As far back as 30 years ago the Federal Court was required to determine whether there was a principle of tax law which held that a trustee in receipt of income from his personal exertion was deemed to derive it beneficially[i]. Hill J could not find the principle, he invited a referral to the Appellate Court but the Commissioner did not accept. The facts triggering this enquiry were that Liedig was a land broker, he had declared himself trustee for his land broking business, the services for which he performed personally, this raising the issue whether he derived the business income as trustee or personally.
The case turned on the Trust Income provisions in Division 6 of the Income Tax Assessment Act 1936 (ITAA 1936) [ii], particularly Section 96 which provides that except as provided in that Act a trustee is not liable as trustee to pay income tax upon the income of the trust estate.
A decade before this and in the interim, the Commissioner had succeeded in applying the general anti-avoidance provision, then in Section 260 of ITAA 1936, in setting aside various arrangements for businesses to be operated through corporate or trust vehicles.[iii] In each case the structures were accepted as vehicles having the legal effect intended but then struck down through Section 260.
These cases contrast with the outcome in other cases[iv], in particular that in FCT v Everett[v] where the majority of the High Court held that the assignment of an interest in a partnership resulted in the assignee deriving the share of partnership income attributable to the assigned interest, this notwithstanding that the partnership income was derived from the personal exertion of the partners.
In Liedig the Commissioner sought to distinguish between businesses where the income should be taken to be assessable as the result “substantially” of the personal exertion of the individual or individuals operating the business and other situations. While that principle was not found, Hill J, he having been one of the authors of Part IVA of ITAA 1936, said that “there is no reason to doubt that Part IVA of the present Act, replacing Section 260, would have the same result”[vi].
An application of Part IVA is complex. First, a scheme needs to be identified that produces a “tax benefit”[vii].
In the context of a business entity deriving the income through personal services of one or more individuals, the tax benefit will need to be found in the business entity facilitating a liability for less income tax to be payable as a result of its inter-position than if the individuals were to have derived this income personally.
The next step requires a determination that, having regard to 8 factors set out in placita (a)-(h) within Section 177D of ITAA 1936, it is to be determined that the dominant purpose of the scheme involving the business entity was to obtain the relevant tax benefit.
Since its inception, the Commissioner has been busy in putting forward views as to the application of Part IVA, mainly in tax rulings[viii].
Notwithstanding these pronouncements, provisions have been inserted in the Income Tax Assessment Act 1997[ix], introducing Divisions 86 and 87, respectively relating to the “alienation of personal services income” (PSI) to a personal services entity (PSE), and to a “personal services business” (PSB), and specifying consequences that follow from the inclusion of PSI in a PSE or a PSB. For a PSB, the provisions include several tests which, if complied with, exclude the PSB from an application of the division, which would otherwise require the net PSI to be attributed to the individual who produced it.
It might be thought that with such specifically directed legislation, the circumstances when income derived by a PSB would and would not be taken to be the PSI of an individual or individuals would be settled according to whether the provisions applied or not. This however has not been the case and the Commissioner, with general support[x], has asserted that even if the income of the PSB complies with tests for the non-application of Division 87, the Commissioner may resort to Part IVA to deny any tax benefit arising from the conduct of the PSB.
A significant specific assertion of this kind was the Commissioner’s publication of PCG 2021/4 entitled, “Alienation of Professional Firm Profits”, in which the Commissioner set out guidance as to arrangements that he warned may attract compliance attention under Part IVA. This PCG adopted a red, amber and green zoning of arrangements by reference to their various features and has been of particular significance for the legal profession.
Further to this focus, and perhaps urged on by the number of Trusts lodging trust tax returns now headed towards one million with perhaps a significant share of these encompassing PSB’s, the Commissioner, on 28 August 2024, published draft PCG 2024/D2 entitled, “Personal Services Businesses and Part IVA of the Income Tax Assessment Act 1936”.
In this PCG the Commissioner sets out low and higher risk circumstances likely or not to attract compliance resources to review arrangements and consider the potential application of Part IVA.
The PCG refers to alienation arrangements characterised as where services of an individual are provided by an interposed entity (PSE) controlled by the individual, alone or with others[xi]. These, the PCG asserts, create higher risk where either, or both, an income splitting, or retention of profit, arrangement diverts PSI away from the individual or facilitates the deferral of tax. Arrangements are considered low risk where tax is assessed on the net income of the PSB to the individual whose personal efforts or skills generated that income, such as through its payment as remuneration to the individual, and tax is not deferred.
The guideline does not apply to alienation arrangements where the income of the interposed entity is not PSI but generated from the supply and sale of goods, the supply and use of income producing assets or from the business structure of the interposed entity, or where the entity does not derive PSI and any PSI is made assessable to an individual who generates it.
Nevertheless, the guideline asserts that income is not considered to be generated from a business structure merely because a PSE is established through which an individual’s personal services are provided, and the PSE carries on a business for tax purposes and qualifies as a PSB in an income year, if the PSE is seen to mis-characterise the PSI it derives from the individual’s personal services as income from the business structure.
While acknowledging that an application of Part IVA will depend on the particular facts and circumstances of each arrangement, the guideline asserts that it is likely to apply where a PSE is a vehicle engaging the supply of personal services of an individual to it, the amount of the distributions paid by the PSE to the individual is less than the amount of income derived by the PSE from the individual’s personal services and that PSI is distributed in part or in full to the individual’s associates who pay tax at a lower rate than if the individual had received the PSI.
In summary, but not necessarily with great clarity, an arrangement is advised to be at higher risk where a tax benefit is obtained from an amount of PSI “that might reasonably be expected to have been included in the individual’s assessable income in the relevant year” being assessed as income of a PSE and not included in the assessable income of the individual in that year.
More helpfully, the guideline sets out two tables, each of which provides indicators that may contribute to an arrangement being assessed, the first table as low risk, the second as higher risk, each as against the proposition that an individual’s PSI is alienated through a PSE conducting a PSB. These indicators are amplified through 13 examples, 6 of which reference low risk arrangements and the remaining 7 of which reference higher risk arrangements.
All of the examples are predicated upon an individual, or individuals, providing personal services, to or through an interposed entity which then derives income in providing those services to others. Higher risk then arises from (broadly) the income derived not fully flowing through to the provider of the personal services, and this resulting in a tax benefit.
Effectively, the guideline presupposes from the existence of the postulated tax benefit, a higher risk that the arrangement, characterised as the interposition of an entity to derive what otherwise is an individual or individuals’ PSI, will be attributed to a dominant purpose of tax avoidance.
Over time, various reasons have been put forward for the interposition of an entity to conduct a business providing personal services of an individual or individuals.
Once this was to enable a greater amount in deductible superannuation contributions to be paid by reason of employment rather than were permitted for a self-employed person, but this reason no longer applies.
The most commonly expressed purpose for a PSB is that of asset protection. While this can be a significant consideration, an examination of risks faced and the relevance of the chosen structure in protecting from them will not always support the utility of the entity for this purpose.
Where a PSB involves more than one individual the prospect of joint and several liability between the individuals commonly motivates them and their advisors to choose the conduct of their business through a corporate entity. This reasoning applies with significant force to individuals conducting a PSB.
Continuity of a corporate entity is another common reason, particularly where next generation members have prospects to join the business.
A corporate entity can also be a preferable structure for a PSB where a future seeking of additional capital or an ultimate sale of the PSB is contemplated however this is not of relevance to a PSB conducted through a discretionary trust, and especially one for which a family trust selection has been made.
Underlying the PCG appears to be an attribution of income derived by a PSB reliant on the personal activities of individuals as attributable wholly to those activities. With the growing use of artificial intelligence and delivery of machine-based learning, the facts and circumstances surrounding the attribution of income to the personal services of individuals may not be quite so simple.
While parts of the PCG relating to higher risk arrangements appear an overreach, engagement with the Commissioner concerning a prospective application of Part IVA can be time consuming, stressful and expensive involving, as it must, questions relating to the relevant scheme, the tax benefit, and careful analysis relating to all the eight matters in Section 177D(2). The PCG will need to be viewed in this context by advisors.
For those PSB proprietors seeking to prevent, or willing to dispute, any potential application of Part IVA, they should have regard to these matters and diligently keep records of their decisions and activities for, and by, the PSB that can provide evidence addressing them. The PCG, at paragraphs 38-42 sets out some records that the Commissioner regards as important in this context.
[i]Liedig v FCT 94 ATC 4269;
[ii]ITAA 1936;
[iii]Tupicoff v FCT 84 ATC 4851, FCT v Gulland, Watson v FCT and Pincus v FCT 85 ATC 4765;
[iv]For example, Bayly v FCT89 FCT 5245, and Jones v FCT 77 ATC 4053;
[v]80 ATC 4076;
[vi]94 ATC 4269 at 4278;
[vii]Section 177C ITAA 1936;
[viii] for example, IT2121 and IT2330;
[ix]ITAA 1997;
[x] Including a legislative note to section 86-10;
[xi]Paragraph 4;
