What is the 80/20 rule for contractors?

What is the 80/20 rule for contractors in Australia?

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.

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.

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