In brief - Federal Court considers results test and unrelated clients test in two recent cases
The Federal Court has recently considered the personal services income provisions in Divisions 84 to 87 of the Income Tax Assessment Act 1997 (Cth) (PSI provisions).
What are the PSI provisions?
Personal services income is income that is derived mainly as a reward for the personal efforts or skills of an individual. If an entity earns personal services income, it is treated as the individual's assessable income unless the entity was carrying on a personal services business or the personal services income was promptly paid to the individual as salary.
A personal services business exists if there is a personal services business determination or if any of the four personal services business tests are met. These tests are: the results test, the unrelated clients test, the employment test, and the business premises test. The unrelated clients test, the employment test and the business premises test can only be applied if less than 80% of the personal services income is from one source. The Federal Court decisions considered the results test and the unrelated clients test.
Douglass was an electronics engineer who provided services through a partnership with his wife. The services were as lead engineer of an iron ore expansion project. The ATO included the income of the partnership in Douglass's assessable income under the PSI provisions and imposed penalties of 50% for recklessness.
The results test has three conditions which must be satisfied for 75% 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
the individual or entity is liable for the cost of rectifying any defective work
The custom or practice of independent contractors performing similar services must be taken into account in working out whether the above conditions are satisfied.
The Administrative Appeals Tribunal found that none of the conditions were satisfied. Douglass appealed to the Federal Court.
Douglass argued that custom or practice modified the results test. If the personal services were provided in a way that was consistent with the custom or practice, the results test was satisfied.
This argument was rejected by the Federal Court and it dismissed the appeal. It found that the text and context of the legislation did not support the argument and that custom or practice was simply something that needed to be taken into account in applying the results test. It was not determinative of itself.
In any case, the evidence of custom or practice did not indicate that the results test was satisfied. The evidence was that:
- time based payment was typical for engineers working on the project, which indicated that the income was not for producing a result
- although engineers were engaged to successfully complete the project, detailed performance obligations were developed in the course of the project not at the time of contracting
- it was very unlikely that the engineers would bear any liability for defects
- the engineers generally used the principal's equipment to complete the project
The decision reinforces the message that the results test is a fact-based test and the evidence led by the taxpayer is critical.
Fortunatow was a business analyst who provided services through a company. The company was engaged to provide services to eight clients by some labour hire or recruitment agencies. Fortunatow maintained an up to date LinkedIn profile which indicated when the company would be available to accept work. He also attended industry functions.
Some of the labour hire or recruitment agencies contacted Fortunatow as a result of the LinkedIn advertising and this resulted in services being provided to five of the eight clients. The services provided to the remaining three clients were due to Fortunatow's relationship with the agencies.
All of the personal services income was paid to Fortunatow's family trust as management fees. The trust had rental losses so no tax was paid on the income.
The unrelated clients test is satisfied in an income year if:
- the individual or entity earns income from providing services to two or more unrelated clients
- the services are provided as a direct result of the individual or entity making offers or invitations to the public (for example, by advertising). This condition is not satisfied if the individual or entity is merely available to provide services through a labour hire or recruitment agency
The Administrative Appeals Tribunal found that as all of the company's work had been sourced by labour hire or recruitment agencies, the second condition was not satisfied.
The Federal Court allowed Fortunatow's appeal and found that the second condition could be satisfied where services were advertised to the public through a forum such as LinkedIn, and also where work was obtained through the involvement of a labour hire or recruitment agency. It does not require an offer or invitation to be made, or relied on, by the end client. It was enough that some of the labour hire or recruitment agencies had approached Fortunatow due to his advertising on LinkedIn and services were provided to end clients as a result.
The second condition is not satisfied if the individual or entity is only available to provide services through some association or connection with a labour hire or recruitment agency.
This means that the unrelated clients test can be satisfied if:
- an individual or entity advertises its services
- a labour hire or recruitment agency approaches the individual or entity to provide services to end clients due to the advertising
- the services are provided to two or more unrelated end clients due to the involvement of the labour hire or recruitment agency
It is curious that the ATO did not rely on the general anti-avoidance provisions to deny the tax benefit arising from diverting personal services income to the company and the payment of management fees to the family trust. This is not addressed in the judgement.
The ATO has indicated that it will consider the decision and whether an appeal is appropriate. If the ATO does not appeal, it will need to consider changes to TR 2001/8.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2023.