If 2009 was the year of the conduit financing case, 2010 will be remembered as the year closely held entities took centre stage in the eternal struggle between taxpayers and tax authorities.
Penny and Hooper became household names, Chicken Little prophecies were made in the media, and taxpayers were left scratching their heads as to what it all means for them.
This Brief Counsel recaps the main tax cases decided in calendar 2010, draws out five key points and predicts what 2011 will bring.
Penny and Hooper
Surgeons Dr Ian Penny and Dr Gary Hooper transferred their practices to family companies which paid them below market salaries in comparison with what they had earned when self-employed. This meant that most of the income from their surgical work was taxed at the lower corporate rate. This income was eventually channelled back for the benefit of the surgeons’ families, with no additional tax.
The Commissioner said the arrangement was tax avoidance because the salaries were not arm’s length.
The High Court1 rejected the IRD’s interpretation and held that nothing in the Income Tax Act requires arm’s-length salaries to be paid. This decision was, however, subsequently overturned by a majority in the Court of Appeal2 which found that the combination of the non-market salaries, corporate structures and the fact that the funds not paid as salary were eventually applied for the sugeons' private benefit meant that the arrangements were not within Parliament’s contemplation and that commercial salaries should have been paid.
Drs Penny and Hooper have been granted leave to appeal to the Supreme Court.
Andrew Krukziener conducted a series of property developments over a number of years through special purpose vehicles, mostly discretionary trusts. Rather than paying him a salary, these vehicles generally gave him interest free loans. Profits were distributed (in a non-cash form) to new development entities with start-up type losses. Most of these loans were eventually repaid out of a capital distribution received by Mr Krukzeiner from another trust.
The Commissioner sought to tax the loans as income under section BG 1. In the Taxation Review Authority, Judge Barber held for the Commissioner. In September the High Court delivered its judgment, dismissing Mr Krukziener’s appeal and largely agreeing with Judge Barber’s analysis.
Mr Krukziener says he will appeal the High Court’s decision.
Dr Philippa White incorporated a company through which she continued her work as an anaesthetist and also leased two avocado orchards. The income the company earned from her anaesthetics practice was offset by the losses generated by the orchards. Dr White received no salary.
In the Taxation Review Authority, Judge Barber held5 that the arrangement was a tax avoidance arrangement. The High Court6 overturned Judge Barber’s decision on the grounds that:
- unlike Penny, this was not a case in which a reduced salary was deliberately paid but where the company lacked the funds to pay a salary
- there was a realistic expectation at the time the structure was implemented that there would be sufficient profit to pay a salary to the anaesthetist, and
- there is a distinction between purpose and effect, and while the effect of the arrangement was, for unforeseen reasons, to negate the need for the anaesthetist to pay income tax, the purpose was not to obtain an impermissible tax advantage.
Chapman Tripp comments
While the law is developing in this area, the following propositions may help in determining whether these cases apply to you.
- They relate only to situations where individuals provide services to related entities, and receive a non-arm’s length salary. The IRD is not attacking (for example) taxpayers who lend money to family trusts interest free.
- A non-arm’s length salary can be justified where:
- funds are reinvested in the business (as was suggested in Penny), and/or
- the business lacks the funds to pay a salary (as in White).
The extent to which a business applies to the personal benefit of its owner funds that are not paid to them directly is relevant. This might be achieved through loans, or payments to family trusts. Courts may view such loans and payments as salary substitutes that are part of a wider tax avoidance arrangement.
If loans are made, these should be documented and consideration should be given as to whether interest should be charged. Documenting and charging interest on loans should help to rebut any salary substitute argument.
The cases have largely turned on objectionable facts such as:
the timing of Dr Hooper’s restructure with the tax rate increase in 2000
the substantial difference between what Dr Penny and Dr Hooper earned before and after their restructures, and
the large interest free loans made to Mr Krukziener over a number of years to pay credit card debts.
The absence of such facts will go some way to immunising an arrangement from allegations of tax avoidance. The lack of coherence in the relevant provisions of the Income Tax Act makes it difficult to see how a Court will find tax avoidance in cases where the facts are less clear.
In May Revenue Minister Peter Dunne announced:
Aligning the top tax rate with the trust rate at 33 per cent ensures that wage earners in the top tax bracket – like many high-school teachers, nurses and police – no longer pay a higher tax rate than wealthy individuals who can structure their tax affairs and effectively select the tax rate they want.
The alignment of the top marginal and trust rates undoubtedly reduces some areas for avoidance. However, the 5 per cent rate differential between the corporate rate and the trustee/top marginal rate means the incentive for this kind of tax structuring remains.
While we hope that the Court of Appeal and Supreme Court will use the appeals by Mr Krukziener and Drs Penny and Hooper to provide more principled guidance in this area, we suspect that the systemic rate differences will mean that closely held entities remain in the spotlight for some years.
Our thanks to Simon Akozu, Solicitor, for writing this Brief Counsel. For further information, please contact the lawyers featured.