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RA 10/01

Revenue Alert

2010 Revenue Alert considers taxpayers who divert income from a business or activity to an associated entity. Updates CIR's view following Penny and Hooper decision.


A Revenue Alert is issued by the Commissioner of Inland Revenue, and provides information about a significant and/or emerging tax planning issue that is of concern to Inland Revenue. At the time an alert is issued risk assessments will already be underway to determine the level of risk and to consider appropriate responses.

A Revenue Alert will identify:

  • the issue (which may be a scheme, arrangement, or particular transaction) which the Commissioner believes may be contrary to the law or is inconsistent with policy;
  • the common features of the issue;
  • our current view; and
  • our current approach.

An alert should not be interpreted as being Inland Revenue's final position. Rather, an alert outlines the Commissioner's current view on how the law should be applied. For any alert we issue it is likely that some investigatory work has already been carried out.

If people have entered into an arrangement similar to the one described or are thinking about it, they should talk to their tax advisor and/or to Inland Revenue for advice about tax implications.

Issue: Diverting personal services income by structuring revenue earning activities through an associated entity such as a trading trust or a company: the circumstances when Inland Revenue will consider this arrangement is tax avoidance.

Note: This Revenue Alert updates the Commissioner's view on this matter following the decision in CIR v Penny and Hooper [2010] NZCA 289 and replaces Revenue Alert RA 08/01 issued in March 2008.

Inland Revenue has always been concerned about arrangements involving taxpayers who arrange to effectively divert some or all of the income they earn (or could earn) from a business or activity of supplying personal services to an associated entity. This is done with the effect of taking advantage of lower marginal income tax rates payable by that entity and/or by family members as beneficiaries or shareholders of that entity, or of other tax benefits.

First we firstly acknowledge that there are legitimate reasons for using entities such as trusts or companies in many business situations. Therefore the mere use of alternative business structures will not, on its own, amount to a tax avoidance arrangement. Further, as we discuss below, there may also be good non-tax reasons as to why a business owner pays himself or herself significantly less of the business' profits than would otherwise be the case. In deciding whether to investigate further, we will review each case on its own facts using the criteria discussed below. Additionally, cases are independently reviewed before a final decision is made.

The recent Court of Appeal decision in CIR v Penny & Hooper confirms that an important part of the scheme of the income tax legislation is that income substantially generated by the direct personal skills, experience or labour of an individual should be subject to tax in the hands of that individual. That tax result applies to any type of services provided by an individual to third parties.

Where a service business relies mainly on an individual's personal skills to generate income, that contribution to the business should be properly reflected in the income returned by that individual - either through an appropriate salary or other taxable distributions to the individual.

Accordingly, we will closely examine situations where an arrangement has the effect of diverting a substantial amount of that personal exertion income for the personal benefit of the individual or their family.

We will generally focus on the most serious and artificial cases - recognising that many ordinary small businesses reasonably make use of different entities to carry on their business.

In many cases, taxpayers entering into these types of arrangements are also benefiting from reduced child support liabilities or student loan repayment obligations. In some cases taxpayers are structuring their remuneration at a level that will allow them access (or greater access) to other non-income tax benefits that rely on income calculated for tax purposes such as Working for Families Tax Credits or other income tested benefits, for example student allowances.


We note that it is often a combination of factors, such as those listed below, that concern us. Where income is generated from the supply of services a combination of some or all of the following factors may contribute to an arrangement being considered artificial, contrived or lacking in commercial reality where a person earns (or is able to earn) income from an activity involving supply of services to customers, where his or her personal contribution in the form of the application of skills is central to that activity, and:

  1. They arrange for an entity, such as a trading trust or company, to operate the business. That entity engages or employs them (or contracts for their services) in return for either no remuneration or for remuneration set at an artificially low level - artificial in that the remuneration does not reflect what a reasonable person in that situation would expect to earn from that activity, having regard to the specialist skills of the taxpayer, other factors that contribute to the success of the business (e.g. capital assets or employees) and of course the profits actually generated;
  2. Where the business has been transferred, whether the business operates substantially as it did before its transfer to the entity;
  3. Whether the business is operated according to the terms of the arrangements entered into. This includes examining the agreements themselves, the manner in which it is actually implemented and also whether the arrangement is commercial having regard to a comparison with relevant standard business practices;
  4. The degree to which they or their family ultimately control the entity, its economic product and cash flows from the business;
  5. Whether there is a redistribution of the underlying income from the entity to the person or to family members, usually via a trust but there are other mechanisms, for example, by way of the employment of family members or related party loans or the payment of management and other service fees to associates;
  6. The relative significance or materiality of non-tax reasons for structuring their particular affairs in the manner they have done relative to the personal attributes of the taxpayer; and
  7. The extent to which, as a consequence of the arrangement, significant tax benefits are obtained e.g.where the entity and/or any beneficiaries or shareholders pay lower marginal tax rates than would have been payable by the taxpayer, but for the arrangement.

Those are non-exclusive factors, but they are the main points of investigative focus for this particular area of tax planning.

Current view

Inland Revenue considers that arrangements that exhibit a combination of the above features may constitute an avoidance arrangement in terms of sections BG 1 or GB 44 of the Income Tax Act 2007.

The particularly important indicators in most cases of closely held service business entities are usually, in our view, the degree of participation by the individual, and the degree to which profits are in substance diverted to other family members, but different fact situations will dictate that greater or lesser weight may apply to other factors.

To determine whether or not there has been tax avoidance we will look at all aspects of these arrangements including all documentation, and the actual behaviours of the persons involved.

Whether or not the level of remuneration paid by the employing entity to the taxpayer is reflective of the taxpayer's contribution to the entity's profits in any given income year is an important indicator (though not conclusive on its own). For example, we are likely to consider the income paid to be too low if it is substantially less than the net amount that would reasonably be distributed (taking into account its business environment, plans and risks, and the income actually generated) by the entity if it was a sole trader enterprise or a partnership and other factors apply.


A successful professional taxpayer derives $850,000 net income from private practice. The taxpayer decides to form a company with 100 shares, 98 of which are held by the family trust, 1 share by the taxpayer's spouse and 1 share by the taxpayer. The taxpayer then sells the practice to the company (with an interest free debt in return).

The company, in turn, employs the taxpayer and pays her an annual salary of $70,000. The bulk of the profit of the company is distributed to the trust by way of dividends. The company employs no other professional staff.

Following the sale of the practice, apart from the employment of the former practice owner, it operates in the same manner as it did when the taxpayer was self-employed. No commercial reason was advanced by the company for the low salary set.

In this example, while it can legitimately be argued that a purpose of the arrangement was to provide for the taxpayer's family, what is equally evident is a purpose of diverting income from the taxpayer to a company to take advantage of a lower tax rate. The $70,000 salary does not reflect the former practice owner's skills and experience and the fact that the company's profits were largely generated from the rendering of services by her. Furthermore no commercial reason was advanced for paying such a low salary. Accordingly, while it is considered that the establishment of the company is permissible when viewed alone, the combination of factors present in this case, and the way the new structure has been used in this example is in our view indicative of a purpose of tax avoidance.

Other considerations

In general we would not expect that remuneration would be paid where there is little or no profit genuinely being generated in economic reality, such as in a start-up phase or in difficult trading conditions. We accept that income can be properly retained for major expenditures or provisioning. Our concerns are not with non-payment of remuneration or with retention of earnings inside an operating business entity, where these are for genuine commercial or economic reasons. In such circumstances, it is unlikely that there would be other distributions of profit from the business to the taxpayer and his or her family.

Conversely, for example, we would be concerned if there were evidence of an artificial or contrived arrangement that shelters income inside an entity, or a taxpayer or related parties enjoying the benefit of personal services income on which tax has been avoided. The particular facts of any situation will be important to assessing such situations. In general we will be concerned about contrived or artificial arrangements that avoid the payment of tax.

Current status

Inland Revenue has investigated a number of these arrangements over recent years. Where we still consider, after initiating the tax disputes process, that the arrangement is tax avoidance, amended assessments will be issued which attribute some or all of the diverted income to the taxpayer, to counteract the tax benefit resulting from the use of this arrangement. Some of those investigations and disputes were deferred awaiting the Court of Appeal's decision in Penny & Hooper.

We will also continue to investigate similar arrangements where there are significant tax benefits. Where the tax avoidance rules apply, we will take steps to counteract the tax benefits obtained.

Options available to Inland Revenue on reconstruction include deeming all of the income to have been derived by the individual, or deeming that individual to have received some other amount of remuneration personally (e.g. an amount that more properly reflects the individual's contribution to the business' profits).

Late payment penalties and use of money interest may be applied to people entering into the type of arrangement described in this Revenue Alert.

Shortfall penalties may also apply, although these may be reduced where a voluntary disclosure is made.

If you consider that our concerns may apply to your situation, we recommend you discuss the matter with your tax advisor or with us, and consider making a voluntary disclosure.

References to consider

The following related references will assist taxpayers with determining whether their arrangement is subject to the avoidance provisions in the Revenue Acts.

Subject references: Tax avoidance
Legislative references: BG 1 ITA 2004 and ITA 2007
GB 1 ITA 2004 and GA 1 ITA 2007
GC 14B ITA 2004 and GB 27 ITA 2007
GC 28 ITA 2004 and GB 44 ITA 2007
Standard practice statements: SPS 09/02 Voluntary Disclosures (see also booklet IR281)
Other policy statements: "Appendix C - Explanation to the application of section 99 of the Income Tax Act 1976" Tax Information Bulletin Vol. 1, No 8 (February 1990).
Revenue Alerts items: RA 08/01
Case Law: Ben Nevis Forestry Ventures Limited v CIR [2009] 2 NZLR 289
CIR v Penny and Hooper [2010] NZCA 231
Case Z24 (2010) 24 NZTC 14,354
Case W33 (2004) 23 NZTC 11,321
Case Y1 (2007) NZTC 13,001
Hadlee & Sydney Bridge Nominees Ltd v CIR (1993) 15 NZTC 10,106
Wells v CIR (1973) 1 NZTC 61,094
Halliwell v CIR (1977) 3 NZTC 61,208
Shine and Laird v CIR (1981) 5 NZTC 61,058
Peate v FCT (1962) 9 AITR 3
FCT v Gulland, Watson (1985) 17 ATR 1
Date issued: June 2010
Authorised by: Graham Tubb
Group Tax Counsel
Legal & Technical Services
Contact for comment (via email): [email protected]
Media queries: David Miller
(04) 890 1743