Understanding Personal Services Income (PSI)
Personal Services Income (PSI) is income that is mainly a reward for the personal efforts and skills completed by an individual. It is common for Sole Traders or individuals through an interposed entity to earn PSI, and thus be subject to PSI rules and structures. In considering the tax planning issues for contractors one must begin with determining whether you in fact are Contractor and not merely an Employee.
Differences between Contractors and Employees
There are many differences between contractors and employees. Understanding these differences is crucial for both the contractor and their hirer, as it will impact on their tax and super obligations, intellectual property ownership, and insurance requirements.
A key factor in deciding if a worker is an employee, is the degree of control that can be exercised over the worker. If the payer has the right to direct how, when, where and who is to perform the work, then the worker is likely to be an employee.
Other key differences between Contractors and Employees include:
Independent contractors, are:
- Paid for results achieved
- Provide all or most of the necessary materials and equipment to complete the work
- Free to delegate work to others
- Have freedom in the way they work
- Provide services to other businesses
- Free to accept or refuse work
- In a position to make a profit or loss
- Can negotiate Contracting arrangements
Employees, however, have little control of the:
- Work they perform
- Their place of work
- Their work hours
Generally, a worker is an employee if he/she, is:
- Is paid for time worked
- Receives paid leave, such as personal, annual or recreation, or long service leave
- Is not responsible for providing the materials or equipment required to do the job
- Must perform the duties of the job position
- Agrees to provide their personal services
- Works hours set by an agreement or award
- Is recognised as an integral part of the employer’s business
- Takes no commercial risks
- Cannot make a profit or loss from the work performed.
Information for Contractors
If you are a Contractor, you will generally provide for your own tax obligations through the pay as you go (PAYG) instalment system. It is likely that you will have or will need an Australian Business Number (ABN). The payer may agree to withhold tax from your payments under a voluntary withholding agreement. If you do not quote an ABN, the payer will be obliged to withhold tax from your payment.
Once you have determined that you are Contractor you then need to determine if your income is subject to PSI rulings. Personal Services Income (PSI) can be defined as a “reward for an individual’s personal efforts or skill.” You need to work out what percentage of the income you receive for each contract, including:
- Labour – That is the skills, knowledge, expertise or efforts of the person who performed the work.
- Materials – That is the materials and /or tools and equipment used to complete the job.
If the majority (51% or more) of the job relies on the skills, knowledge, expertise and effort of the person who performed the work, the income will be classified as PSI.
Income that is not PSI
The income you generate will not be classified as PSI, if it is from selling or supplying goods or services, such as retailing or wholesaling or manufacturing; ass the income will not mainly be a “reward for the personal skill, knowledge and effort”.
By using income producing assets, such as a truck, bulldozer, bobcat or printing press and so, the majority of the work will be generated by these assets, and thus not effected by PSI rules.
Granting of a right to use property, such as intellectual property or copyright as the majority of the income, is generated from the right to use the property, and thus not effected by PSI.
Income created from business structures, such as a large firm or company, are generally not PSI, as the majority of the income is generated from the significant assets, employees, contractors and goodwill, and so on.
For the PSI received, you will need to work out if the PSI rules apply to this income. The rules were introduced to better regulate and monitor income activity, and ensure that contractors are paying their employees correctly, completing related reports, and not taking advantage of lower tax rate and deduction loopholes.
If the income is mainly for your skill/personal efforts then its “your personal income”, regardless of whether it is income of another entity and whether it is for doing work or producing a result or whether its paid under a contract. The PSI rules do not deem contractors to be employees and do not affect the legal relationship between the contractor’s entity and the other parties they are dealing with.
If the PSI rules apply, you: Won’t be able to claim certain deductions against the PSI Will need to meet certain tax return obligations If the rules don’t apply, the only change in your tax obligations is there will be certain reporting obligations for the psi you received.
There are 4 tests to determine if the PSI rules apply to you.
- The Results Test
- The Unrelated Clients Test
- Employment Test.
- Business Premises Test
If you meet one or more of these tests, your personal services income is taken to be generated in the course of conducting Personal Services Business, and the PSI rules will not affect your tax obligations. If the Personal Services Income is paid to your company, partnership or trust, rather than to you directly, then the entity is your personal services entity.
If you do not pass any of the tests, the PSI rules may apply. This means you:
- Won’t be able to claim certain deductions against the PSI. Including rent, mortgage interest, rates, land tax, certain payments to associates; and there are some restrictions on super for associates (see below)
- Will need to meet certain tax reporting obligations. Again if the rules do apply there will be no change in the contractual relationships with your customers – e.g. you don’t become an employee of the customer.
PSI Tests Explained
1, Results Test
If you receive personal services income, you will meet the results test in an income year if, for at least 75% of this income:
- You are paid to achieve a specified result or outcome under your contract or arrangement and will only be paid when result is achieved.
- You have to provide tools or equipment necessary (if any) to do the work (if no tools/equipment are required, answer yes)
- You are liable for rectifying defects in your work.
If you answered “YES” to each of these questions then you have passed this test and the PSI rules do NOT apply to this income (see below).
If you don’t pass the Results Test, you can only move on to the next tests if 80% or less of your PSI comes from any one client If 80% or more of your income comes from one client then you are stuck and the PSI rules apply to you unless you apply for a special determination from the ATO. If each of your client provides less than 80% of your total PSI, then the PSI rules apply unless you can satisfy ONE of the remaining tests being: Unrelated Clients Test, Employment Test or Business Premises Test.
2, Unrelated Clients Test
You will satisfy this test if you answer YES to the following questions:
- Do you receive PSI from two or more “unrelated” clients.
- These clients must be unrelated and not controlled by the same individual or entities.
- Do you provide your services as a direct result of making offers or invitations to the public (e.g. through advertising).
IF you answered YES to these questions, you have passed this test and the PSI rules do not apply to you. IF you could not answer yes, then you need to look at the Employment test.
3, Employment Test
You will pass this test if you can answer YES to one of the following questions:
- Do you get employees, partners of a partnership or contractors to perform at least 20% (by market value) of the principal work? Principal doesn’t include incidental work such as bookkeeping, issuing invoices or running the home office. b. Do you have one or more apprentices for at least half the income year?
If you answer “yes” to either of the questions in the employment test, you have passed the employment test and the PSI rules do not apply. If you didn’t pass either the employment test or unrelated clients test you need to pass the Business premises test if the PSI rules are not to apply.
4, Business Premises Test
You will pass the Business Premises Test in an income year, if you answer “yes” to ALL parts of the following question.
At all times of the income year, were your premises:
- Owned or leased by you
- Used for personal services work more than 50% of the time
- Used exclusively by you
- Physically separate from your residence and that of your associates
- Physically separate from the business address of clients and their associates
If You answered “YES” to all parts of the business premises test, you have passed this test and the PSI rules do not apply to you.
PASSING ONE TEST – PSI RULES DON’T APPLY : If you pass one of the tests, the psi rules will not apply to your income. The only change to your tax affairs is that you will need to complete specific questions on your tax return for the PSI received.
CAUTION: Just because you have satisfied the tests and the PSI rules don’t apply, will not mean it’s all OK. If you have entered into an arrangement where the main purpose is to obtain a tax benefit, for example by income splitting then the anti-avoidance section of the tax act may impose severe penalties.
If you don’t pass the PSI Tests
PASSING NONE OF THE TESTS – THE PSI RULES WILL APPLY:
SOLE TRADER You will not be able to claim certain deductions against your PSI, including: Rent, mortgage interest, rates or land tax for your home office Payments to your spouse (or other associate) for support work such as secretarial duties You will need to declare the PSI you received in your tax return.
COMPANY, PARTNERSHIP AND TRUST WHAT YOU MUST DO: Treat the PSI income received as belonging to each individual who performed the services and each individual will need to declare that income in their tax return. (you will not be able to keep it as part of your business profits) Follow additional PAYG withholding obligations, unless your company, partnership or trust promptly pays the PSI to each individual who performed the services as salary or wages.
WHAT YOU CANNOT CLAIM: Rent, mortgage interest, rates and land tax for your residence when your business premises are at your home. Payments to associates for support work such as incidental or subsidiary work that is not central to meeting the obligations under the contract such as secretarial work or including bookkeeping for your business, issuing invoices and running the home office or any other non-principal work. Super for associates who merely do support work.
WHAT YOU CAN CLAIM: Expenses incurred to gain work- e.g. advertising, tendering and quoting for work. Registration and licensing fees. All Insurance related to earning the psi income such as profit liability, loss of income, public liability and workers comp for salary/wages paid. Salary and wages to arm’s length employee. Reasonable amounts to associates for principal work Super contributions for arm’s length employee Home office running expenses such as heating and lighting (but not rent, rates, land tax and mortgage interest. Depreciation of income-producing assets. Bank keeping fees and expenses Tax-related expenses, such as costs of complying with tax laws. Other expenses will depend on your circumstances.