Income splitting ruled by Court of Appeal as tax avoidance
2010 case note – Penny and Hooper v CIR - derivation of income, tax avoidance arrangement, artificiality and contrivance.
The Court of Appeal by majority ruled that income derived by the companies controlled by the taxpayers was substantially earned through the personal exertions of the taxpayers themselves. Therefore, when looked at objectively, remuneration for tax purposes needed to reflect the correct amount expected to be earned from the skills provided to the company.
Impact of decision
The decision is now the leading case on income splitting and has generated much media comment and some industry controversy. The decision follows on from other post Ben Nevis cases and confirms that the entire factual matrix is important when looking at key factors indicating a tax avoidance arrangement. In particular the artificiality and contrivance aspect of an arrangement will be very fact dependent and needs to be approached on a case by case basis. For more information see the Commissioner's Revenue Alert RA 10/01.
The two plaintiffs are orthopaedic surgeons. Each practices in both the public and private sector. Initially each practiced on their own account but after a period, each incorporated their practice. Each surgeon was then employed by their company to undertake the services they were undertaking as sole practitioners.
Mr Hooper began practicing in the private sector in 1989. The practice operated from a shared Orthopaedic Centre. In 1991 Mr Hooper and his wife were settlors of two "mirror trusts". The Trustees of both trusts were the solicitor and the accountant. The beneficiaries were the spouse, children and grandchildren. The trusts were established to buy a share of the premises occupied by Mr Hooper. In 2000 the practice arrangement was "restructured" and Hooper Orthopaedic Limited (HOL) was formed. The family trusts owned 495 shares each while Mr and Mrs Hooper owned 5 shares each. Mr Hooper was the sole company director. Mr Hooper sold his practice to HOL for $332,473 including goodwill of $330,000.
HOL employed Mr Hooper for a salary of $119,990 between 2001 and 2003. He was the sole orthopaedic surgeon employed by HOL and as sole director he determined the salary. Patient referral was to Mr Hooper personally. HOL received patient fees as income. In 2001 HOL derived $593,914 from patient fees. In 2002 the income derived was $447,915 and in 2003 the amount was $502,882. During the years the trusts received fully imputed dividends from HOL.
Mr Penny commenced practice as a private orthopaedic specialist in 1991. In 1997 he incorporated Penny Orthopaedic Services Limited (POS) of which he was the sole shareholder. He also set up Orthopaedic Surgical Consulting Limited (OSCL) and A C Penny Trust No 1 (The Trust). All shares in POS were owned by the Trust. The trustees of the Trust were the accountant and the solicitor. Final beneficiaries of the Trust were Mr Penny, his wife their children and grandchildren. The premises from which Mr Penny worked were initially leased by Mr Penny to POS and were later sold to the Trust. His orthopaedic practice was transferred to POS in February 1997 for $144,310 which included goodwill of $100,000. In April 1997, OSCL purchased the surgical and medical practice from POS for $1,044,310. Goodwill in that transaction was $1,000,000. After the restructuring OSCL became Mr Penny's employer. OSCL received the patient fees as income. In the year 2001 OSCL had an income of $484,779, in 2002 the income was $609,871 and in 2003 it was $566,183. In each of those three years Mr Penny set his salary at $99,996.
The Commissioner issued notices of proposed adjustments (NOPAs) to both parties for the 2002, 2003 and 2004 years. The proposal by the Commissioner was to assess the salaries at a level which was considered to be a "commercially realistic salary". The tax in issue was the difference between the company rate of 33% and the individual earner rate of 39%. Adjudications found that section BG 1 of the Income Tax Act 1994 applied. The taxpayer(s) commenced proceedings in the High Court after the Commissioner issued assessments. The High Court found for the taxpayers in a decision reported as Penny v CIR; Hooper v CIR (2009) 24 NZTC 23,406. The Commissioner appealed to the Court of Appeal
Randerson J found that a tax avoidance arrangement did exist. Three separate written decisions were delivered by the Court. Randerson and Hammond JJ found for the Commissioner, Ellen France J dissenting. Only Randerson J's decision is reported here.
His Honour used the recent findings of the Supreme Court in Ben Nevis Forestry Ventures Limited v CIR and Glenharrow Holdings Limited v CIR as a basis for his interpretation of section BG1. At paragraph  he referred to paragraphs  and  of Ben Nevis and said the Supreme Court decided that:
- the reconciliation of specific and general anti-avoidance provisions requires a “principled approach which gives proper overall effect to statutory language that expresses different legislative policies”;
- decisions on individual cases are to be made through "the application of a process of statutory construction focussing objectively on features of the arrangement involved, without being distracted by intuitive subjective impressions of the morality of what tax advisers have set up";
- the specific tax provisions and the general anti-avoidance provisions are to be construed together so as to give appropriate effect to each; and
- whether an arrangement constitutes tax avoidance will depend on whether the taxpayer's use of the specific statutory provision has occurred in a manner that is consistent with Parliament's purpose, determined by an objective analysis of the overall scheme and purpose of the Act.
He noted that the principles were expanded upon in paragraphs - of the Ben Nevis decision and particularly noted:
-  Of particular relevance to the present case are the observations made by the Supreme Court to the effect that:
- the manner in which the arrangement is carried out will often be an important consideration;
- so too, the role of the relevant parties and any relationship they may have with the taxpayer;
- the economic and commercial effect of transactions may be significant; and
- a classic indicator of a use that is outside parliamentary contemplation is the structuring of an arrangement so that the taxpayer gains the benefit of the specific provisions "in an artificial and contrived way".
In paragraph  Randerson J endorsed what the Supreme Court said in paragraph  of Glenharrow about looking at the "aim or end in view" of an arrangement. The arrangement needing to be objectively assessed and noting from paragraph  that "The purpose of an arrangement will be deduced from the arrangement itself and its effect …".
When discussing the "nature and scope of the arrangement alleged" he noted at paragraph  of his judgment that "the expression 'arrangement' is very broadly defined". The essential elements relied upon by the Commissioner as constituting a tax avoidance arrangement were:
- the decision of the taxpayers in the relevant income years to operate their private practices through the company and family trust structure;
- the decision by the relevant companies and the individual taxpayers to pay the respondents a salary that was substantially less than a commercially realistic salary;
- channelling the company profits to the trust and allowing the taxpayers to have the benefit of those funds without deriving such funds as their personal income; and
- in Mr Penny's case the decision to advance funds to him from the trust.
Randerson J confirmed that an arrangement is not limited to "a specific transaction or agreement". At paragraph  he stated:
-  I am satisfied that an "arrangement" is not limited to a specific transaction or agreement but may embrace a series of decisions and steps taken which together evidence and constitute and agreement, plan or understanding. Any such arrangement may be continued in each of the income years in question or may be varied from year to year.
After defining what constituted an arrangement Randerson J then looked at "whether or not the arrangement directly or indirectly had tax avoidance as one of its purposes or effects?". He noted at paragraph  that in the absence of a general anti-avoidance provision the taxpayers were entitled to take advantage of the different applicable tax rates. Randerson J then asked "whether viewed in light of the arrangement as a whole, the taxpayer has used the specific provisions of the tax legislation to alter the incidence of income tax in a way that cannot have been within the contemplation of Parliament?". He then confirmed that the answer to the question involves looking at the "scheme and purpose of the Act".
While noting that Parliament introduced Personal Services Attribution ("PSA") rules at the same time as it increased the top rate for personal income tax, Randerson J did not accept that because Parliament addressed the prospect of tax avoidance in one set of circumstances, "… that it did not contemplate that the general tax avoidance provision might apply in other situations". At paragraph  he stated:
-  Moreover, as noted by the Supreme Court in Ben Nevis, one of the reasons for the general anti-avoidance provisions being expressed in broad terms, is the difficulty in predicting in advance the ingenuity of taxpayers in adapting the forms in which they do business.
The significance of Hadlee v CIR was discussed in paragraphs  to . Randerson J accepted that the case was different in so much as Hadlee did not relate to a company which was deriving the income. The diversion of the income generated from personal exertion was however seen as significant when undertaken in "a way which undermines the graduated personal tax regime …".
In conclusion Randerson J noted at paragraph  that:
-  The Supreme Court has made it clear in Ben Nevis that the adoption of legitimate legal structures or entities will not be a barrier to a finding of tax avoidance if the arrangements are artificial, contrived, or amount to a pretence. Findings of that character will be influenced by assessing them in the light of commercial reality and the economic effect of the arrangements. The conclusion of the Supreme Court in this respect is supported by a substantial body of precedent both in this court and the Privy Council.
The arrangements not only had the effect of altering the incidence of income tax but the alteration was at least one of the purposes of the arrangement. His Honour found that the purpose or effect of altering the incidence of tax was not merely an incidental purpose or effect [paragraph 112]. He noted that there was nothing wrong with the change to the use of the company structure. However, he thought it significant that each had previously practiced on their own account and the net income of each dropped significantly after the introduction of the top personal tax rate.
It was also noted that both Mr Penny and Mr Hooper had agreed that their salaries were at levels substantially below what they would have expected had they been employed independently and at arm's length [paragraph 113-114]. Consideration was also given to the fact that the personal exertions of Mr Penny and Hooper were the same as before and that company profits increased. The surplus company profits were then transferred to Mr Penny and Mr Hooper and their families. While accepting that there may have been a secondary purpose or effect for making the arrangements, Randerson J also mentions that any enhanced personal income, after tax, could also have been applied for the benefit of the surgeons and their families [paragraph 120].
At paragraph , Randerson J confirmed that when the overall circumstances were taken into account, the avoidance of tax was more than a merely incidental purpose or effect of the arrangement. He noted that the salaries adopted were so far removed from commercial reality as to be "contrived and artificial". He also noted that the case had some parallels with Hadlee. The amount of goodwill paid by the companies for the services of the surgeons was another factor Randerson J saw as relevant in regards to the "artificiality" of the arrangements [paragraph 124].
Randerson J finished by acknowledging the consequences of the decision, he stated:
-  I am conscious of the practical consequences which may flow from this decision, including the uncertainty which may be created for the Commissioner as well as for taxpayers and their advisers. To what extent and in what circumstances will it be necessary to review the salary levels of employees (particularly in family companies) to determine on which side of the line their salary may fall? It is important to recognise however, that this decision should not be regarded as establishing a principle that salary levels in family companies which are below the levels which could be expected in an arms-length situation, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement.
Income Tax Act 1994