Personal Services Income Explained

One of the most fundamental concepts in Australian taxation law is that of “substance over form”, which seeks to treat any particular arrangement based on the true nature of the arrangement, regardless of how it is labeled.

Over the years, many sections of legislation have sprouted up to formalise the process of classifying arrangements correctly, with a view to ensuring that the tax treatment of such arrangements is reflective of the substance of the arrangement rather than the form. One such area is Personal Services Income (PSI).

Although the PSI rules have been around for some time, many small businesses are either unaware of the rules or do not fully understand them, and it is common for PSI to be treated incorrectly.

What is Personal Services Income (PSI)?

Personal services income (PSI) is any income that is produced mainly from the personal skills or exertion of an individual.

You can receive PSI in almost any industry, trade or profession. Some common examples of people who earn PSI include accountants, lawyers, business consultants, IT consultants, engineers, construction workers and medical practitioners.

By contrast, income you might earn from selling goods would not be PSI as the consideration received is primarily for the goods themselves, rather than for your personal exertion.

Income is classified as PSI when more than 50% of the consideration you receive for a particular contract or transaction is for your labour, skills or expertise.

Who is affected by the PSI rules?

The PSI rules affect any person who provides consulting, professional or other services in a contracting arrangement, either as a sole trader or through a separate entity (eg. a company), rather than being employed directly by the customer.

Any person who falls into the above category is required to use the various PSI tests to determine whether the PSI rules apply to them.

The PSI Tests

A series of tests are used to determine whether an arrangement is in substance an employment-type arrangement (and therefore subject to the PSI rules) or if the income is generated by a Personal Services Business (and therefore the PSI rules do not apply).

The tests must be applied each year there is PSI and, if there are multiple people in the business earning PSI, the tests are applied in respect of each individual.

The table below provides a basic outline of the tests. If you pass the results test, then the PSI rules do not apply. If you fail the results test, then you must pass the 80% rule and at least one of the other three tests.

Test	Criteria
Results Test	For at least 75% of the PSI, you are: Paid to produce a specific result; and Required to provide the equipment or tools necessary to do the work; and Required to rectify defects (or pay for the rectification of defects) in the work at your own expense.
The 80% Rule	No single client contributes to 80% or more to your total PSI.
Unrelated Clients Test	The PSI is received from two or more clients who are unrelated; and Your business provides such services as a direct result of making offers to the public or sections of the public (eg. advertising).
Employment Test	At least 20% of the principal work is performed by employees, partners or other contractors; and/or You have one or more apprentices for at least half of the income year.
Business Premises Test	At all times during the year, your business premises is: Owned or leased by your business; Used for personal services work more than 50% of the time; Used exclusively by your business; Physically separate from the residence of any individuals earning PSI (or their associates); and Physically separate from the business address of clients (or associates).

What happens when PSI rules apply?

The PSI rules are designed to ensure that people who earn income from personal services where the arrangement is in substance an employment-type arrangement are taxed in the same way as an employee would be.

If the PSI rules apply:

The PSI income and related deductions are attributed to the person whose exertion the income relates to.

The income and expenses are pushed through to the individual’s tax return (in a dedicated reporting section) and the net income is taxed at the individual’s marginal rate, regardless of what structure the income was earned in.

There are restrictions on the types of expenses that can be claimed as deductions against the PSI. Generally, the expenses that are claimable are the same as if you were an employee. Some examples of expenses that are not deductible against PSI are:
- Rent, mortgage interest, rates and land tax;
- Payments (including salary, wages, allowances etc) or superannuation contributions to/for associates of the individual (eg. spouse or child) for non-principal work (eg. bookkeeping, administration or secretarial work); and
- Car expenses for more than one vehicle.
If the PSI is earned through a separate entity (ie. other than as a sole trader), the entity is required to withhold tax from the income that is attributed to the individual.

Structuring Considerations

The PSI rules remove any tax advantages that would have existed as a result of earning the PSI through an entity rather than directly by the individual. However, depending on your circumstances, there may still be a number of reasons to operate the business through a separate entity, such as:

A requirement under a contract to operate through a particular structure (eg. a company);
Asset protection; and/or
Future investment by a third party.

What to do if you think you might have PSI

Whether the PSI rules apply to you;
How to meet your tax and PAYG Withholding obligations (if the PSI rules apply);
Whether you need to consider any business structuring issues.

If you are unsure of whether you pass the tests, or have unusual circumstances that prevent you from passing one of the tests, it is possible to apply for a determination by the Commissioner as to whether the rules apply. Catalyst Financial can assist you with preparing a submission to the ATO to request a determination.