Penalties for the understatement of taxes (known as understatement penalties) can have disastrous financial consequences for taxpayers. These penalties range from 10% to 200% of the shortfall in taxes, depending on the blameworthiness of the taxpayer’s behaviour, and must be paid in addition to the tax properly payable for the relevant period, unless the understatement results from a bona fide inadvertent error.
Understatement penalties are only payable if there is an ‘understatement’. This term is defined in the Tax Administration Act to mean any prejudice to SARS or the fiscus as a result of -
- failure to submit a return required under a tax Act or by the Commissioner;
- an omission from a return;
- an incorrect statement in a return;
- if no return is required, the failure to pay the correct amount of ‘tax’; or
- an ‘impermissible avoidance arrangement’.
Taxpayers have in the past argued that an understatement requires a financial prejudice to SARS or the fiscus, failing which understatement penalties do not apply. That argument was finally put to bed by the Supreme Court of Appeal (SCA) in Purlish Holdings v CSARS 81 SATC 204 in which the Court held that in certain circumstances, even the mere use of additional SARS resources for purposes of auditing a taxpayer’s tax affairs could prejudice SARS. Therefore, in the context of understatement penalties, prejudice is not only determinable in financial terms.
Thus, the requirement of prejudice has been given a fairly wide interpretation and taxpayers are generally unlikely to escape the imposition of understatement penalties by raising a lack of prejudice. So, for example, where a taxpayer is in an assessed loss position, understatement penalties could still apply, even if no tax would in any event have been payable. In that case the shortfall is determined as the difference between the amounts of the assessed loss as shown by the taxpayer and the assessed loss as properly determined, multiplied by the relevant tax rate.
Taxpayers are excused from paying understatement penalties if the understatement results from a bona fide inadvertent error. This elusive term is not defined and has been the subject of many debates.
The Tax Court in ITC 1890 79 SATC 62 gave hope to taxpayers when it interpreted the term as “an innocent misstatement by a taxpayer on his or her return, resulting in an understatement, while acting in good faith and without the intention to deceive.” SARS however rejected this interpretation in its Guide to Understatement Penalties which, as SARS states, “it is entitled to do as tax court judgments, although often instructive, have no binding effect”. The Guide is not an ‘official publication’ and accordingly does not create a practice generally prevailing, although the principles set out therein are likely to be followed by SARS officials in practice.
In its interpretation of the term, SARS seems to take an overly narrow approach and concludes in the Guide that bona fide inadvertent errors are unlikely to consist of anything other than typographical mistakes. Even typographical mistakes, in SARS’s view, must be so-called “properly involuntary ones” to amount to bona fide inadvertent errors. So, for example, a capturing error by a clerk which is not detected during a review by a distracted supervising public officer or tax practitioner will, in SARS’s view, not amount to a bona fide inadvertent error as a lack of reasonable care will not be excused.
The Tax Court in IT 24622 (delivered 11 December 2019) agreed with the view that a lack of reasonable care should not be excused in holding that a bona fide inadvertent error should mean “an honest mistake in the tax return of a taxpayer that occurred notwithstanding the maintenance of procedures reasonably adopted to avoid such errors”. The Tax Court in this case stated that a mistake could not constitute a bona fide inadvertent error if the taxpayer committed any of the blameworthy behaviour categories listed in the understatement penalty percentage table. So, for example, where reasonable care was not taken in completing a return, any resultant error would not be inadvertent. This approach is interesting to note, although as stated above, Tax Court judgments have no binding effect.
Despite the narrow interpretation previously placed on the term by SARS and certain courts, the SCA has now seemingly breathed new life into this debate. In CSARS v The Thistle Trust (516/2021) [2022] ZASCA 153 (7 November 2022), SARS succeeded in holding the Thistle Trust liable for capital gains tax in respect of capital gains distributed to it by underlying trusts which the Thistle Trust had in turn distributed to its beneficiaries. In addition to the tax payable, SARS had imposed a 50% understatement penalty based on a standard case of the behaviour: no reasonable grounds for ‘tax position’ taken. This is often SARS’s behaviour of choice when a taxpayer relies on a tax opinion, as the Thistle Trust did. The view usually adopted by SARS is that reliance on a tax opinion could never amount to a bona fide inadvertent error since such reliance involves deliberate planning which could never amount to an inadvertent error.
Predictably, SARS had initially argued that, in light of the tax opinion, the understatement did not result from a bona fide inadvertent error since the Thistle Trust had consciously and deliberately adopted the position it took when it elected to distribute the capital gains as it did. However, during argument before the Court, counsel for SARS conceded that the understatement by the Thistle Trust resulted from a bona fide and inadvertent error as the Thistle Trust had believed that section 25B of the Income Tax Act applied (as supported by the tax opinion). Based on this concession, the Thistle Trust was excused from paying the understatement penalty. Importantly, the SCA gave its stamp of approval to SARS’s concession by stating that it was “correctly” made.
This notable remark by the SCA should hopefully cause SARS to reconsider its overly narrow interpretation of the term bona fide inadvertent error to extend beyond mere typographical mistakes. We however understand that leave has been sought to take the judgment of the SCA on appeal to the Constitutional Court.