Following the Court of Appeal decision in Penny and Hooper case (Indian Newslink, June 15, 2010), an air of apprehension is spreading among professionals and taxpayers that this decision could encourage the Inland Revenue Department (IRD) to prosecute taxpayers hiding behind a trading trust or a company to reduce the incidence of tax.
The Penny and Hooper case involved arrangements that are common in New Zealand.
The Court of Appeal, by a two-to-one majority, decided (on June 22) that the adoption of the company structure and the non-payment of market salaries, without legitimate reason, culminated in tax avoidance.
Uncertainty prevails
However, the decision would create a climate of uncertainty as Chief High Court Judge AP Randerson J confirmed in this decision.
The verdict does not explain how market salary is calculated and what happens if a Company or Trust functioned from the beginning the way in which Penny and Hooper did after the restructure. The decision related to provision of services, but it is unclear as to whether it would apply to the entities selling goods.
IRD had many cases on hold, consequent to the earlier High Court decision, which was in favour of the taxpayers.
Subsequent to the Court of Appeal verdict, IRD has issued a Revenue Alert (see related story in this section).
Revenue Alerts
IR Commissioner issues Revenue Alerts to inform taxpayers of significant and emerging issues relating to tax plans.
The recent Revenue Alert explains the current position of Commissioner on the application of law. It targeted taxpayers who enter into an arrangement to divert their personal services income through a trading trust or company.
It should be noted that every business activity conducted under a Company or a Trust is not a tax avoidance arrangement. The Commissioner has warned that the mere use of a Trading Trust or Company structure will not amount to tax avoidance arrangement.
There could be cogent non-tax reasons for not paying the market salary or legitimate reasons to retain income in the trading entity. These are, for example, the business might be making little or no profit, it is in the start-up phase or is under difficult trading conditions.
The Commissioner has no objection to the taxpayer retaining the income in the trading entity to undertake major expenditure.
Tax Avoidance
It is only where the profits are retained in the trading entity and then allowed to be used for the benefit of the taxpayer or their associated taxpayers that the Commissioner may invoke tax avoidance provisions in the tax laws.
In simple terms, as a taxpayer, if your trading entity (Trust or Company) is generating profit through your personal exertion, and the salary paid is less when compared to your contribution and the profits are used for your benefit or that of your family, this would then be treated as a case of tax avoidance arrangement.
The Revenue Alert enumerates seven factors that will be considered by IRD to determine whether it is a tax avoidance arrangement.
The defendants in the Penny and Hooper case are still considering whether to appeal the Court of Appeal verdict.
It is evident that there are many unanswered questions. It is expected that the Supreme Court will take this opportunity to remove the uncertain area of taxation for the benefit of the taxpayers.
You should seek professional advice if you are in a situation similar to the example given in the Revenue Alert.
Vijay Talekar is Director, Tax Experts Limited (Chartered Accountants), based in Auckland. The above article should be considered only as a guideline and not specific advice. Mr Talekar absolves himself along with the management and staff of Tax Experts Ltd and Indian Newslink of any responsibility or liability that may arise from the above article. Readers should seek professional advice before acting upon any information contained above.
Revenue Alert Example
A successful professional taxpayer derives $850,000 net income from private practice. The taxpayer decides to form a Company with 100 shares, 98 of which are held by the Family Trust, one share each by the taxpayer’s spouse and the taxpayer.
The taxpayer then sells the practice to the Company (with an interest free debt in return).
The Company, in turn, employs the taxpayer and pays her an annual salary of $70,000.
A bulk of the Company’s profit is distributed to the Trust as dividend.
The Company employs no other professional staff.
Following the sale of the practice, apart from the employment of the former practice owner, it operates in the same manner as it did when the taxpayer was self-employed.
The Company does not specify any commercial reason for the low salary paid.
In this example, it can legitimately be argued that the purpose of the Arrangement was to provide for the taxpayer’s family. But it was equally evident that the purpose of diverting income from the taxpayer to a Company was to take advantage of a lower tax rate.
The salary ($70,000) did not reflect the skills and experience of the previous owner of the practice and her services largely generated profits for the Company.
Further, no commercial reason was advanced for paying such a low salary. Accordingly, while the establishment of the Company was permissible when viewed alone, the combination of factors present in this case, and the way the new structure was used, was in our view indicative of a purpose of tax avoidance.
What Judge A P Randerson said in his judgment
I am conscious of the practical consequences, which may flow from this decision, including the uncertainty that may be created for the IRD Commissioner as well as for taxpayers and their advisers: To what extent and in what circumstances will it be necessary to review the salary levels of employees (particularly in family companies) to determine on which side of the line their salary may fall?
It is important to recognise however that this decision should not be regarded as establishing a principle that salary levels which could be expected in an arms-length situation, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement.
It will be a matter of assessing all the circumstances including the extent and nature of any element of artificiality or contrivance in order to determine whether any particular arrangement is within or outside the contemplation of Parliament in enacting the tax legislation. Where there are legitimate reasons ….for adopting a salary markedly below commercial levels, a challenge by the Commissioner may be unlikely to succeed. Nor would I expect the Commissioner to interfere in marginal circumstances.
The difference here is that salaries were adopted at levels so far below ordinary commercial expectations that, in the absence of legitimate reasons for doing so, there is a strong implication of tax avoidance.
