I have written before about Inland Revenue’s win at the Supreme Court in the Penny & Hooper case. As a refresher, the case involved two Christchurch orthopaedic surgeons who each transferred their practices to a company, the shares of which were owned by a family trust. Instead of earning all the surgery income in their own names, the company paid them a (lower) salary, and the rest of the income stayed in the company.  The salaries were determined by reference to public hospital pay rates.

While there were a number of reasons for the restructure, there was a tax advantage as, at the time, the top personal rate was 39 per cent, while the company and trust rate was 33 per cent. In the current tax environment, the tax advantage is less because the top personal tax rate is now also 33 per cent.

Hot on the tail of the court decision, Inland Revenue released a “Revenue Alert” setting out their view that income earned through the direct personal skills,  experience or labour of an individual should generally be taxed in the hands of  that individual. Further, as a general rule, Inland Revenue say that they are “unlikely to investigate a tax position where 80 per cent or more” of the income has been returned by the individual.

Inland Revenue accept that there may be times when it is inappropriate to award that much of the business income to the individual, such as planned capital expenditure, leveraging the work of employees, and business conditions.

That this sort of common-place, ordinary and legitimate business structuring is now considered tax avoidance sticks in the craw. The loss of clarity now faced by business owners is unacceptable, and it is disappointing that this year’s Budget did not tighten up on this new “grey” area of tax law. Inland Revenue have now taken it upon themselves to use the Penny & Hooper decision as some sort of mandate to effectively create their own pseudo-legislation.

Legislation introduced in 2000, when the 39 per cent personal rate was first introduced, specifically addressed the attribution of personal services income. However, it only applies where a company structure or similar is used and 80 per cent or more of services income is generated by an individual, where there 80 per cent or more of the income comes from one customer and there are no significant business assets. In addition to complying with this specific income tax rule, business owners must now also contemplate how the generic rules issued by the Inland Revenue could apply to their situation, and more importantly be applied with the benefit of hindsight by the Inland Revenue.

Adding to this unpalatable situation is Inland Revenue’s recent advice of their plans to increase the level of investigation activity in this area. They advise taxpayers to consider making a voluntary disclosure in respect of past periods so that exposure to penalties can be minimised. The only concession is that they will only amend the two last income years filed before the Penny & Hooper decision. What needs to be appreciated is that it is not just surgeons that will fall prey to Inland Revenue attention. Any business where income is earned through the application of personal skill and effort is at risk of being reviewed, including plumbers, electricians, computer technicians, and hairdressers. Maybe even accountants!

A  good tax system should provide taxpayers with certainty. When judge-made law gets applied with  retrospective effect to areas of tax law already addressed by Parliament, that certainty is lost.

Further enquiries, please contact:

Geordie Hooft           
Partner, Tax            
Grant Thornton New Zealand Ltd
T +64 (0)3 379 9580
E geordie.hooft@nz.gt.com