The Personal Services Income (PSI) rules are designed to prevent income produced through personal labour from being taxed at a lower rate than if it were in your own name.
The PSI rules apply where an entity (that is a company, trust or partnership) generates income mainly from the personal efforts or skills of an individual person. This often comes up as an issue for professionals (such as doctors, dentists, engineers, lawyers, accountants, consultants, entertainers or construction workers, etc). Basically, anyone who uses their personal skill or knowledge to generate income can be caught.
The rules are based on the principle that the money you earn from your labour, expertise or skills should normally be subject to income tax. That is, you shouldn’t be able to hide the income in a company ot prevent it from being taxed at a higher marginal tax rate. The rules are therefore designed to stop you from trying to reduce, or delay, your personal income tax bill by trying to channel your income through a different business structure.
The PSI rules work by:
- Allowing income to be attributed to you directly as an individual (ignoring the company or other structure that the income flows through) – therefore making you liable for income tax on that income.
- Limiting the available tax deductions to only those that can normally be claimed by individuals.
Unfortunately, the PSI rules are complex. Over the years there have been quite a few court cases involving PSI rules. The ATO recently releases draft guidance on how to interpret the rules, bringing together numerous examples.
What happens if the Personal Services Income rules apply?
If the PSI rules apply to your business, then there are two main consequences.
- There are limitations on the types of expenses you can deduct for tax purposes. You can only claim the same deductions you could as an employee, rather than as a business. The aim of the PSI rules is to align the tax consequences of employees with those who perform the same services, just via a company or trust structure.
- You are tax as though you are an employee, not a separate company and you have specific reporting obligations in your tax return.
Do the Personal Services Income rules apply to me?
What’s not caught? The selling of goods or where you receive a salary and wage as an employee.
The first step is to determine whether you earn personal services income. If you do, you still may be exempt from the rules if you qualify as a personal services business (PSB). To see if the PSI rules apply, or whether you are a PSB, work through each of the following steps:
- Step one – working out whether you receive personal services income.
- Step two – seeing if you satisfy the “results test”. Are you engaged in your work to produce a result (as opposed to just charging for your time)?
- Step three – whether you pass the “80% test”. Whether 80% or more of the income come from a single client.
- Step four – this introduces three final tests, which look at the way your business operates. If any of these tests are satisfied, the PSI rules will not apply:
- Do you advertise and provide services to “unrelated clients”,
- whether you operate from business premises; and
- whether you employ others to do work.
We will now guide you through each of these steps.
Step one – do you receive personal services income?
What are the conditions under which you earn income? For example, what the terms and conditions are in the contract, your invoices and any other written agreements you have entered into.
For this step, calculate for each contract what proportion of your income derives from your efforts, labour, knowledge, expertise or skills versus what proportion derives from other sources. Other sources include supplying goods or materials, providing tools, leasing property or equipment or licensing an asset such as software. If more than half your income comes from your personal efforts, then all the income for that contract is treated as PSI.
If income from any of your contracts counts as PSI, you then need to look at steps two to four to see if the PSI rules apply.
Step two – the “results test”
To pass the results test, you need to satisfy all three of the following conditions:
- You are paid to produce a specific result or outcome. This will usually not be satisfied if you are being paid based on an hourly or daily rate.
- You provide the plant, equipment or tools (or the job doesn’t require them).
- You are required to fix any mistakes at your own cost. This will not usually be satisfied if you can charge for your time spent in fixing defects in your work.
If you satisfy all three of these conditions, your business is a PSB, which means the PSI rules don’t apply. But if you don’t pass this test, you must instead progress to step three.
Step three – the “80% test”
In this step, you look at the mix of clients from which you earn PSI.
Firstly calculate what amount of PSI from each client. This includes “associates” – that is, income that comes from family members, business partners or related trustees, beneficiaries or corporate entities is all treated as coming from the single client.
If 80% or more of your PSI comes from a single client (including associates), the PSI rules will apply. It might still be possible for you to apply for a “PSB determination” from the ATO if you think you will pass the employment or business premises test (see step four).
If you don’t have a single client that accounts for 80% or more of the PSI you earn, you can progress to step four.
Step four – the final tests
If you’ve reached this step four, you’re still at risk of the PSI rules applying. However, if you can pass any of these three final tests, you will be allowed to characterise your business as a PSB and the PSI rules will not apply.
These final tests are:
- The unrelated clients test. You pass this test if your PSI comes from at least two different and unrelated clients and you also promote your business generally to the public (for example, via a website, by applying for tenders or advertising).
- The employment test. This test applies if you employ others or engage contractors to do at least 20% of the principal work that generates the PSI. “Principal work” refers to the fee-generating work (and not ancillary tasks, such as business development or invoicing).
- The business premises test. To satisfy the test, your business premises must be used mainly for the personal services work, be used exclusively by you and be physically distinct from your client’s or your own private premises. That is, it cannot be a home office.
You should note that if your business is structured as a company, partnership or trust, and employs more than one individual who generates PSI, the unrelated clients test and the employment test must both be considered in relation to each individual separately. That’s because it’s possible for the business to be a PSB in relation to one individual, but not the other.
If you have been through each of the steps, and you are still not able to satisfy any of these final tests, it is likely that the PSI rules will apply to your income.
If you think there is a chance that your income could be characterised as personal services income, of if you are relying on one of the tests being satisfied, for your business to be classed as a PSB, it’s important that you keep comprehensive and accurate records. This is especially the case where your income comes from different sources, and where you might be required to show how you calculated which proportion was PSI and which proportion was not.
Examples of the types of evidence that you should consider retaining include:
- Contracts with your customers, or other terms and conditions, or correspondence.
- Timesheets or work diaries.
- Tax invoices.
- Records of bank transactions.
- Employee or staffing records.
Even when you understand the concepts underpinning the ATO’s personal services income rules, the application to individual circumstances can still be quite complex. Each of the steps and tests described above are subject to further and more detailed rules, and the interpretation of these rules is not always straightforward. Whether you are looking to set up a business, think that you might fall within the scope of the PSI rules, want to be able to rely on one of the exemptions or wish to apply for a PSB determination, it is always worthwhile getting some expert advice to confirm your position – and to identify and deal with any issues before they might start to become a bigger problem.