In the recent Court of Appeal decision Commissioner of Inland Revenue v Penny and Hooper  NZCA 231 (4 June 2010) it was held that Mr Penny and Mr Hooper entered into a tax avoidance agreement when structuring their affairs in such a way as to avoid paying tax at 39% on the majority of their income. The surgeons have now decided to appeal the case, but if not successful it will have significant implications for a broad sector of the New Zealand public.
What are the facts of the case?
Two surgeons had restructured their practices to take advantage of the disparity between the highest marginal tax rate and the lower trust tax rate. A company provided the services. The surgeons were in turn employed by the company.
The main point the Court of Appeal took issue with was that the surgeons were being paid very little for their very valuable services. Expert evidence suggested that the surgeons should have been earning in the order of $500,000 – $600,000. However, the company they worked for paid them around $100,000. The rest of the money was retained in the company, and then paid out to a family trust as shareholder. The trust would pay tax on the income at 33%, and no further tax would be paid when the money was finally distributed to the surgeons.
If the surgeons had paid themselves the higher salary, then they would have paid tax at the higher rate of 39% on the majority of that salary.
Why is this case so important?
The case is important because it has the potential to impact on many New Zealand businesses that are structured in exactly the same fashion, and for exactly the same reasons. It is important to note that it is not the structure that the Court of Appeal took issue with, but rather the level of remuneration paid.
Randerson J says in the leading majority judgement: “I am conscious of the practical consequences which may flow from this decision, including the uncertainty which may be created for the Commissioner as well as for taxpayers and their advisors. 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 recognize, 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 necessarily to be regarded, without more, as evidence of a tax avoidance arrangement.”
However, the IRD issued a Revenue Alert on the 22 June 2010 setting out its interpretation of the case. Although the Revenue Alert echoes Randerson J’s sentiments, the case has certainly given the IRD carte blanche to investigate any situation where the facts are broadly in line with the Penny and Hooper cases.
What should you do?
If you think that you are in the same situation as Penny and Hooper the IRD suggests you make a voluntary disclosure to the IRD to protect your position. This would also ensure that you access the greatest amount of reductions in penalties that may apply.
Considering the impending appeal, it may be prudent to await its outcome before any action is taken. However, if you are unsure what to do, then the most prudent course of action would be to talk to your tax advisor before the IRD talks to you.
Parry Field Lawyers provide legal advice on a range of tax matters and are able to assist you with any New Zealand tax questions that you might have. Please contact Grant Adams at Parry Field’s Christchurch office (348 8480) for help with tax matters. Please note that this is only a high level overview of the case, and there may be specific situations where a different outcome is reached. Therefore, please don’t rely on this as legal advice.