The introduction of the personal services income (PSI) regime in 2000 changed the way income from personal effort earned by contractors, consultants, and individual practitioners such as doctors is dealt with. There are a number of significant tax consequences for clients caught by these rules.
Personal Services Income (PSI) is income that is mainly derived as a result of the personal efforts (the labour and skill) of an individual who is not an employee or office holder.
It’s quite common for non-employees such as consultants, contractors etc. to operate through an entity such as a trust, company or partnership. With these entities receiving the income (rather than deriving it in a personal capacity), tax advantages may be enjoyed such as paying tax at the lower corporate rate, diverting income to taxpayers on lower marginal tax rates, and more. To curb these advantages in relation to income that is essentially earned by the efforts of an individual, the ATO introduced the “PSI rules”.
The PSI rules are a suite of ATO provisions designed to prevent persons who derive income primarily from their personal services from splitting or alienating that income with other persons. Put simply, the PSI rules treat income earned by the individual but paid to the entity (that is, paid to the trust, company or partnership) as the income of the individual.
Professionals commonly affected by the PSI rules include doctors, construction workers, IT consultants, engineers and financial professionals. For individuals, irrespective of the trading structure they are using, there are a number of tests that need to be considered in order to determine whether or not the income they have derived will be deemed to be PSI as per the following flowchart:
In practical terms, if a client is caught by the PSI rules, what does it mean? There are several tax consequences as follows:
- The PSI, less allowable deductions, will be attributed to the individual (not to a company at the 27.5% tax rate, or not to another beneficiary of a trust etc), and therefore included in their individual tax return, and taxed at marginal tax rates as though they were an employee.
- Payments made to the individual’s spouse (or other associates/relatives) will not be deductible where such a payment relates to non-principal work (e.g. where a spouse keeps the books or issues invoices or performs secretarial work etc. for their husband who is a builder). Nor will superannuation contributions to associates/relatives be deductible for this type of work.
- The individual will be unable to claim certain deductions against their PSI. Broadly speaking, deductions will be limited to those of a normal employee. Consequently the individual or entity cannot deduct rent, mortgage interest, rates or land tax in respect of the individual’s residence.
- The individual will have special tax return obligations.
More information and essential details can be found in the full version of this article, which appears in the November issue of The Taxpayer magazine. Tax & Super Australia members receive this magazine as a member benefit.
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