04 April 2023

If a widely held corporate (resident or not) earns income it is taxed at 28% whilst the same income earned by a resident individual is taxed at up to 39%. This appears counter intuitive. So how do we and why do we favour capital owners and corporates exploiting non-owner labour, including foreign versions of these, over resident individuals?

The source of the decision

In Hadlee and Sydney Bridge Nominees Ltd v CIR (1991) 13 NZTC 8116 CA) Richardson J, then of our Court of Appeal, held (subsequently endorsed by the Privy Council):

“It would be wrong to impute an intention to Parliament that income splitting with its inevitable undermining of the graduated rate structure should be widely available to professional and commercial taxpayers.”

Essentially ignored for many years, that decision underpinned the ‘landmark’ Supreme Court decision in Penny and Hooper ([2011] NZSC 95). Ever since that court decision, the scarcest of our best, brightest, hardest working talents are forced to not just comply with the letter of tax law but to comply with court adjudged imputations, and non-imputations, of what Parliament intended that law to be.

Day to day, this translates into those same taxpayers being forced to comply with what Inland Revenue (IR) imputes - that courts might impute, or not impute, to Parliament - based on what is captured in the imprecise words those courts have used to describe what they have and have not represented as Parliament’s intention in the few cases that have come before them. This tangle is still more complex, since IR’s Operational and Ruling teams may have different ideas on the case law and on Parliament’s intent for a given case.

This situation applies to far more taxpayers than most would imagine. Despite these consequences, our Courts observed this would be the result of the case and dismissed it as being precisely what our Parliament intended – outrageous uncertainty in the tax consequences of common and ordinary dealings.

Christopher Jenkins, of law firm Russell McVeagh, thus noted following the Supreme Court decision in Penny and Hooper:

“If Parliament takes up the challenge of clarifying the law, it would appear to have three options. It can align the rates of tax, kill off trusts, or repeal the GAAR [General Anti Avoidance Rule]. It is for Parliament and Parliament alone to decide which would incur the least collateral damage.”

Is the Parliament decision in Hadlee sensible?

Coming from our highest courts we expect the citation from Hadlee to be sensible. But, by itself, it is the equivalent of arguing whether or not we have mugged high paid employees under the graduated rate structure, and so, it would be wrong not to mug high paid professional and commercial taxpayers.

Never mind comparisons to other categories of taxpayers. such as capital owners and corporates with whom which professionals and commercial taxpayers actually compete head-to-head.

Never-mind the present economic challenges to attract internationally mobile labour.

Never mind that that labour is now scarce across the board.

It would seem to depend on whether Parliament is trying to achieve the correct comparison with employees, as has been assumed, or with other categories of taxpayer. From a tax law interpretation, it is not necessarily a sensible perspective, and that the following are irrelevant for present purpose:

1. A meaningful comparison of the taxation of professional and commercial taxpayers to the taxation of capital owners and corporates, including foreign versions of those; and

2. A meaningful consideration of the economic circumstances in which the tax system might want to favour capital (‘non-industrious’ or ‘passive’ revenue) over labour (‘industrious’ or ‘personal exertion’ revenue) depending on which, if either, is scarce.

An unfair tax system

It is well recognised that a good tax system should meet five basic conditions:

1. fairness,

2. adequacy,

3. simplicity,

4. transparency, and

5. administrative ease

Given variable marginal tax rates applying to different entities, the tax system is not fair and never has been. Hadlee and Penny and Hooper put fairness vis a vis employees front and centre. That is intuitively sensible and appropriate to the extent the taxpayers simply diverted income to private purposes through alternative means. However, it is anything but obvious that it is intuitively sensible or good for NZ Inc when the income is simply not distributed and instead is reinvested in the business, in growing the business and in diversifying the business into allied businesses. In that event, it is strongly arguable that the valid comparison is not with employees but with owners of capital and corporates with whom there is competition.

The Supreme Court in Penny and Hooper agreed there were exceptions for reinvestment but where is the line? In a recent ruling application, IR Operations is in favour of the line being at least as far as diversification into allied businesses meaning those that further the purposes of the existing business. However, IR Rulings took the view that it was only “the existing business” and even then, only if absolutely “needed” (whatever that means) by that existing business. In consequence, even investment in growth to further the existing business could not be ruled out of being tax avoidance. Investing in separate but allied or complementary businesses was in IR Ruling’s view a step too far.

It is one thing to need to convince IR that an investment is closely enough connected to achieving an existing business purpose. That line is typically going to be reasonably clear and sufficiently flexible to not inhibit proper competition altogether. It is quite another, and a step too far, to think that Parliament intended taxpayers to be required to negotiate with IR staff as to what are appropriate investments necessary to the purposes of the existing business. The reasons are somewhat obvious - it breaches every single condition of a good tax system based on an irrational comparison.

Changing economic circumstances

It appears the Hadlee logic might have had intellectual appeal in 1991 even with a comparison to owners of capital and corporates, when the world had yet to be substantially professionalised. It may even have retained some intellectual appeal in 2011, when the Penny and Hooper decision was released, and the joint promises of automation and artificial intelligence were yet to be realised. But, in 2023, when automation and artificial intelligence area very real part of our society, the need for comparison of professionals and commercial taxpayers with owners of capital and corporates is all the more prescient. Would not the relevant proposition of Parliament’s intent as to income reinvestment for industrious income (at least to the extent of furthering the purposes of the existing business) not now be:

“It would be wrong to impute an intention to Parliament that the same income reinvestment tax advantages available to non-industrious capitalists shouldn’t be widely available to our scarce industrious professionals and commercial taxpayers”?

There is precedent for this as we previously taxed capital at much higher rates than labour in the early part of the 20th century. Labour was the critical enabler for increasing productivity and growth, and labour was in short supply then just as professionals and commercial taxpayers are in short supply now across every sector of the economy.

This year's tax wish

IR Ruling’s position on where our courts have drawn the lines on acceptable income reinvestment for professionals and commercial taxpayers is incompatible with a good tax system and needs to be addressed by Parliament through clarifying legislation. Relevant legislation should express that such taxpayers are intended to be able to reinvest income on the same tax footing as owners of capital and corporates at least to the extent of furthering directly or indirectly existing business purposes. Legislation should also express how Parliament’s current priorities are to be taken into account in assessing Parliamentary intent.

It is less than obvious that 2023 is a time Parliament should intend to advantage owners of capital and disadvantage industrious labour, which is as scarce and increasingly mobile as capital.

It would be assuming to think that the parties in these cases and the current Supreme Court would agree, but this is the tax wish for election year 2023.

To talk to a specialist in tax about your circumstances contact Findex here

The views expressed in this article are those of the author and not necessarily aligned with those of Findex.

April 2023