ATO guidance on personal services businesses and Part IVA - Draft PCG 2024/D2

On 28 August 2024, the ATO published Draft PCG 2024/D2 Personal services businesses and Part IVA of the Income Tax Assessment Act 1936 (draft PCG).

This draft PCG sets out the Commissioner’s compliance approach to the potential application of general anti-avoidance provisions in Part IVA to alienation arrangements where an individual derives personal services income (PSI) through a personal services entity (PSE) that is conducting a personal services business (PSB). 

Importantly, the draft PCG comprehensively reaffirms the ATO’s revised guidance (in TR 2022/3 – regarding the PSI and PSB rules), that Part IVA may still apply to cases where a PSE satisfies the PSB tests and the PSI rules in Division 86 do not apply. Particularly, where there are factors indicating that the dominant purpose of the arrangement is to obtain a tax benefit by diverting, alienating, or splitting an individual’s PSI and/or retaining income in the PSE so it is taxed at an overall lower tax rate.

To assist taxpayers, draft PCG 2024/D2 provides a risk assessment framework which identifies the types of alienation arrangements the ATO considers to be either a ‘low’ or ‘higher’ risk of triggering Part IVA.

Application of draft PCG 2024/D2

The draft PCG applies to alienation arrangements where:

• A PSE (e.g. a company or trust) derives the PSI of an individual; and
• The PSI rules do not apply to that PSI because the PSE is conducting a PSB.

However, it doesn’t apply to alienation arrangements where:

• The income of the interposed entity is not PSI, i.e. income is mainly generated from the sale of goods, the use of income producing assets, or from the business structure of the interposed entity. But income is not considered to be generated from a business structure (and therefore not PSI) merely because:
  • A company or trust (the PSE) is established through which to provide an individual's personal services,
  • The PSE carries on business, or
  • It qualifies as a PSB
• The interposed PSE entity does not derive the PSI, whereby the individual rather than the entity will be assessed on the PSI, and
• A PSE has incorrectly self-assessed itself as a PSB, in which case the PSI rules will apply.

If a PSE mischaracterises its PSI as income from a business structure, draft PCG 2024/D2 will still apply.

Overview of PSI and PSB rules

Prior to releasing draft PCG 2024/D2, the ATO issued TR 2022/3 which details its revised guidance on the operation of the PSI and PSB rules. BDO recently issued a technical update on Personal Services Income: ATO’s revised guidance which explains ‘What is PSI and a PSB including the four PSB tests.

Broadly, PSI is income that is ‘mainly’ a reward for an individual’s personal efforts or skills, rather than being generated by the use of assets, the sale of goods, or from a business structure. It can be earned directly by a sole trader, or indirectly through another entity such as a company, partnership or trust that receives the PSI of the individual and is interposed between the individual and the client receiving the services. 

Personal services business

The draft PCG states that where a PSE receives the PSI of an individual, the application of the PSI rules must be considered, including whether the PSE is conducting a PSB.

The four PSB tests against which a PSE can self-assess that it conducts a PSB in relation to an individual's PSI, are broadly the:

• Results test - At least 75 per cent of the PSI is being paid to produce a specific result using the individual’s own tools and equipment, and the individual is required to rectify mistakes
• Unrelated clients test - Less than 80 per cent of the income is from the same entity (including their associates), the taxpayer must have received PSI from 2 or more unrelated clients, and the services must be provided as a direct result of making offers to the public at large or a section of the public
• Employment test - Less than 80 per cent of the income is from the same entity (including their associates) and the entity must employ/contract others to help perform work generating the PSI. In addition, one of the following must be met:
  • At least 20 per cent of the principal work is performed by others, or
  • One or more apprentices are employed for at least 6 months of the income year
• Business premises test - Less than 80 per cent of the income is from the same entity (including their associates) and at all times in the income year the taxpayer maintained and used business premises to conduct the PSI activities that met the following conditions:
  • Used mainly to gain or produce PSI
  • Used exclusively by the taxpayer
  • Physically separate from the taxpayer’s private premises and the clients’ premises.

If it is not possible to self-assess as a PSB for a particular income year, the PSE may be able to apply for a PSB determination (PSBD) from the Commissioner. 

If a PSE is not conducting a PSB because it has not satisfied one the PSB tests or obtained a PSBD, the PSI rules will apply to the PSI the entity has received.

Application of Part IVA and PSBs

In the draft PCG, the Commissioner makes it clear that Part IVA can still apply where a PSB engages in income splitting or retention of profits arrangements where the dominant purpose of the scheme was to obtain a tax benefit.

Even if the PSE meets one of the PSB tests, or obtains a PBSD, the ordinary tax rules continue to apply to that income, and it also retains its character as PSI. Accordingly, it is critical to understand that qualifying as a PSB does not mean that the PSB is legally entitled to divert, or retain, the net PSI to pay an overall lower rate of tax, thereby obtaining a tax benefit for the individual’s PSI. This is despite some taxpayers assuming Part IVA will not apply.

Risk framework

The PCG sets out a two-part risk assessment framework containing “low-risk” or “higher-risk” indicators to determine the likelihood that the ATO will apply compliance resources to review alienation arrangements.

While the draft PCG doesn’t establish an acceptable level of income splitting, the degree to which PSI has been diverted away from the individual is a relevant factor in considering the application of Part IVA.

Low risk arrangements

An arrangement is considered low risk where net PSI received through the PSE is assessed to the individual whose personal efforts or skills generated that income and tax is not deferred.

Broadly, these arrangements are outside the scope of Part IVA because no tax benefit is obtained.

Higher risk arrangements

In contrast, a higher-risk arrangement will include either, or both, an income splitting or retention of profit arrangement which diverts PSI away from the individual or facilitates the deferral of tax.

The draft PCG clarifies that an arrangement that has features which brings Part IVA into question, does not mean that Part IVA will apply. However, it does indicate an increased likelihood of ATO review, which would include a deeper consideration of whether Part IVA should apply. An arrangement is considered higher risk where a tax benefit is obtained for the individual, being the amount of PSI that might reasonably be expected to have been included in the individual's assessable income.

Risk indicator tables

The key features of the ‘low risk’ and ‘higher risk’ indicator tables have been combined in the below table:

Low risk indicators	Higher risk indicators
Net PSI is distributed to the individual whose personal efforts or skills generated the income and taxed at their marginal rate.	Net PSI is distributed to another entity so it is taxed at an overall lower rate than if the individual had received the income directly.
Remuneration received by the individual is substantially commensurate with the value of their personal services.	Remuneration received by the individual is less than commensurate with the value of their personal services.
Remuneration (e.g., salary or wages) is paid to an associate (or a service trust or company) for bona fide services related to the earning of PSI if that amount is reasonable for the services provided by them.	The PSB does not distribute any income to the individual who provided the actual services.
There is a timing difference between earning PSI and distribution of net PSI to the individual for reasons outside the control of the individual and PSB or where delay can be explained by circumstances not attributable to tax. This creates only a temporary deferral of tax to a following income year.	Net PSI (or a part thereof) is split with an associate of the individual, thereby reducing the overall income tax liability.
The PSB makes a superannuation contribution on behalf of the individual, who is an employee of the PSB, for the purpose of providing a superannuation benefit.	Remuneration is paid to an associate (or a service trust) that is not commensurate with the skills exercised or services provided by the associate.
There is a temporary retention of profits to acquire an asset for a clear commercial purpose.	Net PSI (or a part thereof) is retained in the PSB. In most cases, the retained funds are subsequently made available to the individual for their personal use (for example, via a complying Division 7A loan), however, the mere fact that PSI is retained is a sufficiently higher-risk indicator.

Record keeping and evidentiary requirements

The record keeping and evidentiary requirements outlined in the draft PCG are onerous. But they highlight the importance of preparing and keeping good records that document and explain all transactions, decisions, and other acts taxpayers are engaged in with separate entities, such as a company or trust that an individual may use to divert PSI.

Records and documentary evidence is also needed to support the taxpayer’s position and/or verify arguments relating to why an arrangement is low risk and Part IVA does not apply.

List of documents to maintain

The draft PCG provides a non-exhaustive list of documents and records that are required to be retained including:

• Contracts, including contracts between the individual or an associate and PSE, and between the client and PSE
• Bank statements and loan documents
• Dividend or distribution statements
• Wage and superannuation records
• Financial statements including profit and loss statements, balance sheets, depreciation schedules and tax returns
• Minutes of members or directors’ meetings
• Trust deeds (including amendments) and trustee resolutions
• Trust distribution statements
• Contemporaneous records of discussions or meetings explaining the transactions
• Any election, choice, estimate, determination, or calculation and the basis of calculations made by the taxpayer.

Date of effect

When finalised, the draft PCG will apply to arrangements entered into both before and after its date of issue. 

Reach out to your BDO adviser from our tax services team if you would like further information regarding the proposed changes or how our team of experts can help you.