Playing devil’s advocate – the case against upfont fees

A common measure for assessing the value of a financial planning business is the level of ongoing income that is generated.

Charging ongoing fees instead of upfront fees can add significant value to your business and your clients’ wealth.

Businesses are undervalued where the bulk of fees are generated from once-off transactions — for plan preparation, implementation and upfront fees. From a buyer’s perspective this can create a perception of low client loyalty thereby lowering the goodwill value of the practice.

Your client also benefits from a recurring fee restructure since it can often achieve tax savings.

For example, your fee for drawing up a financial plan is not tax deductible, nor is a fee paid for initial investment advice.

Furthermore, upfront fees are also not tax deductible because they are viewed as a capital expense. This capital expense may reduce any future capital gains tax that may be payable upon the eventual sale of an investment.

However, there are ways to legally make the most of your clients’ investments to obtain the most effective tax treatment.

The Australian Taxation Office (ATO), through a tax determination, has allowed trailing commissions from managed funds and from portfolio review fees to be deductible if the income from the investment fund is taxable.

What does this mean for financial advisers?

If you charge an upfront fee (for entry into an investment product), your client cannot claim a deduction for it. You need to convert a capital expense into a deductible income expense. So to allow your clients to claim a deduction, you should charge ongoing monthly review fees to monitor their portfolio.

In the draft tax determination an example was given comparing the construction of a plan with the construction of an investment property.

Particular attention was given to the fact that the ATO would not allow the practice of reducing upfront fees and replacing this fee arrangement with higher ongoing fees.

When the final determination was issued this paragraph was deleted. From this we could possibly infer the ATO has allowed some leeway over the deductibility of fees for ongoing advice.

Grey area

We can conclude from the discussion above that tax deductions are generally not available for investment strategies prepared by advisers. A deduction may be available where a tax agent prepares the investment strategies in connection with the management or administration of the income tax affairs of the taxpayer.

Financial advisers need to be very careful about giving tax advice.

Generally speaking you cannot give tax advice unless you are a registered tax agent within the meaning of Section 69 of the Income Tax Assessment Act 1936.

It is a fine line because you could say that advisers give advice on reasonable benefit limits and tax components in relation to retirement income streams as well as offering gearing products.

Financial advisers often maintain that they do not give tax advice even though the investments they recommend may have tax implications.

You may include disclaimers stating that you are not a tax agent and clients should seek professional taxation advice in relation to any taxation matters.

One grey area is where you may charge the client a fee for drawing up a financial plan costing, say, $1,000.

The entire cost would not represent plan preparation. A good proportion of your time is spent on ongoing investment administration as well as planning future and current levels of income.

This may involve spreading the initial plan fee of $1,000 between capital — $800 — and deductible items — $200, supported by your time records.

Some financial advisers have benefited their clients by dividing their time between initial plan preparation (capital — say $800) and investment administration/ income planning (say $200).

It is arguable they can claim the $200 as a tax deduction. However, the ATO may take a different view. It may treat any investment advice regarding construction of an initial portfolio as non-deductible (the whole $1,000).

In the 1995 Taxation Determination the ATO felt that the expenditure on drawing up a plan is incidental and relevant to outlaying the price of acquiring the investments. In other words it is too early in time to be an expense. It is part of the income-producing process and therefore it is capital in nature.

Many master trusts today offer a great deal of flexibility in terms of remuneration to advisers. In many cases you are able to nominate the level, type and timing of fees. This flexibility allows you to draw up a more favourable fee structure.

The main disadvantage of the ongoing fee structure for you is forgoing a payment for services now in exchange for remuneration spread over a period of 12 months or more. This would not suit many advisers.

Given the ruling how can we obtain greater tax deductions?

Example

Bill and Sue both retired on July 1 aged 60. They have just sold their business and you have placed their retirement assets into a mixture of retirement income streams as well as managed funds. They have investment assets totalling $600,000, of which $400,000 is invested equally in two allocated pensions and the balance in managed funds (see Table 1).

Their fees are structured to be mainly once-off upfront costs. The adviser has calculated that he is charging upfront fees of $8,500 comprised of a plan fee of $2,500 and upfront fees of $6,000. The upfront cost to Bill and Sue is $8,500 with no immediate tax breaks. There is also a trailing commission of $2,400.

From Table 1 we can see that the total fees for Year 1 (entry fee, plan fee and trailing commissions) are $10,900, of which only $800 is deductible for tax.

This represents a mere 7 per cent of the total fees for the year or tax savings of $252 assuming Bill and Sue are on the 30 per cent marginal rate of tax plus Medicare.

You could reduce Bill and Sue’s plan fees by, say, $1,500 (from $2,500 to $1,000) and pay no upfront fees. It can be done by charging an ongoing annual review fee of 1 per cent monthly on the investment assets ($600,000 x 1 per cent = $6,000), as well as a trail commission (assumed to be 0.4 per cent) from their managed investments ($200,000 x 0.4 per cent = $800).

Therefore with some careful planning they could receive a tax deduction of $6,800, thus saving $2,142 — a difference of $1,890 cash in hand ($6,800 by 31.5 per cent = $2,142 less $252 = $1,890).

Trailing commissions paid from allocated pensions are not deductible because the income generated from pension assets is tax exempt in the fund itself. Again you could charge equivalent amounts to clients directly.

The review fee and trail commission fees on the managed funds total 1.4 per cent or about $2,800 in fees — for Bill and Sue combined. This fee would vary each month because the investment itself varies in value.

Your commissions paid from managed funds as well as the ongoing management fees are deductible.

Most fund managers include the adviser trail as part of the total management fees on clients’ tax statements.

Surcharge and pension advantages

Another noteworthy advantage of the restructured portfolio is that its tax effectiveness continues beyond the first year right through clients’ retirement years.

Tax deductions will also benefit couples in surcharge territory if they are below the maximum surcharge threshold. Tax deductions lower their income, thereby lowering the rate of surcharge payable.

Another advantage in reducing the upfront fees to nil on the allocated pensions is the possible higher tax-free amount for life if the pension is solely comprised of undeducted contributions (or exempt CGT amounts or post-1994 invalidity component).

This happens in many situations where a non-working spouse with little or no superannuation assets wishes to start an income stream for retirement.

Assuming $400,000 is invested equally between Bill and Sue, the tax-free amount is calculated by dividing the initial balance less fees at the commencement of the pension by their respective life expectancies (assume no reversion).

The nil entry fees on the pensions deliver a saving of $4,000 worth of undeducted contributions. This results in a higher tax-free amount in the allocated pensions due to 100 per cent of the funds being invested. Bill and Sue’s annual tax-free income threshold jumps up by $100 and $83 respectively (total tax benefit $183). This tax benefit runs for the life of both individuals, not just for that single year.

Table 2 shows the dramatic increase in deductible fees for Bill and Sue after restructure.

With the restructure the client has received $6,983 worth of tax deductions/tax benefits. This is a significant improvement on the original $800 tax deduction.

Total fees the financial adviser receives has dropped to $7,800 (from $10,900) spread over 12 months.

However, this is easily recouped in the following year and subsequent years by ongoing review fees (1 per cent of total assets).

This is far more tax effective than the previous portfolio structure.

When are fees deductible?

If clients already have a detailed plan in place and only minor changes are needed, then this fee for investment advice is deductible. It is allowable to the extent that the investments generate assessable income in accordance with the existing plan.

However, where there is an initial visit by the client with no prior investments and the advice is not acted upon, then no deduction is available (see Table 3).

Business restructure

When business succession planning becomes a major priority then advisers need to look more closely at how fees are charged in their practice. It is prudent to make the structural adjustments today to help maximise the future value of the business.

Employing a simple fee restructure could effectively more than double the value of your business. If we accept that some valuations place a ratio of four-to-one for ongoing fees versus once-off fees then it pays to do the sums.

For example, if once-off fees for a financial planning business are valued at 0.5 times income and recurring fees are valued at two times income then the value of the business based on a recurring income model has increased by 400 per cent.

The small business tax concessions as well as the general 50 per cent capital gains discount allows many advisers to sell their business effectively tax-free.

Before adopting any major fee restructure financial advisers need to consider their own cashflow and business structure.

A financial planner’s practice is far more valuable where there are significant ongoing fees compared with upfront fees.

If properly structured there can be considerable savings and benefits for both the practice and the client.

John Ellison is general manager of Halliday Financial Services.