Term of reference B
To review the Inland Revenue Department’s application of the compliance and penalties regime established under the tax acts, including the process by which and the rate at which use of money interest is set, and also the simultaneous application of late payment penalties
- Late filing penalty
- Non-electronic filing penalty
- Late payment penalty
- Shortfall penalties
- Simultaneous application
- Process for challenging assessments needs review
- Use of money interest
The compliance and penalties regime has been in place for two years, generally effective for income periods from 1 April 1997. The aim of the compliance and penalties reform was to correct deficiencies in the previous provisions and to tighten the legislative structure of taxpayer obligations and penalties for non-compliance with tax law. The policy objective behind the compliance and penalties regime is to promote voluntary compliance and to encourage all taxpayers to pay their taxes on time.
For the legislation to be fair and equitable to all taxpayers it must be based on the premise that most taxpayers are honest and make a genuine attempt to honour their taxation responsibilities. Taxpayers in similar situations should be treated similarly. The standards that taxpayers are expected to meet, and the penalties applied to them, should recognise the differing circumstances and abilities of individual taxpayers. Sanctions should be consistent with the seriousness of the offence and the culpability of the offender.
There is a delicate balance that must be struck between maximising voluntary compliance and not creating a perception that the regime is being applied too harshly. The public good argument in favour of taxation is jeopardised if compliance can only be achieved under the threat of severe penalties and enforcement action. There is a risk that applying the regime too harshly could in effect be counter-productive in ensuring the compliance of some taxpayers. It is the vast majority of taxpayers who attempt to comply voluntarily who ensure the tax system is efficient and effective.
The cornerstone of New Zealand’s tax system is self-assessment. We would like to stress the difference between voluntary compliance and self-assessment. New Zealanders do not pay tax voluntarily, we have a self-assessment system and we pay tax under the threat of penalties if we do not. Under self-assessment, taxpayers determine their own tax liability, notify that in a return to the department and pay the tax. The department’s role is to audit those calculations. Self-assessment itself is an example of a trade-off between compliance costs and administration costs. Its basis lies in the fact that taxpayers have more information about their own affairs than the department does. The assumption is the taxpayer is in a much better position than the department to assess their tax liabilities.
The compliance and penalties provisions apply across virtually all tax types. The provisions cover interest, civil penalties, criminal penalties and remissions. The civil penalties are late filing, non-electronic filing, late payment and shortfall penalties. The previous penalty rules consisted mainly of two types of penalties; additional tax and penal tax. Additional tax was applied to late payments of tax, and the rate varied according to the tax type. Penal tax of up to 300 percent of the deficient tax applied in cases of evasion or fraud, or when the taxpayer failed to account for deduction such as PAYE deductions. It was considered that this regime had its faults and a more comprehensive regime was needed to redress the perceived problems.
The previous Finance and Expenditure Committee stated in the commentary on the Taxpayer Compliance, Penalties, and Disputes Resolution Bill that it was concerned the department might apply the new standards too stringently. The committee voiced a concern that for “ordinary” taxpayers there is a risk that the department may impose penalties in circumstances where the taxpayer’s conduct is not in fact exceptionable or in situations where an ordinary taxpayer clearly misunderstands the ramifications of what is or is bound to become, a legally complex piece of legislation. A recent report from the Commissioner to the Minister of Revenue on the health of the tax administration acknowledges the compliance and penalties regime as a pressure point:
A material proportion of business taxpayers are either not aware of the new compliance and penalties regime (CPR) or, of those that are aware, have negative attitudes about its fairness. This represents a pressure point to the department in that the behavioural shift that the change in penalties was designed to effect may not be achieved for those taxpayers who are not aware of the new rules.
A large number of submissions comment that the penalties regime is too harsh or the department is applying the penalties too harshly. NZLS notes that the absence of any discretion given to the department in the application of penalties means that in many situations the department is forced to impose penalties where the circumstances may dictate that it is not in fact the most appropriate course of action. We considered each of the civil penalties in turn and have the following comments and recommendations.
The tax system now imposes a penalty onto those taxpayers who file a late tax return. In the case of income tax returns there is a standard penalty of $50 for late filing. This rises to $250 if the net income of the entity filing the return exceeds $100,000, and $500 if the net income of the entity filing the return exceeds $1 million. We do not consider that an adjustment to the late filing penalty is required.
Under the 1998 tax simplification legislation, employers are no longer required to file a PAYE reconciliation, but they are required to file a schedule of tax deductions from employees’ wages on a monthly basis.
Employer monthly schedules are fundamental to the operation of the new simplified tax system, so it is appropriate to impose a penalty if the employer does not file in electronic form. Section 139 of the TAA imposes a penalty on employers who do not file the schedules in a prescribed format. There are exemptions in the Act from filing electronically for some employers. The penalty is the greater of $250 or $1 for each person employed at any time during the month to which the employer monthly schedule relates. The penalty will be imposed automatically by FIRST, the department’s computer system. We are not recommending any change to the non-electronic filing penalty.
The late payment penalty is intended to enforce payment of taxes by the due date. It is designed to support efficient collection of revenue through voluntary compliance.
Under the present rules a late payment penalty of five percent is imposed if the payment of the tax is not made by the due date. After that, incremental penalties of two percent each month are charged on the amount outstanding (excluding interest but including earlier unpaid penalties). Late payment penalties are not charged on amounts outstanding of $100 or less. Over this threshold the penalties are imposed automatically by FIRST. Section 183B of the TAA provides for 60 percent of the initial late payment penalty to be cancelled if an arrangement is entered into on or before the payment due date.
The Committee of Experts stated in its report that, "The committee endorses the reasons for the late payment penalty, and considers it inappropriate to depart from giving taxpayers incentives to pay their tax on time. However, the penalty should have less of an impact." A number of submissions held similar views. ICANZ submits that there be no penalty for short term defaults of up to a month, the initial five percent penalty be reduced to two percent and the incremental late payment penalty be reduced from two percent to one percent.
Many submissions comment that the rate of the late payment penalties is excessive. Others claim that the compounding effect of the penalty was too harsh, and that many taxpayers are unaware of the compounding penalty. In their view, the incremental penalty, when considered in conjunction with use of money interest, imposes an effective penalty necessary to ensure compliance.
The department suggests that delaying the imposition of the late payment penalty for 30 days could entice many taxpayers to delay paying by 30 days from the due date. The due date for payment would effectively become the day before the late payment penalty begins. To avoid taxpayers deferring payment in this way, interest for use of money could be charged. The department believes this would ensure that taxpayers had an incentive to pay and enter into instalment arrangements during this 30-day period. The department suggests that the risk of deferral could be reduced slightly if the initial late payment penalty is imposed, then remitted if full payment of the outstanding tax and interest is made within 30 days.
Delaying the imposition of late payment penalties might have positive spin-off effects in other areas such as compliance cost reduction, return filing and debt collection. In this way, compliance costs for taxpayers and, possibly, administrative costs of the department could be reduced. It would also represent a more commercial approach to payment of tax. These benefits would have to be balanced against the risk of significant deferral of tax payments. This delay would have no effect on the debt collection process, as the tax would still be outstanding even though the penalty has not been imposed.
We note that the Government considers that an incremental application of the initial late payment penalty has merit and is proposing a policy change along these lines. We welcome this initiative.
The objective of the incremental late payment penalty is to provide a clear, continuing incentive to comply. The department submits that because the late payment penalty is the principal method by which the Government ensures payment of assessed tax it must be a significant penalty. The rate must exceed the borrowing costs faced by taxpayers, otherwise some may decide to defer payment.
Following evidence to our inquiry the Government has announced it is to consider lowering the incremental two percent late payment penalty to one percent per month. We fully endorse this policy change. Reducing the incremental penalty, which in our view is excessive, will increase the fairness and the integrity of the tax system and it will reduce pressure on processes used to mitigate imposition of the incremental penalty such as disputes procedures and remission requests.
Shortfall penalties replaced the penal tax system two years ago. The department must consider whether to impose a shortfall penalty if a taxpayer pays less tax than that which is due and the rate of a shortfall penalty is a percentage of the tax shortfall. The rate of the penalty depends on the category of fault. There are five categories of fault:
|Penalty||Percentage of resulting tax shortfall|
|Lack of reasonable care||20%|
|Abusive tax position||100%|
|Tax evasion or similar acts||150%|
These penalty rates are non-negotiable and where a default occurs the applicable penalty must be imposed. A taxpayer does, however, have the right to challenge the decision to impose a shortfall penalty but not the amount of penalty.
Many problems experienced by taxpayers in the area of shortfall penalties occur due to the department’s application of the lack of reasonable care and unacceptable interpretation penalties.
The purpose of the lack of reasonable care penalty is to increase voluntary compliance. The standard is the cornerstone of the penalties regime which requires all taxpayers to act reasonably in the conduct of their tax affairs. The test of reasonable care is whether a taxpayer of ordinary skill and prudence would have foreseen as a reasonable probability or likelihood the prospect that an act (or failure to act) would cause a tax shortfall, having regard to all the circumstances. The Committee of Experts agreed that a tax system, based on self-assessment, requires an effective statutory penalties regime to provide taxpayers with appropriate incentives to comply.
We recognise that in the previous select committee’s report on the compliance and penalties regime, the committee was very aware of the problems that could arise due to the application of the lack of reasonable care test. ICANZ notes in its submission that it had sent a memorandum to the department outlining examples of where this test had been applied inappropriately, and where it thought improvements could be made. ICANZ then refers to an internal departmental memorandum published in the Taxation Information Bulletin on 10 June 1998. It explains the reasonable care standard and is the department’s operational guideline when applying the standard:
The Standard recognises taxpayers’ varying abilities and reflects a balance between the need for returns to be correct and the recognition of the difficulties taxpayers may face in ensuring they are correct.
Reasonable care is not intended to be overly onerous to taxpayers and does not mean perfection. Circumstances that may be taken into account when determining whether a taxpayer has exercised reasonable care include:
- the complexity of the law and the transaction (the need to balance the complexity of the law with the category of taxpayer)
- the materiality of the shortfall (consideration must be given not only to the nature of the shortfall, but also the size of the shortfall in relation to the taxpayer)
- the difficulty and expense of taking the precaution (consider whether the types of controls in place are commensurate with the size and nature of the taxpayer)
- the age, health and background of the taxpayer
- the business’s record keeping practices (commensurate with the size and nature of the business and the internal controls).
We are encouraged to note that the department subsequently put into place a number of administrative changes which fully or largely resolved many of the problems which ICANZ had raised regarding the application of the lack of reasonable care standard. However, inconsistencies in the application of the reasonable care standard continue to occur and this is a concern.
NZLS suggests the need for consistency in the application of the penalties regime to ensure that taxpayers do not have a negative perception of the regime. There is obviously considerable potential for some subjectivity in the application of the penalties regime and NZLS suggested that we review the guidelines that have been developed by the department to achieve consistency. We have listened to many submissions where consistency has been an area of concern and we consider that it would be advantageous for the next Finance and Expenditure Committee in conjunction with the Government’s post-implementation review of the compliance and penalties regime to also review the guidelines the department has put in place to guide the department’s officers in their application of the regime.
A number of submitters believe that a penalties regime needs to remain in place, but that the existing penalties regime is harsh. Most submitters recognise the need for a penalties regime to act as an incentive for paying taxes. The major area of concern in the penalties regime involves the many cases where penalties are being applied on the average law abiding taxpayer unreasonably. For example, Nigel Smith and Associates provided us with the following case study:
A client had a business of commercial letting of premises. The lessees questioned the lessors on the market value of the rent being charged. The client obtained a market value rental and found that they had been overcharging the client. When this was established the lessor passed a credit note adjusting the rent and GST charged on it. The lessor claimed the adjustment in the same GST return as the lessee adjusted theirs using the credit note. Although no revenue was lost Inland Revenue imposed a 20% lack of reasonable care penalty on the basis that the lessor was on a payments basis and would not accept that the crediting that would have arose constituted a payment.
The solicitor for the department advised us that they were required to impose the penalty as a mistake had occurred and that they had no power otherwise not to do so. On this interpretation every little mistake would be subject to the penalty.
PricewaterhouseCoopers submits that the shortfall penalties regime should be amended to ensure that taxpayers are not penalised for honest or inadvertent mistakes. Unless the department is more willing to accept that taxpayers can make honest errors and is prepared to allow a greater degree of latitude in applying the shortfall penalties regime, the integrity of the tax system will be eroded. Although a small proportion of taxpayers are intentionally non-compliant, and a reasonably tough penalties regime is required to dissuade them from abusing the tax system at the expense of honest taxpayers, most taxpayers try diligently to meet their tax obligations. Many experience difficulty with the complexity and volume of their responsibilities. This sentiment was shared by many other submitters seeking more discretion in the application of the penalties regime.
We have noted the Government’s intention to undertake a post-implementation review of the penalties provisions. When undertaking this we recommend that:
- a past record of “good behaviour” be taken into account when deciding whether to impose a penalty
- the department exercise a greater degree of flexibility when applying shortfall penalties
- shortfall penalties not apply when it is determined that the taxpayer has made an inadvertent error.
A more consistent, reasonable and flexible application of the lack of reasonable care standard will, in time, be perceived by the taxpaying public as fair and just.
ICANZ suggests that the department develop a systems audit methodology in order to assess whether taxpayers are adopting a reasonable standard of care. Taxpayer confidence in the tax system would be improved if the department’s audit methodology was, in the experience and perception of taxpayers, clearly focussed on whether or not reasonable standard of care systems are in place.
We endorse this idea and recommend the department develop a systems audit methodology to assess whether taxpayers are adopting a reasonable standard of care.
The purpose of the unacceptable interpretation shortfall penalty is to ensure that in a self assessment environment taxpayers who take a position which has significant tax consequences take extra care. It ensures that the conclusions they reach on their tax liability are sound. This is required by the reasonable care standard. The distinguishing feature of the acceptable interpretation standard is that it lacks some of the subjective elements, for example, taxpayer effort, when there is a significant amount of tax at stake.
The unacceptable interpretation test only applies to tax shortfalls where, if viewed objectively, that interpretation or application fails to meet the standard of being about as likely as not to be correct. The unacceptable interpretation standard is an objective test involving an analysis of the law to the relevant facts. It is not relevant that a taxpayer believes that the position taken was an acceptable interpretation.
Section 141B (7) of the TAA provides that the matters that must be considered in determining whether the tax position involves an unacceptable interpretation of a tax law include:
- the actual or potential application to the tax position of all the tax laws that are relevant
- decisions of a court or a Taxation Review Authority on the interpretation of tax laws that are relevant (unless the decision was issued up to one month before the taxpayer takes the taxpayer’s tax position).
Other matters which may be considered in particular circumstances are binding rulings and other published departmental statements, legal articles, statute other than tax law, dictionary meaning and generally accepted accounting practice and commercial practice.
ICANZ submits that the department be required to reinforce internally and publicly the principle that if a taxpayer (or adviser) has not interpreted legislation a penalty for unacceptable interpretation cannot apply. The department has confirmed that where a taxpayer has reasonably relied on an adviser, the taxpayer is considered to have taken reasonable care. In a survey ICANZ did of its members in November 1997, comments were made that to circumvent this arrangement some of the department’s staff were, as an alternative, imposing penalties for unacceptable interpretation.
However, we understand that the department has advised that the unacceptable interpretation standard will apply unless the Commissioner is satisfied that the tax adviser did not apply his or her mind to the tax laws or make an interpretation. The tax adviser must demonstrate he or she has not interpreted the tax laws and exercised his or her judgement. Departmental staff are now taking the view that even where a tax adviser can demonstrate he or she has not interpreted the tax laws or exercised his or her judgement, the tax adviser should have addressed a particular issue and therefore unacceptable interpretation stands. The result of this is that if a tax agent does not address a particular tax law and makes a mistake, unacceptable interpretation applies.
We agree with ICANZ on this matter and understand that the department’s policy is that if a taxpayer or adviser has not interpreted legislation, a penalty for unacceptable interpretation cannot apply. We recommend the department publicise this policy both internally and to the taxpaying public.
Those who fail to comply with the obligations imposed by the Inland Revenue Acts can be subject to the simultaneous imposition of interest and a variety of penalties. If a payment is late, both late payment penalties and interest apply. If at the same time late filing is involved, a late filing penalty can also be applied. In appropriate cases the department considers the imposition of a shortfall penalty. A number of submissions note that it may not be clear to taxpayers that the simultaneous application of penalties applies. The department needs to be more proactive in this area and therefore we expect the department to improve its communication to taxpayers on the issue.
Currently the TAA provides a challenge process to an assessment or disputable decision made by either the Commissioner or a taxpayer. The legislation provides for a two month response period from the taxpayer to the Commissioner’s disputable decision or assessment, or from the taxpayer issuing a Notice of Proposed Adjustment (NOPA) to the Commissioner. However, the two month response period does not apply to the Commissioner in addressing a taxpayer’s Notice of Response (NOR).
One submission comments that the legislation provides an open ended time arrangement for the Commissioner to address any disputable decision derived from the Commissioner’s own NOPA. The submitter suggests that the Commissioner should be on a limited time frame to respond to the NOR. We consider that this is a matter worth considering. A time limit would provide taxpayers challenging decisions with greater certainty and would provide taxpayers with a protection against potential abuses of the challenge system. A time limit would therefore enhance the integrity of the tax system. We recommend that the Government review the process by which assessments can be challenged, placing particular emphasis on assessing the merits of establishing a time limit on the Commissioner when addressing a taxpayer’s NOR.
The principle behind the use of money interest (UOMI) is to protect the department from being used as a financing or investment option. The payment of interest is a cost to both taxpayer and government for having the use of the other party’s money over a period of time. The policy is also aimed at encouraging taxpayers to pay the correct amount of tax on time.
The mechanism for setting interest rates, and the interest rates themselves, are made under Order in Council. The interest rate for overpayments is the 90 day bank bill rate less one percentage point. The interest rate for underpayments is the Reserve Bank base lending rate plus two percentage points. These rates are adjusted when there is an increase or decrease in the Reserve Bank business base lending or 90 day bank bill rates in corresponding amounts to the over/underpayment rates.
For underpayments, the department has adopted the Reserve Bank business base lending rate as its formula because it considers this rate represents the base rate major banks charge good corporate customers. The department notes that for other customers banks generally add a margin of between two and five percentage points. For underpayments, the department considers its formula is appropriate because it recognises that the department is an involuntary lender. The rate applies to all and, although this means it is too high for some and too low for others in some cases, the department believes the rate is below the best available on-demand unsecured bank interest rate.
The majority of submissions on this issue support the concept of the UOMI policy, but not the continued application of such a wide difference in the rates charged and paid by the department. As at 8 March 1999 UOMI was just over 10 percent for the taxpayer (10.59 percent) if tax has been underpaid and just under four percent to the taxpayer (3.38 percent) if tax has been overpaid.
The department’s position, and that of the Committee of Experts, is that without the UOMI provisions, a taxpayer who fully complies may be treated less favourably than a taxpayer who does not. The rates, therefore must recognise that the taxpayer and not the department ultimately chooses whether taxes are underpaid or overpaid. As such the rates must be, on underpayments, close to, but more, than what taxpayers pay for unsecured (short and medium term) borrowing from another source, and on overpayments, close to, but less than what they would receive on short-term deposits of a similar risk.
There is no dispute on the need for differential rates. However, submitters have raised questions about the justification for such a large differential. ICANZ submits the basis of rate setting should be such that the rate charged to taxpayers on underpayments should be no more than the standard bank overdraft rate. ICANZ considers the rate of interest currently charged on underpayments is excessive and significantly higher than the rate at which most taxpayers borrow. Furthermore, ICANZ states the department’s rate of interest on overpayments provides the Government with funding at a lower rate than it can borrow and provides a lower return than a taxpayer can achieve if they voluntarily invested (and significantly lower if the taxpayer has borrowed to fund the overpayment).
ICANZ notes that it has made a series of submissions to the Ministers of Finance and Revenue on this issue and comments that reasons given for rejecting the Institute’s proposals are “specious”. ICANZ suggests the UOMI regime does more than “compensate” the Government for not having the use of its money. ICANZ suggests there is a penal element included in the rate which should not be there.
By way of comparison, ICANZ provides the UOMI rates which apply in Australia and the United States, which it suggests are fairer and more appropriate. The difference in the rates in these countries is one percent to 4.5 percent; in New Zealand it is 6.8 percent. ICANZ also notes that base rates adopted in these countries and the uplifts applied attempt to appropriately charge to or return to taxpayers generally for the use of funds without imposing a penal rate.
The UOMI rules have a particular impact on those taxpayers who pay provisional tax. ICANZ submits there be a difference in the imposition of UOMI rates on tax which can be accurately calculated from provisional tax which cannot be calculated accurately. With provisional tax ICANZ notes that interest is charged on the difference between tax actually paid and the actual tax liability. In this situation, ICANZ submits that a penal rate of interest is neither required nor justified. The Committee of Experts notes that if a taxpayer has no reasonable expectation of having to pay interest at the time of making provisional tax payments, an unexpected breach of the interest thresholds should perhaps find relief from UOMI. We agree with the Committee of Experts on this point.
It is the department’s position that the UOMI rules have resulted in provisional taxpayers meeting their tax liability on time during the income year. The department does not support a reduction in the interest rate on underpayments of provisional tax. It considers such an action would increase the potential for deferrals because those whose cost of borrowing exceeded the underpayment rate could choose not to pay provisional tax. This could lead to the re-introduction of the under-estimation penalty.
We do not consider the department has responded adequately to the ICANZ proposal that the differential between underpayments and overpayments be narrowed. We accept the UOMI policy and the need for different rates for overpayments and underpayments to protect the department from being used as a financing or investment option and to encourage taxpayers to pay the correct amount of tax on time. We also accept that it may be necessary for the differential to be as wide as it is at present. However, we do not consider the department has made a case for this. At present we consider the spread is perceived to be excessive, unfair and to contain a penal element. While we also acknowledge the need to reduce and minimise both administrative and compliance costs, we do not consider this necessarily justifies the continuation of a policy if it is proved inequitable. Therefore, we recommend that the method by which UOMI is calculated be reviewed to determine whether changes to the interest rates for overpayments and underpayments to reduce the differential between the two rates are appropriate.
We agree the UOMI rules for provisional taxpayers should not be changed. The department informs us that the UOMI rules have resulted in the provisional tax payments at the first, second, and third provisional tax dates evening out. We believe this should be encouraged.
9 In Australia the rates are related to the Treasury Yield Note (TYN) which is the weighted average of the latest weekly tender for 13 week Treasury Notes. The rates are set at underpayments—TYN plus four percent; and overpayments—TYN. In the United States the rates are related to the Federal Short Term Rate (FSTR). Underpayments are charged at FSTR plus three percent and overpayments at FSTR plus two percent. Higher rates are charged on under/over payments in excess of $100,000 and $10,000 respectively.