It is not often there is a tax case that can strike fear into the hearts of tax advisers and business owners alike, but the ongoing saga of Penny and Hooper has been one such case, especially given early suggestions that simply the use of company or trust structures could constitute tax avoidance in some circumstances.
You may recall various Otago Daily Times news stories involving the two orthopaedic surgeons, Mssrs Penny and Hooper, who independently of each other transferred their respective businesses to companies which in turn were owned by their family trusts. They then set their salaries at artificially low levels, meaning the significant difference was taxed at 33c, rather than 39c. The question at hand was whether these actions and/or structures constituted tax avoidance.
So what can we take from this case? One positive is that it is not as broad as the decision of the Court of Appeal, and seems, in my view, to be a lot more fact-specific. But it does carry with it a strong message. If you put in place artificial and contrived arrangements (such as artificially low salaries) where there are not overt and defendable reasons for such arrangements or actions, then the courts will likely find tax avoidance, and then will allow the IRD to ignore the wider arrangements/structures in place; at least to some degree.
Notwithstanding this, the court did not suggest that closely held companies must always pay "market" salaries to their shareholders, and went so far as to list examples of situations where non-market salaries would not be tax avoidance (assuming validity), such as low or no profit, real risk mitigation, retaining funds in the company to fund capital expenditure, and the like.
This is a huge positive for those in business because it confirms they do have the ability to make decisions in this area that will not trigger tax avoidance.
The rider to this is comment about validity (versus artificial contrivance). These valid reasons must be genuine and demonstrable. Further actions must support those reasons. Implementation is key. Part of the undoing of Mr Penny was the fact that despite the low salary he received (for whatever asset-protection reasons he portrayed), ultimately his trust structure was employed in such a way to provide him access to the cash being generated, so his actions did not follow the words/intent.
What will be the most interesting aspect of this case is how the IRD will react. At a policy level, we expect it to act with restraint and calm, focusing (initially) on only the very worst cases of "artificiality" and "contrivance" and at the same time release some guidance around its view. Most taxpayers will have little to worry about, even if they are trading through companies or trusts.
Having said that, which cases constitute the "worst cases" will be interesting, because information from the IRD clearly shows that the proportion of taxpayers who received salaries from closely held entities of or about $60,000 and $70,000 (the previous thresholds for higher tax rates) for the years in question were a significant statistical anomaly.
A key indicator of the IRD's view will be the degree to which the affairs of Penny and Hooper are reconstructed, and whether some allowance is given for the "profit" element of the businesses.
Finally, unless there is a change of Government in November, which is not looking likely at this stage, many of the drivers for taxpayers acting as Penny and Hooper did are no longer in play, with the top personal tax rate equal to the tax rate for trusts, and similar to the rate for companies. Until this changes (if it does), Penny and Hooper will only be of historical interest to most owners of small and medium-sized businesses.
In summary, I believe the Supreme Court got this decision right and released a very reasoned and useful decision which, although it may not provide certainty around where the tax avoidance boundary lies, does give us a clearer picture of that boundary without opening the floodgates.
• Scott Mason is tax principal at WHK Dunedin.
