The AAT has affirmed that income received for engineering services was subject to the personal services income (PSI) rules, as the partnership business did not pass the results test.
The facts were as follows:
- The taxpayer was the sole service provider of a control systems engineering business, carried on by the taxpayer and his wife in partnership.
- It typically operated by contracting with a labour hire firm, to provide the taxpayer’s services, to that firm’s clients, including, in this case, working on large infrastructure projects in WA.
- In the dispute years (2013 and 2014), the business income was split equally between the taxpayer and his spouse (via a partnership).
- The ATO issued amended assessments including all the business income in the taxpayer’s assessable income with additional assessments for 50% of the shortfall in tax (applicable for ‘recklessly’ making the false or misleading statements in his income tax return.
The taxpayer argued that income splitting was permissible, despite the operation of the PSI rules. He further argued that the PSI rules did not apply because the business passed the “results test” in s 87-18 of the ITAA 97 (ie principally that at least 75% of the income is for “producing a result”).
The PSI rules are designed to address the tax results of what is sometimes called ‘sham contracting’ (ie. contracting that is in substance employment). It has 2 main focuses:
- First, to trim back deductions that a taxpayer might claim, for being a business, that wouldn’t be available if they were mere employees. This is under Div 85, unless the taxpayer was carrying on a ‘Personal Services Business’.
- Second, to avoid a taxpayer avoiding tax on the income for his/her personal efforts or skills (ie. ‘Personal Services Income’). This is under Div 86, but it does not apply to a ‘personal services entity’ that is carrying on a Personal Services Business (s86-15(3)).
‘Personal Services Business’ therefore is an important term (Div 87).
- The taxpayer must satisfy at least 1 of 4 tests of independence, if 80% or more of the individual’s income comes from the same source (s87-15(2)&(3)).
- Those 4 tests are:
- The ‘results test’ (in s87-18) – which requires the income to have been paid for producing a result, for which the individual/entity would be liable to rectify (if there were a defect) and the individual/entity, supplied all the tools and other plant and equipment.
- The ‘unrelated clients test’ (in s87-20) – which requires the individual/entity to have advertised their services to the public, and have, as a result at least 2 unrelated clients (during the year).
- The ’employees test’ (in s87-25) – which requires the individual/entity to have engaged at least one other (unrelated) entity who/which does at least 20% of the individual’s/entity’s principal work for that year (measured by ‘market value’).
- The ‘business premises test’ (in s87-30) – which requires the individual/entity to conduct the activities (from which the PS income is derived) from business premises, to which the individual/entity has exclusive use and that are physically separate from privately used premises or premises of the client entity (and this is a whole of year test).
The AAT affirmed the amended assessments,
- It said that taxpayer confused “working [as part of a team] for an overall result” with the requirement in s 87-18, ie that of “income…for producing a result”.
- The AAT considered the former to be so general that it would mean that all engineers engaged to work by contract would be excluded from the PSI rules.
- Accordingly, the income received in the dispute years was not for producing a result – but rather was for the work performed by the taxpayer – which meant that the business was NOT a personal services business.
The AAT also upheld the imposition of a 50% penalty for recklessness.
(Douglass v CofT  AATA 3729, AAT, Taylor SM, 3 October 2018.)
NOTE: the Taxpayer has appealed this result (in Nov 2018) – see related Tax Technical article. FJM 29.11.18
CPD questions (answers available)
- Was the result of this case that the taxpayer was assessed on all the income paid for providing his services, to a large WA infrastructure project, through a labour hire firm (instead of half of it being taxed to his wife, as a partner in their so called ‘engineering business’?
- Was this because the PSI rules applied?
- Was the partnership a Personal Services Entity?
- Did it carry on a Person Services Business?
- Did it pass the ‘results test’?
- Did it pass any of the other 3 tests?
- Did the Taxpayer succeed in getting the 50% ‘reckless’ penalty reduced?