Inland Revenue begins Penny & Hooper crackdown

Audit letters are on their way to doctors and other professionals who have failed to make voluntary disclosures to Inland Revenue in the wake of the Supreme Court’s Penny & Hooper tax avoidance decision.

The IRD’s grace period is now over for professionals who have restructured their practices into companies and/or trusts, and may subsequently have underpaid their tax. In the wake of Penny & Hooper, at least 80% of their profits must be returned as taxable income.

Lawyers, doctors, accountants and others whose primary business is providing professional services are the most likely audit targets. But anyone with a specialised skill or area of expertise who is working for themselves in a company or trust structure should review their remuneration and whether it seems adequate.

After the Supreme Court decision, the IRD issued a Revenue Alert, setting a threshold for auditing professionals. If 80% or more of the overall profits from the professional’s practice was being returned by the principal professionals in their own name, they would not be audited. The alert also offered guidance on the kinds of factors that could justify a low (or no) salary being paid in some circumstances.

The IRD has sophisticated ways of tracking situations where the percentage of profits returned by the principal professionals in a practice appears to be low.

Getting your pay or profits right
There is no magic percentage and what is acceptable will be highly dependent on the facts. If you don’t get this right, and the tax rate changes, the IRD will be suspicious of any sudden dips in your remuneration. Your levels of remuneration or allocation of profits should be correct and justifiable whether the tax rate is at 33% or otherwise.

Professionals  need to protect themselves against likely changes in tax rates if Labour wins next year’s election.

Since 2011, the trust and top tax rates have been aligned, at 33%, so regardless of the percentage of profits attributed to professionals operating in company and/or trust structures, the overall tax rate is the same. 

But as Labour has promised to raise the top marginal tax rate, professionals who agree to return unreasonable percentages of profits as their own personal remuneration for historic tax periods, just to get the IRD off their backs, will likely regret this decision. Equally, a reinvigorated IRD is likely to renew its efforts to audit professionals if the top tax rate changes.

This means you should still be considering the appropriate level of remuneration to be returned in your personal name so you’re protected in the event of a tax rate change. If you change the level after the rate change, the risk of the IRD alleging tax avoidance will be high.

Right now, the IRD is focusing on the 2009 income year – the year before the top marginal tax rate and trust rate were aligned. Providing returns were filed on time, the time-bar for reassessment kicks in on March 31, 2014. The department will likely to be speeding up the process to ensure assessments are done before the time bar kicks in.

So what the “right” amount of tax? Is it acceptable to pay tax on less than 80% of your profits? And how might certainty be achieved?

These are difficult questions and, because one size doesn’t fit all, there is considerable uncertainty in the system.

Factors to weigh up
Important factors which can be accepted as reasons for a lower-than-80% remuneration for professionals include:
• Is a spouse or other family member working in the business? Is their salary acceptable for work actually done?
• Has the business been through tough times or been in a period of investment or expansion?
• Are there loans or overdrawn current accounts that could be considered to be in lieu of salary?
• Are there other profit drivers in the business, such as specialised equipment, intellectual property, or other fee -earning staff?

If an audit letter arrives, it must be taken seriously. Get good advice before responding. If the level of remuneration for the principal or principals appears to be acceptable, it is important to explain to the IRD why that is justified and to put some “science” around it. Don’t forget the statute bar, as time is running out for reassessments for the 2009 income year where you have filed your returns on time.

A proactive approach will pay off and the time to act is now.

Kirsty Keating leads the tax controversy practice for New Zealand and is a principal of EY Law