Edited version of private advice

Authorisation Number: 1052299759607

Date of advice: 11 September 2024

Ruling

Subject: Personal services income

Question 1

Was the income received by the Company for the services provided by the test individual in the relevant income year personal services income?

Answer

Yes.

Question 2

If the answer to question 1 is yes, did the Company meet the results test under section 87-18 of the Income Tax Assessment Act 1997 (ITAA 1997) in the relevant income year?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2023

The scheme commenced on:

1 July 2000

Relevant facts and circumstances

Company A (the company) operates in the field of IT development.

In the relevant year, Company A entered into an agreement with Company B to provide software development and consulting services. The test individual provides the services on behalf of the company.

There was no written agreement between the Company A and Company B. The agreement is based on projects/tasks and is not tied to a specific period of time. When Company B requests a new project to be completed, the test individual discusses the details and provides a quote for the effort needed to complete individual projects/tasks and milestones. When necessary, the company has the option to engage subcontractors depending on the nature and size of the task.

In the relevant year, Company A subcontracted some of its work to a freelance developer. The subcontractor is an individual who performed full-stack development work and was paid accordingly for the work performed.

There was no written contract between the company and the subcontractor.

The services are performed from Company A's home office, except for work performed by third-party subcontractors from their own premises. The test individual at times travelled to Company B's business premises to discuss larger projects when applicable.

The effort is measured in hours and, if approved by the Company B, the work is completed and billed at the end of the month alongside any other projects/tasks completed during the same calendar month. If a project is not completed within the month, a tally of the hours already completed is invoiced to Company B, with the remainder invoiced the following month.

Invoices are billed monthly and include a summary of the projects/features/tasks completed during that calendar month. The hours in the invoices reflect the magnitude of the project.

If a defect or bug is detected, Company B has a 30-day warranty period to claim such defects, during which remediation work is performed free of charge. After 30 days, the defect is considered a new feature and therefore a new billable item. The fee is not reimbursed if a bug is found, instead it is fixed.

Company A has one employee who is related to the test individual. The employee undertakes administrative role and maintains a structured time billing system to submit for approval by Company B.

Company A utilises their own equipment, software, and office facilities to conduct their operations. This includes a custom-built desktop computer, two monitors, keyboard and mouse, internet connection, desk and chair.

The income received by the company for the relevant income year came from only one source.

Copies of invoices have been provided showing the amounts paid and description of tasks during the monthly invoicing period.

The company does not hold liability/indemnity insurance policy.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 84-5

Income Tax Assessment Act 1997 section 87-15

Income Tax Assessment Act 1997 section 87-18

Reasons for decision

Question 1

Summary

The income received by the Company for the services performed by the test individual is mainly a reward for his personal efforts and skills and therefore, his PSI.

Detailed reasoning

Personal services income (PSI)

PSI is income that is mainly a reward for an individual's personal efforts or skills (or would mainly be such a reward if it was the income of the individual).

By definition, income earned by an employee is PSI. However, the PSI rules do not apply to income received as an employee unless they are an employee of an interposed entity.

Income that is mainly generated from:

•         the sale or supply of goods;

•         the supply and use of income-producing assets; or

•         a business structure

is not PSI.

Only individuals can have PSI. PSI can be earned directly by an individual or indirectly through a company, partnership or trust (personal services entity).

A personal services entity (PSE) is a partnership, company or trust that receives the PSI of one or more individuals and is interposed between the individual(s) providing the work or services and the service acquirer.

The phrase 'or would mainly be such a reward if it was the income of the individual' applies to situations where the income is legally derived by a PSE and not the individual. If the PSE fails to meet a personal services business test in respect of a test individual, the PSI is deemed to be the income of the individual who earns the PSI and is attributed to that individual.

The use of the word 'mainly' means that the income referred to needs to be 'chiefly', 'principally' or 'primarily' a reward for the provision of the personal efforts of, or for the exercise of the skills of, an individual. That is, more than half (50%) of the ordinary or statutory income received is required to be a reward for the personal efforts and skills of an individual rather than being generated by the use of assets, the sale of goods or by a business structure.

Application to the taxpayer's circumstances

During the 2023 income year, Company A has entered into an agreement with Company B to provide software development and consultancy services. The test individual provided his personal services on behalf of Company A. Based on the information provided, the income received by Company A for the services performed by the test individual is mainly a reward for his personal efforts and skills and therefore, his PSI.

Question 2

Summary

The company did not meet the results test under section 87-18 of the ITAA 1997 as all three conditions of the results test were not satisfied.

Detailed reasoning

As the income received by the company is PSI of the test individual, it is relevant to determine whether the PSI rules apply. The PSI rules do not apply if the PSE or sole trader conducts a personal services business.

Personal services business (PSB)

A taxpayer conducts a 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 PSE will be attributed to the individual who generated that income and available deductions are restricted.

Attribution does not apply to sole traders as they do not earn PSI through a PSE and the PSI is included in the individual's personal tax return.

There are four personal services business tests:

•         the results test[1]

•         the unrelated clients test[2]

•         the business premises test[3], and

•         the employment test[4].

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

In this ruling, the question is about whether the company meets the results test in relation to the personal services provided by the test individual.

The results test

To meet the results test in an income year at least 75% of an individual's PSI in an income year must satisfy all three conditions below:

•         the income is for producing a result; and

•         the individual or PSE is required to supply the plant and equipment and tools of trade needed to perform the work which produces the result; and

•         the individual or PSE is liable for the cost of rectifying defects.

To meet the test all three conditions must be satisfied in relation to 75% of the PSI received.

During the 2023 income year, the company has only one client (being Company B), and 100% of the income received was the test individual's PSI.

Producing a result

In results-based contracts, payment is usually made for a negotiated contract price, as opposed to an hourly or daily rate, and is paid only when the contractual conditions have been fulfilled. Where remuneration is payable on the contractual conditions being fulfilled, the remuneration is for producing a result. The remuneration is often a fixed sum on completion of a particular job as opposed to an amount paid by reference to hours worked.

The essence of the contract must be to achieve a result and not to do work. The fact that an individual or PSE is required to complete identifiable tasks is not the same as achieving a result if those tasks merely form part of the work being paid for on an ongoing basis.

The substantive issue in the requirement for the contract to be for producing a result is the payment conditions. If remuneration is payable when, and only when, the contractual conditions have been fulfilled, the remuneration is for producing a given result.

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

To satisfy the second condition, the individual or PSE must supply any plant and equipment or tools of trade needed to do the actual work which produces the result and which a service acquirer would expect the individual or PSE to provide or which the individual or PSE is contractually required to provide.

There are situations where, having regard to the nature of the work, no plant or equipment or tools of trade are needed to perform the work. Where this is the case, this condition will be met.

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

To satisfy the third condition, the individual or PSE must be liable for the cost of rectifying any defects in the work. There is no requirement that they actually perform the work which rectifies the defect so long as they pay for it.

The main consideration is whether they are exposed to commercial risk.

Where physical rectification is not possible, the purpose of the provision would be satisfied where a right to claim for damages exists in respect of faulty or negligent performance of contractual obligations and the individual or PSE is, or would be, liable for the relevant component of damages awarded for the faulty or defective work.

The existence of a term in an agreement that the individual or personal services entity is liable for the cost of rectifying any defect in the work performed would support the conclusion that liability to make good any faulty workmanship exists, particularly where the individual or PSE and the service acquirer are dealing with each other at arm's length. However, the term in the agreement should not be merely 'window dressing', and regard may be had to all the circumstances of the case in determining whether the relevant liability really exists. A requirement to have indemnity insurance is an indicator that an individual or PSE is liable for rectification where the indemnity insurance is part of the contractual arrangements between the parties.

Application to the taxpayer's circumstances

Company A states that the results test has been met and hence conducting a personal services business.

To determine whether the results test has been met, we examine the conditions under section 87-18 of the ITAA 1997.

Was the income received for producing a result?

A results-based contract generally has a fixed sum on completion of the particular job. In a contract for a result, payment must be contingent upon the achievement of a contractually required outcome. Payment calculated on the basis of time is inconsistent with a results-based contract rather it indicates a contract for work.

Throughout the agreement Company A is renumerated for the tasks completed by the test individual over an invoicing period. Invoices are billed monthly which include a summary of the projects/features/tasks completed during that calendar month. If a work is not completed within the month, a tally of the hours already completed is invoiced to Company B, with the remainder invoiced the following month. The invoices supplied indicated the rate charged for the works undertaken is $XXX per hour.

The information provided states that Company A is responsible for delivering end-to-end features and solutions to Company B. When Company B requests a new project to be completed (via email or phone), the test individual schedules a call with Company B to discuss the details and provides a quote for the effort needed to complete individual projects/tasks and milestones. Whilst Company A is required to achieve a specific outcome or reach agreed objective, payment is made for tasks completed on an ongoing basis and not for a contractually specified result. The facts show that the PSI received was not for producing a result but rather the performance of work the test individual.

Consequently, the first condition of the results test is not satisfied.

Is the company required to supply the plant and equipment, or tools of trade, needed to perform the work that produces a result?

The application states that Company A utilises their own equipment, software, and office facilities to conduct their operations. This includes a custom-built desktop computer, two monitors, keyboard and mouse, internet connection, desk and chair.

In the present case, regardless of whether tools and equipment are required to do the work, the connection to 'producing a result' is not present. As the work completed is not for producing a result, this condition of the results test cannot be satisfied.

Is the company liable for the cost of rectifying any defect in the work performed?

In the present case, Company A does not hold liability/indemnity insurance policy. However the application states that if a defect or bug is detected, the client (in this case, Company B) has a 30-day warranty period to claim such defect, during which remediation work is performed free of charge. After 30 days, the defect is considered a new feature and therefore a new billable item. The fee is not reimbursed if a bug is found, instead it is fixed.

The work undertaken by the test individual is measured in hours and when completed Company A issues invoices at the end of the month. As Company A is paid for the time undertaken by the test individual to complete tasks in a monthly period, rectification of any errors or defects can occur whilst undertaking the tasks. Consequently, the Commissioner is not satisfied that this condition of the results test is met.

Conclusion

To satisfy the results test, at least 75% of the PSI received must meet all three requirements of the test. As all conditions of the results test are not satisfied, the results test is not met pursuant to section 87-18 of the ITAA 1997. Accordingly, the PSI rules apply to the income received by the company in the 2023 income year.

In view of the above, Company A should either:

•         pay the test individual the PSI as salary and wages and withhold and remit tax from these payments; or

•         withhold and remit tax on the PSI attributed to the test individual.

The following deductions cannot be claimed:

•         rent

•         mortgage interest, rates or land tax relating to the home of the test individual

•         payments to their spouse (or other associates) for support work such as secretarial duties.

[1] Section 87-18 of the ITAA 1997.

[2] Section 87-20 of the ITAA 1997.

[3] Section 87-30 of the ITAA 1997.

[4] Section 87-25 of the ITAA 1997.