Commissioner Wins Surgeons' Tax Avoidance Case
The Supreme Court decision in the Penny and Hooper tax avoidance cases was delivered on 24 August 2011. The Court has found unanimously against the taxpayers.
For a copy of the decision from the Supreme Court page on the Courts of NZ site, click here.
Prior notes on this case summarizing the facts can be reviewed here and here.
Three things emerge immediately from the Supreme Courts decision, although it is sure to be the subject of much ongoing analysis and commentary. The three immediate points are:
1. The Court has accepted that one can use structures that are available as a matter of orthodox commercial choice and, as a result, the tax rates that apply to those structures will apply. However, choice of structure does not address what income should be submitted to the applicable tax rate. If that income is set at a less than commercial level (or to take the obverse is artificially inflated), motivated by tax outcomes to more than an incidental degree, avoidance will be involved in the setting of the income level. That one step will taint the otherwise acceptable structure.
2. The Court accepts that there is no such concept under our tax law of a "commercial salary" and it also accepts that family transactions will not always be based on commercial values. Having said that, however, it says that the law expects that one will not structure one’s affairs with a more than merely incidental purpose of obtaining a tax advantage not contemplated by Parliament.
This seems to imply that Parliament has indeed contemplated that salaries will generally be commercially set because without that there is no tax advantage to be addressed. The practical effect of this seems to be that unless an uncommercial level of remuneration is justifiable by reference to non-tax drivers, the anti-avoidance regime may well now incorporate a Parliamentary expectation that shareholder employees of companies must usually be remunerated (and taxed) at commercially acceptable levels. If this is what the Court means, then its decision has enormous implications for all incorporated family businesses, not just incorporated professional practices.
There is one rider to this and that is that the Court seems to have deliberately confined the assumption underpinning the examples it uses in its decision to a company with only one business in which the taxpayer is employed. This might suggest that it meant its observations only to be applied to what might be called the “incorporated sole trader” model.
3. The Court notes that one of the reasons for which a company might decide to set remuneration at less than a commercial level is the need to retain funds in order to make capital expenditure. The Court does not deal with the possibility that such capital expenditure might well include the cost of purchasing the relevant business in the first place.
This issue did not seem to arise in Penny and Hooper because of the level of goodwill payments contracted for in that case, and the way they were dealt with. But if a company agrees to purchase a business and to employ the former owner on less than commercial terms, that may well be because it is obliged to pay the debt it owes on purchase out of its after tax income. Alternatively it may be obliged to borrow funds for such payment and to repay those borrowing from income.
The unanswered question is how to see this payment of purchase price. On one view it should be treated as a genuine obligation on an asset purchase. On that basis it could be seen as a reason the reduced salary should not be regarded as avoidance. On another view the delivery to the former owner (now an employee in the business) of capital instalments of the purchase price after tax had been paid at a lower rate could be seen as that person receiving income in a different form so that he does not suffer the loss of income expected by Parliament as part of the application of a lower rate of tax.
I doubt that the Supreme Court means for the second view to apply generally. If that is wrong, then its decision undercuts the tax outcomes that would be expected in any straightforward business sale into a company. It would mean that although company income was being applied to the purchase of an asset, tax at personal marginal rates would still have to be paid by the vendor shareholder/employee on the “uncommercial” discount which he took on salary to assist the company to finance its purchase.
All that makes no sense if the right of the company to acquire the super-profit arising from the reduced salary payable to its employee has been properly priced and supported by an exclusive service agreement.