If you’re someone who earns income from your personal skills—whether you’re a consultant, contractor, or freelancer—you’ve probably heard about Personal Services Income (PSI) rules. These rules are designed to make sure that you pay the right amount of tax on income generated by your own efforts.
However, if you’ve set up a personal services business (PSB) and think that the PSI rules no longer apply to you, there’s something else to consider: the General Anti-Avoidance Rules (GAAR). These rules could still apply if your arrangement appears to be focused on reducing your tax bill.
So, even though PSI rules don’t affect your income, are you sure your setup won’t trigger GAAR?
What Exactly Are General Anti-Avoidance Rules (GAAR)?
At its core, GAAR is designed to prevent tax avoidance schemes. But what does that really mean? Simply put, if you’re organising your affairs in a way where the sole or dominant purpose is to avoid paying your fair share of tax, GAAR might just step in.
Imagine this: you set up a trust, and most of the income earned from your personal services goes to family members who pay less tax. On the surface, this looks like a great way to reduce your tax bill, right?
But here’s the catch—if the tax office believes that the main goal of this arrangement is to lower your tax obligations, GAAR can apply and cancel out those tax benefits. That’s a stomach-twisting situation no one wants to deal with, especially when those back taxes come knocking.
Where Personal Services Income (PSI) Fits In
Now, you might be wondering, what about PSI? If you’re earning income mainly from your skills and effort—whether as a sole trader or through a company, partnership, or trust—that’s classified as PSI.
And while the PSI rules are there to prevent tax dodging through income splitting or diversion, some might think that declaring themselves as a PSB (Personal Services Business) gives them a free pass. That’s not quite the case.
Even if you’re operating as a PSB and the PSI rules don’t directly apply, GAAR could still come into play. So, if you’re trying to lower your tax liability through income splitting or shifting profits into entities with lower tax rates, you’re not completely off the hook.
When GAAR Could Apply to Your PSI Setup
Let’s break this down with a simple example.
Suppose you provide specialised services—maybe you’re a consultant, designer, or an IT professional—and you do this through a company or trust.
Now, you’re paid a hefty $120,000 a year for your work, but instead of taking that full income, you distribute part of it to family members with lower tax brackets through a trust. You pocket $50,000 as your salary, and the remaining $45,000 is split among your family, saving a significant amount on taxes.
This might seem like a smart, feel-good moment. But when the tax office takes a closer look, it becomes clear that the main purpose of this arrangement is to reduce your tax burden. In such cases, GAAR could be applied, meaning you’ll be required to pay tax as if the full $120,000 was your personal income.
Think about that—an arrangement that felt like a win could quickly turn into a costly mistake.
Key Considerations for Avoiding GAAR
If you’re thinking about your own setup and wondering how GAAR might affect you, there are a few key points to consider:
Is Your Remuneration Fair?
Ask yourself, Am I being paid fairly for the work I do? The salary or wages paid to you should reflect the value of the services you provide. If your company or trust receives $100,000 for your work, and you’re only drawing $30,000 in salary, it could raise red flags.
Are You Splitting Income with Others?
Diverting income to family members who didn’t actually perform the services? That’s a classic signal that you might be attempting to avoid tax. If the income generated is based on your effort, it should be taxed as your income.
Are There Unjustified Deductions?
Some might think they can create extra deductions through the business that wouldn’t otherwise be available if they were a regular employee. But if those deductions don’t hold water, they could be disallowed, leaving you with a bigger tax bill than expected.
Retaining Profits in Low-Taxed Entities
Holding onto profits within a lower-taxed entity, like a company or trust, rather than distributing them to you as income? That might sound clever, but if the purpose is to avoid paying higher tax rates, it could backfire under GAAR.
The Cost of Not Complying
Picture this: you’re hit with a determination from the tax office that your arrangement was primarily set up to avoid tax. Not only will they cancel any tax benefits you’ve received, but you could also be on the hook for penalties and interest on unpaid taxes. The aftermath? Financial headaches and stress that could have been avoided with the right advice and a compliant tax strategy.
So, why take the risk?
How Can You Stay on the Safe Side?
The answer is simple: ensure your income arrangements are fair and transparent. Pay yourself a reasonable salary that reflects the services you provide, and avoid splitting or diverting income in ways that could attract attention. Remember, short-term tax savings aren’t worth the long-term consequences.
If you’re ever unsure about whether your setup is compliant, don’t wait for the tax office to come calling. Seek out expert advice to make sure you’re on the right path. Contact Clear Tax Accountants today!
Final Thoughts- Stay Informed, Stay Compliant
At the end of the day, no one wants to deal with the fallout of a GAAR determination. While it might seem tempting to take shortcuts with income splitting or profit retention, the risk is high, and the tax office is always watching.
So, ask yourself: Is saving a little on taxes now worth the potential trouble down the road? If not, it’s time to review your arrangements and make sure you’re following the rules. After all, when it comes to taxes, playing by the book will always pay off in the long run.
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