By Martin McCoy

Most of you will be aware of the Personal Services Income (“PSI”) Rules, which are in broad terms designed to deal with the common practice of using company and trust structures to deal with income that is a reward for the personal efforts and skills of an individual in a tax effective way.

The PSI Rules have been with us for some time now, and cannot be considered as “new”. 

The ATO has not up until recently made them the subject of extensive audit activity, but I am seeing signs that this is changing.        

The PSI Rules are much misunderstood in the business community generally, particularly at the “small consultant” end of the business community where they have the most application. 

Also, although accountants generally understand how the rules work, they don’t always examine their clients’ affairs in sufficient detail to ensure that the clients get the right advice as to their application.  This is unfortunate, because the PSI Rules can give rise to a number of “grey areas”, because the “right answer” as to their applicability does not lend itself to resolution by a means other than gathering the relevant facts, and then “working through” the rules in a methodical manner. 

The need to approach the problem in this way first came home to me when a friend asked me to advise him on whether the PSI Rules applied to his new business venture.  The friend in question is a professional, but was transitioning from an “in-house” position with a corporate entity to one in which he was a “consultant”.  However, in the initial phase at least, a proportion of his “consulting” income would come from the entity for which he had previously worked in-house.  The scenario in which my friend found himself was a not uncommon one, and I sat down with him to establish the relevant facts, in order to determine how the PSI Rules would affect him. 

Although I was generally familiar with the PSI Rules before that point, this was the first occasion on which I had to “work through” a real-life example.  My conclusion was that, for the first year of operation of my friend’s consulting business at least, there was a distinct possibility that the PSI Rules would affect him adversely.      

Applying the PSI Rules

Determining whether the PSI Rules apply to any particular fact situation involves considering a series of tests.

The first of these tests is to determine whether the PSI Rules have application at all.  This requires you to consider whether the income you earn from a particular contract is more than 50% for your skills, knowledge, expertise or efforts.  This might seem a simple idea, and in circumstances where the services are performed using a substantial piece equipment (the example often given is a bulldozer), then the answer might be obvious enough.  However, there will certainly be instances where the answer isn’t obvious.

If the answer to this question is “yes”, then the income in question is prima facie caught by the PSI Rules.

It is worth noting that a business can have both PSI and non-PSI income, which is why it is necessary to consider the PSI issue on a contract by contract basis.     

Once it has been determined that there is income to which the PSI Rules apply, it is necessary to consider a series of tests to determine what effect the PSI Rules have. These tests are:

• The Results Test;
• The Unrelated Clients Test;
• The Employment Test;
• The Business Premises Test, and
• The 80% Rule.

If these series of tests is passed, then the PSI income in question is considered to be from a “Personal Services Business”, and the PSI Rules to not apply. 

The tests in question are discussed below.

• The Results Test

  Although the Results Test is specific to the PSI Rules, a similar test is relevant to determining questions of who is an “employee” and who is a “contractor” for PAYG deduction and superannuation purposes. 

  From the perspective of the PSI Rules, this test requires that the income from any particular contract be for “producing a result” and that that the entity performing the work provides the tools and equipment necessary to perform it, and is also responsible for remedying any defects in it. 

  The Results Test will sometimes have an obvious answer, but it can also give rise to “grey areas”. 

  If a contractor is engaged to perform a specific task, such as to “paint the office”, then they are probably going to pass the Results Test, whereas if they are engaged to “do such tasks around the office as directed”, then they probably are not going to pass it. 

  It is worth noting that a contractor who is paid by the hour is probably going to struggle to pass the Results Test. 

  If the Results Test gives a “pass”, then the PSI Rules don’t apply in an adverse way.

  On the other hand the tax the Results Test gives a “fail”, then it is necessary to consider three other tests, which are discussed below.  It is only necessary to pass one of these to move to the final step.

• The Unrelated Clients Test

  This is a tricky test, because it has two limbs. A “pass” will occur if a) income is derived from two or more unrelated clients, and b) if services are provided as a direct result of making “offers or invitations (such as advertising) to the public, or a section of the public”. 

  Particular note should be taken of the fact that the services have to be performed “as a direct result” of the offers or invitations to the public.  If offers or invitations are made to the public, but the work is actually obtained by some other means (such as personal contacts), then the test will not be passed. 

  The question of what constitutes “the public, or a section of the public” also needs consideration.  In some industries, the market for the relevant services is small.  There is no point advertising the services of a subsea engineer in the mainstream press.  There is however authority for the proposition that a “section of the public” can comprise those parties that have a use for the services being offered, even if that amounts to only a small number of entities.

• The Employment Test

  This test is a little clearer in its application than the previous two, and requires at least 20% of the work under a contract to be performed by employees, partners or other contractors (or for the entity performing the work to have one or more apprentices for at least half of the relevant income year).

• The Business Premises Test

  This test is also somewhat clearer, and requires a business premises to be used for the production of the PSI for more than 50% of the time.  This business premises must be owned or leased by whoever is performing the services, and must be physically separate from the premises of any of the service provider’s  clients, or their associates.  It may also not form part of the service provider’s residence, or that of an associate of the service provider.  

• The 80% Rule

  Even a “pass” is achieved in one of the above three tests, there is still a further test to navigate in order to escape adverse PSI Rules consequences.  This test requires  each of the clients of the service provider to generate less than 80% of the service provider’s PSI in any income year.  Even if this test results in a “fail”, it is possible to apply to the ATO for a “personal services business determination” which, if favourable, means there will be no adverse consequences under the PSI Rules.

Deciding whether the PSI Rules apply in any income year is a matter of working through the tests having regards to the specific facts of your business.  If income derived is of a PSI nature, there are really no shortcuts. 

The ATO will be increasingly looking at this issue in the next year or two, and if you have any doubts as to how the PSI Rules apply to your business, I encourage you to seek advice from an accountant or lawyer.      

Gold and Platinum Members read on for tips on how to approach the PSI Rules when starting a new business.

Martin is a Principal with Law Central Legal, specialising in tax law and general commercial issues. Formerly a Principal Litigator with the Australian Taxation Office, Martin was responsible for conducting some of the most complex taxation litigation matters in both Western Australia and interstate, including matters involving tax avoidance schemes, as well as "Project Wickenby" matters.

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