Australia’s 80/20 rule for contractors. What’s it all about?
Tax liability and payment are a concern for all contractors, and how their business activity will be viewed by the local authorities. Australia has an unusual approach called the ‘80/20’ rule, to ensure that contractors and their clients are not really engaged in a form of ‘stealth’ employment.
The simple explanation of this rule is that if you work primarily for one client during a tax year, you will be assessed as a Personal Services Business. In this case, the Personal Services Income (PSI) rules will apply. In actual definition, the rule states if you earn 80% or more of your income from one client during a tax year, you will be taxed as an employee rather than an independent contractor. The rule is designed to prevent contractors from reducing taxes as a business entity, when in fact they are dedicated to one client similar to an employee relationship.
The 80/20 rule in Australia means that most traditional limited company contractors could be taxed as PAYG employees on PSI. This removes the traditional full benefits of using a limited company as a contractor. Specifically, by stating a low salary, all expenses and dividends to reduce their tax burden. The financial ramifications are significant as it can reduce net retention by 10-20% depending on circumstances.
In this article, we cover:
80/20 Rule explained
The “Alienation of Personal Services Income Act 2000” or as its more commonly known the “80/20 rule” is specifically aimed at ensuring that the traditional contractor vehicle – a sole trader entity or single director ltd company is taxed at the same rate as a Pay As You Go, employee.
Additionally, the highest rate of personal tax is 47% (for earnings over 60k), there is a 10% Goods and Services Tax, 1.5-2.5% Medicare levies and compulsory Superannuation of 9%.
The evaluation of the 80/20 rule is quite complex:
– A personal services company cannot derive more than 80% of your earnings in one tax year from one END CLIENT (regardless of the agencies involved)
– Contracts should be structured as a reward for results, as opposed to purely payment for time and materials. This can be qualified in terms of risk. Does your contract expose you to risk? (i.e. if your contract guarantees you pay regardless of the outcome or quality of your work, you’ll fail this requirement)
– Contracts should take responsibility for the “rectification” of errors
– Some investment in equipment or tools (i.e. not purely using the end clients resources) is required Additionally the business should meet ONE of the following criteria: *
Unrelated Client: A personal services business must have multiple and unrelated clients. This negates intercompany invoicing and the use of investment income. *
Employee Test: A personal services business must employ people to deliver the service other than the principals *
Separate Business premises test: A personal services business is expected to have its own premises, not a home office or a serviced office. If you’d like more information about the 80 – 20 rule or a free assessment of whether you qualify, we’re always here to help.
How to reduce Australian tax under the 80/20 rule
The main effect of the 80/20 rule is that it removes the attractiveness of a personal limited company for contractors. Running a limited company involves a significant amount of administration. It also carries heavy obligations if the taxes or accounts aren’t filed on time and correctly. These reporting obligations are increased with the PSI rules whilst also dramatically limiting the allowable expense deductions. This leaves two other options for payment – PAYG and umbrella companies.
Pay As You Go
Having contractors paid through PAYG was the Australian government‘s preferred outcome with imposing the 80/20 rule. It requires the least administration of any solution, and it also results in the highest levels of taxation. As a PAYG contractor, you really get the worst of both worlds because you are taxed like a permanent employee. However, you receive none of the associated benefits like sick leave, holiday pay, training and development, etc. The government is assured of receiving the maximum tax revenue, as amounts are calculated and withheld monthly.
Umbrella Company
The other option is using an Australian umbrella company. An umbrella company acts as an intermediary between the client and the contractor, facilitating payment and handling tax withholding. Being paid through an umbrella company offers several benefits with the PSI rules. The best Australian umbrella companies have professional assessors who can advise whether the 80/20 ruling applies to you. Even if it does, they will enable contractors to deduct some degree of expenses, and utilize salary sacrifices on common purchases like cars and laptops to reduce the tax burden. They make the administration exceptionally easy by handling all aspects of invoicing, payment and tax reporting. The contractor’s only responsibility is to send in their timesheets.
If you are contracting in Australia and have questions about the 80/20 rule and whether it applies to you, please contact us at Contractor Taxation. We have a network of fully vetted umbrella companies that can assist you with navigating tax and business rules in Australia.
