Income tax case puts spotlight on professionals

A Court of Appeal decision could open the floodgates for the Inland Revenue Department to prosecute professionals hiding behind company structures to avoid high personal income tax rates.

Polson Higgs tax partner Michael Turner called it the "most authoritative" decision regarding the use of structures that allowed professionals to be taxed at the lower company or trust rate instead of the top personal tax rate.

The case involved Ian David Penny and Gary John Hooper, two orthopaedic surgeons practising in Christchurch, who set up companies to buy their practices in 1997 and 2000 respectively.

In both cases, as a result of salaries from their newly formed companies being lower than their previous self-employed earnings, tax savings were achieved, Turner said. Penny saved $37,000, $34,000 and $31,000 of tax in three consecutive years while Hooper saved $21,000, $24,000 and $20,000 in three consecutive years.

"One of them dropped his salary down from $500,000 in one year to $100,000 in the next. That failed the sniff test immediately," Turner said.

Penny and Hooper won in the High Court but the Court of Appeal, by a two to one majority, concluded that the adoption of the company structure and the non-payment of market salaries, without legitimate reason, amounted to tax avoidance.

"This issue has been uncertain since the Labour-led government introduced a 39 per cent personal tax rate in 2000. We have had 10 years of not knowing what the boundaries have been," Turner said.

At the time the companies were formed, the top tax rate was 39 per cent and the company and trust rates were 33 per cent.

Deloitte tax partner Bruce Wallace said it was common for professionals to use company structures to avoid high income tax.

He said many small business owners had been relying on the views of their accountants and advisers, who considered such structures to be within the law.

A few doctors and dentists would be worried about the Court of Appeal's decision. "The key message is - make sure all your arrangements are commercial and can't be considered artificial or contrived."

Turner said one of the issues that was left unresolved was the definition of a "market rate".

"If you don't pay yourself a market rate, then the IRD has deemed that to be tax avoidance.

"It is a critical decision as it will impact on SME businesses using company structures."

While the decision was aimed at people selling services, it was unclear if it would affect businesses selling goods, he said.

The IRD increased its activity on tax avoidance by focusing on dentists in 2002. More recently, the department had been looking at doctors.

The department was targeting professionals on the basis that often, those people operated as sole traders and it was easy for them to form a company and change the tax rate they paid.

It was easy for the IRD to argue the income belonged to an individual working for that company, Turner said.

The IRD had put a lot of cases on hold when it lost the High Court decision. It was likely to reactivate those cases although it was uncertain if the case would be appealed to the Supreme Court.

Finance Minister Bill English had moved in his May Budget to redress some of the inequity in the tax system by moving the top tax rate down from 38 per cent to 33 per cent with the company rate going down to 28 per cent. That would make it harder to create tax avoidance structures, Turner said.

However, the IRD worked "with the benefit of hindsight" and would look back over the past five years or so for issues similar to the Penny and Hooper cases.

The changes brought in in the Budget would not make any difference to those investigations, Turner said.

- OTAGO DAILY TIMES, ADDITIONAL REPORTING: CHRISTOPHER ADAMS