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Brief Counsel

Penny for your thoughts

26 June 2009

Doctors, dentists, accountants, architects, chiropractors, tradespeople and others considering using a corporate structure for tax purposes can take some confidence from the recent High Court decision in Penny v CIR; Hooper v CIR (CIV-2007-409-1153, CIV-2007-409-1154) (Penny).

But we would still advise caution as the Commissioner of Inland Revenue is taking the case to the Court of Appeal.  This Brief Counsel examines the High Court finding and why the decision should give professionals pause for thought.

Introduction

Doctors Penny and Hooper restructured their respective medical practices so that they were run through companies that paid them a less-than-market salary.  The Commissioner argued that this was income splitting and a tax avoidance arrangement.  The High Court rejected this argument and the Commissioner has appealed.

The decision is significant for a number of reasons: 

  • It is the first tax avoidance case since Ben Nevis and Glenharrow, where the Supreme Court restated the principles and approach to be adopted when applying the avoidance provisions of the Income Tax Act (Act)
  • The High Court decided in favour of the doctors, whereas all previous cases have held that similar income-splitting structures were tax avoidance arrangements, and
  • A variety of professionals currently operate their businesses through companies or may consider doing so.  The ultimate outcome of this case could affect the desirability of the company structure and the tax liabilities of professionals.

The case

Mr Penny and Mr Hooper are specialist orthopaedic surgeons.  Mr Penny commenced private practice in 1991, and began operating his business through his own company in 1997.  Mr Hooper commenced private practice in 1989 and moved to a company structure in 2000.  The tax benefits associated with the restructuring arose when the Government increased the maximum personal income tax rate from 33% to 39% in April 2000.

The Commissioner submitted that the doctors’ restructuring was a tax avoidance arrangement because it was contrary to the "scheme and purpose" of the Act (which was the test endorsed by the Supreme Court in Ben Nevis and Glenharrow).  The Commissioner argued that:

  • One of the purposes or effects of the business structure was to avoid tax, as demonstrated by the artificially low salaries paid to the doctors by their companies, and
  • The arrangement was a form of income splitting, which is a tax avoidance arrangement because Parliament contemplated that “personal exertion income must be derived by the person by whose exertions the income is earned”.

The Commissioner increased the tax liability of each doctor by treating the difference between the salaries they received and a "commercially realistic salary" as income subject to tax at the doctors’ personal income tax rate of 39%, as compared to the corporate rate of 33%.

The case was initially decided in favour of the Commissioner by the Adjudication Unit, although not every submission was accepted.  The Unit held that the personal exertion principle argued by the Commissioner did not apply and the company income could not be attributed to the taxpayer.  However, the Unit concluded that the arrangement involving the carrying on of the medical practice using the company structure and the fixing of the salary of the taxpayer at a level below a commercially realistic salary was tax avoidance.

The High Court rejected the Commissioner’s submissions and reiterated the established principles that:

  • A company is still a valid, separate legal entity even when it is under the effective control of a single person
  • The relationship of employer and employee may validly exist between such a company and the person who is its governing director, and
  • “Generally speaking, the proprietor of a ‘one-man’ business has the choice whether to conduct that business as a sole trader or through a company (or perhaps some other entity).”

The Court noted that if a person is able to choose the entity through which they conduct their business, the incidence of tax on that income can be different from that which would apply if a different taxpaying entity had derived the income.  The result is not, of itself, tax avoidance.

In discerning the "scheme and purpose" of the Act, the High Court rejected the Commissioner’s argument that “it is implausible that Parliament intended to condone income-splitting by professionals”.  MacKenzie J states that the proposition “is not derived from the scheme of the Act viewed objectively”, but rather it involves “an intuitive subjective impression of the morality of income-splitting by professionals and seeks to interpret the Income Tax Act through a subjective lens”.

The Commissioner pointed to the existence of the Personal Services Attribution Rules (PSA Rules) in the Income Tax Act as indicative of an overarching principle that “personal services income derived from the personal exertions of an individual is to be taxed as the income of that person”.  The PSA Rules are an anti-avoidance measure intended to prevent contractors and potential employees from circumventing the 39% top personal tax rate by interposing a company between themselves and their customer or employer in order to access the lower company tax rate.

MacKenzie J did not accept this argument, stating that the PSA Rules “are directed at situations where the company does not have a genuinely independent business, and the relationship with the income provider is akin to one of employment”.  In contrast, the income of the company of each doctor “is not, in substance, employment income”.  His Honour considered that this was not a case of the assignment of personal exertion income, but that the income was derived by the business, as a separate legal entity, regardless of whether it was the product of personal exertion.

Regarding the issue of the doctors’ artificially low salaries, MacKenzie J held that “a commercially realistic salary is not a concept known to tax law, and not a concept which provides a basis for determining whether or not a particular arrangement constitutes tax avoidance”. 

Precedent

One of the main difficulties faced by the doctors was that their business restructuring was similar to arrangements found in a number of previous cases which the courts held to be tax avoidance. For example, in each of the following cases, the court held that the income splitting structure in question was a tax avoidance arrangement:

  • A dentist in Halliwell1 changed his business structure from a partnership to a trading trust
  • A chiropractor in Wells2 set up a company to run his business, sold his equipment to the company and had the company take up the tenancy of the practice premises
  • Two doctors in Lawler3 who were initially in partnership subsequently formed a company to operate their business, the shareholders being their family trusts
  • In Case Y14 a husband and wife restructured their delivery service business by interposing a trading trust between their business partnership and their customer. An artificially low management fee was paid for a management services contract between the trustee company and the partnership
  • The taxpayers in Elmiger5 were earthmoving contractors who restructured their business by setting up a trust and selling and leasing back two machines
  • The farmer in the "Paddock Trust" cases would lease part of the farm to trustees of a family trust. The farmer was employed by the trust, and sold the farm produce on behalf of the trust distributing the profits to his wife and their children6 , and
  • In Peate7, an Australian case factually analogous with Penny, the Privy Council held the restructuring of a medical practice using a company was a tax avoidance arrangement. 

Similarly, the dentist in Case V20 and Case W338 restructured his practice from a partnership into a trading trust.  The dentist set up a family trust with a corporate trustee, sold his share of the practice to the trust, and entered into an employment contract with the trust for an artificially low salary.  The arrangement was held to be tax avoidance.  Although Judge Barber stated that the Duke of Westminster principle entitled the dentist to “order his affairs to minimise the incidence of income tax”, the artificially low salary meant the arrangement was tax avoidance because the income tax saving was not merely incidental.

However, MacKenzie J in Penny states that he would “differ from Judge Barber as to the effect of paying an artificially low salary”.  Judge Barber acknowledges in his judgment in Case Y19, that since deciding Case V20 and Case W33, “there have been various learned articles analysing that and opining that it does not follow from non-payment of a market salary that tax avoidance exists or can be predicated”.  His Honour then states “I agree that the mere absence of a market salary is not tax avoidance in itself and that the IRD cannot demand the payment of a market salary”.

The High Court also addressed and distinguished Hadlee10.  The case involved a taxpayer who was a partner in a firm of chartered accountants.  Although the taxpayer had assigned for valuable consideration a portion of his interest in the partnership, the Privy Council held that he was still subject to tax on that interest because the income which accrued to the assignee flowed not from a capital asset, which was capable of assignment, but from the services of the taxpayer under the partnership contract.  His Honour considered that the income in question was at all times derived by the taxpayer, and the assignment did not change this. In Penny, the business income was derived by the company as a separate legal tax-paying entity.

Conclusion

The Duke of Westminster principle says that taxpayers are entitled to order their affairs to minimise the incidence of income tax.  However, an arrangement is likely to be tax avoidance if a taxpayer makes use of provisions in the Act to minimise his or her incidence of income tax, but does so in a way that is outside parliamentary contemplation or frustrates the scheme and purpose of the Act.

The decision by the doctors in Penny to restructure their medical practice through a company is a common commercial arrangement.  Many professionals choose to operate their business through a company structure, which affords them commercial and tax benefits.

Nor is it unique that the doctors decided to pay themselves a less than commercially realistic salary.  In a competitive market, professionals may reduce their salaries and reinvest profits into their business.

The High Court in Penny held that the doctors were entitled to restructure their business through a company and pay themselves a less than commercially realistic salary.  MacKenzie J concluded that the restructuring was not a tax avoidance arrangement.  His Honour determined that the structure was not outside the scheme and purpose of the Act.

In our view, professionals currently operating or considering a business structure similar to Penny should not immediately rely on the taxpayer-favourable outcome of the High Court decision.  The case is being appealed to the Court of Appeal.

The result of the Commissioner’s appeal will be keenly anticipated.  It will further define the scope of the Commissioner’s anti-avoidance powers, and potentially influence the commercial environment in which professionals choose to operate their businesses.

Footnotes

  1. Halliwell v CIR (1977) 3 NZTC 61,2082.
  2. Wells v CIR (1973) 1 NZTC 61,0943.
  3. Lawler v CIR (1973) 1 NZTC 61,0914.
  4. Case Y1 v CIR (2007) 23 NZTC 13,0015.
  5. Elmiger v CIR [1967] NZLR 1616.
  6. see Marx v Commissioner of Inland Revenue; Carlson v Commissioner of Inland Revenue [1970] NZLR 182 (CA), Mangin v Commissioner of Inland Revenue [1971] NZLR 591 (PC); Gerard v Commissioner of Inland Revenue [1974] 2 NZLR 2797.
  7. Peate v FCT (1964) 111 CLR 4438.
  8. Case V20 v CIR (2002) 20 NZTC 10,233, Case W33 (2004) 21 NZTC 11,3219. 
  9. Case Y1 v CIR (2007) 23 NZTC 13,00110.
  10. Hadlee v CIR [1993] 2 NZLR 385

Our thanks to Nghia Tran, Solicitor, for writing this edition of Brief Counsel. 

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