Contractors and Tax

In the last ten years or so the use of contractors has grown from 3% to more than 10% of the workforce.  Yet even this substantial growth has been held back by business concerns over tax arrangements.  Businesses thinking of using contractors could never be sure if the contractor arrangements they used would be accepted by the tax office.  The tax push was to use PAYE employees.  Contractors were considered by many to be tax evaders.

This is all about to change.  Under the federal tax reforms, contractors are set to enjoy a new tax legitimacy that will remove business worries thus increasing prospects for use.

The tax confusion over the use of contractors has been a result of the Income Tax Acts' tying of the collection of PAYE to master-servant employment.  The courts have used PAYE to denote "controlled" employment, ensuring that PAYE workers were brought within the jurisdiction of industrial relations regulation.  Conversely, PPS payers were taken to be contractors not subject to IR regulation.  As a result, the legislative objective of collecting income tax and the employment definitions used by the Australian Taxation Office have been linked to IR issues, a bad outcome for the ATO and Australian workers and businesses.

Critical to understanding the IR-tax dilemma is the often repeated claim that PPS causes a loss of tax revenue relative to PAYE.  The truth is that PPS and PAYE payers have always paid the same amount of tax.  The difference has been in the method and timing of tax collection.  PAYE workers pay on a sliding scale and enjoy a tax-free threshold.  PPS workers pay at a lower flat rate but from the first dollar earned.  Any differences are corrected by the provisional tax system.

Tax deductions said to be available to PPS contractors but not to PAYE employees merely reflect the transfer of deductions away from a business using PPS workers, who generally supply some tools and on-the-job transport.  They are paid more than PAYE workers by way of compensation, have higher expenses and consequently claim tax deductions for these items which would have been claimed by a business if PAYE workers were used.

The remaining potential tax-revenue problem arises from income splitting.  But even this is not the dramatic issue it is usually claimed to be.  The tax losses from income-splitting have often been alleged to be between $2 billion and $3 billion a year;  but the ATO has shown these figures to be false.

In the most detailed audit for income splitting ever conducted, the ATO, in its Alienation of Personal Services Project, targeted the tax returns of 65,000 taxpayers profiled as likely income splitters.  In an intense eighteen month audit only 714 taxpayers were issued adjustment notices, with increases in tax paid varying from 1.9% to 11.6% per taxpayer.  The audit confirmed that the great bulk of individuals who form companies do so for legitimate business purposes, not to avoid tax.  The audit team was disbanded in late 1998 because the additional tax collected did not cover the cost of the audit.

The Ralph Committee thinks, however, that there is a residual income splitting.  But it is recognised that the issue arises not from contractors as such but from artificial company structuring.  People do not necessarily need to create a company to be a contractor.

The truth has always been that the facts on contractor tax, have not justified the accusations of contractor tax avoidance.

The more serious but largely ignored issue, has been that the tax collection system has been corrupted by being an instrument of industrial relations systems.  The important overriding principle is that legislation should, as far as possible, avoid confusing the ATOs' obligations to collect tax with non-tax issues.

The federal tax reform package addresses this issue, beneficially separating tax from common law employment definitions and thus from industrial relations issues.  Through the interconnecting mechanisms of the Australian Business Number (ABN) and PAYG, all people will pay income tax under PAYG without the legal issues of contracting or employment even being a consideration.

No longer will managers need to sit down and study pages of legalistic style ATO rulings to decide if they should withhold tax.  Managers will not need to become bush lawyers knowledgeable on common law presidential case studies to determine a persons tax status.

The decision will be simple.  If a person supplies an ABN, GST will normally apply and no income tax will be withheld.  If no ABN is supplied income tax will be withheld and remitted to the ATO under PAYG.  Under labour hire, the labour hire company will charge GST and attend to workers income tax under PAYG.

Where community concerns exist over artificial income this will be partially controlled through the ABN because, on achieving an ABN, GST applies.  This, combined with the Ralph Committee's recommendation on personal income tax application where 80 per cent of income is obtained from one source, will limit the commercial incentive to split incomes.

The ABN/PAYG aspect of the new tax system will supply comparative administrative simplicity and legal surety.  Consequently businesses will be able to focus on the true managerial alternatives presented by employment and contracting.

Employment as both a legal and a top driven management paradigm, is about human inequality where control of one human (employee) is exercised by a dominant other human (employer).  In comparison, using contractors involves legal and managerial ideas of equality where control of humans is replaced with achievement of results through mutual agreement.

With these tax changes businesses will be freer to focus on people performance dynamics without having decisions confused by administrative tax demands.

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