Columnist Michael Coote retells the Penny and Hooper tax tale and exposes the perils of tax arbitrage

By Michael Coote*

Tax arbitrage has come to the fore in recent weeks with the widely publicised Penny and Hooper case. Tax arbitrage occurs where taxable income is directed into a lower tax bracket than might otherwise apply.

Although the practice is not intrinsically illegal, and in its legitimate form might be described as tax minimisation or tax efficiency, under certain circumstances it can be classified as tax avoidance or tax evasion prohibited under the Income Tax Act. This uncertainty leaves a grey area wherein it is not necessarily obvious an arbitrage is in fact illegal avoidance or evasion.

It will be recollected that Messrs Penny and Hooper were Christchurch orthopaedic surgeons.

Their tax situation was well summed up by Grant Thornton’s Geordie Hooft as being composed of one part that was held to be legally unobjectionable and another that was adjudged to be illegal tax avoidance. See Amanda Morrall's article here.

On the unojectionable side, Mr Hooft wrote:

“Each [surgeon] transferred their private practice from their own name into a company, the shares of which were held by a trust They paid themselves a salary from the company, with the balance of the company’s profits going to their trust as dividends. As a result, the amount of business income taxed in their names (at higher personal tax rates at the time of up to 39%) was reduced, with a greater proportion taxed at the trust rate of 33%.

In both cases, the surgeons still had access to the income, via the trusts. The Supreme Court said that most of the facts didn’t cause a problem.”

“Delivering the Court’s unanimous decision, Blanchard J described the structure as ‘entirely lawful and unremarkable’ and ‘a choice the taxpayers were entitled to make.’” 

So far, so good.

If you are the self-employed proprietor of a business, you can transfer ownership of that business across to a registered company structure and become a paid employee of the company. You can place that company’s shares in trust, with the company paying over surplus income to the shareholding trust as dividends after wages, salaries and other business expenses have been deducted.

If you are also a beneficiary of the trust, you can receive income tax-paid at the trustee rate that was originally sourced as dividends paid out by the company.

How the surgeons saw their income tax arrangements

While Mr Hooft was positive about the above aspect of the court’s ruling, he had serious concerns with the implications of what the court otherwise decided regarding the question of a “commercially realistic” versus “artificially low” salary drawn from the trust-owned company.

Under the trust-owned company structure, the surgeons had routinely received salaried income for their private practice work.

This salary was calculated on the pay rates they would have earned for doing the same work in public hospital practice, wherein remuneration would have been a lot lower than for private practice, but otherwise was set at an objective arm’s length basis.

This public hospital rate or pay could be called the “market rate” or “benchmark” for what the surgeons’ work was actually worth as company employees rather than as self-employed proprietors.

The “benchmark” part of the surgeons’ earnings attracted up to a 39% marginal tax rate, depending on how much their companies paid them as salary calculated on this rate.

By contrast, the surplus private practice income left over and classified as a company dividend was taxable at the shareholding trustee’s rate of 33%.

There was thus a significant tax arbitrage advantage available where private practice income could be taxed as a company dividend at the 33% trustee rate rather than as salaried income at the 39% personal marginal tax rate. This arbitrage arose from the difference between what the surgeons’ companies actually charged patients for their employees’ services in private practice versus the lower rate the surgeons would be paid for performing the same work in public practice.

At the margin it meant the surgeons having access to income of 67 cents (2/3) in the post-tax dollar from the shareholding trust rather than 61 cents (3/5) as salaried employees (or self-employed proprietors).

Indeed, it would have been in the direct material interests of the surgeons to maximise their private practice earnings relative to the public sector remuneration rates payable for their exertions, as these earnings flowed through to the trust as dividends from the company they worked for. The trust still paid tax on its company dividends received, so the IRD was not being swindled, surely, because everything was being done by the book at the applicable tax rates for trusts and salaries.

The arrangement was one of tax minimisation or tax efficiency, in which it just happened that significant trust income became available to the surgeon’s sourced from the dividends paid by the companies that employed them. All this might seem entirely reasonable, but that was not the way the IRD saw the matter.

The IRD’s contrary view

The IRD took the view that the surgeon employees of the companies were in fact still the working proprietors, regardless of external appearances created by the trust and company arrangements.

These working proprietors were accused of artificially lowering their taxable incomes by setting a rate of remuneration in private practice that was not commercially realistic, notwithstanding the fact that the rate was what was paid for public hospital practice.

On this basis, the IRD effectively “looked through” the shareholding trust to determine that the surgeons in effect drew full benefit from the profits of their businesses.

Accordingly, and despite a “nominal deduction to allow for a return on capital employed in the business”, the IRD deemed that all of those profits arising were personal salary income of the surgeons taxable at the full marginal rates applicable.

The Supreme Court agreed in this particular case.

What this court decision brings out is that the formal arrangements – in this example a company that was owned by a trust – are not by themselves sufficient to prevent a tax arbitrage from being adjudged tax avoidance or tax evasion, even if the tax formally owed under such arrangements has been scrupulously paid.

In effect, the taxman had been shortchanged by the trust-owned company structure, and this created tax arrears liabilities for the two surgeons.

Hope springs eternal

To confuse matters again, however, the Supreme Court did allow that under certain circumstances it could be legitimate for company employees of a formerly working proprietor business to receive salaries that were lower than commercial reality.

Specific examples given were where there was a need for capital investment in the company, or the business was assailed with current or foreseeable financial difficulties.

This was the IRD’s previous position also, but that leaves the matter very much case-by-case, with the risk remaining that a tax arbitrage that looked like legitimate tax efficiency or minimisation might well turn out to be illegal tax avoidance or evasion subject to penalties.

 “It’s not just orthopaedic surgeons that are at risk,” writes Mr Hooft, “Any professional or trades based business is potentially at risk.”

“Business owners will not only have to consider how they deal with salaries in the future,” he continued, “ they will also need to think about how they have dealt with them in the past.”

To clarify matters, the IRD has since put out Revenue alert RA 11/02, but tax practitioners have complained that very little protection is afforded to taxpayers by this particular document and accordingly that the uncertainties of the law around tax avoidance still represent a threat.

*Michael Coote is a freelance financial journalist whose publication list includes interest.co.nz, the National Business Review, New Zealand Investor, The Press, and the New Zealand Centre for Political Research.