The history of PSI is a long road through court and ATO rulings as well as the Ralph Review until we finally got some legislation. But the old ITs and TRs still apply.
The History of PSI
How did the PSI (personal services income) rules come to life? The history of PSI will take you through various court rulings as well as ITs and TRs that are all still relevant since never revoked.
In this episode, Andrew Henshaw of Velocity Legal in Melbourne will walk you through the history of PSI and how they came to be what they are.
So if you have a PSI issue you need to sort out, this episode might give you the references you need to defend your position.
Here is what we learned but please listen in as Andrew explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
The History of PSI
The history of PSI isn’t a short one. The issue of PSI isn’t a new one. And neither are the attempts to split PSI income and claim additional tax deductions.
” Since the dawn of time – man has yearned to incorporate, to split their income with family members, and to pay less tax.”
Michael Butler and Tom Hendrick of Finalysons
But the issue has become a lot more relevant since the 1980s.
And the reason for that is that until then, professional associations didn’t allow the incorporation of their members. So accountants, tax agents, doctors, architects and so on could only practice as individuals alone or in partnership with others. But not through a company or trust.
This started opening up in the 1980s, and so lawyers, accountants and the lot moved their business into companies and trusts, and started reaping significant tax concessions. And those tax concessions – that is what the whole palaver around PSI is about.
Three Court Cases
It didn’t take long for the ATO to start fighting back. It started with three court cases.
1 – Tupicoff
The taxpayer – let’s call him Mr Tupicoff – used to work as an insurance agent, selling life insurance policies for one single life insurance company.
Mr Tupicoff resigned as an individual agent, formed a discretionary trust with a corporate trustee and then appointed the corporate trustee as agent, while he personally continued selling policies.
In 1984, the Federal Court in Tupicoff v FCT 1984 knocked this one back under Section 260 – the old version of Part IVA – and declared Tupicoff’s income as PSI.
2 – The Three Doctors
The three doctors were Dr Pincus, Dr Gulland and Dr Watson, all running their own individual medical practice alone or in partnership.
They formed a unit trust with the units held by the respective trustee of each of their individual family trusts. The corporate trustee of the unit trust then acquired the medical practices and employed the doctors on an agreed salary.
Of course, the agreed salary was much lower than what they earned before. And the profits then went to their respective family trusts to be spread across family members, splitting their income and hence significantly reducing their tax. They basically did what Mr Tupicoff did.
The three doctors lost the court case. By majority, the High Court held that section 260 operated to render the arrangements void for income tax purposes since merely done to avoid tax.
3 – Mockkins
Different from Tupicoff and the three doctors, Mochkins was largely successful in Mochkin v FCT [2002] FCA 675. The court accepted that the dominant purpose of his arrangement was not to save tax but to limit liability.
Four ITs and One TR
To create more clarity around PSI or PSB, the ATO issued four ITs and a TR to shed light on the issue. Remember that this was long before the PSI rules came to light.
These ITs and TR – although ancient by now – haven’t been withdrawn and are still relevant.
1 – IT 2121
Released in December 1984, this IT is a direct response to the Federal Court decision in Tupicoff v FCT 1984.
IT 212 discusses the use of interposed entities to split income from personal exertion. The question is whether the interposed entity itself carries on a business or merely derives income from the personal effort and expertise of an individual. If the latter, Part IVA nullifies the arrangement and cancels the tax benefit.
Para 18 says that Part IVA doesn’t apply when the interposed entity derives significant income from business assets.
2 – IT 2330
IT 2330 was released in June 1986. In para 37 it states that in large professional firms the income is produced by employed staff and hence the income is not personal services income.
See the High Court ruling in the Everett case.
3 – IT 2503
IT 2503 was released in November 1988. This IT focuses on medical practice companies where the main income is the work of one or two medical practitioners aka doctors.
In para 10-12s the IT provides that the retention of profits by the company is generally not acceptable. And that Part IVA will apply to treat any retained amount as personal income (on the basis that incorporation has been undertaken for the purpose of minimizing income tax).
4 – IT 2639
IT 2639 was released June 1991 and contains several rules of thumb, helping to apply the other three ITs.
5 – TR 2006/2
TR 2006/2 advises that Part IVA should not be of concern where service entity arrangements make objective business sense. So the service entity erforms contractual duties. Charges are commercially realistic. And the contract contains no unusual features.
Service Trusts
One side issue to the whole question around personal services income is the role of service trusts among professional service practices.
A service trust usually employs all staff and then charges the business a service fee with a mark up. A separate service trust might also lease or own the business premises.
The big question of course is then how much the service trust charges the business. How high the mark up can be. The more the trust charges, the higher the income splitting.
After FCT v Phillips (1978) 8 ATR 783 it is usually accepted that charges from service trusts are deductible as long as they are realistic and not in excess of commercial rates.
So it is a question of fact whether the fee is calculated on a commercial and practical basis.
The ATO’s ‘safe harbour’ rules for service trusts in medical professions is a mark up of 30% for labour and 10% for all other costs as long as there is a proper service agreement with tax invoices and evidence of payments.
Ralph Review
The whole regulatory body around PSI was really a confusing mess scattered across numerous court and ATO rulings.
And so the Ralph Review of Business Taxation Report of July 1999 urged for action in 1999. As a response to the Ralph review, the PSI rules were introduced into Parliament on 13 April 2000.
However, the actual PSI rules were much weaker than those proposed in the Ralph Report.
Summary
So although we now have the PSI rules – however wobbly they might be – the old ITs and TRs still apply as well, since never revoked. So if the current PSI rules are too hazy for you, have a look at the old ITs and TRs listed here. They might give you the reference you need.
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