This Compendium of comments provides responses to comments received on Draft Practical Compliance Guideline PCG 2024/D2 Personal services business and Part IVA of the Income Tax Assessment Act 1936. It is not a publication that has been approved to allow you to rely on it for any purpose and is not intended to provide you with advice or guidance, nor does it set out the ATO's general administrative practice. Therefore, this Compendium does not provide protection from primary tax, penalties or interest for any taxpayer that purports to rely on any views expressed in it.

It is recommended that the final Guideline addresses genuine partnership situations and 'husband and wife' partnerships.

The final Guideline should be applied prospectively rather than retrospectively.

We have a long-standing view on the treatment of personal services income (PSI) and the potential application of Part IVA of the Income Tax Assessment Act 1936 (Part IVA). Existing judicial decisions and guidance such as Taxation Rulings TR 2001/8 Income tax: what is a personal services business (now withdrawn) and TR 2022/3 Income tax: personal services income and personal services businesses has made clear that Part IVA can apply to alienation arrangements including income splitting and profit retention.

How will companies save for future assets or bring in new employees if they are taxed in the hands of the individual?

Start-up businesses cannot always pay an employee straight away and need time to save money in the company to build the business.

Retention of profit arrangements are indicative of low risk if the intention is to temporarily retain some profit for a clear commercial purpose and that intention is carried out.

This includes situations, for example, where an amount of net PSI is retained in a personal services business (PSB) with the intention to purchase equipment or cover expenses that the individual needs to perform their services. If the purchase of the assets is to enable the individual to charge more for services, take on more clients and increase future profits – this temporary retention of profits is for a clear commercial purpose.

Importantly, the intention is carried out and the amount temporarily retained should only be enough to cover the anticipated expenses.

In paragraph 7 of the draft Guideline, it is unclear which provision 'it' is referring to in the sentence, '… because where it applies no tax benefit is obtained …'. '[I]t' refers to the preceding mention of either the PSI rules of Part IVA, but it becomes apparent only later that it's referring to the PSI rules, disrupting the flow of the sentence.

We recommend changing the part of the sentence quoted above to: '… because, where the PSI rules apply, no tax benefit is obtained …'.

Some companies will only contract with another company (interposed entity) for commercial purposes, which makes attributing PSI more complex.

The final Guideline addresses situations where a PSE is utilised to alienate PSI through profit retention arrangements or income splitting with associates, resulting in a lower overall tax rate and providing a tax benefit to the individual whose PSI is involved.

Record keeping is a challenge for PSBs which are micro or family businesses, where a number of family members perform services, or where they perform a mix of work (supplying goods and providing personal services).

A practical or informal family business approach should be taken to record keeping.

Such businesses should consider whether to seek record-keeping assistance from an appropriately qualified person.

Further examples should be provided in the final Guideline that demonstrate a taxpayer's need to retain profits – for example, to meet ongoing costs.

This is especially so in the case of entities that need to retain profits as part of cashflow management if they are unable to generate income for certain periods of time and need to meet ongoing costs, to fund working capital, purchase trading stock, trade debtors and loans used in the business.

Example 6 of the draft Guideline deals with a situation where a superannuation benefit is provided to the individual undertaking principal work.

It would be helpful if the final Guideline could include one or more examples dealing with situations where superannuation contributions are made for the benefit of a related individual who only performs administrative work in the business.

Those expenses are allowable deductions when calculating net PSI – just as they are for superannuation paid on behalf of the individual engaged as an employee by the PSB to provide the principal personal services.

Taxation Determination TD 2005/29 Income tax: will Part IVA of the Income Tax Assessment Act 1936 always apply if a taxpayer who carries on a business (including a personal services business) pays superannuation contributions that do not exceed the age-based limits but are considerably in excess of the value of the services provided by the employee? sets out our position on the application of Part IVA where a PSB employs a related individual and makes superannuation benefits for that individual that are in excess of the value of the services they have provided.

Example 4 of the draft Guideline is unclear on certain matters, and anomalies arise irrespective of how those uncertain matters might be clarified.

It is recommended that the example be amended to remove anomalies and achieve appropriate tax and commercial outcomes.

Example 4 of the draft Guideline indicates that, in the ATO's view, calculating profit and bonus figures prior to 30 June should be the norm and that undertaking the calculations after year-end is only acceptable in one-off special circumstances. This does not reflect commercial reality.

It is suggested that the final Guideline include a low-risk example which has a PSB finalising their accounts within a reasonable time after year-end or that a sensible time lag be permitted.

The timing of the calculations is simply used to establish the taxpayer's normal pattern of behaviour and thereby identify abnormal behaviours of a kind that fall outside that pattern.

Example 6 of the draft Guideline does not address a number of outcomes and consequences that will arise.

The applicable company tax rate is 25% and profit is equal to taxable income.

There are double taxation issues and anomalies that arise and GST implications for funds retained for purchase.

We have also changed the type of payment in this Example from a bonus to a franked dividend, to prevent double taxation of the $2,000.

Example 9 of the draft Guideline suggests that investing retained profits in a passive investment such as a share portfolio will automatically trigger a higher risk rating.

It would be interesting for the final Guideline to have an example where the passive investment was a modest and highly liquid investment such as a term deposit or cash holdings in high interest accounts, to determine whether it would be considered a low-risk arrangement by the ATO.

The final Guideline should provide clarity and examples of how the ATO would apply the PSI rules and Part IVA on a non-white collar professional business such as a tradesperson or a heavy machinery operator.

The final Guideline should clarify and include an example of how the ATO would apply the PSI rules and Part IVA where a husband and wife employ an apprentice or an employee.

Is the scale of the business activity being carried out such that it amounts to a 'business structure' and thus would not be caught in the realm of the PSI and Part IVA rules?

Paragraph 16 of the final Guideline makes clear that the Guideline does not apply to alienation arrangements where the income generated is not PSI – such as income from a business structure. Paragraph 16, through footnote 11, outlines where to find further guidance on when income is being generated from a business structure.

The final Guideline should provide an example of how the ATO would apply the PSI rules and Part IVA where one partner of the business, that is, a silent partner, such as a retired parent or relative, contributes the funds, and the other partner provides the know-how to starting a business.

Will the ATO allow apportionment of income derived by the business between the partners or will the income be solely attributed to the individual who provides the know-how and generates the income?

In the final Guideline, an alternative outcome should be added into Example 13, outlining the outcome if Tom conducted both his civil engineering consulting and the other business selling goods in his personal name. This will allow Tom to be entitled to all allowable deductions – the losses from other business operations would be deductible against the civil engineering consulting income.

There is no Part IVA risk.

TR 2022/3 provides guidance relevant to individuals who earn PSI but do not work through a PSE (that is, sole traders).

Given that BLD is in losses from its other business operation, the payment of a bonus or salary by BLD to Tom, equal to the net PSI, could have serious risk and cause BLD difficulties in paying its creditors and run the risk of insolvent trading.

In this example (now Example 17 in the final Guideline), the fact that the PSI is retained to offset significant losses from another business activity, may not be for a relevant or appropriate commercial purpose and may require further review.

The final Guideline should confirm that paying an employee higher than award wages will not, in itself, trigger a higher risk rating. We also note that awards do not apply in many industries.

Accordingly, we suggest that in the final Guideline the wording be amended to simply reflect that the employees are being paid commercial, market value wages and salary.

It would be helpful if footnote 7 in paragraph 6 of the draft Guideline explicitly referenced the details of existing guidance and judicial decisions that have 'made clear that Part IVA can apply to alienation arrangements involving income splitting and retention of profits where the dominant purpose of a participant in the scheme was to obtain a tax benefit'.

It is acknowledged that there are references to ATO guidance and judicial decisions in the footnotes, with the exception of TR 2022/3, these references appear to refer to guidance and judicial decisions that were published prior to the introduction of PSI regime and therefore prior to the introduction of the concept of PSB.

The final Guideline includes a reference (at footnote 3) to TR 2001/8 (now withdrawn) which was released shortly after the PSI rules were introduced. TR 2001/8 remained in force until replaced by TR 2022/3.

The introduction of the PSI rules had the practical effect of narrowing the scope for Part IVA to apply to alienation arrangements (because where the PSI rules apply, no tax benefit is obtained), but it did not otherwise affect the continued operation of Part IVA.

The case law provided in the draft Guideline relates to business and work conditions in the early 1980s. The facts and outcome of Commissioner of Taxation v Mochkin [2003] FCAFC 15 (Mochkin) were not highly dependent on the time period involved and unlikely to change the need to consider modern business conditions in assessing the appropriate flexible approach to income splitting or retention by the many PSBs which are modern businesses.

Judicial precedent is adaptable to new facts and circumstances. Courts revisit older case law and interpret it in light of changes in business practices and technology.

In reference to Mochkin at [39], paragraph 27 of the draft Guideline states 'However, Sackville J indicated that it was arguable we could have been successful in the application of Part IVA had the narrower scheme have been argued.'

Respectfully, Mochkin at [39] does not support the draft Guideline's assertion that Sackville J indicated it was arguable the Commissioner could have been successful in the application of Part IVA had the narrower scheme been argued. Instead, it only pointed out that it was arguable for the Commissioner to apply Part IVA on a narrower scheme and that the Commissioner had to show the scheme defined was not so narrow as to deprive it of all practical meaning.

The final Guideline should more accurately reflect Mochkin at [39].

Mochkin does, however, emphasise the point made, in paragraph 32 of the final Guideline, that the facts and circumstances of particular arrangements can result in 2 different schemes. We have included this case as a reference in that paragraph.

Small businesses are met with demands to operate through a corporate entity as imposed by their clients. It is arguable that this crucial precondition for getting work means there was no sole purpose of obtaining a tax benefit from any subsequent income splitting by the test individual.

The draft Guideline addresses this issue at paragraph 26 by suggesting that the Commissioner might choose to identify the relevant scheme narrowly rather than widely.

The effectiveness of such an approach is open to question in light of the decision of the Full Federal Court in Minerva Financial Group Pty Ltd v Commissioner of Taxation [2024] FCAFC 28.

Even if a small business owner is required to operate through a company, Part IVA may still apply where that company has been used to facilitate an income splitting arrangement or a retention of profits arrangement, or both.

If taxpayers and advisers need to reconsider any higher risk arrangements where there is an element of income splitting or profit retention, what are the indicators of red flags to identify a higher risk?

Will there be a dollar value or a percentage? Or a moderate level of income splitting where net PSI allocated to lower associates remains below a threshold for a year of income?

In the final Guideline, Table 2 provides an overview of the higher risk indicators where PSI is alienated through a PSE conducting a PSB.

An alternative approach is to apply risk assessment factors (1) and (2) in Table 1 of Practical Compliance Guideline PCG 2021/4 Allocation of professional firm profits - ATO compliance approach to the net PSI of the PSB.

The risk assessment framework in PCG 2021/4 was designed to encourage individual profession practitioners to self-assess.

In Example 7 of the draft Guideline, the entity passes the PSB tests and has a commercial purpose, however Part IVA is still applied because the distribution is done 'without regard to the value of her personal services which generated income'.

The term 'value of her personal services' is not clearly defined. It is unclear whether 100% of net profit after expenses must be distributed to the individual who generated the PSI or whether there are other parameters that determine the correct 'value' of the personal services.

The examples indicate the types of arrangements in which any deviation away from distributing 100% of the net profits to the individual may attract the application of compliance resources.

Taxpayers and their advisers are not in a position where they can apply Part IVA on behalf of the Commissioner.

The Guideline explains when we will be more likely to have cause to apply compliance resources to consider the potential application of Part IVA to an alienation arrangement where PSI of an individual is derived through a PSE that is conducting a PSB.

The administration and application of Part IVA is available in Law Administration Practice Statement PS LA 2005/24 Application of General Anti- Avoidance Rules.

The ATO views expressed in the Guideline fail to take into account the commercial reality that net PSI derived by a PSE is the culmination of a number of inputs of which only one is the individual's personal efforts or skills.

The PSE should be entitled to attribute part of the net PSI to the other components that generate the PSI and thereby be permitted to direct the value of those components away from the individual to which that income would, according to ATO views, otherwise be attributed.

When a contract involves a number of components, the entity needs to determine if the income derived from that contract is mainly a reward for the personal efforts or skills of the individual. If it is not, then the whole amount received under the contract is not PSI and the Guideline is not relevant to that income.

See paragraphs 46 to 49 of TR 2022/3 for further guidance.

Fees charged represent substantially more than payment for the work done.

The fees necessarily include components attributable to covering other business costs that are otherwise unrewarded including marketing, tendering, canvassing, engagement letters, billing and collection debt. These tasks distinguish a PSE business from an employee who simply turns up for work, does the work and goes home again without concern for these additional requirements of carrying on business.

A PSE will need to consider what the client is actually paying for and whether it is mainly for the reward for the individual's personal efforts or skills. If it is, the entire amount received under the contract is PSI and the character of the income is not changed by a notional allocation to other components for accounting purposes, such as business costs which determines the rate charged to clients.

For example, if a plumber has a charge-out rate of $100 per hour and it is generated from them expending their personal effort as a plumber, that is $100 of PSI, despite it being notionally allocated to labour, business costs or profit for accounting purposes.

It does not make sense that different deliverables are taxed differently.

For example, if a lawyer provides verbal or written legal advice, it is labelled as personal exertion income. However, if a lawyer comes out with an app or writes a book, it is labelled as sale of goods and not personal exertion income subject to the Guideline.

Refer to paragraphs 38 to 39 of TR 2022/3 for detailed guidance.

The unique nature of many businesses is problematic if seeking to apply a 'one size fits all' approach for income splitting purposes.

It is suggested the strict 'one size fits all' low or zero tolerance to income splitting for every PSB which passes the PSI rules should be reconsidered.

The type of scheme to which Part IVA may apply will depend on the particular facts and circumstances of the arrangement.