February 2006
Update November 2020
Important note: Our information of 2006 (below) was and is based on high level advice and consultation with the specialist PSI officers in the ATO. However, by 2015, the ATO had, in our view, without formally changing their policy, effectively removed the certainty of PSI for partnerships as detailed in 2006. This came to our attention and consumed enormous amounts of our time in the Rod Douglas case. The details of Rod’s case are here.
As a result of Rod’s case we hold the view that the ATO’s view and position on this issue is entirely subject to the whim of the ATO as it changes from time to time.
Important development for partnerships
As of December 2005, the ATO accepts that, in the ordinary case, the tax law does not prevent 50:50 income splitting by a genuine partnership conducted by an independent contractor with his or her spouse where there are no unusual features about the partnership or the income split.
Note: The partnership must be genuine and not designed just for tax-scamming purposes. An example of an unusual feature is the splitting of income in different proportions to the splitting of losses.
Before this change the ATO treated partnership income splitting with some suspicion which meant that splitting income could cause an ATO investigation and rejection of the income splitting.
A typical example
If a trade contractor (plumber, carpenter, etc.) legally operates in a partnership with his or her spouse, the income from the partnership can generally be split 50:50 with the spouse. This can apply for IT professionals, engineers, consultants and so on.
Why the change?
In 2003, the ATO announced that it would conduct a test case programme on some tax issues for independent contractors which meant taking specific cases to the courts for a ruling. As a result of court rulings, the ATO has reviewed partnership issues.
The ATO recognises that where independent contractors work through partnerships, not only do the partnerships share income but they also share expenses. Further, if the business goes broke, each partner is legally liable for the debts of the business. Partnerships are not a legal construct to enable the avoidance of debts.
Note: Following the test case programme, the ATO issued the following, Refocus of the Income-Splitting Test Case Program (2005) <http://ato.gov.au/print.asp?doc=/content/67313.htm>
However this link has been removed from the ATO’s updated website.
Source References: ATO and others
The key ATO reference is Part IVA: the general anti‑avoidance rule for income tax Basic principles about how and when it applies (see page 4).
Download original document here. See below for relevant section.
The Commonwealth Government issued the following statement:
Independent Contractors The Essential Handbook (see page 44)
Download original document here. See below for relevant section.
Comment from the Journal of Australian Taxation (2007) is also helpful
Available online here (see page 74)
By Scott Pennicott. See below for relevant section.
Doesn’t apply to companies or trusts
This new rule for partnerships does not apply to companies or trusts. Therefore, the ATO remains cautious and is likely to investigate income splitting and profit retention in companies and trusts. However:
- This only applies to independent contractors who are classified as a Personal Services Business. It does not apply to entities that are classified as Businesses.
- The ATO is continuing the legal test case programme for PSB companies and trusts.
ICA’s view
This development for independent contractors operating as partnerships is most welcome. Partnerships are normally genuine businesses and should be entitled to share income when risk of losses is also shared. There will be many thousands of small partnership which can now approach their business activities with greater certainty on the tax issue. This relieves them of one area of worry and concern.
ICA has supported the ATO test case programme, believing it to be a sensible and genuine approach by the ATO to resolving the issues. The process may take longer than ICA would like, but it is good to see one positive outcome.
ICA looks forward to further clarity coming from the test case program for independent contractors operating through companies and trusts and who are PSBs. In the meantime, independent contractors operating this way should be aware that income splitting and profit retention is a grey area of tax law and could be subject to ATO investigation.
ICA-ATO communication The Commissioner of Taxation announced the partnership changes in December 2005. ICA has consulted with the ATO to ensure that we are correct in our facts before making comment. ICA appreciates the ready contact and assistance we receive from the ATO. Our comments and views, however, are our own
Source References & Quotations
1. From ATO Document: Part IVA: the general anti‑avoidance rule for income tax
Basic principles about how and when it applies.
Guide NAT 14331‑12.2005
Page 4 : Example of where Part IVA does not apply
Part IVA would not apply to a typical husband and wife partnership arrangement where there are no unusual features.
Under such an arrangement, a husband and wife conduct a business in partnership and, as the relevant Partnership Act provides, share equally in profits and losses, notwithstanding that only one party performs the main bulk of the work. This arrangement has the effect of dividing income equally notwithstanding that only one of the partners is the main generator of the income of the partnership.
However, the arrangement also has the very real financial consequence of exposing each partner to full liability for the debts of the partnership. When regard is had to the eight matters in Part IVA, it would not be objectively concluded that the dominant purpose of the partnership arrangement was to obtain a tax benefit through the equal division of profits and losses. Entering into a partnership is an ordinary means for a husband and wife to conduct a business together. There is nothing contrived about the manner of sharing profits and losses because that is what the Partnership Act prescribes as the normal consequence of forming a partnership.
The arrangement is a partnership in form and in substance and it is a way of the husband and wife conducting business over the longer term. In the absence of unusual features, therefore, Part IV A would not apply to such husband and wife partnerships. The sort of unusual features that could see Part IV A apply include where the:
- income generating activity was in reality a disguised employment arrangement, or
- use of the partnership is prohibited by regulatory or other laws.
In employee‑like arrangements, provisions in the income tax law which specifically deal with the alienation of personal services income may apply in any event. This would mean that the partner performing the main bulk of the work is taxed on all of the partnership income. In such cases, Part IVA would have no application.
2. From Commonwealth Government Independent Contractors The Essential Handbook Page 44: Personal services income taxation
In many cases, the income you receive for your work may be classified as personal services income (PSI). PSI is income that is mainly a reward for personal efforts or skills and is generally paid either to you as a contractor or to a personal services entity (a company, partnership or trust).In any one contract, if the majority (more than 50 per cent) of the income you derive from delivering services comes from the use of your skills, knowledge, expertise or efforts, rather than the materials supplied and/or tools and equipment you use to complete the job, then the income for the contract will be classified as PSI.
There are special PSI tax rules to ensure that you do not use business structures to avoid your income tax obligations.
- If you operate as an individual (not a partnership, company or trust) you are entitled to claim certain expenses as tax deductions necessary to earn your income. The PSI rules may affect the deductions you can claim.
- If you operate as a partnership, your partnership is entitled to claim as tax deductions certain expenses necessary to earn partnership revenue. The partnership income is then distributed to each partner. Each partner must pay tax based on net income. The PSI rules may alter the allocation of income and expenses between partners.
- If you operate as a company or trust, the PSI rules may particularly affect you. The rules cover such issues as retaining income in the company, splitting income and some deductions.
3. From Journal of Australian Taxation (2007) Page 74, by Scott Pennicott
According to the explanatory memorandum that accompanied the introduction of Part IVA, the Part was intended to counter tax avoidance arrangements that are ‘blatant, artificial or contrived’. It was not intended to cover ‘arrangements of a normal business or family kind’.The Commissioner has recently confirmed this view, for example where a husband and wife operate a partnership where the husband produces the majority of the partnership’s income.Where both partners are fully liable for the partnership’s debts (as is usually the case) the Commissioner has stated that such an arrangement would not attract the application of Part IVA.This is because sharing profits and losses is a normal consequence of forming a partnership under the Partnership Acts and, having regard to the eight matters in Part IVA, it ‘would not objectively be concluded that the dominant purpose of the partnership agreement was to obtain a tax benefit through the equal division of profits and losses’.
However, the Commissioner has stated that ‘every case turns on its own facts’ and Part IVA could apply in the following cases:
- where regulations or laws prohibit the use of a partnership;
- the contract with the partnership is in fact a ‘disguised employment relationship’; or
- partnership losses are allocated in a different manner compared to profits ‘having regard to the partners’ respective tax positions’.