Tax blow before yuletide

By PHILIP MACALISTER

The weeks before Christmas are a time for spending money, but for high-income earners this year it has become a time to work out ways of avoiding tax.

A key plank of the new Labour-Alliance Government's policy is raising personal income tax for earnings above $60,000 from 33c in the dollar to 39c.

It is already preparing the necessary legislation so the change can be passed and implemented by April 1.

Accountants all around the country report inquiries from people wanting to know how to avoid paying the extra 6c.

PricewaterhouseCoopers tax partner John Shewan says the inquiries are coming from people who aspire to earn more than $60,000, as well as the 5 per cent of the population who already do.

He says it is legitimate for people to explore ways to avoid paying extra.

"They are taking advantage of the choice the Government is giving them."

He sees several ways tax avoidance can be achieved.

Despite the seemingly high interest in avoidance, incoming Finance Minister Michael Cullen believes the tax will raise the $370 million expected.

Dr Cullen acknowledges people are seeking advice on the matter, but he questions whether accountants and lawyers "have really got answers that are tax-effective."

Whether they have the answers will be known in time, but tax experts agree on three main methods of avoiding the 6c tax rise. They are: Establishing a company structure Self-employed people and contractors can avoid the impact of a higher tax rate by setting up a company to own their business. The company then pays a salary of no more than $60,000 that is taxed at 33 per cent and any additional payments can be made to the owner as dividends. Meanwhile, any additional profits made by the company are taxed at a flat rate of 33 per cent.

There is more to this than meets the eye. The new structure that owns the business has to be flexible and practical so it can adapt to changing business circumstances.

Dr Cullen warns people to think very carefully about making changes designed to avoid the tax. The new Government has plans to tighten the anti-avoidance laws which have been sitting on the books for five years. He refuses to give details.

Establishing a trading trust or a family trust A variation on the company theme is establishing a trading trust as the vehicle to own the business. This works in a similar way to the company structure. Business pays income to the trust, which is taxed on the trustees' rate of 33 per cent.

Besides providing income tax savings it also offers asset protection and the option of further tax reductions.

Under the company structure the person being paid has actually to do some work for the company. A trust needs no justification for splitting income among other beneficiaries.

Therefore the trust can distribute income to other beneficiaries, such as children who are on the lowest marginal tax rate (19.5 per cent). This potentially provides tax savings of $5130 a year.

Dr Cullen acknowledges that making changes to the trust laws to stop this type of avoidance is more difficult.

Pay income over $60,000 into a superannuation fund A third option that sounds easy and cost effective is to pay any income over $60,000 into a superannuation fund. That is taxed at 33 per cent, and the earnings are exempt.

Financial planner Murray Weatherston of Financial Focus says this practice was previously known as "salary sacrifice" or having a "top-hat superannuation scheme."

It works like this. The employers would strip out, say, the top $20,000 of salary and pay that amount less withholding tax ($6600 at 33 per cent) into a registered superannuation fund. The fund pays tax on its earnings at 33 per cent, and the employee could withdraw money from the scheme on a tax-free basis when it is needed.

The key points to making this a successful strategy is that the employee has to get the employer to make the payment into the super fund, and that fund has to have low fees and be sufficiently flexible to allow the investor to withdraw money on demand.

While this sounds like a subtle way of giving top income earners an incentive to save, Dr Cullen says it is not designed to do that.

He says one of the questions people considering this option need to cover is whether the payment would be challenged by the Inland Revenue Department.

Mr Shewan says if the IRD saw a salary had been cut from $80,000 to $60,000 and another $20,000 was going into a super fund, it might claim the move was tax avoidance.

Who should do what Investors - Mr Weatherston says many people will breach the $60,000 threshold because their investment income is reasonably high.

In this instance, the only real option available is to pay the money into a family trust, which the trustees can then convert to capital and pay out as a capital distribution.

The other issues investors need to be aware of is the impact a higher tax rate will have on imputation credits.

Dividends are fully imputed when tax is paid at 33 per cent, but a high income earner would be liable to top up the tax to the new rate of 39c.

Mr Shewan expects many companies which traditionally make dividend payments in April will bring them forward next year to avoid shareholders having to make up the shortfall.

Owner-operators/sole traders - Mr Weatherston says many of these who are doing quite well may have previously been advised to own their business under a company or trust structure, but have not made the changes.

He says this tax increase may be the necessary catalyst to push them into a new structure. While there are two options - a company or a trust - he says there can be additional advantages in having a company owning the business, and that company then owned by a trust.

Employees - Much has recently been made of the possibility that employees could adopt the company approach and establish a service company. Under this idea, the employer would engage the company as opposed to the individual.

Mr Shewan says people are over-stating the benefits of this option. It has all the compliance, set-up costs and running costs involved with owning a company.

He says it is highly unlikely suitable and effective arrangements could be put in place to make this idea work.

"From my point of view the service company [option] will be fairly limited."

Who will pay the extra tax?

* Those who willingly pay it. And yes, a lot of people are in this category.

* Those who do not earn much more than $60,000. For these people the cost of implementing avoidance measures will not be cost-effective.

* Those who have no choice. The people who fall into this category are generally employees who have little sway over their remuneration package. But if they are on individual contracts, they may have the chance to renegotiate their remuneration package in the future.

* Lawyers and accountants. One of the ironies of the changes is that the people who will profit from the extra work will have to pay extra tax. Lawyers and accountants have to operate under their own names, rather than under a company or trust structure.

Dr Cullen believes that although avoiding the tax is much discussed, it will generally come to nought.

"My personal advice to people is breath deeply, pay a bit more tax, then when they need an operation they will get it."

Meanwhile, Mr Weatherston says the changes may be the catalyst some people need to restructure their affairs.

His advice to these people is to move sooner rather than later. Once the legislation is introduced it may be too late to make changes.

Long-time tax practitioner Mr Shewan says the changes are a trip down memory lane. "I might get my old Beatles records out."

* Philip Macalister is the editor of online money management magazine Good Returns (www.goodreturns.co.nz). Good Returns provides news on managed funds, mortgages, superannuation and financial planning.