Mark Keating: Court ruling creates taxpayer uncertainty

The decision in Penny and Hooper v CIR in favour of IRD had been widely expected. Photo / APN

The use for tax purposes of company and trust structures by professionals has been thrown into doubt by the unanimous decision of the Supreme Court that it may constitute tax avoidance.

The decision in Penny and Hooper v CIR in favour of IRD had been widely expected. But its effect on taxpayers generally, coupled with IRD's refusal to explain how widely that decision may be applied, will cause concern for both taxpayers and their advisers.

Professionals and tradespeople operating their businesses through companies and trusts (taxed at 33 per cent) rather than have that income taxed to them personally (at 39 per cent) is extremely common and was widely viewed in the tax community as legitimate tax planning.

And the ordinary nature of that structure explains why this decision has caused such concern.

The difficulty in this case was that the payment to each taxpayer of a reduced salary of only $100,000 a year, rather than their former income of more than $500,000, was not an arm's- length salary. The taxpayers themselves conceded they would not have worked for that salary for any other employer.

The court found the taxpayers agreed to the below-market salary because they continue to enjoy the economic benefits of the additional profit from their professional services in their capacity as beneficiaries of their trusts. So the only consequence of adopting the structure was the tax reductions.

Importantly, the Supreme Court did not overturn taxpayers' traditional right to trade through a company or trust structure. The court found these structures were "entirely lawful and unremarkable" and that "adoption of such a familiar trading structure cannot per se be said to involve tax avoidance".

Rather it was the way the taxpayers used that structure in this case that constituted tax avoidance, particularly their drastic reduction in salary.

For other taxpayers who utilise similar structures, the court accepted that non-market salaries can be paid by family companies or trusts in some instances, including:

* Where the business is in the start-up phase

* Where it needed to apply profits to the purchase of capital assets

* Where there are insufficient profits to pay a market salary.

Where those circumstances genuinely exist, the payment of a low or nil salary would not constitute tax avoidance. However, the court found none of those situations applied in this case and the taxpayers' decision to pay themselves artificially low salaries was made almost entirely for tax reasons.

The IRD has repeatedly refused to provide guidance over what level of salary will be acceptable. That uncertainty leaves taxpayers who are employed by their family company or trust with no way of knowing if they also may have crossed the line from legitimate tax planning into tax avoidance. Many taxpayers will be left wondering how they know when they have crossed an invisible line.

Mark Keating is a senior lecturer in tax law at the University of Auckland Business School.