Tax Avoidance - "Surgeons, Salaries and Structures"

CIR v Penny & Hooper

This article updates my previous tax avoidance commentary at “Tax Avoidance Clarified” . To review that commentary, click here.

In a split decision the Court of Appeal recently reversed the High Court’s decision in CIR v Ian David Penny & Gary John Hooper.  To say the least the decision results in an uncertain tax planning landscape.  The decisions of the majority of the Court (Randerson and Hammond JJ) are, with respect, quite unsatisfactory as statements of the law in this area. The minority judgment of Ellen France J laudably eschews any judicial “sniff” test in favour of an approach that recognizes the impossibility of marking out this case from hundreds of thousands in New Zealand. It is, I submit, the correct decision. The judicial score card now stands at 2 all counting the decision at first instance.
The facts of the case will be familiar to all who have read about it recently. Broadly, the case involved two surgeons, Messrs Penny and Hooper, both of whom sold their private practices to companies which were incorporated in 1997 and 2000 respectively. The companies were owned by family trusts whose beneficiaries were members of the surgeons’ respective families.  Each surgeon’s practice was sold into the relevant company for a value struck having regard to the earning power of a practice employing the surgeon vendor. In each case that price was left outstanding as a debt due to the surgeon from the company.
From 2001, when the Government increased the top personal tax rate from 33% to 39%, and left the company rate at 33%, the companies paid the surgeons salaries that were substantially less than the amounts they had received when they were self-employed.  The incidence of tax on the income previously derived by the surgeon personally was altered because tax was payable by a different taxpayer (the company) and the tax rates applicable to that taxpayer were lower than the top personal marginal tax rate.
In the High Court, the Judge (MacKenzie J) applied the Supreme Court’s “scheme and purpose” approach to a tax structure, as set out in Ben Nevis Forestry Ventures Ltd v CIR[2008] NZSC 115. The Judge held that the formation of a company was a valid choice of business structure available to the taxpayer under the scheme of the Income Tax Act.  He observed that under that scheme tax consequences may differ depending on the type of taxpayer deriving the income, and that the Act does not prescribe that some types of structures may only be used by some categories of taxpayer.  He held that where the choice of a business structure is a commercially orthodox one, a taxpayer is not required to demonstrate a commercial justification for the choice of one form of business structure over another.  For that reason the incorporation of the surgical practices was held not to be tax avoidance. 

The Court of Appeal also purported to apply the Supreme Court’s “scheme and purpose” approach to a tax structure but the majority came to the opposite result.  His Honour Randerson J (with whom Hammond J largely agreed) found that:
  1. The conduct of a business through a company owned by a family trust is not, by itself, improper.
  2. In practical terms, the adoption of the structure allowed the surgeons to obtain the advantage of the lower company tax rate while still enjoying the full benefit of the income themselves;
  3. The salaries adopted by both Penny and Hooper were so far removed from commercial reality as to be contrived and artificial.
  4. The adoption of business structures which have the effect of diverting or splitting income generated by the personal exertions of individuals to avoid personal tax rates is significant in assessing whether a structure is within parliamentary contemplation.  In that regard, Parliament did not intend the enactment of the Personal Services Attribution (“PSA”) rules to mean that the general tax avoidance provision might not apply in other circumstances. 
  5. It was significant that Penny and Hooper had been conducting their respective practices on their own account and then chose to incorporate.
The majority of the Court of Appeal did not accept the submission that the company structure was necessary both to protect the surgeons from negligence claims and for ordinary business and family dealings.
In her dissenting judgment, Ellen France J held that:
  1. She essentially agreed with MacKenzie J’s reasoning in the High Court.
  2. The structures used by Penny and Hooper required no particular ‘ingenuity’ such that Parliament could not have contemplated them.  The fact that the PSA rules disallow only a narrow ambit of cases suggests Parliament did not intend to restrict taxpayers from utilising the structures in question in this case.
  3. The case is not one of income splitting because both Penny and Hooper sold their business to companies and goodwill payments were made.
  4. The quantum of the salaries and the taxpayers’ control over them did not amount to artifice or contrivance.
  5. It is odd that whether or not a tax avoidance “arrangement” exists can alter on an annual basis depending on the decision about the level of salary to be paid.  It creates uncertainty for taxpayers if what they do can be acceptable one year but not another.
In particular, France J placed reliance on Loader v CIR [1974] 2 NZLR 472, a case involving a company owned by a trust. In that case Cooke J saw the separate legal identities of company and shareholders and the separate legal existence of trusts as “everyday” elements in business and family dealings.  Further, he did not view it as “abnormally artificial” for one person to have control of the administration of a trust and a company and yet be carrying on business in much the same way as before incorporation.

Criticism of the majority decisions

The majority of the Court of Appeal seemed to take no account of several important issues.
First it seems to mark out income derived from personal exertion for special treatment. This is especially so for professional services income which is derived from the application of personal skills rather than the application of capital equipment. The majority seems almost to say that the incorporation of a professional practice (even where a payment for personal goodwill is made) cannot for tax purposes be assumed to be orthodox. If the personal exertion reward to the company principal is lower than a “market salary”, the tax saving by the application of a corporate tax rate in the company can be avoidance without a commercial rationale being clear.
The case was argued very effectively by counsel for the Commissioner on the basis that it involved an effective assignment of personal services income, something which the Tax Act does not permit (the income has to be derived before it can be assigned). But this simply failed to recognize that the income had not been assigned at all but had been derived by the companies which had bought the right to trade using the personal services of the surgeons. The majority accepted that derivation is different from assignment but held that the assignment cases assisted in deciding whether something artificial had occurred to allow for so-called tax “rate hopping”.  
In coming to this view, however, the majority seems to have taken no account of the fact that the companies paid a price for the right to derive income and the surgeons accepted a salary set on the basis that the “super-profit” they might otherwise have received had they continued to practice as “sole traders”, would henceforth fall to the company. In other words they capitalized for a debt due to them the future cash flows of self employment and instead took a salary from employment by the companies to which they sold their practices.
Thus the majority of the Court has thoroughly confused assignment with derivation and, as a result, has ignored the economic effect of the sale to the company. In short it is saying that even if full value was paid by each company for the opportunity to trade using the skills of the surgeons, the surgeons have to be treated as having continued to derive income which actually falls to the company.

Of course this begs the question whether a proper price was paid for the right to take the practice super profit. If the amount paid for the practice on incorporation was too light, this might permit the Commissioner to argue that the arrangement was artificial. But if a reasonable attempt was made to capitalize the value of profit to be earned over a period of say 5 years, and that was backed with employment agreements for that period pegging shareholder employee remuneration, the opportunity to argue there is an effective assignment of income would be greatly reduced.  
Related to this the majority has also failed to treat the income derived by the companies as nothing more than trading income. Instead it has fixed on the idea that this income was, and so should always be treated as, income derived by the surgeons from their person exertion. Arguably there is no difference between this income and that derived by any company trading in “widgets”. The income has no special quality simply because the company employs a servant to perform services. The only personal services income from that point is the income paid to the surgeon/servant as salary.
On the majority’s approach every shareholder employee of a company is potentially open to the allegation that he or she has effectively assigned income to the company and so should be taxed as if the company does not exist. If it is clear that they could have earned more than is allocated to them as company salary by undertaking the relevant business in their own names, the risk of tax avoidance arises on the basis of this decision.
The majority Judges have tried to provide limited reasons why reduced salary might be acceptable in some cases, such as a company in start up phase or a company which needs to invest in equipment. The very fact that they have referred to this instance suggests that they do not see the case as being limited to professional income. The majority did not however take up the suggestion adopted by Ellen France J in the minority that a desire to have assets accumulate at a shareholder level, usually in a family trust, was a legitimate reason for reducing salaries. Again that is a very concerning development because this motivation for adjustment of remuneration is entirely unexceptional in New Zealand. Despite its comments to the contrary, the majority has given no basis in principle to distinguish the Penny and Hooper cases from hundreds of others where companies pay little to shareholders, retain earnings and allow shareholders access to those earnings through loans or fully imputed dividends, often filtered through family trusts.
There is no comfort either in the approach that says, “Ah ha, but before the company was interposed tax was paid on income of $800,000 and after only on $160,000.” That seems to have been at the heart of the majority’s view but:
  1. It begs the question, whose income is it?
  2. It also begs the question was the right to take the balance over the salaries actually paid for in the sale?
  3. It suggests that once a person has earned income as a sole trader they cannot adopt a corporate alter ego if to do so leads to a marked change in the incidence of tax.
  4. Finally it posits that it is only in extreme cases that avoidance will exist.

As to the first two points the majority seems simply not to have gripped the issues and as a result its decision is fundamentally flawed. As to the third point, it cannot be correct that a person who elects to incorporate their personal services business first is better off under our tax system than the person who, having started as a sole trader, elects later to incorporate (the position in Penny and Hopper). That is a recipe for economic inflexibility and inefficiency but, apart from that, it is fundamentally unfair unless one takes the Court’s proposition as far as to say that, regardless of legal structure in which it is derived, personal services income should bear tax at the rate that would apply if derived by a sole trader.
As to the last point the Court has recently made it clear that tax avoidance takes no note of the amount involved (Education Administration Limited v CIR). It follows that a test for tax avoidance that relies on “extreme cases” is dangerous. Indeed the test ought to be applied theoretically to cases closer to the margin to judge whether it is sound in principle. Had that been done in this case the shortcomings of the majority’s decision would have been obvious.   
The points referred to above are simply not taken up by the majority which goes as far as to say that it cannot and will not mark out broad tests in this area but prefers fact-specific decisions. With respect, that is a poor response and taxpayers could expect more guidance from an appellate court. It deflects attention from an unfortunate lack of analytical rigour.

General Guidance for Taxpayers

While openly acknowledging that his judgment creates uncertainty for taxpayers and their advisors, Randerson J emphasised that:

  1. It will be a matter of assessing all the circumstances including the extent and nature of any element of artificiality or contrivance in order to determine whether any particular arrangement is within or outside the contemplation of Parliament in enacting the tax legislation;
  2. Where there are legitimate reasons for adopting a salary markedly below commercial levels, a challenge by the Commissioner may be unlikely to succeed;
  3. He would not expect the Commissioner to interfere in marginal circumstances; and
  4. The difference in this case is that salaries were adopted at levels so far below ordinary commercial expectations that, in the absence of legitimate reasons for doing so, there is a strong implication of tax avoidance.
The IRD’s revenue alert following the decision also attempts to provide some guidelines for taxpayers, albeit in an imprecise way.  It commented that “this decision should not be regarded as establishing a principle that salary levels in family companies which are below the levels which could be expected in an arms-length situation, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement” and identified the following factors as contributing to an arrangement being considered tax avoidance:
  1. An entity such as a company or trading trust employs the taxpayer for artificially low remuneration.  Remuneration will be compared to what a reasonable person in that situation would expect to earn, having regard to the specialist skills of the taxpayer, other factors which contribute to the success of the business and business profits. 
  2. Whether the business operates in the same manner following the transfer to a new operating structure;
  3. Whether the business is operated in accordance with the terms of the arrangements entered into;
  4. The degree to which the taxpayer or his or her family ultimately control the entity, its economic product and cash flows;
  5. Whether there is any underlying income from the entity back to the taxpayer via a trust or other means such as related party loans;
  6. The non-tax reasons for the structure adopted; and
  7. The extent of the tax benefit as result of the arrangement.
As a result of this decision, trustees and company directors should be more vigilant in determining annual salaries and levels of distributions.  It may be that ‘owner/employees’ should now have some knowledge of the salary that would be paid to them for their services by an arm’s length employer and seek to regulate their salary to ensure that it is aligned to that.

For additional commentary on Penny and Hooper, click here.

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