The recent dispute involving Messrs Penny and Hooper has come to an end with the Supreme Court decision finding in favour of the IRD. The Supreme Court upheld the Court of Appeal’s view that the setting of commercially unrealistic salaries constituted tax avoidance.

Penny and Hooper were both orthopaedic surgeons trading in their personal capacity, but restructured their businesses to trade through companies, owned by family trusts. The companies employed the surgeons for substantially less than what they had been earning prior to the restructure. However, their work load and the nature of work did not change. The Supreme Court stated that while the structures used were valid business structures, the yearly setting of a non-commercial salary constituted tax avoidance.

In response to the finding the IRD has provided guidance, in the form of Revenue Alert RA 11/02, on circumstances in which it considers tax avoidance would arise.

Based on the Revenue Alert, the IRD will look into all aspects of an arrangement, in order to come to a conclusion on whether or not diversion of personal income through other entities, such as companies and trusts, amounts to tax avoidance. The Alert identifies the following factors as being relevant:

• The commercial reality of the service provider’s business structure,
• How profits have been distributed in substance and whether the employee and their family benefit from all profit distributions,
• Whether the remuneration paid to the individual providing the service adequately reflects their contribution to the business’ profits,

Whether there are other reasons, apart from tax, for justifying departure from the norm.

The Alert also identifies situations where a below market salary could be justified, as follows:

• To fund planned capital expenditure,
• To retain profits within the business to provide for future financial difficulties,
• Where profits are down, but most of the profits are still distributed to the service providers, or
• The business relates to a charity and the individual receives less to maximise the charity’s return.

The IRD acknowledge other situations may arise in which it would not be possible to pay a market salary. However, if a business cannot afford to pay a market salary, the IRD would equally expect that it could not afford to make significant distributions (such as dividend payments) to associated entities.

Amongst accounting practitioners the heart of the Penny and Hooper case has been the question of whether private companies, which derive income from personal services performed by its employees, need to pay those employees a market salary. However, the Revenue Alert indicates the IRD may not stop at requiring a fair market salary. The IRD has stated that it is:

“more likely to examine arrangements where the total remuneration and profit distributions received by the individual service provider is less than 80% of the total distributions received by the controller, his/her family and associated entities.”

Paying a commercially realistic salary may not necessarily satisfy the IRD, as the IRD’s focus appears to be on the amount of income received by the service provider as a proportion of the total distributed. It is generally understood that disclosures to IRD are being handled centrally to ensure taxpayers are treated consistently.