Why not make fees for advice tax deductible?

There are many Government (and Opposition) proponents of the Financial Services Reform Act (FSRA) that would prefer to see a fee-for-service rather than a commission-based charge to the investing public.

This view is supported by consumers groups and from within parts of the Australian Securities and Investments Commission (ASIC). And yet recent comments from the Australian Taxation Office (ATO) that it will be implementing strategies to examine claims (for deductions relating to investment seminars) confirm that, from a tax perspective at least, it may not be in the interest of the client for a financial adviser to charge fees, it is more tax efficient for the client if their adviser is paid a commission.

The system discourages fee for service, at least if you accept the view of the ATO. But which ATO view do you accept? The one expressed in its recent press release where it will “take a close look at claims for expenses relating to investment seminars”? Or its April 1980 view in Tax Ruling 39 that expenditure incurred in “servicing” an investment portfolio was deductible? This servicing included consulting with interstate stockbrokers and attending interstate stock exchanges. Or do you suffer the December 1995 ATO view from tax determination 95/60 that “expenditure on drawing up the plan is incidental and relevant to outlaying the price of acquiring the investment, and is so associated with the making of the investments as to warrant the conclusion that it is capital or capital in nature” and therefore not tax deductible?

There is a flaw to the ATO’s view that arises from a misunderstanding of how financial planning works. In the December 1995 Ruling, the ATO accepts that ongoing management fees or retainers are deductible provided “all of a management fee must relate to gaining or producing an assessable income”.

This approach has sound reasoning under taxation law. Mind you, it also says that the parts of the ongoing service fees that relate to Social Security, superannuation (unless it is wholly pension), and estate planning and asset protection are not tax deductible.

Where the dealer and adviser are paid a trail commission from the investment income, before it is credited to the investor client, the client will have tax effectively paid for the dealer/adviser services in a way that could not have been achieved under a fee for service arrangement.

So now there are two taxation reasons to avoid fee for service in favour of commission, both in favour of the client.

What is the Commissioner’s problem? It appears from 95/60 that the ATO is only concerned with initial plans. Consider the following extract from the tax determination:

“We have been asked what is the position where a taxpayer has existing investments and goes to an investment adviser to draw up an investment plan. For example, a taxpayer nearing retirement may have a number of small investments, is expecting a superannuation payment (eligible termination payment (ETP)) and decides to put in place a long-term financial strategy incorporating the investments arising from the ETP. In our view, a fee paid to an investment adviser to draw up an investment plan in these circumstances would be a capital outlay even if some or all of the pre-existing investments were maintained as part of the plan. This is because the fee is for advice that relates to drawing up an investment plan. The character of the outgoing is not altered because the existing investments fit in with the plan. It is still an outgoing of capital for the same reasons as set out in paragraphs three and four above.”

The reasoning is flawed; it starts from the assumption that the investor’s intention is to outlay capital to buy assets. This is clearly wrong. It evidences a misunderstanding of financial planning.

Curiously, the Government colleagues of the ATO at ASIC would question the continuing viability of an adviser who did not draw up plans for prospective clients and regular clients as part of the continuing investment and financial planning services.

The approach of the ATO is a little confusing, it does recognise tax deductibility for ongoing advice, it just has a problem with drawing up plans:

“Over the period of an investment plan advice may be received suggesting changes be made to the mix of investments held. This would normally be part and parcel of managing the investments in accordance with the plan. This advice may be from the original investment adviser or from a new adviser. Provided the advice is not in relation to drawing up an investment plan it will be an allowable deduction.”

The approach expressed by the ATO may be right in some circumstances, but it is clearly not right in the majority of initial financial plans. From a best practice perspective, a new adviser will prepare a plan for a new or prospective client. This may involve recommendations that result in a re-adjustment of investments, but is this any different to an annual review? Did not the client hold income-producing investments prior to the initial advice? Does it make a difference if the client does not accept all of the client recommendations? I suggest not.

And what is the matter with members of the investing public paying seminar fees for general investment education? Isn’t an investing public educated in financial matters a desired outcome for Government?

But before we attack the ATO, remember it is right about the non-deductibility of that part of any service fees (whether initial or ongoing) that are not directed toward producing assessable income.

Again, let’s look at the words of the ATO from TD 95/60:

“... expenditure in ‘servicing’ the portfolio should be regarded as incurred in relation to the management of income producing investments and thus as having an intrinsically revenue character. However, to be wholly deductible, all of a management fee must relate to gaining or producing assessable income. If the advice covers other matters or relates in part to investments that do not produce assessable income, only a proportion of the fee is deductible.”

The obvious part of the financial fee-for-service that is not deductible includes your advice concerning estate planning, asset protection and social security. But it also extends to a large part of your superannuation advice.

Section 8 of the Income Tax Assessment Act 1997 allows tax deductions for losses and outgoings incurred for the purpose of producing assessable income and for carrying on a business that does so. Even if this purpose exists, the deductibility will be denied where it is shown to be of a private or capital nature.

For example, lump sum superannuation is capital in nature. It is the assessable income deeming provisions of the taxation laws (sections 27A through 27G) that make it subject to taxation. But, to the extent that financial planning fees (whether initial or ongoing) relate to lump sum superannuation, basic tax law excludes the fees from tax deductibility, notwithstanding that the adviser discussions turn on the tax liabilities of the client. Only a tax agent or legal practitioner can be paid deductible fees for such a tax-related discussion.

So let’s not pick a fight with the ATO over the deductibility of fee-for-service charges for drawing up a plan, we run the risk of winning the legal principle but losing in the complexity that would follow if the ATO persists with a proper application of the law.

The real answer lies with the Federal Government. An investment advice related expense section is required, similar to the treatment of tax-related expenses in Section 25-5 of the Income Tax Assessment Act, 1997. This section specifically provides a tax deduction for expenses incurred in connection with the person’s tax-related affairs, even expenses of a capital nature that would otherwise be denied under Section 8-1. A similar section could be inserted to make fee-for-service financial planning advice and investment seminar costs tax deductible.

Why should the Government do it? The system currently discriminates against charging on a fee-for-service basis. It follows that there must be some measure of a product-motivated approach to financial planning. Why? Because it is more tax efficient for the dealer/adviser to be paid out of the client’s ‘pre-taxed’ investment earnings.

If the playing field is to be level, if the objectives of FSR are to be achieved, if Government is to listen to its own advisers, the taxation law will be amended. Until then, there is every good tax reason, in the interests of the client, to continue to provide financial planning on an income commission basis.

Peter Bobbin is partner of theArgyle Partnership.