Tax pooling – a tool for optimal tax risk management

 This article first appeared in the July 2009 edition of Boardroom, the newsletter for the Institute of Directors.

When the government provides a facility to reduce taxpayers’ exposure to tax risk, you would expect a strong take-up rate – and by all accounts, the response to the tax pooling legislation passed in 2003 has been steady.

Precise numbers are difficult to estimate but there is now enough demand to support three public “intermediaries”.  It is timely, however, to revisit the benefits which tax pooling can offer – particularly in the current economic climate when the problems attached to the payment of provisional tax are intensified either through lack of cashflow to fund payments or because actual income for the year is less than expected, leading to over-payment.

In either scenario, the deck is stacked against the taxpayer because rates on use of money interest (UOMI) are skewed in the Inland Revenue Department’s favour.  Over-pay your provisional tax and, effective from 28 June last month, the IRD will pay you only 1.82 per cent UOMI on your money.  Under-pay and you will be charged 8.91 per cent on the overdue amount.  Late payment also exposes the taxpayer to substantial additional penalties.

Use of a tax pooling intermediary can significantly reduce the cost incurred by a business if it underpays its provisional tax, and also increase the reward if it overpays.  So, how does it work?

Instead of paying provisional tax to the IRD, businesses pay it to a tax intermediary, which deposits the payments into a tax pooling account with the IRD.  If a company is cash-strapped and is unable to fully pay its provisional tax during the year, rather than incurring the normal 8.91 per cent UOMI on the under-payment, it can “buy” tax deposited in the tax pooling account by other taxpayers on or before its provisional tax payment dates.

The cost will be equal to the amount of tax bought, plus an amount that gives the “seller” a better return than 1.82 per cent but costs the buyer less than 8.91 per cent.  That tax can then be transferred to the taxpayer’s own account with the IRD with effect from the provisional tax due dates.  Consequently, no UOMI or late-payment penalties are payable by the taxpayer. 

There are two restrictions on this.  One is that the taxpayer must buy the tax within 60 days after its terminal tax date for that tax to be offset against its provisional payments for the preceding year (unless the tax arises in the context of a dispute).  The other is that there must be sufficient overpayments of tax in the pool for the taxpayer to purchase.

To address this latter concern, tax pooling agents can arrange to finance a taxpayer’s provisional tax payment in advance.  In this case, the taxpayer pays the intermediary interest in advance, and the intermediary deposits the required amount in the tax pooling account from its own funds or from the funds of a financial institution with which it has an arrangement. 

When the terminal tax is due, the taxpayer pays an amount equal to the principal sum to the intermediary (or financial institution), which will then credit the amount already deposited in the tax pool against the provisional tax payable by the taxpayer earlier in the year (and refund any excess).

Another advantage of tax pooling is that it enables businesses that overestimate their provisional tax to receive a better interest rate on their overpayment.

Should a participating business find at the end of the year that it has overpaid its provisional tax, the intermediary can sell the excess to other taxpayers in the pool who have under-paid.  Even allowing for the intermediary’s profit margin, the over-payer will be paid more and the under-payer will be charged less than the UOMI rates available from the IRD.

Tax pooling can also be used to reduce the amount of interest and late-payment penalties on unpaid terminal tax.  This can be particularly useful if an IRD audit has detected an unrecognised tax shortfall and payment is required for earlier income years.  Tax pooling agents typically pay up to 50 per cent above the IRD’s UOMI rate for tax overpayments, and charge up to 20 per cent below the IRD’s rate for meeting prior tax underpayments.

One thing to bear in mind is that the intermediaries are commercial enterprises and the IRD is not responsible for their actions.  Consequently if an amount deposited with a tax pooling intermediary is not paid to the IRD on behalf of the taxpayer as promised, the taxpayer will be still be liable to the IRD for the tax.  Various safeguards have, however, been put in place to reduce this risk.  Also companies which deposit amounts with intermediaries are entitled to imputation credits on the date of deposit as if they had paid the amount direct to the IRD.

A bill is now before Parliament to extend the benefits of tax pooling to all kinds of tax, including GST and withholding taxes, and to allow tax payments to be transferred between pools.

Our thanks to Sam Rowe for writing this article.

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