Penny and Hooper Decision Finding in Favour of Commissioner Released
The long awaited decision of the Supreme Court was released on 25th August 2011.
The case involved orthopaedic surgeons who sold their businesses to companies owned by family trusts of which they were the sole directors. They then paid themselves a salary significantly less than they were previously receiving which gave them tax savings of 6c in the dollar – being the difference between the company tax rate of 33c and highest marginal tax rate of 39c. The balance of the profits was distributed by dividends to their trusts with tax paid at either 33c (trustee tax rate) or the beneficiaries’ marginal rates.
Penny had established his structure prior to the introduction of the 39c rate but at the time the rate changed he reduced his salary and took the balance of the cash as a loan from the trust interest free (from funds the trust had received as dividends from the company operating the business).
The Commissioner contended that the arrangements were tax avoidance and assessed the taxpayers for an amount he believed to be a commercially realistic salary.
The Supreme Court noted that the structures adopted by the taxpayers were entirely lawful. This was a case in which it was possible to move straight to s BG 1 (tax avoidance) and ask whether the use of the structure which was adopted when the salaries were fixed was beyond parliamentary contemplation and resulted in a tax avoidance arrangement. The question to be asked is why the salary was fixed as it was on a particular occasion. Whether that involved tax avoidance can be answered by looking at the effect produced by the fixing of the level of salary in combination with the operation of the other features of the structure. They found that in reality the taxpayers suffered no financial loss of income but retained a reduction in liability to tax as if they had.
In conclusion, it was accepted that there was no concept of a commercially realistic salary to be found in the Income Tax Act. However the Act does require that taxpayers should not structure their transactions with a more than merely incidental purpose of obtaining a tax advantage unless that advantage is in contemplation of Parliament. If the salary is not commercially realistic or is not motivated by a legitimate (non-tax driven) reason it will be open to the Commissioner to assert that it was, or was part of, a tax avoidance arrangement.
In a press release issued by New Zealand Institute of Chartered Accountant’s (“NZICA”) yesterday, the decision may well be tempered by the strong reliance on the Privy Council’s decision in Peate and thus there is a limit to its wider application. NZICA will seek comment from Inland Revenue on this point.
So what does this mean for practitioners and clients?
Structuring a client’s business affairs with more than a merely incidental purpose of obtaining a tax advantage may be considered tax avoidance.
In setting an appropriate salary level we should consider whether the salary would be acceptable if paid in return for services provided to a third party
If you have any queries regarding this case or how it may affect you we suggest you contact your CST advisor or email us at team@cstnexia.co.nz.
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