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Penny and Hooper – tax avoidance through use of trusts

Penny and Hooper v Commissioner of Inland Revenue  [2011] NZSC 95

The Supreme Court decision in Penny and Hooper was the final instalment in the debate as to whether payment of a below market salary is tax avoidance.   Th facts of the case involve surgeons who restructured their business affairs so that instead of working for themselves, the surgeons were employed by companies, the shares of which were owned by family trusts.  After the restructuring both surgeons accepted vastly reduced salaries.  All profits were still subject to tax.  However, as a result of the restructure most of the profits were taxed at 33% rather than 39%.

There is no provision in the Income Tax Act 2007 that prohibits payment of a below market salary.  However, the Commissioner of Inland Revenue adopted the view that where such a low salary was paid, the general anti-avoidance provision  should apply.  This provision is a back up tax avoidance provision that can be utilised to reconstruct arrangements where the result is something that was beyond Parliament’s contemplation.  The use of the general anti-avoidance provision, rather than the numerous specific provisions is always a qestion of degree as the provision is applied as somewhat of a back stop.

In its decision the Supreme Court noted that there was no question of the taxpayers failing to comply with specific taxation provisions. The trading structure adopted by the taxpayers was a choice they were entitled to make. There was also nothing unusual or artificial in a taxpayer then causing the company under his control to employ him on a salaried basis.  However, the Court found that the structure utilised the taxing provisions that was beyond what Parliament contemplated.

While such a proposition does not provide clear or quantifiable guidance the Supreme Court also outlined situations where a below market salary would not amount to tax avoidance:

  • where a salary was set to a level that would absorb all company profits
  • a company in financial difficulty had insufficient funds to pay a market salary
  • retention of funds in order to make capital expenditure

Viewed objectively, it also appears that a significant factor in the outcome was the amount of control Mr Penny and Mr Hooper had over what became of the balance of the money earned as a result of their services.  What this means practically, is that a safer practice would be to ensure a greater diversity of control with objective and measurable governance.

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