Surviving a tax attack
The Inland Revenue Department has launched a serious tax attack on 500 taxpayers in its “naughty house” for failing to distribute enough profits to themselves from their businesses and professional practices.
These taxpayers also sinned by failing to avail themselves of the commissioner’s grace period for rocking up to the tax confessional.
Shivering in your boots, and wondering why the commissioner doesn’t devote the same time and energy to hounding the criminals who evade tax, is unlikely to resolve this issue.
Our advice? Crouch, pause, hold and engage.
Toughen up and prepare to present your defence. As a starting point, recall the details of the Supreme Court’s decision in Penny & Hooper. The IRD’s response was yet again to rewrite tax law by using the anti avoidance rules.
Tax legislation does not stipulate that full-time shareholder/employees must pay themselves a market salary. Orthopaedic surgeons Penny and Hooper were extreme examples: they were paying themselves substantial salaries, then set up a company and trust structure and paid themselves substantially reduced salary while retaining access to the money.
The other major point (and the court didn’t focus on this) is that in many respects Penny and Hooper continued running their businesses as if they were still sole practitioners. So, in spite of the new company and trust structure, nothing fundamentally changed.
The court accepted the reasons for using a trust company structure were commercially based and designed to protect their assets. The major hiccup was the level of salary they paid themselves and that there was no real explanation for this, other than the associated tax savings.
The court’s decision - that there was tax avoidance - is therefore unlikely to rip the hem of one’s nightwear. But using the decision to focus on hundreds of other taxpayers is therefore, at best, disingenuous.
Adding salt to this wound, the IRD then issued an edict, saying that rather than focusing on the level of salary paid, it expected similar businesses to distribute at least 80% of their profits to the shareholder /employees. This was designed to minimise the compliance issues associated with determining a market salary.
To fight this tax attack, you need documentation to justify why it was not appropriate to distribute 80% or more of your profits to the shareholder /employees. The reasons for this can include:
- The business was in a growth phase and needed working capital
- The business was losing money so it was inappropriate to distribute this level of income
- The business was anticipating capital expenditure that needed to be funded
- Other assets owned by the business, such as intellectual property or processes, meant the business is entitled to retain a higher level of profits to provide an adequate return on these investments.
- There is no evidence of a reduction in income received by the shareholder/employees pre- and post- the company and or trust structure being put in place.
- The salary paid to the shareholder/ employees clearly represents a market.
This issue is all about the IRD protecting the tax base by ensuring shareholder /employees are not being paid an artificially low salary to save taxes by benefiting from the lower tax rates enjoyed by companies and trusts.
This honourable motive does not, in my view, justify the commissioner’s failure to move for changes to the tax legislation as soon as leakages are found and, instead, relying on that ever-shifting line in the sand by using the anti-avoidance rules.
The time delays before the IRD moves on these issues, and the crippling penalties and use-of-money interest, are disastrous for many businesses whose trading conditions are still, at best, challenging. A protracted tax dispute will be a major distraction as well as a financial burden.
The key message: adopt an attitude of proactive engagement rather than the old head- in- the- sand approach. Even if you have an exposure, you are better to take advice and consider making a voluntary disclosure rather than waiting for the tax office to come to you.
Joanna Doolan is a tax partner with EY