Are you paid a market salary?

With increased Inland Revenue (IRD) scrutiny, one of the issues on IRD’s radar is whether

individuals associated with a company are deriving market salaries or not. The IRD’s concern in

these scenarios is whether income is being taxed at a rate less than the top personal marginal

rate of 39%.

For this purpose, two aspects are relevant – first, the personal attribution rules and second, the

principles from the Penny & Hooper court case law.

The personal services attribution rules are legislated provisions within the anti-avoidance part of

the Income Tax Act 2007. If specific tests are met, income derived by a company from personal

services physically performed by an individual may be treated as derived by the individual. These

rules apply if:

 80% or more of the company’s income from personal services is derived from one buyer, and

 80% or more of the company’s income from personal services is derived from work physically

performed by an individual (or their relative) that is associated with the company, and

 the individual’s net income for the income year is more than $78,100, and

 substantial business assets are not required to derive the income. (“substantial business

assets” are defined and broadly comprises assets with a cost of more than $75k or 25% of the

company’s income from personal services).

In 2011, the Supreme Court ruled on the case of Penny & Hooper v IRD. The case involved two

orthopaedic surgeons who operated through companies owned by family trusts and paid

themselves salaries that were artificially low relative to the companies’ earnings from their own

work. The Court accepted that trading through a company was legitimate but held that setting

non-commercial salaries to divert personal exertion income was tax avoidance. IRD has

expressed its view on how the Supreme Court’s decisions in Penny & Hooper applies in practice

in Revenue Alert 21/01.

Although the above provisions are arguably focused on businesses that perform personal

services, there is a risk IRD could assert individuals should be properly remunerated for their role

regardless of the nature of the business. At the risk of taking it out of context, this view is inferred

within the Revenue Alert where it is stated:

“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.”

The lesson here is to be aware that there are two sets of provisions, one of which is prescribed in

the legislation and the other is an IRD view based on case law. With any person’s view, there is a

chance it can change and be applied inconsistently. If a salary looks low it may be worth adjusting

it to stay out of the IRD’s firing line or having a reason in case it is queried.