The Supreme Court has recently released a decision regarding tax avoidance by two orthopaedic surgeons. This decision is highly relevant to health professionals who have structured their practice through a company or a trust.

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

New Zealand's highest court has found that two orthopaedic surgeons improperly avoided paying income tax.  The decision signals that where medical practices are operated through a company, salaries paid to the company's employees (in both instances here, the surgeons) must be commercially realistic, or, if lower than market rates, reduced for primarily non tax related reasons.  This decision is relevant to health professionals who run their practice through a company or trust.

Penny and Hooper each incorporated a company (in 1997 and 2000 respectively) through which they operated their private surgical practices.  Each surgeon was the sole director and an employee of the company he established.  Company shares were held by each of the surgeon's family trusts.

In 2000, when the top personal tax rate increased from 33 to 39 cents in the dollar, each company began to pay the relevant surgeon a low salary, acknowledged to be below market rates.  As a result, only a small portion of each surgeon's personal services income was taxed at the top rate.  The remainder was taxed at the then lower trust rates.  Significant tax savings resulted, while the surgeons and their families were, in practical terms, still able to enjoy the income via the surgeon's family trusts, including by way of loans.

The Commissioner of Inland Revenue assessed the surgeons for tax by deeming their salaries to be what he determined were commercially realistic levels.

The Supreme Court upheld the Commissioner's approach, finding that while the surgeons' business structures were completely lawful and unremarkable, the manner in which the structures were used (to pay a salary that was not commercially realistic, without good reason) was tax avoidance.

Health professionals should note the following points:

  • Use of company / trust structures: While it is valid to operate a medical practice through a company, if a purpose of that structure is to alter the incidence of income tax then it may be considered part of a tax avoidance arrangement. 
  • Potential liability: In light of the Supreme Court’s decision, the Commissioner may show increased interest in other health professionals' tax compliance (particularly those who are effectively self-employed along the lines of Messrs Penny and Hooper).  Health professionals should be aware of their potential liability for situations where an artificially low salary has been paid. 
  • When a salary may be reduced: In some circumstances, it may be legitimate for a person to be paid a reduced salary relative to the market.  Such circumstances need to be assessed on a case by case basis, and the reasons for the reduction should be documented.  Possible reasons that may be acceptable include where a practitioner's responsibilities are reduced, where a company needs to retain funds for anticipated capital expenditure, or where a company experiences financial difficulties and cannot afford to pay a family member employee the equivalent of a commercial rate (for more information see the IRD's Revenue Alert RA 10/01). 

We recommend that health professionals affected by the decision seek further legal advice.  There are strategies available to eliminate or mitigate liability in relation to both historic and future arrangements.