SHAREHOLDER/ EMPLOYEES: Be careful how you pay yourself

About the Author:

Emma Marr

Associate Director at Deloitte
Emma Marr is an Associate Director in Deloitte’s Auckland tax practice, specialising in transaction services and providing tax advice to local and international corporates.

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A recently reported decision of the Taxation Review Authority (TRA) emphasises the need for shareholder/employees to carefully document financial transactions with their own companies, to be clear about what those amounts are paid for, and to ensure they pay tax when required. Failing to do so led to a large tax bill for one particular taxpayer.

The case, Disputant v Commissioner of Inland Revenue [2018] NZTRA 9, concerned a taxpayer who received amounts from, or had her personal living expenses paid by, three separate companies over a period of years. She maintained that all amounts were paid to her, or on her behalf, as repayments of loans she had made to the businesses in earlier years. The Commissioner of Inland Revenue maintained that the amounts were either dividends, wages or simply income under ordinary concepts, and the taxpayer should have paid tax on the amounts.

The Commissioner also imposed shortfall penalties for gross carelessness for the unpaid tax. The taxpayer disputed the assessments and the case went to the TRA, which found for the Commissioner. The taxpayer had to pay both overdue tax and shortfall penalties.

The key problem for the taxpayer was that the onus is on taxpayers in such circumstances to establish, on the balance of probabilities, that the Commissioner’s assessment was wrong. The taxpayer simply didn’t have any evidence to show that she had made the advances to the companies she said she had made, or that the payments made to her or on her behalf by the companies were made to repay those advances. In the absence of any such evidence, the TRA had no choice but to uphold the Commissioner’s assessments.

The taxpayer was either a shareholder in, or was associated with someone who was a shareholder in, the three companies. One company imported goods, another sold those imported goods, and the third company ran a fish and chip shop. Over the relevant income years:

• The first company paid the taxpayer regular amounts of money that were described in the bank statements of both the company and the taxpayer as “drawings”. The Commissioner assessed the taxpayer on the basis that these amounts were taxable dividends, or alternatively, that they were taxable as income under ordinary concepts. 

• The second company’s bank account was used to pay for a number of the taxpayer’s personal expenses, such as insurance, groceries, gym memberships and clothing. In addition the company regularly paid the taxpayer amounts of money that were described in the bank statements of both the company and the taxpayer as “wages”. The Commissioner assessed these amounts as wages. Additional amounts paid by the company to the taxpayer were assessed as taxable dividends, or alternatively, taxable as income under ordinary concepts.

• The third company paid for personal expenses, including groceries, on behalf of the taxpayer. The Commissioner assessed the taxpayer on the basis that these amounts were taxable dividends or, alternatively, that they were taxable as income under ordinary concepts. Other deposits that could be seen in the taxpayer’s bank accounts, but for which company bank statements couldn’t be found, were assessed by the Commissioner as wages.

The taxpayer maintained that every amount paid to her, or paid on her behalf, was a loan repayment by the company concerned. 

There were a number of difficulties with the taxpayer’s evidence. The first was that none of the company documents that the taxpayer produced, including the financial statements that were available (which were only in draft and did not cover all the years in question) showed amounts owing to the taxpayer that corresponded to the amounts she maintained she was owed. In some circumstances, in the years in question, the recorded shareholder balances increased rather than decreased, which contradicted her evidence that the payments she received were to reduce the loans. The taxpayer didn’t produce any other company documents, such as loan agreements, board minutes or resolutions, journals or ledgers that supported the loans she described. She also didn’t produce any personal documents or accounting records to support the existence of the loans.

The taxpayer maintained she couldn’t get all the records she needed because all of the companies had either been in receivership at relevant times or had since been liquidated. However, it was also not disputed by the taxpayer that she had made no effort to get the records from the receivers or liquidators.

Further, the taxpayer’s evidence was that she had asked her accountant whether a loan repayment should be treated as capital to her or income, and that he had advised it would be a capital amount, so not taxable. The TRA did not dispute the correctness of that advice, but noted that it didn’t resolve the question of the character of the payments she had received. If they had been loan payments they would be capital and not taxable but she was unable to prove that they were loan repayments. 

In terms of the payments described as “wages”, the taxpayer maintained they were only described that way because the accounting software used by the company didn’t have a drop-down box for loan repayments. She also gave evidence that the description of the amounts as wages was to reflect the amount of time she spent in the business so their accountant could properly value the business by “factoring in true wages costs.” The TRA noted it was unlikely that an accountant would advise or agree to a company coding amounts that were loan repayments as wages, and that it was more likely the characterisation of the amounts as wages reflected the fact that they were payments for work she actually did for the business. Further, the TRA noted that other amounts paid to the taxpayer were described as “drawings”, which didn’t reconcile with the taxpayer’s evidence that the only way to describe the amounts was as “wages”. 

The TRA concluded that all the Commissioner’s assessments were correct, that the amounts paid were either wages, dividends (being amounts of value transferred to a shareholder due to that shareholding), or income under ordinary concepts. 

The Commissioner had also imposed shortfall penalties for gross carelessness. The TRA considered case law on this penalty, which provides some additional commentary on the circumstances in which the penalty should be imposed. The case law establishes that “gross carelessness” includes situations where:

• the position taken has been taken with a complete or high level of disregard for the consequences (ie, that the correct amount of tax won’t be paid);

• the taxpayer displays conduct which creates a high risk of a tax shortfall occurring, when a reasonable person would have foreseen that happening;

• the taxpayer was reckless.

In addition, tax legislation provides that “acceptable tax position” cannot amount to gross carelessness. An “acceptable tax position” is one that is as likely as not to be correct. The TRA considered the taxpayer’s actions in light of these tests and concluded that the taxpayer had been grossly careless. The TRA found it was highly relevant that the taxpayer had not kept any records evidencing her position, namely that she had made loans to the three companies, and that the payments to her or on her behalf were repayments of those loans. She had made no effort to get records from those who might have them, or keep her own personal records. The taxpayer had shown a high level of disregard for the consequence of her actions in failing to disclose the income she had received and pay tax on those amounts. 

The TRA also found it was notable that the taxpayer took the relevant tax positions when she was already under audit. In those circumstances deciding to completely omit the payments from her tax returns was a fairly high-risk position to take, and the TRA considered that any taxpayer under audit should take particular care with filing their tax returns.

Ultimately, the taxpayer was found to have underpaid tax of around $70,000, and was liable for shortfall penalties of nearly $14,000 (after a 50% reduction for previous good behaviour). The TRA summarised the case by saying:

The obligation was clearly on the disputant to be able to produce contemporaneous documentary evidence to show that amounts paid by her to the companies were loans, and that the amounts paid to her, or on her behalf, were in fact repayments of those loans, and therefore non-taxable.

The key is to create and retain contemporaneous documentary evidence, which reconciles with the facts, and is properly disclosed when taking a tax position. It is also important to note that there are options available, when you wish to take a particular tax position, that will allow you to protect yourself from penalties if the Commissioner disagrees with the tax position taken.

If you have any questions about how to correctly document your own business transactions and/ or protect yourself from penalties, consult your accountant or tax advisor.

Emma Marr

Associate Director

Deloitte

09 303 0700

www.deloitte.co.nz

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