You have probably seen or heard media coverage of the Supreme Court's recent decision in Penny & Hooper v CIR. It has had a lot more media airplay than the average tax avoidance case. This is because it concerns standard business structures of the kind entered into by many ordinary personal services providers. The Supreme Court has emphatically put an end to the use of such structures for tax-driven income "diversion" purposes.
If you are a taxpayer in a similar position to the taxpayers in Penny & Hooper, you need to consider what to do now.
What has the Supreme Court said?
The business structures of the kind at issue in Penny & Hooper are broadly as follows:
- A personal services provider (key individual) sells a business that he or she previously carried on personally, to an entity (operating entity).
- The operating entity is typically a company or trust and is owned or controlled by the key individual, his or her family members, or another entity that they control.
- The operating entity employs the key individual to undertake the business. The practical effect is that the previous business continues substantially unchanged.
IRD in its arguments, and the Supreme Court in its decision, stressed that the attack was not an attack on this type of business structure of itself. The Court said this, and other similar structures, are entirely lawful and unremarkable.
What was objectionable, according to IRD and now the Supreme Court, was utilising the structure in an arrangement that involved:
- fixing the salary the key individual received from the operating entity at an artificially low level, thereby reducing the amount of income generated by his or her exertions that was subject to his or her marginal tax rate; and
- instead funnelling the lion's share of the income from the business to a related person or entity that had a lower marginal tax rate (so that total tax was reduced), with the key individual still having use or enjoyment of the after-tax income.
In Penny & Hooper, the operating entity was a company. It paid a salary that was manifestly below market to the key individual (in each instance, a surgeon). Most of the company's income, generated from services performed by the key individual, was taxed at company level. Its after-tax income was distributed as imputed dividends to a family trust that owned the company, and was treated as trustee income. The surgeons were provided with the use or enjoyment of the after-tax income diverted through the trusts via interest-free advances or use of trust assets.
At the time, this arrangement had the effect of saving the key individual six cents in the dollar of tax on his income from the services he performed, given that the top individual marginal rate (39%) was higher than the company and trustee rates (both 33%). (This particular arrangement would no longer be tax effective, given that the top individual marginal and trustee rates were aligned from October 2010, at 33%. However, income diversion tax savings could still possibly be achieved by other means.)
In Penny & Hooper, IRD assessed the two key individuals as having personally earned what it thought was an appropriate level of income for the services they performed, rather than the low salaries paid to them. IRD did so using its tax avoidance "reconstruction" powers.
To what types of services and firms does the Supreme Court's decision apply?
While Penny & Hooper concerned senior medical practitioners, no sector of the economy is immune to the potential ramifications of the decision. No particular taxpayer can take comfort from the fact that he or she is not a "traditional professional". All types of personal service providers could be affected.
Also, while the decision primarily concerns "one person" service firms, the fact that a firm has multiple employees will by no means automatically be an answer to a challenge. If the other staff are really only in a support role, the key individual could still be exposed.
Further, although the decision specifically concerned a situation in which an existing personal services business had been sold by the key individual to the operating entity, the findings could apply equally where there was no prior business and the key individual simply commenced business through a company/trust structure.
What should potentially affected taxpayers do?
Some tax practitioners may be of the view that the Supreme Court has got it completely or partly wrong. Others will argue that the decision is correct, but poorly reasoned. Such criticisms, however, are really now of academic interest only. If the Supreme Court says something is the law, it is the law. The important role of tax practitioners now is to guide their affected clients through the fallout.
Two immediate practical challenges for taxpayers and their advisers arise where Penny & Hooper-type arrangements have been implemented:
- Determine, to some level of probability, whether the decision affects the taxpayer.
- If it does, work out what (if anything) to do about prior years, and (if necessary) how to change arrangements going forward.
We will now comment on each of these points.
Does Penny & Hooper affect me?
The Supreme Court's decision contains certain qualifications that make it clear that not every income diversion situation is vulnerable, even where the salary drawn from the operating entity is less than a "market" salary the individual would expect from an "arm's length" employer.
It is clear that there is a spectrum of potential scenarios. At one end is a scenario (perhaps exemplified by Penny & Hooper) in which there is no or little commercial justification for the low salary, and with the key individual continuing to have the private use or enjoyment of the after-tax income of the business. At the other is a scenario in which there are compelling non-tax driven business reasons for retaining funds in the operating entity, or for distributions to parties other than the key individual. Drawing the divide between "bad" and "good" is potentially difficult.
In a recent Revenue Alert (RA 11/02), published in light of the Supreme Court's decision, IRD has set out a non-exhaustive list of potential, legitimate, non-tax driven reasons for the payment of a below market salary to the key individual. These include:
- Adverse business conditions mean that the operating entity's profits are down, but most of those profits are still paid out to the key individual.
- It is financially prudent to retain some profits in the operating entity, because it is anticipated that the business may experience financial difficulties in the near future.
- The profits are set aside to acquire business assets in the next financial year.
- The business relates to a charity, and the key individual receives less income to ensure the charity's return is maximised.
A notable omission from this list is the common situation in which the operating entity is using its after-tax income to pay off debt used to finance its acquisition of the business from the key individual. The Supreme Court did not refer to this possibility either. It may well make a difference whether the debt is owed to the key individual, or to the bank. Any debt repayment arrangements will require special consideration.
Another important point to note is that any business need to retain funds within the operating entity (eg to acquire a capital asset) will only be a relevant explanation for paying a below market salary if it relates to the particular personal services business concerned. For example, if in Penny & Hooper money had been retained in the operating entity to fund a side investment in an orchard (a different business from the surgical business), this would have made no difference to the finding of tax avoidance in relation to the setting of the surgeon's salary.
The Revenue Alert recognises that in some situations, related individuals or entities may appropriately receive compensation from the operating entity. For example, they may own capital assets employed in the business, and may therefore be entitled to an appropriate return on those assets.
Further, IRD notes that the greater the level of input required from other skilled staff (rather than purely from the key individual), the more readily will IRD view the operating entity's income as attributable to its own business operation, rather than as diverted income of the key individual.
However, if, on analysis, the key profit driver of a service business - particularly one not requiring a great deal of capital - is a key individual's personal skills and exertion, then IRD's expectation is that the key individual should receive (whether by way of compensation, or profit distributions) at least 80% of the total profits distributed to the individual, his or her family members, and other associated parties (as well as, presumably, of the operating entity's retained profits).
Also, evidence that the key individual's salary is within a "market" range will not be decisive. There may be reasons, indicated by the operating entity's profit level, why the key individual concerned should receive "above market" remuneration. Any "reconstruction" by IRD will be based on these individual considerations, not on evidence of the market norm.
If I am affected, what should I do?
If a particular taxpayer may be affected by Penny & Hooper, careful consideration needs to be given to what to do next. It will be reasonably easy to adjust current year and future arrangements appropriately - but what about prior years?
Two background points are relevant to the treatment of prior years:
- IRD use of money interest (UOMI) will be accruing on the amount of short-paid tax (and will continue to accrue until the tax is paid).
- Shortfall penalties are likely to apply.
In the case of short-paid tax arising from a tax avoidance arrangement, the starting point is an "abusive tax position" shortfall penalty equal to 100% of the tax. However, provided the taxpayer has an unblemished recent tax history with IRD, shortfall penalties should automatically be reduced by 50% (ie from 100% down to 50%).
There may be a further reduction if the taxpayer voluntarily discloses the short-paid tax to IRD:
- If the short paid tax is voluntarily disclosed to IRD before IRD notifies the taxpayer that it is formally initiating a full audit, this further reduction would be 75% (ie down to 12.5% overall, after the 50% reduction above).
- If the short-paid tax is voluntarily disclosed to IRD only after IRD has notified the taxpayer that it is formally initiating a full audit, the further reduction may only be 40% (ie down to 30% overall).
In some instances an even more favourable negotiated settlement might be possible. Therefore, the overall "damage" might be limited to the core tax, UOMI, and a very low level of shortfall penalty. Ensuring the best possible outcome requires a timely approach.
Finally, as we noted at the outset, Penny & Hooper is not an attack on the use of such structures, but only the added feature of a below market salary. Even where Penny & Hooper necessitates financial adjustments, it will be quite proper, and in most cases advisable, for the legal structure to be retained. Further, in those cases where there are legitimate, non-tax driven reasons for the payment of a below market salary to the key individual, any incidental tax benefits will remain intact.