25 Aug 2011

Businesses must be able to justify tax reduction decisions

7:03 am on 25 August 2011

Business people are being warned to ensure there are sound commercial reasons for paying salaries that are below market rates, if they want to avoid a fight with the taxman over tax avoidance.

On Wednesday, the Supreme Court ruled against two orthopaedic surgeons, Ian Penny and Gary Hooper, saying they set up companies in the early 2000s and deliberately paid themselves a lower salary to avoid paying higher marginal personal tax rates.

The Supreme Court decision was unanimous, and PricewaterhouseCoopers chairman John Shewan, who appeared as a witness for the surgeons, says while the two men are free to structure their affairs in the way they did, it can't be used to avoid tax.

He says a company structure owned by a trust, was held by the court to be lawful and unremarkable.

But Mr Shewan says if tax has been saved companies need to be able to answer whether it was an incidental result of the structure which was driven by other commercial considerations.

He says helpfully the court gives some examples where it would be acceptable for companies to pay quite low salaries, such as if they were going to reinvest the capital in a new plant, or if they are going to experience financial difficulties.

Mr Shewan says the second test the court considers is whether parliament would have contemplated that this tax advantage, or tax saving would have arisen.

He says it's important for businesses not to panic, but to review their own circumstances and ensure they have appropriately justified decisions that they have taken that have resulted in a reduction in tax.

Mr Shewan says tens of millions of dollars may now be claimed by Inland Revenue from the cases it still has left open on this matter.

There is still a gap between the top personal tax rate of 33%, and the company rate at 28%, and Mr Shewan says firms need to make sure any below-market salaries can stand up to scrutiny.

He says one question is whether IRD will now go back and revisit cases that it hasn't yet reviewed, but Mr Shewan hopes the focus is on the future.

He says the court has clarified one aspect of where this difficult rule applies and it's now up to businesses to apply it to their own circumstances.