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Sole practitioners beware: operating through a company under your control and drawing an artificially low salary could constitute tax avoidance.
The recent Supreme Court decision in Penny and Hooper v Commissioner of Inland Revenue [2011] NZSC 95 (24 August 2011) noted that there is nothing improper in adopting a corporate and family trust structure; but cautioned that if such a structure is adopted for a more than merely incidental purpose of tax avoidance, it will contravene the Income Tax Act 1994.
In this case, two surgeons each restructured their practices by forming a company under their sole directorship. The shares in each company were held by the family trusts of each surgeon. The surgeons paid themselves artificially low salaries that were commercially unrealistic at less than 20% of their pre-restructuring salary level. The surplus profits earned by the companies benefitted the family trusts by way of dividends. The Court considered that the timing of the restructuring at a time when the personal tax rate was increased from 33 to 39 cents in the dollar was no coincidence. Consequently, the Court found that the income arrangements made by the surgeons constituted tax avoidance such that the Inland Revenue was entitled to treat the arrangements as void for income tax purposes.
This decision makes it clear that income arrangements that benefit taxpayers and their families by artificially reducing their tax liability through commercially unrealistic salaries will not be acceptable. However, whilst it is clear that an artificial salary of less than 20% of the taxpayer’s previous earnings will not be acceptable, it is not clear what an acceptable level of remuneration would be.
Therefore, it is important that a company or family trust structure is implemented properly. The Supreme Court decision provides some guidance to taxpayers in terms of how to properly structure their income arrangements in order to comply with the Act.
If you have any concerns about your income structure, we suggest you seek professional advice and invite you to contact either Brian Burke or the writer, Kiri Hill-Dunne, on 352 2293.
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