Crackerjacks

Topics

• Add new tag
• Business
• Contractors
• facebook
• Getting the Role
• Lifestyle
• linked in
• Marketing
• Media
• Rates
• Running Your Own Business
• social networking
• Using Crackerjacks

The recent Court of Appeal ruling in the Penny and Hooper case last month has provided a useful lesson for contractors in NZ.

Inland Revenue has also provided some guidance on how they intend to apply this case in the Revenue Alert “Diverting personal services income by structuring revenue earning activities through an associated entity such as a trading trust or a company: the circumstances when Inland Revnue will consider this arrangement is tax avoidance”.

The Penny and Hooper case involved surgeons Ian Penny and Gary Hooper who each set up companies to buy their individual practice, they employed themselves in the 2002, 2003 and 2004 tax years at salaries the Inland Revenue Department considered were artificially low.  The IRD took the view that structuring their affairs so their practices were operated through companies and they were paid an artificially low salary amounted to tax avoidance.

The IRD said they took advantage of the lower company tax rate of 33c in the dollar when they should have been taxed at the higher marginal tax rate of 39c on their personal revenue.  Court of Appeal said it was tax avoidance in favour of Inland Revenue.
We would like to summarise the key points we have taken from this case and Inland Revenue’s Alert:

Pay yourself market rate

If you contract as a sole trader through a company or trust and rely on your personal skills to generate an income, you should pay yourself a market rate salary from the revenue earned.

In the Penny & Hooper case both surgeons were paying themselves salaries that were below market rate – respectively $100,000 and $120,000.  During the case they admitted these salaries were lower than what they would have accepted from a third party.  Their profits were circa $700,000, and the majority of the revenue was being taxed at a lower company rate (33%) as opposed to the top income tax level (39%) which they should have been adhering to.

Be aware of IRD’s “Look-through” approach

One of the key lessons illustrated from this case is that Inland Revenue will now review each case where a taxpayer’s arrangement substantively diverts some or all of the income earned from personal services to an associated entity which takes advantage of lower marginal income tax rates by that entity and/or by family members as beneficiaries or shareholders of the entity.  Inland Revenue however has said that they ‘will generally focus on the most serious and artificial cases – recognising that many ordinary small businesses reasonably make use of different entities to carry on their business.”

Inland Revenue do accept 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”.  So depending on the stage a limited company is at (start-up, retrenchment or in a growth phase), their view on tax avoidance will vary.

Inland Revenue has provided a list of guiding factors where a person earns income from personal contribution and supply services to customers which they will examine:

• An entity (such as a company or trading trust) operates the business. This entity engages or employs the person or contracts their services for no remuneration or artificially low remuneration which does not reflect what a reasonable person would expect to earn from that activity.
• Where the business is transferred – did the business operate substantially as it did before it was transferred to the entity?
• Whether the arrangement is commercial in comparison with relevant standard business practices by examining the agreements the business operates under, the manner actually implemented and whether the arrangement is commercial.
• The degree the person or family ultimately controls the entity and cash flows from the business.
• Whether there is a redistribution of the income from the entity to the person or family by employing family members, loans, service fees etc.
• The significance of non tax reasons for structuring the business compared to personal attributes of the taxpayer.
• The extent of significant tax benefits obtained because of the arrangement than would have been payable by the taxpayer.

So if you operate as a contractor through a company or trust then the level of remuneration you pay yourself should reflect your contribution to the profits of the entity but you can take account of the business environment, plans, risks, genuine economic reasons for keeping profits in the entity and how much income is actually generated.

The future …

The Penny and Hooper case is being appealed to the Supreme Court, our highest NZ court so we will have to wait and see if they agree or overturn the Court of Appeal decision.

In the meantime, if you would like professional advice on this matter – please contact your tax advisor or feel free to email us on information@crackerjacks.co.nz and we can assist.