage the trust property. This includes making sure all relevant records show the trustee as the owner of the trust property; to observe the trust deed. Any procedures or processes set down in the trusts deed should be observed at all times; to exercise reasonable care, in the sense of exercising the same care and skill that a reasonable man would take in respect of his own affairs. If there is any doubt as to what this standard is, it is safest to err on the side of caution and if necessary engage experts such as accountants and solicitors to help the trustee with the tasks at hand; not to delegate the trustees duties except as permitted under the deed. But delegation does not mean abdication, and the trustee is still responsible for the delegated task being completed appropriately; to invest the trusts assets in accordance with the law of trusts and any special rules set out in the trust deed. Most trust deeds contain extensive investment powers, and permit a very wide range of investments to be made; to act impartially between the beneficiaries; to maintain proper and complete books of accounts including minutes of meetings of the trustees/directors of the trustee company. Minutes of meetings of the trustees/directors should be created and retained to record all major transactions entered into by the trustee; to deal with the trust property properly and not for the trustees own benefit; prepare and lodge a tax return for the trust each year, and generally comply with the income tax law and related laws; to keep the trusts assets separate from other assets owned by the trustee; and insure the trusts assets, where appropriate.
(v) (vi) (vii) (viii)
(ix) (x) (xi) (xii)
The above list may seem onerous but usually trustees have no problems meeting these standards. Problems are only rarely encountered. Nevertheless a wise trustee will act conservatively and will create sufficient documents to show why and how a particular task was completed, acting on the assumption that one day he or she may have to demonstrate how the above duties were satisfied.
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APPENDIX 2 Year 1 THE LIFE CYCLE OF A TYPICAL FAMILY TRUST
A business or investment opportunity presents. At a meeting with his or her accountant and the client is advised to set up a family trust to take advantage of this opportunity. The accountant instructs FEEST Company Services to prepare the trust deed and, possibly, to set up a company to act as trustee. FEEST Company Services forwards the trust deed and related documents to the accountant who arranges for the clients to sign as appropriate. The accountant refers the trust deed to the State Revenue Office for stamping and, if a company is set up, lodges various documents with the ASIC In the case of a property or business purchase, the client advises the vendor that the purchaser will be Trustee Company Pty Ltd as trustee for the Smith Family Trust. In the case of a business start up, the client makes sure all documents and registrations are in the name of Trustee Company Pty Ltd as trustee for the Smith Family Trust. The accountant arranges for tax file number and ABN applications, GST registration, pay as you go withholdings registration, if employees are involved, workers compensation registrations, and various other compliance tasks as required. The client opens a bank account or a cash management account in the name of the Trustee Company Pty Ltd as trustee for the Smith Family Trust. If the trust is borrowing money, documents are signed in the name of Trustee Company Pty Ltd as trustee for the Smith Family Trust. In many cases where there is low security the bank will require guarantees from the clients to properly secure the loan, but it is better if these guarantees are not given, as this improves the asset protection aspects of the trust.
Year 1 to Year 80
The client runs the business or the property. The client records all receipts and payments made by the trust. At the end of each financial year the client arranges for the accountant to prepare accounts and income tax returns in accordance with the Australian Accounting Standards and the income tax law. This includes a consideration of how any net income derived by the trust should be distributed between the trusts beneficiaries. The decision to distribute net income each year is minuted by the directors of the trustee company, and payment is made as appropriate or, if payments are not made, the amounts are carried to loan accounts in the name of each beneficiary. (In strictness these amounts are not loans, but are amounts held under separate bare trusts. But by convention they are shown as loans in the trusts balance sheet.)
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From time to time additional amounts are paid to the trustee by the client or related parties. These are paid as corpus or capital and are tax-free in the hands of the trust. In some cases reinvesting unpaid distributions to beneficiaries can do this, but your accountants advice should be sought before doing this. From time to time capital amounts may be withdrawn from the trust by the client or related parties. These amounts will usually be tax-free but your accountants advice should always be sought before doing this. This may happen when, for example, a beneficiary needs money to buy a new home or for some other personal purpose. The trust may be used for other business and investment opportunities that present to the client. Whether the existing trust should be used or another separate trust set up to handle that opportunity should be considered in conjunction with the clients accountant on a case-by-case basis. The trust deed may be widened to create more powers for the trustee or to include more persons to be included in the definition of primary beneficiary or general beneficiary. This requires the trustee to sign a deed of amendment. Alternatively, the client may wish to narrow the range of powers held by the trustee or to delete some persons from the definition of primary beneficiary or general beneficiary. This also requires the trustee to sign a deed of amendment. In each case your accountants advice should be obtained before preparing the deed of amendment. But the point is the trust deed is a dynamic document that may need to be changed as the nature of the trusts activities evolves and as the legislative and commercial world evolves. Year 80 At the end of 80 years, or earlier if the trustee determines, the trust will vest or cease. The trustee will at that time get in all the trusts property and either convert it to cash and pay a cash distribution to the beneficiaries or will pay an in-species distribution to the beneficiaries. The duration of the trust may be extended or shortened if all concerned agree to this.
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APPENDIX 3 ARTICLE FROM DECEMBER 2001 PERSONAL MAGAZINE CONCERNING THE TAXATION OF TRUSTS Family Trusts: trust tax boon uncovered By Karin Derkley Doomsayers have been out in force since the Federal Government announced in October that it was targeting family trusts with a new tax regime. Being subject to company tax treatment, the verdict was that those who looked at family trusts as a wealth creation vehicle will have to look elsewhere. But there may just be a silver lining to the family trust cloud. Initial reaction that trusts are dead was premature, says Allan Swan, of legal consulting firm SJQ. The Ralph Review of Business Taxation recommended treating trusts as companies - part of its aim to subject investment vehicles to uniform tax rules. The creation of a consistent tax treatment across companies, fixed and nonfixed trusts formed the cornerstone of the Government's aim of a single entity tax regime. (Fixed trusts include managed funds and unit trusts. Family trusts and discretionary trusts are described as non-fixed because trustees have the discretion to distribute earnings to beneficiaries as they see fit.) After the report was published, it was generally accepted that trusts - both fixed and nonfixed - were likely to lose their special character. They would miss out on the tax discount on half their capital gains, which for individuals compensates for the end of indexation that once accounted for inflation. Trusts would be taxed as companies at 30 per cent. In addition, under the profits-first rule, any distribution from a trust would be assumed to be from profits, even if it represented a loan repayment or an unrealised capital gain. What we learned in early October, however, was that while this new tax regime would indeed apply to family trusts and other discretionary trusts, fixed trusts would be exempt. So while family trust earnings would be taxed before it reached the beneficiaries' hands, distributions from managed funds would be taxed only after it was pocketed by the investor. Family trusts have long been perceived, rightly or wrongly, as hotbeds of abuse by high net worth tax-payers looking to channel their wealth through a low tax environment. What the new legislation seemed to reflect was the Government's determination to crack down on this abuse. Others suspected that fierce lobbying by managed funds was the more likely reason fixed trusts got out of the new regime. Whatever the reason, the new rules seemed to unfairly penalise those ordinary families and small businesses that use trusts to protect family assets, and provide for the needs of vulnerable family members. Slapped with the 30 per cent tax on all earnings within the trust - whether or not those earnings were distributed - family trusts simply looked too expensive, tax-wise, and too complicated to warrant the effort. The figures seemed clear. A $100,000 capital gain, say, made through a family trust would attract a total tax bill of $48,500 for an individual on the top marginal tax rate. By comparison a direct owner would pay tax of only $24,250. Even the grandfathering provisions - where assets acquired within a trust before December 23 last year are exempt from the new tax rules - seemed to make the scenario worse, resulting in January 2002 Page 131 INVESTOR
investors being forced to set up multiple structures to ensure the best tax environment for each asset category. But now the dust is beginning to settle, tax lawyers are taking a closer look at the legislation. And gradually the message is coming through that the doom and gloom was, perhaps, a little premature. Indeed, it seems that not only may the future for family trusts not be as bleak as first thought, some are now arguing that the new regime may have given family trusts a whole new relevance to middle Australian families - and a substantial tax benefit to boot. 'It does seem the initial reaction that trusts are dead may have been a bit premature,' admits Allan Swan, a family trust specialist at legal consulting firm Swan Jones Quay. 'Looking at it more closely, it is still a good tax planning tool - it's just a different creature than the one we've been used to.' Tax lawyer Keith James, of law firm Hall & Wilcox, goes further, declaring that the changes have made family trusts more attractive for investors on a high marginal tax rate than they've ever been. 'Anyone who earns more than they spend who doesn't already have a trust must have one now,' he says, How is it that such different conclusions can be drawn from the same legislation? As Swan puts it, the new-look family trust may not suit everyone, but may make more sense to a whole set of different people than they did before. Taking advantage of family trusts is simply a matter of understanding and working with the new characteristics. Apart from the 30 per cent company tax, the issues that receive attention in critiques of the new system have been the full tax on capital gains and the profits-first rule. And, as Swan admits, 'for people who are used to the old system, these things may feel like a big problem'. But there are compensations for these new rules. The most important is the ability to retain income within the trust. Before the changes, earnings had to be distributed every year by the trustee - otherwise they would be subject to tax at the highest marginal rate. Under the new legislation, that compunction is gone. You can now accumulate income within the trust as long as you wish. While they're in there, earnings are being taxed at the 30 per cent company tax rate, but as James points out, that's a damn sight less than the 48.5 per cent you'd be slugged for if it came into your highly-taxed hands. What that means is that if you can afford to keep earnings within the trust rather than distributing them to beneficiaries each year as before, you'll be able to accumulate income at a potentially much lower tax rate than your own. That makes family trusts an ideal 'passive investment vehicle,' says Keith Drewery, the manager of technical services at Perpetual Private Clients. 'Properly managed, family trusts will be great for storing income at a low tax rate,' he says. In fact, says James, the new legislation has helped erase the traditional distinction between two tax systems that has taxed investments by high earning investors at 48.5 per cent and business people at the 30 per cent company rate. 'It means that individuals can now earn income on investments at the same tax rate business people have enjoyed for years.' January 2002 Page 132
Also, by subjecting family trusts to corporate tax arrangements, the proposed legislation allows the 30 per cent tax the trust pays to constitute a franking credit - meaning that anyone who receives a distribution can claim the 30 per cent already paid by the trust against their own tax rate. Even if it comes into your own hands, you'll only have to pay another 18.5 per cent tax on it. But if you're sensible - and the whole point of trusts is to allow the trustee to distribute funds to any member of the family - earnings will come into the hands of a family member on a low tax rate. If the earnings go to anyone on less than 30 per cent tax, they'll end up with a tax refund which is likely to give a whole new significance to those members of your family on a low tax rate. They've now become walking tax refunds, as long as you don't forget that the money that's distributed to them is theirs, not yours. Take trust earnings directed to, say, an 18-year-old uni student. Instead of having to slave behind the counter of a fast-food outlet, they can benefit from a distribution from the trust - in return for a promise of top grades, of course - and still be able to claim back 10 per cent on the franked credits already paid by the trust. It may not do much for their work ethic, but it will save the family lots of unnecessary tax. Even better, if a female member of the family takes 12 months maternity leave, and she plans it to span the financial year, she'll be able to claim back a 30 per cent tax refund on her income from the trust for that year. As James says: 'It could be a disaster for maternity hospitals crowded with women having babies in August to take advantage of a zero tax financial year.' On the other hand, if you don't need the earnings yourself while you're working, you will be doing well to let the income accumulate inside the trust until you retire. 'Sure you'll have to pay the 30 per cent on your capital gains,' James says. 'But when you retire to a lower tax rate, you may well end up with a nice annual tax refund.' Its also going to be a huge incentive to resist siphoning off investment earnings in the short term, says Drewery. 'As long as you're reinvesting the income, the value of investments in family trusts is going to be greater over the long term than those held in your own hands.' The only catch to this is if you have to draw on unrealised capital gains rather than income. Any capital gains you haven't cashed in yet won't have had company tax paid on them, which means you won't have franking credits to claim against. The way to get around that, says James, is to realize the capital and pay tax on it before you take the gains as a distribution. In the end, it's all about postponing tax liability, says Swan, 'and if you've got children about to turn 18, or you're about to retire yourself, you can postpone that liability indefinitely'. True, if you don't have someone on a low tax rate to distribute to, or you're a long way from retirement, family trusts may not work for you quite as well as they used to. But, as Swan says: 'Anyone who has a low tax beneficiary to distribute to, or who is likely to become a low tax beneficiary themselves in the near future, is probably going to do okay.' Indeed, says James: 'If income splitting was the main benefit of trusts - it still is. And it looks like it could be better for that purpose than it has been since the 60s. Because now you can accumulate, and then income split as you need to.'
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Another benefit of retaining earnings within the trust is especially pertinent to individuals on very high salaries. 'If these individuals took trust distributions each year,' says Swan, 'they're in danger of going over the income threshold, where the 15 per cent super surcharge kicks in. Using the trust to store earnings will overcome that problem.' Where it can get really profitable, according to James, is if you use the trust as a channel for loans and borrowings to make investments. There are three different ways you can use trusts in a borrowing scenario. Each relies on the borrowing arrangement to be conducted on strictly commercial terms. You can borrow money from the trust, lend money to the trust, or use the trust to borrow from the bank. The general principle in each case is that you are using the tax differential between your own tax rate and that of the trust to repay the debt. By getting the trust to repay loans - either to you or to the bank - with after-tax dollars paid at 30 per cent rather than your own after-tax 48.5 per cent dollars - you'll be paying less interest overall, and paying the loan off sooner. On a loan of, say, $250,000, the trust has a tax advantage of $4620 a year on the geared investment. If you use this money to then reduce the debt rather than taking it as a distribution, you can reduce your repayment period from 20 to 15 years - saving nearly $200,000 in interest. You can also use your trust to structure a negative gearing arrangement. If your interest repayments to the trust are greater than the income you earn from the investment, you'll receive a net loss for at least the first part of the investment. The money is still yours, via the trust, but you can use the net loss to reduce your overall annual income and the tax you're liable to pay that year. Then, of course, if you're prepared to wait until you retire before you reap the proceeds of the trust's investments, you'll end up paying minimal tax on the earnings, or even get a tax refund. Of course, setting up these kinds of arrangements requires professional advice specific to your individual situation. Before you do anything, talk to an accountant who specialises in trust structures under the new rules.
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4.4 Ten top tax planning tips
This article was originally published in the June 1997 edition of Medical Observer Business. It has been up-dated to take into account changes to the law since then. TIP 1: Claim deductions for all your cars Many practitioners do not claim enough deductions for car costs. One strategy is to have the more valuable car in the practitioner's own name and run a logbook showing a high business percentage. A high business percentage is simply the result of maximizing business travel and minimizing private travel. The other car(s) should be provided as a fringe benefit. Under the statutory method, the amount of FBT is a function of the cost of the car (direct relationship) and kilometers traveled (inverse relationship). This means FBT falls as the cost of the car falls and the distance driven each year increases. The mix of business and private kilometers doesn't matter: the costs are all deductible. This is usually the cheapest way to own a car. TIP 2: Make sure all interest is tax-deductible It costs almost $2 to pay each $1 of interest. This means a $200,000 home loan at 8% pa eats up the first $30,000 of income each year. Principal payments are extra. Converting this loan to a business or investment loan saves about $8000 a year. Invested at 8% this adds up to nearly $200,000 after 13 years. There are many techniques to convert a loan to a business or investment loan. These techniques are so popular banks are printing glossy brochures, supported by accountants' opinions and references to tax rulings, showing how to do it. The only catch is the high interest rate. Why pay 10.5% when the bank will lend at 6.5% if pushed hard enough? TIP 3: Use your family trust properly Consider setting up a company to receive trust distributions if there aren't any other appropriate beneficiaries. The ATO has recently acknowledged this is acceptable. A Corporate beneficiary is a good way to drag the top tax rate down from 48% to 30%, provided certain conditions are met. Children can receive trust distributions of $643 each without paying tax, not $416 as is commonly thought. The difference is due to the $150 low-income earner rebate. Small amounts add up. Make sure investments are owned by the trust, not the practitioner. This means the tax rate on the investment income is much lower. It also means tax on any capital gain will be minimized, due to the averaging rules for low-income beneficiaries.
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TIP 4: Avoid artificial tax-planning schemes June is the selling season for all sorts of weird and wonderful tax schemes. Films, viticulture, crayfish, ostriches and trees feature in glossy prospectuses claiming immediate up front deductions for a fancy fee funded by a friendly financier quoting double-digit interest rates. We have not yet met the practitioner who, one year later, says "That was good. It made a profit for me. Can we please invest another $100,000 this year?" We expect we never will. However, we have met many who have been assessed under the tax avoidance rules, plus 40% penalties. What should you do if an adviser suggests a tax-planning scheme? Simple. Sack him. TIP 5: Eliminate the negative, accentuate the positive There is something illogical in borrowing $200,000 at, say, 7% to buy an asset with an expected income yield of say, 2 per cent. Yes, the loss of $8000 is deductible, but it is still a loss. Yes, there can be a gain on the ultimate sale - but do not hold your breath. How then do you acquire larger investments? After all, few people have $200,000 cash lying around waiting for a good investment. Positively gear. Do not borrow unless the expected cost of holding the investment, including costs other than interest, exceeds expected income. The banks lend at rates as low as 6.0%, provided the security is residential property. Some shares are yielding 8% fully franked. For most practitioners this is the same as 12% unranked. Commercial property can be bought on a maintainable 10% rental yield. Why negatively gear? TIP 6: Use a DIY super fund DIY superannuation is the best way for practitioners to invest. Contributions have to be paid to the fund before 30 June, and can be in the form of cash or, in some cases, property. The new 15% surcharge is normally not a problem and can be planned for easily. If $10,000 is paid as an employer contribution before 30 June, the practitioner's tax bill falls by $3300 (the difference between the practitioner's marginal tax rate 48 per cent and the super fund's tax rate 15 per cent). This is the equivalent of earning 33% tax free overnight, and sets the stage for solid wealth growth afterwards. DIY funds typically cost $250 to set up and about $2,000 a year to run. TIP 7: Prepay some costs Costs are normally deductible when incurred in the sense that a legally enforceable obligation to pay has arisen. Paying in advance can speed up deductibility. Prepaying costs can be a very good last minute planning option. Costs able to be prepaid include interest and deductible insurance premiums. It's ideal if the payee gives a time discount for early payment. Prepayments are limited to 13 months, so there is a natural limit on how far this technique can be taken. TIP 8: Change the timing of tax payments Generally it's better to pay tax under the provisional tax system, as this defers payment as far as possible. Large provisional tax payments can cause budgeting problems, and shifting to the group tax system can take the pressure off by justifying a provisional tax variation. Conversely, January 2002 Page 136
practitioners on the group tax system may shift to the provisional tax system. This means tax for the year ending 30 June 1998 is pushed back to April 1999. (For provisional tax now read PAYG Instalments system and for group tax read PAYG Withholdings system.) TIP 9: Fringe benefits for public hospital practitioners Practitioners employed by some public hospitals are being offered the option of taking up to 30% of their remuneration as a tax-exempt fringe benefit. Practitioners can ask for, say, $20,000 to be paid off a home loan or a credit card bill. This is the same as $20,000 cash, but there is no tax. It's hard to get better tax planning than this. (This has been capped at $8,000 per employee and $8,000 per employer since 1 April 2000. The limit applies to part time employees too, and it is not uncommon to find practitioners employed at say three different hospitals getting three separate lots of exempt fringe benefits.) TIP 10: Keep an eye on things IMPs, practice trusts, service trusts and DIY funds are wonderful tools to legitimately lower a practitioner's tax bill and leave more cash for other projects. But keep an eye on your structure. With complexity comes room for error. Mistakes can be costly and lost opportunities can't come back. Taking time to understand how your structure works and how it can be used to your advantage is the most important tip for a practitioner. There is no such thing as off-the-shelf advice and readers should get their own advice before adopting any of the above tips.
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4.5 Tax schemes and why you should not touch them
What is a tax scheme? A tax scheme is a legal device put together to allow participants to claim large up-front tax deductions and to defer or even eliminate any income derived from the scheme. There is a strong air of artificiality about tax schemes: the practitioner claims to be in the business of viticulture, but has never set foot on a farm and doesn't know a grape vine from a blackberry bush. Tax schemes are normally "self funding": the promoter lends, say, $100,000 to the practitioner who immediately pays this money back to the promoter as a contribution to the costs of the business. A tax deduction is claimed for the $100,000. This is called a "round robin" of cheques and the practitioner normally does not see a cent: piles of papers are signed and this evidences the claimed business activity and the incurring of the deduction. Nothing real ever happens. What should you do if asked to participate in a tax scheme? Tax schemes should not be touched, even in a desperate situation. This is because they are fundamentally flawed from the investment perspective, the finance perspective and the taxation perspective: (i) on the investment side (a) they do not stack up as investments. If the investment is a good investment why is it being hawked around late June to people the promoter has never heard of? We don't think Warren Buffet invests in pine trees and lobster schemes we have never seen the investment work despite glossy brochures, warm promises and independent experts all saying it's a sure thing; a fundamental rule for investing is never cede control of your money to another person. No matter who you are dealing with you cannot be certain the money will go where they said it will go. (Solicitors are, very unfortunately, not an exception here. Some of the worst examples involve solicitors' trust funds); the investment is illiquid, there is no ready market for resale and any promised cash return is years away; and good future investments are blocked out. We have seen practitioners knocked back on loan applications to buy practices because of the debt attached to a scheme. The practice would have returned more than 50% each year. Remember, there is no matching asset to balance out the debt (who would buy the practitioner's interest in the "Red Claw Lobster Farm", particularly as it is still in the "planning stage"). The banks do not treat them as assets for security purposes, so young practitioners in particular can find themselves hamstrung when they want to borrow for something real later on.
(b)
(c) (d)
(ii)
on the finance side: (a) the interest rates are too high. It's not uncommon for the rate to be six or seven points above the market rate, with penalties for default. (This, of course, impacts the likely investment return. Very few investments can perform if they have to make up an extra 6% or 7% each year for say five years. That's a lot of lead in a saddlebag); Page 138
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(b) the practitioner is dealing with the fringe end of the finance market. It's not the friendly manager down at the NAB. Quite often the debt is assigned to a third party once the documents are in place. The third party has no interest at all in whether the scheme is working, it just wants its money. Every month. The financier will not be as obliging as the NAB or another bank if the practitioner's cash flow position changes for any reason. There is no concept of customer service, because there will not be any repeat business; often there is no real external finance. The money just goes around in big circle, or round robin. Practitioner pays promoter with a cheque, promoter pays money to financier and financier pays practitioner. The practitioner is paying 13% and 14% on his own money; and usually the promoter vanishes after a year or two but the financier always stays around, and so does the practitioners obligations to pay;
(c)
(d) (iii)
on the tax law side, the schemes have never been effective (despite expert letters from all sorts of tax advisors). Either the payment is not deductible under sub-section 51(1) of the Income Tax Assessment Act ("the Act") because it has no connection with assessable income or the general anti-tax avoidance rules in Part 1VA of the Act. Some schemes skate through, relying on non-disclosure and the self-assessment rules, but the ATO knocks back every one it sees and applies penalties of up to 200% plus interest on top of primary tax. The ATO had a big win in the Spotless decision in early 1997 and now reputable tax advisors are concerned that any decision that has a tax orientation is suspect, let alone schemes that actively tout tax savings and rely solely on tax benefits for commercial efficacy. The Spotless decision involved in a much tamer set of facts than the average year-end tax-planning scheme. And you cannot go higher than the High Court for authority on this question.
In summary We have never seen a scheme work as an investment. We have never seen the Commissioner accept the claimed tax advantages, unless it's due to non-disclosure. We have never seen a financier budge an inch while collecting the loan. We have never seen a practitioner glad he did it one year later. We have seen practitioners served with assessments and penalties under Part IVA of the Income Tax Assessment Act. We have seen practitioners dragged into court cases against their will (the documents assign these rights to the manager, but the practitioner pays). We have seen practitioners pursued relentlessly by the financier years after the "investment" has collapsed. We have seen wives served with all sorts of documents from solicitors on things then knew nothing about. Why do some accountants promote tax schemes? Simple. They get paid to do this. By the promoter. Most accountants who recommend schemes get very large commissions from the promoters. Obviously it's their clients who really pay. We have seen commissions as high as 30%. (As an aside, how can an "investment" hope to work if 30% is chopped off on day one, let alone consider the impact of the high interest rates, management fees and so on?) Commissions are an ethical disgrace. It's exactly the same as a practitioner getting paid by a drug company based on prescriptions written. It's also a breach of the Secret Commissions Act and the Commonwealth Crimes Act. January 2002 Page 139
Even when some disclosure is made it's highly unusual for full disclosure to be made, including full details of the all expenses paid trips to WA twice a year to look at the trees, staying in a five star suite at Observation City, for accountant and partner, interest free loans, concessional personal involvement in the scheme, accounting fees for services "provided" to the promoter, cash payments etc. The list goes on. What should you do if your accountant or other advisor suggests a tax-planning scheme? Sack him.
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4.6 Why labor costs cannot be marked up by 50%
Introduction Accountants commonly claim service trusts can mark up labor costs by 50%. This is not correct. Marking up labor costs by 50% is one of the most common mistakes practitioners make with service trusts. To support the claim, the accountants point to Phillip's case, which is the leading case in the service trust area, and which is reproduced in full at part 5.4 of this manual. They say that because the taxpayer won this case, and in this case the mark up was 50%, 50% mark up is a golden rule that can be used in all other cases. This is not correct either. Telling practitioners Phillips case says they can mark up labor costs by 50% is one of the most common mistakes accountants make when advising practitioners about service trusts. The accountants obviously haven't read Phillips case. What did Phillips case really say? You can read Phillips case in full at part 5.4 of this manual. But for now let's just look at what the court actually said about mark ups: "30. The trial judge found that the charges made against the firm by the management company for the services were realistic and not in excess of commercial rates. This is a most important finding and was not subject to any challenge by counsel for the commissioner. As to the rate fixed for staff i.e. in effect a loading of fifty per cent on wages paid, this was the rate charged in the marketplace by a client engaged in hiring of office personnel. In return for paying or incurring this charge the firm not only acquired the services of the staff but was relieved from most problems of staff and office management and all financial obligations in respect of wages, sick leave, annual leave, workmen's compensation, statutory holidays and long service leave. In respect of the leasing charges the trial judge found that the rate fixed represented a return of six per cent to eight per cent on funds employed and that such a return could not be said to be excessive. Similarly, he found that the charge for share registry services could not be said to be excessive. None of these latter findings was challenged on the appeal. (at p408)."
and later "35. A crucially important circumstance in the present matter is the unchallenged finding of the trial judge that the charges paid by the firm were realistic and not in excess of commercial rates. The services were essential to the conduct of the firm's business and the fact that the charges paid were commercially realistic raises at least the presumption that they were a real and genuine cost of earning the firm's income and the cost of that alone. It strongly supports the view that the expenditure was exclusively for business purposes. Without doubt the cost of acquisition of the services was "necessarily incurred" in the sense that it was "clearly appropriate or adapted for" the production of the assessable income: Ronpibon Tin No Liability v. Federal Commissioner of Taxation (1949) 78 CLR 47, at p 56 . (at p410) Doubtless the converse would apply, namely, if the expenditure was grossly excessive, it would raise the presumption that it was not wholly payable for the services and equipment provided, but was for some other purpose. Such is not the case here. (at p410)"
36.
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In other words, the court did not say 50% was an acceptable mark-up. It said the mark up should be "the rate charged in the marketplace by a client (firm) engaged in hiring of office personnel". Twenty years ago Fell and Starkey may have had an office personnel client that was able to charge a 50% mark up, but this is not the prevailing rate in 1997. A realistic mark up for a firm engaged in hiring personnel may be closer to 10% or 15%. This is the amount practitioners should be using in 1997. The courts comment that the mark-up covered sick leave, annual leave and other benefits is also worth noting. In Phillip's case these were not subject to a mark-up. What does the Commissioner of Taxation say? The Commissioner of Taxation is on the record that he will not allow practitioners or practice entities to claim a deduction for mark-ups charged by related service entities if they exceed current market rates and the practitioner is not able to produce evidence of current market rates. In the case of labor mark ups of 50% he has said he will disallow these claims. For example, at paragraph 35 of income tax ruling 2503 the Commissioner said: "35. Taxation Ruling No. IT 25 dealt with the use of service trusts or companies. The instructions contained therein should continue to be applied. Essentially it will be necessary to be satisfied in each case that the service for which payment has been made has in fact been provided and that the amount paid is reasonable for the provision of the particular services."
This ruling is reproduced in full at part 5.1 of this manual. The Commissioner has also said this at various Tax Institute functions. The penalty for getting it wrong can be severe: the deduction for service fees is disallowed, primary tax of 47% is charged, penalty tax of 40% is applied and interest is charged at 14%. Typically deductions are disallowed for the previous four years. The amounts add up quickly: an excessive claim of say $20,000 per year will typically lead to total tax, penalties and interest of more than $50,000 cash. What is the "market rate"? Obviously the reference to "market rates" is a reference to independent firms engaged in the personnel industry, particularly the medical personnel industry. It is not a reference to what other practitioners are doing. The fact that other practitioners are mistakenly using a 50% mark up does not establish it as the market rate for medical personnel mark ups.
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Is there a better way to charge service fees? Many practices charge practitioners a service fee equal to fifty per cent of gross billings. The service trust uses these amounts to pay all relevant practice costs (i.e. all costs other than payments to practitioners, which can only be made by a registered medical practitioner or a practice company). Another way is to have the service trust charge a set fee per month, rather than costs plus a mark up.. Both these methods of charging for services are accepted by the Commissioner and, ironically, typically result in more income being derived in the service trust structure and a lower tax bill for the practitioner. Other Materials Readers should also refer to the materials noted at box 4 of Part 4.12 of this manual.
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4.7 Common tax traps (or missed opportunities?)
(This article was originally published in the August 1997 Medical Observer Business. It has been up-dated for changes in the law since then) It's August, Spring is almost here and, naturally, most practitioners' thoughts turn to tax returns, annual accounts and ASC returns. In this article we look at the common traps practitioners fall into when preparing tax returns. A glass of wine can be half empty or half full. It depends on your life view. Therefore we prefer to see tax traps as opportunities for good planning which can significantly improve a practitioner's net wealth, rather than holes a practitioner can fall into. Obviously this discussion cannot exhaust all relevant thoughts, but hopefully it will prompt ideas to help avoid paying unnecessary tax and give readers an idea of the sort of questions they should ask their accountants as tax return time rolls around again. Remember, $10,000 saved each year compounds to $200,000 after 10 years, $300,000 after 15 years and $400,000 after 18 years. Sometimes, taken on their own, savings do not sound like much. But over time they make a real difference to a practitioner's net wealth position. Superannuation fund members DIY superannuation funds are a powerful way for practitioners to invest and should form a major part of almost every practitioner's overall investment strategy. Many practitioners fail to fully harness this power. Common errors include: (i) not contributing enough. For example, many self-employed practitioners forget they can, with some planning, also superannuate a spouse. These contributions are on top of any other contributions made by a spouse's arm's length employer. They can effectively double the amount of deductible contributions, lifting the total to over $22,000 pa for a practitioner under age 35, $58,000 pa for a practitioner over age 35 and under age 50, and $150,000 pa for a practitioner over age 50 (assuming the spouse is the same age); large cash contributions sound fine in theory, but where does the cash come from? Think about non-cash contributions, particularly listed shares or business real estate as an alternative to cash contributions. Borrow money in a family trust or a practice company to pay the contributions: the interest expense will be effectively deducted at 48% but the income from the investment will only be taxed at 15% (ignoring the 15% surcharge), leaving a 33% tax arbitrage saving; speaking of the 15% surcharge, think about: (a) taking fringe benefits rather than salary. Income for surcharge purposes excludes fringe benefits, so taking benefits can drag surcharge income below the $70,000 pa indexed threshold, and reduce tax in the fund; negative gearing in the practitioner's name. This works for tax purposes but ask whether it works for investment purposes. Better gearing strategies have most deductible interest expense in the name of the practitioner but most of the assessable income in the name of someone else. If the income yield is greater than the interest expense, so the investment is positively geared, so much the better; or Page 144
(ii)
(iii)
(b)
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(c) (iv) superannuating a spouse rather than the practitioner. Most self-employed practitioners can do this; and
if you have spare cash, and cannot pay any more deductible contributions, think about undeducted contributions. These contributions are, as their name suggests, not deductible to the member and are not assessable to the fund. The undeducted contributions are not preserved and can be repaid tax-free to the member on a change of employment (the earnings must stay in the fund). This allows the fund to be used like a low tax bank account: by paying money into the fund income can be shifted from a high tax environment to a low tax environment, which significantly lifts the after tax rate of earnings and accelerates the accumulation process.
Property Owners Many practitioners own investment properties. Many do not claim enough deductions for the costs of owning their properties. Remember: (i) non-deductible interest on other assets can be shifted to the investment property. This is so despite the ATO's recent public statements on certain arrangements being marketed by several large banks. Skill is needed, but it can be done; plant and equipment with an estimated life of less than 3 years, or a cost below $300, can be written off in the year of purchase; borrowing costs, including stamp duty on loans, is deductible over the shorter of the life of the loan or five years; structural improvements can be amortized at 2.5% over 40 years; and there is often "hidden" plant and equipment. This includes air-conditioners, carpets, curtains, heating facilities and so on. Quantity surveyors estimate the cost of these items and the Commissioner accepts the estimates as a base for depreciation charges. Sometimes refunds are available for under claimed depreciation in prior years.
(ii) (iii) (iv) (v)
Capital gains tax ("CGT") Sound planning techniques to minimize or eliminate CGT include: (i) sell early in a quarter, and buy late in a quarter, to maximize the indexation of cost base, which decreases the amount of any capital gain. Further, if you sell early in the September quarter (ie in July) rather than late in the June quarter, the due date for payment of CGT is deferred by a year; acquire investment assets using family trusts. This does not change the amount of the capital gain but it does change the amount of the CGT, by allowing the capital gain to be distributed to beneficiaries who will pay the least amount of CGT. For example, if a practitioner has two university age student children with little or no other income a capital gain of, say, $50,000 can be distributed to them ($25,000 each) and no CGT will be paid. Corporate beneficiaries, who pay tax at 30%, not 48%, and deductible superannuation contributions can also reduce the CGT payable on a capital gain derived by the trustee of a family trust; time disposals of gain assets with disposals of loss assets, since capital losses are Page 145
(ii)
(iii)
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deductible against capital gains but are not deductible against other income; (iv) (v) carefully record the cost of all improvements to properties and add this to cost base, and indexed cost base at the time of sale; and if you own property through a unit trust, which is very common for surgery premises in group practices, make sure any debt is held at the unitholder level and all unpaid distributions are capitalized to maximize cost base on the units. This guards against deemed capital gains if the unit trust distributes an amount to unitholders that is not assessable income. This is a common problem and often practitioners inadvertently fail to disclose deemed capital gains year after year. In an audit the underpaid tax, plus penalties and interest can really add up.
Employee Practitioners Much tax planning presupposes practitioners practice through structures. Of course, not all practitioners do this. Many are employees, whether in the hospital system, larger practices or elsewhere. What opportunities are open to an employee practitioner? Frequently employees fail to claim costs incurred in earning their salary. Common examples include: (i) travel to and from home. If a practitioner has to carry medical bags, drug bags and some basic equipment to complete after hour calls and home visits, home to work travel may be a deductible cost. Up to 90% deductible business travel is a realistic goal for a practitioner's car; depreciation on equipment should be closely watched. This includes depreciation on computers used for employment purposes, which can be 100% in the first year if the computer has an expected life less than 3 years. Software bought separately from hardware can be claimed 100% in the year of purchase; professional libraries may be depreciated, and individual books costing less than $300 (ie almost all books) can be claimed 100% in the year of purchase; financial institutions duty on bank deposits is normally deductible. The position is complex with bank accounts debits tax although some claims may be made; home office expenses, such as depreciation of office furniture, electricity, cleaning and repairs are deductible, although some costs, such as a share of rates and interest may prejudice the CGT exempt status of the home. If you are renting a share of the rent may be deductible as a home office expense; protective clothing is deductible; and tax return fees and investment advice, except for advice on setting up a portfolios, is tax deductible. (You would be surprised how many tax agents fail to remind their clients their fees are deductible.)
(ii)
(iii) (iv) (v)
(vi) (vii)
What does the Commissioner of Taxation say about all this? The Commissioner very helpfully publishes a list of common errors in returns. These include omitting interest and dividends, unsubstantiated deductions and failure to claim one of the 14 January 2002 Page 146
rebates available to individual taxpayers. The Commissioner also publishes an annual "Tax Pack" as a guide to help taxpayers complete and lodge their own tax returns. This is a useful aid but it is no substitute for objective advice and assistance: the Commissioner does not provide taxplanning services and the Tax Pack is of limited practical value for a practitioner. The tax system operates under self-assessment. Tax officers do not study your return: normally the only person who looks at it is the key operator who tells the computer to send an assessment based on what you have said in your return. Tax officers do not compare this year's return with last year's return and ask taxpayers to explain the differences. This is a myth. Enforcement is by audit with heavy penalties and interest charges for non-compliance. Anecdotally a practitioner's prospects of being audited are well below the Commissioner's public claims of 3%, and are probably less than 1%. We lodge more than 2,000 tax returns a year, but we have not had an audit for more than 4 years. Other accountants report similar experiences. Selection for audit is by random sampling or project based selection (for example: this year we will audit 20 practitioners in this area and, if the results are worth it, next year we will audit 200.) The Commissioner normally advises tax agents in advance which occupational groups are chosen for audit. This is part of the strategy to encourage voluntary compliance. Practitioners have not been on the list for a few years now. The initially much publicized desk audit program was quietly abandoned a few years ago. In the last 12 months staff numbers, particularly in the enforcement area, have dropped by more than 2,500. This makes the prospects of being selected for audit even more remote than before. This should not lead to compliance standards dropping. The penalties for getting it wrong are heavy: underpaid primary tax, culpability penalties of up to 200% and interest at more than 14% pa adds up to a huge amount after a few years, and the Commissioner can generally amend a return at any time up to four years after the assessment issues. So care is vital because mistakes can be expensive. Every aspect of your tax profile should be thoroughly documented and filed to defend your position should the Commissioner question it in any way.
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4.8 Taxation and practitioners cars
The question: "What is the best way to own my car?" is one that we hear very often. This is not unexpected. The family cars represent one of the biggest investments and expenditures that you make and structuring the purchase in a way that minimizes the after tax cost of the car is a very sensible thing to do. The common answer The answer to this question is normally: "Through your IMP or through your family trust and for the car to be provided as a fringe benefits as part of your salary package". The employee then contributes to the cost of running the car such that the taxable value of the car is reduced to nil and no fringe benefits tax ("FBT") is payable on the car fringe benefit, although the amount of the contribution must be returned as assessable income by the employer. The contribution can be made through a loan account at year-end so that a cash contribution need not be paid to the employer. The common exception The exception to this answer occurs where the car has a high dollar value car, is being driven less than 10,000 kilometers a year and has a high business usage percentage. In this situation it can be better to own the car in the practitioner's own name and to claim a tax deduction for the costs of running it. These costs can include depreciation and any interest, or lease payments if the car is leased, times the business percentage. The options for computing FBT Once a decision is made to take the car as a fringe benefit a further decision must be made to compute the FBT under one of the two options contained in the Fringe Benefits Tax Assessment Act. These two options provided for under this Act are called the "statutory method" and the "operating cost method". Both have their own set of advantages and disadvantages and each may be more suited to one type of situation. Briefly, the statutory method applies a statutory fraction of .07, 11, .20, or .26 to the cost of the car to determine taxable value (before employee contributions). The operating cost method applies a business usage factor to the actual and deemed costs (including depreciation) incurred in running the car. As a general rule, the statutory method will be more tax efficient than the operating cost method. It is much simpler to apply because there is no need for a logbook and other detailed records to be kept. It is also far less vulnerable in a tax audit. The exception here will be where the proportion of business use is high and the total costs of running the car are low (although this will tend to reverse after four years as the base value of the car under the statutory method will fall by one-third at that time). The key to understanding why this is so is to appreciate that the statutory method is intended to be a simpler method of computing FBT liability on cars and to allow employers to not keep tediously detailed records of the actual costs of running a car. The statutory fractions are also set to reflect an assumption of higher business usage as actual kilometers traveled increases. While it is easy to imagine exceptions to this assumption, as a general proposition it is probably correct: total business kilometers will increase more than proportionately to total kilometers. The statutory fractions used under the statutory method and their implied business proportions are as follows: January 2002 Page 148
Total Kilometers Traveled Less than 15,000 15,000 to 24,999 25,000 to 40,000 Over 40,000 Effective tax rates We have calculated the effective tax rates on two cars, one costing $15,000 and one costing $30,000. The FBT, and therefore the effective tax rate on the car fringe benefit is a function of kilometers traveled. The position can be summarized as follows: Effective Tax Rate Car Costing $15,000 34% 29% 18% 12% 40% 34% 22% 15% Kilometers Traveled Less than 15,000 15,000 to 25,000 25,000 to 40,000 40,000 plus Less than 15,000 15,000 to 25,000 25,000 to 40,000 40,000 plus Cost to Package $10,700 $9,800 $8,600 $8,000 $18,000 $16,500 $14,000 $13,000 Statutory Fraction 0.26 0.20 0.11 0.07 Implied Proportion of Business Usage 54% 77% 80% 90%
Car Costing $30,000
Some examples Some examples may help to explain the practical mechanics of FBT and the rules regarding claiming a tax deduction for the cost of cars owned by employees and shed some light on when one is preferred to the other. The statutory method As indicated above, the statutory method is the most frequently used method for computing FBT on cars. It is also the simplest method and has minimal recording requirements each year. Logbooks are not required but odometer readings as at 31 March each year are required. Assume that a car cost $30,000, is one year old, travels 27,000 kilometers in a normal year and is available for private use for the whole year. The employee did not make a contribution to running the car. The taxable value of the car will be $3,300 computed as follows: (Base value of car) times (statutory fraction) times (number of days available for private use by employees divided by the number of days in the tax year) less (employee contributions). $30,000 times .11 times 365 divided by 365 less nil equals $3,300. The operating cost method The operating cost method is also known as the logbook method. This method requires the employer to record all costs incurred in connection with each car. This includes depreciation and a deemed interest charge. The employer must then identify the business percentage factor applying to each of those cars based on business kilometers traveled during the year as a percentage of the total kilometers traveled, as recorded by a log book maintained for at least a twelve week period in the first year that the car is owned. January 2002 Page 149
Assume a car cost $30,000, is one year old and costs $4,000 a year to run (including petrol, insurance, registration etc). The logbook shows that business percentage is 70%. The statutory interest rate is assumed to be 10%. The taxable value of this car under the operating costs method will be $3,669. This is computed as follows: Maintenance, Fuel, Registration Costs etc Depreciation ($23,250 times .225) Total Operating Costs Times Private Usage Factor Taxable Value An example of the common exception As indicated above, an exception to the normal rule that it is cheaper to have a car owned by an employer and provided to the employee as a fringe benefit may arise. This is where the car has a high dollar value, is being driven less than 10,000 kilometers a year and has a high business usage percentage. In this situation it can be better to own the car in your own name and to claim a tax deduction for the costs of running it, including depreciation and any interest, or lease payments if the car is leased, times the business percentage. Multiple cars There is no limit on the number of cars able to be taken as a fringe benefit by an employee or an associate of an employee and there is no requirement that the practitioner drive the car. Three and four cars are not uncommon. The practitioner uses the first car. The practitioners spouse uses the second car. The children or even their grandparents use the third and fourth car. The cost of each car is deductible to the employer and there is no income tax payable on the benefit. Fringe benefits tax is payable, as discussed above. Note there tends to be little fringe benefits tax payable on the third and fourth cars: under the statutory method FBT is a function of cost, and if the car did not cost much in the first place there can't be much FBT. $4,000 $3,000 $12,230 .30 $3,669
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What is business travel? The question of what is business travel is summarized by the following extract from the Australian Tax Reporter. Note the highlighted reference to practitioners: this presents a tax planning opportunity, since most general practitioners carry bulky equipment with them most of the time. A drug bag and an equipment bag probably suffice (Ballestys case involved nothing more than a rugby players sports bag). But we generally recommend clients also carry some basic emergency medicine equipment as well, to put themselves well within the rules. AAT decision 9235 dated 13 January 1994 is reproduced in full in Part 5.6. [17 285] Travel expenses Travel expenses from home to work are generally not an allowable deduction. The leading case that decided this was the decision of the Full High Court in Lunney v FCT (1958) 7 AITR 166. The reasons are twofold. First, merely because certain expenditure must be incurred in order to be able to derive assessable income, in that unless one arrives at work it is not possible to derive income, does not necessarily mean that the expenditure is incidental and relevant to the derivation of assessable income or that it is incurred in the course of gaining or producing assessable income. It is a prerequisite to the earning of assessable income rather than being incurred in the course of gaining that income. Hence, it does not fulfill the positive limbs of s 8-1(1). Second, the essential character of the expenditure is of a private or domestic nature, relating to personal and living expenses as part of the taxpayer's choice of where to live, in choosing to live away from and at what distance from work. The negative limbs of s 8-1(2) are therefore also breached. There are, however, some exceptions. Certain employees such as professional footballers and musicians have been held to have a base at their home and consequently from the moment they leave that home they are engaged in connection with their work and are entitled to a deduction in respect of the traveling costs incurred: Ballesty v FCT (1977) 7 ATR 411. This is particularly so where transport of bulky equipment is a necessary part of the job: FCT v Vogt (1975) 5 ATR 274. A practitioner was able to obtain a deduction on these
grounds in AAT Case 9235 (1994) 27 ATR 127. (emphasis added)
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4.9 OMIGOD! Its tax time!
(This article is reprinted from the June 1998 edition of Medical Observer Business. It has been up-dated for changes to the law since then. ) OMIGOD! It's tax time! It's half way through June and the tax year is nearly over. Soon tax bills will pile in taking a large part of your hard earned income once again. What should you do? What can you do? What shouldn't you do? What will you do? June 1998 is the perfect time to start tax planning for the year ending 30 June 1999. But June 1998 is not a good time to start tax planning for the year ending 30 June 1998. This is because the range of options is limited by the simple fact the year is almost over. The best tax planning uses legal structure to automatically minimize the amount of tax paid each year irrespective of the level of income and without the need to rush around frantically between now and 30 June. With one or two exceptions, there is not too much that can be done for 1998 now. But 1999 is a clean whiteboard and everything is possible. Before we look at what should be done for the year ending 30 June 1999, lets have a look at what can still be done in the week or so remaining of the year ending 30 June 1998. Tax planning for 30 June 1998 Tactics here include super contributions, including contributions for spouses, pre-payment of expenses, deferral of assessable income and maximizing available deductions. Superannuation contributions Super is still the best tax planning and investment option for practitioners. DIY super coupled with a DIY investment philosophy is the best way to go. Commission free investments tend to be good investments and there is a certain peace of mind knowing you won't wake up to find your money has disappeared. For the self-employed, the first $3,000 contributions and 75% of the contributions above $3,000 are deductible. For both the self-employed and the employed, age based deduction limits apply. In 1998 these are $10,232 if under 35, $28,420 if between 35 and 50 and $70,482 if above 50. (These have increased since 1997.) The 15% surcharge applies to surchargable incomes above $88,910, phasing in from $73,220. Surchargable income includes all the items normally included in assessable income and superannuation contributions but does not include fringe benefits. The surcharge has taken the sparkle from super. But it can be planned for. Negative gearing and fringe benefit planning are commonly quoted solutions. But it can be a lot simpler for selfemployed practitioners to superannuate their spouse rather than themselves. Most practitioners have a surchargable income above $70,000, but their spouses normally do not. Superannuation and spouses January 2002 Page 152
Mention superannuation and spouses and attention focuses on the special rebate of up to $540 for the first $3,000 of contributions for a non-working spouse with an income not greater than $10,800. But this is chicken feed. If a spouse is a director of a company, is under age 65 and has been gainfully employed for more than ten hours a week some time in the last two years, the practitioner can superannuate the spouse up to the age-based deduction limits noted above. This is so irrespective of whether the spouse was gainfully employed in the practitioners practice and whether the spouse receives superannuation support from some other employer. There is no "reasonableness" limit on the amount of deductible contributions as there is for spouse's salaries, so the only limiting factor is available cash (although as noted below, this problem can be solved too.) An example might help. Assume Dr Smith has the choice of superannuating herself or her husband. Her husband works full time as a manager in the state public service. Dr Smith is 32. Her husband is 35. Dr Smith has a surchargable income of $100,000 and her husband has a surchargable income of $35,000 plus state superannuation support. Maximum Super Contribution Tax Benefit for Dr Smith at 48% Tax Charge Paid by Super Fund Surcharge Paid by Super Fund Net Tax Benefit to Dr Smith Dr Smith $10,232 $4,911 $1,534 $1,534 $1,843 Mr Smith $28,420 $13,641 $4,263 Nil $9,378
Dr Smith saves an extra $7,535 by superannuating her husband rather than herself. Yes, in case you are wondering, superannuation benefits are considered by the Family Law Court when allocating assets between parting spouses! Short of cash? Consider borrowing to pay your contributions. But take care, since interest on amounts borrowed to pay contributions is not tax deductible if you are self employed. Interest on amounts borrowed to pay employer contributions is tax deductible. Consider non-cash contributions. Some special rules have to be observed but, in concept, noncash contributions to your own fund (eg listed shares, units in a property trust) are possible. This strategy is particularly suited to businesses run through private companies or trusts, although care must be taken with capital gains tax and stamp duty issues. In some states there is a stamp duty exemption for real estate transferred to superannuation funds for nil consideration.
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Prepay deductible expenses The idea is to bring forward as many deductions as possible to the 1998 tax year. A practitioner can claim deductions for business and investment expenses, including interest, pre-paid up to 13 month in advance. This is just a timing benefit, but can take the pressure off year-end cash flow even if it does reverse itself later. Many make the pre-payments every year, and, if perpetuated, tax deferred becomes tax saved. If the pre-payment is for more than 13 months it is spread over the shorter of that period or 10 years. It is a good idea to negotiate a discount for the pre-payment. For example, a landlord may agree to reduce the rent if a full years rent is paid before 30 June. Negotiating a discount means it cant be said the pre-payment was made just to secure a tax benefit, which can mean the ATO can ignore it and disallow the deduction. Special rules apply to nullify the effect of a pre-payment to a related party. Defer assessable income Most practitioners measure assessable income on a cash receipts basis. This means if a bill is not paid at 30 June it should not be included in the practitioners assessable income. But take care, this does not mean you can stop sending out bills in early March, or sit on cheques for the whole of June! If the receipt of cash is delayed there must be sound commercial reasons for the delay. This only applies to practitioners whose income is personal services income, and does not apply to practitioners whose income is business income. Practitioners whose income is business income will be required to measure assessable income on an accruals basis, which means it doesnt matter if the invoice is raised or not at 30 June. These rules apply to practitioners practising through practice companies as well as practitioners practising in their own names. If a practitioner derived personal services income in 1997, but derived business income in 1998 because, for example, the appointment of an associate practitioner to the practice, the opening value of debtors at 1 July 1997 will not be included in assessable income in either tax year. Maximize available deductions Check that no deductions are inadvertently overlooked. Common omissions include brief cases, technical subscriptions, software costs, home office costs and home telephone calls. Many practitioners overlook case law that can mean some travel to and from work is deductible when working out business percentages on car costs. Plant and equipment costing less than $300 is can be depreciated 100% in the first year. Property deductions are often understated. Barbecues, hot water systems, blinds, white goods, air conditioners and alarm systems are all depreciable plant and equipment. If the contract of purchase was silent on values, or understated values, bring in a quantity surveyor and get a fresh, realistic, depreciation schedule. This may save tens of thousands of dollars of tax. Substantiation rules, including stringent requirements on log books for some cars used for business purposes must be satisfied before a deduction can be claimed. These substantiation requirements are less stringent for companies and trusts than they are for individuals. Capital gains tax
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On the capital gains tax side, if you have realized a capital gain during the year consider disposing of any capital loss assets you may have. Capital losses can only be offset against capital gains, and are not otherwise deductible, which means they can be wasted without sound planning. If you are thinking of selling your Telstra shares, or any other assets with a capital gain on them, leave it to 1 July 1998. This will defer the gain and the tax for a year and leave you with plenty of time for tax planning strategies to be put in place. Beneficiaries of trusts Practitioners should consider the full range of beneficiaries of their family trusts. University age nephews and nieces or pensioner parents with little other income are two types of beneficiaries that can create tax-planning opportunities. Unpaid distributions create bare trusts that can be called in by the beneficiary (or a creditor of the beneficiary). But this is rarely a problem in practice, and while the possibility of a call in should be noted, the probability should not be overstated. Corporate beneficiaries can be used to cap tax on trust distributions at 36%. Senator Kemp issued a press release in April 1998 saying the new rules for assessing private company loans as unranked dividends may apply to unpaid distributions from trusts to private companies. So care is required if this technique is to be used properly for the 1998 tax year. Family trusts are under siege at the moment. Recent developments include rules to restrict the distribution of franking credits through discretionary trusts, rules to prevent trafficking in tax loss trusts (which apply far more widely than originally anticipated and make loss trusts generally problematic) and restrictions to the capital gains tax goodwill exemption where the business is held through a trust. Some are saying trusts may soon be taxed as companies, but many are saying they won't. It's possible any new rules may only apply to trusts set up after the announcement date, so it can be a good idea to set up a new trust now before any new rules start. (The Government has now released the new rules for taxing trusts as companies, and, in a nutshell, they are good news for practitioners. The reasons why are discussed in detail in part 4.3 of this manual.) What about tax schemes? What should you do if your accountant suggests a tax scheme? Simple. Sack him. He is not on your side. He is now working against you, not for you. The commissions paid to the accountant by the promoter can be as high as 20%. The expert opinion proudly shown in the prospectus is always qualified, and always has a few outs. We have never seen a scheme make a profit and we have never seen a scheme a practitioner was happy with a few years later. Few tax schemes pass muster if the ATO looks at them. If the practitioner's tax return is accepted as lodged, this is simply the self-assessment rule working, not a sign all is well. Most tax schemes involve borrowing money from the promoter, or an associate, to pay an allegedly deductible management fee back to the promoter, or an associate. Interest rates are typically twelve per cent or more. Even if the Commissioner did accept the fee and interest is deductible, which he doesn't, so what? You still have to pay the money back and you still have to January 2002 Page 155
pay the interest every year in the meanwhile. Congratulations. The deductions mean you have only lose half the money you put in. The ASC has warned against tax schemes, saying many breach the prospectus requirements of the Corporations Law. Following a recent court judgement against the Spotless group of companies, the Australian Taxation Office is taking an extremely hard line on tax avoidance matters. The attitude is very unforgiving: practitioners investing in tax schemes do not win sympathy points with tax investigators. Tax planning for the year ending 30 June 1999 This is the area with the most promise. Starting in mid-June 1998 a practitioner has plenty of time to organize sound and sensible tax strategies for the year ending 30 June 1999 and beyond. The benefits can be huge. It's not hard to get a tax bill down by $10,000 cash a year or more. Extrapolate this saving out over a lifetime and the cash adds up to hundreds of thousands of dollars, creating permanent wealth bases that reduce stress, create more leisure time, add to quality of life, provide for retirement and pass on a significant sum to the next generation. These strategies are based on generally accepted tax planning principles as applied to the particular circumstances of practitioners. Every part of the strategy is in line with the provisions of the Income Tax Assessment Act (and related legislation), case law, the ATOs published rulings and other published statements, the available technical literature and other authoritative writings. This is critical because an aggressive tax strategy that is out of line with the ATOs view of the world does not really help anyone, no matter how strong the superficial appeal is. These strategies involve practice companies, service trusts and DIY super funds. Practice companies and service trusts Practice companies and service trusts are a standard planning tool for most practitioners. Correctly used, they can save tens of thousands of dollars a year. It is rare for the savings to be less than about $5,000 cash a year. The benefits include: (i) (ii) (iii) (iv) (v) (vii) (viii) greater superannuation contributions (including contributions for spouses); asset protection for both business assets and investment assets; superannuation surcharge savings by choosing which family member should receive the most contributions, subject to statutory minimums; deductibility for interest on amounts borrowed to pay group tax and superannuation contributions, concessional tax treatment for multiple cars under the fringe benefits tax rules; income splitting to lower income beneficiaries including corporate beneficiaries; subject to some special rulings by the ATO, the ability to convert expensive nondeductible interest to cheaper deductible interest;
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(ix) for older practitioners, old age pension advantages as assets in discretionary trusts normally do not count for the assets test.
Where the practitioner's income is business income the practice company can retain profit and pay tax on the profits at just 36%. In Income Ruling 2309 the ATO says he accepts a practitioner's income is business income where, as a rule of thumb, there are more non-owner practitioners working in the practice than owner practitioners. The income of practitioners in larger partnerships is generally business income and is able to be retained by a practice company and taxed at just 36% (now 30%). Practice companies also shield practitioners from personal involvement in legal action connected to a negligent act by a partner, since it is the company, not the employee practitioner, who may be drawn into the action under the doctrine of joint and several liability. (Practice companies cannot shield the treating practitioner in any way.) Superannuation: a tax-favored investment Where the practitioner faces tax of 47% (which is virtually all practitioners) superannuation contributions have a role to play in minimizing tax. Any investment will perform better in a self-managed fund. This is because: (i) the deduction for contributions means up to 33% more cash is available for investment at the beginning of the investment's life (ie 48%, being the member's tax rate less 15%, being the fund's tax rate): because more money can be invested, investment earnings are greater; and the investment earnings are taxed at only 15%, so the after tax rate of return on the investment is much greater than for a 48% taxpayer.
(ii) (iii)
This phenomena is government policy. The population is aging and the old age pension needs to be replaced with a private pension system. Government policy recognizes this, and favorable rules are in place to encourage superannuation. It is almost a mathematical certainty that an investment in a super environment will do better than in a non-super environment. The control aspect of DIY super, coupled with the security of knowing where your money is and the attraction of being able to co-ordinate the DIY fund investments with other business and investment strategies particularly appeals to practitioners. Leases of premises, leases of plant and equipment and, in some cases, even debt factoring transactions between the DIY fund and the practice company and the service trust are possible, provided they are completed on a strict arms length basis and certain other ground rules are observed. DIY super funds can be used with unit trusts to own practitioners' premises. This can be a powerful investment and tax planning strategy. But care still needs to be taken. Daniel Butler, a Melbourne solicitor well known in the DIY super circles says the Insurance and Superannuation Commission had reviewed this practice and will generally accept it provided it is transparent and in line with the strictest interpretation of the law. The risk of getting it wrong is that the fund's assets can be taxed at 47%. Things to watch out for with your 1998 year tax returns January 2002 Page 157
A large number of amendments to the tax law have been introduced which impact the way practitioners income tax returns should be prepared for the 1998 year and their tax planning for later years. Discuss these with your advisor if they have not already been brought to your attention. Private company loans Loans from private companies to shareholders or associates made after 4 December 1997 must be documented as loans, with minimum interest rate, term and repayment requirements. Loans made before this date can also be effected if minimum requirements are not met. Loans not satisfying these rules will be treated as unranked dividends in the hands of the shareholder. In a press release in April 1998 Senator Kemp said the loans must be documented before 30 June 1998, which leaves just a few weeks to get everything in place. It appears the government will now amend the draft legislation to include unpaid distributions to private companies, despite earlier indications to the contrary. 1998 audit program: rental properties and hobby farms The ATO has announced it will target rental property deductions and hobby farms over the next 12 months. Practitioners with rental properties or hobby farms will do well to review their position in detail, and make sure it is bullet proof, before lodging their 1998 returns. Be objective in your analysis, particularly with hobby farms: if you have never made a profit and you are not comfortably inside the ATO's rulings then the losses are probably not deductible. Salaries to spouses We have seen practitioners try to justify salaries to spouses as high as $80,000, or try to raise a journal entry eight months after year-end to claim a deduction for $35,000 of salary to a spouse. Neither claim was allowable. Salaries to spouses must be based on actual work performed and market rates of pay and must be actually paid at the time the work is done. If your spouse spends her time looking after three or four children you are really on the back foot justifying anything but a token salary. This is where trusts come in: income can be distributed to a non-working spouse irrespective of the spouse's involvement, or non-involvement, in the practice.
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Box 1: Some common questions for 1998. True or false? Q A Can the ATO really tell how old the ink is in my car log book? Probably not. But the ATO investigators are obsessed with finding flaws in logbooks, and go to great lengths to catch taxpayers out. Never fill a logbook out after the event or with false information. A false claim can be a fraud on the Commonwealth. This is serious matter that no one, let alone a busy practitioner, wants to deal with. Does the ATO match the interest income in my tax return with my banks records? Yes. Each year each bank and similar organizations are required to provide full details of interest paid during the year. The information is checked against your tax return (by a computer, of course). Expect a please explain letter if you omit or understate your interest income. Can I vary the rules for sharing partnership income and losses at any time during the year? Yes. Provided the partnership agreement permits this, you can vary the proportions for sharing partnership losses or income during the year. Is interest on amounts I borrow to pay my income tax deductible? No, not unless you are in business. Most practitioners are not able to claim interest on amounts borrowed to pay income tax? Can I pay my spouse a salary by book entry when the tax returns are being prepared and my accountant works out how much I need in deductions? No. A salary paid to a spouse must be paid during the year on a strict arms length basis for actual services performed. Book entries posted by the accountant in March 1999 arent good enough. Does my practice company have to break even each year? No. It depends on whether they derive business income or personal services income. If they derive business income they do not have to break even each year. The Commissioner has put out some helpful rulings to provide guidance on this topic. Does the ATO accept a 50% mark up on salaries paid by my service trust? No. The ATO never accepts a 50% mark up. It is on the public record as saying he will disallow such claims if he audits a practitioners service trust. 50% is more than three times above the independent third party benchmark rate and just is not acceptable to the ATO. Can I claim a tax deduction for two business cars? Yes. But the amount of the claim may be limited. It is a safer tactic to take the second (and even the third or fourth) car as a fringe benefit under the statutory method, where the mix between private and business travel is not important. Page 159
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Box 2: 1998 Tax schemes We recently met a specialist who paid $50,000 to his accountant on 27 June 1997 to buy into a tax scheme involving leases of plant and equipment to large construction companies. The accountant rang in the morning, and said he had to have the cheque by 3.00 pm that day or the deal could not be done. Stupidly, the specialist trusted him, and handed over the money on the spot, thinking his accountant would do the right thing. The money never got there, someone was murdered, the client can't claim a tax deduction for the $200,000 (yes, four times the amount put in), faces huge tax penalties and will be audited by the ATO along with every other participant in the scheme. Needless to say, we now have instructions to sue an accountant for negligence, breach of trust, breach of contract and accepting a secret commission. It will not be a hard case to win. We expect an early settlement. Tax schemes do not work. They do not save tax. They make money for the promoters and cost practitioners fortunes in extra tax, legal fees and accounting fees. Box 3: 1998 Tax pack In previous years the ATO delivers a copy of his annual Tax Pack to almost every taxpayer in Australia. This year they will only be sent to people who lodged via the Tax Pack in 1997. This excludes most practitioners, but the Tax Pack is still available from the ATO or the post office. Necessarily general in its content, the Tax Pack is a good attempt at a very hard task and most tax advisors appreciate the ATOs intentions. But the Tax Pack is only suitable for simple tax returns for taxpayers on low incomes and without any complicated claims or legal structures. The Tax Pack is not appropriate for practitioners, and it is not wise for practitioners to prepare their own tax returns. Remember, the ATO sits on the other side of the table. It is on the other side, not your side, and he isnt going to tell you how you can reduce your tax bill. Box 4: Things to watch with your service trust Service trusts have been discussed many times in Medical Observer. Suffice it to say care must be taken to ensure a service contract is in place, services are actually provided by the service trust and invoices are raised and paid on a regular basis. The ATO has never released any guidelines setting out what he thinks are commercially acceptable fees. He says all fees paid to the service trust must be calculated on an arms length basis and must be supported by contemporary third party quotes and price lists. He has publicly stated that fees above an arms length amount will be disallowed and additional tax and interest will be applied as appropriate. The best example of this is marking up administrative salaries by 50%. Phillips' case, the Federal Court decision that gave rise to this practice, was decided in April 1978. The 50% mark up was accepted as a matter of fact because the accountant was able to produce a client who was in the business of providing contract staff and who enjoyed a 50% mark up on the wages paid to his staff.
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In June 1998, some twenty years after Phillips case was decided, 50% is probably more than three times the prevailing commercial rate charged by independent suppliers of contract labor, which tends to be about 15%. As Robert Warnock, legal counsel for the National Tax & Accountant's Association writes in the Associations "Tax Hot Spots" publication: "There is only one rule with respect to the service fees to be charged to the practice: they must be commercially realistic. There is no such thing as a standard mark up. The Commissioner does not accept a standard mark up and there was no such thing as a standard mark up in Phillips' case." In an address at the 1994 Taxation Institute of Australia's Annual Convention a representative of the Australian Taxation Office delivered a paper on service trusts which unequivocally stated 50% mark ups will not be accepted by the Commissioner and will be disallowed in an audit situation. Nevertheless, marking up labor costs by 50% remains one of the most common mistakes made by practitioners using service trusts and the accountants who advise them. Another practical point to watch is the timing of the minute of the trustees resolution to distribute trust income. This has to be done before 30 June each year if the distribution is to be effective and net income is not to be taxed in the trustee's hands. The Commissioner has ruled that he will allow an extra two months for this distribution to be completed. But when this was tested in the Administrative Appeals Tribunal it was found to be ineffective since it is not what the law strictly says. The trustees distribution was treated as being ineffective despite being made before the end of August.
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4.10 Lap top computers
This memorandum explains a tax efficient way of upgrading the practices technology using laptop computers and taking advantage of special exemptions and rules for lap-top computers in the Fringe Benefits Tax Assessment Act and the Income Tax Assessment Act. This means a practitioner who uses a practice company can in effect obtain a double tax deduction for the cost of a laptop computer (or a similar item such as a personal organizer or a brief case.) There is a limit of one item per employee per year. In summary, the procedure is as follows: (a) (b) the practitioner buys a laptop computer for, say, $5,000 including software. The invoice for the computer should be made out to the practitioners name; and soon after the practice company reimburses the practitioner for the cost of the laptop by writing a cheque from the practitioner captioned reimbursement of lap-top computer.
The income tax consequences of this are as follows: (a) the practice company is able to claim a tax deduction for the amount reimbursed to the practitioner. This is because it is a cost of employing an employee and hence apparently deductible, it is not a cost of capital; the reimbursement to the employee is a fringe benefit under the Fringe Benefits Tax Rules, ie. it is specifically treated as an exempt fringe benefit. Therefore, no FBT is payable by the employer on the value of the benefit; the employee is not required to include any amount in assessable income because exempt fringe benefits are deemed to be exempt income in the employees hands; the employees cost base on the laptop stands at $5,000 despite receiving the reimbursement. This is because of the depreciation rules in the Income Tax Assessment Act do not contemplate reimbursements to the cost base of plant and equipment and, in particular, do not require the taxpayer to reduce the cost base for the amount of the reimbursement.
(b)
(c) (d)
There is a limit of one computer per employee per year and it must only be used for business purposes if depreciation is to be claimed. The cost of the laptop includes the cost of software installed at delivery. These rules do not apply to peripherals such as printers, screens and so on. It is possible to apply the above technique to the contemplated upgrade of the IT capability of the general practice. This is done by having the consultants supply the computers and the upgraded software as laptops invoiced directly to the individual partners. The practice company then reimburses the individual partners for the cost of the laptops and the installed software. For example, if an upgrade involving 4 computers and costing, say, $4,000 each and $10,000 of software, each of the 4 partners will be invoiced an amount equal to $6,500. Each partner pays the invoice personally, and is the reimbursed by the practice company. The above consequences then follow on.
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In summary,, assuming a tax rate of 48% is payable by each partner, this means there will be a double tax deduction for the amount of $26,000, leaving a net after tax cost of only $1,040 being 96% of $26,000. (The 96% is derived from 2 x 48%.) It has been a suggested that these rules may change soon, and this should be monitored.
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4.11 Practitioners' guide to year-end tax planning 2001
Introduction Year-end tax planning is only a small part of your overall tax planning strategies. The best tax planning is done prospectively, and is structurally based. By using the best tax structures, particularly family trusts and self-managed superannuation funds, tax will be minimized naturally, for any given level of income. Year-end tax planning is nothing more than a fine-tuning to make sure your structure works optimally and to take advantage of any special features of the particular year in question. This memorandum covers the things you should do now to avoid problems, ie your defensive game, as well as the things you should do now to create opportunities, ie your offensive game. This year the company tax rate falls from 34% to 30% on 1 July 2001, and hence income deferral techniques may be more relevant than in previous years. These are discussed in detail in the following pages. Superannuation planning features, as you would expect. We understand we are now the largest accounting practice in Victoria specializing in self managed superannuation funds, with nearly 1000 funds on our files. Many of these are run for practitioners and dentists and many are run for other persons through a related company Super 2000 Pty Ltd. Australian tax law operates largely under a system of self-assessment. Taxpayers, through their accountants and solicitors, are required to advise the ATO of their taxable income and its composition You will not be surprised to hear us warning about year-end tax planning schemes. Despite ASIC warnings about their (non-existent) investment performance and an ATO crack down, they are out in droves again. This year the big claim is that the promoter has an ATO product ruling. Certainly anything without a product ruling should be dismissed instantly, but we believe even arrangements with product rulings should be avoided. Virtually all schemes, including those with product rulings, are not commercially viable and will not make a profit. We see the aftermath: lenders chasing practitioners for loan repayments years afterwards, broken promises, angst and frustration all around. The best tax deductions in the world cannot turn a bad investment into a good investment. As we have been saying for nearly ten years, we have never heard a practitioner saying that he was happy with his tax scheme investment. And we expect we never will. Pre-paying expenses The rules for pre-paying expenses have changed in the last 12 months but happily these changes do not affect most practitioners. Unless the practitioners turnover is more than $1,000,000 or the practitioner has depreciable assets of more than $3,000,000, prepaid expenses are still effective. The pre-payments will be wholly deductible in the year ending 30 June 2001, provided the term of the pre-payment is no more than 13 months. Investors can also pre-pay expenses for up to 13 months. If the practitioners turnover is more than $1,000,000 or the depreciable assets are more than $3,000,000, 60% of the pre-payment will be deductible in the year ending 30 June 2001, and the remaining 40% in the year ending 30 June 2002. January 2002 Page 164
The usual benefit of pre-paying expenses is connected to the time value of money. One is usually better off paying tax later rather than sooner. This allows the payer to earn interest in the meanwhile, or to pay less interest if in an overdraft situation. It also allows time for other strategies to be invoked. Bearing in mind that next year may not be as good as this year, it almost always makes sense to defer paying tax as long as possible. But this year there is an added plus factor attached to pre-paying expenses. The company tax rate falls from 34% to 30% on 1 July 2001. This means tax on a profit of $10,000 will fall by $400. If you pre-pay an expense of $10,000 you not only get an interest saving of say $700 by deferring the time to pay the tax, but you also get a $400 reduction in the amount of tax you ultimately pay. June 2001 is therefore a good time for practitioners to pre-pay expenses for the coming 12 months, particular larger practices that can use the corporate tax rate on at least some of their earnings. You pre-pay expenses by making sure cheques are drawn for expenses in June 2001 and are not left for say July or August. Ideally the payee will present the cheque before 30 June 2001, but this is not critical and as long as you pay the cheque before then. Examples of expenses that can be pre-paid include: (i) (ii) (iii) (iv) (v) (vi) interest on business loans or investment loans; lease rentals on leased assets; business rent on leased business premises; repairs to premises and plant and equipment; insurance premiums; and stationery and other consumables.
Small items of depreciable plant and equipment Small items of depreciable plant and equipment, ie items costing individually less than $300 each, are able to be written off in the year of income and do not need to be depreciated over a number of years. You should consider speeding up the purchase of any small items of depreciable plant and equipment needed before 30 June 2001. Deferring assessable income The logic of deferring assessable income is very similar to that of pre-paying expenses: the tax payment is delayed by 12 months and, if the company tax rate can be used, the amount of the tax payment will fall from 34% to 30% after 30 June 2001. Practitioners are usually required to account for their income on the so-called cash basis. This means income is only derived when it is received, which is usually signified when it is credited to a bank account. HIC payments and other government payments are typically credited directly to the practitioners bank account, so there is not much room to move here. The best way to defer income here could be to take a holiday in June 2001 rather than leaving it for the school holidays in July 2001! But receipts from persons other than HIC etc may be able to be deferred. We generally encourage practices to demand payment in the day the service is provided, since it does not make sense to have an accounts receivable function for a large number of small dollar value items. But many practices still issue accounts and statements in the mail. Suffice it to say that if payment of these accounts does not occur until after 30 June 2001, the income will not be assessed to income tax in the year ending 30 June 2001. January 2002 Page 165
Interest income for tax purposes is usually only assessable when received. Therefore, consider investing spare cash in commercial bills or other interest bearing deposits that do not mature until after June. To really use this method, consider opening up 12-month term deposits or similar accounts on say 15 July 2001. The income from these investments will not be derived for tax purposes until the year ending 30 June 2003, more than two years from now. Rental income is usually only taxed on actual receipt. Rent that is not paid as at 30 June 2001 will not be included in assessable income and hence taxable income for that year. Rent uncollected at 30 June will be subject to tax in the following financial year. Where the tenant is related to the landlord, as is the case with many practitioners surgeries, the tenant will not be able to claim a deduction for the rent until the year the landlord includes it in assessable income. It is worth considering deferring the realization of fixed assets that will give rise to a depreciation clawback (profit). Alternatively, the amount of the clawback can be offset against any replacement asset acquired in the year ending 30 June 2001, any other asset acquired in the year ending 30 June 2001, and any other asset (in that order). Offsetting a depreciation clawback is generally a recommended strategy It is also worth considering deferring the sale of any capital assets that may give rise to a capital gains tax computation. One months delay here may make a significant difference to the amount of tax ultimately paid. Other thoughts include: (i) is a child (or perhaps a nephew or a niece) going to turn age 18 in the year ending 30 June 2002? Or is someone else going to be an appropriate object of a trust distribution in that year? If so, consider deferring service trust income to that year, and then arrange for it to be distributed to that person. Here the lower tax rate is amplified by having an extra adult beneficiary, and this usually achieves a tax saving of about $8,000 cash a year; older practitioners who are contemplating full or part retirement in the next year or so may benefit from having a lower income in those years, and deferring income to then allows tax to be smoothed out; can income be deferred for a year, bringing the practitioners surchargable income down below the threshold of $81,493 then combined with a large deductible superannuation contribution to pick up a 15% surcharge saving?
(ii)
(iii)
Correct structuring of lease agreements This is something new to us that was brought to out attention in a recent client exercise. Irrespective of the pre-payment rules explained above, if a lease agreement requires the lessee to pay a lump sum or larger payments up-front, then those payments will be deductible in full in the year they are paid. This is provided the lease generally complies with Income Tax Ruling IT 28 dealing generally with lease payments. Superannuation contributions The most important point at this time of year is to ensure superannuation contributions are actually paid before 30 June 2001. This is critical since a deduction is not available unless the contributions are actually paid before the end of the year. Its risky to leave contributions to the January 2002 Page 166
last minute, and we suggest you pay the contributions to the fund by at least 25 June 1998 and make sure they are banked into the fund's bank account as soon as possible thereafter. The age based deduction limits for 2001 are:
Age under 35 Age 35 to 49 Age 50 and over
$11,388 $31,631 $78,445
Please contact us immediately if you are unsure of what should be done with your superannuation contributions before 30 June 2001. If you are paying contributions to your own fund we suggest you simply mark the amount, the date and the name of the fund on your cheque butt, and that you do not identify who they are paid for. This leaves us with some flexibility when completing the accounts and income tax returns later in the year. There is no deduction for superannuation contributions not paid at 30 June 2001. Non-cash superannuation contributions Superannuation contributions are usually in cash, but there are some exceptions. The major exceptions are business real premises (eg the practitioners surgery) and listed Australian shares. Non-cash contributions can be very effective superannuation planning tools. But specific advice is needed and you should contact Tim Pepper in our legal group on 03 9592 9888 or tim@madas.com.au if specific advice is required. Superannuation guarantee The superannuation guarantee rules require all contributions to be paid by 28 July 2001. These rules are different to the rules for income tax deductions. If the superannuation guarantee contributions are not paid as at 30 June 2001 but are paid as at 28 July 2001, there will be no tax deduction until the year ending 30 June 2002, but there will be no penalties under the superannuation guarantee rules. But if the superannuation guarantee contributions are not paid until after 28 July 2001, not only is there no tax deduction but there will be penalties imposed on the employer. Superannuation guarantee contributions should be paid before 30 June 2001, but absolutely must be paid before 28 July 2001. Superannuation contributions for children If your children are aged 18 then you should consider having them join your superannuation fund. Provided they are: (i) (ii) either employed by the practice or a related entity (see below); or a director of an entity and gainfully employed (ie have done more than ten hours work in a one week period at any time in the preceding two years;
The practice will be able to superannuate them. The amount that can be contributed is limited to their age-based limit, ie $11,388. The contributions are taxed in the funds hands at 15%, and usually are not subject to the 15% superannuation surcharge as the childs income is too low. January 2002 Page 167
This means that say $10,000 of contributions will produce about $3,400 of tax benefit to the family. This suggestion is not for everyone, as the contributions vest in the child and, in the case of a self managed superannuation fund, the child has to become a trustee or, if a corporate trustee is used (unusual), a director of the trustee company. The $11,388 deduction limit is in addition to any other superannuation amounts contributed by unrelated employers. Rebatable superannuation contributions for spouses Superannuation contributions for a spouse before 30 June 2001 will create a special rebate of up to $540. While this is nice, deductible superannuation contributions are usually nicer, in the sense that they cost less on an after tax basis. For completeness we cover both areas in the following paragraphs. Rebatable Spouse Superannuation Contributions: If a spouse has assessable income and reportable fringe benefits of less than $10,800, you may be entitled to a rebate of up to 18% of the amount of contributions made for a spouse, up to maximum contributions of $3,000, or a maximum rebate of $540 (ie $3000 times 18%). This rebate is reduced by $1.00 for every $1.00 of income derived by the spouse above $10,800. The contributions are treated as undeducted contributions for superannuation law purposes: this means there is no tax deduction for the payer and there is no tax charge for the fund. The earnings on the contributions are taxed in the hands of the fund, and will comprise part of the members post 30 June 1983 component on ultimate withdrawal from the fund. On retirement the undeducted contributions can be paid to the member (ie the spouse) tax free, and the first $100,000 of the post 30 June 1983 component may be paid to the member tax-free. This means the benefits will almost certainly come out to the spouse 100% tax-free on ultimate retirement. Deductible Spouse Superannuation Contributions: Alternatively practitioners should consider ways of superannuating their spouse out of the practices income. Here the limit is the spouses age based deduction limits (see above) rather than $3,000. It is quite possible for a practitioner to superannuate a spouse over the age of 50 up to the age-based limits of $78,445. Assuming a tax rate of 48% for the practitioner, and no superannuation surcharge, this will generate a net tax benefit of $25,887. This is much greater than the tax rebate of $540. Accordingly we always recommend practitioners consider deductible superannuation contributions rather than rebateable superannuation contributions. Contact Terry McMaster on 9592 9888 or terry@madas.com .au for more information on superannuating a spouse: specific advice is required before implementing these strategies. Bad debts Some larger medical practices return their income on an accruals or an earned basis, rather than on a cash basis. Bad debts must be physically written off before 30 June 2001 if they are to be claimed as a tax deduction in that year. This requires, as a minimum, a piece of paper recording the decision to write them off and specifying the amount and the name of each debtor. It is a good idea to fax this to us as a way of proving the record was created before 30 June 2001: we will date stamp and file it at our end, for prosperitys sake and the sake of any tax audit that may arise. Bad debts are not relevant, for tax purposes at least, where practitioners are on a cash basis. January 2002 Page 168
Employing children It is quite common for a practitioner's children to work in the practice on a casual part time basis. Where they are, salary and wages paid to the children by the practitioner (or more probably the service entity) will be deductible in the payer's hands and assessable in the children's hands and taxed as earned income. If the child earned $6,000 a year the total tax benefit would be $2,880 cash a year. If you are considering employing your child in your practice you should make sure: (i) (ii) (iii) (iv) the work is actually done; work cover premiums are paid were required and any other relevant employment rules are observed; the wages are actually paid to the child before 30 June 2001, preferably under the usual payroll cycle, and not just adjusted for at the end of the year in the accountant's office; the payments are commercial having regard to the actual hours of work completed and the market rate for that type of work. Payments above a commercial amount will not be deductible.
Private company loan accounts Private company loans are causing a lot of concern amongst practitioners. Four times in the last 12 months we have come across loans of more than $300,000, built up over the last few years, and which have not been treated correctly for tax purposes. The result in each case was an unfranked dividend of more than $300,000 and a tax bill of more than $150,000 extra, with a loss of franking credits thrown in as well. In each case the loans had been recommended to the practitioner by an accountant as a way of limiting tax on company withdrawals, and in each case the accountant failed to note the existence of special rules and penalties effectively prohibiting doing this. If a private company has lent money to a shareholder or a related person at 30 June then unless certain restrictive conditions are met the loan will be taxed as an undrinkable dividend in the hands of the shareholder. The definition of a loan specifically includes an unpaid trust distribution. This is discussed further below under the heading corporate beneficiaries. These rules have been in place since 1997. The purpose of these rules is to ensure that the individual tax rate apply to profits moved out of private companies via loans rather than dividends. The fact that the dividend is un-frank able puts a real sting in the tail, since the underlying profit will be taxed twice, once at the company level and again at the shareholder level. The rules cast the responsibility for identifying the unfrank able dividend and disclosing it in the clients tax return on the client, and heavy penalties apply if this is not done. The major exceptions to these rules arise where: (i) (ii) the private company has no profits, including unrealised profits and/or internally generated goodwill; and most importantly, where the loan has been documented as an excluded loan, and Page 169
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satisfies conditions regarding stamp duty, benchmark interest rates (7.8%), minimum principal repayments and minimum terms, ie 7 years for unsecured loans and 25 years for loans secured by a registered mortgage over real property and the value of the real property is 110% or more of the amount of the loan at the time the loan commences. If you believe you have a private company loan that may breach these rules then you should consider what needs to be done about it before 30 June 2001. Possibilities include: (i) (ii) documenting it as a loan, as per the above; or repaying it. This can be done via a cash repayment from the shareholder or the associate, by declaring and paying a dividend or by transferring assets to the company.
It is important that this be done before 30 June 2001 and that you are able to prove it was done before 30 June 2001 if the ATO examines the transaction in any way. Contact Tim Pepper on 9592 9888 or tim@madas.com.au in our legal group if you need a loan to be documented as an excluded loan before 30 June 2001. Directors' fees and bonuses Where medical practice companies, or other companies for that matter, may end up with loans in breach of the above rules, we will generally negate the loan using either: (i) (ii) a dividend declared and paid as at 30 June 2001, with the payment being taken against the loan account, or a directors fee or bonus, again with the payment again being taken against the loan account. Here IT 2534 allows a deduction for the amount even though it is not paid provided the company has become definitely committed to the payment of a quantified amount by passing an appropriate resolution or otherwise becoming obligated to pay the money.
Corporate beneficiaries A corporate beneficiary is simply a colloquialism used to describe a company that is the object of a trust distribution from a related trust. Such a company will be taxed on the amount distributed at the prevailing company tax rate. In the year ending 30 June 2001 this is 34% and in the year ending 30 June 2002 and thereafter it is 30%. In the case of practitioners, it is common to consider using a corporate beneficiary to limit tax on service trust income to no more than the company tax rate and to avoid having to pay tax at the higher top marginal individual rate of 47% plus Medicare levy. This is an excellent strategy and one we recommend. But there is one critical proviso: the cash must actually be paid to the corporate beneficiary before 30 June 2001 or, as a second best, as soon as possible thereafter. If this is not done the unpaid distribution will comprise an undrinkable dividend in the hands of the shareholder, ie the practitioner or a spouse or other relative, and extra tax will be paid. Non-commercial business losses The year ending 30 June 2001 is the first year that special rules have been in place restricting the deductibility of non-commercial business losses. These losses, for example a loss on a small January 2002 Page 170
farm, cannot be offset against income from other sources, for example, the income from a medical practice. But they can be offset against future income from the same activity. Losses will be non-deductible unless: (i) (ii) (iii) (iv) the assessable income from the activity is at least $20,000 a year; the business includes more than $500,000 of real property (excluding a residence; the business has more than $100,000 of plant and equipment (other than cars); or the business has resulted in a taxable income in at least 3 of the last 5 years.
Start-up businesses are an exception, and the ATO has an overriding discretion to allow the loss where it would be unreasonable not to do so. 4.12 Personal Services Income Rules The personal services income (PSI) rules were introduced into Parliament on 13 April 2000. Their purpose is to: (i) (ii) attribute personal services income derived by an interposed entity (ie a company or a trust) to the underlying individual; and prevent deductions being claimed (whether by an individual or by an interposed entity) which would not be allowable had the income been derived as an employee, subject to certain exceptions and modifications, unless
a personal services business is being carried on. The rules apply where the entity derives 80% or more of its income from one source and the Commissioner of Taxation has not determined that the rules should not apply. However, certain income, ie, income from a personal services business is excluded from the PSI regime. A personal services business can occur in any one of three situations. These are: (i) the entity derives income from two or more unrelated clients that are not associates of each other and the services are a direct result of an invitation to the public (probably via advertising); 20% or more, by dollar values, of the entitys income comes from engaging another person, whether as an employee or otherwise; or at all times during the year business premises are maintained.
(ii) (iii)
If the rules apply to an entity the personal services income of the entity will be treated as being derived not by the entity but by the underlying individual, and certain losses and outgoings will not be allowed as deductions. It is very unusual, but not impossible, for these rules to apply to practitioners. This is because practitioners are usually either employees, in which case the rules are irrelevant as the practitioner will be taxed on salary income, or the practitioner is running his or her own practice, whether through a practice company or in his or her own name. Where a practitioner runs his or her own practice the income will come from hundreds, if not thousands, of sources, ie the patients seen during the year. This is so even if the practitioner bulk bills, and, apparently, gets all of his or her income from the HIC. This is because the HIC is not the patient, and is January 2002 Page 171
merely the patients insurer. The HIC is paying the practitioner on behalf of the patient, so the payments are really coming from the patients, and not the HIC. The exception occurs where a practitioner is engaged by a practice or another entity (for example, a community health group or a country hospital) to provide medical services to patients as required during a particular period. Here the practitioner can be fair and square within the rules. This means the income derived from the practice will be taxed in the hands of the individual notwithstanding that an entity is being used to run the practice. This usually means a bigger tax bill and, if previous year tax returns have not been completed correctly, the possibility of penalty taxes and interest charges. For this reason we always recommend that practitioners, and the persons who engage them, take care to ensure that: (i) (ii) they are providing medical or dental services to the patients directly, even if this is arranged for them by another person, in return for a management fee; and are not simply engaged to be available to patients for a set period of time.
This also makes the GST situation much simpler. This is because it is clear that the practitioner is providing (typically) GST free medical services. The services provided under the other arrangements are not in the definition of a GST free medical service and do attract GST. Further, this recommendation usually means the entity engaging the doctor is better off too. This is because: (i) (ii) in most cases the practitioner will be solely responsible for the quality of the work done, and is the only person against whom an aggrieved patient can take legal action; it makes it clear that the practitioner is not an employee and is not subject to the pay as you go withholdings system, the statutory superannuation rules, mandatory annual leave and sick leave rules, work cover and, most importantly for larger practices, the state payroll tax rules.
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4.13 Negative gearing
Readers should also refer to part 11.10, which deals with advanced gearing strategies. The purpose of this section of the manual is to explain what negative gearing is and when it should be used. An investment is negatively geared if the income derived from it is less than the interest incurred on any amounts borrowed to acquire it. An investment is neutrally geared if the income derived from it is (roughly) equal to the interest incurred on any amounts borrowed to acquire it. And, similarly, an investment is positively geared if the income derived from it is greater than the interest incurred on any amounts borrowed to acquire it. The investment may be property, whether residential, retail, commercial or industrial, shares or similar securities in listed or unlisted companies, or managed funds or indexed funds. The word geared is chosen because of its engineering connotations: the idea is that with correct gearing or leverage a result can be obtained that is better than that obtained without gearing. This is usually achieved by expanding the practitioners asset base and allowing time to run, and capital gains to accrue, which more than compensate for the deficiency in cash flow caused by the interest being greater than the income. This technique usually works. But there is no guarantee that it will. It all depends on the quality of the underlying investment. And a word of caution is appropriate: the gearing works in reverse to. The effect of any drop in value will be greater too, and it is possible that the practitioners equity in an investment can be wiped out as a result of this phenomena. An economically rational investor will be prepared to negatively gear an investment if the expected after tax return, including capital gains, is greater than the expected after tax cost of holding the investment. The after tax return will usually be made up of two things; one, the income from the investment (ie rents, dividends, or distributions, depending on the investment, and two, the increase in value, or capital gain, over time. The income can usually be predicted with reasonable certainty. The capital gain is the wild card. No one knows the future, so the best one can do is expect a capital gain. This is where investing becomes an art rather than a science; expectations will be the critical issue. The Australian Master Financial Planning Guide 2001 provides a useful example showing how gearing engineers a greater return for the investor: An investor has several investment options, based on an initial investment amount of $40,000. investing $40,000 as an ungeared investment; investing $80,000 as a geared investment with borrowings of $40,000; and investing $120,000 as a geared investment with borrowings of $80,000.
Assumptions: income from the investment is 4% capital growth is 5% interest on borrowings is 7% Ungeared January 2002 Geared Negatively Geared Page 173
Equity invested Borrowed Total invested Income received Less interest paid Net cash flow Capital growth Total return Equity invested Return on equity invested $40,000 Nil $40,000 $1,600 Nil $1,600 $2,000 $3,600 $40,000 9% $40,000 $40,000 $80,000 $3,200 $2,800 $400 $4,000 $4,400 $40,000 11% $40,000 $80,000 $120,000 $4,800 $5,600 $800 $6,000 $6,800 $40,000 13%
The example shows that the more the investment is geared the greater the return on equity invested, assuming amongst other things, capital growth of 5%. Quite responsibly, the author goes on to show what would happen if the market value goes down by 5% rather than increasing by 5%. The revised table then looks like: Ungeared Equity invested Borrowed Total invested Income received Less interest paid Net cash flow Capital growth Total return Equity invested Return on equity invested $40,000 Nil $40,000 $1,600 Nil $1,600 ($2,000) ($400) $40,000 (1.00%) Geared $40,000 $40,000 $80,000 $3,200 $2,800 $400 ($4,000) ($3,600) $40,000 (9.00%) Negatively Geared $40,000 $80,000 $120,000 $4,800 $5,600 $800 ($6,000) ($5,200) $40,000 (17%)
We have never seen a wealthy person who at some stage has not taken on at least some debt for business or investment purposes. We have also never seen a bankrupt person who has not taken on at least some debt as well. It is clear that debt is a two edged sword: it can increase investment returns and it can reduce investment returns. It is best to keep to sensible debt levels, manage interest costs and to favor higher income yielding investments if the downside of debt is to be avoided. The Australian Master Financial Planning Guide 2001 says that: An investor should only make a negatively geared investment if: the investor has secure and permanent income from other sources sufficient to cover living expenses and all other requirements as well as the shortfall under the negative gearing; where the gearing arrangement or borrowing includes a liability to make margin calls in certain circumstances, the investor can satisfy the margin calls by supplying further security or by payment from other sources to avoid the possibility of a forced sale (keep in mind that the economic conditions that lead to the need for a margin call will, almost certainly, mean that any forced sale will be at depressed prices and will lead to a significant loss to the investor; Page 174
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the investment is made on the understanding that it will be retained for at least five, preferably, ten years or longer; the investment and borrowing have sufficient flexibility to cover events such as death, disablement; major illness or redundancy. The first three of these would normally be covered by insurance or superannuation benefits and redundancy could be covered by an employer pay out. However, even in these circumstances the negative gearing arrangement may need to be terminated. Check whether this can be done without incurring penalties and with the flexibility to avoid suffering loss through a forced sale of the asset; there is flexibility to cover changes in circumstances, such as a transfer overseas (where the tax advantages may not apply) or divorce; and the taxpayer can take full advantage of the tax deduction. Negative gearing normally works best for investors on the highest marginal tax rate but may be of less value to low tax rate or non-tax-paying investors.
The author then warns of the danger of negatively gearing into an already geared investment, such as a listed company or a property trust. This increases both the up-side risk and the downside risk even further. Calculation of rates of return on geared property investments We are able to calculate the after tax rate of return on geared property investments, as well as prepare a variety of forecasts and charts to help analyze these investments. If you wish us to prepare a detailed report on an existing or proposed geared investment, please contact us and provide the following details: (i) (ii) (iii) (iv) (v) (vi) the name of the owner; the owners tax rate; the address of the property; the propertys value; the rental yield; and the expected capital gain.
A fee of $100 will be charged for this service.
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4.14 ATO and Centrelink Websites
The Australian Taxation Office has an extensive website that has a huge amount of useful tax information. Practitioners should take some care with this website, as the content is mechanical, tends to ignore planning opportunities and options, and is obviously skewed towards the ATOs view of the world, which is not always right. Nevertheless, some very interesting and useful information is provided on a range of topics including: Refund Excess Imputation Credits Family Tax Benefit PAYG Summaries Losses Schedule PAYG/GST Capital Gains Tax Alienation of Personal Services Income Non Commercial Losses Prepayments Capital Allowances General To access the ATO website go here: http://www.ato.gov.au/ Centrelink also have a very good website, with a wide range of materials affecting government allowances and pensions. This site is so good that we no longer bother preparing information on these topics, and instead just use the website as required. To access the Centrelink website, go here; http://www.centrelink.gov.au/
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5. 5.1 TAXATION SOURCE MATERIALS OF INTEREST TO PRACTITIONERS Income Tax Ruling 25
INCORPORATION OF MEDICAL PRACTICES Document Reference Number: IT 25 Cross-References are: 159P IT 119 Reference PREAMBLE 1. The following advice issued to branch offices concerning the approach to be taken in relation to the incorporation of medical practices.
RULING 2. Where a company is incorporated in accordance with the by-laws of the N.S.W. Branch of the AMA, and the effect of incorporation is to do nothing more than reduce the amount of income a practitioner might earn by the amount of an appropriate superannuation cover, incorporation of medical practices should be accepted for income tax purposes.
Medical practitioners who are not members of the AMA 3. One of the problems which had to be faced in the consideration of the question of incorporation of medical practices was the ability of patients to obtain reimbursement under the Health Insurance Act in respect of fees paid to medical practice companies. Following advice from the Attorney-General's Department in the context of the AMA proposals the Department of Health advised that there was nothing in the Health Insurance Act which would prevent the payment of medical benefits in respect of services provided by a medical practice company where, amongst other things, the personal responsibility of the medical practitioner to decide that medical services are reasonably necessary for the adequate medical care of patients is maintained. The Department of Health has recently advised that the same principles would apply to the incorporation of medical practices by practitioners who are not members of the AMA. For income tax purposes, incorporation of medical practices by practitioners who are not members of the AMA will be permitted where the constituent documents accord with the by-laws of the AMA approved for these purposes and maintain the personal responsibility of the medical practitioner or practitioners involved.
4.
Shareholders in practice companies 5. One of the requirements for the acceptance of incorporation is that only registered medical practitioners can hold shares in the practice company. In some cases where sole practitioners are seeking to incorporate it has been said that other medical practitioners are unwilling to accept the responsibility of shareholding in the practice company and approval is being sought for other persons including relatives of the medical practitioner, whether qualified or not, to hold shares for the benefit of the practitioner. It is understandable that a medical practitioner may not wish to be a shareholder in a medical practice company where he plays no part in the professional services provided by the company. For this reason no objection will be taken to incorporation where the medical practitioner concerned is unable to obtain the consent of another medical Page 177
6.
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practitioner to be a shareholder and another person holds shares for the benefit of the practitioner involved. This is subject, of course, to there being no diversion of income to the other person as a result of the shareholding. Date of effect 7. As a general rule acceptance of incorporated practices will apply only to incorporations effected subsequent to the advice to the solicitors acting for the AMA giving approval to the proposed arrangements, i.e. 6 November 1980. There may be some isolated cases where incorporation carried out prior to that date conforms to the basis upon which incorporation is now accepted and there are objections or appeals outstanding. These cases may be decided in the light of their own facts.
Basis of accounting 8. Because medical practitioners who incorporate their practices will retain personal accountability for medical services provided by the company, the personal nature of the services rendered by the medical practitioners will not differ in incorporation from that extended by them in partnership or in sole practice. Accordingly returns for practice companies should be lodged on a cash basis. The situation is markedly different from the radiologist company where many staff are employed and the annual turnover is usually substantial. The radiologist company is more akin to the Henderson situation and the earnings basis of deterring assessable income is clearly appropriate. There is a question of the treatment of amounts collected subsequent to incorporation in respect of accounts sent out prior to incorporation. Strictly speaking it would seem that these amounts should be included in the assessable income of the medical practitioner concerned. No objection need be taken, however, if they are returned in the practice company.
9.
10.
Superannuation benefits 11. The question arises as to the expression "appropriate superannuation cover". This refers to cover provided by both pension and lump sum funds. Provided the particular superannuation arrangements otherwise conform to the requirements of this office the benefits on retirement may be payable either as a lump sum or by way of pension.
Existence of service companies 12. In a considerable number of cases service arrangements have been entered into by medical practitioners per medium of companies and trusts. The arrangements generally comply with the official guidelines in this area and have been approved in branch offices for income tax purposes. The existence of an acceptable service arrangement, whether entered into prior to or subsequent to incorporation, will not preclude approval to the incorporation of a medical practice company in accordance with the established principles.
13.
Other professional taxpayers
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14. Should any approach for approval of incorporation be made by other professional taxpayers who, up to now, have not been given approval for incorporation, e.g. dentists, physiotherapists, etc. the matter should be referred to this office for consideration.
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5.2 Income Tax Ruling 2503
INCOME TAX : INCORPORATION OF MEDICAL AND OTHER PROFESSIONAL PRACTICES Document Reference Number: Date of Issue: Date of Effect: Cross-References are: IT 2503 3 November 1988 Immediate 19, 260 PART IVA IT 25 IT 139 IT 2024 IT 2277 IT 2330 IT 2494
Reference NOTE Income Tax Rulings do not have the force of law and each decision made by the Australian Taxation Office is made on the merits of each individual case having regard to any relevant Ruling. PREAMBLE 1. This Ruling reviews the guidelines set out in Taxation Ruling No. IT 25 which dealt with medical practice companies established to take over the activities of medical practices so as to provide superannuation benefits for their employees. The instructions contained therein should continue to be applied unless inconsistent with this Ruling. The companies covered by this Ruling are those formed by professional persons such as medical practitioners, legal practitioners, accountants, engineers, architects, etc., where the ethical and statutory governing bodies of the profession permit members to conduct their professional activities through incorporated bodies. The practice companies may be established to take over all the professional practice, excluding any part required by law to be performed by individuals, for example, audit and liquidation functions. This Ruling relates only to those practice companies whose income flows directly or predominantly from the rendering of personal services by the professional practitioner, as discussed at paragraphs 36 and 37 of Taxation Ruling No. IT 2330.
2.
RULING 3. As a result of representations from various professional bodies etc., the incorporation of professional practices has, for some years now, been accepted by the Australian Taxation Office where:(i) (ii) (iii) (iv) 4. there is nothing in the relevant State or Territory law to prevent incorporation; there are sound business or commercial reasons for incorporation; there is no diversion of income from the personal services of the professional practitioner to family members or other persons; and the only advantage for income tax purposes is access to greater superannuation benefits.
A number of other matters relating to the incorporation of professional practices have been submitted for decision.
Taxable Income of the Company January 2002 Page 180
5. As already indicated, the incorporation of professional practices is accepted for income tax purposes where, inter alia, incorporation does nothing more in relation to income tax than reduce a professional's income by the amount of an appropriate superannuation cover. This position was confirmed by Dawson J. in F.C. OF T. v Gulland 85 ATC 4765 at page 4797: "Of itself and without more, the establishment and operation of a superannuation fund, notwithstanding the opportunity it offers to deduct from assessable income contributions to the fund on behalf of an employee, will not attract s.260." (emphasis added) 6. Generally, this would mean that a practice company should have no taxable income. The total income for a year, after expenses, should have been fully paid out to the professional person by way of a salary. It has been put to the Australian Taxation Office that in practice, however, it is not always possible to achieve this result within the confines of a year, i.e., it is simply not practicable in many cases for the practice company to ascertain its income and determine its allowable income tax deductions by 30 June each year. In the result, it is not possible to determine with accuracy what amount should be paid out by way of salary to the professional practitioner and what amount should be set aside as superannuation cover so as to produce a nil taxable income in the company. A further difficulty arises when the taxable income exceeds the accounting income, for example, where tax deductions for entertainment expenses are denied. Because of these and other similar factors the return of income for the practice company may disclose a taxable income. The retention of profits in the practice company is generally not acceptable. Where profits are retained, salary payments and, therefore, superannuation contributions will be reduced accordingly. Although at times the tax rates on the salary in the hands of the professional and the profits in the company may be the same, the purported main object of the incorporation, obtaining superannuation, will be frustrated. In effect, any retained profits will put in doubt the very basis on which the arrangements have been put forward and accepted, viz., the provision of superannuation benefits. However, where a bona fide attempt has been made to break even but the practice company returns a relatively small taxable income because of the above or similar difficulties, the company should distribute all its taxable income, to the professional person by way of franked dividend, in the following year. This procedure is to be applied to practice company returns of income for the year ended 30 June 1989 and subsequent years. On the other hand, a practice company that makes little or no attempt to distribute the whole of its income to the professional person by way of salary prior to the end of its financial year, or retains income in the company, will not be taken to have made a bona fide attempt to comply with the guidelines. Cases have arisen where the salary paid by the practice company to the professional practitioner is far below that contemplated in the guidelines and the overall result is that the total tax payable by the professional practitioner and the company is significantly less than that which would otherwise be payable. The prima facie conclusion that emerges is that incorporation has been undertaken for the purpose of minimising income tax. In cases of this sort the income Page 181
7.
8. 9. 10.
11.
12.
January 2002
from the practice should be treated as that of the practitioner involved and reliance placed on Part IVA. 13. 14. These procedures will apply regardless of any variations in the marginal tax rates for individuals and companies and even at times when the rates are the same. A practice company that produces a taxable income will, of course, incur an income tax liability. Where, as a result of factors such as those contemplated in paragraph 8, the company has insufficient funds to meet the liability, one suggested solution is for the professional person to loan funds interest-free to the company to pay the income tax. This arrangement is acceptable provided the loans are not repaid by the practice company but are subsequently written off without the professional person seeking a deduction in respect of the write off. Effectively, the arrangement would then result in the income tax liability of the practice company being paid by the professional person in a non-deductible way.
Practice Company Losses 15. It is common for professional practitioners to incorporate part way through a financial year. Where this takes place towards the end of the year, the income of the practice company may not be adequate to cover the superannuation contributions, which have been calculated on an annual salary basis. This generally results in a loss being incurred by the company in its first year of operation. If such a loss is returned by the practice company it should be recouped in the following financial year before any salary is paid to the professional practitioner.
16.
Shareholders and Directors of Practice Companies 17. Another issue is whether or not this Office would have any objection to the participation of the spouse of a professional practitioner in a practice company e.g., the holding of shares in the company or by acting as a director. It has been said that other professional practitioners are unwilling to accept the responsibility of shareholding in the practice company and approval has been sought for other persons, including relatives of the practitioner, whether qualified or not, to hold shares for the practitioner and take on those roles which confer particular duties and liabilities on directors under the companies legislation. In South Australia, for example, the Medical Practitioner's Act 1983, which came into force on 11 August 1983, permits a company whose sole object is to practice medicine to be registered as a medical practitioner. That Act requires that the directors of the company must be natural persons who are medical practitioners. However, where there are only two directors one may be the medical practitioner and the other a prescribed relative of that medical practitioner. A prescribed relative is defined for this purpose as a parent, spouse, child or grandchild of the medical practitioner. The Act further provides that no share issued by the company, and no right to participate in the distribution of the profits of the company, is to be owned beneficially otherwise than by a medical practitioner who is a director or employee of the company or a prescribed relative of that medical practitioner. This would seem to enable the diversion of income to a prescribed relative. Notwithstanding the South Australian or other similar provisions, the holding of a share or the position of director by someone other than the professional practitioner is Page 182
18.
19.
January 2002
acceptable for income tax purposes only where it is allowed by the relevant law or bylaws and there is no diversion of income to that person. In these circumstances it would not be appropriate for the non-professional director to receive remuneration as a director in any form, profits or superannuation benefits. 20. This is not to say, however, that a practice company cannot make arm's length payments to relatives for bona fide services rendered or supplied (other than services as a director as discussed in paragraph 19). It is common for a professional practitioner to employ their spouse in their practice and an income tax deduction is allowed for reasonable remuneration and other benefits paid to the employee. If the practice company continues to employ the spouse, income tax deductions would be similarly allowable to the company.
Goodwill 21. It has been proposed that when professional practitioners incorporate their practices the practice company purchase the goodwill of the professional's practice with funds borrowed from the professional's family trust. The question asked was whether this Office accepts those arrangements if interest is payable to the trust. In the context of the guidelines that provide for the shares in the practice company to be held for the benefit of the professional practitioner, it is difficult to see why the company should pay an amount to the professional practitioner for goodwill. The normal arrangement would seem to be that the professional practitioner would transfer all the assets of the practice, including goodwill, to the company in return for shares that reflected the value of the assets. Under this arrangement, it could be expected that rollover relief under section 160ZZN of the Income Tax Assessment Act would, generally, be applicable. Interest on money borrowed to purchase goodwill in the situation described above, whether borrowed from an arm's-length entity or otherwise, will not be accepted as an allowable deduction. This will not apply to situations where the company is purchasing, including goodwill, an arm's-length practice at commercial rates provided that no diversion of income or other unacceptable consequences result.
22.
23.
Investments 24. The purchase of income producing property by an incorporated professional practice is not generally acceptable. In a case submitted to this Office the reasons given for the purchase of the property by the practice company rather than by the professional practitioner were that a lesser marginal rate of land tax applies to companies and that access to the property would be limited should a case of professional negligence be taken against the professional practitioner. The guidelines have been formulated in the context of the conduct of a professional practice by a corporate body in order to provide the practitioner with a level of superannuation benefits higher than would be available to a sole practitioner or partner. It was not intended that property from any source other than the practice would be held by the practice company. The practice company may own assets used in the conduct of the practice, for example, offices. Where a practice company holds unacceptable investments, the income from the practice should be treated as that of the professional practitioner involved and reliance placed on Part IVA. Page 183
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Basis of Accounting 26. It was explained in Taxation Ruling No. IT 25 that, as medical practitioners who incorporate their practices will retain personal accountability for medical services provided by the company, the personal nature of the services rendered by the medical practitioners will not differ in incorporation from that extended by them in partnership or in sole practice. A similar situation exists in the other professional practices referred to in this Ruling. Accordingly returns for practice companies should be lodged on a cash basis. This requirement has been questioned on the basis that the accounting requirements under the companies legislation are that the companies return their income on an accruals basis. This matter was raised at first instance in Gulland v. F.C. of T., 83 ATC 4352. In that case the medical practice was carried on by a trustee and returns were lodged on an accruals basis. At p.4362 Kennedy J. said:'So far as this qualification is concerned, it appears to me to be clear, and it was not really challenged, that, in the light of C. OF T. (S.A.) v. Executor, Trustee & Agency Co. of S.A. Ltd. (Carden's Case) (1938) 63 CLR 108 and Henderson v. F.C. OF T. 70 ATC 4016; (1970) 119 CLR 612, the method of accounting calculated to give a substantially correct reflex of the taxpayer's true income is that based on cash receipts and payments and not on accruals'. 29. Although the extract refers to the calculation of the particular appellant's taxable income, i.e., Dr. Gulland's, it is seen as supporting the view that the taxable income of a practice company generally should continue to be determined on a cash basis.
27.
28.
Sessional Fees From Public Hospitals 30. Submissions have been made to this Office that sessional fees paid by public hospitals to medical practitioners who have incorporated their medical practices should be included in assessable income of the companies rather than in the income of the practitioners. The object, of course, is that if the sessional fees are included in assessable income of the companies the fees, if ultimately paid out as salaries, may be taken into account in determining superannuation benefits of the employee medical practitioners. In the various States it appears that generally the hospitals have authority to contract for sessional services with medical practitioners only, i.e., contracts must be between the practitioner and the hospital and not with his or her medical practice company. Where a hospital has authority to and does contract with a medical practice company for the services of the practitioner employed by the company, the sessional fees paid by the hospital for those services would be assessable income of the company. However, where a contract is between a hospital and the medical practitioner the fees would be assessable income of the medical practitioner and should be included in the medical practitioner's own return of income.
31.
32.
Keyman Insurance 33. Generally, premiums for keyman insurance would not be deductible in practice companies as those companies should terminate on the death or permanent incapacity of Page 184
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the professional practitioner. However, in practices where such termination would not occur, for example where there is more than one professional practitioner in the practice company, keyman insurance will be acceptable as long as that insurance complies with the guidelines set out in Taxation Ruling No. IT 155. Practice Trust 34. Where a professional practitioner wishes to operate a practice through a trust structure no objection will be taken provided the trust structure achieves the same result for income tax purposes as the basis upon which incorporation of professional practices has been accepted. In particular, it should be ensured that the professional practitioner is the sole beneficiary of the trust.
Service trusts or companies 35. Taxation Ruling No. IT 25 dealt with the use of service trusts or companies. The instructions contained therein should continue to be applied. Essentially it will be necessary to be satisfied in each case that the service for which payment has been made has in fact been provided and that the amount paid is reasonable for the provision of the particular services.
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5.3 Income Tax Ruling 2639
INCOME TAX: PERSONAL SERVICES INCOME Document Reference Number: Date of Issue: Date of Effect: Related Documents are: Cross-References are: IT 2639 20 June 1991 Immediate EDR Ref. 14 6(1) 19 25 IT 25, IT 135, IT 2121, IT 2330, IT 2403, IT 2408, IT 2503
Reference NOTE Income Tax Rulings do not have the force of law. Each decision made by the Australian Taxation Office is made on the merits of each individual case having regard to any relevant Ruling. PREAMBLE 1. This Ruling: a. b. 2. consolidates the views of this Office on the concept of income derived from rendering personal services; and sets out factors for determining whether particular income constitutes income derived from personal services.
The Ruling will assist tax officers and practitioners in applying the following Taxation Rulings: a. Taxation Ruling IT 2503 (Incorporation of medical and other professional practices). It deals with the incorporation of a practice company to take over the activities of a professional practice but is concerned only with those practice companies where income flows directly or predominantly from the rendering of personal services by the professional practitioner. Incorporation here is acceptable if it does nothing more than reduce the professional's income by the amount of an appropriate superannuation cover. Taxation Ruling IT 2121 (Family companies and trusts in relation to income from personal exertion). It deals with income splitting arrangements by which individuals try to split their personal services income among family members by diverting it to a family company or trust. It regards these arrangements as ineffective for income tax purposes under section 260 or Part IVA of the Income Tax Assessment Act 1936 ("the Act"). Taxation Ruling IT 2330 (Income splitting). It is also concerned with the income tax consequences of income splitting arrangements involving trusts and the transfer of income producing assets or the purported transfer of income from the rendering of personal services.
b.
c.
RULING A. Concept of Income Derived from Personal Services
Income from personal services defined January 2002 Page 186
3. "Income from personal services" is income that an individual taxpayer earns predominantly as a direct reward for his or her personal efforts by, for example, the provision of services, exercise of skills or the application of labor. The inclusion of predominantly in this definition allows for the situation where personal services involve the use of some equipment, for example the drawing board of an architect. Some examples of income from personal services included in Taxation Rulings IT 2121 (para 17) and IT 2330 (para 36) are: a. b. c. salary and wages; income derived by a professional person who practices on his or her own account without professional assistance; income payable under a contract, for example a fencing contract, where the payment under the contract relates wholly or principally to the labor of the person concerned; income derived by a professional sportsman or entertainer from the exercise of his or her particular skills.
4.
d. 5.
The concept of income from personal services is to be contrasted with the term "income from personal exertion" as defined in subsection 6(1). That definition includes income consisting of earnings, salaries, wages, commissions, fees, bonuses, pensions, superannuation allowances, retiring allowances and retiring gratuities, allowances and gratuities received in the capacity of employee or in relation to any services rendered, the proceeds of any business carried on by the taxpayer either alone or as a partner with any other person, ... and so on. As can be seen, the concepts of income from personal services and income from personal exertion may overlap but are not coextensive. For a more detailed consideration of the views expressed in paragraphs 3 to 5, see Tupicoff v. F.C. OF T. 84 ATC 4851; 15 ATR 1262 and F.C. OF T. v. Gulland, Watson v. F.C. OF T. and Pincus v. C. of T. 85 ATC 4765; 17 ATR 1. See also IT 25, IT 2121, IT 2330 and IT 2503 for a full discussion of the interactions between personal services income, income splitting, section 260 and Part IVA of the Act.
6.
Income from the business structure defined 7. In this Ruling "income from the business structure" refers to income other than "income from personal services". Income derived by a firm or practice which has substantial income producing assets, or many employees, or both, is more likely to be generated from the income yielding structure of the business rather than from the rendering of personal services. Factors for Identifying Income from Personal Services Whether a taxpayer derives income from rendering personal services is a question of fact and degree to be determined in the circumstances of each case. The crucial issue is the extent of the connection between the income concerned and the services rendered by the particular taxpayer involved. The following factors need to be considered in determining whether a taxpayer derives income from personal services, though no one factor is determinative. Page 187
B. 8.
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a. The nature of the taxpayer's activities The activities of salary and wage earners and professionals practising on their own account clearly generate personal services income. Radiologists or pathologists who operate on their own account, however, often employ many technical staff and operate an array of technical equipment. Their income is generated from the business structure rather than from their rendering of personal services. The activities of consultants, salespersons, journalists, life insurance agents and tradespersons are also likely to give rise to income from personal services. These examples are far from being exhaustive. b. The extent to which the income depends upon the taxpayer's own skill and judgment The more the income producing activities involve the exercise of the taxpayer's own skill and judgment the more probable it is that the income will be derived from personal services rather than from the business structure. c. The extent of the income producing assets used to derive the income The more substantial the income producing assets employed within a practice the more likely it is that the income of the practice will be derived from the business structure rather than from the rendering of personal services. For example, the array of equipment used by radiologists and pathologists may often suggest that their income is being derived from the business structure. However, minor equipment such as the drawing board of an architect or the heart monitor/blood pressure machine of a medical practitioner would not suffice to change what would otherwise be personal service income into income from the business structure. The expression "income producing assets" is used in this context to include any investment of the practice in tangible business assets such as premises, fixtures and fittings, plant, equipment and industrial or intellectual property (whether owned or leased). However, the significance of these assets would have to be weighed against their relevance to the derivation of income given the other factors mentioned in this paragraph. d. The number of employees and others engaged The more substantial the number of employees, practitioners or technicians used in a practice the more probable it is that the income is derived from the business structure rather than from the rendering of personal services (see Henderson v. F.C. of T. 70 ATC 4016; (1970) 1 ATR 596). For example, large accounting and legal firms with tens, or even hundreds, of practitioners but without extensive or substantial equipment would also be considered to be generating their income from their business structure. Income from several sources. 9. In some situations, a taxpayer may derive both personal service income and other income. For example, as explained in Taxation Ruling IT 2408 (Income splitting: insurance commissions), an insurance agent may derive income from initial commissions (personal service income) and from renewal commissions (other income). Similarly, a Page 188
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sole medical practitioner may also derive investment income. In these cases the two types of income should be apportioned and treated independently. Income of a practice company or trust 10. For the purpose of determining whether a practice company or trust falls within the scope of IT 2503 (and only for that purpose), this Office will apply the following guidelines as a general rule of thumb: a. If the practice company or trust has at least as many non-principal practitioners (see paragraph 11) as principal practitioners, then income is considered to be derived from the business structure (and therefore does not fall within the scope of IT 2503). If the practice company or trust has fewer non-principal practitioners than principal practitioners, then whether it derives income from personal services will still need to be determined by considering the factors contained in paragraph 8 of this Ruling and the guidelines in previous Rulings on this issue. If these factors indicate that the practice company or trust derives income from personal services, it will fall within the scope of IT 2503. If they indicate that the practice company or trust derives its income from the business structure, it will not fall within the scope of IT 2503.
b.
11.
In paragraph 10: a. "Practitioners" include both full-time professional and non-professional staff whose function is to derive material fees for the practice. Part-time staff count proportionately. The term does not include administrative, clerical or support staff. For example, a nurse under the direction of a practitioner or a legal secretary under the direction of a solicitor are not "practitioners" unless they earn material fees in their own right. "Principal practitioners" are those practitioners who own or share in the ownership of the practice, whether directly or indirectly. "Non-principal practitioners" are those practitioners who are not "principal practitioners".
b. c. 12.
The paragraph 10 rule of thumb applies to income derived in the income year commencing 1 July 1991 and later years of income.
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5.4 Phillips Case
FEDERAL COURT OF AUSTRALIA GENERAL DIVISION Bowen C.J.(1), Deane(1) and Fisher(2) JJ. Sydney, 1978, April 11, 12; August 8. #DATE 8:8:1978 APPEAL. D. E. Horton Q.C. and D. D. Levine, for the appellant. R. J. Bainton Q.C. and D. G. Hill, for the respondent. Cur. adv. vult. Solicitor for the appellant: Alan R. Neaves (Commonwealth Crown Solicitor). Solicitors for the respondent: Sly & Russell. ADA MOSHINSKY JUDGE1 August 8. The following written judgments were delivered. BOWEN C. J. AND DEANE J. 1. The relevant facts are set out in the judgment of Fisher J., which we have had the benefit of reading. We agree with Fisher J.'s statement of those facts and with his conclusion that the taxpayer was, in each of the relevant years of income, entitled to the benefit of a deduction pursuant to the provisions of s.51 of the Income Tax Assessment Act 1936 ("the Act") in respect of his share of the relevant payments made and liabilities incurred by the firm of Fell & Starkey, of which he was a member, to the First Meritable Trust ("the trust"). (at p400) It is important to distinguish between the purposes underlying the overall rearrangement of the manner in which the partnership of Fell & Starkey carried on its business, including the establishment and equipping of the trust, and the purpose of the subsequent incurring of liabilities and making of payments to the trust. The purposes underlying the overall rearrangement were, to no small extent, of a domestic or private nature. No attack is, however, made by the commissioner on the effectiveness of that rearrangement. It is not suggested that the relevant assets were not in fact effectively transferred. It is not suggested that the relevant staff did not, in truth, cease to be employees of the partnership and become employees of the trust. The commissioner abandoned any suggestion that the provisions of s. 260 of the Act were applicable to avoid, as against him, all or any of the transactions or steps which the rearrangement involved. (at p400) After the rearrangement had been completed, the partnership itself possessed neither the staff nor the furniture or other plant necessary to enable it to carry on its accountancy business. The moneys paid or accrued due to the trust were in respect of services, furniture and other plant which the partnership clearly needed to enable it to carry on that business for the purpose of gaining or producing assessable income. The commissioner has not suggested that any agreement or arrangement relating to the provision by the trust of the relevant services and the rental of the relevant equipment was a sham. The findings of the learned judge at first instance that the agreed rates for Page 190
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the relevant services were realistic and not excessive and that the rate fixed for hire of plant and furniture moneys accrued due were plainly reasonable. In these circumstances, the payments and liabilities were, in the relevant sense, necessarily incurred in carrying on the accountancy business for the purpose of gaining or producing assessable income (see Ronpibon Tin No Liability v. Federal Commissioner of Taxation (1949) 78 CLR 47, at p 56 and Federal Commissioner of Taxation v. Snowden & Willson Pty. Ltd. (1958) 99 CLR 431, at pp 436-437 ). It is not to the point that the reasonable commercial profits which the trust derived as a result of its contractual arrangements with the partnership could reasonably have been expected to have accrued to the partnership if the rearrangement had not been effected or that those profits would, in due course, be credited or distributed either to a partner or to individuals, trusts or companies with which one or more of the partners were associated. Nor, in the absence of any questions involving the effect of s. 260 of the Act, is it to the point that the overall rearrangement had, with taxation and estate planning considerations in view, been effected to achieve, inter alia, those very results. (at p401) 4. There was not, in the present matter, any associated collateral advantage (in terms of either legal entitlement or commercial anticipation) outside the ordinary internal administration of the trust which could properly be seen as a purpose for the making of the payments or the incurring of the liabilities. It is therefore, in the view we take, unnecessary for the taxpayer to rely on the approach which found favor with the majority of their Lordships in Europa Oil (N.Z.) Ltd. (No. 2) v. Inland Revenue Commissioner (N.Z.) (1976) 1 WLR 464 , but which was rejected by Lord Wilberforce in his dissenting opinion. The decision in the present case is governed by the decision of the High Court of Australia in Cecil Bros. Pty. Ltd. v. Federal Commissioner of Taxation (1964) 111 CLR 430 . (at p401) The appeal should be dismissed with costs. (at p401)
5.
FISHER J. 1. This is an appeal brought by the Commissioner of Taxation against a decision of the Supreme Court of New South Wales in its Administrative Law Division. That court allowed appeals of Ian Richard Phillips (hereinafter called "the taxpayer") against two assessments of income tax issued against him by the Commissioner of Taxation, one in respect of the year of income ended 30th June, 1972, and the other in respect of the year of income ended 30th June, 1973. (at p401) In his return for each year the taxpayer, a chartered accountant and a member of the firm of Fell & Starkey, chartered accountants (hereinafter called "the firm"), disclosed the amount of his share in the income of the firm. The commissioner in making his assessment in respect of each year adjusted the taxable income of the taxpayer as returned by adding in respect of the year ended 30th June, 1972, $3,263 and in respect of the year ended 30th June, 1973, $5,905. (at p402) By a letter accompanying the notice of assessment the commissioner indicated that he had made the adjustments because he was of the opinion that the firm was "not entitled to deduct from its assessable income amounts totalling $375,217 in 1972 and $470,954 in 1973 representing secretarial charges and interest". (at p402) The consequence of these adjustments to the assessable income of the firm in each of the years in question was to increase the taxable income of the taxpayer by the amount of his share of each adjustment. (at p402) Page 191
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5. The taxpayer objected by a substantially similar form of objection in respect of each year of income on the ground that the commissioner had overstated the net income of the partnership by the amounts set out above. He contended that these amounts were in each instance properly deductible under s.51 of the Income Tax Assessment Act 1936 (hereinafter called "the Act") as payments made as to the major part thereof for hire of equipment and provision of secretarial and share registry and other necessary services. Payments for interest on moneys borrowed accounted to all intents and purposes for the balance in each year and were similarly claimed to be deductible under s.51. (at p402) The commissioner on 30th September, 1974, disallowed each of the objections and the taxpayer subsequently requested that each objection be treated as an appeal and forwarded to the Supreme Court of New South Wales. (at p402) The taxpayer's appeals were heard together by that court. The commissioner in defending his assessments appears to have conceded that the transactions under consideration were legally effective and not shams. However, he contended that the amounts claimed were not deductible, either wholly or in part, under s.51. Alternatively he claimed that the transactions were void against the commissioner by virtue of the application of s.260 of the Act. On 6th May, 1977, the court upheld the appeals of the taxpayer with costs on the ground that the amounts in question were wholly deductible under s.51 an hat s.260 had no application. A subsidiary argument on the part of the commissioner to the effect that certain income additional to that returned by the firm was deemed to have been derived by the firm pursuant to s. 19 of the Act was also dismissed. (at p402) The commissioner lodged notices of appeal against these decisions but each notice was restricted to what might fairly be called the s.51 and s.19 aspects of the matter. The trial judge's finding that s.260 was inapplicable was not challenged by the notices of appeal nor was that section relied upon at the hearing of the appeals. Upon the commencement of the hearing, counsel for the commissioner abandoned those grounds of appeal which raised the s.19 issues and indicated that he was not pressing another ground which raised a particular aspect of the s. 51 issue. (at p403) The questions before us, therefore, are restricted to the propriety of the inclusion as assessable income by the commissioner of the taxpayer's share in each year of income of amounts equal to the disallowed deductions. The commissioner contends that these sums are not deductible under s.51, or alternatively not wholly deductible. It is appropriate to make the comment at this point that if apportionment of expenditure was rendered necessary by our conclusions, there is no, or at least no satisfactory, evidence before us upon which to base an apportionment or to determine the quantum of non-business expenditure. (at p403) The facts in the matter are complex and relate to arrangements made by the firm. Prior to 1st July, 1971, the taxpayer had been for a number of years a professional employee of the firm. Subsequent to that date, he was at all relevant times a partner. These facts have been set out carefully and fully by the trial judge who was required to consider not only s. 51, but also the applicability of s. 19 and s. 260. The more limited issues before us do not require such a full statement of facts and in particular certain documents set out in the reasons for judgment under appeal need not be repeated here. In addition the essential facts are not in dispute. (at p403) The firm is a large one and carries on business throughout Australia, with branches in each State other than Tasmania. It is a member of an international partnership Whinney, Page 192
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Murray Ernst & Ernst in conjunction with a British and a United States firm. As chartered accountants its business comprises accounting and secretarial work, auditing, taxation and management advice, maintenance of share registers, conduct of liquidations and receivership's. In the course of this business the partners employed substantial numbers of staff, both professional and non-professional. (at p403) 12. The entry of a substantial judgment in the Supreme Court of New South Wales early in 1970 against another large firm of chartered accountants based on professional negligence caused the partners of the firm to consider the impact which such a judgment would have upon their own business. In particular, they were concerned to protect their assets and the assets used in the firm's business against the possibility of an award being made against them in excess of their professional negligence cover. Moreover there was disquiet at the time concerning the considerable increase in premiums payable to obtain cover and whether it might be impossible in the future to obtain the necessary cover at a reasonable cost. (at p404) In or about the month of July 1970 discussions took place with solicitors in Melbourne regarding the possible establishment of a unit trust scheme to take over certain of the activities of the firm and to acquire certain of its assets. A draft trust deed was prepared by the solicitors which was considered by a meeting of all partners held in the month of October 1970. Subsequently a letter dated 30th November, 1970, was sent to the commissioner wherein the proposed establishment of the unit trust scheme was described and its activities were detailed. The letter sought in particular confirmation from the commissioner that payments made by the firm to the trustee of the unit trust would be allowed as deductions. The letter is set out in full in the reasons of the learned trial judge. Whilst the letter and its contents were of some significance on the question of the applicability of s. 260, it is of but limited relevance to the particular issue before us. (at p404) Whilst waiting for a reply from the commissioner (which ultimately was set out in a letter dated 23rd June, 1971) the solicitors instructed by the firm proceeded with the establishment of the scheme. On 22nd December, 1970, two companies were incorporated. Fellstar Holdings Pty. Ltd. (hereinafter called "the trustee company") was set up for the purpose of acting as trustee of the trust deed. However, its function was rather in the nature of a "custodian" trustee in that the second company, Fellstar Secretariat Pty. Ltd., (hereinafter called "the management company") was incorporated to act as manager of the proposed unit trust. (at p404) In mid June 1971 the national committee of the firm decided to proceed with the scheme, and it was about this time that oral advice was received from the commissioner to the effect that he could not accept that the scheme would have the desired consequences for income tax purposes. This advice was confirmed as above mentioned by the letter dated 23rd June, 1971. (at p404) On 30th June, 1971, the trust deed was executed by the trustee company as trustee and by the management company as manager and it provided for execution then or thereafter by persons who applied for units, being beneficial interests in the fund therein defined. The trust and the fund were established by the management company lodging the sum of $100 with the trustee company and the trust thereby constituted was called "The First Meritable Trust". It was contemplated, as was in fact ultimately the case, that units in the trust would be applied for and held by wives, family trusts and companies of the partners. (at p404) Page 193
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17. The essence of the scheme was that certain of the business activities of the firm being those currently performed by the non-professional staff of the firm would be performed by such staff employed by the trustee company. These activities in general comprised typing, secretarial and general clerical work, maintenance of share registers, photocopying and printing work, organisation of seminars and training courses and insurance agency work. In addition it was contemplated that the furniture and equipment would be purchased by the trustee company and leased back to the firm. (at p405) In a circular attached to a memorandum sent out to all partners in the middle of July 1971 an explanation of the scheme was made, its advantages and disadvantages were summarized and the consent of each partner to the scheme was sought. The circular and summary are set out in some detail in the reasons of the learned trial judge and need not be repeated here. Suffice to say that the reasons for establishment of the scheme were stated as follows: "1. To move assets away from partners to minimize consequences of successful litigation. 2. To reduce taxes; income tax during your lifetime and death duties upon your death." The circular also indicated that each partner or his nominee might apply for a specified number of units, the particular number depending upon whether the partner was a full or fractional partner. (at p405) Under the trust deed dated 30th June, 1971, the trustee company was constituted as trustee of the First Meritable Trust. The directors and shareholders of the trustee company were at all relevant times two Melbourne solicitors holding the two issued shares. The deed also constituted the management company as manager of the investments of the trust and any business carried on by the trustee company. There were again only two issued shares held by persons neither of whom was at the time a partner in the firm. These persons were also the sole directors. The powers and duties of the trustee and the manager were set out in the trust deed in some detail and provision was made for creation and issue to other persons of units additional to those subscribed for by the management company. The funds provided by the subscribers were payable to the management company for lodgment by that company with the trustee company and provision was made for investment of the funds in authorised investments selected by the management company. Authorised investments were defined as including inter alia the purchase of chattels including typewriters and other business machines and office equipment and any other equipment used in the conduct of a commercial undertaking or business. A business undertaking acquired by the trustee company at the request of the management company was also an authorised investment. Finally, provision was made for the distribution of the income of the trust fund to the unit holders in proportion to the number of units each held and for the transfer and repurchase of units. (at p405) The circular and memorandum distributed to the partners contemplated the scheme being implemented as from 1st August, 1971. Just prior to that date funds were subscribed by the nominees of the partners in their respective proportions or in one instance by a partner personally. The entitlement of the taxpayer was taken up by his wife who at 30th June, 1972, held 3,000 $1 units paid for out of her resources. In consequence of the overall subscriptions, units to the value of $220,000 were in early August issued to the subscribers. (at p406) behalf of the trust" i.e. on behalf of the trustee company as trustee of the trust fund. All accepted the offer of new employment. On the same day the management company purchased on behalf of the trustee company the whole of the furniture, office machines, partitions and office equipment owned by the firm for $198,973. (at p406) Again on that day the management company by decision of its directors resolved to carry out certain specified business undertakings on behalf of the trustee company as trustee of Page 194
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the First Meritable Trust. These business undertakings included such activities as previously contemplated, namely, the leasing of office furniture, machines, partitions and equipment, provision of clerical and secretarial staff, provision of share registry facilities and printing and photocopying services, making of deposits at call and acting as insurance agents. The resolutions did not spell out that these business undertakings were to be performed only in conjunction with the firm, though with certain minimal exceptions that is what in fact occurred. By the same resolutions the directors also provided for the salaries to be paid to the Sydney and Melbourne managers of the management company. (at p406) 22. On the following day the directors determined upon a charge to be made for the services offered, namely, a percentage on purchase price for the lease of office furniture and equipment, a fee for provision of clerical and secretarial staff based on the formula of: 23. annual salary / number of productive hours times 15% and a fee for share registry services at the rate of 95 cents per shareholder as a maintenance fee and 95 cents for each transfer. (at p406) By letter of the same date the management company by its manager in Melbourne offered the above mentioned services to the firm. The services were offered generally and not for any particular period of time. The firm accepted these services and leasing propositions at the specified rates but again there was on neither side any reference to a term, whether as a minimum period or otherwise. It is common ground that since 1st August, 1971, the management company as manager of the business operations which the trustee company owns as an investment of the trust has provided the secretarial and other services required by the firm and has hired the office plant and equipment used by the firm. These services and hirings are hereinafter compendiously described as "the services." (at p407) It is relevant at this stage to consider the charges made by the management company to the firm for the services in each of the years of income under consideration, and the particular matters in respect of which the charges were made. These charges were made on a monthly basis and were either paid by the firm or alternatively accrued pursuant to a further arrangement (hereinafter called "the amended arrangement") which is later described. (at p407) In the year of income ending 30th June, 1972, a total sum of $375,217 was charged by the management company to the firm. This sum was made up as follows: $ Provision of typing and filing staff, telephonists, receptionists, etc 275,961 Leasing of furniture, fittings, office machines etc 35,533 Provision of share registry services 53,976 Interest on advances made pursuant to the amended arrangement 9,747 _______ 375,217 In the year of income ending 30th June, 1973, a total sum of $470,954 was charged for the services by the management company to the firm. This sum was made up as follows: $ Provision of typing and filing staff, telephonists, receptionists, etc 328,170 Leasing of furniture, fittings, office machines etc 44,168 Page 195
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Provision of share registry services Interest on advances made pursuant to the amended arrangement Professional development costs 77,382 20,381 718 _______ 470,954
27.
In each instance the firm claimed the total sum charged as an allowable deduction. It is the taxpayer's aliquot share of these sums namely $3,263 in the year ended 30th June, 1972, and $5,905 in the year ended 30th June, 1973, which the commissioner disallowed and added back as additional assessable income of the taxpayer. (at p407) The amended arrangement was to the effect that the firm was not required to pay immediately the whole of the charges for services. These charges were rendered on a monthly basis. So much of those charges as remained unpaid was accepted as being loan moneys repayable at call and bearing interest at ten per cent per annum. Subsequently the repayment of these sums (which totalled $174,353 at 30th June, 1972, and $254,444 at 30th June, 1973) was secured by way of a first charge over the book debts of the firm and the interest rate was reduced to eight and a half per cent. (at p408) The trial judge found that the charges made against the firm by the management company for the services were realistic and not in excess of commercial rates. This is a most important finding and was not subject to any challenge by counsel for the commissioner. As to the rate fixed for staff i.e. in effect a loading of fifty per cent on wages paid, this was the rate charged in the marketplace by a client engaged in hiring of office personnel. In return for paying or incurring this charge the firm not only acquired the services of the staff but was relieved from most problems of staff and office management and all financial obligations in respect of wages, sick leave, annual leave, workmen's compensation, statutory holidays and long service leave. In respect of the leasing charges the trial judge found that the rate fixed represented a return of six per cent to eight per cent on funds employed and that such a return could not be said to be excessive. Similarly, he found that the charge for share registry services could not be said to be excessive. None of these latter findings was challenged on the appeal. (at p408) The sale of the plant and equipment of the firm to the trustee company had a benefit to the firm in that it released working capital which might otherwise have had to be provided by bank overdraft or by the partners and also enabled a distribution to be made of profits released for distribution in consequence of the decision in Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612 . Beneficial results also accrued to the firm in consequence of the arrangement whereby charges remained on loan at reasonable rates of interest secured by the first charge over book debts. Again it increased the amount of working capital available to the firm and had the effect of reducing the assets of the firm and protecting these assets against the consequences of an unfavourable judgment against the firm. (at p408) This was the rearrangement of the firm's affairs to which the taxpayer as a party. The benefits were not only those specifically set out above but additionally included the obvious advantage of decreasing what otherwise would have been the taxable income of the taxpayer and providing an income for his wife upon which she was taxable at her relevant rate. The wife's income from this source was $1,016 in the year of income ending 30th June, 1972, and $1,800 in the subsequent year. There is no issue on the question of a contract, scheme or arrangement to which s. 260 might be attracted, and although there was considerable incentive to the firm to use the services thereafter Page 196
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provided by the management company there was no obligation to use them for any prescribed term or to refrain from terminating the arrangement at any time. (at p409) 32. It was the commissioner's rejection of the firm's claim to deduct the cost of the services provided in each year by the management company in arriving at the net income of the firm which prompted the proceedings. Such rejection led to the increase in the assessable income of the taxpayer and the appeal by the taxpayer against the disallowance of the objections. In allowing the taxpayer's appeal on the s. 51 issue the trial judge based his decision on the ratio of Europa Oil (N.Z.) Ltd. (No. 2) v. Inland Revenue Commissioner (N.Z.) (1976) 1 WLR 464 by finding that the firm in engaging the management company and accepting the obligation to pay for the services did not acquire any legally enforceable right otherwise than to the performance of those services. It is my opinion that the trial judge was correct in this finding. However, I am also of opinion that the matter can be determined favourably to the taxpayer on another and perhaps more fundamental point, namely, that from the firm's point of view the only purpose of the expenditure was the acquiring of assessable income or the carrying on of business for that purpose. There was no secondary purpose of benefiting the families of the partners, rather the benefits which accrued to these families were the incentive for the acquisition of the services from the management company rather than from elsewhere. (at p409) The deductibility or otherwise (under s. 51) of expenditure can generally be determined by answering the question whether "the circumstances of its expenditure give it the complexion of money laid out in furtherance of a purpose of gaining income": Robert G. Nall Ltd. v. Federal Commissioner of Taxation (1937) 57 CLR 695, at p 712 per Dixon J. This statement is literally applicable rather to the first limb of s. 51 but would encompass equally the second limb if the words "or are necessarily incurred in carrying on a business for such purpose" were added. The question is ultimately one of fact: Federal Commissioner of Taxation v. Gordon (1930) 43 CLR 456, at p 462 per Dixon J., but the relevance or otherwise of particular circumstances have been considered by the courts on a number of occasions. Such consideration has been undertaken to determine what is invariably the essential question, namely, what is the purpose of the expenditure or what is the legal character of the expenditure? (at p409) A crucially important circumstance in the present matter is the unchallenged finding of the trial judge that the charges paid by the firm were realistic and not in excess of commercial rates. The services were essential to the conduct of the firm's business and the fact that the charges paid were commercially realistic raises at least the presumption that they were a real and genuine cost of earning the firm's income and the cost of that alone. It strongly supports the view that the expenditure was exclusively for business purposes. Without doubt the cost of acquisition of the services was "necessarily incurred" in the sense that it was "clearly appropriate or adapted for" the production of the assessable income: Ronpibon Tin No Liability v. Federal Commissioner of Taxation (1949) 78 CLR 47, at p 56 . (at p410) Doubtless the converse would apply, namely, if the expenditure was grossly excessive, it would raise the presumption that it was not wholly payable for the services and equipment provided, but was for some other purpose. Such is not the case here. (at p410) A circumstance relied upon by counsel for the commissioner was that the amount of the charge was such that it enabled the provider of the services to make a profit. Additionally the charge exceeded the cost which the firm would incur if it reverted to its original practice of employing its own staff and owning the plant and equipment. The relevance of this circumstance in determining the complexion of the expenditure, especially when Page 197
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the expenditure is found to be commercially realistic, is denied by the authority of the Ronpibon Tin case when the court said: "It is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent" (1949) 78 CLR, at p 60 . This statement received the approval of the High Court in Cecil Bros. Pty. Ltd. v. Federal Commissioner of Taxation (1964) 111 CLR 430, at pp 434, 441 and the Privy Council in Inland Revenue Commissioner (N.Z.) v. Europa Oil (N.Z.) Ltd. (1971) AC 760, at p 772 and in the Europa Oil (No. 2) case (1976) 1 WLR 464 . at p410) 37. The Cecil Bros. case is also authority for the proposition that the fact that the expenditure of the taxpayer confers ultimately a benefit (and an intended benefit) on associates or relatives of the taxpayer is nothing to the point. Again it is doubly difficult to challenge the deductibility of the expenditure on this score in the face of the finding that the charges were commercially realistic. In the present matter the firm, whilst under no obligation, was doubtless motivated to engage the management company in the knowledge that it was thereby indirectly benefiting the relatives of the partners. There was considerable incentive for the firm to continue to use the services provided by the management company. However, motive and incentive are not synonymous with purpose: Plimmer v. Commissioner of Inland Revenue (N.Z.) (1957) 11 ATD 480 and XCO Pty. Ltd. v. Federal Commissioner of Taxation (1971) 124 CLR 343, at p 350 per Gibbs J., and s. 51 speaks of purpose and not of motive which is irrelevant. (at p411) Another circumstance which might be regarded as relevant to the question whether the expenditure was exclusively for business purpose is the fact that the services were provided by the management company on behalf of the trustee company. The complex rearrangement of the firm's activities and the setting up of the unit trust scheme enabled services to be provided to the firm in effect by the unit trust. Moreover the rearrangement and the structuring of the scheme were for a nominated purpose. However, in my opinion, such circumstances and the purpose achieved thereby are irrelevant to the ascertainment of the purpose of the firm's expenditure. If s.260 were under consideration, it might well be otherwise. The fact that the firm was under no enforceable obligation to use the services and had the option of reverting or going elsewhere indicates that the purpose of the setting up of the unit trust scheme was a separate and independent purpose without any necessary relevance to the purpose of the expenditure. However, having opted to use the services of the unit trust, the deductibility of the expenditure depends upon the character of the expenditure and not the circumstances which brought about the situation in which the unit trust scheme was enabled to offer and to make available the services. It is my opinion that the latter circumstances are not relevant to the question of the complexion of the expenditure. (at p411) The decision in the Europa Oil (No.1) case (1971) AC 760 established that expenditure is not laid out in furtherance of a purpose of gaining income if the expenditure acquires for the taxpayer a contractually enforceable benefit or advantage not related to the production of assessable income. It was an illustration of a circumstance which denied to the expenditure, at least in part, the relevant complexion. The trial judge in the present case found, and found correctly in my view, that the expenditure did not acquire for the firm and the taxpayer an enforceable advantage. On this ground he found, and again in my view correctly, that the expenditure was wholly deductible. The majority decision of their Lordships in the Europa Oil (No. 1) case is clearly distinguishable on a number of grounds but in particular on the ground that any collateral unrelated advantage was not enforceable by the taxpayer or the firm. But if the assumption is made that there was such a benefit or advantage in the present case this benefit did not arise as it did in the Page 198
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Europa Oil (No. 1) case in consequence of the original rearrangement but in consequence of the continuing decision of the firm to use the services of the management company. It is not possible to find that there was any enforceable collateral advantage provided to the taxpayer or the firm for which portion of the expenditure was consideration. In both the Europa Oil (No. 1) case and the Europa Oil (No. 2) case (1976) 1 WLR 464 the collateral unrelated advantage accrued to the taxpayer. But in the present case any advantage which accrued from the rearrangement accrued to the holders of the units and not to the firm or the taxpayer. The existence in the taxpayer in the Europa Oil (No. 1) case of a right of enforcement was crucial. It is the ground upon which that case is distinguishable from the Europa Oil (No. 2) case where the taxpayer had no right of enforcement of the arrangement which produced the benefit. In the present case neither the taxpayer nor the firm had any right to enforce or supervise the performance of the arrangement which produced the benefit to the holders of the units. Thus the general situation in the Europa Oil cases may shortly be distinguished from the present case on the ground that no collateral unrelated advantage accrued in the present case to the taxpayer or the firm from the expenditure, that any advantage which accrued to the families accrued from the rearrangement, and such advantage was not enforceable by the taxpayer or the firm. (at p412) 40. The evidence in my view clearly establishes that the expenditure was an outgoing reasonably and genuinely incurred in acquiring the assessable income of the firm or in the carrying on of business by the firm for that purpose. The relation between the expenditure and the carrying on of the firm's business is clear. It was necessarily incurred because it was crucial to the business that it be incurred. The expenditure was as regards amount commercially realistic and what was purchased by the expenditure, namely, services and use of plant and equipment, was essential in the conduct of the business. (at p412). The commissioner at the outset contended that no deduction at all should be allowed because the expenditure was not or was not sufficiently connected with the business. It was connected he submitted, rather with the provision of benefits for the families of the partners and the movement of part of the revenue of the firm out of the assessable income of the partners and into the hands of families or family companies. He linked the purpose of the expenditure with the purpose of the initial rearrangement. If the applicability of s. 260 were before the court this argument would be relevant. This approach, however, gains no support at all from the evidence which rather, as I have stated, supports the view that the purpose of the rearrangement was different from the purpose of the expenditure. (at p412). In the alternative the commissioner presented what was his primary submission, namely that an examination of the ends or purposes to be achieved by the expenditure established that it was not exclusively referable to the gaining of assessable income. He contended that an examination of this outgoing indicated that a substantial part thereof, to the extent of the profit content, was private or domestic in that the expenditure of this amount was not dictated by the exigencies of the business. (at p13) This argument runs counter to the established principle already mentioned to the effect that it is not for the court to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent. In essence the commissioner is saying that the services could have been provided more cheaply, that to the extent of the excess the exigencies of the business did not demand the expenditure and that rather it was made for the purpose of benefiting the families. Such an approach required the Cecil Bros. case (1964) 111 CLR 430 to be distinguished and this the commissioner attempted but, in my Page 199
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view, failed to do. He contended that the Cecil Bros. case and the Europa Oil cases should be confined to their special facts, namely, that the expenditure was laid out in acquisition of stock in trade. It is my view that they are not capable of being distinguished on this ground and there is no reason in principle why they should be so distinguished. The commissioner was not able to support his submission with any authority. As has been said, the contrary approach is supported by the Ronpibon Tin case (1949) 78 CLR, at p 60 where the principle finds its genesis and is stated quite generally. The relevant quotation was: "It is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income" and thus was not restricted to expenditure in acquisition of stock in trade. Moreover the expenditure in the Ronpibon Tin case was not referable to the acquisition of stock in trade. (at p13) 44. 45. The conclusions which are appropriate in this matter may be stated as follows: The finding of the trial judge that the expenditure under consideration was commercially realistic raises a presumption that it was laid out for the purpose of obtaining assessable income. Only if the expenditure had been found to be grossly excessive would the finding of a dual purpose of acquiring services and raising of family benefits be open. It is nothing to the point that it might be possible for the services to be provided in other ways more cheaply, and this principle applies equally to the provision of services and to the acquisition of trading stock. The family benefit which accrued in consequence of the use by the firm of the unit trust's services was an inducement or incentive to the firm to avail and to continue to avail itself of this source of services. It was not a purpose of the expenditure. It is only if the taxpayer obtains, for a consideration which is identifiable and quantifiable, an additional advantage unconnected with the business activity hat it can be said that portion of his expenditure is laid out for a purpose other than the acquiring of assessable income. It is in this circumstance that the identifiable portion would not be an allowable deduction. (at p414) It follows that in my opinion the appeal should be dismissed with costs.
46.
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Page 200
5.5 Janmoor Nominees Case: family home in a family trust
Re: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA And: JANMOR NOMINEES PTY. LTD. (AS TRUSTEE OF THE J. REDMAN FAMILY TRUST) Nos. VG386 and VG387 of 1986 Income Tax COURT IN THE FEDERAL COURT OF AUSTRALIA VICTORIA DISTRICT REGISTRY GENERAL DIVISION Fisher (1), Lockhart (2) and Jenkinson (3) JJ. HRNG MELBOURNE DATE 17:9:1987 Counsel for the Appellant: Mr. B.J. Shaw QC and Mrs. A. Moshinsky Solicitor for the Appellant: Australian Government Solicitor Counsel for the Respondent: Mr. J.D. Merralls QC and Mr. K.S. Pose Solicitors for the Respondent: Fernon & Ludescher ORDER Leave be granted to the Commissioner of Taxation of the Commonwealth of Australia to appeal from the judgment of the Supreme Court of Victoria herein handed down 17 October 1986. The appeal be dismissed. The Commissioner do pay to the respondent its costs of the appeal including the costs reserved to this Court by Jenkinson J. of the Notice of Motion of 18 February 1987. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. JUDGE 1 1 2. In this matter I agree with the orders proposed by Lockhart J. and generally with his reasons. In my opinion there is, in the particular circumstances of this matter, an air of unreality attaching to the arguments of the Commissioner in relation to the claimed s.51 deduction and the assessability of the rent paid by Dr. Redman. Considered objectively, the rent has all the hallmarks of assessable income in the hands of the taxpayer trustee and the latter's payments of interest arose out of a commercial arms length transaction. It can hardly be argued that the payments of interest have not the necessary relevance to or in connection with the derivation of assessable income by the trustee taxpayer. The mere fact that the arrangements in relation to the dwelling house were motivated by familial considerations does not deny the interest or the rent their essential characteristics. If it were otherwise, rent or interest paid, for example, by a son-in-law for a home provided for himself, his wife and family would be excluded from the assessable income of the provider. Such a restriction would establish a new and neat form of tax avoidance. Equally it would be most surprising if the fact that a borrower was motivated by familial considerations had any impact upon arms length arrangements with third parties. In the present matter the arrangements in relation to the purchase and letting of the dwelling house may well have been motivated by familial considerations, but motive or subjective purpose is usually nothing to the point in s.51 situations (Magna Alloys v. Commissioner of Taxation) Page 201
January 2002
(1980) 80 ATC 4542 per Brennan J. at 4551-2). Nor has motive any relevance when determining whether a receipt is assessable income. In each instance the essential character is primarily a matter for objective determination. I endorse the reasoning of Jenkinson J. in Federal Commissioner of Taxation v. Groser (1982) 65 FLR 121 in this regard. The Commissioner at all times, at least until it became necessary to support his arguments in Court, correctly accepted the rent as assessable income in the hands of the trustee. His initial disallowance of the interest in part reflected his rejection of 'negative gearing' rather than the propriety of the deduction of the whole amount under s.51. I refer in this regard to the adjustment sheet which accompanied the amended assessment. JUDGE 2 1. This is an appeal from the Supreme Court of Victoria (Murphy J.) dismissing an appeal from a majority decision of the No. 3 Board of Review which allowed the respondent taxpayer's appeal. The Board's decision was to allow the taxpayer to deduct, pursuant to sub-s. 51(1) of the Income Tax Assessment Act 1936 ("the Act"), outgoings in the nature of interest on moneys borrowed to enable the taxpayer to purchase a residence for the purpose of letting it to a surgeon, a Mr. Redman. The Commissioner was in doubt as to whether he could appeal to this Court as of right or by leave. Accordingly, the Commissioner filed a notice of appeal to this Court against the decision of the Supreme Court (VG 387 of 1987) and on the same day filed a notice of application for leave to appeal to this Court against that decision (VG 386 of 1987). A Judge of this Court fixed each proceeding for hearing at the March 1987 sittings of the Full Court in Melbourne. The taxpayer then moved the Court, by notice of motion filed on 18 February 1987, for an order that the hearing of the appeal, if there was to be an appeal, be deferred until a later sitting of the Full Court in Melbourne. Another Judge of this Court heard that motion and found in effect that, on the assumption that leave to appeal was necessary, the Court had no power to make the order sought; but that if the appeal lay as of right then the notice of motion for leave was otiose. His Honour reserved to the Full Court which would hear the motion for leave to appeal each party's costs of the notice of motion of 18 February 1987. On 11 March 1987 the Commissioner filed another notice of otion which sought an order that the motion for leave to appeal be heard concurrently with or immediately before the hearing of the appeal. When the Full Court commenced hearing this matter we were informed by Counsel for both parties that it was agreed that the appeal could only be brought to this Court by its leave. Counsel for the Commissioner asked us to hear the appeal and the motion for leave to appeal concurrently. Counsel for the taxpayer raised no objection to this course. We proceeded accordingly. This was obviously the sensible course for the parties and the Court to take, both to save time and costs, and as the argument on the appeal itself was not expected to take more than one day and it would be necessary for counsel to outline the argument in sufficient detail to enable the Court to consider the questions of law involved for the purpose of deciding whether leave to appeal should be granted. With this rather lengthy, but necessary, introduction to the appeal I shall turn to the facts and to the questions of law involved. The facts are in a short compass and are not in dispute. Mr. Redman was a surgeon who returned to Australia in June 1978 from England where he held an appointment at the University of London. He was married with two children. His wife and he wanted to live in the Frankston - Mt. Eliza area of Victoria. He searched for a house. It was always intended that it be a house in which he and his family would live. In November 1978 Mr. Page 202
2.
3.
4.
January 2002
Redman commenced practice at Frankston and leased a house in that area in which he and his family lived. 5. The taxpayer was incorporated on 16 October 1978 and a family trust, known as the Redman Family Trust, was established on 19 October 1978. The taxpayer was the trustee of the trust which was a discretionary family trust for the members of the Redman family: Mr. Redman, his wife and two children. Mr. Redman and his wife are the sole shareholders and directors of the taxpayer. On 22 January 1979 the taxpayer and Mr. Redman entered into an agreement under which the taxpayer collected Mr. Redman's bills and performed other services for him. In February 1979 the taxpayer purchased office equipment and furniture and leased it to Mr. Redman. Later it purchased surgical equipment and motor vehicles which it similarly leased to him. Thus the taxpayer performed the services of a service company of the kind recognized in Federal Commissioner of Taxation v. Phillips (1978) 78 ATC 4361. By agreement in writing made on 21 October 1979 the taxpayer purchased a house known as "Delamere" at No. 20 Jacksons Road, Mt. Eliza for $206,500. It became registered as proprietor of the property on 13 December 1979. The principal source of funds was $175,000 provided by Sandhurst Mutual Permanent Building Society at a rate of interest of 12.25% per annum with repayments spread over 22 years. The balance of the purchase price came from the purchase of a commercial bill which raised some $50,000. In addition to providing the balance of the purchase price this money was used to pay stamp duty and legal costs relating to the purchase of the property and the purchase of some surgical equipment. Mr. Redman's father in law was an experienced real estate agent and he drew up two leases of the property. One lease was for the whole of the property from the taxpayer to Mr. Redman and the other lease was of one room in the house to him for use as an office. Pursuant to these leases Mr. Redman agreed to pay the taxpayer $200 per week and $130 a month respectively. The rent was submitted to be a realistic commercial rent and was held by the trial Judge to be such and probably even a little more than could have been expected on the open market. Mr. Redman paid the agreed rents to the taxpayer at the end of each month. The trial Judge found that the property was purchased by the taxpayer as trustee for the Redman Family Trust after Mr. Redman's accountant had explained to him the "basic elements of negative gearing". His Honour said that this involved the taxpayer borrowing a substantial portion of the purchase price of a property which was to be used for renting. The interest and revenue expenses of the property would at first exceed the income from rent received, but any reasonable loss sustained would be offset against any other assessable income of the owner. As values rose and the interest bill on the property declined it could be anticipated that the rental value of the property would, if it was wisely purchased, increase. As the venture became profitable another property could be purchased. In accordance with such advice the taxpayer entered into the contract to purchase the property. It borrowed money from the building society and purchased the commercial bill to pay for, inter alia, the property. The relevant tax year with which this appeal is concerned is the year ending 30 June 1980. The outgoings of the taxpayer in that year by way of payment of interest on the moneys borrowed to pay for the purchase of the property and its upkeep exceeded the rental income earned. The income and expenditure statement to 30 June 1980 which accompanied the tax return lodged by the taxpayer provided: Page 203
6.
7.
8.
9.
January 2002
Gross Rentals Received Less: Expenses Borrowing Expenses (Amortized) Depreciation (see below) Interest on Loans (first mortgage) Insurances Rates Repairs and Maintenance including Gardening $6,915 513 2,054 14,251 255 873 1,136 _____ 19,082 ($12,167)
Net Loss 10. 11
The Commissioner issued his assessment which disallowed as a deduction the claimed loss of $12,167 and which stated "Loss on rental property not allowed". The taxpayer lodged a notice of objection. The Commissioner issued an amended assessment with an accompanying adjustment sheet which allowed as deductions: borrowing expenses, depreciation, insurance, rates and part of the costs of repairs on the property. It also allowed interest expenses but only to the extent of income received on letting the property. The Commissioner's reasons for disallowing the taxpayer's claim were stated as follows: "That of the amount of $1,136 claimed as a deduction for repairs and maintenance against gross rental of $6,915 in the return of income for the year ended 30 June 1980, no more than $600 is allowable as a deduction pursuant to the provisions of s. 51 or s. 53 of the Act. That of the amount of $14,251 claimed as a deduction in the return of income for the year ending 30 June 1980, as interest on loans, no more than $6,915 is allowable as a deduction pursuant to the provisions of s. 51(1) of the Act."
12.
13.
The matter went before the No. 3 Board of Review which by a majority upheld the taxpayer's objection and decided to amend the Commissioner's assessment to allow the balance of the interest payments as a deduction. The balance of the claim for repairs was not allowed by the Board and was not the subject of appeal to the Supreme Court and therefore not to this Court. The Commissioner appealed to the Supreme Court which dismissed the appeal. It is from that decision that the Commissioner brings the appeal to this Court. The Supreme Court made the following findings: At the time of purchasing the property the taxpayer intended to lease it to Mr. Redman at whatever the appropriate commercial rent was and that by "negative gearing" it intended to set off any annual loss against other income that it might earn. Then as the property was paid off and generated a profit the taxpayer could invest in other property should that have been advisable. Thus it would acquire income earning assets for its beneficiaries. The leases were effectual notwithstanding certain apparent inconsistencies and inappropriate terms.
14. 15.
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Page 204
The taxpayer received the best return from the property which it could have expected to receive on the market at the time. The taxpayer realised that in the short term its outgoings in respect of the property, including the servicing of the loan would be likely at first to exceed the rent returned to it from leasing the property. Nonetheless, its income from the services provided under the "Phillips" type service arrangements was more than sufficient to enable it to service the loan and defray other expenses. Such moneys as the taxpayer was called upon to pay over and above the return from the property itself would help to secure a capital asset of an income earning nature and would be in reduction of its assessable income and thus lower its taxable income. In any event this is what the taxpayer believed. In the long term the taxpayer would own a valuable property, of an income earning nature, which would be worth much more than had been originally paid for it, even though annual payments of interest would have to be made up for some years from its independent income which could well have been considered to be assured. The matter should be approached on the basis that the taxpayer was earning a substantial income and saw that, by borrowing in order to purchase the property, it had the opportunity to acquire an income producing and an improving capital asset. The borrowings could be serviced from its other income which would at the same time have the effect of reducing its taxable income. Although Mr. Redman, for personal and family reasons was interested in living in the home, the purchase and letting of the home was dictated by "sound business considerations" and the taxpayer did not engage in the exercise for the same familial purposes as inspired Mr. Redman as a husband and father. The purpose of the letting by the taxpayer to Mr. Redman was to obtain the best income return possible at the time on the property such that it would be easier to pay off its borrowings and the interest thereon. The fact that its income tax burden would be reduced, because the outgoings on the property would for some time exceed the rental return from it, would be little consolation to the taxpayer unless over the years it acquired unfettered ownership of the property with its income earning potential. As to s. 260 of the Act, all the taxpayer had done was to adopt a particular course of business conduct which it believed offered, inter alia, certain tax benefits and this did not attract the operation of s. 260. The letting at a commercial rent of the property could not be said to be inexplicable by reference to ordinary business dealings. Even if the arrangement was considered at an earlier stage, namely, when the taxpayer purchased the property, having to borrow the money to do so and intending to let it at a fair rent to Mr. Redman, it could not be suggested that anything in the arrangement, even in so far as it involved "negative gearing", fell outside the scope of ordinary business dealings. Once it can be seen that a particular outgoing incurred has the character of an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing that income, it is a tax deduction for which the Act itself provides and to which s. 260 cannot apply. The fact that the taxpayer was earning income because of the "Phillips" type arrangement in which it had entered with Mr. Redman enabled it to contemplate the further acquisition of income earning assets for the benefit of the trust.
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Page 205
The outgoing of interest on the money borrowed to effect the purchase was an outgoing incurred in gaining or producing the assessable income within the meaning of the first limb of sub-s. 51(1) of the Act. The assessable income was the rent to be earned over the years for which the house was to be let. The fact that Mr. Redman was paying the rent did not cause what was in fact a "commercial rent" to become a "familial contribution". It was at all material times intended by the taxpayer that it should let the premises at the going market rent and this is what it did. There is no warrant for characterising the moneys paid to the taxpayer other than as rent and accordingly as assessable income in its hands. There is nothing to suggest that the loan negotiated with the Sandhurst Mutual Building Society was other than a loan negotiated at arms length at commercial rates; the interest on which the taxpayer was obliged to pay and did pay. It is clear that the moneys borrowed were used to pay for the purchase of the property. In summary, there is nothing to suggest that the taxpayer acted in any way other than in a businesslike manner in entering into the purchase and lease of the property in question. The outgoing of interest was wholly directed to the acquisition of the property as an income earning asset. The rent paid by Mr. Redman was for the enjoyment of a home for himself and his family. Although Mr. Redman's outgoing was no doubt of a private or domestic nature, it did not follow that the taxpayer's outgoing of interest was to be characterized as "private or domestic" and therefore falling outside the qualification for deductibility under sub-s. 51(1) of the Act. 16. The submissions before this Court by counsel for the Commissioner were twofold. It was argued that the rent received by the taxpayer was not assessable income; but, even if the rent was assessable income, the interest payments were not made in gaining or producing the assessable income or, if they were, they were payments of a private or domestic nature. It was argued also that s. 260 of the Act applied to render the arrangements, namely the leases, void. I turn first to the question of the deductibility of the interest payments under sub-s. 51(1) of the Act. In Ronpibon Tin N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47 the High Court provided some guidance on the meaning of the words "incurred in gaining or producing the assessable income" in the context of sub-s. 51(1) of the Act. Their Honours said at pp56-7: "For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words 'incurred in gaining or producing the assessable income' mean in the course of gaining or producing such income. Their operation has been explained in cases decided under the provisions of the previous enactments: see particularly Amalgamated Zinc (de Bavay's) Limited v. Federal Commissioner of Taxation (1935) 54 CLR 295 at pp303-4, 307, 309, 310 and W. Nevill & Co. Ltd. v. Federal Commissioner of Taxation (1937) 56 CLR 290 at pp300, 301, 305-306, 308. "Notwithstanding the differences in other respects in the present provision, the expression 'incurred in gaining or producing the assessable income' has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income." January 2002 Page 206
17. 18.
19. The interest payments are in discharge of an obligation under the mortgage of the property by the taxpayer to a third party at arms length and the rent is received from a letting at commercial rates. It would be odd if the latter is to be treated as assessable income under sub-s. 25(1) but the former not characterized as expenditure incurred in gaining or producing that assessable income and therefore not deductible under s. 51(1). Counsel for the Commissioner recognized this apparent incongruity and submitted that the rent should not be regarded as assessable income notwithstanding that the Commissioner had treated it as assessable income in both the original assessment and the amended assessment; the latter being the subject of the objection which led to these proceedings. It is, of course, open to the Commissioner to argue his case on this footing although he recognized that he could not disturb the amended assessment except to the extent necessary for the Court to adjudicate on the objection. In other words, the treatment in the mended assessment of the receipt of rent by the taxpayer as assessable income cannot be dislodged by this appeal; but the Commissioner may argue his case with respect to the deductibility of the interest payments on assumptions which are inconsistent with the amended assessment. An approach of this kind does not set the stage very favourably for the Commissioner either in his application for leave to appeal or on the merits of the appeal itself. To this observation I should add, however, that it does not follow in revenue law or logic that, if the rent is assessable income in the hands of the taxpayer, the interest payments are necessarily incurred in earning it and are therefore deductible. The Commissioner therefore argued that the rent payments are properly characterized as receipts of a familial nature. There is I think considerable difficulty in accepting the correctness of this argument. Although the Commissioner argued before the Supreme Court that the leases were a sham he abandoned that argument before this Court. The arrangements entered into by Mr. Redman, as director of the taxpayer, for the purchase of the house by the taxpayer and its leasing to him were found by the trial Judge to have been made for mixed purposes. The purchase of the house in the name of the trustee was perceived by Mr. Redman as giving him and his family security from suit if any malpractice proceedings were brought against him. The taxpayer was selected also because of Mr. Redman's desire to minimize death duties in the event of their being reintroduced in Victoria. The trial Judge also concluded that tax advantages for Dr. Redman was a factor in the choice of the taxpayer as the purchaser of the house. Mr. Redman was a medical practitioner recently returned from the United Kingdom with a wife and young family. He liked the Frankston - Mt. Eliza area and established his practice there and wanted to live there. The house is substantial and was purchased with high negative gearing. He and his wife control the taxpayer and therefore the destiny of its assets and the destiny of the Redman Family Trust; a trust which benefits himself, his wife and his children. The more commercial the flavour of the leases and rent payable thereunder then the more successful would be his application for deductions in respect of the lease payments for the room used as an office (the High Court did not decide The Commissioner of Taxation v. Forsyth (1981) 148 CLR 203 until after the arrangements were entered into). It was perceived that for a considerable time the interest payments and the other outgoings in respect of the property would exceed the rent. The only other source of income came from its activities as a "Phillips" type service company. The transaction was in a sense familial in nature in that it was motivated by familial considerations, but that fact is not conclusive of the character of receipt of rent by the taxpayer from Mr. Redman; nor does it determine the character of the payments of interest made under the mortgage. Illustrations abound of arrangements between members of families that nevertheless have a revenue quality. All the relevant Page 207
20.
21.
22.
January 2002
circumstances must be examined to determine whether a receipt or disbursement by a taxpayer is income under s. 25 or a deduction under sub-s. 51(1). 23. There are some elements of the arrangements in this case relating to the purchase, mortgage and lease of the property which have commercial attributes. The mortgage was an arms length transaction at a commercial rate of interest as was the commercial bill for $50,000. The rent payable under the lease was also at market value. It was not argued, however, that the arrangements had a business quality in the sense of the carrying on of a business within the meaning of the second limb of sub-s. 51(1). Although the arrangements were of a familial nature, they were plainly intended to have legal effect. The Commissioner rightly eschewed before us his earlier suggestion of sham (that "popular and pejorative word" to adopt the phrase of Diplock L.J. in Snook v. London and West Riding Investments Ltd (1967) 2 QB 787 at p802). However, his argument that the taxpayer's receipt of rent was not a receipt of income according to ordinary concepts, but some kind of familial receipt, is really an argument of sham in a different guise. Once it is recognized that Mr. Redman and his wife intended to provide for themselves and their family, by obtaining the property as an asset for their mutual benefit and in the expectation of alleviating the burdens of taxation by the use of negative gearing, then the machinery which was used to achieve that object (including the purchase of the property by the taxpayer and the leasing of it to Mr. Redman at a rent determined with market values considerations in mind) necessarily requires that it had legal operation and denies a sham. Therefore, as perceived on the facts of this case, the receipt by the taxpayer of rent under the leases must be a receipt of income according to ordinary concepts and therefore assessable income under sub-s. 25(1). The leases themselves are curious in some respects; especially since the principal lease is of the whole property and the other lease is of the office alone. The reason for the two separate leases is plain enough. Mr. Redman hoped to gain a taxation benefit that might flow from Forsyth's Case which he had read. The trial Judge said that he assumed that Mr. Redman "was referring to the decision in the Board of Review or in the Supreme Court of Victoria or to the decision in the Federal Court". It was not until April 1981 that the High Court, by a majority, disallowed the deductions claimed by Mr. Forsyth. That case involved the licensing by a family company which owned the family home to a barrister of a room which served the dual purpose of a study and dressing room for which a licence fee was paid by the barrister. The taxpayer claimed the licence fee as a deduction under sub-s. 51(1) and he succeeded before the Board of Review and the Supreme Court of Victoria and the Full Court of this Court. The High Court by a majority allowed the Commissioner's appeal. See also Handley v. The Commissioner of Taxation (1981) 148 CLR 182. Notwithstanding certain inconsistencies between the two leases I agree with the trial Judge that they were nevertheless effectual and that the taxpayer, on receiving the rents, became the landlord of Mr. Redman who as tenant paid a genuine rent at regular monthly intervals. The payment of interest by the taxpayer was in my view an outgoing incurred in the course of gaining or producing the assessable income of the taxpayer. The high ratio of borrowed money to the purchase price, reflected in the large payments of interest on the first mortgage which considerably exceeded the rent received by the taxpayer ($6,915 rent and $14,251 interest), does not, in my opinion, deprive the interest payments of their character as outgoings incurred in gaining or producing the assessable income.
24.
25.
26.
January 2002
Page 208
27. Nor can I see any warrant for severing the interest payments into a portion which was paid in gaining or producing assessable income and a portion which was not so paid. It is true that sub-s. 51(1) itself recognises the potential for severance or apportionment of outgoings into components, only some of which are allowable deductions. The words "to the extent to which" the losses or outgoings are incurred in gaining or producing the assessable income (I refer only to the first limb) indicate this. The mere fact that the interest payments exceed the receipts of rent cannot justify the severance sought by the Commissioner and reflected in the amended assessment. It is only the 1980 tax year with which this case is concerned; but the characterisation of the receipts and payments necessarily involves an analysis and interpretation of them from the inception of the arrangements of 1979 including the obligation to pay interest which arose from the terms of the mortgage. So regarded, the interest payments are not divisible for the purposes of the first limb of sub-s. 51(1). There remains the question under s. 51 whether the payments of interest are wholly or in part only outgoings of a private or domestic nature. Whether losses or outgoings incurred in gaining or producing assessable income and losses or outgoings of a capital, private, or domestic nature are mutually exclusive is a question that has attracted little scrutiny by the courts. Menzies J. said in Federal Commissioner of Taxation v. Hatchett (1971) 125 CLR 494 at p498: "It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive." In Federal Commissioner of Taxation v. Faichney (1972) 129 CLR 38 Mason J. said at p44 that such examples of private or domestic expenditure that leapt to the mind were those that "could not conceivably be incurred in gaining assessable income". In Handley's Case (supra) Stephen J. considered this question at pp191-192 and appears to have adopted an approach similar to that of Menzies J. in Hatchett. In Handley's Case Aickin J. said at p200: "Logic would seem to suggest that expenditure incurred on private or domestic matters could not be incurred in gaining or producing assessable income but, as appears from the observations in Ronpibon, and in John Fairfax & Sons Pty. Ltd. v. Federal Commissioner of Taxation (1959) 101 CLR 30, strict logic has not been the sole guide of the draftsman. The fact that s. 51(1) both permits and requires dissection and apportionment of expenditure by the use in the opening words of the expression 'to the extent to which they (i.e. 'all losses and outgoings') are incurred in gaining or producing the assessable income' suggests that some expenditure may be of a mixed character such that it must be apportioned so as to ascertain that amount which can be regarded as expended in gaining or producing assessable income or carrying on a business. Thus the exclusion of expenditure made on, or in so far as it is on, private or domestic matters comes from the requirement of the opening words of s. 51(1) which limit deduction to expenditure incurred in gaining assessable income. The express exclusion in the closing words of the sub-section of expenditure of a private or domestic nature has the same character as the exclusion of expenditure in gaining exempt income; it must be regarded as having been inserted by way of precaution or emphasis - cp. the discussion by Menzies J. in Federal Commissioner of Taxation v. Hatchett (1971) 125 CLR 494, at p498. The fact that the opening words impliedly exclude that which is not incurred in gaining or producing assessable income may make the final express excluding words no more than partly explanatory and partly definitive of what is excluded. In my opinion the section does not require a two-stage apportionment." January 2002 Page 209
28. 29.
30. Mason J. said in Handley's Case at p194 that outgoings incurred in gaining or producing assessable income and outgoings of a capital or domestic nature are not mutually exclusive. His Honour said: "Whether the same is true of outgoings of a private nature is a question that may be left to some future occasion. The very form of s. 51(1) recognises that there are some outgoings which, though incurred in gaining assessable income, nevertheless fall within the exception. Then, to the extent to which they have the latter character, they are not allowable deductions." 31. 32. Wilson J. took a similar view at p202. In Forsyth's Case (supra) Wilson J. said at 216: "I see no reason why it would not be a proper application of s. 51 of the Act in the present case to say that if the proper conclusion on the facts as that the rent was prima facie an outgoing incurred in gaining or producing the assessable income then the exception with respect to outgoings of a domestic nature would operate to exclude it from deductibility." 33. The conclusion of the majority in each case was that the exclusion of a loss or outgoing of a capital or domestic nature is not redundant; but whether the same is true of a loss or outgoing of a private nature is left undetermined. I confess to having difficulty in assigning any subject matter to the exclusion of a loss or outgoing of a private nature. I respectfully agree with Menzies J. in Hatchett's Case in the passage cited above. However, the form of sub-s. 51(1) which recognises in terms that there are some losses or outgoings which, though incurred in gaining or producing assessable income, nevertheless fall within the exception of a loss or outgoing of a private nature suggests that it may have some work to do, rare though its performance would be. The taxpayer is liable to pay interest to the mortgagee, a company at arms length to the taxpayer and Mr. Redman. The taxpayer receives rent at market rates from Mr. Redman. Plainly the payment of rent for the office (and a fortiori for the property as a whole) falls squarely within Forsyth's Case and is therefore not available as a deduction to Mr. Redman. But that is not determinative of the question whether the payments of interest are of a capital, private or domestic nature. The taxpayer derives assessable income from its activities as a service company to Mr. Redman and from payments of rent by him. If the interest payments were distinctly less than the amount of the rent received I doubt if it could be seriously argued that those payments were of a capital, private or domestic nature. Why is there any difference because the interest payments are much higher than the rent received? The section requires with respect to an outgoing which was incurred in gaining or producing the assessable income, dissection or apportionment if it has a mixed character, one element which is of a capital, private or domestic nature. The Commissioner says that either all the interest payments have that character or that a dividing line must be drawn between such of the interest payments as exceed the rent received; the excess representing the capital, private or domestic nature of the interest. I can see no support for any such arbitrary division. In my opinion the obligation of the taxpayer to pay interest, in the circumstances of this case, is excluded from the category of private or domestic outgoings (it was not argued that it was of a capital nature). Page 210
34.
35.
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36. Reliance was placed by counsel for the Commissioner on Ure v. Federal Commissioner of Taxation (1981) 50 FLR 219 where the taxpayer, a solicitor, borrowed money at commercial rates of interest of up to 12.5%, paid interest in the relevant year of income of $8,736 and on-lent the borrowed moneys to his wife and a family company at 1% interest. The principal object of the taxpayer was to reduce his taxable income. An ancillary object was to provide financial benefits to his wife and to a family trust. The taxpayer claimed a deduction for all the interest on his loans but the Commissioner allowed only an amount equal to the 1% interest returned as assessable income. The Commissioner therefore substantially disallowed the claim and allowed only a deduction of $660 for interest being the equivalent of the income received by the taxpayer from the on-lending. The Supreme Court of New South Wales held that, to the extent disallowed by the Commissioner, the payment of interest was an outgoing of a private or domestic nature. The Supreme Court concluded that the only deduction allowable under sub-s. 51(1) was so much of the total interest paid as equalled the amount of interest which the taxpayer was entitled to receive on the on-lending of the money. On appeal to the Full Court of the Federal Court it was held, so far as interest was concerned, that it was necessary to apportion the outgoings in respect of interest between what could properly be regarded as incurred in gaining or producing assessable income (thus not being of a private or domestic nature) and what could not properly be so regarded. The Court declined to interfere with the approach taken by Lee J. in the Supreme Court that the appropriate apportionment was to treat the equivalent of what the taxpayer received from on-lending ($660) as being not of a private or domestic nature and to treat the balance of the interest paid by the taxpayer as being of a private or domestic nature. Ure's Case is plainly distinguishable from the present case. The attribution of a private or domestic nature to the interest paid by the taxpayer in Ure's Case lay essentially in the disparity in interest rates between what was payable to the taxpayer on the money borrowed and what was received by him for the money on-lent. Reliance was also placed by counsel for the Commissioner on Federal Commissioner of Taxation v. Groser (1982) 65 FLR 121. In that case the taxpayer owned a house occupied by his invalid pensioner brother. The taxpayer resided elsewhere. The taxpayer allowed his brother to live in the house for two dollars a week in circumstances where the rack rent at the relevant time was about $75 a week. The taxpayer returned the weekly amounts as income and claimed a deduction for interest and other expenses relating to the property. By agreement between the taxpayer and his brother the pension was paid to the taxpayer who kept an account of expenditure he made on his brother's behalf, including the two dollars a week appropriated by the taxpayer to himself which he called "rent". It was held by the Supreme Court of Victoria that the transactions were of a familial character unconnected with the receipt of income as understood in ordinary usage. The Court held that the two dollars per week did not constitute rent and thus assessable income in the taxpayer's hands, but a contribution towards the funds out of which expenses were defrayed. It followed that the expenses relating to the house were not incurred in producing assessable income and were not deductible. The Court went on to say that, even if the weekly payments were assessable income, the deductions for expenses could not exceed the amount included as assessable income because the outgoings were incurred by the taxpayer mainly for private or domestic considerations, namely, to provide lodgings for his brother. Again, the facts of the present case are plainly distinguishable from those in Groser's Case. Groser's Case was distinguished by the Supreme Court of Queensland in Federal Commissioner of Taxation v. Kowal (1983) 84 ATC 4,001. In that case the taxpayer and his wife purchased his parents' house after the breakup of the parents' marriage when his Page 211
37.
38.
39.
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mother, who was alone in the house, had difficulty meeting mortgage payments and expenses. The property was purchased with money borrowed on mortgage. During the year of income in question the property was rented back to the taxpayer's mother for ten dollars per week when a commercial rent would have been about fifty dollars per week. In his return of income for the relevant tax year the taxpayer included as income half the rent received and claimed as deductions under sub-s. 51(1) half the expenses connected with the property which included the mortgage interest. The Commissioner excluded the rent received from the property from the taxpayer's assessable income and disallowed the deductions claimed. On reference to the No. 3 Board of Review it was held that the rent received by the taxpayer was assessable income, and, by a majority, the taxpayer's claim for deductions under sub-s. 51(1) was allowed. On appeal to the Supreme Court the appeal was allowed in part. The Supreme Court said that the outgoings were to be apportioned between the amount expended in gaining or producing income and that having a private or domestic nature. An appropriate apportionment was 80% of the outgoings as having the requisite characteristics of outgoings incurred in earned assessable income unless 80% of the outgoings was less than the actual amount of assessable income earning from the borrowed funds in which case the appropriate deduction would be such portion of the outgoings as equalled the income earned. In the result, 20% of the expenditure claimed was disallowed on the ground that was a fair assessment of the domestic or private portion of the expenditure in the year in question. 40. 41. Accordingly the Commissioner fails in this appeal unless his argument succeeds with respect to s. 260. I should add that the interpretation of the exception to sub-s. 51(1) of losses or outgoings of a capital, private or domestic nature and their application to the facts of this case raise in my view questions of sufficient importance to warrant the grant of leave to appeal. It is worth noting that negative gearing arrangements such as those involved in the present case are now limited in their operation by subdivision G of Division 3 of Part III of the Act inserted by s.11 of Act No. 46 of 1986 and applies first in relation to the year of income ended 30 June 1986. Broadly speaking the effect of these provisions is that the aggregate amount of interest incurred in a year of income on borrowings to finance rental property investments made after 17 July 1985 is deductible only to the extent of the aggregate net rental income derived in the year from all such investments. It was submitted on behalf of the Commissioner that s. 260 applied. The difficulties in applying s. 260 to extinguish a deduction otherwise allowable under s. 51 have been referred to in decisions of the High Court and previous decisions of this Court. In Cecil Bros. Pty. Ltd. v. Commissioner of Taxation (1964) 111 CLR 430 Dixon C.J. said at p438: "In my opinion, s. 260 of the Act can have no application to such a case as the present. Indeed, in spite of the views expressed by Owen J. and by Menzies J., I have great difficulty in seeing how it could apply to defeat or reduce any deduction otherwise truly allowable under s. 51." 44. Kitto J. agreed with the judgment of Dixon C.J. at p438 and Taylor J. said at the same page that he shared the difficulty of the Chief Justice in seeing how s. 260 could extinguish a deduction otherwise properly allowable under s. 51. As Beaumont J. pointed out in Federal Commissioner of Taxation v. Lau (1984) 84 ATC 4,929 at p4,946, although the High Court in Cecil Bros did not need to decide the question whether s. 260 Page 212
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could operate to defeat or reduce a deduction otherwise truly allowable under s. 51, the expressions of opinion on the point by Dixon C.J., Kitto and Taylor JJ. should be treated as authoritative for present purposes. Jenkinson J. agreed with the judgment of Beaumont J.. In my opinion this Court should follow the same course, with the result that, as I have concluded that a deduction under sub-s. 51(1) is available, the deduction cannot be denied by s. 260. 45. Leave to appeal from the judgment of the Supreme Court of Victoria should be granted and the appeal dismissed with costs including the costs reserved to this Court by Jenkinson J. of the notice of motion of 18 February 1987.
JUDGE 3 1. 2. I agree in the orders proposed by the other members of the Court, and in their reasons for judgment, which I have had the advantage of reading. In support of his submission that the interest payments under the mortgage were "outgoings of a private or domestic nature", within s.51(1) of the Income Tax Assessment Act 1936, counsel for the Commissioner relied upon the circumstances that the taxpayer was a mere instrument of Dr. Redman and that the transactions of which the grant of the mortgage is part were directed by Dr. Redman, as it was submitted, to the private and domestic purpose of providing for him and his wife and children a family home. Counsel submitted that the Court should look through the separate legal personality of the taxpayer to the reality of that family provision. But reality cannot be denied to the trust to which the house was subject. The house was to be not only a family home, but also part of the trust property, which neither the taxpayer nor Dr. Redman could regard as its or his own. In that property the taxpayer could have no beneficial interest. Nor could Dr. Redman have any beneficial interest in the freehold estate in the house or in the proceeds of any sale of that estate unless and until he had first caused the taxpayer to exercise in his favor a discretionary power conferred by the trust deed on the taxpayer as trustee to benefit one or more of the beneficiaries designated by that deed. Not all of the possible beneficiaries have yet been born. Not all of them are, or will be, members of Dr. Redman's family. The trust comprehends identifiable charitable bodies as well as charitable purposes. The decisions taken by the taxpayer to buy the house and to grant the mortgage and to lease the house to Dr. Redman were all taken in exercise of powers conferred, and in performance of duties imposed, on the taxpayer as trustee. Equity required that in the making of those decisions the taxpayer have regard to the interests of all the possible beneficiaries, including those who might enjoy, in the year 2058 or on such earlier day as the trustee might appoint for the termination of the trust, the corpus of the trust estate, of which the house was to form part. There was no finding by the Supreme Court of Victoria, nor evidence to require a finding, that the taxpayer or, if the taxpayer be regarded as a mere instrument, Dr. Redman had wholly disregarded the interests of possible beneficiaries other than himself, his wife and his living children. If it be conceded that regard was had in the making of those decisions to the interests of all whose interests the law required to be considered, the submission that the mortgage interest payments were "outgoings of a private or domestic nature" cannot in my opinion be accepted.
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5.6 Practitioners motor vehicle expenses
AAT CASE 9235 : PRACTITIONERS MOTOR VEHICLE EXPENSES Ref no: VT 93/57 Dec no: 9235 13 January 1994 Melbourne Only paragraphs 15 and 16 relate to motor vehicle expenses. The preceding paragraphs have been deleted for ease of reading.) Losses and outgoings Home office expenses Motor vehicle expenses Medical practitioner Whether home office was place of business Whether motor vehicle expenses from home to attend patients were deductible Whether imposition of additional tax for incorrect return Income Tax Assessment Act 1936 (Cth) ss 51, 223. The applicant taxpayer sought review of a decision by the Commissioner to disallow in part an objection lodged by the taxpayer against an amended assessment of income tax for the year ended 30 June 1989. The amounts in question related to home office expenses and motor vehicle expenses. In addition, he sought review of the decision to impose additional tax for an incorrect return. The taxpayer, a medical practitioner, spent half his time each week conducting private practice from rented rooms at three different hospitals and the other half under contractual employment at a public hospital. In respect of his private practice the taxpayer maintained his practice records, patient records and all administrative facilities at a two room office at his residence. He also conducted some aspects of his private practice and research from there as well as preparation of lectures and clinical presentations as part of his hospital contractual duties. On average, the taxpayer spent 12 to 13 hours per week working in the home office. His wife also carried out her duties there as secretary and practice manager for approximately 24 hours per week. The taxpayer claimed deductions for home office expenses and motor vehicle expenses for travel to and from the hospital, contending that his practice was based at his residence. Held: setting aside the decision under review, affirming the decision of the Commissioner in relation to home office expenses, allowing a deduction for the amount claimed as motor vehicle expenses and remitting the additional tax imposed as a culpability penalty on the claim for home office expenses. (i) The taxpayer's home was not the only place where he conducted his practice. Although it may have been a central base, he did not carry on business there as such. The essential character of the expenditure on mortgage interest, insurance and rates incurred by the taxpayer was for the provision of a home for his family. The study was part of that home even though it was used to earn income. FCT v Faichney (1972) 129 CLR 38; 3 ATR 435, applied The taxpayer's home was a central base from which it was necessary to carry bulky equipment and files to various locations to see patients. The claim for the motor vehicle deduction was therefore allowable. FCT v Vogt (1975) 5 ATR 274; 75 ATC 4073, applied The imposition of a culpability penalty in relation to the disallowance of the claim for home office expenses was not justified in this case. Page 214
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(iii)
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(B H Pascoe) 15. The other matter in dispute was the deduction claimed for motor vehicle expenses. The argument put for the applicant was, in part, related to the argument put in favor of him being seen as having his place of business at his home and therefore the respondent's disallowance on the basis of the cost of traveling from home to another place of business was incorrect. An additional factor put in favor of the deduction was the need of the applicant to carry heavy and bulky equipment with him in his motor vehicle when traveling to and from each of the locations at which he saw patients. The applicant gave evidence that he was required to carry with him on a daily basis electrodiagnostic equipment known as an EMG machine, a camera bag in which were kept various instruments and small items, a brief case, relevant files for the patients to be seen on that day, X-rays relevant to those patients and frequently, medical journals and text books relevant to a particular patient illness. The EMG machine weighs 15 kilograms and its dimensions are 175 millimetres by 455 millimetres by 380 millimetres. It was argued that the applicant's position was analogous to the taxpayer in FCT v Vogt (1975) 5 ATR 274; 75 ATC 4073. In that case the taxpayer was a professional musician who worked at a suburban RSL Club and also earned small amounts from playing at a recording studio and at a musicians' club. In general the taxpayer kept his musical instruments and their associated equipment (trumpet, flugelhorn, acoustic base, electric base and amplifiers) at home. He did so because it was essential to practise on them and because it was the only practicable place to keep them. He used his motor vehicle to transport himself and his instruments between his place of residence and the various places where he worked. The taxpayer was successful in his claim for the relevant motor vehicle expenses. In my view the applicant in this case should also succeed in his claim for the additional motor vehicle expenses disallowed by the respondent. Whilst finding that his home office was not sufficiently "a place of business" so as to allow a deduction for a proportion of that expenditure which was essentially incurred in order to provide a home, the home is, nevertheless, his central base from which he travels to various locations to see patients. In none of those other locations is provided facilities for retention of records or equipment and, each day, he invariably goes to a location different from the one that he was attending the day before. In many respects his position was similar to that of the taxpayer in FCT v Wiener (1978) 8 ATR 335; 78 ATC 4006 where the itinerant nature of the duties made travel essential and Smith J considered that the taxpayer could be said to be traveling in the performance of her duties from the moment of leaving home to the moment of returning there. In any event, the necessity to carry the bulky equipment, files, etc to and from his home each day brings this applicant within the principle established in Vogt's case, supra. There was no dispute as to the quantum in relation to the claim for motor vehicle expenses and, therefore, the respondent's decision in relation to the claim for their expenses should be set aside and a further deduction of $7272 allowed in the relevant year.
16.
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5.7 Interest on amounts borrowed to pay income tax
TAXATION RULING NO. IT 2582 INCOME TAX: DEDUCTIBILITY OF INTEREST INCURRED ON MONEYS BORROWED TO PAY INCOME TAX Document Reference Number: IT 2582 Date of Issue: 18 April 1990 Date of Effect: Immediate Cross-References are: 51(1) CITCM 616 Reference NOTE Income Tax Rulings do not have the force of law Each decision made by the Australian Taxation Office is made on the merits of each individual case having regard to any relevant Ruling. PREAMBLE 1. Recently this Office was asked to consider whether interest incurred on moneys borrowed by companies to pay income tax qualified for deduction under the general deductions provision of the Income Tax Assessment Act. The question of a taxpayer's entitlement to such a deduction, where carrying on a business, has been the subject of detailed examination in this Office on two previous occasions, one as far back as 1921, the other in 1951. Those reviews recognized a number of practical difficulties associated with denying a deduction for taxpayers carrying on a business. Consequently, it was decided that "where a taxpayer carries on a business producing assessable income and pays interest on an overdraft, no action is to be taken to disallow the interest attributable to a part of the bank overdraft equal in amount to the income tax paid out of the bank account which is in debit" (paragraph 6, Canberra Income Tax Circular Memorandum No. 616). This practice has ensued till the present day. The recent representations have caused this Office to, once again, consider whether interest on moneys borrowed by businesses to pay income tax qualifies for deduction. In doing so, particular attention has been given to the overall purpose for the making of such borrowings.
2.
3. 4.
5.
RULING 6. Where a taxpayer carries on a business for the purpose of gaining or producing assessable income and, in connection with the carrying on of that business, borrows money to pay income tax (whether to preserve the assets of the business, maximize the return on them, retain sufficient money to fund the business or otherwise) then it is considered that the interest incurred on those borrowings is a normal incident of conducting that business. That is, such an expense is an expense incurred in carrying on that business and hence qualifies for deduction under the second limb of subsection Page 216
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51(1) of the Act. The judgment in Begg v. FC of T (1937) 4 ATD 257 is considered to add weight to this decision. 7. This Ruling does not apply to interest on borrowings that are not connected with the carrying on of a business for the purpose of producing assessable income.
(COMMISSIONER OF TAXATION)
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6. 6.1 DEBT MANAGEMENT Handy hints on borrowing money
Introduction As a general comment, we are not in favor of borrowing money. If you must borrow money bear in mind that you must also pay it back one day. Normally this must be done with after tax dollars. Also bear in mind that you will have to pay interest on the amount that you borrow. After a few years these amounts can really add up. The eighties are gone and large debts no longer create wealth. Most people realize this and have more mature attitudes to debt than they did ten years ago. There are no quick fixes. But, realistically, every practitioner will borrow at some time or another and this part of the manual looks at what you can do to make this process easier. Part 7.2 looks at how to manage debt once you have it. Handy hints for getting the money Research costs before you sign the contract. Make sure you know the interest rate, the principal repayment rate, the administration costs and the penalties for early repayment. Shop around. The first offer is unlikely to be the best offer. Remember that practitioners are good risks so make sure you get an offer that reflects this. Look for a bank that offers special deals for practitioners. The December 1995 edition of Medical Observer Business identified the National Australia Bank as one bank that will help here. We have excellent connections with the National Australia Bank's Brighton Business Lending Centre and the staff have been able to help quite a few of our practitioner clients. The Commonwealth bank also offers excellent deals to practitioners and dentists under its professionals program. Make sure that your finance application is clear and to the point. Support it with recent accounts, company searches, business plans and similar documents where necessary. These materials are best included as appendices to the main application. Ensure that your finance application shows all repayments can be met out of your existing and expected business cash flows. Financiers are not impressed where the repayment of principal depends on the sale of assets. Do not borrow too much. Most banks work on a debt to equity ratio of about 70:30. But in working out the value of your equity they discount historical cost by factors representing their expected resale experiences. Take account of these discount factors before you commit yourself to a transaction. Ensure that your finance application includes all relevant materials. This should include all financial information that does not favor your application. If something goes wrong later on and the bank finds out that you withheld certain information then, to say the least, tempers could rise. Keep the communication channels clear. If something does go wrong, tell the bank straight away. This is important because banks do base their recovery actions on how they perceive the borrower to have behaved. The banks will normally be reasonable if you are reasonable with them. It is therefore important to play with a straight bat at all times. January 2002 Page 218
Handy hint if you are borrowing to buy property If you are borrowing to buy property consider making your offer subject to finance from a specified branch of a specified bank in a specified time, say a month. If something goes wrong you will probably not lose your deposit. Also, if you change your mind within the specified time frame then you may be able to "arrange" for your finance application to be refused. This means that you can get your deposit back. But make sure that the finance condition specifies which bank and even which branch of that bank. If you do not do this you may find the vendor arranging finance for you through a lender that normally you wouldn't go anywhere near. Handy hints for income tax time Consider choosing a facility such a fully drawn advance, or using a supplementary form of finance such as an overdraft, that allows you to prepay interest. Pre-paid interest is generally tax deductible in the year it is pre-paid, provided that the pre-payment period does not extend for more than thirteen months. Remember that borrowing costs, including stamp duty and legal costs on the loan contract, are tax deductible over the shorter of five years or the term of the loan. Non-deductible debt, ie., debt that is not connected to a business or an investment activity is the most expensive debt. Every $1.00 of interest takes up almost $2.00 of pre-tax income. How do you convert non-deductible interest to deductible interest? There are a number of ways to convert the non-deductible debt to deductible debt, that is, debt that is connected to a business or an investment activity. Ask an accountant for details. Simple techniques include running two loan accounts and banking receipts into the nondeductible loan account one and paying business costs out of a deductible business loan account. Contrary to press reports, the Commissioner accepts the legitimacy of this technique provided there are two separate loan accounts. Another technique involves transferring business assets or investments to a spouse using investment loans and using the sale proceeds to pay off nondeductible debt. This method is described in more detail in Part 6.4.
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Handy hint if you have more than one loan Separate your financiers. For example, consider having your home loan with the ANZ, your business loan with the NAB and your credit card with Westpac and do not let them have cross securities. Each bank should have security over just one asset. Although this sounds messy if something goes wrong it will be a lot harder, if not impossible, for each bank to tie up the various securities provided to them. Bearing in mind our comments elsewhere in this manual on separating valuable assets from risky businesses, this may save the day if something goes wrong. Handy hints for choosing the type of finance: what are the options Pick the right type of finance for different purposes. Different types of finance suit different borrowing needs. For example: (i) commercial hire purchase may be appropriate for a purchase of plant and equipment costing $60,000 where you are putting up $30,000 yourself. This will maximize your depreciation claim and allow you to include your equity in the plant and equipment in other finance applications; some lease contracts (lease contracts classified as "operating leases") do not have to be shown in your business' balance sheet. This can help show a good financial position to other financiers; an overdraft may be appropriate for funding your practice outgoings in February, as the effect of your two-week holiday in January kicks in, or for funding other short term dips in cash flow or unexpected outgoings. But overdrafts are expensive and if they look like becoming permanent then you should consider converting them to a cheaper and more long term type of debt; and an overdraft, being an inherently short term form of debt, is not appropriate for acquiring "long term" assets such as practice premises except where the debt proportion is very small and/or is expected to be paid back very quickly, say within twelve months.
(ii)
(iii)
(iv)
Handy hint: let someone do the work for you Use a consultant who is experienced in dealing with banks and who can represent your interests competently. The consultant should have a good handle on both the accounting and legal aspects of your practice. Consider using a finance broker. They are in touch with the market all day every day and normally can get you a better deal than anyone else can. They are paid by the financier, not by you, so their services will not cost you any more. Try to minimize the time that you spend yourself dealing with the banks: this is time better spent in your practice. You can't bill for time spent talking to your bank manager, or for time spent worrying about what you are going to say to him.
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6.2 How to manage debt
Debt is, unfortunately, a fact of life for many practitioners. Debt may arise as a result of starting a practice, buying into a practice, buying a home or acquiring investments. It requires careful management and control if it is not to become a cause of financial loss and pain rather than a powerful wealth creation tool. Unless you are born with the silver spoon firmly in your mouth, there is normally no choice but to borrow to acquire assets that have any significant value attached to them. It is hard to save up $300,000 to buy a home. By the time you do the children will have grown up and you will probably prefer a retirement home anyway. A controlled amount of debt, used intelligently, can have a great influence on the quality of your life and on your net wealth position. It allows you to acquire assets otherwise outside of your reach and to benefit from holding these assets values rise and as the debt is gradually repaid over an extended period of time. By the same token, whenever we see a client in financial trouble, we normally also see a stack of debt standing behind him or her. The misuse of debt is easily the greatest cause of financial pain we know of. So what should you do? Basically, be careful. A number of simple rules need to be observed when dealing with debt if you are to avoid being financially hurt. These are: (i) don't deal with the fringe players. Deal only with the major trading banks. Yes, they have their moments, but generally they are keen to get the medical profession's business and will even offer special discounts on normal lending rates. Shop around. You will be surprised what you will be offered. Practitioners are almost always good credit risks, so make sure you are not dealing with the shark end of the market, because you certainly do not have to; remember that debt has to be repaid out of after tax dollars. A loan of $300,000 may not sound like much, but it will require almost $600,000 of pre-tax income to be repaid. This applies to all debts, not just private debts; similar to (ii) never borrow without a clear plan for repaying it within a specified time. Debts can be repaid by fresh borrowings, by selling an asset, by cashing out superannuation fund benefits (conditions apply) and by harnessing the practice's cash flow properly. Sometimes a combination of these methods may be used. Each repayment method has its place; never borrow to enter into tax planning schemes such as pine plantations, film investments and primary production schemes. Yes, your tax bill might go down, but that doesn't help you pay the interest or the principal on the loan. Half a loss is still a loss: income tax advantages cannot turn a bad investment into a good investment: they half the pain they do not eliminate it. There is still pain; always pay off non-deductible debt (eg., debt on private credit cards and debt used to buy a home ). These are the most expensive forms of finance because the interest has to be Page 221
(ii)
(iii)
(iv)
(v)
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funded out of pre-tax dollars. Avoid them wherever possible: always borrow so that the interest is tax deductible; (vi) conversely to (v), pay off deductible debt last and where borrowings are required borrow in a form that is tax deductible even if the ultimate use of the funds is private. Most selfemployed practitioners are able to do this. For example, a family trust can borrow money to pay out an unpaid distribution to beneficiaries and the beneficiaries can use the cash for their own purposes. The trust will be able to claim a deduction for the cost of the interest. The are many other ways of achieving the same goal; and consider consolidating all of your debts into one facility and with one lender. This normally lowers both the interest cost and the administrative effort connected to the debts. If things are really out of hand think about extending the loan for say, five extra years. This may take the pressure off a bit and let you get back on your feet. If for any reason assets are at risk it can be a better idea to keep your financiers separate. For example, lease equipment from someone other than your bank.
(vii)
When should we use negative gearing to reduce a tax bill? This is a very frequently asked question. The answer is "never". Only borrow money to buy an asset if the expected before tax income plus the before tax increase in the asset's value exceeds the before tax interest costs and other costs connected to buying and owning the asset. In other words, the expected return must exceed the expected cost of the investment. This means that the expected before tax gross income plus the expected before tax capital gain must be greater than about 11% per annum before a rational investor would borrow to buy an income producing investment. A rate below 11% and you will lose money. How much higher above 11% you should go depends on your perception of the risk implicit in the investment proposal. The answer to this question is essentially subjective, but, as a guide we wouldn't proceed under about 15%. Without such a margin it's just not worth the effort. Your time will be better spent in your practice. If this base condition is not met, it doesn't matter that the net loss on owning or holding the investment is tax deductible. A loss is a loss. All the tax benefits in the world will not change this. You will be better off paying income tax and putting what's left of your money in the bank. This does not mean that one should never borrow to acquire appreciating assets. This can be a strategy. But the basic rules of investing must be satisfied if you are going to be better off as a result of doing this.
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6.3 Sources of debt: What are the options?
This part of the manual sets out an overview of the most common forms of finance used by practitioners to fund their business and investment activities. The overdraft The common bank overdraft is a very simple concept. It is like a bank account, but instead of you being owed money by the bank, you owe money to the bank. The amount that you owe fluctuates over time as cheques pass in and out of the account. Interest is almost always fully tax deductible: this is so even where a private or nonbusiness cheque is written. The revolving nature of the overdraft means that the Commissioner of Taxation is not able to trace through the overdraft account to apportion interest between deductible and non-deductible purposes. Bank overdrafts tend to be at a high rate of interest. At the moment 10% or more is quite common. You also have to factor various bank charges into your assessment of the cost of the finance. These can easily add another 1% or more to the cost of the overdraft. The overdraft has the advantage of being very flexible and this means that you only pay for the money that you use for the time that you use it. Normally banks require a first mortgage over real estate to secure amounts lent under overdraft facilities. The better the security, the lower the interest rate. Overdrafts can be useful for prepaying certain deductible practice expenses, including interest due on other debt instruments and paying deductible contributions, prior to 30 June each year. The interest on these amounts will be deductible. Bank overdrafts are a sensible way of funding most small to medium medical practices and are frequently used by practitioners. Term loans Term loans are the next most common form of finance used by practitioners. Most practices will have them from time to time. Term loans are simply a loan for an agreed period of time. They can be interest only or principal and interest, and they can be a fixed interest rate or a variable interest rate. Some have hidden administration costs and others do not. Term loans can only be repaid early without penalty if the interest rate is variable. If the interest rate is fixed the bank loses if the loan is paid out early. This loss is almost always passed on to the customer. Small term loans can be a suitable way to fund a small to medium medical practice and are a good way of funding property investments and share investments. The rates charged can differ greatly from bank to bank and it can pay to shop around. A number of the larger banks offer special deals to practitioners (this means that you get a nice bag of goodies and, most importantly, a discounted interest rate). But be shy of changing banks just because one is offering an interest rate a percentage point below the others. Ask how long this will last for, and what happens when the facilities are reviewed: will the discount continue then? We expect that the answer will be "no". January 2002 Page 223
Term loans can be used as "cocktails" to create flexible debt packages that achieve personalised financial goals. For example, a practitioner who owes $400,000 on a loan used to buy a property could structure the debt as follows: (i) (ii) $300,000 fixed interest only for five years; and $100,000 variable interest and principal for five years.
This combination means that the practitioner can be reasonably certain of the net cost of the finance for five years (since three quarters of the interest charge is fixed) and can make sure that a significant amount of debt (ie $100,000) on the variable interest loan) will be paid off within five years. Some principal can be repaid early without penalty if this is desired. At the end of the fifth year the remaining debt ($300,000) would be refinanced with the same bank or a new bank in line with the market conditions and the practitioner's circumstances at that time. Bank bills Bank bills were once a very common form of finance, particularly for large and medium sized property transactions. However, they have become less common in recent years as banks have tried to switch customers to other forms of debt on amounts below $500,000 or so to avoid the high costs of administering bills. Bank bills are generally a cheap form of finance, with a cost (discount rate) tied to the bank's prime interest rate plus an administration fee. There is no interest payable on a bank bill. The bank makes its money by discounting the bill, that is, by lending you an amount of money that is less than the amount of money that you have to pay back to the bank. For example, a $1,000,000 bill for a term of six months at 10% interest per annum will mean that you receive a cheque for an amount of $950,000 on, say, 1 January but you will have to pay back an amount of $1,000,000 on June 30. The amount of $50,000, being the amount that you have to pay back less the amount that you received, is called "discount". Bank bills are normally discounted over a period of 30, 60, 90, 120 or 180 days. We are not aware of bills being discounted for longer periods. Normally the bill will be "rolled forward" by the bank at the end of the discount period with little difficulty. Where a bank bill straddles two financial years the discount must be spread over the two financial years on a days basis. For quite a time there was some concerns amongst tax advisors about the correct taxation treatment of bill discount that straddles two financial years. But the Full Federal Court in the Coles Myer Finance Ltd Case has now put these to rest. Banks bills do not have a built in repayment program. The absence of this facility can be problematic, particularly over periods when interest rates rise and asset values fall. You can find that you owe more than you own. Bank bills are administratively complex but are normally cheaper than, say, an equivalent overdraft. They are more suited to funding a larger property transaction and are not appropriate to fund the day-to-day activities of a medical practice. Finance leases Under a finance lease the lessee in effect borrows an amount of money equal to the cost of the asset being leased. The lessor owns the asset but the lessee is able to use the asset provided that January 2002 Page 224
the lease payments are made on a regular basis and (particularly with larger leases) the asset is properly housed, maintained and insured. Finance leases are normally used by practitioners for plant and equipment and furniture and fittings purchases. This includes motor vehicles. The advantage of a finance lease is that all payments made under the lease agreement are tax deductible, being in the nature of a lease rental. This is so despite some part of the payments being in substance a repayment of part of the principal amount borrowed to buy the asset. The taxation advantages of leases can be overstated though: most items of plant and equipment can now be depreciated over either a three or five-year period: the principal amount becomes deductible as depreciation over a short period of time anyway. In the case of a four-year lease of computer equipment, the cost of the equipment would have been depreciated over three years anyway: here a lease would be tax inefficient. Most lease contracts provide for a residual payment at the end of the lease term. If this residual payment is not made possession of the leased asset will revert to the lessor. In most cases the lessee will make residual payments. Lessees should consider not making the residual payment if for any reason the market value of the leased asset falls below its residual value. The Commissioner has released guidelines for the minimum term and residual payments for leases. These guidelines must be satisfied if he is to accept that the finance contract is a lease and therefore that the lease rentals are deductible losses and outgoings for income tax purposes. In summary the minimum acceptable residual values as a percentage of cost are:
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Term of Lease Year 1 Year 2 Year 3 Year 4 Year 5 20% 60% 45% 30% 15% Nil Depreciation Rate Bands 15% 10% 7.5% 64% 67% 68% 52% 60% 62% 41% 52% 55% 30% 45% 50% 19% 38% 45% 5% 70% 65% 60% 55% 50%
For example, if you buy a computer using lease finance over three years, the Commissioner of Taxation will only accept that the lease rentals are deductible if the residual value is not less than 30% of the amount of the cost of the computer. Normally leases do not require any additional security. The leased asset provided sufficient security. However, financiers normally will not enter into lease contracts with companies without directors' guarantees. Larger contracts or contracts for unusual (and hard to sell) plant and equipment may require collateral security. The luxury car depreciation rules do not apply to lease contracts: this makes leases particularly attractive for purchasing cars with a cost of more than about $52,000. All lease rentals, including those connected to the cost above the luxury car limit will be deductible. Commercial hire purchase Commercial hire purchase contracts are functionally similar to lease contracts. They are typically used to buy plant and equipment and furniture and fittings, including cars. But, conceptually, a hire purchase contract is quite different to a lease contract. The borrower borrows money to buy the asset and is the owner of the asset from day one. This means that the borrower is able to depreciate the asset for income tax purposes. The payments made under the hire purchase contract are a mix of principal and interest, and the amount of deductible interest will be calculated using the "rule of 78" method. The principal component of the hire purchase payments will not be tax deductible. Commercial hire purchase will be more attractive than a lease where the borrower has some equity in the asset being financed. This is because the cost of the asset will be depreciable under a hire purchase contract, including the owner's contribution, even though only part of this amount is financed using debt. However, under an equivalent lease contract the lessee's contribution will not be depreciable because the lessee will technically not own the asset. Only an owner can claim a deduction for depreciation. Mortgage originators The last few years have seen the rise of "mortgage originators". These firms now provide a real alternative to traditional bank finance. The Financial Review on 23 January 1995 noted that companies such as Aussie Home Loans and RAMS now account for more than 5% of housing finance in Australia. Clients who have dealt with these companies report well on them. They seem to provide a very good service. They are able to provide lower cost finance because they do not have to support the infrastructure of the larger banks. They just organize loans: they are not the principal lender. The principal lenders are larger merchant banks that are attracted by the security and low administration costs of this type of finance. January 2002 Page 226
Finance brokers It can be a good idea to ask a finance broker to arrange your finances for you. This saves you time dealing with lenders and saves you money because in most cases the broker can get you a better interest rate. Normally using a broker does not cost you anything because they are paid by the bank or financier with whom they place business, not by the borrower. Interest charge checkers A number of firms have entered the personal and small business financial market as interest charge checkers. Often staffed by retired bank managers, they use precise interest rate calculations to identify interest charge errors and bank charge errors. Small amounts add up, particularly if there is a pattern of overcharging. The firms collect the refunds for you. From what we have seen these groups offer a good service and practitioners should use them if they believe they have been overcharged on interest or other bank charges.
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6.4 One way to convert a non-deductible debt to a deductible debt
Background Non-deductible loans are expensive loans. This is because a practitioner has to earn nearly $2.00 of before tax income to pay $1.00 of interest on a non-deductible loan. A non-deductible loan is a loan that is incurred in connection with private or domestic matters, and which does not have a connection with the practitioners business or investment activities. Examples include loans to buy homes, credit card debts connected to private matters such as school fees and similar loans. For example, if a practitioner has a non-deductible loan of $200,000 at an interest rate of 7% pa the interest is $14,000 a year. The practitioner has to earn nearly $28,000 of pre-tax income to pay the interest on the loan. Principal repayments are extra. If interest rates rise the costs of the non-deductible loan will rise too. If this loan was a deductible loan the practitioners cash tax bill will fall by nearly $7,000 a year. If the cash is used to make extra re-payments on the loan, it will be eliminated by about the 16th year with no extra work by the practitioner. If the original loan re-payments are maintained the loan will be eliminated a lot quicker than this. It is very hard to get ahead financially while bearing the burden of a non-deductible loan. The first step towards a strong financial base should always be the repayment of non-deductible loans as fast as possible. How can a practitioner speed up this process? There are a number of ways to do this, and the facts always need to be specifically considered before a strategy is determined. Often the strategy is a cocktail of techniques. Each technique will have a role in achieving the final result: no non-deductible loans. The basic point is that any taxpayer is entitled to use his cash reserves to pay off non-deductible loans before he does anything else. This may mean he has to borrow for other business or investment purposes. If a person wins $50,000 in a lottery, that person may choose to pay off a non-deductible loan if he wishes to. This is so even if the person has deductible loans, or may incur deductible loans in the future because the lottery cash is not available for business of investment purposes. A basic strategy may help explain the basic idea. It fits most practitioners in solo practice in their own name. Many other strategies are available as well. The choice of strategy or strategies will depend on the practitioners circumstances and no strategies should be put in place without first getting specific written legal advice. In the basic strategy the practitioner: (i) arranges a new loan facility with his existing bank. This will be a separate loan to the existing home loan. It will be at the home loan rate, or very close to it, will be secured against the home or some other real estate, and will require all interest due on it to be paid in the period it is due. The purpose of the loan will be stated in writing to be the payment of business outgoings and related business costs and the loan will only be used for this purpose; Page 228
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(ii) (iii) (iv) arranges for his gross practice receipts to be banked directly on to his home loan; uses the home loan draw back facility to pay private costs including income tax; uses the new business loan to pay all practice costs including any service fees paid to a service entity.
If this is done then assuming gross practice receipts of, say, $20,000 a month, draw back for private costs of $10,000 a month and a home loan of $200,000, the home loan will be repaid in about twenty months. Once this is done the process should be continued for some months more, with the gross practice receipts being banked directly on to the new business loan and this facility used to pay all practice costs, so that it turns over and over. This reinforces the business purpose of the loan and hence the deductibility of the interest paid on it. We recommend the cash saved each year, ie about $7,000 cash a year, be used to accelerate the debt reduction process. If existing repayments are maintained this can see the original debt paid back perhaps ten years earlier than otherwise. This technique creates a base for a powerful asset accumulation strategy using the other techniques, particularly the superannuation techniques, explained in this manual. Often the solo practitioner practices in conjunction with a larger practice. The larger practice provides all services required by the solo practitioner in return for a fee of, say, 50% of billings. The solo practitioner is in theory entitled to 100% of billings from his practice, and these are collected by the larger practice, which deducts its management fee and then accounts to the solo practitioner for the balance. In this situation the cash arrangements between the solo practitioner and the larger practice need to be changed. This is done by having the solo practitioner bank 100% of his billings directly on to the home loan and then use the new business loan to pay all practice costs including the 50% management fee due to the larger practice. The next effect cash wise is the same, but the solo practitioner is able to get a better tax result.
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This is better for other reasons too. Cash arrangements like this reinforce the separateness of the solo practitioners practice and make it clear the solo practitioner is running his own practice and is not an employee for group tax and pay roll tax purposes. This will also be important under the GST rules starting on 1 July 2000, as it makes it clearer the solo practitioner is an enterprise for the purposes of these rules, and hence able to claim GST credits. Cooperation of the banks We have arranged these facilities with each of the major banks. The banks will do it for you. The NAB is particularly helpful. Sometimes a bank manager will not agree to the arrangement, or will require an excessive premium on the business loan. If your bank manager tries to do this it is a good time to change bank managers, as he is either very lazy or is trying to rip you off by charging you too much. It is critical that the business loan is at the home loan rate or very close to it. If this is not so the bank gets all the benefit, not the practitioner.. One legitimate concern may relate to the practitioners overall security level. One can understand why a bank does not want to extend an extra $200,000 credit to a practitioner who has only say $250,000 of home and an existing loan of $200,000. We have found the best way to proceed here is to ask for, say, an extra $20,000 business loan, and when this is used, and the home loan has been reduced by $20,000, to have it extended for a further $20,000 and so on. The banks will do this.
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7. 7.1 PRACTICE ISSUES Marketing a medical practice
Marketing a medical practice is not something that is taught at medical school. As is the case with other professionals, lectures, tutorials and seminars look at the technical aspects of a medical career rather than the business aspects of running a medical practice. This is, of course, the way it should be. We do not profess to be expert marketers claiming special skills in marketing of medical practices. We believe the real experts are practitioners who have done it before. And if you think that you are not a good marketer, we suggest that you get some advice from, or at least take the example of, a practitioner who is a good marketer. Some ways of doing this are described in other parts of this manual. For example: (i) in part 3.1, headed "Practice goodwill and therefore profits" we recommend that you study the other practices in your area and then you ask twelve (sample) questions intended to give a picture of what the competition is like; in part 3.2, which deals with the valuation of a medical practice, we set out a subjective and flexible criteria for assessing the worth of a practice, taking into account things which you believe are important to a practice; and in part 3.5, which deals generally with business plans, we recommend you survey a sample set of clients to get an idea of where your patients believe your practice is and how it ranks with competitors.
(ii)
(iii)
Reading marketing texts and publications, and consulting with external experts can have value because marketing concepts are generic and can be adapted to the particular circumstances of a medical practice. A real recommendation: find a real expert Rather than repeat ourselves here, we refer you back to these parts of the manual and urge you to adopt the information gathering processes they outline and then act on the results of that information. This is the critical thing. You must act on the results of the information. If you need help in doing this we suggest you get help from another practitioner, whose opinions and experiences you value, and who you believe runs (or has run) a professionally sound and well marketed medical practice. Get their expert help in obtaining the marketing information and ask their opinion as to what this information means. Then listen carefully to what they say about improving your practice. This recommendation is not unique to a medical practice. It's the sort of advice given to any business in the service sector and medical practices are no exception. Maintain a healthy skepticism for self appointed experts who believe that they can tell you how to do something that they have never done themselves and which they will probably never be able to do. Only take advice from people who are acting within their sphere of competence and experience and in a field that you are not competent or experienced enough to work in. A real expert is one who has done it, not one who talks about it January 2002 Page 231
The best consultant is a more experienced practitioner who will understand you, your practice and the market that you face. That practitioner should be one who you believe has created a good practice and who can genuinely provide you with independent advice regarding what you are doing right and what you are doing wrong. But realize one thing: you must market your practice if you want to maximize its potential. Many professionals are averse to advertising and selling. But marketing is not advertising and selling. It is much more than that. Marketing encompasses the whole range of experiences encountered by your customers, ie. your patients, as they deal with you and your staff. Medicine is a business. If the returns to the owners are to be maximized care is needed with how the business interacts with customers and what sort of image is presented to them. Think about: (i) patient perceptions. Is your practice a pleasant place to visit? Are your staff pleasant to deal with (ie. are they efficient and courteous and do they make patients feel welcome and at home, while retaining the correct professional stance and distance from the patient?) Are you pleasant to deal with?; the strongest form of advertising is word of mouth advertising. This can work for you and it can work against you; most patients have family and friends and they will talk about you with them; and each new patient represents a stream of future income that will add breadth and depth to your business and create the potential for further referrals. A new patient in the waiting room is not worth twenty-five dollars to you. That patient is potentially worth hundreds of dollars, even thousands of dollars, to you if they decide to come back to you and to recommend you to their friends. Bulk Billing
(ii) (iii) (iv)
7.2
The last ten years have seen practitioners' profits squeezed between constantly rising operating costs and fixed fee levels. Profits can be maintained, but this normally means that the practitioner works harder and longer for the same (inflation adjusted) gross income while at the same time doing everything possible to keep a lid on, or even reduce, operating costs. Over the last ten years the Medicare Benefits Schedule has risen at a rate significantly lower than both the inflation rate and average weekly earnings. This means that the purchasing power of practitioners' incomes have fallen and they have not shared in the increases achieved by the rest of the community. To lift profits in this highly competitive environment takes lateral thinking. Just doing what you did last year won't change a thing. You must try something new and if you don't eventually something will give. Common lateral thoughts are: (i) (ii) expand the size and the operating hours of your practice; obtain leverage by using other practitioners (whether as employees or, more commonly, associates); Page 232
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(iii) (iv) (v) sub-let space to related disciplines, so as to get some rental income and to share some fixed costs; reduce average consultation times; and implement debt reduction strategies to reduce interest costs and to restructure the practice so as to reduce the incidence of taxation.
Bulk billing will invariably get a mention in these thought processes. Should you stop bulk billing? Most practitioners, particularly general practitioners, will consider moving off the bulk billing system. (Yes, most general practitioners bulk bill: the December 1995 edition of Medical Observer Business reports that about 75% of Victorian general practitioners bulk bill. This figure is higher in New South Wales). Stopping bulk billing is one way of removing the cap on gross income and lifting the standard consultation fee from about $21.00 per consultation to, say, $27.00 per consultation, or even more. The idea is that an additional $6.00 per consultation is an additional $6.00 of profit per consultation. It does not require you to spend any additional money on costs. Additional revenue should equal additional profit. Is it this simple? No, unfortunately it is not. With vigorous competition patients will substitute each practitioner's services for another's. There is a general resistance to price rises, and there will be some drop in business if you increase prices above your competitors. Is this necessarily a bad thing? No. It is not. You may have too much work on at the moment, so a drop off could be a good thing. Or the drop off may be less than proportional to the increase in price, which means that gross income and net profit will increase. Overall you will be better off. For example, an additional $6.00 per consultation represents a fee increase of about 28%. Provided the drop in business is less than 28%, you will profit by lifting prices above the bulk billing rates. And you will have to do less work to make this greater profit. This is the nicest way to make more profit. The hard bit is working out what the change in patient numbers will be. There is no magic formula. Each practice is different and each practitioner must make a decision based on personal experience of the practice. A marketing strategy designed to educate patients about the change in price structure, and why it is better for them, can be a very timely tactic. Surgery signs should be put up well in advance of the change over so patients aren't surprised in any way. The end result will depend on the profile of the practice. This will include the average level of income of your patients, the level of service that you offer (including accessibility, availability and amicability), the loyalty of your patients, whether your receptionist smiles a lot and remembers patients' names, what other practices in the area are doing and a whole range of other factors that explain why patients see you rather than someone else. January 2002 Page 233
This is shown in the following example: Average Price Per Consultation Number of Consultations Per Day Average Income Per Day Average Income Per Week (5 days) Average Income Per Year (48 weeks) Operating Costs* Profit Increase in Profit Before $ 21 33 693 3,465 166,320 86,625 79,695 After $ 27 29 783 3,915 187,920 86,295 101,295 21,600
(*This assumes that the practice's operating costs stay constant despite the drop in patient consultations.) How do you interpret this example? The number of patients dropped after the price increase, but the drop has been less than proportional to the increase in fees. This means that, overall, gross income has risen by $21,600 despite the drop in patient numbers. Because costs have stayed the same, the increase in gross income of $21,600 has generated an increase in net profit of $21,600. The practitioner is now making more money for doing less work. The practitioner has also created a capacity to take on additional work on the new price structure. This can be in the form of longer consultations, more consultations, more marketing, other work (for example, a session a week at another clinic or hospital), research or further training. These activities may add further to net profit. The practitioner could also just enjoy the lighter workload for a while. (Bulk billing will probably be retained for pensioners and disadvantaged groups). Should you start bulk billing? Faced with stiff competition (both from other practitioners and from other health professionals) and a price sensitive patient base that is prepared to go elsewhere for a lower price (and a simple and more convenient payment method), many practitioners find that they have to go with the flow and bulk bill to remain competitive and to retain patient numbers. Most practitioners bulk bill. This is what patients expect. It is what competitors are doing. Starting bulk billing is one way to increase the number of patients that you see and, therefore, to increase your gross income and your net profit. More patients should mean more profits. Is it this simple? No, unfortunately it is not. Dropping your prices should attract more patients, but profits will only increase if the increase in patient numbers is more than proportional to the decrease in price. And remember, if patient numbers increase the practitioner has to work harder and longer to make the additional profit. Once again, the hard bit is working out what the change in patient numbers will be. There is no magic formula. Each practice will be different and each practitioner must make a decision based on their personal knowledge and experience. January 2002 Page 234
And once again, the end result will depend on the profile of the practice. This will include the average level of income of your patients, the level of service that you offer (including accessibility, availability and amicability), the loyalty of your patients, whether your receptionist smiles a lot and remembers your patients' names, and a whole range of other factors that explain why your patients see you rather than someone else. This is shown in the following example: Average Price Per Consultation Number of Consultations Per Day Average Income Per Day Average Income Per Week (5 days) Average Income Per Year (48 weeks) Operating Costs* Profit Increase in Profit Before $27 28 $756 $3,780 $181,440 $86,625 $94,815 After $21 39 $819 $4,095 $196,560 $86,625 $109,935 $15,120
(*Operating costs stay constant despite the increase in patient consultations.)
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How do you interpret this example? In summary, the increase in patient numbers has been more than proportional to the decrease in price. Overall, gross income has increased by $15,120. Because operating costs have stayed the same the increase in gross income has led to an increase in net profit of $15,120. The practitioner is now making more money. But the practitioner is doing a lot more work. (And the average length of each consultation is probably a lot shorter than before.) This is, of course, the position of most practitioners over the last five years. The fallacy in our example is the assumption of constant costs: this assumption helps simplify the example but it is unrealistic for costs to stay the same despite a significant rise in patient numbers. Are there any conclusions to be drawn from all of this? Yes. Although there is no magic formula, some general conclusions regarding bulk billing can be drawn from the above discussions. In summary, most medical practices bulk bill and this will remain the case, at least in the foreseeable future. Most medical practices will be better off bulk billing because, very simply, this is what the patients expect and it is what most practitioners are doing. However, a practice generally will be better off not bulk billing if this is at all possible. This must be so: assuming that a practitioner has a full book of work, profits must be higher where the price per consultation is higher. This tends to occur where: (i) (ii) (iii) (iv) (v) the patients' incomes are higher; the service is perceived by patients to be above average: "accessibility", "availability" and "amicability" are some key words here); the patients are loyal and believe that the additional service is worth the additional cost; the practice is well established and the patients have a long history of attending the practice; and most importantly, the competition is less and other local practices do not bulk bill.
But in the end at the day each practitioner will have to make up their own minds on what to do here. As a suggestion, consider building the above examples, adjusted for your own circumstances, into the cost-volume-profit analysis and cash budgeting techniques and spreadsheets explained in part 3.6 of this manual. Then try some "what if" type calculations to explore what would happen to profitability and cash flow if you changed your billing procedures. Do this with a variety of assumptions regarding patient reactions to changes in billings and try to plot the range of possibilities. Once you have done this consider ways of influencing patient behavior, that is, how can patient increases be maximized, and how can patient decreases be minimized. Patient communications and marketing are the ways to get the best response here. Other billing procedures An obvious advantage of bulk billing is patient convenience. Having to hand over cash or write a cheque some time later when the bill (or the third statement or reminder letter) comes in the mail can be a real hassle. January 2002 Page 236
A simple expedient is to offer credit card facilities at your reception desk and insist on payment on the day. Most patients carry credit cards (or debit cards) so this should appeal. And up to fifty-five days free interest should appeal even more. Yes, credit card facilities will cost the practice some money. But this will be outweighed by the convenience of an immediate and guaranteed payment and the reduced clerical (practitioner?) time in chasing overdue accounts.
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7.3 Medical negligence and what to do about it
Introduction Medical negligence is a phrase never far from the minds and actions of most practitioners (and most accountants and solicitors, when we think about it). It is also an area where plain English explanations are lacking, and practical general guidelines regarding what to do to avoid being negligent are rarely presented. The purpose of this part is to provide an overview of the law of negligence as it applies to practitioners and to briefly look at the recent cases in this area to get an idea of what approach the courts take to an aggrieved patient. We then set out some ground rules to be followed to minimize a practitioner's prospects of winding up in court. Hopefully this is done in a simple and straightforward way that doesn't use much legal jargon. When can a practitioner be negligent? The law of negligence forms part of an area of law known as the law of torts. This is a French word meaning "wrong". The law of torts becomes relevant whenever person believes that another person has wronged them. This includes situation where a patient suffers allegedly as a result of an act or omission by a practitioner. Therefore, the potential for a legal action based on negligence comes up almost every time a practitioner advises a patient or carries out a treatment for a patient. For a person to have a right of action under the law of negligence against another person for a wrong committed by that other person three essential elements must be present on the facts of the case. These three elements are a duty of care, a breach of the duty of care and, as a result of that breach, damages. More expansively: (i) a duty of care must exist. Lord Atkins in the classic case of Donaghue v Stevenson put this most eloquently when he said: "The rule that you are to love your neighbor becomes, in law, you must not injure your neighbor; and the lawyer's question, Who is my neighbor? receives a restricted reply. You must take reasonable care to avoid acts or omissions which you can reasonably foresee would be likely to injure your neighbor. Who, then, in law is my neighbor? The answer seems to be - persons who are so closely and directly effected by my act that we ought reasonably to have them in contemplation as being so affected when directing my mind to the acts or omissions which are called in question." Clearly a practitioner owes a duty of care to the patient (as noted below, a practitioner can also owe a duty of care to someone who is not a "patient" but who, in an emergency situation, seeks the practitioner's assistance); (ii) the duty of care must be breached in that, on the balance of probabilities a person has failed to achieve a standard of care imposed by the law to protect others against unreasonable risk; This is so will always depend on the facts of the case. The nature of the admissible evidence, and the testimony of any expert witnesses, will be critical here. The standard of care applicable to a practitioner is the standard of care of an ordinary practitioner. The courts will determine what this standard is, not the practitioners, although the evidence of practitioners regarding the standard expected of a practitioner will be relevant; January 2002 Page 238
(iii) the breach of the duty of care must have caused actual damages. There must be a causal relationship between the acts or omissions and the damages. The damages must also be foreseeable, in the sense that the practitioner ought reasonably have had them in contemplation at the time the act or omission was committed. The concept of damages occupies a whole branch of the law, but, in this context, clearly includes actual costs, loss of income and pain and suffering that are reasonably proximate to the act or omission complained of by the patient.
The law of contract The law of contract will also be relevant in most negligence cases. The courts may find that there is an implied term or condition in the contract that the practitioner will exercise the reasonable skill and care of a competent practitioner. Most medical negligence actions involve allegations of both breach of contract and breach of duty of care. How are these rules applied? The first point is to note that a practitioner is not negligent just because a patient suffers some form of financial or physical damage as a result of a medical procedure or advice, or a failure to carry out a medical procedure or to give certain advice. Something more than this is required: the damage must arise because of an act or omission by the practitioner which, according to the objective standard of care laid down by the courts, a reasonable practitioner would not have done or failed to have done. It is not possible to formulate a single sentence or paragraph that tells how this test will be applied in practice. The range of possible situations and possible outcomes is too great. The answer always depends on the facts of the case at hand. Different matters will assume different degrees of importance in different cases. Perhaps the best way to address this problem is to briefly consider a number of major cases that have come before the courts in recent years. We have named these cases "case number one", "number two" and "number three" to help preserve the anonymity of the practitioners and hospitals involved in them. Case number one The patient became paraplegic after being put in traction that severed the patient's spine. This was done on the advice of an orthopedic surgeon. The hospital, a neurosurgeon and the orthopedic surgeon were sued. The court found that the defendants were not negligent. The court said that they acted as "...practitioners and neurosurgeons of ordinary skill and ability would have decided..." and therefore were not responsible for the damages suffered by the patient. The court was influenced by the benefits that the treatment was expected to bring. It also considered the medical dangers, in both the physical and psychological senses, that the patient would have been exposed to in the future has the treatment not been given and the degree of difficulty involved in the treatment. Each of these things combined to see the court say, on the balance of probabilities, there was no negligence. This case gave rise to legal argument regarding the significance of a practitioner following established medical practice, that is, doing what most practitioners do in the situation that the practitioner encountered. The court's view was that conforming with established medical practice could be relevant, but: January 2002 Page 239
"...It is not the law that, if all or most of the medical practitioners in Sydney habitually fail to take an available precaution to avoid foreseeable risk of injury to their patients, then none can be found guilty of negligence..." This is a common theme regarding the standard of care required by professional persons and is not limited to practitioners. The courts believe that if they were to always accept the common practices of a profession as the measure of what should be done they would be abdicating a vital responsibility and power to make law. The courts will not do this. They will not say that just because you did what everyone else did you are not negligent. Nevertheless, for a practitioner to be able to show that the acts or omissions alleged to be negligent conformed with established medical practice is normally of great help to a defendant's case. The solicitors and barristers will spend a lot of time and effort trying to prove that this was so. Written records regarding the case at hand and the testimony of expert witnesses from the ranks of the medical profession will be very important here. This is one reason why it is important for a practitioner to properly document all advices and warnings given to a patient about a proposed treatment. Case number two It was alleged that the practitioner was negligent because he failed to warn the patient of the risks involved, and the possible consequences of, a particular treatment being carried out on the patient's left eye. Complications from this treatment led to the patient losing the sight in her right eye. The High Court found the practitioner was negligent. This was because: (i) the patient repeatedly (even "incessantly") asked the practitioner what the risks of the treatment were and, in particular, whether the treatment created a risk for her remaining good eye; there was a slight chance (ie., less than 1 in 10,000) that the good eye could be damaged; the practitioner did not tell the patient there was a slight risk the good eye could be damaged and did not specifically warn of the risk of something going wrong; the treatment was not necessary to the health of the patient; and although the risk of something going wrong was only slight, the consequences were quite serious.
(ii) (iii) (iv) (v)
Case number three A six-year-old boy had a fit. His sister ran to a nearby surgery and called for help. The practitioner refused to help saying that the boy was not his patient. The boy suffered brain damage as a result of the fit. The court found the practitioner to be negligent. The practitioner should have attended the boy even though the boy was not the practitioner's patient. The urgency of the situation was very important to the court's thinking. What ground rules minimize the prospects of a medical negligence claim? First, proceed cautiously. Bear in mind the possibility that one day your actions could be considered by a court and that in the discovery process your records will be made available to the patient and may be used against you. Second, proceed very cautiously when handling a more serious matter or a matter that is outside of your day-to-day experience. Get a second opinion from another, preferably more experienced, practitioner or even a specialist's opinion if you have any doubts regarding what should be done. January 2002 Page 240
Third, document everything that you do. Complete and well-maintained patient files clearly showing your advice to the patient and your thoughts on the matter generally will go a long way in court. They are certainly a lot better for proving your case than oral assertions as to what you think you said or did. Fourth, make sure that you communicate clearly with the patient and make sure that they understand your advice. Bring potential complications to the patient's attention. Take particular care to properly address any special concerns or fears that the patient may have. Highlight the benefits of the proposed treatment (and document that you have done each of these things.) Fifth, act promptly. A delay may in itself comprise negligence. Sixth, do not be shy to recommend that the patient see you again if you think that this us appropriate. Take particular care when dealing with elective procedures. Seventh, in terms of general practice management: (i) (ii) (iii) (iv) (v) (vi) make certain that patient histories are secure and well maintained; ensure support staff are properly trained and are fully aware of emergency procedures; arrange for junior and less experienced practitioners to be properly supervised; engage other practitioners as associates, not as employees. This removes (reduces?) the chance of being held liable for the negligence of another practitioner under the doctrine of vicarious liability; ensure that professional indemnity insurances are adequate and fully paid for; and do not own assets in your own name or in the name of an IMP. If you do not own it they cannot take it off you.
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7.4 Staff selection procedures
Introduction Good staff, and good staff selection procedures, can make a practice. A smile in the receptionist's voice makes patients and callers feel welcome and wanted. Efficient practice management helps everyone: this is communicated to patients in a hundred conscious and sub-conscious ways and helps them come back again and again. Of course, good staff also help the practitioner and makes for better clinical efficiency too. The less administration the practitioner does the better off the practitioner is. A job description First, work out what you want and who you want. Be specific and write it down. List out the designated tasks to create a job description. This can be a very insightful process. What other tasks should be or could be added. Are you asking too much of one person? Should some of the tasks be allocated to other staff and a more junior candidate taken on? Should some of the tasks of other staff be added to the list and a more senior and experienced person taken on? Often the process of thinking through what you need, or even creating a wish list of what you would get in a perfect world, can focus thoughts and inspire good ideas for practice management. The job description should include, as a minimum: (i) (ii) (iii) (iv) job title; a general description of the position; a list of specific tasks; and comment on relativities within the organization ie, who answers to who and who doesn't answer to who.
The job description should be reflected in any advertisement or communication issued to try to attract candidates for the position. The successful candidate What are the attributes of a successful candidate? How old? How experienced? What sort of references, memberships, qualifications and personal traits are required. Is empathy with the aged required: if so, someone older might be preferred. Are language skills required? Is a particular ethnic background a help? If the practice has a high level of children patients someone who is a mum might be preferred. Empathy and understanding are essential in any people job. (Do not say this explicitly in any advertisement or directly to any candidate, as it could breach antidiscrimination law, but common sense screams that these candidates should be preferred once you are at the interview stage.) Be realistic. Superman is busy defending Gotham City and is unlikely to apply. Experience, presentation and, most importantly, the right attitude are the critical criteria. The ins and outs of most positions can be learnt on the job, so a willingness and an ability to learn are absolute necessities. In most cases the ability to fit in with other staff is also an absolute necessity. It can January 2002 Page 242
be a good idea to involve existing staff in the selection process, particularly at the second interview stage, but the practitioner should always make the final decision. The candidates' quality will be partly determined by the salary and conditions offered. Balance is required: too little and you will not get the right person, which can be worse than not getting a person at all, too much and you will not have any profit left. Paying a margin above market keeps good staff happy and improves retention rates, without breaking the bank. Occasional bonuses, and other signs of appreciation, such as the odd day off, cakes for afternoon tea, prepaying salary where an employee might be running sort of cash and so on can help too. How do you find good staff? This is the hard bit. The best results tend to be through personal connections. The best jobs are often not advertised, and this is the flip side. Ask around. Ask your staff, ask other practitioners, ask former staff, ask friends in fact ask anyone who may be able to help. Most people appreciate being asked because it can lead to them helping a friend or associate. This is also the cheapest way to find someone. The next cheapest way to find someone is through an advertisement. It doesn't cost much to put a small ad in the local paper or even a Saturday paper. The cost probably comes more in the time and effort involved in dealing with responses. (It is amazing how people who obviously do not fit the description will still apply. can't these people read. Be rude. Save time and trouble by not replying: just because they wasted their time applying doesn't mean you have to waste your time responding, despite what the politically correct employment consultants say.) As a last resort, use an agency. This is expensive and a lot of time is taken up talking to the agency as they turn a simple task into a difficult project. Our experiences and observations are this is an expensive option which is unlikely to produce a better result than the first two options and which doesn't give you the feel for the market you get by doing it yourself. You can place a lot of ads for 15% of the first year's salary, and you do not lose the equivalent of a week or more's profit. Anonymity Think about advertising in an area away from your practice, but not so far as to make travel difficult, or advertise in a way that does not identify your practice. This way you will not have the embarrassing problem of declining an application from a patient or friend, or someone connected to a patient or a friend. For example, if your practice is in South Melbourne, use a post office box and say the practice is in the "inner bayside suburbs". This way potential applicants will know generally where the practice is , but will not be able to identify it. The interview This is the easy bit. Once you know who you want to talk to schedule a time free of interruptions and distractions. Do your best to relax the person and encourage them to do the talking. Try to find out what sort of person they are. Questions about family and outside interests can be very useful here. Attitude is the key. Does this person want the job and will they work hard once they have it? Excessive criticism of a current or previous job is a bad sign. The problem may be with the employee rather than the employer. Excessive movements and short times in a job are other bad signs. It's normally not worth the risk of taking someone like this on. Ask the candidate if they are prepared to take on further training (even if you do not want them to). The answer can be January 2002 Page 243
illuminating: negative answers can reveal a lack of commitment and enthusiasm. Look out for signs of personal problems or excessive family or personal commitments. These can manifest quickly into sub-standard work performance and distractions for other staff and for you. Check references and Probation period Never employ someone without checking references verbally. Never employ someone without a probation period of, say, three months. The letter of offer should be limited to this probation period. If things work out a second letter of offer should be sent at the end of the three months. Confidentiality Patient confidentiality and other confidences are critical to a medical practice. This is an inviolable rule. It includes obvious matters such as patient health conditions and the economics of the practice. It also includes less obvious things such a the state of the practitioners' marriages and or romances and whether they are really on the golf course when patients are being told they are at a hospital or on rounds. Confidentiality is an absolute concept and staff simply should not discuss any aspect of the practice with anyone who is not connected to the practice. The duty of confidentiality survives termination of employment. This should be specifically mentioned in all letters of offer and letters of termination.
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7.5 Dealing with an unsatisfactory employee
We are often asked to how clients should deal with unsatisfactory employees. Our standard response is "with great care", and with commercial common sense and with utmost respect for the rights and feelings of the employee. The risk is you will get hit with an unfair dismissal action and will face costs in terms of both money and time dealing with the matter. You also run the risk the remaining staff may be upset if the matter is not dealt with in an appropriate way. For these reasons it is worth considering how systems and procedures can be used to minimize difficulties connected to terminating an unsatisfactory employee and otherwise dealing with situations where an employee's employment must be terminated. A different perspective: does there have to be confrontation? The first point to consider is whether the employee would prefer to leave your employment. Let's assume the employee has ten years of good service with another practitioner before joining you, and all references checked out well. You would have to ask whether there is "something wrong" with your practice if for any reason things were not working out. This is not meant to have connotations. It could be there is just a simple old-fashioned personality clash. You can't leave, because you own the practice. So common sense suggests that, if the employee (or even you) can't adjust, then the employee has to go. Is this a bad thing for the employee? Not really. Handled gently, with reasonable notice, good referrals and an agreed "reason for leaving" the employee will probably be as happy as Larry in a new job before you know it. The new job could even come up before the old job stops (we have seen this happen a few times now). When this happens everyone lives happily ever after and another victory is notched up to common sense. But sometimes things just don't go this smoothly. Sometimes employees can create problems for practitioners, other staff and patients. Here, if something is not done then a real problem will develop and the harmony and profitability of the practice will suffer. You should not let this happen. Your primary duty is to your patients. Their comfort and satisfaction must be considered at all times. You should not tolerate losing patients because of the poor attitude or behavior of an employee. If those patients tell other patients (and potential patients) of their bad experiences then eventually you won't have a practice. What do you do here? Document everything and follow a procedure designed to prove to a court that the dismissal is not unfair or unjust in any way. A good rule is to simply assume everything you do will be eventually put under a spotlight by a court and do everything on this basis. This means you should put everything in writing, including file notes of discussions and specific examples of inappropriate behavior. Get witnesses to watch you do this wherever possible. Get them to sign and date your file notes too.
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Can you be more specific please? In the case of an employee who is not performing properly but who means well and who is not engaging in serious misconduct, the following course of action should be followed: (i) talk with the employee about performance. Let the employee know exactly what is required of them and how you see them falling short of this standard. Try to do this in a friendly and non-threatening way. Too strong an approach may trigger a defensiveness, which may frustrate the whole process; the employee should be given an opportunity to respond to your concerns and to explain their view of the world and how their work performance has been and whether it can be improved; a further meeting should be held, preferably a few days later, when the employee has had the opportunity to reflect on your thoughts unemotionally and perhaps talk with friends and family; at the next meeting performance targets and goals should be set, including time limits. Preferably these targets and goals should be in writing and the agreement of the employee should be obtained and recorded in writing. It is often a good idea for more than one person to be present at each of these meetings. If the employee is a young female and the employer is a male it may be appropriate for this extra person to be an older independent female; hopefully this will be the end of the matter. Both you and the employee will have benefited from a full and frank discussion regarding the matter and the position will improve immediately (or at least improve over the following few weeks). If this discussion is not the end of the matter and after an appropriate period there is no improvement then the above procedure should be repeated. This time your concerns and your proposed course of action should be put in writing (and possibly witnessed by the independent person); (vi) if the position still doesn't improve then a third and final warning should be given. This warning should be very direct and to the point and should refer to all previous discussions and correspondences. It should say unequivocally what the standard of performance required is and that the consequence of the employee not reaching this standard by the specified date will be that the employee should be dismissed. Bear in mind the position of the employee: they may not feel that happy and the mere fact that a third warning has issued may mean the employee has to move on. Favorable references and some common sense on the part of everybody may mean the employee starts looking for another job at this point, and you assist them in doing this; and (vii) if the third warning doesn't work, you may dismiss the employee.
(ii)
(iii)
(iv)
(v)
What does the law say about terminating employees? This is a complex area of law and specific advice should be sought for any specific situation. Get this advice before you terminate the employee. However, and most generally, the Industrial Relations Act provides that an employee should not have his or her employment terminated January 2002 Page 246
unless there is a valid reason for the termination. An employee cannot be dismissed where the dismissal would be harsh, unjust or unreasonable. What is "harsh, unjust or un reasonable" will vary from case to case. An employee cannot be dismissed for the following reasons: (i) (ii) (iii) (iv) (v) (vi) (vii) a short-term absence due to injury or illness; union membership or union activities; non-membership of a union; employee representative activities; engaging in an action against an employer alleging a violation of the law; race, sex, age, religion, pregnancy, marital status, sexual preference, disabilities, social or political background or similar matters; or absence from work while on maternity or paternity leave.
Care must be taken to ensure that an employee dismissed for legitimate reasons is not able to say that the real reason was one of the matters noted at items (i) to (vii). The systems mapped out above are critical here. You will be amazed how often an employee only realizes there has been discrimination after you have told them that they are terminated. Document everything. Period of notice The Industrial Relations Act prescribes the following period of notice: Employee's Continuous Service Less than one year Between one and three years More than three years More than five years Notice Period 1 week 2 weeks 3 weeks 4 weeks
If an employee is over age forty-five, an additional week's notice is required if the employee has more than two weeks' continuous service. Serious misconduct Employers do not have to put up with serious misconduct. Serious misconduct is defined in the Industrial Relations Act to mean "misconduct of a kind such that it would be unreasonable for the employer to continue the employment during the notice period" and which must be taken as a repudiation of the employment contract by the employee. Examples of serious misconduct are dishonesty against the employer, conflict of interest (for example, working for a competitor, or competing with the employer after hours, at least in some industries), referring work away from the employer or committing a serious breach of the law (eg., robbing a bank). Faced with serious misconduct on the part of an employee, such as a significant theft or other dishonesty, an employer should: January 2002 Page 247
(i) investigate the matter fully, reasonably and impartially, and fully document the steps taken in this investigation. It can be a good idea to ask an independent third party, such as an accountant or a solicitor to help you with this investigation; specify exactly what the employee is alleged to have done. Put down all the details, including times, dates and places and the names of any witnesses or the details of any corroborating evidence; speak to the employee, put the allegations to them and allow them to be heard. Consider any mitigating factors (for example, thirty years of happy service may mitigate a minor theft of stationery); consider the other available options. Apart from dismissal, these could include a suspension, a demotion or a transfer. Generally though, if the misconduct is serious, the only solution is to dismiss the employee.
(ii)
(iii)
(iv)
Each of the above steps should be put down in writing and, preferably, should involve an independent person as a witness. Again the witness should sign and date these documents. For obvious reasons any breach of the criminal law should be reported promptly to the police. Let them make up their own minds as to what should be done then. Hopefully, experiences like this will be few and far between and you will never need to go through the above process. But they can crop up from time to time and it is best to be fully prepared for them when they do. Poor economic performance of the employer The poor economic performance of the employer is a valid reason for terminating an employee's position. Sensitivity is particularly important here. So is common sense. An employee cannot expect to be employed in a small business if there is not enough work to do. In the context of a medical practice the best approach for the employer to take is to explain the problem to the employee and to suggest they start looking for alternative employment straight away. Explain that you will provide paid time to do this and favorable written and oral references will be provided to all prospective employers. As a final thought on this topic, if you do need to let a staff member go because of a drop off in business, consider trying to place that staff member with another employer, perhaps a friend or an associate. We have seen this done before with excellent results for all concerned. You never know, your ex-staff member may give you a favorable reference one day if you are this good a boss.
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7.6 Time Management
Introduction Time is allocated to each of us equally. Sixty minutes an hour, twenty-four hours a day, seven days a week for fifty-two weeks in a year. No one gets any more than anyone else. And if you waste time, you never get it back. The flip side, of course, is there is always tomorrow: no matter what mistakes you make today or how you mismanage your time today you always get a chance to do better tomorrow. Practitioners probably do not see themselves as executives. The word "executive" conjures up images of middle level managers driving company cars to company offices to carry out or create company policies for sales, production, employment and so on. Hospital management, the bloke next door and a brother in law are executives, not practitioners. Peter Drucker, the most credible of all management experts, disagrees. He defines an executive as a knowledge worker who makes decisions, who controls the allocation of resources within an organization and is responsible for the results of the organization. (See The Effective Executive. Peter Drucker. Butterworth Heineman. 1967. pages 7 to 8.) Virtually all practitioners are executives under Druckers definition. More practitioners should see themselves this way. Many practitioners are also entrepreneurs, using capital to run businesses, responding to market forces, including competition, to generate a profit. More practitioners should see themselves this way too. In this perspective, time management, that is, the productive use of time, the only finite resource we have, is a crucial skill. This is particularly where practitioners face significant other claims on available time, particularly from family and friends. Bear in mind most practitioners own their own businesses: if the organization is you, so much greater should be the incentive to manage your time well. Its your results that are being improved, not those of some anonymous shareholder. There is only so much time so do not waste it and, to say the same thing another way, make sure its spent productively by allocating it in line with personal and business priorities. Why should you manage your time better? As a general rule, practitioners are good time managers. The economic and physical logistics of practice mean most practitioners are very focused on seeing patients: a long line of patients in the waiting room tends to focus thoughts on how to deal with a lot of work in a short time and still achieve maximum efficiency and effectiveness. Years of training in a demanding academic environment also develops intuitive time management skills. So, time management methods are unlikely to be a magic wand to convert a practitioners day from a hurried experience balancing loads of equally urgent tasks to a serene experience where everything runs smoothly and without hiccups. Lifes not like that. So lets be modest. Lets assume you can save just one hour a day or 5 hours a week by improving time management. Add, say; five hours a week for; say; fifty weeks and the equivalent of more than five full working weeks are wasted each year. What could you do with an extra five weeks a year? Answer: see more patients and make more profit, presumably an extra 20%. (Yes, thats right, an extra 20%. Fees will go up by 10% assuming a 50-hour week, but costs should virtually not go up at all. Assuming costs of 50% this means profit will go up by 20%. Or more. Alternatively, you could get the same amount of work done and spend an extra five weeks on the beach over summer. Or you could do a bit of both. January 2002 Page 249
This is why you should manage your time better. This part of the manual looks at practical ways to make better use of time. It relies heavily on two classics in the area of time management, being The Effective Executive. Peter Drucker. Butterworth Heineman. 1967 and The Time Trap. Alec Mackenzie American Management Association 1990. Both books are recommended reading. They underpin virtually all-later writings on time management, even if these authors pretend their thoughts are their own. We concentrate on ways to avoid wasting time on non-clinical matters, ie, the administration of the practice rather than the patient side of the practice, as we see this as the main area of improvement and are not qualified or experienced to comment on patient management techniques. In part 2 of The Time Trap Mackenzie book identifies the twenty biggest time wasters and how to cure them. Following his format, but throwing in our comments and concerns, is a sensible way to survey the range of practical tips for managing time better and achieving more results. We use ten headings, not twenty, to save time. 1 Meetings
Surveys show half the time spent in meetings is wasted. It is probably more: we expect the respondents just did not want to admit they waste more than half their time. Some meetings go too long. Some meetings should never be held. Before calling or attending a meeting ask: (i) does there need to be a meeting? Perhaps you or one or two others can simply set out proposed solutions and simply ask others involved if these are OK. Can the meeting be deferred: for example, why are so many meetings held monthly? Can it become an every second, or even third month meeting, rather than a monthly meeting. For example, a four partner practice may find it better to nominate someone as managing partner and delegate all routine decisions (eg. hiring a new receptionist, liaising with the practice manager and so on) and make the practice meetings quarterly and focus them on more important issues. The managing partnership role may rotate and a time allocation may be made to compensate for lost earnings (assuming the partnership does not share profits equally). It is much better for one practitioners time to be spent on mundane matters than for four practitioners time be spent on mundane matters; (ii) (iii) do you need to attend. If you do not, the next step is self explanatory; who else is needed?. Do not invite people out of courtesy. This wastes their time and everyone elses time, since invitees always feel they need to say something, even if they do not, and this takes time; prepare and circulate an agenda allocating time to each matter on the agenda; and follow the agenda and the time limits. Travel
(iv) (v) 2
Travel can be a big time waster. First tip, live near your practice (but not too near or privacy will be lost). This is something most practitioners do anyway, but remember 20 minutes each way twice a day adds up over a year. January 2002 Page 250
Second tip, avoid other forms of travel if possible. Use couriers, phones, e-mail or faxes. Soon cheap teleconferencing can be added to this list. This is often not a problem for most practitioners, since patients tend to come to practitioners more than the reverse, but can be a huge problem for others, particularly where long distance travel is involved. 3 The telephone
The telephone can be a big time saver or a big time waster. Properly handled it is a powerful tool that generates significant savings and efficiencies and allow things that otherwise couldnt be done be done. For a practitioner, the most important telephone rule is to have an effective screening mechanism. Calls must be filtered so only urgent calls are taken straight away and other important calls are deferred until it suits the practitioner. A staff member should handle less important calls and other calls should be, if not ignored, answered briskly by a staff member. Do not be shy to tell an unwanted caller (for example a salesman) in very certain terms to go away and not call back. This is the best way of making sure no more time is wasted. The other problem is spending too much time on a call. Politeness is essential, but an hour-tohour account of last months trip to Noosa is not. Learn lines to limit calls to business issues and exclude non-business issues: what can I do for you is brilliant. It smacks of service, is an offer of help and cant be more focused on the issues at hand. Practised lines for ending the call are also needed. To close politely say well, just before you go... or similar words to tell the other person the call is closing, and then close it. And if something else needs to be discussed this is a very quick way of prompting it. 4 How are you spending your time?
It is surprising how few people, practitioners included, know how they are spending their time. Find out. Log how you spend your time over, say, a typical working week. Ask yourself if you have spent your time as best you can. Did you have to do that? Could someone else have done it just as well? Could that meeting or matter have been handled with a telephone call, or sometimes even quicker, a fax or an e-mail? Once you know how you spend your time ask some basic questions. Are you allocating enough time to each task? Most things take longer than people think and under allocations can mean too much is taken on and too little is accomplished. Are you distinguishing between what is important and what is merely urgent? Urgent matters must be dealt with but make sure they do not stop you getting to the really important tasks or projects. This probably does not apply to practitioners, but some studies show up to 40% of executive time is spent on matters that are not important, ranging from the mandatory and irrelevant dissection of the weekends footy results to things nothing short of political gossip and maneuvering. How much response is really required? Do not over respond and respond in the most effective way. A memorable anecdote involved watching my boss labor for two days over a memorandum to a fixed interest manager about complex new tax rules applying to certain fixed interest securities. It was a work of art, true penmanship. Not a word out of place and not a thought unexplored. And my boss was proud of it. Off it went to the fixed interest manager and my boss anxiously awaited the expected lengthy response. January 2002 Page 251
The response came back in five minutes. It was the same document. The fixed interest manager had simply scrawled in red in the top right hand corner we do not have any of these securities. Regards Bob. My boss was professionally miffed: he thought his Herculean effort deserved an equally prolix response, typical of the mid-eighties life office culture. But I got my first real lessons in practical time management. First use the phone. My boss could have simply rung and asked and then logged his call as a file note on the matter. Second, never over respond. The scrawled hand written comment was just as effective as a five-page memorandum, but took only a fraction of the time. The fixed interest manager saved perhaps three hours work. Maybe he got a lot more work done than my boss and maybe he got to play with his kids at night. 5 Are you communicating effectively?
Clear communications save time. This involves listening and reading carefully and speaking and writing carefully to properly understand what has to be done. A staff member coming back for a further explanation of a task costs your time and the staff members time. There is also the time spent by the staff member inefficiently before deciding to revisit the issue with you. When instructing someone, test for receptivity. Ask questions and invite feedback to gauge whether you are being understood. To save time take the time to properly explain things at the beginning. Is the same question being asked repeatedly? If so, consider a memorandum on the topic and give it to everyone involved. Consider amending your practice manual so there is a permanent note on the matter and you do not have to tell everyone the same thing. Consider referring the question to someone else John can show you how to do that so staff train each other rather than you training each staff member each time. 6 Delegation of management tasks
Of course, no one can do the job better than you. But this still does not mean you should do the job. If a task taking, say, three hours is delegated from a practitioner to a staff member the practitioner is able to see, say, fifteen more patients. This may add, say, $300 to the weeks profit (remember, the incremental patient does not add to fixed costs, so the extra fees are almost all profit). Causally speaking, how much has the staff member earned for the practice? $300. But for the staff member practice profits will be $300 less, so its the staff member who has earned the extra profit. This phenomena is the essence of delegation: free up the practitioners time so the practitioner can earn profits. Support staff is a very accurate term. Staff should support you by taking nonmedical tasks away and allowing you to concentrate on patients. The more patients seen the better the practice and the better the profits. This is what economists call opportunity cost, ie the cost of the next alternative. It is a good way of looking at things and allocating time and other resources. Ask the questions can someone else do this job (if not as efficiently as me, at least competently)? Do I want to spend $300 getting this done? Is the opportunity cost worthwhile? If the answer is no, then get someone else to do. And 9 times out of 10 the answer should be no. Some practical guidelines foe effective delegation include: January 2002 Page 252
(i) (ii) (iii) expect mistakes. They are rarely fatal. Staff learn from mistakes. When a mistake occurs look at the system not the incident. If you fix the system the incidents will stop; do not expect perfection. In most cases adequate is enough. Adequate costs less and takes a lot less time; look at the results, not the process. It is the result that matters: if someone else gets there a different way (within reason) it does not matter, as long as the desired result is achieved; and employ good staff.
(iv)
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7 Paper work
Paper work is an essential aspect of all businesses. The electronic revolution is adding to paperwork not reducing it. The problem with paper work is it takes time to create, read and store. Introducing efficient paper handling procedures saves time. Some good ground rules are: (i) (ii) (iii) 8 handle the paper once. Make a decision: more than 80% of matters can be handled at the first thought level; use the cylindrical fling cabinet, ie, the waste paper bin. If you are not going to use it bin it, dont store it; and simplify paper work by developing systems including standardized forms and common filing systems. The right staff
Do you have the right staff? Staff can make a practice. Patients can react to and make decisions based on your staff just as much as they do on you. Without effective and well-trained support staff the best efforts of a practitioner can be wasted and effective delegation of administrative tasks can become impossible. Inefficiencies set in and you end up doing more work, not less work. Two things are critical: you must have sound selection criteria; and you must have sound training programs. Get the right staff in the first place and then develop their skills further both in an on the job setting and a more formal externals settings. External training should emphasis people skills and routine management skills, including personal organization and time management skills. In recruiting, spend time getting to know the candidates and trust your intuition. Check references personally. As a tip, grey hair can be a very valuable asset. If someone has worked well in someone elses practice for, say, ten years, it is likely they will work well in your practice (but still only employ on 3 months probation: this has allowed many decisions that seemed like a good idea at the time to be reversed. Investing in your staff has the obvious benefit of a better-trained and more knowledgeable team, with a correlating high productivity. It also sends the message you are interested in your staff and this in itself can produce excellent results. 9 Self discipline
As a group practitioners are certainly well disciplined. You would expect this. (You may think otherwise, but you should see what others are like!) But there is always room for improvement and bad habits can creep up on you. Vigilance, and a regular return to the basics can help maintain high standards of self-discipline that converts to better time management and better personal productivity. How can self-discipline be improved? January 2002 Page 254
Most fundamentally, by setting goals. These should be for the long term, the short term and the immediate. The degree of precision and detail is greater the shorter the time period. Committing goals to paper and constantly refreshing your memory and consciousness of them creates focus and facilitates achievement. This process should be systemized. A few minutes planning each morning and a brief review each evening, to a more formal process for long term goals (read the section in this manual on business plans for a more information here). How can you achieve your goals if you do not know what they are?. There is something in the title of Wayne Dwyers book You will see it when you believe it: the mere act of putting pen to paper can facilitate achievement by channeling attention to the tasks that deserve it the most. From a list of things to do, maintained daily or even hourly, to a detailed business plan, written goals help achieve goals. Goals should reflect priorities, and should distinguish between important tasks and urgent tasks. The important things should be done in time and, if something must be omitted, make sure its not important. Urgent tasks are the wild card: this is urgent in the sense of time, not importance, and there is a big difference. Develop techniques to handle the urgent unimportant tasks routinely: for example, set aside an hour a day for returning low level calls and correspondence (or, even better, have someone else handle these for you). Make sure your weekly planner has spare space for the (expected) unexpected urgent important tasks, and if it hasnt, make space. A blank hour here and there can make all the difference: do not schedule any meetings or routine work between, say, 1.00 and 2.00 each day and leave this space for the daily crisis. Self assess. Make sure tasks are completed in a timely and competent fashion. Do the same with goals: monitor progress and self correct if you veer off course too much. We are blessed with technology that was unbelievable twenty years ago. Use it. Personal computers, fax machines, automated practice systems including patient recording systems and prescription systems, and newer developments, such as the internet and internal and external email systems are blessings for productivity and hence profitability. The cost is minimal compared to the benefits produced. Some writers say publicizing goals enhances achievement. This may be true but for many it can be a bit brash and take things too far. The writers tend to be from the USA, so our disagreement could be a cultural modesty and aversion to self-promotion. Perhaps the compromise is the confidence of a few good friends or your professional colleagues: for example, all partners in a group practice could be required to detail their goals in the practices business plan and then face peer assessment of their performance. Fear of failure is a powerful motivator. So is healthy competition. 10 Socialising
This is often an area where big savings are possible. At work, prune social time to the minimum. Learn how to politely discontinue non-essential discussions and re-focus thoughts on the matters at hand. The minimum is, of course, a personal thing and taking this tactic too far can lead to loneliness. Socialization is a work place lubricant that helps things happen. January 2002 Page 255
In finding the right balance bear in mind studies have shown more than a third of an executives time can be spent on non-business interaction. In professions where time is money and time is scarce this sort of pattern is not acceptable and leads to sub-optimal performance. Learn how to say no. Do not worry about offending people. Remember, they are probably very busy too. Do not feel every personal reference requires a response from you. Plan the physical lay out of the premises, corridors, traffic patterns, offices and so on, to discourage unnecessary socialization. Avoid employing overly social people: actually ask about this when checking references. Well-developed social skills do not include chatterbox tendencies. Every time a staff member spends five minutes regaling someone else with the story of their weekend the practitioner loses fifteen minutes of effective staff time. This costs money and, worse, can cost the practitioner time.
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7.7 Leasing practice premises
In many cases, and for lots of reasons, buying practice premises may be quite inappropriate. For example, in some areas, particularly rural areas, the value just may not be there. The property just isnt going to perform the way an investment should. Physical requirements can change, and ownership means losing flexibility and a long-term commitment to one spot, which may not be sensible. Most practices, at some stage, have to lease premises. The purpose of this part of the manual is to consider the advantages of leasing and to note common pitfalls practitioners (and others) fall into along the way. At the beginning Property leases should be in writing. While there is no strict requirement for a lease to be in writing, premises are so important to a practice practitioners should insist on the lease being in writing. This gives certainty and helps avoid disputes at a later date. Property leases should be negotiated. Dont assume the first draft, provided to you by the owners estate agent, is the last draft. This draft will probably favor the landlord. Solicitors have tenants leases on their word processors too. Landlords need good tenants, so a practitioner should not be shy to ask for concessions. Good ideas include: (i) when moving in for the first time, ask for a 12 month lease followed by a two year option and then two three year options. This gives you an escape if the practice does not work out in the first 12 months, and means you will not be left with a lease on a property you cannot use profitably. Normally by the end of the first 12 months a practitioner would know whether a particular site is going to work out or not; insist on a right of sub-lease or license. This means you can get other practitioners or health professionals in to share costs without the landlords permission. Its unusual for a landlord to refuse such permission, but making sure is a wise move; make any lease conditional on all required permissions for using the premises for a medical practice, or a similar business being granted and staying current; and asking the landlord to pay all or part of a fit out. The advantage of this is obvious: more money in your pocket. If the landlord will not agree to this make sure you have the right to remove fixtures and that they do not have to stay when you go.
(ii)
(iii) (iv)
Checklist for a lease of practice premises A written lease should only be signed after a thorough consideration of its contents, including external review by a solicitor. This includes: (i) (ii) (iii) (iv) is property insurance required? If so, what sort, at what cost and who pays? is there a right of sub-letting? Is this right subject to any restrictions, such as the landlords consent; can the tenant assign the benefit of the lease without the landlords written consent? who pays outgoings, such as rates, taxes and repairs. It is common practice for outgoings to be paid by the tenant, but this is not carved in stone. Beware of special rates and other generally defined catch alls: these can be very expensive if, for example, new road works are required or a street beautification scheme is introduced; Page 257
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(v) how are outgoings calculated? Land tax is particularly important here. The tenant should insist on land tax being calculated on a single holding basis, ie, as if it were the only property owned by the landlord; what is the term of the lease? How can the term of the lease be extended? What sort of written notice is required? Is a particular form of notice required? limit repair costs and, in particular, exclude air-conditioning costs, which can be very expensive; who is responsible for the costs of preparing the lease, including solicitors fees and stamp duty; does the lessor own the premises? Are the premises encumbered? Is there a prior right of any other person, such as an earlier tenant with an unterminated lease? Should the tenant seek protection against the landlords creditors taking control of the freehold? In an extreme case, should the tenant lodge a caveat on the property at the titles office, to mark its interest in the property to potential purchasers or security providers; what is the rent? When and how is it paid? How can it be increased? Does the tenant have any avenue of appeal should a rent increase be disputed? what happens if the there is a minor breach of the lease? Does this allow the landlord to terminate the lease without any compensation to the tenant? what sort of directors guarantees are required? and is there an arbitration clause? Who is the arbitrator? Who pays for the arbitration? What happens if the arbitration does not work?
(vi) (vii) (viii) (ix)
(x) (xi) (xii) (xiii)
How can rents be increased? General practitioners in particular are susceptible to rent increases. The goodwill of their practices are a mixed function of personality, service and location. But without location a practitioner cannot have a practice. Landlords know this and are often quick to increase rents wherever possible knowing the practitioner must acquiesce or risk losing the goodwill of the practice, often built up over many years. Practitioners should get specific legal advice in each state, but generally, the main methods of increasing rents are: (i) review to market, whereby the landlord, often through an agent or solicitor, simply tells the tenant what it thinks the market rent should be for the coming year. If the tenant agrees, that is that. But if the tenant does not agree, and a compromise cannot be found, then typically a valuer is appointed and the valuation used as a guide to market value. Common traps to watch for include: (a) set acceptance periods of say 14 or 30 days. If the tenant does not advise the landlord it disagrees in this time the tenant is deemed to have agreed to the increase; Page 258
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(b) (c) (ii) (iii) so called ratchet clauses, which mean the rent cannot come down if the market falls, but goes up if the market rises; and the tenant has no right to a review, so if the market falls there is nothing the tenant can do about it;
CPI (or similar) annual increases; or fixed annual increases, expressed as either a percentage or an absolute amount.
Options (ii) and (iii) have the benefit of certainty, but do not have the benefit of responding to market conditions. At the start of a lease it is not possible to say which is best unless you have a crystal ball for movements in the property market over the life of the lease.
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7.8 The practice incentives program
The Practice Incentives Program (PIP) takes over from the Better Practice Program as at 30 June 1998. This was as recommended to the Government some time earlier by the General Practice Strategic Review Group. The PIP forms part of the Governments blended payment approach. It has been introduced at the same time as the General Practice Immunisation Incentives Scheme, and is a further example of the new system of providing extra financial incentives to GPs who achieve certain quality criteria determined by the Government. The PIP is intended to reduce reliance on strict fee for service charging methods and to reward practitioners who satisfy certain quality control and management criteria. A major emphasis is the importance placed on patient numbers and loyalty, rather than the number of consultations completed in a period. This emphasis is deliberate and is intended to reduce the emphasis on completing more consultations as a way of maximizing income. Payments are made based on Medicare and Department of Veterans Affairs data. This is linked to the provider number specified in the practices application form as up-dated to the HIC from time to time. The final composition of the accreditation criteria is still being worked out. There will be extensive consultations with the medical profession and complex models will be determined to ensure an equitable distribution of money amongst general practices. The Government has indicated that ultimately the PIP will be based on: data, practices that provide basic data about their patient base will receive greater payments; after hours care; targeted incentive programs such as the General Practice Immunization Incentives; rurality, the more rural the better; and teaching practices.
Participation in the PIP is voluntary. How much money is paid per practitioner? The Government estimates the PIP will result in payments per equivalent full time practitioner of about $12,000, with larger amounts for rural practices, particularly remote rural practices. The amount of $12,000 per annum per practitioner is about the same payment as we have observed for clients under the Better Practice Program (BPP). This is a lot of money and we believe the PIP should be thoroughly investigated by all GPs or their advisors. $12,000 a year each year for ten years, invested at 8%, adds up to nearly $250,000. If there are four practitioners in the practice, thats $1,000,000. Clients who are participating say there is not much extra paper work and most of the criteria is met naturally by the practice, so there is little extra work. January 2002 Page 260
We recommend our clients join in the PIP wherever possible. What is a general practice? PIP payments are made to bona fide general practices in good standing in the community that have a patient focus. This means: all practice practitioners are vocationally registered, or the equivalent, or are appropriately supervised and are working towards being vocationally registered; practice patients can receive home visits, and 0.2% of all consultations are out of surgery visits or a practice practitioner is a visiting medical officer; the practice provides reasonable 24 hour medical care, whether on its own, or in collaboration with other practices or a local hospital; and has appropriate practice information sheets to advise patients of the above services.
For PIP purposes, a general practice is a practice unit that provides primary, continuing comprehensive care to patients. Practices providing say occupational health services or sports medicine services will not be eligible unless these services are provided as part of a comprehensive range of GP services. A practice unit is defined as: a solo practice which has a medical records system, an appointment system and rooms; or a group practice, if all medical practitioners working at the practice share a medical records system. How do you become eligible for the PIP? Practices have to be accredited by Australian General Practice Accreditation Limited, a company owned by the six Australian general practice organizations. Since it is not possible to accredit all practices overnight, as an interim measure practices receiving the BPP at 30 June 1998 will automatically be eligible for the PIP. The BPP will be abolished once the new arrangements are fully in place. To obtain accreditation a practice must register with Australian General Practice Accreditation Limited and go through a three-year cycle of accreditation involving: self assessment against the RACGPs Entry Standards for General Practices; peer review; and commencement of a quality improvement program.
The Government anticipates appointing companies other than Australian General Practice Accreditation Limited to jointly oversee the accreditation program. Further information? - More information can be obtained from: Australian General Practice Accreditation Limited Telephone: 1300 362 111 Facsimile: 1300 362 110 January 2002 Page 261
Address: Postal Address: Email: Website: Level 1, 4 Park Road, Milton Qld 4064 PO Box 2058, Milton Business Centre, Milton Qld 4064 mailto:info@agpal.com.au www.agpal.com.au
Practice Incentives Program Enquiries Telephone: 1800 222 032 Website: http://www.health.gov.au.hbd.pip.index.htm/
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7.9 Dropping the local letterboxes
First a confession. When a letterbox drop was first suggested to us as a way of promoting a medical practice we simply did not believe it would work. There was also a professional shyness (professional arrogance?) that stopped us from recommending it to clients. Does it work? It works. A number of practitioners, dentists and veterinary surgeon clients have tried it and the results have been quite good. Certainly good enough to justify some more thought and time on our part. What is it? A letterbox drop is simply the distribution of printed material (or similar small items, such as fridge magnets) by hand to the letterboxes of potential patients. In the case of a general medical practice, this will almost certainly be the home of people living in the surrounding suburbs. Who can do it for you? Look under the heading advertising distributors in the yellow pages. The average cost comes out at about 5c a copy. However, cheaper non-unionized rates may be available from your children or the neighbors children, so be prepared to get a competitive quote. Its not hard for two people to cover all of a suburb in a day if they have bikes or walk fast. And remember, you do not have to do it all in day. The job can be spaced out over a few weekends if you wish to. What legal restrictions are there on medical practice advertisements? Most states have some restrictions on what can be said in a medical practice advertisement. The Victorian restrictions are listed below. As you can see, it boils down to a few common sense rules: tell the truth, use good taste and do not directly or indirectly criticize other practices. Be conservative, to avoid potential problems and to stay friends with other practices in the area. no false or deceptive statements no criticisms of other practices or claims of superiority over other practices no testimonials or other endorsements
Other restrictions may apply in other states, so check the local rules if you have any doubts regarding what can be said and what cannot be said.
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DIY newsletters? Some practices prefer to create and distribute their own material. This can be good and desktop publishing systems have come a long way in the last few years. However, professionally finished documents still look a lot more professional and are probably worth the extra cost, particularly as volume rises. Some distributors provide a complete service, including folding and delivery. Again, savings can be made by getting competitive quotes from your children for the folding and delivery phases of the process (although you may breach the Trade Practices Act rules on unfair tactics if you cut off pocket money to get a better quote). What does it cost? Total cost for a full service will tend to be between 10 and 35 cents, depending on size, number and quality of finish. If the total cost of 10,000 newsletters is say $20000, or 20 cents each, and say thirty new families, each with five members, are attracted to the practice, this is a good investment. The cost of the letterbox drop is tax deductible. Think about cost sharing with a local pharmacist or hospital as a way of lowering your costs. Be astute: think about what where and when Timing, as always, can also be an issue. June to August you are likely to be flat out anyway, so a mail drop may just add to costs and your fatigue. December or January may be good times to try this method, particularly if your practice is not at Rosebud or Lorne. If you are introducing a new service or practitioner use the letterbox drop to kill two birds with one stone. Delivering a brochure emphasizing obstetric and pediatric services may not be that good an idea if the local suburb has an older population. Cranbourne is better suited here than Kew. Examine your patient base: as a general proposition, use mailbox drops in your weaker areas that may be naturally positioned to other practices. To an informed reader, generic statements such as we offer top service mean nothing. It is much better to say something specific about what you do and how you do it. For example, comments on the need for vulnerable people to get flu immunisations in May could be quite timely and the underlying thought appreciated by readers, even if they do not all come to your practice as a result. Good karma comes back and the percentages will work in your favor. A number of groups mass pen practitioners newsletters and these can be a good way of obtaining sound quality controlled comments. Consider sharing your own newsletter with another practitioner in another area as another way of pooling resources. Consider the letterbox drop as a way of announcing a coming event. We know of practices that have attracted more than 400 people to a mens health information session. These methods work too. Consider using your newsletter to announce a coming event can help attract favorable attention and thoughts to your practice. This keeps the momentum up once first contact is made and attention is directed to your practice. Follow up
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Some formal monitoring of the results is appropriate. This can be done generally, by observing patient numbers before and after the letter box drop, and specifically, by asking all new patients how they became aware of your practice. A final thought Nothing beats word of mouth advertising, and good medicine will always attract patients. But a letterbox drop can be a good way of speeding up these processes, particularly for a new or expanding practice, or a newly developed area.
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7.10 The Reception Desk: The real front line
The first contact a patient has with your practice is via the reception desk. First contacts count. A good receptionist, or team or receptionists, can make a practice. Patients respond to a warm empathetic style. This, and an underlying efficiency and speed, mean patients are happy. This in turn means they are likely to be relaxed and cooperative during the consultation, likely to come back and likely to recommend your practice to others. On the other side, a poor receptionist, or receptionists, can upset patients, make consultations less pleasant, can waste time, can lower staff morale and create negative word of mouth. All of these things cost money. What is the value of a patient? A discussion some years ago with a food processing company springs to mind. The owner said big customers get top service. I asked what a big customer was. I was told it was a $100,000 of sales. I then asked what a small customer was. I was told there were no small customers. I said how can you have big customers without having small customers, its all relative. The owner said to me: a $10,000 a year customer is $120,000 over ten years. Do you call $120,000 of sales a small customer? Pedantics aside, his thought was brilliant, and I learned another lesson in business: there is no such thing as a small customer, or an unimportant patient, once you take a long-term view of the relationship. And a practitioner patient relationship is a long-term relationship. A young female patient may not seem important today. But in the next ten years she may marry, have three children, and create a family of patients who spend perhaps $1,000 a year at your practice. She recommends you to three friends at the playgroup, and suddenly there is an extra $3,000 per year of income. Remember, an extra patient does not create any (significant) extra costs, so thats an extra $3,000 per year of profit. This is why good reception good support staff are critical to a practices development. Do you want to lose $3,000 profit a day, or do you want to make $3,000 of profit a day? Informal feedback Informal patient feedback is the best feedback. If patients tell you, or otherwise suggest, that a staff member is not cooperative or pleasant listen carefully. It is not inappropriate for you to discretely solicit this sort of feedback from patients, particularly those whose thoughts you trust and value. Do not be satisfied with shes OK as an answer. The average is normally mediocre, and you want something better than that. The required response is excellent. This doesnt mean the receptionist has to be superwoman. Its more a question of attitude: being interested and wanting to help both the patients and the practitioners is the critical thing. Once patients, or customers, perceive a healthy attitude most other things fall into place, and the receptionist will be assessed as excellent. Of course, basic efficiencies, as well as basic amenities and aesthetics, are taken as read. All the positivity in the world cannot help if the basic service and facilities are not up to scratch. Maintaining a good front line People want to be appreciated. A good word, plus good pay and work conditions, is needed to maintain a good standard of work. If Mrs Smith has commented that the receptionist is good, tell the receptionist. Now you have set a standard for her watch her work hard to maintain it. To keep up the good work keep up the good words. What should you do if a receptionist is not up to scratch? January 2002 Page 266
The first step is counseling. Introduce the need for improvement as a positive step, as a way of improving oneself and hence ones prospects and life opportunities. Hopefully the message will be received and improvement will occur. Sometimes inefficiency, particularly in a staff member who performed well before, is a sign something is wrong. Consider what may be wrong and ask is there anything you can do to fix it. If you can fix it, fix it. In our practice time off, on leave, has done the trick a few times, particularly when personal problems impact work performance. It gives the staff member time to refresh and focus, and deal with personal issues. From an employers point of view, if someone is going to feel blue for a few weeks, I would rather it be on their time than my time! Time out is often a cure for poor performance, and can have a very good effect on staff morale. What if counseling does not work? At the end of the day it is the end of the road. A leader has to be prepared to make hard decisions, so the welfare of the group (including your familys future fortunes) is not sacrificed to an individual. This means you should now turn to part 9.6 of this manual, and read dealing with an unsatisfactory employee, particularly the bit about terminating staff.
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7.11 Change in the workplace
People have two fears about the future. The first is that things will never get back to normal. The second is that they already have. Why is it that same people take to change like ducks to water, whereas others will resist, resist, resist. Some people set up barriers to change. Threatened, they become negative, argumentative and defensive. It happens in medical practices too. Understanding why some people resist change can help overcome these barriers. What are the barriers? What are the impediments to change in the work place? The logical barrier This often takes the form of why fix it if its not broken? or this is just change for changes sake. The person behind this barrier is often a logical and methodical person. Explanations that refer to the big picture, vision, mission or practice values will be lost on this person. The answer is to present the reasons for change in that persons language, ie using logic and method. Remember, what is logical to you may not be logical to them. You need to speak their language, not your own, An example jumps to mind. I can recall trying to explain to a practitioner that it was a good idea to transfer units in a property trust to a superannuation fund (it could be done then), and to claim a deduction for this amount in his tax return. This, I stressed, would save $10,000 a year cash. My stress did not create much of an impression. He replied that he did not care much about money, and was only concerned with his patients and his children (not in that order). It occurred to me that unless I spoke in terms of children or patients, I would not convince him to act. So I said, $10,000 a year each year for ten years, invested on to your home loan, will pay for your kids school fees and leave change for university. His attention caught, I prepared a simple spreadsheet showing this. He transferred the units to the fund. And his kids are enrolled at an excellent school. The Closed Mind Barrier This often takes the form of been there, done that (dont you hate that one), we have tried it and it doesnt work. or what do you know about it anyway? Minds are made up before you start. This is a hard position to change. One way is to, diplomatically and discretely, show the person they do not know it all, and take them through a learning process so they can see the benefit of the change for themselves and can understand why it is different to their first conclusion and why the suggestion should be adopted. I can recall commenting to a practitioner that his costs were well above average and he should consider ways to trim them down to the average, or better. His revenue was above average, more than $250,000 pa, but his costs of $160,000 were even more above average, creating a below average profit of only about $90,000. I was expecting a profit of between $120,000 and $150,000 per annum. His response was, to say the least, defensive, and was probably offensive. His was an above average practice, he said, which was probably true, and his performance was above average in all respects. What did I know anyway. January 2002 Page 268
What do you do here? Whats the next step? There was a real concern that the discussions would break down and I would lose a client (in this case, before I even had him: this was our first meeting!) The next step was to ask him to calculate his costs and express them as a percentage of revenue. This was hard to do, because the service trust and the property trust structure used in his practice was unnecessarily complicated and hard (and costly) to understand. Once the calculations were completed he was astonished to find costs were about 65% of (the relatively high) revenue. That is, costs were about $160,000. He knew from other sources that costs should be closer to 50% of revenue, and less if revenue is high, say about $110,000 to $120,000. He realized he was wasting about $50,000 a year, each year. Mission accomplished. He attacked costs and quickly got them back to a more sensible level. I got a Christmas card, but, sadly, did not get the client! But thats OK, because the client got the message and got his costs down. The Fear Barrier This is a basic human extinct. Fight or flight. Fight is shown by aggression, anger and argument. Flight is shown by withdrawal or silence. Changes to the work environment threaten people. Some fear losing their jobs (and sometimes this is a sensible fear). Others fear losing their place on the totem pole, a change in the imprecise and sometimes vague lines of authority and relationships that cannot be shown on any organization chart. In the 1980 Salomon Brothers lost their position as the kings of bonds to Michael Milken. They could have got into junk bonds, but didnt, because the established divisional heads did not want to risk a loss of internal power if the new division worked out too well. In the end that attitude cost them their jobs. In the 1990s some medical practices are not adopting technology, because of a perceived loss of control once a screen is on the desk and a the memory is on the hard disk. But in the 2000s the leading medical practices will be using the new technology. This is a very hard situation to deal with. The best response is to remove the fear. Make it plain jobs will not be lost. The efficiency gains are, for example, needed to accommodate growth, not trim staff. If the change involves improved efficiency, pay the staff more. This is needed to reward as well as retain the retrained and therefore enriched and more marketable staff. Let people know about the pay increases before the change process starts. Consider paying for external training courses in the effected area. Windows for beginners can dispel and lot of concerns and create a base confidence to build the next steps on. If fear of failure is a problem, make sure the staff member goes to the course on their own, so they will not be shy of making a mistake or asking a dumb question (not that there is such a thing, but you know what we mean). The proprietorship barrier This is marked by phrases such as not invented here. New CEOs are often tempted to put recent initiatives on ice, for fear of credit being allocated to someone else. This is short sighted. A real winner realizes two, or twenty, heads are better than one and using other peoples ideas can be a profitable way to go. Look at the Japanese. The Swiss invented the quartz watch, the January 2002 Page 269
Japanese pinched the idea, made a billion, while the Swiss watch industry, world leaders for centuries, collapsed, virtually overnight. How does this apply to a medical practice? Be prepared to watch others and study innovations and ideas. Pick the best of them and apply them to your own practice, adapted as necessary. To introduce the change in your practice make staff and partners proprietal: make them own the idea and become concerned with its outcome and success. Get them to commit to it. One practice manager remarked that allowing four practitioners to each get 4% of the service unit trust has had a profound effect on attitude. Suddenly the practitioners saw themselves as proprietors. Suggested changes were jumped on and made their own, with staff who slipped back to the old ways quickly castigated. Getting everyone on the same side, no matter how you do it, is the answer to this problem. Its a question of attitude, thats all.
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8. 8.1 SMALL COMPANIES What is a company?
A company is a legal person. This person is a legal fiction: the courts and parliaments are basically saying "let's pretend this company is a person and has (most of) the rights, entitlements and obligations of a natural person (ie a human being) and has a number of extra rights, entitlements and obligations created because it is a company". The courts and parliaments have recognized companies as legal persons separate from their owners and directors for many years. Companies can deal with other legal persons and the courts will recognize the contracts created in these dealings and allow companies to enforce these contracts. Companies are subject to most laws made by courts and parliaments, including criminal law. As far as the law is concerned, a company has a legal presence separate from its owners, managers, operators, employees and agents. A company may hold money and own other assets and the law will treat these as belonging to the company. A company has most of the powers an individual has under the law. These include the power to buy, hold and sell real estate and other type of property, contract with other legal persons and to sue and be sued. Companies have perpetual succession. This means they may outlive their shareholders and directors and the shares in the company can be transferred to other persons. Once a company is incorporated its separate legal status continues until the Australian Securities and Investment Commission ("ASIC") cancels the company's registration. Initially companies were formed as a mechanism for allowing more efficient capital formation and larger business enterprises: it's hard to imagine a business growing to the size of BHP without the structure of a company to support it. It's just too much for one person or one small group of people to do on their own. The history of the development of the concept of a company parallels the development of commerce over the last 100 years or so. The use of a company, with its ability to marshal large amounts of capital and to outlive its owners, made larger enterprises possible. Companies are still formed for these purposes. However, most companies formed in Australia (perhaps more than 95%) do things the owners could do themselves if they wanted to. They basically run small and medium sized businesses and own investments. They do this in their own names as principals but, more commonly, they run these businesses and make these investments as trustees of family trusts, unit trusts and superannuation funds. It is outside the scope of this booklet to consider how companies differ from other forms of organization. If you are interested in this topic you should refer the question to your accountant or solicitor. Most textbooks contain comprehensive lists of these differences. A company is formed by process set out in the Corporations Law. In the early years companies needed a special charter from parliament to incorporate and some of Australia's older companies were formed this way. The process is now far more streamlined: a number of documents are completed and lodged with the ASIC. These documents set out the details of the proposed director(s) and the proposed January 2002 Page 271
memorandum and articles of association. On registration of these documents the ASIC will issue the corporators (ie the persons forming the company) with a certificate of incorporation. This certificate states: (i) (ii) that the company is registered and as a result of that registration is an incorporated company; and the day the registration was made.
The shareholders of a company can be natural persons or other companies. Since December 1995 a company only needs one shareholder and one director. This person may also be the company secretary. How does a company deal with other people? A company does not have a physical existence. It is a legal fiction and since it cannot do things itself it must necessarily act through other people. These people are ultimately the directors of a company (although in some cases this will be delegated to accountants and employees). The directors are responsible for the company's business and investment affairs. The articles of association will set out details of how directors' meetings are to be initiated and run. Directors must maintain detailed minutes of the matters discussed and the resolutions passed at directors' meetings. The directors of the company owe their duty to the company, not to the company's shareholders. This can create conflicts of interest when the company deals with the directors in other capacities or with other companies connected to the directors. The shareholders do not own, directly or indirectly, the assets of the company. Their shares only entitle them to receive dividends declared by the company and the right to participate in any distribution of surplus on the winding up of the company. Shareholders' power Shareholders decide how the company should be run. In strictness this power is exercised by passing an appropriate resolution, usually at a formal meeting of shareholders. In practice the power is exercised less formally without a need for special meetings of shareholders. This is because the directors of the company know that a particular shareholder or group of shareholders control the company and therefore they abide by their wishes, subject of course to the Law. The two main types of resolutions are ordinary resolutions and special resolutions. Special resolutions typically relate to the more serious questions impacting the company or the rights of a specific shareholder or group of shareholders. A shareholders' meeting is not required for an ordinary resolution. The shareholders may pass an ordinary resolution without holding a meeting if all shareholders sign a minute setting out the terms of the resolution. This is a common occurrence. If a shareholders' meeting is convened, an ordinary resolution may be passed by a majority of the shareholders able to vote. A shareholder may vote by proxy. A special resolution of shareholders must be passed by a minimum of 75% of shareholders eligible to vote at the meeting. The role of shareholders and company guarantees and securities January 2002 Page 272
Shareholders of a company generally will not be liable for the company's debts, at least in their capacity as shareholders. Generally the only obligation of a shareholder as a shareholder is to pay the company any amount unpaid on the issued shares if asked to do so by the company. The shareholders may be liable for the company's debts if they are also directors or if they guarantee or secure the financial performance of the company in any way. Most banks (and large business suppliers) will require director guarantees and shareholder guarantees when lending money or advancing credit to a private company. The person to whom the guarantee or security is given can enforce the security and force the shareholder to pay the company's debt. This may mean the shareholder loses a family home or any other property given as security for the company's debts. In an extreme case, and there are many examples of the extreme case, it can lead to bankruptcy for the shareholder and, possibly, associates of the shareholder. Shareholders should not give guarantees or securities without being fully aware of the financial implications of doing so. If in any doubt obtain specific accounting and legal advice before agreeing to guarantee or secure a debt or other financial obligation of a company.
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8.2 One-practitioner companies
Once a company had to have at least two directors and two shareholders. This rule no longer applies. Since December 1995 the Corporations Law has permitted companies to have just one director and one shareholder. This change is good news for practitioners. This is because it allows practice companies to convert to one-practitioner companies, taking the second director, typically a spouse or other close relative, out of the firing line on directors' liabilities. It also means matters are simplified as there is no need for declarations of trust and so on to be executed by the non-practitioner shareholder. Should you convert to a one-practitioner company? The answer is probably yes, but it depends on the facts. We typically recommend practitioners convert IMPs to one person companies, with the practitioner as the one director and shareholder, and convert the trustees of the family/service trust to one person companies, with the non-practitioner spouse or other person as the one director and shareholder. This way the practitioner is the only person exposed to the risk of medical negligence claims and the valuable assets accumulated in the family trust are not indirectly exposed to this risk. Exceptions can arise in the case of a married couple who are both practitioners, or where the shares in the IMP have a value and a taxable capital gain will arise on transfer of the shares. Married practitioners will normally need to develop a more sophisticated asset protection strategy. Customized advice is needed here. Where the shares in the IMP have a value and a taxable capital gain will arise on transfer (ie where indexed cost is less than current market value) its best to simply leave the shares where they are, ie not transfer them, and to just have the second person resign as a director. There is no significance in retaining a second shareholder who holds the share on trust for the practitioner and has no other involvement in the company. If for any reason a practitioner is still concerned about this then it is a simple step to issue, say, an extra 100 shares to the practitioner, to leave the other shareholder as a 1% owner. The issue of shares in a company is a tax neutral transaction. Interestingly, in many cases where practitioners think there may be a taxable capital gain on the transfer of the non-practitioner's shares to the practitioner, there will not be. This is because the CGT rules ignore transfers from a bare trustee to the beneficiary of a bare trust: and this is probably what is involved in an IMP. So CGT should normally not be a problem.
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8.3 Company Directors What do you need to know
Most practitioners are a director of a company. This may be an IMP, the trustee of a family trust or superannuation fund or a trading or investment company. To become a director a pile of documents are prepared, signed and lodged with the Australian Securities Commission or stored on the company's register. Many people believe that this is where it all ends. This is not so. Under the Corporations Law a director assumes a number of important responsibilities and obligations. These must be discharged properly and promptly or else the director may face penalties. In the course of many transactions with other persons the company's directors may become exposed to a liability for the actions of the company. This can happen by operation of law, for example where a director permits a company to trade while potentially insolvent or to operate unsafe equipment. It can also happen as a result of something done by the director, for example, where a director signs a guarantee for a loan. Without understating the potential extent of these obligations, as a general rule, being a director is not as hard as it sounds. Directors rarely find themselves liable for the actions of a company except where, for whatever reason, they have been derelict in their conduct as directors or have knowingly agreed to be liable for the actions of the company. The purpose of this part of the booklet is to briefly explain the role and obligations of a director and to try to put these into the correct commercial context. Where does the law come from? The law regarding directors is sourced in the Corporations Law and the common law. The Australian Securities and Investment Commission ("ASIC") administers and enforces the Law. The ASIC also operates a large database containing all relevant details of each company incorporated in Australia. This database is accessible by the public and many accounting and legal firms have direct electronic access to it. The database includes details of each company's directors, shareholders and registered office. This database is a critical part of the philosophy behind the Law and means that any one dealing with a company can identify the natural persons standing behind that company without any great fuss. The ASIC database is up-dated regularly and for this reason companies are required to lodge annual returns and to advise the ASIC on the happening of certain events such as a change of directors. The directors of a company may be liable for statutory penalties if a company fails to do this within the time limits set down in the Law. What is expected of a company director? Every company must have a director. Until recently, every company had to have at least two directors but the law was changed in December 1995 to allow one person private companies to be formed. These rules are still very fresh and most companies still have at least two directors. Each director must consent in writing to be a director and must supply personal details to the ASC for inclusion on its database. These include the director's home address, date and place of birth and occupation. Directors owe the company a fiduciary duty. This is the strongest duty able to be owed by one person to another and is governed by the law of equity. This duty brings with a set of positive January 2002 Page 275
obligations that must be discharged by the director and a set of negative obligations under which the director must avoid doing certain things in connection with the company. The duty was described in Meinhard v Salmon (1928) 248 NY 458 as follows: "Many forms of conduct permissible in a workaday world for those acting at arm's length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior". This means, in a very elegant way, that the director must act with the utmost honor at all times and is required to put the interests of the company above his own interests and the persons who are related to him. There is also a common law duty of care owed by a director to the company and a statutory duty of care is contained in section 232(4) of the Law. The positive set of obligations that are owed to the company and which a director must observe include: (i) the duty to exercise the powers of a director properly and in a way that furthers the purposes of the company as a whole and which is for the benefit of the company as a whole and not for the director personally; the duty to act honestly at all times. At it simplest and most obvious level, this means the director should not steal from the company. But this duty is more complex than this and, generally, a director who, without an intention to defraud, deliberately makes a decision that is not in the overall best interests of the company could not be said to have acted honestly at all times; the duty to act diligently and in good faith and to avoid improprieties. This requires directors to be something more than just rubber stamps (the courts are unforgiving with rubber stamp directors), to take reasonable steps to monitor and control the company's financial decision, to understand the company's financial position and to consider how this position may be changed by economic trends. The courts will consider the special skills or qualifications of the director when considering whether this duty has been properly discharged; and (iv) the duty to properly consider all matters requiring decision and to properly exercise all discretions vested in the director.
(ii)
(iii)
The negative set of obligations that are owed to the company and which must be observed by a director are generally intended to ensure that the director avoids all conflicts of interest with the company. This general rule manifests itself in special rules dealing with such things as insider trading, disclosure of information, and dealings with related parties. Each of these areas is dealt with in the Law. Disclosure of conflict of interest As a general rule disclosure defeats a conflict of interest. So, if for any reason a director believes that they have a conflict of interest they would be well advised to disclose their concerns in writing to the company and to the other directors. It is hard for the company or the other January 2002 Page 276
directors to subsequently complain about a matter that was disclosed to them before it happened and which they could have objected to at the time. Summary of duties of a director The specific duties of a director include: (i) (ii) (iii) (iv) (v) the duty to act honestly and in good faith at all times; the duty to act in the best interests of the company at all times; the duty to avoid (undisclosed) conflicts of interest; the duty to exercise due care and diligence to the standard expected of a director under the Law; if the company is winding up, to report properly and completely to the liquidator on the financial position of the company and to allow access to company records.
Penalties faced by directors The Law contains a number of penalties for directors who fail to discharge their liabilities to a company. In the case of criminal matters these include fines of up to $200,000, five years imprisonment, or both. In the case of civil matters these include fines of up to $200,000. In both civil and criminal matters a director may be liable to a company for losses suffered by a company as a result of a breach of the director's duty. These penalties are rarely applied by the courts, having regard to the large number of people who act as company directors. However, all directors should be aware these penalties exist. The day-to-day tasks of a director The day-to-day tasks of your average director are, thankfully, far simpler than the above paragraphs would have one believe. In the case of smaller companies the directors will typically be the owners of the business. They will be responsible for the day to day running of the company as well as the governance of the company. These duties typically include: (i) arranging occupancy, whether it be in leased premises or in owned premises, or under some other arrangement such as a licence to use another person's premises (this is common for medical associates); arranging finance and managing the working capital of the company's business so that amounts due to the company are collected promptly and amounts owed by the company are paid promptly; ensuring the various regulations and rules applying to the company, whether under the Law, other laws or a professional body such as the AMA, are properly observed; making sure that the day-to-day mechanics of the business is properly attended to. This will include: Page 277
(ii)
(iii) (iv)
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(a) (b) (c) (v) ensuring employees properly discharge all their duties and responsibilities and the appropriate standard of care is exercised at all times; ensuring appropriate registrations and licences under the Corporations Law and otherwise are maintained; and ensuring appropriate legal records are maintained; and
keeping appropriate accounting records and ensuring annual accounts and income tax returns are prepared correctly.
A critical point to understand is that the company is a separate legal person. The director owes a fiduciary duty to the company and this duty must be satisfied no matter what the personal circumstances of the director are. A director must only consider to what is in the best interests of the company and must not consider other matters. For example, a director cannot offer an asset of a company as a security for a debt owed by the director if this would damage the financial position of the company. This breaches the director's duty to the company. Directors should seek professional advice regarding a particular matter if for any reason they feel that they are not able to make this decision themselves. Directors should take an active role in the company's business affairs and should be particularly alert to the financial impact on the company of major decisions made by the directors. What if the company is the trustee of a trust? A large proportion of private companies act as trustees of trusts. So a question often arises as to what extent, if any, a director of a company that acts as trustee of a trust may: (i) (ii) be liable for any economic losses suffered by the trust as a result of their actions or failure to act; and owe a duty to the beneficiaries of the trust.
Under the general law the directors of a company that is the trustee of a trust may be liable for losses suffered by the trust as a result of their actions or failure to act. This general law position is reinforced by a provision of the Law that says the directors may also be severally and jointly liable with the company for any liability incurred by the company which is not covered by the trustee's right of indemnity against trust assets. The extent to which a director owes a duty to the beneficiaries of the trust personally, as opposed to owing a duty to the company that acts as the trustee of the trust, is not yet clear. Certainly there is a potential for this duty to be owed, and directors of trustee companies would be well advised to assume that this duty exists. Who can become a company director? Subject to a number of exceptions noted below, any person who is over the age of eighteen years can act as a company director. The exceptions, unless a Supreme Court or Federal Court says otherwise, include: (i) insolvents under administration (ie. bankrupts and persons in similar situations relating to financial difficulties); Page 278
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(ii) (iii) (iv) a person convicted of a fraud (for five years after being released from prison); a person convicted of certain offences under the Law; and a person ordered by a court to not act as a director of a company on the basis that the person has repeatedly breached the Law or is a director of a company that has repeatedly breached the Law and the director has failed to take reasonable steps to prevent this from happening.
What happens if a company is in financial trouble? A director of a company is subject to a special duty to ensure that the company does not trade and incur further debts while it is insolvent. The director must prevent the company from incurring the debt if there are reasonable grounds for believing that the company is insolvent at the times that it incurred the debt, or will become insolvent as a result of incurring the debt. "Insolvent" means unable to pay its debts as and when they fall due. A director who breaches this duty will be exposed to penalties under the Law and may be personally liable for the debts of the company. It is not possible to set out a complete treatise on when a debt owed by a company will become due and payable. However, if you have doubts regarding the debts that are owed by a company that you are a director of, or have been a director of, you should immediately seek legal advice as to your position. A director may be able to avoid being liable for the debt if it can be shown that the director actually believed that the company was able to pay the debts and that there were reasonable grounds for believing this to be so, or that the director took all reasonable steps to prevent the company from incurring the debt. An absence of financial information regarding the company, or the excuse: "we are not responsible for that side of things", will not help a director of an insolvent company. Each director is responsible for what happens to the company in this situation. The courts are very unforgiving here. The case law includes the case of an old Italian lady who signed on as a director of a company owned by her son and then found herself being sued by the company's creditors. The fact she did not involve herself in the day-to-day affairs of the company and had no understanding of finance generally nor of the financial position of the company did not make any difference. The courts held she failed to exercise the level of skill expected of a reasonable director and that a reasonable director would not have permitted the company to incur the debts and would have believed the company to be insolvent. She lost her home. This may sound like a harsh result. What about the creditors? They are entitled to believe that someone is responsible for the actions of the company, and there is no policy reason why age and commercial naivet should change this result. A final thought The above paragraphs may, at first blush, appear to be saying "its hard to be a director of a company". But this is not really so. A director who gets involved with the company, acts honestly, seeks advice where necessary, and is open with the company and always puts the company's interests ahead of his own is most unlikely to find being a company director a hard task to discharge. January 2002 Page 279
8.4 The taxation of private companies
There are many excellent references explaining the taxation of private companies and we do not wish to repeat their content here. Instead we set out a basic overview of the main taxation rules applying to private companies. The idea is to flag areas of concern so a reader can refer to more specific and comprehensive texts for a full explanation. Readers should be aware companies are not efficient vehicles for holding investments. It is normally a better idea to have the company act as a trustee of a discretionary trust or a unit trust that runs the business or holds the investment. Trust structures are more flexible and generally lead to less tax being paid than is the case under a company structure. Most companies do not pay income tax: they only act as trustee of a trust. These companies are not required to have a tax file number or lodge a tax return in their own name but, of course, must lodge a tax return in their capacity as trustee of the trust. The basic idea A private company is a taxpayer. It is required to lodge an income tax return each year with the Australian Taxation Office ("ATO"), like any other taxpayer. This return will show assessable income, allowable deductions and, therefore, taxable income. It will also show any tax credits or rebates available and tax payable by the company. The tax is payable under an instalment system. Details are set out below. An income tax assessment is deemed to arise on lodgment of the company's annual tax return. The general provisions in the tax law apply to private companies unless specifically excluded. These include rules for objections, penalties, amendments, self assessment, dividend imputation, foreign tax credits, carry forward tax losses, the derivation of income, capital gains and so on. Often these rules are subject to limitations. For example, the carry forward of tax losses is subject to conditions regarding continuity of beneficial ownership and continuity of business. Some rules only apply to companies. An example is the special rule regarding an extra deduction for eligible research and development expenditure and research and development buildings. Another example is the loss transfer rules for wholly owned companies. The computation of taxable income Assessable income is calculated according to ordinary concepts. It also includes specific amounts deemed to be included in assessable income by the Tax Act, such as a net capital gain and franking credits. The assessable income of a company normally comprises business income, interest, dividends, rents, and net capital gains. The rules for computing the amount of these items are largely the same as for other taxpayers. Allowable deductions The general rules of deductibility of losses and outgoings applying to most taxpayers apply to companies. This essentially means any losses or outgoings incurred in production of assessable income will be allowable deductions unless they are capital in nature. If the loss or outgoing is capital and comprises depreciable plant and equipment a depreciation claim will be available over the estimated useful life of the plant and equipment. The company tax rate The company tax rate is 30%. This is lower than the top marginal tax rate of 47%. The marginal tax rate faced by individuals exceeds the company tax rate at an assessable income of about $60,000. This is why many people limit their salary income to January 2002 Page 280
$60,000 per individual and lock the rest of the business' profits up in a company, whether as a corporate beneficiary or otherwise. The company tax instalment system Companies are required to pay income tax under an instalment system. The basic idea is companies self assess their income tax and pay income tax at prescribed times depending on their level of income. Planning for instalments A new company will always have a likely tax of nil, since it will not have a previous year's taxable income. This means a new company with a taxable income above $7,999 will not be required to pay income tax until 1 March in the following year. This is a significant deferral and can create a tax planning incentive to roll a business or investment generating a high level of taxable income to a new company or to introduce a new corporate beneficiary into a trust based structure. Intercompany dividend rebates A rebate applies to private companies receiving dividends from other private companies provided the dividend is franked or each company is in the same group (ie have 100% common ownership). Rebatable dividends are effectively tax-free because the rebate offsets the tax on the dividend. Dividends should not be paid to a private company with tax losses as the benefit of the rebate will be lost. The imputation system Prior to 1987 Australia had a classical system of taxing company profits. The company paid tax on its profits (at rates of up to 46%) and the ultimate individual shareholders paid tax on dividends (at rates of up to 67%) without relief for tax previously paid by the company. This meant the effective tax rate on profits could be as high as 82%. Its no wonder a tax avoidance industry flourished. This has now changed. The company tax rate is down to 36% and the ultimate individual shareholders can claim credits for the tax paid by the company. This is known as the imputation system of taxing company profits. A simple example may help explain how the imputation system works. Assume a company makes a before tax profit of $3,000 and pays a fully franked dividend. The company has three shareholders. The first shareholder has other taxable income of $50,000, the second shareholder has other taxable income of $20,000 and the third shareholder has no other taxable income. The benefit of the franking credit will depend on the level of other income derived by each shareholder. This is shown as follows: Companys Position Company Profit Before Tax Tax Payable by Company at 36% Company Profit After Tax $ 3,000 1,080 1,920 $ 3,000 1,080 1,920 $ 3,000 1,080 1,920
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Shareholders Position Cash Dividend Franking Credit Amount Included in Assessable Income Total Income Tax on Total Income Less: Franking Rebate Net Income Tax Payable Tax on Other Taxable Income (before dividend) Additional Tax Paid on Franked Dividend Shareholder One $ 640 360 1,000 _____ 51,000 14,572 360 14,212 14,102 ______ 110 Shareholder Two $ 640 360 1,000 _____ 21,000 3,162 360 2,802 2,920 ______ (118) Shareholder Three $ 640 360 1,000 _____ 1,000 Nil 360 Nil Nil _____ (Nil)
The shareholder with other taxable income of $50,000 has to pay extra tax of $110, since the marginal tax rate is above 30%. The shareholder with other income of $20,000 has an excess franking credit of $118, since the marginal tax rate is below 30%. This excess franking credit shelters other income from tax and any remaining excess is refunded. Planning for imputation credits Simple ground rules can help get the best result from the dividend imputation system: (i) (ii) having all or some of the shares in the company owned by a discretionary trust. The trustee can distribute the franked dividends and attached credits included in trust net income to the beneficiaries who can best use them; stopping salary to owners and paying owners through fully franked dividends instead. This generates cash flow advantages as the company can stop paying group tax and instead use its franking credits. This can also help clear loan accounts. A person with no other income can get about $60,000 of cash dividend each year fully franked without any further income tax being paid on the $60,000.
Capital gains tax Appreciating assets, ie assets expected to go up in value, should not be held in companies. This is because once the assets are sold at profit: (i) (ii) it is very hard to draw the cash out of the company without triggering a tax charge (this is compared to discretionary trusts and unit trusts); and the tax-free component of a capital gain cannot be paid without triggering a tax charge.
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8.5 Common questions and answers
This part of the manual considers common questions on a range of matters relevant to directors of companies and other people involved in small companies. It deals with common questions and areas of concern. It is not a complete coverage of all areas of relevance and once again, we suggest readers obtain legal and accounting advice before using their companies in any way. This part of the manual was written in 1997 before the start of new rules dealing with the replacement of articles of association with constitutions and related changes. These changes do not materially change the following comments. How do you set up a new company? This is usually done by ordering a company from a provider. Although there is a bit more work involved in incorporating a new company from scratch it's easier and quicker to do it this way if you want a special name. If the company's name doesn't matter it's simplest to order an existing company. The people setting up the company apply to the ASIC for the company to be registered. Since December 1995 a proprietary company limited by shares need only have one initial director and one initial shareholder. Details of that person (ie date and place of birth, address, occupation and details of any public company directorships) and details of the proposed company's articles and memorandum of association are lodged with the ASIC. The proposed memorandum of association will set out: (i) (ii) (iii) (iv) the company's name, the addresses and names of the first shareholders; the total amount of the share capital and its classification; and a statement that the shareholders' liability is fixed.
The constitution controls the relationship between the company, its shareholders and the directors. Procedures for meetings, procedures for voting, details of who can be a director and other housekeeping matters are covered in the articles of association. A company may adopt the standard constitution set out in the Law instead of adopting its own if it wishes to do so. What's in a name? A company can have any name provided it is not offensive or already used by another company. There is no special rule to stop a new company having a name very similar to an existing company name. However, doing this is normally not recommended. Should the new company pass itself off as the existing company the new company may face legal action under tort law or the Trade Practices Act. The words "Proprietary Limited" or "Pty Ltd" must be included in every company name. The company's name must be displayed outside every place that it carries on business that is open to the public or at its registered office. Most companies have the accountant's office as a registered office. A company may change its name. This requires reservation of the new name January 2002 Page 283
with the ASIC, a special resolution and, finally, the approval of the new name by the ASIC. If a company carries on a business under another name it must register that other name under the relevant business names legislation in each state. There is no need to register the company's own name under that legislation. What's in a number? The ASIC gives each company an Australian Company Number ("ACN"). This is a nine-digit number to identify the company that is used as a code for the company by the ASIC. The ACN must appear on the company's seal, most of its public documents, its cheques and all ASIC documents. As a general rule, if you are unsure of whether an ACN is required its a good idea to show it. There are no penalties for using an ACN where it is strictly not required but there are penalties for not using an ACN where it is required. The ACN must appear on the company's seal. It is possible for a company to use its ACN as its name. Companies that are incorporated under a special Act will have an "Australian Registered Body Number" rather than an ACN. The Law permits "Australian" to be abbreviated to "Aust.", "Company" to "Co.", and "Australian Company Number" to "ACN" or "A.C.N.". What is a common seal? The common seal is the plastic and rubber stamp included in the company's corporate register. It must show the company's name and its Australian Company Number. The application of a company's seal to a document, properly witnessed by directors and company secretaries, generally has the same significance and status as the signature of a natural person on a document. The use of the company seal must be properly logged in the company's seal register, which is included in the corporate register. A director and a company secretary or two directors must witness the application of a seal. In the case of a one-person company where the one director is also the secretary, that person can sign as both the director and the company secretary. It is not mandatory for a company to have a company seal, although most do. Under recent Corporations Law changes companies do not need to have a seal but most do, and the practice of recording the companys agreement to a document by applying its seal and having one or two directors sign has continued. What is a pre-incorporation contract? Occasionally the proposed directors of a new company will commit the company to a course of action before the company is formally incorporated. This commitment creates a "preincorporation contract". For a pre-incorporation contract to be binding on the company the company must ratify the contract. If this does not happen the person who committed the company may be personally liable under the contract. It is a good to make sure the company is not committed to any course of action prior to its incorporation. If for any reason this must happen, the pre-incorporation contract should be ratified as soon as possible after incorporation. What can other people assume about the company Once the company is incorporated a person dealing with it is entitled to assume it has legal capacity unless the person knows, or ought to know, otherwise. This is called the doctrine of January 2002 Page 284
ostensible authority. For example, under the doctrine of ostensible authority a person dealing with the company is entitled to assume that: (i) (ii) a person shown in an ASIC notice as a director or company secretary has been properly appointed and is authorized to act for the company; and a person held out by the company to be a company director, company secretary or agent has been properly appointed and is authorized to act for the company.
The doctrine of ostensible authority allows other people to deal with the company with confidence that its representatives are authorized to act for it. It highlights why you should only allow people you know and trust to be directors of your company. How do you know who a director or company secretary of a company is? You can access the ASIC's database to search for the details of the directors and company secretary of any company incorporated in Australia. On-line access fees and professional fees may be charged for this information. It is a good idea to obtain a company search on any company with which you deal on a significant basis, particularly if you are giving them credit for goods or services supplied. Who are the first director and the first company secretary? The shareholders appoint the first directors. The directors appoint the first company secretary. Any person who becomes a director or a company secretary must consent in writing to the appointment. The resignation of a person as a director or a company secretary must be in writing. It is common for the company secretary to be a director. Where is the registered office? Every company must have a registered office. The registered office is often the accountant's office. This is because it is the accountant who attends to the administrative matters and the accountant's office is open to the public during normal working hours. But this is not a legal requirement. The registered office must be in Australia. If the company does not occupy the premises used as the registered office the occupier must consent in writing to the company having the premises as its registered office. The registered office must be open for at least five hours each working day between 10.00 am and 4.00 pm unless alternative arrangements are made with the ASIC. The company's name and ASIC must be shown at the registered office. The ASIC must be notified of any change in the registered office within seven days of the change occurring. What is the "corporate register"? The corporate register is a folder of documents containing the records of the company and the various registers to be maintained under the Law. The register may be kept electronically provided it can be printed in English in hard copy. The corporate register is normally maintained by the accountant and is normally kept at the accountant's office. The ASIC audits corporate registers. The directors of the company are responsible for the proper maintenance of the corporate register. This responsibility continues even if the task is delegated to the accountant. What specific registers must be kept? January 2002 Page 285
The company must keep a number of specific registers. These include the seal register, the register of shareholders, the register of option holders, register of debenture holders, register of prescribed interests and the register of charges. These registers must be kept at the registered office unless the ASIC is advised otherwise. The seal register is a register of the documents to which the seal has been applied. The register of shareholders is a record of the shareholder information including the names and addresses of its shareholders and details of shares held by individual shareholders. The register of option holders, the register of debentures and the register of prescribed interests are similar to the register of shareholders. The register of charges is a record of the charges, including mortgages, given by a company to a creditor or a financier over its assets. What happens if a shareholder has a disagreement with the company? Disagreements may arise where a shareholder is a minority shareholder. A disgruntled shareholder in this position has a number of options. These include: (i) (ii) putting up with the problem; negotiating with the majority shareholders so that: (a) the majority shareholders cease the action complained of; (b) the majority shareholders compensate the disgruntled shareholder; (c) the majority shareholders buy the disgruntled shareholder's shares; (d) the disgruntled shareholder buys the majority shareholder's shares; or (e) the company buys back the disgruntled shareholder's shares. if (i) and (ii) do not work, or are not commercially feasible, apply to the Supreme Court for an order to wind the company up or to appoint a receiver. This is a last resort in most cases because of the high cost involved in running a legal action like this that because of its very nature, will almost certainly be vigorously contested.
(iii)
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Can the company issue more shares? Yes, the company can issue more shares. This is done by a special resolution and executing appropriate minutes and preparing fresh share certificates. A form 207 "Notification of allotment of shares" must be lodged with the ASIC within one month of the allotment. Conditions can be attached to the new shares. For example, the new shares may have limited voting rights or may entitle the shareholder to priority in a wind up situation. The company should not issue new shares without getting legal and accounting advice. What paperwork is required each year? A company must lodge an annual return with the ASIC. This normally needs to be done by January 31 of the calendar year following the end of the previous calendar year. The return contains the following information: (i) (ii) (iii) (iv) (v) the name and address of each director; the name and address of the company secretary; details of issued shares; details of shareholders, including details of whether the shares are held beneficially; and the address of the company's registered office.
Often the ASIC sends a partly completed annual return to and complete send back to the ASIC. However, a company must lodge an annual return with the ASIC each year even if the ASIC does not send a partially completed annual return to the company. It is the responsibility of each director to make sure the ASIC return is prepared properly and lodged on time each year. The ASIC return must be accompanied by a cheque for $200.00 made payable to the ASIC. What happens if the company gets into financial trouble? If a company is in financial trouble the director may potentially be liable for any of the debts incurred by the company while in trouble as well as any specific debts covered by guarantees or securities. Therefore appropriate legal and accounting advice is the first consideration. Broadly speaking, if this advice is that the financial troubles are serious and are not going to be fixed easily otherwise, the director's broad options are: (i) voluntary administration. The directors can appoint an administrator to operate the company and to determine if the creditors and the company can solve the company's financial difficulties. This may include the company's creditors accepting payment of a reduced amount in satisfaction of all debts due to them, or allowing the company extra time to pay. It may also include the sale of an asset, such as a property, a business or a part of a business. If no solution emerges, and the company's financial position does not improve, the company will eventually be wound up; receivership. A receiver may be appointed by a court or by a secured creditor to take over some or all of the company's assets; and liquidation. A liquidator may be appointed by a court or by the directors of the company. The liquidator is required to: Page 287
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(a) (b) (c) (d) (e) (f) take possession of the company's assets; ascertain the company's debts; sell the company's assets; pay the creditors of the company (the Law sets out the order of payment); distribute the remaining assets (if any) to the shareholders in accordance with the articles of association and any arrangements between the shareholders; and to dissolve the company.
What accounts have to be prepared each year? The Corporations Law distinguishes between small and large companies in determining what accounting requirements need to be completed each year. A small company is a company that passes two out of the following three tests: (i) (ii) (iii) fewer than fifty employees at the close of the financial year; gross assets of not more than $5,000,000 at the close of the financial year; or gross operating revenue of not more than $10,000,000 at the close of the year.
The reporting requirements are relaxed for small companies. Most companies are small companies. All small companies must maintain accounting records sufficient to allow annual accounts to be prepared and audited. However, annual accounts do not need to be prepared and an audit is not needed unless the company is requested to do so by: (i) (ii) shareholders who together hold 5% or more of the voting shares; or the ASIC.
In this context "accounting records" means more than a collection of cheque counterfoils, receipts, invoices rendered and invoices received. It requires a systematic record of all of the company's transactions. Despite this relaxation of reporting requirements most companies are required to maintain more detailed accounting systems under laws other than the Corporations Law. For example, a company acting as trustee of a family trust will be required to maintain accounts under the trust deed and under trust law. The Income Tax Assessment Act also sets out detailed financial recording and reporting requirements for companies.
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How do you get a dividend? Companies may pass rewards to their shareholders in a number of ways. These include: (i) the payment of a dividend. This may be an un-franked, partly franked or fully franked dividend depending on the company's tax profile and the nature of its underlying profits. If a dividend is franked it carries with it a credit for the tax previously paid by the company. Fully franked dividends create interesting income tax planning opportunities. Your accountant can advise you further here; share buy back schemes. These are not very popular. The cost and complexity makes it prohibitive for most companies. They are really only options for larger companies; and liquidator's dividends. This can be an extreme way of getting money out of a company. Often the business and other assets of a company will be transferred to a new company before the old company is liquidated. Certain profits can be paid out to shareholders as a liquidator's dividend without a tax charge arising. Your accountant can advise you more fully on how and when this can be done.
(ii) (iii)
Shareholders may also enter into service agreements and supply contracts with companies. This can be a complex area and if it is done on any scale you should get specific advice as to how the arrangement should be structured and documented. When does the ASIC have to be notified of changes to the company? The company must notify the ASIC if certain events occur impacting the information maintained by the ASIC on its database. The following table sets out the major events that require ASIC notification. Event Period of Notice Form No: Section Reference (a) a company allots shares Within 1 month after 207 Section 187 the change (b) a company changes the location of Within 7 days of the 909 Section 216E a register change Section 1302 (c) a company changes the address of Within 7 days of the 203 Section 218 its registered office change (d) a company changes the opening Within 7 days of the 203 Section 218 hours of its registered office change (e) A company changes its directors or Within 1 month after 304 Section 242 company secretary the change (f) There is a change in the name or Within 1 month of 304 Section 242 address of the directors or the change secretary (g) The company gives certain charges Within 45 days of the 309 Section 263 charge being given
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How do you lodge documents with the ASIC? Most documents can be lodged by mail. Urgent documents should be lodged by hand at an ASIC Business Centre or a regional or state office. These documents include incorporation documents, documents recording charges over company assets and similar matters. A fee must accompany most documents. The fee depends on the document. How do you arrange a meeting of shareholders? A director may call a meeting of a class of shareholders or a meeting of all the shareholders of a company. The procedure for doing this, including required periods of notice, location, voting procedures, rules for proxies and so on are included in the company's articles of association. Certain minimum standards are set out in the Corporations Law. The chairman will be required to sign a minute of the meeting. This is a formal record of the meeting: where and when it was held, who attended, what was discussed and what was decided. The company is required to maintain these minutes in its corporate register. Who and what is a company secretary? Each company must have a company secretary. The company secretary is an officer of the company and is responsible for a number of matters under the Corporations Law. These responsibilities include maintaining correct details on the ASIC database and preparing and lodging an annual ASIC return. The directors appoint the secretary. The secretary must consent in writing to the appointment and the company must retain a copy of the consent. The ASIC must be informed of the appointment. The company secretary is often a director of the company. The company may have more than one company secretary. The company secretary must be at least eighteen years of age and at least one company secretary must reside in Australia. A company secretary may resign by giving written notice to the company. Written notice of the resignation must also be given to the ASIC. Cessation of business While a company is registered it must lodge an annual return with the ASIC and otherwise comply with the Corporations Law at all times. This is so even if the company is dormant. Sometimes a company will pass its use by date and for any number of reasons the directors or shareholders will be interested in winding it up. If the directors of a company wish to wind the company up they have two broad options. If the company has assets or liabilities it should be put in to liquidation. Liquidation is a complex area that is outside the scope of this booklet. Expert advice should be sought from your accountant if you believe liquidation is appropriate. Otherwise a simper option is to deregister the company. This can only be done if the company has no assets and all appropriate returns have been lodged with the ASIC. The company completes a form 528 "Application for deregistration of a defunct company" to ask the ASIC to use its discretion to deregister the company. Once the application is lodged the company must advertise a notice of intention to deregister in a daily newspaper in each state in which the company has carried on business in any of the previous five years. For obvious reasons the Australian newspaper is a popular choice here. A copy of the advertisement must be forwarded to the ASIC. If no one objects to deregistration the company will normally be deregistered by the ASIC three months later. Satisfied company charges January 2002 Page 290
Complex notification rules apply where a company grants a charge over all of some of its assets. Readers should ask their accountants or solicitors to advise on the procedures to be followed when a charge is created. When a company satisfies a charge it should lodge a form 312 "Notification of discharge or release of property from a charge" with the ASIC. Special resolutions If the shareholders pass a special resolution the company must complete and lodge a form 205 "Notification of resolution" with the ASIC.
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8.6 New rules for distributions from private companies
This memorandum was originally prepared as an article in the April 1998 edition of Medical Observer Business. Since then the law has been extended to include unpaid distributions for trusts. Introduction This memorandum considers new provisions of the Income Tax Assessment Act (The Act") applying to private company distributions made on or after 4 December 1997. The provisions are contained in the Taxation Laws Amendment Bill (No.7) 1997 that was introduced into the Parliament on 4 December 1997. For convenience, these provisions will be called "the new rules" and the old section 108 of the Act, which still applies to loans made up to 4 December 1997, will be called the "old rules". "New loans and "old loans" have corresponding meanings. In a nutshell The new rules include payments made by a private company to a shareholder or an associate in the assessable income of the shareholder to the extent there are profits in the company. The new rules also apply to back-to-back arrangements involving third parties, to debt forgiveness arrangements and to loan guarantees. The new rules do not apply to repayments of genuine loans, loans to other companies, payments that are otherwise assessable income of the payee, ordinary business loans and loans that are properly documented with specified minimum interest rates and specified maximum terms. The rules apply to all loans and payments made after 4/12/97. An old loan can become a new loan if its term is extended or it is increased. The capitalization of interest increases a loan amount and converts the old loan to a new loan. The new rules apply to loans that are forgiven even if the loan arose before 4 December 1997. Loans and payments assessed under the new rules cannot be franked. However, they trigger a debit in the company's franking account and therefore penalize the company and the shareholder. This comprises a very serious financial cost. What was wrong with the old rules? The old rules intend to stop companies distributing profits to shareholders as tax-free loans and other advances or as other amounts credited to shareholders and associates. The old rules require the Commissioner to form an opinion that an advance or a loan to a shareholder or an associate is in substance an intentional distribution of profits. The first problem is the requirement for the Commissioner to form an opinion. Under self-assessment this meant the old rules were in effect only applied in a tax audit, which limited their practical significance. In the Australian Tax Practice Weekly Tax Bulletin for 26 January 1998 Wouter Scholtz identifies four other problems with the old rules. These are:
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(i) (ii) (iii) (iv) when was there a getting in of money, to imply the loan was not intended to be repaid? when was there a distribution out of profits, particularly when the accounts do not show a profit? when was there no intention or capacity to repay, particularly if some amount is repaid from time to time or some other indicia of loan exists? certain back-to-back loans.
How are these problems dealt with in the new rules? The first problem is dealt with by removing the requirement for the ATO to form an opinion that an advance or a loan to a shareholder or an associate is in substance a distribution of profits. The new rules apply automatically, and do not require an audit or a similar event as a trigger. This is particularly concerning because under self assessment taxpayers are required to measure their own assessable income and return this in their tax returns. The new rules reverse the onus, to apply as of right rather than as an exception. Advisors are, of course, subject to a duty of care and a contractual duty to advise clients on the correct measure of assessable income and the related income tax liability. This reversal is accompanied by a more stringent set of definitions that generally do not require any intention on the part of the company and the shareholder. These definitions create strict rules that apply almost automatically to assess a loan or payment unless it falls into one or other of the specified exceptions. The intention of the company and the shareholder is irrelevant under the new rules. The Government believes about one quarter of businesses run through private companies will be effected by the new rules. There will be much greater compliance as the onus is shifted from the Commissioner's opinion to automatic compliance by taxpayers on the advice of accountants under the self-assessment regime. The new rules The pivotal section is section 109C(1). It says: "A private company is taken to pay a dividend to an entity at the end of the private company's year of income if the private company pays an amount to the entity during the year and either: (a) (b) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been a shareholder or associate at some time."
Such amounts will be included in the shareholder's assessable income under section 44. This rule is augmented by sub-sections 109C(2) to (4) which:
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(i) (ii) (iii) limit the amount of the deemed dividend to the amount of the company's distributable surplus [(s109C(2)]. The concept of "distributable surplus" is discussed below; deem a payment to include payments on behalf of an entity, crediting an amount for the benefit of an entity and the transfer of property to an entity [s109C(3)]; and introduce an arms length value rule for non-cash transactions [s109C(4)].
"Loan" is widely defined. It includes all the things normally thought of as loans, advances or provisions of credit as well as transactions that in substance affect a loan of money [s109D(3)]. The giving of a guarantee is deemed to be a payment under rules set out in section 109U. Back to back loans, payments or guarantees involving interposed third parties are deemed to be loans, payments or guarantees to the end party (s109T and s109U). A loan is made at the time the loan is made or the other transaction occurs [(s109D(4)]. These inclusive rules are subject to a number of exclusions. These are: (i) (ii) (iii) (iv) (v) (vii) payments of genuine debts (s109J); payments to other companies (s109K); payments that are otherwise assessable income (s109L); loans to other companies (s109K) other than as a trustee (s109ZE); loans that are otherwise assessable; loans made in the ordinary course of business on ordinary commercial terms (s109M); loans that are appropriately documented with certain minimum interest rates and maximum terms (s109N). Currently the minimum interest rate is 7.5% and the maximum term is 25 years if appropriately secured by a registered mortgage over real estate. The security must not exceed 90% of the value of the property less any other loans secured by the property. In other cases the term of the loan cannot exceed 7 years. Failure to make the minimum payment may mean the whole of the loan is assessed as a dividend in the year the failure occurs. Certain loans must be amalgamated and treated as one loan for these purposes; and loans repaid before 30 June in the year they are created, subject to avoidance rules that apply if a loan is repaid before 30 June and redrawn shortly after.
(viii)
The concept of a "distributable surplus" The amount of deemed dividends cannot exceed a company's "distributable surplus". This term is defined in section 109Y(2) to be a measure of accumulated profits based on balance sheet items. It is a measure of the accumulated net wealth in a company after share capital. It is measured by: (i) (ii) the excess of the book value of a company's assets over its liabilities at 30 June; less the paid up share capital of the company, including any share premium reserves, less the amount of any loans deemed to be dividends in prior years under the new rules. Page 294
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The ATO may adjust the book values of liabilities and assets in a company's balance sheet if he believes they significantly undervalue assets or overvalue liabilities. This means the measure is effectively based on the market value of assets and liabilities, not book values. The measure also includes unrealised profits. Debt forgiveness The new rules deem certain debts forgiven after 4 December 1997 to be dividends. This is so even where the debt arose prior to that date. A debt is forgiven if the debtors is extinguished, the company loses its right to recover the act due to the effluxion of time or similar event, or the debtor is released from an obligation to repay the debt, whether or not this release is legally enforceable. A reasonable person test is created under each of sections 109F(5) and 109F(6) to apply where there is some doubt as to the intention of the parties to replace the debt. The exceptions to the general rule deeming forgiven debts to be dividends are: (i) (ii) (iii) (iv) a debt owed by another company other than as a trustee [s109ZE]; where the debtor becomes a bankrupt or enters into Part X arrangement under the Bankruptcy Act; where the forgiven loan has previously been deemed to be a dividend under the new rules; and where the ATO exercises a discretion to exclude the forgiven loan on the basis of an original genuine intention and capacity to repay a debt followed by a loss of capacity to repay the debt because of circumstance beyond the debtors control.
Debt guarantees The guarantee of a debt by a private company for the direct or indirect benefit of a shareholder or an associate may be a dividend in the hands of the shareholder under section 109U. Little guidance is given as to how this will work in practice. The example given in the Explanatory Memorandum involves a company guaranteeing a debt owed by a shareholder to a bank. The company is treated under section 109T and section 109W as if it has made a payment to the shareholder. This rule does not apply to a guarantee for another company other than a trustee.
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Practical problems with the new rules The media has reported many evidently unintended applications for the new rules. Mr Robert Warnock, Legal Counsel for the National Tax & Accountants Association has described the new rules as "steam roller legislation" designed to crack nuts. He notes the new rules apply to a wide variety of almost absurd situations, including shareholder/employee benefits charged to fringe benefits tax where an employee contribution reduces the taxable value of the fringe benefit to nil, certain exempt fringe benefits and certain superannuation payments. Mr Rodney Rosenblum, in a letter to the Australian Financial Review published on 3 March 1998, notes a series of factual situations where the new rules appear to have unintended applications, including the taxing of a payment made by a company to a shareholder in consideration for the transfer of an asset at market value: the new rules do not provide relief for the value of the transferred asset. Similar problems have been reported elsewhere. Realistically the more extreme of these problems will disappear as the new rules are fine tuned to remove unintended consequences. One easily expects double taxation rules and market value consideration rules to be introduced to remove these anomalies. Maureen Muriel reported in the Age on Monday 2 March 1998 that discussions were occurring and the Commissioner had said "the discussions were constructive and the tax office recognized the problems and inequities. More profoundly Excess attention to these matters shifts focus from the more profound issues for advisors. These are: (i) the wide potential application of the rules to everyday transactions which do not comprise an in substance dividend to shareholders. An example is the debt guarantee rules: it is common practice for a bank to require private company shareholders to guarantee the debts of the company. Conversely, it is just as common for the company to be required to guarantee the debts of the shareholder since typically the wealth of . In many cases the mutual guarantees comprise a net detriment to the shareholder, rather than in an substance dividend, but the debt guarantee rules do not reflect this; how the new rules will apply to unpaid distributions to company beneficiaries from discretionary trusts. The better view seems to be there is no application because the transaction creates a bare trust rather than a loan. The Arthur Andersen Private Client Services newsletter for January 1998 says the Commissioner of Taxation has orally advised the new rules are not intended to apply to corporate beneficiaries, but the newsletter does not say why; the strong reasons to avoid private company structures, compared to trust based structures, wherever possible on account of their rigidity and lack of tax planning flexibility. The high cost of deemed unranked dividends under the new rules strengthens the arguments against companies significantly. the potential application of the new rules to discretionary trusts and unit trusts if trusts are taxed as companies. The Age newspaper on Tuesday 24 March 1998 reported the Treasurer Mr Peter Costello as saying this was a likely development under the current tax reform processes; and Page 296
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(iii)
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(v) the need to properly document all loans subject to the minimum interest rate and the maximum repayment terms before 30 June 1998.
General planning issues The new rules raise a plethora of planning points to ponder. The most obvious point is to ask "are the new rules all that difficult to work with?" In many cases the answer will be "No.". For example, under the old rules a large loan to a shareholder always had some doubt about it. What would happen if the Commissioner of Taxation looked at? Some advisors took this too far and just assumed any debit loan to a shareholder was suspect, without asking whether it was in truth a distribution of profit to a shareholder or a real loan or something else. Now there can be some certainty. One recent example involves a medical practice company with accounting losses of $100,000 attributable to the amortization of goodwill. This company does not have a distributable surplus. This means the company can lend the shareholder's family trust $100,000 without the new rules applying to the loan. The loan to the shareholder's family trust will be used to pay out unpaid distributions to beneficiaries. The loan has been documented to evidence the transaction and to record the deductible purpose of the loan for the family trust. The interest paid by the family trust will be deductible and the interest derived by the medical practice company will be assessable, so the transaction is tax neutral. Loans to companies other than trustees are not covered by the new rules, which remove some areas of potential concern under the old rules. Bear in mind the new rules do not apply to documented loans which carry interest at 7.5% or more and which have a term of no more than seven years if unsecured and twenty five years if secured by a registered mortgage against appropriate real estate. The secured loan must not exceed 90% of the value of the property less any other loans secured by the property. The registered mortgage does not have to be a first mortgage. It can be a second or third mortgage. This rule will create many planning opportunities: it is not hard to imagine twenty five loans to shareholders at 7.5% interest being the preferred cash extraction option for, say, large unranked profit reserves created by realized or unrealised capital gains. Taking the cash now, and paying 7.5% interest afterwards, may be a much better alternative than receiving an unranked dividend for a 47% tax rate shareholder. Other thoughts include: (i) old loans may need to be charged interest to prevent the old rules from applying or to negate a loan fringe benefit's taxable value under the Fringe Benefits Tax Assessment Act. A failure to actually pay the charged interest, ie the capitalization of interest, can comprise an addition to the old loan so the old loan becomes a new loan. Perhaps a new loan can be drawn under the new rules (and documented appropriately) and the cash received used to pay interest due on the old loan; whether a loan should be repaid, in cash or otherwise before 30 June 1998 to remove any chance of the new rules applying. Simplicity has its attractions; whether to repay a new loan by the declaration of a dividend under section 44, so the assessable amount is covered by franking credits. If a dividend must be included in assessable income it seems sensible to make sure franking credits can be claimed and are not needlessly lost. Care should be taken to be able to prove the dividend was declared before 30 June and not afterwards: if not the ATO may ignore the declaration and treat the loan as standing at 30 June and assess it as an unranked dividend; whether it is possible to convert private companies to trust based structures or to Page 297
(ii) (iii)
(iv)
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introduce profit extraction through service trust arrangements. If this is done the cash extraction advantages of trust-based structures can be achieved without regard to the new rules. In both cases the potential application of the general anti-tax avoidance rules and the capital gains tax rules needs to be considered. Generally the arguments in favor of trust-based structures are strengthened by the new rules; (v) bear in mind the old rules still apply to old loans, ie. loans made before 4 December 1997. An old loan can still trigger a tax charge. However, new loans should be repaid first because, generally the new rules are more easily triggered than the old rules; and whether superannuation contributions, both deducted and undeducted, and untaxed fringe benefits should be deferred until, and if, the anomalies noted above are removed and the law is clarified.
(vi)
Unpaid distributions from trusts When the private company loan rules were first introduced, for technical reasons they did not apply to "loans" from trusts created by unpaid distributions. The law has merged, and now they do. Distributions from trusts to companies must be paid out to the company to be effective for tax purposes.
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8.7 Use of the company seal
We are often asked how and when a company seal should be used. This was made more complex in recent years with the introduction of one-person companies (1997) and the abolition of the strict requirement that a company have a company seal (1998). The Company Law Review Act 1998 The Company Law Review Act 1998 changes the ways a company may execute (ie sign) documents. Under section 123 it is no longer mandatory for a company to have a company seal if this is permitted by its articles and memorandum of association, which are now referred to as the companys constitution. More formally, company will not have a company seal if it was set up after 1 July 1998 and has adopted the model constitution set out in The Company Law Review Act 1998 or was set up before 1 July 1998 and has resolved in a meeting of its shareholders to change its constitution and dispense with a common seal. What if a company does not have a common seal? If a company does not have a common seal it should execute documents by having two directors or a director and company secretary sign the document. If the company is a one-person company (which most practice companies should be) the document may be signed by one person as both the sole director and the sole secretary. Any person signing for the company must print under their signature their name, usual address and the office they hold in the company. (Sub-section 127(1) of The Company Law Review Act 1998). What if a company does have a common seal? A company that does have a common seal should execute documents by affixing the company seal to the document in the presence of two directors or one director and one company secretary, or, in the case of a one-person company, the one director and secretary. (Sub-section 127(1) of The Company Law Review Act 1998). What else is required? The Corporations Law generally requires the use of the company seal to be properly recorded in the seal register. It is a good idea to consider and approve the proposed use of the company seal or signing of company documents in a meeting of directors called for this purpose beforehand. These minutes should be signed and stored in the companys register once completed. A draft minute of a meeting of directors is attached as an appendix.
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MINUTE OF A MEETING OF THE DIRECTORS OF THE SMITH SERVICE TRUST PTY LTD (ACN 000 000 000) HELD AT THE REGISTERED OFFICE ON 31 DECEMBER 1998 Present: Jack Smith Jill Smith Betty Smith Peter Smith
Capacity The directors met in the capacity of trustee of the Smith Unit Trust. Chairperson Jill Smith was elected chairperson. Previous minutes The minutes of the previous meeting were read and confirmed as correct. Cancellation of units The chairperson advised the meeting the Trust had been approached to cancel the units in the Trust issued to Smith Pty Ltd and persons connected to Smith Pty Ltd as at 31 December 1998. The chairperson noted that the meeting considered the requirements of the provisions of the Trusts deed regarding the cancellation of units. Resolutions The meeting resolved to approve the cancellation of the units in the Trust issued to Smith Pty Ltd and persons connected to Smith Pty Ltd as at 31 December 1998. Smith Pty Ltd shall retain all entitlements to the Trusts net income up to 31 December 1998. The meeting resolved to not follow the procedure set out in the Trusts deed regarding the cancellation of units and to waive any notice requirements or other restrictions on the cancellation of units contained in the Trusts deed or otherwise applying to this transaction. Peter Smith agreed to appoint the Chairperson as his nominee and attorney for the purpose of signing all other documents required to give effect to these resolutions. The meeting resolved that the signature of Peter Smith on this minute of a meeting shall be sufficient evidence of Peter Smiths consent to the above resolutions and to the appointment of an attorney. The chairperson was authorized to do all things necessary to give effect to these resolutions including making an appropriate entry in the unit register and attaching the company seal as appropriate. The resolution had the approval of all directors of the company. Closure There being no further business the meeting closed. Signed as a full and true record ............................................... Jill Smith Chairperson ............................................... Peter Smith
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9. 9.1 THE NEW TAX SYSTEM Introduction
This part of the manual explains how practitioners, dentists and other health professionals should prepare a business activity statement (BAS) and an instalment activity statement (IAS). We believe that this is not a hard task and that you will be able to do this by yourself quite easily, with minimum input (and hence fees) from us. We deliberately encourage clients to deal with the New Tax System on a do it yourself basis. This is because it is the cheapest and most efficient way to do this. The New Tax System is easier than the old tax system. The Goods and Services Tax (GST) is a simple tax collection system; its application to health professionals, where most services are GST free, is particularly simple. The new BAS system is simpler than the various separate tax collection systems it replaces. 9.2 Some BAS basics
This part of the manual explains the basic concepts behind the BAS and its basic mechanics. It is intended to provide a broad overview of the BAS before we look at the specific position of practitioners, dentists and other health professionals. What is a BAS? A BAS is a two-page form summarizing the information needed to pay your various GST, income tax and other tax liabilities or obtain a refund of the amounts already paid. The BAS deals with the GST and also replaces the paper work required to comply with up to eleven other tax collection systems operating before 1 July 2000. Of these, only three were usually relevant to practitioners. These were: (i) (ii) (iii) the group tax collection system, now replaced by the Pay As You Go Withholdings System (the PAYGWS); the company and superannuation fund instalment system, now replaced by the Pay As You Go Instalments System (the PAYGIS); the fringe benefits tax system (although most practitioners avoid lodging an FBT return by eliminating the taxable value of fringe benefits by loan account adjustments).
The BAS is more efficient than its predecessors: it reduces unnecessary paper work and streamlines the information required to discharge your tax liabilities into one document. The BAS does not replace your annual income tax return. Who has to lodge a BAS? If you are subject to GST, the PAYGWS, the PAYGIS or FBT you have to lodge a BAS at the end of each tax period (typically a quarter for practitioners but sometimes a month). If you are required to withhold more than $25,000 tax from salaries and wages you must also lodge a BAS each month. How do you get your BAS? January 2002 Page 301
The ATO will send you your BAS if you are required to lodge one. Some parts of your BAS will already be filled in by the ATO, and will include a pre-printed and unique document identification number. The pre-printed information will include details of the due date for lodgment of the BAS and the period it relates to. Your postal address for ATO purposes is now your home address and is no longer our office. This should speed up the receipt of your BAS and similar ATO documents. When is your BAS due to be lodged? Your BAS is due to be lodged within 21 days of the end of each tax period. When is a monthly BAS required? A monthly BAS is required where withholdings from salaries and similar amounts are more than $25,000 but less than $1,000,000 in the previous financial year. This monthly BAS only shows the PAYGWS details and does not show the other details included in the quarterly BAS. Example One A practitioner who paid more than $25,000 group tax on employees salaries and wages in the year ended 30 June 2000 is required to lodge a monthly BAS for July 2000 and August 2000. This BAS will show just the PAYWS details. The practitioner must lodge a quarterly BAS for September 2000. This BAS will show the PAYGWS details for the month of September 2000 plus the GST, FBT and PAYGIS details for the September 2000 quarter. Example Two A dentist who paid less than $25,000 group tax on employees salaries and wages in the year ended 30 June 2000 only needs to lodge a quarterly BAS. This BAS will show the GST, FBT PAYGIS and PAYWS details for the September 2000 quarter. Election to lodge a monthly BAS You may elect to lodge a full monthly BAS showing all details (ie GST, FBT, PAYGIS and PAYGWS details) rather than a quarterly BAS should you wish to do so. Please do not do this without first discussing it in detail with us. In the remainder of this manual you should assume a reference to a BAS is to a quarterly full BAS unless otherwise indicated. How do you lodge your BAS? You may lodge your BAS manually or electronically. The choice depends on what is most convenient for you. If you lodge your BAS manually you should mail it to the ATO address shown on the preprinted envelope shown on the pre-printed BAS form. It is a good idea to record this address for future correspondence with the ATO. If you lodge your BAS electronically you need to access the ATOs internet based electronic commerce system. If you have told the ATO you wish to lodge your BAS electronically you will have received an information pack explaining how to do this. This information is also available at the ATO website at www.taxreform.ato.gov.au or by contacting the ATO on 13 24 78. If you need help using the ATOs electronic commerce system contact the ATO on 1300 139 373. January 2002 Page 302
How do you pay your tax? If you lodge your BAS electronically you will usually be required to pay any amount owed to the ATO electronically. Full details of the ATOs electronic payment options and manual payment options are set out in appendix X of this guide. How do you get a refund? Many practitioners will receive a refund when they lodge their BASs. This is because the GST credit on their creditable acquisitions will be greater than the sum of their other tax liabilities. The excess will be refunded by the ATO. If you are due to receive a refund the ATO will make a payment into your bank account within 14 days of your BAS being lodged. Interest will be paid if the refund cheque takes more than 14 days to be sent. If you owe the ATO any money from other activities the amount of the refund will be offset against this debt. The refund will only be paid by direct credit to a nominated account with an Australian financial institution. You will have provided the details of this account to the ATO when you registered for the New Tax System. If you wish to change your nominated account you should contact the ATO on 12 24 78 with details of your new nominated account and proof of identity. What is an IAS? An Instalment Activity Statement (IAS) is similar to a BAS and must be used if you are not registered for the GST and subject to the PAYGWS or the PAYGIS rules described in this manual. For example, if you or a family member are employees, but receive investment income or trust distributions you may be required to lodge an IAS each quarter to comply with the PAYGIS rules. The IAS looks like a BAS, except it only shows information relating to your PAYGWS or PAYGIS obligations. It does not show information relating to the GST. The sections in this guide dealing with PAYGWS and PAYGIS are relevant to the IAS. The other sections in this guide are not relevant to the IAS and you do not need to read them if you are only required to lodge an IAS and not a BAS. In the remainder of this guide we do not make special reference to the IAS and only refer to the BAS.
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9.3 Practitioners and the GST
The topic of practitioners and the GST is covered in detail in our manual Medical and Dental GST Manual. You should have received a copy of this manual, but if for any reason you have not we suggest you contact us for a fresh copy. This part of the manual looks briefly at the broad application of GST to medical and dental practices as it applies to the BAS, emphasizing the practical aspects. This part of the manual does not consider service trusts and the BAS. Executive summary Completing the GST part of the BAS is a simple task for most practitioners and dentists. This is because the information required to do this is readily available and can be easily summarized and inserted into the appropriate label on the BAS. Practitioners and dentists do not need to complete all the labels on the GST part of the BAS. Most medical and dental services are GST free. This means the major point of interest for practitioners and is getting an appropriate GST refund as soon as possible. Most practitioners and dentists will have to complete at least two BASs: one for the practice entity and one for the service trust. Some will have to complete more than two BASs. Introduction to GST and the BAS Most medical services provided by practitioners are GST free. This means GST taxable supplies are nil or close to nil. Most exceptions arise where the practitioner does something other than treat the patient. These are well known and are not discussed here. The major GST point of interest for practitioners is claiming GST credits for the GST included in their operating costs, including capital costs. These costs are known as creditable acquisitions. The total amount of GST credits is shown at label 20 on the BAS. Getting the right GST refund as soon as possible will be a point of interest for most practitioners and dentists, particularly where the refund is greater than the amount payable under the PAYGIS and PAYGWS rules, leading to a net refund overall. The BAS form requires practitioners to complete 20 labels dealing with GST. Labels G1 to G9 calculate the value of taxable supplies and labels G10 to G20 calculate the GST credit on goods and services paid. Do you have to fill out each label? Probably not. If you choose the GST derived from accounts option whereby your underlying accounting records are satisfactory you only have to provide: (i) (ii) (iii) accurate figures at labels G9 and 1A to calculate your GST payable; accurate figures at labels G20 and 1B to calculate your total input tax credits; and reasonable estimates of the amounts required to be shown at labels G1, G2, G3, G10, G11 and G12. Estimates are satisfactory because these amounts do not impact the amount of GST payable and are only required for statistical purposes. Page 304
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The GST derived from accounts option: a convenient short cut This means the GST derived from accounts option is a convenient short cut. It makes the task of completing the GST part of the BAS much quicker and simpler than otherwise. In most cases the GST part of a practitioners BAS can be completed in a few minutes. This is a critical point to note: only labels G9 and G20 are critical for GST purposes. As long as these two labels are correct the GST section of the BAS can be completed without any fuss or great effort. The importance of this is hard to underestimate since it makes the task of completing the GST part of the BAS very simple. This is because: (i) Label G9 will tend to be nil or a very low figure for most practitioners, since it is basically the value of non-GST free medical services provided in the relevant period before GST times 10% (or the total of all non-GST free medical services including GST divided by 11). The value of G9 can be obtained by listing such services and multiplying the total by 10%; and Item G20 is the value of all creditable acquisitions (ie costs you paid that included GST) before GST times 10% (or the total of all costs you paid that included GST after GST divided by 11). The value of G20 can be obtained by listing these costs and multiplying the total by 10%.
(ii)
Otherwise you must use the GST calculation sheet option. This option requires you to must complete each of labels G1 to G20. This is not hard to do either, but will usually take a bit more time than the GST derived from accounts option. Whichever option you use, you must use the correct ATOs BAS form. Facsimiles, including documents prepared by accounting packages that look like the ATOs BAS form cannot be used. When can the GST derived from accounts option be used? The ATO has advised that the GST derived from accounts option may be used where the underlying accounting system is reliable and can accurately provide full details of all amounts shown on the BAS if required to do so and incorporates appropriate audit trails. If Medical and Dental Accounting Services Pty Ltd completes your accounts then you are able to use the GST derived from accounts option. This is because for each transaction involving a taxable supply we record the amount of GST you have to pay and bring this amount into a GST payable control account and for each transaction involving a creditable acquisition we record the amount of GST you are entitled to claim a credit for and bring this amount into an input tax credit control account. Software like MYOB and Quickbooks and their equivalents also satisfy these rules. A summary of the BAS GST labels A brief explanation of the labels and comments on their practical significance is a useful tool for getting to know the BAS. A draft BAS is included on appendix B of this manual so you can see what the actual document looks like. The 20 GST labels are located at the top of page 2 of the BAS. They are marked G1 to G20. January 2002 Page 305
Some require you to insert fresh data, and some are simply totals of other sets of labels or similar internal calculations. Labels G1 to G9 deal with the amount of GST due on your taxable supplies. For most practitioners this is nil or close to nil. Labels G10 to G20 deal with the amount of GST credits available to you. For most practitioners this will be a reasonably large figure and therefore the major point of interest. Some of the labels are used by the Government to collect statistical information to be used for various government purposes. Only labels 8 and 18 are critical and must be correct if your GST liability is to be correctly calculated. A brief tour of the GST part of the BAS is a useful way to get a handle on the issues faced by practitioners. All labels other than Label 9 and Label 20 are inclusive of GST. Labels 9 and 20 are amounts of GST payable or creditable. G1 Total sales & income & other supplies This is your total income from all sources during the tax period including GST charged on them, if any. It includes PPS payments and other blended payments (although we generally prefer these to be banked by service trusts where possible). The amount will usually be determined on a cash basis. That is, only the amounts received in the period will be shown, and opening and closing debtors should be ignored. G2 Exports (GST-free supplies) Practitioners usually do not have exports and can ignore label G2. G3 Other GST free supplies The amount of your GST free medical services received during the tax period should be shown here. If all your income is GST free medical services income and you have no other income then Label G3 should equal Label G1. G4 Input taxed sales & income & other supplies Practitioners usually do not have input taxed sales and can ignore label G4. Interest income and residential rent income should be shown here if these amounts have been included in the total income figure shown at item G1.
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G5 Add G2 + G3+ G4 This bit is easy. G6 G1-G5 This represents total taxable supplies. Ie, your total sales less GST free sales and input taxed sales. It should be a low figure unless your practice is providing a lot of non-GST free medical services. In some cases this figure will be nil, ie, where the practice is only providing GST free medical services and has no other income. G7 Adjustments This is mistakes or omissions from prior periods. G8 Add G6 + G8 This amount represents the total of your taxable supplies less adjustments. It for practitioners it will usually be a low figure since most medical services are GST free, and GST free services are not included in this figure. G9 Divide G8 by eleven This is the amount of GST payable, before the credits shown at item G20 are considered. This amount should be transferred to label 1A on page 1 of the BAS. G10 Capital acquisitions This is the sum of capital costs paid by the medical practice that have attracted GST. If you are using a service trust this amount should be nil since the service trust pays all capital costs and provides them to the practitioner under its management agreement. G11 Other acquisitions This is a badly captioned section. Other acquisitions means all non-capital costs ie expenses paid by the practice that have attracted GST. If you are not using a service trust this includes items like rent (assuming the landlord has turnover above $50,000 pa and is required to charge GST), consultants (but not salary and wages), utilities, consumables and similar costs. If you are using a service trust it should only be the amount of the service fees charged by the service trust. G12 Add G10 + G11 This is the total of all costs paid that have attracted GST. G13 Acquisitions for making input taxed sales & income & other supplies This will usually be nil for medical practices. If for any reason residential rent has been included at label G4 Input taxed sales & income & other supplies the any costs that relate to this income should be shown at item G13. See appendix X for a list of common items. G14 Acquisitions with no GST in the price This amount includes supplies that are GST free or input taxed. Examples are superannuation contributions and interest paid or rent on commercial premises where the landlord has not registered for GST.
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G15 Total of estimated private use of acquisitions + non-income tax deductible acquisitions This is self-explanatory. G16 Add G13+G14+G15 This is self-explanatory too. G17 G12 minus G16 This is the total of creditable acquisitions. G18 Adjustments This is mistakes or omissions from prior periods. It should be nil in your first BAS. G19 Add G17+G18 This is the total of creditable acquisitions after adjustments. G20 Divide G19 by 11 This is the amount of your credit for GST paid. This amount should be transferred to label 1B on page 1 of the BAS.
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9.4 Service Trusts and the BAS
Service trusts are enterprises for GST purposes and must complete and lodge a BAS with the ATO each quarter and if the service trusts withholdings on salary and wages and similar amounts exceeded $25,000 in the prior year the service trust must also complete and lodge a BAS showing its PAYGWS details each month. Service trusts are usually not subject to the PAYGIS because they usually do not pay income tax. However, income derived by the service trust is treated as distributed to beneficiaries (including unitholders in the case of unit trusts). The general comments in this guide apply to service trusts as much as any other entity. The following comments draw your attention to specific issues regarding service trusts; (i) the service trusts income should consist largely of management fees charged to the lead medical practice(s) and, in some cases, to other practitioners to whom the service trust provides services; the service trust should pay all costs connected to the lead medical practice(s) other than salaries to practitioners. The lead medical practice(s) should only pay salaries to practitioners and possibly similar costs such as superannuation contributions. Bank charges and certain other small dollar value costs will also tend to be incurred, but these should be paid by the service trust, and not the lead medical practice, wherever possible. Following this simple rule simplifies the BAS for each of the lead medical practice and the service trust (and also means the service trust arrangement will be accepted for income tax purposes); the service trust will usually be required to prepare its BAS on a cash receipts basis. This means it is a good idea to pay all invoices before the last day of the quarter to ensure all GST credits are available as soon as possible. It is also a good idea to have the medical practice pay the service trusts invoice for management fees before the last day of the quarter, so the medical practice is able to claim a GST credit for the GST included in the service fees for that quarter (ie usually three monthly invoices); a common question relates to the treatment of GST paid by the service trust, and whether the GST inclusive amount should be invoiced by the service trust to the medical practice. Arguments can be made either way. The attraction of the yes answer is that a lot more income can be shifted to the service trust and this is generally a good thing. But on balance at present we are recommending no, meaning the costs invoiced back to the practice company should not include the GST component. This is a deliberately conservative approach and we are keeping the question under review.
(ii)
(iii)
(iv)
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9.5 The Pay As You Go Instalment System PAYGIS
This part of the manual to the BAS is broken into three sub-parts. These are Part X.1 Overview, Part X.2 Partnerships and the PAYGIS and Part X.3 Trusts and the PAYGIS. Overview The PAYGIS is part of the new tax system that started on 1 July 2000. The PAYGIS replaces the provisional tax system, the company tax instalment system and the superannuation fund instalment system. It requires clients who have income other than salary income and capital gains, ie, investment income or business income, to pay tax on a quarterly basis during the tax year. The PAYGIS replaces the provisional tax system and the company and superannuation fund instalment system. The PAYGIS instalments are notified to the ATO in your Business Activity Statement. Who pays PAYGIS instalments? Anyone who has registered for the GST, has investment income or has business income. This includes most companies, superannuation funds and individuals. It does not normally include trusts and partnerships. If your only income is salary and wages you do not pay PAYGIS instalments. When are the instalments payable? The payment is made on the due date for lodging the persons Business Activity Statement (BAS). In the case of the BAS for the quarter ended 30 September 1999 the first payment will be made on 11 November 2000, being the usual 21 days after the end of the quarter, plus the special three week extension to allow clients extra time to get used to the new tax system and its various requirements. Four PAYGIS instalments are payable for the 2001 year. These are due 6 weeks after 30 September 2000, five weeks after 31 December 2001, four weeks after 31 March 2001 and three weeks after 30 June 2001. The specific dates are: First quarter ending 30 September 2000 Second quarter ending 31 December 2000 Third quarter ending 31 March 2000 Fourth quarter ending 30 June 2000 Thereafter How is the instalment calculated? The instalment is equal to your instalment income times your instalment rate. What is Instalment Income? Your instalment income is your assessable income for the quarter. Assessable income is your gross income, ie your income before deductions, not your taxable income, ie your income after deductions. Instalment income includes your gross sales, your gross professional fees, your interest income, your rental income, your dividends and other types of business income or investment income. January 2002 Page 310 11 November 2000 4 February 2000 28 April 2000 21 July 2001 21 days after the end of each quarter
Instalment income also includes your share of any partnership net income and any trust net income. In each case the amount to be included is equal to: Your income from the Trust/ Partnership last year Trust/Partnership's net income last year times Trust/Partnership's net income this quarter 1
Income from partnerships is dealt with in more detail in Part 5.2 and income from trusts is dealt with in more detail in Part 5.3. GST charged to clients, patients or customers is not included in instalment income. Salary and other income taxed at source are not included in instalment income. If you are not sure what is included in your instalment income please contact us for help. What is the Instalment Rate? The instalment rate is the rate of tax paid on your assessable income for the previous year. The effective tax rate reflects your deductions, so the higher your deductions the lower the instalment rate. The instalment rate is advised to you by the ATO in a notice sent out in July 2000. This notice is kept on our files. The instalment rate will appear on the pre-printed BAS forms sent to you by the ATO before the end of each quarter. The instalment amount will be added to any withholdings due on employee salaries and any GST paid on non-GST free medical supplies. This total will be reduced by the amount of any GST credit on the practitioners inputs (ie accountants fees etc) to determine whether the practitioner has to pay tax to the ATO, or is due a refund of tax from the ATO. What if you have not been notified by the ATO of your instalment rate? A person who has not been notified by the ATO of his, her or its instalment rate does not have to complete the PAYIS labels of the BAS. What does the instalment represent? The instalment will be credited against your tax liability for the 2001 year, in the same way provisional tax and company instalments were credited in previous years. Your final tax liability will not be known until your 2001 income tax return is lodged. Some examples A practitioner who practices in his own name had assessable income of $300,000 and costs of $200,000 in 1999. Tax on the profit of $100,000 at 2000 rates is about $32,000. The practitioner bills $80,000 in the quarter ending 30 September 2000. The practitioners instalment income is $80,000. The practitioners instalment rate is 10.66%, being $32,000 as a percentage of $300,000. The amount of the September 2000 instalment is therefore $8,528, being $80,000 times 10.66%. The practitioner will show his instalment income of $80,000 at label T1 on the back of his BAS, and the instalment rate at label T2 on the back of his BAS. The practitioner will show the amount of the instalment, ie $8,528, at label 5A on the front of his BAS.
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A superannuation fund had contributions income of $60,000 and investment income of $50,000 in 1999. Costs were $5,000. Tax on the profit of $105,000 is $15,750. Investment income of $20,000 is received in the quarter ending 30 September 2000. The funds instalment income is $20,000. The funds instalment rate is 14.30%, being $15,750 as a percentage of $110,000. The amount of the September 2000 instalment is therefore $2,860, being $20,000 times 14.3%. The fund will show its instalment income of $20,000 at label T1 on the back of its BAS, and the instalment rate at label T2 on the back of its BAS. The fund will show the amount of the instalment, ie $2,860, at label 5A on the front of its BAS. What if you expect to pay less tax in 2001? If you expect to pay less tax in the year ending 30 June 2001 you may reduce the instalment rate. But be careful, as there are significant penalties for getting it wrong. Do not do reduce the instalment rate without discussing the matter with us first. What if you expect to pay more tax in 2001? If you expect to pay more tax in the year ending 30 June 2001 you may increase the instalment rate. We generally do not recommend you do this. Can you elect to pay annual instalments? You can elect to pay annual instalments if your total tax for the year ending 30 June 2001 is expected to be less than $8,000. You should advise the ATO of this election at the time the first instalment is due (21 November 2000). You should not elect to pay annual instalments without discussing the matter with us first. PAYGIS and Partnerships Partnerships do not pay tax on the partnerships net income. Instead the partnerships net income is allocated to the partners who do pay tax on the partnerships net income. This means partnerships per se are not subject to the PAYGIS. But from 1 July 2000 individual partners who paid tax under the provisional tax system pay tax under the PAYGIS, and corporate partners who previously paid tax under the company tax instalment system pay tax under the PAYGIS. The partnership is required to estimate its instalment income for the period, and then each partner includes a share of this amount in his her or its BAS for that period. The amount of this share is based on the break up of the partnerships net income in the preceding year. In the September 2000 quarter this is calculated as follows: Partners share of net income for the year ended 30 June 2000 Partnerships instalment income for the year ended 30 June 2000 times Partnerships instalment income for the September 2000 quarter
The partnerships instalment income will comprise items such as total business income, distributions from other partnerships and trusts, gross rent, gross interest, dividends, and so on. It is calculated gross of deductions (with an exception for distributions from trusts and partnerships, which are in effect shown net of the trusts or partnerships deductions). The need for estimates January 2002 Page 312
It is quite possible that by 11 November 2000 the exact amount of the partnerships net income for the year ended 30 June 2000 will not be known precisely. If this is the case we recommend that a reasonable estimate of the partnerships net income for the year ended 30 June 2000 and the partnerships net income for the September 2000 quarter be used. Practitioners and dentists incomes tend to be predictable, so estimates will suffice. As the exact amount of the partnerships net income for the year ended 30 June 2000 becomes known in, say, the quarter ending 31 December 2000 or the quarter ending 31 March 2000, adjustments can be made to move to the correct figures. An example Dr Smith is a 50% partner in a partnership. The partnerships instalment income in the year ended 30 June 2000 was $200,000. Deductions were $50,000. Dr Smiths share of net partnership income was $75,000, being 50% of ($200,000 less $50,000). Dr Smith has been advised by the ATO that his instalment rate is 30%. In the September 2000 quarter the partnerships instalment income is estimated to be $60,000. Dr Smith derived $2,500 from non-partnership sources.
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Step 1: Calculate Dr Smiths share of the partnerships instalment income For the September 2000 quarter Partners share of net income for the year ended 30 June 2000 times Partnerships instalment income for Partnerships instalment income the September 2000 quarter for the year ended 30 June 2000 $75,000 $200,000 times $60,000 = $22,500
Step 2: Calculate Dr Smiths total instalment income This is $25,000, being $22,500 from the partnership and $2,500 from other sources. Step 3: Calculate the instalment payment This is $7,500, being the total instalment income of $25,000 times the instalment rate of 30% advised by the ATO (and shown as a pre-printed label on the BAS). Dr Smith decided this was a reasonable estimate of his part year tax liability and decided to not vary the instalment rate. Step 4: Complete the PAYGIS part of the BAS: On page 2 of the BAS Label T1 $7,500 Label T2 30% (Instalment income) (Instalment Rate) On page 1 of the BAS Label 5A $$7,500 Label T3 Blank (New Varied IR)
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Partnership Instalment Income Worksheet This part of the Guide is based on the ATOs fact sheet for the PAYGIS and partnerships. Its purpose is to calculate a partners share of the instalment income of a partnership. It can be easily modified to calculate a beneficiary share of the instalment income of a trust. A B Assessable income from the partnership for 2000 (item 51) Partnership instalment income for the last income year $ $ $
Total Business Income (item 4) Distributions from partnerships (items 8A and 8B) Distributions from trusts (items 8Z and 8R) Gross rent (item 9f) Gross interest (item 10J) Dividends received (items 11K and 11L) Other Australian income (item 12O) Other assessable foreign income (item 20B) Total C Partnerships instalment income for the current period
$ $
Partners proportion of the partnerships instalment income is: A B times C $
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PAYGIS and Trusts Trusts do not pay tax on the trusts net income. Instead the trusts net income is allocated to its beneficiaries (unitholders in the case of a unit trust) who do pay tax on the trusts net income. This means trusts per se are not subject to the PAYGIS. But from 1 July 2000 individual beneficiaries who paid tax under the provisional tax system pay tax under the PAYGIS, and corporate beneficiaries who previously paid tax under the company tax instalment system pay tax under the PAYGIS. This will change on 1 July 2001, when trusts begin to be taxed as companies. From then on the PAYGIS rules for companies will also apply to trusts. The trust is required to estimate its instalment income for the period, and then each beneficiary includes a share of this amount in his her or its BAS for that period. The amount of this share is based on the distribution of the trusts net income in the preceding year. In the September 2000 quarter this is calculated as follows: Beneficiarys share of net income for the year ended 30 June 2000 Trusts instalment income for the year ended 30 June 2000 times Trusts instalment income for the September 2000 quarter
The trusts instalment income will comprise items such as total business income, distributions from other partnerships and trusts, gross rent, gross interest, dividends, and so on. It is calculated gross of deductions (with an exception for distributions from trusts and partnerships, which are in effect shown net of the trusts or partnerships deductions). The need for estimates It is quite possible that by 11 November 2000 the exact amount of the trusts net income for the year ended 30 June 2000 will not be known precisely. If this is the case we recommend a reasonable estimate of the trusts net income for the year ended 30 June 2000 and the trusts net income for the September 2000 quarter be used. Practitioners and dentists service trust incomes tend to be predictable, so estimates will suffice. As the exact amount of the trusts net income for the year ended 30 June 2000 becomes known in, say, the quarter ending 31 December 2000 or the quarter ending 31 March 2000, adjustments can be made to move to the correct figures. What if a trust receives a distribution from another trust or from a partnership? This is actually quite common for practitioners in group practices. The service trust is typically a unit trust and the units in the unit trust are owned by the practitioners family trusts. This has the potential to be quite difficult but the situation has been kept simple by having the family trusts include their share of the unit trusts net income for the quarter in the family trusts instalment income (rather than a share of the unit trusts gross income). The same rule applies if a partnership receives a distribution from another partnership or trust.
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An example Mrs Smith is married to Dr Smith, whose circumstances are described in Part 4.2. She is a beneficiary of the Smith Family Trust. The Smith Family Trust owns half the units in the Partnerships Service Trust, which is a unit trust. The Partnerships Service Trust net income in the year ended 30 June 2000 was $100,000. The Smith Family Trusts share of net trust income was $50,000, being 50% of ($300,000 less $200,000). All of this income was distributed to Mrs Smith. Mrs Smith has been advised by the ATO that her instalment rate is 24%. In the September 2000 quarter the Partnerships Trusts net income is estimated to be $30,000. The Smith Family Trust received half of this, being $15,000. The Smith Family Trust and Mrs Smith have no other income. Step 1: Calculate Mrs Smiths share of the trusts instalment income For the September 2000 quarter Beneficiarys share of net income for the year ended 30 June 2000 Trusts instalment income for the year ended 30 June 2000 $50,000 $50,000 times times Trusts instalment income for the September 2000 quarter $15,000 = $15,000
Step 2: Calculate Mrs Smiths total instalment income This is $15,000, being $15,000 from the Smith Family Trust (through the Smith Family Trust) and nil from other sources. Step 3: Calculate the instalment payment This is $3,600, being the total instalment income of $15,000 times the instalment rate of 24% advised by the ATO (and shown as a pre-printed label on the BAS). Mrs Smith decided this was an excessive estimate of her tax liability and decided to vary the instalment rate to 20%. This means the adjusted instalment payment is $5,000, being the total instalment income of $15,000 times the varied instalment rate of 20%. Step 4: Complete the PAYGIS part of the BAS: On page 2 of the BAS Label T1 $15,000 (Instalment income) Label T4 1 (Reason for variation) On page 1 of the BAS Label 5A $3,000 Label T2 30% (Instalment Rate) Label T3 20% (New Varied IR)
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9.6 The Pay As You Go Withholding System (PAYGWS)
Introduction Practitioners have to withhold tax from salary and wage paid to employees. Up to 30 June 2000 these withholdings were controlled by the PAYE group tax rules. These rules have now been replaced by the PAYGWS, which for practitioners purposes is the same as the old PAYE group tax rules. The PAYGWS also introduces a new tax collection system applying to any payments made to a person other than an employee who does not quote an ABN prior to payment. Tax of 48.5% must be withheld from these payments. What payments are subject to the PAYGWS? A practitioner must withhold tax from the following payments: (i) salaries, wages, bonuses and commissions paid to employees; (ii) payments to company directors; (iii) eligible termination payments; (iv) payments for unused leave; and (v) compensation, leave or accident payments. Tax must be withheld from both cash and non-cash payments. How much tax has to be withheld? The ATO publishes the withholding rates in various schedule and regulations. They are based on the individual tax rates at the time of the payment. If the payee does not provide you with a properly completed tax file number declaration tax must be withheld at the highest marginal tax rate, plus Medicare (currently 48.5%). If an employee has been issued with a variation by the ATO tax may instead be withheld at the lower rate specified by the ATO. This only applies to variations issued on or after 1 July 2000. Variations issued before 1 July 2000 are no longer valid. What type of withholder? Withholders are classified as small, medium or large. Small withholders are employers which withhold less than $25,000 a year, medium withholders are SMSFs that withhold more than $25,000 but less than $1,000,000 a year and large withholders are those than withhold more than $1,000,000 a year. Small withholders must complete the PAYGWS section of the BAS (labels W1 to W4) and forward the appropriate amount of tax to the Commissioner of Taxation each quarter. Medium withholders must do this each month. Large withholders must do so within eight days of making each payment. Many practitioners pay more than $25,000 withholding tax each year. Here a monthly BAS is required, but the monthly BAS only relates to the withholding payment and does not affect its other tax obligations. What if the practitioner pays group tax as at 30 June 2000? January 2002 Page 318
If the practitioner was registered for group tax at 30 June 2000 its registration under the old group tax system carries over to the new taxation system. Can a practitioner be subject to other withholding obligations? Yes. A practitioner can be subject to other withholding obligations under the general rules applying to all taxpayers. For example, if a practitioner is supplied with services without an ABN on the suppliers invoice, the practitioner must withhold an amount from the payment of that invoice at the top marginal rate plus the Medicare levy. This is currently 48.5%. What else do employers have to do? Certain other obligations arise where the employer is required to withhold tax from PAYG payments. These include: registering for the PAYGWS (group tax registrations at 30 June 2000 automatically carry over to the PAYGWS); paying the amounts withheld to the ATO; providing an end of year summary to all recipients sending tax file number declarations to the ATO; and providing an annual reconciliation to the ATO on all withholdings.
Registering with the ATO Employers who were registered under the old group tax rules at 30 June 2000 are automatically registered under the PAYGWS. If you make a payment for the first time after 1 July 2000 you must register with the ATO by the day you are first required to withhold the amounts from the payments. This registration is different to registering for the new tax system and requires a special form to be prepared and lodged with the ATO. When do you have to send the withheld amounts to the ATO? As indicated above, if withholdings are less than $25,000 a year, in your quarterly BAS. If withholdings are more than $25,000 a year but less than $1,000,000, in a monthly BAS (but PAYGIS payments, GST and other payments continue to be paid quarterly). Payment details are provided at appendix X of this guide.
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9.7 The timing of tax payments
The purpose of this part of the Guide is to help explain how and when these tax payments will be collected and to assist you in budgeting for these payments. Introduction There are two parts to the PAYG. These are: the instalment system, or PAYGIS; which controls the payment of tax on your income (and any companies or superannuation funds you control). The PAYGIS basically replaces the old provisional tax system and the company and superannuation fund instalment system; and the withholding system, or PAYGWS, which controls the payment of income tax due in respect of tax withheld on salary payments (and payments made to a business that did not quote an ABN). The PAYGWS basically replaces the old group tax system.
The GST cash collection system is another separate system. Each of these three systems use the same ATO forms- known as activity statements- these forms are being sent out by the ATO at the moment and the purpose of this Activity statements Activity statements are the forms used to advise the ATO of the amounts due to it under the GST and the PAYGIS and the PAGWS. There are two types of activity statements. The first type of statement is the Business Activity Statement (BAS) and the second is the Instalment Activity Statement (IAS. The BAS is used if you are registered for GST and the IAS is used if you are not. BAS and IAS lodgment dates BASs and IASs are generally required to be lodged no later than 21 days after the end of the relevant period. PAYGWS One area generating a lot of questions is the PAYGWS. Persons with annual withholdings of more than $25,000 but less than $1,000,000 are required to lodge monthly activity statements to remit tax deducted from employees salaries and wages (and payments to businesses that have not provided an ABN). This is so even though even though the person has to only provide GST and PAYGIS information on a monthly basis. If annual withholdings are less than $25,000 the person is required to remit withholdings on a quarterly basis. If annual withholdings are more than $1,000,000 the person is required to remit withholdings within 7 days of making the payment.
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PAYGIS Tables A, B and C below summarise the payment dates for small companies and superannuation funds (ie < $8,000 of tax pa), medium companies and superannuation funds (ie between $8,000 and $300,000 of tax pa) and large companies and superannuation funds (ie > $300,000 of tax pa). The ordinary due date for PAYG amounts will be 21 days after the end of each quarter. This means most companies and superannuation funds will be paying their income tax earlier than in prior years. To lessen the cash flow strain connected to this a concession has been put in place for the first year. This concession involves removing an instalment for the year ended 30 June 2000 for small and medium companies and superannuation funds and deferring the time for the payment of the final instalment of tax for the year ending 30 June 2001. These arrangements are reflected in tables A, B and C below. TABLE A Small Companies and Funds (ie < $8,000 of tax p.a) Date Instalment Details 11 November 2000 First instalment for 2001. 15 December 2000 Instalment for 2000 removed under the concessional rules. No payment required on this day. 4 February 2001 Second instalment for 2001. 15 March 2001 Final payment for 2000 due but up to 100% of tax assessed for 2000 deferred interest-free over 21 quarters. 28 April 2001 Third instalment for 2001 due plus first instalment of the tax deferred on 15.3.01 21 July 2001 Fourth instalment for 2001 due plus second instalment of the tax deferred on 15.3.01 TABLE B Medium Companies and Funds (ie $8,000-$300,000 tax pa) Date Instalment Details 1 September 2000 Second instalment for 2000. 11 November 2000 First instalment for 2001. 1 December 2000 Third instalment for 2000 removed. No payment required. 4 February 2001 Second instalment for 2001. 1 March 2001 Final payment for 2000 due. (But up to 42% of tax for 2000 may be deferred interest-free over 21 quarters) 28 April 2001 Third instalment for 2001 plus first instalment of the tax deferred on 1.3.01 21 July 2001 Fourth instalment for 2001 plus second instalment of the tax deferred on 1.3.01.
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TABLE C Large Companies and Funds (>$300,000 of tax pa ) Date Instalment Details 1 September 2000 Third instalment for 2000. 11 November 2000 First instalment for 2001. 1 December 2000 Final payment for 2000 due. (But up to 20% of the tax deferred interest-free over 10 quarters) 4 February 2001 Second instalment for 2001 plus first quarterly payment of the tax deferred on 1 December 2000. 1 March 2001 Third instalment for 2001 plus second quarterly payment of the tax deferred on 1 December 2000. 28 April 2001 Fourth instalment for 2001 plus third quarterly instalment of the tax deferred on 1 December 2000.
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CHECK LIST OF COSTS NOT ELIGIBLE FOR AN INPUT TAX CREDIT (Based on NTAA GST Update Seminar September 2000) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Acquisitions where a valid tax invoice is not held but is required to be held S.29-10(3). Expenses relating to residential rental properties. The acquisition of real property where the vendor has used the margin scheme. The acquisitions of a private or domestic nature. The acquisition of residential premises. The acquisition of GST-free items under Division 38, such as basic food, childcare, water and sewerage. Compulsory third-party motor vehicle insurance. Non-deductible expenses under Division 69, That part of the cost of the car exceeding $55,134 where an input-tax credit is otherwise allowable refer S.69-10. New motor vehicles acquired before 1 July 2001 refer S.20 GST Transition Act. Government taxes, fees and charges that are excluded from the GST by the Treasurers Determination under Division 81, such as: various ASIC fees; primary industry levies; local council rates; motor driver and boat and liquor licenses; various court fees, tax agent registration and re-registration fees; FBT, pay-roll tax etc. Acquisitions from GST group members; Pre-establishment costs (but note exception in Division 60).
12. 13.
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10. THE BUSINESS OF MEDICINE
These materials are newsletters produced for our clients at various time. They should not be used without careful checking to make sure the law has not changed. They are included to help readers understand the approach we take with our clients. 10.1 Change, change and change
We live in interesting times. Tax and super are again up for grabs. The GST, new rules for taxing trusts and new rules for super funds mean the slate is clean regarding the best way to structure a practice. Most of these changes do not start until 1 July 2000, but it is wise to start to think about them now as the implementation of strategies to deal with them may take some time. GST and Practitioners After a few false starts, it looks like we will have a GST from 1 July 2000. Health services are exempt. At first blush this makes the GST sound like a non-issue for practitioners. But it is not. The GST will change the way practices are set up and the economics of practice. The extra paper work is only the start of it. The GST may be a boon to practitioners, since many inputs are now taxed under the wholesale sales tax regime, but will not be taxed after 1 July 2000. How will computers be treated? How will cars used exclusively for medical purposes be treated? How will the costs of building medical surgeries be taxed? Will these inputs be GST free too? The answer is no one knows. But it is clear the GST may lower the costs of practice. Most service trust arrangements may have to be re-thought. The practice will be exempt, and will be able to claim a refund for GST paid on inputs, but the trust may not be exempt. This means there may be no refund for the GST paid on the trusts mark up, ie its profit. This means, for example, if a trust has a profit of $30,000, $3,000 of GST will be paid. In some cases, the GST will just have to be paid, and the existing arrangements will be the best way to go. In other cases other income splitting devices put in place. The common practice of engaging other practitioners as self-employed contractors rather than as employees may also need to be reconsidered. Service trusts to be taxed Trusts will be taxed at the company tax rate from 1 July 2000 and most of the rules for taxing companies will also apply to trusts from that date. However, the income splitting advantage of service trusts will be untouched by this development. This is because any tax paid by the trustee will be imputed to the beneficiary and will be claimed as a credit in the beneficiarys tax return. Trusts will use franking accounts, as companies do now. Under separate arrangements, from 1 July 2000 unused franking credits will be refunded so the amount of tax paid cannot be greater than before. Some of the other tax advantages of trusts will disappear. For example, the ability to distribute the tax free indexed part of a capital gain will disappear on 1 July 2000, as will the ability to January 2002 Page 324
channel capital gains to low tax beneficiaries who pay no tax on them. New superannuation rules On 22 April 1999, the Government announced an easing of the rules for small funds acquiring business real property from members or relatives. It is again possible for a practitioners fund to be used to acquire surgery premises from the practitioner and to lease them back to the practitioner or a related party. The rules against geared unit trusts remains. Other new rules introduce the definition of a self-managed superannuation fund (previously known as an "excluded superannuation fund"). Such a fund must have no more than four members and all members must have a business or family relationship. All members must be trustees of the fund, or directors of the trustee company. The regulation of self-managed super will be transferred to the Tax Office from 1 July 1999. Funds with less than 5 members which do not comply with the new conditions of the definition will not be considered self-managed funds. Such funds will be required, by 31 March 2000, to have "approved trustees" (ie, trustees approved by APRA) and responsibility for their supervision will remain with APRA. Generally self-managed funds will be wise to comply with the new conditions and to come under the Commissioner of Taxations control. Although not a strict legal requirement, most trust deeds will need to be amended. This is to make sure they comply with the new rules and the new definitions and concepts introduced by them. This is not required until 31 March 2000, so it seems wise to wait a while yet before attending to this task. We offer all practitioners a complimentary review of their legal and taxation profile, including a detailed written report quantifying the possible tax benefits and considering how the new rules explained above apply. Contact Michael Waycott at 1140 Burke Road Balwyn on 9819 7308 (Michael@mada.com.au) or Terry McMaster at 144 Church Street Brighton on 9592 9888 (terry@madas.com.au) to arrange a meeting.
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10.2 June 2000
The GST countdown continues. The GST is a major part of the Governments tax reform platform and represents a watershed change in the way Australian business is conducted. Most practitioners will have a handle on the major issues by now and in this newsletter we cover areas of particular interest to practitioners as 1 July approaches. GST Stationery Invoices have to show the enterprises ABN from 1 July 2000. If you use externally printed stationery you make sure your printer has the required details as soon as possible. If you have excess stationery without the ABN we suggest you get a rubber stamp with the enterprises ABN and stamp the excess stationery rather than waste otherwise good paper. GST Grouping Rules The ATO has released new GST grouping rules to allow related entities to lodge compendious Business Activity Statements each GST period. In most cases preparing a group BAS involves more work than preparing single BASs for each entity in the group, and we generally recommend that group BASs not be used. Incurring of GST costs: some problem areas Only a GST enterprise can claim a GST credit. This means if a person other than a GST enterprise incurs a cost then that person is not able to claim a credit for any GST payable on it. Care is needed to ensure maximum GST credits are available. There can be a problem with partners in partnerships incurring costs subject to GST. If a GST credit is to be available the partner has to either: (i) (ii) rely on the partnerships GST registration (ie, treat the cost as a partnership cost and adjust the partners share of profit accordingly); or maintain a GST registration separate to the partnerships GST registration.
In each case planning is required. Cars can be a particular problem in partnerships. The rule is costs attracting GST should only be incurred by an entity that has registered for GST and can claim GST credits. If you are concerned that someone other than a GST entity may incur GST costs please contact us immediately. Employees and GST Credits Employees cannot claim GST credits, only employers can. This means employees should not incur business costs subject to GST. Employers should incur these costs. In the case of related party employees, we suggest employment agreements be amended to appoint the employee as the employers agent for GST purposes. This means the employer will be able to claim a credit for the GST on costs incurred initially by the employee. In the case of non-related party employees, you should consider allowing employees to salary sacrifice their deductible GST costs. This means the employer pays the tax invoice including the GST, claims a credit for the GST and reduces the employees salary by the amount of the invoice January 2002 Page 326
before GST. The employer is in the same cash position as before, but the employee is better off because his or her salary has been decreased by say $1000, rather than having had to pay $1,100. Practitioners and HIC and TAC Payments The HIC is asking practitioners to supply ABNs so it does not have to deduct tax at 48.5% from all bulk billing payments. Only individual practitioners can have a service provider number. Practice companies cannot have service provider numbers. This raises the question of what happens if the individual practitioner uses a practice company or if the individual practitioner is employed by a larger practice. Both are common scenarios. We have discussed this matter with the Australian Taxation Office. It indicated that a practitioner should quote the ABN of the practice company or the employer practice, as this the entity deriving the income. This means the practice companys ABN or the employer practices ABN should be quoted to the HIC and the TAC. The TAC has apparently taken the view that the ABN for the practice company or the employer practice is not sufficient, as the TAC believes it is dealing with the individual practitioner, not the practice company or the employer practice. The issue boils down to this: (i) (iii) the ATO believes the payment is going to the practice company or the employer practice; whereas the HIC and the TAC believe the payment is going to the individual practitioner.
The issue cannot be resolved by just getting an ABN for the individual practitioners: they are not enterprises under the ABN rules so are not able to register for an ABN and are not entitled to GST credits. The issue must be resolved by the three organisations working out a common position. In the meanwhile, practitioners are somewhere between a rock and a hard place. Hopefully common sense will prevail before 1 July 2000! We are monitoring the position and will let you know of any developments. Please do not hesitate to contact Terry McMaster on 03 9592 9888 or terry@madas.com.au should you wish to discuss these matters further. Terry is a solicitor and a consultant to Medical and Dental Accounting Services Pty Ltd, Public Accountants. Terry practices from two locations: 144 Church Street Brighton and Unit 13/828 High Street Kew.
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10.3 Rising Goodwills
This article summarises recent trends in practice values, based on actual sales, and suggests strategies to improve the value of your practice. Please do not hesitate to contact us if more specific advice or assistance is required regarding the value of your practice. Historically general practices have been valued on a percentage, say 15% to 25%, of gross practice fees for the previous two or three years. We believe this is inappropriate since costs, and hence profits are not properly considered. A new owner is interested in future net profits rather than past gross fees. This method looks backwards rather than forward and does not give any clues as to what future profits will be. This method also does not consider the hours needed to be worked by the owners. A simple question: if two practices have the same gross fees and one requires you to work 35 hours a week and the other requires you to work 55 hours a week, which would you value the highest? We believe medical practices should be valued on the same basis as any other asset. This means that if the practice is not able to make a profit above the market price of the owners labor its goodwill will be low. It will be not much more than the market value of the plant and equipment plus a small premium for the benefit of the location and the continuing relations with staff and other input suppliers. But if the practice is able to make a profit above and beyond the market price of the owners labor then significant goodwill is often found. Goodwill values are higher where the practice does not depend on the owners efforts and has a life separate to the owner. Practices with a stable team of practitioners and staff do well. Practices with a diversified income stream, possibly from relations with other health professionals, and a secure location do very well Trends in Valuations of General Practices Goodwill values have increased, particularly larger general practices where the future profits do not depend on one particular practitioner. We know of sales where a large practice has bought other general practices. The goodwill valuations have been based on a multiple of between 2 and 3 times profits less a notional salary to the owner practitioner(s). For example, if profit to each practitioner is $150,000, and a notional salary is $100,000, goodwill is between $100,000 and $150,000 per practitioner. In one sale the purchaser was a very large private company. Four practitioners were involved in the practice, each working between 40 hours and 60 hours a week. The practice bulk billed all patients. The practice makes $480,000 profit a year, before payments to the three practitioners. The practice was located in an area where it is hard to get practitioners to live, largely because of the distance from a capital city. The purchaser paid more than $1,500,000 for this practice. Each practitioner agreed to subsequently work for the purchaser for five years for 45% of gross fees billed. It appears the purchaser factored future pathology and radiology references into its offer price. It has interests in pathology and radiology practices, and was obviously prepared to pay a premium to secure future business for these other practices. A buyer connected to a pathology practice is courting a number of Melbourne practices at present. Large goodwill payments are offered. In one case $600,000 was offered for a half interest in the goodwill of a four-practitioner practice. This offer was based on estimated patient January 2002 Page 328
numbers and the offeror did not have access to the financial performance of the practice when the offer was made. A buyer connected to a Melbourne based accounting and financial planning practice has paid more than $400,000 for a one third interest in rural general practice. We are aware of private hospital groups that are interested in buying general practices in Melbourne (and presumably interstate) on a similar basis. Investing in a general practice is often the best investment a practitioner ever makes. Rewards rarely fall below 30% pa. Female practitioners appear less inclined to become proprietors than male practitioners do. We are not sure this is wise, provided the co-ownership agreement allows time off for childbirth and child caring. (We know this sounds politically incorrect, but it is what female practitioners are telling us they want: perhaps you should consider this if you are contemplating a partnership admission.) Please do not hesitate to contact Terry McMaster on 9592 9888 or terry@madas.com.au should you wish to discuss these matters further. Terry practices from two locations: 144 Church Street Brighton and Unit 13/828 High Street Kew. There is no charge for the initial meeting. Medical and Dental Accounting Services Pty Ltd acts for more than 500 practitioners and dentists right around Australia. It has twenty staff and partners, and specialises in the full range of accounting and tax services required by practitioners and dentists.
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10.4 An investment reality check
We are often asked how practitioners self-managed superannuation funds (SMSFs) compare with managed funds. That is, do practitioners handling their own investments achieve better returns than the professional advisors and fund managers? The answer is yes. The evidence shows SMSFs outperform managed investments. For example, the March 2000 edition of Personal Investment Magazine looked at information for the year ended 31 December 1999 provided by amongst others, Rainmaker Information Services, a superannuation research company and collated by Rice Kachor Research, a specialist actuarial and research company. The study shows most SMSFs beat most managed funds by about 3%. The results were summarized as follows:
Self managed superannuation funds

Conservative Managed Aggressive Total Market
6.19% 11.20% 15.78% 11.09% 3.74% 8.23% 3% 4.74% .67% 19.55% 7.6%
Personal superannuation funds (ie managed funds)

Capital Stable Managed Australian Shares Fixed Interest Property International Total Market
This study was consistent with earlier studies. For example, in June 1998 Personal Investment magazine published a study showing an even bigger performance gap over each of the three earlier years. Many people are surprised by these results. It is not what the managed fund industrys hype says. So what other evidence is there to support the conclusion that practitioners are better off investing themselves? Anecdotal evidence abounds. For example, In December 1999 the editor of Shares magazine, Tony Featherstone, writes: Our first and last feature on hot broker tips was a disaster. Shares asked brokers to name their best stock for 1998. Their performance was appalling. Eight out of ten stocks had lost more than half their value by November 1998. And this was in a record bull market. In Sensible Share Investing (3rd edition) Austin Donnelly writes: Despite all the claims by fund managers and commission-based advisors about their alleged expertise, experience shows that the vast majority of fund managers fail to do as well as the market average. What makes it worse is that the few examples of superior performances of some managers, in periods of one, five or even ten years, are usually followed by well-below average performance in the next periods.
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10.5 How can we help you?
We are constantly asking ourselves how we can help our clients. The purpose of this letter is to explain how we can help you. Please do not hesitate to arrange a complimentary meeting and written report on how we can help you. Ring Terry McMaster on 9592 9888 or e-mail terry@madas.com.au. Our technical manuals The Business of Medicine 2002 is a 370 page technical manual dealing with a wide range of matters relating to general practice. The Self-Managed Retirement Manual is a 310 page manual dealing with self managed superannuation funds, allocated pensions, complying pensions, planning strategies, wills and estate planning. The Practitioners GST manual is a 60 page manual dealing with the GST and general practices: it explains how the GST works and how it can be used to reduce practice costs and improve practice cash flow. Please contact Lisamaree on 9592 9888 or e-mail lisamaree@madas.com.au if you would like a complimentary copy of any or all of our manuals. How can we help you now? With the exigencies of practice it is hard to be as proactive as we would like to be. Hopefully our newsletters and manuals go someway to doing this. We try hard, and appear to do it better than our competitors. But there is no substitute for face-to-face meetings to discuss things. You would be surprised how often loose meetings to discuss things generate good ideas and strategies. In fact the hit rate is virtually 100%. Recent hits include: (i) a question about a practitioners father led to a re-jig of the fathers superannuation strategy to qualify for an old age pension. This increased the fathers quality of life (and the practitioners expected inheritance); a discussion regarding billing methods led to a shift from bulk billing to private billing. Patient numbers went down, but revenue went up by more, leading to increased profits with less work. This, incidentally, is the usual response; a discussion with a large practice regarding under-performing practitioners whose costs exceeded billings led to some practitioners being let go. This increased profit by more than $10,000 in the following month; a discussion regarding the costs of solo practice, and the difficulty of winding down a solo practice while maintaining profitability. This led to the sixty-year old dentist abandoning his practice and moving to a nearby practice on a fee split basis. The result is a three day week for 70% of the full time profit, and no administration, rather than a three day week for 30% of the full time profit; a meeting on self-managed superannuation. As a result, the practitioner stopped superannuating himself and started to superannuate his spouse. This saved $4,500 of surcharge a year. The practitioner also put in place automatic transfers from his practice company to his superannuation fund totaling $30,000 a year. In ten years time this should add up to $600,000; Page 331
(ii)
(iii)
(iv)
(v)
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(vi) a question about wills. This led to testamentary trusts being created for a married couple to create tax advantages and to protect the survivor and the four children from the effect of divorce or bankruptcy. Thankfully the clients have not died yet, but one day they will and when this happens the fantastic advantages of testamentary trusts will be open to their children; a short comment about GST and service fees led to a restructure. This reduced internal administration, external accounting costs and will save income tax; and a discussion about cars led to the third car being bought in the trusts name. This meant half the costs of the teenage daughters car were tax deductible even though no business kilometers were involved.
(vii) (viii)
The list goes on. This is what we do every day. How can you get the benefit of these strategies? What is the solution? The solution is for you to contact us to arrange a meeting to discuss things and to see if things can be improved on the financial front. We both need to find the time to do this. The cost of the time will almost certainly be covered by the identified improvements and if they are not its nice to know everything is being done correctly. The need to work with accountants who specialise in medical practices and how have developed procedures to deal with the needs of medical practices is obvious. If you wish to discuss what needs to be done to improve your tax profile, contact Terry McMaster. We do not charge for the initial consultation or the written report.
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10.6 The GST and Medical Practitioners
We have just completed writing The MADAS GST Manual. This is a 50 page manual explaining how the new 10% GST applies to medical practices. The manual explains the broad concepts involved in the GST, and what has to be done by all enterprises including medical practices before 30 June 2000. We explain how the GST applies to health services generally, and then considers the specific circumstances of medical practitioners and service trusts used by medical practitioners. Planning opportunities are discussed, and we show how careful planning can create a significant cash flow advantage. We explain how larger practices, particularly associateships, can restructure to simplify GST and obtain better income tax results at the same time. We summarise what practitioners accounting systems have to be able to do to comply with the GST and to get refunds as soon as possible after the end of each GST period. This manual is available free of charge to practitioners. Simply ring Lisamaree on 9592 9888, fax 9592 9198 or e-mail Lisamaree@madas.com.au simplest and cheapest for us to send the manual to you by e-mail. This manual and additional GST materials are being distributed to our clients at the moment. There is no other GST manual in Australia specifically written for practitioners. The MADAS GST Manual is part of our continuing commitment to the compilation and dissemination of free, unbiased and specific tax technical literature to practitioners. How does the GST apply to practitioners? Medical services are GST-free, except for cosmetic procedures. But practitioners have to pay GST on their inputs, other than salary and wages. Practitioners have to lodge a GST return each GST period, ie, at least each quarter but probably each month. GST included in their taxable supplies will be refunded within 14 days of lodging the GST return. Sounds simple enough, but what are the issues? Issues abound. For example, it can make sense to defer capital equipment purchases until after 1 July 2000, to get a GST refund of 11% of the listed price (ie 10% of the pre-GST price). New cars, particularly after 1 July 2002, will be much cheaper. To the extent the car (or cars, if things are planned properly) is used for business purposes, which should be 100%, the GST on the new car will be refunded. The practitioners choice of accounting method, ie accrual method or cash method, and the choice of GST period, ie each quarter or each month, will largely determine the cash flow effect of this new tax. As indicated above, these rules can be used to create a cash flow advantage. This is done by arranging things so part of the practice gets a GST refund months before another part of the practice pays the GST to the ATO.
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Practitioners who are engaged as independent contractors at larger medical centres have a lot of work to do if the ATO is to accept they are enterprises, ie businesses, and are able to be registered for GST. If they are not registered for GST pay as you go withholdings system and the medical center will have to deduct tax from their payments. This has serious consequences for the medical centres that engage them: in many cases payroll tax and other employment on costs may become payable, greatly eroding the profitability of the medical centre. Most GST writers have flagged this problem certainly on the ATOs agenda. Ignoring it will not make it go away. Many practitioners will have to improve their accounting systems and methods. The GST means practitioners face one or three month tax periods, and the return has to be completed perfectly within 21 days of the end of the period. This compares with a twelve-month period now, with 9 months to complete the return. Obviously speed and accuracy will become more and more important. The GST accounting system will have to dovetail with the income tax accounting system to avoid unnecessary costs and duplications. Planning is required to do this. Realistically, practice staff will have to develop new skills, in conjunction with the practices accountants, so the GST return can be completed internally with limited reference to the accountant. The GST also produces business opportunities for practitioners. On premises sales of goods usually subject to GST used in treating patients will be GST-free. It is worth considering whether to introduce product sales as part of your practice. This is an established and profitable part of many other health practices, and the GST-free status of the medical practitioner creates significant cost advantages over competitors. The need to work with accountants who specialise in medical practices and how have developed procedures to deal with the specific GST circumstances of medical practices is obvious. If you wish to discuss what needs to be done to prepare your practice for the GST, and generally find out how to improve your tax profile, contact Terry McMaster on 9592 9888.
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10.6 An overview
Our number is 9592 9888. Isnt it time you rang? We have covered a lot of ground in the last twelve months. A wide range of issues has been explored and many practical planning suggestions have been mapped out. This months article is a short synopsis of that ground. It underlines our question: ie, isnt it time you rang? Practitioners should not have non-deductible debt. Non-deductible debt is expensive debt. A GP can almost always structure his or her cash flow so, over time, non-deductible debt is replaced by deductible debt. The Commissioner of Taxation accepts these techniques are legitimate and do not attract the tax avoidance rules. The effect of replacing non-deductible debt with deductible debt is profound: assuming a loan of, say, $200,000, and interest rates of, say, 7%, the benefit is about $6,720 cash a year. How many patients do you have to see to make $6,720 a year? After about 13 years, $6,720 a year reinvested at 7% pa will pay off the original non-deductible loan of $200,000. Practice companies or practice trusts are the best way to structure a general practice. The reasons abound. For GPs in group practices the practice company shields the GP from the risk of patient litigation from associates and partners. (The word associates is in inverted commas because most practitioners who call themselves associates are in fact partners, and the doctrine of joint and several liability does apply, but thats another story.) Practice companies also open up a large number of valuable tax planning strategies. For example: (i) the ATO says practice companies may retain profits and pay tax on them if the income from the practice is business income. Most group practice income is business income. This means most GPs in group practices can limit their tax rate to 36% if they wish to do so; the tax law permits the second (and third and fourth) car to be taken as a deductible fringe benefit, and the practice company, by employing the GP, brings these cars within the realm of fringe benefits. This normally saves the GP $5,000 cash a year; the practice company creates superannuation benefits for the practitioner. These include the ability to avoid the 15% surcharge by superannuating a spouse rather than the GP and, in some cases, the ability to eliminate the 15% contributions tax and the 15% surcharge altogether; and the practice company opens the door to other fringe benefits tax planning strategies. For example, with careful planning it is possible to get a double deduction for the cost of a lap top computer, including software. This means the computer is virtually free. Some larger practices have used this technique to get up to $40,000 worth of computers and software. This technique is widely known and has been around since the start of FBT in 1987. It is even written up in the basic textbooks.
(ii)
(iii)
(iv)
We reminded GPs, again, of the perils of investing in tax schemes. We noted the conflict of interest and breach of ethics in accountants pocketing large commissions from advice to clients and the fact that the Commissioner of Taxation does not allow the deduction, no matter what the prospectus says. (Thousands of investors have since found this out for themselves.) We warned that the ASIC says less than 5% of schemes generate any return for the investor, and in many cases the money never makes it to the film, the grapes or whatever it is thats being January 2002 Page 335
flogged this year. We explained the merits of self managed superannuation funds and direct investment through low cost brokers into the share market. Research published in the Personal Investment magazine shows this yields the best returns, often doubling the results achieved by most fund managers. Self managed superannuation funds only cost $200 to set up and are remarkably cheap to run, even with small amounts of money. They have the benefit of control and security: the GP has the chequebook, and he will not wake up tomorrow to find someone has run off with the money. Our two technical manuals, the Business of Medicine 1999 and the Self-Managed Retirement Manual cover the above ground in detail, and more. They also include a wide variety of source documents, supporting the statements made in the manuals. They are available free of charge in hard copy or by e-mail. Just ring Lisamaree on 9592 9888 or e-mail Terry on terry@madas.com.au. We offer all practitioners a complimentary review and a detailed written report on their tax profiles. The reports often run to ten pages and quantify the tax benefits connected to our recommendations. Isnt it time you rang? Medical and Dental Accounting Services Pty Ltd, public accountants. 144 Church Street Brighton Victoria 3186 03, 9592 9888, fax 03 9592 9198, e-mail terry@madas.com.au. Unit 13/828 High Street Kew Victoria 3101.
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11. AUSTRALIAN DOCTOR ARTICLES
This part of the manual reproduces a number of articles written by Terry McMaster for Australian Doctor. 11.1 Some Super Strategies
The end of the tax year is fast approaching and, as always, thoughts are turning to superannuation and what needs to be done before 30 June 2001. Superannuation remains the most tax efficient investment option open to GPs. The 15% surcharge has robbed it of some of its sparkle, but the Government is still encouraging retirement self-sufficiency by creating special tax benefits for superannuation funds. These include deductions for contributions, a 15% tax on income and a 10% tax on capital gains, and concessional taxation on withdrawals, particularly for pensions. These tax benefits mean most investments will do better in a superannuation fund than otherwise. Self-managed superannuation funds (SMSFs) are of particular appeal to GPs. The low set up and running costs and the absence of senseless commissions translate to more money for the GP. The extra control and security appeal too. The studies show that SMSFs have consistently outperformed managed superannuation investments in recent years, and SMSFs run by GPs are no exceptions to this phenomenon. Superannuation should feature in a GPs tax planning, particularly after age 40 and the home loan is under control. Most Australians are under superannuated, and so are most GPs, relative to their incomes. A realistic minimum contribution is $10,000 pa, and it is easiest to achieve this by automatic transfers each month: frequent small contributions are far more manageable than large annual contributions. Once the automatic transfer is set up, it should be set and forget for the rest of the year. $10,000 pa is the minimum needed to ensure the GPs retirement is comfortable and a sensible legacy is left to the kids. Preferably larger contributions will be made, particularly as the GP gets older. Superannuation contributions have to be paid before 30 June 2001 to be deductible in this financial year. The payer cannot claim a tax deduction for any contributions above the members age based limit. These are $11,388 if under 35, $31,631 if between 35 to 50 and $78,445 if above 50. Members above 65 must be working at least 10 hours a week and members above 70 usually cannot be superannuated further. Are there any special strategies for GPs to consider? Yes there are. Consider: 1. ensure the GP is not on a salary if the GPs surchargable income (basically taxable income, fringe benefits plus superannuation contributions), are more than $81,493 a year. Instead superannuate a lower income spouse, (or perhaps even a child, although thats another story). This can be done even if the spouse has only a minimal involvement in the practice. For example, a 51-year-old spouse who is a director of a service trust and is paid $12,000 pa as an employee can receive $70,000 of superannuation contributions each year; if two or more unrelated parties employ the GP, arranging for each employer to superannuate the GP up to the GPs age based limit. The age based limits apply separately to each employer, and this can drastically increase the total amount of superannuation benefits able to be accumulated; Page 337
2.
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3. 4. borrowing to pay employer superannuation contributions. The interest is deductible, and the tax benefits mean that more money is available at the end to retire the debt; and contributing listed shares or business premises to a SMSF. SMSF contributions do not have to be in cash, and non-cash contributions mean the tax benefit is achieved without reducing the amount of cash available for the GPs day to day living costs. Transaction costs like capital gains tax and stamp duty have to be considered, but usually these can be worked out without any difficulty.
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11.2 Dr Suzies Not So Super Super
Women are seriously under-represented in the superannuation stakes. The reasons for this are quite obvious: women spend less time in the paid workforce, due to child-care and earlier retirement ages. Women usually have lower incomes than their male counterparts. They are also less likely to regard themselves as being responsible for their own retirement planning and more likely to consume than save, with an emphasis on family. An article in the Age dated Saturday 7 July 2001 interviewing a collection of prominent feminists stressed that most family units still regard the females income as pin money and not a main stay of the familys budget or a base for future investments. Female practitioners generally have more income and more superannuation than other women, and are less likely to fall into this stereotype. But they are still putting away far less than they need to live comfortably in old age, which for these purposes is probably the thirty or so years from age 60 to about age 90, which if you are age 40, most of the rest of your life. But superannuation is probably more important for women than it is for men, since women live longer, and are increasing less likely to be married or otherwise part of a family economic unit in the future. Ally McBeal needs superannuation more than she needs a man! She just does not know it. The 2001 study, 'Women and Superannuation in the 21st Century: Poverty or Plenty? by the National Centre for Social and Economic Modeling at the University of Canberra, has found that unless there is complete equality in the labor force roles women's superannuation will remain lower than men's due to lower female earnings and different workforce participation. The study found that in 1993 women's average accumulated superannuation was only $9,647, less than half of the average accumulated superannuation of men. By 2030 the average woman's superannuation nest egg will increase nine-fold to $89,591 in 1999 dollars, but it will still only be 70% of men's. The study also found that 10% of women aged 55 to 64 will have accumulated less than $27,300 in superannuation by 2010. This is obviously not enough. But it is still a vast improvement over the 2000 picture, when the bottom 10% of women considering retirement had superannuation nest eggs of less than $3,850. The problem is particularly pronounced for older women, say the 40 plus group. Most have little or no superannuation and the high costs of raising families in the next ten years or so means for most the situation will not change before age 50. At age 50 most women have less than ten years of equivalent full time work ahead of them. By then its usually too late to make a dint in the problem. Phillip Smith, the AFAS Chief Executive, is reported as saying: Super rules need to take account of the broken work patterns now common for both women and men. Women are most behind the eight ball at this stage. We need to look at ways of helping them save for retirement.
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11.3 Is it time for some time?
Many GPs, particular solo GPs, find it hard to retire. Concern for patients and the economics of maintaining the surgery combine to keep the GP in harness much longer than is preferred. More than one wife has confided that her husband falls into bed exhausted at the end of each day. She is worried sick about his health and feels they may miss out on the things they have worked so hard for: time for travel, time for each other and time with the grandchildren. She knows you cant buy memories. The economics of solo practice make semi-retirement hard. A solo GP may make $130,000 a year, or $13,000 a session, working ten sessions a week. This equates to $13,000 a session. Therefore, he reasons, if he cuts back to six sessions a week, profit will be $78,000 a year. Great! He says. Now the kids are gone we can easily live on that, and have some left for super. Wrong. It does not work like this. Solo GPs who reduce their sessions usually find profit falls more than proportionately. This is because fixed costs stand intact no matter how few sessions are completed, and older practitioners tend to see fewer patients per session than younger practitioners. A client is in exactly this situation. He has reduced his sessions and, in his words, is now working just to keep his receptionists employed; there is no profit left for him. As is usually the case, he is tremendously concerned about his patients, (in fact he seems convinced they will die if he is not there). He feels he has to keep going, even without reward, for the sake of his patients. Time for travel, time for his wife and time for his grandchildren will just have to wait. One solution is to join up with a younger practitioner or group of practitioners in his area. He asked himself who did he feel most comfortable with, and then approached them with a deal. This was it: I move in with you, and you provide me with the services I need to see my patients. I pay you a management fee equal to 35% of my fees (ie less the market rate). This year I will work five sessions a week but I will be away from May to late July. Next year I will work four sessions a week except for winter, when I will be gone. If you are short of practitioners for other sessions I will help out if I can. You see my patients when I am not there and I will do my best to make sure they stay with you when I am gone. The other practitioners agreed. And why wouldnt they? GPs are hard to get and they had a spare consulting room that was not earning anything. 35% is less than market but is more than nothing, so they make a good profit. They basically get my clients practice for nil, and get extra profit without any extra work (and that is the best type of extra profit you can get!). What was in it for my client? Now all his costs are variable costs and he has no fixed costs. No matter how few sessions he has or how few patients he sees each session, he will always make a profit. This means he can reduce his workload as he gets older and still make a profit. And most importantly he has not abandoned his patients and knows they will be looked after when he is not there. And he finally has some time. And you cannot buy memories.
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11.4 This kid is foreman material!
Nowadays it is not unusual for GPs to bring along their children for meetings with their accountant or solicitor. My initial reticence to discuss private matters in front of third parties, albeit closely related third parties has now faded. If the client brings the children along for the meeting, I figure they must want me to explain and inform the children abut mum and dads financial affairs. Why else are they there? I therefore fully involve the child in the meeting, taking care to simplify things and to carefully answer any questions they may ask. Occasionally deliberately delicate words are selected, and I always watch closely for cues from mum and dad as to where any boundaries might lie. But otherwise its business as usual. One interesting by-product is that I now have a stock of humorous anecdotes to relate at dinner parties, because sometimes out of the mouth of babes. There was the trio of County Road clad young twenty-somethings, all private school educated, all still at university, and all still at home enjoying the life of Riley, including driving new cars paid for by mum and dad, who aggressively interrogated their poor parents as to exactly why they had not managed to accumulate significant wealth over the last ten years. My three-pronged defence of their astonished parents was frank and to the point, but it seems it somehow still missed its mark, because nothing changed. And there was the day I got a call from a ten year old, demanding to know the balance of her beneficiary loan account from the family trust, and just when she could expect to collect payment. (Important lesson: she might look like she is playing with her Barbies, but she isnt. Take care.) Sometimes the interesting by-products are more serious. In one meeting I learned that the eight year old was partly blind. Blindness is a disability for tax purposes. And disabled children under the age of 18 are eligible for special tax treatment that can save their parents up to $8,000 cash a year. The GPs trust is now distributing $30,000 pa of income to the child, and she is taxed on it as an adult, because disabled children are exempt from the special rules that tax the unearned income of minors at penalty rates of tax. Usually the meetings are less memorable and are just another small increment in the learning curve of childhood and parenthood. However, the other day an obvious issue popped up that was relevant to many GPs. I feel silly for not having addressed it before. And if asked, I would always have said Yes. Yes. Of Course. But the question had just not been asked before. The boy simply asked why he was not being paid for the work he did in the practice. It turned out the each of the two children, one age 16 and one age 15, in fact did work in the practice. They assist with filing and other light office duties, gardening and cleaning. Why werent they being paid for this work? Good question. It is common for the GPs children to work in the practice on a casual part time basis. Where they are, wages will be deductible in the payer's hands and assessable in the children's hands and taxed as earned income, that is, not as unearned income subject to penalty tax rates. Here the children are now formally on the payroll for $4,000 a year: the service trust can claim a deduction for the amount paid to each child and the income is effectively tax free in the children's hands because it is less than $6,000. This wages are in effect deducted at 48%, since this is the parents tax rate. The total tax benefit to the family is about $3,840 cash a year. If you are considering employing your child in your practice you should make sure: (i) (ii) the work is done; work cover premiums are paid were required and any other relevant employment rules Page 341
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(iii) (iv) are observed; the wages are physically paid to the child, preferably under the usual payroll cycle, and not just adjusted for at the end of the year in the accountant's office; the payments are commercially sensible having regard to the actual hours of work completed and the market rate for that type of work. Payments above a commercially acceptable amount will not be deductible.
These strategies can be dovetailed with other familial financial arrangements. For example, the child may be responsible for their own clothing and entertainment costs: all good stuff which is likely to help turn out a financially responsible adult who understands the value of a dollar, and who knows income is connected to effort.
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11.5 Family Trusts: Better than ever
The proposed rules for taxing non-fixed trusts from 1 July 2001 (now postponed to 30 June 2002) are good news for practitioners. This is because the tax rate is 30%, and trusts may retain profits and reinvest them until a low tax rate beneficiary is available for a distribution. This means less tax will be paid, in some cases far less than 30%, on trust income. Consider an older practitioner with no low tax rate family members. Under the old rules a service trust was no help because there was no one to distribute to. But from 1 July 2001 the trust can pay tax on retained profit at 30% and then distribute the total accumulated income to the practitioner years after he finally retires. The trust smooths income away from the practitioners high tax working years to his low tax retirement years. In fact, a case can be made for using trusts over superannuation for retirement planning. Consider a couple, both practitioners, with young children. So far a trust has not been used to invest because distributions to children are taxed at penalty rates, and there is no one else to distribute to. Soon profits can be taxed at 30%, reinvested in a 30% tax environment, and then paid as franked distributions once the children turn age 18. Excess franking credits will be refunded, meaning the effective tax rate can be less than 30%. Debt can be repaid out of dollars taxed at 30% rather than dollars taxed at 48%. Assume a practitioner buys a practice for, say, $100,000 and is taxed at 48.5%. If the practice is held in the practitioners name the practitioner has to earn $194,174 in pre-tax dollars to pay for the practice, whereas if it is in the trust the practitioner only has to earn $142,857. This is a significant saving, and means the risk of borrowing is far less if the asset is owned by a trust. Can a family trust own a medical practice? The ATO says yes, provided it has more non-owner practitioners than owner practitioners. And the recent sales of general practices to corporates show that the service trust owns the goodwill, and not the practitioners themselves. One concern is tax on capital gains. One half the capital gain after 12 months on a new investment by an individual is taxed, but all the capital gain on a new investment by a family trust is taxed. At first this seems a serious concern. But only in rare cases will more tax be paid by a trust. This is because: the certain benefit of having the income taxed at no more than 30% compensates for the chance of extra tax being paid at 24% if there is a capital gain; the 30% trust tax rate is close to the effective tax rate of 24% (ie one half of 48%) paid by individuals; the 30% trust tax rate is a maximum, and may be less with refunded franking credits; capital gains can be planned for. For example, they may be used to pay a large deductible superannuation contribution; certain goodwill exemptions and active asset exemptions apply to trusts, and these can seriously reduce, if not eliminate tax on any capital gain.
The new rules have not been passed by the Senate, and until then practitioners should do nothing. But once the rules are passed most family trust deeds should be amended to ensure the trustee can retain profit and pay tax properly. This amendment should cost no more than $150: a small price to pay for some excellent tax planning opportunities. We will keep you up to date as the rules pass through the Senate. January 2002 Page 343
11.6 Year end tax planning, for 2002
Now is the time to think about cutting your tax bill for the year ending 30 June 2002. Apart from superannuation contributions and the pre-payment of some expenses, there is not much you can do now for the year just ending. It is far more productive to cast thoughts forward to 2002 and consider what must be done now to save tax then. The best tax planning is structural, not schematic. Tax driven schemes do not work, as many GPs have learned in the last year. On the tax side, round robin investments into films, alpacas, vine yards and their ilk are not accepted by the ATO and do not carry the tax benefits their promoters claim. On the investment side, the ASIC has warned that most never return a cent to the investor. The only person who makes a buck out of a tax scheme is the promoter: the commissions can be as much as 30% plus on going management fees for the life of the scheme. I have never seen a GP happy with his tax scheme, and I expect I never will. What is structural tax planning? How can GPs make sure their structure is optimal for tax purposes and as administratively efficient and cheap to set up and run? The answers are straightforward and largely depend on the number of GPs and other fee earners engaged in the practice. If there are more non-owner fee earners than owner fee earners on an equivalent full time basis, the ATO believes that the practices income is business income, not personal services income. This means the practice may be structured like any other business, and no special restrictions apply. In particular, there is no rule that says a GPs practice company or practice trust has to break even each year. These entities can make a profit and this profit does not need to be distributed to the GP. In the case of a practice company, the profit can be retained and taxed at only 30% from 1 July 2001 on. In the case of a practice trust the whole of the profit can be distributed to family members and other related persons, so that the total tax charge is much less than if the profit is distributed to the practitioner. Practice trusts and companies have the advantage of simplicity: often there is no need for a service trust so GPs using them have lower costs and fewer complications. GST compliance costs and bank charges are two areas where significant savings can be achieved. If there are not more non-owner fee earners than owner fee earners on an equivalent full time basis, the ATOs rulings on professional practices must be observed. This means practice trusts and companies cannot be used unless the only tax benefit is the benefit connected to superannuation. Service trusts are the main structural tax planning tool here, and in most cases they can be used as conduits to stream income away from the GPs highly taxed hands to the lower taxed hands of family members and, in some cases, and provided some special rules are observed, related companies.
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11.7 Five Ways To Increase Profits
Specializing in accounting for GPs provides some interesting insights into the interplay of the various variables that produce practice profits. Increasing your practices profits is a sensible goal. Not only does it have the obvious effect of putting more dollars in your pocket, but it also provides more resources for practitioners, staff and patients. This has a multiplier effect on profit. For example, if profits are good the GP can afford to renovate the reception area or pay staff a bit more: do not underestimate the importance of staff morale to a happy practice, or the GPs sanity for that matter. How can profits be increased? Theoretically speaking there are at least five ways for a GP to increase profits. These can be summarized as more, longer, faster, lower and higher. As you can see, some work better than others. And we certainly have one preferred option for our clients. More Practitioners More practitioners means higher profits. Putting on an extra GP, provided its the right GP, will usually lift profits by about $40,000 a year. This is obvious and something all GPs are aware of. There is just once catch: there are precious few extra GPs available. The shortage is particular acute in the less fashionable metropolitan areas and all rural and semi rural areas. Its not just a question of putting an ad in Saturdays paper and starting the interviews on Monday morning. We do not have a magic wand for recruiting practitioners Putting on an extra practitioner sounds good in theory but is often impossible in practice. It may be simplest to scratch this one from your list. A good compromise may be too engage a physiotherapist, naturopath or other health professional. The extra profits tend to be lower than for an extra GP but are better than nothing. Particularly as there is no extra work for the GP. One good idea is to employ a dentist: this can be extremely profitable and there are now no restraints on who can own a dental practice. Longer Hours If the GP works longer hours profits will increase. But who wants to be the hardest working GP in the cemetery? And who wants the social and family costs connected to mum, dad or partner not being there when they should be? Younger GPs, particularly females, tend to work shorter hours than their elders, and probably show a lot of common sense in doing so. Working longer hours can be a very short-term solution. Faster Consultations Clinical priorities dominate here, and it is probably not for anyone but another GP, and certainly not for an accountant or solicitor, to comment on these priorities. We just observe that seeing, say, two extra patients a week may add up to an extra $700 profit a week, or an extra $35,000 profit a year. Faster consultations can lift profits, but it is often not as simple as that, and all the implications need to be thought through. Lower Costs Lower costs means increased profits. But costs come right out of the GPs wallet and therefore January 2002 Page 345
they tend to be well contained. Rent and salaries are the big-ticket items, and usually these are outside the GPs control. Attempts to lower salaries often end in disaster, and there is a good reason for paying an experienced 40 year old receptionist $35,000 a year rather than using CentreLinks offer of the month. One works and the other does not. If anything, many GP have costs too well under control. It is probable that in many cases spending a bit more on staff and facilities may add to profits. There can be exceptions, but usually the GPs costs are well under control. Higher Prices Now we are talking. If prices increase by, say, $5.00 a patient, and the GP sees 40 patients a day for 50 weeks a year, this adds up to an extra profit of $50,000 a year. What happens to patient numbers when prices increase? Sometimes the numbers dip, but they soon recover and sometimes end up higher than before. This is so for practices located right across the socio-economic landscape. Certainly the price increases tend to be proportionately greater than any drop in patient numbers, meaning more profit for less work afterwards. The GP wins on both counts. Interestingly, it seems the corporates intend to increase prices in the practices they run, often starting with no bulk billing on weekends or evenings. Rest assured they have done their homework before committing to these strategies. Higher prices makes it easier to attract extra GPs, particularly if they are retained on a fee split basis. Fifty five per cent of $40 a patient is a lot better than fifty five per cent of a $30 patient. This can increase profits further. Higher prices also mean the GP can afford to invest back into the practice, with new equipment and new services, which helps maintain the practices viability and profitability into the future. Communication seems to be the key. Write to patients explaining the reasons for the increase and the need to maintain and increase the quality of service and to make sure enough GPs are there when needed. Its hard for the patient to complain when it is put to them this way. And if they do they can always make alternative arrangements. Increasing prices mean higher profits for GPs. And we recommend it to you.
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11.8 A child in every home
The world of work is changing, and its not a good idea to assume your children will enjoy safe employment with just one or two employer during their working lives. More probably, as Hugh Mackay tells us, they will have a patchwork of part-time and casual engagements, with nothing like the secure tenure that typified their fathers and mothers employment experiences. Your kids will be bright, thats almost genetically guaranteed, and bright people tend to do well financially. But it is still not a safe bet that they will blitz their way in and out of university and then into the top echelons of the work force. The competition is tough, and is going to get tougher. And what about housing prices? Melbournes house prices have become astronomical this year, and Sydneys have been astronomical for years. One can understand why children are staying home well into their mid-twenties. They have no choice: they cannot afford to leave. The entry price into most popular suburbs in Sydney and Melbourne is becoming too high for most people under age 40, including GPs. You would be amazed how often the new home is only afforded with a bit of discrete help from grandma and grandpa. Its just not possible otherwise, particular if there are kids in the kitchen or on the horizon. What will housing prices be like in 20 years time? Who knows. How will your children afford to pay these prices? Who knows. What can you do about this? Simple. Buy your child a home now. It does not have to be something they will live in when they are 50. But it should be in a Sydney or Melbourne and have good growth prospects. If a GPs home is worth, say, $500,000 and is paid off or nearly paid off, any of the banks will lend that much again at home loan rates without any fuss or bother. Make sure the interest rate is the same as the home loan rate: the banks will often try to squeeze an extra percentage point or two here, and have been known to tell GPs that they have no choice but to charge that bit extra. Space does not allow us to explain the tax maths of all this. But if it did the maths would show that a small after tax cost to mum and dad in the early years spares the child a large before tax cost in the later years. This sparing gives the child a real economic head start in life and, with a bit of luck, the childs own efforts will amplify this head start many times over. The bottom line is that its almost cash-flow neutral to 100% gear a rental property if the interest rate is 7% and the rental yield is 5%: the tenant and the tax office basically pay it off for you. This strategy works with one, two or even three children. The maths becomes a bit daunting with four or more children, but perhaps here the idea can be modified by buying the homes a few years apart or buying lower priced homes and letting the children up-grade them later on under their own steam. And this is even more important for your daughters. Its 80 years since the suffragettes but we still do not have equal incomes or workplace opportunities. Most women have less than $30,000 of superannuation on retirement. That wont go far. Virginia Woolf wrote about a room of ones own as a pre-condition for gender equality. Wed change that to a home of ones own. When was the best time to implement this strategy? About ten years ago. When is the next best time? Probably now! January 2002 Page 347
11.9 Service fees and service trusts
Most GPs are familiar with the concept of service trusts, and their ability to shift taxable income from the GPs highly taxed hands to the lower taxed hands of the GPs family members, thereby reducing the overall amount of tax paid by the GP. The proposed new rules for taxing trusts as companies will make service trusts better than ever, allowing for each years taxable income to be distributed tax efficiently amongst family members over several years, rather than in just one year, as the case is now. Popular now, service trusts will become even more popular in the next few years The ATO accepts service trusts provided certain conditions are met. These are that: (i) (ii) (iii) (iv) (v) the service must be provided; the fee for the service must be calculated on an arms length basis; tax invoices must be rendered regularly, including GST; the tax invoices must be paid regularly; and a service agreement is in place between the service trust and the GP.
(A sample tax invoice for a service trust is reproduced in part 13.12) If any one of these conditions is not met the ATO may ignore the service trust and tax the GP as if it did not exist. Ultimately this means the GP misses out on the tax planning advantages and ends up paying interest and penalty tax to the ATO. These amounts an add up quickly: a disallowed deduction of, say, $20,000 per year for four years (ie the statutory amendment period) typically leads to total additional tax, penalties and interest of more than $50,000 cash. Expensive stuff. And its very frustrating because it can be easily avoided by taking some basic precautions. The most common practical problem relates to item (iii) above, that the condition that the fee for the service must be calculated on an arms length basis. Accountants commonly claim service trusts can mark up labor costs by 50%. This is not correct. To support the claim, the accountants point to Phillip's case, which is the leading case in the service trust area. They say that because the taxpayer won this case, and in this case the mark up was 50%, the 50% mark up is a golden rule that can be used in all other cases. This is not correct either. The accountants obviously haven't read Phillips case. Phillips case did not say 50% was an acceptable mark-up. It did say the mark up should be "the rate charged in the marketplace by a client (firm) engaged in hiring of office personnel". Twenty years ago an accounting firm may have had an office personnel client that was able to charge a 50% mark up, but this is not the prevailing rate for long term medical support staff in 2001. And it does not mean GPs can use this rate now. A more realistic mark up for medical support staff is closer to 10% or 15%. Anything greater than this does not satisfy the ATOs condition that the service fee must be calculated on an arms length basis. The ATO is on the record that it will not allow GPs to claim a deduction for mark-ups charged by related service entities if they exceed current market rates and the practitioner is not able to produce evidence of current market rates. To avoid problems like this it may be a better idea to have the service trust charge a set fee per month, rather than costs plus a mark up. The ATO accepts this method of charging for services and, ironically, it often result in more income being shifted to the service trust and therefore more income being distributed to family members and therefore a lower tax bill for the GP. January 2002 Page 348
11.10 Advanced gearing strategies
An employee practitioner has asked what can be done now to improve his tax profile for the year ending 30 June 2002, and to ensure a healthy refund cheque arrives in July 2002. Often tax planning strategies are limited to practitioners who are self-employed, and are harder to implement if a person is an employee. But there is still a lot than can be done for employee practitioners. Typically this involves superannuation, negative gearing and pre-paying deductible costs. If each of these three are combined the results can be excellent. Bill is employed by a hospital and is paid $100,000 pa plus superannuation (after exempt fringe benefits). He is 55 years old. His wife, Sue, a nurse, is also 55 years old and earns $30,000 a year. Both Bill and Sue are in Hospital Super. They own their home but, apart from $150,000 in Hospital Super and $50,000 cash in Sues name, do not have any investments. Bill and Sue are conservative and do not want to do anything to raise the ire of the ATO. (This is always a good strategy!) Salary sacrificing into superannuation appeals, but the 15% surcharge is a concern. They are interested in buying a residential rental property built five years ago in the CBD because of what they see as an attractive capital gain potential to help pay for their retirement, but worry that they cannot meet the repayments and maintain the desired lifestyle. We suggested Bill and Sue: buy the property in Bills name with 100% borrowed funds, using the family home for extra security to minimize the interest cost, and make sure the interest rate is variable, since interest rates are tipped to fall later this year; arrange for the loan to be interest only and for a years interest to be pre-paid before 30 June 2002. All interest should be paid using a separate loan facility. Once this is done, arrange for the cash from the rentals to be paid to Hospital Super as an undeducted contribution for Sue; arrange for a quantity surveyors report identifying the maximum amount of depreciable plant and equipment and deductible capital expenditure: this usually generates tax deductions equal to at least 20% of the cost of the property; arrange for the Pay As You Go Withholding amounts on Bills hospital salary to be reduced in 2002, in anticipation of a negative gearing loss being incurred; and arrange for an extra $20,000 of salary sacrifice deductible employer superannuation contributions to be made to Hospital Super for Bill before 30 June 2002. (This will strain the family budget, but the cash held by Sue can be used to supplement the familys living costs over the next few months: people live on cash, not income. And the family has plenty of cash.)
This strategy means that Bill and Sues tax bills are minimized, while maximizing the cash available for family living and helping provide for their retirement. All debt is tax deductible and new investments are in a low tax superannuation environment, via deducted and undeducted contributions, and this will create further tax benefits in the years to come. Bills tax and superannuation surcharge bill will fall by more than $25,000 in 2002. The benefits will not be as great in future years, but they will still be significant. Combining superannuation planning, negative gearing and the pre-payment of deductible costs can create excellent planning strategies for employee practitioners. And they are well within the boundaries of accepted tax planning, so it is easy to sleep at night. January 2002 Page 349
11.11 A Retiring Type
The ABS says that most men have retired by age 58. Its even younger for women. This is a scary thought for most GPs: I mean, retiring young might sound great, and it probably is great for a few days, weeks or even months, but ultimately you are retired for a long time, and most people have nowhere near the amount of money needed to maintain their pre-retirement lifestyles. Philipa Smith, the CEO of ASFA, has described retirement as a life of virtual imprisonment, with the padlock being a serious lack of money. This is where medicine as a career choice really excels. Medicine is unrivalled for the stability and longevity of its income streams. There is a serious shortage of GPs and this means a high income (even if its not high enough!) is virtually guaranteed even into your early 70s. We have 70-year old clients making $60,000 a year working half time, and loving it. It beats watching day-timetelly. A common presentation involves a 50-year-old male GP. He has been working or studying hard since age 15, who is tired, and who is very aware that he has already done more work than most men do by age 65. He has a house, a super fund, one or two investment properties and the kids have left uni and are finally working. He is wondering what to do with the rest of his life, and hoping its not all work. A common solution is to start retiring now, and finish retiring in 20 years time. Work, say, 4 days a week for ten months of the year, and spend the other two months in the northern hemisphere, or at least northern Australia. Then slowly wind down from there, paying more and more attention to the other aspects of your life as you go. There are books to read, countries to visit, grandchildren to play with and wines to drink, as well as patients to see. Moderation in all things is the key. The economic paradox is that he who retires first makes the most money. I would not mind betting that in most cases its better to work less for a longer period, say 20 years, than it is to work more for a shorter period, say 10 years. Particular if the retirement at age 65 is sudden, permanent and preceded by a heart attack. I cannot point to any studies here, but common sense says this is so. The lifestyle paradox is that if I am wrong, who cares. If fate intervenes and you die prematurely, then you have had a better time, even if you have not made more money! No GP on their deathbed ever said I wish I spent more time at the surgery! But I expect many will say I wish I spent less time at the surgery!. Health management is critical, and this is probably easier if you are working fewer hours and taking more breaks. One macabre perspective is that for every extra year of work there is one less year of self-funded retirement. If the average lifespan is 78, and you can work to say, age 72, then you probably only need enough money to last another 6 years. You need less to retire, because you retire later. A graduated retirement has the best of both worlds. You can make more money and you can enjoy life more while you are still able to. A graduated retirement is a lifestyle choice. The decision to start can be hard to make, but once its done few complain. In fact most marvel at how much there is to do, and regret not having started earlier. And we have the post cards to prove it.
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11.12 Practitioners and investments
It is not uncommon to hear GPs berating themselves for what they say are their poor investment skills. The theory is that, lacking training in investing, and in business and finance generally, and culturally required to work long and hard hours with patients, GPs have little knowledge or time to invest properly. Not surprisingly, their investment and financial advisors are usually quick to reinforce this theory. I mean, who wants their client to think that they can do it themselves, or even be in a position to ask an informed and challenging question? This will not help the advisor maximize returns! The truth is, that like most things GPs turn their hands to, GPs are better than average investors. Many of our clients do extremely well, and need little encouragement to take advantage of opportunities that present to them. Direct shares investments, including the various variations involving derivatives, margin lending, instalment warrants and other unusual forms of financing, property investments, indexed funds and even some managed funds are areas where they have the score on the board, in most cases a run rate well ahead of the market average. Others clients need a little direction and encouragement. Here our motto is the important thing is to do something, because if you do nothing, nothing happens. Sometimes the best strategies are the simplest ones: increasing your superannuation cover and speeding up debt repayments, particularly for non-deductible debt, are usually very powerful wealth creation tactics. And you do not need a masters degree in investment finance to implement them. Once the superannuation benefits have built up, consider investing in Australian shares so the benefits of franking credits can be achieved, and once the debt falls, consider borrowing to buy an investment property, and then pay the debt off as fast as possible again. Its not rocket science, and its usually very effective, particularly after five or ten years, when short-term price fluctuations have ironed themselves out and time and the principles of compound interest have done their work. . If you are not confident of your ability to choose the right shares or the right properties use an advisor. A good advisor can be worth his or her weight in gold. But proceed with caution as they are hard to find, and not always what they first appear to be: Australian GPs have not always had the benefit of objectivity and independence amongst their investment advisors. I am sure you have met some of them! If you have not, you will! As we often say, any investment advisor who is dogmatic about what is best for you is probably a salesman, and there is an obvious concern about the objectivity of someone who is paid by commissions rather than time. Look for recommendations from other GPs, a balanced approach rather than a bias to one investment type (after all, who really knows the future?) and a time based billing system. And always write the cheques direct to the target investment, and not to the advisor. Just to make sure they really are good advisor! If you are not confident of your ability to choose the right shares or the right properties, even with an advisor, consider using indexed share funds and indexed property funds. These are becoming increasingly popular. They are a cost efficient way to make a conservative investment that by definition will never beat the market but will never be beaten by the market either. Indexed funds usually deal directly with the investor without involving intermediaries, and this is one of the ways costs are kept down. And by the way, we do not give investment advice.
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11.13 A Valuable Employee
GPs often ask if they should engage other practitioners in their practices, whether as employees or assistants, and whether this increases profits or whether it causes more problems than it is worth. The answer to this question, like most others, is "it depends". There is no doubt that the more profitable practices have one, two or even more extra hands on deck, but there are also many examples where the extra hands cost more than they earn, and drag profits down. The answer to this question really depends on which practitioner and, in particular, the level of fees generated by that practitioner. The answer is usually that the employment of a practitioner adds to practice profits and also creates other advantages for the owner practitioner. It is common for an employee practitioner to be paid, say, the greater of 55% of billings or $50.00 an hour, plus sick leave, plus super plus one month's annual leave. If the payment is a net $60 an hour (allowing $10.00 an hour for labor on-costs sick leave, annual leave etc), then anything billed above $60 an hour is a contribution to profit. Apart from the employee practitioners salary, and possibly some extra reception time, there are few significant extra costs connected to employing the practitioner, so the extra billings tend to be all profit. But you probably need the employee practitioner to gross $100 per hour to cover the practitioner's salary, ie $55 per hour, plus, say, $20 for a share of overheads, ie $10 labor on-costs plus $10.00 for other overheads, and make a small profit. (The $20 per hour overhead rate is calculated via the time honored atmospheric extraction method: the cost accountants write books on the best method of allocating overheads, but I am not convinced any are better than this.) This leaves $25.00 an hour profit for the practice. Assuming an eight-hour day, five days a week, for, say, 48 weeks a year, this extrapolates to an extra $48,000 profit per employee practitioner per year. This is a significant extra profit, and one that you observe when you analyze the profitability of general practices that employ practitioners. The successful engagement of one full time employee practitioner (or as an assistant) lifts the median profit of a solo practice from about $120,000 per year to about $170,000: this makes a big difference, particularly after a few years. Incidentally, we always encourage practitioners to raise their prices: patient numbers rarely fall and profits therefore increase when prices increase. One great advantage of higher prices is that the employee practitioners income rises too, making it easier to attract and retain good employee practitioners in a very competitive labor market right around Australia. This profit also creates goodwill for the owner practitioner, and may create a better tax profile so that the extra $48,000 is taxed at 30% (from 1 July 2001) or even less than this. Owner practitioners should support their employee practitioners by instructing receptionists to fill up the employee practitioner's patient lists. The standard line should be that "Dr Black (ie the owner practitioner) is running an hour late, but Dr Brown (ie the new employee practitioner) can see you now...". If this is done the employee practitioner will become profitable as soon as possible. In summary, employing a practitioner is usually profitable, and should be a practice priority. But if the employee cannot achieve the required level of billings then you may find yourself paying more than the employee is billing. Some owner practitioners are happy to cop this to make their lives easier: there may not be any profit but at least they get home earlier and have professional support within their rooms. But its nice if there is a profit too, and as we have always said, the January 2002 Page 352
nicest profit is one made for you by someone else!
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11.14 Some Super Strategies
The end of the tax year is fast approaching and, as always, thoughts are turning to superannuation and what needs to be done before 30 June 2001. Superannuation remains the most tax efficient investment option open to GPs. The 15% surcharge has robbed it of some of its sparkle, but the Government is still encouraging retirement self-sufficiency by creating special tax benefits for superannuation funds. These include deductions for contributions, a 15% tax on income and a 10% tax on capital gains, and concessional taxation on withdrawals, particularly for pensions. These tax benefits mean most investments will do better in a superannuation fund than otherwise. Self-managed superannuation funds (SMSFs) are of particular appeal to GPs. The low set up and running costs and the absence of senseless commissions translate to more money for the GP. The extra control and security appeal too. The studies show that SMSFs have consistently outperformed managed superannuation investments in recent years, and SMSFs run by GPs are no exceptions to this phenomenon. Superannuation should feature in a GPs tax planning, particularly after age 40 and the home loan is under control. Most Australians are under superannuated, and so are most GPs, relative to their incomes. A realistic minimum contribution is $10,000 pa, and it is easiest to achieve this by automatic transfers each month: frequent small contributions are far more manageable than large annual contributions. Once the automatic transfer is set up, it should be set and forget for the rest of the year. $10,000 pa is the minimum needed to ensure the GPs retirement is comfortable and a sensible legacy is left to the kids. Preferably larger contributions will be made, particularly as the GP gets older. Superannuation contributions have to be paid before 30 June 2001 to be deductible in this financial year. The payer cannot claim a tax deduction for any contributions above the members age based limit. These are $11,388 if under 35, $31,631 if between 35 to 50 and $78,445 if above 50. Members above 65 must be working at least 10 hours a week and members above 70 usually cannot be superannuated further. Are there any special strategies for GPs to consider? Yes there are. Consider: ensure the GP is not on a salary if the GPs surchargable income (basically taxable income, fringe benefits plus superannuation contributions), are more than $81,493 a year. Instead superannuate a lower income spouse, (or perhaps even a child, although thats another story). This can be done even if the spouse has only a minimal involvement in the practice. For example, a 51-year-old spouse who is a director of a service trust and is paid $12,000 pa as an employee can receive $70,000 of superannuation contributions each year; if two or more unrelated parties employ the GP, arranging for each employer to superannuate the GP up to the GPs age based limit. The age based limits apply separately to each employer, and this can drastically increase the total amount of superannuation benefits able to be accumulated; borrowing to pay employer superannuation contributions. The interest is deductible, and the tax benefits mean that more money is available at the end to retire the debt; and contributing listed shares or business premises to a SMSF. SMSF contributions do not Page 354
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have to be in cash, and non-cash contributions mean the tax benefit is achieved without reducing the amount of cash available for the GPs day to day living costs. Transaction costs like capital gains tax and stamp duty have to be considered, but usually these can be worked out without any difficulty.
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11.15 New BAS rules
The Treasurer has announced simpler GST and PAYG Instalment arrangements for the Business Activity Statement (BAS). These changes reduce the compliance workload for GPs under the New Tax System. The Treasurers announcement, and the associated paper paraphernalia, is actually anything but simple. Nevertheless, once deciphered, its good news for GPs and will make BASs a lot easier to prepare. Certainly most GPs will save either time or accountants fees under the new rules. The main impact of the announcement for GPs with quarterly BASs is to: (a) in the case of the GST reporting arrangements: (i) introduce streamlined quarterly payment arrangements with only three BAS boxes to be filled in. These boxes are: turnover, GST collected on sales and GST paid on purchases. The quarterly BASs will be supplemented by an annual information report due no later than the GPs income tax return. Adjustments will be made to the amount of GST collected, based on this annual instalment report; and (ii) introduce simpler payment arrangements for GPs with annual turnover less than $2,000,000. This is done by providing an option to elect for the four quarterly instalments to be based on 25% of the previous years net GST amount, increased by a GDP factor, rather than calculating the GST liability accurately each quarter. The last two BASs for the year ending 30 June 2001 will be based on the December 2000 quarter; and in the case of the PAYG instalment system, allow individual GPs and GPs who are members of GST registered partnerships to elect to have their instalments based on the last tax return lodged, in much the same way as the old provisional tax system. Companies and superannuation funds with turnover less than $1,000,000 may also elect to have their instalments based on the last tax return lodged, in much the same way as the old company tax instalment system.
(b)
These new arrangements apply immediately. However, it is possible that many GPs will not elect for the GST instalments to be based on the previous years net GST amount, increased by a GDP factor, and instead may continue to calculate the GST liability accurately each quarter. Medical services are largely GST free and GPs get credits for the GST included in their purchases. This means most GPs get GST refunds. The Treasurers announcement indicates that taxpayers whose second BAS included a GST refund (ie most GPs) will not be required to pay GST instalments in their third and fourth BASs. But it is not clear from the announcement that a GST refund will automatically be paid. The refund may have to wait until the tax return for the year ending 30 June 2001 is lodged, or 28 February 2002. This is not fair, and will have a cash flow cost for most GPs. Hopefully the Government will clarify the treatment of GST refunds for GPs before the third BAS and fourth BASs are lodged on 28 April 2001 and 28 July respectively. But it may be that to get the refund of GST on lodging their BASs GPs will have to stay with the old system and calculate the amount of the GST refund themselves, thus eliminating most of the intended compliance savings. A number of other matters were also dealt with in the Treasurers announcement. Taxpayers with less than $250 on their last assessment will be taken out of the PAYG system and only need pay tax on annual assessment. Further, for quarterly lodgers, the due dates for payments will be 28 October, 28 February, 28 April and 28 July.
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12 12.1 MADAS CLIENT NEWSLETTERS Estate planning: do not leave it too late
Estate planning covers the management of all your assets and how they will be dealt with as you get older and once you ultimately die. Wills, tax planning and asset protection planning using trusts feature in the thought processes. Estate planning is an integral part of your wealth management approach. How your assets should be dealt with when you die is very important issue, particularly if a business is involved or significant assets have been acquired. It is even more important, and complicated, if there has been a divorce and a remarriage and there are extra family members who are not blood relatives. Here your intentions must be made crystal clear: if your will is not well drafted it may be challenged and your estate disposed of in a way you did not intend. Trusts complicate things: assets in trusts are not covered by wills and therefore different rules apply to how these assets are dealt with. Good estate planning is critical here. The trend to longer living means there is an increased need for living wills covering what happens if you lose your capacity to make decisions. Things like what sort of care you receive will become critical: perhaps your concept of what is appropriate will differ a little from that of your children! This year we are concentrating on getting our clients estate planning affairs in good order. Tim Pepper, an experienced solicitor with an extensive background in estate planning is handling this project. Please contact Tim at our Brighton office on 9592 9888 or tim@madas.com.au to make a time to meet to discuss your wills and your estate planning needs generally.
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12.2 How to get wealthy, really
A recent client meeting showed just how much can be done to improve the performance of a property investment if simple and sound tax planning tools are used. John is a superannuation fund client. A large company employs him and his salary is $100,000 pa plus superannuation. He is 50 years old and has two teenage children. His wife. Betty, works as a nurse and earns $30,000 a year. John and Betty own their home but, apart from $150,000 in Johns superannuation fund and $50,000 cash in Bettys name, do not have any investment assets. John is interested in salary sacrificing some of his salary into his superannuation fund, but is disheartened by the effect of the 15% surcharge, and would like to by a rental property but is concerned that this is an area he knows nothing about. What should he do? The first thought was that, as Roosevelt once said, the important thing is to try something. If you do nothing, nothing will happen. The second thought was that we do not provide investment advice so if you are interested in buying residential property and do not know how to proceed consider engaging a property consultant or a buyers advocate. This is becoming very popular but in fact has been around for years as an informal service offered by most real estate agents. Once the property is bought though, we can help. Our strategy was to: acquire the property in Johns name using 100% borrowed funds, using the family home for extra security; make sure the loan is at the lowest possible rate, which can be as low as 6% at present, and make sure the loan is variable, since interest rates will probably fall later this year; arrange for the loan to be interest only (ie no principal repayments), and for the interest to be capitalized against the loan, ie for John to borrow to pay the interest; arrange for the cash from the rentals to be paid directly to the superannuation fund as an undeducted contribution for Betty (undeducted contributions are powerful savings tools and are discussed in detail in our various manuals); arrange for Frank Kendall, our consultant quantity surveyor, to prepare a depreciation report identifying the maximum amount of depreciable plant and equipment and, possibly, deductible capital expenditure: this usually generates tax depreciation claims equal to at least 20% of the cost of the property; arrange for the Pay As You Go Withholding amounts deducted each month from Johns salary payments by his employer to be reduced, in anticipation of a negative gearing loss being incurred; and arrange for an extra $20,000 of salary sacrifice deductible employer superannuation contributions to be made to Johns superannuation fund by his employer, before 30 June, using some of the cash held by Betty to supplement the familys living costs. Page 358
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This strategy means that Johns taxable income is minimized while maintaining (in fact increasing) the amount of cash available for family living. More wealth is shifted to the low tax superannuation environment (ie an extra $35,000 a year) and this will create further tax benefits in the years to come. Johns tax and superannuation surcharge bill falls by more than $25,000 in the first year and this calculation is set out in the following paragraphs. There is also a Medicare levy saving and John and Betty have become eligible for Family Allowance payments through Centre Link: overall the familys cash position has improved by more than $30,000. Obviously the best tax planning in the world cannot turn a bad property investment into a good one, and this strategy should not be used unless you are confident that the underlying investment is a sound one. But once you have made this decision the benefits of sound tax planning can be incredible. E-mail Lisamaree on lisamaree@madas.com.au or your usual consultant to arrange a meeting to discuss how these strategies can be used for you. Appendix: Tax Calculations Salary Rental Loss (see below) Taxable Income Superannuation Contributions Total Tax & Surcharge Amount 100,000 Nil 100,000 8,000 BEFORE Tax 35,000 2,400 $37,400 SOON Amount 80,000 41,000 39,000 28,000 Tax 8,000 4,200 $12,200
Rental Loss: assuming the property costs $300,000 and settlement is on 1 July 2001. Rent Less: Deductions Interest Paid Pre-Paid Interest on $300,000 loan at 6% pa Depreciation (assume $10,000 pa for 4 years) Repairs, Rates & Other Minor Outgoings Net Loss 15,000 18,000 18,000 10,000 2,000
48,000 $41,000
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12.3 Trust Boon Uncovered Again
In December we referred you to an interesting article in Personal Investor about how the proposed new rules for taxing trusts would benefit clients and would lead to an increase in the popularity of trusts. (See the appendix to part 4.3 for a copy of this article.) This article is very interesting because it accords with the views we expressed in June 2000 that these rules would be good for taxpayers, particularly practitioners using trusts as service entities and for investment activities. The key issue is the retention of profits in the trust: if this can be done within the familys budget then tax will fall dramatically under these new rules. The articles explains how most tax advisors got it wrong, and are still getting it wrong, and that far from seeing the end of trusts as a tax planning tool, these new rules will in fact make them more popular than ever before, since 30% tax is a lot less than 48% tax.. Trust deeds will need to be amended and we will proceed with this program once the Senate passes the new rules, which should be some time in February 2001. However, the Sydney Morning Herald has run articles saying that the proposals may be scrapped after all (perhaps the Government read the Personal Investor article!), so who knows what will happen. It is certainly premature to be doing anything now. Please make sure you touch base with us if you are contemplating any property or share purchases, particularly if these involve debt: your choice of whether or not to use a trust may have very significant tax implications. 12.4 FBT For Public Hospitals
From 1 April 2000, public hospitals that are public benevolent institutions have a capping threshold placed on the amount of FBT-free fringe benefits that may be provided to employees. The concessional FBT treatment to these hospitals will be capped at $17,000 of grossed-up taxable value of fringe benefits provided to each employee. Previously it was common for practitioners and others employed in public hospitals to have up to 30% of their total remuneration paid in the form of tax-exempt fringe benefits. The most popular choice was loan repayment fringe benefits, which in effect meant the practitioner received tax free cash, since the repayment of a debt is tantamount to a receipt of cash, and you cannot get better tax planning than no tax! This strategy sometimes raised eyebrows, but was in fact deliberate government policy to ease the impact of FBT on public hospital employers at the time FBT was introduced. The ATO has posted on its ATOassist website a fact sheet explaining the operation of the FBT to these hospitals. The facts sheet is the same facts sheet previously found on the ATO's tax reform website and is dated 6 November 2000. For more information, go here http://www.ato.gov.au/content.asp?doc=/content/Tax_reform/nat3469.htm STS & PRE- PAYMENTS - GOVT'S FINAL POSITION The New Business Tax System (Simplified Tax System) Bill 2000 introduced in December 2000 implements the final position of the Government with respect to pre-payments. Under these amendments, from 1 July 2001: January 2002 Page 360
the 13-month pre-payment period is to be shortened to 12 months and it will be necessary for the 12-months period to end no later than the next subsequent income year; and pre-payments for non-business expenditure (eg interest on a negatively geared incomeproducing asset that is not part of a business) are to be restricted to individual taxpayers.
However, STS taxpayers of whatever kind (whether individuals, trusts, companies or partnerships) will be able to take advantage of the 12-months pre-payment rule. Business taxpayers who are not STS taxpayers and non-individual taxpayers who are not STS taxpayers and incur deductible non-business expenditure (eg interest on a rental property loan) will no longer qualify for the pre-payment deduction rule. These taxpayers are, however, subject to transitional arrangements. An STS taxpayer that is not an individual may gain the benefit of the 12-months pre-payment rule in relation to non-business expenditure. This is because, once an entity is an STS taxpayer, this will entitle the taxpayer to claim the benefit of the pre-payment rule, regardless of whether the pre-payment is related to the business of the STS taxpayer. These changes make it clear that pre-paying business expenditure for one year is a legitimate tax planning tool and will be accepted by the ATO without query provided the basic ground rules outlined above are observed. FREQUENTLY ASKED QUESTIONS ABOUT ACTIVITY STATEMENTS In October 2000, the ATO conducted 143 Activity Statement workshops attended by approximately 6,000 Tax Practitioners. The ATO has now published the 10 most commonly asked questions and answers from the workshops on its taxreform website. For more information, go here: http://www.taxreform.ato.gov.au/qa/topten/toptenqa.htm
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CORRECTING BAS MISTAKES In addition to the information contained in the publication "BAS Basics" - see item (10) - the ATO has published on its tax-reform website a fact sheet entitled "Correcting GST mistakes". The fact sheet explains when businesses can use a later BAS to correct mistakes made in an earlier BAS. For more information, go here: http://www.taxreform.ato.gov.au/factsh/2001/nat3936/index.htm ATO HELP WITH SECOND QUARTERLY BAS With the second quarterly BAS due on 4 February 2001, the ATO announced in a media release issued on 11 January 2001 that 2000 ATO officers will be available for pre-booked personal appointments during the period 15 January to 4 February 2001 to provide assistance to businesses that want help with their second Business Activity Statement (BAS). In subsequent media releases issued on 18 January and 21 January 2001, the Commissioner commented that requests for assistance with the second quarterly BAS have been slower compared with the first quarterly BAS. In addition to the appointments, the ATO is mailing every business preparing its own BAS a copy of the new at-a-glance guide to the BAS called BAS Basics. This booklet has tips on completing the BAS and answers to common questions, including when you can use a subsequent BAS to correct a mistake made in an earlier BAS. Clients can also access the booklet on the ATOassist website at http://www.ato.gov.au/content.asp?doc=/content/Tax_reform/nat3898.htm From 1 April 2000, fringe benefits are grossed-up at either of two different rates according to whether or not GST input tax credits are available. The ATO has posted on its ATOassist website a fact sheet explaining the interaction between FBT and GST. The fact sheet is the same fact sheet previously found on the ATO's taxreform website and is dated 6 November 2000. For a copy of the fact sheet, go here http://www.ato.gov.au/content.asp?doc=/content/Tax_reform/nat3516.htm
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12.5 When will the kids leave home?
You will be aware that the Federal Government has doubled the first home grant from $7,000 to $14,000 for new homes or properties not previously occupied or sold. Clients with children over the age of 18 should seriously consider encouraging their children to use this grant to buy their first home. Coupled with a guarantee from Mum and Dad (see below for further comment), this grant allows young people to enter the property market much earlier than otherwise meaning they can buy properties at 2001 prices rather than, say, 2005 prices. An example may help explain. In the early 80's when still a student I was amazed when a friend told me he had just bought a four bedroom home in Northcote (an inner northern Melbourne suburb, reasonably close to Melbourne Uni), even though he has was still a full time student and had never worked (except for the usual round of part time and vacation jobs). He was from Ballarat (ie rural Victoria), and his father had "encouraged" him to apply for the first home buyers' grant and use it as a deposit on the house. He lived in one room and the other three rooms were let to other students, in the classic student house model. The cash from the other three rooms more than covered the loan repayments and the father's guarantee meant there was no problem getting the loan. The property was sold last year, unrenovated, for about $450,000, tax free, city views included. On one view the Federal Government gave my friend $450,000. Not a bad result from an initial investment of nil. (I confess to not being impressed by this "Rich Dad Poor Dad" stuff. I just wish my dad was his dad! What a great set of genes!) Seriously, this is a strategy to consider for adult children, particularly those in the age range 18 to about 25, who have probably not yet entered the property market, but wish to do so. It allows them to enter the property market perhaps five years or more earlier than they otherwise may, which probably means a serious and permanent headstart in the wealth accumulation stakes. It also means they can do this off their own bats, adding to their sense of dignity and achievement (and meaning they are less likely to cost you money in the future!). The cash from the room rentals is considered by the ATO to be an offset to domestic costs, rather than assessable income, and hence is tax-free. There is an ATO ruling to this effect. Overall its a very good strategy, and one that should particularly appeal to country clients where mum and dad often seriously subidise the children's living costs: this was my friend's situation back in the early 80's. The only real downside is the risk that the property may fall in value and mum and dad (ie you!) become exposed under the guarantee. But this is a manageable risk and one most can live with. This risk is there any way, and the grant in effect mitigates some of this risk. As a general comment, consider the lower end of the market, so that the grant is a higher percentage of the total cost, and state government stamp duty takes less of it away. Make sure you buy according to the fundamentals: some agents, I am sure, bumped prices up $8,000 on Saturday morning, secure that their target market now has an extra $7,000 to spend. The grant's basic conditions, according to Saturday's Age, are: the property must be a new home or one already built but not previously occupied or sold (this includes many inner city developments, close to universities and hospitals);
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the property must be the applicant first home in Australia as an owner; new contracts must be signed between 9 March 2001, and 31 December 2001; contracts must be completed within 12 months; the applicant must be an Australian citizen or permanent resident; and married or defacto partners are limited to one application.
I also understand the applicant must live in the property for at least 6 months after its purchase. The grant is $7,000 for other first home buyers.
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12.6 But before the kids leave home, put them to work
It is quite common for a practitioner's children to work in the practice on a casual part time basis. Where they are, salary and wages paid to the children by the practitioner (or more probably the service entity) will be deductible in the payer's hands and assessable in the children's hands and taxed as earned income. In a recent client meeting it turned out the each of the two children, one age 16 and one age 15, in fact do work in the practice. They assist with filing and other light office duties, gardening and cleaning. Previously they had not been formally paid for this work, just getting some pocket money for their trouble. But now the are formally going on the payroll: the service entity can claim a deduction for the amounts paid to each child and the income will be effectively tax free in the children's hands because it is less than $6,000. Each child will be paid $4,000 a year for his or her efforts. This cost is effectively shifted back to the practitioner under the service fee arrangements and therefore is deducted at 48%. The total tax benefit is therefore $3,840 cash a year. If the child earned $6,000 a year the total tax benefit would be $5,760 cash a year. If you are considering employing your child in your practice you should make sure: (i) (ii) (iii) (iv) the work is actually done; work cover premiums are paid were required and any other relevant employment rules are observed; the wages are actually paid to the child, preferably under the usual payroll cycle, and not just adjusted for at the end of the year in the accountant's office; the payments are commercially sensible having regard to the actual hours of work completed and the market rate for that type of work. Payments above a commercially acceptable amount will not be deductible.
These strategies can be dovetailed with other arrangements involving children. For example, the child may be made responsible for their own clothing and entertainment costs, and paying their share of holiday costs etc: all good stuff which is likely to help turn out a financially responsible adult who understands the value of a dollar, and who knows income is connected to effort. It is probably not realistic to employ children under the age of 12.
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13. FURTHER COPIES OF THIS MANUAL
Do you want another copy of the Business of Medicine 2002 sent to a friend or an associate? If so, simply fill in the details below and fax or e-mail this page to us. DETAILS: NAME OF PRACTITIONER: EMAIL ADDRESS: ADDRESS OF PRACTITIONER: (preferred mailing address) EMAIL TO: terry@madas.com.au FAX TO: Medical and Dental Accounting Services Pty Ltd (03) 9592 9198 MAIL TO: Medical and Dental Accounting Services Pty Ltd Post Office Box 203 Brighton Vic 3186 INCIDENTALLY, WE PREFER EMAIL. ITS A LOT CHEAPER THAN THE ALTERNATIVES.
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THE BUSINESS OF MEDICINE 2002

MEDICAL & DENTAL ACCOUNTING SERVICES PTY LTD

(c) (ii) (iii)

(xii) (xiii) (xiv)

(iv) (v) (vi)

(v) (vi) (vii) (viii)

(ii) (iii) (iv) (v)

(vii) (viii) (ix)

2.2 2.3 2.4

Some common questions about amalgamations

(vi) (vii) (viii) (ix)

(iv) (v) (vi)

(v) (vi) (vii) (viii)

(ix) (x) (xi) (xii)

(ii) (iii) (iv) (v)

(iii) (iv) (v)

Car Costing $30,000

grounds in AAT Case 9235 (1994) 27 ATR 127. (emphasis added)

Age under 35 Age 35 to 49 Age 50 and over

$11,388 $31,631 $78,445

A fee of $100 will be charged for this service.

Other professional taxpayers

Taxable Income of the Company January 2002 Page 180

RULING A. Concept of Income Derived from Personal Services

Income from personal services defined January 2002 Page 186

Net Loss 10. 11

(ii) (iii) (iv)

(*Operating costs stay constant despite the increase in patient consultations.)

(ii) (iii) (iv) (v)

(vi) (vii) (viii) (ix)

(x) (xi) (xii) (xiii)

Partners proportion of the partnerships instalment income is: A B times C $

Self managed superannuation funds

Personal superannuation funds (ie managed funds)

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