The article and spreadsheet below identifies an IRD practice of double taxing small business owners who have been caught under-declaring income. We agree penalties should apply, but not double tax.

From time to time, some business owners take advantage of an opportunity to take cash out of their business without declaring it for income tax or GST purposes.

Most New Zealanders will regard this as unacceptable, and readers will be no doubt aware that in recent years, Inland Revenue has been targeting the so-called “cash economy”.

In principle we endorse IRD’s actions. There are however aspects of the way IRD is conducting its investigations that cause us very grave concern.

One in particular concerns small business owners that trade through a company. It has become apparent that some IRD staff believe undeclared income must be taxed at both the company and the shareholder levels.

In our view this approach:

  1. contradicts previously stated IRD policy
  2. is unfair and punitive
  3. defies economic reality,
  4. ignores the intention behind the imputation system,
  5. discriminates against businesses trading through companies
  6. will have a serious negative impact on IRDs obligations under the Tax Administration Act.

We implore IRD to:

  1. Correct this misconception amongst staff
  2. Confirm that in all but very unusual (and specified) circumstances, the default position is that such income is derived solely by the individuals
  3. Correct any examples of double tax that come to hand, both currently and also from past assessments

We discuss this issue under the following headings:

  1. The imputation system is designed to tax income once
  2. Some IRD staff try to tax the income twice
  3. Variations are possible – but do not undermine the principle
  4. IRD’s explanation for imposing tax twice
  5. We have experienced this before and IRD claimed to have ceased the practice
  6. Conclusion

The imputation system is designed to tax income once

Where a business is operated through a company, the intention and effect behind New Zealand’s imputation system is that profits are taxed initially at company level, then when the profits are distributed through to shareholders who are on a higher marginal tax rate, they pay a top up. In simple terms, total tax will be paid at the higher of the two rates.

To take a very simple example, a $100 profit is taxed at the company rate of 28%, i.e. $28*. Once distributed through to a shareholder at a 33% marginal tax rate, the shareholder will pay $33 but get a credit for the $28 company tax, leaving a $5 top up. Total tax paid is $33.

*This and all other calculations are excluding GST. We have set them out in a detailed table at the end of this article.

Now consider a business which, for whatever reason, has not declared that hundred dollars, because the shareholders have taken it out of the till and spent it on themselves.

There are a large number of variations on possible outcomes, but we will pick just one.

IRD writes to the taxpayer announcing an intention to carry out an audit, and inviting a voluntary disclosure.

The taxpayer puts their hand up, admits taking money out, makes a formal voluntary disclosure and offers to pay the tax and an appropriate penalty.

In our view the income has never been derived by the company, the income should only be taxed once in the hands of the person getting the benefit, ie the shareholder/employee. Imputation becomes irrelevant.

The base penalty for tax evasion is 150% of the $33 received by the individual, i.e. $49.50. This may be reduced by 40% for having made a “post notification” voluntary disclosure, and a further 50% for having a history of previous “good behaviour”, that is not having been penalised in the previous four years. The evasion penalty drops to $14.85.

Having under declared $100, the taxpayer ends up paying $47.85 including the penalty. In addition the taxpayer will pay backdated “use of money interest”, and having paid the advisors fees, this will be an expensive exercise. Hopefully they won’t do it again!

Some IRD staff try to tax the income twice

Regrettably, some IRD staff try to considerably ramp up the tax.

A number of IRD staff around the country have taken the stance that they will tax the company first, and then tax the individual on top of that. One group even claim this is IRD policy.

Based on the previous example:

  • $100 of under declared income gives rise to $28 of income tax, plus another $12.60 of evasion penalty (after the applicable reductions).
  • The taxpayer has supposedly received a $72 distribution by way of dividend, tax at 33% is $23.76, and another evasion penalty of $10.69.
  • In total, having under declared $100, the taxpayer is expected to fork out a total of just over $75, i.e. a 75% tax rate

Add in backdated use of money interest and the bill could easily go up to 100% of the income or even more, even where the shortfall is disclosed voluntarily. There is a serious disincentive to cooperate with IRD at all.

Variations are possible – but do not undermine the principle

There can be an almost unlimited number of variations on this example.

  • The taxpayer could get in early, before IRD notified an audit (a prenotification disclosure), and the core penalty could be reduced by 75% instead of 40%.
  • IRD might only apply a penalty to the company and not the shareholder, or vice versa
  • Inland Revenue might leap straight to carrying out an audit, and the taxpayer loses the opportunity to get a reduction for voluntary disclosure.
  • Perhaps in the previous four years the taxpayer has incurred a penalty for some unrelated mistake, and they lose the reduction for previous “good behaviour”.

However these only muddy the water. The bottom line is that post the imputation system the income tax liability should be broadly the same whether income is derived by an individual, or via a company intermediary.

IRDs decision to tax income twice contradicts that design.

IRD’s explanation for imposing tax twice

IRD appears to base its conclusions on an assumption that the company has actually received $100 and deliberately not declared it, and then the shareholders have misappropriated the money, giving rise to a second layer of tax.

We consider this is complete nonsense.

In the (fairly typical) scenario we have set out, the company either never sees the income at all and so cannot have derived it (the shareholder pays the tax and the penalties), or sees the income and passes it on as remuneration earned by the shareholder (the shareholder pays the tax and the penalties), or the company sees the income and advances it to the shareholder (the company pays the tax and the penalties).

The adoption by IRD of a policy that is targeted at double tax and double penalties and that assumes a factual interpretation that in all likelihood is incorrect is neither fair nor appropriate.

It discriminates against taxpayers trading through companies by exposing them to double tax and double penalties and ignores any number of rational and more appropriate assessments of fact that can generally be made when income is not declared.

And finally it contradicts IRD’s own national policy – the right hand doesn’t know what the left hand is doing, or does but ignores it.

We have experienced this before and IRD claimed to have ceased the practice

Regrettably, a few years ago we went through an extensive debate with Inland Revenue for a medium-sized business caught up in such a situation, the taxpayer made a voluntary disclosure and in good faith paid tax and a penalty on the correct basis. IRD dragged out an audit for over two years, which ultimately led to a formal complaint to the Institute of Chartered Accountants, a very expensive investigation into IRD’s actions, an apology and a compensation payout to the taxpayer.

In the meantime, in March 2008 a senior IRD manager wrote to us and stated:

[this] issue relates to the cash taken by the shareholder/employee [Mr Taxpayer], which was not declared by either the company or Mr Taxpayer. You were of the view that this undeclared money should be reported as a salary or bonus. However, your concern was that Inland Revenue took the position that the company must pay GST and income tax on the undeclared income, and then the amount in question was also to be treated as an un-imputed dividend solely returnable as income in the returns of Mr Taxpayer.

This case has presented an opportunity for Inland Revenue to review its approach with respect to how unreported income [tax evasion] should be treated once identified.

The position initially taken by the Department was premised on a historical policy on deemed dividends, as set out in Public Information Bulletin 125 published in March 1984 (“PIB 125”).

….

As a result of the changes to the [1985] legislation, it is now clear that the previous practice of deeming all receipts of suppressed income

from a company to be dividends, as set out in PIB 125, no longer correctly reflects the law.

Accordingly, it is no longer appropriate for Inland Revenue to assess all cases of suppressed income by a company to be a deemed dividend. Rather, the Department should look further into the circumstances of each case and consider all the requirements of the legislation, such as the shareholder capacity test, in order to determine the most appropriate treatment for suppressed income.

Your contribution in establishing this is appreciated.

IRD’s current position clearly contradicts that.

A similar issue arose a number of years ago when tax discrepancies were found with Loss Attributing Qualifying Companies. Attempts by IRD to apply double penalties for a single discrepancy, by imposing penalties on both the company and then on the shareholders who were attributed the tax losses, were duly shut down through a legislative change to the penalty rules.

Conclusion

Some might say that a taxpayer who under declares tax deserves all they get. They could also say that if someone exceeds the speed limit between Wellington and Auckland then they should get a speeding ticket for each kilometre they speed, and get 10 speeding tickets for exceeding the limit for 10 km.

By applying this so called “policy” to double tax small tax payers on a one by one basis, and failing to engage at a leadership level, IRD is just setting out to bully taxpayers into excessive settlements. I certainly can’t see IRD taking such an approach with (for example) a large bank or insurance company who can afford to spend millions of dollars on lawyers.

The tax system must not only support taxpayers who comply with the law, but also encourage those that don’t to come forward and put matters right.

IRD’s current approach will undermine that, and must be corrected as a matter of urgency

This spreadsheet illustrates how IRD is double taxing income and compares with the correct tax regime.