Personal services income (PSI) is income produced mainly from your personal skills or efforts as an individual, other than from salary and wages.
Income is classified as PSI when more than 50% of the amount you received for a contract was for your labour, skills or expertise.
When working out if the PSI rules apply, you need to look at each contract or job to determine if you have received PSI. If you have received PSI (including if you’ve received it as a company, partnership or trust), you then need to work out if the PSI rules apply to that income.
A common scenario that we see is where an individual wants to establish a company to operate a consultancy business. There will be one client, whom the individual has had previous employment with who will be providing a substantial amount of the work (approximately 75%), and a number of smaller clients who the individual has obtained from her work as an employee. The individual will be completing all of the work themselves with no employees and will be paid on an hourly basis. They are not required to provide any tools or equipment to perform the job as they will be working at the clients’ premises. The individual will pay themselves a wage from the company, expecting that any remaining profit can be retained in the company and taxed at the corporate tax rate.
There are a number of steps to work through in determining if the PSI rules apply. We will go through these steps with reference to the above scenario.
Step 1: Have you received PSI?
When working out if your income is PSI, you need to look at the income received from each separate contract. The terms and conditions of the contract, as well as invoices and written agreements (which show the arrangement for the work) are important in working out if the income is PSI.
If more than 50% of the income received for a contract was for your labour, skills or expertise, then all income for that contract is PSI. If 50% or less of the income received for a contract was for your labour, skills or expertise, then none of the income for that contract is PSI.
In regards to our scenario above, the income will be considered PSI as the income is derived from consultancy which is 100% from the skills and expertise of the individual.
Step 2: Results test
If you’ve worked out that your income includes PSI, your next step is to work through the results test. This test is about the nature of your agreement to perform the work, including the basis on which you are paid.
To pass the results test in an income year, you need to meet the following three conditions:
- Paid to produce a specific result
- Required to provide the equipment or tools
- Required to fix mistakes at your own cost
If you pass the test, your business is a personal services business (PSB) for that income year and the PSI rules don’t apply.
You may find that some of your business contracts meet the three conditions of the test and some don’t. To pass the results test, you need to meet all three conditions for at least 75% of the PSI for the income year.
In our scenario above the individual is paid on an hourly rate and therefore, is not paid to produce a specific result. They are also not required to provide any tools or equipment to complete the job. As such, the results test is not passed.
Step 3: The 80% rule
If you’ve worked through the results test but did not pass, your next step is to apply the 80% rule. This step is about your PSI client base and how much of your PSI comes from one client.
For this step, you need to work out the amount of PSI that comes from each client (including their associates) in an income year. If more than 80% of your income is from one client, this test is not passed and your income is all attributed to you and assessed at your marginal tax rate. You satisfy this test where each of your clients provide less than 80% of the total PSI and you meet one of the remaining tests below.
In our scenario above, one client is providing 75% of the income and therefore the 80% test has been passed. Therefore, one of the remaining tests must be passed in order for the business to be classified as a personal services business.
Step 4: The remaining tests
If your result at Step 3 is ‘less than 80%’, there are three remaining tests to work through:
Unrelated clients test
To pass the unrelated clients test your PSI must be produced from two or more clients who are not related or connected, and the work must be obtained by making offers to the public.
Given that the individual above has not advertised their services or made any offers to the public (the work has simply come from their previous employment), this test is not passed.
To pass the employment test in an income year, your business must employ or contract others to help complete the work that generates your PSI.
To pass the test, other employees or contractors that you engage must perform at least 20% of the principal work. This principal work must be central to meeting contractual obligations and not work that supports you in meeting these obligations, such as bookkeeping or administration.
In the scenario above, the individual is performing all of the work themselves and therefore does not pass this test.
Business premises test
To pass the business premises test in an income year, your business premises must meet certain location and usage criteria.
You pass the test if at all times in the income year, your business premises meets all of the following:
- Used mainly for personal services work
- Used exclusively for your business
- Physically separate from your home
- Physically separate from your clients
The individual above will be performing the work at their clients’ premises and therefore, does not pass this test.
Given that the individual above does not satisfy any of the tests above, the income is considered Personal Services Income and must be attributed to them and taxed at their marginal tax rate. There are also limitations on the deductions that can be claimed against this income.
There are various tax outcomes depending on whether the income is considered Personal Services Income, Personal Services Business or whether the rules are deemed to not apply. If the company (or other legal entity) is a personal services entity that fails the personal services business tests, it must attribute all of the net income to the individual where income will be assessed and taxed at their marginal tax rate.
If the company is considered a personal services business, some of the income may be attributed to other individuals who are performing the income earning activities with the remainder being attributed to the individual.
Finally, if it is determined that the PSI regime doesn’t apply, then income may be permitted to be retained and taxed in the company.
If you would like to discuss the tax status of your business, please contact one of our experts who will be more than happy to discuss the personal services income rules with you.