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In this edition, I continue to discuss the current rule on tax avoidance – the Parliamentary Contemplation Test – by way of another practical example.
Let us take an example. A taxpayer, a medical practitioner, started a business in a partnership with his wife. His wife is not a qualified person, and is just assisting him on the accounting side of the business. The partnership has now established a profitable business as the partnership generates a gross turnover of $1,100,000 per annum. On advice from the accountant, he changed the entity to a company. He appointed himself and his wife as directors, and also set up a family trust where all his children, whether minor or otherwise, were appointed as beneficiaries. His wife’s role remained largely unchanged. The family trust is holding company shares. At the end of the financial year, he instructs his accountant to prepare a tax return where he is going to receive director’s remuneration of $78,000 only. He also allocated another $78,000 to his wife, a co-director. Again, he allocated $150,000 to himself and his wife each on account of shareholder-salaries. Then, he distributed all the balance to the family trust and then he, as a trustee of the trust, further instructs the accountant to distribute all the income to the beneficiary on equal shares, leaving nothing in the hands of the trustee. The company eventually makes a small nominal payment of income tax. He, by way of restructuring of the business format, is able to enjoy $150,000 tax savings.
The issue we need to consider is whether sBG1 is applicable to the arrangement(s) mentioned above.
Let us turn to the stage 1 – what is the arrangement(s)? A taxpayer, running a medical practice, changes the business structure to one of the companies, from a partnership. He also set up a family trust and allocated all the shares of the company to the trust. He appointed his wife as a co-director and then is able to allocate some income to her on account of director’s remuneration and shareholder salaries.
It is important to realize that Part C of the Act provides all the different categories of income, whereas Part B and G provide various categories of avoidance, following that if there is one section applicable to the instant example, we may be able to conclude that the scheme or arrangement is subject to tax avoidance. Nonetheless, let us examine the tax effect of the arrangement – 2nd step of the text. sCD1 provides that a dividend is an income in the hands of the recipient. sCD2 provides that distribution is an income. sCD20 provides that a shareholder-salary is an income in the hands of the recipient. sHC17 provides that an amount received in the hands of the beneficiary under a trust is an income of that person.
More importantly, sGB23 provides that an excessive remuneration to relatives may be classified as an avoidance. In the instant case, the amount paid to the wife on account of director’s remuneration (together with the payment on shareholder-salaries) may be challenged as excessive as she does not do any real sense of director-related work. sGB25 again provides that a close company remuneration to shareholders, directors and relatives may be challenged as excessive. In the instant case, the allocation to the beneficiary of the trust may be subject to this.
Turning on to the stage 2 and the issue to determine is what is (or are) the tax effect of the arrangement? Part C of the Act, as mentioned is designed to provide you all the list of income. Likewise, Part G of the Act is designed to provide you with a list of avoidance measures.
Let us turn to stage 3 and the question is to ascertain the intention of the Parliament by reference to statues, case laws and any extrinsic materials. The Parliament intends that income from business is assessable by virtue of sCB1. Parliament also intends to allow deductions of the expenses provided the expenses are not a private nature and non-capital by virtue of sDA 1 and Ben Nevis. Parliament also intends not to allow excessive remuneration as deductible by virtue of sGB25. Parliament however does intend to allow a shareholder-employee to receive income on account of shareholder salaries by virtue of sCB20 provided that the payment is made on a market level. Parliament does intend, also, that if there is a genuine work, the expenses incurred are to be allowed as deductible. The rationale for this is that we always need to be aware that it is the market, not the paper or form, to determine the genuineness and deductibility of the costs. Tale Holdings Ltd is an authority for this. In this context, the payment made to the wife on account of director’s remuneration (and also on the account of shareholder-salaries) is likely to be challenged. Likewise, the payments made to the children/beneficiaries are likely to be challenged as well.
What is the next stage? We need to identify the features and attributes of the arrangements that need to be present (or absent). We need to make sure the subject income is only from the medical practice business. We also need to make sure whether making payment to the wife/director on account of director’s remuneration, while she is one of those sleeping directors, makes market sense. Likewise, we also need to make sure that the payment to the wife/shareholder on account of shareholder-employee makes any market sense. We also need to make sure that the child/beneficiaries do not contribute any toward the derivation of the income of the company.
Now let us turn to stage 5 – examination of the entire arrangement. You will see that the payments made to the wife is not on an arm’s length conditions. The payments to the beneficiaries/children were not on an arms’ length deal and there is clear element of artificiality here. Not all the payments are genuine.
Finally, we need to consider whether there is any potential defense in the instant case. The test is whether the outcome/tax savings is merely incidental to the whole arrangement without having to have any intention to defeat the intention of the parliament. You will easily see that the tax savings would not have been possible without the restructuring of the business and also the restructuring involves payments on non-arms-length deal.
Accordingly, it is reasonable to see that an audience can reach a view that the arrangement does contain element(s) of tax avoidance.
This article is designed to give general information to the audiences and readers of this article. This is not designed to provide a legal advice to a particular person of particular circumstance. If you have any enquiries, you should seek legal advice on that issue. A. B. Lawyers Limited does not accept any liability arising from misjudgment by the audience, without having independent legal advice on his/her case.
The writer advises that translation to Chinese, from English version, is done by one of the office legal assistant. There may be occasions you notice misinterpretation, despite we do our best to make correct translation. If you notice that, it is much appreciated you let us know that.