Bills Digest No. 161  1999-2000New Business Tax System (Alienation of Personal Services Income) Bill 2000

Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details

Passage History

New Business Tax System (Alienation of Personal Services Income) Bill 2000

Date Introduced: 13 April 2000

House: House of Representatives

Portfolio: Treasury

Commencement: Royal Assent. However, the measures contained in the Schedule to the Bill relating to personal income will apply, subject to transitional provisions that will allow a two year deferral, from 1 July 2000 (item 26 of Schedule 1).

Purpose

To include in an individual's assessable income, and restrict deductions available, where an interposed entity such as a company or trust is used to receive income which otherwise would be included as in the individual's assessable income. The amendments will not apply in a number of situations, principally where the individual or entity is conducting a 'personal services business'.

Background

Alienation of personal income refers to situations where a person is able to have amounts paid for personal exertion that would otherwise be subject to normal employee tax arrangements paid to another entity, such as a company or partnership. Such an arrangement is used to gain tax advantages, principally income splitting and larger deductions, than are available to an employee taxed under the normal employee PAYE (or from 1 July PAYG) arrangements.

The issue was examined in the Review of Business Taxation (Ralph Report) ('the Report') which found that the number of owner managers of incorporated business increased by more than 400% while the number of self-employed and all employed increased by only 50%. While recognising that factors other than taxation contributed to the growth in the proportion of owner-operated businesses, the Report considered that the area posed implications for the integrity of the taxation system that required a systemic approach to rectify.⁽¹⁾

There can be a number of reasons other than the taxation implications for a person to choose to operate through an interposed entity, such as greater freedom of negotiation, less restriction on how work is to be performed, ability to seek a wider range of work and to meet enterprise demands for greater non-employee input. The latter can be seen in the increasing use of 'outsourcing' in both government and private sector. This can offer a number of advantages for enterprises including greater flexibility, reductions in the role of employee organisations and removal of the need to ensure compliance with some employee statutory rights such as long service leave, workers compensation and superannuation. The Ralph Report makes it clear that its recommendations are not intended to interfere with such arrangements but solely to remove any taxation advantages that may apply under the arrangements for employee-like situations.⁽²⁾

Under current tax law, a person will be taxed as an employee where a common law employment relationship exists (the test for this deals with how a number of matters apply to the relationship, including the degree of control exercised by the 'employer').⁽³⁾ In circumstances other than a common law employment relationship the general anti-avoidance rules contained in Part IVA of the Income Tax Assessment Act 1936 must be used to apply employee tax arrangements. While rulings may be made outlining the conditions when the Commissioner considers Part IVA applies, its application and enforcement often involves the examination of individual cases to determine if a case can be made out for the Part to apply. This not only involves a considerable workload but also ensures that only a limited number of cases can be examined, providing an incentive for people to 'see if they will be caught' particularly if they think that they are not in an employment relationship.

The major tax advantages that can be gained by alienating personal income were found by the Ralph Report to be:

• Income splitting - this allows the amount received to be split among two or more people, often immediate family members, so that a lower marginal rate of tax is paid than if the amount were received by a single person. This will apply even if distribution of tax is traced through the entity to the ultimate beneficiary or, due to imputation, an interposed company is used. It also enables more tax free thresholds to be claimed, further reducing the amount of tax paid.
• Greater deductions: This applies particularly to travel expenses to and from the place of work. While such expenses will generally not be deductible for employees, independent contractors can generally claim such a deduction. Another example is the ability to claim deductions in respect of costs associated with business premises even though such premises are located in the place of residence. The Report gives the example of part deductions for mortgage expenses. However, in recognition that interposed entities may be used for a number of purposes and not desiring to increase the cost of using such arrangements the Report specifically recommends that the costs associated with maintaining the entity be recognised (deductible) first in the hands of the entity or, if its income is insufficient, in the hands of the person providing the services.⁽⁴⁾
• Deferral of tax - Where a company is used as the interposed entity, profits can be retained in the company at times when their distribution would result in a higher marginal rate of tax being paid if profits were immediately distributed. Instead, the retained profits will be distributed at times when this will either not increase the marginal rate of tax payable or reduce it to a lesser degree. This may be seen as a form of income averaging not available to employees or for distributions made through other entities where full distribution occurs or is deemed to occur.

The Report also noted that these methods of reducing taxable income could also be used to increase eligibility for benefits and to avoid or reduce obligations. This will apply where taxable income is used for income tested assistance, principally social security benefits, or obligations, such as HECS repayments..⁽⁵⁾

The Report recommended that alienation of personal income be addressed not only because of the risk to revenue but also to ensure compliance with the principle that 'economic transactions having the same economic substance should be taxed similarly, irrespective of their legal form.' Action was therefore recommended to 'address the inconsistent and inequitable treatment' that currently applies.⁽⁶⁾

The Report recommended⁽⁷⁾ that if an entity is interposed between a person or entity requiring services and an individual who performs or is responsible for performing those services (the service provider), the amount received should be treated as income of the service provider where:

• The interposed entity receives 80% or more of its receipts in respect of personal services from one source, including associates of that source⁽⁸⁾ ( the recommendations do not include exemptions from this rule other than a determination - see below), or
• The services are provided in an 'employee-like manner' to be determined by a range of specific conditions: the Report examined a number of conditions that may be taken into account, including:

• the degree of control
• if the services are contracted to the public
• whether the entity provides substantial income producing assets so that the provision of personal services is only incidental
• whether more than one person is contracted to, and actually provides, the services, and
• the degree of entrepreneurial risk.⁽⁹⁾

• there is a declaration from the Commissioner in force. As noted above, this was seen as a possible exemption to the 80% rule. It was considered that the exemption should apply on the facts of an individual case and not be given if the entity has consistently been received payments from one source and it cannot be demonstrated that the entity is conducting an independent trade or business.⁽¹⁰⁾

The Government's response to this issue was contained a press release issued by the Treasurer on 11 November 1999 in its Stage 2 response to the Ralph Report and accepts the general recommendations made in respect of the alienation of personal income. Attachment B to the Press Release states that 'detailed criteria will be developed (based on the criteria in the Ralph Report)...'.

In response to a letter from the Shadow Treasurer relating to conditions under which the ALP would support the various proposed changes to business tax (many of which are already contained in legislation with the Opposition voting with the Government) the Treasurer stated:

In a Press Release associated with the introduction of this Bill the Treasurer dealt with the application of the recommend 80% rule by stating:

A second change was also announced, ie that there would be a transitional 2 year period during which the Commissioner would be able to declare that a contractor who has made payee declarations under the Prescribed Payments System as of the day of announcement would not be subject to the new rules. This was seen as a measure to help minimise compliance burdens on taxpayers as they adjust to the new tax system (principally the GST).⁽¹²⁾

These two measures comprise a weakening of the Ralph recommendations and should allow contractors who receive 80% or more of their income from one source to arrange their affairs to fit within the exemptions. The two year transitional provisions were not recommended in the Ralph Report and will allow time for arrangements to be changed to show compliance with the proposed rules when the transitional period ends.

Media reports on the changes have stated:

And:

In an interview, the Treasurer responded to criticisms of the changes stating that the legislation was to protect genuine contractors and contined:

In response to the change the Shadow Treasurer's view was that it amounted to:

The Shadow Treasurer also expressed concern regarding the impact the changes would have on the estimated revenue to be raised by the measures, and in particular the two year transition period.⁽¹⁷⁾

A comparison of the estimated revenue to be raised as announced in the Treasurer's Press release of 11 November 1999 announcing the measures and those in the explanatory memorandum (EM) to the Bill shows

Main Provisions

Item 3 of Schedule 1 will insert a new Part 2-42 into the Income Tax Assessment Act 1997 dealing with personal services income. The proposed Part is not to imply that a person is an employee for any other purposes (proposed section 84-10).

Amounts to be included as Individual Income

Personal services income (PSY) of an entity is defined to be income received mainly as a reward for personal efforts or skill (proposed section 84-5).

The general rule is that an individual's assessable income is to include their PSY received through a personal services entity (a company partnership or trust whose income includes PSY of one or more individuals). Exemptions from the rule are:

• Income earned through an entity conducting a personal services business (see below)
• Amounts paid as wages or salary, or
• Amounts received that would otherwise be exempt (proposed section 86-15).

When a personal service business is being conducted is dealt with in proposed Division 87. Generally this will be when at least one of the personal service business tests (see below) is satisfied. However, where more than 80% of an individuals PSY is from the same entity (including associates of such an entity), the income will not be taken to be from a personal services business unless there is a personal services business declaration in force for the entity (see below) and the income is from that entity (proposed section 87-15).

The personal services business tests are:

• Unrelated clients: The entity gains income from two or more unassociated parties during the year and that income is the result of offers or invitations to the public or a section of the public to provide the services (an example given is advertisement). However, only listing that the services are available with a business that arranges to provide services directly for clients of the entity will not be taken as an offer to the public (proposed section 87-20).
• Employment: For an individual, the individual engages one or more entities to perform at least 20% of the entities work for the year (at market value). The other entity or entities must actually perform at least 20% of the individuals principal work for the year (the term principal work is not defined).

• a personal entity will satisfy the test if the entity engages another entity or entities and they perform at least 20% of the entities principal work for the year. The other entity or entities must not be an individual whose PSY is included in the entities income (this will prevent the amount paid from simply being recycled into the original entity), or
• the individual or entity has one or more apprentices for at least half of the year (proposed section 87-25).

• Business Premises: The individual or entity maintains and uses business premises:

• at which they mainly conduct their business activities from which PSY is gained
• they have exclusive use
• which are physically separate from premises of the individual/entity, or an associate that are used for private purposes and from the premises of an individual or entity, or an associate, to which services are provided (proposed section 87-30).

Personal service business determinations for individuals are dealt with in proposed section 87-60. The Commissioner may make or vary such a determination which may be subject to conditions. A determination must not be made unless the Commissioner is satisfied in relation to the year in which the determination is made (determinations may last for a period specified by the Commissioner) that the individual has met or could reasonably be expected to meet either the employment or business premises test; or, but for unusual circumstances, would meet any of the tests. The individuals PSY must also be reasonably expected from the source that satisfies this requirement.

Unusual circumstances will include where a business is started or where during the year income is received from one source but the relevant test has been met in at least the preceding year and can reasonably be expected to be met in subsequent years.

The Commissioner may also make a determination if satisfied that the individual's PSY is for producing a result, the individual is required to provide plant and equipment or tools of trade necessary to perform the work and the individual would be required to rectify any defect in the work. In determining if these matters apply the Commissioner is to have regard to the relevant custom or practice of performing the work (proposed subsection 87-60(5)).

The Commissioner may make a determination for an entity on similar grounds to that for an individual (proposed section 87-65).

(The use of the word 'may' rather than 'must' in these proposed sections allows the Commissioner a discretion of whether to make the determination even if these conditions are satisfied and could apply in cases of avoidance. Presumably a ruling will be made to this effect.)

Decisions regarding determinations will be subject to appeal to the Commissioner at first instance and then under the provisions of the Taxation Administration Act 1953 (proposed section 87-85).

Deductions

Proposed Division 85 deals with deductions relating to PSY. For deductions relating to the gaining or producing of income, the general rule is that they will only be allowed if the taxpayer were an employee. Exemptions to this rule are expenditure relating to:

• Gaining work (again the example of an advertisement is used)
• Insuring against loss of income or the capacity to earn, or for liability that may arise in the course of earning income
• Engaging another who is not an associate to perform work, or engaging an associate to perform work that is part of the principal work from which income is gained or produced
• Contributing to a fund to obtain superannuation for yourself or for dependants in case of death
• Payments to meet obligations under a workers' compensation law, and
• Meeting obligations under GST law (proposed section 85-10).

Proposed section 85-15 will specifically exclude deductions relating to rent, mortgage, rates and land tax to the extent that they relate to the earning of PSY. Deductions for payments to associations in the same circumstances are disallowed by proposed section 85-20. Deductions in respect of superannuation for an associate will only be allowed to the extent that the associate performs part of the principal work for which the person claiming the deduction makes their PSY and then only to the extent required to comply with the superannuation guarantee scheme (proposed section 85-25).

The proposed Division will not apply to amounts that relate to conducting a personal services business (proposed section 85-30).

Where a personal service entity's income is included in that of an individual due to the operation of the above provisions relating to income, deductions relating to maintaining the entity (eg registration or other costs related to compliance with the law) may be offset against the individual's PSY (proposed section 86-20)

The deductions which may be claimed by the personal services entity will be restricted by proposed subdivision 86-B. The general rule is that an entity will only be able to claim a deduction to the extent that the individual could have made the claim or the deduction that relates to a personal services business (proposed section 86-60), although this will not prevent the entity from claiming maintenance expenses as a deduction (proposed section 86-65).

Car expenses may only be claimed by the entity where:

• The vehicle is not used for private purposes, or
• The claim is for vehicle expenses or fringe benefits costs of the entity to a limit of one vehicle per person receiving PSY from the entity (proposed section 86-70).
• The entity may also deduct superannuation costs relating to a person who receives PSY from the entity, although if the individual performs less than 20% of the principal work of the entity, the deduction will be limited to the amount required to comply with the superannuation guarantee scheme. (proposed section 86-75).
• Wages or salaries paid by the entity within 14 days of the end of the PAYG period during which the entity received the amount may also be deducted (proposed section 86-80) as may deductions for amounts incurred by the entity in allowing the individual to gain assessable income or for plant and equipment provided for the individual to earn assessable income (proposed section 86-85).

Application and Transitional Provisions

The amendments will apply to assessments for the 2000-01 and later income years. However, the Commissioner may declare, before 1 July 2000, that the amendments apply to an entity that has made a PAYE declaration under the prescribed payments system before 13 April 2000 as if the entity was a personal services business, and therefore exempt from the new rules (item 26).

Concluding Comments

The Bill is not a complete implementation of the recommendations of the Ralph Report. It appears to mingle the Ralph criteria for whether an employee-like situation exists with the 80% rule, although under the Ralph recommendations these are separate issues. This has led to a substantial weakening of the original criteria, particularly regarding the 80% rule.

The personal services business tests proposed in the Bill should be relatively easily satisfied, so that income is treated as personal business service, rather than personal income and not taxed in the hands of the individual. For example, the business premises test requires that the business premises be 'physically separate' from residential premises. Presumably a separate structure on the same legally defined piece of land, such as a shed, which has separate utility supplies, principally electricity, could be set up as a physically separate business premises. (Premises dedicated to a business with a separate entrance, utility billing but physically attached to the relevant residence would fail the test even if they have been used for a significant period.) Dealings could be conducted on a mobile phone and accounting etc. on a laptop computer located within the physically separate business premises. While this may be regarded by some as an extreme example which would be caught by the Part IVA anti-avoidance provisions, or not be issued with a determination by the Commissioner, it can be assumed that legal/accounting advisers will rapidly develop acceptable, minimal cost schemes which will satisfy the requirements.

The business services test seems to encourage, rather than remove, opportunities for contrived arrangements to emerge to defeat the principals espoused in the Ralph Report.

Endnotes

1. Review of Business Taxation, A Tax System Redesigned, July 1999, p. 288, 289 and 290.
2. ibid., p. 289.
3. This may be contrasted with other connected areas, such as compulsory superannuation, where an expa

   nded range of relationships can give rise to an obligation.

4. ibid., p. 294.
5. ibid., 7.2 to 7.4.
6. ibid., p. 288.
7. ibid., p. 286 and 7.
8. The Ralph Report saw the Commissioner's discretion being used on a case by case method as a safeguard. The measures announced will allow whole classes of operations to be excluded under the discretion, with refusal to grant an exemption being a safeguard to prevent abuse.
9. ibid., p. 291
10. ibid., p. 292.
11. Letter from the Treasurer to the Deputy Leader of the Opposition and Shadow Treasurer, 24 November 1999, point 2.

12. Treasurer, Press Release, 13 April 2000.

13. Australian Financial Review, 13 April 1999 (ie published on the day the Treasurer announced the changes).

14. Australian Financial Review, 15 April 2000.

15. The Age 14 April 2000.

16. Transcript, ABC Radio AM, interview recorded 13 April 2000, 3.30 p.m.

17. House of Representatives, Hansard, p. 15198.

Contact Officer and Copyright Details

Chris Field
9 May 2000
Bills Digest Service
Information and Research Services

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ISSN 1328-8091
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Published by the Department of the Parliamentary Library, 2000.

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