Tax shortfall penalties: understanding the trends

By Virag Singh and Hamish Tait

Earlier this year, Inland Revenue released its 2014 financial year report to the Minister of Finance on penalties applied in relation to tax shortfalls under the Tax Administration Act 1994 (“TAA”).  Shortfall penalty reports must be prepared annually and presented to Parliament pursuant to section 141L of the TAA.  These reports provide interesting insights into both taxpayer behaviour and the level and nature of Inland Revenue review activity in various areas.

In this article, we briefly summarise the NZ penalty regime by way of background.  We then review and analyse Inland Revenue’s penalty activity for the year.

NZ Tax Shortfall Penalty System

Where a taxpayer takes an incorrect tax position, that taxpayer may be liable to pay a tax shortfall penalty.  The framework for this is set out in Part 9 of the TAA.

Shortfall penalties are generally imposed as a percentage of the taxpayer’s tax shortfall.  The percentages are determined by reference to a framework which aims to assess the taxpayer’s level of culpability for the shortfall.  The table below summarises the range of penalties.

Shortfall penalties may be remitted where the taxpayer meets certain criteria.  Full reductions are available where the taxpayer makes a full voluntary disclosure to Inland Revenue before the taxpayer is notified of an impending audit or investigation (in cases where the shortfall penalty is for not taking reasonable care or for taking an unacceptable tax position, or a 75% reduction for other penalties).  A 40% reduction in shortfall penalties is available where voluntary disclosures are made post notification but prior to the start of an audit.  Taxpayers also benefit from a 50% reduction for “prior good behaviour” (essentially where the taxpayer has not had a penalty of that type in the preceding four years).

Inland Revenue Reports

The dollar value of penalties shown below is after available reductions, unless otherwise stated.

Note: The data referred to/graphed in this article is sourced from Inland Revenue’s reports on the application of shortfall penalties pursuant to section 141L of the TAA, for the years ended 30 June 2011-14.

The incidence of penalties for unacceptable tax positions (20%) and abusive tax positions (100%) has remained relatively static since FY 11.  However, it is clear there has been significant movement in the imposition of other penalties.

There has been a clear upwards trend in penalties for evasion or a similar act (150%).  In FY 14, this was the most commonly charged of all penalty types.

However, perhaps a more interesting trend is the decrease in the incidence of the not taking reasonable care penalty (20%), together with an increase in the incidence of the gross carelessness penalty (40%).  In FY 14, taxpayers were penalised for gross carelessness 2,202 times (FY 13: 1,759 times), while in respect of not taking reasonable care, penalties were imposed 1,067 times (FY 13: 1,553 times).

It is of course difficult to draw firm conclusions based on this limited data.  However, assuming similar taxpayer behaviour across these years, the data may indicate a trend of Inland Revenue increasingly applying the 40% gross carelessness penalty instead of the 20% not taking reasonable care penalty.  There could be a couple of reasons for this.  Inland Revenue could be taking a particularly aggressive view of taxpayer culpability, or through the voluntary disclosure regime, there may now be more taxpayers who are coming forward to make disclosures of tax shortfalls.  Further information from Inland Revenue allowing more analysis of this trend would be welcome. The increase in the incidence of the evasion penalty reflects Inland Revenue’s increased focus on the cash economy and more sophistication in its investigative techniques and analytics tools.

Dollar Value by Penalty Type

Probably unsurprisingly, the abusive tax position penalty (100%), which in all years has been applied well under 200 times, is the highest source of shortfall penalty income for Inland Revenue.  In FY 14, although applied in just 171 out of 5,984 cases, penalties totalling $34.8 million were charged for abusive tax positions.  In FY 12, this penalty topped $47.0 million.  Despite the relatively small number of arrangements considered to involve taking an abusive tax position, the absolute value of the funds involved is very large.  This corresponds to Inland Revenue’s on-going success in general anti-avoidance cases both in the courts and prior to litigation through the disputes process.

An important point to note in relation to the penalty for taking abusive tax positions is that the Inland Revenue must first be able to establish that the taxpayer had taken an unacceptable tax position i.e. when viewed objectively, the tax position of the taxpayer fails to meet the standard of being “about as likely as not to be correct.”  When reporting back on the legislation introducing the unacceptable tax position test, the Finance and Expenditure Committee (“FEC”) confirmed that Inland Revenue officials had assured the FEC that a position that was “about as likely as not to be correct” was a position which would be seriously considered by a court. 

We do not have confidence that, in practice, in cases involving assertions of tax avoidance, Inland Revenue is interpreting the unacceptable tax position test as confirmed by the FEC, and by case law consistent with this.  In practice, we have seen legal propositions relied upon by the taxpayer, where there was little doubt that the tax position adopted would be one that would be seriously considered by a court.  However, the Inland Revenue has instead categorised this as an abusive tax position.  This is concerning behaviour by Inland Revenue officers in charge of tax disputes and arguably translates into the significantly higher abusive tax penalties being imposed in dollar value terms, particularly where the relevant taxpayers do not have the resources to pursue and complete the disputes process.  Inland Revenue has recognised the issue of shortfall penalties being used as ‘leverage’ in the below comments included in its recent Standard Practice Statement entitled “SPS 15/01 - Finalising agreements in tax investigations”:

"… staff may not use the potential of increasing the category of shortfall penalty or the likelihood of prosecution action being taken by the Commissioner, as leverage for finalising tax investigations."

By contrast with the abusive tax position penalty, the promoter penalty has been infrequently applied.  While penalties of $12.7 million were charged in FY 11, this was only in relation to two tax shortfalls.  No promoter penalties have been applied from FY 12 to FY 14.

Penalties by Tax Type

Perhaps surprisingly, of all tax types, GST is the most common tax for which a shortfall penalty is charged.  Of the 5,984 penalties charged in FY 14, 3,300 (55%) of these were in relation to GST.  It is difficult to tell whether this is due to higher levels of compliance activity in this area by Inland Revenue, taxpayer difficulties with compliance (or outright non-compliance), or both.  Regardless, it is clear that a relatively significant number of taxpayers are getting ‘caught out’ in relation to GST.

We strongly recommend that taxpayers undertake GST reviews on a regular basis and seek specialist GST advice in respect of one-off major transactions.

However, as shown above, the clear winner by dollar value of penalties is income tax.  In FY 14, while only being applied in 1,370 instances, income tax penalties were charged in the sum of $48.9 million.  This was 85% of penalties by dollar value in that year.  The graph above also shows that after dipping around 2012 – 2013, the penalties in respect of income tax are again on the rise.

Conclusion

Unfortunately, while the intention of the reports is clearly to keep Parliament appraised of Inland Revenue’s operations in collecting tax revenue through the penalties regime, it is difficult to draw too many conclusions based on the data provided.  We are unable to tell, for example, whether an increase in the incidence of gross carelessness is attributable to income tax or GST.  It is not clear whether penalties are imposed at an early stage by Inland Revenue, as a result of a protracted disputes process, or following Court action.  We would welcome additional transparency around penalties from Inland Revenue – which could foster taxpayers’ perceptions of the integrity of the tax system, voluntary compliance, and provide a ‘check and balance’ on Inland Revenue’s imposition of penalties.

Nevertheless, these reports are a valuable tool to gauge Inland Revenue activity.  They also highlight the availability of reductions.  Voluntary disclosures can reduce penalties where this is done in advance of an audit or investigation commencing.  We therefore encourage clients to talk to us immediately when they are contacted about prior periods by Inland Revenue, or where they are concerned they have not obtained advice to sufficiently justify their tax positions.

It is also interesting to see that GST is an area where taxpayers are more often being charged shortfall penalties – in our experience this is often an area where returns are not reviewed by external advisers as consistently as for income tax.

For advice on mitigating Inland Revenue penalties, what to do when faced with the imposition of shortfall penalties, or any general tax dispute queries, please contact your usual Deloitte tax advisor.