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Revenue Alert 10/01 – Taxation by Press Release?

Most of the reaction to the Revenue Alert 10/01 from the tax community has been guarded. In general practitioners seem politely resigned to the uncertainty that the case entails and have grudgingly welcomed the Commissioner’s attempt to calm taxpayer fears on how he will apply the ruling in this case.
Only a few others, including well-regarded experts such as John Shewan, seem to be expressing what I believe to be an appropriate amount of outrage as to the way in which the Penny & Hooper litigation is being played out.
The Revenue Alert in fact provides very little in the way of comfort for taxpayers or guidance for practitioners.  It lists seven factors of a tax avoidance arrangement, all of which are ordinary features of a small NZ business and any combination of which could amount to tax avoidance.
The two key factors the Revenue says it will focus on are (i) the extent to which the business relies on the services of a key individual and (ii) the degree to which profits are “in substance diverted” to members of that individuals family. “In substance diversion” here means paying a dividend to the family trust rather than paying yourself a salary.

In reality the factor IRD auditors are most likely to focus on is non-arm’s length salaries.  Thanks to the Court of Appeal’s carte blanche in Penny &  Hooper, Inland Revenue Officials now have the authority under the Income Tax Act to tell taxpayers how much money they ought to be making and even, the Revenue Alert suggests, what the ongoing capital requirements of their business will be.

The Revenue Alert is the logical corollary of the Court’s failure to provide any guidance on the application of the anti avoidance rule.  Tax is supposed to be something levied by Parliament under statute, not pursuant to a press release issued by an Inland Revenue Official – yet this is what our tax system has come to.

If the Court of Appeal just throws up its hands and confesses it cannot say for certain what tax avoidance is, then the Commissioner must step into the gap, substituting his own view of the law for the silence of the judiciary.  I am not aware of any other OECD country where the Courts have ceded their responsibilities for interpreting tax statutes to the tax administration in this manner.

I am certain that there are very few New Zealanders who care about the fate of Messrs Penny and Hooper.  Maybe there is something in the phrase “tax avoidance” that causes the NZ public to imagine these Christchurch surgeons were up to no good.

The reality is that Mr Penny & Hooper paid far more attention to their tax compliance obligations than most ordinary New Zealanders.  Those ordinary New Zealanders, of course, think that Penny & Hooper have avoided paying  a “fair” amount of tax.  I suspect however, those same New Zealanders would not be surprised to learn that there is no rule in the NZ taxing statute that requires only a “fair” amount of tax to be paid.  Tax law is a bunch of rules telling us what kind of transactions are subject to tax and what kinds are not.  That kind of certainty is at the core of a self-assesment tax system and it is being steadily undermined.

Tax advisors tend to go on about certainty a lot.  What they really mean is the rule of law.  Certainty is important because, in the absence of certainty, the taxpayer simply ends up paying the amount of tax the Commissioner demands (plus penalties and interest).  Without rules, opposition to state action is futile.  The unlimited resources and powers of the Inland Revenue combined with grinding buearacratic processes of the disputes regime make resistance difficult.  Without any certainty as to the outcome resistance is often pointless.  Most taxpayers with disputes have given up before they even get anywhere near a court.

What is to be done?

In the absence of widespread public support for those who the Commissioner chooses to brand as tax avoiders, and in the absence of a new political party proposing changes to the general anti avoidance rule, it can only come down to us, the advisors.

If, as professionals, we care about what is being done to the New Zealand tax system (and we must) we have to fight our own corner.  Every major law and accounting firm in the country should, in my view, be offering the victims of this latest Revenue Alert the opportunity for independent legal advice backed by a willingness to litigate these cases, for free if necessary, in order to return some semblance of certainty to the law.

2 Responses

Gerard Gunn on June 25, 2010 at 3:29 pm

I must agree. I am surprised that the reality of what this new law, created retropsectively ,can do to our ecomony and it is not being recognised. It has and will stop economic activity due to the “uncertainies” The tax rules make it difficult enough in some cases already, an issue we must deal with.

If Penny & Hooper is not appealed then hopefully when another case is started, application can be made under sectionn 138N(3) of the TAA to go direct to the CA. Hopefully different judges are appointed or better lines are drawn.

To quote an earlier commentor “I reckon Judge Randerson has given IRD a tiger to try and tame by holding onto its tail” Can IRD tame the tiger, without much more resources?

If a person in business needs to pay tax on all profits before investing those funds in another activity that may make initial losses then that risk maybe too much. I know that history has highlighted the abuse of that past right but it seems only the bad stories make good reading.

Like Australia, if that is the way it’s going to be and it’s what our government wants, shouldn’t the government decide the rules not IRD, retrospectively? Shouldn’t that change go through the correct political process? Eg the associated pesons test and property developers. Look at what the FEC committe did with IRD recommendations. Without those changes the tests proposed by IRD would have ground down economic activity

Also ths is only one situation in respect to the decision. What happens when the principle of the decision is applied to other situations? Having worked on tax avoidance issues for both IRD and the private sector for many years, I see a great deal of future issues if IRD choose to apply the principle elsewhere and nobody else can judge the issue. Simply pay up or settle

It seems as if we are to some extent copying Australia by this decision, but is our economy the same? I do not think so? Again the few that work hard to earn and make the economy grow will find it much harder, because of this perceived immoral behaviour. There may well be some tax “leakage” by not having rock tight rules , but rock tight rules can stop economic activity and economic activity generates tax revenue. Why did the FEC lighten up the associated peson test proposed by IRD? Clearly because it went too far and would curtail tax generating economic activity

Jim Black on July 2, 2010 at 2:30 pm

Well I have written to IRD re their Alert asking for comments.

Basically what I suggested to them was Penny Hooper needs to be appealed by IRD.
The concept of market salaries is a nonsense. Income is income, a dollar is a dollar.

Who is going to set the salary for our cannabis growing operation ?

And why should a Doctor in Auckland maybe pay more tax than one in Tokoroa, because the Health Bord salaries in each place are different. ?

But my suggestion;

First, if the top tax rate was the same for company, trust , individual the IRD would not be interested . They would probably be back looking at the opposite ie excess salaries to relatives ??
This hope is maybe some years away .

But a practical alternative.

(The numbers/ levels picked are just to produce an example. It may be possible with Treasury and IRD statistics to come up with maybe fairer or more logical thresholds. I am simply guessing that at $250k it would mean the majority of small NZ businesses would fall outside the default regime.
And that the default would then catch the worst excesses ie Surgeons like Hooper and Penny, which is what the judges have urged the IRD to do.

A default formulae.
I suggested for close companies and trading trusts you establish an income for the entity before any salaries to the income generators (probably more often than not the shareholders or directors.)

If that income figure is less than $250k IRD will not interfere in salary setting. If more than $250k , then starting at $250k 50% Salary 50% company then on an increasing sliding scale
Adjusting to at $400k to 65% salary and 35% company

Above 400k 65% Salary 35 % company.

Where there are compelling, supportable reasons why ‘default” is inappropriate to a set of circumstances, then tax practitioners or whomever can go outside the default, but they are as it were on their own.
And they can maybe consult with IRD to obtain approval to use something different.

For all the rest, you adopt the “default ” regime
It doesn’t matter whether you have reconstructed, old money, new money, earned it by your skills with your hands or brains, or whether you earn it by employing 3000 fruit pickers or buying and selling construction machinery.

Then for the majority we would all know the rules.

We wouldn’t need to concern ourselves with issues of “well is this just a little bit of tax avoidance so its ok.
or well on a look through it looks bad, but the numbers are not too high so it will probably be ok ?? Whats being a bit too aggressive mean?.

Under the above scenario the Surgeon on $700k would have a deemed salary of $457k
But the heavy machinery retailer, or dentist, or cannabis grower on the same income would all be the same.

I fundamentally believe the Judges in Hooper and Penny read the prior decision. They simply said aha we can see tax avoidance here. Then they did a bit of a trawl through past decisions, and wrote a bit of an epistle to support the decision already made.
W 20 and W33 were appallingly inconsistent. In w 33 the salary or adjustment was set so they didn’t qualify for family support. That’s not market salary.
How can you set a market salary for a man with a truck delivering cakes from a place like Mokau. The IRD counsel acquiesced in this decision.

Who wants to pay Tax advisors to take expert advice on what would be an appropriate salary. The Judges seem to infer that Tax advisors know in great detail the details of every industry their clients operate in. The truth is they don’t. They often may only see a client once a year. They may often not really know what the client actually does.
Clients businesses move and shake.
All IRD should be interested in is the taxable income.

Just as an aside I am awaiting an answer from IRD to the question.

If a client takes funds invested in a Term deposit in individuals name, and individual is a high income individual, (33% new tax rate on marginal income ) and he transfers and puts the Investment into a PIE, that is capped at 28% , is this tax avoidance.
Because under the Penny Hooper look through, the tax will be reduced.

Now IRD has had success with vendors selling speculator sections around Queens town, who never built, just bought to sell as a spec.
Because vendors could offer no other reason for the purchase other than to on sell.

So how do you defend the Investor above. Because applying the same analysis.
How do you defend the claim from IRD ” the reason for making the change was that you Taxpayer wanted to take advantage of the lower PIE rate ?? so its tax avoidance.

Because you tell me why we persecute the Surgeons, and on the other hand allow someone who has a lot to invest to prosper.

Jim Black

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