by John Jeffreys
In a kind of companion piece to PCG 2021/D2, the ATO has also released a draft ruling, TR 2021/D2, that consolidates and updates earlier guidance material on the operation of the personal service income and personal service business rules (TR 2001/7 and TR 2001/8).
These highly prescriptive substance-over-form rules were introduced into the Income Tax Assessment Act 1997 (Part 2-42) with effect from the 2000-01 year of income, following recommendations made in the 1999 Review of Business Taxation Report (the Ralph Report). The Ralph Report had raised concerns that the income tax base was being eroded through the extensive alienation of personal exertion income by individuals posing as contractors and splitting their income with associates using interposed entities and claiming a greater range of deductions than those available to employees generally.
The draft ruling updates the previous two rulings to reflect the various court and tribunal decisions thathave shed light on these provisions over the last 20 years and freshens up the examples used (there are 40 examples all told). However, TR 2021/D2 does not appear to signal any major departure from the way the ATO has (or has not) been administering these provisions up to now.
The personal services income (PSI) and personal services business (PSB) rules can apply in virtually any business sphere, but the more common examples would be lawyers and accountants, medical practitioners, architects and engineers, business consultants and IT professionals. With the gig economy on the rise, the numbers affected can only increase.
The 50% test
The PSI rules involve a series of tests to work out whether the arrangement is in substance an employment-like arrangement. The initial test is simply whether more than 50% of the consideration received in respect of a particular contract is a reward for the efforts and skills of the individual. That is a fact and circumstances question, and the draft ruling includes a number of examples of how to determine whether the 50% threshold is met. If it is, the income is prima facie PSI income, unless the application of a further series of tests determines that the interposed entity (the PSE) is carrying on a personal services business (PSB).
The results test
Before applying the PSB test, however, an individual with prima facie PSI is excluded from the regime if they can satisfy the results test. The results test requires that for at least 75% of the PSI, the individual is:
- paid to produce a specific result;
- required to provide whatever tools and equipment are required to do the work; and
- required to rectify any defects in the work at their own expense. Example 16 in the draft ruling involves an IT consultant who is paid on an hourly basis, uses mainly the client’s equipment and other resources (apart from their own laptop), works under the direction of the client and is not liable to rectify any faulty work – the results test is not met in those circumstances.
The IT consultant in example 17 of the draft ruling however is paid by results when the work is completed to specifications, uses primarily their own tools and equipment, and is also responsible for rectifying any faults without being able to charge any additional amounts under the contract. The conditions of the results test are met in that case.
Note that all three limbs of the results test have to be satisfied.
Where the individual has prima facie PSI and does not pass the results test, there is still scope for escaping the application of the PSI rules. This involves the PSB rules, which amount to a rough and ready test of whether the interposed entity (usually a trust or a company) is carrying on a business.
The 80% test
The first leg of the PSB regime is the 80% rule – no single client can represent more than 80% of the individual’s total PSI. Where that is the case, the individual must also satisfy at least one of three other tests:
- unrelated clients test – The PSI is sourced from two or more unrelated clients and must be a direct result of making offers to the public (or sections of the public).
- employment test – At least 20% of the principal work (not incidental administrative work) must be performed by others and/or you have at least one apprentice for at least half the year of income; or
- business premises test – The individual owns or leases separate business premises and uses these for the work more than 50% of the time.
The tests have to be carried out every year there is prima facie PSI, and where the interposed entity has several persons with PSI, the test need to be applied separately for each individual.
Where the PSI rules apply (and the PSB rules do not) the PSI and related deductions are attributed to the individual whose personal efforts gave rise to the income (and those amounts are excluded from the interposed entity, the PSE).
There are also limitations on the types of deductions that can be claimed by the individual in respect of the attributed PSI. Non-deductible expenses include:
- deductions that could not be claimed if they were incurred as an employee (eg the cost of travel between home and a place of business);
- mortgage interest, rent, rates and land tax on the individual’s residence (or an associate’s residence); and
- payments, including superannuation contributions, made to associates for non-principal work performed.
While Part 2-42 is a very specific provision, it has always been clear that even where the application of the various tests results in the non-application of the PSI rules, the general anti-avoidance provisions of Part IVA can nevertheless still apply to the arrangement to negate any tax benefit that arises from splitting the income among lower tax associates. Sec 86-10, which describes the objects of subdiv 86A, includes a note which provides:
“The general anti-avoidance provisions of Part IVA of the Income Tax Assessment Act 1936 may still apply to cases of alienation of personal services income that fall outside this Division.”
TR 2001/7 sets out the operation of the alienation measures. TR 2001/8, at paras 261-267, makes it very clear that where an examination of the various factors points to a dominant purpose of income splitting, Part IVA could be applied to the arrangement. A specific example envisages a contractor being paid less than their true worth by an interposed entity, leaving a net profit in the entity that is distributed to associates with a lower rate of tax.
TR 2021/D2 includes a very specific example (#40 – they saved the best for last) involving a computing consultant who has prima facie PSI that passes the results test. That gets him off the hook as far as the PSI rules are concerned, but the ATO signals it would be likely to apply Part IVA because the consultant was underpaid by the PSE to the tune of $40,000. It is not clear whether this amounts to the application of the GAAR or a de facto domestic transfer pricing rule, but the result is the same.
In spite of all this sabre rattling, there does not seem to be much evidence that over the last 20 years the ATO has been aggressively applying Part IVA as a last-ditch line of attack against arrangements that fall outside the PSI rules. Perhaps that is because asset protection is often a lot more than a fig leaf to cover a dominant purpose of obtaining a tax benefit. In many cases having an incorporated entity fronting the business presents more professionally to prospective clients, while in others the clients in fact insist on dealing with a corporate entity.
It is not clear whether it would be best to challenge the ATO’s position and argue that the PSI rules should be seen as an exclusive code or just to let sleeping dogs lie.