'Don't panic' over latest tax decision says IRD

The tax affairs of two Christchurch surgeons have prompted fears that many small business owners may fall foul of tax rules. File photo / Dean Purcell

The Inland Revenue Department is moving to dampen fears that thousands of small business owners' tax arrangements could fall foul of tax avoidance rules because of last week's landmark Court of Appeal ruling in the so-called "Penny and Hooper" case.

The case involved Christchurch surgeons Ian Penny and Gary Hooper, who restructured their affairs to pay income tax on far lower salaries than they had previously earned, after the top personal tax rate was raised to 39 per cent in April 2000.

Their families continued to receive substantial additional income, paid as dividends by the companies set up to employ the surgeons, and taxed through a family trust at a lower rate.

Penny and Hooper was the last in a series of tax cases in the past six years that have shifted the way the courts approach tax avoidance.

In essence, these decisions allow judges to "look through" the individual elements of a taxpayer's arrangements to determine whether or not their combined effect amounts to tax avoidance.

In the past, the approach has been to break transactions into their individual parts, with each of those tested separately against general rules preventing tax avoidance. If each step of the arrangements was deemed lawful, the whole arrangement could not be deemed tax avoidance.

However, Justice Tony Randerson was the latest New Zealand judge to dismiss that approach in last week's Court of Appeal majority decision, saying "what might be termed a purely doctrinal approach to taxation advice is thereby left in its 20th century wastepaper basket".

In an interview with BusinessWire, the IRD's group tax counsel, Graham Tubb, said it was important for taxpayers to realise that the avoidance tests created by this growing body of common law was less threatening than many taxpayers feared. A very specific combination of factors was at play in the Penny and Hooper case, he said.

"This is not about whether you've got a company or a trust. It's really about how you use them.

"If you are the person generating the profits in the company and you contrive to direct that income to your benefit and your family's benefit, and pay yourself a less amount as salary than represents your contribution to the profit to the business, and most importantly, it's personal exertion income, that combination of things, people have to be on guard that they might come in for some attention."

The circumstances were most likely to relate to companies employing a single person, whose "personal exertion" was the source of the company's income.

"The whole idea that someone can really earn $700,000 and only pay tax on $100,000 is beyond the pale," said Tubb, "but it will be a question for us of time and resources."

"We won't apply a lot of resource to look at these cases," said Tubb. "There are always a few such cases that we take forward, but not a massive number."

A further important marker would be where there was clear evidence of a rearrangement of affairs.

Tubb says IRD is urgently updating the Tax Alert it issued in April 2008 on these issues, to reflect the outcome in Penny and Hooper, which it does not expect will be appealed to the Supreme Court.

In addition, another part of the department is advancing work on a long-delayed update of a fuller "exposure draft" for public consultation covering interpretation of the general anti-avoidance provisions.

The last such draft was issued in 2004, but consultations were never completed because the department wanted resolutions to the series of landmark cases, of which Penny and Hooper represented the last.