IRD – One step forward, two steps back
Firms re-arranging their business structure to fit within a specific tax provision, to reduce their tax
liabilities, has always been an issue for the IRD. For example, when the Labour Government raised the top personal tax rate to 39% on income over $60,000 from 1 April 2000, it created an incentive for people trading through companies or trusts to set their salaries at $60,000.
This resulted in a spike in the number of people earning salaries of on or around that amount. It also motivated sole traders to sell their businesses into companies or trusts to achieve the same result by effectively capping the tax rate at 33%.
Based on the broad premise that actions of this nature constituted tax avoidance, as detailed in the IRD’s Revenue Alert 08/01, the IRD invested resources into attacking what it believed to be tax avoidance arrangements that circumvented the 39% tax rate. Five years ago the IRD gained some traction in this area when the Taxation Review Authority, in Case W33, ruled that a dentist had entered into a tax avoidance arrangement by re-structuring his affairs to trade through a trust.
However, the IRD suffered a considerable setback in March 2009 as a result of a decision of the High Court in Penny & Hooper v CIR. This case, involving similar facts to Case W33,concerned two orthopaedic surgeons who initially traded in their personal names. However, in 1997 Mr Penny, and in 2000 Mr Hooper, sold their respective practices to related companies with the shares held by their family trusts.
From 2000 - 2003 the salary of each doctor was $100,000 to $120,000. The practice income was about $450,000 - $600,000 and the IRD viewed the salary paid as being less than a “commercially realistic salary”.
The IRD did not assert that failure to pay a commercially realistic salary was tax avoidance in itself, but that tax avoidance arose by the manner in which the company and trust structures had been used, based on:
- the artificially low salaries paid to the individuals
- the fact the trading entities were controlled by the individuals
- the continued use of the practice income by the individuals and their families to live
- the lack of commercial rationale for the re-structure
- the fact the businesses were sold for inadequate consideration, and
- the tax advantage gained.
To determine whether the arrangement constituted tax avoidance, the High Court relied on recent New Zealand Supreme Court decisions which took a “scheme and purpose” approach and considered legislative policies to determine if a particular tax outcome was acceptable. Past cases indicate that it was not Parliament’s intention for an artificial or contrived arrangement to be used to fit within a specific tax provision.
The High Court considered the individual elements of the arrangements before considering the arrangement as a whole. On this basis it was determined that this case did not constitute tax avoidance. A fundamental element of the judgment was whether the sale of a business to a company was tax avoidance and, although it was recognised that re-structuring the practices to operate through companies altered the amount of tax payable, it was held not to be tax avoidance. In essence, where the choice of corporate form is a commercially orthodox one neither individual nor company taxpayers are required to demonstrate a commercial justification for the choice of one form over another.
The IRD placed strong reliance on the principle that income derived by a person’s exertions must be taxed in the hands of that person. In Penny & Hooper no legislative intention for some categories of income to be taxed at personal tax rates, rather than the company rate, could be found and therefore this was not indicative of tax avoidance.
Rather than arguing against the IRD’s assertion that a commercially realistic salary was not paid, the taxpayers basically argued that legislation does not require such a salary to be paid and therefore it cannot provide a basis for identifying a tax avoidance arrangement. The taxpayers were successful. The judge confirmed that the Act determines whether a receipt is or is not income, it does not in these particular circumstances determine the amount of that receipt.
In viewing the arrangement as a whole, the Court found in favour of the taxpayers. The legislation did not intend that professionals should be prohibited from trading through companies and the IRD had taken an “intuitive subjective impression of the morality of income splitting by professionals” – which the Court found to be an unacceptable approach. The IRD has recently filed a notice of appeal.
Author - C 2009 University of Waikato