Inland Revenue to make it harder for wealthy to sidestep 39 per cent top tax rate

Wednesday, 16 March 2022

Moves to shore up the 39 per cent tax rate look set to draw IR into some grey areas.

Inland Revenue is proposing to make it harder for higher earners to side-step the 39 per cent top tax rate that was introduced last year by clamping down on a form of “dividend stripping”.

It is also separately proposing to make it harder for people who provide personal professional services such as consulting services to operate through companies or trusts that lower their tax bills.

When people take the traditional option of withdrawing profits from businesses they own and control in the form of dividends, they are taxed at their income tax rate.

But IR is concerned the new top tax rate has increased the incentive for wealthy individuals to instead retain profits within businesses on the assumption that they will be able to bank those profits later when they sell shares in those companies or wind them up.

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Profits from the sale of shares are generally treated as capital gains that are not usually subject to income tax, IR noted.

IR is proposing to tackle that issue by treating profits from the sale of shares in tightly-held companies as a taxable dividend, to the extent that those profits were derived from retained earnings held by the company in question rather than from capital gains.

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The tax department said research on the financial affairs of 350 “high wealth individuals” with more than $50 million in assets found that they used or controlled a total of 8468 companies and 1867 trusts.

In 2018, those 350 individuals paid $26 million in income tax, while their companies and trusts – which would generally be taxed at a lower tax rate – paid $639m and $102m in tax respectively, it said.

IR said those figures showed “a significant amount of income” was being earned through what it described as lower-tax-rate entities.

Deloitte tax partner Patrick McCalman said he saw real issues with the approach IR was taking to tackle what he described as a “perceived mischief”.

It would be difficult to ensure the proposed regime did not end up applying income tax to the retained profits of businesses that were actually needed or intended as working capital, McCalman said.

“There are a range of people who are going to get caught,” he said. “It is a pretty rough tool.

“The proposals while they sound attractive are going to have some unintended consequences that need to be worked through and addressed.”

McCalman said the second change proposed by IR could have an even bigger impact.

The tax department is considering further measures to prevent high earners having income they earn from providing “personal services”, such as consulting services, taxed at lower tax rates simply by providing those services through a company or trust.

“There is a risk that taxpayers on the 39 per cent personal tax rate will use trusts and companies to obtain a lower tax rate on what is in fact personal services income,” IR said.

“The economic reality is that the taxpayer is performing work and being paid for it – the entity is a conduit for the taxpayer’s income-earning. Consequently, the taxpayer should be taxed on their personal services income at the applicable marginal rate,” it said.

IR already has some rules that are designed to prevent people from channelling income through what are in effect shell companies that have few assets simply to benefit from their lower tax rates.

But it is proposing to tighten those rules by treating income as personal income in a wider range of circumstances.

“I think there are lot of people who have ‘incorporated’ for a reason, but who are going to be treated as though that is ‘their’ income,” McCalman said.

There was something of a continuum between businesses that had been set up to channel personal income for tax purposes and those that fulfilled a more genuine function, he agreed.

Identifying what should be the tipping point for the purposes of tax policy would be a challenge, he said.

But IR’s proposal would capture “a lot more people that it should”, he said.

Inland Revenue is seeking submissions on its discussion document by April 29.