Tax Alert September 2011

Over the past few years there have been an increasing number of tax avoidance cases making their way through the Courts. While it is welcoming to receive guidance on how the anti-avoidance provisions apply, this is still an area where advisors and their clients need to tread with care.

A recent case found its way to the Supreme Court of New Zealand and the judgement was released in August this year.   The Penny and Hooper case1 concerned two orthopaedic surgeons who sold their practice into companies where the family trusts owned the majority of the shares. Around the time the top marginal tax rate increased from 33% to 39%, the salaries that the doctors received were considerably lower (about 18% of prior years’ earnings) than their pre-incorporation income. Essentially this led to the main issue which the Courts focused on, i.e. had the taxpayers avoided tax by failing to pay themselves a market salary, enabling the Inland Revenue to treat the arrangement as void under the general anti-avoidance provisions?

The taxpayers argued that there was no concept of a minimum salary within the Income Tax Act and that the Hadlee decision concerning inalienation of earned income had no application. They also argued that none of the specific anti-avoidance provisions applied and therefore the taxpayers’ use of the structure with reduced salary payments was not tax avoidance. Furthermore, the taxpayers argued that the tax benefits (between $20K-$30K per annum) resulting from the company structure were merely incidental. Whilst the first argument above was not rejected (unlike the others), the fact that there is nothing in the Income Tax Act requiring a minimum salary did not preclude the taking of a non-commercial salary being a step in a tax avoidance arrangement.

Inland Revenue took the view that the taxpayers had purposely avoided the application of the top marginal tax rate. They retained control of all the income, and all the income was applied to the taxpayers for the benefit of themselves or their families through the company / trust structure. The taxpayers had also made a decision to fix an artificially low salary.

It is not surprising that both the Court of Appeal and Supreme Court found in favour of the Inland Revenue. Whilst there are no doubt a number of taxpayers to whom this decision has potential application, we believe that its application is not as wide as the IRD tax alert indicates. We believe it will only apply to taxpayers in situations where the following three criteria are met:

(i)       The salary paid to the controlling owner must clearly be non-commercial;

(ii)        The shareholder-employee takes significant cash out of the company over and above their salary for personal use;

1 Penny and Hooper v CIR [2011] NZSC 95

(iii)       The profits of the entity arise substantially from the personal exertion of the shareholder- employee.

It should be kept in mind that this is a historical issue as there is no current tax advantage with the top personal tax rate and trust tax rate aligned at 33% and the Inland Revenue are prevented from going back to re-assess years that are statute barred (i.e. 2006 or earlier income years).

The following examples indicate how this decision would apply for an existing structure or in instances when considering to restructure clients’ affairs.

Example 1

A software developer decides to set up his own company taking a salary similar to that paid by his previous employer. During the first year in business, he develops some software which proves to be quite successful; so much so that within 18 months the royalties being received amount to $800,000 whilst he takes a shareholder-employee salary of $100,000.

In this example, we do not consider that the decision in Penny and Hooper has any application as the income is derived not from the shareholder-employee’s physical exertion but, rather, from licensing the software.

Example 2

A solicitor incorporates his practice following the introduction of the Lawyers and Conveyancers Act 2006. The rationale for incorporation is to endeavour to create a business which has a personality distinct from his own and, ultimately, to create value in the company as part of an exit strategy. Prior to incorporation the solicitor was earning $400,000 from his sole practice in which he employed two professional staff.

Following incorporation he makes some enquiries as to what is a reasonable salary and also analyses his accounts which show that after allocating a fair share of the overhead to the other professional staff, at least $200,000 of the profits arise from work done by his staff. Upon enquiry, he ascertains that no-one is likely to pay him more than $170,000 as a salary.

In our opinion, if a taxpayer takes a salary of (say) $170,000, then Penny and Hooper has no application because the profits do not arise from the owner’s own physical exertion and the remuneration taken is not demonstrably non-commercial. That is not to say that this type of restructuring could not otherwise be seen to be tax avoidance as tax avoidance includes “directly or indirectly altering the incidence of any income tax” and a tax avoidance arrangement includes “an arrangement that has tax avoidance as its purpose or effect”. If the solicitor had not previously carried on a practice in his own name then clearly there could be no tax avoidance.

It can be seen from the above examples that the application of the Penny and Hooper case will depend on the circumstances applying to each taxpayer. Following the release of the Supreme Court decision, the Inland Revenue have issued Revenue Alert (RA 11/02) attempting to clarify how this decision will affect taxpayers. In their Alert, the Inland Revenue indicate that they will consider arrangements where the total remuneration paid to the controller is less than 80% of the total distributions taken by the controller, his/her family and associated entities.

The Inland Revenue provide the following list which they consider as drivers which businesses use in determining the way in which profits are distributed. Such drivers include:

• the controller / owner’s personal skill, judgement and exertion, i.e. the more marketable these attributes are, the greater the remuneration should be;

• the use of capital assets;

• services provided by other staff;

• intangible assets;

• return on business risk.

The Inland Revenue also agree with the Court of Appeal and the Supreme Court on a number of reasons why businesses may not be able to distribute all the profits to the individual owner. These may include:

• adverse business conditions;

• the need to retain profits within the business to meet future expenses;

• use of profits to acquire business assets in future years;

• the business is a charity and the individual chooses to receive less to maximise the charity’s profit.

The IRD also note that where an individual is receiving less than an arm’s-length salary, they would not expect to see any significant distributions being made to associated entities.

What can be taken from this decision and other similar decisions is that where there is a significant benefit in the form of tax savings arising from a restructure, there is a risk that the general anti-avoidance provisions will apply.   Unless there are very solid non-tax related reasons for a restructure, we recommend that specialist tax advice is sought before proceeding. Also, if you have clients who have been receiving below-market salaries, think twice before suddenly increasing them significantly. This is likely to be a flag to IRD.