High Court provides guidance on shortfall penalties
Tax Alert - October 2017
By Emma Marr and April Wong
In what may seem like a purely capital-vs-revenue case, a closer look into the High Court case of Easy Park Limited v Commissioner of Inland Revenue (Easy Park) reveals valuable judicial commentary on the criteria that must be met for an “unacceptable” tax position shortfall penalty. Easy Park is interesting because it is not often that a court considers shortfall penalties and this decision provides some parameters for considering this particular penalty.
Shortfall penalties in a nutshell
Shortfall penalties are imposed where there is a shortfall in the amount of tax paid or an overstatement of a tax benefit, credit or advantage, calculated as a percentage of the tax shortfall. The level of penalty imposed depends on the severity of the behaviour that led to the shortfall. For example, where a taxpayer has failed to take reasonable care or has taken an unacceptable tax position, the penalty imposed is 20% of the tax shortfall. Where the taxpayer has taken an abusive tax position or has evaded their taxes, however, the penalty imposed is 100% or 150% of the tax shortfall respectively. Reductions can apply where no similar penalty has been previously imposed and for voluntary disclosure.
Background of the case
Easy Park Limited owned two commercial buildings in Wellington and derived its income from leasing out these buildings. Easy Park had received $1.1 million in exchange for the early surrender of one of the building’s commercial leases. In its 2012 tax return filed, Easy Park did not declare this amount as income. Easy Park maintained the view that, contrary to the Inland Revenue’s published view of lease surrender payments in a binding public ruling (BR Pub 09/06: Lease surrender payments received by a landlord – income tax treatment), the lease surrender payment it received was capital and not assessable for income tax. The Commissioner reassessed the amount as income to Easy Park and issued a tax assessment for $308,000. In addition to this, the Commissioner imposed a 10% shortfall penalty ($30,800) on Easy Park for taking an “unacceptable tax position”. We assume in this case that the shortfall penalty was “reduced to 50% of the amount that would be payable by [Easy Park]” for previous good behaviour (section 141FB(2) of the Tax Administration Act 1994). The Commissioner took the view that, when “viewed objectively the tax position [taken by Easy Park] fails to meet the standard of being as likely as not to be correct” (section 141B of the Tax Administration Act 1994), due to Inland Revenue’s position in BR Pub 09/06 and relevant case law.
In this particular case, the High Court agreed with the Commissioner that the lease surrender payment was income, however, on the question of shortfall penalties, Ellis J found that no shortfall penalty was warranted – even if the tax position taken by Easy Park was incorrect.
We note that this case was heard prior to a law change in 2013, which specifically provided for all lease inducement and lease surrender payments to be treated as taxable income. If the case was heard today, we would expect the ruling on the shortfall penalty point would be different, as the tax position taken would be directly contradictory to the legislation. Nevertheless, the comments on the decision not to impose a shortfall penalty are useful.
When is a tax position deemed to be “unacceptable”?
A shortfall penalty will be imposed where the taxpayer is deemed to have taken an “unacceptable tax position” in their tax return. This does not necessarily mean that a shortfall penalty will be imposed if the tax position taken is incorrect. If the tax position in question “can objectively be said to be one that, while wrong, could be argued on rational grounds to be right” (per Ellis J, citing Walstern v Commissioner of Taxation (2003) 138 FCR 1), shortfall penalties may not be imposed.
Ellis J found that shortfall penalties were not appropriate in this case as Easy Park had a reasonable and objective reason to conclude that lease surrender payments were capital – even if this tax position was in conflict with BR Pub 09/06 and relevant case law. Ellis J acknowledged that public rulings are not necessarily binding on taxpayers. Further, the capital/revenue distinction is not always easy to discern, and had it not been for the 2013 amendment to the law treating all lease surrender payments as assessable income, there were certainly situations where such payments could arguably have been capital receipts and therefore not taxable. In the present case, it was conceivable that Easy Park could have, when viewed objectively, regarded the payment as capital. As such, a shortfall penalty in this situation was not deemed to be appropriate.
Therefore, in some cases (as was the case in Easy Park), even where the tax position taken is incorrect in the Court’s eyes and is contrary to the Commissioner’s published view, a shortfall penalty may not be imposed. Arriving at the correct tax position can be a challenge at times given that the law is not always black and white. There is always the possibility that Inland Revenue may review a tax position, decide that it is incorrect and charge penalties and use of money interest on the tax shortfall. It is comforting to know that the Court provides some leeway where there is a good objective reason for a taxpayer to reach a certain tax position (even if incorrect).
Taxpayers do in some circumstances decide to file a tax return conservatively, taking the position that they will pay tax that they may not consider is technically payable, and then issue a notice of proposed adjustment (NOPA) to the Commissioner to request a re-assessment (i.e. reversal) of the tax position taken. This is not a process that Easy Park followed in this instance, however Ellis J made some brief comments on the practice anyway. She commented that a taxpayer filing and then immediately issuing a NOPA once the Commissioner has issued an assessment can be construed as “artificial” and “arguably dishonest” given that a taxpayer is expected to sign a tax return on the grounds that they believe it to be “true and correct”.
This is an interesting observation. A NOPA is simply a process whereby a taxpayer proposes that a tax position may not be as declared in their return. It seems plausible to take that position, while equally believing the return to be true and correct (i.e. there is a possibility it may not be, and so that is what is tested by the taxpayer commencing a dispute process by issuing a NOPA). There are very few ways in which a taxpayer can achieve certainty on a less than straightforward/clear-cut tax position without high cost or high risk. Obtaining a ruling before filing can be a lengthy and expensive process. A taxpayer filing on the basis that tax is payable is not obtaining the benefit of having the tax sitting in their bank account while they wait to see if they got it right, so it seems entirely appropriate that if, in the end, the taxpayer and the Commissioner don’t agree, the Commissioner should have no ability to impose penalties or use of money interest: there has been no tax shortfall. Parliament has given taxpayers the option of a taxpayer initiated NOPA to address uncertainty – while Inland Revenue may not necessarily welcome the prospect of disputes commenced by taxpayers, it does not appear unreasonable as an option to resolve the uncertainty, particularly if Inland Revenue is not out-of-pocket in the meantime.
October 2017 Tax Alert contents
- Tax Alert - October 2017
- GST on Mortgagee Sales
- OECD adds complexity and uncertainty to intangible property pricing
- New Customs law to be implemented next year – how prepared is your business
- High Court provides guidance on shortfall penalties
- Country-by-Country Reporting: What is your risk profile?
- A snapshot of recent developments