Personal Services Income Attribution Rules
The reinstatement of the 39% tax rate for an individual’s income greater than $180,000 has resulted in the government proposing new measures to address matters that the IRD perceives as tax avoidance.
The attribution rule prevents an individual from avoiding the top personal tax rate (39%) by diverting income to an associated company or trust. It is common for an individual, a builder, for example, to incorporate a company and provide their services through this structure. The company allocates the builder a shareholder salary, and any profits retained in the company will be taxed at 28% (corporate tax rate). However, that salary may be below market rates. To this extent, the difference between the allocated salary and the market value of that salary creates a tax advantage.
This practice gained notoriety due to the 2011 decision in Penny and Hooper v Commissioner of Inland Revenue that went to the Supreme Court. That case involved two Christchurch orthopaedic surgeons who used company structures and family trusts to avoid higher personal income tax rates by artificially lowering their salaries. 50% below what was perceived to be market value by the Inland Revenue Department. Both individuals were found to have had a tax avoidance purpose.
This case creates a precedent which further supports the government’s motivation behind the personal services income attribution rules and the proposed amendments.
The existing personal services income attribution rule is subject to three principal criteria. These are:
The 80% Single Source Rule – at least 80% of the associated company (or trust’s) income from personal services during the income year is derived from the supply of services to a single third-party customer;
The 80% Single Supplier Rule – at least 80% of the associated company (or trust’s) income from personal services during the income year is derived from services that are performed by the individual;
Substantial business assets (property with a cost of more than $75,000 or 25% of the company – or trust’s – total income from services for the income year) are not a necessary part of the business structure that is used to derive the business income.
Note that the attribution rule only applies where a minimum threshold of $70,000 annual earnings is reached.
So what are the proposed changes up for discussion? The proposal suggests a number of options for broadening the scope of the personal services attribution rule. If implemented, the changes suggested in this proposal would represent a shift in the focus of the rule from narrowly targeting taxpayers who are similar to employees to capture a wider array of scenarios where an individual may use an associated entity as a channel for selling their personal services to one or more customers.
It is proposed that the 80% single source rule be removed altogether. Inland Revenue is also considering lowering the threshold for the single supplier rule from 80% to 50% and increasing the threshold for the substantial business assets to either $150,000 or $200,000 (or 25% of the company or trust’s annual income).
What does this mean? Take our builder example, a sole employee and shareholder of their company working on multiple projects for various clients. Currently, the company pays the 28% corporate tax rate on the income from building services provided to clients and pays a salary of $70,000 to the sole shareholder. Any residual profits are retained in the company. If these proposed changes were to pass, the personal services attribution rule would apply so that all the income of the builder’s company (the associated entity) is attributed to the sole shareholder (the working person).
The IRD’s intention is to ensure that taxpayers cannot avoid the highest personal tax rate. The IRD are putting more resources into this area to ensure taxpayers are returning the appropriate amount of tax. If you think the attribution rules may apply to you, please seek professional advice.