Trends in shortfall penalties

Tax Alert - April 2022

By Virag Singh

As required under the Tax Administration Act 1994 (TAA), Inland Revenue recently issued its annual report on the application of shortfall penalties “Application of shortfall penalties under the Tax Administration Act 1994 for the year ended 30 June 2021” (2021 SFP Report).

The shortfall penalty regime is one of the most powerful tools Inland Revenue has at its disposal to encourage and enforce compliance with tax laws.

Every year Inland Revenue impose thousands of shortfall penalties amounting to millions of dollars to taxpayers who take incorrect tax positions. To put some figures around it, in the eleven years from 1 July 2010 to 30 June 2021 67,380 shortfall penalties were imposed amounting to a total dollar value of $430,083,681 (after the application of voluntary disclosure and previous good behaviour adjustments).

This article will first provide a brief overview of the shortfall penalties regime before looking at the trends in shortfall penalties between 1 July 2010 and 30 June 2021. The 2021 SFP Report itself only compares data between the years ended 30 June 2020 and 30 June 2021.

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 – 2021.

The shortfall penalty regime

Where a taxpayer takes an incorrect tax position, that taxpayer may be liable to pay a tax shortfall penalty. Or to put it another way, if a taxpayer pays an amount of tax that is lower than what Inland Revenue determines the taxpayer owes, that taxpayer may be charged a penalty.
The purposes of the penalties regime (including the civil shortfall penalties regime) as set out in Part 9 of the TAA is to encourage voluntary compliance with tax obligations, ensure impartial and consistent application of penalties and impose penalties at a level proportionate to the seriousness of the non-compliance with tax obligations.

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


Penalty Type	Percentage of Tax Shortfall	Apples when

Not taking reasonable care	20%	Taxpayer does not take reasonable care in taking a tax position
Unacceptable tax position	20%	Viewed objectively, the tax position fails to meet the standard of being about as likely as not to be correct. Must exceed $50k or 1% of total tax for relevant return period.
Gross carelessness	40%	Doing or not doing something in a way that in all the circumstances suggests or implies complete or a high level of disregard for the consequences.
Abusive tax position	100%	Having met the unacceptable tax position threshold, a taxpayer enters into or acts in respect of arrangements or interprets or applies tax laws with a dominant purpose of taking, or of supporting the taking of, tax positions that reduce or remove tax liabilities or give tax benefits.
Evasion or similar act	150%	Evades the assessment or payment of tax by thetaxpayer or another person under a tax law or a similar act.
Promoter Penalty	The sum of the tax shortfalls arising as if the promoter had been the party to the arrangement	Applies to a ‘promoter’ who has sold, offered,issued or promoted an arrangement to 10 or more persons, where a shortfallpenalty for an abusive tax position is imposed on a party to the arrangement asa result.

A purpose of the penalties regime to ensure the level of the penalty is proportionate to the seriousness of the breach is met, and as such the amount of a shortfall penalty may be reduced, in some circumstances. A reduction of 100% (in cases where the shortfall penalty imposed is for not taking reasonable care or for taking an unacceptable tax position, or a 75% reduction for other penalties) is available where the taxpayer makes a full unprompted voluntary disclosure to Inland Revenue before the taxpayer is notified of an impending audit or investigation. A 40% reduction in shortfall penalties is available where voluntary disclosures are made post notification, but before, the start of an audit. In 2021 reductions in shortfall penalties payable due to voluntary disclosures totalled $43,352,347. Taxpayers can 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 two years for PAYE, FBT, GST and RWT or four years for other tax types). In 2021 97.3% of shortfall penalties imposed were given a 50% reduction for “prior good behaviour”.

Incidence trends in shortfall penalties

Over the last eleven years, the number of shortfall penalties has fluctuated. In the year ended 30 June 2011, there were 5,180 penalties issued. This figure rose to a peak of 9,029 in the year ended 30 June 2017 before dropping to 6,360 in the year ended 30 June 2019. The 2020 and 2021 years were again lower. Inland Revenue has noted in the 2021 SFP Report that the impact of COVID-19 saw more Inland Revenue staff time spent assisting customers than on audit activity. While there has been a general decline in the number of shortfall penalties across all tax types broadly since 2017, the decline in respect of GST has been particularly noticeable (5,688 in 2017 compared to 2,433 in 2021).

One might reach the conclusion that the lower number of penalties is correlated to the reduction in Inland Revenue staff and reallocation of resources at Inland Revenue arising from the Business Transformation project. However there could be other explanations, such as an increased focus on taxpayer education and processes to help taxpayers take correct tax positions in the first instance (the “Right from the Start” approach).

The two most common types of penalties imposed throughout the period reviewed have been for evasion or similar act (150%) and gross carelessness (40%). The incidence of these two shortfall penalties types reduced significantly from 2017 on. The number of penalties imposed for promoter, unacceptable tax position and abusive tax position has remained consistently low over the period. What this may show is that taxpayers are generally very compliant, and enforcement time is being directed toward taxpayers who are wilfully evading tax obligations.

Total dollar value trends

The dollar values of penalties imposed by tax types (excluding income tax) and by shortfall penalty types have remained steady over the last eleven years. The dollar value of penalties imposed for income tax has, however, fluctuated markedly over the review period. There is a distinct correlation between fluctuation in dollar value for shortfall penalties imposed for abusive tax positions and shortfall penalties imposed in respect of the income tax type. Other than the spikes in 2012, 2014 and 2019, there has been a general and more pronounced decline in the dollar values of penalties imposed for abusive tax positions for income tax. This may be indicative of a calmer period post-settlement of most of the tax avoidance cases associated with the Trinity scheme and the use of mandatory convertible notes and optional convertible notes. Taxpayers also have not had much success with challenging Inland Revenue on tax avoidance matters as part of the disputes process. Taxpayer fatigue and costs burden associated with the tax disputes process often results in taxpayers opting to settle the dispute with Inland Revenue with the reduction in shortfall penalties one of the levers used to negotiate a settlement.

Conclusion

There are some clear trends in the graphics over the past eleven years. The imposition of shortfall penalties has seen a steady decline. The reduction in staff and reallocation of duties with Inland Revenue because of the Business Transformation project could be a factor. In the last two years, COVID-19 could also be a factor with resources diverted to other priorities and taxpayers being given some breathing space from audit action.

There is possibly some credence in the argument that Business Transformation has resulted in enhanced collection and matching of data which allows earlier identification of errors or discrepancies which can be fixed without active reviews, investigations or audits.

A number of significant and complex tax regimes have been enacted in recent times, including the BEPS regime (which incorporates anti-hybrid rules, restricted transfer pricing rules and tougher thin capitalisation rules). Time bar for transfer pricing related matters has also been extended and tax rules in relation to land transactions have also become more complicated. At some stage as pressures grow to increase government revenue, Inland Revenue are likely to need to increase audit activity to ascertain compliance with these tax regimes. This could result in additional tax and shortfall penalties to pay.

This is also a timely reminder that taxpayers can use the voluntary disclosure regime to reduce their exposure to penalties and undertake regular reviews of their tax functions and processes to ensure compliance.

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.