Are small business owners paying their fair share of tax?
Tax Alert - April 2022
By Robyn Walker & Veronica Harley
Small business owners are the target of a recent Government proposal to extend tax avoidance laws to a wider range of small business owners to make sure they are paying their fair share.
New Zealand has had personal services income attribution (PSIA) rules since the 39% top personal tax rate was introduced in 2000. Now that the 39% tax rate has been reinstated, the Government is proposing to widen their ambit considerably. Proposals are contained in the Government Discussion Document “Dividend Integrity and Personal Services Income Attribution”.
What are the current personal services income attribution rules?
Included in the Income Tax Act 2007 is an anti-avoidance rule (that has applied from 1 April 2000) broadly aimed at individuals who seek to circumvent the top personal tax rate by interposing a company, trust or partnership between themselves and the party engaging their services in order to have their income taxed at a lower rate. Many people may have heard of situations where a person has resigned from their job but subsequently returns to do a similar role in a contracting capacity; its these sorts of arrangements which were at least partly in mind when the PSIA rules were designed, however they have always captured more than this.
Its relevance has increased with the (re)introduction of a top tax rate of 39 percent on income over $180,000 per annum from 1 April 2021, as this may provide an incentive to structure personal services contracting arrangements to reduce the tax liability.
Broadly, individuals may see an incentive to form and interpose a company between themselves and the party contracting their services which is taxed at a lower tax rate and then only draws enough salary from the company not to trigger the top tax rate. The buyer of the services deals with the associated entity, which derives the income arising, but it is the working person who actually provides the services.
Where certain criteria are met, the interposed associated entity must attribute an amount to the working person. Attribution to the working person may be required when the services are acquired and provided by different persons as noted above, and the following criteria are satisfied:
- 80% or more of the associated entity’s total assessable income from personal services during the income year is derived from the supply of services to the buyer of the services or an associate of the buyer (this is known as the “80% one buyer rule”); and
- 80% or more of the associated entity’s total assessable income from personal services is derived through services personally performed by the working person or a relative (this is known as the “80% one natural person supplier rule”); and
- The working person’s net income for the income year exceeds $70,000, including any amounts available for attribution; and
- Substantial business assets (broadly defined as total depreciable assets with a cost of more than $75,000 or 25% to the entity's total income from services) are not a necessary part of the business structure used to derive the associated entity’s assessable income.
What is proposed?
There is concern that the current rules apply too narrowly and shouldn’t just apply to “employment like” situations. It’s felt the existing criteria are not effectively supporting the integrity of the 39% tax rate. The Discussion Document also references the “Penny & Hooper” case (which did not involve the PSIA rules) where two surgeons changed from being sole traders to incorporated companies and formed trusts and ultimately were found to have committed tax avoidance by paying themselves artificially low salaries. The Discussion Document notes it is resource-intensive for Inland Revenue to apply the general tax avoidance law and specific “black letter” rules are preferable.
Consequently, it is proposed to:
- Remove the 80% one buyer rule;
- Lower the threshold for the 80% one natural person supplier rule to 50% (i.e. the rule moves from largely being limited to sole traders to including businesses that have an employee); and
- Increase the substantial business asset threshold to either $150,000 or $200,000 (or 25% of income from personal services, if lower). Any passenger or luxury vehicles will not count toward the asset threshold.
The net income of $70,000 test is not proposed to change as the Government is still concerned that some individuals may be seeking to avoid the 33% personal tax rate which applies at $70,000.
Example (adapted from the Discussion Document):
Bill is an accountant who is the sole employee and shareholder of his company, A Plus Accounting Ltd. The company pays the 28% corporate tax rate on the income from accounting services provided to clients and pays a salary to Bill of $70,000. Under the existing rules, any residual profits are either retained in the company or made available to Bill as loans. The PSIA rules do not apply as Bill has many clients.
Under the proposed rules, Bill will be subject to the PSIA rules as he is personally performing services, Bill’s net income is more than $70,000 and substantial business assets are not required for the business as Bill only has basic office furniture and equipment costing $20,000.
What does this mean?
New Zealand is a country of small businesses. Of the over 500,000 businesses in New Zealand, 71 percent have zero employees, and an additional 18% have 1-5 employees. It’s assumed that many of these businesses will be operating as companies due to the non-tax benefits associated with limited liability.
The expansion of the PSIA criteria is likely to capture a large number of these businesses within its ambit. What does this mean? These businesses will need to attribute business earnings out to owners, meaning that there will be a higher tax cost on the profits that are retained as working capital to grow the business, which will in turn reduce the funds available for reinvestment. Businesses could be incentivised to amalgamate; for example, rather than 3 plumbers running separate businesses which are subject to the PSIA rule, the 3 plumbers form a single company so the “[50%] one natural person supplier rule” can’t apply.
The rules assume that a business and its owner should essentially be viewed as a single entity, with all profits subject to tax at personal marginal tax rates. This may be appropriate in circumstances where the PSIA rules currently already apply, particularly if there are additional steps that would essentially put all business income in the hands of its owner (for example if the business is providing loans to its shareholders of its retained earnings). However, for many businesses profits are left in the company to fund its growth and future plans. Taking the example of Bill and A Plus Accounting Ltd (above), there may be plans to invest in a new larger printer (so he can print all of Inland Revenue’s latest guidance), hire an employee, enter a lease for new premises, to send staff on training courses to maintain skills, to undertake an extensive marketing plan etc. Subjecting such retained profits to the 39% tax rate rather than the 28% company rate is simply not appropriate.
Deloitte does not support these changes for several reasons. There is no compelling evidence that change is required and Inland Revenue already has other mechanisms at its disposal to void any egregious arrangements where individuals are accessing cash from a business and not paying the appropriate individual tax on the cash received. In addition, these proposals will introduce inappropriate distortions between services and other types of small businesses where some will be subject to tax at individual tax rates and others will be able to continue to benefit from the lower company tax rate.
Submissions on the Discussion Document close on 29 April 2022.
For more information contact your usual Deloitte advisor.
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