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The ATO’s new focus on income splitting: are you at risk?
Income splitting is a practice sometimes used by professionals and small businesses. It involves an individual’s income being paid into a company or trust, where it can be distributed to others (such as family members), instead of being paid to them directly.
Often this is done to make use of lower tax thresholds, and it’s a practice the Australian Tax Office (ATO) may view as tax avoidance if certain criteria aren’t met.
To provide more clarity over what is and what isn’t considered tax avoidance when it comes to income splitting, the ATO recently released a new Practical Compliance Guideline.
Understanding personal services and income splitting
For tax purposes, income splitting centres around two key concepts: personal services income and personal services business.
Personal services income (PSI) is income that is mainly a reward for an individual’s personal effort, skills, or expertise – not from selling goods or using income-producing assets.
PSI is commonly earned by contractors, consultants, and professionals such as:
- engineers
- IT specialists
- lawyers
- accountants
- doctors
The PSI rules determine how this income is taxed. If the ATO assesses that it is personal services income, the individual will be taxed as such even if it’s paid into a company, trust, or partnership. Any attempt to divert that income to others for tax reduction is considered tax avoidance and penalties can apply.
A personal services business (PSB) is basically an exception to PSI rules. Where income is earned from an individual’s personal effort or skills, the PSI rules will not apply if the business meets one or more of the PSB criteria which show it operates as a genuine business rather than a vehicle for the person’s labour.
This criteria includes:
- You are paid for a result, supply your own tools, and fix defects at your own cost.
- You earn PSI from two or more unrelated clients.
- You employ or contract others to perform at least 20% of the principal work, or you have one or more full time equivalent employees (excluding administrative staff) for a significant part of the year.
- You operate from a separate business premises (not your home or a client’s premises).
Meeting these criteria helps show that your activities reflect that of a legitimate business, not an arrangement designed to sidestep the PSI rules.
The grey areas of income splitting: Part IVA
Part IVA of the Income Tax Assessment Act 1936 gives the ATO power to cancel tax benefits where a scheme is entered into mainly to avoid tax, even if the arrangement technically complies with other tax laws.
It’s this power the ATO uses to crack down on income splitting arrangements, however it hasn’t always been clear when and how they decide to apply it. Grey areas exist – such as when a family member works in the business too. For example, a spouse or child managing administration or bookkeeping.
The purpose of the new Practical Compliance Guideline is to provide more clarity on when Part IVA applies. It details what is considered a low risk or high risk arrangement, which can help you determine if your structure is more likely to attract ATO scrutiny.
Here is a basic overview of the various risk profiles:
Low risk | High risk |
| Tax applies to the individual who earns it. | Income is distributed to those who didn’t earn it. |
| You are compensated appropriately for your work. | Profits remain in the company while you underpay yourself, without a valid business reason. |
| Family members are paid fairly for genuine work. | Family or associates receive high pay for minimal work. |
| Profits kept in the business serve genuine business purposes. | Profits remain in the business but are used personally, such as borrowing from the business. |
The guideline also includes a number of practical examples. Here is an overview of a low risk and high risk example provided in the PCG:
Low risk example
Ellen, a contractor engineer, provides services through her company.
She earns income from multiple unrelated clients, pays herself a salary that reflects her work, and ensures profits are retained in the company only for legitimate business reasons.
Because all income is ultimately taxed to her and the arrangement meets the personal services business tests, this is considered low risk.
High risk example
Adam, an IT consultant, operates through a discretionary trust.
He receives a small portion of the income as personal pay, leaves large profits in the trust, and distributes those profits to family members who did not perform the work.
This arrangement diverts personal services income away from the person who earned it to lower tax beneficiaries, making it high risk.
Lower your risk of income splitting penalties
The new PCG confirms people will have until 30 June 2027 to transition to a low risk arrangement without risk of retrospective compliance action.
After this date, the normal process will apply. This includes the ATO’s ability to go back in time and make an individual liable for all the tax they should have paid in any year where they were inappropriately income splitting (plus penalties).
To help you transition to a low risk arrangement, here are 3 steps you can take:
1. Assess your situation
Ask an experienced business or tax adviser to review your income arrangements and ensure they comply with tax law and the new guideline. Aim to operate fully within a low risk zone, including any arrangements that could be seen as income splitting with a spouse. The PCG provides guidance around this and your adviser can help you interpret it.
2. Keep clear records
If your arrangements could be considered high risk, you’ll need to justify your decisions. For example, if you retain profits in a company then you must maintain clear records explaining why and how the funds will be used. The PCG outlines the types of documents the ATO expects, with an emphasis on contemporaneous documentation (keeping records in real time).
3. Stay vigilant
With automation and AI, the ATO now has more powerful data-matching tools than ever. Sophisticated methods allow them to spot red flags quickly, so don’t assume you will fly under the radar. Given the severe penalties, it’s important to stay proactive and keep your arrangements compliant.
If you’re unsure whether the new compliance guideline affects you, or if your income arrangements could be viewed as splitting, now is the time to act.
RSM’s experienced advisers are highly familiar with tax law and the new PCG, and can:
- review your structures
- clarify your level of risk
- guide you on steps to stay fully compliant
Addressing this early will give you confidence in your arrangements moving forward, and ensure your income is structured with fewer risks and more certainty for the future.
To learn more about the ATO’s new guideline, or to speak with a business or tax adviser from RSM, contact your local RSM office.
