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Making tax simpler - A Government green paper on tax administration

Appendix 2 - The future for business processes – PAYE

2.1 PAYE (pay as you earn) is a tax withholding regime for salary and wages. PAYE information is received monthly from employers (or PAYE intermediaries) through the provision of Employer Monthly Schedules (EMS). Income, tax code, and tax deduction information is accumulated on an income year basis and used to support the administration of the income tax and social policy systems.

2.2 The PAYE system is also used to collect:

  • ACC earner levies;
  • Child support obligations;
  • Student loan repayment obligations;
  • Employer superannuation contribution tax;
  • tax arrears; and
  • KiwiSaver and complying superannuation fund contributions (both employer and employee contributions).

2.3 This appendix looks at three issues relating to employment income and similar income types. These are:

  • the collection of PAYE information;
  • modernisation of the PAYE rules more generally; and
  • enhancing withholding taxes to cover ‘employment-like’ income.

COLLECTION OF PAYE INFORMATION

2.4 The changes described in this Green paper are premised, amongst other things, on the efficient provision of information – in particular the timely supply of information that can be effectively used by taxpayers, Inland Revenue and, where appropriate, wider government.

2.5 The EMS has, in theory, a lot of positive attributes. It provides a wealth of relevant information that is vital when determining the tax position of New Zealand salary and wage earners.

2.6 The EMS therefore provides the starting point for any wider policy-led transformation changes, in particular, addressing some of the problems that limit its current effectiveness.

Current problems

2.7 The methods used by employers to submit PAYE information is still largely paper-based. Even when electronic filing is used or required, the submission of returns is often an additional process for businesses and is not aligned to businesses’ accounting or payroll processes.

2.8 From an Inland Revenue perspective, there is also currently limited validation occurring at the time information is submitted, meaning that inaccurate information is being accepted. The information collected also lacks sufficient detail to allow deduction accuracy to be checked. This, in turn, places limitations on downstream interventions.

2.9 The level of duplication, correction or other interventions required by employers or Inland Revenue before the information can be effectively used is a severe shortcoming in the current provision of EMSs. Also, the inefficient use of available information from an all-of-government perspective, where appropriate, is not realising the full potential of information held.

Potential changes

Objectives

2.10 Greater use of digital services provides an opportunity to:

  • make better use of businesses' natural systems to provide information;
  • improve the timeliness and accuracy of information received;
  • have accurate business rules incorporated into software packages;
  • reduce the level of duplication, correction and other interventions required by employers, intermediaries or Inland Revenue before the information can be effectively used; and
  • improve the use of available information from an all-of-government perspective, and to help ensure customers only have to supply information to government once.

2.11 Some specific objectives for streamlining the collection of PAYE information are that any proposed solution should:

  • wherever possible, be integrated into employers' own systems;
  • be low effort for customers, and reduce compliance costs for all, including reducing the need for employers to contact Inland Revenue;
  • produce timely information from employers which is accurate (right amount), complete (error free);
  • be shared with other agencies (where appropriate);
  • allow Inland Revenue to pro-actively identify any incorrect data or assumptions, so that employers can correct information immediately and not have to deal with errors at a later date;
  • deliver digital and paperless interactions – for example, transactions that are processed directly from employers' own systems to Inland Revenue, with certainty of delivery and outcome;
  • be co-designed with taxpayers and their intermediaries (e.g. software developers and agents);
  • be able to be reused for other products and services; and
  • be agile and allow future changes (to policy and processes) to be made easily, quickly and cheaply.
Likely scope of review

2.12 The policy and legislative framework must be fit-for-purpose to improve and streamline the collection of PAYE information. In developing this framework, the following issues will need to be carefully considered.

2.13 Systems issues – Replacing current EMS and employer deduction (and GST return) forms with automatic digital data transfers – for example, via payroll/accounting software rather than as a separate manual intensive process. However, this begs the question about what to do for employers that do not currently use electronic business processes.

2.14 Information requirement issues – How should Inland Revenue ideally obtain information about employees? For example, employees could themselves provide or update information directly to Inland Revenue through digital channels, rather than via their employer. Alternatively, employers could provide employee information to Inland Revenue for subsequent validation.

2.15 At what point is information considered accurate and complete? If Inland Revenue does not accept a return until it is correct, or rejects it, what is the status of the information in the meantime? What happens if a taxpayer challenges the information?

2.16 Privacy and employee information – Should employees be able to keep private information (for example, child support information) between themselves and Inland Revenue rather than involving their employer, with employers seeing only the overall deduction amount or rate?

2.17 Timing issues – Should the timing of PAYE information provided to Inland Revenue align to the time that salaries are paid to employees? Or, should payment dates for PAYE align to the time that salary/wages are paid to employees, or continue to be paid at a later date?

2.18 Validation issues – Receiving information in a more timely manner will likely give Inland Revenue the ability to determine whether there are mistakes – for example, when an individual clearly appears to be on an incorrect tax code. What interventions could Inland Revenue potentially make to remedy likely mistakes more quickly?

2.19 Other issues:

  • What happens when a business starts or ceases to be an employer?
  • What happens when a new employee is taken on, or one leaves?
  • What happens to casual or seasonal employees who work for several employers, or to beneficiaries who are also working?
  • Should there be consistency between paper returns (to the extent they remain) and new electronic processes?
  • What are the likely impacts for agents, nominated persons, software providers etc?
  • Is it appropriate to review the policy settings for the current payroll subsidy to assess if it could be used more?

2.20 At this stage, no specific proposals are being made on any of these issues. The comments here are a series of considerations that are required to be worked through by further policy development and consultation.

Initial options for consideration

2.21 Potential high-level changes that could be made to improve the way the EMS operates for employers, intermediaries and Inland Revenue, and to provide a platform for wider changes include:

  • avoiding unnecessary duplication by integrating PAYE into existing business systems (for example, the payroll system), so that EMS becomes part of a wider process rather than an additional process;
  • allowing business systems to talk directly to Inland Revenue systems, and vice versa;
  • easy amendment and correction of tax codes;
  • ensuring that information provided is validated immediately; and
  • verification of information to allow EMS to be better used to increase accuracy of payments and to collect any underpayments of tax.

2.22 A focus on the transfer of data, rather than on the current prescriptive filing of 'returns', means information can potentially be provided any time during an applicable period, rather than just at the end of a month. Although there will still likely be time limits by when information (and payment) must be made, such a change will none-the-less provide more flexibility for employers. For example, it might allow for corrections to be made on an on-going basis rather than at a later date.

2.23 Any future changes will still require data to be accurate and timely before any new process can be considered effective. Innovation by the private sector will therefore be an important factor in ensuring that any PAYE changes are successful, in particular in relation to making sure that 'normal' business processes are used wherever possible.

2.24 These changes will not just be confined to the PAYE information – the same issues and principles will also apply to other requirements. For example, the ability to use a business’s own systems should equally apply to GST information requirements.

MODERNISING THE PAYE RULES MORE GENERALLY

2.25 In addition to looking at issues connected to potential changes to the way that PAYE information is provided, it is also timely to look at the PAYE rules more generally, to ensure that they remain fit-for-purpose.

2.26 The rules have not been fundamentally reviewed since their introduction in 1957, so it is important to investigate whether improvements can be made and to investigate whether the rules still reflect modern employment practices.

Current problems

2.27 PAYE is an efficient and effective means to collect income tax from salary or wage income. It is important to note that the underlying policy for PAYE remains sound.

2.28 That said, as part of the focus to remove salary or wage earners from the requirement to file annual tax returns, some complexity has been added to the PAYE rules to ensure that tax is withheld at the correct current marginal rate wherever possible.[3]

2.29 Further complexity has also been added due to the non-alignment of rules in certain circumstances – for example, separate rules exist for income tax rates and KiwiSaver rates. This can cause practical difficulties when these rates change.

2.30 There may now be an opportunity, therefore, to review the PAYE rules to see if they can be simplified. This is because the need for precise accuracy could potentially be reduced if there is no longer a desire to reduce the number of individuals required to interact with the revenue system (for further details see Appendix 5 on individuals).

Potential changes

Objectives

2.31 Removing undue complexity and providing more clarity in the application of the PAYE rules so that they are more user-friendly is likely to be positive for employers.

2.32 One of the key objectives should be to reduce some of the unnecessary compliance costs currently experienced by employers in applying the current rules. Employers and payroll developers frequently experience a number of issues in relation to the application of the PAYE rules. Although individual issues may be minor, they can cause annoyance.

2.33 Inland Revenue’s business transformation programme affords the opportunity to review these rules as part of the wider review of tax administration. This is particularly important given the fact that PAYE collects such a significant part of New Zealand's revenue.

Likely scope of review

2.34 There are a number of factors influencing the accuracy of the amount of PAYE deducted. These include use of the correct tax code, calculation accuracy (for both payroll packages and manual calculations), and other changes in employee information.

2.35 The scope of any wider look at the PAYE rules will likely cover:

  • A review of existing PAYE rules to ensure that they are fit for purpose under a future PAYE (where calculations are, in general, done by software and not manually), with a particular focus on:
    • extra pays, due to the complexity of the current calculation;
    • holiday pay, due to the lack of clarity over how holiday pay is to be taxed (lump sum payments versus regular payments of holiday pay in lieu of actual salary or wages);
    • IR 56 payers – whether the payer should be made to withhold and deal with the PAYE obligations rather than the recipient;
    • the employer superannuation contribution tax (ESCT)[4] deduction rate, due to the compliance costs associated with the annual calculation of the rate to be applied for the current year;
    • secondary tax codes and other flat PAYE rates – for example, is it possible to deal with these rates through the use of special tax codes (due to better income information being received during the year); and
    • how to apportion tax when there is a change in the rate of withholding during a pay period.
  • Rationalisation of how employment remuneration is taxed and whether all forms of remuneration can be brought under the PAYE umbrella. For example, can some or all of fringe benefits, employer superannuation contributions and employee share schemes income be incorporated into the PAYE rules?
  • Whether one-off payments can be included in the PAYE rules to avoid taxpayers becoming provisional tax payers.
  • Review of how the PAYE rules apply to cross-border employment relationships (for example, a New Zealand business setting up a branch in a foreign jurisdiction, and whether the PAYE rules apply to the employment of workers resident in the foreign jurisdiction).
  • Wage protection – in exploring whether more deductions through PAYE is appropriate, consideration of a cap on the level of these deductions to ensure employees receive a sufficient minimum net payment will be important.

2.36 Again, it should be noted that no firm proposals are being made at this stage – instead, the issues noted above need to be explored in more detail before this can occur.

ENHANCING WITHHOLDING TAXES TO COVER ‘EMPLOYMENT-LIKE’ INCOME

2.37 Withholding tax arrangements are generally considered to be the foundation of an effective tax administration. Such arrangements impose an obligation on third parties (such as employers or banks) to withhold an amount of tax from payment of income to taxpayers.

2.38 Withholding taxes are a more cost-effective way for taxpayers and the revenue authority to transact. They help reduce the ability to understate income, and reduce the incidence of unpaid taxes.

2.39 New Zealand currently has a robust framework for the withholding of employment income as it relates to those in a traditional employer-employee situation. Such workers are subject to PAYE on progressive income tax rates. For many of these workers these source deductions provide a fairly accurate withholding of their tax obligation.

2.40 For those people who earn their employment income in less standard work arrangements (for example, as self-employed or independent contractors) the picture is less simple. Certain types of income fall within the 'schedular payment' rules (a subset of the PAYE rules) and deductions at a flat rate must be made by the payer.

2.41 Independent contractor income that does not fall within the schedular payment rules is not subject to source deduction. These taxpayers must instead file income tax returns each year and pay their tax themselves and, if they have a year-end tax liability of greater than $2,500, pay provisional tax. In this case it is not clear that the framework is as robust.

2.42 Business transformation provides an opportunity to consider whether there are ways to improve and simplify taxpayers’ interactions with Inland Revenue in this area.

2.43 As the tax administration system works well in respect of salary and wages – where there is a well-established withholding regime – consideration should be given to whether there is scope to expand withholding to cover a greater range of employment-like payments. This could provide scope to improve compliance, fairness and efficiency.

Current problems

2.44 The schedular payment rules were introduced in 1957, alongside the introduction of PAYE. The rules generally cover situations when there is no true employment relationship (noting that since 1986 receivers of schedular payments are able to claim expenditure incurred in deriving their income, while employees are not).

2.45 The rules apply to payments for certain listed activities. Activities subject to this form of withholding range from the provision of personal care, to agricultural services and non-resident contractors, and include proceeds from the sales of goods such as whitebait and sphagnum moss. There are a number of exclusions, including salary and wages, extra pays and any payments covered by an exemption certificate.

2.46 Although the scope of the rules and the tax rates have been reviewed from time to time, the rules have evolved through piecemeal extension, rather than as a result of a fundamental review of the type of tax deduction system needed to complement the PAYE system.

2.47 Given there have been significant changes to the economy and to the way in which some people are engaged during this period, inconsistencies in the rules have emerged. For example, there has been growth in new industries which provide for stand-alone contractors who have few, if any, expenses.

2.48 Those industries with low or no expenses might be considered good candidates for inclusion in a more comprehensive withholding regime, as the lack of expenses would indicate that withholding at (or near) marginal tax rates would be reasonably accurate. This would likely have the benefit of taking a number of contractors out of the provisional tax regime, and reduce the added compliance this brings.

2.49 Another area of concern is potential non-compliance by migrant workers. For example, preliminary analysis over the past three years indicates that some migrant workers are incorporating companies, which are excluded from withholding requirements, and entering into contracts to provide their services to New Zealand businesses. There is a risk that these individuals may leave New Zealand within two years and not comply with their tax obligations – that is, not file tax returns and not pay tax.

2.50 This tax compliance concern could potentially apply to certain geographical areas as well as to industries that heavily rely on migrant workers operating as contractors (for example, some parts of the tourism industry).

2.51 As previously noted, another important aspect of the Government's modernisation programme is improving the information that Inland Revenue collects and holds regarding taxpayers and their obligations, and streamlining and improving the collection of this information.

2.52 Expanding withholding taxes would assist in improving gaps in information collected. Indeed, there may be a case for some payments to not require withholding, but rather to have enhanced reporting requirements imposed on some people who engage contractors or make significant payments in cash.

Potential changes

Objectives

2.53 As the Government envisages a future where customers’ systems are able to interact more freely with Inland Revenue’s system, there is an opportunity to expand withholding and/or reporting without significantly increasing the compliance costs of the parties making payments (provided the design of systems allows the required information to easily be extracted from customers' systems and passed through to Inland Revenue).

2.54 The main objective is the provision of timely information from businesses which is accurate, comprehensive, error-free and able to be shared with other government agencies, where appropriate.

2.55 Solutions in this area would ideally reduce the sum of compliance and administration costs for customers and the Government as a whole, while at the same time increase compliance levels from all customers. Ideally there would be other benefits as well, such as reducing the possibility of customers falling into debt. In practice there are likely to be trade-offs in all of this. An important consideration is to ensure that any change does not just merely shift the cost of compliance from Inland Revenue to business.

Likely scope of review

2.56 This review will initially look at withholding taxes in situations that are similar to employment – such as those characterised as independent contractors. This means predominantly focussing on contracts for the supply of labour (and labour and materials).

2.57 In particular, key areas that are proposed as part of this work include:

  • Whether withholding at source can also be considered in a wider range of situations (for example, to cover particular industries)?
  • What degree of accuracy is desirable when withholding – for example, the use of a single flat rate, a range of flat rates, or some degree of greater accuracy via the use of PAYE rates or special tax codes?
  • Who specifically will be subject to withholding – which payees and which payers?  
  • Are there situations when reporting requirements rather than withholding would be sufficient?
  • What is done for those people in situations when withholding is not possible (either in part or in full)?
  • To what extent would corporate contractors fit within any new rules (given currently, in most circumstances, withholding only applies to individuals, not corporates). For example, would it only cover individuals and entities with one employee, or might it extend further?  

2.58 The review will also include consideration of the existing schedular payment rules and whether this is a model that should remain, be expanded upon, or be included in any new withholding rules.

2.59 The Government may, where it has concerns with voluntary compliance, look to address the scope of the PAYE and the schedular payment rules.

2.60 Also, implications outside of the tax system will need to be taken into account – for example, ACC levies, minimum wage obligations and other general employment law considerations.

 

3 The marginal tax rate is the tax on the next dollar earned.

4 Employer superannuation contribution tax is the tax deducted by the employer on employer contributions to a superannuation fund for example, KiwiSaver.