Are you working independently as a contractor, consultant, or freelancer?
Is your income primarily derived from your personal skills and labour?
If so, it’s essential to understand that the income you earn might fall under the category of Personal Services Income (PSI). Specific tax rules apply to the treatment of PSI earned by sole traders, and it’s important to be aware of them.
What is Personal Services Income (PSI)?
PSI refers to income primarily earned through your personal skills or individual efforts.
If more than 50% of your income from a contract or invoice is a result of your labour, skills, or expertise, rather than being generated by assets, the sale of goods, or a business structure, then that income is considered PSI. PSI can be earned across various industries, trades, or professions, such as financial consulting, IT services, construction work, or medical practice. The PSI rules are designed to prevent the diversion or splitting of PSI with other individuals or entities as an attempt to reduce tax liability.
Examples of PSI and Non-PSI Income
Let’s illustrate this with some examples.
Suppose you’re a recruitment consultant operating as a sole trader:
Contract 1: You provide a 1-hour staff training course for a client, charging $1,000, including $100 for training materials. Since $900 (90% of the contract) reflects your skills and expertise, this is considered PSI, and you can report it as such.
Why? Because more than 50% of the contract is income as a result of your labour / skills / expertise.
Contract 2: You provide management software to a client for a total fee of $10,000, including $8,000 for the software license. As only $2,000 (20% of the contract) relates to your skills and expertise, this is not considered PSI, and you cannot report it as such.
Why? Because less than 50% of the contract is income as a result of your labour / skills / expertise.
Just like these examples, your taxable income may consist of a combination of PSI and other types of income.
Determining if You Earn PSI
You can use the Personal Services Income tool provided by the ATO to determine whether you have PSI and if the PSI rules are applicable in your case.
It’s important to note that you can earn PSI even if you’re not a sole trader.
If you’re generating PSI through a company, partnership, or trust, and the PSI rules apply, the income will be treated as your individual income for tax purposes. Therefore, it’s important to factor these rules into your business structure setup decision if you’re considering setting yourself up as a company / trust.
When the PSI rules apply, they impact:
• The tax deductions you can claim for PSI.
• How you report PSI within your tax return.
(All other income follows standard tax rules).
Under PSI rules, certain deductions CANNOT be claimed including;
• Rent, mortgage interest, rates, and land tax.
• Payments to associates for non-principal work.
• Superannuation contributions for associates’ non-principal work.
• Personal services income is also ineligible for the Small Business Income Tax Offset.
The following deductions CAN be claimed for expenses related to earning PSI:
• Costs associated with acquiring work, like advertising, tenders, and quotes.
• Registration and licensing fees.
• Account-keeping fees, including bank charges.
• Some insurance expenses, including public liability and professional indemnity insurance.
• Salary or wages and superannuation contributions for employees engaged at arm’s length (not associates).
• A portion of home office expenses, such as heating, lighting, phone, and internet (excluding rent, mortgage interest, rates, or land taxes).
• Depending on your business type and contracts, you may be eligible for other deductions.
When PSI Rules Do Not Apply
If you operate your business through a company or trust, income earned by that entity from providing your personal services (PSI) will be attributed to you unless:
• The company or trust operates as a Personal Services Business (PSB).
• The PSI was promptly paid to you as a salary or wages.
A PSB is determined by meeting at least one of four tests:
• The results test, which assesses whether you resemble an independent contractor under common law. Under this test you must be paid to produce a specific result, required to provide tools or equipment, and fix mistakes at your own cost.
• The unrelated clients test, requiring PSI from at least two unrelated clients who contract your services following public offers.
• The employment test, stipulating that at least 20% of your work is performed by employees.
• The business premises test, necessitating specific conditions for using business premises.
If 80% or more of your PSI comes from one client (or the client and their associates) and the results test is not met, your company or trust can be considered a PSB only if granted a PSB determination by the ATO.
If a company or trust does not qualify as a PSB and the PSI wasn’t promptly paid to you as salary or wages, the PSI is attributed to you. The company or trust has PAYG withholding obligations, and certain deductions are limited. Deductions related to gaining or producing PSI cannot be claimed unless they could have been claimed as an individual, or the company or trust received the PSI while conducting a PSB.
The PSI rules can be complex, so, if you provide (or are considering providing) your services through a company or trust structure be sure to get in touch with our team to further discuss your situation.
