Inland Revenue Department (IRD) won another landmark tax avoidance case, when the Court of Appeal delivered its judgment in the ‘Penny and Hooper Case,’ overturning the High Court decision delivered in taxpayer’s favour.
The decision goes to the heart of the New Zealand’s small to medium businesses and practices, since many professionals have structured their practices on similar lines.
Tax planning schemes are influenced by the design of the tax system.
Tax planning arrangement could be legitimate tax avoidance.
Identification of the tax evasion is easy, since it involves misstatement of taxpayer’s position. The line of demarcation between legitimate tax avoidance and tax planning is very thin but court decisions help in removing this uncertainty.
The taxpayers involved in the ‘Penny and Hooper Case’ were Gary John Hooper and Ian David Penny, both orthopedic surgeons.
These were two separate cases but heard together as they involved similar facts.
The orthopedic surgeons had each set up a company, with majority shares held by their family trusts. The companies employed them to provide orthopedic surgical services. Earlier, the surgeons had their practice as sole traders.
The salary that they earned subsequent to the establishment of their companies was found to be significantly less than the market rate. The effect of these arrangements was that their earnings were taxed at 33% rather than 39% applicable if they were sole traders.
While one company was formed in the 1990s when the top marginal tax rates for individuals and companies were the same, the other company was set up following the tax rate changes.
IRD Commissioner undertook reviews of the tax returns and adjusted the salary paid. The effect of the adjustment in each case was to increase the taxable income to the amount, which the Commissioner thought would be a commercially realistic salary for the services rendered to the companies.
This was done as the rates of income tax payable on income derived by a company differed from that of an individual taxpayer.
IRD argued that the formation of the two companies, low salaries and the payment from the companies to the trusts were to avoid tax. In presenting its argument, the Department charged that the salaries were artificially low, the taxpayers controlled the companies and the trusts, they had access to all income and that the change in practice was not commercially driven.
The defendants denied attempt to avoid tax, saying that two family companies had employed their surgeons and that neither of them derived employment income that was commercially realistic.
“The Income Tax Act does not contain any notion of the commercially realistic salary concept within the purview of its statutory scheme. The Commissioner has made it up in an effort to eliminate the rate advantage,” they said.
The adjudication unit concluded that the personal exertion principle argued by the Commissioner did not apply in this context. However, the arrangement to continue the practice, using the company structure and the fixing the salary at a level below commercially realistic salary was an arrangement treated as tax avoidance.
The High Court decided that while the alteration of income tax rate (33% and not 39%) was within the scheme and purpose of the income tax legislation.
“Relationship of employer and employee may exist between such a company and the person who is its governing director. A choice made by a person who is able to conduct his or her profession, trade or calling either as an individual or through a company controlled and operated by that individual does not fall outside the intended scheme and purpose of the Act. Tax consequence will differ depending on the category of the taxpayer who has derived it,” the Court said.
The High Court had said that transfer of the practice to the company was not a sham.
The presiding judge said the concept of a commercially realistic salary is neither known to tax law nor provided a basis for determining whether a particular arrangement constituted tax avoidance.
“The Income Tax Act does not dictate the level of income which a particular taxpayer must earn. It defines what is income and taxes. The scheme and purpose of the Act is not to dictate the quantum of salary.”
The Court of Appeal ruled in favour of IRD- 2 to 1.
This seesaw tax battle between these two surgeons and IRD will be surely fought in the Supreme Court. Meanwhile, taxpayers should carefully consider their approach to the general anti-avoidance rule when making tax-planning decisions.
Vijay Talekar is a director of Tax Experts Limited, Chartered Accountants (www.taxeperts.co.nz). 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.
