On 23 November 2022, the Australian Tax Office (ATO) released Taxation Ruling TR 2022/3, finalising its views on personal services income (PSI) and personal services businesses (PSB).
We previously wrote about TR 2022/3’s draft ruling, TR 2021/D2 (Draft Ruling) here and while TR 2022/3 keeps the bulk of the ATO’s views unchanged, there are interesting updates that deserve highlighting.
But first, it is helpful to give a brief overview of PSI.
What is PSI?
PSI is defined as income that is mainly a reward for an individual’s personal efforts or skills (or would be such a reward if it were the income of the individual). Only individuals can have PSI and examples include (see paragraph 3 of TR 2022/3):
salary or wages (although employees do not fall within PSI rules);
income of a professional person practising on their own account without professional assistance;
income payable under a contract which is wholly or principally for the labour or services of a person;
income derived by a professional sportsperson or entertainer from the exercise of their professional skills; and
income derived by consultants, for example, computer consultants or engineers, from the exercise of personal expertise.
PSI can be earned directly by a sole trader or indirectly through an interposed personal services entity (PSE). However, the PSI rules do not apply when the individual or PSE conducts a PSB.
A PSE or sole trader conducts a PSB if it meets at least one of the following PSB tests:
results test;
unrelated clients test;
employment test; or
business premises test.
The ATO may also make a determination on whether a PSB exists.
Key Change 1: Removed inference based on equity
TR 2022/3 removed an inference that the ATO makes when determining whether the income is generated from a business structure instead of through personal services.
The Draft Ruling previously contained a starting point that if a company (or trust) has more non-principal practitioners (individuals without equity in the business) than principal practitioners (individuals with equity), then the ATO considered income of the company (or trust) to be derived from a business structure and therefore would be from a PSB and not fall within the PSI rules. If the inverse was true, then no inferences are made and the ATO would skip to considering the factors listed below.
TR 2022/3 removed all mentions of this inference, resulting in a starting point unburdened by preconceived inferences.
The factors that the ATO consider include (see paragraph 44):
the number of arm's length employees or others engaged by the entity to perform work and their relative contribution to the income earning activities;
the existence of goodwill;
the extent to which income-producing assets of the business are used to derive the income;
the nature of the activities carried out;
the size of the operation; and
the extent to which the income is dependent upon a particular individual's own personal skills, efforts, or expertise.
Key Change 2: New rule on whose PSI it is
TR 2022/3 and the Draft Ruling emphasises that PSI derived under the contract belongs to the individual with the contractual obligation to provide their services (Test Individual). For example, even if a sole trader engaged another individual to help with the work, the PSI is only attributable to the sole trader if they are the only individual with an obligation under contract.
For multiple individuals working through a PSE, each discrete amount of income received by the PSE must be examined to determine which individual did the work. Unlike directly contracted individuals, this analysis is not limited to the contract, but also the invoice.
TR 2022/3 added a new Example 13 illustrating this point. This example has multiple individuals subcontracted to work through a PSE. Critically, the work contract did not stipulate that any particular individual was to provide any particular service. After the work, the invoice listed the individuals who provided services. This led to the conclusion that each of the subcontracting individuals were Test Individuals.
Potential difficulties arise where the contract stipulates contracting a certain Test Individual to do work, but an individual who is not a Test Individual does most of the work and generates PSI. Under the Draft Ruling, the PSI is attributable to the Test Individual without exception.
Example 12 illustrates this difficulty. In the Draft Ruling, it described a situation where the Test Individual subcontracted 55% of the work in a month to another person, but the PSI was attributable to the Test Individual because the contract was only with the Test Individual and not with the subcontractor.
Example 12 in the Draft Ruling drew criticism, so TR 2022/3 added guidance that if a Test Individual is contracted to work but there is “contemporaneous evidence” that shows another entity did 50% or more of the work, then the PSI will not belong to the Test Individual. TR 2022/3 contains no further guidance on this point.
Additionally, instead of using Example 12 to highlight this new guidance, TR 2022/3 amended the example to say that the contract spanned over 6 months, where the Test Individual did all the work themselves for the first 5 months but subcontracted 55% of the work to another person in the final month. This clarification highlighted that for the duration of the contract, the Test Individual did closer to 91% of the work instead of 45% as suggested in the Draft Ruling. This ensured that Example 12 fell outside the scope of the new rule.
More guidance on this new rule would be welcome, but if the PSI would belong to the subcontractor, this new rule helps the ATO achieve its objective of ensuring individuals cannot alienate their income in another. For example, an individual cannot do most of the work but have another individual in a lower marginal tax bracket be the only contracting party (that is, the only Test Individual) to avoid tax obligations.
Conclusion
TR 2022/3 is a welcome addition that modernised the ATO’s views.
Finally, TR 2022/3 applies to income years commencing both before and after its date of issue. We emphasise the importance of reviewing your arrangements against these updates. If you believe these changes could affect you or have any questions about what these changes will mean for you or your arrangements, please contact:
Neil Brydges
Principal Lawyer | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au
Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 | T +61 3 9611 0105
E: dsmedley@sladen.com.au
Edward Hennebry
Senior Associate
T +61 3 9611 0113 | M +61 405 847 261
E: ehennebry@sladen.com.au
James Gao
Graduate Lawyer
T +61 3 9611 0166
E jgao@sladen.com.au
