Taxpayers have won a significant courtroom victory against the IRD

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Jo Doolan & Tim McLeod

After a string of losses spread over several years, taxpayers have finally won a significant courtroom victory against the Inland Revenue Department.

The IRD has decided not to appeal a High Court decision by Justice Paul Heath, who overturned a ruling by the Taxation Review Authority against anaesthetist Philippa Catherine White.

Accusing Dr White of tax avoidance, the IRD had reassessed her income and ruled an extra $50,800 was payable for the 2003 and 2004 years. While this was a relatively modest amount, White would have been liable for extra taxes for the subsequent income years had the commissioner won.

At issue was a company structure involving two avocado orchards White and her husband ran alongside her work as an anaesthetist. Their company, Wharfedale, employed White; a family trust leased the two orchards back to the company.

During 2003 and 2004, the orchards ran at a loss, which was offset against Wharfedale’s income – received largely from White’s medical work. Wharfedale did not pay her a salary in 2003 and 2004 as it had no money, so White paid no personal income tax. The IRD reassessed her income and sent her a bill.

In finding for White, Justice Heath cancelled the IRD’s assessments, saying the doctor had established the commissioner was wrong.

Referring to the case of Penny and Hooper, two Christchurch orthopaedic surgeons found last year by the Supreme Court to have avoided tax, the judge said the courts seemed to have accepted that company and trust structures could be used in cases like these.

“In arranging her affairs in that way, Dr White did nothing more than obtain the tax advantage that Parliament intended would flow to someone in her position.”

But, unlike Penny and Hooper, White had not deliberately been paid a reduced salary. “Rather, it was a case in which salary was not paid because the company lacked the funds to do so,” Heath said. These were real losses incurred from White’s business activities and could be legitimately offset against her professional services income.

It took the IRD two years to decide not to appeal the High Court decision.

The White case involves many features demonised by Inland Revenue, such as paying non-market salaries, paying salaries to children, and other related party transactions.

But as taxpayers dance in the street to celebrate their first win in years, they should heed the judge’s warning: his ruling was based on a very specific set of facts. Of particular importance were the reasons the taxpayers made certain decisions and what they contemplated at the time the arrangement was entered into.

White and her husband operated the businesses through a company while a family trust held the assets and leased them back to the company. The losses from the orchards were, in part, caused by the salaries paid to the taxpayers’ children and payments to lease the orchard properties from the trust.

The court accepted there was nothing sinister about the company operating a combination of both loss-making and profit-making activities. This makes sense, since the losses could have been legitimately offset by other means such as through the then-LAQC regime, or by grouping.

The couple’s financial affairs were restructured to overcome a genuine concern about potential exposure to claims by White’s clients. The losses were “real” and resulted from unexpected factors such as poor weather, costs, lack of market demand and variability of exchange rates. In fact, the taxpayers had expected the business would turn a profit and White had made provisional tax payments on this basis. The couple had deliberately chosen not to enter the LAQC regime for the same reason.

The High Court also held there was nothing sinister about paying salaries to the taxpayers’ children and the payments made under the lease with the family trust.

But the judge was careful to point out that his findings were not intended to endorse payments to taxpayers’ children per se. Again, the decision was based on the specific facts; the salaries related to actual services provided by the children for orchard work and the payments were at reasonable market rates.

The court didn’t focus greatly on the lease payments other than to acknowledge it was only with hindsight that they seemed slightly above market value but still they added nothing to the IRD’s case.

The commissioner appears not to have considered what happened to the lease payments after they were made to the trust.

In Penny & Hooper the courts were significantly influence by the fact that cash paid to Ian Penny’s trust ultimately flowed back to him via unsecured, interest-free advances with no specified repayment terms. So he ultimately received the benefit of the funds as though they formed part of his salary.

For other taxpayers, the lesson to be drawn is that they must be able to justify the decisions they make. The justification will include factors they contemplated at the time and alternate courses of action they considered.

Decisions must be justified when they are made, not after the event. Do not be complacent when it comes to documentation and evidence.

Joanna Doolan is a tax partner and Tim McLeod a senior tax manager at EY