This week on Tolerable Tax, let’s talk Personal Services Income (PSI)! Rather than having you nod off while I start this week by excitedly listing all the legislative references and case law surrounding this topic, I thought it would be more interesting to simply introduce you to Ms April One.
April is a financial consultant (by day… and all round prankster by night!). April is seeking to start up a new consulting business. April’s business plan is as follows:
• April wants to establish a company to operate the business; she will be the sole director and her Family Trust the sole shareholder;
• There will be one client, whom April has advised with in a previous employment role;
• April does not wish to take on any employees and will perform all of the principle consulting work herself;
• April will have a laptop to access her client’s financial platform, no other equipment is provided;
• April will likely be working at the clients premises and her personal study (at her residence);
• April will pay herself a commercial wage from her company, expecting that any balance of net profit can be retained by the company and taxed at the corporate tax rate of 30%.
This is an all too common scenario in the business services industry, whereby experts who have built up their knowledge and skills over their working life seek to branch out on their own. Unfortunately for these experts (and April), the PSI provisions will seek to limit diversion of income derived from an individual’s personal effort and skill to a separate entity.
Returning to April… after we break the news that the income she will be deriving in the company would be considered PSI – being income from her personal efforts or skill – we explain that the company is therefore a Personal Services Entity. It is then important to establish whether or not the company would be considered a Personal Services Business and if so, whether the business being run via a business structure* (whoa… April is understandably fooled by these terms!). So for April’s benefit, let’s consider the various tax outcomes that would be applicable, depending on which of these scenarios is applicable:
• If the company is a Personal Services Entity that fails the Personal Services Business tests, it must attribute the net personal services income to April. The company will not be subject to tax on the PSI, instead April will be assessed on the income and taxed at her individual marginal tax rate;
• If the company is considered a Personal Services Business (i.e. it satisfied the Personal Services Business tests) and the income is NOT considered to be derived from a business structure*, the income is will ultimately be assessable to April and taxed at her marginal tax rates; or
• If the company is considered a Personal Services Business (i.e. it satisfied the Personal Services Business tests) and the income is considered to be derived from a business structure*, the company will be assessed on all it’s income (including any Personal Services Income) and taxed at the corporate tax rate.
* The consideration of “business structure”, whilst technically being beyond the standard PSI provisions, is extremely important to consider as the Australian Taxation Office released guidelines explaining how they will assess the risk of Part IVA applying to the allocation of profits from a professional firm carried on through a partnership, trust or company, where the income of the firm is not personal services income. Please let me know in the comments if you would like a discussion of “business structure” as it applies to Professional Services firms and I will be happy to cover this is a future post of TT!
I know I am interrupting April’s story again…. but it’s important to briefly make you aware of the tests that are used to determine whether a business deriving personal services income is considered a Personal Services Business! The tests are:
The Results Test
This test requires you to consider whether you receive payment for achieving a specific result or outcome. You will satisfy this test if (for at least 75% of your PSI) you:
1. Receive payment for a specified result; and
2. Provide your own equipment and/or tools of trade; and
3. Are obligated/required to rectify any defects or a liable for costs to rectify.If you fail this test, you must consider the second test, the 80% Rule.
The 80% Rule
You satisfy this test where each of your clients/customers provide less than 80% of the total PSI and you meet 1 of the following 3 tests:
1. The Unrelated client rule;
2. The employment test;
3. The business premises test.
So given April’s business plan, and after reviewing the requirements of PSI, it is clear that the consulting income being derived by her through the company will be considered PSI. The company would be considered a Personal Services Entity and not a Personal Services Business as it does not meet the Results Test or 80% Rule. There is also no business structure (as April is the sole earner of all professional services income). As a result, it is likely that all net income of the business will be attributed to April, assessed at her personal tax rates.
Now, in saying all this, businesses are a moving beast, circumstances will change. If April expanded her business, commenced deriving income from more than 1 client, took on employees who assisted with the principle consulting work (not simply administration tasks), leased office space (separate from any of her clients premises and not connected to her main residence), the company may then be considered to be carrying on a Personal Services Business. This may change the taxing point of the PSI. Continued monitoring is required.
As a footnote to our story… April decided that she needed a sea change, ceasing business as a financial consultant, she opened a retail store called “Fooled You”, selling whoopee cushions and snakes hidden in nut tins (that never gets old!)! We wish her the best!
So where to from here?
• Are you a contractor seeking to start a new business? Be mindful of PSI;
• Whether you decide to start your business as a sole trader or via a separate entity (partnership, trust or company), PSI will apply to varying degrees;
• Speak to your tax advisor during the planning phase of your business, there may be opportunities that will limit the application of the PSI regime;
• Be aware of the ATO Risk Guidelines relating to the allocation of profits of professional services businesses carried on as a partnership, trust or company.
Please let me know if you would like a particular topic discussed in a future instalment of TT and I will do my best to accommodate! Remember, I am unable to give advice, but am always happy to share my thoughts on an area of tax. For specific advice, talk to your advisors or contact us. Next week, I will be discussing use of Corporate Beneficiaries. If you have a trust structure or clients that do, put a reminder in your calendars as you won’t want to miss this!
So until then, may your tax be tolerable!