Income tax penalties: what has to happen first, and what stops one

What has to happen before a penalty can be imposed

The single most useful thing to know is that a penalty is a separate proceeding with its own procedure, its own order and its own appeal. It is not an automatic consequence of an addition in an assessment, and it does not follow simply because tax was found to be due.

Three things stand between an addition and a penalty. The proceeding has to be initiated. A show-cause has to be issued, telling you what penalty is proposed and why. And you have to be given a reasonable opportunity of being heard before any order is made. An order made without that opportunity is defective in a way that goes to its validity rather than merely to its amount.

There is also an outer time limit on the proceeding itself, so a penalty cannot be pursued indefinitely after the assessment it arises from. Where a penalty order arrives long after everything else has gone quiet, the date is worth checking before the merits are.

50% or 200% — the difference is an argument, not a calculation

The principal penalty on additions is charged on the tax on the under-reported income, and it comes at two rates. Under-reporting attracts 50%. Under-reporting in consequence of misreporting attracts 200%. The rates did not change when the Act was renumbered; only the section did.

Four times the penalty turns on a single characterisation, and that characterisation is not a matter of the amount involved. It is about the nature of what happened — misreporting is directed at things like suppression of facts, false entries, claims not substantiated by evidence, and failure to record receipts. An honest difference of opinion about whether something was taxable, a valuation that turned out to be wrong, or a claim made on a debatable interpretation is not, on the face of it, misreporting at all.

This is why the show-cause matters more than anything on this page. If the show-cause proposes 200%, the reply has to engage with the characterisation directly and on its own terms, not merely argue that the addition was wrong. Arguing only the quantum concedes the characterisation by silence.

The reasonable cause defence

For a long list of penalties — not all, but most of the ones ordinary taxpayers meet — the Act provides that no penalty shall be imposed if the person proves that there was reasonable cause for the failure. It is a complete answer where it applies, and it is under-used because people argue about whether the failure happened rather than about why.

Reasonable cause is not an excuse. It means a cause that would prevent a reasonable person of ordinary prudence, acting without negligence and in good faith, from doing the thing required. The burden is on you, and it is discharged with evidence rather than assertion.

• A genuine and reasonable belief on a debatable point of law, particularly where the position was arguable at the time it was taken.
• A bona fide belief that a payment fell outside a withholding obligation, where the belief was reasonable on the facts then known.
• Records lost to a genuine event — a fire, a flood, a seizure — evidenced rather than merely stated.
• Serious illness or comparable incapacity at the relevant time, again evidenced.
• Reliance on a professional who failed, where the reliance itself was reasonable and can be shown.
• A transaction that was real, between identifiable parties, and fully recorded — which goes to characterisation as well as to cause.

The immunity route: paying to make it go away

There is a route that trades your appeal for a clean exit, and it is worth understanding precisely because the trade is irreversible.

Where an assessment or reassessment order has been made, you may apply for immunity from the penalty and from prosecution, on two conditions: you have paid the tax and interest specified in the demand notice within the period allowed by it, and you have not filed an appeal against that order. The application is made within one month from the end of the month in which the order was received.

So the bargain is: pay 100% of the tax and the interest, give up the right to argue that the addition was wrong at all, and in exchange there is no penalty and no criminal case. Where the addition is probably right and the exposure is a 200% penalty, that is often the best available outcome. Where the addition is genuinely arguable and the amount is large, giving up the appeal to save a penalty that might have been 50% or nothing is an expensive way to buy certainty.

The other penalties people actually meet

Beyond the penalty on additions there is a long series covering specific failures. The full list runs to dozens of provisions, and reproducing it is what every competitor page does and why none of them is useful. These are the ones that actually turn up.

Appealing a penalty order

A penalty order is separately appealable. It is not swept up in an appeal against the assessment, and it is not answered by having appealed the assessment — the two run separately, and both have to be filed.

The clock is the ordinary one: thirty days from service of the demand notice that follows the penalty order, to the Commissioner (Appeals). The fee is the ordinary appeal fee, and the demand created by the penalty behaves like any other demand — interest, possible recovery, and set-off against refunds — unless it is stayed.

One point is worth taking seriously if the assessment is also under appeal. Where the addition itself is deleted or reduced on appeal, the penalty computed on the tax on that addition has nothing left to stand on. So keeping the penalty appeal alive while the quantum appeal is pending is normal and sensible, and abandoning the penalty appeal because the quantum appeal looks strong is a mistake.

Worked examples