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.

So we’ve got a handy formula for you to work from when undertaking  this task.  This is an extract from the Crackerjacks How to Guide for Contracting. Follow this link to find out how:

Crackerjacks Permanent to Contract Rates

If you would like to know more information about this report, please contact us on info@crackerjacks.co.nz

In three weeks we will be releasing the National Professional Contracting Rates Guide, so it is very important your rates on Crackerjacks are current.  This information is used to help create the guide, simply log in, select the Your Profile tab and Rates, to ensure that your rates reflect your current expectations.

This information is also important so you can be considered for suitable jobs. When a business searches for contractors, your rates are one of the key factors used to determine whether you’re a good match for the job.  We encourage you to log in and check what you’ve listed.  Is it up to date?

Click here for the full article on Computerworld

IT contractors are more optimistic about future pay rates than their counterparts in many other professions, according to a survey by specialist contract staffing provider Crackerjacks.

The survey, carried out in September, looked at contractors in a range of occupations, including IT. A total of 1053 IT contractors replied to the survey.

The result was that on average, IT contractors had an expected hourly pay rate of $66, up 4.8 percent from the previous survey, in March.

Of the 21 occupations surveyed only half registered an increase in pay expectations, and while IT didn’t register the highest increase – that went to retail and scientific, which both reported a 20 percent rise in expectations – the result is good news for the industry, says Crackerjacks managing director Tony Wai.

“It has been a hard year and the outlook for 2010 is better,” Wai says.

The increased pay expectations are a sign of increased demand for IT contractors, which is being driven by increasing project work, particularly in the private sector, he says.

“While there are some central and local government projects, there has been more of a push from the private sector.”

Different areas within IT are seeing more demand than others, he says, with specialist programming skills such as Ruby developers in demand, and business analysts are also sought-after.

On the other hand, “some of the more general skills, such as network administration and technical support, haven’t lifted as much.”

Wai says the upturn in contractors’ pay expectations may be a precursor to an upturn in the permanent IT recruitment scene.

“What we’re finding is that contract rates tend to be a lead indicator regarding permanent roles.

“In some professions, it is the other way around, but with IT, it is a lead indicator, because IT is a contractor-dominated market”.

While the past 12 months have been tough for contractors, many have remained employed by moving around the country or going overseas.

“Contractors have been fairly mobile and there has still been strong demand for good contractors.”

Comments from IT contractors who responded to Crackerjacks’ survey include:

“Rates have come down across the IT industry over the past year. It is an employers’ market; there are not enough contracts for all of the IT professionals seeking work.

“Businesses are also looking to pay less while still expecting a high level of skill when hiring.

“I am hoping that things will pick up in the New Year. It appears businesses are holding off to kick-off projects until 2010. Naturally, when this occurs, there will be a larger supply of contracts available in the IT industry.

“Particularly focusing on the banking industry, a number of IT projects are being shifted offshore to Australia.

“I have concerns that these projects may not return when things start to pick up again in New Zealand.”

Another respondent notes: “I personally entered the contracting market because of a redundancy; as a result, I have a view on both the contracting and permanent employoment markets.

“In my opinion, over the past two years there has been a 25% (approx) cut in remuneration across the board for permanent and contract jobs.

“It is my expectation that things will start to strengthen over the next six months and we are already starting to see glimmers of this happening.

“The permanent market has not turned yet – salaried jobs are still difficult to source and the remuneration offered for these roles is not what it should be, because it has not kept up with inflation.

“The contracting market is more responsive to change and is starting to strengthen.

“Looking at the IT industry in Auckland, I believe there will be surges of opportunities for individuals who possess specific skill-sets, but professionals who are more ‘generalised’ will still find it difficult to find work.

“Clients can afford to be specific about the person they hire, so naturally they will gravitate towards professionals with niche skills.”

As reported on NZI Business recently, wage expectations for Accounting and IT contractors have increased between 4% to 6% since March this year.  But this optimism was not experienced in the Sales, Marketing or Management professions, with wage expectations actually decreasing in these areas.

View video – Wage expectations

For more information on the Crackerjacks professional contracting Survey that revealed these varying wage expectations  – contact us on question@crackerjacks.co.nz quoting “Professional Contracting Rate Guide”.

One of the great things about contracting through Crackerjacks is that you get to determine what you’ll work for. In other words – you get to set your own rate. While this will depend largely on market rates, and on the particular skills that you bring to a contract, it’s important to have a good knowledge of the industry, the value of the services you’re offering and an understanding of how employment costs are calculated.

Factors To Consider

Contractors and permanent employees differ in their rights and benefits. Permanent employees have access to a range of benefits which impact their actual available hours: annual leave, sick leave, paid public holidays, long-service leave, superannuation, jury leave, compassionate leave, family leave, professional development, and retrenchment/redundancy provisions. As a contractor you may not have access to these benefits, so you might want to factor these into your hourly fee.

So how do you do this? You can start by working out how many hours a year you’d be looking at working if you were a permanent employee, and then deducting hours to account for whatever benefits are relevant to you. These might include leave, superannuation, insurance and other regular benefits of employment. At minimum you should be factoring in some annual leave.

Additionally, if it’s a short term contract that you’re completing, it’s a good idea to factor in potential downtime and overheads that may occur while you’re searching for new work. Allowing a factor of 10-20% for this is about how much you should be looking at. Remember, though, as a Crackerjack you can be in the market for new contracts even while you’re working – just make sure that your calendar reflects your availability and let the contracts find you.

Let’s Take You Through An Example

Based on a 40 hour week, the number of hours you would work per year is 40 hours x 52 weeks = 2,080 hours per year. This is the number you start with. The next step is to factor in the benefits you’re missing out on as a contractor.

So if you wanted to account for all of these factors in your rate, your hourly fee would be based on 2,080 hours per year – 558 hours of benefits = 1,522 hours.

If the contract was a short term one and you wanted to factor in downtime of, say, 15% you’d take this into account by dividing the number of hours per year you’re factoring into your rate by 1 plus your downtime factor. I.e. your rate would be based on 1,522 hours / (1 + 0.15) = 1,323 hours.

So then to work out an hourly rate, you take your target salary and divide it by the total number of hours of benefits and work in a year.

Say your target salary (before tax) was $50,000 a year.

For a full-time permanent employee, the hourly rate is $50,000 / 2,080 hours = $24.04.

For a long-term contract, the hourly rate is $50,000 / 1,522 hours = $32.86.

For a short-term contract, the hourly rate is $50,000 / 1,323 hours = $37.79.

Based on all these factors, for a long-term contract your hourly rate is about 137% of a permanent employees’ and 157% of a permanent employees’ rate for a short-term contract.

A Few Key Points

Remember, we’re not here to tell you how much you can or should charge. Not all of these benefits may be relevant to you, we may have missed out some that are, you may be able to factor in a premium for your skills, plus you can’t forget to look at the market and what other people in your field are charging.

Sound confusing? Working out your rate can be one of the toughest things as a contractor. It’s a never ending process too; whichever way you choose to calculate your rate, you should review it on a regular basis. You may choose to increase or decrease your rate based on how attractive the role on offer is, the length of the role or how much your skills have increased over time. On another note, if you’re a top-rated Crackerjack and constantly receiving excellent performance reviews, you may find that you can charge more of a premium.

Happy contracting.