Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 2 - Personal services income
Outline of chapter
2.1 These amendments to Part 2-42 of the ITAA 1997, the ITAA 1936 and the TAA 1953 will clarify particular aspects of how the personal services income provisions operate. The most important amendment will ensure that a taxpayer satisfies the results test for conducting a personal services business if the conditions are satisfied for 75% of their personal services income for the income year.
Context of amendments
2.2 Amendment 1 amends the commencement clause in the bill to ensure that items 4A, 4B and 4C (inserted by amendment 8) commence at the appropriate times. These items will apply to assessments for the 2002-2003 income year and later income years (amendment 23 to Schedule 6).
2.3 The results test for conducting a personal services business, in section 87-18 of the bill, requires that the personal services income of the individual during the year has to satisfy 3 conditions (that the income is for producing a result, that the tools of trade or plant and equipment needed is required to be provided (if any), and that the individual or personal services entity is liable for the cost of rectifying any defect in the work). However, the provision does not expressly state how to apply the test where some personal services income satisfies the conditions and some does not.
2.4 Amendment 4 will ensure that the results test can be met even where the taxpayer does not work exclusively in a way that would otherwise meet the results test. Accordingly, to clarify the application of the results test in a particular income year, where not all of a taxpayers personal services income satisfies the results test, a percentage basis for the amount of income that must meet the test will be inserted. The amendment requires that, in determining whether the taxpayer meets the results test, they must receive at least 75% of their personal services income, not including income received as an employee or office holder, for producing a result. This means that the individual may have some personal services income that is for producing a result and some that is not, and still pass the test and therefore conduct a personal services business.
2.5 Amendment 5 makes a minor wording change to the first condition of the results test to better reflect the percentage approach.
2.6 Amendments 6 and 7 have the same effect as amendments 4 and 5 except that they apply to personal services entities.
2.7 The 80% test in subsection 87-15(3) refers to the individual or entity receiving 80% or more of an individuals personal services income from the same entity (or one entity and its associates). Where an individual or entity meets the 80% test, but does not pass the results test in section 87-18, the individuals personal services income is not taken to be from conducting a personal services business unless a personal services business determination is in force. Therefore, it is important to establish what income is to be included in the 80% test to accurately determine whether the 80% test is met.
2.8 The personal services income rules (in Part 2-42 of the ITAA 1997) have no operation for employees (leaving aside those who are employees of interposed entities). Consequently, the provisions are directed at personal services income derived under non-employment arrangements. However, personal services income is broadly defined to mean income that is mainly a reward for your personal efforts or skills and, consequently, may include income as an employee.
2.9 As subsection 87-15(3) currently stands, the 80% test takes into account salary or wages and income from holding an office. This could distort who must seek a personal services business determination from the Commissioner in order to be outside the measure, and therefore cause some workers to be covered by the measure who would otherwise have been outside it (and vice versa).
2.10 Amendment 8 ensures that income that an individual gains as an employee or an office holder is not included in calculating whether the individual obtains 80% or more of their personal services income from the same entity (or one entity and its associates). Amendment 8 also ensures that the 80% test ignores personal services income received by an individual to the extent that they are payments subject to the proposed new withholding arrangements for religious practitioners. The proposed new withholding arrangements for religious practitioners are contained in Taxation Laws Amendment Bill (No. 5) 2001.
2.11 Under subsection 87-25(2), an entity will meet the employment test if it engages one or more other entities to perform work and that entity, or those entities together, perform at least 20%, by market value, of the individuals principal work.
2.12 It is possible that a partner in a partnership will be performing principal work that is helping to generate the personal services income of another partner. However, in this case, the partnership has not engaged another entity because the first mentioned partner is not a separate entity from the partnership. This can result in partnerships not passing the employment test where it was intended that they would - thus treating partnerships more harshly than companies or trusts.
2.13 Amendment 9, which will insert subsection 87-25(2A) into the employment test, will ensure that the test takes into account the principal work performed by a partner that helps to generate the personal services income of another partner, thereby treating partnerships in the same way as companies or trusts.
2.14 The current definition of payer applying to the TFN provisions in the ITAA 1936 does not take account of the personal services income measure. Under the TFN provisions, a TFN declaration may be made to a payer where a person is a recipient of the payer. The payer is a person who makes an eligible PAYG payment which, by definition, includes an alienated personal services payment. These payments are made to the entity by the service acquirer. Consequently, where a worker quotes their TFN under the PAYG alienation rules (to avoid withholding at the top marginal rate) the rules incorrectly contemplate quotation to the service acquirer, instead of the personal services entity.
2.15 Amendment 10 is designed to allow an individual providing personal services income through an interposed entity to make a TFN declaration to the interposed entity rather than the service acquirer. This is more appropriate because it is the entity that must calculate the amount of a possible PAYG withholding obligation under Division 13 of Schedule 1 to the TAA 1953. To achieve this, amendment 10 makes 2 changes.
2.16 First, amendment 10 adjusts the definition of payer in section 202A of the ITAA 1936 to include a person who receives an alienated personal services payment, or is likely to receive such a payment. This person is the personal services entity (company, partnership or trust) through which the individual service provider operates.
2.17 Amendment 10 also amends the definition of recipient in section 202A to include a person in relation to whose personal services income a payer receives an alienated personal services payment, or is likely to receive such a payment. The effect of this is to make the individual service provider the party that can quote their TFN.
2.18 Division 9 of Part VI of the ITAA 1936 deals with penalties for directors of companies who fail to remit amounts withheld under the PAYG withholding provisions. The Division ensures that companies meet their obligations under, among other provisions, Subdivision 16-B of the TAA 1953, to pay withheld amounts to the Commissioner, or to go promptly into voluntary administration or liquidation. The Division imposes a duty on directors to cause the company to do so and this duty is enforced by penalties.
2.19 When the personal services income provisions were enacted, there were consequential amendments to Division 9 (e.g. to the application provision, section 222AOA). These were intended to support the collection of the additional PAYG withholding obligations where the payer was a company. However, some of the necessary amendments were overlooked.
2.20 As Division 9 currently stands, there is no obligation on directors of companies to cause the company to remit or go into voluntary administration or liquidation if the requirements of Division 13 (alienated personal services payments) are not met. Amendment 11 inserts new section 222AOBAA whichwill ensure that obligations are placed on directors to cause the company to comply with the PAYG rules. Amendment 12 inserts new subsection 222AOC(1) which will impose a penalty on directors for failing to comply with the obligations in section 222AOBAA. There are also flow-on changes, in amendments 13 to 17, to section 222AOD (penalty for new directors), section 222AOE (Commissioner must give 14 days notice before recovering penalty), section 222AOG (remission of penalty if sections complied with), section 222AOH (effect of director paying penalty or company discharging underlying liability) and section 222AOJ (defences).
2.21 An individual deriving personal services income cannot deduct payments (including payments in kind, e.g. most fringe benefits) to an associate for non-principal work. The personal services income law does not exclude the non-deductible amount from the assessable income of the associate, which effectively results in the same amount being taxed twice, once in the hands of the service provider and then in the hands of the associate.
2.22 Amendment 18, which inserts subsection 85-20(3), ensures that there is not double taxation of the non-deductible amount. The amount is to be treated as neither assessable nor exempt income of the associate.
2.23 This amendment reflects the general policy of the income tax law of not taxing the same amount twice. In particular, the provisions are not intended to tax an individual service provider and an associate on the same amount or benefit. Nor are they intended to tax a personal services entity and a service provider (or a related party, such as their spouse) on the same amount (see section 86-35).
2.24 The personal services income regime includes personal services income generated by an individual who works through an entity in the individuals assessable income. However, this does not apply to amounts of personal services income that the entity promptly pays to the individual service provider as salary or wages (section 86-15 of the ITAA 1997).
2.25 In addition, amounts received by a personal services entity for the personal services of an individual, and promptly paid to the individual as salary or wages, is deductible to the personal services entity. Under section 86-20 this deduction will reduce the amount of personal services income included in the individuals assessable income.
2.26 Some tax practitioners have argued that, under section 86-20 in its current form, the worker could effectively get a double benefit for the same amount where only part of the personal services income is paid as salary or wages. This interpretation is contrary to the intended scheme of Division 86, that the prompt payment of the whole of personal services income (less permitted other deductions) to the service provider as salary or wages would result in no attribution of personal services income to that service provider.
2.27 Amendment 19, which amends section 86-20, ensures that the reduction of the amount included in the individual workers assessable income excludes an amount obtained by the entity that is promptly paid to the individual as salary or wages.
2.28 The alienation rules currently contain provisions designed to prevent double taxation where personal services income received by an entity is assessed to the individual service provider. The rules ensure that the amounts actually distributed to the service provider (or associates) are not assessed to the extent that they are already assessable to the service provider.
2.29 The rule applies where the entity is a partnership or trust and the service provider is entitled to a share of the net income (including personal services income) of the entity. This rule is intended to apply whether or not the individual receives the share, because the rules for assessing partnerships and beneficiaries of trusts depend on entitlement, but this is not clear from the provision.
2.30 Amendment 20, which amends subsection 86-35(2), will clarify that the relief from double taxation applies whether or not the individual service provider (or associate) receives their share of the net income.
2.31 Schedule 1 to the TAA 1953 contains the PAYG provisions. In subsection 45-120(3), an asterisk has been used to denote that amounts is a defined term. However, as in the ITAA 1997, amount is a basic term that is not identified with an asterisk (see section 2-15 of the ITAA 1997 and section 3AA of the TAA 1953). Furthermore, the asterisk does not denote a longer defined term such as amounts required to be paid under Division 13.
Application and transitional provisions
2.32 Amendments 22 to 24 amend the application provision (item 19 of Schedule 6) for the personal services income amendments in the bill. Amendments 11 to 17 will apply from the date of Royal Assent. Amendments 8 and 19 will apply from the 2002-2003 income year. Item 18A applies, and is taken to have applied, to an amount received, or a non-cash benefit provided, on or after 1 July 2000. The remaining amendments are to apply from the 2000-2001 income year because they can only benefit taxpayers.
Correction to the explanatory memorandum
2.33 Paragraphs 7.12 and 7.14 to 7.16 have an incorrect reference to paragraphs 87-40(1)(a) to (d). These references should be to paragraphs 87-40(2)(a) to (d).
2.34 The last sentence of paragraph 7.16 contains the phrase not merely receiving referrals from their principal or other parties. This phrase should be amended to read not merely receiving referrals from their principal. The reference to other parties should be omitted.
2.35 The following paragraph should be inserted before paragraph 7.32:
"7.31A It is necessary to consider the personal services business tests only if an individual (working as a sole trader or through an entity) has personal services income. Personal services income is income that is mainly a reward for a particular individuals personal efforts or skills. An entitys income from the rendering of personal services by an arms length employee of the entity is not normally personal services income of such an employee, if the employee has no entitlement to that income of the entity other than as salary, wages, commissions, bonuses or allowances."
2.36 The reference to Example 7.3 in paragraph 7.43 should be omitted.
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