Are we enlightened by the draft PSI and Part IVA PCG, or more in the dark than before?

Over time, administration of the tax law changes. In the 1980s and 1990s there was a focus on enacting specific taxation rules over the generic.  This occurred after a string of losses by the ATO and the perception that section 260, the forerunner to Part IVA was a “toothless tiger”.  From 1986, self-assessment put the onus on the taxpayer to know and understand the law, apply it correctly and be able to defend their position. By contrast, law where the Commissioner had to make decisions to tax an amount has been progressively replaced with law that caused an amount to be taxable if certain conditions were met.  These changes include:

• Part IVA replaced section 260;
• Division 7A replaced section 108;
• The non-commercial loss rules codified previous case law regarding whether a small business was genuine or a hobby;
• The holding period rule was replaced by … let me think … not much at all. But the ATO still applies it even though it was repealed in 2006; and
• Most relevantly here the PSI rules in Divisions 84 to 87 codified and extended the common law personal exertion cases.

The intention of these changes was that the Commissioner wouldn’t have to make a specific decision to make something taxable or apply the general anti-avoidance rule through the courts to achieve his desired tax outcome.  Now more than ever the taxpayer has to ensure their tax affairs are in order (and increasingly prove this in a post-assessment review or audit) or tax, and likely penalties, would follow.

Now the approach is changing again. Situations where the specific rules aren’t taxing in a way that the Commissioner thinks should occur are now the subject of Practical Compliance Guidelines (PCGs) and traffic light “rules” about what they should do, even without the underlying law changing (see earlier article about how Federal Parliament has vacated this space, leaving the ATO either needing to fill the gap, or with free rein – depending on one’s viewpoint). Putting taxpayers on notice via a PCG seems to be a proxy for doing a taxpayer review, with the warning provided by the PCG then used as a justification for penalties if a taxpayer ‘gets it wrong’. It also has the effect of having taxpayers and their tax agents do most of the work.

The most recent example of this approach is PCG 2024/D2, wherein the Commissioner sets out a view that allows Part IVA to apply to tax income to a single individual in circumstances where the PSI tests are passed. This has always been a risk, as the old pre-PSI cases relating to Gulland, Watson, Pincus, Mochkin and others from the 1980s to the early 2000s are still precedent for the Commissioner seeking to argue that income is personal exertion income, and thus derived by the relevant individual. There is also a note to section 86-10 which states that Part IVA may still apply to alienation of PSI that falls outside the PSI rules. The draft PCG is the latest expression of the Commissioner’s view which applies Part IVA to increase the tax payable, notwithstanding compliance with the statutory PSI rules if the Commissioner is dissatisfied with the amount of tax paid by the principal.

There are some similarities in approach here with the professional services firm PCG. In PCG 2021/4, as well as the categorisation of risk to low, medium and high via a traffic light colour theme, the Commissioner is focussed on smaller businesses. However, where PCG 2021/4 only relates to professional firms, the new draft PCG could cover any situation where there is a single individual who is the customer-facing fee earner. The examples all are about professional service providers, but this expansion in scope could easily be seen as being applicable to other areas, most notably the husband and wife tradie business where one individual is on the tools doing the customer-facing work and the other does admin (or perhaps not even that).

The message of the draft PCG is that the customer-facing individual is earning the income and so they should be taxed on all the profit. If another individual contributes to the business but does so in a way which does not directly generate income then all they should earn is award wages for doing so.

The draft PCG is helpful in that it allows for profits to be retained to fund genuine commercial capital expenditure. This is similar to the concession in the PSI rules allowing otherwise deductible items to reduce any attributed PSI and is both sensible and the expected outcome. Sadly, the concession doesn’t go so far as to allow the business to retain profits to fund working capital items such as stock or trade debtors. How Part IVA would apply to deny this type of expenditure is a subject not considered in the draft PCG.

However, the tradie and their partner who are in the situation noted above where one works and one doesn’t are presumably now on notice that there are tax risks in a structure which has seemingly been accepted by the ATO for decades. But they are left wondering what the situation is as soon as an apprentice is hired, as the draft PCG doesn’t cover such a situation.

There are 13 examples, none of which go past a single income-generating individual. As there are no examples where there is an income-generating employee, the Commissioner provides no guidance about whether Part IVA would apply to such situations, and (if so) whether the Commissioner would seek some sort of profit apportionment (and how that might work, or what calculations or evidence a business might require to justify any such apportionment).

None of the examples cover a situation where any significant capital expenditure is required to start a business. So, a business started where a silent partner contributes funds and an otherwise penniless but brilliant individual with drive and a great idea get together and start a business are none the wiser about their tax situation. The latter does all the work, but the business wouldn’t exist without the monies required to set it up. We don’t know if the Commissioner will say this is high risk and try to tax the ideas person on all the profit or whether he will accept that the partner making the financial contribution is to be taxed on their share.

The examples provided are all ones in professions similar to the ones covered in PCG 2021/4 dealing with professional practices, which raises further questions. Does the ATO see some deficiency in those rules which could not have been addressed there? Also, the guidelines would seem to apply to a much wider range of trades and professions than the ATO’s examples indicate, such as the tradie example mentioned earlier. So why not have a suitable example?

All we can say for sure is that some taxpayers now have an idea what the Commissioner is thinking if they are individuals generating their own income. But for everyone else, including those who hire a client-facing employee, no new light is shed on the tax outcomes. Possibly the light shone on one situation, makes similar but different businesses feel like they are more in the dark than before.

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