When commencing or acquiring a business, all of us will consider which type of structure best suits our circumstances.
The least complicated structure is the sole trader, whereby you operate the business in your own name. This structure could only be recommended for those with low incomes and little perceived commercial risk in an increasingly litigious society. If you hold non-business assets in your own name, this could be a concern, and this would have to be carefully considered.
You may decide to join with other persons or entities electing to share profits or losses in an agreed ratio, in which case you will be operating as a partnership.
Other business structures worthy of consideration include companies and trusts. There are many forms a trust may take, including discretionary trusts (often referred to as “family trusts”), fixed trusts, and unit trusts.
PARTNERSHIPS
Reduced to its simplest form of individual family members. Operating in a partnership makes tax savings possible because each partner is taxed separately on their share of partnership income.
The total tax paid by the family due to “income splitting” results in individuals enjoying lower marginal tax rates. It is recommended that such arrangements be documented to establish that all concerned are actually and legally in partnership.
The ATO look at a number of factors when deciding whether a partnership exists for tax purposes. These include:
Intention:
- Mutual consent and intention of parties.
Conduct:
- Has a partnership agreement been drawn up that provides for profit or loss sharing, including paying partners’ salaries?
- Does a partnership bank account exist, and are partners signatories?
- What are the capital contributions made by each partner?
- Is all trading in the name of the partnership (invoices etc.)?
All business documentation and correspondence should contain the partnership name. ABN and GST registration should be in the name of the partnership.
It is necessary to annually prepare financial statements and lodge a taxation return in the partnership’s name. The taxable income is distributed to the partners and included in their individual tax returns.
It should be noted that Partners can be “jointly and severally” liable, meaning that if the partnership gets into financial difficulties and Partner 1 has no assets, Partner 2 may have to meet the entire shortfall. This can have disastrous consequences for individuals. For this reason, where more than one family are involved in a partnership, it is not uncommon to see a partnership of companies and trusts. In such cases, assets are not usually accumulated in these entities. Asset protection must be considered in tandem with tax benefits.
COMPANIES
Under the Tax Act, the definition of a “company” includes all bodies or associations, whether they are incorporated or not. Companies are subject to tax in their own right, and unlike Partnerships, they are separate legal entities.
Companies pay a flat rate of tax of 30 per cent. After that, dividends may be distributed to shareholders who are taxable on those dividends with a reduction for any franking rebates available. Note that a reduced corporate rate of 25% applies for the 2021/22 income year to a corporate tax entity that is a base rate entity. A corporate tax entity will be a base rate entity in the 2022 year if it carries on a business and has a turnover of less than $50 million – see chapter 1.
Note changes from 1 July 2015 for companies that are SBEs (see Chapters 5 & 12) and the proposed staggered reductions in company tax announced in the May 2016 Federal Budget.
For taxation purposes, the following entities are considered companies:
- Public Companies
- Private Companies
- Corporate Unit Trusts
- Co-Operative Companies
- Corporate Unit Trusts
- Clubs and Associations
- Limited Partnerships
- Non-profit Companies
- Public Trading Trusts
- Pooled Developed Funds
- Strata Title Body Corporates
- Registered Associations
Annual tax returns must be lodged by every Australian company that derives assessable income. Every non-resident company with a permanent establishment in Australia must also lodge a tax return.
Usually, companies pay their tax liability in instalments under the PAYG instalment system on a rate or amount based on the prior year’s tax liability. Paid instalments are credited against the total tax liability payable when the annual tax return is lodged.
Since 1990, companies have been subject to the self-assessment system. The onus is on the company to determine the correct taxable income and tax payable as no formal notice of assessment is issued.
The ATO issues no official assessment notice. In effect, the lodged tax return becomes the tax assessment. It is important to pay any company tax owing by the due date.
Companies are regulated by the Australian Securities and Investment Commission (ASIC) under the Corporations Act 2001.
STARTING A COMPANY
The most convenient option is to buy a “shelf” company from an organisation that specialises in this practice. They will only charge a small fee for this service and provide you with all necessary constituent documents. The other option, which is to apply to ASIC yourself for registration of the company, is not recommended.
FEATURES OF A COMPANY – Separate Legal Entity
As mentioned, a company has a separate legal existence distinct and separate from its officers and shareholders, meaning it may operate a business, incur debts, own property, sue and be sued in its own right. This status continues until the company ceases to exist by way of de-registration by ASIC.
LIMITED LIABILITY
Shareholders are not personally liable for debts of the company unless they have given personal guarantees. In the event of the company getting into financial distress, they may be obliged to pay the company any amount which may be unpaid on their shares (partly paid shares).
Of course, if the shareholder owes the company money, this may also be called up by the liquidator.
Directors oversee the operations of a company. Major decisions require resolutions to be signed. Sole Directors will simply document and sign their decisions as they too are accountable to the shareholders.
It should be noted that directors may be liable for debts incurred by insolvent trading (where the company is unable to pay its debts as and when they fall due). If a director has given a personal guarantee, he has a potential liability to debts incurred by the company. If a director has been negligent or breached duty, he may be sued for any losses sustained.
Due to the Covid-19 crisis, the Federal Government granted temporary relief from insolvent trading until 25 December 2020. After this date, we suggest that many directors will have to consider their position seriously.
Subject to this, if directors act honestly, in good faith and with due care and skill, and prevent insolvent trading, they generally will not be held personally liable in the event of company failure.
In this event, the liability of shareholders is generally limited to the unpaid capital on their shares. Normally this is not a consideration as in a small company. Shares are usually issued as “fully paid”.
There is also potential for an individual exposure where the ATO issues Directors’ Penalty Notices (DPNs) for a company’s unreported, unpaid superannuation and PAYG withheld from wages as these are not complied with. See our Asset Protection bonus issue. Note that from 1 April 2020, the DPN regime has been extended to GST liabilities.
DPNs do not have to be issued if a company is three months late in reporting these liabilities in their BAS. This means the directors automatically become liable, and for this reason, it is essential that you lodge the BAS on time.
CONSTITUTION
The rules for operating a Company are set out in its Constitution, which complies with the Corporations Law.
CONTINUOUS EXISTENCE
Even if shareholders have sold their shares or died, a company will continue to exist as it has a separate legal identity.
In the event of the death of a sole shareholder in a company, that shareholder’s executor assumes responsibility.
SHAREHOLDERS
Although a company has a separate legal existence, shareholders usually own the company in proportions determined by the number of shares they hold.
This is the case if ordinary shares of the same class are issued. On occasion, a company may issue shares of a special class that confers special rights and entitlements to these shareholders regarding voting and dividend entitlements. This will usually occur at company incorporation.
Shareholders make decisions about the company, particularly the election of directors. A simple majority of votes passes ordinary resolutions, while special resolutions require at least 75 per cent of the votes cast.
A sole shareholder records a resolution by way of appropriate minutes and signed minutes of shareholders’ meetings, and resolutions must be retained for seven years.
PROPRIETARY COMPANY
If a small business chooses a company structure, a Proprietary Company will almost always be the most suitable.
Features include:
- One or more directors.
- At least one, but not more than 50 shareholders (excluding employees).
REGISTERED OFFICE
A requirement upon incorporation is that a company have a registered office in Australia and that ASIC is duly notified of the location.
This is the place where all official notices and communications are normally sent. Should the registered office change, ASIC must be notified within one month.
Due to recent case law and legislative changes, this should not be ignored. A Company director is in some circumstances deemed to have received a notice if it is sent to the last known address. This can have terrible consequences in relation to the ATO’s directors’ penalty regime for PAYG and Superannuation.
PRINCIPAL PLACE OF BUSINESS
Again, this address must be notified to ASIC. The Principal Place of Business may or may not be in the same location as the registered office.
REGISTERS AND RECORD-KEEPING
Shelf company organisations provide a company register containing information relevant to inception and guide future changes and transactions. This includes a register of shareholders and a register of charges over company assets.
ANNUAL REVIEW
Each year ASIC will mail to a company’s registered office a notice (Annual Review Statement), including the following details:
- Address of registered office
- Address of principal place of business
- Names of each director and company secretary
- Issued shares and options granted.
This statement should be perused, and if any details are incorrect, the company must notify ASIC either in printed form or electronically.
An annual review fee (currently $273) is payable to ASIC ($55 for SMSF Trustee Companies).
DIRECTORS’ DUTIES
Directors have an obligation to shareholders to:
- Act in the best interests of the company and avoid conflicts of interest between the directors’ own personal interests and those of the company
- Act in good faith
- Act honestly
- Exercise due care and diligence; and
- Prevent the company from trading whilst insolvent.
Directors may be subject to civil penalties or even be found guilty of a criminal offence in the event of failure to carry out the above duties.
COMPANY SECRETARY
As far as ASIC is concerned, this is the person responsible for lodging all requisite documents and overseeing company compliance.
These include:
- Changes in the location of the company register
- Changes to the address of the registered office
- Share issues
- Changes to directors or company secretaries
- Change in the principal place of business
- Change in name or address of company officeholders
- Creation of charges over company assets.
FINANCIAL REPORTS
Small Proprietary Companies with a turnover of less than $10m must keep financial records to verify and explain their transactions and financial position, allowing true and fair financial statements to be prepared and audited.
Under the Corporations Act, annual financial reports are not necessary unless either ASIC or shareholders with at least 5 per cent of the vote direct so. However, under the self-assessment provisions of the Tax Act, financial reports are necessary to enable companies to determine their taxable income.
In contrast, large Proprietary Companies must prepare annual financial reports and a directors’ report, both of which must be audited and be sent to the shareholders. This can prove to be an expensive exercise, and it is possible to apply for an exemption to ASIC if all shareholders agree.
WHETHER TO INCORPORATE?
It is important to review your circumstances and weigh up the advantages and disadvantages.
ADVANTAGES
Flexibility
Multiple ownership is easily achieved by the issue of any number of shares. Be mindful, however, if the company has been in operation and there are retained earnings, care should be taken if you plan to issue more shares, and advice should be sought (value shifting).
Different classes of shares allow further flexibility in the streaming of dividends etc.
Lower tax rates
As mentioned, non-base rate companies are taxed at a flat rate of 30% (base rate companies 25% for 2021/22) which compares well with the highest individual tax rate of 47 per cent, including Medicare levy.
A director can receive a salary of say $120,000 from the company resulting in a maximum marginal tax rate of 34.5 per cent and retain any further profits in the company, paying the company tax of 30% (25% for base rate entities).
No further taxes will be payable until dividends are paid to shareholders. However, we mention in passing Division 7A of the Tax Act and note that a situation where debt loan accounts build-up, i.e. the shareholders owe the company money, should be carefully monitored.
In essence, retaining profits in a company may only result in a deferral of tax because eventually, most shareholders will want to receive dividends.
This is an important issue because the ATO is currently ramping up audit activities around Division 7A issues. The ATO has issued many rulings and determinations, notably on Unpaid Present Entitlements (UPEs) – see TR 2010/3 and TD 2015/20. Practice Statement Law Administration PSLA 2010/1 also gives valuable guidance on this topic.
Permanency
It is possible for companies to continue indefinitely as they are not dependent on the continued presence of one individual.
Officeholders and shareholders may change over time; however, a company has a permanent existence unless the shareholders or creditors (if the company cannot pay its debts) decide to liquidate it.
DISADVANTAGES
Capital Gains Tax
Companies are not eligible for the 50 per cent discount on assets held longer than 12 months.
Whilst the company tax rate is only 30 per cent (25% for base rate entities), companies are subject to CGT on the full gain of all assets sold, with indexation frozen at 30 September 1999.
When dividends are paid to shareholders, further tax is payable by them if their marginal tax rate exceeds 30 per cent.
For the progressive changes that apply to company rates of tax from 1 July 2016, refer to Chapter 1.
Liquidation
Distributions to shareholders upon liquidation of a company normally must be declared as taxable dividends. An exception to this is gains on the sale of assets purchased prior to the CGT regime (20 September 1985) if the funds are properly and separately accounted for (Archer Bros principle).
Distributions
Companies pay tax at the entity level, and there is an issue with non-taxable capital gains because of this. Such gains, when passed on to shareholders, are unfranked dividends and are fully taxable. This compares unfavourably with “flow-through” entities such as discretionary trusts and partnerships, where the recipients receive the distribution as non-taxable profits.
Carried forward losses
A company can only deduct a loss from a previous income year if it satisfies a continuity of ownership test or fails the same business test.
The continuity of ownership test requires that at all times during both the loss year and the income year, the same shareholders hold more than 50 per cent of the voting power and dividend and capital distribution rights.
If a discretionary trust holds shares, consider making a family trust election. Otherwise, the ATO will view that the continuity of ownership test is not satisfied where a company is majority-owned by one or more discretionary trusts. This is because the shares are not beneficially owned by anyone.
In situations where the company fails the continuity of ownership test, it may still deduct a tax loss from an earlier year if it satisfies the same business test. The company must not derive assessable income from any new business source or transaction to satisfy this test. The same business test was abolished on 1 July 2005 for companies with over $100 million annual turnover.
LOANS TO SHAREHOLDERS
Under Division 7A of the Tax Act, any loans to shareholders or associates which are outstanding at year end must be treated as unfranked dividends to shareholders unless a loan facility agreement exists and there is a genuine intention to repay the loan.
The loan must provide for an interest rate equal to a benchmark rate, with principal payments being made at least annually so that the loan term is no more than seven years for an unsecured loan or 25 years for a secured loan.
The benchmark rate of interest is 4.52% for 2021/22 and 4.8% for 2020/21.
In view of Taxation Ruling TR 2010/3, particular care needs to be taken when a trust makes a distribution to a company that is an eligible beneficiary of the trust. This is done because the 30% (25% for SBE’s) company tax rate compares well to the highest marginal individual rate of 47%. Often the distribution is a paper entry with no actual payment made to the company. When this happens, the company is said to have an unpaid present entitlement.
TR 2010/3 sets the opinion of the Commissioner on the circumstances in which a private company having a present entitlement to an amount from an associated trust estate makes a loan to that trust, within the meaning of section 109D (3) of Division 7A.
IMPUTATION SYSTEM
Under the imputation system, any income tax paid by a company is passed on to shareholders as an imputation credit which is available to be offset against their tax liability.
This effectively eliminates the double taxation of company earnings.
Adequate franking account records of these transactions must be retained. At year end, the franking account balance will determine whether a franking account surplus is available to be carried forward or franking deficit tax is payable.
Franking credits may include the following:
- Payment of company tax and tax instalments
- Any franking surplus carried forward
- Fully franked dividends received by the company (dividend x 30/70) – for large companies
- Imputation credits attached to franked dividends received from a partnership or trust.
Note that the maximum credit that can be allocated to a frankable distribution paid by a base rate entity has been reduced to 25% from the 2021/22 income year. This is in line with the small business tax rate for the income year.
If there is a franking account surplus, franking credits up to the amount of the surplus can be attached to dividends paid. If the franking credit attached to the dividend exceeds the surplus available, the company may pay the franking deficit tax.
FRANKING CREDIT TRADING
To validly use franking account credits, it is necessary to hold ordinary shares for at least 45 days, during which the share becomes ex-dividend.
If a shareholder is a discretionary trust, a family trust election must be made. The intention of this measure is to eliminate trading in shares to achieve benefits from franking credits and dividend streaming.
These rules do not apply to shareholders claiming less than $5,000 of franking credits in their tax return.
TRUSTS
A trust is a relationship between a person or company (called the trustee) and another person (called the beneficiary), in which the trustee holds property (called the trust property or the trust fund) for the benefit of the beneficiary.
The ATO is reluctant to accept the existence of any trust which is not evidenced in writing (e.g. in a trust deed or will). However, the terms of a trust can be established by conduct, implication, or a decision of the courts.
The four most common types of trusts are:
- “Family” trusts (trusts that have elected to be family trusts for tax purposes).
- Other discretionary trusts.
- Unit trusts.
- Hybrid trusts (partly fixed and partly discretionary).
“FAMILY” TRUSTS
The ATO requires family trust elections to be lodged for three primary purposes:
- Companies claiming prior year losses under (continuity of ownership) provisions where one or more discretionary trusts hold over 50 per cent of the shares.
- If the trust is claiming a deduction for trust losses.
- Claiming franking credits on dividends.
A family trust election limits tax effective distributions to within a ‘family group’ defined by choice of a primary individual. Some care and thought should be applied before proceeding because an election, once made, is irrevocable.
From 1 July 2008, the definition of ‘family’ in the family trust election rules was changed to limit lineal descendants to children or grandchildren of the test individual or the test individual’s spouse.
DISCRETIONARY TRUSTS
Discretionary trusts are usually created by having a settlor contribute a nominal sum to establish the trust and are commonly used as tax-effective vehicles and in asset protection planning.
After a trust has been established, business or investment assets are then transferred into the trust. A trustee is appointed, and his powers, responsibilities and obligations are normally defined in the trust deed and at trust law. Ultimate power usually rests in the hands of a principal or appointor who has the power to change the trustee.
From an asset protection perspective and in view of the “Richstar” case, when establishing a trust, particular care should be taken in deciding who the “Appointor” or “Principal” should be.
Further, in view of the Bamford decision handed down by the High Court on 30 March 2010, existing trust deeds should be reviewed by a legal practitioner to ensure they:
- – Define the trust income as being equal to section 95 net income, excluding “notional amounts”, but
- – Also, provide that the trustee has a discretion to adopt alternative concepts of income in any year; and
- – Allow the trustee a discretion to make distributions from gross income before deducting expenses.
Discretionary trusts can be created by the terms of a Will and are known as testamentary trusts. The trustee has a discretion regarding how the trust’s income and/or capital is to be allocated among the beneficiaries identified in the trust deed. Given this high degree of flexibility, the trustee is able to make tax-effective distributions and vary allocations to suit family circumstances.
Having covered discretionary trusts, we mention in passing the key features of a bloodline trust:
- It is a fully discretionary trust.
- The rules of the bloodline trust categorically provide that the capital (assets) of the trust can never go outside the bloodline during the life of the trust.
- Income may be allocated to in-laws, but the deed strictly stipulates that capital must stay within the bloodline.
These trusts are sometimes used in succession planning in the rural sector to ensure land and assets are passed on to the next generations.
However, we stress there can be a lack of flexibility and real issues (stamp duty and capital gains tax) if you want to add a beneficiary at a later date.
TRUSTEE RESOLUTIONS
In February 2012, tax agents were advised that the ATO will undertake an educational campaign, including a mail-out of approximately 1,200 letters, to representatives of trustees of trust estates.
The purpose of the campaign was to make representatives of trustees aware that, from the 2012 income year, trustees who make beneficiaries entitled to trust income by way of resolution must do so by the end of an income year (30 June) for it to be effective in determining who is to be assessed on the trust’s income.
Ruling IT 328 and IT 329 were withdrawn with effect from September 2011. These former rulings reflected the Commissioner’s administrative treatment of allowing certain trustees until the 31 August that followed the income year to appoint the trust’s income. The ATO now views that following the decision in Colonial First State Investments v FC of T 2011 ATC 20-235, trustees must now resolve to distribute the current year’s income on or before year end – which is usually 30 June.
It follows that in the absence of a default beneficiary clause, if a trustee fails to make a resolution to appoint the income of the trust before the end of an income year, the trustee may be assessed on the trust income at the highest marginal tax rate, rather than the intended beneficiary(s).
We are now seeing some limited compliance activities by the ATO post 30 June each income year. This includes requests for a selected number of trustees to provide a copy of the trustees’ income resolutions that evidence that the trustee distributed the trust’s income for the relevant income year before 30 June. This activity is ongoing for the 2021/22 year.
With regards to streaming of trust income, we refer you to Taxation Determination TD2012/11.
UNIT TRUSTS
A unit trust is a trust in which the entitlement of the beneficiaries is divided into units. The amount of a beneficiary’s entitlement to income or capital of the unit trust is determined by the number of units held.
The trustee distributes income and capital to the unitholders in proportion to the number of units each beneficiary holds. A unit trust in this respect is described as being “fixed” and is distinguished from a discretionary trust, in which a trustee may distribute income and capital in proportions as seen fit.
A unit trust is normally established by subscription for units. This involves the initial unit holders or subscribers paying funds to the trustee for the issue to them of units in a manner similar to shareholders subscribing for shares when a company is incorporated.
Income, including business income, franked dividends and capital gains, retains its character as it flows through the trust, and such distributions are accounted for in the unit holders’ taxation returns.
HYBRID TRUSTS
The hybrid trust has the features of both a discretionary trust and a unit trust.
The hybrid trust is based on the standard discretionary trust with the added feature that it also offers a fixed (by unit) system of interest in the trust.
Hybrid trusts had become popular as vehicles for negatively gearing investment property with asset protection benefits. If a hybrid discretionary trust purchases a property, the taxpayer can gear the units, thereby claiming a tax deduction.
However, in view of Taxpayer Alert 2008/03 and the Taxpayer and FC of T (2008) AATA 325, we recommend caution when making such tax claims. In the above case, the taxpayer was denied a deduction for interest on loan funds used to acquire units in the hybrid trust.
A negatively geared investment will not work in a family trust with no other income to offset the loss. In trusts and companies, losses are quarantined and carried forward to the next year.
The beneficiaries or shareholders cannot get the benefits of those losses to reduce their income. However, the hybrid discretionary trust can be administered as a normal discretionary trust for a couple of years until the investment funds are required. The trustee can then issue units. There is no need to issue units when the trust is set up. The flexibility is with the trustee, and generally, there are no stamp duties or capital gains tax implications.
IMMEDIATE DEDUCTIBILITY FOR PROFESSIONAL EXPENSES
The Government will allow businesses to immediately deduct a range of professional expenses associated with starting a new business, such as professional, legal, and accounting advice. This measure will be available to businesses from the 2015-16 income year.
In the past, some professional costs associated with a new business start-up were deducted over a five-year period.
CAPITAL GAINS TAX ROLL-OVER RELIEF FOR CHANGES TO ENTITY STRUCTURE
The Government allows small businesses with aggregated annual turnover of less than $10 million to change legal structure without attracting a capital gains tax (CGT) liability at that point.
Formerly a major impediment to the restructure of a business is the tax liabilities associated with the transfer of ownership of CGT assets, plant & equipment, and trading stock.
The roll-over allows eligible small businesses to avoid those tax liabilities so that they can readily adapt their legal structures to meet the requirements of their business as they change over time.
For the transfer of a CGT asset, the income tax law will apply under the roll-over as if the asset had been transferred for the amount that would result in the transaction making neither a capital gain nor capital loss, that is as if the asset had been transferred for an amount equal to the cost base of the asset.
However, do keep in mind that there is some complexity in the detail that does not need to be addressed prior to applying the roll-over.
Broadly, a genuine restructure is one undertaken for the benefit of the business, and that is not:
- Artificial or unduly tax-driven; and/or
- A divestment or a preliminary step to facilitate a divestment.
The roll-over can only be applied to the transfer of “active” business assets, plant and equipment and trading stock used by a small business.
Note that the ultimate economic ownership must not be changed by the restructure. However, it will be possible to transfer assets to discretionary trusts provided that they have a family trust election in place.
The transfer and transferee must both choose to apply the roll-over, must be tax residents and must not be tax-exempt or a complying superannuation fund.
Such a roll-over may move certain assets to a structure that offers enhanced asset protection and tax efficiency.
CGT roll-over relief is currently available for individuals who incorporate, but all other entity type changes have the potential to trigger a CGT liability. This measure recognises that new small businesses might choose an initial legal structure that they later find does not suit them when the business is more established.
PERSONAL SERVICES INCOME (PSI)
The PSI rules were introduced to effectively tax contractors earning their income from their own skills, expertise, or personal services, on a similar basis to employees. These rules apply regardless of whether the contractor operates as a sole trader or through a partnership, trust, or company.
The PSI provisions are designed to nullify the use of these entities to claim larger tax deductions, split income, or take advantage of lower company tax rates.
If the PSI rules apply to you, your personal services income will be treated as your income, and you must include it in your individual tax return. The changes to the tax law do not affect your legal, contractual or workplace arrangements with clients.
The changes do not apply to personal services income earned by employees, except where the individual is an employee of a personal services entity. The changes also do not apply to personal services income earned in the course of conducting a personal services business.
You qualify as a personal services business if:
- You meet the results test; or
- Less than 80 per cent of your personal services income in an income year comes from each client, and you meet one of the other three personal services business tests (the unrelated client’s test, employment test or business premises test); or
- You obtain a determination from the Tax Office confirming that you are a personal services business.
Even if your income is not affected by the changes, the general anti-avoidance provisions of Part IVA may still apply to schemes to reduce income tax by income splitting.
The PSI rules clarify what deductions can be claimed against affected personal services income and limit some deductions. In addition, a personal services entity may have an additional PAYG withholding obligation in relation to affected income that has not been paid out within a certain time as salary or wages to the individual service provider.
What is Personal Services Income?
This is income that is mainly a reward for an individual’s personal efforts or skills. It does not include income that is mainly:
- For supplying or selling goods (for example, from retailing, wholesaling, or manufacturing); or
- Generated by an income-producing asset (such as a bulldozer); or
- For granting a right to use property (for example, the copyright to a computer program); or
- Generated by a business structure (for example, an accountant working for a large accounting firm).
If personal services income is channelled through a company, partnership, or trust (a personal services entity), it is still the individual’s personal services income for income tax purposes. PSI rules only apply to personal services income.
Example: New ITP Pty Ltd provides computer programming services, but Ron does all the work involved in providing those services. Ron is the only employee of New ITP Pty Ltd. Ron uses the client’s equipment and software to do the work. New ITP’s income from providing the services is Ron’s personal services income because it is a reward for his personal efforts and skills.
Example: Tom owns and drives a semi-trailer that he uses to transport goods. The income is not Tom’s personal services income because it is produced mainly by using the semi-trailer and not by his personal efforts or skills.
What if you work under a contract?
Personal services income may be earned under a contract if the income is mainly for your personal efforts or skills. The terms and conditions of the contract, as well as other evidence of your working arrangements, such as letters or invoices, are important in determining whether the income is personal services income.
What if your income is mainly from supplying or selling goods?
Income mainly for supplying or selling goods, including retailing, wholesaling, or manufacturing, is not personal services income and therefore is not affected by changes to the tax law.
Example: Alan builds reproduction furniture, which he sells through a friend’s shop. The income from the sale of the furniture is not Alan’s personal services income because the buyers are mainly paying for the supply of furniture and not for Alan’s personal skills and effort in building the furniture.
Example: Joe is a tax expert who writes a book on the new PAYG measures. He approaches several publishing houses to get it printed and finally enters into a contract under which he sells the copyright to the book for $20,000, plus a royalty of 40 cents per book.
Income from the sale of the copyright is not personal services income. Rather, the income is in consideration for the transfer of Joe’s rights in the book to the publishing house.
However, if you are being paid to use your efforts or skills to produce something that becomes your client’s asset, this income is regarded as personal services income.
Example: Sam is a consulting engineer with a six-month contract to design a new production line. Under this contract, his client owns all rights to the design. The income earned under the contract is Sam’s personal services income.
Example: Joe is commissioned by a publisher of taxation books to write a book on the new Pay As You Go measures. The contract specifies that when the book is finished, and the copyright passes from Joe to the publisher, Joe will be paid a sum of $150,000.
The contract is not for the sale of property because the substance of the contract is the provision of Joe’s efforts or skills. Therefore, Joe’s income under the contract is personal services income.
What if your income is mainly from supplying or using assets?
If your income is mainly generated by income-producing assets rather than your personal efforts or skills, it is not personal services income. This applies even if some personal efforts or skills are involved in operating the asset.
Where the asset is:
- large-scale or high value; and
- essential to performing the work; and
- specified in the contract.
It is more likely that the income is being generated by the asset rather than by your efforts or skills and therefore is not personal services income.
If your personal skills or effort mainly generates the income, but you also supply some equipment to do the work, it will be personal services income. Still, you may meet one of the tests for a personal services business known as the results test.
Example: Ian’s company, Ian Pty Ltd, has a contract to supply an excavator to level uneven surfaces. The income mainly comes from the supply and use of the income-producing equipment, namely the excavator. The income is not Ian’s personal services income.
What if you supply some materials?
Supplying some materials on the job does not in itself prevent the income from being personal services income. Hence, there are no following examples if the use of materials is regarded as secondary to earning personal services income.
What if your income is generated from a business structure?
Where the income of an entity is generated by a business structure rather than the personal services of an individual, it is not personal services income. This depends on a number of factors, including:
- The extent to which the income depends upon the efforts, expertise, or skills of an individual.
- The number of employees or contractors engaged by the entity to perform work.
- The nature of the activities being conducted by the entity that generates the income.
- The existence of goodwill or substantial income-producing assets; and
- The size of the business operation.
What is a personal services business determination?
This is a notice from the Tax Office stating that you are conducting a personal services business and that the changes to the tax law do not apply to your income.
You can apply for a determination if:
- You are not sure whether you meet one or more of the personal services business tests; or
- You do not meet the results test, and 80% or more of your personal services income comes from one client; or
- Unusual circumstances prevent you from meeting one or more of the tests.
What are unusual circumstances?
Unusual circumstances are circumstances that are completely out of the ordinary and prevent you from meeting a test. The circumstances must only be temporary, with the normal circumstances due to resume in the short-term. If you expect them to continue indefinitely, this suggests they are no longer unusual.
If you are not sure whether or not your income is personal services income, you can apply to the Tax Office for a determination.
You can seek a private binding ruling from the Tax Office on any law issue. Including whether you receive personal services income, whether you meet any of the tests for conducting a personal services business, or whether the general anti-avoidance provisions of Part IVA apply to you.