Penny & Hooper - The History and the Result

The Supreme Court has dismissed the taxpayers’ appeal from the Court of Appeal’s decision  reported as C of IR v Penny and Hooper (2010) 24 NZTC 24,287 and held that the fixing of the taxpayers’ salaries at artificially low levels so that the incidence of tax at the highest personal rate was avoided constituted tax avoidance.

Background

The taxpayers practised as orthopaedic surgeons. Initially, they each conducted their practice on their own account but then restructured their practice arrangements. The restructuring of Mr Hooper’s practice occurred in 2000 and that of Mr Penny’s in 1997. Each set up a company to purchase their practice.  The companies were owned substantially by the taxpayers’ family trusts. Thereafter, each taxpayer was employed by their respective companies at a salary the Commissioner considered artificially low. The balance of the practice income in each case was treated as company income and paid by way of shareholder dividend to the family trusts.

Mr Penny had established a company/trust structure several years before the increase in the maximum individual tax rate from 33 cents in the dollar to 39 cents in the dollar took effect from 1 April 2000. However, after the tax rate change took effect, he limited the level of his salary and arranged for his family trust to lend back to him (interest free and with no repayment terms) a large part of the distributions of company profits that it received by way of dividend.

The Commissioner made assessments increasing the taxable incomes of Messrs Penny and Hooper for the tax years ending 31 March 2002, 2003, and 2004 by the amount equal to the difference between the salaries actually paid and what the Commissioner assessed as commercially realistic salaries for their services. The taxpayers appealed to the High Court.

In a decision reported as Penny v C of IR; Hooper v C of IR (2009) 24 NZTC 23,406 , the High Court found that what each taxpayer did was not an arrangement, which had the purpose or effect of tax avoidance. The Commissioner appealed to the Court of Appeal.

The Court of Appeal reversed the High Court’s decision and declared the arrangements void against the Commissioner for income tax purposes. The taxpayers’ application for leave to appeal to the Supreme Court was granted ( Penny and Hooper v C of IR (2010) 24 NZTC 24,396 ).

The Supreme Court

The Supreme Court noted that the case differed from Ben Nevis Forestry Ventures Ltd v C of IR (2009) 24 NZTC 23,188 in which the Supreme Court explained the proper approach to questions of tax avoidance. In the present case, 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. There was also no failure to comply with any express requirement of the Income Tax Act in the setting of the salaries, since there was none. The Supreme Court said that this was therefore a case in which, compliance in other respects being accepted, it was possible to move straight to s BG 1 and to ask whether the use of the structure, which was adopted when the salaries were fixed, was beyond Parliamentary contemplation and resulted in a tax avoidance arrangement.

The Commissioner’s case was that the avoidance resulted from a single step taken by each taxpayer, which took advantage of an otherwise unobjectionable business structure. That step was the taxpayer’s actions on each side of the employment contract relationship (as controlling director of the employer and as employee) in setting an artificially low level of salary, which had the effect of altering the incidence of taxation. Once that artificial step was taken, matters proceeded in an orthodox manner with the payment of the bulk of the company’s profits on a fully imputed basis to the shareholding trusts. That step made possible the distributions of dividends and the benefits, which followed.

The Supreme Court held as follows:

1.     Tax avoidance can be found in an individual step in a wider arrangement. That step, when taken can make the wider arrangement a tax avoidance arrangement. Where a particular step is done repetitively, such as in this case in the annual setting of the salary levels, the step may or may not amount to a tax avoidance arrangement depending on its purpose or effect on each occasion.

2.     If the setting of the annual salary is influenced in more than an incidental way by a consideration of the impact of taxation, the use of the structure in that way will be tax avoidance.

3.     The question of whether the fixing of a salary on a particular occasion involved tax avoidance could be answered by looking at the effect produced by the fixing of the level of the salary in combination with the operation of the other features of the structure.

4.     The fixing of the low salary in this case enabled most of the profits of the company from the professional practice to be transferred by way of dividends straight through to the trust, avoiding payment of the highest personal tax rate, and then used by the trust for the taxpayers’ family purposes.

5.     Although another purpose of the arrangement was the protection of assets from   professional negligence claims, this could not have been the sole or dominant purpose because of the protection already in place through the combination of the accident compensation scheme and insurance cover. The taxation advantage produced by the fixing of the salaries at low levels was the predominant purpose.

6.     Although the New Zealand tax statute and some business practices have changed considerably since the decisions of the High Court of Australia and the Privy Council in Peate v Commissioner of Taxation of Commonwealth of Australia (1962-1964) 111 CLR 443, affirmed [1967] 1 AC 308 (PC), Parliament has deliberately preserved, and in fact enlarged, the New Zealand general antiavoidance provision which corresponded to s 260 in Peate.

7.     The artificially low salary settings in this case reduced each taxpayer’s earnings but at the same time enabled the company’s earnings (derived only because of the setting of the salary levels) to be made available to him through the family trusts. In reality, the taxpayers suffered no actual loss of income but obtained a reduction in liability to tax as if they had ( Challenge Corporation Ltd v Commissioner of Inland Revenue [1986] 2 NZLR 513 (CA); Challenge Corporation Ltd v Commissioner of Inland Revenue [1986] 2 NZLR 555 (PC) cited).

8.     Although there was no concept of a commercially realistic salary to be found in the Income Tax Act, the Act does require that taxpayers should not structure their transactions with a more than merely incidental purpose of obtaining a tax advantage unless that advantage was in the contemplation of Parliament.

9.     If the salary is not commercially realistic or, objectively, is not motivated by a legitimate (that is, non-tax driven) reason, it will be open to the Commissioner to assert that it was, or was part of, a tax avoidance arrangement.

The Supreme Court concluded that the taxpayers had failed to show that the Commissioner acted incorrectly in treating the arrangements made by the taxpayers as void against him for income tax purposes under s BG 1.

Penny and Hooper v C of IR SC SC62/2010 [2011] NZSC 95, 24 August 2011.