Penny & Hooper: When the IRD speaks you’d better listen

IRD has issued their views on what level of profits in a service business should be allocated and taxed in the hands of the owner, in light of last week’s Supreme Court decision in the Penny & Hooper case.  There are potentially a huge number of businesses that IRD might investigate to determine whether tax avoidance has occurred.

IRD’s approach will focus on two things:

• Is the owner appropriately compensated for his skill & exertion?  This requires an understanding of what drives profit in the business and also how much is paid to the owner.
• If not, what is the valid commercial justification for the owner receiving a lower level of income?

The profits of a service business will generally be driven by a combination of the following:

1. The owners personal skill, judgement and exertion
2. The use of capital assets
3. Services provided by other staff
4. Intangible assets such as know-how & intellectual property
5. Return on business risks

In circumstances where the owner’s personal skills & exertions is the main profit driver (and particularly where the asset needs are not large) then they will be looking to see whether the owner personally receives taxable income from the business of at least 80% of the business profit.  Why 80%?  Well, IRD says they’re going to focus on the commercial reality of the business and how much the owner contributes to the profits of a business,  not market salaries or comparable industry averages. This is a departure from what has previously been accepted as a fair and justifiable approach.

They do accept that there may be situations where 80% or more of the  income is not allocated to the owner, and examples include:

1. Where adverse business conditions mean that profits are down but most of the profits are still paid out to the principal income generators;
2. Where profits are retained because an anticipated downturn in the near future;
3. Where profits are retained to finance the purchase of business assets in the following year; or
4. Where the business relates to a charity and there is a  desire to increase the charity’s return.

There are some investigations and disputes that have been deferred, pending the outcome of this case.  IRD intends to continue to investigate similar arrangements where there may have been significant tax benefits received.  Their investigations will focus  on an examination of:

• The reality of the business structure and how it operates commercially;
• Whether or how the business profits have been distributed in substance to the wider family members or a trust – ie. looking at things like inflated salaries to family members, or management fees to related entities, or making loans or capital distributions;
• Whether the owners remuneration reflects their contribution to the business’ profit; and
• Whether there are other commercial (and non-tax) reasons that justify a lower level of remuneration.