Edited version of private advice

Authorisation Number: 1052147538456

Date of advice: 11 August 2023

Ruling

Subject: Unrelated clients test

Question

Does the taxpayer pass the unrelated clients test for PSI?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2023

Year ending 30 June 2024

The scheme commenced on:

1 July 2022

Relevant facts and circumstances

The taxpayer applied for a private ruling for the relevant income year. The application relates to consultancy services.

The taxpayer has provided professional services to numerous clients in the relevant income year. Information has been provided for the relevant income years.

The taxpayer has advised that they meet the unrelated clients test on the basis of being in a niche industry that has a small number of potential service acquirers.

The taxpayer obtained their clients through the use of networking at various conferences and the word of mouth referrals. They are able to source enough work to keep them busy all year round and do not find it necessary to advertise to the general public as they are well known in their field.

The taxpayer advised that they operate in a specialised, niche industry where word of mouth and networking at conferences worldwide reaches their whole potential market and therefore should pass the unrelated clients test.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 84-5

Income Tax Assessment Act 1997 Section 87-15/p>

Income Tax Assessment Act 1997 Section 87-20p>

Reasons for decision

Personal services business (PSB)

A taxpayer conducts a personal services business (PSB), and the PSI rules will not apply, if one of the four personal services business tests is met in the income year.

If the PSI rules apply, the net PSI received by the personal services entity (PSE) will be attributed to the individual who generated that income and available deductions are restricted.

There are four personal services business tests:

•         the results test

•         the unrelated clients test

•         the business premises test, and

•         the employment test

Only one test is required to be met for the PSI rules not to apply.

The 80% rule

Individuals/PSEs can self-assess against the results test irrespective of how much income comes from one source. If less than 80% of the PSI is from one source, an individual/PSE can self-assess against the other tests. However, if more than 80% of the individual's PSI is from one source, the individual/PSE must hold a Personal Services Business Determination (PSBD) from the Commissioner for the PSI rules not to apply to that income.

The 80% rule itself is not a personal services business test but relates to whether self-assessment is available. For the Commissioner to issue a PSBD one of the personal services business tests must be met. The Commissioner can only issue a PSBD in the following circumstances:

•         the results test, business premises test or employment test is met

•         unusual circumstances prevented the results, employment or business premises test from being met

•         the unrelated clients test was met but unusual circumstances prevented the 80% rule from being satisfied

•         unusual circumstances prevented the unrelated clients test and 80% rule from being met.

The unrelated clients test

To meet the unrelated clients test in an income year:

•         an individual or PSE is required to gain or produce the PSI from providing services to two or more entities. Those entities cannot be associates of each other or associated to the individual or PSE and

•         the services must be provided as a direct result of making offers or invitations (for example, by advertising) and those offers must be made to the public at large or a section of the public.

If the services are provided by registering through a labour hire firm or similar arrangement, the test will not be met as the required offer or invitation has not been made to the public at large or a section of the public.

Direct result of making offers or invitations

To meet this condition, the offer or invitation must be the reason why the work was obtained and there must be a close and significant connection between the offer or invitation and obtaining the work.

A wide variety of activities can constitute making offers or invitations such as print advertising, printing posters, radio and television broadcasting, public tender, having a website and posting internet advertisements but all require the involvement of making public announcements.

Registering with labour hire firms, or similar, or responding to advertisements on web-based recruitment sites, will not meet this condition.

The public or a section of the public

An offer or invitation is made to 'the public at large' where any interested member of the public is capable of accepting it. An offer or invitation to 'a section of the public' is made in situations where only a select group is chosen to whom the invitation is made. Making an offer or invitation to 'a section of the public' could include offering to provide services to one entity in certain circumstances for example in relation to competitive tenders.

A word of mouth referral is not generally considered to satisfy the requirements of the unrelated clients test.

A word of mouth referral is where work is offered because of a recommendation from a previous client or industry contact. However, offers made by word of mouth in a specialised or niche industry where there are only a very small number of potential clients may, in limited circumstances, meet this condition.

Where a prior or subsisting relationship exists between the parties the following factors are relevant to determining whether the offer or invitation is made to 'a section of the public':

•         the number of persons or entities to which the offer is made

•         the nature and content of the offer e.g. competitive commercial process such as public tender

•         the nature of the relationship between the parties - where the parties deal with each other on an arm's length basis, the commercial character of the transaction is maintained so even if services had been provided sometime in the past, this element may still be satisfied.

The unrelated clients test requires an offer or invitation to be made to 'the public at large' where any interested member of the public is capable of accepting it, or a 'section of the public,' where a select group is chosen to whom the invitation is made. The offer to provide services must be made by the PSE. Where an offer is made by an individual, and it is clear that the offer is made by the individual as a representative of the PSE, then the offer is considered to have been made by the PSE.

In the application, it states the taxpayer provides consultancy services. In the relevant income year, the taxpayer gained or produced PSI from providing services to numerous entities. There is only one entity which is an associate of the taxpayer.

The taxpayer stated the manner by which it obtained its contracts was word of mouth referrals. They advise that they obtain their clients through the use of networking at various conferences and word of mouth referrals. The taxpayer does not find it necessary to advertise to the general public as the service provider is well known in their field.

The taxpayer states that word of mouth referrals should be accepted as they are in a niche industry as demonstrated in Yalos Engineering Pty Ltd v FC of T [2010] AATA 408 at [24 (Yalos).

As stated above, word of mouth referrals will only meet the requirement of the unrelated clients test if the skills and expertise of the individual are highly specialised resulting in only a small potential pool of clients being able to be serviced. The highly specialised skills are only suited to a specialised or niche industry. Where a large client base exists, a word of mouth offer is not an offer or invitation made to the public at large or a section of the public that will meet the requirements of the unrelated clients test.

Based on the information provided, there does not seem to be a very small pool of clients that would obtain these consultancy services. In the information provided, there is a large variety of service acquirers. The wide variety of clients are similar in the other income years.

The potential number of clients for which the Company could undertake work across a diverse range of industries and entities can be contrasted with the highly specific niche industry in Yalos. In the Yalos case, a small number of companies were engaged in offshore petroleum exploration and mining and were considered to be a section of the public for the purposes of 87-20(1)(b) of the ITAA 1997. Whilst the industry is considered to be specialised, there is a large market of prospective clients which require the taxpayer's consultancy services. Although advertising to the public is not necessary for the Company, this does not mean that word of mouth referrals is accepted. There needs to be a small pool of potential service acquirers which make it unsuitable to advertise to the public.

Clients obtained via word of mouth, direct approach and direct approach from representatives with a previous work association by the taxpayer cannot be considered for the purposes of the unrelated clients test as they do not meet the requirements that the services have been provided as a direct result of making offers or invitations to the public at large or a section of the public.

The Commissioner considers the way in which contracts were obtained, as detailed above, are not as a direct result of the Company making offers or invitations to the public at large or a section of the public to provide its services.

Consequently, the Commissioner is not satisfied that the unrelated clients test was met in the relevant income year.

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