Report to the Treasurer and Minister of revenue - by a committee of experts on tax compliance

Bill Birch Treasurer

Report to the Treasurer and Minister of revenue

By a committee of experts on tax compliance

Chapter 11 -
Assessments and Disputes Resolution

Withholding Payment Regulations

11.1 New Zealand operates a tax system based on voluntary compliance. A key component of this system is the removal, where possible, of opportunities for non-compliance through the use of a comprehensive system of withholding taxes. Withholding systems play an important role in the tax system, ensuring that tax is paid on income that might otherwise not be reported.

11.2 The Income Tax (Withholding Payments) Regulations were introduced in 1957 as part of the PAYE legislation. They were intended to complement the PAYE system for income from salary and wages by applying withholding taxes to certain classes of payments which were neither business income nor salary or wages. The regulations generally cover situations where no true master-servant relationship exists.

11.3 Although the scope of the regulations and the tax rates have been reviewed from time to time, the regulations 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. The regulations were last reviewed in 1979.

11.4 The regulations apply to payments for a defined list of activities, for example, certain labour-only services, game hunting and sphagnum moss collection. Some payments are excluded from the regulations, including salary and wages, payments to a Maori authority, a public authority, or a company (not being a non-resident entertainer or a non-resident contractor), and any payments exempted by certificate.

11.5 The person making the withholding payment (the payer) is required to deduct tax from the gross GST-exclusive amount of the payment, if the payee is GST registered and provides a tax invoice. If the payee is not GST registered, tax must be deducted from the amount paid. Deductions must be made at the set rates at the time the payment is made, the rates varying between categories of payments. The payee generally receives no allowance for expenses in calculating the amount of tax deduction, but can claim for expenditure incurred during the year in their annual return. Failure to deduct withholding tax and to pay it to the Inland Revenue Department by the due date renders the payer liable to penalties and prosecution.

Key principles underlying withholding systems

11.6 The increasing use of and reliance on withholding systems in the tax collection process recognises several advantages of these systems. The first is that collecting tax at the source of the income reduces the scope for tax evasion and reduces debt recovery work for the Inland Revenue Department. Secondly, if there are a small number of payers and a large number of payees, it is more efficient to impose a withholding obligation on payers rather than collecting tax directly from payees. Finally, the tax system can be greatly simplified by reducing the number of provisional taxpayers.

11.7 The committee believes that the ideal withholding tax system should, as far as possible, eliminate the scope for tax evasion while not imposing additional costs on people who are responsible for making deductions, or who must disclose their income to the Inland Revenue Department. Such a system provides an efficient means of collecting income tax by ensuring that some tax is collected at the point of transaction.

11.8 The committee recognises that in practice, however, this ideal is impossible to achieve because it is necessary to take into account compliance and administrative costs, and to consider the incentives that must be provided to those who are being asked to withhold tax.

11.9 In terms of compliance costs, even the simplest withholding tax system imposes costs on both payers and payees. But at the same time, withholding taxes permit a reduction in other compliance costs, such as those arising from the provisional tax system. High administrative costs are incurred by the Inland Revenue Department in running a withholding tax system. However, other possible sources of administrative costs, such as audit and recovery costs, may be reduced. As a third consideration, if those who are being asked to withhold have no incentive to deduct payments, both compliance and administrative costs tend to increase. Designing a withholding tax system requires the careful balancing of these considerations to achieve the greatest possible reduction in tax evasion at the lowest possible cost.

A withholding tax for services

11.10 A comprehensive withholding payments system for resident contractors was proposed in the government's economic statement of 17 December 1987, and the proposal was revisited in 1991. However, the proposal did not proceed because of the compliance costs that would be imposed.

11.11 The committee has identified that introducing a withholding tax on the labour income received by resident contractors could reduce the scope for resident contractors to evade income tax by failing to declare the income they received. It would also provide a more efficient means of collecting tax on that income, and by reducing the number of provisional taxpayers, it would simplify the tax system.

11.12 However, the committee acknowledges that extending the withholding system to payments made to resident contractors would be likely to increase the compliance costs incurred by both the people who would be required to deduct the withholding tax, and the resident contractors from whom tax would be withheld. In addition, implementing this system would entail considerable administrative costs for the Inland Revenue Department. The committee, therefore, does not support this approach unless or until technological advances are available to reduce these costs so as to make this option viable.

A reporting system

11.13 The committee considered the suggestion that regulations should be geared towards reporting of recipient details by the payer, and consequent disallowance of deductions for unreported payments. Payers would not be required to deduct withholding tax, but would be required to report the recipient's name, the amount of the payment and other details. The reporting requirement would apply only in relation to payments over a specified threshold. If payers did not comply with this requirement, they would be denied a deduction for their payments.

11.14 The main advantages of this approach would be first, lower overall compliance costs in comparison with the costs of withholding systems. The costs of collecting and accounting for withholding tax would be eliminated. Secondly, there would be better integration with normal business practices. Because of this integration, reporting systems would generally be more acceptable. Thirdly, in terms of flexibility, reporting systems are more easily introduced or removed as required for particular industries and classes of payers and payees.

11.15 There are, however, some disadvantages with this approach. The first and main disadvantage would be the risk that income might not be reported to the Inland Revenue Department. Although denying deductions for expenses associated with withholding payments would provide sufficient incentive for business taxpayers to report their payments, it generally would not work for the household sector, because deductions in that sector are not permitted. Withholding systems ensure that at least some tax is paid, even if comprehensive matching is not undertaken. A further disadvantage would be that additional administrative costs would be incurred by the Inland Revenue Department in ensuring that taxpayers declared the income they received. Debt recovery work would also increase.

11.16 The committee believes that the current withholding system should continue to apply if, and to the extent, there is a risk that the business to which the withholding system applies may not be in a position to meet its income tax liability. Smaller businesses, irregular activities, or infrequent activities, such as sphagnum moss collection, game hunting and certain labour-only services, which are activities specifically covered by the regulations, are more likely to run this risk. Therefore, subject to the committee's comments on exemptions from withholding tax in paras 11.18 to 11.28, the committee recommends the continued application of a withholding tax system in these cases.

Deficiencies

11.17 The committee noted the concern in submissions that the impact of the new compliance and penalty provisions has caused taxpayers and their advisers to take a fresh look at some long-standing practices that developed in the absence of an effective system of enforcement and, as a result, appear to be inconsistent with the law. The principal submission to the committee asked it to address several deficiencies in the existing regulations, in particular, in relation to payments made to GST registered contractors, and to payments made by the household sector.

Payments made to GST registered contractors

11.18 Some businesses pay GST registered contractors without deducting the required withholding tax and, as a result, they may be liable for penalties. It is assumed that because the contractors are GST registered, they also have a certificate of exemption from withholding tax, but this is not always the case. The committee is aware of the practice of GST registered contractors presenting tax invoices to contracting businesses, indicating that on that basis they are not subject to the withholding requirements. Administratively, on occasions the Inland Revenue Department has accepted this practice. Although it may be expedient, it appears to be inconsistent with the law.

11.19 This problem could be addressed by amending the regulations to exclude from the definition of 'withholding payment', payments made to GST registered contractors for their taxable activities. Such payments then would not be subject to withholding tax. Restricting the exclusion to payments made for a person's taxable activity would ensure that hobbies, which are not taxable activities under the GST legislation, would not be excluded from the regulations. Contracting businesses would be required only to hold a tax invoice disclosing the GST-inclusive value of the supply of services.

11.20 The committee considers that this amendment would simplify the obligations for contracting businesses, and would reduce their compliance costs. The amendment would also reduce administrative costs for the Inland Revenue Department by removing the need for annual applications for exemption certificates for this class of payee.

11.21 It is possible that removing these payments from the scope of the regulations might have the effect of undermining the withholding system and increasing the risk of non-reporting of income. The committee considers, however, that if the contractors are GST registered, then bearing in mind both the penalties provisions and Inland Revenue's audit programme, it is most unlikely that these contractors would not return the income they receive. Requiring a tax invoice also creates an audit trail which the Inland Revenue Department could use as a cross-check against the contractors' receipts.

11.22 The committee therefore recommends that payments to a GST registered person for a supply services should be excluded from the definition of 'withholding payment', if the payer holds at the time a GST tax invoice disclosing the GST-inclusive value of that supply, except in areas of revenue risk.

Payments made by the household sector

11.23 Whether the household sector is required to deduct withholding tax from payments made for services carried out for their private residences is uncertain. At present, householders do not have to deduct withholding tax from payments they make to private domestic workers, such as nannies, gardeners and other home-helpers190. Private domestic workers are required to account for their own tax.

11.24 The definition of 'private domestic worker' seems to include some people who are covered by the regulations. For example, a householder would be required to deduct withholding tax from payments to freelance musicians hired to play for a private party at a private house. In such cases, deductions are not in fact made, and it would be idle to insist on their being made.

11.25 To provide greater certainty in this matter, the committee re-commends that the regulations should be amended to exclude payments made by people in the household sector from the requirement to withhold tax to the extent that the payments relate to their private residences, or otherwise are of a private nature.

11.26 The committee believes that both measures, if adopted, would improve the consistency and efficiency of the regulations, while at the same time minimising opportunities for non-compliance. Both measures highlight the trade-off between encouraging compliance by taxpayers and minimising compliance costs.

11.27 The effect of the double amendment would be that only payments made by GST registered persons to the extent that those payments relate to a taxable activity, or payments made by non-registered persons if the payments are not of a private nature, would be subject to the deduction of withholding tax.

11.28 In summary, then, the committee recommends that the regulations should be amended to exclude from the definition of 'withholding payment':

    payments made to a GST registered person for the supply of services when the payer holds at the time a GST tax invoice disclosing the GST-inclusive value of that supply, except in specific areas of revenue risk; and

    payments made by people in the household sector to the extent that the payments are of a private nature.

Interest on Underpayments

Introduction

11.29 Part VII of the Tax Administration Act 1994 provides for the payment of interest on underpayments and overpayments of tax. This payment is generally known as 'use of money interest'. It applies to both overpaid and underpaid tax from the due date for payment of that tax until the day that the tax is paid. Different rates of interest are paid on overpaid and underpaid tax.

11.30 Submissions to the committee raised concerns about both the levels of interest charged and the disparity between the overpayment and underpayment rates for use of money interest. In addressing these concerns, the committee believes it is important that taxpayers understand how these rates are set. The twin objectives of the rates are first, to compensate fairly the party (either the Crown or the taxpayer) who has lost the use of their money, and secondly, to encourage taxpayers to pay the right amount at the right time.

Rates

11.31 To some extent these objectives conflict. No single interest rate can both compensate the 'lender' fully, and also ensure that overpayments of tax are minimised. The government wants to minimise overpayments of tax by setting the interest slightly lower than the rate taxpayers would normally receive on short-term deposits for two reasons. First, because the government's procedure for changing rates in response to changes in market interest rates is relatively slow, the government does not want inadvertently to be in the position of being the best source of short-term finance if market rates were to fall quickly. Secondly, the government wants to avoid introducing additional uncertainty in its revenue forecasts. Uncertainty would occur if the overpayment rate was more generous than that offered by financial institutions, so encouraging overpayments of tax. In practice, the rates must recognise that the taxpayer and not the department ultimately chooses whether taxes are underpaid or overpaid. Further, the rates need to be set having regard to the borrowing rates for taxpayers in general, and not the circumstances of individual taxpayers. This broad-brush approach means that the rates may result in some inequities for individual taxpayers.

11.32 Taking these objectives into consideration then, the rates must be, for underpayments, close to, but more than what taxpayers generally would pay for unsecured borrowing from another source; and, for overpayments, close to, but less than what taxpayers generally would receive on short-term deposits of similar risk.

11.33 The criteria to be considered for changing the rates are as follows:

  1. Both rates should be adjusted following:
    1. an increase or decrease of 2 per cent in the Reserve Bank business base lending rate, the base rate for the underpayment rate; or
    2. an increase or decrease of 1 per cent in the Reserve Bank 90 day bank bill rate, the base rate for the overpayment rate.
  2. Adjustments in the underlying market interest rates should be measured from the date the rates were last set.
  3. The rates should be reset to underlying market interest rates if the rates have not been adjusted during any 12-month period, with consultation on whether the misalignment of rates is sufficient to require a change.
  4. 4 When an adjustment is proposed, the government should consult with interested parties concerning timing, on the basis that:
    1. as a general principle, adjustments should apply from the next standard provisional tax payment date (7 March, 7 July or 7 November), but
    2. if consultation suggests an earlier change is required, the adjustment should take effect from the 7th of the next month, which would be a non-standard provisional tax payment date.

11.34 The use of money interest rules are generally well understood and are operating efficiently. The committee considers that the process of setting rates is efficient, and that the existing consideration of the compliance cost impact of any change in the interest rates is appropriate.

11.35 However, the committee considers that even though a rational basis for setting the use of money interest rates exist, and even though an efficient administrative system calculates taxpayer liabilities, it does not necessarily follow that the rules are seen by taxpayers as operating equitably. There are many circumstances when it may reasonably be argued that there is inequality in the imposition of interest, or in the level of interest. Some examples of perceived inequities occur to the committee, and others have been suggested in submissions, including the following cases.

    If the department issues a non-binding ruling on an expected tax treatment, no interest or penalties should result for any tax position subsequently assessed because of a changed departmental stance.

    If no shortfall penalty has been attracted by the taxpayer's actions, use of money interest should perhaps be wholly or partly relieved.

    If the taxpayer had 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 use of money interest.

The examples are illustrative only. The committee notes that other situations may deserve consideration for possible relief.

11.36 The use of money interest rules compensate both taxpayers and the government when incorrect payments of tax are made, regardless of the reason. Without the use of money interest provisions, a taxpayer who pays tax correctly would be in a worse position than a taxpayer who defers a payment by taking an incorrect tax position but one which does not incur a shortfall penalty. Taxpayers who accurately forecast their income and paid tax accordingly would be treated less favourably than taxpayers who made no effort to forecast their income.

11.37 This most important topic - one which generates considerable dissatisfaction with the tax system - should be investigated further. The committee is aware that the penalties provisions are scheduled for a full review in 1999 and, therefore, the committee recommends that questions about relief from the use of money interest rules should be fully addressed then.

Late payment penalty and use of money interest

11.38 The late payment penalty comprises an automatic 5 per cent penalty on underpayments not paid by the due date, and an additional 2 per cent penalty charged for each month until the tax is paid. Use of money interest also applies to outstanding balances (not including penalties) until such amounts are paid. The combined impost is intended to reinforce a fundamental obligation of the tax system - the requirement to pay taxes by the due date. The committee considers that the late payment penalty appears to be overly punitive, when combined with use of money interest on underpayments.

11.39 The committee accepts that the due date would be meaningless if some sort of penalty did not apply for late payments. The initial 5 per cent penalty is intended to provide sufficient incentive to pay on time, without being overly punitive. Previously, the penalty was 10 per cent.

11.40 The committee considers that the government should consider reducing the 5 per cent penalty for taxpayers who fail to pay on time, but who correct that error within a few days of the due date for payment of the tax. In these cases, the late payment penalty is significant, even if the taxpayer did not have a reasonable cause for failing to pay on time.

11.41 The additional 2 per cent monthly penalty combined with use of money interest ensures a continual incentive to pay, or to apply to the Inland Revenue Department either for remission or to pay by instalment. If the penalty were a single occurrence, without an additional incremental penalty, taxpayers would lack any incentive to pay once the initial late payment penalty was incurred. Interest would be charged, but this charge is intended to be neutral in effect, approximately equalling the benefit to the taxpayer of retaining the tax. The incremental penalty provides a continuing incentive for the taxpayer to pay the tax as soon as possible.

11.42 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. Although previously, the late payment penalty on income tax amounted to 10 per cent every six months, and also a lesser overall penalty is now imposed in the cases of short-term failure to pay, the new rules provide a more significant penalty after the first two months. The committee notes that the combined late payment penalty and use of money interest could impose an overall impost in excess of 50 per cent over a 12-month period.

11.43 In summary, therefore, the committee recommends that the 5 per cent penalty should not apply to taxpayers who fail to pay on time, but who correct that error within a few days of the due date for payment. The committee also recommends that the government should consider reducing the incremental late payment penalty of 2 per cent per month to 1 per cent per month.

Tax Recovery

Introduction

11.44 This part of the chapter considers the effectiveness of the tax recovery provision, section HK 11 of the Income Tax Act 1994. The section provides that directors and shareholders of a company are liable in certain circumstances for tax payable by the company if it is left with insufficient assets to meet its tax liability.

11.45 Section HK 11 is directed at arrangements which deplete a company's assets so that it is unable to meet its tax liabilities. The company itself is often liquidated as part of the arrangement, or simply because after a transaction is completed, the company serves no useful purpose. Such arrangements were a feature of transactions considered by the Davison Commission.

Operation of the section

11.46 The tax recovery provisions in section HK 11 apply when an arrangement has the effect of leaving a company unable to satisfy an existing or future tax liability, and it is reasonable to conclude that if a director of the company had made all reasonable inquiries into the affairs of the company at the time it entered into the arrangement, the director would have anticipated that the tax liability would be required to be met by the company, and that a purpose of the arrangement was to avoid meeting the tax liability.

11.47 Directors or controlling shareholders at the time the arrangement was entered into, or non-controlling shareholders at that time, if it was reasonable to conclude, having regard to any benefit derived by the shareholder, that the shareholder was a party to the arrangement, may be liable as agents of the company under section HK 11.

11.48 Certain statutory defences are provided. For example, directors are not liable if they can satisfy the Commissioner that they were not involved in the executive management of the company, and had no knowledge of the arrangement at the material time. If none of the statutory defences applies, the directors of the company are jointly and severally liable for the full amount of the tax liability. Shareholders who come within the ambit of section HK 11 are liable for the recovery of tax to the extent of the greater of the market value of their direct and indirect shareholding in the company, and the value of the benefit they derived from the arrangement, and the relevant proportion of any late payment penalty or interest.

Purpose of tax avoidance

11.49 The committee is concerned with one aspect of subsection (1) of section HK 11, namely, its requirement that a purpose of the arrangement must be to avoid tax. This provision is set out below:

This section shall apply where -

  1. Any arrangement has been entered into in relation to a company; and
  2. An effect of that arrangement is that the company is unable to satisfy under this Act a liability for income tax (referred to in this subsection as the 'tax liability') of the company, whether the tax liability exists at the time of entry into the arrangement or arises subsequently; and
  3. It can reasonably be concluded that -
    1. A director of the company at the time of entry into the arrangement who had made all reasonable inquiries into the affairs of the company would have anticipated at that time that the tax liability would be, or would be likely to be, required to be satisfied by the company under this Act; and
    2. A purpose of the arrangement was to have the effect specified in paragraph (b).

11.50 The committee considers that the requirement in subsection (1)(c)(ii), that a purpose of the arrangement was to have the effect of tax avoidance, makes the tax recovery provision too difficult to apply because it requires the Commissioner to show subjective intent. A court would be unlikely in all but the most blatant circumstances to conclude that a purpose of the impugned arrangement was to avoid payment of tax. This purpose would have to be a foreseen and intended consequence or a goal of the arrangement.

11.51 In addition, the second limb of paragraph (c) seems to frustrate the objective component of the first limb, which sets out the test of a director who had made all reasonable enquiries into the company's affairs and what he or she would have anticipated as likely. This first limb seems to be designed to target recklessness, negligence or oversight on the directors' part. However, if the directors have not made all reasonable enquiries, and therefore do not know of the looming tax liability, how can they be said to have a purpose of avoiding tax under subsection (1)(c)(ii)? It follows that the second limb would always rule out recklessness, negligence, or oversight.

11.53 The committee recommends that the government should amend section HK 11 to make the tax recovery provisions more effective by changing the requirement for an avoidance purpose in subsection (1)(c)(ii) so that it is an alternative or disjunctive requirement only. The effect of such an amendment would be to make the requirement for reasonable enquiries by a director the main test for determining the application of section HK 11. The committee does not propose any amendment to subsection (4), which lists classes of shareholders who can be made liable for the unpaid tax of a company. Section HK 11 will continue to apply primarily to controlling shareholders. It will apply to non-controlling shareholders only when it is reasonable to conclude, having regard to the materiality of any benefit derived by such shareholders, that they were a party to the arrangement which left the company unable to satisfy its tax liability.

Footnotes

190 Section OB 1, Income Tax Act 1994 defines 'private domestic worker' as being a person who is employed by another person to perform part-time work in or about that person's private residence.