Fresh from Penny and Hooper victory, taxman plans to put figure on how much profit a company can pay its shareholder-employees, E and Y says

Ernst & Young is warning that, fresh from its victory in the high profile Penny & Hooper case, the Inland Revenue Department (IRD) is planning to put a figure on the amount of profit a company should pay shareholder-employees.

Ernst & Young tax partner Jo Doolan says she understands IRD is proposing a starting point of 80% of the companies profits that should be paid out to shareholder-employees in service industries.

After six-years of legal wrangling with IRD, orthopedic surgeons Ian Penny and Gary Hooper  - who went into business for themselves as sole directors of registered companies and then paid themselves sub-market rate salaries, channelling company profits into trusts as dividends - were told by the Supreme Court last month that the practice constituted tax avoidance. See full story here.

Doolan says if the IRD wants to extend the court's decision beyond market salaries and focus on requiring a specific percentage of profits being paid to shareholders, it should ask the government to change the Income Tax Act.

"Let's not forget the New Zealand's Courts at every level in the Penny & Hooper decision said that the company/ trust structure used was perfectly legitimate, but the ultimate ruling was the salaries were too low," says Doolan.

"No matter how you look at this if it is not a method dictated by the legislation or authorised by our Judiciary - this type of approach is simply not okay. The IRD could find themselves accused of taking things too far in the attempt to gather revenue at the expense of taxpayer certainty and the health of our New Zealand closely held businesses."

'Mischievous comments' IRD retorts

However, Graham Tubb IRD's group tax counsel, hit back at Doolan, telling interest.co.nz that her comments were "mischievous."

"What we recognise with the Supreme Court decision is we need to put some more information out to the public about how we do select cases, - tax avoidance investigations," says Tubb. "We're not proposing or saying that we're going to be investigating every case involving personal services generated income, such as the orthopedic surgeons in Penny and Hooper, who haven't paid themselves up to 80%."

"All we're saying is, you can probably sleep soundly if you have paid over that amount to yourself as the principal generator of the income."

Doolan says IRD's approach of not focusing on the market salary and dictating a percentage of profit that has to be taxed to the individual shareholder could actually have the effect of requiring much more than a market salary to be paid. This would "completely ignore" the Court, and have the practical effect of virtually ignoring the taxpayer's legitimate choice of business structuring.

"The latest attempt by the IRD to use this decision to dictate the percentage of profits a company has to have taxed to individual shareholder employees, is therefore considered to be at best disingenuous to taxpayers, and at worst it flies in the face of the concept of preserving the integrity of the tax system," Doolan says.

'Slap in the face'

Although New Zealanders are distracted by the Rugby World Cup and the upcoming November 26 general election, they shouldn't sit back and accept this sort of "slap in the face."

"It is high time taxpayers actually remind the Inland Revenue and the Revenue Minister (Peter Dunne) that administering our tax system in this manner is totally unacceptable. If the Inland Revenue want to bring in a fixed percentage of distribution and extend the application of the Penny & Hooper decision, then there is a proper process to go through," says Doolan.

"This involves our democratically elected Government changing the Legislation. If we continue to adopt an approach of creating tax rules by stealth and ignoring proper process and our judicial decisions, then we may find ourselves guilty of engaging in an undemocratic processes."

But Tubb says IRD's not trying to create arbitrary rules.

"We're simply talking about what sort of cases we would be looking at. Really it's about the most blatant, the most serious cases," says Tubb.

He says Doolan appears to have taken the 80% figure from a Revenue Alert note IRD has issued. 

'Had more positive feedback from reputable firms'

"Her comments seem quite mischievous quite frankly. We've had some quite positive feedback from reputable firms such as Chapman Tripp and even from the New Zealand Institute of Chartered Accountants, really applauding us for explaining the principles more clearly and starting a proper debate. I don't think these comments from Ernst & Young are at all helpful in terms of the discussions Inland Revenue and the profession are having going forward," Tubb says.

There are "valid reasons" why sometimes someone has a low salary from a business and it's the most serious cases of diversion of income to family trusts IRD's most interested in."

"I don't think we are trying to distort or undermine in any way what the Supreme Court said. We're trying to explain what our operational response is to it," Tubb adds.

Although there are potentially quite a few of these type of cases, Tubb says IRD's not putting a massive amount of resource into them.

"We've got to be reasonably careful about which cases we might take on to have a look at. We're certainly not wanting to suggest that every single case of a business being owned by a trust is liable to be investigated."

(Updates add response from IRD group tax counsel Graham Tubb and link to IRD's Revenue Alert).