Personal Services Businesses – ATO risk guidance

Varun Kumar

4 September 2024

The Australian Taxation Office (ATO) has released Draft Practical Compliance Guideline (PCG) 2024/D2 which considers the risk of Part IVA (general anti-avoidance provision) applying to personal services entities. This practical guidance is important for individuals trading through interposed entities (trusts and companies) in delivering their personal services to their clients.

It is also important to note that these views apply equally across various industries, and although all the examples in PCG 2024/D2 relate to professionals (doctors, lawyers, accountants etc.), these views could be applied to individuals in other vocations such as plumbers, bricklayers and any type of businesses where the income earnt is from the provision of an individual’s services as opposed to income being generated by a business structure.

Background

The personal services income (PSI) provisions are in place to limit the types of deductions an entity can claim in respect of income being derived from the personal services of an individual. The PSI provisions act as an anti-avoidance provision to ensure the entity is restricted to claiming certain deductions only and any income derived is then attributed to the individual.

However, if certain tests are passed, the PSI provisions do not apply as the entity is carrying on a personal services business (PSB). However, just because an entity is not subject to the PSI restrictions does not mean the nature of income is business income and retains its characteristics as being personal services income.

Historically, the ATO has always held a view that if this income derived by a PSB is distributed to an associate (e.g., children or spouse not working within the PSB) or retained in a lower tax paying entity, Part IVA could apply. However, they have not provided any recent significant guidance on when Part IVA could apply to these sorts of arrangements.

For example, let’s assume Tim is providing legal services through Tims Consulting Pty Ltd (Tims Consulting). There are two ways Tims Consulting will be taxed:

If entity does not pass the one of the PSB tests	If entity passes one of the PSB tests
Tims Consulting cannot claim certain deductions (such as payments to Tim's spouse for administrative tasks, certain motor vehicle expenses etc.)	Tims Consulting can pay Tim's spouse a reasonable wage for administrative tasks and is not restricted to other deductions denied under the PSI provisions.
Any net income after claiming allowable deductions in Tims Consulting must be "attributed" to Tim.	Income does not have to be “attributed” to Tim and may be distributed by way of dividends to Tim's family members if they are shareholders of the company- *but Part IVA could apply.*
Tim effectively pays tax on the income at his marginal tax rates which could be higher than the company tax rate of 25% or 30%.	Income does not have to be "attributed" to Tim and may be retained in the company and be subject to 25% or 30% tax - *but Part IVA could apply.*

The whole purpose of this ATO guidance is to shed light on the “but Part IVA could apply” aspect of the above.

The ATO’s risk guidance

The indicators for low and high risk arrangements are as follows:

Low-risk indicator	Higher-risk indicator
The net PSI is distributed to the individual whose personal efforts or skills generated the income and taxed at their marginal rate.	The net PSI is distributed to another entity so that it is taxed at an overall lower rate than if the individual had received the income directly.
The remuneration received by the individual is substantially commensurate with the value of their personal services.	The remuneration received by the individual is less than commensurate with the value of their personal services.
Remuneration (for example, salary or wages) is paid to an associate (or a service trust or company) for bona fide services related to the earning of the PSI if that amount is reasonable for the services provided by them.	The PSB does not distribute any income to the individual who provided the actual services.
There is a timing difference between the earning of the PSI and the distribution of net PSI to the individual for reasons outside the control of the individual and PSB or where the delay can be explained by circumstances not attributable to tax. This creates only a temporary deferral of tax to a following income year.	The net PSI (or a part thereof) is split with an associate of the individual, thereby reducing the overall income tax liability.
The PSB makes a superannuation contribution on behalf of the individual, who is an employee of the PSB, for the purpose of providing a superannuation benefit.	Remuneration is paid to an associate (or a service trust) that is not commensurate with the skills exercised or services provided by the associate.
There is a temporary retention of profits to acquire an asset for a clear commercial purpose.	The net PSI (or a part thereof) is retained in the PSB. In most cases, the retained funds are subsequently made available to the individual for their personal use (for example, via a complying Division 7A loan), however, the mere fact that PSI is retained is a sufficiently higher-risk indicator.

The ATO’s view of remuneration being commensurate to the services being provided by the individual is as follows:

In most cases, a salary or other distribution that is commensurate with the duties and responsibilities of the individual will be the gross amount received by the PSE less allowable deductions (other than deductions associated with income splitting).

The key theme of the PGC 2024/D2 is that if substantial amounts of income is being retained in a structure (e.g., company) or the income is being distributed to family members which would exceed their contributions to the PSB, Part IVA could apply meaning the taxpayer could be subject to higher rates of tax, penalties and interest charges.

Going back to the example of Tim’s Consulting above, we make the following observations:

If Tim’s Consulting generates $500,000 income in a particular year, the company can pay Tim’s spouse a reasonable wage for services rendered to the business. This needs to be documented to ensure the wage is reasonable and if the company is paying an unreasonably high salary to his spouse, Part IVA could apply.
Tim’s Consulting can claim a deduction for his spouses’ wages and other entity specific deductions (ASIC fees, accounting and tax services etc.).
Let’s assume, after claiming all the allowable deductions above, Tim’s Consulting has a profit of $400,000.
Tim’s Consulting pays Tim:
- $200,000 in wages and retains the remaining $200,000 which is then subject to the 25% corporate tax rate. Tim’s rationale for doing this is that if he was working in a consulting firm, that is a reasonable wage to the principals/directors.
  
  In this circumstance, Part IVA could be a risk even though Tim is drawing a substantial salary. The ATO’s view is that $200,000 is being retained in the company and subject to the 25% corporate tax rate. This could be subject to the anti-avoidance provisions because the tax rate is lower than Tim’s marginal tax rate (47%) and the remuneration received by Tim may not be substantially commensurate with the value of his personal services.
- $375,000 in wages and retains $25,000 for working capital. In this circumstance, the Part IVA risk may be considered low.

Next steps

If you are trading through an interposed entity and are impacted by the ATO’s guidelines, get in touch with your Moore Australia advisor to see how these views may impact your tax planning and strategies going forward.