Alan Scott: A silly time to get too clever with your tax strategy

In New Zealand, the gap between the top personal tax rate (38 per cent) and the lower/middle personal tax rates - as well as the company rate of 30 per cent and the trust rate of 33 per cent - continues to make structuring and income-splitting extremely sensitive for owners and advisers of family businesses, and small to medium-sized enterprises (SMEs).

That's especially so given the state of tax avoidance law in New Zealand.

A good example of the state of that law is two recent High Court tax avoidance cases - the decision in Penny v Commissioner of Inland Revenue, and Hooper v Commissioner of Inland Revenue. Both cases were won by the taxpayer.

The cases deal with the blurred issue of whether a professional can restructure his or her sole trader business into a corporate form, without crossing the tax avoidance line, when one of the outcomes of doing so results in undistributed income being subject to tax at the corporate rate - rather than at the top personal tax rate.

Penny & Hooper provides authority for the proposition that using a corporate structure is a legitimate vehicle - even if changing from a different structure.

However, don't be fooled. The Commissioner is appealing this decision and has stated in the May 2009 Tax Information Bulletin that he "does not consider the decision correctly reflects the law on tax avoidance". Rather, the Commissioner considers that "the use of company and trust structures to avoid higher personal tax rates can be tax avoidance".

So what structure should an aspiring business owner adopt?

Sole trader

Because of risk, there will seldom be a good reason for a person to commence a business as a sole trader.

Company

For most family-owned and managed business, or SMEs, a company will be the first structuring option that comes to mind as it provides limited liability, is easily understood by most people and is a common vehicle for operating a business.

From a tax perspective, earning income through a company has advantages as profits are taxed at the company rate of 30 per cent, compared to the top personal tax rate of 38 per cent.

While profits may eventually be taxed at the shareholder's marginal tax rate (but capped at the top personal rate, or at the trustee rate of 33 per cent), benefits can be obtained from tax deferral if profits are retained in the company before being paid out as dividends.

However, take care to ensure that using a company will not create an extra layer of tax. The imputation credit regime ensures that income earned through a company bears a single layer of tax, but an imputation credit is only available for New Zealand tax paid.

There are a number of scenarios where using a company will create an unnecessary layer of tax.

It is worth considering the qualifying company regime, which is an elective regime for companies.

One advantage is the ability to pay dividends out of revalued asset reserves and/or capital reserves and, to the extent that there are insufficient imputation credits at the end of the imputation year, the dividend will be exempt income of the shareholder.

This can assist with overdrawn current account problems. The biggest disadvantage is personal tax liability for shareholders.

Trust or a combination company/trust option

For some, it may be appropriate for the business to be owned by a dual trust structure, which sees the business owned and operated by a trading trust, but with a separate discretionary trust as a beneficiary of the trading trust - distinct from the business being run through a company with the shares held in a trust.

From a creditor risk perspective, the business assets could instead be owned by the beneficiary trust, which would lease those assets to the trading trust.

Use of a trust enables income to be taxed at the trustee rate of 33 per cent, rather than taxed at the personal marginal tax rates.

This is achieved by way of income (whether direct, in the case of a trading trust, or dividend income in the case of a trust owning shares in a trading company) being retained by a trust as trustee income. There is no further layer of tax when that income is later distributed to a New Zealand resident beneficiary.

Also, compared to a company structure, trading trusts enable more flexibility with distributions to non-working owners/family members, if those persons are beneficiaries. For example, trustees will generally have absolute discretion to allocate income and capital to one or more beneficiaries as they see fit, which may avoid problems with overdrawn owner current accounts.

It is virtually impossible to achieve the same "distribution" flexibility with a company structure - possibly the reason why trading trusts have received closer scrutiny from Inland Revenue in recent years.

Because trusts are not separate legal entities, trustees are generally personally liable for trust debts, which may be overcome by using a corporate trustee.

While a trading trust option provides more flexibility with income and capital distribution, and access to lower marginal tax rates (for non-minor beneficiaries), ensure that such a structure is understood by the owner, and will be readily accepted in the industry the business operates in.

Where to from here?

According to Treasury reports, the Government is well aware of the many structuring incentives, recognising the "increasingly large 'spikes' in taxpayer income distribution at personal incomes around $38k and $60k, with equivalent 'troughs' immediately above those values".

It's also watching the growth in use of trusts and other tax-planning activities, including the issues surrounding the Working for Families tax credit package, which has, to an extent, exacerbated avoidance incentives.

Unsurprisingly, the IRD has stated that it will focus on tax planning schemes during the 2009-10 year.

While all business owners should carefully manage their tax affairs to ensure they do not pay too much tax, with our tax system in a state of flux, caution is advised before embarking on an overly complex or aggressive tax-planning path.

* Alan Scott is Tax Partner with BDO Wellington, an independent member firm of BDO New Zealand's network of independent Chartered Accounting and Advisory Firms. www.bdo.co.nz