Retrospective Adjustments To Salaries Paid To Shareholder-Employees (WITHDRAWN)

Introduction

1. This Standard Practice Statement (SPS) sets out the criteria for considering whether the circumstances are appropriate for the Commissioner of Inland Revenue to permit retrospective adjustments to salaries paid to shareholder-employees where an error has been made in the preparation of a company's accounts.

Application

2. This SPS replaces the QWBA item entitled Retrospective adjustment to salaries paid to shareholder-employees published in Tax Information Bulletin Vol 9, No 4 (April 1997) at page 9.  It addresses the question of when a correction to a shareholder-employee's salary may be made and should not be taken as being applicable to situations where other mistakes have been made in a company's accounts and the company is seeking to rectify them.
   
   
3. This SPS will apply from 1 July 2003.

Background

4. In Tax Information Bulletin Vol 9, No 4 (April 1997) at page 9 we published a QWBA item entitled Retrospective adjustment to salaries paid to shareholder-employees.  Its effect is that where an error has been made in the preparation of the accounts of a company, Inland Revenue will amend the company's assessment to take account of the additional expenses that should have been included in the original return.  However, it will not agree to consequential adjustments that the company and the shareholder-employee may wish to make in relation to any salary that was originally agreed to be paid.  So neither the company's nor the individual's assessments would be amended to reflect the fact that a reduced salary would be paid.
   
   
5. Subsequently Case U27  (1999) 19 NZTC 9,261 considered this same issue and the Taxation Review Authority, his Honour Willy DJ, arrived at a different conclusion, holding that decisions as to the amounts of a shareholder-employee's salary for two income years that were made mistakenly could be reversed or amended.  The facts in that case were that the accountant was not fully informed of the company's financial affairs (there was, unknown to him, a tax dispute with Inland Revenue) and this led him to prepare end of year accounts that did not accurately reflect the company's true position.
   
   
6. The company had over several years fallen behind in accounting for PAYE, GST, ACC premiums and FBT to the Commissioner.  The omitted taxes and penalties not accounted for in error resulted in a substantial overstatement of the resulting profit.  This was important because these salaries in this company were only ever paid out of profits.  So the level of salaries was based on incorrect profit figures.  Although the resolutions authorizing the salaries were prepared these were never signed.  When he discovered his mistake new resolutions were prepared to authorize the distribution of reduced salaries. 
   
   
7. The Taxation Review Authority held that section 75 of the Income Tax Act 1976 (now section EB 1 of the Income Tax Act 1994), which deems a person to have derived income when it has been dealt with in the person's interest or on his or her behalf in any of various ways, including being “credited in account”, took effect accordingly, i.e. it operated on the circumstances brought about by the company resolutions correcting the error.  His Honour decided that the company was entitled to and did rectify the error when it came to its notice and the shareholder-employee was obliged to pay tax only on the reduced amounts of income for the relevant income years.
   
   
8. In the light of Case U27 it has been decided that the 1997 QWBA should now be withdrawn and replaced by this item.
   

Legislation

Income Tax Act 1994

EB 1     Income credited in account or otherwise dealt with—

1. For the purposes of this Act an amount shall be deemed to have been derived by a person although it has not been actually paid to or received by the person, or already become due or receivable, but has been credited in account, or reinvested, or accumulated, or capitalised, or carried to any reserve, sinking, or insurance fund, or otherwise dealt with in the person's interest or on the person's behalf. 
   
2. ....
   
3. Notwithstanding anything in subsection (1), where a deduction is allowed to a company for an income year in respect of expenditure incurred by way of monetary remuneration paid or payable to a person who in relation to the company is a shareholder-employee, the shareholder-employee shall for the purposes of this Act be deemed to have derived the monetary remuneration—
   
   
   1. As to an amount equal to—
      
      
      1. The amount of the deduction allowable to the company under this Act in respect of that income year and that expenditure; less 
         
      2. Such amount (if any) of that expenditure as is treated as the unexpired portion of accrual expenditure by virtue of section EF 1(5)(c),— 
         
          in the same income year as that in which the deduction was allowed to the company; and 
         
   2. As to the balance of the monetary remuneration, in such income year, or income years, as the expenditure of the company in respect of the monetary remuneration ceases to be treated by virtue of section EF 1(5)(c) as the unexpired portion of accrual expenditure of the company.
      
4. For the purposes of subsection (3),—
   
   
   1. Where a company referred to in that subsection is a person with a non-standard accounting year, the “same income year” means the income year to which the accounting year in which the deduction was allowed corresponds:
      
   2. Where the shareholder-employee referred to in that subsection is a person with a non-standard accounting year, the "same income year" means the accounting year of the shareholder-employee that corresponds to the income year—
      
      
      1. In which the deduction was allowed to the company; or 
         
      2. To which the accounting year of the company in which the deduction was allowed corresponds (where the company is of the kind referred to in paragraph (a).
         

Standard Practice

9. Provided full disclosure is made, and the relevant financial statements are amended and lodged, then generally Inland Revenue, where
   
   
   • a genuine error has been made in the accounts as a result of which a deduction has not been claimed for legitimate expenditure incurred, or a receipt has been incorrectly categorized,
     
   • the company has passed a resolution reflecting the change in light of the relationship between the company and the shareholder-employee, and
     a request for correction has been filed with a copy of the resolution,
     
   • a request for correction has been filed with a copy of the resolution
   • 
     
   will consider the request in accordance with Standard Practice Statement INV-510 entitled Requests to amend assessments published in Tax Information Bulletin Vol 14, No 8 (August 2002) and the principles set out therein.
   
   
10. It is expected that requests of this nature will be made in a timely fashion.  What is timely involves an exercise of judgment.  There are two aspects of timeliness here:
    
    
    • Once a mistake has been discovered then the parties should set about attending to it promptly.  In the majority of cases a month should be a sufficient period of time to discuss, prepare amending resolutions, hold a formal meeting and then to file fresh accounts with the Department.
      
    • As to how long a mistake may go undetected, the answer is less certain.  Timeliness requires that a mistake is discovered when in the course of events and in the circumstances of the taxpayer company one would have expected it to have been discovered.  It could be that many months may go by before the error is detected.  The Commissioner will not adopt “the normal course of events” criterion for some cases will be unusual.  For example, Case U27 was unusual in that there was a lack of communication between the accountant and principal shareholder and director.  The latter kept certain information about the arrears of taxes to himself. 
      
      
11. Where Inland Revenue agrees to approve such a retrospective adjustment, section EB 1 will deem the shareholder-employee's salary to be the amount as determined by the amending resolution and under section 113 of the Tax Administration Act 1994 Inland Revenue will adjust the company's and employee's assessments accordingly. 

Examples

12. The following situations may give some guidance as to when Inland Revenue will permit adjustments to be made.
    
    
    1. Incorrect treatment of receipt
       Where there is an error in the categorization of a loan receipt as revenue and this results in an overstatement of income, an adjustment may be made. 
       
    2. Omission of expenditure
       Where an error arises from the omission of expenditure incurred in the current year an adjustment may be made.  However, for a loss to trigger an adjustment it should be a real loss.
         
    3. Company still in profit even though error made
       Although an error has been made in the accounts that error is not sufficient to produce an overall loss and the company still has sufficient profit after the accounts have been corrected to cover the salary originally agreed to be paid.  In this situation Inland Revenue will consider each application for an adjustment on its merits.  The Commissioner will need to consider the nature of the contract between the parties and past practice.  While in this circumstance there would not be the same pressing need to amend or rescind the salary declaration, nevertheless the company could find the situation inconvenient and desire that the amount credited to the shareholder-employee at least be reduced to some extent.
       
    4. Accrual expenditure
       A company has committed itself to certain expenditure in one year although it has not had to discharge or bear that expense until a following year.  If such an item has been overlooked and the accounts need revision then it would be less likely for the amounts credited to the shareholder-employee as salary to be revised as well.  There may still be funds available to pay them.  Once again this is a matter where circumstances will vary.  Where there is accrual expenditure the answer will depend on the amount of the unexpired portion of that expenditure relating to future income years.  The Commissioner will consider each application for an adjustment on its merits.

This Standard Practice Statement is signed by me on 17 June 2003.

Margaret Cotton
National Manager
Technical Standards