By Amanda Morrall
A Supreme Court ruling in the case of two surgeons who used trusts to reduce their tax bill could have small business owners in New Zealand flocking to see their accountants.
After six-years of legal wrangling with Inland Revenue orthopaedic surgeons Ian Penny and Gary Hooper - who went into business for themselves as registered companies and sole directors then paid themselves sub-market salaries, channelling company profits into trusts as dividends - were told the practice constituted tax avoidance.
PriceWaterhouseCooper tax partner John Shewan, an expert witness in the case, said the decision had wide application for New Zealand businesses.
"There are thousands of small businesses that operate through companies and which pay salaries or wages to their owner operators. Today's judgement confirms the Commissioner's view that where the amount paid is artificially low that may well constitute tax avoidance."
For separate and different circumstances, both Penny and Hooper had established their own businesses that worked in tandem with family trusts.
They had each set up a registered business under the Companies Act, where the taxpayer was sole director and shares were held by family trusts. As employees of the business their salaries were fixed below market rate. Profits from the company were paid as dividends to the trust which is taxed at lower marginal rate. Annual tax savings for the pair were estimated between NZ$20,000-$NZ30,000.
Hooper had net earnings from his practice before interest and tax of NZ$659,000 in 1999/2000, but the trust paid him a salary of NZ$120,000 even though it was receiving income of between NZ$500,000 and NZ$700,000. The trust paid out dividends ranging from NZ$228,000 to NZ392,000 to the beneficiaries, including children, at tax rates of 33 cents. At the time the top income tax rate was 39 cents.
"The retained earnings of the Hooper trusts were invested in the family home and a holiday home and in bank deposits. No distribution or loans have been made to Mr or Mrs Hooper, although obviously they and their family enjoy the benefit of the two homes owned by their trusts," the Appeal Court said.
A High Court ruling initially found in favour of Penny and Hooper, but this was overturned by an Appeal Court.
Revenue Minister Peter Dunne hailed the decision as correct and fair, arguing it would restore the integrity of the New Zealand tax system by ensuring that everyone one paid their "fair share of tax.''
"The Court's decision is a clear signal that people cannot structure their income arrangements in such a way that they artificially reduce their tax liability and still receive the benefits.''
Tax specialist Terry Baucher said the ruling was no surprise given Inland Revenue's intensifying efforts to crack down on trust abuses. Historically speaking, the tax department has had the court of law on its side, he observed.
"The IRD hasn't lost a case since the Supreme Court was established (in 2004)."
'Time to panic?'
Greg Haddon, a tax partner with Deloitte, said the decision would undoubtedly have small businesses owners panicking.
Haddon said the ruling, while in need of further clarification by IRD, was positive in the sense that it validated the use of corporate structures involving the use of trusts.
"It has clearly stated that some of these corporate structures or trust structures that a lot New Zealand business use is okay in itself.''
Haddon said the take home message for businesses operating under such models was that they needed to be well documented, properly set up with appropriate market salaries paid to directors.
"You have to make sure that when you use these structures you use them appropriately and you don't do something artificial as part of that process to get a tax advantage. For a trade person or a builder using a corporate structure, just make sure you get your administration right, and pay yourself an appropriate market salary.
He didn't believe that the ruling would be an impediment to growing one's businesses because the judges acknowledges there would be some circumstances that might require salaries set lower than market value.
"Justice Elias Blanchard also gave some flexibility. He said there might be circumstances where you don't pay yourself the market salary because you want to build up the business and the business requires net to buy equipment or something like that and for cash flow reasons you might not be able to.''
Haddon said the IRD would need to provide clarity on the finer points of parliament intention, which had a bearing what circumstances would be permissible.
"I think there is now a big onus on the IRD to release their detailed views of how they would go about analysing how the anti-avoidance rule should be applied. It's a very broad provision and it doesn't have specific rule saying you're either here or there. It just takes the position that if it believes there is a case of avoidance, it will apply the rules. So we need to know what and how the department will apply it.''
'Tax experts see plenty of grey areas'
KMPG tax partner John Cantin said how one perceived the Supreme Court ruling would depend on their optics.
"It depends if you are a half full or half empty person. As it's pored over people on both sides of the fence will be quite happy with bits to support either part I expect.''
Cantin said the small businesses could a tougher line of questioning from the IRD that went something like this: "Tell me why commercially you're doing this and if you can justify that then you are over the line.''
From an accountancy point of view, Cantin concurred with Haddon that there remained many grey areas.
"It's not entirely clear where it is going, I'd expect both taxpayers and Inland Revenue to take comfort from it, however to some extent it leaves unanswered questions.''
"Tax is so much a part of what people do, it's hard to extricate.''
30 Comments
Gee it's hard to know what to think about this.
On the one hand extreme avoidance leaves a bad taste in the mouth from a moral sense.
On the other hand the government made the rules so why do they prosecute those who play to them?
On the other hand it doesn't seem right that you would be guilty until you prove you are innocent (... if you can justify it then you are over the line).
And if we're playing the moral card on the side of the government - since when are governments or tax departments immune from using laws like this in an immoral way.
Actually, having typed it out on the basis the number of really extreme instances is probably very low in the real world I probably against it because it's a dangeous precedent.
Yes thats true and there isnt much dispute about tthat.and the decision is correct morally/sensibly. but in making it tax avoidance the court has to give a reason why and thats the issue
RD are using the decision to apply tax avoidance to anything they do not like and with cuts in government expenditure civil servants are very keen to justify their job/salary.
Do you have 100k to fight IRD??
Really the legislation was weak so the court had to come up with a very wishy washy rule.which is open to manyy interpretations. Great for whats left of businesses in NZ
No it is not tax evasion.It is tax avoidance.Professional advisors have promoted these structures to their clients.It is salesmanship with a lack of academia.Haddon's comments are not logical,if advisors have transmitted the correct academic theory to their clients.Commercial reality is paramount at all timesThis case has only cemented what all technically proficient advisors always knew.I understand that 15 to 20 of these ortho surgeons went to a conference where this type of structure was promoted,and that there are a number of other cases in the wings.It is great that Penny and Hooper have spent hundred of thousands of dollars to take the case to the Supreme Court,but I do feel that they have been poorly advised all along.They would have been best advised to surrender at the first available opportunity and cough up the tax.As for the comments of Speckles,clearly Penny and Hooper's advisors did not give them the correct message in the first instance.Tribeless and Brent Gilchrist will be spluttering at this one.
Penny and Hooper;
Firstly, it would not have been an issue if Michael Cullen's envy tax had not been brought in.
Those professionals wanted to care for their families in case they were ever sued for big money. They put their assets in a trust. One of them had a smaller salary credited to him because otherwise the divorce settlement would have been too much. If that is unreasonable behaviour,,,,,,,,,,,,,,then, I give up.
This has been a deplorable decision. The Tax Department's discretionary powers are now so big that all New Zealanders must feel free to lick the haemorrhoids on civil servants. Maybe that is acceptable behaviour for those who voted for the winner in Wellington Central, with its huge number of public servants and the type of constituency M.P. they chose. I do not think that way.
And another thing; the Tax Act has laws that prohibit large salaries being paid or credited to associated people. That is needed for prevent tax avoidance. There is absolutely NOTHING in the Income Tax Act 2007 or any of its preceding acts, to prohibit small salaries being paid or credited. The judges, just like Lord Cooke of Thorndon, are making the laws. That is the politicians' job. It is the job of elected people; not appointed people.
Penny and Hooper would have taken out P I insurance,just as any other self-employed person does,as demonstrated by Bob Jones versus the WHK predecessor.And remember that the ACC system we have in NZ,significantly reduces the exposure of certain occurences being litigated.
This has been a fantastic and very pleasing decision.It is common sense prevailing.it just reflects the naivity of those promoting such schemes.
Of course excessive remuneration can be attacked if paid to associates.And so it should be.That is tax avoidance.Tax avoidance takes a number of disguises.As for politicans making the law,who is trying to fool who.The average politician is not a lawyer,Judges are lawyers and must have risen to the top of their profession to be appointed to the bench.It is they who are qualified to set the law,and as anyone who has ever studied any legal subject knows,so they have over many centuries.There have been some simply brilliant judges.For instance anyone involved in the commercial world will be familiar with the many landmark decisions made by the legendary Lord Justice Denning.
An excellent decision. These guys were just trying to rort the system and in so doing screw every other taxpayer in NZ who pays their dues. If it does shake up the rest of the system and catches others at the same game then its an excellent result. The whole industry built up around Trusts etc needs to be the subject of vigorous assault.
But the "whole industry built up around Trusts" as you put it only exists because it has been government policy to create it.
How can you build a complex system of regulations and then moan how people use the regulations you created?
Thay are only doing what the system says they can.
What this court win does is give the government it's cake and eat it too. You can both create a regulation but then prosecute someone on 'intent'.
Ralph, these tax loopholes are left open so that the elites can avoid the rules, but at the same time persecute the bottom feeders.
However, once the bottom feeders get in on the act, then the tax losses become and issue, so they tighten the rules again - just leaving enough room for those who can afford expensive tax advisors to wriggle free..
Then it becomes common practice, so away we go again (laqc's,trust's being a prime example).
The rules are only meant for the bottom feeders, not the special people.
I am not sure you can claim it was official government policy to create trusts. Government inertia certainly, government ineptitude very probably, but stated government policy?
The trust industry has benefitted swathes of the legal and accounting profession and has no doubt cost the government coffers (and by extension the taxpayer) considerable amounts via tax dodging . You can argue till the cows come home as to how it was allowed to happen - personally I am just delighted to see the system being dismantled - the sooner the better.
"... but stated government policy?"
It's been the clear effect of government policy for a long time.
If you make a law that says sneeches with stars get a tax break it's pretty thin to argue the explosion of star bellied sneeches isn't governmetn policy simply because it's not stated.
Were do you think these guys are going to go?
They'd be copping 50% top tax rates in the UK, 40% + in Oz.
With a massive $600,000+ income they are prepared to indulge in these desperate games to save a miserable 4% tax. I don't think ther'll be much sympathy out there.
There's a reason they have to pay top money to get folk to work in Saudi Arabia, I'm sure a slight differance in tax rates wouldn't persaude many to relocate to some Middle East hell hole. Although this pair sound greedy enough to do it
Global wage variations are not what we're dicussing here.
You haven't been to Saudi I take it (let alone lived there)?
Frankly alarmist talk that highly paid individuals will leave because they are not allowed to rort our tax system doesnt cut any ice with me. They will encounter higher tax rates almost wherever they go and if they wish to rort those overseas systems so be it.
I doubt we will have too much problem attracting replacements in the non too distant future as the benefits of Lifeboat New Zealand become increasingly obvious.
Guilty as charged Ralph - I have not the slightest sympathy for tax dodgers, and do indeed wish that the punishment could be made more substantial. If these two wish to ship off I''ll carry their bags to the wharf.
I agree with the comment posted elsewhere - move to the Scandinavian model of full disclosure.
The point is Ralph that justice is being done on the rest of us.....It's about time the troughers at the top had to comply...
by way of example - if you have any kids at Uni, go ask them whoose getting student allowance. Answer, not the poor south auckland kids *that don't go anyway) it's the troughers kids, the ones who are asset rich, income avoided .
I even know of local GP who manages a 2 month overseas holiday each year, yet has a Community Services card. Go figure?
Justice is fine...if we all face it. At the moment, we don't.
It is clear that several correspondents have not read the judgement itself. John Shewan had his expert brief discounted because he did not behave professionally as an expert witness should. An own goal. The decision was written by Justice Blanchard, not Justice Elias Blanchard. The method of tax avoidance is not new. It was the subject of a major court case 50 years ago that went to the Privy Council. The principles are not difficult to apply. If a company employs a professional at a below-market wage, and the professional can rely on the company to behave indirectly towards the professional in a way that differs significantly from its behaviour towards an unrelated third party, then the distortion would prima facie be evidence of avoidance. Hooper is wrong in saying that the courts are now deciding what an orthopaedic surgeon should be paid. The court is saying the Commissioner will decide. Finally, I am someone who cannot avoid paying tax. I welcome the Supreme Court decision.
There are plenty of things wrong with our tax system but this is not one of them. That was the correct decision from the judiciary.
What it comes down to is what the statute has said, that to undertake actions where the commercial rationale is to reduce taxation, is classified as tax avoidance.
The courts' responsibility was simply to judge the facts of the case. It was clear that the structures were put in place for no reason other than minimisation of tax.
Nothing has changed. There is nothing 'landmark' about this finding.
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