Centre for Tax Policy and Administration

Organisation for Economic Co-operation and Development

WITHHOLDING REGIMES FOR SMALL / MEDIUM BUSINESS AND SELF EMPLOYED TAXPAYERS

Matthijs AlinkSenior Advisor OECD/CTPA/GR

Conference on Taxing Micro and Small

BusinessesManila, Philippines, 2 – 5 March

2010

Withholding and Micro and Small Businesses

Principles of taxation Core activities of tax administration Withholding at source Collection by Advance instalment payment Pre populated tax returns Withholding at source – cornerstone of effective taxation Withholding and SMEs Overview of regimes for business taxpayers Purpose of withholding and reporting regimes Practical problems The potential of reducing non-compliance Administrative burden on business Conclusions and recommendations

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Principles of Taxation

Equality: contribution in proportion to ability / revenue

Certainty: time of payment, manner of payment, quantity to be paid clear

Convenient timing for the taxpayer Efficient collection: lowest cost for taxpayer and

tax administration

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Core Activities of tax administration

Information is key

Collecting information from taxpayers Collecting information from third parties Providing information to taxpayers Providing information to third parties

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Withholding at source

The amount of income tax returns to be declared by employees can be reduced by introducing of a withholding system.

If the withholdings are calculated based on the same systematic, that is used for income tax purposes, cumulated and including eventually progression, then the amount of wage tax and social security contributions withheld during the year approximates to the full-year income tax and social security liability.

In these cases there is no need for employees to file income tax returns at the end of the year.

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Withholding at source(2)

Employers must provide the tax administration with information on salaries and wages paid to individual taxpayers and the taxes and social security contributions withheld in respect of these individuals. 

This system is very cost effective for the tax administration. It puts the administrative burden on the employers.

The information given by the employers to the tax administration is used to check the income tax returns of the individual employees. 

Withholding at source also being used for tax on dividends and interest

  

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Different types of withholding systems

Cumulative withholding – largely return free Non-cumulative withholding – annual tax return

required Pre-populated returns sent to taxpayers No withholding; taxpayers’ pay by instalment –

annual tax return required

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Collection of income taxes by advance/instalment payments of tax

In the absence of a withholding system, there is a need for an alternate approach to ensure a timely flow of tax revenue

Advance payments/instalments of tax for PIT and CIT

Design considerations for advance payments systems:

Reasonable compliance burden for taxpayer Reasonable workload for Tax Administration

(efficiency) Effective payment levels Government cash flow requirements Equal treatment of taxpayers

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Pre-populated tax returns

A pre-populated tax return is a tax return prepared by the tax administration for the taxpayer.

To prepare these tax returns, the tax administration is using information from its own records and also information from third-parties.

Pre-populated tax returns include relevant information on Personal identification of the taxpayer (including spouse

and other dependents) Income sources and amounts of income paid to the

taxpayer Tax withheld at source, specific deductions, personal relief,

tax credits Relevant prior taxpayer history information Calculations of tax payable/refundable based on known

information.

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Precondition for introducing a system of pre-populated tax returns

Absolute precondition for introducing a system of pre-populated tax returns is the availability of third party information.

Legal obligation requiring third parties to report income (for example wages, pensions, government benefits, interest and dividends), assets and deduction-related information (home mortgage interest, child care, pension contributions) at the individual taxpayer level to the tax administration.

Third parties should use personal identification numbers to identify the taxpayers involved and also the employers and banks and other parties involved.

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Role of taxpayers

Taxpayers are required to respond to the return they have received

Either by confirming that the return is complete and correct

Or by providing additional information to give a complete and accurate picture of their tax affairs.

More sophisticated is a system of “deeming acceptance” if no reaction is received after a prescribed period.

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Benefits of the system of pre-populated tax returns

The benefits of this system both for the taxpayers and for the tax administration are more significant the lower the rate of non-adjustments by the taxpayers is.

Reasons for adjustments are generally deduction-related or in the sphere of income not taxable for wage taxes.

The introduction of a pre-populated tax return system can be an incentive to simplify the tax legislation by limiting the range of deductions to verifiable deductions using third party information or by using a system of fixed amounts that can be calculated by the tax administration.

The system is giving certainty to the taxpayer in advance and is reducing the numbers of disputed assessments.

Improvement of overall compliance may be expected where the system serves the taxpayer and gives the tax administration the opportunity to demonstrate which information it has. 12

Withholding at source cornerstone of effective taxation

Withholding at source arrangements are generally regarded as the cornerstone of an effective personal income tax system

Obligation on third parties to withhold an amount of tax from payments of income to taxpayers reduces / eliminates their ability to understate such income for tax assessment purposes

Cost efficient both for taxpayers and Tax Administration

Reduces the incidence of unpaid taxes by taxpayers who otherwise might properly report their income but are unable to pay

Proper flow of revenue assists budgetary management

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SMEs / Self employed taxpayersCompliance rationale for Withholding and /

or Information Reporting regimes

Research provides evidence that very high levels of compliance can be (and are being) achieved in respect of income that is subject to both withholding and information reporting requirements

Lesser (but still reasonable high) levels of compliance can be achieved in respect of income that is subject to substantial information reporting (that is used systematically by the tax administration)

Compliance is likely to be considerably less in respect of income from SME/ self-employment activities that is neither subject to withholding nor information reporting requirements

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Overview of regimes for business taxpayers in seven surveyed countries(1)

Country

Name of regime Nature of regime

Industries targeted

Year begun

Canada Contract Payments Reporting System

Reporting only

Construction & goods and services provided to Federal government Bodies

1999

Ireland Relevant Contracts Tax

Reporting Construction, meat processing & forestry

1970

Professional Services Withholding Tax

Withholding & Reporting

Professional services

1987

Third Party Returns

Reporting Very broad coverage

1992

Japan Statutory Withholding & Reporting

Withholding & Reporting

Specific categories of remuneration & fees

1899

NZ Schedular payments

Withholding & Reporting

Very broad coverage

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Overview of regimes for business taxpayers in seven surveyed countries (2)

Country

Name of regime Nature of regime

Industries targeted

Year begun

Norway Withholding tax fishermen

Withholding & Reporting

Fishing 1956

Contracts with foreign enterprises or self employed

Reporting Building & Construction and selected other services

2008

UK Construction Industry Scheme

Withholding & Reporting

Construction 1972

USA Information Returns Program and Backup withholding

Reporting & Withholding

Very broad coverage

195419842011

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Target groups

The industries targeted for either withholding and / or reporting vary across countries

Fairly common are: Construction. Professional Services Agriculture including fishing Contract payments by Government bodies

(including local government and quasi-government agencies

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Purpose of withholding and reporting regimes

Improved compliance and risk detection (taxpayers operating in cash economy)

Equity/alignment between taxpayers (self-employed and employees)

Budgetary management Convenient timing of payment for taxpayers

(reducing compliance burden for taxpayers)

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Key features of withholding regimes

Rates of withholding are variable Frequency of tax withholding payments is usually

monthly Reporting frequency is a mixture of immediate,

monthly and annual Electronic reporting is possible in most countries.

In a number of countries electronic reporting is mandatory for larger taxpayers

However in most cases Tax Administrations are still receiving the vast majority of information on paper

Effective reporting regimes require the use of high integrity taxpayer identifiers (TIN)

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Administrative features matching process

Matching process produces a large inventory of cases requiring some form of follow up attention

The extend to which understatements of reported income can be accurately identified and quantified depends on whether corresponding income items are separately identified in taxpayers’ returns (which is not always the case).

Automated selection systems are used to deliver cases to tax officials ( including audit staff) for review

Linkages exist to non-filer/ late filer programs, enabling use of the reports to determine potentially productive cases for follow up action20

Practical problems that hinder or complicate the operation of the

regimes Taxpayer identification (obtaining correct TINs

and associated information) Paper reports: large volumes receiving low

priority and reducing the ability of computerised matching to detect omissions of income and to rank cases on revenue potential

Tax return form design: matching systems are most effective when reported payments by third parties can be matched with corresponding information in tax returns. This is complicated for SME/ self employed income because not all sources of income are covered by reporting information and taxpayers only provide aggregate information in their tax returns 21

Other practical problems

Confusion or lack of awareness by taxpayers and others concerning reporting obligations

This would require: Better taxpayer education Clear reporting obligations Increasing outreach activities to tax preparers

and software vendors to promote awareness of reporting obligations

Providing Internet-based forms for reporting purposes

Standardizing reporting due dates for all information categories

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Reducing non-compliance of SME taxpayers the potential of withholding and reporting

regimes Compliance related research provides evidence

of the relative effectiveness of withholding programmes in achieving high levels of compliance by taxpayers

This also applies for reporting programmes where these are systematically enforced and applied

There are indications of a trend to make greater use of these tools for compliance improvement objectives

Surveyed Tax Administrations consider these tools to be very effective

However they require a fair administrative effort on their part to be fully effective

And also efforts are required to keep the administrative burden put on business at a minimum.

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Administrative burden on business

Data availability: VAT systems already operate on the basis of and invoice between contracting parties containing all of the information required for an information reporting regime. Accounting software packages can produce aggregated invoice payment data to support an annual reporting application.

Equity and revenue: Business and governments are already required to report payments to their employees. And financial institutions and corporations on interest and dividend payments to their investors.

Helping taxpayers by convenient timing of tax payments by using withholding mechanisms.24

Conclusions (1)

A number of Tax administrations administer extensive withholding and / or reporting regimes in respect of the incomes of SME/ self employed taxpayers

Governments prefer reporting-only regimes Some reporting regimes provide for a withholding

component as a sanction for inadequate taxpayer identification or poor compliance

There is a lack of quantitative information on the actual compliance impacts of the regimes in the SME/ self employed sector ( research findings for other income categories such as employment and investment are high)25

Conclusions (2)

Compliance cost considerations are a critical issue

Critical design and operational features include:1.High integrity taxpayer identification2.Annual reporting system3. Information reporting via electronic means

(mandated if needed)4.Systematically enforcement of reporting

obligations5.Capability within the tax administration to deal

with high volumes of discrepant reports produced by matching programs

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Future arrangements could entail An annual information reporting regime requiring

third party reporting from business, government bodies, and others involved in payments made to/by business

This could include a withholding component as a sanction for inadequate taxpayer identification or poor compliance history

Mandated use of electronic reporting by larger business and government bodies and user friendly web-based reporting facilities for smaller business

Innovative uses of such third party reporting to assist taxpayers correctly prepare their tax returns – get it right from the start! – to reduce the need for post-assessment verification action

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Recommendations

Ministries of Finance and Tax Administrations seeking to achieve significant improvements in voluntary compliance by SME/ self-employed taxpayers are strongly encouraged to explore the potential benefits and costs of withholding and reporting regimes where such arrangements are currently not being used

Tax Administrations operating withholding/reporting systems, or planning to do so, are encouraged to put in place an appropriate set of performance measures to enable them to periodically evaluate their regimes’ operation and compliance impacts

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