Interpretation Note for public comment: Understatement penalty and meaning of “maximum tax rate applicable to the taxpayer”

SARS released an Interpretation Note in March 2022 for public comment due on or before 27 May 2022.

The relevant law is Section 222(5) of the Tax Administration Act.

This Note provides clarity on the interpretation and application of the phrase “maximum tax rate applicable to the taxpayer” used in section 222(5) when the tax rate applicable to the shortfall determined under subsections (3) and (4) is applied.

The TA Act provides for an understatement penalty to be imposed where a taxpayer has made an understatement. The main purpose of the understatement penalty regime is to deter behaviours that result in non-compliant reporting, and the understatement penalty framework aims at ensuring consistent and equal treatment of taxpayers in comparable circumstances.

Section 222(2) stipulates that the highest understatement penalty percentage must be applied to each shortfall determined under subsections (3) and (4). Section 222(5) provides that the tax rate applicable to the shortfall determined under thesesubsections is the “maximum tax rate applicable to the taxpayer, ignoring an assessed loss or any other benefit brought forward from a preceding tax period to the tax period”.

There is uncertainty as to how the “maximum tax rate applicable to the taxpayer” may be applied to a taxpayer that has made an understatement and is in an assessed loss position. This Note provides clarity on the rate to be applied in circumstances where the taxpayer is in an assessed loss position after the understatement is corrected.

Section 222 of the TAA is given below.



Interpretation and application of the law

Section 222(1) provides that in the event of an understatement by a taxpayer, an understatement penalty determined under subsection (2) must be paid in addition to the tax payable for the tax period, unless the understatement is as a result of a bona fide inadvertent error.

An “understatement” is defined in section 221 and means any prejudice to SARS or the fiscus as a result of:

(a) failure to submit a return required under a tax Act or by the Commissioner;
(b) an omission from a return;
(c) an incorrect statement in a return;
(d) if no return is required, the failure to pay the correct amount of “tax”; or
(e) an “impermissible avoidance arrangement”.

In accordance with section 222(2), the understatement penalty is determined in relation to each understatement by applying the highest applicable understatement penalty percentage to each shortfall determined under subsections (3) and (4).

Section 222(3) provides that the shortfall is the sum of:

(i) the difference between the amount of ‘tax’ properly chargeable for the tax period and the amount of ‘tax’ that would have been chargeable for the tax period if the ‘understatement’ were accepted;
(ii) the difference between the amount properly refundable for the tax period and the amount that would have been refundable if the ‘understatement’ were accepted; and
(iii) the difference between the amount of an assessed loss or any other benefit to the taxpayer properly carried forward from the tax period to a succeeding tax period and the amount that would have been carried forward if the understatement were accepted, multiplied by the tax rate determined under subsection (5).

“Shortfall” in tax [section 222(3)]

The first step in calculating the understatement penalty is to determine the “shortfall”.

The shortfall is essentially the sum of the difference between the correct amount of tax and the tax that was reported by a taxpayer during a tax period.

However, not all taxpayers are in a tax payable position as some taxpayers may, after the correction of the understatement, have an assessed loss for the tax period resulting in no tax being payable. In such cases, the shortfall is determined in reference to the specific position of a taxpayer in the tax period in which an understatement is made.

Shortfall when a taxpayer is in a tax payable position [section 222(3)(a)]

Section 222(3)(a) applies when a taxpayer is in a tax payable position after the understatement is corrected. A taxpayer may, however, be in a loss position before the understatement is corrected, in which case section 222(3)(c) also applies as inaccordance with section 222(3), the shortfall is the sum of paragraphs (a), (b) and (c). As it pertains to the tax payable position, the “shortfall” is the difference between the amount of tax properly chargeable for the tax period and the amount of tax that would have been chargeable if the understatement were accepted by SARS.

The amount of “tax properly chargeable” is the correct amount of tax determined under a tax Act after correcting the understatement.

As this calculation determines the tax payable portion of the shortfall, the revised taxable income or taxable turnover will be subject to either a flat or progressive rate of tax in accordance with the applicable legislation. Since the shortfall associated with the understatement is expressed in an amount of tax, section 222(5) is not applicable.

SARS has provided some excellent examples to assist the reader. These are given below as extracts from the Guidance Note.



Shortfall when the taxpayer is in a refund position [section 222(3)(b)]

Section 222(3)(b) applies when the amount properly refundable for the tax period reduces the amount that would have been refundable if the understatement were accepted. As the refund before and after the correction of the understatement is stated
in an amount in tax, section 222(5) is not applicable.



Shortfall when the taxpayer is in an assessed loss position [section 222(3)(c)]

Section 222(3)(c) applies when a taxpayer is in a loss position before the understatement is corrected. A taxpayer may, however, be in a tax payable position after the understatement is corrected, in which case section 222(3)(a) also applies as in accordance with section 222(3), the shortfall is the sum of paragraphs (a), (b) and (c). As it pertains to the loss position, the shortfall is the difference between the amount of an assessed loss or any other benefit to the taxpayer properly carried forward from the tax period in which the understatement occurs to a succeeding tax period and the amount that would have been carried forward if the understatement were accepted, multiplied by the tax rate determined under subsection (5).

Since the calculation in the scenario under section 222(3)(c), determines the loss position, there is no tax properly chargeable. Therefore, to determine the shortfall in tax, the tax rate to be applied to the aforementioned difference as provided in section 222(5), is the “maximum tax rate applicable to the taxpayer”. This tax rate is determined by ignoring any assessed loss or any other benefit brought forward from the preceding tax period to the tax period concerned.

Meaning of “maximum tax rate applicable to the taxpayer”

The phrase “maximum tax rate applicable to the taxpayer” used in section 222(5) for purposes of levying the understatement penalty under circumstances envisaged in section 222(3)(c) requires scrutiny based on the ordinary principles of interpretation. Commentary from tax court cases assist in this regard.

In C: SARS v Terraplas SA (Pty) Ltd, Judge JA Navsa said, “Any one of a number of dictionary meanings of a word is not necessarily conclusive in the interpretation of words and phrases in statutes and documents. Meanings have to be determined contextually.”

Therefore, a dictionary meaning of a word cannot be conclusive on its interpretation. It can only afford a starting point, and where a word has more than one meaning, as the dictionary does not prescribe priorities of meaning, the applicable meaning must be discerned from the context of the particular section under consideration.

In order to interpret the ordinary meaning of the phrase “maximum tax rate applicable to the taxpayer”, regard must be given to the context in which the phrase appears in section 222(5) and the purpose of the legislation.

Returning to the phrase “maximum tax rate applicable to the taxpayer”, the word “maximum” is used to describe the legislated tax rate to be applied to the shortfall. The ordinary meaning of the word “maximum” when used as an adjective is defined in the Lexico Dictionary as follows: “As great, high or intense as possible or permitted”.

It is thus clear that the highest possible or permitted tax rate, applicable to that taxpayer, must be applied to the difference between the stated and properly carried forward amount described in section 222(3)(c) to determine the shortfall in the amount of tax. This tax rate must, however, be applied to “the taxpayer” who has made the understatement and it must be determined by ignoring the assessed losses or any other benefits brought forward from a preceding tax period.

Conclusion
Section 222 imposes an understatement penalty in the event of an understatement by a taxpayer, except if the understatement is as a result of a bona fide inadvertent error.

The understatement penalty is determined by applying the highest applicable understatement penalty percentage in accordance with the table in section 223 to each shortfall. Each “shortfall” is determined under section 222(3) as the sum of paragraph (a), (b) and (c) depending on the specific facts of the taxpayer for the respective tax period to determine the shortfall in tax.

The facts and circumstances of each taxpayer must be considered to determine what tax rate will apply when determining the “maximum tax rate” for purposes of determining the shortfall in tax under section 222(3)(c).

A second article will deal with aspects of “flat rate of tax” and “progressive rate of tax” for sections 222 and 223 of the TAA and the taxpayer and the applicable penalty percentages.

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