Brian Fallow: Tax avoidance case has professionals reeling

Will the Penny and Hooper judgment be used for low-hanging fruit, or to strip the tree? Photo / Hawke's Bay Today

Cock your ears and listen closely and you may hear the sound of mass gulping as people, especially in the professions, contemplate the Court of Appeal's recent decision in a tax avoidance case.

How valid that concern is will not be clear until the Inland Revenue Department issues its view of how widely it is reading the court's (majority) decision. It is expected in a couple of weeks.

The case concerns two orthopaedic surgeons, Ian David Penny and Gary John Hooper.

In 1997 and 2000 respectively they restructured their practices so that instead of operating (so to speak) as sole traders, each became the employee of a company owned by a family trust.

In the years in dispute they drew salaries which were a fraction of what they would have commanded on an arms-length basis. When the top tax rate of 39 per cent was introduced in 2000 these structures allowed them to pay tax on the bulk of their income at a maximum rate of 33 per cent.

Justice Grant Hammond concluded this was incontrovertibly a case of tax avoidance:

"Income derived from personal exertion should belong in its appropriate taxation band - here the highest band - in a graduated personal tax scheme. It should not be inappropriately diverted away.

"These doctors were in the top personal tax rate as a result of their personal skill and exertion. When Parliament increased the top rate to 39 per cent the doctors deliberately took themselves out of that category by interposing a company/trust structure.

"Very significantly, they retained control over the whole of the income generated (notwithstanding the company/trust structure). They then applied the income so earned for the benefit of themselves and their families.

"Their salaries were fixed at artificially low levels which did not on any view of the matter conform with anything approaching commercial reality."

They were not alone. The Buckle tax working group pointed to clear evidence of widespread restructuring in the wake of the introduction of the 39 per cent rate, including a sudden spike in the number of taxpayers earning just under $60,000 a year (the initial threshold for the top rate) and a sudden but sustained rise in the amount of income accumulating in trusts.

This was an entirely predictable, and indeed predicted, response to the incentives created by the tax change.

Yet the Court of Appeal's decision rests on a judgment that an outcome like that in the surgeons' case is tax avoidance because it falls outside what Parliament could have contemplated when it passed the legislation.

That "parliamentary contemplation test" flows from the Supreme Court's ruling in the Ben Nevis case: "If ... it is apparent that the taxpayer has used the specific provision, and thereby altered the incidence of income tax, in a way that cannot have been within the contemplation and purpose of Parliament when it enacted the provision, the arrangement will be a tax avoidance arrangement."

Tax practitioners use words like "bizarre" and "scary" to describe this test. Are they supposed to advise their clients on the basis of a thought experiment - hypothetically reconvening Parliament and imagining what lawmakers would have wanted had they contemplated a specific case?

The risk is a line of reasoning that starts with "This outcome is just wrong", goes to "so it can't be what Parliament intended" and concludes "so it is tax avoidance".

In the Penny and Hooper case, the majority judgment seems to be that Parliament could not have anticipated all the ingenious ways taxpayers would find to avoid the 39 per cent rate. So even though the legislation had specific fixes in some areas, the IRD was entitled to rely on general anti-avoidance provisions to deal with the rest.

But the dissenting view from Justice Ellen France is that "what the taxpayer has done here did not require any particular ingenuity such that Parliament could not have contemplated the use of company structures in this way".

That the court split on this question suggests the parliamentary contemplation test is at least a difficult one to apply.

Hardly less problematic is the concept of what a commercially realistic salary would be.

It is apparently a novel concept in tax law and the court offers no guidance on how it might be arrived at. The approach seems to have been: we know it when we see it and we don't see it here.

Justice Tony Randerson acknowledges the uncertainty the judgment creates for the IRD, taxpayers and their advisers, including when and to what extent it will be necessary to review the salary levels of employees of family companies.

The decision, he said, should not be regarded as establishing a principle that salary levels in family companies that are below levels which could be expected in an arms-length situation are necessarily to be regarded, without something more, as evidence of a tax avoidance arrangement.

Among the exceptions might be companies in a development stage which need to build up capital, companies needing to buy a substantial asset or companies which have had a bad year and can't afford to pay a proper salary.

There is also an issue of justice delayed. It is 10 years since the tax rate changes which gave rise to these issues occurred.

If it is unreasonable to expect tax legislation to anticipate and close every loophole, it is also unreasonable for the IRD to stand aside, arms folded, and wait for judicial landmines to start exploding years later.

There was a need for guidance from the department about how it would interpret and respond to such obvious stratagems as were adopted in the Penny and Hooper case and the many like it. Accountants sought it. It was not forthcoming. It is woefully late now.

A potentially sinister twist to this is the provision in the Budget of an additional $120 million in funding over the next four years for audit and compliance activity.

This is earmarked for scrutiny of property transactions, the black economy and debt collection.

The expectation is that every dollar spent on this will come back as $6 of revenue. It is one of the things the Government is counting on to come within hailing distance of fiscal neutrality for its tax package.

But it may turn out that pursuing errant taxpayers in the property development sector in particular will leave the taxman standing forlornly before bare cupboards.

In that eventuality, would the Government be philosophical about the fiscal disappointment?

Or would it use the Penny and Hooper judgment not only for the egregious low-hanging fruit, but as a cherry-picker to strip the entire tree?