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 7^th 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.