Contractors & Personal Services Income - Part 1

Introduction

The independent contractors industry has been the subject of focused review by the Australian Taxation Office (ATO), the State Revenue Office (SRO) and the Fair Work Ombudsman (FWO).

The Federal and State taxation and regulation of labour is complex, inconsistent and uncertain.

Incorrectly classifying the relationship between the end user, any intermediary and the worker can have significant tax consequences for them.

Tax planning and non-compliance are of significant concern to revenue authorities since personal income tax accounts for 37% of total Federal tax revenue and payroll tax accounts for 46.6% of total Victorian tax revenues (Henry Review at A1.4 & 11; VSRO ANN-016 pg. 14).

Legislative references are to the Income Tax Assessment Act 1936 (ITAA 1936), the Income Tax Assessment Act 1997 (ITAA 1997), the Taxation Administration Act 1953 (TAA 1953), the Superannuation Guarantee (Administration) Act 1992 (SGAA 1992) and the Payroll Tax Act 2007 (Vic) (PTAV 2007).

Personal Services Income (PSI) Reviews & Taskforces

The Board of Taxation PSI Report (2009) and Henry Review (2010) have identified numerous issues with the PSI regime and has recommended legislative amendments and more robust reporting and data matching.

The ANAO’s PSI Review of the ATO administration of PSI (2013) has noted an 81.5% audit adjustment rate, increased voluntary reporting of PSI, an increase in the net PSI declared and a decrease in the use of interposed entities.

The Coalition Government has confirmed its commitments to independent contractors, has stated it will not change the current laws relating to the treatment of PSI and has criticised the ATO, SRO and FWO for an attack on the self-employed (AICD Magazine 01/02/2014 Q & A with Bruce Billson).

Where that leaves needed PSI legislative and tax administration reform is unclear.  The Tax White Paper will hopefully address PSI reform.

Relationship classification

Various tax legislation distinguish between an employee, a dependent contractor that is treated as an employee equivalent and an independent contractor.  It is difficult to draw a clear dividing line separating an employee from a dependent contractor and from an independent contractor.

On Call Interpreters & Translators Agency P/L v FCT (No 3) [2011] FCA 366 arguably represents an evolution in the approach to separating an employee from an independent contractor by adopting the ‘entrepreneur test’:

  • is the worker an entrepreneur owner and operating a business; and
  • is the worker working in that business or in the business receiving the work?

The court posed 9 questions in determining whether the worker is conducting a personal service business and 17 questions in determining in whose business the activities are being performed.  These questions employ the relationship principles detailed in TR 2005/16 and SGR 2005/1 (e.g. control, orginisation integration, results contracts, subcontracting rights, risk liability, etc.).

After properly weighing these relationship principles, reasonable practitioners can still differ on whether the same worker is an employee, a dependent contractor or an independent contractor.

Dependent Contractors

To address difficulties with delineating employees from contractors that are employee-like, various legislation has enacted extended definitions of employee to include dependent contractors that are employee-like.

Under the PSI rules, income derived by an individual or entity mainly from the personal efforts or skills of an individual is treated and taxed similarly to employment income, unless the individual or entity is conducting a personal services business.

The SG Charge has extended the definition of employee to a person under a contract that is wholly or principally for the labour of the person (whether of that or another entity) (SGR 2005/1).

Payroll tax applies to relevant contracts under which a designated person (i.e. contractors) in the course of a business supplies to or receives from another person services for or in relation to the performance of work.

WorkCover obligations applies to contractors where the provision of materials or equipment are not a principal object of the arrangement, at least 80% of the work by gross contractual income is performed by the same individual and at least 80% of the work by gross contractual income is earned from the same end user (VWA Contractor Guideline).

Long service leave does not generally apply to independent contractors.  However, outworkers in the clothing industry are deemed worker for long service leave (Outworkers (Improved Protection) Act 2003 (Vic)).

A number of contractor relationships relevantly dependent on an employee like relationship are taxed as employees for some, but not other legislative purposes.

Odco Tri-partite Structuring

A common planning approach was to enter into a tri-partite relationship between the worker, the end user and the intermediary to diffuse the relationship principles so that worker is not an employee of either the end user or the intermediary (BWIUA v Odco P/L (1991) 29 FCR 104; ACC v Odco P/L [1990] HCA 43).

To address the structure, intermediary provisions have been enacted for PAYG withholding (sec. 12-60 TAA 1953) and payroll tax (Pt. 3 Div. 8 PTAV 2007).  The ATO also applies the extended definition of ‘employee’ in the SG Charge legislation to intermediaries (SGR 2005/2).

Independent Contractors

If a worker is not subject to the above, then the worker will be an independent contractor.

Remuneration taxation

Remuneration paid to the worker (sec. 6-5(1) ITAA 1997) or applied or dealt with on behalf of or as directed by the worker (e.g. paid to an interposed entity) (sec. 6-5(4) ITAA 1997) is taxed to the worker.

If a payment to an interposed entity is applied or dealt with on behalf of or as directed by the worker, the worker is taxed on the payment before receipt by the interposed entity and the PSI rules do not apply.

It is unclear whether an existing right to a present or future receipt of remuneration or some degree of control over the payment or the amount of the payment is a precondition to sec. 6-5(4) ITAA 1997 applying (R. Parsons, Income Taxation in Australia, at 766).

The better view is that an existing right to a present or future receipt of remuneration is a precondition to sec. 6-5(4) ITAA 1997 applying (FCT v Mochkin [2003] FCAFC 15; TD 2001/10; Clarke v FCT (1992) 23 ATR 102; (1992) 24 ATR 230).

Statements in FCT v White [2010] FCA 730 at [6] & [14] might infer that no existing right to the income is necessary and that no control of the payment or amount of the payment is necessary.  Arguably, the court’s statement must be read down in light of the Tribunal’s conclusion that the worker controlled the payer and the recipient entities.

The ATO appears to be applying the broader interpretation so that where the payer is unrelated and there is no direction from the taxpayer, any payment to the interposed entity would be derived by the worker under sec. 6-5(4) ITAA 1997.

There will be no derivation or constructive receipt by the worker where there is a valid assignment of property or future rights to income to an interposed entity (IT 2121 at [20]; IT 2403; FCT v Purcell [1921] HCA 59; FCT v Everett [1980] HCA 6 FCT v Mochkin [2003] FCAFC 15).

If the payment is not remuneration for services under the above rules, then the personal services income (PSI) rules may apply.

PSI rules taxation

Income derived by an individual or entity mainly from the personal efforts or skills of an individual is treated and taxed similarly to employment income, unless the individual or entity is conducting a personal services business (sec. 86-10 ITAA 1997) or the ATO makes a PSI business determination.

The results test, unrelated clients test, employment test and the business premises test determine whether a personal services business is being conducted (TR 2001/8).

The results test is satisfied in an income year if, in relation to at least 75% of the personal services income, the income is for producing a defined result and the individual or entity is responsible for providing any necessary plant, equipment and tools and for rectifying any defective work (sec. 87-18 ITAA 1997).

The worker cannot apply the unrelated clients test, the employment test or the business premises test if 80% or more of the personal services income is derived from the same entity (or the entity’s associates) (sec. 87-15(3) ITAA 1997).

The unrelated clients test is satisfied in an income year if, 80% of the personal services income is not derived the same entity (or associated group of entities), and the individual or entity providing the services offers services to the public at large (sec. 87-20, 87-15(3) ITAA 1997).

The employment test is satisfied if at least 20% of the income by value is earned from engaging at least one non-associate to perform the principal work (e.g. consulting not administration).  The engaged entities must not be individuals whose PSI is included in the entity’s income (sec. 87-25 ITAA 1997; ATOID 2002/805).

The business premises test is satisfied if at all times the work is done from exclusive use premises that are physically separate from any domestic premises (e.g. main residence or holiday home) and from any associate’s premises (sec. 87-30 ITAA 1997).

Instead of self-assessing the PSI rules, a worker or interposed entity can apply for a personal services business determination if the results test, unrelated clients test, employment test or business premises test is met or could reasonably be expected to be met and there are special circumstances for not meeting the test (sec. 87-60 ITAA 1997 (individuals) or sec. 87-65 ITAA 1997 (entities)).

The expression of the personal services business determination conditions is convoluted and appears to be administered restrictively, particularly in regard to what constitutes unusual circumstances (Creaton P/L v FCT [2002] AATA 1121).

GAAR

Where a taxpayer obtains a tax benefit under a scheme and the taxpayer or some other person entered into or carried out the scheme for the sole or dominant purpose of enabling the taxpayer to obtain the tax benefit, the ATO may disregard the scheme and reconstruct the scheme and tax the taxpayer on the reconstructed basis (Part IVA ITAA 1936).

The GAAR does not apply to the provision of work through an interposed entity (company, trust or partnership) when the arrangement is explicable as an ordinary business or commercial arrangement (IT 2330 at [7(5)]) or step to take, does not result in the splitting of income and the arrangement is conducted along normal business lines (IT 2373 at [5]).

The 8 criteria of Part IVA, can be analysed having regard to the following PSI principles (IT 2121; IT 2330; IT 2373; IT 2503):

  • The interposed entity must not be a sham so has legal effect.

  • The interposed entity must be carrying on or actively engaged in the enterprise.

  • The interposed entity must assist the provision of the activities such as providing limitation of liability.

  • The interposed entity must own any assets and carry on the enterprise for the benefit of the interposed entity.

  • The interposed entity must be lawfully permitted to carry on the enterprise.

  • The interposed entity is not conducted as the alter-ego of the worker-owner.

  • The nature or source of the income must not be ‘predominantly’ from the personal exertion of the worker-owner.

  • The interposed company does not retain income taxed at corporate rates.

  • The worker-owner does not retain the power to revoke or alter the transfer of the enterprise to the interposed entity.

  • There must be a change in the control by and the operation procedures between the end user and the worker-owner.

  • The end user must not continue to provide the worker-owner employee equivalent benefits (leave, expense reimbursements).

In determining whether income is from personal exertion so is being split, the ATO has inferred a dichotomy between ‘income from personal services’ and ‘income from the business structure’ (IT 2639 at [8]).  This dichotomy is being reviewed (TA 2013/23).

The objective assumption of and liability for trading and financing risk should be the central issue to determine the application of the GAAR.  Silent partners or investors and owners that do not actively work in the enterprise that are fully exposed to the trading and financing risk are being rewarded for that risk and the GAAR under the guise of personal exertion income should not remove the return for that risk.  FCT v Mochkin [2003] FCAFC 15 can be interpreted in this light.

The scheme can be framed as the interposing of an entity to divert income to others or the interposing of an entity and the failure to pay minimum remuneration to the worker (Case W58 89 ATC 524; FCT v Mochkin [2003] FCAFC 15).

The ATO asserts that Part IVA may apply to the failure of an interposed entity to pay an owner-worker remuneration commensurate with the continuing duties and responsibilities performed for the interposed entity (IT 2330 at [29).

Minimum professional remuneration equivalent

On 1 September 2014, the ATO issued draft Guidelines for the allocation of profits within professional services firms where the income of the firm is not personal services income.  The Guidelines rate an arrangement as low risk and not subject to compliance action if directly or indirectly:

  • the owner-practitioner receives assessable income at least equivalent to the highest band of professional employees providing equivalent services to the firm, or if there a no such employees, as determined by reference to comparable firm or industry benchmarks;
  • the owner-practitioner receives at least equivalent to 50% of the income to which the owner-practitioner and associated entities are collectively entitled; or
  • the owner-practitioner receives and any associated entities that receive distribution are subject to at least an effective 30% tax rate.

The BOT PSI review recommended legislative change to attribute a minimum remuneration to the services of the worker as PSI under a domestic transfer pricing rule.  The Coalition Government appear to have rejected the recommendation.

Arguably, the ATO through Guidelines should not administratively impose a minimum remuneration requirement that is not supported by legislation, is contrary to the stated policy position of Government and is inconsistent with the rights of taxpayers to structure business and investments (Victorian Stevedoring & General Contracting Co P/L v Dignan (1931) 46 CLR 73; Tweddle v FCT (1942) 7 ATD 186; Cecil Bros P/L v FCT (1964) 111 CLR 430).

Professional discretionary trusts

In TA 2013/23, the ATO has stated that the making of a discretionary trust a partner in a professional practice that does not actively engage in the conduct of the firm’s practice, does not hold professional qualifications, does not limit the practitioner-worker’s liabilities, does not pay a commercial remuneration to the practitioner-worker or continues to represent the practitioner-worker to the public as a partner may not be effective to split income under PSI rules and the GAAR.

The alert raises a number of potential issues, including the ability for fixed draw rather than equity practitioner-workers to make a discretionary trust a partner in a professional practice and the ability for the practitioner-worker and a related discretionary trust to both be partners in the professional practice (a relatively common structure).

Importantly, TA 2013/23 formally advises practitioners that the current rulings of Part IVA professional practices and alienation of personal exertion income are under review.