It’s not just tax boffins who should take interest in the Supreme Court’s recent decision in Penny & Hooper v Commissioner of Inland Revenue. The case has implications for many business owners. What has been normal commercial practice may now be tax avoidance.

The case involved two orthopaedic surgeons. Each transferred their private practice from their own name to 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.” This is good news from the Court, given serious questions were being raised about the appropriateness of what have become normal commercial structures. However, in the Court’s view, tax avoidance arose when the structure was coupled with fixing salaries at an “artificially low” level, while effectively keeping full access to the same funds they would have previously had. That had the effect of altering the incidence of tax in a way that was not contemplated by Parliament.

But who decides what constitutes a “commercially realistic” salary? As pointed out by the surgeons’ counsel, it is not a concept that can be found in the Income Tax Act – although the Act does contain rules against salaries that are too high (dating back to when company tax rates were higher than the personal tax rates) and provisions that attribute company income to owners in specific circumstances (the “personal attribution” rules).

The surgeons in the present case bench-marked their salaries to those earned from their hospital work. A bench-marking approach seems to be an entirely appropriate way of setting a salary. In other words, set the salary at the amount required to pay someone on an arm’s length basis for their labour input to the business. The question was whether this was an appropriate benchmark for a private practice.

In contrast, Inland Revenue’s approach was that all of the profit of the business should be allocated as a salary to the owner, but with a nominal retention in the company to allow for a return on capital employed in the business. Such methodology is not much more than an attribution of the earnings of the business to the working proprietor.

If there is any saving grace, it is in the Supreme Court’s recognition that there may be circumstances where a lower salary might be acceptable. Examples cited include retaining profits for capital investments or if there are current or anticipated financial difficulties. This reflects the Inland Revenue’s stated position following the Court of Appeal decision.

The Penny & Hooper case provides another insight into the current judicial approach to tax avoidance. It is a two-stage query, asking first whether the “black letter” of the law has been complied with. If the answer is yes, the next question is whether it has been complied with in a way that is “within the contemplation of Parliament.”

Many may wonder what Parliament is contemplating at the best of times. In a taxation context, it requires reviewing the overall scheme of the Income Tax Act to try to understand what the legislators had in mind when they enacted particular provisions.

Immediately after the Supreme Court decision, Inland Revenue issued Revenue Alert (RA 11/02).  It notes that a combination of the following features may constitute tax avoidance:

• The controllers of a business transfer it to a new structure, such as a company, which then employs them.
• The business continues to operate substantially the same way as before the transfer.
• The business may not be operated in accordance with the arrangements entered into, which may not be a “commercial” arrangement having regard to standard business practice.
• Ultimate control of the entity remains with the individual service provider.
• The working owner has access to funds previously at their full disposal but now routed through an intermediary structure.
• There are no extenuating circumstances to justify the low salary (eg capital commitments, expected poor financial performance).
• There are significant tax benefits from use of the structure.

Inland Revenue notes that the profits of a business are attributable to a number of factors, including:  the individuals’ personal skill, judgement and exertion; services provided by other staff; intangible assets; and return on business risks.  As a general rule, the more that a business relies on the personal skills and exertions of the controllers of the business, and less on the capital employed, the stronger the argument for allocating profits as salary.

Inland Revenue has been reviewing a number of cases similar to Penny & Hooper, but placed those investigations on hold pending the decision.  The outcome of any investigation may involve deeming controlling individuals to have derived higher salaries than previously credited, up to the amount of profit of the enterprise.  The Revenue Alert notes that interest and penalties may also apply, including shortfall penalties (reduced for any voluntary disclosures made).

It’s not just orthopaedic surgeons that are at risk. Any professional or trades based business is potentially at risk. At less risk are businesses that depend more on the trading of goods or a high level of capital investment for their profits.

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

In summary, the following points are key:

• The use of companies, including companies whose shares are held by a trust, continues to be a legitimate form of business structure.
• A low salary is acceptable, provided there is commercial justification. It would be prudent to document any the rationale for a low salary at the time of determining it.
• The circularity of funds (the owner’s continued access to funds) is an important factor.
• Existing businesses that restructure are at greater risk than new businesses that adopt such structures from the beginning.
• Although a structure may have a valid foundation, how it is used (especially in respect of setting salaries) should be reviewed on an annual basis.

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Further enquiries, please contact:

Geordie Hooft

Partner, Tax

T +64 (0)3 379 9580

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Issued on: 19 September 2011