Individuals or those with companies that earn income through personal effort and skills should be familiar with the concept of personal services income (PSI). This includes tradespeople but also for consultants that work in a wide variety of fields. Earning PSI is not an ideal outcome as it can limit the deductions you can claim. However, this situation can be potentially avoided if you satisfy the criteria for a personal services business (PSB) or apply to the ATO for a Personal Services Business Determination.
The ATO has recently updated its ruling on Personal Services Income (PSI) to incorporate a myriad of significant court and AAT decisions that have occurred since the original rulings were issued almost 20 years ago. While the principals remain the same, the subsequent court decisions provided clarification on certain aspects of the law. So now is the perfect time for a refresher on the basics of PSI and associated personal services entities (PSEs).
Firstly, PSI only applies to individuals and is income that is mainly reward for personal effort or skills. That is, more than 50% of the ordinary or statutory income received needs to be reward for personal efforts and skills of the individual. Income that is principally generated from supply or sale of goods, supply and use of income-producing assets, or by a specific business structure are not considered to be PSI.
A simple real world example would be a sole trader using their skills to earning income either directly, or through an interposed entity (ie a PSE).
If you're determined to have earned PSI, the deductions that can be claimed will be limited to the deductions that you could've claimed if you were an employee and the income earned was salary and wages. This means that, for example, you'll be unable to deduct rent, mortgage, interest, rates or land tax in relation to a residence or part of a residence that you use to gain or produce PSI. This also largely applies to PSEs in relation to the "test individual".
To avoid that outcome, an individual/PSE can self-assess whether or not they conduct a Personal Services Business (PSB) in an income year, against one of the 4 tests set out below. If any one of the 4 tests is met during an income year, the PSI rules will not apply to limit deductions:
- results test – can be satisfied if at least 75% of a test individual's PSI in an income year is for producing a result as well as being responsible for the cost of rectifying all defects. The individual is also required to supply the plant, equipment and tools of trade needed to do the work.
- unrelated clients test – can be met if an individual or PSE gains or produces income during the year from 2 or more entities that are not associates of each other (or associates of the individual or PSE), and the services must be provided as a direct result of making offers/invitations (eg advertising) to the public at large or a section of the public.
- employment test – is met where the individual/PSE engages one or more entities to perform at least 20% (by market value) of the individual/PSE's principal work. Note, however, test individuals of the PSE do not count towards the employment test.
- business premises test – can be satisfied if the individual or PSE maintains and uses business premises at all times during the income year that meet certain conditions such as being physically separate from premises used for private purposes.
However, if more than 80% of the PSI or PSE's income is from one source (ie the same entity and/or its associates), then only the results test can be used to self-assess whether they conduct a PSB. Individuals and PSEs can also apply to the Commissioner for a Personal Services Business Determination to get certainty on their unique situation.
Want to confirm whether you're still a PSB?
If you're a sole trader with a business and are not sure whether you meet the updated definition of a PSB, we can help you work it out and apply for a personal services business determination if necessary. Don't risk your deductions, contact us today for expert help and advice.
