Diverting income could get you in IRD hot water
Diverting personal services income by structuring revenue earning activities through an associated entity such as a trading trust or a company may cause Inland Revenue to consider such arrangement as tax avoidance.
The key issues for IRD are:
- The use of companies, trusts and other business structures do not of themselves give rise to avoidance concerns;
- However, the use of those structures can provide the controllers of the business with an opportunity to divert income away from themselves;
- When the business involves the provision of services, whether that diversion is legitimate or not requires a focus on two issues:
- Is that individual controller appropriately compensated for his or her skill and exertion? This requires an examination of the respective drivers of profit for the particular services provider and how the profits of the business are actually distributed
- If not, are there any valid commercial reasons for the individual receiving a reduced level of remuneration? Here the focus is on whether there are particular reasons why the individual is accepting an unreasonably low level of remuneration.
- We will be concerned with arrangements where the compensation received by the individual is artificially low while related entities benefit (or the individual ultimately benefits), and any commercial reasons for that transaction do not justify the low level of remuneration.
The IRD view on income diversion
Inland Revenue has always been concerned about arrangements involving taxpayers who arrange to effectively divert to an associated entity some or all of the income they earn (or could earn) from a business or activity of supplying personal services – where it has the effect of taking advantage of lower marginal income tax rates payable by that entity and/or by family members as beneficiaries or shareholders of that entity.
Other tax-linked benefits (such as certain entitlements and obligations such as Child Support) may also arise under the arrangement. There are legitimate reasons for using entities such as trusts or companies in many business situations. Therefore the mere use of alternative business structures will not, on its own, amount to a tax avoidance arrangement.
Further, the profit generated by the business may not be wholly generated by the individual and there may also be good non-tax reasons as to why the controller of a business receives significantly less of the business’ profits than would otherwise be the case.
Provision of personal services and income diversion
Where the business involves the provision of services, IRD are likely to examine closely any arrangement where the individual service provider (usually the real owner or owners or controllers of the business) is not receiving a significant portion of the profits derived from the business. This is particularly so where there is an absence of other business profit drivers and other non-tax reasons do not justify the level of remuneration received by the individual.
Inland Revenue’s position in this regard has recently been confirmed by the Supreme Court in a decision that confirmed that income substantially generated by the direct personal skills, experience or labour of an individual should generally be subject to tax in the hands of that individual.
The individual’s contribution to the business should be properly reflected in the income returned by that individual – either through an appropriate salary or other taxable distributions to the individual.
IRD considered that the Supreme Court’s position endorsed earlier cases decided in this area, and potentially applies to any type of services provided by an individual to third parties.
Therefore, IRD will closely examine situations where an arrangement has the effect of diverting a substantial amount of that personal exertion income but the benefit of those diverted funds are still enjoyed, directly or indirectly, by the individual or their family or associates.
They will generally focus on the most serious and artificial cases – where the arrangement results in a substantial proportion of the income generated by the business being diverted away from the individual service providers.
In many cases, taxpayers entering into these types of arrangements are also benefiting from reduced child support liabilities or student loan repayment obligations. In some cases taxpayers are structuring their remuneration at a level that will allow them access (or greater access) to other non-income tax benefits that rely on income calculated for tax purposes.