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Posted: 2002 by Ken Phillips
An edited and updated version of a paper delivered at a conference considering Independent Contractors, Employees and Tax. Albury, Australia, 6 May 2000
(Updated to be current as of October 2001)
Income-tax collection processes and industrial relations issues have been intimately connected since the Second World War. The core issue is and has been the legislative power of the Tax Commissioner to collect income tax at source. This core item usually becomes lost, however, in the debate over the related issues of income-splitting and tax deductions.
In the total social dynamic, the income tax collection system has been more important to industrial relations coverage than has any other factor. This dynamic has changed.
Let me explain.
The capacity of the industrial relations system to rule over people's working lives is confined to people who are working in a common-law, master-and-servant employment relationship. That is, one person (the employer) has the legal right to control the other person (the employee). People working outside the master--servant relationship are not ordinarily subject to the powers of industrial relations authorities. They are subject to regulations of a commercial sort.
In the tax area, the way in which the Australian Tax Commissioner had been able to collect income tax at source was legislatively dependent on common-law employment determinations.
This common dependence of income tax collection systems and industrial relations powers, on determinations of master-and-servant employment, had over time caused tax-collecting authorities to become engaged in an alliance with industrial relations regulators. The two authorities with outwardly different agendas had found themselves in the same colluding bed.
This outcome corrupted the integrity of the tax collection system.
The reform of the Australian tax collection system in 2000 under PAYG had as one of its objectives the breaking of the nexus between common-law employment and income-tax collection. The outcome is liberty for the Tax Commissioner from common-law employment problems and greater freedom for people to choose the nature of the common-law status they wish to have when working.
Historical Background
The noted economist Milton Friedman, with some regret, describes his work as one of the architects of the income tax system in the USA. He says that Federal income tax was meant to be a temporary measure to overcome the problem of funding the Second World War. USA Treasury concern in the 1940s was that massive debt funding of World War 1 was a major contributor to the Great Depression. Friedman bemoans how temporary measures become permanent, and then grow when government has its hands in the public's purse. Australia has followed a similar course, as has the UK.
In the 1920s, 1930s and 1940s, the legal master-and-servant employment model was perhaps at its dominant height as the method for organizing business in capitalist societies. It was understandable that, in designing an income tax system, that tax legislation should tie the power of tax officials to collect income tax at source to common-law employment. Common-law employment-dependent tax powers at the time would have caught almost all of the working population. This was the legislative model used in North America, the UK and Australia.
Around the late 1970s, significant change in legal work engagement methods began to emerge and have since accelerated. People are deserting the master-and-servant, employment, wage slave model for reasons unrelated to tax. But one consequence of this is that there has been a diminishing of tax officials' legislative reach.
The scale of the social movement away from wage slavery has only recently been authoritatively identified. In the first survey on this issue undertaken by the Australian Bureau of Statistics (released in February 2000), as of August 1998:
59% of the workforce identify themselves as working in a full-time employment relationship.
20% of the workforce identify themselves as being self-employed.
Surveys by the South Australian Institute of Labour, in 1989, put the self-employed figure at somewhere around 3%.
These Australian statistics reflect world-wide trends that have alarmed tax authorities in USA, Canada, the UK and Australia at least. Many tax commentators and designers have not understood or accepted the social movement, but have instead interpreted it as a massive and sinister tax-avoidance scam.
The Australian Tax Commissioner's approach to the diminution of collection authority had been a combination of accommodation and aggression. The domestic building industry had been at the pointy end of the interface with the Commissioner, because most houses built in Australia are built by independent contractors. The spread of independent contracting is, however, wide, and now dominates the information technology and film industries, and is penetrating traditional areas of manufacturing, finance and even the public service.
Changes to the Income Tax Collection System
It is important to understand clearly the problem from the tax system and tax officials' perspective. Tax officials are charged with fulfilling a legislative instruction to collect tax. From an administrative angle, the most effective tax systems are those in which voluntary compliance is maximized and in which tax is collected at source. Tax auditing and compliance activity is expensive, is not cost effective and is something tax designers seek to minimize.
In Australia, the Pay As You Earn (PAYE) arrangements evolved as the primary 'at-source' collection system, and it was around these that the ATO's administration systems were constructed. But PAYE legislation only gave the Commissioner power to collect an individual's income tax at source if the individual was in a common-law, master-and-servant employment relationship. The key provision was Section 211C of the Income Tax Assessment Act 1936 which required 'employers' to deduct instalments of tax from payments of salary or wages to 'employees'.
In an effort to overcome independent contractor leakage from PAYE, the Australian Tax Commissioner had argued that the legislative powers under section 221A(1) of the Act being 'wholly or principally for labourÉ', extended the Commissioner's powers to contractors.
To prove the point, the Commissioner had aggressively sought to enforce this legislative extension view. The Courts, however, did not agree with the Commissioner. During the late 1980s and 1990s, on 10 separate occasions, the High Court rejected the Commissioner's view that PAYE legislative powers extended beyond common-law employees.
Another approach had been to attempt to change income-tax legislation to bring independent contractors into PAYE. The last time this was attempted was under Federal Treasurer Willis (1994). The problem was that the Willis amendments sought to deny independent contractors the right to exist by legislatively declaring contractors to be common-law employees. The Willis amendments were dropped when a change of government occurred.
Had the Willis tax amendments succeeded, they would have put the Tax Commissioner on a collision course with a broad social movement toward freedom, equity and justice. Bad for tax collection and bad for society!
The other approach of the Tax Commissioner was to create an administrative tax collection system, at source, for contractors, called PPS. When developed, the PPS system was limited to the building and related industries. PPS had always been seen by the Commissioner as administratively messy and at best providing a temporary plug to an expanding hole.
The Historical Problem
We come then to the state of the dilemma as it has stood through most of the 1990s:
PAYE had been declining as the dominant revenue base.As independent contracting grew, PPS was under pressure to be expanded beyond the building industry.The Tax Commissioner had developed tests to limit people entering the PPS system and prevent PAYE disintegration. In effect, the tests became quasi-common-law rulings, a task for which the Commissioner had no expertise or legitimate authority.Because the quasi-common-law tax tests largely sought proof of contractor status on the basis of the existence of company structures, the impetus for structuring was enormous.In the Commissioner's view, structuring enabled individuals to split income and claim deductions so as to avoid tax.
In short, the linking of the Tax Commissioner's 'at source' income-tax collection powers to common-law, master-and-servant employment relationships was a negative in times of vast social change:
It corrupted the tax collection system, making it an instrument of the industrial relations system.It limited the right of people to free themselves from the inequality and injustice of the master-and-servant employment relationship.
With at least 1 in 5 of the Australian workforce not working in a traditional employment relationship, and with the trend growing rapidly, the tax collection system had to modernise.
Basic Principles
The tax-collection system was in urgent need of updating to accommodate a changed and changing society. It was unfair to force the Tax Commissioner to be an arbitrator or commentator on the relationships people choose to have when they work.
The Tax Commissioner's powers are silent on, and irrelevant to, the cohabitation preferences of people. Whether people are married, de facto, transient, heterosexual, gay, bi, swinging, open, religious, irreligious, eco-pure, eco-ravaging or anything else is not of legislative concern to the Tax Commissioner in the power to collect income tax. Equally, the Tax Commissioner should not have to be dependent on common law status at work.
The Redesign
In 1 July 2000, the first true redesign of the tax-collection system was introduced. By design, one of its primary objectives was to untie the Tax Commissioner's collection powers from common-law dependency.
Enter Pay As You Go (PAYG)
The objective of neutralizing common-law employment dependency is central to the new PAYG system, an objective generally not recognized and one that became confused in the debate over income-splitting.
The Government's intent was evidenced in two key documents:
'Tax Reform not a new tax a new tax system.' (ANTS)
The 'ANTS' document as it was known in Treasury, was the principal document produced by the Federal Government in 1998 that established the principles and structures of the proposed reformed tax system and upon which the Government went to the 1998 election. The PAYG components established in ANTS are substantially intact in the 2000 legislative form.
ANTS says:
'...Australia's core withholding system---the Pay As You Earn (PAYE) system---relies heavily on outmoded ideas of master and servant to define obligations. It simply has not kept pace with labour market trends and is falling further behind. Australia needs a modern, comprehensive withholding system for payments to workers.'
'Treasury Fact Sheet No 703'
Fact sheet 703 is the primary fact sheet explaining what was the intent of the Ralph Review on income-splitting. In all the processes proposed, Treasury states:
'It (the measures) will have no effect on the legal relationship between the entity and the person paying for the services.'
In putting this intention into effective practice in 2000, the government has achieved important reform with wide-reaching implications.
The Tax Commissioner now has a clear legislative brief to collect income tax at source without having dependency on lifestyle and managerial choices made by people.The corrupting linkages between the tax system and the industrial relations system have been removed, enabling debate and choices on our working lives to be conducted specifically on the working life issues.
In understanding how this has been achieved, the key pieces of legislation to understand are the GST, ABN and PAYG legislation. These first appeared in early 1999. The legislation uses new terminology that has specific administrative tax meaning only. The terminology includes: 'withholding', 'instalment income', 'instalment group', 'entity', 'activity statement', 'notional tax'.
The following is fact:
The battle between PPS and PAYE no longer exists, as both are consumed in the new catchall system PAYG.Common-law employees are clearly caught within PAYG.Independent contractors who work through labour hire are caught within PAYG.Independent contractors who work direct and have an ABN can choose to be caught within PAYG by signing a 'voluntary agreement.'Independent contractors who do not wish to enter PAYG can remit their own income tax at source but require an ABN if they don't want their client/s to withhold 48.5% of invoices.
This multi-pronged process is designed to maximize pressure on all income earners to be within the PAYG system. It successfully and broadly nets income earners no matter what their common-law work status.
Income Splitting and 'alienation'
The debate over income-splitting has generated great heat and many accusations that the Australian government had wanted to get rid of independent contractors. The debate reached its height in mid-2001 and has been resolved under the Personal Services Income Legislation.
Contrary to most accusations, and on the best available evidence, large-scale income-splitting in the Australian community was unproven. In the only authoritative and detailed investigation done of income-splitting, the practice was shown to be minor.
During 1997 and 1998 the ATO conducted the 'Alienation of Personal Services Project.' An ATO status report of December 1998 showed the following:
65,000 taxpayers were profiled for investigation as likely income-splitters.55,000 notices were sent to taxpayers initiating review of tax returns.5,403 taxpayers were specifically targeted for tax review.1,104 tax agents were visited in the taxpayer's review process.714 taxpayers were issued adjustments notices.Percentage increases in tax paid varied from 1.9% to 11.6% per taxpayer.An unspecified number of taxpayers were found to have overpaid tax and were entitled to a refund.
It is understood that the additional tax raised was below that expected of any random audit of taxpayers' returns. The conclusion of the audit was that the vast majority of people structure themselves as a business for legitimate business purposes and not for tax purposes.
The audit was the only factual analysis of allegations of income-splitting ever undertaken in Australia, but oddly, during the highly politicised debate in 2001, was given little attention and perhaps even suppressed.
Income-splitting has been one of those issues that everyone seems to think everyone understands, but when it comes to precision of definition there is mute silence. Those who make accusations of income-splitting have a responsibility to define precisely the point in a transaction at which a payment to an individual from an entity ceases to be an expense in earning an income and becomes a tax dodge.
In a typical example used: if the spouse of a carpenter contractor is a partner in the contractors business, at what point do payments to the spouse cease to be legitimate partnership payments and become income-splitting? Are partnerships to be disallowed? Are two-person companies to be abolished?
The task under legislation is to find a legal answer to this question that will guide the tax office, taxpayers and the courts when called on to settle disputes. Under the Personal Services Income (PSI) legislation the solution was ultimately found by drawing on the basic common-law definition of the commercial contract.
A market economy operates with two core legal contract types: the employment contract and the commercial contract, both of which are regulated but in different ways. For tax purposes these two basic contract types are administered differently because the way in which transactions are structured are different. What was confusing tax administrators was that individuals were choosing to earn income under the commercial contract instead of the employment contract. This was alien to the social context in which the income tax system was designed (in the 1940s) and the reasoning was that somehow loss of tax revenue must be occurring.
In seeking to stop this perceived revenue loss, tax designers tried to create a set of separate administrative mechanisms that caught what they saw as a grey area between the employment and commercial contract. Their initial model of early 2001 tried to ignore the existence of the commercial contract and instead stated that a business that earned more than 80 per cent of its income from one source would be treated for tax purposes as an employee. It took several months for the implications of this to be realised by the community and then a political storm broke!
Twenty per cent of the Australian workforce directly earn their living under the regulative structures of the commercial contract. These people are the vast array of independent contractors working in a huge variety of industries and in many different ways. As these people became aware of how the 80 per cent rule would adversely affect their ability to operate their personal business, an enormous and sustained political eruption occurred. The intense lobbying of politicians and tax officials by people explaining the implications for their business activity proved to be an effective education process. The PSI legislation was altered.
The final PSI legislation, passed in September 2001, came back to core principles and uses the difference between the employment contract and the commercial contract as the defining distinction.
If a person earns income under an employment contract, they are taxed and treated as an employee.If a person earns income under a commercial contract (an independent contractor), they are taxed and treated as a business.
The legislative wording that explains this is convoluted, but the core principle has been set.
Tax fraud
None of this suggests that a person can commit tax fraud. The clear suggestion in the debate against independent contractors was that persons who sought to become independent contractors did so to avoid tax. The inference was that the process of an individual person earning income through commercial contract regulations, of itself caused tax fraud. This was not a sustainable argument given the facts.
There are people in all communities who will seek to conduct tax fraud, but being an independent contractor or an employee does not, in itself, predetermine that a person will commit, or has a greater capacity to commit, tax fraud. Although not specifically stated, this has now being effectively recognised in the PSI legislation. Instead, the PSI legislation makes it plain that accessing business type tax status does not allow a person to commit tax fraud. The tax fraud provisions of the income tax Act will be robustly used against people---employees and independent contractors---who commit tax fraud.
Summary
The highly protracted Australian debate over independent contractors and tax has come to a conclusion. There is now legislative and administrative acceptance of the business status of independent contractors. The tax system does not seek to change an independent contractor's legal and commercial status, but instead takes a neutral stance.
The tax system now treats independent contractors as it would any other income-earner and, importantly, the Australian tax system has effective legislative powers and administrative process to:
Collect income tax from independent contractors at the point (source) they earn the income.Handle the business-type tax deductions of independent contractors in the same way that any business is treated.
This resolution removes the tax discrimination against independent contractors, creates tax equity between employees and independent contractors, and gives the tax authorities effective capacity to undertake their required task of tax collection.
The United Kingdom
The United Kingdom is involved in a similar tax debate on independent contractors highlighted by their controversial tax provision IR35. IR35 effectively creates tax discrimination against independent contractors and reflects the erroneous and negative view of independent contractors displayed during the 1990s in Australia. Rather than resolving the issue, IR35 has inflamed it.
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