4.33 Interest and Penalties

Primary Reference to Article 20 – Interest and Penalties

Overview

In recent times jurisdictions around the world have moved more and more towards a tax regime based on self-assessment principles. This changes fundamentally the obligations and role of taxpayers vis a vis those of the tax authority. The result is that much more responsibility is cast upon the shoulders both of taxpayers and their tax advisors. For example, rather than submit information for assessment with the calculation of taxable income and tax liability done by the tax authority, taxpayers became obliged to ascertain their own taxable income and, often, their tax liability. The tax authority then accepts the taxpayer's tax return at face value and issues an assessment, and where a refund is due, an accompanying cheque. Should, however, it subsequently be found (at audit, for example) that there has been a tax shortfall, then the taxing Act provides for the taxpayer to be liable for interest and in certain circumstances for a penalty. The level of penalty is often determined on the basis of the tax shortfall, and whether that shortfall is due for example to such factors as a failure to take reasonable care, recklessness or intentional disregard of the law, with accordingly increasing levels of penalty.

In addition, there are penalties where a taxpayer refuses or fails to furnish on time any required return or information.

Taken together, such provisions have made it clear that the taxpayer has the primary responsibility for lodging a correct tax return. They also have placed upon tax advisors an additional burden of responsibility, for taxpayers normally rely on them to 'get it right' and so ensure no liability for interest or penalty arises.

Interest

Over time, even at the modest interest rates currently applicable, interest can be substantial. Disputes can take a long time to resolve. It is not unusual for the interest to accumulate to an amount similar to or greater than the tax itself. So the issue of interest is a serious one.

The issue of interest can arise in several ways. A taxpayer may simply be late in discharging an undisputed tax liability. Another is that a tax liability may be seriously in dispute, but payment pending resolution of the dispute may be commercially impractical. A further possibility is that the taxpayer may have actually paid the disputed tax and then be entitled to a refund, either directly or to a related entity which paid tax elsewhere (for example, in the context of a transfer pricing dispute).

Many jurisdictions have applied differing interest rates, taking into account that late payment should not become a means of using the state as a source of finance. The trend is for the gap between the interest rate charged and also the refund rate to widen. Also, refund interest may be taxable while interest charged is often not deductible. Lastly, interest may only be paid after a waiting period (say 30 days after the tax return is filed) while it is charged from day one when owed. Taken together, the system favours the tax authority in most if not all aspects.

Fairness requires that the state should not obtain an advantage from improperly collecting tax ultimately determined not to be owing, or that those taxpayers who choose to not discharge their liabilities when due should obtain an advantage over the general body of taxpayers. And there is certainly an argument that there needs to be active discouragement of taxpayers from simply using the state as a funding source – which they do if they simply choose not to pay, but do not if delay is the result of a process for which they are not responsible.

Where tax has been paid by another entity in association with the same transaction either to the same tax authority (in the context of alternative assessments) or to another tax authority (in the context of a transfer pricing dispute), interest should not be chargeable, except to the extent that it recoups any interest paid by a tax authority to a related taxpayer as part of resolution of the dispute. As part of resolving the tax issues in dispute, the interest should be settled in a way which is fair as well.

It is difficult to summarize all the circumstances where interest could arise, assign relative responsibility between the taxpayer and tax authority and then develop a regime for what interest should be charged or refunded. The number of situations and circumstances is large. So instead we have derived a general principle that the treatment of interest should be reciprocal. Interest should not be a windfall to the state nor should it be, in effect, a penalty. Fairness dictates that in general the rate of interest charged be no higher than the rate given on tax overpayments. Otherwise what is really being charged is a penalty. But where the taxpayer is late in paying tax due, an additional charge can then be considered as warranted.

One argument to justify a higher rate of interest on payments than refunds is that the state has to exert collection effort and has bad debt experience. In short, the state is more credit worthy than the average taxpayer. But the unfairness of this argument is obvious. Why should a credit worthy taxpayer who is compliant be prejudiced by the bad debt experience of another taxpayer? So we reject this argument which is often used to justify the rate differential.

Instead of charging an interest rate differential, charge a late payment penalty where circumstances warrant, which separates the compliant taxpayer from the non-compliant, the taxpayer who pays on time but is reassessed from the taxpayer who is intentionally and habitually late.

Penalties

In levying penalties, the Taxpayer Charter contains several provisions which derive from the principle of fairness. They are:

  • Penalties should not be charged where there is no fault of the taxpayer or compliance with legislation was not reasonably possible
  • The legislation should clearly state when penalties will be levied and how they are calculated
  • The burden of proof should rest on the tax authority
  • The penalty should be proportional to the circumstances
  • Penalties may be waived where circumstances so warrant.

The need for a system of penalties should tax shortfalls occur arises from the need to provide appropriate incentives for responsible taxpayer behaviour in the context of a self assessment system.

Penalties should, however, reflect the various levels of fault which can arise in that context. The usual categories identified are failure to take reasonable care, recklessness, and intentional disregard of the law including evasion. In the context of reasonable care, an additional consideration which might be taken into account where significant amounts of tax are involved is whether the position taken by the taxpayer is reasonably arguable.

Some jurisdictions provide additional penalties for such matters as failure to lodge returns on time, the making of false or incomplete statements, and other administrative failings.

In general terms, the consequences for failure to comply with the requirements of the tax system should include interest and penalties.  The penalties should be proportionate to the quantum involved and the circumstances.  No penalty should arise in "no fault situations".

In broad terms, the penalty regime should recognise that if a taxpayer takes a reasonably arguable position, based on appropriate professional advice, and is ultimately found to be wrong (say by a court), there should not be a penalty.  Even more so where the shortfall does not really involve the taxpayer at all, but a dispute between tax authorities such as occurs in a transfer pricing dispute. In such cases, the amount of the tax shortfall upon which any penalty is calculated should be based on the net amount of tax payable (if any) by all the taxpayers involved in the dispute taken together.

There is, however, one area in which severe penalties are warranted.  That occurs in cases where a taxpayer has withheld money which discharges the tax liability of another person. Deductions from employee salaries, withholding taxes, and VAT, provide relevant examples. In such cases, no reasonable argument can be put forward by the person who has failed to remit the money.  Failure in this case to remit to the tax authority is almost the equivalent of theft, and appropriate penalties should apply.