SKY UPDATE | PERSONAL SERVICES BUSINESS & APPLICATION OF THE PART IVA GENERAL ANTI-AVOIDANCE PROVISIONS

01 October 2024

The Personal Services Income (PSI) rules are a significant feature of the Australian tax system, affecting those businesses that generate income through an individual’s personal efforts, skills or expertise.

Whilst the PSI rules have been a feature on the tax landscape for nearly 25 years, their correct application continues to be an issue that has seen the ATO issue and revise multiple tax rulings, and that continues to produce a steady stream of disputes that find their way into the court system.

In the latest, the ATO have issued Draft Practical Compliance Guideline (PCG) 2024/D2 to address scenarios where PSI tests are passed but where the ATO may still apply the Part IVA general anti-avoidance provisions.

The ATO is taking comments/submissions on PCG 2024/D2 up to 11 October, after which time they will seek to finalise the guideline.

The following is a brief explanation of where/how this PCG will come into play.

Personal Services Income (PSI): The Basics:

PSI is defined as income generated mainly (>50%) through an individual’s personal efforts, skills, or expertise.

Common examples include freelance consultants, IT contractors, and medical professionals who earn income for providing services rather than selling goods or through the use of assets.

Where an entity derives PSI, it must apply several tests in order to determine whether it is seen to be a Personal Services Business (PSB). Where an entity is seen to be a PSB, the PSI rules do not have application.

The first test is the ‘Results Test’ that requires that for at least 75% of the PSI earnt during the tax year:

You must be paid to produce a specific result; and
You are required to provide equipment or tools (if required); and
You are required to fix mistakes at your own cost.

If you are not able to pass the Results Test, there are three additional tests. If any one of those tests is passed, the entity will be regarded as a PSB. Those tests are:

Unrelated Clients Test: The PSI has been received from two or more unrelated clients.
Employment Test: You employ or contract others to perform at least 20% of the principal work.
Business Premises Test: Business premises are used to generate the PSI and you have exclusive use of those premises which must be physically separate to both your residence and your clients’ premises.

Enter Draft PCG 2024/D2 – PSI and Part IVA:

Draft PCG 2024/D2 has been put out by the ATO to clarify their view that whilst an entity may pass the PSI tests to be regarded as a PSB such that the PSI rules do not apply, the entities arrangements may still be challenged by the ATO under Part IVA.

In the draft PCG, the ATO are focussed on arrangements involving income splitting and retention of profits where the dominant purpose is to obtain a tax benefit.

This involves situations where it might reasonably be expected that the income would otherwise have been declared by the individual(s) who produced it, who would pay a higher amount of tax.

Critical to application of Part IVA is a finding that the dominant purpose of the arrangements (‘scheme’) was to obtain a tax benefit.

Where arrangements are inconsistent with normal commercial practice, are complex and/or convoluted and/or do not reflect the economic substance, it is more likely that Part IVA may applied to cancel the tax benefits obtained.

The draft PCG includes a number of examples to assist taxpayers to understand the arrangements that are high risk in the eyes of the ATO versus those that are unlikely to be challenged.

The draft PCG reflects the ATO’s ongoing focus on arrangements that involve income splitting and/or retention of profits in lower tax paying entities.

We will provide an update when the ATO finalise the PCG. In the meantime, if you derive PSI and want to ensure that your tax affairs are not only compliant, but structure in the best possible way, please get in touch.