Personal services income rules can trap the unwary

The alienation of personal services income rules (PSI rules) in the tax law can limit tax deductions available to individuals and can also attribute income derived by an interposed entity (eg. a company) back to the taxpayer. Personal services income is ordinary income derived mainly for the personal efforts or skills of an individual.

Examples of personal services income are salary and wages, income of a professional person (eg. accountant, architect or lawyer) practising as a sole practitioner, and income paid wholly or principally for the labour or services of an individual (including, for example, entertainers and consultants).

There are many cases that have been decided by courts and tribunals on these rules which have involved income derived by companies from hiring out the services of, for example, IT consultants, engineers, etc. The income was held to be the income of the consultant or engineer, etc and not of the company.

These laws have been there for awhile now, but cases are still coming before the courts and tribunals disputing the way the laws operate. I’ll explain a recent one below which illustrates the traps people need to be wary of, but first, I need to explain a little background.

Sometimes people may structure their affairs by setting up a company, for example to derive the income they earn from various activities )eg. people in the information technology industry, architects, etc). Companies pay tax at 30% (which can be lower than the individual’s personal tax rate), can claim a range of tax deductions and can distribute franked dividends to shareholders. However, the tax law was amended with effect from 1 July 2000 to limit the tax deductions available to individuals in these circumstances, and to effectively negate the company-type structure, where they cannot meet certain tests.

There is an exemption from these rules where an individual or entity carries on a personal services business (which I explain briefly below).

You’ll be surprised to learn that the tax law in this area is complex (!), so I won’t go into great detail here, but it’s important to get an idea of how this all works.

Generally, if a person or the personal services entity do not satisfy what is known as a “results test” (see below) and that person or the personal services entity get 80% or more of the personal services income from one source, they will be subject to the alienation of income rules. The “results test” is satisfied where you work to produce a result, and you provide the tools and equipment necessary (if any) to produce the result, and you are liable for the cost of rectifying any defective work.

The PSI rules are structured so that an individual or a personal services entity carries on a personal services business (and so is exempt from the rules) if:

• the individual or, where the individual’s PSI is included in a personal services entity’s income, the entity meets the results test; or
  
• not more than 80% of the individual’s or entity’s PSI in an income year comes from the one client (and associates of the client) and the individual or entity meets at least one of the unrelated clients test, employment test and business premises test; or
  
• a personal services business (PSB) determination is in force. A PSB determination from the Tax Commissioner is necessary if the “80% threshold” and the results test are not met.

Many small business operators, whether operating as individuals or through interposed entities, may find it difficult to pass the relevant tests to be regarded as carrying on a personal services business.