Accountant cries foul as taxman targets company tax loophole

Accountant cries foul as taxman targets company tax loophole

by Pattrick Smellie

Sept. 25 (BusinessDesk) – A senior tax accountant is crying foul over a tax department guideline that will stop the self-employed exploiting the difference between the 28% company tax rate and the top personal tax rate of 33%.

Jo Doolan, a partner and regular tax commentator from Ernst & Young, says the Inland Revenue Department is wrongly using its Supreme Court victory in the so-called “Penny and Hooper” tax avoidance case to force companies to pay shareholder-employees at least 80% of the company’s income.

The IRD issued the guidance shortly after the Supreme Court created a new benchmark for tax avoidance.

The court ruled against two Christchurch surgeons who artificially reduced their salaries to well below market rates and channelled profits of their businesses through lower-taxed company and family trust structures instead.

IRD argued the April 2000 increase in the top personal tax rate from 33% to 39% was the catalyst for the under-declaration, because it opened up a large gap with the 33% company tax rate. The opportunity was particularly attractive to small service industry businesses, where a single high income earner was often the company’s principal revenue earner.

The Supreme Court decision has sent shockwaves through the accounting profession and many clients potentially caught by the Penny and Hooper ruling.

Doolan now says the IRD is trying to take the ruling step further than the Supreme Court decision or current law allows by judging potential avoidance not on whether realistic market salaries are being paid, but on the proportion of the company’s earnings that are being paid out.

The new 80% rule “could well have the effect of requiring much more than a market salary to be paid,” she said. “This completely ignores the Court, and has the practical effect of virtually ignoring the taxpayer’s legitimate choice of business structuring.”

In a taxpayer alert issued shortly after the Penny and Hooper decision, the IRD says it is “more 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, his/her family and associated entities.”

But Doolan says “if the IRD seeks to extend the court's decision beyond market salaries and focus instead on requiring a specific percentage of profits to be paid to shareholders, it should ask the government to change the Income Tax Act.

“If you want this much change, you can’t do it by stealth,” she told BusinessDesk.

“The move not only increases uncertainty for taxpayers at a time when businesses need to focus on growth and creating jobs it is a huge stretch on what the decision and the legislation enables them to do.

”The opportunity exploited in the Penny and Hooper case ceased to exist on April 1 this year, when the top personal and trust tax rates both moved to 33%.

However, both Doolan and the IRD’s senior tax counsel, Graham Tubb, agree taxpayers can still try to exploit the widening gap between the top personal tax rate of 33% and the new company tax rate, which has dropped to 28%, although “the arbitrage isn’t as high as it was,” said Tubb.

There was ample evidence that trusts had been “used to divert income in a way which ramps the capacity to avoid paying tax that people really should be paying,” he said. Wider moves since the 2010 Budget had already targeted self-employed people who were under-declaring income to qualify for Working for Families, or to avoid family support and student loan payments.

He defended the IRD’s interpretation of Penny and Hooper.“The department’s approach focuses on the commercial reality of the business, and not on ‘market’ salaries or comparable industry averages,” the IRD guidance note says.

Doolan says while she “doesn’t disagree” with the IRD’s approach in principle, “that’s not what the tax rules say, that’s not what Penny and Hooper said, and if you are going to create some certainty you need to change the rules themselves.”

Tubb, however, says the guidance is providing the certainty taxpayers have been crying out for, and does not go beyond either existing law or the Penny and Hooper decision.

“The New Zealand Institute of Chartered Accountants is very pleased we’re trying to describe this,” he told BusinessDesk. “And we won’t select every case up to 79%. If someone is putting that spin on it, I think that’s unwarranted.”

The department would only focus on the “most aggressive” cases. “The reference to 80% is meant as a safe harbour in terms of how we would allocate resources.”

(BusinessDesk) 16:58:32

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