Talking Tax – Issue 170
Meeting the personal services business tests
The Administrative Appeals Tribunal (Tribunal) in the case of Ariss v Commissioner of Taxation  AATA 2958 has held that money generated by the Taxpayer’s activities as an IT consultant, and split between the Taxpayer and his wife via a third-party trust arrangement, was in fact personal services income (PSI) and directly assessable to the Taxpayer.
The Taxpayer failed each of the personal services business (PSB) tests. Accordingly, the Tribunal concluded that the Taxpayer was not carrying on a PSB and the fees paid to the Trustee were assessable directly to the Taxpayer as PSI. The Tribunal considered that the taxpayer was carrying on a business as a ‘sole trader’, using his own intellect, skills and expert knowledge.
This case is a reminder of the importance of seeking appropriate advice when it comes to business structuring, and ensuring that the substance of your ongoing activities align with your tax planning.
The Taxpayer was an IT consultant who operated out of a home office. The Taxpayer’s wife would help with research and administrative tasks but was never formally engaged as an employee.
The Taxpayer directed that fees charged for his services be paid to the professional third-party trustee (Trustee) of the ARMS Trust (Trust). The Trustee would then distribute the funds from the Trust to the Taxpayer and his wife as beneficiaries.
The Taxpayer was audited by the ATO and the Commissioner of Taxation (Commissioner) issued amended assessments for the 2010, 2012 and 2013 income years assessing the taxpayer for the full amount paid to the Trustee. The issue became whether the money paid to the Trustee was attributable to the Taxpayer as PSI.
The Taxpayer argued that the PSI rules did not apply to him because he was conducting a PSB. For an individual to be conducting a PSB, they must satisfy at least one of the four PSB tests provided by section 87-15(2) of the 1997 Act.
The ‘results test’: section 87-18
The Taxpayer failed to satisfy the results test because he could not show that he was being paid for producing a result. Indeed, the Taxpayer was paid a daily rate regardless of whether or not he actually finished the project he was working on. Accordingly, it could not be said that he was being paid to produce a result.
The ‘unrelated clients test’: section 87-20
The Taxpayer failed to satisfy the unrelated clients test as there was no evidence that he made direct offers or invitations to the public by way of advertising and instead obtained work through existing business relationships and contacts. The Taxpayer’s clients could therefore not be said to be unrelated.
The ‘employment test’: section 87-25
The Taxpayer did not have any employees and therefore could not satisfy the employment test. The Taxpayer’s wife was never engaged as an employee and could not be said to be a partner in the business or an independent contractor.
The ‘business premises test’: section 87-30
Finally, the Taxpayer did not satisfy the business premises test because he provided his services from a single room (a dedicated home office) in his private residence, which the Tribunal concluded was not sufficient to satisfy the test.
A final point from the case was that the Taxpayer was unable to claim a deduction for superannuation contributions, as there was no evidence he gave notice to the trustee of his superannuation fund of his intention to claim a tax deduction under section 290-60 of the 1997 Act, within the required timeframe.
Recently released draft ATO guidance
The Australian Taxation Office (ATO) has recently released the following draft administrative guidance:
- Draft Taxation Determination (TD) 2019/D5: This TD provides guidance on the tax incentives available for investors in early stage innovation companies (ESIC) under Subdivision 360 of the Income Tax Assessment Act 1997 (Cth) (1997 Act).
- Draft Taxation Determination (TD) 2019/D6: This TD confirms that Subdivision 855-A (or subsection 786-915(1)) of the 1997 Act will not disregard a capital gain that is made by a foreign resident (or temporary resident) beneficiary of a resident discretionary trust.
- Draft Taxation Determination (TD) 2019/D7: This TD provides the Commissioner’s view that the ‘source’ concept in Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act) does not apply when determining whether a non-resident beneficiary of a resident trust (or trustee for them) is assessed on an amount of a trust capital gain arising under Subdivision 115-C of the 1997 Act.
- Draft Practical Compliance Guideline (PCG) 2019/D3: This PCG provides guidance and a risk assessment framework on the application of the arm’s length debt test contained in section 820-105 and section 820-215 of the 1997 Act. Importantly, PCG 2019/D3 is to be read in conjunction with the previously released Taxation Ruling 2019/D2 - Income tax: thin capitalisation - the arm’s length debt test.
To be entitled to a tax offset under Subdivision 360 of the 1997 Act, an investor must be issued with shares in a company that satisfies the ‘early stage test’ and ‘innovation test’ provided by subsection 360-40(1) of the 1997 Act immediately after the shares are issued.
These tests rely on the terms ‘expenses’ and ‘incurred’. TD 2019/D5 provides guidance on the meaning of these terms in this context.
As the word ‘expenses’ is not defined in the relevant provisions, the ATO consider that it will adopt its ordinary meaning in the context in which it appears. Having regard to the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (Cth) which introduced these provisions, and the Australian Accounting Standards Board Framework for the Preparation and Presentation of Financial Statements, the ATO takes the view that an amount will be an ‘expense’ where it results in a decrease in the equity of the potential ESIC, otherwise than by distribution to its members.
The ATO has determined that ‘incurred’ in this context is to be given its general tax law meaning and will be treated with the same interpretation of the word ‘incurred’ under section 8-1 of the 1997 Act.
As a general rule, where a trust’s net income includes a capital gain and a beneficiary is made presently entitled to all or part of that gain, the beneficiary is taken to have made a capital gain equal to their share of the gain.
Despite this, a foreign resident beneficiary of a resident fixed trust is entitled to disregard a capital gain made by that trust and to which they are made presently entitled where the asset is not Taxable Australian Property (TAP) of the trust.
The argument has been advanced by some taxpayers that a foreign resident beneficiary of a resident non-fixed (ie discretionary or hybrid) trust may similarly disregard all or part of a capital gain realised by that trust where the asset is not TAP, and to which they are made presently entitled.
In the ATO’s view, this is incorrect: Subdivision 855-A of the 1997 Act does not enable a foreign resident beneficiary (or temporary resident beneficiary) of a resident discretionary trust to disregard their share of a non-taxable Australian property capital gain.
As noted above, as a general rule, where a trust’s net income includes a capital gain and a beneficiary (resident or non-resident) is made presently entitled to all or part of that gain, the beneficiary is taken to have made a capital gain equal to their share of the gain.
However, where a non-resident beneficiary is made presently entitled to all or part of the trust’s net capital gain, section 115-220 of the 1997 Act makes that part assessable and taxable to the trustee under section 98 of the 1936 Act.
In the Commissioner’s view, this section does not go any further. Specifically, it does not test whether the beneficiary’s attributable gain satisfies the conditions in section 98 of the 1936 Act.
Separately, Division 6 of the 1936 Act contains a 'source concept'. This refers to the limitation on the assessment of non-residents (or trustees) to amounts 'attributable to sources in Australia'. This TD confirms the Commissioner’s view that the source concept is irrelevant to the operation of section 115-220 of the 1997 Act.
Importantly, TD 2019/D7 does not consider the application of other provisions that allow for non-resident beneficiaries to disregard capital gains, such as those provided in Subdivision 855-A of the 1997 Act.
The arm’s length debt test is one test used to establish an entity’s maximum allowable debt under the thin capitalisation rules. The test focuses on identifying an amount of debt that a notional stand-alone Australian business would reasonably be expected to borrow, and what independent commercial lenders would reasonably be expected to lend on arm’s length terms and conditions.
This PCG provides guidance on how to apply this test, along with a risk assessment framework that outlines the ATO’s compliance approach to an application of the arm's length debt test in certain circumstances that fit into a white, low or medium-high risk zone.
The Commissioner stresses throughout the PCG that the application of the arm’s length debt test is highly dependent on the facts of any given case. Accordingly, it is important that those seeking to apply the arm’s length debt test seek professional assistance, especially where the risk zone may be considered medium-high.
This article was written with the assistance of Charlie Renney, Lawyer.
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