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Tax Avoidance

John Kahukiwa
John Kahukiwa

ARTICLE by John Kahukiwa, Partner
June 2010

 “Family business structures found guilty of tax avoidance”


 Introduction

 On the 4th June 2010 Court of Appeal, by a 2 – 1 majority, has found that two Christchurch orthopaedic surgeons (independently of each other) deliberately avoided paying higher taxes. Each Surgeon set up his practice so that it was run by a company and owned substantially by his respective family trust. The case is worthwhile noting, because of the common use of this type of structure across New Zealand, and its relevance to a range of family run businesses.

 The Facts

 The facts are that Ian Penney and Gary Hooper (the subject tax payers) initially conducted their practices on their own accounts but later set up companies to buy their practices. The companies were owned substantially by Mr Penney's and Mr Hooper's family trusts respectively and the men were employed by them at salaries determined by the companies.

 The Commissioner’s case

 The Commissioner of Inland Revenue said that the employments were conducted under what he considered to be “artificially and contrived low salaries”. He said that the surgeons had structured the practices in this way to avoid paying higher taxes taking advantage of the lower company tax rate of 33 cents per dollar when they should have been taxed at the higher rate of 39 cents given their personal revenue.

 The Court of Appeal

 The majority of the Court of Appeal found that the tax payers had adopted commercially unrealistic salary levels, and were unable to give sufficient “other” reasons as to why such drastically reduced levels (in comparison to pre-structure years) were legitimate and this amounted to tax avoidance.  They said that taking into account the circumstances overall all, the avoidance of tax was more than “merely incidental” or “an effect” of this arrangement.  The court said:

 “The salaries adopted were so far removed from commercial reality as to be contrived and artificial. They could not be regarded in any sense as within the acceptable limits of commercial practice. It could not have been within the contemplation of Parliament that a company director/employee could adopt a salary of less than one-fifth of a proper commercial salary and thereby secure significant tax advantages while still receiving, in practical terms, the benefit of the company’s entire net income for himself and his family.

 Comment

 This case clearly raises some uncertainty for tax payers around what might constitute tax avoidance in relation to such commonly operated family business structures, a point that was not lost on the Court of Appeal. In that regard Randerson J said:

 “It is important to recognise, 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 transaction, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement.

 Without being clearer, he indicated that in certain circumstances it may well be legitimate for a significantly reduced salary not to be categorised as tax avoidance. In that regard he referred to the following possibilities (also set out at paragraph 98 of the judgment) which might not be likely to succeed: 

  • Where the company is in a developmental phase and there is a need to build up capital;
  • Where the company needs to purchase a substantial asset for the business;
  • Where the director/employee does not work full-time;
  • Where the company has had a poor financial year;
  • Where the company is engaged in charitable purposes; or
  • Where the directors and shareholders of a company wish to maximise the transfer of profit from the company to trustee shareholders for their benefit.

Subsequent to the decision the IRD’s position has been stated as follows:

"This is not about whether you've got a company or a trust. It's really about how you use them.

"If you are the person generating the profits in the company and you contrive to direct that income to your benefit and your family's benefit, and pay yourself a less amount as salary than represents your contribution to the profit to the business, and most importantly, it's personal exertion income, that combination of things, people have to be on guard that they might come in for some attention."

The circumstances were most likely to relate to companies employing a single person, whose "personal exertion" was the source of the company's income.

Conclusion

 The latest budget has reduced the differential between the company tax rate (30%) and the highest individual rate (33%). Accordingly there is still an incentive for taxpayers to utilise structures like the structure used by the orthopaedic surgeons to avoid paying the higher marginal rate. Notwithstanding the decision there is clearly some uncertainty around the effectiveness of the structures used. The judges in the high court and the court of appeal are split equally and the case may still be the subject of appeal by the tax payers to the Supreme Court.

 You may wish to discuss the effect of this case on yourself with us or your financial advisors.