Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 12 - Amendments to the alienation of personal services income provisions
Outline of chapter
12.1 Schedule 12 to this bill amends the alienation of personal services income (PSI) provisions contained in Part 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997) to clarify when the Commissioner of Taxation (Commissioner) can make a personal services business (PSB) determination as is consistent with the policy intent. The effect of the Commissioner granting a PSB determination is that the PSI provisions do not apply to the taxpayer.
12.2 The amendments will ensure that:
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- the Commissioner may provide a PSB determination in cases where a taxpayer satisfies the unrelated clients test and, but for unusual circumstances, less than 80% of the individual's PSI would come from one source; and
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- the Commissioner may not provide a PSB determination to those taxpayers who, but for unusual circumstances, would satisfy the unrelated clients test, but did not satisfy or would not have satisfied, the rule requiring that less than 80% of the individual's PSI is derived from one source.
Context of amendments
12.3 The PSI provisions, which have applied from 1 July 2000, implemented the recommendations of the Ralph Review of Business Taxation. The provisions are an important integrity feature of the income tax law which helps to ensure that the tax system is working fairly for all taxpayers.
12.4 The PSI provisions prevent individuals from reducing their tax by alienating income from their personal services to an associated entity (such as a company, trust or partnership) or claiming inappropriate 'business' deductions that would otherwise not be available if the individual were directly employed.
12.5 Unless certain key tests contained in the PSI provisions are satisfied, the PSI derived through the entity will be treated as income of the individual, and taxed accordingly.
12.6 The PSI legislation sets out four objective tests to allow individuals, and individuals operating through interposed entities, to self-assess whether they are carrying on a genuine PSB.
12.7 The primary test is the results test which considers whether the income earned is for producing a result, or whether the service provider has to supply the tools of trade or has to rectify any defects. If taxpayers satisfy this test, they are considered to be carrying on a PSB and the PSI provisions do not apply.
12.8 If taxpayers fail the results test, then they can self-assess to be carrying on a PSB provided:
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- less than 80% of an individual's PSI comes from the one source (the 80% rule); and
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- at least one of the following tests is passed:
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- the employment test;
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- the separate business premises test; or
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- the unrelated clients test.
12.9 Notwithstanding the above, taxpayers can apply to the Commissioner for a PSB determination. The effect of the Commissioner granting a PSB determination is that the PSI provisions do not apply to the taxpayer. The Commissioner may only make a PSB determination where either:
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- in the absence of any unusual circumstances, the Commissioner is satisfied that the taxpayer could reasonably be expected to meet, or has met, either the results test, employment test, or separate business premises test (the unrelated clients test is not included as it is considered not rigorous enough in normal circumstances); and
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- where there are unusual circumstances, the Commissioner must be satisfied that, but for those unusual circumstances, the taxpayer would have passed at least one of the four PSB tests.
12.10 These amendments will clarify in which circumstances the Commissioner may or may not provide a PSB determination for the purposes of the unrelated clients test and whether the taxpayer satisfies the 80% rule or not.
Summary of new law
12.11 Under the new law, the Commissioner:
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- will be able to make a PSB determination in relation to those taxpayers who satisfy the unrelated clients test and, but for unusual circumstances, would also satisfy the 80% rule (Part 1 of Schedule 12); and
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- will not be able to make a PSB determination in relation to those taxpayers who, but for unusual circumstances, would satisfy the unrelated clients test, but did not or would not normally satisfy the 80% rule (Part 2 of Schedule 12).
12.12 These changes are of a technical nature which clarify the original policy of the PSI provisions.
Comparison of key features of new law and current law
| New law | Current law |
|---|---|
| The Commissioner may appropriately provide a PSB determination to those taxpayers who actually satisfy the unrelated clients test and, but for unusual circumstances, would also satisfy the 80% rule. | It is unclear whether the Commissioner is able to provide a PSB determination to those taxpayers who actually satisfy the unrelated clients test and, but for unusual circumstances, would also satisfy the 80% rule. |
| The Commissioner may not provide a PSB determination to those taxpayers who, but for unusual circumstances, would satisfy the unrelated clients test, but did not satisfy, and would not normally have satisfied, the 80% rule. | The Commissioner may be obliged to provide a PSB determination to those taxpayers who, but for unusual circumstances, would satisfy the unrelated clients test, but did not satisfy, or would not have satisfied, the 80% rule. |
Detailed explanation of new law
Part 1 - Amendments applying from the 2000-2001 income year
12.13 The amendment repeals subsection 87-60(3) and replaces it with new provisions clarifying when the Commissioner may provide a PSB determination for an individual. The Commissioner may not provide a determination under subsection 87-60(1) unless he is satisfied that in the income year during which the PSB determination first has effect, or is taken to have first had effect at least one of the following alternatives in Table 12.1 is satisfied. [Schedule 12, item 1, subsection 87-60(3)]
| Provision | Alternatives | Conditions |
|---|---|---|
| Subsection 87-60(3A) | Results test, employment test or business premises test (this replicates the repealed subparagraphs 87-60(3)(a)(i) and 87-60(3)(b)(i)). |
|
| Subsection 87-60(3B) | Unusual circumstances prevented one of the four PSB tests from being met, including the unrelated clients test (this replicates the repealed subparagraphs 87-60(3)(a)(ii) and 87-60(3)(b)(ii)). |
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| Subsection 87-60(4) | Unrelated clients test was met, but 80% or more of income was from the same source because of unusual circumstances. |
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12.14 The first and second alternatives replicate the repealed subsection 87-60(3). The third alternative clarifies that the Commissioner may provide a PSB determination in cases where an individual satisfies the unrelated clients test and, if it weren't for unusual circumstances, would satisfy the 80% rule.
12.15 The amendment repeals subsection 87-65(3) and replaces it with new provisions clarifying when the Commissioner may provide a PSB determination for personal services entities. Generally, the Commissioner may not provide a PSB determination under subsection 87-65(1) unless satisfied that in the income year during which the determination first has effect, or is taken to have first had effect, at least one of the alternatives in Table 12.1 is satisfied for the personal services entity rather than for the individual. [Schedule 12, item 5, subsection 87-65(3)]
12.16 The third alternative in Table 12.1 applied to the personal services entity clarifies that the Commissioner can provide a PSB determination in cases where a personal services entity satisfies the unrelated clients test and, if it weren't for unusual circumstances, would satisfy the 80% rule.
Example 12.1
David provides consultancy services to the food and beverage industry. He receives 60% and 40% of his PSI from two unrelated clients, client X and client Y respectively, for the 2000-2001, 2001-2002 and 2002-2003 income years. David self-assesses that he is carrying on a PSB.
During the 2003-2004 income year, David receives 95% of his PSI from client X because he takes a one-off, large contract from this client. He receives 5% of his PSI from client Y. He self-assesses that he is not a PSB because, although he passes the unrelated clients test, he fails the 80% rule (and nor does he pass the results test, employment test or business premises test).
However, under new subsection 87-60(5) he can seek a PSB determination from the Commissioner because:
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- he passed the unrelated clients test during that income year;
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- due to unusual circumstances, more than 80% of his PSI was income from the same client; and
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- David's PSI was from conducting activities that met the unrelated clients test.
Part 2 - Amendments applying from the income year after the income year in which this bill receives Royal Assent
12.17 Section 87-60 is amended, after the amendments in Part 1 of Schedule 12 have taken place, by deleting the reference to the unrelated clients test in subsection 87-60(3B) and adding a fourth alternative that confines when the Commissioner may provide a PSB determination in relation to the unrelated clients test, consistent with the policy intent. Under this additional alternative, the Commissioner may provide a determination under the following conditions:
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- if it weren't for unusual circumstances applying to the individual in that year, the individual could reasonably have been expected to meet, or would have met, the unrelated clients test;
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- if 80% or more of the PSI of the individual could reasonably have been expected to be, or would have been, derived from the same entity, this was only because of unusual circumstances applying to the individual in the income year; and
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- the PSI of the individual could reasonably be expected to be, or was, derived from the individual conducting activities that met the unrelated clients test.
[Schedule 12, items 10 to 12, subsection 87-60(3), paragraph 87-60(3B)(a), section 87-60]
12.18 This amendment to Part 1 of Schedule 12 will ensure that the Commissioner may not provide a PSB determination to those individuals who, but for unusual circumstances, would satisfy the unrelated clients test, but did not satisfy and would not normally have satisfied, the 80% rule.
12.19 Part 1 of Schedule 12 is amended to ensure that the Commissioner may not provide a PSB determination to those entities who, but for unusual circumstances, would satisfy the unrelated clients test, but did not satisfy and would not normally have satisfied, the 80% rule.
12.20 Section 87-65, after the amendments in Part 1 have taken effect, is amended to ensure that in relation to the unrelated clients test, the Commissioner can only provide a PSB determination if the conditions applying to individuals in Part 2, applies to the entity. The unrelated clients test and the 80% rule apply, in this instance, to the personal services entity rather than the individual. [Schedule 12, items 13 to 15, subsection 87-65(3), paragraph 87-65(3B)(a), section 87-65]
Example 12.2
Robert provides consultancy services to the Information Technology industry through the SML family trust. He works mainly for only one client but also does a small amount (20% or less) of work for another client.
SML does not pass the 80% rule (and neither passes the results test, employment test nor the business premises test), but passes the unrelated clients test. SML cannot self-assess as a PSB, and nor can the Commissioner provide a PSB determination.
In a later year of income, due to unusual circumstances, SML temporarily loses its minor client. As such, SML fails the unrelated clients test.
However, the Commissioner cannot provide a PSB determination because SML usually fails the 80% rule and therefore, the condition in the new paragraph 87-65(6)(b) is not satisfied.
Consequential amendments
12.21 Items 2, 3, 6 and 7 make consequential changes to sections 87-60 and 87-65. [Schedule 12, items 2, 3, 6 and 7]
Application and transitional provisions
12.22 The amendments made by Part 1 of this Schedule, which will benefit taxpayers, will apply to assessments for the 2000-2001 income year and each subsequent income year. [Schedule 12, item 9]
12.23 The amendments made by Part 2 of this Schedule will apply to assessments for the income year following the year in which this bill receives Royal Assent and each subsequent income year. [Schedule 12, item 16]