There is a complex set of tax rules that deal with what is known as personal services income (PSI). PSI results from the efforts of human beings, where the income is mainly a reward for the personal efforts and skills of an individual.
Many occupations derive personal services income. These include both so-called professionals and tradespeople. In the right circumstances, electricians, plumbers, doctors, bricklayers, accountants, engineers, architects, and many other occupations can generate PSI.
Business structure vs personal services income
When a business grows to the extent that it has a so-called business structure, the income is no longer considered to be produced purely by the personal efforts and skills of an individual. Instead, the income is seen as being generated by the structure of the business itself.
For example, the ATO would typically view an architect operating alone as producing personal services income. However, if that architect employed another architect full-time, it’s likely the ATO would determine the business had transitioned to a structure that is no longer solely reliant on one person’s skills.
The PSI rules: Part 2-42 of the ITAA 1997
If a business is producing personal services income, Part 2-42 of the Income Tax Assessment Act 1997 may apply. This section can result in the income being attributed to the individual who performs the work, even if the business is operated through a company or trust. Rather than being taxed as a business, the income is effectively taxed as if it were earned personally by the individual. This often leads to a higher tax bill.
To avoid the application of Part 2-42, the business must pass one of four tests, allowing it to be classified as a personal services business (PSB). If successful, the PSI rules won’t apply, and the profits won’t automatically be attributed to the individual.
Enter Part IVA: The ATO’s general anti-avoidance rule
Even if a business passes a PSI test and is considered a personal services business, the ATO may still apply Part IVA—the general anti-avoidance rule (GAAR). This rule allows the ATO to cancel the tax benefit of any arrangement that appears to be entered into with the sole or dominant purpose of avoiding tax.
This is particularly relevant to arrangements where personal services income is diverted to another entity, or where tax is deferred.
Draft guidance from the ATO: PCG 2024/D2
On 28 August 2024, the ATO released draft Practical Compliance Guideline PCG 2024/D2, outlining its current view on how the PSI rules interact with Part IVA. This guideline is expected to create challenges for many small and micro businesses that provide services via a company, trust, or partnership.
Paragraph 9 of the draft states:
“An arrangement is considered low risk where the net PSI received through the personal services entity is assessed in the form of assessable income to the individual whose personal efforts or skills generated that income, and tax is not deferred.”
If PSI is being earned and not fully assessed to the individual who performed the work, the ATO may consider the arrangement to be higher risk. This could lead to the application of Part IVA and additional tax and penalties.
What should small business owners do?
The ATO’s position on personal services income is not new, but this draft guideline formalises long-standing views. While its legal standing may be debated in court, the implications for small business owners are immediate.
If your business generates personal services income, especially through a company or trust, now is the time to review your structure. This is particularly important where the income is not being fully assessed to the individual who generated it.
Need help understanding how the PSI rules affect you?
If you’re unsure whether your business income qualifies as personal services income, or how to manage PSI in light of Part IVA and PCG 2024/D2, we’re here to help.
Contact the team at MacMillan Cowan & Co for tailored tax guidance and peace of mind.