According to the ATO’s small business advice and guidance area, the application of the personal services income (PSI) is one of the top questions business clients have. To recap, the PSI rules are a suite of ATO provisions designed to prevent persons who derive income from their personal services from “splitting” or “alienating” that income with other persons and therefore minimising the overall tax payable.
If you cannot pass one of the tests within the PSI Rules and do not have a personal services business determination (PSBD) from the Commissioner, 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 your business income if you operate through a company won’t be taxed at the company tax rate of and won’t be able to be paid as a dividend to other shareholders of the company. Or, where 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, and
- You will have special tax return obligations.
Below, a flowchart setting out the operation of the PSI rules and can be used to determine whether the PSI rules apply.
The ruling, which applies retrospectively to income years commencing both before 23 November 2022 and after this date, considers:
- How to identify PSI
- How the PSI rules apply to an individual or entity, and
- The application of the personal services business (PSB) tests.
What is PSI?
PSI can be derived in almost all industries and is essentially a reward for an individual’s personal efforts and skills. Though it 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).
The reference to ‘or would mainly be such a reward if it was the income of the individual' applies to situations where the income is legally derived by a PSE and not the individual. If a PSE fails to meet a PSB test in respect of a test individual, the net PSI is deemed to be the income of the test individual and is attributed to that individual.
As TR 2022/3 notes, 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.
As the ruling notes (with accompanying example) income that it not captured as PSI includes:
- Salary and wages (an employment relationship must be in play which draws in the employee/contractor distinction, but not the extended definition of employee contained in section 12(3) of the Superannuation Guarantee Administration Act)
- Supplying or selling goods (example 5)
- Supplying or using an income-producing asset (example 4)
- Income from a business structure (this will likely apply where a business has substantial income-producing assets, a number of employees, or both). (Examples 6, 7 and 8).
Helpfully Taxation Ruling TR 2022/3 contains the following flowchart which illustrates the operation of the rules and can be used to determine whether the PSI regime applies (at paragraph 270):
Unrelated clients test
The new ruling provides additional guidance and clarifies the ATO’s view on this aspect of the unrelated clients test following a recent Full Federal Court decision.1 In that case, the taxpayer provided services to just over half a dozen clients via his company, and maintained a Linkedin profile which was used by recruitment agencies to assess his suitability for roles. The Full Court ruled that because none of the end clients were engaged by the taxpayer as a direct result of the Linkedin profile, the unrelated clients test was not met.
This fresh guidance is particularly welcome given the enormous growth in online profiles/advertisements since the original PSI ruling was issued by the ATO back in 2001. To be clear, it is not sufficient to point to a online profile or advertisement. Instead. there must be a real and causal connection between it, and the obtaining of work from it.
Other points about this test that are noted in the ruling include:
- Public at large – 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.
- Labour hire firms – 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
- Examples of offers – 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.
- Word of mouth – A word-of-mouth referral is not generally considered to satisfy the requirements of the unrelated clients test
- Offer made by service acquirer – 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.
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.
The ruling provides only one other example (example 41). This is in contrast the now withdrawn TR 2001/8 which is very expansive on Part IVA including providing many more examples (which are still relevant) than the fresh ruling.
Differences from the draft ruling
The finalised ruling makes two important changes from the draft.
Firstly, the final ruling totally dispenses with a starting point contained in the draft ruling. That starting point was that in determining whether the income from a practice company or trust is from a business structure and not from PSI the Commissioner’s starting point was that:
- Where a practice company or trust has at least as many non-principal practitioners as principal practitioners, the income of the entity is considered to be derived from a business structure.
- Where a practice company or trust has fewer non-principal practitioners than principal practitioners, then whether the income is considered to be from a business structure will need to be determined by considering the various factors discussed later in the draft ruling.
The finalized ruling removes this assumption entirely by deleting the relevant paragraphs.
Secondly, the finalized ruling provides clarity around whose PSI it is. Both the draft and final ruling state that PSI derived under a contract belongs to the individual with the contractual obligation to provide their services (the Test Individual). Consequently, even where a sole trader engages another person to help with the work, the PSI belongs to the sole trader if they are the only individual with an obligation under the contract.
In the case of multiple individuals working through a PSE, each separate amount of income received by the PSE must be examined to determine which individual did the work. However, unlike directly contracted individuals, determination are not limited to just the contract, but also include the invoice. The finalised ruling adds a new example (Example 13) to illustrate this point.
Example – multiple service providers
Matthew is a management consultant who works through his company MC Pty Ltd, which enters into a contract with BC Energy Pty Ltd to provide its broad range of services. The contract does not stipulate a particular individual who is required to provide any of the particular services. MC Pty Ltd engages 3 subcontractors who, along with Matthew, perform the various services.
BC Energy Pty Ltd issues work orders for separate pieces of work required to be completed under the contract.
MC Pty Ltd issues invoices to BC Energy Pty Ltd each month for the work performed during the month on each work order. The invoices state which individual performed the services. While the contract between MC Pty Ltd and BC Energy Pty Ltd is broad, the relevant business records and communications (for example, invoices and emails) provide factual clarity that each individual performed specific work and it is their personal effort and skills that are being rewarded. Each discrete amount of income invoiced and received by MC Pty Ltd will be the PSI of the test individual who generated it as it is mainly a reward for their individual personal efforts and skills and may be attributed to and included in the assessable income of each test individual depending on whether MC Pty Ltd passes or fails the PSB test by reference to each test individual.
Each of the individuals are test individuals. The invoices issued under the contract evidence that they were responsible for performing the services that utilise their personal efforts and skill.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.