Personal Services Income (PSI)

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Contents

  • What is PSI?
  • Effect of the PSI rules
  • Results test
  • Unrelated clients test
  • Employment test
  • Business premises test
  • Anti-avoidance

The Personal Services Income (PSI) rules are designed to prevent persons who derive income from their personal services from “splitting” that income with other persons and therefore minimising the overall tax payable. The PSI rules are in Part 2-42 of the ITAA 1997. Taxation Ruling TR 2022/3 contains the Australian Taxation Office (ATO) interpretation of the PSI rules and how they apply. This article mostly quotes directly from TR 2022/3.

What is PSI?

PSI is income earned from an individual’s personal efforts and skills. The following are examples of PSI:

  • salary or wages
  • income of a professional person practising on their own account without professional assistance
  • income payable under a contract which is wholly or principally for the labour or services of a person
  • income derived by a professional sportsperson or entertainer from the exercise of their professional skills, and
  • income derived by consultants; for example, computer consultants or engineers from the exercise of personal expertise.

Though PSI can be earned directly as a sole trader it can also be earned via an entity such as a partnership, company or trust (a personal services entity).

Income is classified as PSI when more than 50% of the income you’ve received from a contract is a reward for your personal efforts or skills, rather than being generated by the use of assets, the sale of goods, or from a business structure. When working out if your income is PSI, you need to look at the income you have received from each contract separately. If 50% or less of the income received from a contract was for your personal efforts or skills, then none of the income from that contract is PSI.

Income that is not classified as PSI includes income earned from:

  • Supplying or selling goods 
  • Supplying or using an income-producing asset
  • A business structure (this will likely apply where a business has substantial income-producing assets, a number of employees, or both). 
An open coworking space, representing the concept of personal services income.

Effect of the PSI rules

If you cannot pass one of the Personal Services Business (PSB) tests within the PSI Rules or do not have a personal services business determination (PSBD) from the ATO, then regardless of the trading structure you choose, your PSI derived will be classified as PSI, which means:

  • You will be unable to claim certain deductions against your PSI (basically, your deductions will be limited to those of a normal employee)
  • Your PSI, less allowable deductions, will be attributed to you, and therefore included in your individual tax return, and taxed at your individual marginal tax rate as though you were an employee. This means that if you operate through a company your business income won’t be taxed at the company tax rate and won’t be able to be paid as a dividend to other shareholders of the company. Or if you operate through a trust, you won’t be able to minimise the tax payable by distributing the PSI to other beneficiaries of the trust.

PSB Tests

The PSB Tests are the:

  • results test
  • unrelated clients test
  • employment test
  • business premises test

Results test

The results test is satisfied if at least 75% of a test individual’s PSI in an income year meets all the following 3 conditions:

  • the income is for producing a result
  • the sole trader or PSE is required to supply the plant, equipment and tools of trade needed to do the work that produces the result, and
  • the sole trader or PSE is, or would be, liable for the cost of rectifying defects.

The results test is based on the common law indicia for distinguishing an independent contractor from an employee. However, it is a statutory provision to be interpreted on the words contained in the provision. As such, where other indicia of an independent contractor are present but the 3 results test conditions are absent, the sole trader or PSE will not satisfy the test.

When applying the results test, it is necessary to consider the contractual arrangement entered into between the sole trader or PSE and the payer. All aspects of the contractual arrangement need to be carefully weighed up, especially when some contractual terms may support a conclusion that the sole trader or PSE is contracting to produce a result and other contractual terms support a conclusion that the sole trader of PSE is contracting to supply the services of a test individual. Contractual clauses that label the nature of the thing being supplied will not be determinative, particularly if they contradict the overall effect of the contractual arrangement. In certain circumstances, it may be necessary to look beyond the terms of a written contract to determine whether the relevant contractual liability actually exists or has been varied by the conduct of the parties, or is a sham.

When working out if a sole trader or PSE (in relation to a particular test individual) meets the 3 conditions of the results test, the custom or practice in the particular industry is a relevant consideration.

The reference to custom or practice in the PSI rules is to act as a safety net for a sole trader or PSE who works in an industry where participants would generally meet the results test but whose contract may not clearly indicate that a particular condition is met. In such a case, the sole trader or PSE can rely on custom and practice to support a conclusion that they meet the particular condition.

However, custom or practice is not intended to override the 3 conditions required to meet the results test. For example, the fact that participants in a particular industry are generally paid for their time will not result in the first condition being met where their agreement clearly indicates that they are not being paid for producing a result.

The income is for producing a result

To satisfy the first condition, the income must be for producing a result.

In contracts that are for producing a result, payment is usually made for a negotiated contract price to achieve a specified outcome. As opposed to an hourly or daily rate for doing work, payment is made when the contractually specified results have been fulfilled. A contract price for achieving a specified result may be calculated by reference to an estimated number of hours applied to an hourly rate. If that estimate changes, a new contract or a variation to the original contract may be agreed between parties, allowing for a change to the negotiated contract for producing the result. What needs to be considered is whether the contract price is for achieving a specified result and not merely payment for the hours worked.

The essence of the contract must be to achieve a result and not to do work. The fact that a sole trader or PSE is required to complete identifiable tasks is not the same as achieving a contractually specified result if those tasks merely form part of the work being paid for on an ongoing basis.

The condition will not be satisfied merely because the contract states that the contract is for producing a result. Consideration should be given to the substance of the arrangement between the sole trader or PSE and the service acquirer and what the sole trader or the PSE is actually being paid for.

Supply of plant, equipment and tools of trade needed to perform the work

To satisfy the second condition, the sole trader or PSE must supply any plant and equipment or tools of trade needed to do the work that produces the result and which a service acquirer would expect the sole trader or PSE to provide or which the sole trader or PSE is contractually required to provide.

There are situations where, having regard to the nature of the work, no plant or equipment or tools of trade are needed to perform the work. Where this is the case, this condition will be met.

Minimal usage of the tools or equipment of others will not of itself disqualify the taxpayer from meeting this condition.

Liability for the cost of rectifying defects

To satisfy the third condition, the sole trader or PSE is, or would be, liable for the cost of rectifying any defects in the work. There is no requirement that they actually perform the work which rectifies the defect, so long as they are liable for the cost of rectifying any defect in the work performed.

The main consideration is whether they are exposed to commercial risk.

Where physical rectification is not possible, the purpose of the provision would be satisfied where a right to claim for damages exists in respect of faulty or negligent performance of contractual obligations and the sole trader or PSE is, or would be, liable for the relevant component of damages awarded for the faulty or defective work.

A requirement to have professional indemnity insurance is an indicator that the sole trader or PSE is liable for rectification where the indemnity insurance is part of the contractual arrangements between the parties. However, the fact that a person may be subject to disciplinary action by a professional body for misconduct is not sufficient to satisfy the rectification element of the test.

This condition will not be satisfied where rectification occurs in circumstances where the sole trader or PSE has not been liable for the cost of rectification.

A contractual term stating the sole trader or PSE has the liability for the cost of rectification of defects would support the conclusion that this condition could be satisfied if the term creates an actual liability.

Having a client refuse to pay for work done if they are unhappy with the service provided is considered a different risk to having the liability to pay for the rectification of defects and will not satisfy this condition.

Unrelated clients test

To meet the unrelated clients test:

  • a sole trader or PSE is required to gain or produce the PSI from providing services to 2 or more entities; those entities cannot be associates of each other or associated with the sole trader or PSE, and
  • the services must be provided as a direct result of making offers or invitations (for example, by advertising) and those offers must be made to the public at large or a section of the public.

If the services are provided by registering through a labour-hire firm or similar arrangement, the test will not be met as the required offer or invitation has not been made to the public at large or to a section of the public.

Direct result of making offers or invitations

To meet this condition, the offer or invitation must be the reason that the sole trader or PSE obtained the work from the client and there must be a direct causal effect between the offer or invitation and obtaining the work.

A wide variety of activities can constitute making offers or invitations (such as print advertising, printing posters, radio and television broadcasting, public tender, having a website and posting internet advertisements), but all require the involvement of making public announcements.

To meet the test, the offer or invitation must operate directly on the client, not the intermediary. Offers or invitations accepted by labour-hire firms or similar intermediaries, registering with labour-hire firms or similar intermediaries, or responding to advertisements on web-based recruitment sites will not meet this condition.

Where it can be demonstrated that a sole trader or PSE has made an offer to the public at large or a section of the public and (as a direct result of that offer) the service acquirer decides to engage the services of the sole trader or PSE but, as a requirement of that engagement directs the sole trader or PSE to a labour-hire firm or similar intermediary as part of the service acquirer’s requirements, the service acquirer will count as part of the unrelated clients test. However, they will not be counted as the source of PSI for purposes of the 80% rule because it is the labour-hire firm or similar intermediary that has the contractual obligation to pay the service provider.

The public or a section of the public

An offer or invitation is made to ‘the public at large’ where any interested member of the public is capable of accepting it. An offer or invitation to ‘a section of the public’ is made in situations where only a select group is chosen to whom the invitation is made. Making an offer or invitation to a section of the public could include offering to provide services to one entity in certain circumstances; for example, in relation to competitive tenders.

A word-of-mouth referral is not generally considered to satisfy the requirements of the unrelated clients test. A word-of-mouth referral is when a sole trader or PSE is offered work because of a recommendation from a previous client or industry contact. However, offers made by word of mouth in a very specialised or niche industry where there are only a very small number of potential service acquirers may, in limited circumstances, meet this condition.

Where there is a prior or subsisting relationship between the parties to an offer or invitation, the following factors are relevant when determining whether the offer or invitation made by the sole trader or PSE is made to a section of the public:

  • The number of people or entities to which the offer or invitation is made. While not determinative, it is likely to be a public offer or invitation if more entities are involved.
  • The nature and content of the offer or invitation. Where the offer or invitation is made as part of a competitive commercial process, such as a public tender, a prior relationship may not detract from the offer being made to the public.
  • The nature of the particular relationship between the parties to the offer or invitation. Where the parties to the relationship deal with each other on an arm’s length basis, the commercial character of the transaction is maintained. Accordingly, the fact that a sole trader or PSE may have worked for or provided services to an entity sometime in the past does not necessarily operate to exclude the sole trader or PSE from satisfying this test.

Who must make the offer

The offer must be made by the sole trader or PSE.

Where an offer is made by an individual and it is clear that the offer is made by the individual as a representative of the PSE, then the offer is considered to have been made by the PSE and this element of the test will be met.

Where an offer is made to a sole trader or PSE by the service acquirer, this element is not satisfied because it is the potential client (service acquirer) making the offer rather than the sole trader or PSE.

Employment test

Sole trader

A sole trader meets the employment test in an income year if they engage one or more entities that perform at least 20% (by market value) of the sole trader’s principal work.

Any individual engaged by the sole trader to perform principal work counts towards the employment test even if they are an associate of the sole trader. Other types of entities engaged by the sole trader to perform principal work only count towards the employment test if they are not an associate of the sole trader.

Personal services entity

A PSE meets the employment test in an income year if it engages one or more entities that perform at least 20% (by market value) of the entity’s principal work. However, test individuals of the PSE do not count towards the employment test.

The first requirement in order to meet the employment test is that there is the actual engagement of another entity by the sole trader or PSE. ‘Engages’ includes making a contractual arrangement or agreement for the services of another entity.

Any other individual who is not a test individual and who is engaged by the PSE to perform principal work counts towards the employment test even if the individual is an associate of the PSE. Entities, other than individuals, engaged to perform principal work only count towards the employment test if they are not associates of the PSE.

If the PSE is a partnership, a partner performing principal work for another partner can be counted for the employment test if they are not also test individuals of the partnership.

In most cases, all partners within a partnership would be test individuals (that is, earning PSI through the partnership) so no such partner could count towards the employment test even if they performed principal work for another partner.

However, a partner who does not earn PSI through the partnership (for example, a ‘husband and wife’ partnership where typically only one partner earns PSI) may count towards the employment test if they are paid to perform principal work for one of the other partners.

A sole trader or PSE will also meet the test if for at least half the income year it has one or more apprentices.

20% (by market value) – single contract in the income year

The ATO will accept the following formula for determining whether at least 20% (by market value) of the principal work is performed by another entity (or entities):

% = (market value amount ÷ contract price) × 100

The market value amount is what the sole trader or PSE charged the service acquirer on an arm’s length basis for the principal work performed by the entity (or entities) engaged by the sole trader or PSE (the charge-out rate).

The contract price is the total amount paid under the agreement between the sole trader or PSE and the service acquirer.

The market value amount would normally exceed the amount that the sole trader or PSE pays to the entity they have engaged.

Where the parties performing the work are not dealing with each other at arm’s length, the market value amount is the market rate that the sole trader or PSE would ordinarily charge a service acquirer on an arm’s length basis for the services of the entity.

20% (by market value) – multiple contracts in the income year

Where the sole trader or PSE provides services under multiple contracts over the course of an income year, the contract price is the sum of all of the contract prices for the year relating to the test individual’s PSI regardless of whether an entity was engaged to assist the sole trader or PSE’s principal work.

The market value amount is, in the case of:

  • arm’s length parties – the sum of all of the amounts charged to the service acquirer for the services supplied by the engaged entity or entities, and
  • non-arm’s length parties – the sum of all the amounts that represent the market rate that the sole trader or PSE would ordinarily charge a service provider on an arm’s length basis for the services supplied by the engaged entity or entities.

Contracts that straddle income years

The employment test is applied in an income year. If a contract goes across more than one income year, the contract price and market value only include the amounts derived in the relevant income year.

Apprentice

An apprentice is a natural person who works for another person for a fixed time under an apprenticeship or trainee arrangement. This is a formal arrangement involving an obligation to learn a trade, business or skill.

The apprentice need not be directly apprenticed to the sole trader or PSE. An apprentice that is supplied by a Group Training scheme or similar type of arrangement to work for the sole trader or PSE as part of their trade training would meet the requirement.

The employment test does not require that the same apprentice is engaged or that the qualifying period comprises consecutive days.

Business premises test

The business premises test requires that at all times during the income year, the sole trader or PSE maintains and uses business premises:

  • where the main activities conducted there gain or produce PSI
  • of which they have exclusive use
  • that are physically separate from any premises that they (or any associate) uses for private purposes, and
  • that are physically separate from the premises of the service acquirer (or any associate of the service acquirer).
    Business premises

Business premises are premises that have the usual physical attributes and fixtures associated with commercial or business usage and, from a business and commercial perspective, are apt for the purpose of carrying on a business.

Maintains and uses

It is a requirement that the sole trader or PSE maintains and uses the business premises at all times in the income year. This means that the sole trader or PSE must do more than merely have leased premises in its name to pass the test. The premises should actually be used to produce the PSI.

Business premises are maintained when they are kept in existence or retained. Business premises may be maintained by ownership or by way of occupancy under a lease, sublease, licence or possession. However, not all of these occupancy arrangements satisfy the ‘exclusive use’ requirement of the test.

There is no requirement for running costs associated with the premises, such as cleaning or utility costs, to be borne by the sole trader or PSE.

At all times in the income year

The sole trader or PSE must have business premises for the whole period during which activities are conducted for the purpose of generating PSI.

Where a sole trader or PSE commences or ceases activities during the income year, it is sufficient that the business premises are maintained and used for that part of the income year in which the activities are conducted.

Changing business premises

A sole trader or PSE is not required to maintain and use the same business premises throughout the whole year; however, they need to have business premises at all relevant times during the year.

Main activities generate personal services income

The generation of PSI must be the primary usage to which the business premises are put. Where more than one activity is conducted at the premises it is necessary to determine which activities generate PSI and which activities generate non-PSI. This requirement will be met where more than 50% of the activities conducted at the premises are directed at producing PSI.

This requirement can still be satisfied even if the sole trader or PSE conducts activities from other premises.

Exclusive use

A sole trader or PSE is required to have exclusive use of the business premises.

This will be satisfied where premises are occupied under ownership or lease as the legal nature of the proprietary interest allows the holder to determine who may or may not enter the premises and, therefore, they have exclusive use for the purposes of the test.

A sole trader or PSE cannot have exclusive use of the premises if they do not have exclusive possession. If the owner grants permission for the occupation of premises amounting to a licence and not a lease, the individual sole trader or PSE does not have exclusive use of the premises.

A sole trader or PSE cannot lease premises together with another individual or entity on the basis that they share the premises to meet this requirement. As joint lessees, neither lessee has exclusive use of the premises.

Shared areas

Shared areas, such as reception and waiting rooms, are considered ancillary to the business premises and are not included for the purposes of the business premises test.

Physically separate

Business premises must be physically separate from premises that the sole trader or PSE (or their associates) use for private purposes.

For example, a PSE may lease a shed in an associate’s backyard as its business premises. As the shed is part of the premises consisting as the entirety of the dwelling and surrounds (curtilage) used by the associate for private purposes, the shed will not be considered to be physically separate.

On the other hand, if the PSE leased a shed in an associate’s backyard that had its own entry from the road and was blocked off from the associate’s private residence by a fence with no access to the private residence, the shed would, in this scenario, be considered to be physically separate to the associate’s private premises.

The business premises must also be physically separate from the premises of the service acquirer or an associate of the service acquirer. For example, where a sole trader or PSE leases a room within the premises of the service acquirer for its business premises, the room is not considered to be physically separate from the premises of the service acquirer and would not meet what is required for the business premises test.

On the other hand, where a sole trader or PSE leases a discrete floor or part of a floor from the service acquirer for its business premises, such premises may be physically separate from the premises of the service acquirer depending on such factors as:

  • the extent to which the floors or parts of floors are functionally and physically integrated with each other
  • entry and exit facilities
  • signage
  • security arrangements, and
  • occupancy rights.
A woman working in a cafe.

Anti-avoidance

The ruling reminds readers the general anti-avoidance provisions contained in Part IVA of the Income Tax Act (1936) may still apply to cases where the PSE is considered to be conducting a PSB and the PSI rules do not otherwise apply. The ATO may seek to apply Part IVA where there are factors indicating that the dominant purpose of the arrangement is to obtain a tax benefit by diverting, alienating or splitting an individual’s PSI or retaining profits in the lower taxed PSB.

In deciding whether the PSB and test individual has engaged in income splitting in order to gain a tax benefit, the following considerations may be relevant:

  • whether the salary or wages paid to the test individual is commensurate with the skills exercised or services provided, and with the income received by the PSB for those services
  • whether the PSB distributes income to associates and does not distribute income to the test individual who provided the actual services, and
  • whether the salary or wages paid to associates by the sole trader or PSB is not commensurate with the skills exercised and services provided, and the income received by the sole trader or PSB is for services performed by the test individual.

The most obvious example of a situation where there may be income splitting to which Part IVA could apply would be where an independent contractor (conducting a PSB through an interposed entity) is paid less than the contracted price for their work and the profit made as a result of paying less than the contracted price is distributed to the contractor’s relatives who are on a lower marginal tax rate or accumulated in the interposed entity and taxed at a lower marginal rate of tax.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.