Supreme Court decision creates 'new playing field' for tax avoidance

PricewaterhouseCoopers chairman and tax expert John Shewan. Photo / Supplied

Today's landmark Supreme Court ruling on tax avoidance by two Christchurch surgeons shows there is a "new playing field with regard to the application of tax avoidance rules in New Zealand," says the chairman of PricewaterhouseCoopers in New Zealand, John Shewan.

"The key is for people to understand this and to respect the fact that the Courts have made it very clear that the avoidance provisions will be applied more literally than previously," said Shewan, one of the country's most respected tax advisers, whose expert evidence in the case was criticised by both the Court of Appeal and Supreme Court.

Shewan advised small business owners to review their salary arrangements to ensure they couldn't be caught for tax avoidance, as the Supreme Court has ruled that company and trust structures cannot be used to artificially reduce taxable income from "personal exertion" - a catch-all definition for the work that professionals and small businesspeople do.

"There are thousands of small businesses that operate through companies and which pay salaries or wages to their owner operators," said Shewan. The judgement found that where the amount paid is artificially low "that may well constitute tax avoidance.

Shewan's expert evidence in the case was set aside by both the Court of Appeal and Supreme Court because it strayed too far into commentary on the legal issues in the case, and earned counsel for the two Christchurch surgeons, Ian Penny and Gary Hooper, a rebuke from the Supreme Court.

The decision was the latest in a string of court victories for the Inland Revenue Department, which are significantly recasting the legal and accounting professions' understanding of what constitutes tax avoidance.

Penny and Hooper were found to have paid themselves artificially low salaries to reduce their tax bills after the top personal tax rate rose to 39 per cent in April 2000.

"Small and medium-sized enterprises do not need to panic over the decision, but they will want to review their circumstances to ensure they are on the right side of the line," said Shewan. "The decision is helpful in pointing to some cases where avoidance would not be involved, such as the need to retain funds to make capital expenditure or where the company is experiencing financial difficulties or it would be imprudent to pay a market salary.

"As a practical matter it will be necessary for Inland Revenue to issue further guidance along these lines because it is in everyone's interests for there to be reasonable certainty as to where the boundaries lie," he said.

The decision also reinforced the importance of documenting the reasons behind business decisions. The courts rejected the surgeons' argument that they restructured their affairs to avoid the impact that professional negligence claims could have on themselves and their families, and that lower tax bills were a by-product of those arrangements.

"Taxpayers need to be able to demonstrate why they did what they did," said Shewan. "The second step is that if what they did reduces their tax they need to be able to satisfy themselves and Inland Revenue that it is an advantage that Parliament would have contemplated.

"We have some concerns over how the Parliamentary contemplation test will be applied in practice. What Parliament intends is sometimes hard to fathom" said Shewan.