Chapter 6 – Current law and problems
Dividend integrity and personal services income attribution
A Government discussion document
Hon Grant Robertson
Minister of Finance
Hon David Parker
Minister of Revenue
Chapter 6 – Current law and problems
- Attribution rule for income from personal services
- Background and current law
This chapter examines the current law concerning the attribution of personal services income. First, it looks at the personal services attribution rule, which applies in certain circumstances when income from “personal services” performed by an individual is earned through an entity, such as a company or a trust. It then examines the precedent set by the Penny and Hooper case and the challenges for Inland Revenue in applying this precedent to cases where a taxpayer uses an associated entity as a conduit for selling personal services.
Attribution rule for income from personal services
6.1 The Income Tax Act 2007 contains an attribution rule for income from personal services. The attribution rule, contained in sections GB 27 to GB 29, prevents an individual avoiding the top personal tax rate by diverting income to an associated entity. A typical scenario is where an individual incorporates a company to contract for services. The company contracts with the customer and pays the 28% corporate tax rate on its fee income. The company then employs or sub-contracts with the individual to provide the service, often at a below-market rate. The company can either retain its profit or pass the profit back to the taxpayer in a tax-advantaged manner (for example, through a trust).
6.2 The attribution rule for income from personal services applies when an individual (the working person), who performs personal services, is associated with an entity (the associated entity) that provides those personal services to a third person (the buyer). The rule only applies when various threshold tests are met, most notably:
- At least 80 percent of the associated entity’s income from personal services during the income year is derived from the supply of services to the buyer or an associate of the buyer (or some combination thereof). This is referred to throughout this chapter as the “80 percent one buyer” rule.
- At least 80 percent of the associated entity’s income from personal services during the income year is derived from services that are performed by the working person or a relative of theirs (or some combination thereof). This is referred to as the “80 percent one natural person supplier” rule.
- “Substantial business assets” are not a necessary part of the business structure that is used to derive the associated entity’s income from personal services.
6.3 The combination of these tests targets the rule at individuals who, using an interposed entity, sell their labour to a buyer in the specific situation where these individuals would likely have traditionally supplied their labour as employees, rather than as independent contractors.
Background and current law
Personal services attribution rule
6.4 The top personal tax rate was first increased to 39% in the year 2000. This provided an incentive for some employees and contractors to arrange their affairs so that they avoided paying the 39% rate. One of the responses was that simple avoidance schemes were targeted at people who would normally be regarded as employees. The policy response to this problem was to introduce the personal services attribution rule in 2000, shortly after the increase in the top personal rate took effect.
6.5 Under the personal services attribution rule, an amount of income of an associated entity is attributed to the working person, provided that:
- during the income year, the buyer acquires services from the associated entity
- the services are personally performed by the working person
- the working person is associated with the associated entity at the time the services are personally performed by the working person (using the general definition of “associated persons” in subpart YB of the Income Tax Act 2007)
- the two 80 percent tests (referred to above) are both met
- the working person’s net income for the income year – assuming the personal services attribution rule applies to attribute the income of the associated entity to the working person – is more than $70,000, and
- as mentioned above, “substantial business assets” are not a necessary part of the business structure that is used to derive the associated entity’s total income from personal services.
6.6 In relation to the last of these conditions, “substantial business assets” means depreciable property that, at the end of the associated entity’s corresponding income year, has a total cost of more than either $75,000 or 25 percent of the associated entity’s total income from services for the income year. In the case of depreciable property subject to a finance lease or hire purchase agreement, the cost of the property includes the consideration provided to the lessee, including expenditure or loss incurred by the lessee in installing the asset for use unless the lessee is allowed a deduction for the expenditure or loss.
6.7 Section GB 27(3) provides a number of exemptions from the personal services attribution rule. Under the listed exemptions, the attribution of personal services income does not occur:
- if both the associated entity and working person are non-residents or, in some circumstances, if the associated entity is a controlled foreign company
- if the associated entity is a natural person and neither a partner of a partnership nor the trustee of a trust
- if the total amount of personal services income to be attributed to the working person is less than $5,000, or
- to the extent to which the services personally performed by the working person are essential support for a product supplied by the associated entity.
Penny and Hooper v Commissioner of Inland Revenue
6.8 The top personal rate of 39% when viewed against the trustee and company tax rates (both of which remained at 33% in 2000 following the increase in the top personal rate) also provided an incentive for people who were not employees but who were instead operating small and medium businesses to arrange their affairs so that they avoided paying the 39% rate.
6.9 The most well-known of these cases, Penny and Hooper v Commissioner of Inland Revenue (referred to onwards as Penny and Hooper), concerned two orthopaedic surgeons who had both previously operated their surgery practices as sole traders – and who both (independently of one another) switched to operating their practices through a company they had incorporated before the increase in the top personal tax rate from 33% to 39%. Once the increase in the top personal tax rate took effect, each of the surgeons received a salary from his company that was well below the amount of income he had earned previously and was found to be well below market rates. The balance of the annual net income derived by each company from its surgery practice was distributed to the surgeon’s family trust and taxed at the trustee rate of 33%. The effect of this arrangement was to avoid paying the top-up tax of six cents in the dollar.
6.10 Having been introduced in 2000, the personal services attribution rule was in place during the income years that were at issue in Penny and Hooper. However, as the personal services attribution rule was introduced for a different purpose (being to address the specific issue with contractors who were similar to employees arranging their affairs to avoid the top personal tax rate), it did not apply to the facts of that specific case.
6.11 The case instead centred around whether the taxpayers’ use of corporate and family trust structures, combined with the “artificially low” salaries was tax avoidance for the purpose of the general anti-avoidance rule in section BG 1. In its ruling, the Supreme Court recognised there may be legitimate reasons for taxpayers to structure their business affairs using entities such as companies and trusts, but as the salaries were considered “contrived and artificial”, the Court upheld the earlier decision of the Court of Appeal that the arrangements in question were tax avoidance arrangements.
6.12 Now that a new top personal rate has been introduced at 39%, the Government is considering whether the current settings of the personal services attribution rule are still appropriate or if they might need to be updated.
6.13 As part of this, consideration is being given to whether the fundamental rationale and design of the personal services attribution rule should be shifted from its original purpose of capturing employment like situations to instead apply more broadly to help to support the integrity of the 39% personal tax rate. This is because there is some concern that the rule in its current form may apply too narrowly, and therefore may not be effectively supporting the 39% personal tax rate as it is too easy for taxpayers to work around the rule.
6.14 There is a risk that taxpayers on the top personal tax rate of 39% will use trusts and companies to obtain a lower tax rate on what is in fact personal services income. This is an issue both for taxpayers providing personal services to a single customer (in which case the personal services attribution rule may apply) and taxpayers providing personal services to multiple customers (in which case the personal services attribution rule will not apply). In both cases, the economic reality is that the taxpayer is performing work and being paid for it – the entity is effectively just a conduit for the taxpayer’s income-earning activity. Consequently, the taxpayer should be taxed on their fee income at the applicable marginal rate. However, the legal structure used allows tax to be paid at the lower corporate rate. As such, there may be grounds in some instances for attributing the personal services income to the individual taxpayer and taxing it at their marginal rate.
6.15 The precedent set by the Supreme Court’s decision in Penny and Hooper covers similar ground to the personal services attribution rule. In some respects, the potential application of the Penny and Hooper precedent is broader than that of the personal services attribution rule, as the former is not constrained by the various threshold tests that limit the scope of the latter.
6.16 At the same time, reliance on the Penny and Hooper precedent has significant limitations from Inland Revenue’s perspective, owing to the fact that it is premised on the application of the general anti-avoidance rule in section BG 1. In particular the Penny and Hooper precedent will only apply to arrangements where there is an evident purpose of tax avoidance. It is not always obvious whether arrangements have such a purpose, and it can be time consuming and resource intensive to prove that there is one. The general experience has been that, when there is a specific and identifiable situation where avoidance is a concern, it is usually better to have a specific rule that addresses that concern than it is to rely on the general anti-avoidance rule. Further, the policy concern about the derivation of personal services income through companies is not restricted to arrangements with a purpose of tax avoidance. Therefore, it is preferable to have a specific “black letter” rule dealing with personal services rather than relying on section BG 1.