Supreme Court backs taxman in landmark avoidance case

The Supreme Court building in Wellington. The court has backed Inland Revenue in the way it treated two Christchurch surgeons who used family trusts to artificially lower their salaries. Photo / Mark Mitchell

The Supreme Court has sided with the tax department in its judgment on a landmark tax avoidance case involving two Christchurch surgeons who used company structures and family trusts to artificially lower their salaries to avoid the top personal income tax rate

The unanimous decision of the bench of five Supreme Court judges, led by Chief Justice Sian Elias, agreed with the Court of Appeal that "income derived from personal exertion should belong in its appropriate taxation band and should not be inappropriately diverted away."

The country's highest court also admonished the way evidence was presented in the surgeons' favour by PricewaterhouseCoopers New Zealand chairman, John Shewan, and dismissed suggestions the decision can be seen as "revolutionary", given similar decisions 50 years ago in the Australian High Court and Privy Council.

The case is being closely watched by tax lawyers and accountants because of fears it strikes at the commonplace and legitimate use by individuals of companies and trusts to organise their commercial affairs.

However, the Supreme Court is clear it has no objection to such arrangements, describing them as "entirely lawful and unremarkable", and that the Income Tax Act does not stipulate the setting of commercially realistic salaries, even though both surgeons had acknowledged at trial that their post-2000 salaries were below market value.

The finding of tax avoidance turned on the "single step" taken by both taxpayers to place themselves on "each side of the employment contract relationship (as controlling director of the employer and as employee) in setting an artificially low level of salary which had the effect of altering the incidence of taxation."

"If the sitting of the annual salary is influenced in more than an incidental way by a consideration of the impact of taxation, the use of the structure in that way will be tax avoidance," the judges said.

The case saw the two Christchurch orthopaedic surgeons, Ian Penny and Gary Hooper, declaring annual incomes of between $655,000 and $832,000 in the years prior to the April 2000 increase in the top personal tax rate to 39 cents in the dollar.

After that date, they declared personal incomes of between $100,000 and $120,000, while funnelling income previously declared as personal through companies they established to employ them, and distributing that income to their families through family trusts.

Total tax avoided between 2001 and 2004 amounted to no more than $90,000 each, but the principles around the common use of such structures saw the issue fought all the way to the country's highest court.

The Supreme Court rejected arguments, accepted in the High Court trial, that the surgeons had restructured their affairs partly to shelter their assets from potential professional negligence claims against them.

"It cannot have been the sole or a dominant purpose because of the protection already in place through the combination of the accident compensation scheme and insurance cover," the Supreme Court found. "This is demonstrated by Mr Penny's preparedness to borrow money back (indeed it never actually left his hands) regardless of the supposed risk to him of claims by patients.

"The taxation advantage produced by the fixing of the salaries at low levels can fairly be seen as the predominant purpose.

"If all this is now thought to be revolutionary by tax planners...our response is that nearly 50 years ago, in a similar case involving incorporation and the use of family trusts by medical practitioners, neither the High Court of Australia nor the Privy Council had any hesitation in finding that there was tax avoidance" - the so-called "Peate" case.

In an unusual twist, the court acknowledged that little had been made of "Peate" in the hearings, and that the judges had only been drawn to it by a note on the Court of Appeal decision by an Auckland University tax academic, Michael Littlewood.

The court was critical of John Shewan's expert witness evidence, which included views on the legal issues in the case, leading to both the Appeal and Supreme Courts setting his evidence "to one side".

"It is undesirable and wasteful of time and effort of both parties when such material appears in expert briefs of evidence," the Supreme Court judgment says. "The practice of including it should stop. If it persists, courts should require amended briefs to be filed."

Shewan also copped flak for his role in advising Westpac on acceptable levels of declared income for tax purposes in another of the recent string of wins for the tax department, which lead to a record $2.2 billion out of court settlement of tax avoidance claims against several foreign-owned banks in 2009.