A much-awaited decision of the Court of Appeal could open the floodgates of Inland Revenue Department prosecuting professionals hiding behind a company structure to avoid high personal income tax rates.
The court released its decision late last week.
After poring over the decision during the weekend, Polson Higgs tax partner Michael Turner called it the "most authoritative" New Zealand court decision regarding the use of structures by small to medium-size enterprises (SMEs) where those structures resulted in the top personal tax rate being replaced by the lower company or trust rate.
The case involved Ian Penny and Gary Hooper, two orthopaedic surgeons practising in Christchurch as sole traders, who restructured their businesses so that they were carried on by companies in 1997 and 2000 respectively.
In both cases, as a result of salaries from their newly formed companies being lower than their previous self-employed earnings, significant tax savings were achieved, Mr Turner said.
Mr Penny saved $37,000, $34,000 and $31,000 of tax in three consecutive years while Mr Hooper saved $21,000, $24,000 and $20,000 in three consecutive years.
"One of them dropped his salary down from $500,000 in one year to $100,000 in the next. That failed the sniff test immediately," he said.
Mr Penny and Mr Hooper won in the High Court, but the Court of Appeal, by a two-to-one majority, concluded that the adoption of the company structure and the non-payment of market salaries, without legitimate reason, amounted to tax avoidance.
"This issue has been uncertain since the Labour-led government introduced a 39% personal tax rate in 2000.
We have had 10 years of not knowing what the boundaries have been.
"Issues in this case were identified to the Labour government from day one."
At the time the companies were formed, the top tax rate was 39% and the company and trust rates were 33%.
One of the issues that was left unresolved by the court decision was the definition of a "market rate", Mr Turner said.
"If you don't pay yourself a market rate, then the IRD has deemed that to be tax avoidance.
It is a critical decision as it will impact on SME businesses using company structures."
While the decision was aimed at people selling services, it was unclear if it would affect businesses selling goods, he said.
The IRD increased its activity regarding tax avoidance by "having a crack at dentists" in 2002.
More recently, the department had been looking at doctors.
The department was targeting professionals on the basis that those people often operated as sole traders and it was easy for them to form a company and change the tax rate they paid.
It was easy for the IRD to argue the income belonged to an individual working for that company, Mr Turner said.
The IRD had put a lot of cases on hold when it lost the High Court decision.
It was likely to reactivate those cases, although it was uncertain if they would be appealed to the Supreme Court.
Finance Minister Bill English had moved in his May Budget to redress some of the inequity in the tax system by moving the top tax rate down from 38% to 33% and the company rate down to 28%.
That would make it harder to create tax-avoidance structures, he said.
However, the IRD worked "with the benefit of hindsight" and would look back over the past five years or so for issues similar to the Penny and Hooper cases.
The changes heralded in the Budget would not make any difference to those investigations, Mr Turner said.
While the decision had been much awaited, it was unlikely to be the final word as several issues had not been addressed.
They included:What if a company structure was adopted from the first day? No-one knew the answer to that.
What was the market salary?
Evidence suggested that the IRD's view and the taxpayers' views were some distance apart.
What the taxpayers had done had not required particular "ingenuity" such that Parliament could not have contemplated the use of company structures in that way.
"These issues are likely to continue to cause frustration for taxpayers and undoubtedly further time and cost will be incurred in trying to establish where the boundaries lie. A company tax rate aligned to the top individual tax rate does of course avoid all these issues," Mr Turner said.
