By Phil Barlow – 7 December 2011

In life nothing is certain but death and taxes, a saying that was recently reinforced by the Supreme Court ruling of the landmark case of Ian Penny and Gary Hooper. The Commissioner alleged that the Christchurch orthopaedic surgeons used corporate and family trust structures as a means of tax avoidance.

While the majority of the Court of Appeal agreed with this decision, the High Court, did not. In its recent judgement, the Supreme Court unanimously agreed with the Commissioner’s position and has upheld the Court of Appeal’s decision.  The Supreme Court maintained that although the structures themselves were entirely lawful and unremarkable, the use of those structures by Penny and Hooper to pay artificially low salaries amounted to tax avoidance.

For some, this judgement was not a surprise. However, it does still leave a degree of uncertainty hanging over taxpayers, because in the case of Penny and Hooper, although the structure itself was perfectly acceptable, the outcome was not. The judgement has reconfirmed the need for people to be more vigilant when restructuring their affairs.

The IRD has released a Revenue Alert RA 11/02 on this issue. Whether you believe the decision is right or wrong, as a taxpayer, you probably do not want to end up in litigation.  Consequently, you should generally be following the IRD guidelines.

In our view

The one exception would be the 80:20 rule (outlined on page 4 of the Revenue Alert RA 11/02). The 20% business profits (80% salary) for entrepreneurship, intellectual property, businessknow-how, etc is pure guesswork by the IRD. Businesses have many varied profit drivers outside of the individual’s skill and personal exertion. What’s more, the market salaries (based on locum rates, temporary employee hourly rates, etc) provided by many of our clients do not support the 80:20 rule.

Irrespective of this, moving forward you will need to ensure you do some homework in this area. At Hayes Knight, we believe that our clients typically know their industry and market best and therefore they’re generally in a better position to make a call on what is a ‘market salary’. In our view, it’s not something that a person’s adviser – or, for that matter, the IRD – can guess; although a person’s adviser may be able to help them in reaching a figure that everyone is comfortable with.

Where you believe there is a possibility that your historic salary may not be considered to be market, the Penny and Hooper decision should definitely be discussed with your adviser to work out the best course of action. Suddenly significantly increased salaries is likely to show up on IRD exception reports and we suggest people exercise an element of caution in doing this.

The Penny and Hooper decision is a change from the past. We are now seeing court decisions based on public sentiment. The current public perception is that trusts are shams, used to avoid tax and evade creditors.

We would hope the New Zealand Institute of Chartered Accountants (NZICA) and others will lobby the IRD to reconfirm the circumstances under which they will and will not seek to apply this case. The danger, otherwise, is that this case will be used carte blanche to support any position the IRD intends to take.

It is also worth noting that this case relates to tax years in which the tax rates were not aligned. However, based on the tax rates currently in place, perhaps this case has less application moving forward, given there is potentially no tax advantage. That said, in certain circumstances, there could still be timing advantages.

If you have any concerns regarding the restructuring of your affairs, we recommend that you seek advice from your Hayes Knight adviser. Alternatively, please contact our Tax Team:

Phil Barlow
Tax Director
T + 64 9 414 5444
E phil.barlow@hayesknight.co.nz

Shelley-ann Brinkley
Senior Tax Manager
T +64 9 414 5444
E shelley-ann.brinkley@hayesknight.co.nz