PERSONAL SERVICES INCOME PART IVA ISSUES
The New Business Tax System (Alienation of Personal Services Income) Act 2000 introduced changes to the tax treatment of personal services by contractors and consultants. Various criteria which have now been modified by further legislation passed during 2001 satisfied result in the relevant taxpayer being able to qualify as a personal services business. Given the complicated nature of these provisions and their requirements to meet the various tests and the context of the fanfare with which this structural change was announced, this should be sufficient to enable taxpayers to have certainty of outcomes. However, that is not the case. Even if the tests with respect to a personal service business are met or the taxpayer holds a Personal Services Binding Determination ("PSBD") from the Australian Taxation Office ("ATO"), the general anti-avoidance provisions of Part IVA can still be applied by the ATO to any schemes to reduce income tax by income splitting, or the diversion of personal services income to interposed entities. The ATO has made it quite clear that Part IVA applies where income derived under the contract is predominantly from the provision of individual personal services given that the Courts and Tribunals have often disallowed arrangements which have as their dominant purpose the alienation of personal services income. Examples are to be found in: 1. The decision of the Full Court of the Federal Court of Australia in Tupicoff v FCT (1984) 84 ATC 4851. 2. The decision of the Federal Court of Australia in Bunting v FCT (1989) 89 ATC 5245 (Full Court Federal Court). 3. Daniels v FCT (1989) 89 ATC 4830. 4. Various decisions of the Administrative Appeals Tribunal ("AAT") for example Case [1999] AATA 165. The various Court and AAT cases initially rely on the anti-avoidance provisions in the ITAA – initially section 260 and in later cases Part IVA. In a number of subsequent rulings IT2121, IT2330 and IT2639 and more recently in TR2001/8, the ATO has made it quite clear in regard to income splitting arrangements by individuals diverting that income to a family company or trust or transfer of income from rendering of personal services to will be ineffective for income tax purposes under section 260 or Part IVA of the ITAA. By way of example, in Taxation Ruling IT2121 the ATO made it clear that in the kind of arrangements the Commissioner would give consideration to having struck down under the anti-avoidance provisions, the most commonly found features were: 1. The taxpayer performs the same task as employees might ordinarily perform and generally works under the same physical conditions as other employees. 2. The taxpayer attends throughout normal business hours the premises of the firm for which personal services are rendered through the interposed entity. 3. The basis of payment of the income is akin to that normally paid for the personal services. 4. In the performance of the duties the taxpayer is subject to a measure of control by the firm for which personal services are rendered. 5. The firm has a right to dismiss the taxpayer. These features are of course present in the employment services agreement and reiterating those or similar provisions in a contract involving an interposed entity would result in the ATO striking the arrangement down under the anti-avoidance provisions. This is emphasised in ruling IT2330 in which the Commission indicated that the anti-avoidance provisions of section 260 or Part IVA will be applicable where the income of the business flows predominantly not from business assets, but from the rendering of personal services by "the principal" in the business. Taxation Ruling IT2639 clarifies what the Commissioner regards as income derived from personal services to be income that an individual taxpayer earns predominantly as a direct reward for his or her personal efforts by for example, provision of services, exercise of skills or the application of labour. It made it clear that it was distinct from income from a business structure and the Ruling was released to give guidance on the application of Rulings IT2121 and IT2330. That Ruling discussed the various factors for identifying income from personal services. In TR2001/8 the ATO refers to Tax Rulings IT2121, IT12330 and IT2639 in reiterating the ATO view as to the application of Part IVA. Among the main points made in IT2121 which was released on December 12, 1984 following the Tupicoff decision which was handed down on November 21, 1984 are: 1. An arrangement whereby a taxpayer ceases to be an employee and interposes a company or a trust between himself and his former employer, may be characterised as arrangements entered into primarily, or principally, or predominantly to avoid liability for income tax by means of the splitting of income. They are not explicable as ordinary business or family dealing and, to the extent that the arrangements were entered into prior to 28 May, 1981, sec. 260 will operate to nullify them for income tax purposes. To the extent that the arrangements were entered into on or after that date, the tax benefit arising out of the arrangements will be removed through the application of Part IVA. 2. The same view applies if, when arrangements are made for a taxpayer’s personal employee-like services to be provided to a firm, the taxpayer has in, or brings into, existence and works through an interposed company or trust that is a vehicle by which the resulting remuneration is split with family members. 3. The Ruling applies to personal exertion income in the sense of the reward to a person for his or her personal services. The Ruling is thus capable of application to income arising under a contract wholly or principally to the labour of the individual concerned. Similarly, it has application to the income derived by a professional sportsman, or entertainer, from the exercise of his or her particular attributes or skills, for example, the income derived by a professional football player from the actual playing of football or public appearances etc. On the other hand, the Ruling does not apply to income derived by a professional sportsman from the endorsement of products since, in the context of the Ruling, income from this source would not represent income from personal exertion. As can be seen the Commissioner’s views as to the applicability of the anti-avoidance provisions of the ITAA are of long standing and have been reiterated through various Rulings on a number of occasions. Similarly the applicability of anti-avoidance provisions to attempts to divert personal exertion income from the relevant individuals to an interposed entity is also of long standing. In the Tupicoff decision, the Full Court of the Federal Court made it clear that the activities of the taxpayer, and the actions of the taxpayer to restructure his activities so as to become an employee of the family trust which then received the commissions formerly paid to the taxpayer, was struck down by the anti-avoidance provisions of section 260 and in so doing Fisher J said: "In my opinion the only significant discernible purpose was that of income splitting. The contention of the taxpayer that he avoided the application of S260 on the ground of ordinary business dealing was thus correctly rejected by the trial Judge." Similarly in Daniel v F.C.T a contract draftsman who immigrated to Australia, and after arriving in Australia, did a small amount of contract work, and then arranged the incorporation of a trustee company and the preparation of a family trust. That trustee company then carried on the business of providing drafting services to various firms on a totally arms length basis and on an assignment by assignment basis, and received those contractor’s fees and paid the taxpayer’s salary. The arrangement was struck down under section 260 with Sweeney J saying: "In my opinion, the overt acts which were done under the taxpayer’s plan are not fairly explicable without an inference being drawn that tax avoidance was at the very least a main purpose of the arrangement as a whole. The taxpayer used a method which diverted income away from him to or for the benefit of his family in order to avoid a substantial part of the tax which would have been incurred if the income had first been derived by him and then applied for the benefit of his family…the present case falls, plainly as I venture to think, within the application of section 260. The decisions of the respondent disallowing the taxpayer’s objections should stand." Section 260 clearly applied where the practical, although not the legal, source of the income was the personal exertion of the taxpayer. Similarly in Bunting v F.C.T. in which the Full Court of the Federal Court applied the anti-avoidance provisions of section 260 to a computer specialist who also utilised a family trust for the derivation of income, Gummow J concluded: "In the present case the application of S260 reveals the derivation from the personal exertions of the taxpayer. And as was pointed out, by Kitto J in Peate’s case….S19 of the Act which provides, inter alia, that income shall be deemed to have been derived by a person although not actually paid over to him if it is dealt with on his behalf or as he directs, has a role to play in this situation;… A consequence which follows from the annihilation effected by S260 of the arrangements which vested in a person or persons other than the taxpayer the right to receive and deal with the income in question, is that the Commissioner is entitled in the manner described earlier in these reasons to treat the taxpayer as having derived the income which was the return from his own activities." His Honour held that what was done was not fairly explicable without an inference being drawn that a purpose, if not the primary purpose, was to "split" income derived from the personal exertion of the taxpayer between himself and the members of his family. Even leaving aside the recent provisions which have been inserted in ITAA 1997 with respect to personal services income, the application of the anti-avoidance sections of the Act including Part IVA by the ATO to attempts to divert personal exertion income is a wide ranging and longstanding one with a number of Court and Tribunal decisions in the ATO’s favour. TR2001/8 sets out the Commissioner’s views with respect to a number of relevant factors in determining whether Part IVA applies which include: 1. Whether the interposed entity derives income from sources other than from the services provided by the individual who controls or is associated with that entity, that is a service provider. Examples include employment of other individuals by the interposed entity, substantial assets or substantial business structure used in the production of the relevant income. Similarly the extent to which the interposed entity deals with and provides its service to the public at large or is limited to contracting with one party. 2. Whether the expenses claimed by the interposed entity demonstrate the existence of a business operation or structure eg. rental of premises, employment of others, use of raw materials or stock – factors which all point to there being a business structure in existence. 3. Whether the factor generating the income is the individual providing the services rather than the assets or good will of the interposed entity. 4. Whether the interposed entity distributes income only to the service provider and the arrangement has been implemented only for the purpose of providing additional superannuation benefits for the service provider – in these circumstances Part IVA will not generally apply. 5. The interposed entity distributes income to family members or associated person of the service provider and /or does not distribute any income to any employee who provides the actual services. 6. There has been a Friday night/Monday morning change of status. 7. Whether there has been a substantial change in activities which the individual performed prior to incorporation or any other significant external indicators that the arrangements have changed. It would appear that even if the various tests as to a personal services business are satisfied, there still would be a high likelihood of Part IVA applied against any arrangement involving the interposing of the service entity particularly given the provisions of section 177D which contains the criteria as to whether the relevant taxpayer has obtained a tax benefit. An illustration of the application of Part IVA in a recent decision is to be found in the case of Egan v Commissioner of Taxation [2001] AATA 449 (25 May, 2001). The
fundamental issue was whether there was a scheme to obtain a tax benefit where a computer consultant had, together with his wife, formed a family company to provide services to another company which was owned in equal shares by his family company and another company. That operating company provided computer consulting and software development, and paid a management fee to the taxpayer owned company which provided the services of the taxpayer to the operating company. Senior Member Pascoe found: 1. The technical expertise of the taxpayer was the principal reason which enabled the family company to derive fees; 2. The taxpayer was the director and one of the two driving forces behind the operating company obtaining contracts, yet he was not paid any directors’ fee, salary or any other form of income by the operating company, and the fees charged to the family company were for the services of the taxpayer; 3. There clearly was a scheme to enable the family company to the recipient of the fees from services performed by the taxpayer involving paying the taxpayer a modest salary by the family company, having the family company pay a salary to his wife, making superannuation contributed for both and the remaining excess income in the company to be taxed corporate rates; 4. The dominant purpose of the scheme was to obtain a tax benefit. The predominant or sole role of the family company was to provide the services of the taxpayer to the operating company. Any work done for the operating company by the taxpayer’s wife was minimal. The family company owned some minimal equipment which was no more than what a busy computer consultant would have in his home. There was no objective commercial explanation for the fees paid by the operating company to the family company other than to enable the taxpayer to spread the earnings between himself, his wife and the family company. Accordingly, not only was the assessment affirmed but so was the imposition of additional tax at 25% imposed under section 226 of the ITAA 1936. Morris Milder
