The New Zealand Supreme Court delivered a landmark judgment on August 24.
Tax professionals and the business community has waited long for the verdict.
Revenue Minister Peter Dunne said businesses often use companies and trusts for legitimate reasons but this did not always constitute tax avoidance.
But Inland Revenue (IR), as a part of its compliance focus takes tax avoidance very seriously and the Supreme Court’s decision on the Penny and Hooper case was a clear signal to the taxpayers that they cannot structure their affairs or enter into arrangements whereby they artificially reduce their tax obligations and still receive the benefits,
Penny and Hooper are orthopedic surgeons. According to IRD, they used certain corporate and family trust structures breaching the provisions of the Income Tax Act and hence were evading tax.
The surgeons restructured their tax affairs and sold their orthopedic practice to a company, the shares of which were held by their family trusts. The companies employed the surgeons who performed the same type of work as before.
New set-up
In 2000, the Government changed the marginal income tax rate and companies tax respectively to 39% and 33%.
The surgeons paid themselves significantly lower salaries and distributed the balance of the revenue to the family trusts as dividends. The income tax rate for the company and the family trust was 33%, thus denying IR 6%.
Considering this as tax avoidance, IR asked the surgeons to pay tax at 39%.
The High Court decided in favour of the surgeons, stating that the Income Tax Act did not require the surgeons to derive the funds as a personal income.
The Court of Appeal overturned the High Court’s decision.
The ‘Revenue Alert’ issued by IR following that decision is relevant here.
The Department said it would consider the following factors before treating any arrangement as tax avoidance. 1. A business activity employing the services of a shareholder or a beneficiary without financial compensation 2. A new entity into which business of another entity or individual is transferred but activities continue uninterrupted 3. Whether the entity follows standard business practices 4. The ultimate family control over the income and funds 5. Repayment of loans or salaries to family members 6. Materiality of non-tax reasons for restructuring the business 7. Tax benefits accrued
These factors will be indicative factors considered by Inland Revenue before a decision is taken on the tax avoidance of an arrangement.
Accountants view
The New Zealand Institute of Chartered Accountants (NZICA) had predicted that in its view, the Supreme Court would not overturn the decision of Court of Appeal.
It expected guidance to taxpayers and their advisors about the boundary between a legitimate and reasonable salary and an avoidance arrangement. The Court has stated that if the salary paid is not commercially realistic or is not motivated by legitimate (non-tax driven) factors, it would be an open invitation to IR to treat the arrangement as a case of tax avoidance.
Thus, while deciding on the level of salary a good yardstick would be to determine whether the salary would be an acceptable salary if it were paid in return for the services rendered to an outside party or at an arms-length level.
The Supreme Court ruled that the surgeons took reduced salaries, making available income retained as dividends through the Family Trust.
This was a classic example of taxpayers complying with the ‘black-letter’ of the law, at the same time not acting within the ‘scheme and purpose’ of the Income Tax Act.
Vijay Talekar is Director of Tax Experts Limited, Chartered Accountants (www.taxeperts.co.nz) Telephone (09) 2792987. The above article should be considered only as a guideline and not a 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.
