As those who read this blog will know, I have put up several posts about the role of Trusts and how many people use the Trust structure to avoid paying their correct rate of tax.
Well, in Saturday’s Dominion there was an interesting article briefly outlining the case, and the decision, behind one of the more significant tax precedents of recent times (amazingly, not reported in any of the Sunday papers, but written up in the NBR. Somewhat surprisingly for a business newspaper, however, the NBR reporter missed the point and therefore got the details wrong. To be fair, so did the Dom – as I understand the case…
The precedent came from a Court of Appeal decision in the case between the IRD and 2 orthopaedic surgeons (Penny and Hooper) who, according to the IRD, had set up family trust-owned companies to avoid paying their full tax entitlement.
As posted before, the disbursements from a Trust are taxed at a final rate of 33% (unlike, for example, company dividends, which are taxed at a person’s correct marginal tax rate). These two men had set up companies that were then owned by Trusts (on advice from their lawyers and accountants…) and channelled their salaries through these entities, thus avoided paying the 39% rate, by only paying the Trust rate of 33% on the bulk of their earnings. The tax avoided between 2002 – 2004 was around $168,000.
I am not going to post all the details of the case here, but needless to say, this decision will probably go to the Supreme court due to its significance, but if it doesn’t (or it does and is up-held) it will mean that the IRD now has the legal right to pursue possibly thousands of sole traders, who have, on advice, set up their affairs under the same structure.
The new tax regime that aligns the top personal rate with the trust rate at 33%, has rendered this particular tax structuring irrelevant, however, it still gives the IRD the power to chase thousands of sole traders who had also set up trust-owned companies in the past. This, in turn, could well set in course a number of legal suits against the lawyers and accountants who provided the advice… Watch this space, but there will be a large number of very nervous business men and women out there, and, no doubt, a few professionals checking their professional indemnity insurance polices come Tuesday…
This is an interesting development, for sure. If the Supreme Court does uphold this appeal, it will close one of the doors on a significant tax evasion.
Concepts such as a “market salary” could soon be finding their way into NZ common law.
Unfortunately, certain types will always attempt tax gaming because they don’t believe in a progressive tax system.
I should explain why I think the Dom and the NBR got the details of the case slightly wrong. It’s important to note that Penny and Hooper had companies owned by family Trusts. Both papers stated that avoidance occured because P&H’s income was taxed at the 33% corporate rate, thereby avoiding the 39% top marginal tax rate. While 33% was the corporate rate at the time, it was also the Trust rate. How this scheme works is that dividends from the company are paid to the trust (the company’s owner), which then disburses profits to the Trust beneficiaries at the final trust rate of 33%. If the mens’ companies had paid out profits to the men personally in the form of a dividend, they would have been taxed at their top marginal rate of 39%. Therefore, it was the Trust rate of 33%, not the corporate rate of 33%. Stuart
Also worth noting that this was a 2-1 decision. One justice (Ellen France) said that arrangements that produced tax benefits did not necessarily constitute tax avoidance.
I think also there was such a huge difference between their personal income they made from the business before the trust arrangements ($500K-600K) and afterwards ($120K)
But how many of the Supreme Court justices will recuse themselves if they hear the case as these sort of arrangements are endemic amongst the legal, medical and accounting professions.
Stuart
If this is upheld by the SC (if it travels there) as good law, does this mean that those who can create companies and work their income through that, will be better off, because it will be harder to get this kind of decision against a company structure?
I guess I am asking if the new tax rate has actually create a new, and easier to uphold way to lessen personal income tax?
Did you actually readthe case. It has nothing to do with dividends. It has to do with market salaries.
The Docs didn’t pay a market salary to themselves so they could funnel profits to there trusts by way of dividends. The avoidance was the salary, not the dividends.
The structure still works, provided they pay a market salary.
Frankly, I hope the Supreme Court will overturn the decision. And I am saying that not because I am in favour of any form of tax evasion. It’s just that this decision if upheld will open up a huge can of worms. It is better if specific tax legislation is introduced to spell out what’s allowed and what’s not allowed, including if necessary, the considerations around market salary.
Let me just give several examples to highlight the inconsistencies and confusion that can arise:
1. An accountant (or lawyer or other time-based professionals) who pays himself lower than the market rate: In this case, it is reasonably clear that the accountant sells his time and therefore market salary is probably quite easy to work out. But then there is a wide range of salaries in any profession. Should it be the lowest of the range?
2. An investor who invests his money via a company, and he hardly does anything but watch his investments grow. And he pays himself small amounts.
3. An importer — his business is basically merchandising. With the right product, even a one or two-man operation can make millions. How much should his company pay the shareholders?
4. An internet marketer who owns a successful website that rakes in millions through advertising, etc, but is a practically hands-off business. So much so that perhaps the owner of the website spends most of his time playing golf or fishing. He practically doesn’t do any work at all apart from originally setting it up.
Etc..etc..
Those are examples of the top of my heads. Others may have better examples. But I just want to highlight that much confusion can arise if the issue is not properly legislated.
4.
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I think this decision, and if appealed and upheld by SC, WILL lead to legislation outlining specifics as you say. The problem with specifics, is that clever lawyers and accountants can find ways to construct things which sit outside the specifics, but which were largely intended to be the type of behaviour not permitted. In this sense I wonder what the answer is.
When the Court of Appeal said claims relating tot he Seabed and foreshore had to go the Maori court, we ended up with the debate over that issue, the Orewa speech, and a general outcry which was almost unrleated to the decision. By that I mean the CA didnt say Maori would GET rights to seabed and foreshore, it said Maori Court was best to decide that issue.
National and Act when on their One Nation tyrade, kicked up a storm, didnt think labour went far enough, Labour succumbed to populist rhetoric and presto.
Sometimes Parliament (the legislature) need a kick in the pants from the judiciary to sort it out, perhaps this case will precipitate this.
Perhaps Labour could get the jump by proposing a way to resolve it
I’m glad the courts have seen sense on the issue and ruled against the people who tax avoid that way although I wasn’t really sure if the legislation was wide enough to allow them to decide that. More legislation to punish tax fraud was exactly what we needed rather than the aligning and due to the aligning National may now refuse to pass any legislation on it because the time has already passed. It would need to be entirely retrospective to deal with trusts. I can’t see them tackling the issue of company evasion properly given they probably have many conflict of interests in that area from friends/relatives as no doubt several Labour MPs would too…
I personally don’t know of any Labour MPs with trading / family trusts owning businesses for the purpose of tax avoidance. I do know that quite a few (including myself) do have trusts for asset protection, and I also have a superannuation trust, however, this is not for tax avoidance or mitigation at all – simply for asset protection. Stuart
Tracey – “I think this decision, and if appealed and upheld by SC, WILL lead to legislation outlining specifics”
I think if the SC upholds the decision, it sets a precedent and makes legislation less necessary. The door will then be open to various contortions of legal gymnastics. Then lawyers will have a field day and small businesses will find it harder to survive having to pay exorbitant legal fees.
We’ll agree to disagree, I think this is exactly the kind of judicial decison which leads to legislation.
Dream , the decision basically looked at a business based on the labour of the owners.
And as Stuart points about the current situation will be changed by the new tax rates.
So the result if it lasts, will only be about tax clawback for previous evasion. Im sure IRD wont be going after those with a business with fluctuations in income or retaining profits for future growth. The example they have of two professionals with a huge drop in salary soley because of the trust structure would be the situation most at risk.
I find your comments that the tax law should not be decided by the courts to be a bit simple as the laws are perfectly straightforward but up till recently the courts have all ways interpreted them very narrowly and blatant cases of avoidance have been allowed to occur.
Media companies being amoung the users of such artificial schemes
Ghost , they might seem simple but imo they need to be MUCH clearer about the distinction between tax avoidance and tax evasion. In fact let’s just make both illegal
[deleted personal - chris]
Tracey, one of these is illegial the other is generally sourced from poor legislation being enacted or loopholes that exist being ignored by the legislative and left wide open. There will always be loop holes for me the essential question is who and how many can benfit from these loopholes. If it is only available to the extremely wealthly unfortunately(lesser of 2 evils) they have the funds available to pay for expensive hired guns to setup complicated structures that are not available to the masses to enable arbitrage arrangements. They will always have the ability it is when this becomes endemic to a wider group of people e.g. Rorts on landlords that are so wide spread that it does become an accepted inferred govt subsidy to a large minority to the detrement to the many. For me this is so wide spread that politicial parties have become appologists to the extreme to why these are still remaining and not being addressed.
IMO its quite simple, if it looks like its dodgy it probably is. If you are payed a salary and you divert that into a company to pay a lower tax rate its quite clear you are doing something ethically wrong. If its ethically wrongs its probably borderline leagaly wrong.
Throw the book at them i say, its people that do things like this that stuff NZ for teh rest of us. They treat having a business a a perk to pay less tax than averge wage / salary earners. I know enough small busness people to know that they claim GST on absolutely everything they can as long as it can remotely be linked to the business.
H & W that is why I say make both evasion and avoidance illegal, couldn’t be much clearer?
I cannot fathom the trust and top tax coming in line but company dipping 5% below them, just more restructuring to avoid taxes ahead?
tracey, transferring assets from one form of ownership to another is not that easy and in many cases quite costly. It is not like selling something on trade me from Tacey as a person to Tracey Trust to Tracey & co. There will be some who the cause is so large that it is worth the effort but you will never be able to stop the elite wealthy. In changing from one entity to another some setups that are grey will become totally illegical, like house trading it is getting the authorities geared up in resources and directed into investigation backed by good legislation.
The corner-of-the-mouth-spittle-with-excitement I see here at the prospect of criminalizing portions of our citizenry is rather chilling.
Stuart – fantastic!
While is seems a little unfair that this will catch those who set up the trusts solely on advice from their accountants believing it to be legal, it will be a good reminder that regardless of who does your taxes, you as the individual are always the one who is deemed to be responsible under the law.
A lot of people who use accountants put so much blind faith in them and have been caught out so many times.
I would imagine that if IRD goes all out this will impact many people.
However, seeing as it is so expensive to set up a trust, I would imagine that it will only affect, by and large, the big players…poetic justice if you ask me!
And more fool them – the tax laws are so clear when it comes to avoidance & evasion.
That’s the whole problem Rebecca. The law is NOT clear.
Accountants make sure page 1 of everything they do is a big fat disclaimer, never responsible for anything they tell you.
H, my background is in law so I understand the cost of asset transfers, restructuring etc. Interestingly, the cost of setting up seems always to be worth the outcome. O fcourse people will fight changes. There’s a reason National hasnt moved to address this very issue, and it has alot to do with a portion of its constituency.
“we took your need for trusts away by lowering the top tax rate, but dont worry we’ve given you the vehicle of a compnay with a 5% bonus”
Shane , only those who haven taken outlandish steps to minimise their taxes are effected- its not criminalising either, you are just making that up as the only penalties are monetary not imprisonment.
As the two surgeons were reported to have said , getting a salary of $120,000 pa was ludicrous yet they ( or their accountants) ran their affairs soley to do this.
Looks like they will have to back to buying expensive art for the waiting room
Shane what a bizarre statement given that the Government, rather than pursuing a portion of people for potential wrong doing simply lowered the tax rate to ensure everything would now be hunky dory. There are not many sections of society who can lay claim tot hat kind of special treatment.
Good point!
I was not referring to the law change as the source of excitement, rather the ‘catch the buggers that are spoiling it for others’ mentality I see here.
Accursed rorting Doctors! Get thee hence!
Well, they will get hence, because they can. And do.
How is this for an outlandish solution:
In cases of tax evasion, why not just deny them access to government funded services?
Shane I knew what you were referring to and addressed it.
Why are you blogging on the evils of trusts when it appears you have one. Deleted. Tim fair enough to ask the question. You don’t need to make accusations. Clare
Tim, I am more than happy to talk about the use of trusts set up for the purpose of tax avoidance: in my view this is the misuse of the Trust structure. As mentioned in the blog link, I have posted on this before. As mentioned, my trusts are for asset protection only, and certainly not for tax avoidance.
Quote a tax specialist in the article: “There is no black and white answer; it’s a very slippery slope.”
I think the general consensus is that the whole issue needs clarification either via legislation or by the Supreme Court.
I guess that the 2-to-1 majority decision by the Appeal Court might have been intentional, a reflection that it’s in the “too hard basket” for them, and so they want to make a hospital pass to the Supreme Court to determine.
Shane , how about they pay the tax back, its only less than $200K. One of the doctors got a tax free dividend of $900K by upping the goodwill on his business from $100k to $1mill in 2 months.
As in many of these things they get greedy, spurred on by lugubrious accountants
Chris – Personal? Mr Nash is posting on trusts therefore questions about his own are perfectly legitimate. Need I remind you that Labour is developing a policy based on openness and transparency in government?
To Tim, sean14, and others who question the fact that Mr Nash uses a trust.
My understanding of Stuart Nash’s trust is for asset protection. In another post, he himself says, “I actually have a trust for asset protection – set up from my business days, but definitely maintained during political career. Don’t run any income through it though. Yes, cost can be high to both set up and maintain properly.”
But this post is addressing the particular issue of the evil of avoiding tax by channeling income through trusts, which is not the case in Mr Nash’s situation. His is only for asset protection.
The issue is on avoiding tax by channeling income through trusts, thereby paying a lower tax rate. M
Dream – Thank you. This is correct, and the point I have made before (both in this post and in other posts). Stuart
Oops, last line not supposed to be there. Forgot to delete. I dream of an Edit feature for the comments
So, no takers for the concept of refusing access to service then?
No pay, no use.
Just to reiterate, I have blogged on the use of trusts before (there is a link in the first sentence of this post to another post I did on the different types of trusts).
I am more than happy to talk about my trusts – as mentioned, they are purely for asset protection and certainly not for tax avoidance.
Richard yes the law IS clear – or at least to those who CHOOSE to be law-abiding & above board.
Only the dishonest seek to make use of the loopholes or blindly accept the advice of their accountants etc.
If you can run a business then you can understand basic tax law.
Rebecca,
With respect, please do not over-generalise:
- “Richard yes the law IS clear – or at least to those who CHOOSE to be law-abiding & above board.”
I am law-abiding and above-board in running my (small) business, but I personally, as a self-employed business owner, find that the tax law is something that is not clear to me, and I have to use an accountant (a reputable firm) to prepare my annual tax returns.
- “Only the dishonest seek to make use of the loopholes or blindly accept the advice of their accountants etc.”
What do you define as loophole? Every person and business, generally, pays the minimum required by law, i.e. minimizes their tax liability. Is the ability tax liability within the tax laws considered a loophole? I shouldn’t think so, because I understand even the IRD does not want us to pay more tax than necessary, they want us to pay the lowest tax within the law.
Then let us consider this particular “loophole” of channelling of income into trusts to avoid tax. Now, is that really a loophole? If it is a loophole, why did Bill English took away the differential between the top personal tax rate and the trust tax rate, only to re-introduce the differential via the difference between the top personal tax rate and the corporate tax rate?
Gareth Morgan has an article on the shifting of the income/trust tax wedge to income/company: http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10648752&pnum=2
- “If you can run a business then you can understand basic tax law.”
The only time I understood baskc tax law was when I was working for other people. Then it was merely a case of filing my own personal income tax return. After I started doing my own business, things got too complicated for me. It was not an easy decision to use an accountant — he cost me thousands of dollars — but I had to.
(By the way, I do not have any trust at all)
Good on you for being more up front than Chris seems willing to let you be Stuart.
Stuart, your Trusts (as are ALL your personal affairs) are, well, your personal affairs and of NO concern to others.
Your first responsibility surely is to yourself and your family.
In fact, it is your duty.
Thereafter, you are free to assist your fellow man, as you seem willing to do, & I commend you for that, sir.
Ditto IDAD – have run my own company for 15 years and tax and general accounting is still a mystery to me.
Lots of talk about how the law is not clear. I was most interested in the question I believe was asked of the Drs in the case – “would you accept this salary if it was paid by an independent company?”. This seems like a reasonable test that could be be relatively simply answered.
Part of the problem seems to be that advisors on tax issues don’t particularly like simple tests – leaves less room to provide advice at cost!
If this test was applied – the “independent employer test” I belieeve that in most cases it would be clear to advisors and settlors of Trusts whether the Trust is actually a vehicle to protect against creditor claims or a vehicle for avoiding top personal tax rates. I do not think it is as hard as claimed to determine a market salary – I am sure that most professionals that use Trusts as a vehicle for reducing tax on income are well aware of how much their services are worth in the marketplace. They seem to be very aware of this when asked to accept less than the market rate!
CB – I dont think it is that which is not clear, what is not clear is what is regarded as legitimate use of different structures like companies sand trusts, and what is not.
It makes me really upset to see how much Labour-heads truly hate anyone who runs their own business. Stuart, you have the nerve to sit there and gloat about people being nervous about this issue! (For good reason, IRD penalties and interest cause the amount owed to double every 3 years, depending on the exact category).
I don’t have a trust of any kind, but this issue still scares me a great deal. The test quoted, “would you accept this salary if it was paid by an independent company?” has nothing to do with the trust funneling income. I pay myself far less than market value, because we’re reinvesting the profits in the business. While this can only be good for the country, I could now be ruined by the IRD for not disbursing all my profits. Of course, National haven’t made this any better, there’s still a 5c gap between the top personal tax rate and the company rate. So now, people like me who reinvest will be the ONLY people the IRD can pursue, because the trust rate is aligned.
The generally ill-informed, petty-minded, selfish & selfserving opinions expressed here remind me exactly why I voted for John Key after a lifetime (27years) of voting Labour. Your naked envy of the minority of people who actually stand on their own 2 feet, support themselves & then make the wealth for NZers so the generally lazy majority can sponge of it via taxes is typical of your previous leaders rhetoric. Who now has one of the biggest tax giveaway jobs in the world – the limit of her ambition because she could never get her mind around how to create the income in the first place.
How you deduce that Labour and supporters have “naked envy” from this post and subsequent comments is beyond me. Your accusation that the ‘generally lazy majority can sponge of it via taxes’ shows you probably have a couple of issues you need to work through. Critising Helen in the way you have just shows that perhaps one of these issues is that you don’t like successful women… Anyway, in future, please limit your comments to those that are constructive – or at least fact-based.
I dreamed a dream – fair enough. I can definitely understand how tax may seem difficult to understand or seems daunting.
However, where matters of honesty & legality of your actions are concerned, I would always be double checking the information that any accountant gave me with IRD – they do still see people face-to-face! That way you will have covered all your bases so as to avoid being caught out; unfortunately (from what I have gathered) they seem to follow the mantra that , ignorance is no excuse under the law.
@Robbie, As a business owner who stands on his own two feet, I would have to disagree with your assertion that the people here are petty-minded, self-serving, selfish, with naked envy.
Many of them may be ignorant of business, and I don’t even blame them if they are indeed ignorant. For a long time now, the public sometimes tend to think of “business” as a bad word because there’s been a lot of bad press about “business”. To them business means those rich pricks who run away with investors’ money, global financial meltdown, CEO’s being paid millions while their companies are not performing, Madoff, BP Oil Leak, Privatisation of public assets, SuperCity corporatisation, tax avoidance via Trusts, etc, etc, etc. Now wonder “business” can be such a bad word in society.
Even on a personal level, when I tell someone that I do my own business, one of the first responses usually is “You must be making a lot of money!” Even my pastor once thought the business people were generally mean — I had to correct him.
What people don’t realise, and I don’t blame them, are things like:
- most startup businesses fail within the first year, only about 5% survive after 5 years, and only 1 % do well, and a tiny fraction do supremely well.
- starting a business requires a lot of sacrifice, like not being able to draw a decent salary and having to reinvest profits if any (as Hayden Peake pointed out above)
- most businesses just barely survive.
- when people get into business, they get out of their comfort zone and take risks, leaving behind a regular dependable income
- family has to endure sacrifices too, having to go without things, having to forgo some holidays, etc.
- long hours have to be put in
- etc, etc, etc.
So, there are a lot of public misconceptions about business. But I don’t blame them.
And I am happy to pay tax towards a more just and compassionate society. Go Labour!
Tracey said that is it is the legitimate use of trusts and company structures that is not clear. I am sure I will be corrected if I have this wrong, but I have always understood that the legitimate use of trusts is for the benefit & protection of the beneficiaries rather than as a vehicle for reducing tax, which can be an incidental purpose but not the primary purpose.
With the difference in trust tax rates and personal tax rates there was a sudden upsurge in establishing trusts. I would argue that many of these trusts were established for primary reasons of taxation reduction, rather than protection or advantage for beneficiaries.
I foresee that once the IRD have got this issue sorted out to their satisfaction that the next step will be looking closer at the operation of trusts – are they being operated as separate legal entities or merely as an extension of the settlors’ personal financial affairs? If this further test was applied I think that many trusts would fall over – their operation would not meet that test any more than the primary purpose would be for the benefit of the beneficiries rather than tax reduction.
Company structure has always been regarded as a separation of personal and corporate actions. LAQCs, by their nature invited using the structure for tax reduction but I beleive the original intention was to provide support for startup businesses that ran at losses in the beginning and then to recover those losses in the future from tax once the business was profitable. That seems a fair exchange – the present risk for future gain and compensation via carrying forward losses.
Many of these issues are not about playing with “what one can get away with” but looking at the spirit of the “rules” and working within them whilst still taking action to address perceived inequities.
When I was a banker 20 years ago (Ha – in the old days of banking!)I was taught that a business should never be structured or run primarliy to reduce tax. The structure chosen should be that which allows the business to acheive its full potential. When businesses are structured primarily for tax reasons they often fail because the focus is not on growth but on reducing tax which in itself is not a productive activity.
I think we have seen the same with many investments over the years – film, vineyards, racing partnerships, ostrich farms, alpaca farms and loss-making investment properties are a few that spring to mind. Many of these investments would never have been made if there was no offsetting tax write-off.
I guess I must be old-fashioned – I do not believe in paying more tax than necessary but I also believe that business should not be structured for tax reduction but should be structured for profitable growth. All too often structuring for tax reduction only grows the profits of accountants and the IRD staff numbers. Structuring for profitable growth of a productive business grows jobs, R & D, GDP and incidentally, the tax take which is distributed and further supports the growth of the business (educated & healthy employees,roads and rail to transport goods, security through policing, electricity and water supply etc.)
Those that are prepared to enter business face the risk of loss and a lot of hard work but also the opportunity of substantial reward that would not be achieved as an employee.
I suspect that if those that started NZs most successful businesses were asked if they focused on tax reduction or on growing their business, they would say that growth was their aim.
For those that do not work that way, then maybe closing this avenue might redirect their energy towards productive actions or maybe they will then spend their energy looking for another loophole?
Is it really fair that someone that makes sufficient profit to pay a $650k salary only end up paying tax on $120k? Doesn’t seem quite “right” to me, old fashioned as I am.
@CB Thank you for your very balanced comments!