A growing trend in recent years has been for experienced senior executives to develop what is known as a “patchwork career”, where they take on a number of advisory roles – including non-executive directorships and consultancy work – as part of their transition to retirement.
This can be a very attractive option, allowing people to utilise their years of experience and knowledge but also provide more flexibility as they approach retirement than a more traditional full-time job.
However, there are some traps to be aware of, particularly when it comes to tax, and specifically the Personal Services Income (PSI) tax rules.
These tax rules apply to anyone who is being paid primarily for their personal skills, as a way of ensuring they are taxed in a way similar to an employee. The cut-off is that if 50 percent or more of a person’s income is generated from personal efforts or skill (rather than from the sale of goods, use of assets, or from a business structure) then it will be counted as PSI, and taxed accordingly.
The main intention behind the PSI rules is to prevent income splitting, or income being taxed at a lower rate (such as through a company) and also to prevent a consultant from claiming deductions that they would not otherwise have been able to claim as an employee.
For example, anyone receiving the majority of their income as a consultant based on their personal expertise is likely to be taxed at the marginal tax rate under PSI rules. It also applies to a contractor based on services, or a professional practitioner in a sole practice.
There are a number of tests to help people work out whether they fall within the PSI rules. Two of the most common are the results test and the unrelated clients test. If either of these tests can be satisfied, then people may be able to argue that the PSI rules don’t apply to them.
Results test
The results test has three key criteria, all of which must be met. They are: the consultant is being paid by a client to produce a specific result; they provide their own tools and equipment (where relevant); and are liable for rectifying any defects arising from their work. If all three rules can be satisfied, then the PSI rules don’t apply.
For example, if a consultant is paid based on the number of hours worked, rather than achieving specific deliverables or meeting certain performance targets, then they cannot use the results test to avoid application of the PSI rules.
Example 1 – Contract to develop an IT product – results test met
Mary is contracted to develop a specified IT system for use by a government department within a timeframe of 12 months, with instalment payments made on achievement of specific milestones. She generally uses her own equipment, is responsible for rectifying any defects if the system does not operate as intended or does not meet the required specifications and is liable to pay damages if she does not do so. The ATO would regard the results test as having been satisfied as all the required conditions are present.
Example 2 – Contract to provide engineering services – results test not met
Tim has a company Tim’s Contracting Pty Limited that contracts with a property developer to perform planning services in relation to various projects over an 18-month period, which is subsequently renewed for another 12 months. Under the contract Tim is required to carry out the work as assigned to him by the developer, mostly at their premises on or site. Tim is provided with administrative support and can use the developer’s equipment as required.
The fees paid to him are calculated at an hourly rate and Tim is paid following submission of timesheets, while he is not responsible to remedy defects at his own cost. While Tim is contracted to achieve the successful completion of the relevant contracts, the ATO would not accept that he satisfies all of the requirements to rely on the results test, making it more likely that Tim will be taxed personally on the income under the PSI rules.
Common situations where the results test might apply include where someone is contracted to oversee a specific project such as a marketing campaign to increases sales, or the successful sale of a business. Having specific outcomes that determine the consulting fees or receiving a success fee make the applicability of this test more likely.
Unrelated clients test
A consultant will often have multiple clients that are unrelated to each other. As long as no more than 80 per cent of their personal services income for a year is received from a single client, the PSI test may not apply.
However, a critical part of this test is that not only is the consultant offering their services to the public at large, but that consulting engagements are received from offers to the public or a section of the public.
The most common sources of work for many consultants are referrals from their existing contacts, word of mouth referrals or their strong personal reputation. The ATO’s view as summarised in Taxation Ruling TR 2022/3 is that this is not sufficient to meet the unrelated clients test and the PSI tests may be failed, meaning, for example, that consulting income received through a company may be attributed under the PSI rules to the individual consultant, and some company deductions may be denied.
Another common approach is for people to use the fact that they have a website and a LinkedIn profile, and that they undertake promotional activities such as speaking at conferences and publishing articles in industry journals. However unless they can show that there is a direct connection between this promotion to the public and receiving the consulting engagements, it is not enough to pass the test.
In order to satisfy the unrelated client test, it is necessary to show that at least some of the consulting work was obtained from sources such as the website or LinkedIn enquiries, conference attendees or readers of published articles, or from direct advertising, sponsorship or other marketing activities, rather than simply from word of mouth or contact referrals.
Example 3 – making offers to provide services through a website and receiving referrals
The ATO gives the example of Deb, a graphic artist who works through her company Debart Pty Ltd. Deb is the sole director and shareholder of the company. Debart Pty Ltd advertises to provide services on a website and also through advertising in online industry newsletters. Sometimes work is referred to her by word of mouth from Deb’s industry contacts.
Any clients that Debart Pty Ltd sources from the website or as a result of advertising in the industry newsletters would meet the requirements of the unrelated clients test for making offers or invitations to the public at large or a section of the public, as these forms of advertising are capable of reaching a wide audience.
As Debart Pty Ltd does not provide services in an industry that could be described as a niche industry, any clients obtained through the word-of-mouth referrals would not be counted for the purposes of the unrelated clients test.
Example 4 – word-of-mouth offers in a niche industry – unrelated clients test met
By contrast the ATO also gives the example of Mike who works as an undersea diver on offshore oil rigs. During the income year, he entered into two contracts with unrelated companies to provide his services. He heard about the availability of work from another diver and contacted the companies to offer his services.
Undersea diving on offshore oil rigs is a niche industry and the work he does is highly specialised. Because of this, there are only a very small number of potential clients for him to access. In cases where there is a niche market for highly specialised skills and only a very small number of potential clients to make offers of work, the unrelated clients test will be met when an offer is made through word-of-mouth referrals.
It is important for consultants to be aware of the risks of the PSI rules applying, especially where they want to split their income or work through a company. The risks will be reduced if they can clearly show that they have contracted to achieve a result, as none of the other PSI tests will have to be applied.
Failing that, if consultants seek to rely on the unrelated clients test it is critical that they take steps to show that they are offering their services to the public and that they are able to show that at least some of their consulting engagements were received directly through their own promotional activities.
Recent ATO guidance
To make matters even more complicated, on 28 August 2024 the ATO released a “practical compliance guideline” (PCG) on the PSI rules. While still in draft, the PCG makes it clear that the ATO is looking closely at anyone who claims exemption from the PSI tax regime.
If it believes people are using the exemptions to unfairly reduce their tax, the guidance explains that the ATO can still apply the Part IVA anti-avoidance rules. The PCG also outlines the type of arrangements the ATO considers to be high and low risk, although this is still highly subjective which makes it extremely hard for people to have certainty that their arrangements will be accepted by the ATO.
It is there more important than ever for people to ensure they are acting in good faith when it comes to their personal tax arrangements and to seek appropriate tax advice.