PAYE where income received fraudulently or in error (December 2004)
QB (Dec 2004) considers PAYE consequences where any amount has been received fraudulently or in error and PAYE has been deducted.
Inland Revenue has been asked to clarify the tax effects of amounts received fraudulently or in error, in the context of source deduction payments.
This item considers PAYE consequences where any amount has been received fraudulently or in error and PAYE has been deducted. The income may be employment income, an income-tested benefit, or self-employment income under the Income Tax (Withholding Payments) Regulations 1979.
All references are to the Income Tax Act 1994 unless stated otherwise.
Where a person receives amounts without "claim of right" they are included as gross income pursuant to section CD 6. Section OB 1 defines "claim of right" as follows:
"Claim of right", in relation to any act, means a belief that the act is lawful, although that belief may be based on ignorance or mistake of fact of any matter of law other than the enactment against which the offence is alleged to have been committed.
The essence of "claim of right" is that the person must have a genuine belief that the act is lawful. The above definition was inserted with effect from 1 October 2003.
Previously, section CD 6 referred to the term "colour of right". Section 2 of the Crimes Act 1961 used to define "colour of right" as follows:
"Colour of right", in relation to any act, means an honest belief that the act is justifiable, although that belief may be based on ignorance or mistake of fact or of any matter of law other than the enactment against which the offence is alleged to have been committed
If the person repays that income they are entitled to a deduction for the amount repaid in the year it is repaid, pursuant to section DJ 18.
Whether a recipient of an incorrect payment has received it without "claim of right" essentially requires some evidence of fraud or criminal dishonesty, rather than merely passively receiving a payment in error. If the taxpayer knows an error has occurred, they may not be able to establish a claim of right, but Inland Revenue is often unable to establish whether or not the taxpayer genuinely believed (rightly or wrongly) that he or she was entitled to the payment.
Inland Revenue will generally be unable to apply section CD 6 without material evidence of wrongdoing, and as a matter of practice will usually apply section CD 6 only where a prosecution has been commenced (usually by the police, but also in civil recovery action) against the taxpayer. Section EN 5(2) explains that income under section CD 6 is deemed to be derived in the income year that possession or control of the property is obtained.
The PAYE rules apply to source deduction payments. Section OB 2 defines "source deduction payment" as:
- In this Act, except as provided in subsection (2), "source deduction payment" means a payment by way of salary or wages, an extra emolument, or a withholding payment, but does not include an amount attributed in accordance with section GC 14D.
Generally, in determining the nature of the obligation, PAYE will not be deductible against income that has been received by a recipient either fraudulently or in error.
Employment or benefit income received fraudulently by a person
Where a person receives income fraudulently it is gross income for the purpose of tax, under section CD 6. However, as the recipient is not entitled to the income it is not a payment subject to PAYE. If PAYE has been deducted, the Commissioner will repay that amount to the person who made the payment on request in writing.
The amount assessed to the recipient is the net amount of the fraudulent payment; that is, the amount actually received by them. The recipient is then responsible for meeting their tax liability on that income. Usually this will require completion of an Income tax return for individual taxpayers (IR3
If the recipient repays any of the income, they can claim a deduction in the year of repayment under section DJ 18.
An employee responsible for salary and wages at a small company makes fraudulent payments to himself on a fortnightly basis of $200. The employer discovers this as part of an audit after 24 weeks. In total the company paid an additional $2,400.
The employee received $1,944 net in this way and $456 was paid as PAYE in the employee's name.
The employee should be assessed income of $1,944. The $456 paid as PAYE should be returned to the employer.
Income received in error from an employer
Where an employer has paid an employee in error an amount to which the employee is not entitled (and where section CD 6 does not apply), it is not income the employee is entitled to. Therefore, it is not a payment subject to PAYE and Inland Revenue will return the PAYE to the employer on request in writing. Income that is received in error and repaid will not be assessable to the employee, and employees cannot claim a deduction in the year of repayment. An agreement to repay amounts between employers and employees is a private arrangement.
If an employer supplies a letter with amended salary or wages for a prior year (where section CD 6 does not apply), the employee's Personal Tax Summary or Return of Income will be amended to show the new figures.
Sometimes overpayments of salary and wages occur through simple oversight and are immediately identified, and repaid perhaps in the next pay period. Assuming that sections CD 6 and DJ 18 do not usually apply, if the situation is corrected within the same period, Inland Revenue will permit the employer to correct the matter in the Employer Monthly Schedule filed.
However, for various reasons the employer and employee may come to a different arrangement regarding the amount paid in error. For example, they may decide to treat it as income in advance or a bonus. In these situations the income may be accepted as having the characteristics of a source deduction payment and be subject to PAYE. The employer or company would not seek a refund of the PAYE, and Inland Revenue would retain the PAYE as a credit against the employee's tax liability.
The character of a payment made in error is a question of fact. This will need to be considered in each case.
A bonus payment of $500 is mistakenly paid to the wrong employee. The employee receives $405 and $95 is paid to Inland Revenue as PAYE. The employee, believing it to be an undeclared bonus, spends it. When the error is identified the employee is told of the mistake, but at that time is unable to repay the money.
The employer as a matter of goodwill agrees to treat the payment as a bonus. The employee will be taxed on the gross amount, $500. Inland Revenue will retain the PAYE as a credit against the employee's tax liability.
Income received in error by way of a benefit
Where income is received in error by way of a benefit (in circumstances where section CD 6 does not apply), the person is not entitled to the receipt of it. The rules are the same as for salary and wages. The overpayment is not a source deduction payment and PAYE does not apply. The recipient has an obligation to repay the amount received.
If deducted, the PAYE would be returned by Inland Revenue to the payer, usually Work and Income, on request in writing.
If the recipient repays the benefit received in error they get no deduction for the repayments.
If Work and Income supply written confirmation of the amended benefit for a prior year (where section CD 6 does not apply), the beneficiary's Personal Tax Summary or Return of Income will be amended to show the new figures.
In any of the above situations, the employer must provide a written request, with the full factual situation, before Inland Revenue will investigate the refund of any PAYE received.