There is a complex set of tax rules that deal with what is known as ‘personal services income’ (PSI). PSI results from the efforts of human beings where the income is mainly a reward for the personal efforts and skills of an individual.
Many occupations derive PSI. They include both so-called ‘professionals’ and trades people. So, in the right circumstances electricians, plumbers, doctors, bricklayers, accountants, engineers, architects and many other occupations can produce PSI.
However, when a business grows to the extent that it has a so-called ‘business structure’, the income is no longer produced by the personal efforts and skills of an individual. Instead, the income of the business is considered to be produced from its structure and not from the efforts of the people engaged in the business.
For example, the ATO would consider an architect operating a business by themselves as producing PSI. However, if the architect was to employ another architect full-time, it is likely that the ATO would consider the business had crossed the threshold into being a business structure.
If a business is producing PSI, Part 2-42 of the Income Tax Assessment Act 1997 can have application. If it operates, broadly, it will force the income earned by the business to be assessed to the individual deriving the PSI where the business is being operated through an entity such as a company or trust. Rather than the tax rules that are applicable for companies or trusts applying, broadly, Part 2-42 will make the individual taxable on the profits of the business. This frequently means more tax is paid.
However, for a genuine business, it is often quite easy to avoid the operation of Part 2-42 by passing one of four tests. If one of these tests are passed, the business becomes a ‘personal services business’ (PSB) and Part 2-42 does not apply and the individual earning the PSI is not forced into being assessed on all the profit of the business.
However, that’s not the end of the story. Enter Part IVA of the Income Tax Assessment Act 1936.
Part IVA is known as the ‘general anti-avoidance rule’ (GAAR) of the Australian income tax law. This provision gives the ATO the ability to undo (for tax purposes) the income tax effect of an arrangement where it is objectively concluded that the arrangement was entered into for the sole or dominant purpose of obtaining a ‘tax benefit’.
The key point to understand is that the ATO considers Part IVA can apply to a situation where PSI is being earned even if one or more of the tests in Part 2-42 have been passed, thus making the business a PSB. The ATO have adopted this position ever since Part 2-42 was enacted but have only recently put out an official document on its position.
On 28 August 2024, the ATO released for comment draft PCG 2024/D2. This practical compliance guideline sets out the ATO’s general view regarding the interaction of Part 2-42 and Part IVA – and it will create a lot of difficulties for many thousands of small businesses that provide PSI.
A key paragraph of the ruling [9] says:
‘An arrangement is considered low risk where the net PSI received through the personal services entity is assessed in the form of assessable income to the individual whose personal efforts or skills generated that income and tax is not deferred. In contrast, a higher-risk arrangement will include either, or both an income splitting or retention of profit arrangement which diverts PSI away from the individual or facilitates the deferral of tax’.
Put simply, if PSI is being earned through a company, trust or partnership and the PSI is not being fully assessed to the individual whose efforts and skills generated the PSI, the ATO will consider this situation to be ‘higher risk’ and might consider the application of the GAAR. This could result in the individual being assessed on all the income. Very likely higher tax will be paid and penalties will be applied.
The position adopted by the ATO is open to considerable debate and may not be supported by the courts. Nevertheless, it will be of concern to possibly hundreds of thousands of small and micro businesses that operate in Australia.
Although PCG 2024/D2 is a draft for comment, it is unlikely that the ATO will change its views because it has expressed these views in other formats for 24 years.
If your business earns, or could be earning PSI, you should discuss this issue with your tax professional and determine what course of action you should take. This is particularly so if less than 100% of the profits of the business are being assessed to any entity or person other than the individual whose efforts or skills derived the PSI.