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Submission No. 293 Back to full list of submissions
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Contractors and Income Tax

Submission to the Ralph Review of Business Taxation

22/6/99

1. Background

In the GST deal between the Democrats and the Federal Government agreement was made to have contractor tax issues reviewed by the Ralph Committee.

Any review of contractors and tax needs to be seen within the background of a concerted anti-contractor campaign being run by a coalition of forces headed by the ACTU.

The Australian union movement has long maintained an aggressive, active stance against contracting and independent contractors. This was formalised in 1998 as official ACTU policy. The anti-contractor campaign is most active in the mining (in particular coal) and commercial building industries with strong pressure in manufacturing. As part of the campaign physical and verbal intimidation of contractors is common. In 1999 building sites have been closed by unions until independent contractors were removed from site.

The anti-contractor accusations being made are many and varied but chief amongst these is that contracting is used as an income tax avoidance system.

This paper focuses only on the tax issue and seeks to demonstrate that;

  • Contracting per se is not about tax avoidance.
  • Significant improvement has been made in contractor tax collection capacity.
  • Reforms to the tax systems should provide the ATO with a strong capacity to collect tax at source.
  • Contractor common law status should not be affected by reforms to the tax system.
  • Equity in tax application for all Australians should apply regardless of the common law status when earning income.

2. Source Deduction; PAYE and PPS

The administrative ability of the ATO to cost effectively collect tax is heavily dependent upon the ability of the ATO to achieve income tax remittance at source.

When source deduction does not occur the ATO has resource constraints which limit its ability to find income earners who fail to declare income or under-declare income.

The ATO has had an historical administrative preference for income tax source deduction to occur through the PAYE system.

Collection of PAYE tax is legislatively tied to the common law employer-employee test.

The courts have consistently rejected the ATO view that PAYE extends beyond the employer-employee test of "right to control" (Approx 10 test cases in 10 years)

Contractor numbers in the workforce have risen since 1989 from 3.3% of the workforce to over 9.8% of the workforce (late 1998) and representing somewhere in excess of 800,00 people.

Income tax source deduction for contractors has occurred under the PPS system but until recently been limited to specified industry areas. Contractor growth outside the specified industries is significant.

3. Attempts to eliminate contracting.

Previous attempts to apply income tax source deduction to all contractors has approached the issue by legislatively attempting to declare contracting to be master servant PAYE employment. (The attempts have been to legislatively call a chicken a duck even though a chicken is still a chicken.)

The problems with this approach have been that;

  • It defied the commonsense, common law reality that contracting is still contracting. Legislation does not change reality.
  • Would have still left the legislative provisions subject to common law challenge by contractors and not effectively cemented income tax source deduction.
  • The "elimination of contracting" approach was/is not driven by tax collection motivations but by industrial relations agendas. The courts use PAYE as an indicator of master servant employment. Industrial relations players sought and seek to use the PAYE tax provisions to argue that contractors are in fact common law employees.
  • Using PAYE for industrial relations purposes was and is commercially damaging for key industry sectors. For example the domestic housing and information technology industries are almost exclusively built around contracting. Forcing these two industries into the industrial relations system through tax mechanisms had and has huge competitive and performance implications.

4. Source Deduction Dilemma.

The ATO has been frustrated in its ability to achieve contractor source deduction.

By arguing that the only solution was and is to use the Income Tax Act to enforce common law master servant status on contractors, proponents of this approach were creating a tax loophole through which unscrupulous people could seek to avoid income tax source deduction.

Given that there are more that 800,000 independent contractors with only 200,000 (approx) currently caught in the PPS system, the hole in the source deduction capacity of the ATO is obvious and of concern. All attempts to enforce application of PAYE have failed and created a tax collection problem.

Regardless of personal views of industrial relations issues and contractors, it is not legitimate to use the tax system as an instrument to enforce the application of one form of workforce engagement or another. Such attempts have worked to the detriment of an effective and equitable tax collection regime.

5. Extension of the PPS System

The application of PPS deductions outside the prescribed industries was introduced in early 1999 under the Voluntary Contracts provisions (PPS Bulletin Number 10, 22/12/98). This expansion of the PPS system makes it possible for all contractors to be caught within ATO source deduction mechanisms without impacting on the contractors common law status.

Through the dual administrative systems of PAYE (common law employees) and PPS (contractors/non-employees) the ATO now have full reach for source deduction to all income earners save for the undeclared economy.

The problems of identifying undeclared income are equally common for employees under PAYE and contractors under PPS.

The application of PPS for all contractors now available offers the greatest opportunity to ensure effective full reach of income tax source deduction and to close tax collection holes.

6. Specific Issues PAYE versus PPS.

6.1 Tax Deductions

An often made accusation against contractors is that contractors can claim tax deductions which employees cannot, creating inequity and losses for revenue collection. An investigation of the facts indicates that this is not true demonstrated by two examples;

6.1.1 Travel expenses. With employment, employees are normally provided with work-related travel by their employer. While the employee cannot claim the travel as an expense, the employer can and does claim travel costs as a legitimate business expense. With a contractor the fee that an individual contractor will charge a client will be higher than that of an employee partly reflecting the fact that the contractor is responsible for their own expenses. The contractor can and should be able to claim the travel expenses as a legitimate business cost.

6.1.2 Home office expenses; Employees are normally supplied a place of work expenses of which are covered and claimed as a business expense by the employer. Contractors, particularly in the IT industry for example often work from an office at their home. The charge rate that a home based contractor makes for their work will be higher than that of an employee in part reflecting the cost of providing an office at home which an employee does not provide. The contractor can claim the home office expenses as a legitimate business cost deduction. It should also be noted that in claiming home office expenses, if the home is sold that portion of the home claimed as an office becomes subject to capital gains tax.

These tax deduction possibilities are not the automatic or exclusive preserve of contractors. Employees in similar circumstances are assessed in the same way. In both these examples and others which could be raised the Tax Act "looks through" the common law test of employment or contracting and to the facts of the business operation when assessing the legitimacy of the claimed deductions.

When other supposed examples of contractors receiving tax deduction advantages are examined the facts rarely support the accusations.

6.2 Lower Tax Rates for Contractors

It is often claimed that lower rates of tax apply for PPS contractors than apply to PAYE employees. This is false. Tax liability is the same for all income earners regardless of the common law status of their engagement. Variations in the timing and amounts of tax deducted at source throughout a year can occur for both employees and contractors depending on individual circumstances. At the end of each financial year equity is applied across the system with underpayment of tax being caught in the provisional tax net and overpayment being reimbursed to the tax payer.

To demonstrate;

6.2.1 PAYE employees usually have tax deducted at source on a sliding scale dependent on income. If an employee works for different or multiple employers in a year on different pay rates or has periods of unemployment, tax is deducted at different rates through the year with total liability assessed at the end of the year.

6.2.2 Likewise contractors can work for different clients in a year but with PPS deducted at a standard rate of 20% applicable from first dollar earned. Total liability is assessable at the end of the financial year and overpayment refunded or underpayment caught by provisional tax. PPS contractors can elect to have a higher rate of tax deducted at source to avoid provisional tax application.

6.2.3 Not commonly known is that PAYE at flat rates of deduction apply in the farm produce picking industry (15%) and shearing industry (15%). No suggestions of inequity are made against these flat PAYE deduction arrangements which adds force to the view that the main argument against PPS contractors is motivated by industrial relations agenda rather than tax equity issues.

6.3 Income Splitting (Personal Services Alienation)

A primary concern often expressed is that "contracting" is frequently used as a method of artificial income splitting. The process generally is thought to involve an individual creating a company where the income of the primary and often sole earner is fed into the company with income then artificially distributed to a non working shareholder, usually a spouse. Conceptually the process enables tax to be paid against lower rates than would be the case if attributable against the lump sum thus producing significant savings for the tax payer/s.

"Contracting" in this sense is a misused word and several comments need to be made.

6.3.1 Contracting does not necessarily involve the creation of a company structure.

6.3.2 Contractors who operate as natural persons cannot artificially split income. Where PPS source deduction is paid income is clearly identifiable to the person who performed the work and tax is paid on the lump sum. The PPS arrangements (both previous and expanded) enable the ATO to identify income from source.

6.3.3 The income splitting problem chiefly occurs where "contracting" operates under a company structure. The identification of the income earner/s can be difficult particularly with small companies (2 shareholders etc). The problem of income splitting does not relate to "contracting" as such but rather to company structure creation specifically designed to minimise tax. This tax minimisation process is not generally available to those on low or average incomes. The cost of structuring and administering a company (several tax returns a year, additional book keeping, ASIC reports, accounting and legal fees etc) mean that tax savings need to be significant to offset the additional cost. As a result the ATO auditing focus on income splitting needs to be with higher income earners.

6.3.4 Many small company structures exist not for tax purposes but for genuine business reasons, the most common being the family farm, tradespeople, small franchises, small retailers, etc where the shareholders actively work in the business.

The problem of income splitting where it exists, is to identify company structures specifically established for the purposes of income splitting and isolate those from company structures established for legitimate commercial purposes.

6.4 ATO Investigation of Income Splitting

In response to concerns over believed tax losses from income splitting the ATO has undertaken an extensive audit of small companies under the name of the "Alienation of Personal Services Project". The project was conducted during 1997 and 1998. An ATO status report of December 1998 shows 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 taxpayers review process.
  • 714 taxpayers have been issued adjustment notices.
  • Percentage increases in tax paid has varied from 1.9% to 11.6% per taxpayer.

It is understood that as a consequence of these results

  • The cost of the project has exceeded the additional tax revenue raised.
  • The Alienation of Personal Services Project is being wound down.

The project outcomes appear to show that the vast bulk of small company structures are created for legitimate commercial, business purposes and not for the specific intent of avoiding tax. The revenue hole believed to exist and the inequity assumed to occur through income splitting does not appear to be anywhere near the problem which some publicity would suggest.

The facts suggest that taxpayers in small companies access the same level of deductions available to other taxpayers and perhaps make similar percentage of errors in calculation of their tax liability as do other taxpayers. For example it is understood that in ATO audits of employee work expense claims it is generally expected that where additional tax is required the average increase is in the order of 17%. (Subject to ATO confirmation). This is a notably higher rate of employee taxpayer error than that evidenced in current figures of the ATO income splitting audit.

7. State Issues; Workers Compensation and Payroll Tax

Often accusations are made against contracting that contractors avoid payroll tax and workers compensation liabilities.

Given that the primary legislative test for inclusion in these regimes in each State is the finding of common law employment, the suggestion is that Australians not in a common law employment status are somehow avoiding statutory responsibilities. Further, the suggestion often is that the Federal income tax system should be used to force Australians into common law employment thus ensuring application of State workers compensation and payroll tax regimes.

These accusations are in ignorance of the facts.

  1. In each State payroll tax legislation has broad reach well supported by the courts. The deeming and grouping provisions in each State create wide coverage of all forms of contracting largely eliminating avoidance of payroll tax.
  2. Each State has different approaches covering the intent and scope of their workers compensation schemes with some states fully embracing all contractors and some States specifically seeking to legislatively exclude contractors from their schemes.

The States have amply demonstrated their competence in creating legislation which reflects their views on these matters. It is not for the Federal income tax system to be used as a method of dictation to the States the reach of their payroll tax and workers compensation schemes.

8. Conclusion

On the investigation of the facts, it appears that accusations that contractors and independent contractors benefit from artificial tax benefits or savings in comparison to PAYE employees or other tax payers, is false.

9. Recommendations to the Ralph Review.

The recommendations herein relate exclusively to the issue of equity in tax treatment between common law employees and contractors (non-employees)

It is submitted that

  1. The ability of the ATO to effect source deduction from contractors has been substantially improved since the enhancement of the PPS system through the Voluntary Contracts Provisions.
  2. Attempts to force contractors into PAYE would recreate difficulties for the ATO in effecting universal source deduction and create tax avoidance.
  3. In reviewing business tax and tax collection issues the Ralph Review should be mindful not to allow tax issues to be confused by or caught in, industrial relations agendas.

General Recommended Principles

In applying an income tax system;

  • ATO income tax collection systems should not discriminate against Australians based on their choice of common law workforce engagement status and in particular the tax system should not impose "employment" as a preferred or required status on Australians.
  • The ATO should have effective administrative mechanisms for generating income tax at source, regardless of common law status of taxpayers.

The two systems currently in use PPS for contractors and PAYE for employees should equitably be applied so as not to interfere with Australians legitimate choice of workforce engagement types.