WITHHOLDING REGIMES FOR SMALL / MEDIUM BUSINESS AND SELF EMPLOYED TAXPAYERS

WITHHOLDING REGIMES FOR SMALL / MEDIUM BUSINESS AND SELF EMPLOYED TAXPAYERS Matthijs Alink Senior Advisor OECD/CTPA/GR Conference on Taxing Micro and Small Businesses Manila, 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

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

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

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.

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 sourcealso being used for tax on dividends and interest

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

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

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.

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.

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.

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.

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

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

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

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

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

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)

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)

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 action

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

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

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.

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.

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)

Conclusions (2) • Compliance cost considerations are a critical issue • Critical design and operational features include: • High integrity taxpayer identification • Annual reporting system • Information reporting via electronic means (mandated if needed) • Systematically enforcement of reporting obligations • Capability within the tax administration to deal with high volumes of discrepant reports produced by matching programs

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

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

WITHHOLDING REGIMES FOR SMALL / MEDIUM BUSINESS AND SELF EMPLOYED TAXPAYERS