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Opinion article

12 June 2010

Our recent coverage of contractor tax issues in Australia and tax developments in the UK has caused one IT contractor to express his extreme frustration. He's read our information and sent us a pretty angry article on the catch-22 facing IT contractors in Australia. This is because governments, major companies and labour hire business all force contracts on to IT contractors that fall foul of tax law. The IT contractors have no choice! It's an interesting and lively opinion piece.

IT Contractors are sitting ducks

 The Personal Services Income tax legislation has largely been a mystery to most IT contractors for the past decade. Introduced in 2000, it is yet another attempt by the ATO to enshrine the cultural norm in Australia of the tall poppy syndrome and an effort to stymie entrepreneurialism. The recent Henry Tax review by the Labor Government has rejuvenated the focus of the ATO on independent contractors. As a result, independent contractors should be aware of the implications from the insidious PSI legislation.

Two key tests cases have been heard by the courts involving independent contractors over the past 2 years which have serious implications for IT contractors. The first case, Taneja v ATO, involved an IT contractor who had failed the 'results test'. Consequently his company's income was declared to be his personal income and so he lost the benefits of the company entity under which he operated, and was not able to claim a range of deductions. In effect, Taneja's company was considered null and void from a tax perspective for the year in which he operated. This meant that regardless of the fact that he had paid several thousands to establish and operate the company, in addition to any insurances and other financial obligations, the income earned through his company was regarded as personal income. In the second case, IRG Technical Services v DCT, a similar approach was taken by the ATO with two engineers. As a consequence, the engineers were also denied the ability to use their company structure as a tax-effective mechanism.

The rulings by the Federal AAT and the Federal Court, upholding the ATO's actions, are dangerously applicable to independent IT contractors that operate through a company structure. If the income for the company structure is primarily derived from their own labour, then the income is considered personal income, not company income. To be a bona fide company for tax purposes and avoid the implications of Personal Services Income (PSI) tax liabilities, then you and your company must satisfy the results test. The results test has about 11 sub-tests to it and you have to satisfy these tests for at least 75% of your income in a year. If you fail the results test, there are three additional criteria that can be considered. Many, if not all, IT contractors would fail these tests. If you do not have a separate business premises (home offices are not considered a separate business premises), and you operate through a recruitment agency then there is a high probability of failing the tests. The ATO does not consider operating through recruitment firms as offering your services to the public at large.

The other particular problem for IT contractors is that they are required to operate on the site of the client and so use that client's equipment. The ATO does not consider the use of a client's equipment as incidental to the performance of the role. Even if you do supply your own equipment, it is the client's equipment that is taken as being required for you to provide your services. The end result is that even if you are cautious enough to have two clients or more in one year and maintain your income split at under 80/20, then you may still fail the PSI rules. The end result is that IT contractors are sitting ducks when it comes to a tax audit if you are operating through a company.

The best form of defence is to ensure that IT contractors have in place a contract that clearly addresses the issues that the ATO is now focussing on. In particular, providing your services to deliver a result rather than working on a time basis. But this is not the only requirement. If you sign a contract that has a notice period, the recent ruling of the AAT upheld the inference that you are working on a time basis rather than for a result. In addition, you also need to ensure that the contract that you sign has a clause specifying that you are liable for any rectification work. This cannot be implied or assumed. If it is not in there, then you are not liable for rectifications and so you don't have it. There are several other clauses that you need to be aware of to ensure that you are a bona fide Personal Services Business (PSB). If you don't know what they are, then you probably don't even know what to look for and you are exposed.

Even if you are aware of all these clauses, the simple fact is that if you work through a recruitment firm, as almost all IT contractors do, then you are deemed not to be providing your services to the public at large, hence more like an employee than a PSB. Worse still is that the contracts that recruitment firms create have absolutely no protection for IT contractors. It is not their concern that they specify you working on an hourly rate in a particular position. It is not their concern that there is a notice period---despite the fact that the notice periods are generally for you to provide notice but them to provide none. It is not their concern that a raft of other clauses are not in their contract. As a result, you are extremely exposed if you are an independent IT contractor operating through a company structure and you sign a recruitment firm's contract.

The problem is that if you wanted to include these terms to protect yourself, the recruitment firms will simply reject them. They will certainly not include terms that alter the nature of their contract. What this means is that all independent contractors---not just IT contractors---that operate through recruitment firms are exposed if they sign the contract without the necessary terms to protect them from being deemed an employee. Considering that most recruitment firm and hirers' contracts are simply variations of employment agreements, then its highly likely that IT contractors will fail the PSI tests.

If the point has still not sunk in, then consider the facts of the test case IRG Technical services v DCT. This case involved two engineers who operated as a PSB. They applied for a determination to verify their PSB status with the ATO. The Deputy Commissioner of Taxation rejected the application and they appealed the decision to the Federal Court. The Court found that the engineers entered into a contract to provide their services on an hourly rate, at their client's premises where the engineers used the client's equipment and were required to submit timesheets. Sound familiar? The Federal Court then determined that even though the engineers entered the contract with the hiring firm as corporate entities, the services were delivered in an 'employee like' manner. To verify this, the court referred to the contract between the recruitment firm and the hirer rather than the recruitment firm and the engineers. In relation to the contract between the recruitment firm and the engineers the court found no evidence that the engineers operated as a business. Their contracts indicated that they were being paid a fee for service, hence they were not working towards providing a result. The presence of the timesheet is a strong indicator that the person is working on a time basis unless the contract states otherwise. Of significant concern in this case is the Court's attention on the contract between the recruitment firm and the hirer. Most independent contractors never see this contract and yet the courts are using it to determine their status!!

Working through the results test, the Federal Court found that the engineers did not satisfy the requirements of the test at all. This should be a wake-up call for all IT contractors. It does not matter what you think or what you verbally agree with your client, all that matters is what is in the contract. Not just your contract with the recruitment firm but the contract between the recruitment firm and the client. If the contract does not acknowledge that you are producing a result and have high levels of discretion in providing the result, and an explicit requirement to rectify defects (at the very least) then you will not be deemed a PSB. The effect of this is that all of the 'company-like' deductions that you claim will become null and void. Your entire income will be assessed as if you were an employee. The consequences of which could be devastating for many independent IT contractors.

This situation requires serious and immediate attention. There needs to be a standard form contract that covers all of these issues, and the emerging ones, that is controlled by a peak body. Most independent contractors just do not have the time to stay abreast of all these changes, and few accountants and lawyers are even aware of what is going on. The regulators are so far behind in addressing these issues it is not funny. The Minister for Independent Contractors is still producing guides that define the difference between employees and independent contractors. There is little or no recognition of the issues in the contracts that independent contractors are required to sign. Federal Government departments are still imposing draconian contracts on recruitment firms and creating a situation of entrapment for independent contractors. It is not only negligent for them to do so, it is unconscionable. But why should they care? As long as they obtain what they want (a result) it does not matter to them if their contracts are written in terms of an hourly rate.

The ATO's conduct in this matter certainly requires closer examination. After almost a decade it is only now becoming evident how dangerous this piece of legislation is for independent contractors. Only last year the ATO requested all the records of payments made to independent IT contractors operating through at least one large IT recruiter. This is like shooting a gun into a fish bowl. You are certain to hit something. At the same time, the ATO is one of the single largest engagers of IT contractors and they knowingly contract through recruitment firms in terms that expose these people to severe financial imposts. If there is a case of not being able to trust the government, then this must be a salient and deplorable example.

The simple reality is that independent contractors need to combine and act in their own interests. If they had a central control mechanism, like a union, then they could withhold their services from recruitment firms until the situation is resolved. But it is simply not realistic to do so, as independent contractors still need to work. If you are in a situation where you think you might be exposed, then you need to make your concerns known to the political establishment and anyone else in the government who might listen. Send something off, now, to the Minister for Independent Contractors, the Department of Employment and a range of other Departments that are dabbling in this area. Make your concerns known to recruitment firms and obtain the advice you need to have your contracts reflect the terms that protect you---not them. If you don't, then you simply deserve what is coming to you. The alternative is to go back to being an employee. What is worse?