Taxwise: Proposal to end loophole

Since my last article on the personal services income attribution rule, the Taxation (Annual Rates, GST and Miscellaneous Provisions) Bill has been reported back from the finance and expenditure committee.

The committee recommends material changes to the attribution rules, as well as to other proposed amendments to the GST, Tax Administration and Income Tax Acts.

The attribution rule determines that taxpayers providing personal services to a third party through an interposed entity - such as a company or trust - would have all the income derived by the interposed entity in relation to the services attributed to them.

This new set of rules - to be contained in the Income Tax Act - aims to stop taxpayers with income in the 39 per cent tax bracket from reducing their income by putting an entity between them and the entity to which they are providing services.

For example, computer programmer 'C' works directly for M Limited ('M').

If C earned $100,000 a year, C would pay tax at 39 per cent on income above $60,000. Alternatively, C could form a trust ('T') and be employed by it.

The trust would provide the services to M and C could earn a salary of $60,000 from T and the trust would retain the other $40,000 and pay tax on that income at the trustee rate of 33 per cent (or less if distributed to beneficiaries on lower incomes). This results is a loss of revenue to the Government of about $2400.

The attribution rule as first drafted was to apply in the following situation:

C and T are associated.

80 per cent or more of T's income is from services provided to M or an associate of M.

80 per cent or more of T's income comes from services personally performed by C or a relative of C, and

No substantial business assets are necessary in deriving T's gross income.

A new requirement has been added by the committee - that the rule will apply only if C has personal services income (after attribution) greater than $60,000, targeting high-income earners. The committee has also added the following limitations:

The provisions do not apply where T and C are both non-residents; and

The provisions do not apply to the extent that C's services are essential support for a product supplied by the trust, for example software support services. (What is meant by "essential support" is not defined, nor is it a common term used in taxation legislation, so this may be subject to further changes or expansion.)

The test for being "associated" that is applied in the provisions is the widest of all applied in the Income Tax Act.

But there are exclusions for public authorities such as Government departments and also where C is unaware of an association between M and another service recipient.

Further changes have been made to the substantial business asset component. The asset, which must be depreciable property, must have cost either more than $75,000 or 25 per cent or more of T's gross income from services for the income year.

The asset must not be used for private use or enjoyment more than 20 per cent of the time.

Once all the above requirements are satisfied, the personal services income of T will be attributed to C.

A provision added allows T to offset losses arising from the provision of personal services against the personal services income (only where T is a trust or a company) and ensures that all deductions are taken into account where the interposed entity is a partnership.

Finally, the recommendations made by the committee require trustees, where the interposed entity is a trust, to ensure that the attribution rules do not result in a net loss to the trust.

The effect of this provision is that any amounts paid out to beneficiaries must be clawed back.

This, with the proposal to tax minor beneficiaries at the trustee tax rate, is a further illustration of trust beneficiaries suffering from the effects of anti-avoidance measures that target higher income earners.

*Denham Martin is the principal of Denham Martin.