Personal Services Income (PSI) Rules in Australia

What is Personal Services Income (PSI)?

Personal Services Income (PSI) is income that is mainly a reward for an individual's personal efforts or skills. This contrasts with income largely derived from generating a return on assets, selling goods, or from the efforts of other employees. The defining characteristic is that if more than 50% of the income received from a contract or arrangement is attributable to the individual's personal skills, labour, or expertise, that income is classified as PSI. This applies even if the income is paid to an entity such as a company, partnership, or trust that the individual operates.

The Australian Taxation Office (ATO) provides guidance on how to identify PSI. Examples of income typically considered PSI include:

• Income for a consultant who provides their expertise directly.
• Fees for a medical practitioner working as a contractor.
• Income for an IT professional providing their coding or development skills.
• Earnings for a professional sportsperson or entertainer.

Conversely, income that is not typically PSI includes:

• Income from selling goods.
• Income from supplying and maintaining equipment.
• Income generated by the efforts of employees.
• Income from the use of intellectual property, such as royalties from a patent.

The determination of whether income is PSI does not depend on the legal structure through which it is received. A company, partnership, or trust receiving income that is predominantly a reward for one individual's efforts will still have that income categorised as PSI in the hands of that individual.

The Purpose of the PSI Rules

The Personal Services Income rules are anti-avoidance provisions enacted to prevent two main tax practices:

1. Income Splitting: Without the PSI rules, individuals might direct their PSI to a company or trust and then distribute that income to family members on lower marginal tax rates. This practice, known as income splitting, reduces the overall tax paid on that income. The PSI rules aim to ensure that income earned from personal effort is taxed primarily at the individual's marginal tax rate.
2. Deduction Mismatches: The rules also prevent individuals from claiming business deductions that would not be available to an ordinary employee. Employees have limited deductions, whereas businesses can claim a broader range of expenses. The PSI rules restrict deductions for individuals who are effectively employees in substance but operate through a company or trust, preventing them from accessing inappropriate tax benefits.

The primary legislation governing these rules is the Income Tax Assessment Act 1997 (Cth), particularly Division 84 and Division 86. The ATO is the federal regulator responsible for administering and enforcing these tax laws.

Determining if the PSI Rules Apply to You

The process of determining whether the PSI rules apply involves a multi-step approach:

1. Is the income PSI? First, assess whether more than 50% of the income from a contract is a reward for personal effort or skills. If not, the income is not PSI, and the rules do not apply.
2. Are you conducting a Personal Services Business (PSB)? If the income is PSI, the next step is to determine if you are carrying on a Personal Services Business (PSB). If you are operating a PSB, the restrictive PSI rules relating to deductions and attribution do not apply.

The PSB Tests

To qualify as a PSB, a contractor must satisfy at least one of the following four tests in relation to their PSI:

1. The Results Test

This is the most definitive test. You will pass the Results Test if, for at least 75% of your PSI, you satisfy all three of the following conditions:

• You are paid to achieve a specific result or outcome, rather than for the hours you work.
• You are required to provide the majority of the tools and equipment necessary to perform the work.
• You are liable for the cost of rectifying any defects in the work.

This test reflects a genuine independent contractor arrangement where the service provider takes on commercial risks and responsibilities akin to a true business. For instance, a builder paid a fixed price to construct a deck, using their own tools, and responsible for fixing any errors, would likely pass this test.

2. The Unrelated Clients Test

You will pass this test if you provide services to two or more unrelated clients, and you actively make your services available to the public. For tax purposes, 'unrelated clients' means clients who are not associates of each other or of the individual. 'Actively making services available to the public' typically involves genuine advertising, having a public business presence (e.g., a website, business cards, directory listings), and not being exclusively engaged through labour hire firms or word-of-mouth without broader public promotion.

3. The Employment Test

This test is met if you engage one or more employees (or contractors) to perform at least 20% of the principal work for which you receive PSI. The engaged individuals must not be your associates (e.g., family members). The work they perform must be central to generating the PSI, not merely administrative tasks.

4. The Business Premises Test

You will pass this test if you maintain and use business premises that are:

• Used mainly for the purpose of earning your PSI.
• Used exclusively by you.
• Separated from your home and your clients' premises.

This test focuses on whether you operate from a distinct, independent business location. A contractor who works solely from a dedicated office or workshop that is not part of their home and not provided by a client would satisfy this test.

The 80% Rule and PSB Determinations

There's an important caveat to the PSB tests: the '80% rule'. If 80% or more of your PSI comes from one client (or an associated group of clients), you generally cannot self-assess as a PSB using the Unrelated Clients, Employment, or Business Premises tests. In such cases, you can only qualify as a PSB if you pass the Results Test. If you don't pass the Results Test, and 80% of your PSI comes from one client, you must apply to the ATO for a Personal Services Business Determination if you wish for the PSI rules not to apply to your income. The ATO will evaluate your circumstances based on the PSB tests and other factors to decide if you are operating a PSB.

Further official guidance on the PSI rules can be found on the Australian Taxation Office website.

Consequences if PSI Rules Apply (No PSB)

If your income is PSI and you do not operate a PSB, the tax implications are significant:

1. Attribution of Income: The PSI is attributed to the individual who performed the services, even if paid to a company, partnership, or trust. This means the individual is personally taxed on that income at their marginal tax rate.
2. Restricted Deductions: The company, partnership, or trust cannot claim deductions for expenses that an employee could not claim. Restricted deductions include:
   • Rent, mortgage interest, or rates for home offices.
   • Motor vehicle expenses (unless travelling between non-client workplaces).
   • Payments to associates for non-principal work (e.g., administrative tasks).
   • Superannuation contributions for associates.

These restrictions align the tax treatment of the contractor more closely with that of an employee, preventing the tax advantages that the anti-avoidance rules target.

Structuring and Compliance

Simply establishing a company or trust does not automatically bypass the PSI rules. The substance of the arrangement, not just the legal form, is what the ATO scrutinises. Considerations such as the wording of service agreements, the mix of clients, and operational practices are far more important than the choice of entity.

Contractors and businesses that engage contractors should regularly review their arrangements to ensure ongoing compliance with the PSI rules. This includes:

• Periodically assessing whether the income generated is PSI.
• Re-evaluating whether the PSB tests are met, particularly if client relationships or business practices change.
• Maintaining accurate records to substantiate claims made under the PSB tests.

Understanding and applying the PSI rules correctly is complex and requires careful consideration of individual circumstances. Incorrect application can lead to reassessments, interest charges, and penalties. Professional legal and tax advice is essential for navigating these provisions effectively.

Envision Legal reviews contractor arrangements alongside tax advisers for a coordinated PSI strategy.

This article contains general information only and does not constitute legal advice. Envision Legal accepts no liability for any loss arising from reliance on this content. You should seek independent legal advice tailored to your specific circumstances.