Personal Services Income can be a confusing topic, particularly if you’re a sole trader. However, it’s vital to understand what it is so you know what tax deductions you can claim. Personal Services Income (PSI) is a concept introduced by the Australian Taxation Office (ATO) to govern how income from personal services is reported and taxed. PSI is particularly relevant for independent contractors, freelancers, and consultants who provide their professional or technical expertise. The ATO’s guidelines around PSI help ensure that individuals who earn a significant portion of their income from their personal efforts or skills pay the appropriate amount of tax. So what is personal services income? In this blog we’ll explain the PSI rules, outline how it is calculated and explore its impact on tax deductions.

What is Personal Services Income (PSI)?

Personal Services Income refers to income that is primarily generated from your personal skills or efforts as an individual. According to the ATO, income is classified as PSI if more than 50% of the amount you received for a contract was for your labour, skills or expertise. The concept is usually applicable to knowledge-based services such as:

However, it doesn’t apply if your income is generated from the use or sale of a product, the use of an income-producing asset or other business structures involving more than just personal effort.

Examples of PSI and Non-PSI Income

Jayne is a marketing consultant operating as a sole trader. She has two clients who she has recently completed work for.

Client 1: Jayne delivered a Marketing Strategy training session for her client. She charged the client $1,500 for the session which included materials that cost $150. That means that $1,350  or 90% of the work was for her personal skills and knowledge and should be classified as PSI.

Client 2: Jayne provided email marketing software for a client for which she charged $5,000. The cost of the software licence was $4,000 and the remainder was for her skills and expertise in setting up the software for the client. Since only 20% of the cost was for her expertise, this is not classified as PSI.

While your taxable income can be a mix of PSI and non PSI you should establish whether you are a personal service business (PSB) in the year that you received the PSI income as this affects the deductions you can claim.

PSI Rules

The PSI rules are in place to determine how income is reported and what deductions are permissible. The purpose of these rules is to prevent individuals from diverting their income through companies, partnerships or trusts to exploit lower tax rates. Essentially, if the PSI rules apply, the income is treated as personal income and taxed at individual tax rates.

To determine if the PSI rules apply to you, the ATO applies a series of tests:

  • The Results Test: You must be paid for producing a specific result, use your own equipment, and be liable for rectifying any defects in your work.
  • The 80% Rule: No more than 80% of your PSI can come from one client, unless the unusual circumstances exemption applies.
  • The Unrelated Clients Test: You must provide services to two or more unrelated clients who are not associated with each other.
  • The Employment Test: Your business must employ others who do at least 20% of the principal work.

If you fail these tests, you need to treat your income as PSI and comply with the relevant tax implications.

Why Were The Personal Service Income Rules Introduced?

The Personal Services Income (PSI) rules were introduced by the Australian Taxation Office (ATO) to address tax avoidance issues associated with the income earned primarily from the personal skills or efforts of an individual. Essentially the rules ensure that contractors pay similar amounts of tax as those who are employed, preventing them from gaining tax advantages by diverting their income through companies, trusts, or partnerships. The PSI rules now prevent the misuse of business structures for the purpose of tax minimisation.

Before the PSI rules, individuals could reduce their tax liability by channeling their income through such entities. These entities would then potentially claim deductions that would not normally be available to an individual, or split income among various members to reduce the overall tax rate. This approach could substantially lower the tax obligations compared to what an individual might pay if taxed at personal income rates.

Calculating PSI and Tax Implications

Calculating your PSI involves identifying all income received from personal efforts and applying the relevant PSI rules to determine your taxable income. If the PSI rules apply, you will need to attribute all income and deductions to yourself, regardless of whether your business structure involves other entities.

The PSI determination directly influences how you claim deductions. Generally, deductions are allowed for expenses incurred in generating PSI, including:

  • Salaries and wages for individuals directly engaged in producing PSI.
  • Operating expenses related to performing the services.
  • Equipment used directly in performing the services.

However, certain deductions, typically available to businesses, may not be claimable if they do not directly relate to the earning of PSI. These may include rent, occupancy expenses, or salaries paid to associates who do not contribute directly to contract fulfilment.

Key Takeaways

For professionals and freelancers, understanding PSI is crucial to ensuring compliance with ATO guidelines and optimising tax obligations. Here are the main points to remember:

  • Determine if your income qualifies as PSI based on the nature of your work and how it is earned.
  • Understand the PSI rules and apply them to ascertain if your income is treated as PSI.
  • Be mindful of how PSI is calculated and ensure accurate reporting.
  • Know what deductions are permissible under the PSI rules to avoid potential audits or penalties.

By understanding and adhering to the PSI rules, individuals can better navigate their tax obligations and plan their financial affairs accordingly. For further guidance, consulting a tax professional or visiting the ATO’s website can provide additional clarity and personalised advice.

This overview should serve as a starting point for anyone dealing with PSI and aiming for a compliant and optimised tax handling of their personal services income in Australia.

If you require assistance with understanding your tax obligations and ensuring you claim the correct tax deductions, our team of expert business tax accountants can help.