Chapter 1 - Overview
1.1 One of the basic design principles of GST is that businesses should not be subject to the tax when producing goods and services. The credit-invoice mechanism, which ensures that the legal incidence of the tax is removed on most business purchases, prevents that happening. It also prevents the tax from "cascading" as goods and services are supplied between businesses that are registered for GST.
1.2 The compliance costs inherent in the credit-invoice mechanism are a trade-off against the benefit that comes from the comprehensive application of GST to goods and services that are imported, produced and distributed in New Zealand. The mechanism also ensures that businesses are tax-neutral in the sense that when a business pays GST, it can deduct input tax.
1.3 The operation of GST in this manner is not, however, without its problems, particularly for transactions involving the supply of significant assets, such as the sale of businesses, land, or other high-value assets. These problems can include, for example, a transaction not qualifying under the legislation that would zero-rate a "going concern" or an invoicing error resulting in a purchaser's expected input tax (sometimes referred to as a GST "refund" or GST "credit") entitlement being denied. Because the assets are significant, they are infrequently traded and can create GST consequences that businesses may not have expected or planned for.
1.4 Such GST errors can be particularly costly for businesses, resulting in penalties and use-of-money interest being applied and the reduction of any profit margin on the transaction if the tax becomes an irrecoverable business cost. Government revenue losses can also occur if an input tax entitlement does not result in the corresponding payment of GST to Inland Revenue as a result of arrangements aimed at achieving this effect.
1.5 The purpose of this officials' paper is to suggest a number of options to solve the problems that can arise in connection with the supply of significant assets, and to improve the operation of the Goods and Services Tax Act 1985 for businesses and the government. As part of the discussion, we have suggested measures to help ensure business neutrality and reduce base maintenance risks associated with GST. The rules applicable to changes in taxable use and the supply of accommodation are also considered. Our objective is to seek public comment on a range of policy solutions before formal recommendations are made to the government.
Business-to-business neutrality explained
1.6 Because GST is designed to tax consumption rather than production, transactions between businesses should generally be GST-neutral unless express exemptions are provided (for example, the supply of financial services). The terms "GST-neutral" and "business-to-business neutrality" describe the situation where GST paid by a business can be claimed against the GST payable on taxable supplies. A business is "neutral" about the purchase of goods and services if the GST it pays does not become a permanent business cost.
1.7 To reduce revenue risks to the government that could arise if GST were deductible by individuals or entities that make minimal or no supplies on which GST is charged, the GST Act prescribes the circumstances for neutrality to occur. These include the requirements to carry on a "taxable activity" and register for GST. There should also be a connection with making taxable supplies. These requirements set the necessary parameters for taxpayers to be viewed as being involved in the intermediate production of goods and services so that they are entitled to deduct input tax.
1.8 The ideal consumption tax system would ensure perfect neutrality for both businesses and the government in business-to-business transactions. Perfect neutrality would be achievable in practice if GST did not apply at every stage of production and distribution but applied only at the point of final consumption, as happens with retail sales taxes. However, retail sales taxes are more likely to be exposed to evasion than is GST because of the opportunity for goods and services to be untaxed if acquired by consumers from wholesalers, importers or other providers who are not identified as "retailers".
1.9 The trade-off associated with the government preferring GST over a retail sales tax is the challenge of ensuring that business neutrality is achieved to the greatest extent possible. This includes the need to ensure that in all but exceptional business-to-business transactions, refunds of GST will be met by a corresponding payment of GST.
1.10 We have reviewed the treatment of business-to-business supplies and, in summary, consider that:
- GST is not designed to be a tax on business, with suppliers of exempt goods and services being the exception.
- GST-registered businesses have an expectation that GST should not be a direct cost on businesses. This means that input tax entitlements should be promptly refunded, subject to the appropriate level of Inland Revenue enquiry.
- Similarly, the government should have an expectation that transactions between GST-registered businesses are neutral.
- The GST Act should provide effective and clear rules that ensure that GST does not unnecessarily hinder transactions between GST-registered persons.
1.11 As we have noted, if GST-registered businesses are not entitled to input tax deductions, GST can have a direct negative operational effect on the distribution of resources and profitability. In line with this theme, this document considers:
- the cashflow cost associated with collecting GST (which can arise if GST is paid but is not recoverable as input tax until a later date);
- the treatment of high-value, one-off transactions (where neutrality is critical); and
- the potential for over-taxation when nominees are involved in transactions.
1.12 This issues paper places emphasis on aspects of the GST system that create a risk to the tax base. GST creates the unique situation whereby Inland Revenue regularly refunds GST-registered persons for excess input tax deductions. Another unique feature of the GST system is that it allows taxpayers to use different GST accounting bases and different taxable periods. Aggressive arrangements such as those present in the series of Court decisions concerning Ch'elle, demonstrate that the government's revenue base is at risk from business structures that are designed to exploit these aspects of the GST system. The inevitable complexity and pace of litigation in this area suggests a need to address the issues not only at an operational level but in terms of possible amendments to the GST Act. "Phoenix fraud" (discussed in chapter 5) and the emergence of "carousel" or "missing trader" fraud (which has had a material effect on the revenue collections for some countries), should, in our view, also be considered in developing any legislative changes.
1.13 Options canvassed in this paper include greater scope for setting off GST liabilities and corresponding deductions and a review of the accounting bases among the range of possible measures for addressing these tax base concerns.
Other possible measures
1.14 Significant capital assets also present special concerns for the application of the change-in-use or apportionment rules as these assets can be consumed over a number of taxable periods and be applied for a variety of mixed purposes over their lifetime. This paper includes a number of suggestions to improve and clarify the application of the change-in-use rules to capital assets such as land.
1.15 The paper also considers the treatment of holiday and short-term accommodation. The changes suggested in this paper respond to concerns that have been raised in submissions about the correct legislative framework that applies to supplies of accommodation following the Inland Revenue's draft interpretation statement about the exemption for accommodation provided in a dwelling.
1.16 In this paper we have considered a series of possible options to enhance the neutrality of some transactions and reduce the risk that GST can present to businesses and the government. In some cases, common solutions could deal with both business and government concerns. The current rules governing the supply of a "going concern" are an example of the GST Act providing both a business-to-business neutral solution and an anti-avoidance rule.
1.17 The options outlined in this paper aim to provide a more certain GST outcome for both GST-registered persons and the government. The options discussed in the document have therefore been developed with the following principles in mind:
- preserving the policy objective that GST applies to the widest possible range of goods and services supplied in New Zealand, at a uniform low rate;
- reducing, as far as practical, compliance and administrative costs arising from the application of GST;
- ensuring that the obligations facing those required to comply with the GST Act are clear and straightforward; and
- limiting the scope for erosion of the GST base.
1.18 All section references in this paper refer to the GST Act unless otherwise specified. Amounts and values used in this document to describe transactions are also expressed as including GST.
Summary of Suggested Options
This paper outlines a range of options to ensure that business-to-business transactions are GST-neutral. Submissions are invited on which options should be considered in preference to others.
Legislating for business-to-business neutrality - Chapter 4
Suggestions are made to improve the GST consequences arising from transactions involving high-value assets such as "going concerns", assets with a value of $50 million or more, and land, using a mechanism known as a "domestic reverse charge".
The GST treatment of nominee transactions is also discussed.
Managing the government's revenue risk - Chapter 5
"Phoenix" entities are a particular problem for GST systems that are based on the "credit-invoice" method. Three options for reducing this risk are suggested:
- Enforcing GST neutrality on certain transactions created between close associates.
- Allowing Inland Revenue to impose caveats on certain land transactions.
- Extending the time available before Inland Revenue is required to release a refund.
The accounting bases - Chapter 6
The incidence of "timing mismatches" created by the operation of the various accounting bases allowed under the GST Act is noted.
The policy reasons for the various accounting bases are discussed and two options are suggested to reduce revenue risk:
- Limiting access to the invoice basis of accounting.
- Strengthening the application of existing anti-avoidance measures accompanied by an increase in the payments basis threshold.
The payments basis - Chapter 7
Further adjustments to the current limitations for using the payments basis are considered.
Change-in-use adjustments - Chapter 8
A number of changes are suggested to simplify and clarify the change-in-use rules.
The relationship between the application of the change-in-use adjustment rules when the use of assets changes from non-taxable to taxable, and the deduction for second-hand goods are discussed.
Accommodation - Chapter 9
Options to clarify the GST treatment of short-term accommodation include:
- Redefining the terms "dwelling" and "commercial dwelling".
- Removing very small-scale and non-commercial activities involving the supply of accommodation from the definition of "taxable activity".
1.19 Submissions are invited on the merits of the options suggested in this officials' paper. We also welcome submissions on alternative measures that meet the objectives of enhancing business neutrality as it affects the application of GST to day-to-day business activities. Those who make submissions are asked to:
- discuss whether, and how, the suggested changes would achieve GST neutrality without compromising the integrity of the GST base; and
- prioritise these initiatives and any others put forward.
1.20 Submissions should include a brief summary of major points and recommendations. They should also indicate whether it would be acceptable for officials from Inland Revenue and the Treasury to contact you about your submission to discuss the points raised.
1.21 Submissions should be made by 11 July 2008 and be addressed to:
GST: Strengthening business-to-business neutrality
C/- Deputy Commissioner, Policy
Policy Advice Division
Inland Revenue Department
PO Box 2198
Or e-mail [email protected] with "GST: Strengthening business-to-business neutrality" in the subject line.
1.22 Submissions may be the source of a request under the Official Information Act 1982, which may result in their publication. The withholding of particular submissions on the grounds of privacy, or for any other reason, will be determined in accordance with that Act. If you think any part of your submission should properly be withheld under the Act, you should indicate this clearly.
5 See Ch'elle Properties (New Zealand) Limited v Commissioner of Inland Revenue  NZCA 299; Ch'elle Properties (New Zealand) Limited v Commissioner of Inland Revenue (2004) 21 NZTC 18,618 and Case W22 (2003) 21 NZTC 11,212.
6 Michael Keen, VAT attacks!, International Monetary Fund Working Paper WP/07/142 June 2007; Michael Keen and Stephen Smith, VAT fraud and evasion: what do we know and what can be done?, National Tax Journal, Vol. LIX, No 4 December 2006.