Inland Revenue is currently scrutinising the amounts that doctors, surgeons, dentists, architects, and other personal service providers trading through family-owned companies or family trusts are paying themselves.

Background on Inland Revenue’s concerns over personal services income allocation

In 2011, the Supreme Court in the Penny & Hooper Case established the principle that personal services income should be attributed to the individuals whose personal exertion led to the business earning the income.

Following this case, Inland Revenue issued a Revenue Alert advising taxpayers providing personal services through closely held companies and family trusts on what Inland Revenue considered was and was not acceptable use of such entities to derive personal services income.

Inland Revenue was particularly concerned with arrangements where an individual's compensation was perceived to be artificially low, while the associated entity benefited from and returned income derived from the individual's efforts.

Particularly, where this income was subsequently distributed to the individual or their family as a tax-free distribution or where the individual and their family enjoyed utilised company or trust-owned assets, (such as holiday homes, motor vehicles, and boats) purchased with the income. With the top personal marginal tax rate increasing to 39% from 1 April 2021, there was an increased incentive for taxpayers to divert personal services income to companies (taxed at 28%) and trusts (currently taxed at 33%, but soon to be 39%) to reduce their tax bill.

Inland Revenue’s review of tax returns for the 2022 tax year has resulted in a concern that some taxpayers are inappropriately retaining their personal services income in companies or trusts.

Consequently, Inland Revenue approached taxpayers and suggested they voluntarily request an amendment to their tax return to increase the income allocated to them by their company or trust for the 2022 income year.

Inland Revenue’s current position on personal services income allocation

Inland Revenue’s position is that companies or trusts should allocate 100% of the net income arising from the provision of personal services to the individual who generated that income. Where less than 100% of the income is allocated, Inland Revenue requires taxpayers to provide a justification for the lower allocation.

In Inland Revenue’s view, valid justifications include:

• retaining funds to invest in additional capital assets for use in the business,

• providing a return on capital invested in the business, or

• where some of the personal services income is attributable to the efforts of other employees.

Inland Revenue does not consider that:

• retaining income in companies and trusts for asset protection or estate planning purposes is a valid reason for not passing personal services income out to the individual that generates it.

• the trust or company retains the funds and invests them, rather than distributes them to the individual as an after-tax payment, as justifying the income’s retention.

Finally, Inland Revenue notes that it is not concerned with whether what the company or trust is paying the individual is a “market salary”, “fair and reasonable salary”, or “comparable to industry averages”. Inland Revenue is concerned with whether the remuneration the individual receives reflects their contribution to the generation of business profits.

If you are operating a business providing personal services through a company or trust, we strongly encourage you to watch the NZ Year-end Tax Planning webinar where our expert tax advisors guide you through the implications of Inland Revenue’s approach and the potential risks you may encounter.

To get tailored advice for your specific circumstances, reach out to our Tax Advisory team today.

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