Accountants Client Newsletter Alternative Article

May 2010 – July 2010

Company Salaries - Cause for Alarm

Whether a trust or company is required to pay a fair market salary to an associated employee has received considerable attention in recent years. Another case involving the issue was recently heard by the Taxation Review Authority (‘TRA’), but the decision included a statement that may start alarm bells ringing.

The case involved a husband and wife who re-structured their activities to operate through a company. The wife was an anaesthetist working part-time in the public sector and also part-time on a private basis through her family trust. The husband operated a quality assurance business. The pair ceased to be self employed in 2002 and were instead employed by the company. The family trust acquired two orchards in 2002 – one from the husband and wife and the other from a third party. The company operated the orchards by leasing both the orchards and equipment from the family trust.

Prior to the restructure, the wife’s public sector income as an anaesthetist was approximately $120,000 per annum. After the re-structure, the company barely made a profit due to losses incurred by the orchard business. Due to the low profit, salaries attributed to the taxpayer were either very low or non-existent during the years in dispute.

The IRD argued that the rent from the leasing of the orchards and equipment that was paid to the family trust was too high, and that the salary paid to the taxpayer was commercially unrealistic, i.e. too low.

In relation to the rent paid to the family trust, the Judge found that though it seemed a little high, the accountant had taken a fairly sensible approach to fixing the orchard rental, and the Judge could not find evidence that there was anything artificial or contrived about the fixing of the rent.

When looking at the salaries paid to the taxpayer however, the Judge found this case to be straightforward. He was of the opinion that the taxpayer had entered into an artificial, contrived and uncommercial arrangement. The Judge agreed with the IRD that the structure was used to significantly reduce the taxpayers income tax liability from personal exertions, while retaining full control and benefiting from the income. This arrangement therefore amounted to tax avoidance.

In the Judge’s view, the only reason someone would agree to take such a significant reduction in income was that the income was controlled by a related entity and was still available to them or their family in some other way.

The Judge acknowledged that the same result could have been achieved by paying a fair market salary and electing for the company to be an LAQC or through the use of a partnership. The Judge also commented that a fair market salary could have been payable by the company if it had borrowed against future profits, in effect, causing the company to incur tax losses to be carried forward for future years.

Surprisingly, the High Court decision in the Penny & Hooper case was not discussed, which found in favour of the taxpayer on the market salary issue. The High Court decision was appealed and the Court of Appeal’s decision is currently due to be released. If the Court of Appeal rules in favour of the IRD the TRA decision above is worrying because it is the first time the Authority has taken the view that a company should incur a loss in order to pay a fair market salary and it could be seen as a further movement of the tax avoidance boundary.

© 2010