Decision date: 24 August 2011
Case: Penny and Hooper v Commissioner of Inland Revenue
Act(s): Income Tax Act 1994, Tax Administration Act 1994
Keywords: Avoidance, income splitting, income diversion, commercially realistic salary, evidence exclusion
Two surgeons who used companies and trusts to divert what was previously personal income were held by the Supreme Court to have avoided tax under section BG 1 of the Income Tax Act 1994 ("ITA"). The structures they used were of themselves legitimate, but they were used in conjunction with artificially low salaries, paid to the surgeons personally, which amounted to tax avoidance.
The Commissioner has released a revised revenue alert setting out his views on the practical implications of this highly precedential decision. The Revenue Alert RA 11/02 has been published on our website and also in the Tax Information Bulletin Vol 23, No 8 (October 2011).
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 they each incorporated their practices. Each surgeon was then employed by their company to undertake the services they provided 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 their solicitor and their 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. Mr Hooper was the sole company director. Mr Hooper then sold his practice to HOL. 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. HOL received patient fees as income. HOL derived $593,914 from patient fees in 2001, $447,915 in 2002, and $502,882 in 2003. During this time the mirror 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 AC Penny Trust No 1 ("the Trust"). All shares in POS were owned by the Trust. 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. In April 1997, OSCL purchased the surgical and medical practice and goodwill from POS. After the restructuring, OSCL became Mr Penny's employer. OSCL received the patient fees as income. OSCL had incomes of $484,779 in 2001, $609,871 in 2002, and $566,183 in 2003. In each of those three years his salary was set at $99,996.
The salary alterations took effect around the time the top marginal tax rate was increased from 33 to 39 cents in the dollar.
The case summaries published in respect of the High Court and Court of Appeal decisions can be found in the "Case notes 2010" section of our website.
The Court held unanimously that the arrangements constituted tax avoidance.
In a preliminary matter, the Court considered the operation of the evidence exclusion rule in section 138G of the Tax Administration Act 1994 ("TAA"). The Appellants argued that the Commissioner's evidence about loans made to the taxpayers by the Trust was excluded under section 138G of the TAA. The Commissioner, they argued, had not set these facts out as part of the "arrangement" until after the discovery process. The Court held that such was the function of discovery that these facts were not disclosed until then, and that in any event, the Commissioner was entitled to respond to certain statements in Mr Penny's SOP which entrained the loan issue.
The Commissioner had also argued that large parts of Mr Shewan's evidence in the High Court were inadmissible. The Supreme Court upheld the Court of Appeal's decision to disregard such argument in the guise of evidence. It went further to state:
On the substantive tax avoidance issue, the Court noted at the outset that the case differed from Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue  NZSC 115,  2 NZLR 289. The Court stated that there was nothing wrong with the structure the Appellants had adopted, and that the use of such a "familiar trading structure" was a choice they were entitled to make.
Neither was there anything wrong with the Appellants being employed within that structure on a salaried basis. Further, the Court said there was nothing in the ITA that required salaries to be set at any particular level. There was thus no issue with any failure to comply with any express provision of the ITA and it was possible to move straight to a consideration of section BG 1.
The Court considered there were some instances where such an arrangement might not amount to tax avoidance, such as setting a salary to absorb profits, or to allow for business development or meet financial difficulties. However, "... 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".
The Court then examined why the Appellants' salaries were set at the level they were. In so doing, the Court discounted arguments that such structuring minimised exposure to professional negligence claims. It noted that such protection already existed through accident compensation and insurance cover. The Court also observed that Mr Penny immediately borrowed the money back so that it "never left his hands".
This was not a revolutionary concept the Court said, referring to the 50-year-old Privy Council case of Peate v Commissioner of Taxation of Commonwealth of Australia (1962-1964)111 CLR 443, which concerned eight doctors restructuring a partnership into company shareholdings. In particular, the Court took notice of dicta within the decision of the High Court of Australia. As in the present matter, the Court in Peate found that it was not the novelty of trading through corporate structures that was offensive, but the way they used those structures to obtain tax advantages. Legislative and mechanical differences (such as reconstruction rules) had no bearing on the applicability of this authority to the present dispute.
Analysing other authorities, the Court held that the role of section BG 1 was, following Challenge Corporation Ltd v Commissioner of Inland Revenue  2 NZLR 513 (CA), to be "... able to thwart technically correct but contrived transactions set up as a means of exploiting the Act for tax advantages". Nor did any specific anti-avoidance rules (such as the Personal Services Attribution “PSA” rules) override the general anti-avoidance provision, which continues to have a residual function.
The Appellants argued that there was no concept of a "commercially realistic salary" within the ITA. The Court in response agreed that the choice of structures was open to taxpayers to address commercial or family needs. However, that can not be the case where a more than merely incidental purpose of the reduced salary is to obtain tax advantages. It also noted that legislation sometimes sanctions the choice of a lower tax rate, such as with the PIE regime (Portfolio Investment Entities), but such parliamentary contemplation must be obvious.
The Court considered also the applicability of two earlier authorities; Hadlee v Commissioner of Inland Revenue  3 NZLR 517 ("Hadlee") and Loader v Commissioner of Inland Revenue  2 NZLR 472 (SC) ("Loader"). In the former, the Appellants argued that the context differed from the present matter and that an assignment was not to be compared with an outright sale. The Court considered that the case was nonetheless analogous but left open the question of whether Hadlee has wider application. In the case of Loader, a similar company/trust structure was set up to conduct an earthmoving business, and the taxpayer's salary was set at a level that left the company with substantial profits. Cooke J had held that the arrangement was not tax avoidance as there were accepted business and family reasons for so doing. The Court considered while tax saving was a motive, it was purely incidental and the Commissioner's attack on the arrangement was centred on the formation of the company rather than the setting of the salary level. Accordingly, the case was of little support to the Appellants' arguments in this case.
The appeal was dismissed with costs of $25,000 and reasonable disbursements to the Commissioner.