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Business structures and tax avoidance

Patrick McCalman, Partner, Taxation Advisory Services, Deloitte. 02 September 2011, 2:12 pm
Business structures and tax avoidance

What's the difference between an orthopaedic surgeon and a software developer? Probably a great deal but potentially little when it comes to tax. Last week saw the release of the Supreme Court decision in the case Penny & Hooper v CIR.

How Penny & Hooper structured their businesses

Ian Penny and Gary Hooper practiced as orthopaedic surgeons in their own names for years, but were concerned about financial exposure to medical negligence claims. On advice from their accountants they incorporated companies through which they then ran their practices.

Hooper restructured his practice in 2000, the same year the top personal tax rate was increased. He incorporated a company in which Hooper, his wife and family trust were shareholders.

Penny's restructure was similar, but notably it took place in 1997, several years before the tax rate increase.

As employees, both Penny and Hooper paid themselves relatively modest salaries in comparison to the income they earned before they restructured. Both indicated their salaries were at levels substantially below what they would have accepted in an arms-length context.

For instance, Hooper admitted that, had he been employed by an independent company, he would not have accepted the salary he effectively paid himself.

The effect of the arrangements was that, from 1 April 2000, the majority of the income earned as a result of the surgeons' work was subject to the 33% corporate tax rate as opposed to the 39% rate that would have applied had they derived the income in their own names.

Both surgeons controlled the retained earnings, the majority of which ended up in their family trusts. Funds from Hooper's trust were used for Hooper's family home and holiday home. Penny's trust advanced substantial sums to Penny on an unsecured interest-free basis with no term specified for repayment.

Legal battle ensues between IRD and surgeons

Penny and Hooper's business structures didn't go down well with the IRD however. The Commissioner of Inland Revenue alleged that the company and trust structures were used in a way which constituted tax avoidance.

The case went to the High Court which initially found in favour of the surgeons. It held that there was no tax avoidance in the arrangements.

That decision was reversed by the Court of Appeal which held that the incorporation of the practices and the payment of salaries at artificially low levels represented tax avoidance which was more than a merely incidental purpose or effect of the arrangements.

Next, the Supreme Court unanimously found in favour of Inland Revenue and upheld the finding of the Court of Appeal. It was held that although the structures themselves were entirely lawful and unremarkable, the use of those structures by Penny and Hooper to pay themselves artificially low salaries constituted a tax avoidance arrangement.

The Commissioner of Inland Revenue is therefore entitled to treat the arrangements as void against him for income tax purposes.

The consequences for businesses

Note that the commercial choices adopted by the taxpayers were not in themselves objectionable. Instead, the issue was the influence of tax on the particular aspects of the structure, which turned what was otherwise a bone fide structure into tax avoidance.

As noted by the Court in the judgment:

"If the setting of the annual salary is influenced in more than an incidental way by a consideration of the impact of taxation, the use of the structure in that way will be tax avoidance."

Taxpayers should learn the case that they must take even greater care around evidencing and documenting the commerciality of their arrangements, including all component parts. In essence, you need more than tax reasons when structuring business affairs. This especially if as a result you move between tax rates.

Before having too many sleepless nights considering your current business structure, it is important to bear in mind that the Penny & Hooper decision has largely been decided on its facts. The further away your businesses facts are from the facts of Messrs Penny and Hooper the better.

Since the Supreme Court's decision, the Inland Revenue has indicated that it will be taking a 'measured approach' to how the decision is applied. This means that not every incorporated business, or one that is managed through a family or trading trust, is a tax avoidance arrangement.

The issue is about balancing various factors, such as how entities are managed, and the deliberate use of companies and trusts to divert income and reduce a person's tax obligations.

If your software business is largely one of a sole trader, but has been set up or restructured using company or trust vehicles, it is worthwhile considering whether any salaries paid are set at commercially justifiable levels.

With the company (28 per cent) and top personal tax (33 per cent) rates having a five per cent differential Inland Revenue may still see this as a fertile area for investigation.

Patrick McCalman is a Partner in Taxation Advisory Services at Deloitte You can follow the latest tax news at @DeloitteNZTax


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