The Australian Taxation Office (ATO) has issued revised guidance on the operation of the personal services income (PSI) and personal services business (PSB) rules. Contractors who previously thought they passed the PSI rules under the unrelated client test by having a social media account or other advertisement that listed their services, may now fail that test as per the revised guidance unless they can show that the acquisition of their customers or clients directly resulted from and was caused by the information publicised on the advertisement, or social media account.
On 23 November 2022, the ATO finalised Taxation Ruling TR 2022/3 (the ruling), detailing its guidance on the operation of the PSI and PSB rules. The ruling combines and replaces the ATO’s previous rulings, TR 2001/7 on the meaning of PSI, as well as TR 2001/8 defining a PSB. Both have now been withdrawn. The ATO states that the principles set out in the old rulings have not changed however, TR 2022/3 further clarifies the view of the ATO to take into consideration several judicial decisions handed down since 2001. Particularly in relation to the types of arrangements that will satisfy the unrelated clients test used in determining whether a taxpayer is conducting a PSB.
TR 2022/3 applies retrospectively to income years commencing both before 23 November 2022 and after this date.
What is personal services income?
The ruling explains that PSI is income that is ‘mainly’ a reward for an individual’s ‘personal efforts and skills’. Only individuals can have PSI. It can be earned directly by a sole trader, or indirectly through an entity known as a personal services entity (PSE), i.e. a company, partnership or trust that receives the PSI of the individual and is interposed between the individual and the client receiving the services.
Why were the PSI rules introduced?
The PSI rules are designed to mitigate individuals reducing or deferring income tax by splitting their PSI to other individuals by limiting certain tax deductions. The PSI rules are also designed to limit the diversion of PSI to associated entities through company’s, partnerships, or trusts. Where the PSI rules apply in these circumstances, the PSI received by the company, partnership or trust will be attributed back to the individual who performed the personal services. The PSI rules also restrict the types of deductions that can be claimed against PSI for sole traders and PSEs.
What is not PSI?
Generally, income is not PSI if it is mainly generated from the:
- Supply and sale of goods – for example, the manufacture and sale of furniture. Although personal efforts and skills may be required to produce the furniture, the contract is for the sale of the furniture, rather than the individual’s personal efforts or skills
- Supply and use of income-producing assets – for example, income received from the use of a truck and backhoe to do construction work, where the value or significance of the equipment is greater than the value of any personal services provided to operate the equipment
- Business structure of an entity – for example, where the entity has substantial income producing assets and/or a number of arm’s length employees and generates income from the profit-yielding structure of the business. The income is more likely to be generated by the profit-yielding structure of the business rather than from the rendering of personal services by the principles of the business.
What is a personal services business?
A PSB is conducted in an income year if:
- One of the following four PSB tests is met, or
- If there is a personal services business determination (PSBD) issued by the Commissioner in relation to the PSI of an individual.
The four PSB tests are:
- Results test
- Unrelated clients test
- Employment test, and
- Business premises test.
If one of the PSB tests is met in an income year, the PSI rules will not apply.
Unrelated clients test update
TR 2022/3 provides additional guidance and clarifies the ATO’s view of the operation of the unrelated clients test following the decision of the Full Federal Court in FCT v Fortunatow [2020] FCAFC 139 (Fortunatow’s case).
To pass the unrelated clients test, a sole trader or PSE must meet both the following conditions:
- provide services to two or more clients, not associated with each other or associated with sole trader/PSE, and
- the services must be provided as a direct result of making offers to the public at large or a section of the public.
However, clients obtained merely through registration with employment agencies or labour hire firms will not meet this condition.
In Fortunatow’s case, the Full Federal Court examined whether the income derived from Mr Fortunatow’s services and conducted through his company was caught by the PSI rules or the arrangement satisfied the unrelated clients test under the PSB rules.
Mr Fortunatow provided services to eight different end clients through his company. He also maintained a LinkedIn profile which was used by recruitment agencies to assess his suitability for roles. The Full Federal Court found that to meet the unrelated clients test, there needs to be ‘a direct causal connection’ between the services provided and the offer to the public. As clients engaged Mr Fortunatow through recruitment agencies, and none of the clients engaged him as a direct result of his LinkedIn profile, he did not satisfy the unrelated clients test.
ATO’s view on the unrelated client test in ruling
The ruling states that:
- The work obtained from the client must be as a direct result of the offer or invitation, i.e. the offer or invitation must be the reason that the sole trader or PSE obtained the work from the client and there must be a direct causal effect between the offer and obtaining the work
- The offer can constitute a wide variety of activities including print or internet advertising (we assume this would cover social media and other contemporary forms of advertising), but all offers must involve making public announcements and cannot be made through a labour hire-firm or similar intermediary
- The ruling also confirmed that an offer to ‘a section of the public’ can include situations where the invitation is extended to a select group of the public
- Word-of-mouth referrals generally won’t satisfy the conditions unless offers are made to specialised or niche industries
- Where there is an existing relationship between the parties to the contract, the ATO recommends considering whether the individual or PSE is making an offer to a section of the public.
Anti-avoidance rules may still apply
The ruling states that the general anti-avoidance provisions in Part IVA of the ITAA 1936 may still apply to cases where a PSE is considered to be conducting a PSB and the PSI rules do not apply. Particularly 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.
For example, Jason is an independent contractor conducting a PSB through an interposed company that is a PSB because it passes the results test in relation to Jason’s PSI. Jason is the only employee of the company, and he is paid salary from the company that is substantially less than the contracted price for his work. The profit made as a result of paying Jason’s salary less than the contracted price is either distributed to Jason’s spouse who is on a lower marginal tax rate, or the income is accumulated in the interposed company and taxed at the lower company tax rate (i.e. 25%). Were the ATO determines the dominate purpose of this arrangement is to obtain a tax benefit, Part IVA may apply to reverse the tax benefit.
BDO Comment
BDO is pleased the ATO has updated its guidance on the PSI rules, particularly for clarifying the ATO view of the unrelated client test following the recent court cases that dealt with this test. Any clients that have relied on passing the unrelated clients test by advertising on social media or elsewhere, need to reconsider this test to ensure that there is a direct causal connection between the clients that were obtained, and the information on the advertisement/social media account.
It is also a timely reminder that passing the PSB tests does not necessarily mean other anti-avoidance tests will not apply, for example the general anti-avoidance rules in Part IVA may have application if the dominate purpose of entering the arrangement was to obtain a tax benefit.
If you have any questions about this technical update, or would like more information on personal services income, please contact your local BDO tax adviser.