Login
iscover
Thousands of small businesses could be hit with higher tax following the recent ATO guideline.
Newsletter
What PCG 2024/D2 means for small businesses
06 September 2024
•
17 minute read
You’re out of free articles for this month
To continue reading the rest of this article, please log in.
Create free account to get unlimited news articles and more!
Imagine this scenario.
Dirk is an employee plumber being paid about $100,000 per year. He decides to start a plumbing business and quits his job. He asks around and concludes that running his new business through a company would be the safest option. Because they share everything, he decides to have the shareholding 50% held by him and 50% by his life partner, Diedre.
The business goes well. He earns fees of $250,000 in a year mainly from his own personal efforts. He decides to pay himself a salary of $120,000 plus superannuation. The company makes an after-tax profit, after Dirk’s salary and other expenses, of $80,000. He decides to pay a fully franked dividend of $10,000 each to himself and Diedre, meaning there is $60,000 of retained profits.
Anything wrong with that scenario from a tax perspective? Yes, according to the ATO. Dirk is a tax avoider and should probably be hit with an assessment under the general anti-avoidance rule (GAAR) of the tax law plus penalties.
This is illustrative of the shock that is coming to possibly hundreds of thousands of small and micro businesses in Australia. This follows the release on 28 August 2024 by the ATO of draft practical compliance guideline PCG 2024/D2.
Why has Dirk become a pariah on the Australian taxation system? Because, according to the ATO he has split his personal services income (PSI) with his partner and retained some of the profits of the business in the company. To do so is, according to the ATO, illegal. This is because the overall rate of tax payable on the company’s income is lower than if the whole amount had been taxed to Dirk personally.
==
==
PCG 2024/D2 is a very long-awaited statement by the ATO on how the PSI rules of the tax law interact with the GAAR of the tax law, Part IVA ITAA 1936. The PSI rules were introduced in 2000. The purpose of those rules was to set out conditions, that if not passed, broadly meant that the income derived by a ‘personal services entity’ would be taxed to the individual that earned the PSI.
Instead of seeing the PSI rules as an exclusive code for the taxation of personal services income, the ATO has always maintained that even if the PSI conditions are passed, the GAAR can still have application. That view is supported in a note to the PSI rules.
PSI is income earned by an individual that is mainly (50%+) a reward for the personal services of the individual. This law applies to a very wide range of professions and occupations. These include doctors, dentists, plumbers, electricians, carpenters, bricklayers, accountants, lawyers, beauticians, hairdressers and so forth. There would be hundreds of thousands of these types of businesses in Australia.
The position of the ATO is that unless (nearly) 100% of the personal services income derived by an individual through an entity is taxed to the individual, the individual should be forced to pay extra tax by operation of the GAAR by taxing the individual on all the PSI. This is so even if the PSI anti-avoidance rules are passed.
In my view, the draft PCG proceeds on a fundamental technical flaw. This is a somewhat technical point, so I will do my best to explain it.
Before the current GAAR existed (introduced in 1981), the previous GAAR was section 260 ITAA 1936. During the 1980s, when considering section 260, the High Court decided in a number of cases that PSI could not be ‘alienated’. This means that PSI could not be taxed to a taxpayer other than the individual that earned the PSI. This was a clear principle.
However, during the 1990s, because of such such things as the recession, more women entering the workforce, the explosion of the IT industry and the significant gap between the top marginal individual tax rate and the company tax rate, many thousands of businesses did, in fact, alienate their PSI. This was due to the proliferation of contracting, the use of interposed entities and flexible quasi-employment arrangements to provide personal services.
The problem was that the ATO could not cope with this situation. In order to combat all the businesses alienating their PSI (contrary to the High Court’s decision) the ATO would have had to apply the GAAR to each of the individual arrangements of these taxpayers and the task was simply too big and too hard.
Enter Peter Costello (Treasurer), the Ralph Review, the ‘New Tax System’ and Part 2-42 ITAA 1997.
The idea of Part 2-42 (the PSI rules) was to codify the situations in which individuals would be forced to be taxed on their PSI. This would not be the case if it could be shown that one of four tests were passed that made the personal services entity a ‘personal services business’ (PSB). If a PSB existed, the new rules had no application. However, it was still theoretically possible for the GAAR to attack the arrangement.
I maintain that there was a fundamental technical shift when Part 2-42 was introduced. I am of the view that the ATO has never acknowledged, or will not acknowledge, this important technical point. The technical change, in my view, was that the alienation of PSI was now sanctioned by the tax law. In effect, the enactment of the PSI rules, by parliament, overrode the decisions of the High Court in the 1980s that said PSI could not be alienated.
In my view, Part 2-42 is predicated on the assumption that PSI can be alienated legally. If this is not the case, that Part makes no sense and would seem to be otiose.
For example, section 86-10 ITAA 1997 says: “The object of this Division is to ensure that individuals cannot reduce or defer their income tax (and other liabilities) by alienating their PSI through companies, partnerships or trust that are not conducting personal services businesses”. [Emphasis added]
The plain reading of that section is that the alienation of PSI is now permitted if you are conducting a PSB. The vast majority of businesses that earn PSI are conducted through PSBs.
In reading the draft PCG, it seems to me that the ATO is stuck on the views of the High Court in the 1980s. Further, the ATO still has on issue a number of old tax rulings that were released many years prior to the introduction of the PSI rules which the ATO still considers to be relevant to PSI, even after the PSI rules were introduced. I think this approach is technically flawed because it mixes the old outdated law with the ‘new’ law in Part 2-42.
In my experience, the most confusing aspect of the Australian tax law for accountants in public practice is the taxation of PSI. This confusion results from the mashing together of the old ATO tax rulings in the 1980s with the PSI rules introduced in 2000. There is wide-spread confusion among the accounting/tax agent profession as to how these rules operate. The draft PCG will only heighten this confusion.
In order to eradicate this confusion, all of the pre 2000 tax rulings on PSI should be withdrawn. Further, the ATO should acknowledge what is abundantly clear from the PSI rules that parliament intended for PSI to be alienated, provided a PSB was being operated.
The assumed ability of the ATO to apply the GAAR to the higher risk cases set out in the draft PCG is a highly debatable proposition. The ATO has had mixed success with Part IVA and, in my view, will have a difficult task to successfully apply the GAAR, except to the most egregious PSI alienation situations.
A major hurdle the ATO must overcome is to apply Part IVA when an arrangement has already passed the detailed and prescriptive anti-avoidance provisions of Part 2-42. Part 2-42 cannot be otiose. This Part is a substantial piece of anti-avoidance legislation, and courts will ensure it is given its full intended purpose.
Also missing from the draft PCG is any meaningful discussion on the non-tax reasons why individuals provide their PSI through interposed entities. This is a very important and common aspect of how modern small businesses offer their services. Individuals set up companies and trusts for reasons that have nothing to do with tax motivation such as risk minimisation and the ability to present themselves as a corporation and not just as a sole practitioner. Further, those that engage people offering PSI often require that there be an entity with which to contract in order to avoid employment related tax issues.
Why should PSI businesses not be able to retain profits, just like any other business? Why should PSI businesses not be able to share profits, just like any other business?
I predict that there will be an ‘uproar’ from the small business community about the position the ATO has adopted in this draft PCG. The ATO makes it plain that the only situation it will consider ‘low risk’ is where all of the net profit of a PSI business is assessed to the individual that earned the PSI and there is no deferral of taxation. That will be a shock to thousands of ordinary family businesses and their advisers. The extra tax payable by small business will be a very significant amount.
The accounting profession should not let this chance go by to lobby the ATO, Treasury and Government for this tax issue, which affects hundreds of thousands of taxpayers and their families, to be clarified.
If this is not done, test cases in the courts are the only hope for clarity.
In the meantime, the SME community and their advisers will need to deal with the uncertainty – and SMEs will almost certainly pay a good deal more tax if they want no tax risk.
John Jeffreys is a Chartered Accountant, Chartered Tax Adviser and director of John Jeffreys Tax Pty Ltd.
You are not authorised to post comments.
Comments will undergo moderation before they get published.