Administrative Directives, Part 2

by Tom Yamachika, President, Tax Foundation Hawaii

Last week, we wrote about “Administrative Directives,“ which are instructions from the Director of Taxation to his staff. We asked for all of them under Hawaii‘s version of the Freedom of Information Act. The Department produced 11 documents. We are asking for help from the Hawaii Office of Information Practices to get the rest.

This week, we will focus on one of the documents that the department produced, AD 2021–01. This document contains instructions to the Department’s staff about how to apply the negligence penalty.

Under Hawaii tax law, a 25% penalty is imposed whenever a taxpayer takes a position on a tax return that results in paying less tax than is actually due, and the taxpayer‘s position was due to negligence or intentional disregard of rules and regulations. In other words, the taxpayer shorted the government and didn’t have a legitimate basis for doing so according to the Hawaii tax laws and rules. The penalty is imposed on the deficiency, namely, how much the government was shorted.

AD 2021–01, linked here, tells the Department staff that they can use the negligence penalty to punish a taxpayer who has not been sufficiently responsive to a request for information from an auditor or examiner.

It says that if a second request for information is made, and the taxpayer doesn’t respond to the second request within 10 business days, then staff are to impose the penalty. If the taxpayer comes back with a good case that there was no negligence, then the penalty may be removed.

But there is a problem here.

The law says: “If any part of any underpayment is due to negligence or intentional disregard of rules (but without intent to defraud), there shall be added to the tax an amount up to twenty-five per cent of the underpayment as determined by the director.”

The problem is that failure of the taxpayer to produce documents in response to an auditor’s request has nothing to do with whether tax as shown on the return is deficient, or whether the taxpayer hasn’t filed a return but should have filed and paid. The negligence penalty punishes a taxpayer who has taken an unreasonable position on a tax return, or who hasn’t filed a return but clearly was supposed to. The Department, however, is saying that the taxpayer can be punished with this penalty for an act that happens later, namely a failure to respond to a request from an examiner after the return (or lack thereof) has been selected for examination.

During this past legislative session, the Department was pushing a bill that would have given it the ability to impose a different kind of penalty for the same kind of conduct. If the taxpayer didn’t produce documents requested by a certain deadline, those documents could not be used as evidence if the taxpayer appealed from an assessment. That bill, Senate Bill 3176, passed out of committees in both the House and the Senate, but the House-Senate conference committee was unable to agree on a final bill version.

That inaction, however, doesn’t justify the use of a completely unrelated penalty to bludgeon taxpayers with. The Department already has tools it can use against recalcitrant taxpayers, such as the ability to make an assessment on “best available information” and throw the burden upon the taxpayer to prove that the assessment is wrong. Tax assessments should be made and upheld on the facts and law, not on whether the taxpayer, for whatever reason, happens to displease the auditor.