Professional consultants and the personal services income rules

It is becoming increasingly common for people to become consultants after a successful career as a senior executive. While this may offer greater rewards and flexibility, there are several traps to watch out for under the Personal Services Income (PSI) tax rules.

The aim of the PSI rules is to ensure that when an individual is paid primarily for their personal efforts or skills, they are taxed personally in a way similar to an employee.

When the PSI rules apply, the main impacts are 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.

While there are several tests in the PSI rules, two of the most common exclusions from PSI are the results test and the unrelated clients test. If either of these tests can be satisfied, then the consultant may be able to split income with their spouse, for example, using a family trust, or through a company or by claiming deductions for certain additional business costs that do not relate to the consulting income.

Results test

If a consultant can show that they are paid by a client to produce a specific result, provide their own tools and equipment (where relevant), and are liable for rectifying any defects arising from their work, then they will not have to meet PSI rules.

This test will often fail where the consultant is paid based on the number of hours worked, rather than achieving specific deliverables or meeting certain performance targets.

Common situations where the results test might apply include where an individual 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.

A consultant may point to the fact that they have a website, a LinkedIn profile and undertake promotional activities such as speaking at conferences and publishing articles in industry journals. The problem is that unless they can show that there is a direct connection between the promotion to the public and receiving the consulting engagements, the ATO considers that this is not enough to pass the test.

In order to satisfy the unrelated client test, it is necessary to show that the consulting work was obtained from sources such as website or LinkedIn enquiries, conference attendees or readers of the consultant’s articles, or from direct advertising, sponsorship or other marketing activities rather than simply from word of mouth or contact 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.

This article was published in the Spring 2024 issue of Financial Times.