CALCULATING TAX PAYABLE AND ASSESSABLE INCOME ATL001 CTA1 Foundations 9 9 9 9 9 9 In this module we review and expand your understanding of the income tax formula and tax payable concepts introduced in the first module of CTA1 Foundations. Our objective is to become proficient at calculating a taxpayer’s final liability to the ATO (or refund) for an income year in common situations. The calculation of a taxpayer’s taxable income is central to determining their final liability or refund. This module considers the first part of determining a taxpayer’s taxable income: calculating the taxpayer’s assessable income. The next module considers the second part of determining taxable income: deductions. There are eight basic steps in the process to calculate a taxpayer’s liability to the ATO (or refund) for the CIY: Calculate the taxpayer’s taxable income Calculate the basic income tax liability on the taxpayer’s taxable income Subtract: non-refundable tax offsets (noting that any resulting excess is not refunded) Add: Medicare levy and surcharge Add: HELP/TSLP repayment Subtract: refundable tax offsets Subtract: tax credits (eg PAYG instalments and PAYG withholding amounts) Equals: net amount payable (or, if negative, refundable). Additional complexities may arise in some situations, such as where the taxpayer is a primary producer who applies an income averaging regime, or where the taxpayer has a foreign income offset. We do not consider these issues in this subject. In the remainder of this module, we consider the first aspect of determining a taxpayer’s taxable income: assessable income. Section 6-5(1) of ITAA97 states: Your assessable income includes income according to ordinary concepts, which is called ordinary income. Ordinary income is not defined in the tax law; as such, s 6-5 is simply refers to concepts of income that exist in common law (case law). One of the most fundamental distinctions in tax law is the difference between income (according to ordinary concepts) and capital. In the US case of Eisner v Macomber 252 US 189 (1919), the two concepts are described at 206-207: the fundamental relation of ‘capital’ to ‘income’ has been much discussed by accountants, the former being likened to the tree or the land, the latter to the fruit or the crop: the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time. Drawing on the examples above, we can see that income is like a crop harvested from the land, because it represents a gain for the taxpayer’s benefit that is derived from property, is a reward for services or is profit from the carrying on of a business. The crop (that is, the income) can be expected flow on a regular basis from that same land. In contrast, capital is the thing that produces the income and therefore, in the ordinary course of a business’ activities, is not usually dealt with other than to be used for income producing activities, or replaced with another capital asset for the continued production of income. Therefore, the money received when capital is disposed of does not have the character of ordinary income because its sale represents the conversion of one asset (e.g. land) into another (e.g. cash). Several general principles about the character of ordinary income have emerged from case law: Income is a flow: it is a return from the provision of personal services, a return on business activities, or a return on property. Income from personal exertion includes salary, wages, commissions, bonuses and employment allowances. Income from personal exertion is often received by a taxpayer as a reward for their services as an employee, although it is not restricted to employment scenarios (eg contractors). Employment is essentially the exchange of the taxpayer’s time and skill for the payment of salary or wages. In this case, the employer is the person running the business and the employee taxpayer is working in a position within the employing organisation. Income from business includes the proceeds of selling trading stock. Income from property includes rent, dividends, interest and royalties. The Commissioner considers that interest income in a joint bank account is assessable to the account holders in proportion to their beneficial ownership of funds in the account: TD 2017/11. It is presumed that the account holders own the funds in equal proportion, unless there is evidence to the contrary. Also, where a parent operates an account on behalf of a child, the parent can show the interest in a tax return lodged for the child, and a trust return is not required Note that the special tax rates for minors may be relevant in this situation (see Module 1 ‘Introduction to the Australian Tax System’). An unrealised gain in the value of an asset is not ordinary income. A realised gain in the value of an asset may be ordinary income if it is sufficiently connected to the taxpayer’s business activities. For an amount to be income, it must be money or capable of being converted into money. Section 21A ITAA36 is also relevant in the context of non-cash business benefits. The receipt must be in the nature of income. This means that the court will look at the nature of the receipt and enquire whether it ought to be properly classified as income or whether, for example, it is merely a gift. Therefore, the nature and circumstances of the payment are relevant. Normally income is received regularly and is recurring, eg wages and salaries. Compensation receipts for the loss of an amount that would have been ordinary income are ordinary income, whereas compensation for the loss of capital is regarded as a capital receipt. Windfall gains, such as winning the lottery, are not income. Money received from illegal activities will be income if they otherwise have the characteristics of income. Capital receipts are not income at common law, although as previously noted, they might be assessable income if they are statutory income. In this section we expand on the treatment of ordinary business income. The first issue to examine in this context is whether a taxpayer actually carries on a business. We consider some of the receipts that are regarded as ordinary business income, as well as income from isolated business transactions. The tax treatment of trading stock for taxpayers carrying on businesses is also examined. Is the taxpayer in business? Of the activities that constitute the carrying on of a business, it is important to distinguish between those from which income is derived and those from which income is not derived. It is a question of fact as to whether a taxpayer is carrying on a business. For smaller-scale operations, the distinction is made between a hobby or pastime and the conduct of a business. The question of whether activities constitute the carrying on of a business is answered by consideration of a number of factors, such as the: repetition of acts and transactions commercial character of the activities size and scale of the activities (in excess of domestic needs), including the amount of capital invested intention to make profits from the activities, or the taxpayer having a reasonable expectation that they will be profitable in the long term, and carrying on of the activities in a systematic and business-like manner when compared to the conduct of others carrying on similar activities (e.g. the keeping of important records or the general organisation of the taxpayer’s affairs may be important). There are several reasons why this distinction is important. First, the normal proceeds from carrying on a business constitute income according to ordinary concepts and are assessable under s 6-5 ITAA97. Second, a supplier who is carrying on a business is required by law to quote their ABN. If they do not quote an ABN when required, the payer may be required to withhold 47% from any payment due and remit this payment to the ATO (subject to some exceptions). Businesses often change In the case of some businesses, the proprietor or owner will have commenced a particular activity on a small scale, for example while employed full-time. The activity later expands from a hobby into a full-time business operation. It is then a question of fact as to when the activity stopped being a hobby and became a business. Of course, not every business starts out as a hobby. Many businesses are set up as full-scale operations from day one, exhibiting many of the characteristics of a business. Normal proceeds of operating a business Once it is determined that a taxpayer is carrying on a business, the taxpayer’s ordinary business income includes amounts received in the ordinary course of operating the business. Receipts that are normal incidents of operating the taxpayer’s business are also included in ordinary business income. Examples of the proceeds of operating a business include: selling trading stock; fees for services (e.g. fees for legal or accounting services) and retainers; business commissions; payments for selling know-how; prizes or awards received that are related to the taxpayer’s business (e.g. a business taxpayer receiving a prize from a supplier, such as a motor vehicle, for being the best business in their area); in this regard, s 21A ITAA36 is relevant – this provision overcomes the requirement that non-cash business benefits must be convertible into cash before they can be ordinary income (s 21A(1)), noting that such benefits also need to be regarded as income from the taxpayer’s business; the provision also provides a valuation rule for all non-cash business benefits (s 21A(2) to (4)); subsidies to assist the taxpayer to carrying on their business activities –TR 2006/3 provides examples of such amounts; and compensation for the loss of trading stock, for interruption to business activities, and for the cancellation of ordinary business contracts. It is always necessary to examine the nature of a particular receipt and its connection to the taxpayer’s business activities to determine whether it qualifies as ordinary business income. Sale of trading stock The proceeds from the sale of trading stock is one of the most common forms of business income. Division 70 ITAA97 outlines special rules governing the tax treatment of trading stock. Definition of trading stock The definition of trading stock in s 70-10 ITAA97 is inclusive. That is, the term is given its ordinary commercial meaning and is then extended by the definition in the Act. Trading stock in the Act includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business, and also includes livestock. This definition is wide and applies only to stock purchased for the purposes of the taxpayer’s business. The following are examples of items that may be considered to be trading stock: land, where the land is part of a trading activity (FCT v St Hubert’s Island Pty Ltd (1978) 138 CLR 210) shares of a share trader (Investment and Merchant Finance Corp Ltd v FCT (1971) 125 CLR 249). Goods on consignment would not ordinarily be considered to be trading stock, as owners can generally recover those goods at any time. If they cannot, then it is trading stock of the trader, and the purchaser will be able to claim a deduction for the cost of the goods at the time of their delivery (IT 2472). Spare parts and consumables Spare parts held for the maintenance of plant are not trading stock. They are not acquired for the ‘purpose of manufacture, sale or exchange’. Consumables (e.g. oil and petrol) are also not trading stock. Goods acquired for hire to customers Goods acquired for hire to customers are not trading stock (FCT v Cyclone Scaffolding Pty Ltd (1987) 87 ATC 5083) unless the taxpayer can also be said to be in the business of selling such stock. Financial accounting treatment of inventory Before considering the tax treatment of trading stock, it is useful to consider the financial accounting treatment of inventory and compare it with the tax treatment. In financial accounting, inventory is accounted for as follows: The reason the value of closing stock is added back is the matching principle. It is considered that purchases should not be an expense if the revenue from the sale of those purchases is not derived until a future financial year. Therefore, the expense is deferred until the relevant stock is sold. Tax treatment of trading stock The tax approach is similar. ITAA97 will, however, include items in assessable income or provide for a deduction. Thus: sales that have been derived are included in assessable income as ordinary income (s 6-5) purchases that are on hand are a deduction (s 8-1 ITAA97) the excess of closing stock over opening stock on hand is included in assessable income (s 70-35(2) ITAA97) the excess of opening stock over closing stock on hand is an allowable deduction (s 70-35(3)). Note that different outcomes might be achieved between the financial accounting and tax treatment of the stock depending on how the closing stock is valued for tax purposes (see below). Trading stock not purchased at arm’s length If the combined purchase price and delivery costs paid for trading stock are greater than the market value and the parties were not dealing with each other on an arm’s length basis, the stock will be deemed to have been bought and sold at market value (s 70-20 ITAA97). Disposal of trading stock outside the ordinary course of business If a taxpayer disposes of trading stock outside the ordinary course of their business, they are deemed to have disposed of the stock at market value at the disposal time. The stock’s market value is included in assessable income at the disposal time (s 70-90 ITAA97). Items that become trading stock When an asset is not initially bought as trading stock but is subsequently converted to trading stock, the owner will be deemed to have sold the asset at either cost or market value (at the owner’s election) and bought it back for the same amount as trading stock (s 70-30 ITAA97). Trading stock and small business entities An SBE taxpayer does not have to account for any changes in the value of their trading stock during the year, provided the difference between the opening stock and the estimated value of closing stock on hand is less than $5,000 (s 328-285 ITAA97). Trading stock must be on hand It is important to determine whether trading stock is on hand for tax purposes, for two reasons: a tax deduction is available for the purchase of trading stock only if the stock is on hand (s 70-15 ITAA97). Therefore, if a taxpayer prepays for trading stock that is not yet on hand, no deduction is allowed until the stock becomes on hand in determining the value of closing stock for tax purposes only, stock on hand is included in the closing value of trading stock (s 70-35). Stock is trading stock on hand when a taxpayer has the power to deal with the stock as if it were their own. The fact that the stock is not owned is not decisive if the goods are in the taxpayer’s possession and are to be sold in the ordinary course of that person’s business (FCT v Suttons Motors (Chullora) Wholesale Pty Ltd 82 ATC 4415). Trading stock is no longer considered to be on hand when it is irrevocably delivered to a third party (ie the taxpayer no longer controls its disposition), even though the taxpayer retains ownership (Farnsworth v FCT (1948) 78 CLR 504). Stock in transit is stock on hand, provided the dispositive power over the stock has passed to the taxpayer (FCT v All States Frozen Food Pty Ltd 89 ATC 135). Lost or destroyed stock on hand No additional deduction is available when stock is lost or destroyed. The deduction has already been allowed for in the cost at the time of purchase (s 8-1). When the stock is lost or destroyed, that stock will no longer form part of closing stock at the end of the year of income, and thus an effective deduction will be obtained via the closing/opening stock on hand mechanism in s 70-35. Any insurance proceeds are, however, included in assessable income under s 6-5 or s 70-115 ITAA97. Valuing closing stock There are four bases of valuing closing stock under s 70-45 and 70-50 ITAA97: cost price, market selling value, replacement price and obsolescence. A different method can be used to value each separate item of trading stock. The value of opening stock must be equal to the value of the previous year’s closing stock (s 70-40 ITAA97). Generally, stock will be valued using the basis that will result in the lowest value. The lower the value of closing stock, the lower will be the taxable income of the taxpayer. The election concerning the value of trading stock is, however, the simplest method of increasing the taxable income of a taxpayer, if the taxpayer chooses to do so. The GST component of trading stock is disregarded where an input tax credit has been claimed. Cost Cost includes freight, insurance and duties. It is often impossible to identify the actual cost of items of closing stock on hand, since all identical stock will be aggregated together in a warehouse. In these situations, there are several accounting methods that can be used to value closing stock. These methods are only used when it is not possible or practicable to ascertain the actual cost of stock: First-in-first-out method (FIFO): the cost of closing stock is calculated on the assumption that the first stock that was purchased or produced was the first stock that has been sold. Average cost: closing stock is calculated using a weighted average cost of all items on hand at the start of the year of income plus all purchases made during the year of income. Retail inventory: closing stock is valued at retail selling price for that item, discounted by the average mark-up for that item. This method may not be available if old stock is marked down as it falls in value. Standard cost: closing stock is valued using predetermined standard costs. The last-in-first-out (LIFO) method is not accepted for valuing closing stock for tax purposes. In determining cost, absorption costing rather than direct costing must be used (Phillip Morris v FCT 74 ATC 4532 and IT 2350). Under absorption costing, fixed overhead production costs such as rent and administration are included to determine the cost of producing the closing stock. Generally, all costs of a manufacturing business that relate to production (excluding selling and marketing costs) should be taken into account. Market selling value This is the amount that the taxpayer would realise if the stock was sold in the ordinary course of the business. It does not take into account anticipated selling expenses. Market selling value is not net realisable value. Replacement price This is the price at which the taxpayer could replace goods on the final day of the year of income (either by making it, if he or she is a manufacturer, or buying it). The replacement price may not be available as a basis of valuation if the calculation of a replacement price cannot reasonably be made. Obsolescence Where the taxpayer is satisfied that, because of obsolescence or any other special circumstances, the value of closing stock is less than all of the three above bases, he or she may elect to value it at its reasonable value (s 70-50 ITAA97). Trading stock and the dissolution of partnerships When there is a change in the composition of a partnership, such when a partner retires, a new partner is admitted or a sole trader takes someone into the partnership, the tax law in s 70-100(1)–(3) ITAA97 deems the old partnership to have disposed of the trading stock for its market value to the new partnership. However, a roll-over relief is available pursuant to s 70-100(4), which allows the transferors and transferees (ie all the old and new partners) to jointly elect that the trading stock is to be disposed of for its value as trading stock on hand for the transferor on that day (as if that was the end of the income year). The effect of such an election is to prevent a profit or loss arising from the disposal of the stock from the old partnership to the new partnership. To be eligible to make the election, the old partners must continue to own at least 25% of the stock after the establishment of the new partnership. Isolated business transactions The courts have held that sometimes a profit on a one-off or isolated transaction may constitute ordinary business income. The ATO summarises the law in this area in TR 92/3 as follows: [w]hether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present: (a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and (b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction. These principles are illustrated in the following examples which are adapted from TR 92/3. These examples highlight that a key distinction in this area is whether an isolated transaction constitutes a business operation or commercial transaction on the one hand, or the realisation of a mere investment on the other, especially where the taxpayer has no existing business. TR 92/3 (at paragraph 13) outlines some of the factors relevant in addressing this distinction. Tax accounting for ordinary income The calculation of a taxpayer’s assessable income depends firstly on determining whether a receipt is assessable income (e.g. income from personal exertion, income from a business, income from property, etc.). If it is, the second issue is the time at which the receipt should be recognised. In this section we examine the timing rules related to the recognition of ordinary income. According to s 6-5(2) and s 6-5(3), ordinary income is recognised when it is derived. Note that s 6-5(4) provides that derived also includes the constructive receipt of ordinary income. There are two main methods of deriving ordinary income for the purposes of ITAA97: the cash (or receipts) basis – ordinary income is recognised when it is actually received by the taxpayer, or constructively under s 6-5(4). An example of when the constructive receipt of income occurs is when a bank credits a customer’s account with interest. the accruals (or earnings) basis – ordinary income is recognised when the right to receive the income occurs (ie a legally recoverable debt is created). Identifying the correct method The courts have been called on to determine the correct method of accounting for assessable income on numerous occasions. The result in each case has been contingent on the specific facts surrounding the taxpayer’s business. Timing is an important consideration in when income is derived and returned. The method that gives the correct reflex to the taxpayer’s true income is the method that is adopted: Carden’s case. The cash basis is generally applied to income other than business or trading income. For example, interest and dividend income of investors, salary and wage income, and professional services income (where the income can be said to be derived from the provision of property or personal services, rather than as part of a larger business activity). Personal services income Salary, wage and other personal services income is returned in the year of receipt, regardless of when the services to which the payments relate were performed. It follows that back pay or any retrospective adjustment to salary or wages will be assessable in the year of receipt, rather than apportioned over the period in which the services were performed. A taxpayer who derives income from rendering personal services may sometimes also sell trading stock (eg a hairdresser who is a sole trader and sells hair care products). If the sale of the stock does not represent a significant part of the taxpayer’s income, the taxpayer would continue to use the cash basis. See Example 1 of Taxation Ruling TR 1998/1. Business income For business and trading income, whether the cash or accruals basis is most appropriate will depend on the particular circumstances. The factors taken into account are: the size of the business the type of business method of accounting current practice in the industry overhead costs policy for recovery of outstanding debts. The relative importance of each of these factors will depend on the particular circumstances of each case. Generally, the smaller the business, the more likely the cash method should be used. It is important to note that there is no threshold relating to size which will determine the most appropriate method. Where the accruals basis is the legally correct method to use, trading income is generally derived when the right to receive the income crystallises into a debt due and owing. If special circumstances exist whereby goods have been delivered but the debt is unascertained, then it is usual practice to regard the income as derived when it is received. Prepaid business receipts Where a taxpayer uses the accruals method to recognise business income and an advance payment is received for specific future services, the taxpayer does not usually derive the income until the services are progressively provided. This will usually be the case when the income is placed in an unearned income account and there is the possibility that the money may have to be refunded. Interest income Interest is generally considered to be derived on a receipts basis. However, financial institutions whose business consists of lending money will generally be considered to have derived interest income on an accruals basis. Rental receipts Rent is usually considered to have been derived upon receipt. An exception may arise where the taxpayer is considered to be carrying on a business of renting or leasing properties. In such cases, the accruals method may be more appropriate. Receiving rent from one or two rental properties is not considered to be carrying on a business. Dividends Dividends are regarded as ordinary income. However, they are also statutory income under s 44 ITAA36, which provides that the assessable income of a shareholder includes dividends paid to them out of a company’s profits. Due to the anti-overlap provision in s 6-25(2), dividends should be returned as assessable when ‘paid’ and not when they are received by the taxpayer. This can be determined by looking at a dividend statement which shows a payment date. Partnership income A partnership is not taxable in its own right, but each partner is taxed on their share of the net income or loss of the partnership for the year. This is the case regardless of when the income or loss is distributed to the partner. The general principles set out above should be applied in determining the appropriate method of accounting for the partnership’s income. Trust income Division 6 ITAA36 deals with the taxation of trusts. A trust must calculate its net income for tax purposes. To the extent that the trust’s assessable income includes ordinary income, it will be included on a cash or accruals basis according to the principles set out above. In general terms, a trustee is only taxed on the income derived by the trust if no beneficiary is presently entitled to that income. Beneficiaries are assessed on the net income to which they are presently entitled (if they are not under a legal disability), regardless of whether a distribution has been made. The details of the taxation of trust income are set out in the Structures module. Superannuation funds Superannuation funds generally return ordinary income on a cash basis. As previously noted, assessable income includes amounts that are not ordinary income, yet are included in assessable income by specific provisions of ITAA36 or ITAA97. Such amounts are referred to as statutory income. Common examples of statutory income are set out in Div 15 ITAA97. In addition, dividends are ultimately included in a taxpayer’s assessable income as statutory income under s 44 ITAA36, along with any attached franking credits under s 207-20 ITAA97. Net capital gains are also regarded as statutory income. Gains on the disposal of some depreciating assets (s 40-285(1)) may also be statutory income, which is explored in the Deductions module. Div 15 ITAA97 is a miscellaneous list of provisions that includes the amounts specified in each of the sections in the Division in a taxpayer’s assessable income as statutory income. In broad terms, a dividend is a distribution of a company’s profits to a shareholder. Dividends are included in a taxpayer’s assessable income as statutory income under s 44(1) ITAA36, and not s 6-5 of ITAA97 (because of the anti-overlap provision in s 6-25(2)). In relation to resident shareholders, s 44(1)(a) states that: [t]he assessable income of a shareholder in a company (whether the company is a resident or non-resident) includes: (a) if the shareholder is a resident: (i) dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source; and (ii) all non-share dividends paid to the shareholder by the company [emphasis added]. Accordingly, s 44(1) recognises dividends in a shareholder’s assessable income when they are paid to the shareholder by the company. Paid includes ‘credited or distributed’ (s 6(1) ITAA36). A dividend is defined in s 6(1) as including “any distribution made by a company to its shareholders” but does not include moneys “debited against … the share capital account of the company”. The definition of dividend specifically includes situations in which the dividend has been credited to an account of the shareholder (with the knowledge of the shareholder). A company is under no legal obligation to distribute profits to its shareholders. Under Australia’s dividend imputation system, when a company pays a dividend to its shareholders and chooses to attach credits to the dividend for income tax already paid by the company (known as franking credits), the dividends are described as franked. The shareholder receives the benefit of the tax that the company has already paid. The mechanism by which this is achieved is for the franking credits to be included in the shareholder’s statutory income (under s 207-20(1)) along with the s 44 dividend, and for the shareholder to claim a franking tax offset (under s 207-20(2)) equal to the franking credits attached to the dividend. The dividend imputation system is designed to prevent the double taxation of a company’s profits, at least in relation to fully-franked dividends. The following example sets out the logic of the imputation system for fully-franked dividends. To calculate the amount of franking credits attached to a franked dividend, you will need two formulas. These calculations are made more complicated due to the fact that Australia now has two company tax rates (30% and 27.5%). Calculating the maximum franking credit on a dividend The first formula calculates the maximum franking credit on a dividend. It is based on the ‘corporate tax rate for imputation purposes’ of the company paying the dividend. For the year in which a dividend is paid, the formula is: To understand this formula, assume a company pays a dividend to a shareholder during the CIY. As the year is not yet completed, the company may not yet know its actual aggregated turnover for the CIY to determine if it has a 27.5% or 30% company tax rate when lodging its income tax return for that year. To adjust for this practical reality, a definition of “corporate tax rate for imputation purposes” was inserted into the law. If a company’s aggregated turnover (as defined in Module 1) for the income year preceding payment of the dividend (PIY) is less than the aggregated business turnover threshold* for the dividend payment year (CIY), the 27.5% tax rate will be its ‘corporate tax rate for imputation purposes’ for the payment year (CIY); otherwise it is 30%. However, the 27.5% rate is also used for this purpose for the first income year that a company exists. The first formula is derived from s 202-60(2), in conjunction with the definitions in s 995-1(1) of: “corporate tax gross-up rate”, “corporate tax rate for imputation purposes”, and “corporate tax rate”. Calculating a dividend’s franking percentage The second formula calculates a dividend’s franking percentage, which is (s 203-35(1)): Statutory income includes net capital gains (s 102-5), which will be examined in detail in the Capital Gains Tax module. Because a net capital gain is statutory income and income tax may be levied on the gain, you should note that CGT is not a separate taxing regime, but part of the income tax regime. Even if a receipt is regarded as ordinary income or statutory income, the legislation sometimes requires the amount not to be included in assessable income. This will occur where the legislation also characterises the amount as exempt income, or non-assessable non-exempt (NANE) income (ss 6-15, 6-20 and 6-23). The Introduction to the Australian Tax System module contains examples of amounts that are characterized as exempt income of NANE income, which you should review. Div 11 ITAA97 lists other examples of exempt income or NANE income referred to in the assessment Acts and provides cross-references to the relevant provisions. Section 11-5 lists the entities whose income is exempt irrespective of the kind of income they earn, eg a registered charity (s 50-5). Section 11-15 identifies ordinary or statutory income that is exempt. An example is certain interest earned on judgment debts relating to personal injury (s 51-57), or certain child care benefits (s 52-150). Section 11-55 lists amounts that are regarded as NANE income with cross-references to the relevant provisions. You should always refer to the relevant specific provision to determine whether the requirements for characterisation as exempt or NANE income are satisfied. Examples include fringe benefits (s 23L(1)) and the GST on a taxable supply (s 17-5). The personal services income (PSI) legislation in Divs 84 to 87 ITAA97 is concerned with two issues relating to personal services income. First, the legislation sometimes limits the deductions an individual can claim relating to their personal services income. Second, it sets out the tax consequences for individuals who divert their personal services income to other entities (eg trusts or companies). The regime does not apply to individuals who conduct personal services businesses in accordance with Div 87 (e.g. genuine independent contractors). It also does not apply to income received as an employee. Even though the PSI legislation acts as a deduction denial regime, the question of whether a taxpayer is conducting a personal services business is central to the operation of the provisions. Indeed, the regime requires a taxpayer to measure their income from their personal services activities (other than as an employee) and to examine those activities against a series of tests. For these reasons, a discussion of the regime has been included in this module. You should review these rules again after you have completed the Deductions module. Figure 1 provides an overview of the PSI tests applied to determine whether income is personal services income. Income is personal services income if it is mainly a reward for an individual’s personal efforts or skills. This applies regardless of whether the income is received directly by the individual or is received by a company, trust or partnership (known as a personal services entity). However, income received as an employee is not counted when applying the PSI rules (s 85-35). If the PSI rules apply, the PSI is treated as the individual’s income and is included in his or her individual tax return. The changes to the tax law do not affect the individual’s legal, contractual or workplace arrangements with clients. Nor do they affect a taxpayer’s ability to apply for an ABN or register for GST. The object of Div 85 ITAA97 on PSI (s 84-1 ITAA97) is to ensure that individuals who receive PSI and are not conducting a personal service business are restricted in the type and amount of deductions available to them. It is important to understand the terminology used in this section, so that you understand the different entities being discussed: Personal services income (PSI): income received for the reward of an individual’s personal efforts or skills. Personal services entity (PSE): an entity (company, partnership or trust) that an individual operates through and which receives income for the reward of the individual’s personal efforts or skill. Personal services business: an individual or other entity who receives income as a reward for the individual’s personal efforts or skill but is regarded as a personal services business and is not affected by PSI legislation. PSI does not include income that is mainly: for supplying or selling goods (e.g. from retailing, wholesaling or manufacturing) generated by an income-producing asset (e.g. a semitrailer) for granting a right to use property (e.g. the copyright to a training manual) generated by a business structure (e.g. an accountant working for a large accounting firm). If PSI is channelled through a PSE being a company, partnership or trust, it is still treated as the individual’s PSI. The PSI rules do not apply if the client qualifies as a personal services business. To qualify as a personal services business, an individual or PSE who receives PSI must pass a series of tests. The results test A taxpayer will pass the results test and not be subjected to the PSI rules in relation to their PSI if they can answer ‘yes’ to all of the following questions in relation to at least 75% of their PSI: Under the contract or arrangement, is the PSI paid to achieve a specified result or outcome? Does the taxpayer have to provide the tools or equipment necessary (if any) to do the work? (If the work does not involve tools or equipment, answer ‘yes’.) Is the taxpayer liable for rectifying defects in the work? The PSE will also pass the results test in relation to the PSI if it meets the requirements set out above in relation to that income. In TR 2001/8, the ATO explains that the results test is based on the traditional criteria for distinguishing independent contractors from employees. TR 2005/16 lists the relevant factors to consider. The 80% rule where the results test is not satisfied If the taxpayer does not meet the results test, he or she can self-assess against the other tests (see below) for an income year if 80% or more of their PSI does not come from only one source. Alternatively, if 80% or more of a taxpayer’s PSI comes from only one source, it is not possible to self-assess against the other tests outlined below. In this situation, the PSI rules will apply unless a personal services business determination is obtained from the ATO. Special rules for agents are found in s 87-40 ITAA97. Other tests If the results test is not satisfied and 80% or more of a taxpayer’s PSI does not come from only one source, it is necessary for the taxpayer to pass any one of the following tests to avoid the application of the PSI rules. Unrelated clients test The unrelated clients test will be met for an income year if a taxpayer can answer ‘yes’ to both the following questions: Does the individual doing the personal services work have personal services income from two or more clients who are not associated with each other or with the individual? Have the personal services been provided as a direct result of making offers to the public, for example, by advertising or word of mouth? Do not answer ‘yes’ if the clients have been obtained through a labour hire firm, placement agency or similar organisation. Note: If the PSI is paid to a company, partnership or trust, the tests apply to that entity. Under s 87-40(5), where services are provided to a customer by the agent on the principal’s behalf in an income year, for which the agent gains or produces PSI income during that year for the principal, then those services are treated as being provided by the agent and not by the principal. Employment test The employment test will be met for an income year if the taxpayer can answer ‘yes’ to either of the following questions: Does the taxpayer have employees (not including associates) or engage subcontractors or entities who perform at least 20% (by market value) of the principal work? Does the taxpayer have apprentice(s) for at least half the income year? Note: If the PSI is paid to a company, partnership or trust, the tests apply to that entity. Business premises test The business premises test will be met in an income year if the taxpayer can answer ‘yes’ to all of the following questions: Did the taxpayer own or lease a business premises? Were the taxpayer’s business premises mainly used for personal services work (e.g. more than 50% of the time) by the individual doing the work? Were the taxpayer’s business premises used exclusively by the taxpayer? Were the taxpayer’s business premises physically separate from the private residence of the individual doing the personal services work, or their associates? TR 2001/8 contains the Commissioner’s guidelines on when premises will be physically separate. Personal services business determinations An individual or personal services entity can apply to the Commissioner for a personal services business determination. If granted, the individual or entity is regarded as conducing a personal services business so that the PSI rules will not apply to them. Read s 87-60 for a list of the matters that the Commissioner must be satisfied of before making a personal services business determination. When the business does not pass any of the tests When individuals or personal services entities receive PSI and do not pass any of the personal services business tests or a personal services business determination is not made, the rules have a twofold effect: for individuals and personal service entities, their deductions against PSI will be limited (see Table 1); and for personal service entities, any PSI will instead be attributed directly to the individual who performed the work (after taking into account relevant deductions incurred to produce that income (in accordance with s 86-20)), and included in that individual’s assessable income. PAYG withholding applies to any attributed amounts. This attribution dos not apply if the PSI is paid to the individual promptly as salary or wages (less any PAYG withholding). The rules in relation to the deductions that cannot be claimed by taxpayers subject to the PSI rules are summarised in the following table, and are the subject of TR 2003/10: Income tax: deductions that relate to personal services income. Note: An associate is a relative, spouse, child or partner of the individual (see definition s 318 ITAA36). Principal work is the main work that generates the PSI and does not usually include support work such as secretarial duties. The individual taxpayer or the PSE can, however, deduct the following expenses: costs of gaining work where s 8-1 is satisfied home office running costs (e.g. electricity, office telephone expenses, depreciation on office equipment etc.) insuring against loss of income public liability and professional indemnity insurance engaging any entity that is not an associate to perform work personal contributions to a superannuation fund where the deductibility tests for such contributions are satisfied workers compensation payments GST compliance costs.
