Report on Aspects of Income Tax Self Assessment
This Chapter makes recommendations for change to the design of the General Interest Charge (GIC) to improve its operation in the context of self assessment. It proposes a separate interest charge, with a lower rate, for shortfall cases.
The discussion paper noted that the GIC applies a uniform rate of interest to all overdue tax, whether or not a taxpayer has acted knowingly to create the debt. Thus the GIC outcome is the same for the taxpayer who assesses correctly and leaves $100 unpaid, as the one who under assesses by $100, but pays on time.
In response to the discussion paper, some submissions argued for a lower GIC rate overall. Most, however, focussed on the GIC that accumulates prior to the shortfall being identified and the assessment amended. Many felt that, as a general rule, the Tax Office is too reluctant to remit GIC from the statutory rate, despite seemingly wide powers. This Report proposes a reduced interest rate to apply to shortfalls during the pre-amendment period, and has identified categories of circumstances where interest should be remitted below this benchmark.
In formal terms, the GIC rate is determined by adding a 7% uplift factor to the 90-day bank bill rate (the ‘base rate’).51 The base rate feeds through movements in the overall profile of interest rates, ensuring that the GIC retains commercial relevance. The uplift factor’s role is to make the GIC rate sufficiently high to encourage the payment of tax liabilities when due, discouraging the use of tax debts as a source of business or private finance. Although the GIC is calculated by adding the uplift factor to the base rate, the uplift factor is not intended to reflect the risk premium that applies to the normal finance costs of affected taxpayers, nor to serve as a penalty for having engaged in blameworthy conduct.52
The nominal annual GIC rate is converted to a rate, which is compounded on a daily basis. For the quarter July to September 2004, the GIC rate is 12.51% per annum (0.03418033% per day). Allowing for daily compounding over a year, this would be equivalent to a simple interest rate of 13.32% per annum. That is, a $100 underpayment left to compound daily at the GIC rate would grow to $113.32 over a year.
In recent years, the GIC rate has varied between 11% and 14%.53 For ease of discussion, this Chapter will adopt a 12.5% GIC rate unless stated otherwise.
The GIC resulting from a shortfall will escalate over time, due to the effects of compound interest. Figure 5.1 presents, as a percentage of the shortfall, the GIC that would accrue at an interest rate of 12.5%, for periods up to six years.
Figure 5.1: Accumulation of 12.5% GIC as percentage of shortfall
At a GIC rate of 12.5%, interest charges would be approximately 28% of the shortfall after two years, 65% by the end of the normal four year review period and 112% after six years.
In many (but not all) cases, these figures exaggerate the adverse impact that the GIC would have on a taxpayer, as they do not take account of the ‘loan benefit’ from the use of the shortfall funds. The extent to which a taxpayer receives a loan benefit that offsets the impact of shortfall GIC will depend on a range of factors.54
Businesses tend to carry tax deductible debt as part of their financing structure and the GIC is therefore primarily a cost of finance issue. By design, the GIC will generally impose a substantial premium over the rates at which healthy businesses would normally borrow, the extent of that premium varying according to the businesses’ credit ratings.
With individuals and very small businesses, the impacts can vary significantly. For some, the net impact of the GIC could be favourable or negligible, while others could experience a penalty effect. The fact that many businesses incur GIC, rather than borrow commercially to clear crystallised tax debts, indicates that the GIC rate is not excessive in many instances — and may even constitute a ‘soft’, application-free source of finance. However, for others, rather than providing loan benefits, shortfalls can cause a cash flow crisis, or cause larger debts than a proprietor would voluntarily have allowed to accrue.
The GIC was introduced in 1999 to simplify a complex array of penalties and interest charges applying to late payments and tax shortfalls.55 In the case of shortfalls, this simplification exercise resulted in higher interest for the pre-amendment period.56
By design, for many affected taxpayers the GIC rate will be higher than a readily available commercial alternative. In the situation of non-payment of a known tax debt, this premium can be managed or avoided by arranging to use their alternative lower cost finance. However, in shortfall cases, taxpayers are unaware of their debts. Therefore, any differential between the GIC and their alternative borrowing rate strikes them as a penalty that has been imposed irrespective of whether the conditions for a formal culpability penalty (such as lack of reasonable care) have been triggered. 57
Because taxpayers are not usually in a position to respond to the GIC in shortfall cases, the Review has concluded that full statutory GIC should not apply to shortfalls during the pre-amendment period. The extent to which the application of GIC to shortfalls needs modifying depends on which of three possible roles for shortfall interest charges is considered most appropriate:
- Should shortfalls attract a high interest charge to encourage taxpayers to assess correctly and avoid ‘aggressive’ interpretations of the law?
- Should shortfalls merely attract an interest charge sufficient to compensate the revenue for the delay in receipt of taxes?
- Should the purpose of the shortfall interest charge be to prevent a taxpayer benefiting from having made a shortfall?
The discussion paper canvassed the idea that the GIC’s ‘incentive to pay’ premium might be viewed as an ‘incentive to assess correctly’ in the shortfall context, irrespective of any culpability penalties that might apply. That is, the threat of the GIC (being at a high commercial rate) should encourage taxpayers to take steps to ensure they assess correctly and avoid ‘aggressive’ interpretations of the law. Shortfall GIC would therefore serve as a strict liability quasi-penalty in cases that fell below the ‘lack of reasonable care’ culpability threshold for applying penalties under the penalties regime. Respondents to the discussion paper overwhelmingly rejected such an incentive/penalty role for the GIC, viewing that function as properly the province of the penalties regime.58
This Review concurs with that view. An interest charge is ill suited to such a de facto penalty role, imposing an uncertain effect that depends significantly on factors other than the size of the shortfall and the degree of culpability. In particular, the effect of imposing a penalty interest rate on shortfalls would depend on the period taken for the shortfall to be identified and the rate at which the taxpayer would voluntarily have borrowed a similar amount. Furthermore, the perception that taxpayers are being penalised twice for the same offence, or being penalised where it was decided that no culpability penalty should apply, is undesirable.
In finding that the full GIC rate is excessive for shortfall cases, the Review also considers that capping shortfall GIC — either in proportion to the size of the shortfall or after it has accrued for a certain period — would not be a satisfactory solution. Capping would implicitly accept that a penalty effect was acceptable up to a point.59
The Review recognises that reducing shortfall interest charges might increase the incentives to deliberately under assess. However, this concern should be addressed through the culpability penalty regime, rather than by having a shortfall interest charge regime that implicitly assumes the worst about the cause of shortfalls.
As noted in the discussion paper, a secondary function served by the GIC is to compensate government for the impact of late payments, as delays in tax receipts mean that government borrowing and interest costs are higher than otherwise need be. The base rate is generally accepted as indicating the ‘time value of money’ for government.
A number of submissions asked that the shortfall interest rate be set equal to the base rate (possibly with a small surcharge for administration costs), on the principle that this would put the revenue in the equivalent position to that which would have arisen from correctly assessing in the first place. However, for many taxpayers the base rate would be below — sometimes well below — their normal borrowing rate, potentially giving them significant loan benefits from having made a shortfall. This could provide an incentive for risk-taking across a wide range of high risk sectors. It should also be noted that, because of tax deductibility, the base rate would not normally compensate the revenue fully for the time value of money.60
The Review considers that, in principle, the objective of a shortfall interest charge should be to neutralise loan benefits that taxpayers might typically receive from their shortfall, so that they do not receive an advantage over those who assess correctly.
Ideally, the shortfall interest charge for a given taxpayer would be set at a level just sufficient to offset the loan benefit that the taxpayer received from the shortfall. Given that the GIC is designed to be higher than the borrowing rate for most affected taxpayers, an offsetting rate would, in most instances, be lower than the GIC. The level of that rate would also depend on whether the taxpayer normally had access to tax deductible financing.
In practice, it is not feasible to fine-tune the interest charge to the circumstances of each taxpayer. Further, it is not feasible to apply differential rates to different market segments (such as individuals, very small businesses and other businesses), because the loan benefit within segments can vary widely. Similarly, because tax deductibility is only one factor affecting the impact of shortfall interest on a particular taxpayer, the Review does not recommend altering current arrangements whereby all GIC is tax deductible.
The Review therefore proposes a uniform interest charge on shortfall amounts. A consequence of having a single rate is that, in practice, some taxpayers will receive a loan benefit and some taxpayers will incur a penalty effect after paying the shortfall interest charge. Once the shortfall and related interest have been notified to the taxpayer, the GIC should operate normally at the usual rate.
From the 2004-05 income year, the standard interest charge applying to income tax shortfalls (that is, the tax difference between the original and amended assessment) should be lower than the GIC rate, reflecting the benchmark cost of finance for a business.
Review participants were overwhelmingly in favour of a lower shortfall interest rate being implemented through a legislative regime, rather than being subject to Tax Office discretion by implementation through remission powers.
The Review concurs with this approach. Legislating the new benchmark as a separate charge — rather than as a standardised remission of GIC — would provide better certainty and transparency for taxpayers.
Moreover, the Review was unable to identify circumstances that warrant retaining a discretion to apply the full GIC rate to shortfalls during the pre-amendment period. While several participants suggested retaining full GIC in cases of fraud and evasion, the Review considers that even these cases should be penalised under the culpability penalty regime, rather than through the uncertain impact of a high interest rate.
The new lower uplift factor should be implemented by a separate pre-amendment shortfall interest charge, in lieu of the GIC. GIC will continue to apply to crystallised debts from the new due date.
Section 8AAG of the Taxation Administration Act 1953 provides the Tax Office with the power to remit GIC in certain circumstances. The Tax Office’s remission policy is presented in Part F, Chapter 93 of its Receivables Policy.61 However, both the Act and the Receivables Policy predominantly address GIC incurred on late payments of assessed tax, rather than remission in shortfall cases.
In interpreting how its GIC remission power should be used and requiring taxpayers to apply for remission, the Tax Office places significant emphasis on a presumption that full GIC should normally apply.
Under the current rules, if the Tax Office decides not to remit an amount of GIC in full, a taxpayer cannot use the normal objection and review provisions to obtain a review on the merits of the Tax Office’s decision. However, the taxpayer can use administrative law actions to challenge whether a decision not to remit was made according to law.
Although the law ultimately places the responsibility for assessment on the taxpayer, the Review recognises that faults in the law or its administration can be a factor behind some shortfall cases. This will not be a problem where the shortfall interest charge merely offsets the loan benefit that a taxpayer received from having made a shortfall. However, even at the new, lower rate for shortfalls, there will be instances where a taxpayer will experience a penalty effect by virtue of that rate being above that at which they would knowingly have borrowed. The potential penalty effect makes it appropriate that remission of shortfall interest from the new benchmark should still be allowable.
Given that practical administration necessitates a uniform rate, the presence of a penalty effect should not, of itself, provide a basis for remission nor need it be established as a pre-requisite to remission. Rather, remission should generally require circumstances such as delay, contributory cause or fault on the part of the Tax Office or other parties that would justify the revenue bearing part of the cost of delayed receipt of taxes.62 Where these circumstances are readily apparent, the Tax Office should initiate remission. To provide flexibility and to guard against taxpayers acting in ‘bad faith’, the Commissioner would retain the discretion not to remit.
The Commissioner should have a broad discretion to remit the new shortfall interest charge, where he considers it fair and reasonable.
Without limiting the generality of the above:
The following examples illustrate where remission in part would generally be appropriate and remission in full should be considered. None of these examples should be taken as grounds for remission unless the taxpayer has acted in good faith.
To limit the consequences of uncertainty that taxpayers face in undertaking self assessment, remission of shortfall interest should be considered where:
- the Tax Office took longer to complete an audit than could reasonably have been expected, having regard to all the facts and circumstances of the case
- even though there was no delay by the Tax Office, the complexity of issues involved resulted in an abnormal time between the commencement of the audit and the amendment of the assessment
- the Tax Office has, by advice or action, contributed to the taxpayer’s error giving rise to the shortfall
- taxpayers relied on the statute law or judicial interpretation as it stood at the time, only to find that subsequent events proved they were not applicable
- taxpayers are affected by a retrospective change in legislation
- a shortfall caused negligible revenue impact. An example of this would be where joint income has been incorrectly apportioned between taxpayers with equal marginal rates. In such cases, shortfall interest should merely offset the related interest on overpayments.
Remission may also be considered to encourage taxpayers to voluntarily self amend when they become aware that they have a shortfall. This would not generally include cases where a taxpayer is merely responding to a Tax Office announcement that certain arrangements were ineffective — although the Tax Office may also offer interest incentives to settle in such cases. Similarly, specific interest rate remission policies could be adopted by the Tax Office as part of particular compliance programs.
Participants supported remission decisions being reviewable. The Review supports such a review right where the shortfall interest imposed exceeds 20% of the tax shortfall. Below this, the cost of objections and appeals would be excessive and may outweigh the potential for a penalty effect from the shortfall interest rate being above the taxpayer’s borrowing rate. Reviews would be based on the considerations outlined above.
Where unremitted shortfall interest exceeds 20% of the tax shortfall, the taxpayer should be entitled to object to the decision not to remit. Objection decisions should be subject to review and appeal where the shortfall interest remaining after determination of the objection exceeds 20% of the tax shortfall.
To ensure taxpayers know their rights, the Tax Office should advise them how to seek remission when notifying them of a shortfall interest liability.
When notifying taxpayers of a shortfall interest liability, the Tax Office should advise taxpayers on how to seek remission.
To improve confidence in the objectivity of Tax Office remission decisions, the Tax Office should provide reasons for rejecting requests for remission of shortfall interest.
The Tax Office should provide reasons for rejecting shortfall interest remission requests.
51 . Section 8AAD TAA. More fully, the base interest rate is the monthly average yield of 90-day Bank Accepted Bills published by the Reserve Bank of Australia for the middle month of the preceding quarter. The uplift factor was reduced in 2001 from its original value of 8%.
52 . Culpability penalties are discussed in Chapter 4.
54 . The discussion paper (pp. 60–63) illustrated these factors through a series of cameos. Key issues are the taxpayer’s alternative borrowing rate, any abnormal benefit from tax deductibility and how the shortfall funds are applied.
55 . The Small Business Deregulation Task Force reported confusion among small business over how penalties were determined (Commonwealth of Australia 1996, Time for Business: Report of the small business deregulation task force, Commonwealth of Australia, Canberra – the Bell Report pp. 44–45). In response, the Government considered the complexity of penalty arrangements to be the major factor behind taxpayer confusion and misunderstanding, and asked the Tax Office to develop options for simplification (Commonwealth of Australia statement by the Prime Minister, the Honourable John Howard, MP 1997, More Time for Business, Commonwealth of Australia, Canberra).
56 . Previously, income tax shortfalls were subject to Underpayment Interest, a (tax deductible) interest charge equal to the base rate plus 4%. An equivalent uplift factor applied to the interest charge (Late Payment Interest) imposed on late payments of assessed income tax — but such late payments were also subject to a (non tax deductible) Late Payment Penalty of 8% per annum.
57 . Deliberate shortfalls are discussed at section 5.3.
58 . Some participants were, however, less concerned about applying full GIC to shortfalls that did not result from inadvertence or differing interpretation of tax law — particularly where fraud or evasion are involved (see section 5.3).
59 . Capping can, however, be an appropriate tool where circumstances warrant partial remission of GIC that accrues on late payments of assessed taxes. See discussion paper at section 5.4.
60 . However, as noted in the discussion paper, this consideration need not preclude shortfall interest charges being at, or even below, the base rate, where there are reasons why the government should accept delay in revenue collection without full compensation (see subsection 5.4.1 of this report).
61 . Australian Taxation Office 2003, Australian Taxation Office Receivables Policy, Australian Taxation Office, Canberra, <http://law.ato.gov.au/atolaw/view.htm?docid=RMP/RP0001>.
62 . A remission power would also give the Commissioner flexibility to remit where otherwise appropriate.
Next: Chapter 6: Other issues