Tax Guide For Professionals

On this page, we try to provide an understanding of the income tax rules that are applicable to professionals working as independent contractors. We start with a question-answer section to gain a basic understanding of the rules, followed by a flowchart that you can use to assess your business and finally we provide a checklist for tax-deductions.

Introduction 

The primary area of taxation that deals with professionals working as contractors are Personal Services Income (PSI) contained in Divisions 84 to 87 ITAA97.  The personal services income regime taxes individual contractors on a similar basis as employees where income is derived mainly from the individual’s own skills, expertise or the provision of personal services. The measures also apply to companies, trusts and partnerships where income is derived by the entity primarily as a result of an individual’s personal efforts or skills. 

Tax Regime for Professionals

Personal Service Income

What is considered as personal services income? (PSI)


Income received on a contract is PSI if more than 50% of it relates to an individual’s labour, skills, knowledge, expertise or efforts in the provision of their services.

One 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.

The PSI rules will apply regardless of whether or not they operate through an interposed entity.

Eaxample - A taxpayer provides a computer programming service but she does all of the work involved in providing those services and uses the client’s equipment and software to do the work. The income derived would be treated as PSI as it is a reward for his or her personal efforts or skills.




What is not PSI?


To gain a better understanding of the PSI rules, it is important to understand what is not a PSI. If more than 50% of the income is derived from the supply or sale of goods, or derived from the supply or use of an income-producing asset or derived through a business structure with substantial assets or employees. Here are a couple of examples to understand it better. A taxpayer owns one semi-trailer and he is the only person who drives it. The income derived from driving the truck is not PSI because it is mainly produced by the use of the truck and not mainly as a reward for the personal services of the taxpayer. Here the key is the use of an asset. A taxpayer works as a lawyer with a large firm. None of the firm’s ordinary or statutory income is PSI because it is produced mainly by the firm’s structure and not mainly for his personal efforts or skills. Here the key is structure and employees working for the firm.




Why were the PSI rules introduced?


The Alienation of Personal Services Income (PSI) legislation was enacted on 1 July 2000 in response to recommendations set out in the Ralph Report. The legislation was intended to prevent individuals who generate income from their personal services from reducing their liability to taxation by diverting income through a company, partnership or trust, and to limit and clarify the work-related deductions available to the individual and the interposed entity. The ATO put in place Taxation Rulings which detailed a range of personal services business tests to determine how contractor status would be applied. The ATO also states,” 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. 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.




What are the tax-deduction restrictions if PSI rules apply?


When personal services income (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.

  • ​Deductions cannot be claimed for rent, mortgage interest, rates and land tax for a residence
  • Payments to associate for non-principal is not tax-deductible, sych as:
  1. remuneration such as a salary or commission
  2. super contributions
  3. an allowance
  4. reimbursement of an expense
  5. rent
  6. interest on a loan.




Are there any exceptions?


One of the key exceptions for assessing whether the restrictions in the PSI rules apply to a taxpayer or entity if they are conducting a personal services business.

Go to our next segment to learn all about personal service business (PSB).





Key Exception

Do I pass the 'results test'?


Results test is the first step in determining whether the PSI restrictions apply to your operations or not. If a contractor or an entity clears the results test, they will be regarded as a Personal Service Business (PSB) and the PSI restrictions will not apply to them. An individual or personal services entity satisfies the results test in an income year if all of the following conditions are met for at least 75% of a taxpayer’s PSI during the year:

  1. Income is generated for producing a specific result – must only receive payment when a specific result or outcome has been produced. For example, on completion of a specific job or objective (a tailor contracted to sew an agreed number of uniforms for a business). The results test is likely to be failed for payments received on an hourly basis or daily rate.
  2. Own plant, equipment or tools are provided – This condition is satisfied if any of the following requirements are met:
    • The contractor is required to supply their own equipment or tools of trade that is needed to perform their work.
    • The type of work performed does not require plant, equipment or tools of trade.
    • The client supplies only minor tools or equipment.
  3. Rectification of defective work – This condition is satisfied if defects are fixed at their own cost by the contractor, but not if time spent to fix defects may be billed to a client.




What is a personal services business (PSB)?


A personal service business is an entity or contractor who predominantly generates income from skill, labour or knowledge, however, their activities are more akin to a business. The PSI rules are not intended to create a disadvantage for such taxpayers. A personal services business arises where an individual or interposed entity:

  • passes the results test

OR

  • passes the 80/20 test and also satisfies one of three business-based tests,
  1. the unrelated clients test
  2. the employment test
  3. the business premises test.

Lastly, If the taxpayer is in doubt, they can apply for a PSB determination from the Commissioner.




I don't pass the result test, what next? The 80/20 test.


Apply the 80/20 test and the three business-based tests

Satisfaction of the 80/20 test broadly requires contractor to ensure that less than 80% of their income comes from the one client (and/or associates)

Must also satisfy at least one of the three following additional business-based conditions:

(a) Unrelated clients test – this test is satisfied if, the contractor gains or produce income from providing services to two or more entities which are not associates of one another or the contractor. – Their provision of services is a direct result of making offers to the public at large (or to a section of the public). Examples include advertising on magazines or digital platforms such as LinkedIn etc..

(b) Employment test – this test is satisfied in an income year if one or more entities are engaged to perform at least 20% of contractor’s principal work for that year. An alternative method of satisfying the employment test arises where a contractor employs one or more apprentices for at least six months (cumulatively) of the income year.

(c) Business premises test –this test is satisfied in an income year if a contractor maintains and uses exclusive business premise that are physically separate from any premises they use for private purposes (home) ; and that are physically separate from premises of their clients. These premises must be used to conduct activities from which income is gained and must be used throughout the year.




I am a PSB, what are the benefits?


If you are a running a personal service 'business' the restrictions under the PSI rules do not apply. Most of the tax deductions availalbe to general business are available to you. You may start claiming tax dedcutions for 1. Salay and super contributions for an assocaite for doing administrative or secraterial work (non-prinicpal) 2. Occupancy expenses such as rent, mortgage interest, land tax etc.. provided it is for your principal and primary place of work. (not just a home office for convinience) 3.Use of FBT concessions for cars and claim tax-dedcutions for mutliple cars including cars with zero business use 4. Use of FBT exemptions for providing a benefit to your associates (spouse, family memebers etc..)




Can a PSB split income?


If you are considered a personal services business, income splitting is still considered high risk. The income generated is due to your personal skill, efforts, knowledge etc.. The general anti-avoidance provisions contained in Part IVA ITAA36 may still be applied to the entity. The anti-avoidance provisions may be applied to any scheme where the dominant purpose is to gain a tax advantage. As a thumb rule, income splitting is considered low risk when an entity or contractor hires another principal worker (employee or contractor). The ratio of the owner to the employees must be at least 1:1.





Tax Savings

I do not pass any of the tests, is it bad news?


It is important to note that a contractor is still entitled to claim certain deductions, even though they are governed by the PSI rules. However, the tax-deductions that can be claimed are limited. The expenses that can be claimed vary according to whether a contractor is operating through an entity or whether they are operating as a sole trader (i.e., in their own name). In almost all cases, there is a significant tax advantage for operating through an interposed entity when various FBT concessions are incorporated. Also, certain asset protection advantages may be available. For example, an interposed entity subject to the PSI rules is generally entitled to claim a tax deduction and GST input tax credits associated with the costs of providing exempt fringe benefits such as laptops, computers, or mobile phones. However, the FBT exemption on these items is contingent upon them being provided primarily for use in the employee's employment. If the contractor were operating as a sole trader, only the laptop's work-related percentage would be deductible. Check our tax deductions checklist at the bottom of this page to see what tax deductions are available for professionals operating under an interposed entity.




How much tax can a professional save by using an interposed entity?


The PSI rules are extremely complex and there are a lot of variable factors at play. So, it requires a thorough understanding of the client's circumstances. While it is impossible to generalize the savings that can be achieved, most professionals working through an interposed entity can legitimately increase net disposable between $10,000 to $20,000 on an average every year. The savings could be even higher if your activities can be regarded as a personal service business. Take up our free financial check-up to receive a free quote on how much tax can be saved in your case. The personal services income rules have been around for two decades but the tax-payers continue to challenge the ATO's interpretation of the rules evidenced by the number of court decisions that come out in this area every year. It is extremely important to make sure you receive the right advice.




How can a business split income?


In simple terms, to qualify for income splitting and to remain as a low-risk taxpayer in the eyes of the tax office, a business will need to hire one or more principal workers to carry out income-generating activities. The ratio of the owner to that of employee/contractor must be at least 1:1. After a business qualifies, they may split income with a family member on a lower tax bracket provided the splitting arrange meets the guidelines published by the ATO. One of the most effective ways of saving tax is by using a bucket/investment company. Such an arrangement can lead to massive tax savings for many years. The best part is the savings will grow in proportion to the growth of the business. The benefits don’t end there, the tax paid by companies are stored as credits and distributed to that shareholders. It means you can stream dividends to a family member and get refunds every year or enjoy tax refunds in your retirement years. Contact us to receive a customized long term-tax planning strategy.





Decision Tool

The Personal Service Income Rules and its tests are complex. We have designed an easy to use decision tool which works on an easy question-answer format, use it to find out if the PSI restrictions apply to you or not. As a bonus, the decision tool also checks if you are using the best structure for maximising tax efficiency and asset protection. 

Annotation 2020-07-04 191804.jpg
Flowchart to PSI Rules

Find out what you need to do to be considered as a Personal Services Business at which point the PSI rules no longer apply, We have developed a flow chart where all the tests can be seen at one place. Use it to gain a full understanding of all the tests. Click the flowchart on the right to enlarge it. 

Flowchart_edited.jpg
Image by Glenn Carstens-Peters

Tax-Deduction Checklists

Here we have prepared three checklists. The first one contains all the expenses that are deductible if the PSI rules apply regardless of the structure you operate in. The second and third checklist highlights the benefits of operating through an interposed entity. 

Businessmen

Many professional are unaware of the benefits that are available to them if they work through an interposed entity. It is a common myth that contractors caught in the PSI rules can't achieve any tax savings by  using an interposed entity. We debunk that myth here. 

Tax Savings

We work out two cases. In the first case, a contractor is restricted by PSI rules but saves $16,000 every year. In the second case, due to the expansion of business, the PSI rules no longer apply, they save $31,500 every year. 

©2020 by Riva Financial