Personal Services Income - To be Included or Not to be Included, That is the Question?
As central to the question of existence contemplated by Shakespeare's Hamlet is the question posed by the results test with reference to personal tax obligations. In a previous blog (click here to read that blog) I discussed the myths (a polite term for rubbish) surrounding the contractor or employee discussion and this blog expands on and explains Personal Services Income in more detail.
It is important to reiterate that a person can be a bona-fide contractor with regard to PAYGW, Workcover, and Super Guarantee but the income earned from that contract could still be taxed to the individual person irrespective of any company, trust, or partnership structure providing the contracted service.
The other point I will make here is that this summary is just a summary and not advice. The actual personal services income determination can get complex. Our role is to work with your specific circumstances and objectives to develop a legitimate strategy to achieve your tax and business outcomes. I recommend you seek specific advice before entering into any arrangements that may trigger personal services income issues.
An effective tax strategy seeks to minimise the tax payable on income earned. Because individuals are subject to a marginal tax rate that increases the rate of tax as income increases, it is often preferable to have business income earned by other persons or legal entities. The top personal tax rate is currently 49% (allowing for the Budget Repair and Medicare levies) whereas the company tax rate is only 30% (or less in 2016 for small business).
The ATO is not silly though. The Personal Services Income regime seeks to look through intermediary structures, where income is earned from personal services, to tax the individual providing the service as an employee.
If you operate a business providing personal services then the assumption is that income is taxable to the individual who provides the service unless you can show that income passes one of a series of tests. The results test is the first test and passing that will exclude income from the personal services income net and mean the tax liability will not automatically fall to the individual.
The application of these tests can get complex so we recommend you take advice.
What is the Results Test?
The results test examines the underlying substance of a contract for an individual to provide services irrespective of whether that income was earned through a company, trust, or partnership. The test itself poses 3 questions (in accordance with Section 87-18 of the Income Tax Assessment Act 1997).
The results test will be passed (and the income therefore not subject to the Personal Services Income regime) if, in relation to 75% of the individuals personal services income (whether charged through a trust, company or partnership) during the income year an individual is:
paid to produce a result; and
required to supply the equipment and tools needed to perform the result; and
is, or would be, liable to meet the cost to rectify any defective work performed.
All of these questions must be answered yes for the results test to be passed.
The take away point: If you operate a personal service business and are seeking to effectively stream business income to a lower taxed person then part of your solution may be to structure contract arrangements so as to pass the results test.
If you cannot answer these questions positively then you can look to the other tests to ascertain whether or not your income is captured by the personal services income net.
The 80/20 Rule
Failing the results test means the much maligned and misunderstood 80/20 test could be the saving grace of your tax minimisation strategy.
Although the test can get quite complex, in its simplest form it says that you will fail to show your income is not personal services income (and it will therefore be taxable to the individual irrespective of any intermediary structure) if 80% or more of your income is derived from one single customer (where customer includes related persons). Note also, that per my previous post, this test does not mean you cannot be a contractor, if you have only one client (a mining company for example) it simply helps determine how that contract income will be taxed and to whom. There may be other quite relevant factors that mean you still wish to trade through a company, not the least of which is that the customer requires it.
If you can satisfy the 80/20 rule then you still have to meet one of three more tests for the income to be excluded from the personal services income net.
The Unrelated Clients Test
You will pass this test if you provide services to at least 2 clients who are not related to each other or to you.
The Employment Test
You will pass this test if you have employee's who carry out a minimum of 20% of the value of the work or if you have an apprentice for half the tax year.
The Business Premises Test
You will pass this test if you have a separate business premise for the full year that is not connected to your residence.
The Personal Services Income regime is complex and assumes all service income is Personal Services Income unless one or more of the tests summarised above is passed.
This is a summary so take advice. For $150 we can review your circumstances and give you specific advice on your situation and what you can do to achieve your tax and business objectives.