May 2008
The ATO has released a commentary/opinion on the implications of this important test case. In essence, the judgment affirmed the ATO’s position in relation to independent contractors using discretionary trusts and company structures. Click here for the ATO opinion.
First test case on PSI Rules
December 2007
IRG Technical Services Pty Ltd v Deputy Commissioner of Taxation [2007] FCA 1867 (5 December 2007)
This is an important case for the ATO and independent contractors. For an overview of the issues and implications, read ICA’s public comment (click here).
Summary
The Federal Court upheld the position of the Australian Taxation Office that two independent contractors—one working through his own company and the other working through his discretionary family trust—did not pass the results test under the Personal Services Income tax laws. This means that all income earned by the two independent contractors will be taxed as if it were their personal income. They will not be able to split their incomes with their spouses or claim business-like tax deductions.
Summary of the circumstances
The case involved two independent contractors—Mr Green and Mr Owen—who were both highly skilled engineers doing designs for the Woodside gas plant in Western Australia.
Each did the work personally, but
- Mr Green worked through a company structure of which he was the sole director and shareholder.
- Mr Owen worked through his family discretionary trust.
They were engaged through one labour hire company, then changed to another labour hire company called Dare, apparently because Dare offered better arrangements for PSI purposes The work was done at the premises of KJV—a business division supplying services to Woodside. They worked regular set hours over about a three- year period using all the facilities of KJV. They made some, but limited, use of their own personal computers for the work.
They were both paid on an hourly rate and invoiced. A supervisor kept a time sheet and each was paid regularly, based on the time sheet, even if they had forgotten to submit an invoice. There was no clause in the contract between Dare and KJV requiring personnel provided by Dare to have any responsibility for rectifying any defects found in the course of their work.
His Honour’s observations
The defendants’ legal counsel relied entirely on the text of the contracts for the defence. But his Honour said that the totality of the relationship was important and that depending on the contracts alone was not sufficient to determine if work that was occurring was based on a result.
His Honour took into account the Ralph Report (around 2000) which argued that the tax rules should stop income-splitting in certain circumstances. This seemed to have influenced his Honour in regard to the intent of the PSI legislation.
He accepted that Mr Green and Mr Owen were not employees of the labour hire company Dare, and also that they did not provide their services to the labour hire company but to the Woodside project. Mr Green and Owen appeared to be very much integrated into the business of KJV (Woodside).
Of Messrs Owen and Green his Honour said: ‘Both were honest. Both were experienced and intelligent men. Each had attempted to organize his employment affairs in a way that would bring about the most advantageous taxation treatment. There is nothing inappropriate in that’.
He made an interesting comment on tax rulings, which confirmed that rulings are not law but an opinion of the Tax Commissioner:
‘While these rulings may in various degrees ‘bind’ the (Tax) Commissioner in the conduct of his duties they do not bind me….’ (Paragraph ref 38)
He also made it clear that the PSI laws are only relevant to tax issues and have no implications for the status of independent contractors. Hence his ruling on the results test did not have implications for Mr Owen or Mr Green in terms of their common law status as independent contractors. His Honour said ‘It is not intended that the Divisions apply to independent contractors’ (s 87-1 tax act).
ICA comment
Results Test: His Honour made it clear that there was a distinct difference between the results test under PSI law and common law determinations of independent contracting. It was recognised that the results test is based on common law, but that any decision on the results test does not determine the common-law position of the individual person for other purposes, for example, industrial relations.
Tax rulings: Further, the judge was quite clear that the ATO believed that it was bound by its tax rulings. However, tax rulings did not bind the judge. In other words, that tax rulings are an expression of the opinion of the Tax Commissioner and are not an expression of legal fact.
The question his Honour had to consider was whether Messrs Green and Owen worked for a ‘result’ as defined under the PSI rules. The question was whether the entities passed the results test for Personal Services Business determination purposes and hence could split income. (Nb: PSB is a category within the PSI structure.)
Partnerships: The ATO has made it clear that if partnerships split income, the ATO policy is normally to accept this—subject, of course, to the Part IVA (general anti-avoidance rules). (Click here for ATO statement.) The reasoning is that, under partnerships, the liabilities of the entity are clearly the legal responsibility of each individual partner. On this reasoning, the ATO says that if each individual partner is totally responsible for liabilities, then they should be entitled to the proceeds of the business.
Companies and Trusts: However, the ATO has also maintained a watching brief on company structures and trusts. The reasoning is that both these structures enable income earners to avoid liabilities. Hence, it is open to question—depending on the circumstances—when income-splitting should be allowed. The ATO has made it quite clear that where companies and trusts seek to split income, the ATO could, and is likely to, investigate and challenge. ICA has stated before that people in such circumstances should have their eyes wide open and not be naive or complain if they are investigated.
ATO test cases: The ATO also said that it would undertake a legal test case process to have the courts give legal guidance under companies and trusts. ICA strongly supported this test case programme when it was announced some three years ago. It was the correct thing for the ATO to do, rather than just relying on its own rulings. ICA understands that the test case programme involves the ATO covering the legal fees of the defendants. This test case described above is, we believe, the first outcome of the ATO’s approach and is a win for the ATO. The lessons are clear.
ICA’s conclusions
The ATO now has a firm legal precedent upon which to reject income-splitting, profit retention and business-style tax deductions when independent contractors operate through companies or discretionary trusts under similar circumstances to Mr Green or Mr Owen. Note: it is not the fact of working through a company or trust that is the issue, but whether or not the way you work passes the results test.
It is clear that simply going to lawyers and relying on a written contract will not enable one to pass the results test. This is no surprise to ICA. It has always been our view that it is the behaviours and the way in which the relationships operate that are important.
Income-splitting can be legitimate and is accepted by the ATO if independent contractors make sure that they conform with the results test’s requirements. Even though the results test is not specifically a common-law test, there are strong parallels. ICA’s common law check list and swinging pendulum test may assist here.
In summary:
- Individuals: The case doesn’t affect independent contractors who operate on an individual basis.
- Partnerships: Independent contractors who work through a partnership are unaffected and should normally be able to split income with their spouses—subject, of course, to the Part IVA (general anti-avoidance rules). (see ICA explanation: ICA members)
- Companies/trusts: Independent contractors who work through companies or trusts need to be careful about splitting income, retaining profit and claiming many business-type tax deductions. Great care needs to be taken with the legal structure and with how the business relationship with clients operates on a day-to-day basis to ensure passing of the results test.