The ATO yesterday released a draft Practical Compliance Guideline, PCG 2024/D2 (Personal services businesses and Part IVA of the Income Tax Assessment Act 1936) (PCG), outlining its compliance approach to the application of the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (1936 Act) to personal services income (PSI) derived through a personal services entity (PSE) conducting a personal services business (PSB).
The PCG reaffirms the ATO’s position (previously expressed in Taxation Ruling TR 2022/3 (Income tax: personal services income and personal services businesses)) that Part IVA may still apply to cases where a PSE is conducting a PSB and the PSI rules do not apply. In particular, the ATO perceives there to be a risk for alienation arrangements where:
- income is retained in a PSE (referred to as ‘retention of profits’ arrangements); and/or
- income is diverted to associates of the individual who performs the services (referred to as ‘income splitting’ arrangements),
such that the income received in connection with the individual’s services is taxed at an overall lower rate or another benefit is otherwise obtained, such as a timing benefit.
Key takeaways
- The PCG sets out a two-part risk assessment framework in the form of tables containing ‘low-risk indicators’ and ‘higher-risk indicators’ respectively, and provides 13 examples of scenarios in which these indicators may be present. In practice, however, the ATO admits that the quantum of the income diverted via the PSE will be a factor in whether it applies its resources to pursue a Part IVA audit.
- While the PCG highlights alienation arrangement ‘red flags’ which are likely to attract the ATO’s scrutiny, it does not provide substantive guidance on the manner in which Part IVA may apply to such arrangements from a legal perspective. In particular, the PCG does not engage in any substantive manner with the concept of ‘dominant purpose’ as it applies to alienation arrangements.
- In this regard, the PCG is intended to stand alongside existing guidance material covering the administration and application of Part IVA more broadly including Administration Practice Statement PS LA 2005/24 (Application of General Anti-Avoidance Rules).
- The PCG suggests that when determining what is the relevant ‘scheme’ to which Part IVA may apply, the ATO may consider if a narrow scheme is more appropriate given that in a wider scheme, there may be commercial reasons for interposing a PSE (noting that the use of a PSE may, for example, be a tender requirement). Another factor which may weigh against a finding that the requisite ‘dominant purpose’ test is satisfied with respect to a wider scheme is the use of a PSE for asset protection purposes.
- The record keeping and evidentiary requirements outlined in the draft PCG are onerous but nonetheless highlight, yet again, the importance of contemporaneous documentation. While the ATO acknowledges that family arrangements are typically conducted with a greater level of informality than third party dealings, taxpayers should carefully consider what documentation should be prepared when they are entering into new alienation arrangements, and whether the documentation for existing arrangements is sufficient.
- Stakeholders have until 11 October 2024 to provide comments on the PCG before it is finalised. Please contact us if you wish to discuss the potential impact of the PCG on your business.
Overview
The PSI rules contained in Part 2-42 of the Income Tax Assessment Act 1997 (1997 Act) provide that individuals cannot reduce or defer income tax by alienating or splitting income earned principally as a reward for their personal efforts or skills through the use of interposed companies, partnerships or trusts (termed PSEs).
This is achieved by attributing the PSI received by a PSE to the individual who performed the personal services, and limiting the deductions available to PSEs and sole traders. However, the PSI rules do not apply if the PSE or sole trader conducts a PSB by virtue of meeting either the ‘results’, ‘unrelated clients’, ‘employment’ or ‘business premises’ tests, with the result that a PSB is treated concessionally for tax purposes on effectively the same basis as a company.
While the introduction of the PSI rules had the practical effect of narrowing the scope for Part IVA to apply to alienation arrangements (because no tax benefit is obtained where they apply as the income is taxed in the hands of the relevant individual), the ATO’s stated aim in releasing the PCG is to relieve taxpayers of any misapprehension that Part IVA will not apply to their income splitting or retention of profits arrangements where a PSB is being conducted.
Examples of higher-risk and low-risk arrangements
The PCG contains various examples of arrangements which will be considered by the ATO as low-risk and higher-risk. Some of the key themes arising from these examples are summarised below.
Examples of low-risk arrangements:
- Where the entire net PSI which is received by an interposed PSE (such as a trust or company which has self-assessed as a PSB) is ultimately recognised as assessable income of the relevant individual who produced the relevant income, such an arrangement will generally be viewed as low-risk by the ATO.
- This will generally be the case regardless of how the relevant income has been paid or distributed to the individual via an interposed entity or entities.
- Where a portion of the income received by an interposed entity is retained or used by an interposed entity for some other purpose however, the ATO has recognised that such an arrangement will be viewed as low-risk where the retention or splitting of the income was clearly not for the dominant purpose of obtaining a tax benefit (such as providing a superannuation benefit or acquiring an asset).
Examples of higher-risk arrangements:
- The examples of higher-risk arrangements set out in the PCG exhibit a number of characteristics which the Commissioner considers will “bring Part IVA into question”. While a more detailed list of ‘higher-risk indicators’ is contained in Table 2 of the Risk Assessment Framework, key characteristics found throughout the higher-risk examples broadly include:
- arrangements involving the splitting of an individual’s income with another entity, resulting in a reduction or deferral of income tax which would otherwise be payable in respect of the income referable to the individual’s services;
- arrangements where there is a disconnect between the amount of income which is distributed to an individual (or an amount of remuneration paid to an associate) on the one hand, and the value of the personal services which produced that income on the other; and
- arrangements involving the retention of a significant part of such income in a lower‑taxed entity.
