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Making tax simpler Better administration of individuals income tax

Chapter 2 - Framework and opportunity for change

There are two basic approaches used to administer income tax:

  • Payers of certain types of income, such as salary or wages, are required to withhold tax from the income they pay to individuals, remit the tax withheld and report the income and tax information to Inland Revenue (a withholding tax system).
  • Individuals are required to report the taxable income they have earned to Inland Revenue, calculate any tax payable and pay the tax due either during the tax period or after the end of the tax period (a tax period disclosure system).

This chapter discusses the framework for thinking about how individuals’ income is taxed, and how individuals and other entities should interact with the tax system to ensure that they are meeting their income tax obligations. It also outlines the ideas proposed in the Green Paper about improving tax administration for individuals and the feedback received. Finally, it sets out the opportunities for modernising and simplifying tax administration for individuals to achieve the following outcomes:

  • A tax system that is fair and supports high levels of compliance.
  • Payment requirements that are easy to get right and difficult to get wrong.
  • Compliance obligations that are quick and low effort for individuals.
  • Processes that are more certain and provide confidence that the right thing has been done.
  • A tax administration that costs less to administer and that lowers overall compliance costs.

Framework for taxing individuals' income

Income tax is charged on a person’s annual taxable income. Generally, a person’s taxable income is the sum of the gross income received, minus any deductions for expenditure or losses to the extent to which they are incurred in deriving that income, or incurred in carrying on a business. Income tax is calculated on the person’s total taxable income for the year at the applicable tax rates.[1]

There are two basic approaches used to administer income tax:

  • Payers of certain types of income, such as salary or wages, are required to withhold tax from the income they pay to individuals, remit the tax withheld, and report the income and tax information to Inland Revenue (a withholding tax system).
  • Individuals are required to report the taxable income they have earned to Inland Revenue, calculate any tax payable and pay the tax due either during the tax period or after the end of the tax period (a tax-period disclosure system).

These two approaches are supplemented with additional third- party reporting to increase overall compliance. Regardless of which approach is used, the underlying requirement to comply with income tax obligations ultimately lies with, and will continue to lie with, the individual. This is because they fully understand what income they have earned and expenses they have incurred. In other words, income tax will continue to be based on a self-assessment model.

... income tax will continue to be based on a self-assessment model.

The Government intends to continue using these two approaches to administer income tax. Depending on the sources of their income, a person may be covered by one of these approaches or both. The Government will look to increase the use of withholding tax systems where appropriate in order to reduce compliance costs on individuals and ensure tax is paid accurately during the year. The Government recently extended the schedular payments withholding tax system to labour hire firms.[2] Inland Revenue will continue to supplement these approaches with third party reporting under existing rules. The Government is also considering a more transparent framework for large third-party dataset collection, where the dataset is to be collected regularly, as discussed in Making Tax Simpler: Proposals for Modernising the Tax Administration Act.[3]

The Government recognises that withholding tax systems impose compliance costs on the payers of income subject to these rules. However, such systems reduce compliance costs for the recipients of the income, reduce administrative costs and increase overall compliance. These benefits usually outweigh the compliance costs imposed on payers. The key is getting the balance right.

Withholding tax systems are generally considered to be the foundation of an effective tax administration for the reasons outlined above. They ensure that an appropriate amount of tax is withheld from the income earned and are most efficient in getting it about right if the gross income and taxable income are the same. That is, if the recipient of the income has not incurred any deductible expenditure or losses in earning that income.

One important caveat to the general ability to claim deductions is that employees cannot deduct costs incurred in deriving income from employment. The Government has no intention to change that policy setting. Individuals can claim for income protection insurance, and the costs associated with preparing an income tax return. Tax credits can also be claimed for qualifying donations made to donee organisations by individuals if they earned taxable income in the period they are claiming for.

For individuals who only earn income that has tax withheld from it and paid to Inland Revenue, the amount of tax paid during the year is generally close to being right. However, withholding tax systems do not ensure perfect accuracy as they are still based on expected income. Any difference between the income that was actually earned, compared with what was anticipated, will mean that the withheld amount will vary from the ultimate tax liability. This can occur when there are multiple sources of income and/or when tax on income is not withheld or withheld at a rate that is too high or low. For example, when someone receives a bonus or promotion, or takes leave without pay, the withholding rate can be incorrect.

A key component of a withholding tax system is the reporting of the underlying income information and tax withheld. The more frequently this information is received, the greater the ability for Inland Revenue to monitor whether tax is being withheld at the appropriate rate and, if not, to take corrective action. This will ensure that the right amount, or close to the right amount, of tax is withheld during the year and reduce the number of individuals who should need to file income tax returns at the end of the year.

The proposals in this discussion document primarily focus on the end-of-year obligations for individuals who earn only income that is subject to withholding.

A key component of a withholding tax system is the reporting of the underlying income information and tax withheld. The more frequently this information is received, the greater the ability for Inland Revenue to monitor whether tax is being withheld at the appropriate rate and, if not, to take corrective action. This will ensure that the right amount, or close to the right amount, of tax is withheld during the year and reduce the number of individuals who should need to file income tax returns at the end of the year.

Implication for income tax returns

This framework allows for the income tax system to be administered as follows:

  • An individual who earns income that is not subject to withholding (such as business income or foreign income) is required to report the taxable income earned to Inland Revenue, calculate the tax payable and pay the tax due either during or after the tax period.
  • An individual who earns income subject to withholding as well as income not subject to withholding is required to report all the income earned to Inland Revenue, calculate the tax payable and pay the tax due either during or after the tax period. Income information Inland Revenue holds is provided to the individual to assist them in meeting their tax obligations.
  • For an individual who earns only income subject to withholding, the Government can either:
    • require the individual to report (or confirm) the taxable income earned to Inland Revenue, which would then result in a tax refund or further tax to pay; or
    • treat the amount withheld as the final tax liability for the year, which means the individual’s tax obligations will be totally managed via the withholding tax system.

The proposals in this discussion document primarily focus on the end-of-year obligations for individuals who earn only income that is subject to withholding. It is recognised that an individual may move between these categories over their lifetime as their income sources change.

As noted in chapter 1, the Government is not proposing that all individuals should have to provide information to Inland Revenue on an annual basis in a process similar to the current obligations on individuals who are required to file income tax returns. Throughout this document that is referred to as “providing information to Inland Revenue”.

Other approaches used to reduce end-of-year filing obligations

Cumulative withholding

New Zealand requires withholders to deduct tax according to tax codes that are based on an individual’s expected annual income, and requires individuals to undertake an annual process to ‘square up’ their tax position each year if necessary.

Some countries use a cumulative model of withholding tax instead. A cumulative model means the withholding tax rates are adjusted throughout the year. Such a system endeavours to attain accuracy of tax withheld throughout the year. The rationale behind a cumulative system is that if the correct amount of tax is deducted during the year, the total amount of tax collected will equal the individual’s overall liability. This theoretically eliminates the need for most employees to file a tax return.

Under the cumulative withholding system, an individual’s tax liability is not calculated on the payment they receive for a period in isolation. Instead, the actual amount of tax deducted in a pay period depends on the income already received in the tax year, as well as the income received in the current period. The tax, which must be deducted in each pay period, is the cumulative tax due from the beginning of the year to that date, reduced by the amount of tax already deducted in other pay periods. Consequently, this type of system can be complex for those who are required to withhold the tax, such as employers.

The cumulative model does not always achieve the accuracy it is designed to achieve. When an individual works more than one job, it is complex to administer as each withholder needs to understand the total amount of tax already deducted. This document does not propose changing to a cumulative withholding model in New Zealand.

"Full and final" taxation in a period

A discussion document called Making tax easier was released for public consultation in June 2010. One item which was considered in that document was an option to treat PAYE as a “final tax”, so the amount of tax actually deducted from PAYE would be treated as the individual’s final tax liability (even if it was over-or under- deducted). Inland Revenue would not collect some amounts of tax to pay, and would not pay out some refunds. This option was not supported by submitters and was not pursued. This document does not propose changing to a final tax approach.

…better and timelier information allows the Government to re-think tax administration for individuals, particularly those who only receive employment and/or investment income.

Background - Green Paper and feedback

The Green Paper outlined an initial option for consultation that could require all individuals to interact at some level with Inland Revenue, albeit in a much easier way than currently.[4] It suggested an electronic filing system pre-populated by information from timely and accurate withholding systems. The majority of individuals would then only be required to check and confirm the information held by Inland Revenue and include any income that had not been pre-populated.

One of the premises underpinning this option was that it would allow individuals to understand their own tax obligations and how the wider tax system works, which would support compliance over time. The current filing obligations for individuals vary, based on historical and sometimes arbitrary distinctions. This results in some individuals being unaware of their filing obligations.

As discussed in the Green Paper, the key to modernising and simplifying tax administration is the use of digital services and channels, the pre-population of information held by Inland Revenue and the use of analytics to achieve the above outcomes.

Feedback about the initial option to require all individuals to interact with Inland Revenue via pre-populated digital tax statements was divided.[5] Some submitters were concerned about whether people without easy access to internet or who were not proficient technologically could effectively manage this interaction. Others saw any increase in interaction with Inland Revenue as undesirable. A few also queried Inland Revenue’s ability to pre-populate information such as donations. Other saw the proposals as positive, particularly those who currently file returns, believing it would make the return filing process easier. Finally, some submitters also noted that some interaction with Inland Revenue might encourage people to better understand their tax circumstances and obligations.

The following chapters discuss approaches and options to make tax obligations more simple, open and certain for individuals. The chapters outline what interactions could happen during the tax year to assist with getting the withholding more accurate and what interactions could occur at year-end.

The opportunity for change

As noted earlier, the Government has recently introduced legislation into Parliament that once passed, will give effect to the proposals outlined in the Better administration of PAYE and GST and the Investment Income Information discussion documents. These proposals will require income payers to provide more information more often about the individuals to whom they pay income. This better and timelier information allows the Government to re-think tax administration for individuals, particularly those who only receive employment and/or investment income.

Furthermore, the current tax rules for individuals who earn most of their income from employment and/or investment sources that are subject to tax at source are complex to understand and administer.[6] For example, based on the information it holds, Inland Revenue will issue personal tax summaries to some people at year-end. If a personal tax summary is not issued, individuals need to determine whether they need to request a personal tax summary. If they do not need to, they may still do so in order to receive any tax refund they are entitled to.

This better and timelier information allows the Government to re-think whether the current rules for the administration of income tax for individuals can be improved to simplify the rules and reduce compliance and administration costs. This can be achieved by re-thinking how Inland Revenue can:

  • deliver better in-year services to assist individuals in ensuring they are using the correct tax code, or a tax code (such as a special tax code) that will meet the needs of their circumstances; and
  • simplify the end-of-year obligations by reducing the complexity of the current rules for people who only earn employment income and/or investment income that is subject to withholding at source.
 

1 Certain types of income are treated as schedular income and taxed in their own right. These are not included in a person’s total taxable income, such as certain kinds of non-resident passive income.

2 Taxation (Business Tax, Exchange of Information, and Remedial Matters) Act 2017

3 Released for public consultation on 8 December 2016.

4 See Appendix 5 page 61 to 63 and in particular paragraphs 5.15 to 5.20 of the Green Paper.

5 See Making Tax Simpler - Green Paper & Better Digital Services: Summary of Feedback and in particular, pages 22 to 24.

6 Section 33AA of the Tax Administration Act allows a person to earn up to $200 of income that is not subject to withholding tax and still not be required to request a personal tax summary.