Selling your skills, knowledge or advice

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Consulting and contracting

The results test |  Alienation rules |  The 80% rule |  Limiting deductions

There are a number of reasons for a business to use the services of a consultant. Apart from tapping into a source of knowledge that is not a usual part of an enterprise's day-to-day skill set, there is the convenience of having that extra 'pair of hands' without having to enter into an employment relationship.

For many businesses, highly skilled jobs (or perhaps a build-up of essential tasks) are able to be outsourced in a more cost-effective way. And if a project is completed or work dries up, it is often easier to end a consultant's contract than to sack or re-deploy a staff member.

A consultant can operate as a sole trader. Alternatively, they can operate through a company, trust or partnership that in turn contracts with the client – and so is not unlike any other business. Such an entity is known as a 'personal services entity'. However unlike with an employment relationship, a contractor invoices for services rendered, provides their own insurance cover for things like public liability, and will have to supply and maintain necessary work items such as a computer (if they are not at the workplace already).

The working life of a consultant or contractor can seem better than the '9-to-5' alternative – you set your own hours (more or less), make the call about how the work will be done, pick up other jobs at the same time, and maybe sub-contract out the tedious bits. But while working as a consultant can offer some freedom in the work/life balance area (you might be able to factor in time for Friday golf in your arrangements, for example) and gives you more control over what work you actually do, there can be constraints when it comes to how income is taxed.

For starters, make sure that you (or the business that you are employed by) quote your ABN when submitting a tax invoice for work. Otherwise the employing business is obliged to withhold tax at the top marginal personal tax rate of 46.5%. Even though you can claim back any overpaid tax in your tax return, it's not great from a cash flow perspective to have nearly half your income withheld at the payment of every invoice. You may need to be registered for GST and charge 10% on the supply of services (if your turnover is greater than $75,000, but if less than that you can still choose to be registered to charge GST).

The results test
The principal test for determining whether an individual has derived 'personal services income' is called the 'results' test, and is that at least 75% of the income is for the consultant (or the personal services entity if the consultant is working through one) producing a certain result, the consultant (or the entity) provides the tools or equipment (if any) necessary for this, and is liable for the cost of rectifying any defective work.

Personal services income (PSI) is singled out for the '80% rule', and is defined as being 'a reward for an individual's personal efforts or skills'. This excludes simply providing goods, as with a retailer or manufacturer, or only using a physical asset like a truck or tractor to generate that income.

Alienation rules
A contractor or consultant operating through any business structure may come under the scrutiny of the Tax Office's 'alienation of personal services income' legislation. This tax law was drawn up basically to try to stop the 'tax leakage' that occurs from rewards for work undertaken by an individual on the basis of their skills and expertise (that is, PSI) being taxed at lower rates by streaming the income through a company, trust or partnership (and perhaps into the hands of members of the individual's family on lower tax rates).

The 80% rule
If the results test is not satisfied, there is also the requirement that no more than 80% of a consultant or contractor's PSI in any tax year should come from the one client. Otherwise, the personal services entity may be obliged to withhold additional amounts of tax, through the PAYG system, on the consultant's personal services income that has not been paid in the form of a salary .

The tax rules around PSI were designed to alleviate the practice of businesses trying to escape employer obligations by re-employing a worker, who would otherwise be a bona fide employee, as a consultant/contractor. The problem of 'fake' consultants hasn't gone away, and is one of the reasons why the Tax Office is so focused on the clear definition of what constitutes an 'employee', and uses more than one yardstick to measure the distinction (see Employee or contractor?).

In fact, the Board of Taxation has found a low level of compliance in this area, and has advised the government to ramp up its crackdown on sham contracting arrangements, and has put forward recommendations about increased reporting and testing requirements.

There are tests under the PSI rules that if not passed will see income treated as belonging to the consultant as an individual (not to his or her business) and taxed as such. These tests concern whether you use physically separate premises to operate your business, if you engage others to do at least 20% of the work, and that clients must be 'unrelated' to each other or to the consultant or their business entity. (The premises test however has been criticised as perhaps an anachronism for some knowledge-based operations.)

Satisfying these tests will place the consulting or contracting business under the 'personal services business' banner in the eyes of the Tax Office, and the income will be taxed as the income of the business and not be attributed to the individual.

If you or your business does not pass the results test, the 80% test or any of the personal services business tests, you can apply for a determination to be classified as a personal services business, depending on your circumstances. You can apply for a determination from the Tax Office with this application form.

Limiting deductions
It is also important to maintain your status as a personal services business for the tax deductions that are available. Otherwise deductions will be limited to those that are available for individuals in their capacity as employees, and you would not, for example, be able to claim rent, mortgage insurance or rates on premises, even if you are using the premises for business purposes.

Also, travel from home to a client's office could not be claimed, nor any payments made to an associate (mainly for non-principal work, such as to a spouse for bookkeeping for example).

It is still possible however to make claims that are specified in other legislation. This can include income protection or public liability insurance and WorkCover and superannuation for associates who perform principal work.

BONUS: A government handbook for all things an independent contractor will need to know. Download 'Contracts Made Simple' or the earlier brochure 'Independent Contractors: The Essential Handbook' here (they're 89 and 84 pages, so you might like to order your free copy from the independent contractors hotline on 1300 667 850).