Navigating the World of Personal Services Income

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Liz Gibbs • Nov 28, 2017

Personal services income (PSI) is income produced mainly from your personal skills or efforts as an individual. The first thing you need to do is work out if any of your income is classified as PSI. If it is, you then need to work out if special tax rules (the PSI rules) apply to that income. If the PSI rules apply, they affect how you report your PSI to the ATO and what deductions you can claim.

The personal services income (PSI) rules were introduced to prevent people from reducing their tax liability by diverting their PSI to an associated entity (a personal services entity, PSE). The PSI regime is contained in Pt 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997).

The PSI regime does not apply to income you derive as an employee or office holder, or income you derive from conducting a personal services business (PSB). There are a number of tests that determine whether a person or a PSE is conducting a PSB.

General rules

Section 84-5 of ITAA 1997 provides that a person's income is PSI if the income is mainly a reward for the individual's personal efforts or skills, regardless of whether it is income of another entity. Taxation Ruling TR 2001/7 provides further guidelines on the meaning of PSI.

Example

Comp Pty Ltd provides computer programming services, but Harold carries out all the work to provide those services. He uses his clients' equipment to do the work. The company's ordinary income from providing the services is Harold's PSI, because it is a reward for his personal efforts and skills.

Broadly, a PSE is a company, partnership or trust whose income includes the PSI of an individual.Where the PSI rules apply, the PSI is treated as the assessable income of the individual. This person is treated as if they are an employee of the PSE, which generally means any deductions are limited to expenses that an employee would be able to claim. The PSE may also have additional PAYG withholding obligations in relation to the person's PSI.

The PSI rules do not treat income as PSI if the individual or PSE (collectively referred to as "the provider") derives income from conducting a PSB.

The tests to determine whether there is a PSB are the results test or, failing that, the 80% rule and one of the additional tests (Div 87 of ITAA 1997). The Commissioner of Taxation has also provided the ATO's view on these tests in Taxation Ruling TR 2001/8.

What are the PSB tests?

The results test

A PSB exists (and therefore the PSI rules do not apply) if the following are satisfied in relation to 75% of the total income:

The work is to achieve a specific result; for example, the contract is to produce a specified outcome and payment is based on performance of the contract.
The provider supplies its own equipment or tools of trade necessary to perform the work, having regards to custom and practice in the particular industry. In TR 2001/8, it is the Commissioner's view that if no tools are required to perform the work, this condition is satisfied.
The provider bears the commercial risks, including liability for defective work; for example, the provider is liable to correct any defects in their work and they bear the cost for the fixing sub-standard work.

If the entity does not meet the conditions of the results test, the alternative is to consider the 80% rule and one of the additional tests.

The 80% rule and additional tests

The 80% rule broadly asks whether 80% of the PSI comes from one client (or from a single client and their associates). If the income from one client and their associates is less than 80% of the individual's PSI, the individual or the PSE is taken to be conducting a PSB if they satisfy any one of the additional tests.

Associates include relatives, partners in a business and their direct relatives, and any controlling or controlled entities (s 318 of the ITAA 1936).

Three additional tests are available:

the unrelated clients test;
the employment test; and
the business premises test.

Unrelated clients test

To pass this test, the provider must be deriving PSI from two or more clients that are not associates of each other and are not associates of the provider. It is the Commissioner's view (TR 2001/8) that if an independent contractor does not know or could not reasonably be expected to know that the clients are associates, the fact that the clients are associates of each other will not cause the test to be failed.

The provider must also be providing the services as a direct result of usual commercial advertising or offers made to the public (eg maintaining a website, advertising in a newspaper or applying for competitive public tenders). There must be a clear link or a causal connection between the activities of making offers to the public and the work engagements.

Employment test

To satisfy this test, the entity must engage others (eg by employment or sub-contracting) to perform at least 20% (by market value) of the work that generates the PSI (known as the principal work). Those engaged to carry out the work cannot be non-individual associates of the provider and they cannot be an individual whose PSI is included in the PSE's income. "Principal work" does not include incidental clerical or administrative work.

A provider also satisfies this test if it engages one or more apprentices for a period of at least six months during the income year.

TR 2001/8 provides the following formula to determine whether at least 20% (by market value) of the principal work is performed by the engaged entity:

The contract price is the total amount paid under the agreement between the provider and the client.

The market value amount is:

the amount paid, if the parties are dealing with each other at arm's length and the amount paid is at least 20% of the contract price – this represents an arm's length charge-out rate for the relevant work; or
the market rate for the principal work performed by the provider, if the parties are not dealing with each other at arm's length.

Business premises test

A provider generally passes this test if it maintains, at all relevant times during the income year, separate business premises used exclusively to conduct the activities from which the PSI is gained, and the premises are not located within the individual's private premises or the client's premises.

The following conditions must be met:

The provider maintains the business premises and mainly uses it to carry out activities from which PSI is gained. "Mainly" means predominantly; that is, making up more than half of the use (TR 2001/8).
The provider has exclusive use of the premises. While the sharing of premises may indicate non-exclusive use, this should be reviewed on a case-by-case basis – the required exclusive use of the business premises is in relation to the relevant work and the relevant lease or other arrangements.
The premises are physically separate from the individual's private premises and from the client's premises.

The business premises should be seen as physically distinct from any adjoining or surrounding premises. The factors relevant to making this determination includes whether (TR 2001/8):

the business premises are detached from the other buildings;
the business premises are functionally dependent upon surrounding buildings;
there is a separate entry for clients and employees; or
the physical appearance of the business premises makes them distinct and separate from adjoining or surrounding premises.

Illustrative example

Sharna is an architect and operates through her company, Sharna Wills Pty Ltd.

In June 2016, the company entered into a two-year contract with a government department to carry out assigned planning projects. The contract stipulates that Sharna is to perform the work assigned to her and she performs all the principal work.

The majority of the work is undertaken at the department's premises or on the job site, with equipment provided by the department.

The fee specified in the contract is fixed at $384,000. Payment is made upon submission of a weekly invoice and is calculated on a time basis (40 hours per week for 96 weeks) at a fixed rate of $100 per hour.

Sharna is not required to remedy defects at her own expense or to indemnify the department for the cost of remedying such defects.

Is the work to achieve a specific result?

No. Payment is not contingent on a result being produced. Sharna is paid weekly for hours worked and she must work on projects assigned to her. There is no requirement that she must complete a project before commencing another.

Does she supply her own equipment or tools of trade necessary to perform the work?

This condition is considered to be satisfied, having regard to department practice; that is, it is common practice that government departments that engage architects provide the equipment necessary to perform the work.

Is the PSE liable, or would it be liable, for the cost of rectifying any defective work?

Neither Sharna nor her company are liable for the cost of rectifying defective work.

The results test is not met. Therefore, the income of Sharna's company is assessable to her at her marginal rates.

It is also unlikely that the 80% rule would be satisfied, as 80% of the PSI comes from a single client.

Want to find out more?

The procedural nature of the PSI rules and the PSB tests mean that you should take the time to carefully navigate them, and it is particularly important to periodically review your circumstances. Careful planning to avoid inadvertently falling within the PSI rules will help alleviate potential issues before they occur.

Please contact us if you would like more information. Call us at Robert Goodman Accountants on 07 3289 1700 or email us at reception@rgoodman.com.au .