1)    What is Personal Services Income (PSI)

PSI is income produced from your personal skills or efforts as an individual. You can receive PSI in almost any industry, trade or profession. However, some common examples include financial professionals, information technology consultants, engineers, construction workers and medical practitioners.

2)    PSI Trigger

Income is classified as PSI when more than 50% of the amount you received for a contract was for your labour, skills or expertise. This affects a lot of professions particularly when you are an independent operator or contractor.

3)    Personal Services Business (PSB) Tests

a) If at face value, you determine that some or all of your income is classified as PSI then the next steps are to determine whether you’re running a Personal Services Business (PSB)

b) There are a series of tests and sub-tests, outlined later in this fact sheet at Clause 11 and 16, in determining whether you are running a PSB. The tests are very detailed, however, quite easy to understand and work through. It is just a matter of working through them to reach a result

c) If you are a PSB then PSI rules do NOT apply so there are less restrictions in deductibility of certain expenses. A PSB is still subject to general anti-avoidance measures around such things as income splitting. See clauses 16 through 18 of this fact sheet

d) If you do not pass the tests and in particular the test regarding the 80% rule you can still apply for a PSB determination if you think your circumstances are unusual

e) Link to apply for a PSB Determination

4)    Taxation Ruling TR 2001/7 Income Tax: the meaning of personal services income

a) This is the key piece of legislation around PSI

b) Taxation Ruling TR 2001/7 explains the meaning of personal services income contained in Division 84 of Part 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997) (the alienation measure)

c) Importantly it provides a diagram of the Alienation Measures

5)    Taxation Ruling TR 2001/8 Income Tax: what is a personal services business

a) This is the key piece of legislation around a PSB

b) The ruling reminds taxpayers who qualify as personal services businesses that they are in exactly the same position that they would have been prior to the enactment of the alienation measure. For example, Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) may apply where income splitting occurs.

6)    What is NOT personal services income

a) PSI does not affect you if you’re an employee receiving only salaries and wages

b) Additionally, you do not earn PSI if
– Less than 50% of your income from a contract is for your skills, knowledge, expertise or efforts
– You receive income from selling or supplying finished goods, even if you made these goods
– You receive income from an income-producing asset, such as renting a vehicle or piece of machinery such as a bulldozer
– your income comes from licencing your intellectual property, such as a patent or the copyright to a computer program
– generated by a business structure, for example, a large accounting firm.

7)    Effect of PSI and Deductions you can claim

a) For sole traders, understanding how much PSI you earn is important as it can affect what tax deductions you can claim. When the PSI rules apply, your tax deductions and income tax return obligations will be affected.

b) When PSI rules apply, there are limitations for deductions that can be claimed against this income. In general, an individual who earns PSI is treated as though they are in the same position as an employee.

c) Remember, this only applies to income that is PSI. All other income you earn is subject to normal tax rules.
– Deductions you can claim. You can claim deductions against your PSI if the expense occurred in earning this income.
– Some examples include:
– the cost of gaining work, such as advertising, tenders and quotes
– registration and licencing fees
– account-keeping fees, including bank fees
– some insurance costs, including public liability and professional indemnity insurance fees
– the salary/wages and super contributions for an employee, or reasonable amounts payed to an associate for ‘principle work’
– a portion of home office expenses, such as heating, lighting, phone and internet (but not rent, mortgage interest, rates or land taxes
– motor vehicle expenses where they relate specifically to earning of income and qualify as business related
– travel costs where they are directly associated with deriving income

d) If the PSI rules apply, they affect how you report your PSI to the ATO and the deductions you can claim.

e) If the PSI rules don’t apply, your business is a personal services business (PSB). When you’re a PSB, there are no changes to your tax obligations, except that you need to declare any PSI on your tax return.

f) You can receive PSI even if you’re not a sole trader. If you’re producing PSI through a company, partnership or trust and the PSI rules apply, the income will be treated as your individual income for tax purposes.

8)    Deductions that cannot be claimed under PSI rules

a) Rent, mortgage interest, rates and land tax
– Deductions cannot be claimed for rent, mortgage interest, rates and land tax for a residence, where those expenses relate to a person’s PSI.

b) Payments to associates for non-principal work
– Payments made to an associate (for example, spouse, child or other relative) cannot be claimed as a deduction for performing non-principal work.
– Principal work is the work a business must perform under a contract to receive payment.
– Non-principal work is incidental or support work that is not central to meeting obligations under a contract. Examples include bookkeeping, issuing invoices, secretarial duties and running the home office.

9)    Non-deductible expenses

a) There is an interesting consequence in the example of the non-deductibility of payments made to associate for non-principle work.
– Non-deductible expenses can’t be claimed against your income. These expenses can’t be used to reduce PSI attributed to the individual, which is included in their individual tax return.
– To prevent double taxation, where a payment to an associate (for example, a salary payment) is non-deductible under the PSI rules, the amount received by the associate is not included in their assessable income.
– Example: Salary not deductible
(1) Julie is a sole trader who pays a salary to Frank to do the bookwork and run the home office (that is, non-principal work). Julie is not entitled to claim a deduction for the salary she pays to Frank because he is not performing principal work.
(2) As Julie cannot claim a deduction for the salary she pays to Frank, the salary Frank receives is not included in his income tax return as assessable income. Any PAYG withholding tax Julie pays on behalf of Frank is credited to Julie when she completes her individual tax return.

(10)    PSI Examples

a) Susan is a management consultant operating as a sole trader. She recently completed contracts for two of her clients.

– Contract 1: Susan provided a 1 hour training course for a client. She charged $1 000 for her course, which included training materials that cost $100. Since $900 (90% of the contract) is for her skills and expertise, this is personal services income. Susan should report the $1 000 as PSI.
– Contract 2: Susan was contracted to provide management software for a client. Susan charged $10 000 in total, of which $8 000 covered the cost of the software licence. Since $2 000 (20% of the contract) is for her skills and expertise, this is not personal services income. Susan should NOT report PSI for this contract.

Like Susan in the example above, your taxable income can be a mix of PSI and other income.

11)    PSI Tests – Self-Assessment

a) The first thing you need to do is work out if any of your income is classified as PSI. If it is, you then need to work out if special tax rules (the PSI rules) apply to that income. There’s a series of steps to follow to help you do this.

b) If the PSI rules apply, they affect how you report your PSI to us and the deductions you can claim.

c) If the PSI rules don’t apply, your business is a personal services business (PSB). When you’re a PSB, there are no changes to your tax obligations, except that you need to declare any PSI on your tax return.

d) You can receive PSI even if you’re not a sole trader. If you’re producing PSI through a company, partnership or trust and the PSI rules apply, the income will be treated as your individual income for tax purposes.

e) When the ATO say ‘you’ or ‘your business’, they mean you as a sole trader or the entity you operate through (whether that is a company, partnership or trust).

12)    Step 1 – Have you received PSI?

a) When working out if your income is PSI, you need to look at the income received from each separate contract. The terms and conditions of the contract, as well as invoices and written agreements (which show the arrangement for the work) are important in working out if the income is PSI.

b) Calculate what percentage of income from each contract was for:

c) Your labour, skills, knowledge, expertise or efforts for the services you provided

d) Anything else, such as the materials supplied and/or tools and equipment used to complete the project

e) If more than 50% of the income received for a contract was for your labour, skills or expertise, then all income for that contract is PSI

f) If 50% or less of the income received for a contract was for your labour, skills or expertise, then none of the income for that contract is PSI.

g) Salary and wages as an employee and some other types of income will not be affected by the PSI rules

13)    Step 2 -Results Test

a) This test is about the nature of your agreement to perform the work, including the basis on which you are paid.

b) To pass the results test in an income year, you need to meet the following three conditions:

1. Paid to produce a specific result
– To meet the first condition of the results test, you must produce a specific result or outcome before being paid
– Note: If you’re paid on an hourly basis or daily rate for the services you provide, it’s unlikely that you will meet the first condition of the results test. This is because these payments are not generally linked to producing a specific result or outcome.
– Generally, you are paid to produce a specific result when:
– Outcomes and costs are agreed with the client prior to commencing the work
– Payment is only on completion of each job or specific objectives (this can include receiving progress payments and deposits)
– Being paid an amount per completed item or activity – for example, a furniture upholstering business that is contracted to a furniture factory and paid per lounge suite completed.
– Generally, you are not paid to produce a specific result if you are paid:
– after submitting timesheets
– regardless of achieving a specific outcome or reaching agreed objectives.

2. Required to provide the equipment or tools
– You meet the second condition of the results test if you satisfy any of the following:
– you’re required to supply the plant and equipment or tools to complete the service
– the type of work you are performing does not need plant, equipment or tools of trade
– the client supplies only minor tools or equipment items, or
– in your industry, it’s common for the contractor to use a client’s plant, equipment or tools.

3. Required to fix mistakes at your own costs
– You meet the second condition of the results test if you satisfy any of the following:
– you’re required to supply the plant and equipment or tools to complete the service
– the type of work you are performing does not need plant, equipment or tools of trade
– the client supplies only minor tools or equipment items, or
– in your industry, it’s common for the contractor to use a client’s plant, equipment or tools.

c) If you pass the test, your business is a personal services business (PSB) for that income year and the PSI rules don’t apply.

d) You may find that some of your business contracts meet the three conditions of the test and some don’t. To pass the results test, you need to meet all three conditions for at least 75% of the PSI for the income year.

e) When working out whether you meet each of the conditions of the results test, you must consider what is the custom or practice in the industry for the work you’re performing.

f) If more than 25% of your PSI came from an agency (such as a labour hire firm), you are not likely to pass the results test as you generally contract with an agency to provide services at the direction of the end client.

g) If you’re a company, partnership or trust and you have more than one individual generating PSI, you will need to work out whether you pass the results test for each individual. It is possible to be a PSB for one individual but not another

14)    Step 3 – the 80% rule – this is a crucial test

a) This step is about your PSI client base and how much of your PSI comes from one client

b) For this step, you need to work out the amount of PSI that comes from each client (including their associates) in an income year. If you’re a commission agent, the clients of a principal can be treated as your own clients. If you’re paid by a labour hire firm, the labour hire firm is treated as your client

c) If less than 80% of the PSI being tested comes from one client, then you need to look at the remaining tests in Step 4

d) If more than 80% of the PSI being tested comes from one client, then you fail this test and PSI rules apply. If you think your circumstances are unusual and in that case you can apply for a PSB determination

15)    Step 4 – the remaining tests

a) There are three remaining tests to work through:

i) Unrelated clients test
– To pass the unrelated clients test your PSI must be produced from two or more clients who are not related or connected, and the work must be obtained by making offers to the public or sections of the public.
– You do not pass the unrelated clients test if you source all your work through arrangements such as a labour hire firm.

ii) Employment test
– To pass the employment test in an income year, your business must employ or contract others to help complete the work that generates your PSI.
– To meet this condition, other employees or contractors that you engage must perform at least 20% of the principal work.
– Principal work is the work you must perform under a contract and for which you are paid. It is work that is central to meeting contractual obligations between you and the acquirer of the services. It does not include work that supports you in meeting your contractual obligations, such as bookkeeping.
– It’s important to consider the market value of the principal work performed. Market value is the amount other professionals in the industry would be paid for the same work.
– You can count principal work performed by a family member

iii) Business premises test.
-To pass the business premises test in an income year, your business premises must meet certain location and usage criteria.
– You pass the test if at all times in the income year, your business premises meets all of the following:

  • Used mainly for personal services work
    • To meet this condition, you must use the business premises mainly (that is, more than 50%) for work that generates your PSI. It is not enough to own or lease the premises and conduct activities that are unrelated to your personal services work at the premises.
  • Used exclusively for your business
    • To meet this condition, your business must have exclusive use of the premises.
    • If your business shares or jointly leases premises with another person/business that isn’t performing work for your business, this would not be considered exclusive use.
    • However, if the premises are shared with parties who complete work for your business – for example, if three people perform work for your business and these three people work from the premises – it would still be considered exclusive use.
  • Physically separate from your home
    • To meet this condition, the business premises must be separate from any premises which you or your associates use for private purposes. This means that business premises within private premises (for example, within your home) generally won’t be considered physically separate.
    • the physical appearance of the business premises is distinct and separate from adjoining or surrounding private premises
    • other building structures on the land are detached from the business premises
    • access to the business premises for you and your clients is separate from access to your home
    • the adjoining or surrounding private premises are not functionally incorporated into the business premises
    • facilities and staff are not shared with occupants of adjoining or surrounding premises.
  • Physically separate from your clients
    • The premises must also be physically separate from the premises of your clients (or their associates).
    • There are more detailed explanations and examples of this test on the ATO website.If you’ve correctly worked through steps 1, 2 and 3, and you pass at least one of the remaining tests, your business is a personal services business (PSB) and the PSI rules do not apply to the PSI you received.

16)    PSI Tests – Using the ATO Decision Tool

a) We encourage the use of the PSI Decision Tool on the ATO website

b) In some cases, the ATO will need to issue you with a PSB determination for the PSI rules not to apply to you. In this situation, we may need to send the ATO your result.

c) To answer the questions in the PSI decision tool you may need:
– Details of contracts or written agreements with your clients during the income year
– Invoices from work performed during the income year
– records of payments to any employees or subcontractors

d) The tool should take 5 to 20 minutes to complete.

e) Here is the link to use the  Personal services income toolon the  ATO website.

17)    Complex Arrangements and Private Rulings

a) Note: complex arrangements are not within this tool’s scope. If you have complex affairs, you should discuss your situation with David Boca which may result in applying for private ruling for your specific situation. Here is the link to apply for a private ruling instead of relying on the tool.

18)    General anti-avoidance rules and PSI

a) This information is relevant to you if both of the following apply: you receive personal services income (PSI) through your company, partnership or trust or, the PSI rules do not apply to your income because you’re carrying on a personal services business (PSB).

b) The PSI rules were introduced to prevent the shifting or splitting of income with other individuals or entities in an attempt to pay less tax. This strategy is known as the alienation of PSI.

c) Alienation of PSI occurs when the services of an individual are provided through a business entity (company, partnership or trust) rather than directly by the individual who performs the services.

d) Alienation occurs when personal services income received is retained by the entity and/or diverted to associates, allowing a lower rate of tax to be paid on that income. The use of these arrangements is also used by some taxpayers to create an entitlement to a range of deductions which wouldn’t be available to an individual providing the same services as an employee.

e) If you have arrangements where your PSI is alienated and is taxed at a lower rate than if you had received the income yourself, you may attract the general anti-avoidance rules (GAAR).

19)    How the GAAR apply

a) The general anti-avoidance rules (GAAR) will only apply if the dominant purpose of your arrangement is to obtain a tax benefit. For example, if you use a company or trust to retain profits from PSI in your business or split PSI with an associate which reduces your overall income tax liability.

b) However, if you’re operating as a company or trust, you can pay remuneration (for example, salary or wages) to yourself or an associate for work related to the earning of your PSI, if it is equal to the value of their services.

c) In most cases, a salary equal to the value of your services will be the gross amount received by your business for your services less allowable deductions (other than deductions associated with income splitting). If the remuneration is less than the market value for the services provided, then the arrangement may attract the GAAR.

Example: How the GAAR apply

John receives a salary which is paid to him as a principal worker of his company Smith Pty Ltd. His salary is not equal to the value of the services he provides and the remaining income is distributed to his wife and brother who provide administration assistance. The GAAR may apply to the arrangement Smith Pty Ltd has in place, as John may be obtaining a tax benefit from splitting the income with his associates.

20)    GAAR and Companies, partnerships and trusts

a) Take the following steps to prevent the GAAR potentially applying to your situation if you are a PSB that is a company, partnership or trust.

Companies

If you operate a PSB through a company and there is no income splitting and profits are not retained in the company then the GAAR will generally not apply. If a genuine attempt is made to break-even, a relatively small amount of taxable income may be paid to you by the company, provided that income is distributed to you via a franked dividend in the following year.

Partnerships

If you have a PSB with your spouse through a genuine partnership, in which you both share equally in profits and losses, and are jointly liable for debts and obligations, the GAAR will not apply where income is divided equally, even if one spouse is the main generator of the income.

Trusts

If you operate a PSB through a trust with a corporate trustee, the conditions are the same as for companies. You should receive income from the trust in relation to the PSI that is commensurate with your services, or be the sole trader.

5ivestar Business Services are tax agents located in Carina Heights on Brisbane’s Southside. We service all areas of Brisbane, Ipswich and the Sunshine Coast for tax, BAS and bookkeeping. We also practice as virtual CFOs, take on interim CFO engagements as well and  financial management, reengineering and restructures including business turnarounds and transformations and expert financial modelling.
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