Personal services income and ATO reviews

Personal services income (PSI) is income that is mainly a reward for an individual's personal efforts or skills, whether it is paid to the individual or to their company, trust or partnership. Unless it comes from a personal services business, the PSI rules limit deductions and, where an entity receives the income, generally tax it as the worker's own income.

This is general information, and the answer usually turns on your contracts. We act in ATO audits, reviews and objections about PSI, working alongside your accountant (see how we work with accountants).

What is personal services income?

Income is your PSI if it is mainly a reward for your personal efforts or skills, even if it is paid to another entity (Income Tax Assessment Act 1997 (ITAA 1997), s 84-5(1)), and whether you are paid for doing work or for producing a result (s 84-5(3)). The ATO reads "mainly" as more than 50% (Taxation Ruling TR 2022/3, para 37).

Typical examples are consultants, contractors paid for their labour and professionals working alone (TR 2022/3, para 3). Income is generally not PSI if it is mainly from:

• selling goods (paras 38–39),
• using income-producing assets, such as a semi-trailer that does most of the earning (s 84-5(1), example 2), or
• a business structure, such as a firm with many employees, substantial assets and goodwill (s 84-5(1), example 3; TR 2022/3, paras 42–44).

The rules generally don't apply to your income as an employee of the business you work for (s 85-35; TR 2022/3, para 9). Being employed by your own company or trust doesn't help: the rules can still apply to the income that entity earns from your work (para 58). Nor do the rules make you anyone's employee (s 84-10).

When do the PSI rules apply?

The PSI rules don't apply to income from conducting a personal services business (ss 85-30, 86-15(3)). You or your entity conduct one in an income year if a personal services business determination is in force, or if you meet at least one of four tests that year (s 87-15(1)), subject to the 80% rule. Each year, and each individual whose PSI an entity receives, is tested separately (TR 2022/3, paras 68, 76).

Even if the rules don't apply, you must still declare PSI in your tax return (ATO, Personal services income).

What are the personal services business tests?

Test	What it requires, broadly	Section
Results test	For at least 75% of the PSI: you are paid to produce a result, supply the plant, equipment or tools needed, and are liable for the cost of fixing defects	s 87-18
Unrelated clients test	Income from two or more clients that aren't associates of each other or of you, obtained as a direct result of offers or invitations to the public or a section of it	s 87-20
Employment test	Others you engage perform at least 20% (by market value) of your principal work, or you have an apprentice for at least half the year	s 87-25
Business premises test	At all times in the year, you maintain and use business premises that you use exclusively, mainly for PSI work, physically separate from any premises you or an associate use privately and from your client's premises	s 87-30

The results test

The results test matters most, because it can be self-assessed even if all your income comes from one client (s 87-15(3)). In the ATO's view, a contract for a result usually pays an agreed price for a specified outcome rather than an hourly or daily rate, and a label in the contract isn't enough (TR 2022/3, paras 84–86). Industry custom or practice is relevant (s 87-18(4)) but, in the ATO's view, can't override clear contract terms (para 82).

On defects, the ATO asks whether you carry the commercial risk: professional indemnity insurance required by the contract points that way, but a client's ability to withhold payment for unsatisfactory work doesn't (paras 91, 93, 96).

The 80% rule

If 80% or more of your PSI in a year comes from one entity (or one entity and its associates) and the results test isn't met, the other three tests don't count, and the income is not from a personal services business unless a determination is in force (s 87-15(3)). Employee income is left out of the count (s 87-15(4)), and special rules apply to government clients and some commission-based agents (ss 87-35, 87-40).

In the ATO's view, the source is whoever is contractually obliged to pay you, so a labour-hire firm that engages you is usually the one source, however many end clients you work for (TR 2022/3, paras 69–72). The ATO notes, but does not follow, a tribunal decision that looked through to the end client (para 71).

The unrelated clients test and agencies

The services must be provided as a direct result of your offers or invitations to the public (s 87-20(1)(b)). Simply being available through an agency that places people with clients isn't an offer (s 87-20(2)).

In Commissioner of Taxation v Fortunatow [2020] FCAFC 139, a business analyst with a LinkedIn profile got his contracts through recruitment agencies, and the Full Federal Court held the test was not met. The client's own decision to engage you must be a direct result of the offer, and an offer that only influences an intermediary loses that direct effect ([17], [19]–[22]). In the ATO's view, word-of-mouth referrals and replying to ads on recruitment websites generally don't count either (TR 2022/3, paras 101, 104).

The employment and business premises tests

For the employment test, principal work is the work central to the contract, not bookkeeping or answering phones (TR 2022/3, para 26). A family member you engage can count, unless their own PSI is received by the same entity (paras 110, 111, 113).

For the business premises test, a home office inside your home won't do (s 87-30(1)(c)). In the ATO's view, nor will a room at your client's premises, space you occupy under a licence rather than a lease, or premises you lease jointly with someone else (paras 141, 142, 147).

What is a personal services business determination?

If you can't self-assess, you can apply to the ATO for a determination (ss 87-60, 87-65, 87-70). Broadly, the ATO must be satisfied that in the first year the determination covers, you met or could reasonably be expected to meet the results, employment or business premises test, or that, but for unusual circumstances, you would have met a test or (where you meet the unrelated clients test) stayed under the 80% rule (ss 87-60(3)–(6), 87-65(3)–(6)).

Unusual circumstances include having too few clients for the unrelated clients test because you started a business that year, or having one client after meeting the test in earlier years, if you can reasonably expect to meet it in later years (ss 87-60(4), 87-65(4)). The ATO says they must be temporary and particular to you, so an industry downturn won't do (TR 2022/3, paras 155–158).

A determination can take effect from a date before it is made, for a set period and on conditions (ss 87-60(2), 87-65(2), 87-75). If the ATO hasn't decided within 60 days, you can give written notice treating the application as refused (s 87-70(3)). Time waiting for information the ATO has asked for doesn't count towards the 60 days (s 87-70(5)).

You can object to a refusal, or to a decision to vary or revoke a determination, under Part IVC of the Taxation Administration Act 1953 (TAA) (s 87-85), generally within 60 days after notice of the decision is served (TAA s 14ZW(1)(c)). If you gave notice treating the application as refused, the refusal is taken to happen that day (s 87-70(4)), so it is safest to object within 60 days of it.

What happens if the PSI rules apply?

Sole traders

You can't deduct amounts relating to your PSI that an employee couldn't deduct (s 85-10(1)), although costs of gaining work, income protection and professional indemnity insurance, paying unrelated people to do work, and your own super remain deductible (s 85-10(2)). Rent, mortgage interest, rates and land tax for your home aren't deductible (s 85-15), and payments to associates generally aren't unless they do principal work (s 85-20).

Companies, trusts and partnerships

• Attribution. The entity's PSI is included in your assessable income (s 86-15(1)), except to the extent it is paid to you as salary within 14 days after the end of the PAYG payment period (s 86-15(4)).
• Deductions. That amount is reduced by the entity's deductions relating to your PSI (s 86-20), but the entity can generally deduct only what you could have, plus items such as bank fees, one private-use car, super and salary paid in time (ss 86-60 to 86-80).
• No double tax. The attributed income isn't the entity's assessable income, and later payments or distributions of it to you or your associates are ignored for income tax purposes (ss 86-30, 86-35).
• PAYG. The entity generally has to pay PAYG amounts to the ATO on attributed income (TAA Sch 1 ss 13-5, 13-15).

For example, suppose an IT contractor's company earns $200,000 for her work through one labour-hire firm at an hourly rate, pays her a $60,000 salary and passes the rest to family members through a trust. If no test is met and there is no determination, she is generally taxed on the $200,000 (ignoring GST), less allowable deductions, and the amounts passed to family aren't taxed again.

Can Part IVA apply even if you pass a test?

Yes. Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) may still apply to alienation of PSI outside the PSI rules (ITAA 1997 s 86-10, note). In the ATO's view, that includes arrangements with the dominant purpose of getting a tax benefit by splitting PSI with associates or keeping profits in a lower-taxed entity, even where the entity is a personal services business (TR 2022/3, paras 14, 75, 160). Its indicators include a salary out of line with the work and fees, and distributions to associates but not the worker (para 161). In the ruling's Example 41, the results test is met but the ATO would still consider Part IVA.

For professional firms whose income is outside the PSI rules, a separate ATO guideline warns that Part IVA may apply to arrangements designed to pay a practitioner substantially less than their services are worth (PCG 2021/4, paras 28, 34, 36).

If Part IVA applies, the Commissioner can cancel the tax benefit (ITAA 1936 s 177F), a base penalty of 50% of the scheme shortfall (25% if reasonably arguable) can apply (TAA Sch 1 s 284-160), and the ATO generally has four years to amend, not the two years that apply to many individuals and smaller businesses (ITAA 1936 s 170(1), items 1–4). See Part IVA in ATO disputes and how far back the ATO can audit.

Which PSI arrangements are most exposed in an ATO review?

Based on the law and TR 2022/3, these features are the most open to challenge:

• most PSI from one client or labour-hire firm, with a test other than the results test claimed,
• the unrelated clients test claimed for work found through recruitment agencies,
• the results test claimed for hourly or daily work,
• little or no salary to the worker, with profits going to family or kept in a company, and
• deductions the rules deny, such as rent on your home, a spouse paid for administration, or several private-use cars.

For other triggers, see ATO audit red flags.

How to respond to an ATO PSI review or audit

1. Confirm the scope. Note the years, entities, issues and deadlines, including the date for any reply to a position paper.
2. Gather the evidence. Contracts, invoices, insurance policies, leases and evidence of why each client engaged you.
3. Test each year and each person. A test can be met in one year and not another, and a determination can cover an earlier date.
4. Correct errors early. A voluntary disclosure in the approved form, made before the ATO tells you it is examining your affairs, generally reduces the base penalty by 80%, or to nil if the shortfall is under $1,000 (TAA Sch 1 s 284-225(2)–(4)). After that notice, the reduction is generally 20%, and only if the disclosure saves the ATO significant time or resources, although the ATO can treat it as made before the notice (s 284-225(1), (5)). See voluntary disclosures.
5. Object if needed. You can generally object to an amended assessment by the later of 2 or 4 years after the original notice of assessment (depending on the taxpayer) and 60 days after the amended notice is served (TAA s 14ZW(1)(aa), (1B), (1BA)). See ATO objections.

Next step

Send us the ATO's letter or position paper, the contracts and invoices for the years under review, the entity's tax returns, and a short note of how you found each client and who paid you, including any labour-hire or recruitment agency. On a first call we'll tell you which test, if any, is realistic and what to do before the ATO's deadline.