Andrew Briggs and Craig Holland from Deloitte Touche Tohmatsu warn that you need to be aware of the tax implications of engaging in practices which aim to reduce the tax liability on fees received for being a company director.
There is no question that salary and wages or directors’ fees received for carrying out the role of company director need to be declared as assessable income. Yet over many years individuals and business owners have structured their affairs with the aim of reducing their tax liability. A common practice is for taxpayers to set up a family company or trust to receive income from what are basically personal services provided by the taxpayer on an employee-like basis. The objective of this arrangement is to reduce their overall tax liability by diverting income to taxpayers who are in lower tax brackets. As you would expect, a large body of taxation rulings and legislation has been built up to enable the ATO to defeat taxpayers in achieving this objective.
Once the ATO is aware of a director ‘alienating’ income derived from their personal exertion what might their response be? On the assumption that the companies involved allow such an arrangement, the ATO may choose to review the documentation to determine whether the income has been successfully alienated to another entity or whether the income has been merely diverted after it has been received by the director. The latter outcome would result in the director being taxed on this income. Alternatively, the ATO might choose to look at the substance of the arrangement rather than the legal form with a view to reclassifying the director as an employee of the company in question rather than a contractor. Again, this would result in the director being taxed on the income.
However, there is a much easier avenue for the ATO to pursue, and that is to accept that the income from personal services has been successfully alienated and then rely on the provisions contained in Divisions 84 to 87 of the Income Tax Assessment Act 1997. These provisions, known as the Alienation of Personal Services Income (APSI) rules, came into affect from 1 July 2001. Essentially they restrict the ability of a taxpayer to alienate income derived from providing personal services. As you will appreciate, these provisions directly impact upon an individual carrying out the role of company director. Particularly where the director is maintaining that the income derived for carrying out the role is not their assessable income.
The APSI rules do not operate to categorise an individual as an employee. Rather, their effect is to treat the income, whether derived by an individual or through an interposed entity, as income of the individual.
Main points of the APSI rules
- The rules target ordinary and statutory income that is gained mainly as a reward for an individual’s personal efforts and skills. The ATO’s view is that the characterisation of income as personal services income (PSI) will be dependent on the facts of a particular case and ‘mainly’ in this context is defined as more than 50 per cent of the income is a reward for the personal skills or efforts of the individual. It is important to note that income derived from the exploitation of assets would not be classified as PSI.
- An entity whose ordinary or statutory income includes the PSI of one or more individuals is defined as a personal services entity. Typically the entity is interposed between the individual providing the personal services and the entity paying for
- PSI received or diverted to a personal services entity will be attributed to the individual and included in their assessable income. Therefore, the PSI will not be available to income split to associates or to be left in the personal services entity to benefit from a lower rate of tax.
- There are exceptions to the attribution rules. PSI will not be included in the assessable income of the individual if the income is gained in the course of conducting a personal services business or to the extent that amounts are paid to the individual as employee salary or wages within prescribed time limits.
- The amount of PSI included in the individual’s assessable income may be reduced (but not below nil) by the amount of specified tax deductions to which the personal services entity is entitled.
Where an individual or an entity does not pass the personal services business test, tax deductions relating to the PSI are limited.
What is a personal services business?
Personal services income will not be included in the assessable income of the individual if the income is derived in the course of conducting a personal services business. The diagram below, reproduced from section 87-5 ITAA 1997, illustrates how to determine whether PSI is income from conducting a personal services business.
The APSI rules prescribe that:
- the results test must be met; or
- less than 80 per cent of personal services income is from one source and one of three other tests is met; or
- a personal services business determination is in force.
The results test will be satisfied where in relation to at least 75 per cent of the personal services income:
- the income is for producing a result.
- the individual or entity is required to supply the plant and equipment, or tools of trade, needed to perform the work from which the individual or personal services entity produces the result; and
- the individual or personal services entity is, or would be, liable for the cost of rectifying any defect in the work performed.
Where less than 80 per cent of the PSI is from one source, the individual or a personal services entity is considered to be conducting a personal services business where any one of the following tests are met:
- Unrelated clients test – broadly where services are provided to two or more unrelated clients and the services are provided as a direct result of making offers or invitations to the public or to a section of the public.
- Employment test – broadly if at least 20 per cent (by market value) of the individual’s principal work for the year is performed by unassociated entity(s) engaged by the individual.
- Business premises test – broadly if at all times during the year, the service provider maintains and uses physically separate business premises that are available for their exclusive use to mainly conduct their activities.
If more than 80 per cent of the PSI is from one source or any of the personal services business tests cannot be met due to exceptional circumstances, an individual or personal services entity may be able to obtain a determination from the Commissioner that a personal services business is being conducted.
Given the nature of a director’s duties, the individual director will have to consider the application of the APSI rules to their own circumstances. The ATO has numerous booklets, fact sheets and taxation rulings available on its website to assist in this process. The individual director can self assess if less than 80 per cent of the PSI is from one source and one of the personal services business tests are met and it is open to them to determine that they are carrying on a personal services business. The risk is that the ATO may not reach the same conclusion with the consequence that the director may face the prospect of amended assessments that result in additional tax, penalties and interest. This may be significant where the adjustment relates to a number of income years.
Even where the director convinces the ATO that they are carrying on a personal services business, this may not be the end of the story. The ATO has stated that it will seek to apply the anti-avoidance provisions to set aside any taxation benefit where other factors clearly indicate that the dominant purpose of the arrangement is income splitting.
The views in this article are those of the authors and do not represent the views of Deloitte Touche Tohmatsu or any of its related practice entities (Deloitte). This article is provided as general information only and does not consider any one’s specific objectives, situation or needs. You should not rely on the information in this article. Neither the authors nor Deloitte accept any duty of care or liability to anyone regarding this article or any loss suffered in connection with the use of this article or any of its content.
Craig Holland heads the Melbourne Growth Solutions Tax Group, has over 16 years experience and specialises in servicing the tax needs of high net worth individuals, families, private businesses and small cap listed companies.
Andy Briggs is a principal in the Melbourne Growth Solutions Tax Group at Deloitte and has 21 years experience in advising high net worth individuals and their family groups on personal and business related taxation issues.
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