Three recent tax avoidance decisions raise questions of consistency. The majority decisions of the Court of Appeal in Penny and Hooper and the decision of the High Court on appeal in Russell (No 2) have tried to determine the extent to which a person may incorporate an income earning business previously conducted outside a company, and thereby reduce the taxable income allocated to them personally.
In Penny and Hooper the Court upheld the approach by the IRD that incorporation was void against the Commissioner to the extent of a deficit between a “reasonable salary” and the actual remuneration paid to the shareholder employee. In Russell (No 2) it upheld an approach that attributed to Mr Russell personally every cent of income derived ostensibly by “his” companies.
In applying the anti tax avoidance rules in the Income Tax Act the Courts have in each case stated that they have no problem in principle with a person who has hitherto derived income from personal exertion, setting up a company within which to continue that activity. Their problem is with the way the company is used.
Leaving aside for the moment whether the Court’s approach was correct, in Penny and Hooper this pernicious use was the company retaining too much income, instead of paying it as remuneration to a shareholder employee. As a result, a lower rate of tax was applied to the income than would have been the case if it had been paid out. In Russell (No 2) the use was more convoluted and consisted of companies entering into multiple service agreements for the payment between them of fees which might otherwise have been derived by Mr Russell personally. The effect was that the income was shifted to loss bearing entities so that tax on the income was reduced markedly overall.
As noted, the IRD took and the Courts allowed quite different approaches to post avoidance reconstruction in each case. In Penny and Hooper the IRD never sought to allocate to the shareholder employee any more than a reasonable salary. It accepted that the company was entitled to retain a share of the revenues which it derived from contracting for the supply of surgical services using the skills of its shareholder employee. The issue was always to determine a reasonable level of shareholder remuneration that should be deducted from those revenues and taxed as personal income of the shareholder.
By contrast in Russell (No 2) the IRD treated all of the $15 million derived by Mr Russell’s entities over 10 years or so as having been derived entirely by him. Why the difference? Is it justified?
In both cases the Court noted that the individuals concerned effectively controlled what happened with the income which the companies ostensibly derived. But the difference seems to be that in one case tax was paid at least at the company rate while in the other losses were utilized so that no tax was paid at all.
In Penny and Hooper the income retained by the companies was directed by dividend to shareholder trusts and then to other family members. Indeed in a similar case I have seen the trust distributions advanced straight back to the company as a credit to the shareholder’s current account. The dividend was fully imputed with the company tax that was paid. The rate of tax due at the trustee level was the same, so no more tax was charged on the trust’s receipt. If income was passed through to beneficiaries who were taxed at lower marginal tax rates, a credit fell due to them. But at least the company rate of tax was being paid on the retained earnings, and personal tax was being paid on the salary actually declared to the shareholder employee. What was at stake for the fisc was the loss of a “mark up” of 6% to the top personal marginal tax rate on income retained by the company.
In Russell (No 2) Mr Russell paid himself a modest income out of the considerable earnings his endeavours produced. I assume that was taxed to him but the vast majority of earnings were then diverted through management fee charges to be offset against losses in other entities. The fees appear to have been manipulated artificially to “follow” available losses, though all services were actually performed by Mr Russell. In this case even the allocation to Mr Russell of a reasonable salary would probably have left too large a part of the income sheltered and tax free for any self respecting tax collector to stomach. Better to send it all back to Russell and ignore the losses altogether.
But is that a reason for one company to be recognised as retaining earnings for tax purposes and the other to be dealt with on the basis that the earnings are wholly void against the Commissioner and to be allocated entirely to someone else?
Perhaps the answer to that question lies in what the Commissioner is required to counteract, once tax avoidance has been confirmed. He must counteract the “tax advantage” that has accrued through the avoidance arrangement. Where some tax has been paid in one case but none has been paid in another, there are arguably different tax advantages to be counteracted. The one that is essentially an advantage about the applicable rate of tax may best be dealt with by limiting the amount of tax which is subject to the lesser rate, as was done in Penny and Hooper.
The other, which is essentially an advantage obtained from the artificial accessing of losses so that no tax is paid, may only be dealt with by denying the loss offset. If the losses are not themselves the product of an arrangement and so cannot simply be disallowed, that advantage can only be reversed by withdrawing the income from the entities which legitimately held losses, and re-allocating the income to another. But in Russell (No 2) the Commissioner and the Court did not simply deny access to the losses by returning income the entities that had paid it as fees to the loss bearing companies. Those paying entities were companies as well and one might have thought that a Penny and Hooper between compay and Mr Russell could have been considered. Instead the Court looked through the first tier of companies and treated all of the income as Mr Russell's.
It seems possible that Mr Russell could have asserted that a Penny and Hooper allocation might have been made in his case after the losses were efffectively withdrawn. Although it is not dealt with specifically it appears that he only ever contracted for his management services through companies that bore losses. Those companies effectively stripped out the profits made by his flagship entities from the sale of Mr Russell’s services and products to end users. The immediate tax advantage was therefore not a matter requiring reallocation of personal exertion income between person and company. It was a matter of denying the manipulated access to otherwise legitimate losses. However, a secondary consideration ought to have arisen which would have required a Penny and Hooper allocation.
Considered in this way Mr Russell might have argued that, on the authority of Penny and Hooper, the only income that ought to have been allocated to him was a reasonable salary. He might not have been able to escape the denial of losses. That is because the use to which he put his companies was quite different from the use to which the surgeons put theirs, at least in the first instance. That use accessed losses. That was the immediate advantage to be reversed. The surgeons’ use was to retain earnings in a company so that it was subject to tax at a lower than personal rate. But that is a secondary aspect of Russell (No 2) that seems to have been overlooked, perhaps because the appeal was argued on limited grounds.
The impact of losses as a factor on which possibly to distinguish Penny and Hooper raises other questions. For example, what would the position in that case have been if the surgeons’ companies had pre-existing losses so that no tax was paid by them on their retained earnings? If the earnings had been distributed to trustee shareholders, tax would be paid at that level because the dividends could not be imputed. In that instance the case may well have been decided in the same way because the same tax advantage would be at stake. But if the funds had been lent by the company to its shareholder and not distributed as a dividend, so that the tax shelter of the losses was perpetuated, the use to which the company was put may possibly have been seen as different again.
Indeed that scenario could bring into play the issues at the heart of a third recent tax avoidance case, Krukziener. Once again in that case the Commissioner sought to reclassify the entire sum originally advanced as loans to Mr Krukziener as income, rather than to treat his case as one where there was excessive, though not wholly impermissible, access to capital instead of orthodox remuneration. The use by Mr Krukziener of the companies and trusts he set up was simply not of the same type as Russell (No 2). The use was more about the rate applicable to income in the sense that capital receipts such as loans are not taxed at all, ie they are zero rated. The artificial accessing of losses in Russell (No 2) as a possible (though in my view flawed) basis for arguing that all surrogate income should be allocated to an individual, has no conceptual equivalent in Krukziener.
Quite apart from anything else, therefore, based on the Commissioner’s case and the Court of Appeal’s view in Penny and Hooper, the most that ought to have occurred in Krukziener was to allocate from the loans made to the taxpayer a reasonable salary and no more. For in truth the only use to which the companies and trusts in that case were put, which the Court could possibly have found to offend the anti avoidance rule, was to take advantage of the zero rate of tax applicable to loans. That is no more than Penny and Hooper writ large and, regardless of one’s view of their correctness as decisions, a consistent approach should have been applied by the Commissioner and the Courts in the two cases. Indeed it is arguable on the same principles that, although Mr Russell might not have been permitted access to losses, the amount ultimately allocated to him as personal income is too great.
© G D Clews, November 2010