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% 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 will be liable 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% 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 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.
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 therefore 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.
Peter Bembrick is a Tax Partner at HLB Mann Judd, Sydney. This article is for general information only. It should not be accepted as authoritative advice and any person wishing to act upon the material should obtain properly considered advice which will take into account their own specific circumstances.