The outcome in Penny and Hooper v CIR is relevant to a much broader swathe of the economy than any tax case in the past 35 years, potentially affecting the related party employees of any family company.
As is well known, the Supreme Court sided with the IRD. Had the decision, or its application by IRD, been broadly enough framed, any such employee worth more than $60,000 a year and paid less than a market salary could have been liable for an unexpected dose of income tax, served with a chaser of penalties and interest.
Fears of a judicial or administrative over-reach have so far, however, proved groundless. Particularly for family companies, their family employees and their tax advisors, it is worth emphasising the limits on the decision, as expressed by the Court itself and as further developed by the IRD in Revenue Alert RA 11/02.
These will provide guidance as to whether taxpayers should make a voluntary disclosure of a tax shortfall, or vigorously contest any attempt by IRD investigations staff to apply the anti-avoidance provision. Of course, since 1 April this year, the coalescing of the trust and top individual rates means there is currently no benefit from Penny and Hooper structures.
The key factual underpinning for the Supreme Court’s decision was that tax savings were the primary reason for Messrs Penny and Hooper fixing their salaries at a fraction of what they had earned when practising on their own accounts. There was no intention to build up the assets of the relevant company, or to pay a dividend to third party shareholders. The surgeons and their families continued to access all the earnings of their practices, but through the enjoyment of the assets of the shareholding family trusts, rather than by way of direct ownership of those assets.
Like Randerson J in the Court of Appeal, Blanchard J in the Supreme Court listed a number of reasons for paying a low salary to a family employee which, had they existed, would have provided a good defence to an avoidance-based assessment by the Commissioner. These were if the company:
- was making a low taxable profit, and paying all or most of it out to the employee
- needed the funds for capital expansion, or
- was experiencing financial difficulties, or feared it might do so in the future.
The question to be asked, the Court said, is “why the salary was fixed as it was on [the] particular occasion”. If the answer is “for tax reasons”, then it will not be surprising if the anti-avoidance provision is applicable.
It is worth focussing on the fact that, where non-tax reasons do exist for payment of a below-market salary, the result of this analysis is to approve the tax saving from incorporation. In a sole (i.e. unincorporated) practice, the retention of earnings to fund capital expansion or to provide a buffer against misfortune will not prevent tax being imposed at the appropriate marginal rate on the retained earnings.
In a company, however, it will do.
This approach is refreshingly direct and soundly based on the actual words of the anti-avoidance provision (albeit the Court slips somewhat, when it refers to the “merely incidental” test as an element of “policy”, rather than an explicit element of the legislation). It will, however, strike issues in its application.
- What if the financial difficulties which are the basis for a low salary never eventuate, and the next year the company pays out all of the profit (generated by the low salary) as a dividend?
- What if (as is the case in some current litigation) the reason for the company having low taxable profits is that the company was engaged in another loss-making business?
These are difficult questions, which it may take further litigation to answer.
However, at least at a published level, the IRD appears not only to be taking an appropriately limited view of its victory in Penny and Hooper but going further and providing the basis for a safe-harbour rule that could remove from many potentially affected taxpayers the spectre of an avoidance investigation. While this statement may require reinforcement and refinement, it is a welcome development.
In Revenue Alert 11/02, the IRD provides a broad guide to those considerations which will inform its approach to applying Penny and Hooper:
- it will focus on the most serious and artificial cases – where the arrangement results in a substantial portion of the income generated from a business being diverted away from its individual service providers
- a desire to achieve asset protection, limited liability and business continuity may justify the decision to incorporate and to retain earnings in a company
- the existence of substantial tangible or intangible assets in a company, or non-family staff, will provide a basis for retention of profits in a family company
- other reasons for not paying a usual market salary to family company family employees include:
- reduced profits due to adverse business conditions
- fear of financial difficulties in the near future
- capital expansion in the next financial year (the “next” requirement is surely an unjustified gloss on the Supreme Court dicta), and
- an intention to give the retained profits to charity.
Before providing this list, the IRD states:
“We are more likely to examine arrangements where the total remuneration and profit distributions received by the individual service provider is less than 80% of the total distributions received by the controller, his family and associated entities”.
Accepting that it is sincerely meant, this statement is significant. Regardless of the presence or otherwise of the kind of factors referred to above, if the profit paid out by the family company to an individual service provider is at least 80% of the total amount distributed to his or her associates (presumably in the same tax year or shortly thereafter) the IRD is “less likely” to seek to apply section BG 1 to the arrangement.
This policy appears to allow the company to retain any amount of income, for any reason. It is a sensible administrative rule, allowing taxpayers to perform an objective numerical test, to determine whether or not they are in danger under section BG 1.
In order for this statement to be truly useful to taxpayers, it needs to be more definitive. It needs to state, for instance, that the IRD will not (in the absence of special factors) examine the specified type of arrangements. It also needs to deal with timing issues (as mentioned above). If these and similar issues can be resolved, it may be the beginning of a rule which has the potential to bring clarity into the administration of this potentially fraught area.
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