Understatement Penalties in hindsight

taxation 2Some 20 months after the introduction of Understatement Penalties, it is worth taking stock of where taxpayers find themselves following their introduction, and highlighting some of the challenges they are experiencing.

Many taxpayers have become all too familiar with this Understatement Penalty Percentage Table (fig. 1 below) contained in section 223 of the Tax Administration Act No 28 of 2011 (“the TAA”), which was mercifully amended earlier this year by the reduction of some of the penalty percentages:

Figure 1. Understatement Penalty Percentage Table

Item Behaviour Standard case If obstructive, or if it is a ‘repeat case’ Voluntary disclosure after notification of audit or investigation Voluntary disclosure before notification of audit or investigation
(i) ‘Substantial understatement’ 10% 20% 5% 0%
(ii) Reasonable care not taken in completing return 25% 50% 15% 0%
(iii) No reasonable grounds for ‘tax position’ taken 50% 75% 25% 0%
(iv) Gross negligence 100% 125% 50% 5%
(v) Intentional tax evasion 150% 200% 75% 10%

 

The understatement penalties – not to be confused with underestimation penalties imposed for underestimating provisional tax – are levied as result of a taxpayer’s understatement. An understatement is defined to mean any prejudice to SARS or the fiscus due to a default, omission, incorrect statement, or the failure to pay the correct amount of tax.

Burden of proof
Section 222(2) of the TAA requires the penalties to be calculated by applying the highest applicable understatement penalty to the relevant shortfall. Although the burden of proof, which it determines the applicable understatement penalty, is legislatively placed on SARS, we find that taxpayers are typically compelled to justify why SARS should not levy the more onerous percentages listed in the table.

Assessed losses and penalties
Taxpayers who find themselves in assessed loss positions have regularly been taken aback by SARS levying the penalties where timing errors have occurred. While an uncorrected error made by a taxpayer still in an assessed loss position will result in an understatement in a future year of assessment, by definition, an understatement cannot occur in the year of assessment. SARS, however, levy penalties on shortfalls resulting from the difference between the balance of an assessed loss corrected for an error and an assessed loss affected by an error. But it fails to consider whether SARS or the fiscus was prejudiced as a result or not.

Bona fide errors
SARS may not levy the penalties if an understatement results from a ‘bona fide inadvertent error’. The term is unfortunately not defined and taxpayers are accordingly at the mercy of what SARS perceives this concept to mean. To date, we are yet to see SARS acknowledge that once the corporate veil is pierced a taxpayer is but human and prone to making mistakes, even where reasonable care is taken.

Retrospective application
While it’s one thing to be aware of these penalties and to plan one’s tax matters accordingly, it’s quite another to be subjected to them on matters arising before their introduction. Currently, the penalties are levied retrospectively to understatements that occurred before the introduction of the penalty legislation. Our view is that it is unconstitutional and administratively unjust to apply legislation retrospectively, but this assessment is not shared by SARS.

Voluntary disclosure
As illustrated in the table, a taxpayer can avail itself of the Voluntary Disclosure Program (VDP) to disclose errors to SARS, preferably before notification of an audit or investigation, thereby reducing the penalty percentages significantly. However, disclosure under the VDP nevertheless requires awareness of errors and as humans, we unfortunately and inadvertently make errors without being aware of them.

We hope that in time, taxpayers and SARS can see eye-to-eye on these challenges. In the meantime, taxpayers are cautioned to take extra care in managing their tax matters, past and present.

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