CIR vs Penny & Hooper - Change To Company Structure was Tax Avoidance

A much awaited decision of the Court of Appeal was delivered on 4 June 2010. This is the most recent and most authoritative NZ Court decision regarding the use of structures by Small to Medium size entities where those structures result in the top personal tax rate being replaced by the lower company/trust tax rate.

Penny & Hooper were both orthopaedic surgeons practicing in Christchurch as sole traders who restructured their businesses so that they were carried on by companies in 1997 and 2000 respectively. In both cases, as a result of salaries from the newly formed companies being lower than their previous self employed earnings, significant tax savings were achieved.

The Court of Appeal, by a two-to-one majority, concluded that the adoption of the company structure and the non-payment of market salaries, without legitimate reason, amounted to tax avoidance. This issue has been uncertain since Labour introduced a 39% personal tax rate in 2000 and the Taxation Review Authority first considered the use of a structure which had the effect of avoiding the top personal rate in 2002 (Case V 20)

In reaching the above conclusions the Court of Appeal observed:

• Both doctors chose to incorporate after operating on their own account. (i.e. there was a change in structure)
• There was no valid criticism of adopting the company structure.
• Net income from personal exertion (via salary) was dramatically reduced, and it was no coincidence this drop in income coincided with the increase in the top personal tax rate to 39% on 1 April 2000.
• Salaries paid by the companies were substantially below what could have been expected on an arms-length basis.
• “...in general terms the Act is not concerned with the level of salaries paid to employees in family-owned companies?” and “...there may be good reasons why an employee would agree with an employer to accept a salary reduction”, but none of those reasons applied in this case.
• The increased company profits (because of the lower salaries) still had the effect of benefiting the doctors and their families, i.e. the taxpayers still enjoyed the full benefit of the income of the companies.
• It was not considered that the structure was necessary to protect the doctors from negligence claims.
• “It could not have been within the contemplation of Parliament that a company director/employee could adopt a salary of less than one-fifth of a proper commercial salary and thereby secure significant tax advantages while still receiving, in practical terms, the benefit of the company’s entire net income...”
• The way the businesses were transferred to the companies also tended to emphasise the artificiality of the arrangement (goodwill was seen as very low given the income levels involved)
• The Commissioner should not interfere in marginal circumstances.
• The Court of Appeal was not asked to determine the fiscal effects of concluding that the payment of a non-market salary was tax avoidance.

The Court concluded

“It is important to recognise, however, that this decision should not be regarded as establishing a principle that salary levels in family companies which are below the levels which could be expected in an arms-length situation, are necessary 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” “And the Court can only determine one case at a time”

While this decision has been much awaited, it is unlikely to be the final word in this area. There are a number of issues which have not been addressed, for example

• What if a company structure was adopted from day one?
• What is the market salary? (While the Court of Appeal was not asked to determine this, the evidence suggests that the IRD’s view and taxpayers’ views are some distance apart)
• “?what the taxpayers here have done has not required particular “ingenuity” such that Parliament could not have contemplated the use of company structures in this way.”  Ellen Frances J

We will not know for some time if this decision will be appealed to the Supreme Court, nor how broadly the IRD will look to use the decision to challenge structures. Accordingly this issue is likely to continue to cause frustration for taxpayers and undoubtedly further time and cost will be incurred in trying to establish where the boundaries lie.  A company tax rate aligned to the top individual tax rate does of course avoid all these issues.

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