Penny & Hooper Case – Contracting Tax Avoidance
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Wednesday, 7 July, 2010 | Tagged in Running Your Own Business | Written by Crackerjacks
The recent land mark Court of Appeal ruling in the Penny and Hooper case has raised alarms within professional circles and amongst small business owners. The case involved two Christchurch orthopedic surgeons who previously operated their practices as sole traders.
However, around the time when the top personal tax rate was raised to 39%, Mr Penny and Mr Hooper incorporated their businesses. In each case the surgeon was employed by their company and paid a salary of $100,000 and $120,000 respectively, although both companies were deriving profits circa $700,000.
Remarkably, both surgeons admitted during the case hearing that the salaries paid were less than the market rate they would have accepted from a third party. The result was that the top income tax rate of 39% was applied to a minimal amount and most of their profits were taxed at a lower company or trust tax rate of 33% and then distributed to the trusts.
Ultimately both surgeons and their families were receiving substantial additional income without attracting additional income tax liability.
What distinguishes Penny and Hooper’s decision from other tax avoidance cases is that the judges adopted a “look through” approach to the taxpayers’ arrangements to determine whether the combined effect amounted to tax avoidance, where in the past each transaction was tested separately.
Amongst other concerns within the business community, a key concern is whether Inland Revenue’s focus is on professional people only, (such as doctors, dentists, accountants) who structure their professional services through companies and trusts, or whether the Penny and Hooper decision might be applied to any tradesman operating through a company.
In an attempt to clarify the Commissioner’s position the Inland Revenue has released a Revenue Alert. The Revenue Alert states that “where a service business relies mainly on an individual’s personal skills to generate income, than contribution to the business should be properly reflected in the income returned by that individual”.
In his comments on the Revenue Alert Craig Macalister, NZICA’s tax director, noted that in the context of the Revenue Alert “it is hard to distinguish, for example, between a medical practitioner, an electrician, a company director, or anyone that relies mainly on personal skills to generate income”.
However, the Inland Revenue accepts that there are genuine commercial reasons why profits may be kept in a company and “would not expect that remuneration would be paid where there is little or no profit genuinely being generated in economic reality, such as in a start-up phase or in difficult trading conditions”.
The Inland Revenue accepts “that income can be properly retained for major expenditures or provisioning” and their “concerns are not with non-payment of remuneration or with retention of earnings inside an operating business entity, where these are for genuine commercial or economic reasons. In such circumstances, it is unlikely that there would be other distributions of profit from the business to the taxpayer and his or her family”.
From 1 April 2011 the difference between the top personal tax rate and the company tax rate will fall to 5%. However, the 5% tax benefit will be merely a timing difference. When the income is paid as a dividend the difference will need to be paid by the shareholder.
Source: RSM Prince – Chartered Accountants. The information supplied in this article has been researched with care. However, the author and the company accept no responsibility to anyone for any error which may occur in the information provided. Readers are advised to consult their normal source of expert advice before acting on anything.
Contact RSM Prince on Ph: 09-3795324, e-mail: office@rsmprince.co.nz
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