New Zealand Inland Revenue aim to focus on industry benchmarking
The New Zealand Inland Revenue has recently reiterated that it will focus on industry benchmarking with the aim of reducing the use of structures similar to that found in Penny and Hooper v CIR  NZSC 95 ("Penny & Hooper").
In Penny & Hooper, the Supreme Court held that an arrangement in which two doctors transferred their practices to companies that were solely owned by their family trusts, while paying themselves substantially lower than market salaries, amounted to tax avoidance.
While the Inland Revenue accepts that the use of companies, trusts and other business structures do not themselves give rise to avoidance concerns, it is concerned that the use of those structures can provide the controllers of the business with an opportunity to divert income to other people and entities that are charged to tax at lower tax rates.
In response to the Penny & Hooper decision, the Inland Revenue issued a Revenue Alert which stated that in making a decision whether to initiate an audit on professionals with this structure, the Inland Revenue would expect to see at least 80% of the profits derived by the business to be taxable at the "controller's" tax rate.
If this did not happen, there could be an audit to see whether the receipt of less than 80% of the profits of the business is commercially justifiable.
The Inland Revenue will challenge arrangements where the compensation received by the individual is considered to be artificially low, particularly in cases where related persons or the individual ultimately benefits from the total profits, and there are no commercial reasons to justify the level of remuneration. Justifiable reasons can include start-up periods, periods of capital investment, or where the relevant business is in a loss position.
The Inland Revenue will be using industry benchmarks along with other indicators to identify such taxpayers and will compare the information in the taxpayer's financial statements and tax returns with the benchmark for that industry.
Although the Inland Revenue has recently published benchmarks for a limited number of industries (based on data from the 2009/10 financial year), it will endeavor to provide benchmarks for other industries in time. Where a taxpayer's income is outside the industry benchmarks, the Inland Revenue may ask the taxpayer to justify the position taken.
As the Inland Revenue may examine the position taken some years after the income tax return has been filed, it is imperative that taxpayers who run professional services organizations document the reasons for salary decisions at the time those decisions are made.
In addition, taxpayers who are not covered by the Inland Revenue's published benchmarks should support their position with reference to external benchmarking standards.
Where an organization has other profit drivers such as multiple fee earning staff, branding, or capital profit drivers, a function, assets and risk type analysis can be useful support for the determination of appropriate and justifiable remuneration levels.
The New Zealand Ernst & Young Tax Controversy team can assist taxpayers in determining the best way to deal with historic and future issues related to this type of business structure.
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