Understanding ATO's Personal Service Income Rules

It's quite common for people to structure their professional affairs by setting up an entity to run their business through. This could be a trust, a partnership or, most often, a company.

The tax rate for small companies is just 25% which compares very favourably with the top personal tax rate of 45%. In addition, companies can claim a wider range of tax deductions and have the freedom to distribute franked dividends to shareholders (or alternatively to retain the profits in the business).

Clearly, this could be a very effective way of sheltering profits for a small business and for that reason, the ATO often seeks to apply what are known as the personal services income (PSI) rules to regulate such situations.

The impact of the PSI rules, for those affected by them, is:

• income within the so-called interposed personal services entity (PSE) typically a company, can be attributed back to the individual taxpayer
• the range of deductions available is limited to those typically available to individuals.

In short then, if you fall into the scope of the PSI rules, you can find the ATO "looking through" your business structure and taxing you as an individual.

Who is affected?

The measures apply to companies, trusts and partnerships where the income of the entity is derived primarily as a result of the personal efforts or skills of an individual.

The rules do not apply to income that is mainly:

• for supplying or selling goods (for example, from retailing, wholesaling or manufacturing), or
• generated by an income-producing asset (such as a bulldozer) or
• for granting a right to use property (for example, the copyright to a computer program), or
• generated by a business structure (for example, an accountant working for a large accounting firm).

In practice, the rules would impact the following professions where the practitioner is running their small business through another entity:

• Medical practitioners
• Dentists
• Accountants
• Lawyers
• Engineers
• Architects
• IT consultants
• Entertainers

Example:

CPS Pty Ltd provides computer programming services but David does all the work involved in providing those services. David is the only employee of CPS Pty Ltd. David uses the client's equipment and software to do the work. CPS's income from providing the services is David's personal services income because it is a reward for his personal efforts and skills.

Example:

Bert owns and drives a bulldozer that he uses on building sites. The income is not Bert's personal services income because it is derived mainly by the use of the bulldozer and not by Bert's personal efforts or skills.

How do the rules work?

First things first: these rules are complex! Given the scope of the rules to catch the activities of many professionals and the difficulty which many people have in working out if they are caught, it is essential that you take professional advice.

If you receive income that is mainly a reward for your personal efforts or skills, you may fall within the PSI rules.

To be exempt from the rules, you need to be a personal services business (PSB). For a business where more than one individual generates the PSI, the rules need to be applied to each individual. It is possible for one individual to conduct a PSB but not another.

You qualify as a PSB if:

• you meet the results test
• less than 80 per cent of your personal services income in an income year comes from one client and you meet one of the other three personal services business tests (the unrelated clients test, employment test or business premises test), or
• you obtain a determination from the ATO confirming that you are a personal services business.

The results test

The results test is a self-assessment test and a PSE can self-assess that it conducts a PSB in relation to test individual's PSI in an income year if it meets the results test in relation to at least 75% of that test individual's PSI.

To pass the results test –

• the individual works to produce a result. For example, a contract to build or produce a software program for a fixed set price would be a contract for a result. In contrast the payment of an hourly rate to develop the software program is more likely a contract for personal services and would not satisfy this criterion;
• the individual provides the tools and equipment necessary (if any) to produce the result; and
• the individual is (or would be) liable for the cost of rectifying any defective work.

If the results test is not satisfied, there are three other tests available to self-assess against. These tests can only be considered if 80% or more of the personal service income does not come from one source.

If the 80% threshold is breached, the individual cannot consider the other tests and must apply to the ATO for a PSB determination in order to be classified as a PSB.

The three tests are:

1. The unrelated clients test: The unrelated clients test will be satisfied if the PSI services are provided to 2 or more entities that are not associates of each other and are also not associates of the individual or entity. The services must also be provided as a direct result of making offers or invitations to the public at large (or to a section of the public). Making an offer to the public includes advertising, tendering for work, maintaining a website or word of mouth referrals. Services offered through labour hire companies and other such businesses that arrange to provide services directly for clients do not qualify under this test.
2. The employment test: The employment test will be satisfied if the business engages one or more entities during the income year, and that entity, or those entities together perform at least 20% of the market value of the principal work for the year. For partnerships, the value of work performed by one partner for another in generating any personal services income is taken into account. The employment test will also be satisfied if the business has one or more apprentices for at least 50% of the income year.
3. The business premises test. The business premises test is satisfied by either an individual or personal service entity if at all times during the income year they maintain and use business premises at which the individual or entity mainly conducts activities from which personal services income is gained or produced, and that are –

• used exclusively by the individual or personal service entity;
• physically separated from the premises of any of their clients (or associates of those clients) to which they provide services.
• physically separated from any other premise that is used for private purposes by the individual or personal service entity or any of their associates which includes:
  • a relative,
  • a spouse,
  • a partner or a partnership of which you are a partner,
  • a trust of which you are a trustee or a beneficiary, or
  • a company which you control

Personal services business determination

Taxpayers can apply to the ATO for a personal services business determination.

This is available regardless of whether the taxpayer derives more or less than 80% of their personal services income from a single source.

For taxpayers who receive more than 80% from a single source, this is the only way to be treated as a personal services business.

A individual or entity can apply for a Personal Services Business Determination from the Commissioner under any of the following circumstances:

• They could be reasonably expected to meet the results, employment or business services test
• Unusual circumstances prevented the results, employment or business services test from being met
• The unrelated clients test was met, or or could reasonably be expected to be met, but unusual circumstances prevented the 80% rule from being satisfied
• Unusual circumstances prevented the unrelated clients test and 80% rule from being met. 

To issue a Personal Services Business Deterimation, the Commissioner must be satisfied that, if not for the unusual circumstances, the individual or entity would have met, or could reasonably be expected to meet, the tests.

What now?

Contact H&R Block for further guidance, particularly if you're starting out in a career in one of the professions likely affected by the rules (listed above) or if you're already in one of those professions and aren't sure you've got the most tax efficient structure. Contact our Business Services team on 13 40 42 or email tbs@hrblock.com.au

June 2024