On 25 August 2011 the Supreme Court issued its decision in this landmark case: Penny and Hooper v Commissioner of Inland Revenue  NZSC 95.
The Court unanimously found Christchurch orthopaedic surgeons, Ian Penny and Gary Hooper, who were paid artificially low salaries, via their business structures, were avoiding tax.
Implications & Impact
The decision will have a widespread impact on small businesses which have the same company/trust set up.
The business structures themselves are entirely lawful and not of themselves a tax avoidance mechanism. If, however, they are used to artificially lower salaries (thereby lowering tax rates) for no sound business reason whilst retaining control and full income benefits, this will amount to tax avoidance. The decision reflects the Court’s broad application of the parliamentary contemplation test behind the anti-avoidance legislation.
The taxpayers, (Penny and Hooper), independently of the other each other owned substantial revenue generating practices. They each set up a business structure comprising a company (with their respective wives and family trust as shareholders) and the practices were sold to the company at a time when the maximum personal tax rate was increased from 33 cents in the dollar to 39 cents in the dollar. The practices continued on as in the past except the taxpayers became employees of the companies and they were paid artificially low salaries (salaries significantly lower than they were earning prior to their restructuring). The balance of the annual net income was distributed to the family trusts as a dividend and taxed at the 33 cent rate for trustee income.
How the Court saw it
Unlike the other leading case on tax avoidance, Ben Nevis there was no question of the taxpayers failing to comply with specific tax provisions. The taxpayers were entitled to set up their business structures as they did and the Court accepted there were other reasons for the setting up of these structures such as the protection of assets from professional claims. However, it was the Court’s view that the policy underlying the general anti-avoidance provision in the Income Tax Act is to negate any structuring of a taxpayer’s affairs whether or not done as a matter of ordinary business or family dealings unless any tax advantage is just an incidental feature. On an objective basis it was held that the fixing of the salaries at low levels was the predominant purpose of the arrangements. While this can be for acceptable reasons such as financial difficulties that was not the situation in this case, the artificially low salaries reduced the taxpayer’s earnings but at the same time enabled the company’s earnings (derived only because of the setting of the salary levels) to be made available to him through the family trusts. The taxpayers in reality suffered no financial loss of income but retained a reduction in liability to tax.
The Supreme Court decision can be viewed in Brookers Tax Service online where you can also read our collection of online media releases discussing the significance and impact of the decision.