Personal Services Income, or PSI, is given as a reward for an individual's personal efforts and skills. At least, that's how the Australian Tax Office sums it up. When it comes to your taxes, PSI is a common type of income for Sole Traders and individuals who earn money through an interposed entity (consultants and contractors) like a company or family trust.
If you earn PSI, that income is subject to the corresponding rules and structures. So, when considering the tax planning problems that can arise for such individuals, you have to begin by determining whether you are a Contractor or an Employee.
Let's go through how to make this important determination and the impact the result will have on your taxes.
Are You A Contractor or Employee?
Many things set contractors apart from employees, and knowing the difference is critical for both the hirer and the worker. Depending on how you're classified, your tax and super obligations will change and so will the insurance requirements and rules regarding intellectual property ownership.
The degree of control the hirer has over a given worker is a key factor in determining whether they are an employee or a contractor. If the payer has the right to direct the worker in how, where, and when they perform work, then they are likely an employee. Below is a list of other qualifying factors.
You are an independent contractor if:
- You are paid for the results you achieve
- You provide all or most of the equipment and materials to do your work
- You are able to delegate your work to others
- You have freedom in how you work
- You can prove services to more than one business at a time
- You are free to refuse or accept work at your leisure
- You are able to make a profit or lose money
- You can negotiate your contracting arrangements
Generally, a person is an employee if they have little control of the work they perform, the place of work, and the work hours.
You are an employee if:
- You are paid for the time you work
- You receive paid leave, like personal, annual, recreation, or long service leave
- You are not responsible for providing equipment and materials to do your work
- You must perform a list of duties associated with your job's position
- You can’t delegate/hire someone to do the work on your behalf
- Your work hours are set by the hirer
- You take no commercial risk in your work
- You cannot make a profit or lose money for the work you do
The ATO has an online tool to help you work it out. If you take this test and determine that you're a contractor, you need to consider the implications of Personal Services Income.
Considerations For Contractors
Typically, a contractor will take care of their own tax obligations using the PAYG (Pay As You Go) installment system. If you don't already have one, you may need an Australian Business Number (ABN) and register for GST.
When being hired as a contractor, failing to quote your ABN means the payer will have to withhold taxes from the payment they make to you. Otherwise, they may agree to withhold tax from your payments if you get into a voluntary withholding agreement.
Working as a contractor
Once you've determined that you can be classified as a contractor and not an employee, you need to figure out if the income you earn is subject to PSI. The tricky part is that only part of your income will be subject to PSI as it is defined as the monetary reward you receive for your personal efforts or skill.
You'll need to break down what percentage of income you receive for each of your contracts comes from your personal efforts or skill. In general, you can break your income down into two categories:
Labour: This sums up the knowledge, expertise, skills, and efforts of the person performing the work.
Materials: This sums up the tools, equipment, or other materials required to complete the job.
If more than 50% of a given job relies on labour, all of the income from that contract will be considered PSI.
Once you have determined if you have earned any PSI, you need to determine if the PSI rules actually apply. If your PSI income is primarily generated by your skills/personal efforts, then it's classified as your personal income regardless of whether it's from doing work, producing a result, paid under contract, or income from another entity.
In other words, the PSI rules do not make contractors employees of themselves and they do not impact the legal relationship between a contractor and the parties that contractor deals with. It is important to note that, even if you aren’t subject to PSI rules, you will still need to report on the PSI income you receive.
If you find that PSI rules do apply you will not be able to claim certain deductions against PSI and you will need to meet certain tax obligations. So, how do you know if PSI rules apply to you? There are four tests.
Income That Isn't Personal Services Income
If you earn income from selling or supplying goods and services, like manufacturing, retailing, or wholesaling, that income doesn't qualify as Personal Services Income because it's not a reward for your personal skills, knowledge, or effort.
Using income-producing assets, be it your truck, bobcat, bulldozer, printing press, or other, means the majority of your work was generated by these assets. Therefore, it's not PSI and is not subject to PSI rules.
Additionally, if you earn income from granting someone the right to use your property, like copyright or intellectual property, that's not effected by PSI rulings, either.
Finally, income earned through business structures (like a large company or firm) generally doesn't qualify as PSI. Neither does the majority of income people generate from employees, contractors, goodwill, or significant assets.
The Four Tests Of Personal Services Income
There are four tests you should consider when determining if your income is subject to PSI. If you meet one or more of these tests, your PSI will be considered a result of conducting a Personal Services Business. That means the PSI rules won't impact your tax obligations. However, if the PSI is paid to your trust, partnership, or company, rather than directly to you, than the entity will be considered your personal services entity.
If you aren't able to pass any of these tests, then the PSI rules may apply to you. This means:
- You won't be able to claim certain deductions against the PSI. This includes deductions for rent, mortgage interest, land tax, rates, and certain payments to associates.
- You will find there are some restrictions on super payments for associates.
- You will need to meet certain obligations for reporting your taxes.
With that in mind, let's jump into these four tests.
Test 1: The Results Test
If you receive any personal services income, you will meet the results test for a given year if, for at least 75% of this income:
- You are paid to achieve a specific outcome or result under a contract or agreement and will only be paid when that result is achieved.
- You have to provide your own tools, materials, and/or equipment (if any) to do the work. If no tools, materials, and/or equipment is required, answer "yes" to this question.
- You are completely liable for rectifying any defects in your work (at your own time & cost).
If your answer is yes to all of these questions, then you pass this test and the PSI rules do not apply. If you don't pass the results test, you can only move onto the next test if less than 80% of your PSI comes from a single client. If more than 80% of your income comes from a single client, the PSI rules apply to you unless you request a special determination from the ATO.
Test 2: Unrelated Clients Test
You'll satisfy this second test if you answer yes to all of these questions:
- Do you receive PSI from at least two unrelated clients?
- Do you provide services as a direct result of inviting or making offers to the public?
Realize that "unrelated" clients are not directed or controlled by the same entity or individual. If you can't answer yes to both of these questions, you need to look at the employment test.
Test 3: Employment Test
You'll satisfy this third test if you can answer yes to at least one of these questions:
- Do the partners, employees, or contractors perform at least 20% of your principal work (determined by market value)? Don't include incidental work like issuing invoices, bookkeeping, or running the home office.
- Do you have at least one apprentice for more than half the income year?
If you don't pass this test or the unrelated clients test, you need to pass the business premises test. Otherwise the PSI rules will apply to you.
Test 4: Business Premises Test
If you can answer "yes" to all of these questions, you will pass the business premises test for a given income year.
For all times of the income year, were your premises:
- Leased or owned by you;
- Used for personal services at least 51% of the time;
- Used exclusively by you;
- Physically separate from your residence and the residence(s) of your associate(s);
- Physically separate from the business address of your clients and their associates?
If you can answer yes to all of these questions, the PSI rules do not apply to you.
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What Your Test Results Mean
If you pass one of these four tests, the PSI rules do not apply to your income. The only change you'll see in your tax affairs is the requirement to answer specific questions on your tax return about the PSI you received during the income year.
Realize that entering an arrangement with the primary purpose of obtaining a tax benefit, like by splitting income, then the anti-avoidance section of the tax act may lead to several penalties.
If you do not pass any of the tests, the Personal Services Income rules will apply. Here's what that means for these entities:
If you qualify as a sole trader, you won't be able to take certain deductions against your PSI. This includes deductions for rates, land tax, mortgage interest, or rent for your home office; payments to your associate or spouse for supporting your work (like secretarial duties); and you'll have to declare your PSI on your tax return.
Company, Partnership, or Trust
These entities should treat any PSI income they receive as belonging to each individual that performed the services and each individual will have to declare that income on their return. You'll also need to follow additional withholding obligations for PAYG unless the company/partnership/trust promptly pays the PSI as salary or wages to the individuals who performed the services.
If you're subject to PSI rules, you're still able to claim expenses that you incur in gaining work, like advertising or quoting for work. You can also claim registration and licensing fees; insurance related to earning the PSI income (like professional indemnity, public liability, workers comp, or loss of income insurance); salary and wages paid to arm's length employee; reasonable amounts paid to associates for principal work; and contributions made to the super of an arm's length employee.
If you work from home, you can also claim the expenses of running a home office like heating and lighting (but not rent, mortgage interest, land tax, or rates); depreciation of assets that produce income; bank keeping expenses and fees; tax-related expenses, like the cost of complying with tax laws; and other expenses depending on your circumstances.
The big drawback of the PSI rules for those who structure through a company or trust is that you can’t retain the profits in the company (and only pay the company tax rate) or distribute profits to beneficiaries through a trust. Rather the person generating the PSI income gets taxed at their marginal rates, thus ruling out any tax deferral benefits of a structure. Of course a company or trust may still be beneficial for asset protection and in some cases required by the client (many mining companies require their contractors to have a company).