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Supreme Court Decision in Penny & Hooper
On 24 August 2011 the Supreme Court delivered its decision in the case of Penny & Hooper v C of IR (2011). The Supreme Court upheld the Court of Appeal decision which found in favour of the Commissioner of Inland Revenue (IRD). This decision may now have a significant impact on the arrangements of entities where an individual taxpayer is earning revenue from delivering personal services.
The Facts in Penny & Hooper:
Penny & Hooper are orthopedic surgeons in Christchurch. Originally the surgeons traded as individuals and the net revenue generated each year through their businesses was taxed in their own names.
The surgeon’s eventually sold their practices to a company structure in which they became employees of the companies. They were each the sole Director of these companies and the entire shareholding was held by their respective family trusts.
When the Government increased the top marginal tax rates from 33% to 39% in 2000, the salaries that were paid to the surgeons were set at a significantly lower level than they had been earning when the practice was in their own names. The balance of the companies profit was paid out as dividends to the family trusts.
IRD argued that the arrangements constituted tax avoidance on the basis that the fixing of the salaries at the artificially low levels resulted in the avoidance of tax. The ensuing litigation eventually rested with the Supreme Court decision in August 2011.
The Supreme Court Decision:
The Supreme Court decision found in favour of the IRD argument that the setting of the low salary each year was the part of the arrangement that was deemed to be tax avoidance. This was due to the taxpayers suffering no actual loss of income, but obtaining a reduction in tax liability as if they had.
The Court also confirmed that it had no issue with the business structures adopted by the surgeons and that the structures (companies owned by trusts) were “entirely lawful and unremarkable” and there was nothing “unusual or artificial” in the taxpayers being employed by the companies under their control.
The IRD Response:
IRD have responded to the Supreme Court decision with a Revenue Alert publication outlining their position. IRD have stated that they will look at all aspects of an arrangement including the documentation and the behavior of the persons involved.
Specifically they will examine:
- The reality of the structure and how it operates commercially,
- How the profits of the business have been distributed – including whether the individual and their family continue to receive the benefit of all profit distributions
- Whether the remuneration received by the individual service provider appropriately reflects the individual’s contribution to the business profit
- Whether there are particular non tax reasons justifying a departure from that standard
How will this affect you:
While the IRD have highlighted the areas of interest, this does create some uncertainty for businesses that operate in a similar structure. Particularly those structures which have the following features:
- The business is highly dependent on the physical exertion of personal services by the business owner.
- The business has changed to a corporate structure.
- A lack of documentation to support commercial arguments for setting of salaries.
- A situation where the business owner still has access to the residual business profits after their salary has been allocated.
If you would like to know more about this topic please contact your advisor.