Conduct of this review
1.1 This is the report of the Inspector-General of Taxation's (IGT) review into the Australian Taxation Office's (ATO) use of benchmarking to target the cash economy. The report is produced pursuant to section 10 of the Inspector-General of Taxation Act 2003 (the IGT Act 2003).
1.2 During public consultation for the IGT's 2011-12 work program, submissions were received from a range of taxpayers, tax practitioners and their representative bodies that raised concerns about the ATO's use of benchmarks in the cash business segment. Upon inclusion into the work program, the IGT undertook further community consultation to identify stakeholders' concerns. These concerns were reflected in the terms of reference which the IGT issued on 28 November 2011 and are reproduced in Appendix 1.
1.3 During the review, the IGT received a number of submissions from taxpayers and their representatives as well as professional bodies.
1.4 The IGT was also made aware that many small businesses and tax practitioners may not have the time or resources to make detailed submissions. To ensure that the IGT heard from a range of stakeholders affected by the ATO's cash economy benchmarking compliance activities, the IGT identified from representative bodies and the ATO's records those taxpayers and tax practitioners who had been subject to these ATO activities and directly contacted a number of them to better understand their experiences.
1.5 Stakeholders recognised the need for the ATO to have an effective risk identification tool. Whilst generally supportive of the ATO's use of benchmarking conceptually for risk identification, submissions and discussions raised a number of concerns in relation to the benchmarks themselves and the way in which the ATO used them for compliance activities.
1.6 Firstly, stakeholders raised concerns about the transparency of the ATO process for developing the benchmarks. In particular, stakeholders wanted more information on the data inputs and the methodology the ATO uses to arrive at a benchmark. Doubts were expressed regarding whether sufficiently similar businesses were being compared with each other. Stakeholders also sought greater assurance on the statistical validity of the process.
1.7 Secondly, concerns were raised about aspects of the ATO's approach in using benchmarking as a risk identification tool. Stakeholders were particularly concerned that the ATO appeared to equate those businesses with financial performance 'significantly outside' the benchmarks with those representing a higher risk of underreported income without consideration of other factors. As a result, they considered compliant taxpayers were being unnecessarily targeted. They believed that the costs associated with ATO compliance activities, especially audits, warranted further risk identification work to be undertaken by the ATO beyond the use of benchmarks.
1.8 Thirdly, stakeholders expressed concerns as to whether the ATO had had sufficient regard to the individual circumstances of taxpayers during audit activity. In particular, whether ATO auditors consistently solicited and relied upon all available evidence in determining whether taxpayers had underreported their income.
1.9 Fourthly, stakeholders also raised concerns with the manner in which the ATO took into account taxpayers' compliance with record keeping obligations during audits as compared to their obligation to accurately report their income.
1.10 Lastly, stakeholders raised concerns about the ATO's use of benchmarks in issuing default or amended assessments. Stakeholders were concerned that the ATO used benchmarks instead of evidence more pertinent to the taxpayer's particular circumstances as a basis for assessing taxation liabilities.
1.11 The IGT review team has also discussed the above issues extensively with relevant ATO senior management and staff within its Cash Economy stream.1
How this report is structured
1.12 This report is composed of several related chapters, with each focussing on a particular issue. Chapter 2 provides the reader with background on the ATO's benchmark approach and the cash economy program.
1.13 Chapter 3 focuses on the development and communication of the small business benchmarks themselves and makes recommendations to improve transparency with a view to increasing confidence in the process and, ultimately, the benchmarks.
1.14 Chapter 4 considers the adequacy of the ATO's current use of benchmarks as a risk identification tool. This chapter seeks to improve the ATO's risk identification process and minimise taxpayers' compliance costs through a more staged approach to the ATO's information gathering and verification activities.
1.15 Where a taxpayer remains a concern to the ATO after the risk identification process, the ATO may commence an audit. Chapter 5 considers the distinction between records and evidence and its impact on the conduct of correspondence audits. Certain taxpayers may not have appropriate evidence to support their obligation to accurately report their income and expenses. In this case, the ATO may decide to amend their tax liability using a default assessment. Chapter 5 also considers the circumstances in which the ATO should use the applicable benchmark to issue default assessments.
1.16 Chapter 6 focuses on specific aspects of the way in which ATO auditors conduct various compliance activities under the benchmarking strategy. The conduct of correspondence audits is a particular focus, including the evidentiary basis for the application of penalties and other practices that were observed to contribute to compliance costs.
1.17 The following chapter, chapter 7, takes a broader view of record keeping. This chapter makes recommendations to enhance the long term capability of the small business sector to maintain appropriate records and the ATO's ability to gain an assurance about the quality of a taxpayer's record keeping without intensive verification activity.
1.18 Also in chapter 7 the role of tax agents and BAS agents in helping small business owners to comply with their record keeping obligations is discussed.
Figure 1: Structure of this report
1 The Cash Economy stream is located within the ATO's Tax Practitioner and Lodgment Strategy business line.