Much has been made of the case Ian David Penny and Gary John Hooper v Commissioner of Inland Revenue [2011] NZSC 95. On first appearances, it seems to undermine a business structure which is commonly recommended by accountants and lawyers for small, closely held businesses.

Mr Penny and Mr Hooper are both orthopedic surgeons and each have their own private practice in Christchurch. Acting completely independently of each other, they sold their practices to companies in which the shares were held solely by their respective family trusts. Following the maximum personal tax increase in 2007 from 33 cents to 39 cents in the dollar, each entered into an employment contract with their company for a substantially reduced income comparative to their previous year’s earnings. Both surgeons acknowledged that the salaries were “commercially unrealistic”.

The Supreme Court confirmed the findings of the Court of Appeal – that the business structures constituted tax avoidance arrangements for the purposes of the Income Tax Act 1994.

However, the Court acknowledged that the business structure itself was “entirely lawful and unremarkable”. It also agreed that paying a lesser salary was an acceptable commercial practice and did not automatically lead to an assumption of tax avoidance. Helpfully, the Court identified a number of legitimate circumstances in which a low salary might be set:

  • so as to absorb all of the company’s profits;
  • because the company had a commercial need to retain funds for the purpose of capital expenditure;
  • because the company is experiencing financial difficulty or might reasonably expect to do so in the future; and
  • because it was not financially prudent to pay a higher salary.

The Court found that the act of avoidance could be identified in the motivation behind the creation of this “entirely lawful and unremarkable” business structure. In this case, considerable weight was given to the timing at which the employment contracts were entered into, together with the lack of any persuasive evidence that they were entered into for any reason other than tax avoidance. The Court concluded that “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.”

So on reflection, we believe that the decision is not surprising and only goes to re-emphasise what we already knew – that:

  1. Careful consideration must be given before any business structure is entered into.
  2. The reasons for entering into a particular business structure must be clearly documented.
  3. The business and family trust activities must always be properly documented.
  4. A business should not structure its transaction in such a way so that the ‘predominant purpose’ is to obtain a tax advantage.

If you have any concerns surrounding your existing business structure or if you think that you would benefit from a review of your existing structure, then give us a call on (04) 970 3600 and we will be happy to chat things through with you.