Part IVA looms over PSI rules

The ATO’s position is neither new nor surprising, given the context in which the position evolved, as I explain below. Yet some practitioners may have advised clients on their PSI arrangements based on a different interpretation of the rules.

Somewhat surprisingly, the courts have not yet examined the ATO’s stance, and a judicial review of its approach would be beneficial given the uncertainty of this issue over several decades. Nonetheless, the position adopted by the ATO appears to be well-founded. Part IVA can still apply to a PSI arrangement, even if the PSI tests are satisfied. This position may not accord with the understanding of some practitioners.

The emergence of case law in the 1980s

The ATO’s long-standing views on the treatment of PSI and the potential application of Part IVA to income splitting and profit retention arrangements originally stemmed from the predecessor to Part IVA, former section 260 of the ITAA 1936. That provision was considered by the courts more than 40 years ago in several unrelated cases, which concluded that the general anti-avoidance rule could apply where PSI was alienated. Notable cases include the Federal Court decision in Tupicoff v Commissioner of Taxation [1984] FCA 353 and the High Court ‘Three Doctors case’, Federal Commissioner of Taxation v Gulland, Watson and Pincus [1985] HCA 83.

The ATO’s published view followed these decisions, in the form of taxation rulings IT 2121, IT 2330, IT 2503 and IT 2639. The rulings are still in force, reflecting the ATO’s long-held view that income derived from personal exertion should be assessed to the individual whose personal efforts and skills led to the earning of that income.

Designing the PSI rules

Emerging from the 1999 Review of Business Taxation, page 287 of the review’s final report, A Tax System Redesigned (final report), states: ‘It is a fundamental principle of most tax systems that income derived from the personal exertion of an individual – payments in respect of personal services – cannot be alienated.’

The PSI provisions commenced on 1 July 2000. They were designed to codify in legislation the principles established by case law and the ATO’s long-entrenched view in the old series of taxation rulings, as explained on page 290 of the final report:

Case law in Australia supports the view that, for income tax purposes, the income in these cases is properly that of the individual performing the services. However, no specific provisions in the taxation law deal with the taxation consequences of such arrangements. The current approach generally requires that the general anti-avoidance rule be applied to the facts of each individual arrangement on a case-by-case basis and that the Commissioner of Taxation determine that the purpose of entering into an arrangement was to gain a tax benefit.

The final report also mentions on page 292 that:

Alienation cases that are not employment-like will continue to be considered under the general principles of the taxation law, including the general anti-avoidance rule.

Subsequently, the early taxation rulings on the PSI rules (issued in 2001) were rewritten as TR 2022/3, which explains that the general anti-avoidance provisions of Part IVA may still apply to cases where the PSE is considered to be conducting a PSB and the PSI rules do not apply. In particular, the ATO may seek to apply Part IVA where there are factors indicating that the dominant purpose of the arrangement is to obtain a tax benefit by diverting, alienating, or splitting an individual’s PSI, or by retaining profits in a lower-taxed PSE.

Deciphering how Part IVA can apply where the PSI tests are satisfied

Income from a business structure versus PSI

The threshold question as to whether income is PSI is a common area of confusion.

It is pertinent to remember that the PSI rules do not apply to income generated from the profit-yielding structure of the business carried on by an entity. Whether income is mainly a reward for the personal efforts or skills of an individual or is derived from a business structure depends on various factors, including:

• The number of arm’s length employees or others engaged by the entity to perform work and their relative contribution to the income-earning activities.

• The existence of goodwill.

• The size of the operation.

• The extent to which the income is dependent upon a particular individual’s own personal skills, efforts or expertise.

These factors are particularly relevant to professional services firms. With respect to the factor of the number of arm’s length employees, paragraph 8 of IT 2639 explains:

The more substantial the number of employees, practitioners or technicians used in a practice the more probable it is that the income is derived from the business structure rather than from the rendering of personal services … For example, large accounting and legal firms with tens, or even hundreds, of practitioners but without extensive or substantial equipment would also be considered to be generating their income from their business structure.

Income from supplying and selling goods is not PSI and can be split with family members or related entities.

But not all income earned by professional persons is derived from a business structure. The income of a professional practising on their own account without professional assistance, or income payable under a contract which is wholly or principally for the labour or services of a person, is PSI. Such income:

• Is generated from the professional’s personal efforts or skills.

• Represents PSI of the professional.

• Cannot be split.

It follows that the tax on that income should be borne by the person who derived it. This applies to all ‘white-collar professionals’, such as doctors, lawyers, architects, and IT professionals, as well as to ‘blue-collar professionals’ and skilled tradespersons, such as electricians and plumbers.

Consequences of conducting a personal services business

Where a PSE satisfies one or more of the PSI tests, the PSE is conducting a PSB. The benefits of conducting a PSB are threefold (the three consequences):

1. The PSI derived by the PSE is not attributed by the PSI rules to the individual.

2. The PSI rules do not restrict deductions that would otherwise be limited if the PSE were not conducting a PSB.

3. The PSE does not have additional pay-as-you-go (PAYG) withholding obligations if the PSI received by the PSE was not promptly paid as salary or wages to each individual who performed the service.

Nothing in the PSI rules prevents Part IVA from applying to income-splitting arrangements. In fact, while the object of the alienation provisions is to ensure that individuals cannot reduce or defer their income tax (and other liabilities) by alienating their PSI through companies, partnerships or trusts that are not conducting PSBs, a note in section 86-10 of the Income Tax Assessment Act 1997 (ITAA 1997) specifically states that the general anti-avoidance provisions of Part IVA may still apply to cases of alienation of PSI that fall outside Division 86. The ATO clarifies this at paragraph 160 of TR 2022/3, which states that Part IVA may still apply to cases where the entity is conducting a PSB, and the PSI rules do not apply.

Some taxpayers have wrongly assumed that Part IVA cannot apply to their arrangements where they pass the PSI tests and are conducting a PSB, but Part IVA has always had the potential to apply in these circumstances. These misperceptions have persisted for as long as the rules have been around, despite:

• The existence of the PSI regime in the tax law for 25 years.

• The ATO’s long-standing published view that Part IVA (and its pre-1981 predecessor, former section 260) can apply to income splitting and profit retention arrangements.

• The tax law stating that Part IVA can apply.

• Many court cases where these provisions have been found to apply to the alienation of PSI.

The key misunderstanding relates to the benefit of conducting a PSB – a PSE that conducts a PSB does not have carte blanche to split or alienate its income. Conducting a PSB doesn’t mean the PSE can split the income; it means the three consequences outlined above do not arise. Why? Because it’s still PSI and is therefore personal exertion income. Personal exertion income cannot be diverted, alienated or split, and generally cannot be retained within the entity to be taxed at a lower tax rate. If the income wasn’t PSI (refer to the threshold question above), there would be no need to apply the PSI tests in the first place. The counterclaim that satisfying the PSI tests means Part IVA cannot apply is not supported by the legislative framework and the historical case law.

As discussed, the ATO’s guidance from the mid-1980s and judicial decisions have confirmed that Part IVA can apply to alienation arrangements involving income splitting and retention of profits where the dominant purpose of a participant in a scheme is to obtain a tax benefit. However, the formation of these principles predates the commencement of the PSI rules in July 2000. Some taxpayers may not have fully appreciated the ongoing relevance and application of the older case law precedents and guidance to arrangements where the PSI rules do not apply.

With the focus on the current legislative provisions and contemporary ATO guidance, it’s understandable why the principles regarding alienation of personal exertion income, which are not enshrined in legislation, and which were established in the late 1970s and 1980s, may have been overlooked in some cases.

ATO’s latest guidance

The ATO’s latest guidance in Practical Compliance Guideline PCG 2025/5 seeks to explain when the ATO is more likely to apply its compliance resources to consider the potential application of Part IVA to an income splitting arrangement where the PSI of an individual is derived through a PSE that is conducting a PSB (i.e. even where the PSI rules don’t apply to attribute the income).

The PCG states that it applies to arrangements entered into both before and after 28 November 2025 (being the release date of PCG 2025/5). This means that past arrangements, as well as future arrangements, could attract the ATO’s attention where they are considered ‘higher-risk’. The ATO is less likely to apply its compliance resources to ‘low-risk’ arrangements.

Importantly, the PCG does not indicate the likelihood of Part IVA applying to an arrangement; only the likelihood of the arrangement bringing Part IVA into question and the ATO reviewing that arrangement. There is no ‘safe’ level of PSI diversion, but the greater the extent to which PSI is alienated, the higher the likelihood of Part IVA applying to the arrangement.

Retention of income in a company at a lower tax rate than that faced by the individual, inadequate remuneration paid by the entity to the individual for their services, or splitting of their income with an associate are all considered higher-risk arrangements.

A comment on service entity arrangements

Interestingly, the inclusion of amounts paid to a related service trust that is not commensurate with the services provided by the associate is also deemed a higher-risk arrangement. Service entities attracted the ATO’s attention nearly 50 years ago, with Federal Commissioner of Taxation v Phillips [1978] FCA 28. Taxation ruling IT 276 was issued in response, supplemented by the issue of TR 2006/2 in 2006 to address misconceptions and confusion about the use of service entities.

There are legitimate, commercial reasons why service entity arrangements may be used, which the ATO accepts (in TR 2006/2). However, the charging of service fees by a related entity can constitute an income splitting arrangement, designed to divert PSI to another entity. This can occur where the service fees are artificially inflated or have little or no commercial basis. Such a contrivance would generally already be of interest to the ATO, so the potential diversion of PSI only increases the risk of ATO compliance activity.

Closing comments

Given the number of decades the ATO has been trying to reinforce their position on the application of Part IVA to income-splitting arrangements where the PSI rules do not apply to attribute the income to the individual (because an entity carries on a PSB), the release of this latest guidance is unsurprising.

It would be prudent for taxpayers to review their arrangements and ensure they do not alienate their PSI, even where a PSB is being conducted.

Robyn Jacobson is a tax advocate and specialist with over 30 years in the tax profession.