Has your client been hit by a PSI "desk audit"?

Alienation of Personal Services Income ("PSI") is identified by the Commissioner as an area of special focus in the ATO 2008/2009 Compliance Program. It was always expected that the ATO - fresh from a number of ATO funded test cases where the Court had agreed with the ATO's interpretation of the PSI rules and therefore, confident of its approach - would be aggressive in its audit activities. However, no one expected "desk audits".

Those the subject of a "desk audit" received a PSI "audit" stating that their tax returns are reviewed for the relevant years and the ATO discovered irregularities. The letter attaches a schedule called, "Position Paper". This is where the Commissioner - solely based on income tax returns of the relevant taxpayer - comes to the conclusion that your client's entity is not carrying on a "personal services business". The letter also contains a Schedule with the relevant adjustments to the relevant entity's tax return.

A similar letter is issued to the person in receipt of the PSI as the ATO identifies. The letter follows along the same lines as that of the personal services entity. However, there is an addition: the adjustments for the tax shortfall, penalties and interest are also included. The Commissioner states that it won't exercise its discretion to remit interest and penalties. Not a very friendly letter.

What are your clients' options - according to the ATO?

In its letter the ATO provides two options:

1. Do nothing and the ATO assumes your client agrees with the ATO. Within 28 days the ATO automatically adjusts your client's tax returns. Your client pays the extra tax together with penalties and interest.

2. If your client disagrees, your client has to "telephone" the ATO and provide additional information or your contentions within 28 days from receipt of the ATO's letter.

Which option is the right one for your client?

Before deciding, conduct a forensic investigation. For example, the "results test" is still a grey area. Even armed with a full understanding of the facts, different minds can come to different conclusions in applying the results test. However, notwithstanding the importance of the factual circumstances in PSI matters, the PSI "desk audit" draws a conclusion not from examination and weighing of any facts but solely by looking at the source of income. In this regard, if you have derived income from a labour hire firm you are more likely to have received a letter.

Taking into account the lack of analysis of the factual information, the "desk audit" cannot be treated as a proper application of the laws to the facts. In our view, recourse to tax returns and nothing else means that the "desk audit" and the adjustment is likely to be a fishing expedition, to catch and penalise the frightened and ill-advised not all relevant factual information is taken into account.

What is also concerning is that by agreeing to the adjustments, your client may be consenting to what we refer to as a "gratuitous donation" to the Government's Budget deficit. Not only is your client agreeing to pay more tax than would otherwise be properly payable but also to pay penalties and interest.

Conduct of ATO audit

If you choose to disagree with the ATO's "desk audit" position, then the ATO states that it will conduct an "audit".

In our view, the "audit" can be used as an opportunity to consolidate your position.

In the first instance, through a forensic investigation of the facts, our objective is to determine whether the facts adequately support the assertion that the entity/individual is carrying on a personal services business. If you lose on that, all is not lost. If neither the individual nor the entity is carrying on a personal services business, we seek the legal and factual basis as to why the relevant expenditures identified by the ATO is deductible to the individual deriving the PSI.

Best to get your tax litigation team involved at the audit level. We work with the accountant to identify the appropriate strategy. This strategy enhances the chance of getting the ATO off your client's back - or reducing penalties and interest. If the matter proceeds to an objection stage then be cautious. The drafting of the objection and your conduct during the objection stage can be equally as important in the outcome of your tax dispute. Whatever you argue in the objection is all you can argue at the AAT. This is unless you seek permission to amend your grounds of objection (expensive and time wasting).

Tax is complex. Tax dispute is a specialist area of tax. Clients are concerned with the legal costs for specialist representation. It is for this reason that Brett Davies Lawyers and specialist tax lawyers at Maddocks come together to provide a tailored tax dispute package for accountants, tax agents and advisers. From day one, we can often fix fee everything from Audit - Objection - AAT. To find out more about the package or a confidential discussion about your client please telephone: