Consultants cautioned on tax traps with PSI rules

With more professionals now becoming consultants following successful careers as senior executives, HLB Mann Judd partner of tax consulting, Peter Bembrick, said it is important to be aware of the tax traps that can arise.

Bembrick noted while consulting can provide greater rewards and flexibility, it is critical to beware of how the personal service income (PSI) tax rules operate.

“The aim of the PSI rules is to ensure that when an individual is paid primarily for their personal efforts or skills, they are taxed personally in a way similar to an employee,” said Bembrick.

“When the PSI rules apply, the main impacts are to prevent income splitting, or income being taxed at a lower rate (such as through a company) and also to prevent a consultant from claiming deductions that they would not otherwise have been able to claim as an employee.”

Bembrick said while there are several tests in the PSI rules, two of the most common exclusions from PSI are the results test and the unrelated clients test.

“If either of these tests can be satisfied, then the consultant may be able to split income with their spouse, for example, using a family trust, or through a company or by claiming deductions for certain additional business costs that do not relate to the consulting income.”

He explained that if a consultant can show that they are paid by a client to produce a specific result, provide their own tools and equipment (where relevant), and are liable for rectifying any defects arising from their work, then they will not have to meet PSI rules.

“This test will often fail where the consultant is paid based on the number of hours worked, rather than achieving specific deliverables or meeting certain performance targets,” he said.

“Common situations where the results test might apply include where an individual is contracted to oversee a specific project such as a marketing campaign to increases sales, or the successful sale of a business. Having specific outcomes that determine the consulting fees or receiving a success fee make the applicability of this test more likely.”

The unrelated clients test may apply where a consultant has multiple clients that are unrelated to each other.

“As long as no more than 80 per cent of their personal services income for a year is received from a single client, the PSI test may not apply,” Bembrick explained.

“However, a critical part of this test is that not only is the consultant offering their services to the public at large, but that consulting engagements are received from offers to the public or a section of the public.”

Bembrick noted that the most common sources of work for many consultants are referrals from their existing contacts, word of mouth referrals or their strong personal reputation.

“The ATO’s view as summarised in Taxation Ruling TR 2022/3 is that this is not sufficient to meet the unrelated clients test and the PSI tests may be failed, meaning, for example, that consulting income received through a company may be attributed under the PSI rules to the individual consultant, and some company deductions may be denied,” he said.

“A consultant may point to the fact that they have a website, a LinkedIn profile and undertake promotional activities such as speaking at conferences and publishing articles in industry journals. The problem is that unless they can show that there is a direct connection between the promotion to the public and receiving the consulting engagements, the ATO considers that this is not enough to pass the test.”

In order to satisfy the unrelated client test, Bembrick said it is necessary to show that the consulting work was obtained from sources such as website or LinkedIn enquiries, conference attendees, or readers of the consultant’s articles, or from direct advertising, sponsorship, or other marketing activities rather than simply from word of mouth or contact referrals.

“It is important for consultants to be aware of the risks of the PSI rules applying, especially where they want to split their income or work through a company,” he said.

“The risks will be reduced if they can clearly show that they have contracted to achieve a result, as none of the other PSI tests will have to be applied.”

If consultants do seek to rely on the unrelated clients test, Bembrick said it is critical that they take steps to show that they are offering their services to the public and that they are able to show that at least some of their consulting engagements were received directly through their own promotional activities.