Report on Aspects of Income Tax Self Assessment
This Chapter recommends changes to improve the transparency of the process of imposing penalties on taxpayers who understate a tax liability and the abolition of the separate penalty for failing to follow a Tax Office private ruling. It also recommends administrative action to clarify the standard of care required of taxpayers.
Penalties exist as incentives for taxpayers to comply with their various tax obligations. The penalties relevant to this Review are those that apply where, in self assessing, a taxpayer understates their liability and therefore pays less tax than they ought to. The penalties that can apply in these circumstances are known as tax shortfall penalties.
Tax shortfall penalties may apply, depending on the degree of blameworthiness or culpability on the taxpayer’s part, if a taxpayer has a tax shortfall resulting from any of the following:
- making a false or misleading statement. Omitting income, over-claiming deductions or claiming deductions that are not allowable will generally fall into this category
- failing to provide a document that the Tax Office needs to work out liability
- applying an income tax law in a way that is not reasonably arguable (but only if the tax shortfall amount exceeds the greater of $10,000 or 1% of the income tax payable by the taxpayer)
- disregarding a private ruling
- entering into a tax avoidance scheme or having a transfer pricing adjustment.
These culpability penalties are different from the General Interest Charge (see Chapter 5).
The same penalty regime generally applies to all taxes administered by the Tax Office.
The amount of shortfall penalty for which a taxpayer may be liable depends on the reason for the shortfall, as set out in the following scale.
Table 4.1: Scale of shortfall penalties
Cause of shortfall
Base penalty amount
Intentional disregard of a taxation law
Failure to provide a document necessary for the Commissioner to work out the liability
Lack of reasonable care
Taking a position that is not reasonably arguable on a large item
Disregard of a private ruling
The starting point (or base) for determining the penalty amount is a percentage of the shortfall. This can be varied up or down according to whether the taxpayer has hindered the Tax Office in investigating the shortfall, has previously had a shortfall with a similar cause, or has made a voluntary disclosure of the shortfall. The scale works so that a taxpayer is not penalised for making a false or misleading statement if they have taken reasonable care to be truthful and accurate in making the statement.
A taxpayer cannot be penalised for a shortfall caused by relying on Tax Office advice or general administrative practice.41
The Tax Office can reduce penalties partly or in full. This is known formally as the Commissioner’s ‘power of remission’. A taxpayer can apply for remission of penalty, or the Tax Office can remit the penalty on its own initiative. The Tax Office must advise the taxpayer in writing if it decides not to remit the penalty, or decides to remit only part of it. Objection and review procedures apply to the remission decision if the amount of the penalty not remitted exceeds two penalty units (currently $220).
As explained in Chapter 1, penalties are a potential consequence of uncertainty for taxpayers. Before the preparation of the discussion paper, practitioners and industry groups said that:
- The meanings of key concepts such as ‘reasonable care’ and ‘reasonably arguable position’ were not sufficiently clear.
- The penalty for failure to follow a private ruling should not apply if the taxpayer has taken reasonable care and, for a large item, has a reasonably arguable position.
- When a tax agent makes a mistake, penalties should not apply to a taxpayer who has taken reasonable care to provide correct information to the agent.
- The Tax Office ought to be more flexible in remitting penalties.
Submissions responding to the discussion paper also argued that there needs to be greater transparency about how the Tax Office determines that a penalty applies and exercises its remission powers.
These issues, along with the appropriateness of the current scale of penalties, are considered in more detail below.
‘Reasonable care’ is not defined in the tax law and ‘reasonably arguable’ is only defined in general terms. The Explanatory Memorandum to the A New Tax System (Tax Administration) Act (No. 2) 2000 (the EM) provides some explanation of these concepts and the Tax Office has issued Taxation Rulings42 to explain their meaning. More recently, the courts have also provided guidance, for example in the recent Walstern case.43
Lack of reasonable care
The EM makes the following points about the reasonable care test:
- The test requires a taxpayer to exercise the care that a reasonable person would be likely to have exercised in the circumstances of the taxpayer (including their knowledge, education, experience and skill).
- Taxpayers must take reasonable care not only in the preparation of their tax returns, but throughout the year on matters that may impact on their tax obligations, for example, record keeping.
- The reasonable care test is not intended to be overly onerous for taxpayers completing their own returns. For most taxpayers, an earnest effort to follow TaxPack instructions would usually be sufficient to pass the test.
- On questions of interpretation, if the taxpayer is uncertain about the correct treatment of a tax-related matter, reasonable care requires that they make reasonable enquiries to resolve the issue. Reasonable enquiry would include consulting someone or reference to a Tax Office publication to satisfy themselves about the proper tax treatment of the matter.
- Where a tax agent completes a return, the standard of care expected of the agent is much higher than the standard expected of the client.44
Reasonably arguable position
For large items,45 taxpayers must not only take reasonable care, but must also adopt a reasonably arguable position. A position is reasonably arguable if it would be concluded in the circumstances, having regard to relevant authorities, that it is at least as likely to be correct as incorrect.46
The EM explained that ‘[t]he test does not require the taxpayer's position to be the “better view”; the standard is “as likely correct as incorrect”, and not “more likely to be than not”'.
Similarly, in the Walstern case, Justice Hill said (at paragraph 108 of his judgment) that ‘[t]here must, in other words, be room for a real and rational difference of opinion between the two views such that while the taxpayer’s view is ultimately seen to be wrong it is nevertheless “about” as likely to be correct as the correct view’.
Although some submissions advocated amending the law to clarify the meaning of reasonable care and/or reasonably arguable position, the majority argued that the concepts should be clarified by Tax Office rulings and developed as necessary by court decisions.
The Tax Office has advised the Review that it is currently drafting a ruling and addenda to existing tax rulings to further clarify the application of the concepts.
Because of the infinite variety of possible cases, it would be counter-productive for the law to attempt to prescribe in detail what constitutes reasonable care or a reasonably arguable position in given cases. The current approach of relying on general principles is sound. However, it is important that the Tax Office provides taxpayers and practitioners with clear guidance as to the standard of care expected of them.
The Tax Office should revise its rulings on reasonable care and reasonably arguable position, with a view to providing clearer guidance and further examples as to what conduct will, or will not, attract a penalty.
One submission drew attention to a possible technical deficiency in the definition of when a matter is ‘reasonably arguable’. The definition that applied up to the 1999-2000 income year (in section 222C of the ITAA36) said that the standard required was ‘about as likely to be correct as incorrect’. The current definition (in section 284-15 of Schedule 1 to the TAA) uses the words ‘is as likely to be correct as incorrect, or is more likely to be correct than incorrect’. The EM said that ‘[a]lthough the wording has been refined, the concept has the same meaning as in section 222C’.
The Tax Office has interpreted the current definition in accordance with the legislative intention that the relevant standard is about as likely to be correct as incorrect (or more likely to be correct than incorrect). However, on their face, the words require a higher standard. It would be better if the law clearly reflected the policy intent.
The definition of when a matter is ‘reasonably arguable’ should be amended to confirm that the relevant standard is about as likely to be correct as incorrect (or more likely to be correct than incorrect) — not as likely to be correct as incorrect.
The scale of penalties in Australia is similar to that in Canada, New Zealand, the United Kingdom (UK) and the United States (US). The UK and New Zealand both have higher maximum penalties and the US and New Zealand have a slightly lower penalty (20% of the tax shortfall) for failing to take reasonable care.
The Review notes that the Tax Office has a liberal remission practice for taxpayers who fail to take reasonable care.47 In particular, the Tax Office generally remits the penalty where a taxpayer's overall level of compliance is sound, and in all the circumstances of the case it is clear that the taxpayer has made an honest mistake. The result is that a taxpayer whose liability is being adjusted for the first time and who made an honest mistake normally suffers no penalty at all (rather than a 25% penalty).
The submissions did not criticise the current scale of penalties, which was enacted as part of the generic penalties regime in 2000 and closely followed the scale that applied for income tax from 1992 to 2000.
The Review has concluded that the scale of penalties need not be adjusted.
Where a person has asked the Tax Office for a private ruling and failed to follow it, resulting in a tax shortfall, a penalty applies. This approach is not followed in Canada, New Zealand, the UK or the US. The original rationale for applying this penalty was that, where the Tax Office has issued a private ruling, the taxpayer has sufficient guidance as to the law and, if they disregard it, they have no longer taken reasonable care. Rather than simply ignoring a private ruling, a taxpayer can challenge it if they disagree — either through the objection and appeal processes or by assessing in accordance with the ruling and then objecting to the assessment.
The Review of Business Taxation (commonly called the Ralph Review) took a different view as to the role of private rulings and therefore recommended abolishing this penalty.48
Responses to the discussion paper almost unanimously supported removal of the penalty. They asserted that the penalty can operate as an inappropriate disincentive to taxpayers seeking Tax Office advice and that there are otherwise adequate protections for the revenue if the penalty were abolished. For example, a taxpayer not following a private ruling could still be liable for a penalty for failing to take reasonable care or, for a large item, not having a reasonably arguable position if that is what the facts showed. Also, it would be open to the Tax Office to implement procedures to check whether a taxpayer has followed a ruling, perhaps by requiring a declaration in their tax return.
The penalty for a tax shortfall resulting from a failure to follow a private ruling should be abolished.
Under the existing law, as before self assessment, taxpayers are responsible for errors in returns made by their tax agents. There are no penalties directly for agents, although the criminal offence provisions can apply to them.
On 6 April 1998, the then Assistant Treasurer, Senator the Hon Rod Kemp, announced that the Government had approved a new legislative framework for tax agent services. He said that:
‘The proposals will give taxpayers who engage a tax agent a ‘safe harbour’ from penalties, providing they exercise reasonable care in furnishing all the relevant taxation information to their tax agent.
There will be no sanctions against tax agents who meet a defined standard of reasonable care in the preparation of tax returns … Instead the tax agent may be subject to a disciplinary measure.’
At the request of industry representatives, the Government deferred the implementation of that announcement. There have been recent consultations between government officials and industry representatives about giving effect to this decision, in the context of developing a framework for the regulation of tax agent services.
As these issues are well advanced through a separate process, the Review makes no recommendation in relation to them.
The Tax Office’s power to remit shortfall penalties is theoretically unrestricted. While the law does not set out any conditions or grounds for remission, the Tax Office has published guidelines for its staff in Practice Statements, the most recent being Practice Statement PS LA 2004/5.
The current system of imposition matches the base amount of the penalty to the seriousness of the wrongdoing and fine-tunes that base amount for aggravating or mitigating factors. Consequently, remission of penalties should not be as prevalent as it was before self assessment, when there was a statutory 200% penalty for false or misleading statements as the starting point before remission.
Practitioners and industry representatives have submitted that the Tax Office applies penalties in a ‘speeding infringement’ fashion, even where it may have contributed to the taxpayer failing to meet their obligations. However, the raw quantitative evidence does not show that the Tax Office applies penalties (or fails to remit them) indiscriminately.49
Although the Tax Office has issued a Practice Statement on exercising its remission power, most submissions have said that the Tax Office has not provided sufficient guidance about how it will exercise the power, especially in circumstances where it applies Part IVA (the general anti-avoidance provision).
The Tax Office should explain more fully, for example in a ruling or Practice Statement, how it exercises the discretion to remit tax shortfall penalties, including in Part IVA cases.
If the Tax Office decides not to remit a penalty in full, the current law requires it to notify the taxpayer in writing of the remission decision,50 but does not require reasons for the decision to be given. Submissions to the Review expressed concern that the Tax Office does not adequately explain its penalty decisions — either why the penalty applied or why the Tax Office has not remitted the penalty.
As a matter of fairness, it is important that taxpayers who are subject to a penalty understand why they have been penalised. Furthermore, the Tax Office explaining penalty decisions is consistent with the Tax Office’s Taxpayers’ Charter which says that ‘[y]ou can expect the Tax Office to … explain to you the decisions we make about your tax affairs.’
Currently, when the Tax Office finalises an audit case it gives the taxpayer a full explanation of any penalties imposed. In other cases, such as omission of dividends and interest from returns, the Tax Office provides a full explanation of any penalties on request, but not as a matter of course.
Where the Tax Office decides that a penalty applies and should not be remitted in full, the Tax Office should provide an explanation of why the penalty has been imposed (for example, why the taxpayer has not taken reasonable care or does not have a reasonably arguable position) and why the penalty has not been remitted in full.
One submission argued that there should be a materiality threshold for tax shortfall penalties, when compared to the taxpayer's total liability. In exercising its remission power, the Tax Office does have regard to the materiality of a tax shortfall in some circumstances. Practice Statement PS LA 2004/5 says at paragraph 43 that:
‘If, during an audit activity, a tax officer finds a shortfall amount that results from a lack of reasonable care but in the circumstances of the case the amount is not material, the penalty will be remitted where it is evident that the taxpayer and the tax agent (if any) have, on the whole, made a genuine attempt to comply with the taxpayer’s obligations, and the taxpayer’s overall level of compliance is satisfactory.’
The Tax Office has advised the Review that it intends to draft another Practice Statement to further explain what understatements of liability it regards as immaterial for tax shortfall purposes. The Review has concluded that, because of the administrative action that the Tax Office has taken (and intends to take), it is unnecessary to amend the law to include express rules about remitting where the amount of tax shortfall is immaterial.
The Tax Office should further explain in a ruling or Practice Statement what understatements of liability it regards as immaterial for tax shortfall purposes.
41 . Subsection 284-215(1) of Schedule 1 to the TAA.
42 . Australian Taxation Office 1994, Taxation Rulings TR 94/4 and TR 94/5, Australian Taxation Office, Canberra.
43 . Walstern Pty. Ltd. v Commissioner of Taxation  FCA 1428, which considered section 226K of the ITAA36, the precursor of the current penalty for not having a reasonably arguable position.
44 . The project on the regulation of the tax profession is considering the issue of the appropriate standard of care for taxpayers and tax agents (see below at subsection 4.2.4).
45 . Large items are tax shortfalls exceeding the greater of $10,000 or 1% of the income tax payable.
46 . Section 284-15 of Schedule 1 to the TAA.
47 . Australian Taxation Office 2004, Practice Statement PS LA 2004/5, Australian Taxation Office, Canberra.
48 . Commonwealth of Australia 1999, Review of Business Taxation: A tax system redesigned, July 1999, Commonwealth of Australia, Canberra — the Ralph Review, Recommendation 3.4.
49 . In the 2002-03 year, for example, the Tax Office initiated debit amendments for individuals not in business (excluding tax avoidance cases) that raised total primary tax of around $160 million. Although 90% of these amendments were for omitted income, the total penalty imposed was under $9 million.
50 . Subsection 298-20(2) of Schedule 1 to the TAA.