Tax system provides opportunities and risks

THE DOMINION POST - MONDAY 21 JUNE 2010

Benjamin Franklin said that nothing is certain in life except death and taxes. But there is a perception that for shrewd businesses and the wealthy, death is the only certainty. Our tax legislation has provisions to prevent tax avoidance, but the courts have always allowed people to arrange their affairs in ways that minimise their tax.

Much publicity was given to the case of two well known orthopaedic surgeons who rearranged their practices so that they lowered their tax liability. Ian Penny is a surgeon to famous sportspeople. Gary Hooper is the head of orthopaedics and musculoskeletal medicine at Otago University's Christchurch campus. Both set up largely family trust-owned companies that purchased their practices.

The companies then paid the surgeons well below what they would normally expect to receive as income and, accordingly, their tax rates fell into a lower bracket. Mr Hooper's salary dropped by $530,000 a year and Mr Penny's eventually by around $202,000 a year. Both were being paid far less than the average salary for professionals in their field. Clearly, the balance of what they would otherwise have earnt was distributed to their companies and family trusts, which were taxed at lower rates. The surgeons were attempting to rearrange their affairs to their tax advantage.

Both the IRD and the Court of Appeal said that the surgeons were guilty of tax avoidance. They had fixed their salaries at artificially low levels bearing no relation to economic reality.

They were paying far less tax than they would otherwise be paying.

Readers will have come across tradespeople who want to be paid in cash. Others may have heard stories of restaurants where people are paid under the table.

For a tax system to be effective it must have the support of the majority of the population. When people believe that others are not paying appropriate tax, they too may become complicit in undermining the system. Accordingly, cases like that of the surgeons and how the courts deal with them will be closely watched by readers. Where people feel that appropriate tax is paid by most people, the pay- under-the-table arrangements are less likely to find favour.

That has to be weighed against the entitlement of businesses or individual taxpayers to arrange their affairs in a way that meets the needs of themselves and their families. It is not easy to see where the line should be drawn. The High Court concluded that the surgeons were able to use these arrangements to minimise their tax obligations. The Court of Appeal disagreed by a majority. The dissenting judge said that arrangements such as the surgeons' that produce tax benefits do not necessarily constitute tax avoidance and didn't here. You can see that even the experts disagree on where the line should be drawn.

Many tax experts and business owners would agree that the arrangements the surgeons set up were reasonably commonplace and not of great concern. Such views are backed up by court decisions that have found that a variety of arrangements that reduce tax may be lawful. The most famous case involved the Duke of Westminster's pay arrangements for staff. That case goes back to 1935. The House of Lords famously said that a person can make any lawful arrangement of his affairs that he sees fit, to reduce tax liability.

The question of whether a tax arrangement affording benefits is a sham is a complex one. The fact that there are no precise lines to be drawn was again highlighted in the case of two 80s New Zealand feature films, Utu and The Lie of the Land. In that case, high-rate taxpayers were induced to invest. They had the prospect of obtaining a depreciation allowance. Ultimately, it was decided that there had been no tax avoidance, but only after the issues had been battled right up to the Privy Council.

Other cases in New Zealand have ruled arrangements unlawful. In one such case, where an arrangement had its dominant purpose as the avoidance of tax, the judge said that the investors involved had "at best shut their eyes to what they must have known was a scheme that was too good to be true".

Our Supreme Court, commenting on a forestry scheme set up by a clever lawyer for the generation of "spectacular tax benefits", gave the lawyer his own epithet. The judges said the lawyer was clever but "this cleverness should not be allowed to obscure the reality that this particular emperor has no clothes".

The surgeons' case is a good example of the risks taxpayers face. If clever advisers help companies and individuals rearrange their tax affairs, there is a risk to their clients. The cheekier the scheme the greater the risk. The risk is that the courts will decide that the arrangement is unlawful and significant back tax with penalties and interest may be owed. Many readers may prefer to err on the side of caution so that they are not exposed to those risks.

Reasonable enforcement of tax legislation by the courts is important to obtain public confidence in the system. Arrange your business affairs sensibly by all means, but the emperor, as the Supreme Court would have it, must still be modestly clad.