Contractors working in Australia are subject to a set of well-developed tests designed to determine if a contractor’s business is generating ‘personal services income’ (PSI). If caught, the contractor’s PSI is treated as personal income and the contractor is taxed accordingly, similar to the UK's IR35 legislation.
The PSI tests, enforced by Australia’s equivalent of HMRC, the Australian Taxation Office (ATO), are quite different from the IR35 tests of employment used to determine whether UK contractors are caught by IR35 and disguised employees. They are less ambiguous than the UK’s employment tests, being mostly based on fixed performance measures.
However, the industry body representing contractors’ interests in Australia, Independent Contractors Australia, is campaigning against proposed changes to the rules that could result in a tougher regime being implemented. So the future of PSI legislation in Australia is as closely followed by contractors there as the UK's IR35 legislative future is being followed in the UK.
What is Personal Services Income (PSI)?
According to the ATO, a contractor’s business income is potentially classified as personal services income if more than 50% of the income for a specific project is paying for “the skills, knowledge, expertise or efforts of the individuals who performed the services”.
Under this definition, the vast majority of knowledge workers – such as IT & telecoms contractors, engineers, interim management contractors, creative and marketing freelancers and construction professionals – could have their contracting income classed as PSI.
However, where the cost of materials, tools and equipment is greater than 50% of the value of the contract, the income is not classed as PSI. So a contract for a plumber to fit a bath where the bath and materials cost more than 50% of the job’s total value would fall outside the PSI rules.
The three step tests to determine if PSI rules apply
Having established that a contract’s income is potentially subject to the PSI rules, a contractor must next go through three further steps that apply tests to determine what income is PSI. The three steps are:
- The results test
- The 80% rule
- The other tests – unrelated clients, employment test, business premises test.
Step 1: The results test; a contractor’s business will pass this test in a given financial year if they can answer ‘yes’ to all three of the following tests for at least 75% of the income that is potentially PSI:
- Is payment only received after the work is completed?
- Does the contractor’s business need to provide tools and equipment?
- Is the contractor required to correct mistakes and defects at their own cost?
Payment on job completion can include milestone payments, but contractors paid hourly or daily are unlikely to pass this test. However, the second test could be passed if, as in the case of many knowledge workers, no plant, equipment or tools are required.
Passing this test means PSI does not apply, but if the answer to any of these questions is ‘no’, then the contractor goes onto the next step.
Step 2: The 80% rule; If 80% of a contractor’s business in a given financial year comes from a single client, then according to the ATO they must automatically apply for a ‘personal services business determination’, completed by the tax office. But if no one single client provided greater than 80% of income, a contractor passes to Step 3.
Step 3: Other tests: There are three further tests that can help a contractor determine whether PSI rules apply:
- Unrelated clients test – does the contractor’s business receive income from two or more unrelated clients, and does the contractor advertise externally for new work?
- Employment test – do employees or other partners complete at least 20% of the work?
- Business premises test – through the tax year, were business premises owned or leased, used for personal services for more than 50% of the time, used exclusively by the contractor’s business and not shared with another organisation, separate from the contractors home client sites.
If a contractor working in Australia fails all the PSI tests and the PSI rules apply, they will pay Australian income taxes and employment insurances as if they were an employee
If the contractor falls into the domain of any of these ‘other tests’, then PSI rules apply.
IR35 future – if PSI rules apply, contractors pay more tax
If a contractor working in Australia fails all the PSI tests and the PSI rules apply, they will pay Australian income taxes and employment insurances as if they were an employee. This is similar to tax rules applied to UK-based contractors who fall foul of IR35. So, as with IR35, falling within PSI legislation means that Australia-based contractors will be unable to offset a range of business expenses against taxation, which would normally be allowable for a business. And more importantly they cannot make use of the tax advantages of running their own limited company.
Business organisations in Australia, such as Independent Contractors Australia, have criticised the PSI rules for being too draconian. There appears to be a similar conflict, mainly fought in the courts, between the contractor establishment and tax authorities in Australia, as there is between HMRC and the contracting sector in the UK.
In the event that measures such as those enshrined in Australian law were imported to the UK, the tax landscape for contractors would look very different, and future IR35-type legislation that incorporated similar rules to PSI would, in many ways, be far more draconian. Most importantly, the Australian system is similar to the UK’s under IR35, as the contractor pays the additional tax if found to be a disguised employee.
Updated: Monday, April 23, 2012
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