By Hayes Knight – 7 July 2010

Whilst the Revenue Alert is a good step in the right direction, the Alert is unlikely to put minds at ease. Although the Inland Revenue has stated it will only focus on the most serious and artificial cases, the full implications of this case are still unclear. There is obviously scope for the Inland Revenue to apply this decision across the board, and accordingly, the decision has far reaching consequences for small businesses in New Zealand.

For many years the Inland Revenue has been asked to publish its policy on shareholder salaries.  This has never happened.  It would therefore clearly be unfair and unjust if the Inland Revenue was to take a hard line (retrospectively) across the board, in respect to shareholder salaries.  We would hope that common sense will prevail.

It is evident further guidance will be required from the Inland Revenue going forward.

The Facts of the Penny and Hooper case

Mr Penny and Mr Hooper were practicing as orthopaedic surgeons on their own account. Later, each set up a company to purchase their orthopaedic practice. The companies were owned substantially by their respective family trusts. Mr Penny and Mr Hooper were then employed by the respective companies. The companies paid the surgeons salaries much lower than they had received when they were working on their own account.

The tax advantage from this structure was that a portion of the income derived from the surgeons services was subject to a company tax rate of 33%, rather than the top individual tax rate of 39% (applicable at the time) if the surgeons had continued to operate as sole traders.

The Commissioner argued that operating through a company/trust structure and receiving a salary that was significantly less that a commercially realistic salary amounted to tax avoidance.

The Decisions

The High Court found for the taxpayer and held that the arrangement did not amount to tax avoidance. However, the Court of Appeal (by a two to one majority) found for the Commissioner and held that the arrangement amounted to tax avoidance.

The Court of Appeal reasoned that the arrangement as a whole was artificial and contrived. The company/family trust structure allowed the surgeons to obtain the advantage of the lower company tax rate while still receiving the full benefit of the income themselves. The Court found that the salaries paid to the surgeons were not commercially realistic and contributed to the arrangement being artificial and contrived.

However, the Court stressed that the use of a company/trust structure and a failure to pay a market salary does not in itself constitute tax avoidance. There could be legitimate reasons for paying a below-market salary. The Court stated that it is a matter of assessing all the circumstances including the extent of any element of artificiality or contrivance to determine whether an arrangement amounts to tax avoidance.

IRD’s Revenue Alert

The IRD has stated that:

  • Where a service business relies mainly on individual’s personal skills to generate income, that contribution to the business should be properly reflected in the income returned by that individual.
  • The Revenue Alert details a list of factors that may contribute to an arrangement being artificial, contrived or lacking commercial reality. It was noted in light of these factors:
    • Particularly important indicators are the degree of participation by the individual and the degree to which profits are in substance diverted to other family members.
    • The level of remuneration is an important indicator though not conclusive on its own.
    • Generally, the IRD would not expect that remuneration would be paid where there is little or no profit genuinely being generated in economic reality (e.g. start-up, difficult trading conditions). The IRD also accept that income can be retained for major expenditure or provisioning.

Furthermore, the IRD have expressly stated that they will generally focus on the most serious and artificial cases.

A copy of the Revenue Alert can be found here: http://www.ird.govt.nz/technical-tax/revenue-alerts/revenue-alert-ra1001.html

If you would like to further discuss the potential impact this case has on your business structure, please contact Phil Barlow or Shelley-ann Brinkley.