EY Law’s Tori Sullivan, Director of the Tax Controversy Team, discusses how Inland Revenue is tightening its income attribution rules, so taxpayers using a company to minimise tax should take note.
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Are you using a company to reduce tax? Inland Revenue is tightening its income attribution rules
When individuals, trusts and companies all pay the same tax rates, there is little incentive for taxpayers to “stream” income between their different entities to reduce their overall tax.
Between 1999 and 2010, the company and trust tax rates remained at 33% but the top individual tax rate was 39%. This created an obvious incentive for individuals to divert their personal income into companies or trusts to pay a lower rate of tax.
Throughout that decade, Inland Revenue fought several battles with taxpayers who had established company and trust structures to reduce their personal tax rates, eventually resulting in the Supreme Court decision in Penny & Hooper v CIR (2011) 25 NZTC 20-073. The case confirmed that in many circumstances income derived by professionals and other businesspeople from their personal services performed through companies or trusts should be taxable to them personally.
Ironically, the Supreme Court’s decision coincided with the reduction in the highest individual tax rate to 33%, removing the incentive those taxpayers had sought to exploit. So many taxpayers and advisers presumed that issue was closed.
But while the top individual and trust rates have remained at 33%, the company tax rate has dropped to 28%, again creating the opportunity for taxpayers to interpose a private company to derive their income and therefore reduce their overall tax (at least until that income is distributed to the shareholder personally). Inland Revenue has responded by reminding taxpayers of its earlier victories and advised it will once again turn its attention to this kind of arrangement.
In June 2018, Inland Revenue released PUB00301 “Attribution rule for income from personal services” (“PUB”) in draft form. This relates to the scope and application of a specific tax avoidance rule in Part GB of theIncome Tax Act 2007, enacted in 2000 to bolster Inland Revenue’s ability to re-assess taxpayers who used structures to get around the increase to the top individual tax rate.
This rule works more narrowly than the general anti-avoidance provision used by the commissioner to counteract the trust and company structures of the kind found in Penny & Hooper. Instead, it is aimed at individuals who provide personal services, largely to a single client. For those taxpayers, the rule automatically attributes the full income derived by the company to the individual who performed the personal services. For tax purposes it ignores any company used to derive and retain income generated from their personal services so that individual is subject to tax on the company’s full income at the 33% rather than the company paying tax at the 28% rate.
This rule is not intended to catch all companies that are used to earn personal services income. It applies where the company is being used to prevent the operation of the highest tax rate, meaning it applies only when the combined income of the company and the individual providing the services exceeds $70,000 each year (the level at which the highest individual tax rate kicks in).
It is also intended to apply only to arrangements that are akin to employer-employee relationships and not to normal business trading, so it applies only when at least 80% of the company’s income is derived from a single source.
Finally, it is intended to apply only to income generated from personal services and not the sale of goods or use of capital assets. So it does not apply when the work requires the use of “substantial business assets” (generally defined as those costing $75,000 or more) that are a “necessary” part of the business structure.
These parameters mean the rule appears relatively clear in its scope and application. However, the (draft) PUB highlights some areas of potential controversy that may inform Inland Revenue’s future audit activity.
Firstly, the (draft) PUB reinforces that in determining whether 80% of the company’s income is derived from a business source, it is necessary to look not only at the buyer but anyone associated with the buyer as well. So if, for example, a company provides services to two companies that are associated for tax purposes, it will potentially be caught by the rule. The (draft) PUB recognises this is an objective test and will thus apply where the taxpayer should reasonably have known the two buyers were associated. This requires taxpayers to undertake and document their due diligence on the buyer (for example, looking at publically available information) to establish that it could not have reasonably formed the view that they buyers were associated.
Secondly, the (draft) PUB recognises that Inland Revenue will take a narrow view on what assets are considered to be a “necessary” part of the business structure. For example, the (draft) PUB recognises that a motor vehicle used by the taxpayer to drive from his private residence to the buyer’s premises may not qualify. If an asset is used in a business then it is presumably because the taxpayer has determined it to be necessary; however, the (draft) PUB empowers Inland Revenue to second-guess that decision and widen the potential scope of the rule.
We expect these two factors will be scrutinised by Inland Revenue during audits so more taxpayers are brought within the net of this specific avoidance rule. The (draft) PUB is a timely reminder to taxpayers who have forgotten, or became lulled into a false sense of security, when individuals and companies had the same tax rates.
Inland Revenue will once again be searching for individuals who fall within those rules but who attempt to use their company to reduce their overall tax.
Tori Sullivan has practiced for more than 10 years, and has extensive experience helping clients in tax advisory and compliance. She focuses on the technical and tactical management of tax and tax-related enquiries, working with the Inland Revenue and clients on risk reviews and tax audits.
Tori is also experienced in Tax Administration issues, Tax Disputes and Litigation (involving individuals and multinationals), and helps her clients to gain more certainty in relation to their tax positions which include Commissioner’s Official Opinions, Binding Rulings, tailored Corporate Governance and Risk Management solutions. Contact Tori at Tori.Sullivan@nz.ey.com
