Shen Loi

April 22, 2024

Categories: DFK Gooding Partners News, Small Business, Tax Advisory & Compliance

Personal Services Income (PSI) is a special tax regime introduced to prevent individuals from reducing their tax by diverting their PSI to an associated company, partnership, trust or individual, or by claiming inappropriate “business” deductions.

For individuals reliant on their skills and expertise to earn income through personal service provision, understanding the rules of PSI is important to ensure tax compliance and no surprises when the tax office performs a review on your income tax return. Although the PSI rules have been around for many years, it is often a focus area for the ATO, with a new tax ruling issued recently to clarify how the rules operate.

In this article, we will delve into what PSI is, the circumstances under which the rules apply, and the tax implications.

What is Personal Services Income (PSI)?

Personal services income (PSI) is income that is rewarded mainly for an individual’s personal efforts or skills. This income can originate from services rendered directly by an individual or through a Personal Services Entity (PSE) (e.g.: a company, partnership, trust, or other individual).

Income which is generated from a business structure of an entity is not considered to be PSI, e.g. where there are substantial income producing assets or number of employees.

Once PSI is identified, PSI rules will apply and seek to prevent the diversion of income derived from personal effort and skill to separate entities.

There are exceptions where an individual or PSE entity earning PSI is running a business that qualifies as a Personal Services Business (PSB), thereby exempting them from PSI rules. This is explained below in the PSI Rule Tests.

PSI Rule Tests

There are 2 tests applied on a yearly basis to determine whether a business earning PSI qualifies as a PSB. These are The Results Test and The 80% rule.

Keep reading for an explanation of each, and working example of the unrelated clients test using a graphic design business.

The Results Test

This test requires you to consider whether you receive payment for achieving a specific result or outcome. You will satisfy this test if (for at least 75% of your PSI) you:

  1. Receive payment for a specified result; and
  2. Provide your own equipment and/or tools of trade; and
  3. Are obligated/required to rectify any defects or are liable for costs to rectify.
  4. If you fail this test, you must consider the second test, the 80% Rule.

The 80% Rule

You satisfy this test where each of your clients/customers (together with their associates) provide less than 80% of the total PSI for the year and you meet 1 of the following 3 tests:

1. The unrelated client test

To pass the unrelated client test, both of the following conditions must be satisfied:

  1. You must have received PSI from 2 or more unrelated clients.
  2. There must be a direct connection between offers to the public (e.g. advertising) and you being engaged to perform the work.

2. The employment test

To pass the employment test, your business must employ or contract others to perform work that generates your PSI, and you must meet one of the following conditions:

  1. At least 20% of the principal work is performed by others.
  2. One or more apprentices are employed for at least 6 months of the income year.

3. The business premises test

To pass the business premises test you must have maintained and used business premises which meets all the following requirements at all times during the income year.

  1. Used mainly to gain or produce PSI.
  2. Used exclusively by you.
  3. Physically separate from your private premises
  4. Physically separate from your clients’ premises

Working example: Unrelated clients test from Taxation Ruling TR 2022/3:

Deb is a graphic artist who works through her company, Debart Pty Ltd. Deb is the sole director and shareholder of the company. Debart Pty Ltd advertises to provide services on a website and also through advertising in industry periodicals. Sometimes work is referred to her by word of mouth from Deb’s industry contacts.

Any clients that Debart Pty Ltd sources from the website or as a result of advertising in the industry periodicals would meet the requirements of the unrelated clients test for making offers or invitations to the public at large or a section of the public, as these forms of advertising are capable of reaching a wide audience.

As Debart Pty Ltd does not provide services in an industry that could be described as a niche industry, any clients obtained through the word-of-mouth referrals would not be counted for the purposes of the unrelated clients test.

PSI Applications

Where the entity earns PSI and does not qualify as a PSB (i.e.: Does not meet either of the Results Test or the 80% Rule), the PSI regime has the following main effects:

  • PSI will be included in the assessable income of the individual whose personal efforts or skills generated the income and be assessed at the individual’s marginal tax rate.
  • Deductions that are claimed by the individual or PSE may be restricted, so that they broadly correspond to the deductions available to employees (e.g., expenses relating to running a home office, certain travel expenses, and payments made to a spouse, associate, or unrelated person to perform principal work).
  • The PSE may have additional PAYG withholding and superannuation obligations.

If circumstances change and the business qualifies as a PSB, the PSI provisions and the related implications noted above would not apply. For example where you expand the business, commence deriving income from more than 1 client, take on employees who assist with the principal work (not simply administration tasks), lease office space (separate from any of the client’s premises, not connected to the individual’s main residence, and not coworking office space), you may then be considered a PSB. This may change the taxing point of the PSI.

If you would otherwise qualify as a PSB but for unusual circumstances, the ATO may allow you to be treated as a PSB. This requires a detailed application to be lodged with the ATO outlining the reasons.

If you qualify as a PSB, beware of income splitting

Although PBS’s are not subject to the PSI rules, the ATO may still seek apply the general anti-avoidance provisions to income splitting or retention of profits arrangements with the sole or dominant purpose of obtaining a tax benefit. This could apply where the personal services income is allocated to an associate with a lower marginal tax rate than the person generating the income.

The ATO have recently issued updated guidance on their approach to the allocation of professional firm profits in PCG 2021/4, which adopts a very prescriptive approach to determining if an arrangement has a low, moderate, or high risk of attracting an ATO review.

So where to from here?

  • Are you a contractor seeking to start a new business? Be mindful of PSI when considering pros and cons of different business structures;
  • Whether you decide to start your business as a sole trader or via a separate entity (partnership, trust or company), PSI will apply to varying degrees;
  • Speak to your tax advisor during the planning phase of your business, there may be opportunities that will limit the application of the PSI regime;
  • Consider the PSI rules each year during tax planning and speak to your tax advisor if circumstances have changed from prior years.
  • If you operate a company, partnership or trust that is subject to PSI, ensure that you understand your obligations for PAYG withholding and superannuation contributions.
  • Be aware of the ATO Risk Guidelines relating to the allocation of profits of professional services businesses carried on as a partnership, trust or company.

Speak to us regarding your personal services income requirements

Complete the quick contact form below with your details and one of our team will be in touch to discuss your requirements. Alternatively, you can call us (08) 9327 1777 or email info@dfkgpca.com.au.

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