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How to avoid the 39 cent tax rate

Philip Macalister looks at the options for avoiding the Government's new 39 cent tax rate on earnings of more than $60,000ð?

Sunday, December 5th 1999, 12:00AM

by Philip Macalister

The weeks before Christmas are a time for spending money, but for high-income earners this year it has become a time to work out ways of avoiding tax.

A key plank of the new Labour-Alliance Government is a plan to raise the personal income tax rate for earnings above $60,000 from 33 cents in the dollar to 39 cents.

Although the government is yet to be sworn in it is already preparing the necessary legislation so the change can be passed and implemented by April 1.

Accountants around the country report that they are getting a large number of enquiries from people wanting to know how to avoid paying the extra tax.

PricewaterhouseCoopers tax partner John Shewan says the enquiries are coming from people who aspire to earn more than $60,000, as well as the five per cent of the population who are already high-income earners.

He says it is quite legitimate for people to explore way to avoid paying the extra tax.

"They are taking advantage of the choice the Government is giving them."

He says there are a number of ways tax avoidance can be achieved.

Despite the seemingly high interest in avoiding the tax, incoming Finance Minister Michael Cullen doesn't believe there will be much slippage and the tax will raise the $370 million expected.

Cullen acknowledges people are seeking advice on the matter, but he questions whether accountants and lawyers "have really got answers that are tax effective."

Whether they have the answers will be known over time, however tax experts agree there are three main methods of avoiding the extra 6 cent tax rise. They are:

  • Establish a company structure to receive remuneration
  • Establish a trading trust or a family trust
  • Pay income over $60,000 into a superannuation fund
  • Establishing a company structure

    Self-employed people and contractors can avoid the impact of a higher tax rate by setting up a company to own their business. The company then pays a salary of no more than $60,000 that is taxed at 33 per cent and any additional payments can be made to the owner as dividends. Meanwhile, any additional profits made by the company are taxed at a flat rate of 33 per cent.

    There is more to this than meets the eye through. The new structure that owns the business has to be flexible and practical so that it can adapt to changing business circumstances.

    Cullen warns people to think very carefully about making any changes designed at avoiding the tax as the new Government has plans to tighten the anti-avoidance laws which have been sitting on the books for five years.

    However, he refuses to give details of what might happen.

    Establishing a trading trust or a family trust
    A variation on the company theme is that people establish a trading trust as the vehicle to own the business. This works in a similar way to the company structure as business pays income to the trust, which is taxed on the trustees' rate of 33 per cent.

    Besides providing income tax savings it also offers asset protection and the option of further tax reductions.

    Under the company structure the person being paid has to actually do some work for the company, however a trust needs no justification for splitting income among other beneficiaries.

    Therefore the trust can distribute income to other beneficiaries such as children who are on the lowest marginal tax rate (19.5 per cent). This potentially provides tax savings of $5,130 per year.

    Cullen acknowledges that making changes to the trust laws to stop this type of avoidance is more difficult than the other two options.

    Pay income over $60,000 into a superannuation fund

    A third option that sounds easy and is cost effective is to pay any income over $60,000 into a superannuation fund as that only gets taxed at 33 per cent, and the earnings are exempt.

    Financial planner Murray Weatherston of Financial Focus says this practice was previously known as "salary sacrifice" or having a "top-hat superannuation scheme".

    It works like this. The employers would strip out, say, the top $20,000 of salary and pays that amount less withholding tax ($6,600 at 33 per cent) into a registered superannuation fund. That fund pays tax on its earnings at 33 per cent, and the employee could withdraw money from the scheme on a tax-free basis when it is needed.

    The key points to making this a successful strategy is that the employee has to get the employer to make the payment into the super fund, and that fund has to have low fees and be sufficiently flexible to allow the investor to withdraw money on demand.

    While this sounds like a subtle way of giving top income earners an incentive to save it's not designed to do that, Cullen says.

    He says one of the questions people considering this option need to cover is whether or not the payment would be challenged by the Inland Revenue Department. Shewan says if the IRD saw a salary had been cut from $80,000 to $60,000 and with another $20,000 going into a super fund it may claim the move was tax avoidance.

    If it does then there is little point in adopting this practice.

    Who should do what

    Weatherston believes there are a significant number of people who will breach the $60,000 threshold because their investment income is reasonably high.

    In this instance the only real option available is to pay the money into a family trust, which the trustees can then convert to capital and pay out as a capital distribution.

    The other issues investors need to be aware of is the impact a higher tax rate will have on imputation credits.

    Dividends are fully imputed when tax is paid at 33 per cent, however in a high income earner would be liable to top the tax up to the new rate of 39 cents.

    Shewan expects that many companies which traditionally make dividend payments in April will bring those forward next year to avoid shareholders having to makeup the shortfall.

    Owner-operators/Sole traders
    Weatherston says many owner-operators or sole traders who are doing quite well may have previously been advised to own their business under a company or trust structure, but not made the changes.

    He says this tax increase may be the necessary catalyst to push them into a new structure. While there are two options, a company or a trust, he says there can be additional advantages in having a company owning the business, and that company is then owned by a trust.

    Much has recently been made of the possibility that employees could adopt the company approach and could establish a service company. Under this idea the employer would engage the company, as opposed to the individual.

    Shewan says people are over-stating the benefits of this option as there are all the compliance, set up costs and running costs involved with owning a company.

    He says it is highly unlikely that suitable and effective arrangements could be put in place to make this idea work.

    "From my point of view the service company (option) will be fairly limited."

    Who will pay the extra tax?
    There are four groups of people who will pay the additional six cents in the dollar tax. They are;

  • Those who willingly pay it, and yes there are a lot of people in this category.
  • Those who don't earn much more than $60,000. For these people the cost of implementing avoidance measures won't be cost effective.
  • Those who have no choice. The people who fall into this category are generally employees who have little sway over their remuneration package. However, if they are on individual contracts there is the opportunity to renegotiate their remuneration package in the future.
  • Lawyers and accountants. One of the ironies of the changes is that the people who will profit from the extra work will have to pay extra tax. Currently, lawyers and accountants have to operate under their own names, rather than under a company or trust structure, so the avoidance measures are in fact voided.
  • Cullen believes that although there is a lot of discussion about how to avoid the extra tax, it will generally come to nought.

    "My personal advice to people is breath deeply, pay a bit more tax, then when they need an operation they will get it."

    Meanwhile, Weatherston says the changes may be the catalyst that some people need to restructure their affairs.

    His advice to these people is that it is better to move sooner rather than later as once the legislation is introduced it may be too late to make changes.

    As for long time tax practitioner John Shewan the changes are a trip down memory lane.

    "I might get my old Beatles records out," he says.

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