This month, my column focuses on the PAYG withholding obligations that can arise under the Personal Services Income (PSI) rules. Both the PSI and the PAYG withholding rules have been around for 20 years, but there are still misunderstandings about their interaction.
The PSI rules
The PSI rules were introduced in 2000 to ensure that individuals could not alienate their PSI. This happens when individuals use companies and trusts in an attempt to alienate income that would be assessable to the individual and instead seek to tax the income at the corporate tax rate or split the income with other taxpayers, typically family members through the use of a trust. The rules continue to be a frequent source of confusion for taxpayers and practitioners. There is some commentary that incorrectly believes that the current rules support alienation of PSI, whereas they actually codify and strengthen the court rulings of the 1980s that clamped down on such practices.
An entity that derives PSI is referred to as a “personal services entity” (PSE). Where a PSE does not conduct a personal services business (PSB), certain tax consequences arise. The meanings of “PSI” and “PSB” are contained in Div 84 and Div 87 of the ITAA 1997, respectively, and ATO rulings TR 2001/7 and TR 2001/8 provide further guidance. Broadly, PSI is income that is mainly a reward for the individual’s personal efforts or skills.
Broadly, a PSE conducts a PSB if it:
○ the results test;
○ the unrelated clients test;
○ the employment test; or
○ the business premises test; or
• obtains a PSB determination from the ATO.
Where a PSE is not conducting a PSB, the rules operate to attribute the PSI derived by the PSE to an individual. This is achieved by requiring the individual to include the attributed income in their assessable income.
However, the rules do not:
• imply that the individual is an employee nor treat them as if they are an employee; or
• displace any commercial or contractual relationships nor treat the PSE as if it were not carrying on a business.
A PSE that fails the PSI tests is not conducting a PSB, but this does not mean the PSE is not carrying on a business for other purposes. This distinction means that, even if it is not conducting a PSB, a PSE may still be eligible for COVID-19 stimulus measures such as the cash-flow boost (confirmed by recent legislative amendments) and JobKeeper and for other business concessions such as the $150,000 instant asset write-off.
Even if a PSE conducts a PSB, it needs to have regard to the general anti-avoidance rules in Part IVA which may apply if the company or trust is used to retain profits from PSI in the entity or split PSI with an associate which reduces the overall income tax liability. Satisfying the PSI tests does not change the nature of the income — it is still personal exertion income.
Consequences if the PSI tests are failed
If the PSE does not conduct a PSB, there are three tax consequences:
- The income is attributed to the individual and included in their assessable income.
- Deductions are limited when working out the amount of net PSI that is attributed (see Div 85 and Div 86).
- The entity has additional PAYG withholding obligations if the PSI received by the PSE is not promptly paid to the individual who performed the service as salary or wages.
“Promptly paid” means the salary or wages are paid within 14 days after the end of the PAYG payment period in which the income was derived by the PSE. When a PSE works out how much income is attributed to the individual, certain amounts can be taken into account such as entity maintenance deductions, some car expenses and superannuation contributions, and salary or wages promptly paid to the individual. Salary or wages promptly paid are deductible to the PSE but are removed from the amount that is attributed to the individual because such amounts are already assessable to the individual.
PAYG withholding obligations
A PSE has PAYG withholding obligations for:
• salary or wages promptly paid to the individual who produced the PSI;
• amounts attributed to the individual who produced the PSI which has not been promptly paid to them as salary or wages.
If the PSE has a net PSI loss for an income year, there are no additional PAYG withholding obligations as there is no income to attribute.
How often does the PSE need to pay PAYG withholding?
The PSE needs to work out any additional PAYG withholding amounts for each activity statement so the correct tax can be paid in respect of the attributed PSI. The frequency of paying and reporting withheld amounts depends on whether the PSE is a small or medium withholder (a PSE is unlikely to withhold amounts totalling more than $1 million).
If the PSE withholds:
• no more than $25,000 a year – it is a small withholder and must pay and report quarterly;
• more than $25,000 to $1 million a year – it is a medium withholder and must pay and report monthly.
Annual earnings of $100,000 equates to withholding of more than $25,000. This illustrates the relatively low threshold that applies for a PSE to be a monthly withholder.
Some PSEs fail to report and pay PAYG withholding on PSI, thinking it is acceptable for the individual to declare the amounts in their tax return and rely on the PAYG instalment system to deal with the tax. While this may not result in the wrong amount of tax ultimately being paid, it is not correct under the law. Where a new business is involved, other PSEs register for PAYG withholding after the end of the year instead of when the business commences. Such PSEs could face penalties and company directors could face personal liability for unpaid or late-paid PAYG withholding.
It may be difficult for a PSE to accurately work out the attributed income amount each month or quarter, so there are two simplified methods, in addition to the legislative method. If either of the two simplified methods are correctly used, penalties will not apply if, at the end of the income year, less tax is withheld than should have been.
ATO guidance explains in detail how to work out any additional PAYG withholding amounts.
Better described as the “actual method”, this method requires the PSE to work out the attributed PSI for each PAYG payment period by taking the actual PSI (excluding GST) received by the business and subtracting salary or wages promptly paid to the individual and deducting certain amounts that can be claimed against the PSI.
The legislative method more closely matches the PAYG withholding obligations with the actual PSI and expenses. However, it is more time-consuming, requires greater accuracy and increases the risk of penalties if the calculations are incorrect and insufficient tax is withheld.
70% of PSI method
This alternative method requires the PSE to report and pay PAYG withholding on 70 per cent of the PSI (excluding GST) received in the PAYG payment period.
This method is the simplest, does not require deductions to be taken into account and minimises the risk of penalties for underpayment of tax.
Percentage from previous income year method
This alternative method requires the PSE to report and pay PAYG withholding based on the percentage the net PSI bore to the gross PSI from the previous income year.
Regardless of the method chosen, the attributed income should be shown at label W1 on the activity statement and the amount of tax withheld at label W2.
An employer who reports through Single Touch Payroll is not required to provide their employees with a payment summary after the end of each income year. Alienated PSI payments cannot be reported through Single Touch Payroll, so the PSE is still required to issue a PAYG payment summary – business and personal services income to the individual by 14 July each year and report the PAYG withholding to the ATO by 14 August using a payment summary annual report.
Alienated PSI payments do not form part of “ordinary time earnings”, so they are not subject to superannuation guarantee and they are generally not subject to WorkCover either.
The Board of Taxation reviewed the PSI regime in 2009. In releasing the Board of Taxation’s review into whether the tax rules on the alienation of PSI are proving effective, the then assistant treasurer, Nick Sherry, announced on 16 December 2009 that:
The Board has found evidence of a low level of compliance and a degree of uncertainty or “greyness” around the rules, such that it has found the alienation of [PSI] rules in their current form do not provide acceptable levels of integrity and equity.
The assistant treasurer also stated:
… these findings are of concern, so we have passed the Board’s report to the Australia’s Future Tax System review. The Government will wait for the final report of the Henry review before determining the appropriate action in this area.
Recommendation 10 of the Henry review recommended a revised regime to prevent the alienation of PSI. However, no reforms to the PSI rules emerged from the Henry review and the concerns raised by the Board of Taxation in 2009 remain valid today. This area of taxation can be added to the growing list of those in need of reform.
Robyn Jacobson, senior advocate, The Tax Institute