Tax Structuring for the 39% Tax Rate
In the 2020 election, Labour promised to introduce a new top tax rate of 39% on income over $180,000, likely to take effect from 1 April 2021. While taxpayers at risk of falling into this bracket may find it tempting to restructure their way out of this, tax advice should always be sought beforehand to ensure you do not fall foul of established tax avoidance principals such as Penny & Hooper v CIR (2011) NZSC.
Penny & Hooper v CIR was a landmark tax case that went to the Supreme Court of New Zealand, bringing attention to professionals using ordinary business vehicles, like companies and trusts, to reduce the tax they pay on their income. This was done by diverting income earnt, or that could be earnt, to other taxpayers on lower marginal tax rates. These arrangements are not uncommon but those utilising them must be cautious of the anti-avoidance tax laws which can be triggered. Taxpayers concerned about the new 39% tax rate should not panic and always take precautions before restructuring their incomes.
In Penny & Hooper v CIR, Mr Penny and Mr Hooper each conducted their medical practices in their own names. They subsequently set up companies, owned substantially by their family trusts, to purchase their practices. Mr Penny and Mr Hooper were then employed by their own companies with no change to the work they completed or operation of their business. Prior to this change, the surgeons had been earning well over $500,000 a year, but as employees of the companies, they earned $120,000. The balance of the practice income was treated as company income. After deductions (such as their salaries), it was paid to the family trusts as a shareholder dividend. Despite their decreased salaries, the money they earned was still available to the surgeons for family purposes, with a lower tax rate applied. The surgeons both admitted during proceedings that they would not have worked for such a low salary otherwise.
Had the income been earned directly by the surgeons it would have been taxed at 39% (this was the applicable tax rate at the time), however, the arrangement resulted in the company income being taxed at 33% and the fully imputed income was passed to the trust, which resulted in savings of 6 cents in every dollar. The Commissioner considered that the surgeons’ salary was set at an artificially low level to take advantage of the lower company tax rate. Therefore the Commissioner attributed them a salary that was “commercially realistic” in the circumstances. The Supreme Court found in the Commissioner’s favour as the tax advantage was at least one of the principal purposes or effects of the arrangement.
The transfer of a sole trader business to a company or trust is not automatically objectionable. Rather, the arrangement in Penny & Hooper was found to be tax avoidance as it was based on minimising tax rather than for any commercial considerations. The payment of below-market salaries is not necessarily tax avoidance either, even where it does result in less tax. However, when the setting of an annual salary is influenced in a more than incidental way by the impact of the taxation, that structure will likely be considered tax avoidance. In situations where a company is experiencing financial difficulties or needs the funds for genuine capital expenditure, it will likely not be.
Inland Revenue stated in Revenue Alert 11/02 (post Penny & Hooper) that they would be focusing on the more artificial arrangements, and that they would be most likely to examine arrangements where the total remuneration and profit distributions received by the individual service provider is less than 80% of the total distributions received by the controller, their family and associated entities. While 80% may seem like a safe harbour, it certainly is not the case, and legislation does not provide any support to this 80%. I have seen cases where much lower amounts were allowed by Inland Revenue when considering all of the circumstances. It is essential to seek tax advice prior to restructuring to ensure you correctly consider the tax avoidance risk.
Taxpayers need to be aware of the possible ramifications of their actions in diverting their income to avoid the new 39% tax bracket. Arrangements that reduce the tax paid may seem effective in the short term but may cause much greater problems in the future. Seeking tax advice sooner rather than later can help taxpayers avoid headaches and make good decisions with their hard earned income.
For further advice on structuring, or for assistance with other tax related matters, please contact us.