By Amanda Morrall
A Supreme Court ruling in the case of two surgeons who used trusts to reduce their tax bill could have small business owners in New Zealand flocking to see their accountants.
After six-years of legal wrangling with Inland Revenue orthopaedic surgeons Ian Penny and Gary Hooper - who went into business for themselves as registered companies and sole directors then paid themselves sub-market salaries, channelling company profits into trusts as dividends - were told the practice constituted tax avoidance.
PriceWaterhouseCooper tax partner John Shewan, an expert witness in the case, said the decision had wide application for New Zealand businesses.
"There are thousands of small businesses that operate through companies and which pay salaries or wages to their owner operators. Today's judgement confirms the Commissioner's view that where the amount paid is artificially low that may well constitute tax avoidance."
For separate and different circumstances, both Penny and Hooper had established their own businesses that worked in tandem with family trusts.
They had each set up a registered business under the Companies Act, where the taxpayer was sole director and shares were held by family trusts. As employees of the business their salaries were fixed below market rate. Profits from the company were paid as dividends to the trust which is taxed at lower marginal rate. Annual tax savings for the pair were estimated between NZ$20,000-$NZ30,000.
Hooper had net earnings from his practice before interest and tax of NZ$659,000 in 1999/2000, but the trust paid him a salary of NZ$120,000 even though it was receiving income of between NZ$500,000 and NZ$700,000. The trust paid out dividends ranging from NZ$228,000 to NZ392,000 to the beneficiaries, including children, at tax rates of 33 cents. At the time the top income tax rate was 39 cents.
"The retained earnings of the Hooper trusts were invested in the family home and a holiday home and in bank deposits. No distribution or loans have been made to Mr or Mrs Hooper, although obviously they and their family enjoy the benefit of the two homes owned by their trusts," the Appeal Court said.
A High Court ruling initially found in favour of Penny and Hooper, but this was overturned by an Appeal Court.
Revenue Minister Peter Dunne hailed the decision as correct and fair, arguing it would restore the integrity of the New Zealand tax system by ensuring that everyone one paid their "fair share of tax.''
"The Court's decision is a clear signal that people cannot structure their income arrangements in such a way that they artificially reduce their tax liability and still receive the benefits.''
Tax specialist Terry Baucher said the ruling was no surprise given Inland Revenue's intensifying efforts to crack down on trust abuses. Historically speaking, the tax department has had the court of law on its side, he observed.
"The IRD hasn't lost a case since the Supreme Court was established (in 2004)."
'Time to panic?'
Greg Haddon, a tax partner with Deloitte, said the decision would undoubtedly have small businesses owners panicking.
Haddon said the ruling, while in need of further clarification by IRD, was positive in the sense that it validated the use of corporate structures involving the use of trusts.
"It has clearly stated that some of these corporate structures or trust structures that a lot New Zealand business use is okay in itself.''
Haddon said the take home message for businesses operating under such models was that they needed to be well documented, properly set up with appropriate market salaries paid to directors.
"You have to make sure that when you use these structures you use them appropriately and you don't do something artificial as part of that process to get a tax advantage. For a trade person or a builder using a corporate structure, just make sure you get your administration right, and pay yourself an appropriate market salary.
He didn't believe that the ruling would be an impediment to growing one's businesses because the judges acknowledges there would be some circumstances that might require salaries set lower than market value.
"Justice Elias Blanchard also gave some flexibility. He said there might be circumstances where you don't pay yourself the market salary because you want to build up the business and the business requires net to buy equipment or something like that and for cash flow reasons you might not be able to.''
Haddon said the IRD would need to provide clarity on the finer points of parliament intention, which had a bearing what circumstances would be permissible.
"I think there is now a big onus on the IRD to release their detailed views of how they would go about analysing how the anti-avoidance rule should be applied. It's a very broad provision and it doesn't have specific rule saying you're either here or there. It just takes the position that if it believes there is a case of avoidance, it will apply the rules. So we need to know what and how the department will apply it.''
'Tax experts see plenty of grey areas'
KMPG tax partner John Cantin said how one perceived the Supreme Court ruling would depend on their optics.
"It depends if you are a half full or half empty person. As it's pored over people on both sides of the fence will be quite happy with bits to support either part I expect.''
Cantin said the small businesses could a tougher line of questioning from the IRD that went something like this: "Tell me why commercially you're doing this and if you can justify that then you are over the line.''
From an accountancy point of view, Cantin concurred with Haddon that there remained many grey areas.
"It's not entirely clear where it is going, I'd expect both taxpayers and Inland Revenue to take comfort from it, however to some extent it leaves unanswered questions.''
"Tax is so much a part of what people do, it's hard to extricate.''
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