Edited version of your written advice

Authorisation Number: 1013027389478

Date of advice: 2 June 2016

Ruling

Subject: Personal services income rules

Question 1

Is X a personal services entity within the meaning of subsection 86-15(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Does X satisfy the 'Results Test' contained in section 87-18 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2016

The scheme commences on:

2015

Relevant facts and circumstances

X is a privately owned company. The sole director, shareholder and employee of X is Y.

X receives income from a sole client, Z under a Trading Agreement (the Agreement). The activities carried out by X under the Agreement are performed by Y (the Individual).

X also receives an incidental amount of interest income.

Z is a proprietary trading firm, which acquires and disposes of equities and derivative assets. Z trains, mentors and houses traders to undertake buying and selling activities for and on behalf of Z. Initially, traders are housed internally, but in time it is possible for traders working for and on behalf of Z to trade from independent business locations, and through their own entities.

Prior to entering a work contract with Z, the Individual undertook training via a simulated trading environment, provided by and within the offices of Z, during which no income was paid.

The Individual signed their first contract with Z, as a sole trader during which time she/he continued to receive training from Z. After approximately six to 12 months, X was established and the trading activities carried out by the Individual were transferred to that entity.

Activities

Under the Agreement, X is required to carry out the following activities for and on behalf of Z:

• Z agrees that the trader shall use their particular skills and knowledge to carry out trading on behalf and to the account of Z within the guidelines and terms of this Agreement.

• The Trader is to trade derivatives, equities and other products on behalf of Z within the guidelines set out in the Agreement and within the compliance framework that governs the derivatives and equities industries.

• The Trader's objective is to maximise return on Z's capital by trading within the Trader's position limits and maintaining responsible Risk Management procedures.

The Agreement, stipulates:

• The Trader may assign or subcontract its obligations under this Agreement with the written consent of Z.

• Z shall monitor and review the Trader with regard to performance under this Agreement. Such monitoring and review may be undertaken by any persons so authorised by Z.

• The Trader shall be responsible for the payment of any tax, superannuation and/or to the activities of the Trader as a result of this Agreement.

• The Trader must at all times comply with directions given to you by senior management of Z.

X intends to engage and train other individuals to perform trading activities.

Remuneration

The Agreement states:

'Z enters this agreement with the Trader on the understanding that the Trader is being contracted to produce a Result (namely profitable trading) and the Trader will be remunerated for achieving this Result by way of a Profit Share.'

The Agreement states that X is to be paid a profit share percentage of trading profits in excess of desk costs.

The Agreement states that no amount is payable by Z for a disbursement unless Z has provided prior consent, and such disbursements and expenses have been reasonably and properly incurred.

You advised that you are unaware of any reason why Z would refuse to provide 'prior consent', other than for breach of the Agreement as discussed below. To date, on submitting invoices Z has not withheld consent regarding payment.

Plant and equipment

The Agreement states 'X shall use their best endeavours to protect property provided by Z and ensure such property is returned to Z when no longer required'. The Agreement discusses 'documentation and systems' provided by Z.

When asked to provide details of services, documentation and/or property (including equipment, software, technology, market access) provided by Z to carry out the Agreement, you advised that Z provides X access to a number of software systems that are required for the Individual to conduct trades. Z also provides X access to:

• contractors to assist with the use of the trading and charting software,

• daily audio-clips of Market Updates,

• weekly and bi-weekly chart analysis updates,

• the Z intranet which includes web-client based software which monitors trading positions, profit/loss for the day, and sends notifications regarding orders in the market.

X pays Z for these accesses through 'system costs' and 'desk costs' as provided in the Agreement.

X leases business premises, from which the Individual carries out the activities required under the Agreement. X also provides computers, printers, and internet access to the Individual to perform the activities under the Agreement.

X also uses Z's capital to conduct trades, which results in Z becoming the owner of assets purchased, and receiving the income from the assets when sold and prior to distribution of Xs profit share to X under the Agreement.

X initiated trades are processed using software via Z and then cleared at a state-owned bank who is certified by the Australian Stock Exchange.

Risk

The Agreement states:

'The Trader shall not enter trades on behalf of Z in derivatives or equities once the Trader has reached the Stop Loss Limit set out in [the] Agreement or such other Stop Loss Limit as may be directed by Z from time to time. In the event of the Trader exceeding the existing Stop Loss Limit such action shall be a fundamental breach of the terms of this Agreement and shall entitle Z to cancel the Agreement forthwith. Further, the Trader shall be liable to Z for the entirety of loss incurred by Z as a result of trades entered by the Trader.'

The Agreement discusses Trading Losses and states:

'The amounts of any trading losses incurred as a result of trades executed by the Trader in breach of these Terms or executed by the Trader after the Trader's account has exceeded the nominated Stop Loss Limit (…) will be repayable in their entirety by the Trader to Z forthwith upon demand.'

The Stop Loss Limit is provided in the Agreement.

The Agreement states:

Risk must be covered at all times, either by the physical presence of the Trader in the trading room or within easy access of an electronic trading platform, or by utilisation of stop loss orders left with Z's authorised representatives. The Trader must be contactable at all times if the Trader currently holds open trade positions.

You advised that X has two primary measures to prevent/mitigate risk:

• The first is an agreement with Z, which limits the amount of risk X may continuously add upon breaching a Stop. This does not force X out of the risky position if it is theoretically over the Stop, it only prevents X from continuously building a position and compounding a loss.

• The second measure is a Risk Buffer which is agreed upon before-hand. X must leave a minimum of TWO "one session full stops" in the account in order to take the risk that it does. For example, a Daily Stop of $100,000 requires $200,000 to be left into the Z account. This acts as a buffer to mitigate risk. However, in the event of a crisis, if the account is wiped to $100,000 (negative) in the red, then X is fully liable for all losses and cannot issue an invoice until it is restored.

X must apply the Risk Buffer to mitigate any trading losses that occur below the 'Stop Loss Limit'. This means that X is liable to any losses which do not exceed the 'Stop Loss Limit'.

The Agreement discusses terminating the Agreement and states:

a. This Agreement can be terminated by Z giving XX calendar days written notice to the Trader.

b. Either party may terminate the Agreement by written notice to the other party if a material breach has not been remedied within fourteen calendar days of receipt of notification of such breach. In the event of a breach of a fundamental term including a breach of the provisions as to Stop Loss Limit, Z shall be entitled to immediately terminate the Agreement at its option. Such termination shall not release the other party from liability nor affect any accrued rights or remedies of either party.

c. Either party may terminate the Agreement immediately by written notice to the other party if that party enters into any agreement or proceedings for the purpose of insolvency administration or is placed under official management.

X's director has provided a guarantee to Z that:

'if at any time default shall be made in the payment of any monies due by the Trader to Z under the Agreement or the performance or observation or any term or condition of the Agreement to be performed or observed by the Trader, [he] will forthwith on demand by Z pay to Z the monies that are due under the Agreement by the Trader to Z and will keep Z indemnified against all losses, charges and expenses which Z may incur as a result of the default on behalf of the Trader.'

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 45-40

Income Tax Assessment Act 1997 Part 2-42

Income Tax Assessment Act 1997 subsection 84-5(1)

Income Tax Assessment Act 1997 Division 85

Income Tax Assessment Act 1997 Division 86

Income Tax Assessment Act 1997 subsection 86-15(2)

Income Tax Assessment Act 1997 section 87-1

Income Tax Assessment Act 1997 subsection 87-15(1)

Income Tax Assessment Act 1997 section 87-18

Income Tax Assessment Act 1997 subsection 87-18(3)

Income Tax Assessment Act 1997 paragraph 87-18(3)(a)

Income Tax Assessment Act 1997 paragraph 87-18(3)(b)

Income Tax Assessment Act 1997 paragraph 87-18(3)(c)

Income Tax Assessment Act 1997 former subsection 87-60(5)

Income Tax Assessment Act 1997 former subsection 87-60(6)

Income Tax Assessment Act 1997 former subsection 87-60(7)

Income Tax Assessment Act 1997 former subsection 87-65(5)

Income Tax Assessment Act 1997 former subsection 87-65(6)

Income Tax Assessment Act 1997 former subsection 87-65(7)

Income Tax Assessment Act 1997 section 995 -1

Reasons for decision

Issue 1

Question 1

Is X a personal services entity (PSE) within the meaning of subsection 86-15(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

Yes. X is a PSE within the meaning of subsection 86-15(2) of the ITAA 1997 because the ordinary income of X includes the personal services income (PSI) of the Individual.

Detailed reasoning

The PSI regime in Part 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997) was introduced to:

• limit and clarify the deductions available against PSI for both individuals carrying on business and other entities (Division 85); and

• ensure that any income remaining, after allowing certain deductions, is attributed to the individual for taxation purposes (Division 86).

The ordinary or statutory income of an individual, or of any other entity, that is mainly a reward for the personal efforts or skills of the individual, is the individual's PSI (subsection 84-5(1) of the ITAA 1997).

Subsection 86-15(2) explains that a company, partnership or trust whose ordinary income or statutory income includes the PSI of one or more individuals is a PSE.

Taxation Ruling TR 2001/7 Income tax: the meaning of personal services income (TR 2001/7) explains the meaning of PSI is wider than that which might otherwise be the case under the common law, but it does not include income that is mainly:

• from an entity supplying goods or granting a right to use property;

• generated by assets an entity holds; or

• generated by the business structure (paragraph 29).

Under the Agreement, X has been engaged to trade derivatives, equities and other products on behalf of Z. It is X who is entitled to receive payment for the services provided, and the amounts received by X pursuant to the Agreement, are ordinary or statutory income of X.

Although X buys and sells the derivatives, equities and other products, X uses capital of Z to carry out the trading activities. As such, Z is the owner of the assets purchased and sold, and receives any income from the sale of the assets. The amounts received by X are not received from the sale of goods or assets owned by X.

The amounts received by X are for trading activities carried out by the Individual for and on behalf of Z, as X's employee. These activities are carried out predominantly through the use of the Individual's skills and knowledge.

Consistent with ATO ID 2002/802 Alienation of Personal Services Income - Personal Services Entity, the payments received by X are mainly a reward for the personal efforts or skills of the Individual within the meaning of subsection 84-5(1) of the ITAA 1997, and are the Individuals PSI.

As X's ordinary income includes the PSI of the Individual, X is a PSE as defined in subsection 86-15(2) of the ITAA 1997.

X also receives an incidental amount of interest income. This income is not mainly a reward for the personal efforts or skills of an individual accordingly, it is not PSI.

Question 2

Does X satisfy the 'Results Test' contained in section 87-18 of the ITAA 1997?

Summary

Yes. X satisfies the 'Results Test' contained in section 87-18 of the ITAA 1997 accordingly, X is conducting a personal services business (PSB) as outlined in section 87-15 of the ITAA 1997, and is therefore, excluded from the PSI rules in Divisions 85 and 86.

NOTE: The legal reasoning below discusses the PSI regime applied to PSEs only.

Personal services business

Section 87-1 of the ITAA 1997 clarifies that Divisions 85 and 86 do not apply to PSI that is income from an individual or other entity conducting a PSB. A PSE conducts a PSB if:

• a PSB determination is in force relating to an individual whose PSI is included in the entity's ordinary or statutory income, or

• the entity meets at least one of the four PSB tests in the relevant income year (subsection 87-15(1) of the ITAA 1997).

The first of the four tests, the 'results test', is provided in section 87-18 of the ITAA 1997. This test is the only PSB test that is available for self-assessment when 80% or more of an individual's PSI is from one source.

If 80% or more of an individual's PSI is from one source and the PSE does not meet the 'results test', unless a PSB determination is obtained from the Commissioner, the PSI alienation measures will apply.

The results test

Subsection 87-18(3) of the ITAA 1997 provides that a PSE meets the 'results test' in an income year if, in relation to at least 75% of the PSI that is included in the PSE's ordinary or statutory income during the income year:

(a) The income is for producing a result; and

(b) The individual is required to supply the plant and equipment, or tools of trade, needed to perform the work from which the individual produces the result; and

(c) The individual is, or would be, liable for the cost of rectifying any defect in the work performed.

As most of the income in the test year comes from the Agreement with Z, in order to satisfy the 75% requirement, the Agreement needs to meet the results test.

Taxation Ruling TR 2001/8 Income tax: what is a personal services business (TR 2001/8) provides guidance for interpreting and applying the 'results test', as provided in former subsections 87-60(5) to (7) and 87-65(5) to (7) of the ITAA 1997, and can be applied similarly in relation to section 87-18.

Paragraph 34 of TR 2001/8 clarifies that the 'results test' will be met where:

(a) The contract is to produce a specified outcome or result and payment is based on performance of the contract (i.e., for producing the outcome or result);

(b) You provide the equipment and tools, if any, necessary for doing the work; and

(c) You bear the commercial risks, including liability for defective work.

TR 2001/8 (paragraph 110) explains that the 'results test' is based on the traditional criteria for distinguishing independent contractors from employees. Guidance on this distinction is provided in Taxation Ruling TR 2005/16 Income tax: Pay As You Go - withholding from payments to employees (TR 2005/16).

Producing a result

Under the Agreement with Z, X is required to provide the services of the Individual to trade derivatives, equities and other products on behalf of Z; ATO ID 2002/803 Alienation of Personal Services Income - Results Test deals with a similar factual situation to the current case.

In ATO ID 2002/803, the taxpayer had contracted to supply its employees to a licensed dealer in securities. These individuals were then appointed as proper authority holders (PAH) under subsection 94(2) of the then Corporations Act 1989. Under the contract the taxpayer received commissions determined by reference to corporate advisory transactions as well as equity and derivatives business written by the individuals for the dealer.

The individuals performed the usual functions of a PAH for the Dealer. Contractually, the functions were performed in each individual's personal capacity for the Dealer and not as an employee of the taxpayer. The individuals were not entitled to any remuneration from the Dealer. It was considered that the taxpayer merely supplied the individuals to the Dealer and did nothing else. That is, the arrangement was for the hire of the individuals to the Dealer.

A contract for hire is not a contract for producing a result within the case law meaning or the meaning explained in TR 2001/8. Under a contract for hire, there is nothing created or produced by the supplying party. There is simply the provision of a pre-existing asset (in this case human capital). Accordingly in ATO ID 2002/803, the first condition of the results test was not satisfied therefore the taxpayer did meet the results test.

It is considered that the current case can however, be distinguished from the situation in ATO ID 2002/803. Changes to the Corporations Act mean that individuals are no longer required to be appointed as PAHs therefore, an individual is now able to perform trading services in their capacity as an employee; and is not required to do so as an individual in their personal capacity. It is considered that under the Agreement with Z, the Individual performs the trading activities as an employee of X.

The first condition of the results test requires the PSI is from producing a result. The meaning of 'producing a result' is explained in Taxation Ruling TR 2001/8 to be inter alia, a contract to achieve a specified outcome. In essence, for a contract to be for producing a result, there must be some task required where it is left to the performing party to determine how the task is to be performed. Entitlement to payment in turn must be tied to completing the task.

Under the Agreement, the Individual who is the employee of X, is required to use their skills and knowledge to trade derivatives, equities and other products on behalf of Z to produce a profitable trading result. The stated objective is to maximise return on Z's capital by trading within the Trader's position limits and maintaining responsible Risk Management procedures.

It is considered that X is free to employ its own means to achieve the specified outcome. For example, X can choose when and where the work is done and the amount of time spent working; payment is not by reference to the number of hours worked; and X can decide whether or not to utilise any of the resources (charting and trading software, and market updates) made available by Z (and leased by X). There are no restrictions on the use of other products. X also intends to engage and train other individuals to perform trading activities. Assigning or subcontracting obligations is provided for under the Agreement.

Under the Agreement Z retains a measure of control, in that X must comply with directions given by senior management of Z, and that no amount is payable for disbursement to X unless Z has provided prior consent. It is considered that these controls are in place to ensure appropriate risk measures are in place, and that disbursements and expenses have been reasonably and properly incurred, and are not evident of an employer/employee level of control.

Paragraph 120 of TR 2001/8 states that if remuneration is payable when, and only when, the contractual conditions have been fulfilled, the remuneration is for producing a given result. This means that it is not enough that you are required to produce results from your work payment must be contingent on the achievement of contractually specified results.

Payment to X for the provision of the trading services to Z is contingent on achieving the contractually specified result of a profitable trading outcome. It is considered that X is not paid based for completing the trades, rather it is paid on the successful outcome of a period of trades. The essence of the Agreement is producing a specified result rather performing work.

Accordingly, X satisfies paragraph 87-18(3) (a) of the ITAA 1997.

Required to supply the plant and equipment, or tools of trade, needed to perform the work

The second condition for the results test is that the individual or PSE is required to supply the plant and equipment or tools of trade necessary to perform the work.

TR 2001/8 at paragraphs 124-125 explain that the plant, equipment or tools to be provided are those that are necessary to do the actual work that the PSE is contractually required to perform. Further, having regard to custom and practice in relation to particular work, there may be an expectation that a genuine independent contractor would be required to supply the necessary plant, equipment or tools.

Where such an expectation exists, or where the contractual requirements require the supply of necessary plant, equipment or tools, the PSE must supply the plant, equipment or tools in order to meet the 'results test' (TR 2001/8 paragraph 124).

De minimus, or insignificant, use of plant, equipment or tools of others will not of itself disqualify the taxpayer (TR 2001/8 paragraph 126).

A range of plant, tools and equipment are needed to perform the trading services under the Agreement.

X leases business premises from which the Individual carries out the activities required under the Agreement. X also provides equipment and internet access to the Individual to perform the activities under the Agreement.

In addition X provides the individual with resources such as software, and market updates. X currently leases such resources from Z. X can decide whether or not to utilise any of these resources. There are no restrictions on the use of other products.

X initiated trades are processed using software through Z and then cleared at a state-owned bank who are certified by the Australian Stock Exchange. The costs of using the software are borne by X.

X also uses Z capital to conduct trades, which results in Z:

• becoming the owner of assets purchased, and

• receiving income from the sale of the assets, prior to distributing Xs profit share under the Agreement.

"Plant" is a defined term under section 995-1 of the ITAA 1997; and has the meaning in section 45-40. Z supplying capital for use by X is not considered to be supply of plant for the purposes paragraph 87-18(3)(b).

X pays the costs for all tools and equipment necessary to do the work that is required to be performed. Accordingly it is considered that X satisfies the requirements of paragraph 87-18(3)(b) of the ITAA 1997.

Liable for the cost of rectifying any defect in the work performed

Paragraph 87-18(3)(c) of the ITAA 1997 will be satisfied where there is a liability for the cost of rectifying any defect in the relevant work performed, including situations where action is taken to rectify the error at the PSE's own cost prior to completion of the task or prior to the taking of legal action (TR 2001/8, paragraph 36).

In circumstances where physical repair of the defect is not possible, being 'liable for the cost of rectifying any defect in the work performed' would be satisfied where a right to claim for damages exists and the PSE is liable for the relevant component of damages awarded for the faulty or defective work (TR 2001/8, paragraph 37).

Paragraph 131 of TR 2008/1 explains that the emphasis here is on "liability for the cost" of rectifying faulty work. That is, the key underlying consideration is whether the PSE is exposed to commercial risk in terms of a liability to cover the cost of rectifying defective work. It is only the cost of rectification that must be met by the PSE - there is no requirement that the PSE actually perform the work which rectifies the defect so long as they pay for it.

Payment to X for the provision of the trading services to Z is contingent on achieving the contractually specified result. The required result under the Agreement is to achieve a profitable trading outcome; accordingly, defects in the work performed would equate to generating a loss outcome.

You advised that there are two primary measures to prevent/mitigate risk:

• The first is an agreement with Z, which limits the amount of risk X may continuously add upon breaching a Stop. This does not force X out of the risky position if it is theoretically over the Stop, it only prevents X from continuously building a position and compounding a loss.

• The second measure is a Risk Buffer which is agreed upon before-hand. X must leave a minimum of TWO "one session full stops" in the account in order to take the risk that it does. For example, a Daily Stop of $100,000 requires $200,000 to be left into the Z account. This acts as a buffer to mitigate risk. However, in the event of a crisis, if the account is wiped to $100,000 (negative) in the red, then X is fully liable for all losses and cannot issue an invoice until it is restored.

X must apply the Risk Buffer to mitigate any trading losses that occur below the 'Stop Loss Limit'. This means that X is liable to any losses which do not exceed the 'Stop Loss Limit'.

Whilst there are measures in place to try to minimise defects in the work performed, these measures do not prevent X from exposure to commercial risk. It is considered that X is ultimately liable for the cost of rectifying defects in the work performed therefore, X meets the requirements of paragraph 87-18(3)(c) of the ITAA 1997

In the test year, X satisfies the 'Results Test' contained in section 87-18 of the ITAA 1997 accordingly, X is conducting a PSB as outlined in section 87-15, and is therefore, excluded from the PSI rules in Divisions 85 and 86.