Orthopaedic surgeons use of family trusts to transfer profits to family members has been ruled tax avoidance by the Court of Appeal. By exploiting the difference between the 33 percent tax rate for a family trust and the then 39 per cent marginal tax rate on personal income, one surgeon made tax savings of about $65,000 for the three tax years in question; the other, tax savings of some $103,000.
The effect of the court ruling is that these tax savings will be taxed as the personal income of each surgeon.
Evidence was given that the two surgeons split their work between salaried employment with the Canterbury District Health Board and private practice. Each was earning gross fees in private practice of some $1.1 million dollars in a typical year. Net income for each from private practice over the period 1999-2004 varied from year to year: in a range from $567,000 to $832,000.
In 2000, acting on professional advice in anticipation of the top marginal tax rate increasing to 39 per cent, the two surgeons restructured their private practices. Their respective businesses were sold to newly-formed companies with a family trust as the primary shareholder. On the surface there was no day-to-day change: patients were still referred to the two surgeons personally who continued to practise as previously. But net income derived from the businesses was attributed to the family trusts after payment of a salary to the two surgeons. Annual salaries were set within the range $100,000 to $125,000. It was agreed that these payments were below the level of salary each could command after arms-length negotiations in a commercial context.
Inland Revenue argued that payment of an artificially low salary amounted to tax avoidance. It enabled income otherwise taxable in the surgeons’ hands to be diverted to family members on lower marginal tax rates.
The surgeons argued tax law has no rules governing levels of remuneration – other than assessments where family members are being paid inflated salaries in family companies for minimal work.
While taxpayers decide their preferred legal structure for business activities, the Court of Appeal said that does not stop the mechanism used amounting to tax avoidance if the arrangements are artificial, contrived or amount to a pretence.
In this case, the legal structure used was designed to exploit the difference in marginal tax rates for the personal benefit of the two surgeons and their families. Income was generated by the surgeons own personal skills and disposition of net income was controlled by the same surgeons through their control of both their companies and their family trusts.
The majority in the Court of Appeal ruled this practice amounted to tax avoidance.
The other judge, Justice Ellen France, decided otherwise: the surgeons had taken advantage of a difference in tax rates in a way that is within the limits of acceptable commercial practice.
CIR v. Penny – Court of Appeal (04.06.10)
06.10.001