ATO draft Practical Compliance Guideline PCG 2024/D2: Impact on personal services income

The ATO has released a draft Practical Compliance Guideline, PCG 2024/D2 (PCG) which outlines how general anti-avoidance rules apply to personal services income (PSI) earned through a personal services entity (PSE) operating as a personal services business (PSB).

The PSI rules were enacted to ensure that income derived by a PSE would be taxed to the individual earning the PSI. The PSI rules also limit the types of deductions an entity can claim in respect to income being derived from the personal services of an individual. 

If certain conditions are met, the PSE may be treated as conducting PSB. In these cases, the PSI provisions are exempted and the income would not be taxed to the individual.

The PCG confirms the ATO’s position, as stated in Taxation Ruling TR 2022/3, that the general anti-avoidance provisions in Part IVA applies when a PSE conducts a PSB. Therefore, any tax benefit obtained from an arrangement would be ‘unwound’ despite meeting the PSI rules. This could impact any person operating a business through a company or trust structure in industries including:

• Sole practitioner consulting/ professional services (legal, accounting, engineering, IT etc)
• Constructions and building trades
• Medical (doctor, dentist etc) and
• Other business where income is mainly derived from personal efforts/exertion.

Two main types of arrangements

Specifically, the PCG addresses concerns around two main types of alienation arrangements:

Retention of profits arrangements

The PSE retains income rather than distributing it to the individual who performed the services. By retaining profits within the PSE, tax on that income is often deferred, allowing the income to be taxed at a lower corporate rate or retained for future use.

In some cases, this results in the profits being distributed at a more advantageous time, or for the income to be used for non-commercial purposes, raising the risk of Part IVA being applied if the dominant purpose is to obtain a tax benefit through deferral.

Income splitting arrangements

This occurs when the income earned by the individual providing the personal services is diverted to associates (such as family members or related entities) rather than being fully allocated to the individual. It aims to reduce the overall tax by distributing income to entities at relatively lower tax rates, achieving a reduced overall tax rate or gaining other benefits such as spreading income across multiple taxpayers.

The ATO views these arrangements as higher risk under Part IVA, particularly if the income split is disproportionate to the value of the services provided by the associates.

Key takeaways

• The PCG introduces a two-part risk assessment framework categorising arrangements into ‘low-risk’ and ‘higher-risk’ using specific indicators.
• It provides 13 examples illustrating these indicators and guiding how different scenarios might be assessed. The ATO indicates that it will dedicate compliance resources towards higher-risk arrangements, particularly those involving significant income diversion or retention.
• The PCG is drafted to complement existing guidance materials and judicial decisions (such as Law Administration Practice Statement PS LA 2005/24) and does not provide extensive legal guidance on the application of Part IVA. It provides no substantive guidance on the ‘dominant purpose’ test for such alienation arrangements.
• The ATO suggested that a narrower scheme for Part IVA may be taken where a PSE is interposed for clearly commercial reasons (such as where the use of a PSE is a tender requirement).  
• The PCG emphasises the importance of maintaining thorough and contemporaneous records. Notwithstanding the informal nature of family arrangements, proper documentation will be critical for demonstrating compliance and mitigating risks.

Low-risk arrangements

The following are features of low-risk arrangements:

• full attribution – when the entire PSI received by a PSE is affirmed as assessable income of the individual performing the services
• non–tax purpose – if a portion of income is retained or used by the PSE for non-tax reasons, such as providing a superannuation benefit or acquiring assets, and this is not done primarily to obtain a tax benefit

Higher risk arrangements

The following are features of a higher-risk arrangement:

• income splitting – arrangements where income is split with another entity, reducing or deferring tax that would otherwise be payable
• value mismatch – significant discrepancies between distributed income and value of the services provided
• retention in lower–taxed entities – substantial amounts of income retained in entities subject to lower tax rates

Key actions required

The PSI rules apply to various professionals including doctors, dentists, plumbers, electricians, carpenters, accountants and lawyers.

Taxpayers using PSEs to derive PSI must review their current arrangements to determine whether any income-splitting or profit retention practices positions them in the higher-risk category for Part IVA scrutiny.

1. Review income-splitting or profit retention arrangements used within the PSE: If the arrangements primarily aim to gain a tax benefit, there is a higher risk of triggering Part IVA.
2. Maintain comprehensive documentation of all transactions, decisions, contracts, and agreements involving the PSE: Detailed record-keeping is essential for justifying the rationale behind income-splitting or profit-retention decisions if reviewed by the ATO.
3. Seek professional advice: Taxpayers unsure about their arrangement’s risk level or whether Part IVA applies should consult a tax professional to assess compliance and make necessary adjustments

How SW can help

Stakeholders have until 11 October 2024 to submit comments on the PCG before it is finalised.

Please reach out to an SW advisor to discuss the potential impact of the PCG on your business to mitigate any risks of current and future arrangements

Contributors

Ned Galloway

Eric Lay