This article was originally created for Hayes Knight (now Nexia Auckland).
Home > Updates > IRD shines light on Penny and Hooper
For many years the Inland Revenue has been asked to publish its policy on shareholder salaries. This has never happened. It would therefore clearly be unfair and unjust if the Inland Revenue was to take a hard line (retrospectively) across the board, in respect to shareholder salaries. We would hope that common sense will prevail.
It is evident further guidance will be required from the Inland Revenue going forward.
The Facts of the Penny and Hooper case
Mr Penny and Mr Hooper were practicing as orthopaedic surgeons on their own account. Later, each set up a company to purchase their orthopaedic practice. The companies were owned substantially by their respective family trusts. Mr Penny and Mr Hooper were then employed by the respective companies. The companies paid the surgeons salaries much lower than they had received when they were working on their own account.
The tax advantage from this structure was that a portion of the income derived from the surgeons services was subject to a company tax rate of 33%, rather than the top individual tax rate of 39% (applicable at the time) if the surgeons had continued to operate as sole traders.
The Commissioner argued that operating through a company/trust structure and receiving a salary that was significantly less that a commercially realistic salary amounted to tax avoidance.
The High Court found for the taxpayer and held that the arrangement did not amount to tax avoidance. However, the Court of Appeal (by a two to one majority) found for the Commissioner and held that the arrangement amounted to tax avoidance.
The Court of Appeal reasoned that the arrangement as a whole was artificial and contrived. The company/family trust structure allowed the surgeons to obtain the advantage of the lower company tax rate while still receiving the full benefit of the income themselves. The Court found that the salaries paid to the surgeons were not commercially realistic and contributed to the arrangement being artificial and contrived.
However, the Court stressed that the use of a company/trust structure and a failure to pay a market salary does not in itself constitute tax avoidance. There could be legitimate reasons for paying a below-market salary. The Court stated that it is a matter of assessing all the circumstances including the extent of any element of artificiality or contrivance to determine whether an arrangement amounts to tax avoidance.
IRD’s Revenue Alert
The IRD has stated that:
Furthermore, the IRD have expressly stated that they will generally focus on the most serious and artificial cases.
A copy of the Revenue Alert can be found here: http://www.ird.govt.nz/technical-tax/revenue-alerts/revenue-alert-ra1001.html
If you would like to further discuss the potential impact this case has on your business structure, please contact Phil Barlow or Shelley-ann Brinkley.