House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 1 - Alienation of personal services income

Outline of Chapter

1.1 This Chapter explains Part 2-42 of the ITAA 1997 which is about the tax treatment of personal services income of an individual that is either their ordinary income or statutory income or the ordinary income or statutory income of a company, partnership or trust (an interposed entity) where that individual or entity does not conduct a personal services business.

1.2 Individuals and interposed entities which will potentially come within Part 2-42 are those who get 80% or more of their income from one source (i.e. have few clients), have no employees and do not maintain a separate business premises and are unable to get a determination from the Commissioner that they are a personal services business.

1.3 Part 2-42 contains new Divisions 84 to 87 of the ITAA 1997. Division 84 defines the term personal services income . Division 85 limits the entitlements of individuals to deductions that can be claimed against personal services income. Division 86 introduces rules governing the income tax treatment of personal services income paid to interposed entities including deductions allowed against that income. Division 87 determines when an individual or entity is conducting a personal services business.

1.4 In addition, this Chapter explains new Division 13 of Schedule 1 to the TAA 1953 and related amendments. These amendments allow for the application of the PAYG withholding system to personal services income affected by the rules in Division 86.

Context of Reform

Need for equity in taxing income from personal services

1.5 These amendments were announced in Treasurer's Press Release No. 74 of 11 November 1999. The announcement stated that the Government would introduce legislation implementing recommendations 7.2 to 7.4 of A Tax System Redesigned . The recommendations were aimed at improving the integrity and equity in the tax system. In particular, they addressed the increasing trends in:

•

the alienation of personal services income; and

•

the over claiming of income tax deductions by individual contractors and interposed entities providing personal services.

1.6 Alienation of personal services income occurs when the services of an individual are provided through an interposed entity rather than directly by the individual who performs the services. When alienation occurs, income may be retained in the entity and either taxed at the lower rate available to the entity and/or diverted to associates, allowing a lower rate of tax to be paid on that income. The use of interposed entities is also seen by some taxpayers as creating an entitlement to a range of deductions which would not be available to an individual providing the same services as an employee.

1.7 Likewise, there is a perception that if an individual holds himself or herself out to be a business, the individual can claim deductions that are not available if an employee provides those services.

1.8 For example, deductions are incorrectly claimed for travel between home and work and a proportion of mortgage interest on the basis that a home office is their business base when, in practice, most of the work is provided on the premises of a service acquirer.

1.9 These practices raise significant issues of equity and pose a growing threat to the revenue. It is inequitable that some individuals are able to adopt these practices while others, deriving similar personal services income, including salary and wage earners, pay the correct amount of tax.

1.10 In addition to the tax consequences, these practices result in individuals being able to reduce their taxable income to a level that entitles them and members of their families to a range of income-tested government payments. Furthermore, the practices can enable these individuals to avoid other obligations such as Medicare levy surcharge, the superannuation surcharge and child support.

Why is there a need for specific rules to deal with issues relating to personal services income?

1.11 The current deduction rules have not stopped a growing perception that interposed entities and individual contractors affected by this measure are entitled to deductions which are not available to employees working in similar circumstances.

1.12 Apart from the existing general anti-avoidance provisions of Part IVA of the ITAA 1936, there are no specific rules to address the adverse revenue implications which can result when alienation occurs. The courts have held that Part IVA can be used to counter alienation practices. Applying Part IVA has to be on a case by case basis which is labour intensive and an inefficient use of ATO resources.

1.13 The rules proposed, in so far as they apply to alienation practices, should produce a similar outcome as that obtained from the application of Part IVA. They also reflect the outcome which should result if taxpayers comply with the Commissioner's rulings which explain how personal services income should be treated for tax purposes. Introducing specific rules in the law which outline the tax consequences for certain personal services income will provide certainty for those taxpayers affected, and address any potential alienation of that income.

1.14 The new arrangements will not impinge on any commercial or contractual obligations between parties affected by the measures and will not impact on genuine business undertakings. Nor will the measures treat the individual as a common law employee for taxation or any other purpose. The arrangements will achieve a consistent taxation treatment for personal services income irrespective of the structures in place to receive that income.

What are the new rules?

1.15 The new rules in Part 2-42 will overcome the difficulties in paragraph 1.5 by:

•

ensuring income for the provision of personal services, whether paid directly to an individual or channelled through an interposed entity, will be treated for taxation purposes in the same way; and

•

clarifying the deductions available (both for individuals and other entities) in the gaining of personal services income.

Summary of new law

1.16 The features of Part 2-42 are shown in Diagram 1.1. The diagram uses abbreviations of PSB, PSE, and PSI to refer to concepts of a Personal Services Business (Division 87), a Personal Services Entity (subsection 86-15(2)) and Personal Services Income (Division 84).

Diagram 1.1: Rules for Personal Services Income

Comparison of key features of new law and current law

1.17 This table compares key features of the income tax regime for personal services income with the existing position.

Detailed explanation of new law

1.18 This explanation is divided into 3 parts. Part 1 explains personal services income and the deductions which individuals will be able to claim against personal services income.

Part 2 will explain the new rules about:

•

attributing personal services income to an individual;

•

working out how much to attribute to an individual; and

•

the deductions an entity (other than an individual) can claim against personal services income.

Part 3 will explain the application of the PAYG withholding arrangements to income and entities affected by the new rules.

1.19 The Commissioner will publish a detailed ruling to support the new regime for personal services income and explain the main concepts used in the legislation.

PART 1: PERSONAL SERVICES INCOME

1.20 This Part is divided into the following sections:

Section 1:

Meaning of personal services income; and

Section 2:

Deductions for individuals relating to personal services income.

Section 1: Meaning of personal services income

Division 84 Personal services income

1.21 Section 84-5 defines the term personal services income . This concept is central to the new rules in Divisions 85, 86 and 87. For example, Division 85 limits the amount an individual can deduct to the extent that the amount relates to his or her personal services income.

1.22 Section 84-5 defines personal services income as income (whether ordinary or statutory income) that is gained mainly as a reward for the personal efforts or skills of an individual. Income that is gained by an entity (e.g. a company, partnership or trust) for the personal efforts or skills of an individual will still be personal services income. [Schedule 1, item 3, subsection 84-5(1)]

1.23 By reason of this definition, income which is:

•

ancillary to an entity supplying goods or granting a right to use property; or

•

principally generated by assets an entity holds;

is not personal services income as it is not paid mainly as a reward for an individual's personal effort. Rather, it is paid mainly as consideration for the provision of the goods or due to the use of an asset. Example 2 in subsection 84-5(1) provides an example of income from the use of an asset in the form of a semi-trailer.

1.24 Subsection 84-5(3) extends the definition of personal services income to income that is for doing work or for producing a result. However, the result must be produced mainly from the individual's personal effort or skills.

1.25 Subsection 84-5(4) clarifies that the fact income is paid under a contract does not stop the income being for an individual's personal effort or skill. This provision is intended to overcome any argument that particular income does not fall within the definition of personal services income because it results from a contractual right to income as consideration for services rendered, rather than income that is a reward for the provision of those services themselves.

1.26 Whether an arrangement involves the rendering of personal services, or is for the production of a result that is from the personal services of an individual, will depend on the circumstances of each case. Decisions on this question will therefore need to be made on a case by case basis. Whilst the terms and conditions of contracts will be important, regard will need to be had to all the circumstances of each case to determine the true nature of the contractual obligations of either an individual or a personal services entity to a service acquirer.

1.27 Examples of income that will clearly be from personal services are:

•

salary or wages;

•

income of a professional person practising on his or her own account without professional assistance for example, a medical practitioner in a sole practice;

•

income payable under a contract which is wholly or principally for the labour or services of a person;

•

income derived by a professional sports person or entertainer from the exercise of his or her professional skills. This does not include income from endorsement by the person of a sponsor's products; and

•

income derived by consultants, for example, computer consultants or engineers from the exercise of personal expertise.

1.28 The reference in subsection 84-5(1) to the income that is mainly a reward for the personal efforts or skills of an individual, requires a conclusion as to the substance of contractual arrangements between the relevant parties to those contracts. Whether the provision of the personal efforts or skills of an individual to a service acquirer is the chief or the principal component of a contract will depend on the terms and conditions of that contract.

The distinction between personal services income and income for the supply or sale of goods

1.29 Where personal effort or skill is used in the production of something that is to be sold, then any later contract for the sale of that item or property would be for the sale or supply of goods. The rendering of personal effort or the exercise of skill that results in the production of goods for sale would be regarded as being ancillary to the production of goods that are sold. In these cases, income would be mainly for the supply of goods. Part 2-42 would have no application in these circumstances.

Example 1.1

Frances is a computer programmer, who operates through a family company, Franc Pty Ltd. During the income year 2000-2001, she has been working on developing a computer program that will assist large retail stores to automatically change on-line prices to cater for the GST.

Franc Pty Ltd has copyright over the program and once it is operating grants to a retail store chain the right to use the program for consideration of $25,000.

Franc Pty Ltd provides the services of Frances to install and test the program and to provide a one-off training program to staff of the retail store chain on how to operate the system. The cost of installing and testing the program and to provide training is built into the total price that the retail store chain pays to Franc Pty Ltd.

Income of Franc Pty Ltd is mainly from the granting of the right to use the computer program. The services that Frances provides to install and test the program and to provide training is ancillary to the supply of goods. Part 2-42 would not apply as the income is not personal services income as defined in section 84-5.

1.30 Where, however, the substance of a contract was the doing of work or the exercise of the skills of an individual for a service acquirer, or where a result is produced for a service acquirer from that work or from the exercise of those skills, the fact that ownership of materials that are used passes to the service acquirer does not alter the substance of the contract being for the effort and skills of the individual. Income in these circumstances will be mainly for the personal effort or skills of that individual, and Part 2-42 of the ITAA 1997 will apply.

Example 1.2

Wade is a computer programmer who operates in partnership with his spouse. On 11 July 2000 the partnership contracts with 2001 Computer Pty Ltd to develop a software program for use in space crafts.

A term of the contract is that any know-how, or intellectual property that arises from the work to be done by the partnership is to vest in 2001 Computer Pty Ltd and that the partnership is to have no right, title or interest in such property.

The contract also stipulates that the work is to be done by Wade at the premises of 2001 Computer Pty Ltd. The partnership is to maintain strict confidentiality about the nature of the work to be done by Wade. The partnership receives $145,000 for the work that is done by Wade in the year ended 30 June 2001.

In this instance, income received by the partnership is from the personal effort and skills of Wade. The partnership does not supply goods, nor is there any income that is mainly for the use of assets in the income producing activity of the partnership. Income from 2001 Computer Pty Ltd received by the partnership will be regarded as personal services income of Wade.

The distinction between personal services income and income for the supply and use of assets

1.31 The reference to the income that is mainly a reward for the personal efforts or skills of an individual does not preclude situations where the provision of personal services involves the use of some equipment, for example, a personal computer of a computer consultant.

1.32 In relation to the use of property in the activity that generates income, regard could be had to whether or not the contract is for the supply and use of assets in the activity that gains or produces income. Where a contract does not require the supply or use of assets, but where plant and equipment are used by the individual in that activity, the contract would generally be regarded as one that is for the personal effort, or the skills of the individual. Income from that effort or the exercise of those skills, in these circumstances, would be regarded as personal services income. However, the plant or equipment used could be of such a nature that the income could be treated in some cases as from their use.

Example 1.3

Michelle is a draftsperson who operates through a family trust of which Mich Pty Ltd is the trustee. Michelle is the sole shareholder in Mich Pty Ltd An agreement is entered into between Big Drafting Co Ltd and Mich Pty Ltd to supply Michelle's services for a period of 18 months starting on 1 July 2000. The agreement does not specify what assets are to be used by Michelle or Mich Pty Ltd in doing the work. Mich Pty Ltd has an AUTOCAD machine and computer equipment that is used by Michelle in doing the work.

As the contract is only for the provision by Mich Pty Ltd of the services of Michelle, the use of the AUTOCAD machine and the computer equipment would be regarded as ancillary to the provision of the personal services and skills of Michelle. Income received by Mich Pty Ltd under the agreement with Big Drafting Co Ltd would be regarded as Michelle's personal services income.

1.33 Where a contract specifies that particular assets are to be supplied and used, or the nature of the contract is such that without those assets an individual or a personal services entity would be unable to perform their contractual obligations, and the use of those assets are not dependent on any particular skills of the individual, it is likely that income would be regarded as being for the supply and use of income-producing assets. Income, in these cases, would not come within the meaning of personal services income in section 84-5.

Example 1.4

Mick is a backhoe operator. His family company MickJill Pty Ltd owns a 10 tonne truck and a backhoe tractor. MickJill enters into a contract with a State Main Roads Department to dig trenches for the laying of sewage pipes. The contract is for a period of 9 months commencing on 1 August 2000. The contract specifies that MickJill is to supply a tractor with a backhoe and other special attachments. Mick drives the truck to various locations at the request of the Main Roads Department and uses the tractor to do the work that the company has contracted to do. A drainage engineer from the Department supervises his work.

MickJill receives total income under the contract of $300,000. MickJill pays Mick a salary of $55,000.

As the contract requires MickJill to provide specific plant and equipment to do the job, without which it would not be able to gain or produce income, the income would not be considered to be for the personal services of Mick but for the supply and use of income-producing assets . Part 2-42 does not apply to MickJill.

1.34 However, there may be other situations where assets are used, but nevertheless the analysis of results from the use of the assets are dependent on the personal skills or qualifications of the individual. In these cases, the conclusion may still be reached that income is personal services income within the meaning of section 84-5.

Individuals affected are not employees

1.35 Section 84-10 ensures that the application of Part 2-42 to an individual does not make the individual an employee for the purposes of any Australian law or any instrument made under an Australian law.

Section 2: Deductions for individuals relating to personal services income

Division 85 Overview

1.36 Division 85 sets out the deductions that an individual can and cannot claim against personal services income. Entities other than individuals will use the rules in Subdivision 86-B to determine the deductions that can be claimed against personal services income. A detailed explanation of Subdivision 86-B and its interaction with Division 85 can be found in Part 2 of this Chapter.

1.37 The rules in Division 85 apply to individuals (except employees and certain office holders) earning personal services income. For example, the rules will apply to an independent contractor who provides services in his or her own right directly to another person rather than through a personal services entity. [Schedule 1, item 3, section 85-10]

The basic rule

1.38 Subsection 85-10(1) provides that an individual cannot deduct an amount that relates to his or her personal services income where:

•

the income is payable to the individual, except as an employee; and

•

the individual would not be able to deduct the amount if the income were payable to the individual as an employee.

1.39 Essentially, subsection 85-10(1) limits individuals to the deductions that could be claimed against personal services income by an employee under the rules about deductions in the ITAA 1997.

1.40 Subsection 85-10(2) sets out a number of exceptions to the basic rule in subsection 85-10(1). These exceptions are explained below.

1.41 In addition, Division 85:

•

denies an individual a deduction for an amount of rent, mortgage interest, rates or land tax relating to his or her residence; and

•

limits the amount an individual can deduct for payments to associates and superannuation contributions for associates,

to the extent that the amount relates to gaining or producing the individual's personal services income. These rules, which are explained below, can deny or limit a deduction that the basic rule does not deny. [Schedule 1, item 3, sections 85-15 to 85-25]

Exception for personal services businesses

1.42 The general rule in subsection 85-10(1) and limitations in sections 85-15 to 85-25 do not apply where an amount relates to personal services income gained by an individual conducting a personal services business. This is explained below. [Schedule 1, item 3, section 85-30]

Determining whether an amount can be deducted

1.43 Subsection 85-10(1) provides that an individual cannot deduct an amount that relates to gaining or producing their personal services income, if the individual would not be able to deduct the amount if the income was payable to him or her as an employee.

1.44 To determine whether they would have been able to claim a deduction, if the personal services income were payable to them as an employee, the individual will need to apply the general rules about deducting amounts in the ITAA 1997 and other relevant deduction provisions. In particular, the rules in section 8-1 of that Act will need to be considered.

Example 1.5

Chris is a bookkeeper and operates under the business name of GT Bookkeeping Services. Chris does all the work herself and receives personal services income from MEZ Pty Ltd, who she contracts with to prepare its financial accounts. Chris travels from home to MEZ's offices each day. Under section 8-1 of the ITAA 1997, an employee will generally not be able to deduct these costs because they are not incurred in the course of gaining assessable income and because they are private in nature. For this reason Chris will not be able to deduct these costs against her personal services income under the rule in subsection 85-10(1). In this case subsection 85-10(1) confirms the result that section 8-1 should produce anyway.

Amounts that can be deducted

1.45 Subsection 85-10(2) ensures that certain deductions, which may be denied by the rule in subsection 85-10(1), can still be deducted. However, the subsection does not create an entitlement to deduct an amount and the amount must still be deductible under another provision of the income tax law.

1.46 Subsection 85-10(2) provides that subsection 85-10(1) will not stop an individual deducting an amount, where it relates to personal services income, to the extent that it relates to:

•

gaining work;

•

insuring against the loss of the individual's income or income earning capacity;

•

insuring against liability arising from the individual's acts or omissions in the course of earning income;

•

engaging an entity who is not the individual's associate;

•

engaging an associate to perform work that forms part of the principal work for which the individual gains or produces his or her personal services income;

•

superannuation contributions for the benefit of the individual;

•

complying with obligations under a workers' compensation law; and

•

meeting obligations, or exercising rights under the GST law.

Gaining work

1.47 Subsection 85-10(1) does not stop an individual from deducting expenditure for gaining work, where it relates to the individual's personal services income. Examples of this kind of expenditure include advertising, tendering and quoting for work. [Schedule 1, item 3, paragraph 85-10(2)(a)]

Insuring against the loss of the individual's earning capacity

1.48 Subsection 85-10(1) does not stop an individual from deducting costs for insuring against the loss of the individual's income or income earning capacity, where it relates to the individual's personal services income. Examples of this kind of expenditure include sickness, accident and disability insurance. [Schedule 1, item 3, paragraph 85-10(2)(b)]

Insuring against liability arising from the individual's acts or omissions in the course of earning income

1.49 Subsection 85-10(1) does not stop an individual from deducting the cost of insuring against liability arising from the individual's acts or omissions in the course of earning income, where it relates to the individual's personal services income. Examples of this kind of expenditure include public liability insurance and professional indemnity insurance. [Schedule 1, item 3, paragraph 85-10(2)(c)]

Engaging an entity who is not the individual's associate

1.50 A deduction will not be denied by subsection 85-10(1) for an amount that relates to engaging an entity that is not an associate of the individual to perform work. [Schedule 1, item 3, paragraph 85-10(2)(d)]

1.51 To determine whether an entity is an associate, the definition of associate in section 318 of the ITAA 1936 will need to be applied. This definition includes the spouse or defacto spouse of the individual, together with certain other relatives, partners, trustees and companies.

Engaging an associate to perform work, that forms part of the principal work

1.52 Subsection 85-10(1) does not stop an individual from deducting an amount to the extent that it relates to employing (or otherwise engaging) an associate (as defined in section 318 of the ITAA 1936) to perform work, that forms part of the principal work for which the individual gains or produces his or her personal services income. [Schedule 1, item 3, paragraph 85-10(2)(e)]

Principal Work

1.53 The term 'principal work' will not be defined for the purposes of the new rules and so takes on its ordinary meaning. This is because whether an associate is performing work which forms part of the principal work of the individual is a question of fact that must be decided on a case by case basis.

1.54 As a general guide, the principal work of an individual can be described as that work that is central to meeting the individual's obligations under agreements between himself or herself, or a personal services entity, and the acquirer of the personal services. It is work that is essential to the generation of income of the relevant individual or entity from the personal services of an individual.

1.55 The concept of principal work does not include work which is ancillary in nature such as helping or aiding the work of the individual, unless this directly contributes to meeting the end result of the agreement. Work that is associated with the administration of the personal services entity such as bookkeeping, answering telephones or other clerical work is considered to be ancillary to the principal work of the individual and therefore not the principal work.

Example 1.6

Karen contracts through Skills Pty Ltd, a personal services entity of which she is the sole director, to personally provide staff training and development services to TUV Pty Ltd. Under the contract, Karen is required to design and establish training systems for TUV Pty Ltd's staff. She is also responsible for recruiting staff for TUV Pty Ltd to deliver training programs on an ongoing basis.

Skills Pty Ltd employs Karen's sister Rita as its receptionist and bookkeeper. In performing her duties at Skills Pty Ltd, Rita mainly answers telephone calls from prospective clients and prepares invoices for services provided by Skills Pty Ltd. Rita is not performing any of the principal work for which Karen receives personal services income from TUV Pty Ltd. She has no involvement either in designing staff training and development programs for TUV Pty Ltd or in recruiting staff to deliver those programs.

Skills Pty Ltd also employs Karen's other sister Leonie to assist Karen in assessing TUV Pty Ltd's training needs and preparing training materials for future training programs. The work Leonie undertakes forms part of the principal work for which Karen receives personal services income. This work directly assists Karen in delivering the services Skills Pty Ltd has contracted with TUV Pty Ltd to perform.

Example 1.7

Bill is a computer consultant who, through Flowerpot Pty Ltd, a personal services entity he controls, is contracted to work for a government department to install software. Bill's principal work is the installation of the software and liaising with the IT section of the department to conduct training in the new software.

Flowerpot Pty Ltd employs Ben, Bill's cousin. Ben is employed to test the software that Bill is installing to ensure that it performs satisfactorily and conforms to relevant standards. Ben has a tertiary qualification in information technology. The tasks that Ben is performing are part of the principal work of Bill because they assist Bill in providing the services Flowerpot Pty Ltd has contracted to provide and for which he will receive personal services income.

Superannuation contributions

1.56 Subsection 85-10(1) does not stop an individual from deducting amounts that are contributed to a superannuation fund or RSA to provide for superannuation benefits payable to the individual or, in the case of the individual's death, his or her dependants. [Schedule 1, item 3, paragraph 85-10(2)(f)]

Complying with obligations under a workers' compensation law

1.57 Subsection 85-10(1) does not stop an individual from deducting premiums, contributions and similar payments incurred in complying with his or her obligations under a workers' compensation law. The term, workers' compensation law is defined in subsection 136(1) of the FBTAA 1986. [Schedule 1, item 3, paragraph 85-10 (2)(g)]

1.58 For example, subsection 85-10(1) does not stop an individual from deducting a premium paid for their employee's workers' compensation insurance.

1.59 In addition, subsection 85-10(1) does not stop an individual from deducting payments to an employee for compensable work-related trauma. Compensable work-related trauma is defined in subsection 136(1) of the FBTAA 1986. [Schedule 1, item 3, paragraph 85-10(2)(g)]

1.60 For example, if an individual makes a payment, under a workers' compensation law (as defined in subsection 136(1) of the FBTAA 1986), to his or her employee in respect of their work-related injury, subsection 85-10(1) will not stop the individual from deducting this payment. In addition, the deduction will not be denied if there is no workers' compensation law that applies to the employment of the employee and the payment would be required under an Australian workers' compensation law if it had applied (as defined in subsection 136(1) of the FBTAA 1986).

Meeting GST obligations

1.61 Subsection 85-10(1) does not stop an individual deducting amounts which relate to meeting GST obligations. [Schedule 1, item 3, paragraph 85-10(2)(h)]

Deductions that cannot be claimed by an individual against personal services income

1.62 Sections 85-15 to 85-25 set out amounts which cannot be deducted by an individual, to the extent that the amounts relate to gaining or producing his or her personal services income.

Deductions for rent, mortgage interest, rates or land tax

1.63 An individual, who is not an employee and derives personal services income cannot deduct an amount of rent, mortgage interest, rates or land tax for his or her residence, or the residence of the individual's associates, to the extent it relates to gaining or producing the individual's personal services income. [Schedule 1, item 3, section 85-15]

1.64 However, section 85-15 does not prevent a deduction for amounts incurred by the individual for running expenses for using a room in the individual's home as a home office or study, for example heating and lighting. Such amounts are incurred where the individual uses the room to earn assessable income, but does so out of convenience rather than as a place of business. These amounts are allowable as deductions to employee-like individuals and therefore continue to be allowable to individuals to which Part 2-42 applies.

Example 1.8

On weekdays Nick, who contracts through a personal services entity, works at the premises of the company that he performs services for. On some weekends Nick uses the study in his home to continue work needed for his contract. Nick is able to claim a deduction for that proportion of lighting and heating/cooling expenses that is incurred for the study for those days.

Deductions for payments to associates

1.65 An individual cannot deduct any payment made to an associate or any loss or outgoing which the individual incurs from an obligation he or she has to an associate, where the payment, loss or outgoing relates to personal services income. [Schedule 1, item 3, subsection 85-20(1)]

Example 1.9

Maria is a landscape gardener who receives personal services income from the provision of garden landscaping services to a local council. Maria is not conducting a personal services business. Maria pays her husband Peter a fortnightly amount equal to 25% of the personal services income she receives. The payments are made to Peter for answering the telephone and taking messages from potential clients when Maria is unavailable. Maria's husband, Peter, would fall within the definition of associate. Under subsection 85-20(1), Maria will therefore not be able to deduct the amounts she pays to her husband for answering the telephone.

1.66 However, subsection 85-20(2) provides that an individual can deduct an amount to the extent that it relates to engaging an associate to perform work, that forms part of the principal work, for which the individual gains or produces his or her personal services income. When an individual's associate will be performing part of the principal work is explained above.

Deduction for superannuation contributions for associates

1.67 An individual cannot deduct a contribution made to a fund or a RSA to provide for superannuation benefits payable for his or her associate to the extent that the associate's work for the individual relates to gaining or producing personal services income. [Schedule 1, item 3, subsection 85-25(1)]

1.68 However, subsection 85-25(1) does not stop an individual from deducting a contribution to the extent that it relates to the associate's performance of work, that forms part of the principal work, for which the individual gains or produces personal services income. Whether an associate is performing work that forms part of the principal work of the individual is explained above. [Schedule 1, item 3, subsection 85-25(2)]

1.69 The amount that can be deducted under subsection 85-25(2) is limited to the amount worked out under subsection 85-25(3) and subsection 85-25(4). This is the amount that the individual would have to contribute for the benefit of the associate to avoid an individual guarantee shortfall for that associate, as defined by section 19 of the Superannuation Guarantee (Administration) Act 1992 .

Exception for individuals conducting a personal services business

1.70 The rules in Division 85 do not apply to individuals gaining personal services income in the course of conducting a personal services business. [Schedule 1, item 3, section 85-30]

1.71 To determine whether the individual gains income in the course of conducting a personal services business, the tests in Division 87 will need to be applied. These are explained in Section 2 of Part 2 of this Chapter.

Exception for employees and certain office holders

1.72 The rules in Division 85 do not apply to amounts received as an:

•

employee;

•

individual mentioned in paragraphs 12-45(1)(a),(b),(c),(d) or (e) in Schedule 1 to the TAA 1953 (e.g. Defence Force members, members of Parliaments and local government bodies).

[Schedule 1, item 3, section 85-35]

Substantiating work expenses for non-employees

1.73 Section 85-40 ensures that Division 85 does not have the effect of applying Subdivision 900-B (about substantiating work expenses) of the ITAA 1997 to an individual who is not an employee.

1.74 The rules in Subdivision 900-B require that an individual have certain documentary evidence of having incurred an expense, before the individual can claim a deduction for that expense.

1.75 However, section 85-40 does not stop the substantiation of work expenses rules from applying to an individual, where the rules apply regardless of Division 85. This is because section 85-40 only stops these rules from applying where they would otherwise apply because of Division 85. For example, section 85-40 will not stop the substantiation of work expenses rules from applying to a company director's personal services income, because the substantiation rules specifically apply to a company director and do not apply only because of Division 85.

1.76 In addition, section 85-40 will not stop the application of the record keeping requirements of section 262A of the ITAA 1936. Broadly, section 262A requires records to be kept for all transactions relevant to the tax law, including expenditure.

Example 1.10

David is a bookkeeper, who works for BigCo Pty Ltd, through a personal services entity he controls, Davo Pty Ltd. David attends a course to update his bookkeeping knowledge which cost him $400. To deduct this amount, David need not substantiate the cost as an employee has to do because section 85-40 excludes David from these substantiation rules and he is not subject to the substantiation rules regardless of Division 85. However, David will still need to keep a record of the cost as required by section 262A of the ITAA 1936.

PART 2: ALIENATION OF PERSONAL SERVICES INCOME

1.77 This Part is divided into the following sections:

Section 1:

Attributing personal services income to an individual

Section 2:

When personal services income will not be attributed

Section 3:

Calculating how much to attribute to an individual

Section 4:

The deductions an entity can claim against personal services income

Section 1: Attributing personal services income to the individual who performs the services

The basic rule

1.78 Under subsection 86-15(1), an individual will be required to include in his or her assessable income any income, whether ordinary or statutory, that another entity gains for the individual's personal services. However, this rule does not apply if:

•

the other entity gains the income in the course of conducting a personal services business; or

•

the income is promptly paid to the individual by the entity as salary or wages.

These exceptions are explained below.

1.79 Under section 86-20 the personal services income included in the individual's assessable income may be reduced by deductions to which the other entity is entitled. This reduction is explained at paragraph 1.131.

1.80 Section 86-15 will not apply to attribute to an individual exempt or non-assessable income, or income that is neither exempt nor assessable, that is received by the personal services entity. [Schedule 1, item 3, subsection 86-15(5)]

1.81 Consequently, if a personal services entity receives personal services income for a service, and GST is payable on the supply of that service, the GST component of the payment will not be included in the amount attributed to the individual under subsection 86-15(1). This isbecause under section 17-5 of the ITAA 1997, the GST payable on a supply is neither assessable income nor exempt income of an entity.

Example 1.11

Robyn is an environmental management expert who provides consulting services through her private company RedRobyn Pty Ltd. RedRobyn receives a payment of $33,000 for Robyn's personal services provided to a paper mill, which includes the GST payable on the services. The GST component of this payment is $3,000. Only the amount of $30,000, which is the amount of the payment less the GST component, will be attributed to Robyn under subsection 86-15(1).

Chains of personal services entities

1.82 Where more than one personal services entity is interposed between an individual and the entity that the individual performs work for, the income gained by those interposed entities for the personal services of the individual will still be personal services income attributable to the individual under section 86-15.

1.83 This is because the income gained by those interposed entities retains its character as income for the personal services provided by the individual to the ultimate service acquirer. The fact that the income is transferred from one interposed entity to another interposed entity does not have the effect of altering the character of the income being transferred.

1.84 As such the income will continue to fall within the definition of personal services income in section 84-5, and the entities gaining the income will continue to be personal services entities under subsection 86-15(2). The income will therefore remain income that can be attributed to the individual under section 86-15. It will also remain income affected by the deduction limitation rules in Division 85 and Subdivision 86-B.

Example 1.12

Keith forms 2 private companies C Pty Ltd and PS Pty Ltd. C Pty Ltd, contracts with PS Pty Ltd for Keith to perform computer consultant services for clients of PS Pty Ltd as required. PS Pty Ltd then contracts with Ultimate Acquirer Pty Ltd for Keith to perform computer consultant services for that company.

Under this arrangement, the ordinary or statutory income gained by PS Pty Ltd for Keith's services is the personal services income of Keith, as it is a reward for Keith's personal effort and the application of his skill and knowledge in providing consulting services to Ultimate Acquirer Pty Ltd.

PS Pty Ltd will attribute the income to Keith under section 86-15. If PS Pty Ltd makes any payments from the ordinary or statutory income of Keith to C Pty Ltd, it will not be assessable or exempt income to C Pty Ltd due to the application of section 86-35.

Section 2: When personal services income will not be attributed to the individual

1.85 Personal services income will not be attributed to an individual under subsection 86-15(1) if:

•

the personal services entity gains the income in the course of conducting a personal services business [Schedule 1, item 3, subsection 86-15(3)] ; or

•

the personal services income is paid promptly as salary to the individual [Schedule 1, item 3, subsection 86-15(4)] .

Determining whether there is a personal services business

1.86 To determine whether an individual or personal services entity gains personal services income in the course of conducting a personal services business, the tests in Division 87 must be applied. Under these tests, an individual or personal services entity will be considered to be carrying on a personal services business for the purposes of this measure if:

•

it receives less than 80% of its personal services income in respect of an individual from one source and is able to satisfy one of the 3 personal service business tests [Schedule 1, item 3, section 87-15] ;or

•

it receives 80% or more of its personal services income in respect of an individual from one source and is able to obtain a determination from the Commissioner that it gains personal services income in the course of conducting a personal services business [Schedule 1, item 3, section 87-15] .

80% or more of the personal services income for an individual is received from one source

1.87 An individual or personal services entity will not be treated as conducting a personal services business if:

•

in the case of an individual, that individual gains 80% or more of its personal services income from the one entity and/or that entity's associates; or

•

in the case of a personal services entity, that entity gains 80% or more of its personal services income for an individual from the one entity and/or that entity's associates.

[Schedule 1, item 3, subsection 87-15(2)]

1.88 As a result, the rules in Division 86 will apply to attribute the personal services income gained by the individual or personal services entity to the individual who performed the personal services to which the income relates.

1.89 However, where an individual or entity meets this 80% test, it can choose to apply to the Commissioner for a determination that it is conducting a personal services business. There is no obligation to apply for a determination. The individual or personal services entity can proceed on the basis that the personal services income regime applies. [Schedule 1, item 3, Subdivision 87-B]

1.90 If the entity is unsuccessful in obtaining that determination, the rules in Division 86 will apply, and the personal services income the individual or entity gains will be attributable to the individual. If the entity is successful the Division 86 rules will not apply.

Personal services business tests

1.91 A personal services entity will be treated as conducting a personal services business for the purposes of this measure if at least one of the following tests are satisfied:

•

unrelated clients test;

•

employment test;

•

business premises test.

[Schedule 1, item 3, subsection 87-15(1)]

These tests are explained in paragraphs 1.92 to 1.101.

Unrelated clients test

1.92 An individual or personal services entity meets the unrelated clients test if, during the year:

•

the individual or entity gains or produces income from providing services to 2 or more entities that are not associates of each other, the individual or the personal services entity; and

•

the services are provided as a direct result of the individual or entity making offers or invitations (e.g. by advertising) to the public or a section of the public to provide the services.

[Schedule 1, item 3, subsection 87-20(1)]

1.93 An individual or personal services entity does not satisfy the condition about offering services to the public by registering with a labour hire firm or placement agency. [Schedule 1, item 3, subsection 87-20(2)]

Employment test

1.94 An individual meets the employment test for the income year if he or she engages one or more entities to perform work and those entities together perform at least 20%, by market value, of the individual's principal work. The employment test will also be met if, for at least half the year, the individual has an apprentice. [Schedule 1, item 3, subsections 87-25(1) and (3)]

1.95 The term 'principal work' is discussed in Section 2, Part 1 of this Chapter.

1.96 Similarly, a personal services entity meets the employment test for an income year if it engages one or more entities (except the individual) to perform work. Those entities together, must perform at least 20%, by market value, of the entity's principal work. The employment test will also be met if, for at least half the year, the entity has an apprentice. [Schedule 1, item 3, subsection 87-25(2) and (3)]

Business premises test

1.97 An individual or a personal services entity meets the business premises test for the income year if, at all times during the income year, the individual or entity maintains and uses business premises. [Schedule 1, item 3, subsection 87-30(1)]

1.98 The business premises must be used mainly by the individual or entity to conduct activities producing personal services income. This means that the individual or entity must do more than merely have leased premises in its name to pass the test. The premises should actually be used to produce the personal services income. [Schedule 1, item 3, paragraph 87-30(1)(a)]

Example 1.13

Rose's personal services entity, ROB Pty Ltd, leases an office at the local shopping centre. The office has a desk and a phone. Rose conducts most of her business from her home in her spare room. ROB does not pass the business premises test because the office is not used for the main activities of the personal services entity.

1.99 The individual or entity must also have exclusive use of the premises. This means that the individual or entity cannot lease premises together with another individual or entity on the basis that they share the premises. [Schedule 1, item 3, paragraph 87-30(1)(b)]

1.100 The business premises must also be physically separate from any premises used for private purposes of the individual, the entity or an associate of the individual or entity. [Schedule 1, item 3, paragraph 87-30(1)(c)]

Example 1.14

Rose leases the shed in her brother's back garden from which to conduct her business. As the shed is part of the premises used by Rose's brother for private purposes, Rose does not meet the business premises test.

1.101 The business premises must be physically separate from the premises of the entity (or associate) to which the individual or entity provides personal services. [Schedule 1, item 3, paragraph 87-30(1)(d)]

Example 1.15

Rose provides personal services, through her personal services entity, to BOR Pty Ltd. Rose leases a room at BOR's premises from which to conduct her business. Rose does not meet the business premises test, as her business premises are not physically separate from the entity that she is providing personal services to.

1.102 The individual or entity does not have to maintain and use the same business premises throughout the whole year. This means that the individual or entity can change business premises during the year as long as at all times during the income year, the individual or entity has premises, which satisfy the requirements in subsection 87-30(1), to conduct business from. [Schedule 1, item 3, subsection 87-30(2)]

Personal services income from Australian government agencies

1.103 To determine whether 80% of an individual or entity's personal services income is gained from one entity and/or that entity's associates, the following entities will not be treated as associates of each other:

•

Australian government agencies as defined in subsection 995-1(1) of the ITAA 1997;

•

each agency within the meaning of the Public Service Act 1999 . Each such agency will also not be considered to be an associate of any Australian government agency; and

•

each part of the Government of a State or Territory and each part of an authority of the State or Territory that has, under an Australian law, a status corresponding to an Agency within the meaning of the Public Service Act 1999 . Each such part will also not be treated as an associate of any Australian government agency. [Schedule 1, item 3, section 87-35]

1.104 This rule will ensure that where an individual or personal services entity gains personal services income from a range of different government agencies, these different agencies will not be taken as one source for the purposes of the 80% test outlined above.

Personal services business determinations

1.105 An individual conducts a personal services business during an income year if a personal services business determination is in force relating to the individual. [Schedule 1, item 3, subsection 87-55(1)

1.106 A personal services entity conducts a personal services business during an income year if a personal services business determination is in force relating to an individual whose personal services income is included in the entity's ordinary or statutory income. [Schedule 1, item 3, subsection 87-55(2)]

Individuals

1.107 The Commissioner may, by written notice given to an individual, make a personal services business determination relating to the individual. The Commissioner may also vary any such determination. [Schedule 1, item 3, subsection 87-60(1)]

1.108 The notice may specify the period for which the determination has effect together with any conditions to which it is subject. [Schedule 1, item 3, subsection 87-60(2)]

1.109 The Commissioner must not make the determination under subsection 87-60(1) unless satisfied that in the income year during which the determination first has effect, or is taken to have first had effect:

•

the individual:

-

could reasonably be expected to meet, or met, the employment test under section 87-25 or the business premises test under section 87-30, or both [Schedule 1, item 3, subparagraph87-60(3)(a)(I)] ; or

-

but for unusual circumstances applying to the individual in that year, could reasonably have been expected to meet, or would have met, at least one of the 3 personal services business tests;

•

the individual's personal services income could reasonably be expected to be, or was, from the individual conducting activities. [Schedule 1, item 3, paragraph 87-60(3)(b)] ;and

•

80% or more of the individual's personal services income could reasonably be expected to be, or was, income from the same entity and/or its associates [Schedule 1, item 3, paragraph 87-60(3)(c)] .

1.110 The rule in paragraph 87-60(3)(a) requires the Commissioner to apply the personal services business tests set out in Subdivision 87-A. However, it also allows the Commissioner to take into account unusual circumstances the individual is experiencing which prevent him or her from satisfying those tests for the income year in question. If the Commissioner considers that, but for those unusual circumstances, the individual would satisfy at least one of the personal services business tests, paragraph 87-60(3)(a) will be satisfied. Examples of unusual circumstances include where:

•

an individual who, for a number of years, has provided personal services to a range of different clients, decides to accept a long term contract with a single client; or

•

an individual is unable to satisfy the business premises test in section 87-30 because he or she has only been conducting activities from which personal services income is gained for part of the relevant income year.

Subsection 87-30(4) provides 2 further examples of unusual circumstances.

1.111 The rule in paragraph 87-60(3)(c) above ensures that the Commissioner will only be able to make a determination about an individual who can reasonably be expected to gain, or gains, 80% or more of his or her personal services income from the one source. The Commissioner will be unable to make a determination for an individual who does not satisfy this test. For this reason, individuals wishing to seek a determination from the Commissioner should first work out whether they can show that they satisfy the 80% test in paragraph 87-60(3)(c).

Further grounds for making the determination

1.112 Subsection 87-60(5) allows the Commissioner to make a determination if satisfied that the individual performs work in a certain manner. The Commissioner has to be satisfied that:

•

the individual's personal services income is for producing a result [Schedule 1, item 3, paragraph 87-60(5)(a)] ;

•

the individual is required to supply the plant and equipment, or tools of trade, needed to perform the work from which the individual produces the result [Schedule 1, item 3, paragraph 87-60(5)(b)] ; and

•

the individual is, or would be, liable for the cost of rectifying any defect in the work performed [Schedule 1, item 3, paragraph 87-60(5)(c)] .

1.113 In making the determination, the Commissioner may have regard to whether it is the normal custom or practice, when work of that kind is performed by an entity other than an employee:

•

for the income from the work to be for producing a result;

•

for the entity to be required to supply the plant and equipment, or tools of trade, needed to perform the work; and

•

for the entity to be liable for the cost of rectifying any defect in the work performed.

[Schedule 1, item 3, subsection 87-60(6)]

1.114 An individual will not satisfy the test in paragraph 87-60(5)(a) merely because the contract states that the personal services income is for producing a result. The individual must actually be paid on the basis of achieving a result, rather than, for example, for hours worked. For example, if a management consultant's contract requires the consultant to produce a report but he or she is paid according to the hours worked, not a price for the report, the consultant will not satisfy this condition.

1.115 To satisfy the test in paragraph 87-60(5)(b), the individual must be able to demonstrate that he or she is required to provide all necessary plant, tools and other equipment to produce the result. If no plant and equipment or tools of trade are needed to perform the work, the condition is not satisfied.

1.116 To satisfy the test in paragraph 87-60(5)(c) the individual must actually cover the cost of rectifying defects to the work that he or she performs not merely have a term in a contract including such an obligation.

1.117 Satisfaction of the conditions would not be met where the custom is not to provide equipment and tools (irrespective of whether they are supplied by the individual) or the services themselves do not rely on the use of equipment and tools.

1.118 The Commissioner can make a determination based on the further grounds regardless of whether he is satisfied that the individual meets any of the 3 personal services business tests. [Schedule 1, item 3, subsection 87-60(7)]

Entities

1.119 Under section 87-65 the Commissioner may, by giving written notice to a personal services entity whose income includes an individual's personal services income, make a personal services business determination relating to the individual's personal services income included in the entity's ordinary or statutory income. The Commissioner may also vary such a determination. [Schedule 1, item 3, subsection 87-65(1)]

1.120 The notice may specify the period for which the determination has effect together with any conditions to which it is subject. [Schedule 1, item 3, subsection 87-65(2)]

1.121 The Commissioner must not make a 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:

•

the entity:

-

could reasonably be expected to meet, or met, the employment test under section 87-25 or the business premises test under section 87-30, or both [Schedule 1, item 3, subparagraph 87-65(3)(a)(i)] ; or

-

but for unusual circumstances applying to the entity in that year, could reasonably have been expected to meet, or would have met, at least one of the 3 personal services business tests [Schedule 1, item 3, subparagraph 87-65(3)(a)(ii)] ; and

•

the individual's personal services income included in the entity's ordinary income or statutory income could reasonably be expected to be, or was, from the entity conducting activities that met:

-

if subparagraph (a)(i) applies the employment test under section 87-25 or the business premises test under section 87-30, or both [Schedule 1, item 3, subparagraph 87-65(3)(b)(i)] ; or

-

if subparagraph (a)(ii) applies at least one of the 3 personal services business tests [Schedule 1, item 3, subparagraph 87-65(3)(b)(ii)] ; and

•

80% or more of the individual's personal services income could reasonably be expected to be, or was, income from the same entity and/or its associates [Schedule 1, item 3, paragraph 87-65(3)(c)] .

1.122 The rule in paragraph 87-65(3)(a) requires the Commissioner to apply the personal services business tests set out in Subdivision 87-A. However, it also allows the Commissioner to also take into account unusual circumstances the entity is experiencing which prevent it from satisfying those tests for the income year in question. If the Commissioner considers that, but for those unusual circumstances, the entity would satisfy at least one of the personal services business tests, paragraph 87-65(3)(a) will be satisfied. Examples of unusual circumstances include where:

•

an entity who, for a number of years, has provided personal services to a range of different clients, decides to accept a one year full time contract with a single client; or

•

an entity is unable to satisfy the business premises test in section 87-30 because it has only been conducting activities from which personal services income is gained for part of the relevant income year.

1.123 The rule in paragraph 87-65(3)(c) ensures that the Commissioner will only be able to make a determination about an entity who can reasonably be expected to gain, or gains, 80% or more of its personal services income from the one source. The Commissioner will be unable to make a determination for an entity who does not satisfy this test. For this reason, entities wishing to seek a determination from the Commissioner should first work out whether they can show that they satisfy the 80% test in paragraph 87-65(3)(c).

Further grounds for making the determination

1.124 Subsection 87-65(5) allows the Commissioner to make a determination if satisfied that the personal services entity performs work in a certain manner. The basis for that determination is similar to that for when the Commissioner makes a determination under subsection 87-60(5) in relation to an individual.

1.125 Subsection 87-65(5) can apply whether or not the Commissioner is satisfied that the personal services entity and the individual meets the requirements of subsection 87-65(3). [Schedule 1, item 3, subsection 87-65(7)]

Applying for a determination

1.126 An individual or a personal services entity may apply to the Commissioner for a personal services business determination, or for a variation to a personal services determination, in the approved form. [Schedule 1, item 3, subsection 87-70(1)]

1.127 The Commissioner can request the individual or entity that has made an application to provide additional information or documentation where this is needed to assist the Commissioner in reaching a decision. [Schedule 1, item 3, subsection 87-70(2)]

1.128 If the Commissioner does not decide the application within 60 days after it is made, the individual or entity may at any time give the Commissioner written notice that they wish to treat the application as having been refused. Where an applicant gives this notice to the Commissioner, the Commissioner will be taken to have refused the application on the date of the notice. [Schedule 1, item 3, subsections 87-70(3) and (4)]

1.129 In measuring the 60 day period above, the time between the day the Commissioner requests further information and the day that information is given by the applicant is not taken into account. [Schedule 1, item 3, subsection 87-70(5)]

When determination is in effect

1.130 Personal services business determinations, and variations of personal services business determinations, take effect from the date specified in the notice as the day on which the determination takes effect. If no date is specified, then the date of effect is the day on which the notice is given. [Schedule 1, item 3, subsection 87-75(1)]

1.131 A determination will cease to have effect when either:

•

one or more of the conditions to which the personal services determination was subject are no longer met;

•

the Commissioner revokes the determination; or

•

the period for which the determination was effective ends,

whichever is the earlier. [Schedule 1, item 3, subsection 87-75(2)]

Revoking a determination

1.132 Under section 87-80, the Commissioner must revoke a personal services determination given to an individual or entity where he or she is no longer satisfied that:

•

the individual or entity is conducting a personal services business [Schedule 1, item 3, paragraph 87-80(a)] ;

•

if the individual made the application on which the determination was made the income is not from the individual conducting a personal services business [Schedule 1, item 3, paragraph 87-80(b)] ;

•

if the entity made the application on which the determination was made the individual's personal services income included in the entity's income was not from the entity conducting a personal services business [Schedule 1, item 3, paragraph 87-80(c)] .

1.133 The Commissioner must give the individual or entity written notice of the decision to revoke the determination.

Objection rights

1.134 Objections may be made against a decision of the Commissioner to make, vary or revoke a personal services business determination, or a refusal by the Commissioner to grant or vary a personal services business determination. Part IVC of the TAA 1953sets out the way in which a person can object if they are dissatisfied with a decision or a refusal of the Commissioner in regards to a personal services business determination. [Schedule 1, item 3, section 87-85]

Less than 80% of the personal services income for an individual is received from one source

1.135 If a personal services entity receives less than 80% of its personal services income for the services of an individual from one entity and/or its associates, the entity must then determine whether it is conducting a personal services business. To determine this, the entity must work out whether it satisfies at least one of the 3 personal services business tests in section 87-20, 87-25 or 87-30 at all times during the income year. These tests are explained above.

Where income is paid promptly to the individual as salary

1.136 Amounts of personal services income will not be included in an individual's assessable income under subsection 86-15(1), where those amounts are actually paid to the individual as salary before the end of the fourteenth day after the PAYG payment period, during which the personal services entity received the income. [Schedule 1, item 3, subsection 86-15(4)]

1.137 Under Division 16 of Schedule 1 to the TAA 1953, a personal services entity is obliged to pay to the Commissioner amounts withheld from withholding payments made during a certain period. A personal services entity also has to pay to the Commissioner amounts withheld from withholding payments during the PAYG payment period. The PAYG payment period is defined in subsection 995-1(1) to be:

•

for a small withholder, a quarter; and

•

for any other personal services entity, a month.

1.138 Amounts received by a personal services entity for the personal services of an individual, and paid promptly to the individual as salary by the relevant period or day, will be deductible to the personal services entity. Under section 86-20, this deduction will reduce the amount of personal services income included in the individual's assessable income.

1.139 Amounts of personal services income promptly paid out as salary will be assessable income of the individual when paid and taxed at the marginal personal income tax rates as ordinary salary payments.

Example 1.16

Emma is a management consultant and she and her husband are the directors and shareholders of Management Services Pty Ltd (MS Pty Ltd). MS Pty Ltd is a quarterly PAYG remitter. Over the income year 2000-2001 the following receipts and payments occurred:

Quarter/PAYG period ending	14th day after period	PSI received during quarter	Salary paid from PSI	Date salary paid
30 Sep	14 Oct	$50,000	$15,000	2 Oct
31 Dec	14 Jan	$40,000	NIL	-
31 March	14 April	$60,000	$20,000	10 April
30 June	14 July	$30,000	$8,000	18 July

The payments for the September and March quarters were made before the end of the 14th day after the relevant PAYG payment period. These amounts will not be included in the amount of personal services income that is attributed to Emma under subsection 86-15(1). They will be assessable as salary to Emma, and will be deductible to MS Pty Ltd in the income year they were incurred. [Schedule 1, item 3, subsection 86-15(4)]

The personal services income received for the December quarter will be included in Emma's assessable income under subsection 86-15(1) as this amount was not paid as salary but retained in the company. The personal services income received for the June quarter will also be included in Emma's assessable income under subsection 86-15(1) because it was paid as salary after the 14th day following the PAYG period during which it was received.

Section 3: Calculating how much personal services income to include in the individual's assessable income

1.140 As explained above, income for an individual's personal services will be included in that individual's assessable income under subsection 86-15(1) where the income is gained by an entity that is not a personal services business. To work out how much to include in the individual's assessable income, the method statement in section 86-20 must be used.

1.141 At the outset, the total income of the personal services entity needs to be divided into either personal services income or other income. To do this, the definition of personal services income in section 84-5 will need to be considered. Once the entity's income has been divided into personal services income (excluding any GST component) and other income, the deductions available to the entity also need to be categorised. The deductions of the entity will fall into 3 classes:

•

Personal services income deductions , which are deductions that can be claimed against personal services income. Broadly, these are limited to amounts that an employee would be able to deduct in the same circumstances;

•

Entity maintenance deductions such as bank and government charges, statutory fees and tax-related expenses which are offset against other income and, in some circumstances, personal services income (these deductions are defined in subsection 86-65(2)); and

•

Other income deductions for expenses incurred in earning the assessable income of the entity that is not personal services income.

1.142 Once the income and deductions of the personal services entity have been determined, the entity maintenance deductions must first be offset against the entity's other income. This must be the initial step in determining the income to be attributed to the individual. The other income deductions cannot be offset against the other income of the entity before the entity maintenance deductions.

1.143 Offsetting the entity maintenance deductions against the other income of the entity will give rise to one of 2 outcomes. The first is where the entity maintenance deductions do not exceed the other income, and the second is where the entity maintenance deductions do exceed the other income. For each outcome there are different steps to follow to determine how much income to attribute to the individual.

Where the entity maintenance deductions do not exceed other income

1.144 Where the entity maintenance deductions do not exceed the other income of the personal services entity, steps 1 to 4 and then step 6 of the method statement in subsection 86-20(2) should be followed. This calculation will determine the amount by which the personal services income should be reduced before it is attributed to the individual. The steps in the method statement are as follows:

•

Steps 1 to 3 Work out the personal services income deductions, the entity maintenance deductions and the other income of the entity.

•

Step 4 Subtract the other income from the entity maintenance deductions. As the entity maintenance deductions in this scenario are either equal to or less than the other income, the result of the calculation will either be zero or negative. This signifies that there will either be other income left in the entity or the entity will have a balance of zero after this step.

•

Step 5 This step does not apply to this scenario as the amount in step 4 is not greater than zero.

•

Step 6 As the entity maintenance deductions do not exceed the other income, the total of these deductions have been offset against the other income and as such none of these deductions are offset against the personal services income. Therefore step 6 ensures that only the personal services income deductions are offset against the personal services income.

1.145 After the calculation of the income attributable to the individual under section 86-25 has been completed, the income for the personal services entity can be determined. The balance of other income, after it has initially been reduced by the entity maintenance deductions, is reduced by the other income deductions. This will create either a profit or loss in the entity depending on the amount of the other income deductions.

1.146 If the personal services entity is a partnership which has a loss, subsection 92(2) of the ITAA 1936 (partnership loss) may apply to allow a deduction to the partner to the extent of the partner's interest in the partnership. If the personal services entity is either a company or trust, the loss will be retained in the entity.

Example 1.17

George is a computer consultant. He provides his consulting services through his private company, JungleGeorge Pty Ltd. The company has contracted with B Pty Ltd for George to provide consulting services for software development and network design maintenance. The income gained by JungleGeorge Pty Ltd for personal services is personal services income and will be attributed to George and included in his assessable income.

The income and deductions of the personal services entity consist of:

PSI	$100,000
Assessable income of the Entity (Other Income)	$4,000
Entity Maintenance Deductions	$3,000
Other Income Deductions	$500
PSI Deductions	$55,000

To determine the amount by which the personal services income should be reduced, the steps in the method statement should be followed:

Step 1	PS1 Deductions	$55,000
Step 2	Entity Maintenance Deductions	$3,000
Step 3	Other Income	$4,000
Step 4	Entity Maintenance Deductions minus Other Income (step 2 step 3)	-$1,000
Step 5	This step does not apply as the amount in step 4 is not greater than zero.
Step 6	As the amount in step 4 is not greater than zero, the personal services income is reduced by the amount in step 1	$55,000

Under step 6, George's personal services income will be reduced by $55,000. Therefore the amount attributed to George is:

$100,000 - $55,000 = $45,000


The amount of $45,000 is included in George's assessable income to be taxed at marginal income tax rates.

The balance of the other income of the entity is reduced by the other income deductions:

$1,000 - $500 = $500


The personal services entity has an assessable income of $500. This amount is retained in the entity.

Where the entity maintenance deductions exceed other income

1.147 Where the entity maintenance deductions exceed the other income, steps 1 to 5 of the method statement in subsection 86-20(2) should be followed to determine how much the personal services income will be reduced.

•

Steps 1 to 3 Work out the personal services income deductions, the entity maintenance deductions and the other income of the entity.

•

Step 4 Subtract the other income from the entity maintenance deductions. As the entity maintenance deductions in this scenario are equal to or exceed the other income, the result of the calculation will either be zero or positive. This signifies that the other income of the entity has been reduced to zero and there are excess entity maintenance deductions to be offset against personal services income.

•

Step 5 The sum of the excess of the entity maintenance deductions in step 4 and the personal services income deductions in step 1 will reduce the personal services income of the individual.

•

Step 6 This step will not apply as the amount in step 4 is greater than zero.

1.148 After the calculation of the income attributable to the individual under section 86-20 has been completed, the income for the personal services entity can be determined. The balance of other income, after it has initially been reduced by the entity maintenance deductions, is reduced by the other income deductions. This will create a loss in the entity, as the entity maintenance deductions have reduced the other income to zero.

1.149 If the personal services entity is a partnership which has a loss, subsection 92(2) of the ITAA 1936 (partnership loss) may apply to allow a deduction to the partner to the extent of the partner's interest in the partnership. If the personal services entity is either a company or trust, the loss will be retained in the entity.

Example 1.18

Following the same facts as Example 1.17. The income and deductions of the personal services entity consist of:

PSI	$100,000
Other Income	$4,000
Entity Maintenance Deductions	$5,000
Other Income Deductions	$500
PSI Deductions	$55,000

To determine the amount by which the personal services income should be reduced, the steps in the method statement should be followed:

Step 1	PS1 Deductions	$55,000
Step 2	Entity Maintenance Deductions	$5,000
Step 3	Other Income	$4,000
Step 4	Entity Maintenance Deductions minus Other Income (step 2 - step 3)	$1,000
Step 5	PSI is reduced by the sum of step 1 and step 4 ($55,000 + $1,000)	$56,000
Step 6	This step does not apply as the amount under step 4 is greater than zero.

Under step 5, George's personal services income will be reduced by $56,000. The amount attributed to George is:

$100,000 - $56,000 = $44,000


Therefore, $44,000 is included in George's assessable income to be taxed at marginal income tax rates.

The balance of the other income of the entity is reduced by the other income deductions:

$0 - $500 = ($500)


The personal services entity has a loss of $500. This loss is retained in the entity to be offset against future income that the entity earns.

1.150 The following tables provide some worked examples of how the method statement in section 86-20 will apply.

Examples where entity maintenance deductions exceed assessable income of the personal services entity

Table 1.1

The amount in step 5 is subtracted from the personal services income of the individual. The resulting amount is attributed to the individual and included in his or her assessable income to be taxed at the marginal tax rates applicable to the individual.

Because the other income of the entity is exhausted by the entity maintenance deductions under step 4 of the method statement, any other deductions relating to the other income will create a loss for the entity.

Examples where entity maintenance deductions do not exceed assessable income of the personal services entity

Table 1.2

The amount in step 6 is subtracted from the personal services income of the individual. The resulting amount is attributed to the individual and included in his or her assessable income to be taxed at the marginal tax rates applicable to the individual.

The other income of the entity remaining after step 4 of the method statement will be further reduced by any deductions relating to other income.

Where personal services income deductions exceed personal services income

1.151 Where the amount in subsection 86-20(2) is greater than the personal services income of the individual, a loss will be created. Subsection 86-20(1) only allows the personal services income to be reduced to nil. Therefore, where the personal services income deductions exceed the personal services income, the loss will be applied in the personal services entity to the entity's other income.

1.152 The personal services entity can offset the excess personal services income deductions against other income, but only after the other income has been reduced by the other income deductions. Where this calculation creates a loss, the loss will be carried forward to the next income year and included in the step 1 amount to be offset against personal services income.

1.153 However, if the personal services entity is a partnership, subsection 92(2) of the ITAA 1936 (partnership loss) may apply to allow a deduction to the partner to the extent of the partner's interest in the partnership.

Example 1.19

Felicity is an architect who provides personal services for Arch Pty Ltd, through her company Felly Pty Ltd. In the income year 2000-2001, the personal services income gained by Felly Pty Ltd is $40,000. The personal services income deductions are $60,000. This creates a loss for Felicity of $20,000 ($40,000 $60,000). As Felly Pty Ltd has no other income, this loss is retained in Felly Pty Ltd and carried forward to the next financial year to be offset against future personal services income.

In the income year 2001-2002 Felly Pty Ltd gains personal services income of $60,000. It also has personal services income deductions of $40,000, which includes the $20,000 carried forward deduction from the previous financial year. The income attributed to Felicity is $20,000 ($60,000 $40,000).

Apportionment of entity maintenance deductions where several individuals

1.154 The personal services income regime is intended to apply to cases where individuals 'team up' to operate through one entity. Section 86-25 explains how to apply a personal services entity's deductions in such cases.

1.155 The personal services income will need to be attributed to each individual and the correct proportion included in each individual's assessable income. To determine the amount of income to be attributed, the entity will follow the same rules outlined above. However, in these situations each individual may contribute to the cost of maintaining the personal services entity and will be entitled to receive a portion of the deduction for entity maintenance expenses.

1.156 Section 86-25 provides a formula for working out how much of the entity maintenance deductions are to be offset against each individual's personal services income. This formula is only applied in those situations where the entity maintenance deductions exceed the other income of the entity.

1.157 Steps 1 to 4 of the method statement should be followed to determine by how much the entity maintenance deductions exceed the other income. The formula in section 86-20 is then applied to determine how much of the excess of the deductions can be claimed by each of the individuals against their personal services income.

Example 1.20

Continuing Example 1.17: Michael, who is a computer consultant, joins George's company, which gains his personal services income. Both Michael and George contribute to entity maintenance expenses and are entitled to a deduction for the amounts incurred. The income and deductions for the personal services entity consist of:

Total PSI of the entity	$200,000
PSI of Michael	$100,000
Assessable Income of the Entity (Other Income)	$4,000
Entity Maintenance Deductions	$6,000
Other Income Deductions	$1,000
PSI Deductions (Michael only)	$55,000

To determine how much of the entity maintenance deductions Michael can claim, steps 1 to 4 of the method statement in subsection 86-20(2) should be followed:

Step 1	PSI Deductions	$55,000
Step 2	Entity Maintenance Deductions	$6,000
Step 3	Assessable Income of the Entity (Other Income)	$4,000
Step 4	Entity Maintenance Deductions minus Other Income (step 2 - step 3)	$2,000

The amount of $2,000 has to be apportioned between Michael and George using the formula in section 86-25:

Original step 4 amount x (Your Personal Services Income / Total Personal Services Income)


= $2,000 x ($100,000 / $200,000)


= $1,000


Michael can claim $1,000 for entity maintenance deductions.

To determine the total amount that Michael's income is reduced by, the remaining steps in the method statement should be followed:

Step 5	As the amount in step is not greater than zero, the PSI is reduced by the sum of step 1 and the new amount worked out under section 86-20 ($55,000 + $1,000)	$56,000
Step 6	This step does not apply as the amount in step 4 is not greater than zero.

Michael's personal services income is reduced by the amount in step 5:

$100,000 - $56,000 = $44,000


Therefore, $44,000 is attributed to Michael and included in his assessable income to be taxed at marginal income tax rates.

The effect on the personal services entity's assessable income

1.158 The income of a personal services entity may consist of personal services income earned by an individual and income from other sources such as investment income.

1.159 Income received by the personal services entity for the personal services of an individual will be treated as the income of the individual for income tax purposes. The income that the personal services entity receives through other sources will remain the income of the entity. The entity can claim deductions against this income. The resulting profit or loss will be retained in the entity. [Schedule 1, item 3, subsection 86-15(1)]

1.160 Personal services income which is included in the assessable income of an individual under subsection 86-15(1), will effectively be nullified in the hands of the personal services entity. It will be non-assessable, non-exempt income and will not give rise to a capital gain. [Schedule 1, item 3, subsection 86-30]

Later payments of personal services income

1.161 Section 86-35 ensures that where a personal services entity pays an individual or their associate income that has been included in the individual's assessable income under subsection 86-15(1) that income:

•

does not constitute assessable income or exempt income of the individual or the associate receiving the amount; and

•

is not deductible by the personal services entity or associate paying the income.

1.162 The section is designed to produce the same result where there is a chain of entities and personal services income flows through them to the individual or their associate. This is intended to prevent double taxation by effectively ignoring those payments for income tax purposes.

Salary payments shortly after an income year

1.163 Under ordinary principles, salary or wages is assessable income in the income year in which it is received. Therefore, if the individual received a payment after 30 June, even though it was attributable to work performed in the previous income year, it would be included in the income year it was received. However, this will not apply to certain payments of personal services income.

1.164 Under section 86-40 payments of personal services income as salary or wages made up to 14 days after the end of an income year will be taken to have been received on 30 June of the preceding income year and will be included in the individual's assessable income for that preceding year.

Example 1.21

EFG Pty Ltd is a small withholder for PAYG withholding purposes. It's PAYG payment for the period covering April 2001 to June 2001 is the quarter ending 30 June 2001. During this period, EFG Pty Ltd receives Ella's personal services income of $25,000 (less any reductions). It pays Ella $25,000 on 8 July 2001.

The $25,000 that Ella receives is her assessable income for the income year ended 30 June 2001.

1.165 The timing of a personal services entity's entitlement to deductions for salary paid, and the timing of the entity's obligations under the PAYG withholding arrangements, will not be affected by this rule. In accordance with ordinary principles, the entity will be entitled to a deduction for the salary payment in the income year in which it is actually incurred. The entity must withhold from the salary or wages when the payment is made. [Schedule 1, item 3, subsection 86-40(2)]

1.166 Individuals with income years not ending on 30 June will not be affected by this rule.

Section 4: A personal services entity's entitlement to deductions

The general rule

1.167 Section 86-60 provides that a personal services entity cannot deduct an amount to the extent that it relates to gaining or producing an individual's personal services income, unless the individual could have deducted the amount under the ITAA 1997 if the circumstances giving rise to the deduction had applied to the individual. [Schedule 1, item 3, paragraph 86-60(a)]

1.168 Section 86-60 will not apply where the personal services entity gains the individual's personal services income in the course of conducting a personal services business. [Schedule 1, item 3, paragraph 86-60(b)]

Example 1.22

XYZ Pty Ltd is a personal services entity receiving the personal services income of Angus. XYZ purchases a briefcase for Angus, which he uses solely for work purposes. XYZ can claim a deduction for the cost of the briefcase against the personal services income of Angus, as Angus would have incurred the amount and been able to deduct it under section 42-15 of the ITAA 1997, if he had incurred the amount.

XYZ Pty Ltd pays for Angus' lunches on weekdays. XYZ cannot deduct these amounts against personal services income as Angus would not have been entitled to a deduction as it is considered to be private expenditure.

The interaction between Division 85 and Subdivision 86-B

1.169 Before an entity can claim a deduction against personal services income, paragraph 86-60(a) requires that the entity determine whether the individual would be able to claim a deduction for the loss or outgoing had they actually incurred it. To determine this, the entity will need to examine the rules in Division 85which govern when an individual will be able to claim a deduction against personal services income.

1.170 If, under the rules in sections 85-10 to 85-25, the individual would not have been able to claim a deduction for the particular loss or outgoing, the entity will likewise not be able to deduct that amount. [Schedule 1, item 3, section 86-60]

1.171 This general rule is, however, subject to the exceptions set out in sections 86-65 to 86-80. These sections set out amounts that can be deducted by a personal services entity against personal services income even though an individual could not deduct those amounts under the rules in Division 85 or the ITAA 1997 generally. These exceptions are explained below.

Entity maintenance deductions

1.172 Section 86-65 allows a personal services entity to deduct amounts that are incurred in maintaining a personal services entity despite the general rule about deductions in section 86-60. These are amounts that would be incurred even if the entity did not provide any personal services.

1.173 Amounts for maintaining an entity would not normally be an allowable deduction to employee-like individuals as expenses in relation to an entity are not incurred in earning the assessable income of the individual. This is due to individuals being hired personally and not through an entity such as a company.

1.174 The following types of expenses are definedin subsection 86-65(2) to be entity maintenance deductions:

1.175 Subsection 86-65(3) prevents an entity from deducting any payment it makes to an associate for the preparation or lodgment of any document the entity is required to lodge under the Corporations Law .

Car Expenses

1.176 The general rule in subsection 86-70(1) does not prevent a personal services entity deducting amounts for certain car expenses. [Schedule 1, item 3, section 86-70]

Cars with no private use

1.177 Under subsection 86-70(1), a personal services entity can deduct a car expense, as defined in Division 28 of the ITAA 1997, for any car which is used entirely for business purposes. [Schedule 1, item 3, subsection 86-70(1)]

Example 1.23

Lou is an electrical engineer who works through a partnership with his wife. Lou uses a ute to carry his equipment and materials to work sites. The ute is used 100% for business purposes and Lou can deduct all expenses that are incurred in running the ute.

Cars used for part personal services income and part other income activities

1.178 Where one car is used solely for business purposes but this is divided between activities in gaining personal services income and activities in gaining other income of the entity, the business use needs to be apportioned. The entity can claim a deduction for the relevant proportion of usage against either the personal services income or the other income.

Other cars

1.179 Under subsection 86-70(2) a personal services entity will also be able to claim deductions for one car which is used partly or solely for private purposes.

1.180 Subsection 86-70(2) allows the personal services entity to deduct the following amounts for that one car:

•

car expenses that are incurred in running the car; or

•

an amount of tax payable under the FBTAA 1986 for a car fringe benefit provided in relation to that car.

1.181 If the entity provides more than one car that is used partly or solely for private purposes, the entity will not be able to claim deductions for the additional cars.

Example 1.24

BAM Pty Ltd provides 2 cars for private use. Emma, the individual providing the personal services, uses the first car and Wade, her husband, uses the other. BAM is a personal services entity and cannot provide more than one car for private use under Subdivision 86-B. BAM can deduct the expenses incurred in running the car used by Emma. The amount of $20,000 that BAM incurs for the second car used by Wade cannot be deducted.

1.182 Where an entity provides more than one car with private use during a period, the entity must choose which of the cars it wishes to claim deductions for. The entity must maintain that choice until it ceases to hold the chosen car. This ensures that the entity cannot vary the cars for which it claims deductions and thereby obtain a greater amount of deductions. [Schedule 1, item 3, subsection 86-70(3)]

Example 1.25

Smithie Pty Ltd, a personal services entity owns 2 cars but only provides one car to Bob for private use. Midway through the income year Smithie sells the car being used by Bob. As Smithie ceases to hold the car, it can now choose to provide the other car to Bob for private purposes. Smithie only provides one car to Bob for private purposes at one time.

1.183 The provision of private use cars by personal services entities to individuals and/or those individual's associates is a practice currently used to enable a greater amount of deductions to be claimed by the entity. This in turn has the effect of reducing the amount of tax ultimately payable on the income generated through provision of the individual's personal services. Restricting the number of private use cars for which personal services entities can claim deductions will help to ensure that individuals operating through personal services entities, but not carrying on a genuine personal services business, are unable to obtain a greater range of deductions than individuals providing personal services directly.

1.184 The personal services entity can provide extra benefits, but where such benefits are made available, it is the individual that has to pay for them. Therefore, if there is a second car provided, this car is a private expense that is paid for by the individual out of his or her after tax income, as is the case with employee-like individuals purchasing and running a private vehicle. The entity therefore includes an equivalent amount in the individual's assessable income to show that the amount has been paid for out of the individual's income.

A private use car can be provided to each individual performing personal services through an entity

1.185 Where 2 or more individuals work through one personal services entity, the entity is able to provide one car to each individual for private use. This only applies where each of the individuals is conducting work that is not part of the other individual's work. That is, the individuals work independently of each other and one is not engaged to do the work of the other.

Example 1.26

Moe, who is an architect, and Larry, who is a skilling consultant, work through their interposed entity MoeJoe Pty Ltd. Moe and Larry do not work on the same contracts. MoeJoe can provide one car to Moe and one to Larry for private purposes. The deduction for the Moe's car expenses will be claimed against his personal services income. The deductions for Larry's car expenses will be claimed against Larry's personal services income.

Interaction with FBT legislation

1.186 The FBTAA 1986 will be amended as a result of the introduction of Division 86 with new subsection 8(4) being inserted into that Act. [Item 61]

1.187 Section 8 of the FBTAA 1986 applies to cars provided to an employee that are exempt from car FBT. The new subsection 8(4) will state that a personal services entity can only provide the fringe benefit of one car for private use to an individual.

1.188 All of the FBTAA 1986 requirements will continue to apply to personal services entities in relation to the provision of the one fringe benefit and entities will continue to pay instalments of FBT and comply with other FBT requirements under the FBT legislation.

1.189 As the FBT year and the income tax year are run over different periods, there will be an interaction between the requirements under each of the laws.

1.190 The FBT year runs from 1 April to 31 March. The new provisions will commence on 1 July 2000, which is the start of the income year. An interaction in the requirements under the FBT law and the new provisions will occur where the entity provides fringe benefits at the start of the FBT year consisting of more than one car.

1.191 Instalments of FBT are generally calculated based on the notional amount of tax from the previous FBT year, which includes amounts in relation to extra benefits. For personal services entities within the new alienation provisions, the FBT instalment amounts from 1 July 2000 can be varied to reflect the fact that the personal services entity is only providing the fringe benefit of one car.

1.192 The BAS makes provision for the personal services entity to vary the FBT it pays by notifying the Commissioner of its estimated tax based on the reduced fringe benefits it is providing to the individual.

Example 1.27

At the start of the FBT year on 1 April 2000, JungleGeorge Pty Ltd provides one car to George and one to George's wife. JungleGeorge has been providing the same benefits for the last 3 years. From 1 July 2000, JungleGeorge is classed as a personal services entity that receives personal services income. From that date JungleGeorge stops providing the fringe benefit of a car to George's wife. JungleGeorge informs the Commissioner, through the BAS, that it has a varied estimate of tax for the year due to providing only one car. It will pay less FBT instalments based on the reduced amount of fringe benefits provided.

Superannuation

1.193 A personal services entity can claim a deduction against the personal services income of the individual for contributions that are made to a superannuation fund or RSA for the purpose of providing superannuation benefits for that individual. In contrast, deductions for the benefit of an associate will be limited or not allowed (see earlier discussion about section 85-25 at paragraph 1.167). [Schedule 1, item 3, section 86-75]

Salary to the individual

1.194 Subsection 86-60(1) does not prevent a personal services entity deducting an amount for the salary that it pays to an individual. To obtain a deduction the salary needs to be paid to the individual within 14 days of the end of the PAYG period. [Schedule 1, item 3, section 86-80]

Deductions for personal services entities against personal services income

1.195 Under the ordinary rules of deductibility of expenses, an amount can only be deducted by a taxpayer if it is incurred in gaining or producing that taxpayer's assessable income. Therefore, the person who claims the deduction needs to be gaining assessable income and to have incurred an expense in gaining that income.

1.196 Personal services entities that gain income attributed to an individual under section 86-15 would not, under these rules, be able to claim deductions against the personal services income as it is not the entity's income and therefore the expense is not incurred in gaining or producing the entity's assessable income.

1.197 Section 86-85 will operate in these circumstances to allow the entity to claim a deduction against the personal services income for these amounts. The fact that the expense incurred is related to the personal services income of the individual, does not stop the entity deducting the amount against the personal services income.

Example 1.28

ABC Pty Ltd, a personal services entity, purchases a subscription to journals that Joe needs to keep up to date in his profession. Under normal circumstances Joe must have incurred the amount to deduct it against his personal services income. However, applying section 86-85, ABC can claim a deduction for the amount against the personal services income of Joe.

Application of the car expense and substantiation rules to personal services entities

1.198Section 86-90 ensures that Division 86 does not have the effect of applying Division 28 (about deducting car expenses) of the ITAA 1997 or Division 900 (about substantiating expenses) of the ITAA 1997 to a personal services entity.

1.199 The rules in Division 28 set out how certain individuals and partnerships can claim deductions for car expenses. The rules in Division 900 require that certain individuals and partnerships have certain documentary evidence of having incurred an expense before the individual or partnership can claim a deduction for that expense.

1.200 However, section 86-90 does not stop the car expense and substantiation rules from applying to a personal services entity, where the rules apply regardless of Division 86. For example, section 86-90 will not stop car expense and substantiation rules from applying to a partnership that includes one individual partner and derives personal services income, because those rules specifically apply to such a partnership and do not apply only because of Division 86.

1.201 The record keeping requirements of section 262A of the ITAA 1936 will generally apply to personal services income. Broadly, section 262A requires records to be kept for all transactions relevant to the tax law, including expenditure.

Example 1.29

To deduct the cost of subscribing to the professional magazines, ABC Pty Ltd does not need to substantiate this cost under the rules in Division 900. This is although ABC can only deduct what an individual can, and an individual must substantiate the amount. This is because section 86-90 excludes ABC from these substantiation rules and it is not subject to the substantiation rules regardless of Division 86. However, ABC will still need to keep a record of the cost as required by section 262A of the ITAA 1936.

PART 3: PAYG WITHHOLDING AND PERSONAL SERVICES INCOME

1.202 This Bill inserts Division 13 into Schedule 1 of the TAA 1953. Division 13 applies the PAYG withholding arrangements in Part 2-5 of that Schedule to personal services income attributed to an individual under subsection 86-15(1 ) .

The basic rule

1.203 Under subsection 13-5(1), a personal services entity must pay an amount to the Commissioner if it:

•

receives an alienated personal services payment; and

•

receives that payment during a PAYG payment period for which it is a personal services payment remitter.

1.204 An alienated personal services payment is a payment of personal services income that is received by a personal services entity and assessed to an individual under the rules in Division 86. [Schedule 1, item 28, section 13-10]

When will a personal services entity be a personal services payment remitter?

1.205 To determine whether a personal services entity is a personal services payment remitter for a PAYG payment period, the entity must look to the income year preceding the relevant period. For example, if the PAYG payment period is the quarter ending 30 September 2000, the entity will need to consider the 1999-2000 income year (assuming it does not have a substituted accounting period).

1.206 The personal services entity will be a personal services payment remitter for the period if during that preceding income year:

•

the entity's income included an individual's personal services income; and

•

the entity was not conducting a personal services business when it received that income.

1.207 A personal services entity which commences during a PAYG payment period, or a personal services entity which begins to receive personal services income for the first time during a PAYG payment period, will need to consider whether or not it is a personal services payment remitter. This decision will be based on a reasonable expectation of the entity's circumstances for the income year in which that period occurs. If it is reasonable to expect that the entity will receive personal services income during that year but not in the course of conducting a personal services business, then it will be a personal services payment remitter. [Schedule 1, item 28, subsection 13-15(2)]

1.208 However, it is not reasonable for an entity to expect that it will not receive an individual's personal services income in the course of conducting a personal services business during that year, if it is reasonable to expect that 80% or more of that income will be received from one entity and/or that entity's associates. [Schedule 1, item 28, subsection 13-15(3)]

1.209 An entity is not a personal services payment remitter for a PAYG payment period if a personal services business determination applies during that period or an earlier period in the same income year. For example, a quarterly remitter will not be a personal services payment remitter for the period ending 31 December (or the rest of the income year) if a personal services business determination applied during the September quarter but the Commissioner revoked it in September.

How much must the entity pay to the Commissioner?

1.210 A personal services entity will not be required to pay any amounts to the Commissioner under Division 13 if it promptly pays all the personal services income (less any deductions allowed) to the relevant individual as salary or wages. In those circumstances there is no alienated personal services payment.

1.211 The personal services entity is obliged to pay an amount to the Commissioner if it receives an alienated personal services payment during a PAYG period for which it is a personal services payment remitter. [Schedule 1, item 28, subsection 13-5(1)]

1.212 Subsection 13-5(2) provides a method statement for the personal services entity to follow to determine the amount that it has to pay to the Commissioner. The steps are explained in paragraphs 1.204 to 1.210.

Step 1

1.213 Step 1 of the method statement in subsection 13-5(2) requires the personal services entity to determine the amount of payments it has made to the individual during the PAYG period, that are withholding payments covered by section 12-35. These payments are primarily payments to an employee such as salary, wages, commissions, bonuses or allowances. [Schedule 1, item 28, subsection 13-5(2)]

1.214 These payments have been made to the individual before the end of the 14th day after the PAYG payment period during which the personal services entity received the payment. As such they are not affected by the attribution rule in section 86-15. [Schedule 1, item 28, subsection 13-5(2)]

Step 2

1.215 Step 2 of the method statement requires the personal services entity to determine the amounts that are included in the assessable income of the individual under section 86-15 of the ITAA 1997 and relate to alienated personal services payments the entity receives during that period. These are the amounts that have not been paid as salary to the individual but are attributed to the individual by the application of section 86-15 of the ITAA 1997. [Schedule 1, item 28, subsection 13-5(2)]

Step 3

1.216 Step 3 of the method statement requires the personal services entity to work out the sum of all the amounts that Division 12 would require the entity to withhold, had the payments made under step 2 been payments of salary from which Subdivision 12-B requires the entity to withhold amounts. [Schedule 1, item 28, subsection 13-5(2)]

1.217 The calculation under step 3 will include the payments from which the entity withheld under step 1 of the method statement. Therefore, the calculation will be the total amount that the entity would have been required to withhold if all of the payments of attributed personal services income received by the entity had been paid as salary by the entity to the individual and subject to withholding under section 12-35 of Schedule 1 to the TAA 1953.

Step 4

1.218 The amount to work out in step 4 is the amount that the personal services entity has withheld from payments identified in step 1.

Step 5

1.219 The step 5 amount is the step 4 amount, the amount already withheld from salary, subtracted from the step 3 amount, the amount that should have withheld from the attributed personal services income if it had been paid as salary. The result of this calculation will determine the amount that the personal services entity is required to pay to the Commissioner under this section.

Example 1.30

MUD Pty Ltd, a personal services entity, receives personal services income of Max of $40,000 during the PAYG payment period 1 April 2001 to 30 June 2001.

MUD has to determine, using the method statement in subsection 13-5(2), how much it needs to pay to the Commissioner.

MUD paid Max a salary of $10,000, from which it withholds amounts to pay to the Commissioner under section 12-35. This is the step 1 amount.

$30,000 of the amount received by MUD was included in Max's assessable income under section 86-15 of ITAA 1997. This is the step 2 amount.

If MUD had paid all of the amounts under step 1 and step 2 as salary, the total that it would have withheld from the amounts would be $8,000. This is the step 3 amount.

MUD withheld $2,000from the salary paid under step 1 as required by section 12-35. This is the step 4 amount.

The step 4 amount of $2,000 subtracted from the step 3 amount of $8,000 is $6,000. This is the step 5 amount.

MUD has to pay to the Commissioner $6,000 under this section.

When must the entity pay the amounts?

1.220 Subsection 13-5(3) requires that the entity pay the amount worked out under subsection 13-5(2) to the Commissioner on or before the day on which Division 16 of Schedule 1 to the TAA 1953 would have required the amount to be paid, if Division 12 of that Schedule had required the entity to withhold the amount.

1.221 The entity will therefore need to apply the rules in Division 16 to work out when the amount must be paid by.

1.222 Table 1.3 explains when to pay.

Table 1.3

Example 1.31

Continuing Example 1.30: In the quarter April 2001 to June 2001, MUD withholds an amount of $8,000 from payments to Max. As MUD is a small withholder for PAYG withholding purposes, it has to remit the amounts by the 21st day of the month after the end of the quarter in which the amount was withheld, that is 21 July 2001.

Special rule for the 2000-2001 income year

1.223 The general rule above does not apply to alienated personal services payments received by a personal services entity during the 2000-2001 income year. For this transitional year, the entity will pay amounts under subsection 13-5(1) by the 21st day after the end of the quarter in which the alienated personal services payment is received by the entity. [Schedule 1, item 28, section 13-20]

1.224 This is so regardless of the entity's withholding status under Division 16. For example, if the entity also has withholding obligations under Division 12 of Schedule 1 to the TAA 1953, and is classed as a medium withholder under Division 16 of that Schedule, for months during the 2000-2001 financial year, the entity can pay amounts under subsection 13-5(1) each quarter despite the fact that it must pay other withholding amounts monthly. This rule is aimed at assisting affected entities with the transition to the new arrangements.

Amounts paid under section 13-5 affect an entity's withholding status

1.225 Under the new arrangements an entity will be required to take into account any amounts paid to the Commissioner under section 13-5 when determining whether it is a small, medium or large withholder for the purposes of the rules in Division 16 of Schedule 1 to the TAA 1953. A personal services entity's withholding status will determine when and how it must pay withheld amounts to the Commissioner. [Item 9]

Application and transitional provisions

1.226 The amendments will apply to assessments for the 2000-2001 income year and later income years. [Item 24]

1.227 The collection rules under Division 13 of Schedule 1 to the TAA 1953 will commence on 1 July 2000. Under section 13-20 these payments will be due quarterly during the 2000-2001 income year. [Item 58]

Payees under the Prescribed Payments System

1.228 There will also be a special transitional arrangement for the 2000-2001 and 2001-2002 income years under which the Commissioner will be able to make a declaration about a class of entities who are payees under the Prescribed Payment System who have payee declarations with the Commissioner as of 13 April 2000. The Commissioner will be able to declare that for those income years the alienation provisions apply to those entities as if they were personal services businesses (and did not need to apply to the Commissioner for a personal services business determination). [Item 24]

1.229 Where the Commissioner makes such a determination, its effect will be that the regime will not apply to the class of entities for the first 2 income years of its operation.

1.230 The Government proposes this transitional arrangement to reflect the unusual compliance burden that contractors currently in the Prescribed Payment System face in transferring to the new tax system.

Imposition Acts

1.231 The legislation to implement the alienation measure includes 2 imposition Bills: New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 1) 2000 and New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 2) 2000. These are necessary to safeguard the alienation legislation against possible constitutional challenge.

1.232 The No. 1 Bill protects the additional liability placed on the individual worker where income gained by an interposed entity is included in the individual's assessable income. The No. 2 Bill protects the obligation placed on the interposed entity to pay amounts under the PAYG withholding system.

Consequential amendments

Amendments to the ITAA 1997

1.233 Items 6, 7, 11 to 21 and 23 include a number of new definitions in subsection 995-1(1) of the ITAA 1997. These define terms used for the first time in the new alienation provisions. Items 8, 9 and 22 amend the definitions of 'withholding payment', 'amount withheld' and 'amount required to be withheld' currently in subsection 995-1(1) to ensure these concepts cover payments required to be made to the Commissioner under Division 13 of Schedule 1 to the TAA 1953. Item 1 includes alienated personal services income in the list of particular kinds of assessable income in section 10-5 of the ITAA 1997. Item 2 includes personal services income in the list of rules about deducting amounts in section 12-5 of the ITAA 1997. Item 4 amends Subdivision 118-A to ensure that a payment of personal services income included in an individual's assessable income under section 86-15 is not to be counted as a capital loss of an entity.

Amendments to the TAA 1953

1.234 Item 25 amends section 10-1 of Schedule 1 to the TAA 1953 (the Schedule) to explain how the rules in Division 13 of that Schedule form part of the PAYG withholding arrangements.

1.235 Item 26 amends section 10-5 of the Schedule to provide that payments made under Division 13 are withholding payments for the purposes of the PAYG withholding legislation.

1.236 Section 12-7 at item 27excludes alienated personal service payments from the operation of Division 12 of the Schedule. This reflects the fact that these payments are to be dealt with under Division 13 and are not subject to withholding under the rules in Division 12.

1.237 Items 29 and 30 amend Division 15 of the Schedule to ensure that an entity can use the withholding schedules published by the Commissioner under section 15-25 of the Schedule to work out how much to pay to the Commissioner under Division 13. They also ensure that an individual receiving an alienated personal services payment can give a declaration to the payer under section 15-50 about matters affecting how much is paid under Division 13.

1.238 Items 31 to 55 amend various provisions in Division 16 and 18 of the Schedule to ensure the rules in those Divisions about:

•

how and when payments must be made;

•

payer registration;

•

notifying the Commissioner of liabilities;

•

annual payer reporting;

•

payment summaries; and

•

credit entitlements,

also apply to income and entities affected by Division 13.

Other Acts

1.239 Items 59 to 72 make a small number of consequential amendments to the Child Support (Registration and Collection) Act 1988 , the FBTAA 1986 and the ITAA 1936 to include references where relevant to income attributed to an individual under Division 86 and amounts that must be paid to the Commissioner under Division 13.

1.240 Item 62 amends subsection 82AAC(1) of the ITAA 1936 to include a note highlighting that deductions for superannuation contributions under that section may be affected by the new rule in section 85-25.

1.241 Items 63 and 64 amend section 202A of the ITAA 1936 to ensure individuals receiving alienated personal services income payments can give the entity making the payment a TFN declaration under Division 3 of Part VA of that Act.