5.1 Stakeholders have raised concerns that correspondence audits expose many taxpayers to the risk of increased tax liabilities and penalties for what they perceived to be technical record keeping deficiencies rather than omitted income evidential requirements. The interaction between taxpayers' record keeping obligations and the ATO's identification of omitted income in the context of audits and default assessments is discussed later in this section.

Record keeping obligations

5.2 As mentioned in chapter 2, taxpayers have an obligation under section 262A of the ITAA 1936 to keep records of their business transactions 'so as to enable the person's liability under this Act to be readily ascertained'. Furthermore, where a taxpayer fails to keep or retain records as required by section 262A, they may be liable for a $2200 administrative penalty under section 288-25 of Schedule 1 to the Taxation Administration Act 1953.

5.3 Taxpayers may enlist the services of a tax practitioner to assist with the management of their tax affairs, including record keeping. In this respect, the ATO advises that 93 per cent of micro businesses use registered tax agents to lodge income tax returns and 50 per cent use a BAS agent to lodge Business Activity Statements.

5.4 Tax agents and BAS agents are regulated by the Tax Agent Services Act 2009 (TASA 2009) which includes a Code of Professional Conduct, pursuant to section 30-10 of the TASA 2009. One principle of this Code is:

(9) You must take reasonable care in ascertaining a client's state of affairs, to the extent that ascertaining the state of those affairs is relevant to a statement you are making or a thing you are doing on behalf of a client.

5.5 The Tax Practitioners Board (TPB) administers the TASA 2009 and the Code. In this respect, the TPB has issued an Explanatory Paper109 which sets out its interpretation of the principle above:

124. It should be noted at the outset that this requirement under the Code does not create a requirement that a tax agent or BAS agent effectively 'audits' all of the agent's clients before providing tax agent services to avoid breaching the Code.

125. Rather, this requirement is a duty of tax agents and BAS agents to take care beyond placing complete reliance on the accounts prepared, or work done, by a person without considering their level of knowledge and/or understanding of the taxation laws and the correctness of their work to ensure that the information upon which the provision of the tax agent's services is based is accurate.

126. In most cases, this will require that a tax agent or BAS agent ask the client appropriate questions, based on the agent's professional knowledge and experience, to ascertain the accurate factual basis upon which the tax agent services are provided and, where appropriate, to obtain supporting documents and records evidencing these facts.

128. Taking reasonable care will in many cases require that a tax agent or BAS agent ask questions based on their professional knowledge and experience in seeking information. Where there are grounds to doubt the information provided by a client, the tax agent or BAS agent must take positive steps and make reasonable enquiries to satisfy themselves as to the completeness and/or accuracy of that information.

129. Where a statement provided by a client seems plausible and is consistent with previously established statements and the agent has no basis on which to doubt the client's reliability or the veracity of the information supplied, the tax agent or BAS agent may discharge their responsibility by accepting the statement provided by the client without further checking.

130. However, if the information supplied by a client seems implausible or inconsistent with a previous pattern of claim or statement, further enquiries would be required.

131. Again, whilst there is no requirement to audit, examine or review books and records or other source documents supplied by a client, a tax agent or BAS agent does not discharge their responsibility in such a case by simply accepting what they have been told.

5.6 The TPB's interpretation indicates that whilst small business record keeping is the responsibility of the taxpayer, tax practitioners do have certain duties as noted.

The ATO approach to record keeping

5.7 The ATO has identified micro business record keeping as a strategic risk to the tax system. In particular, the risk is that if a business does not accurately record their income, the business may subsequently underreport income in their tax return.110

5.8 As mentioned in chapter 4, the ATO reports that inadequate record keeping often arises 'due to a lack of understanding and low skill levels, rather than any deliberate intention not to comply.'111 The ATO therefore addresses this risk through a range of activities and publications, with the focus on help and education, including the following:112

Our emphasis is to improve record keeping practices through help and education.

We have field officers who visit businesses and assess their record keeping practices. They will provide a written report to each business, including any suggestions for improvement.

If we visit you and assess your records as needing improvement, we generally give you an opportunity to improve your record keeping to an acceptable standard before we consider applying a penalty.

If we believe that a weakness in your record keeping may lead to non-compliance with the tax laws, we may make a return visit to ensure you have improved your record keeping practices.

5.9 This approach is also reflected in Law Administration Practice Statement PSLA 2005/2 Penalty for failure to keep or retain records.

5.10 The ATO also conducts record keeping audits as a compliance tool which allows the ATO to verify the extent to which taxpayers are complying with their record keeping obligations under section 262A of the ITAA 1936.

The role of records and other evidence in correspondence audits

5.11 The ATO has indicated that it focuses on record keeping since 'a clear link exists between compliance with tax obligations and good record-keeping practices.'113 With reference to the cash economy benchmarking strategy in particular, the ATO advises on its Small business benchmarks webpage:

If you find you are outside the benchmarks for your industry, you should check that you have correctly recorded and reported income and deductions for your business. To do this you should review your record-keeping practices to ensure they meet the legal requirements.114

5.12 With respect to the correspondence audit, the audit confirmation letter advises the taxpayer:

You need to record all your business income and keep records that enable us to readily ascertain your tax liability.115

5.13 The letter also highlights that the taxpayer is required to 'keep detailed records of every sale unless you conduct and retain reconciliations of your daily sales and banking'. The letter requests specific types of records along with 'any other relevant information'.

5.14 The letter advises the taxpayer that the ATO:

will examine your records and other information you supply to support your reported income. If your records do not support your reported income or you fail to provide the information requested, we will use the benchmark figures as a reasonable basis for making a revision assessment.

5.15 Where the evidence provided supports the income figures reported in the tax return, the case would normally be closed with no further action and recorded as a 'nil outcome'.

5.16 Where a taxpayer does not produce the specifically requested records, the taxpayer may nevertheless supply other evidence to support the income figures reported in their tax return. For example, a taxpayer may not have all the records that comply with their technical record keeping obligations, but they may have sufficient evidence of regular cash deposits into a business bank account and a record of wages and other expenses being paid out of the cash register before banking. Other evidence may include indications of margins such as price lists and purchase records.

5.17 In the event the taxpayer cannot provide acceptable evidence to show how they arrived at their reported income figure in their income tax return, the ATO would then regard that as evidence of underreported income.

5.18 A taxpayer may also submit evidence which supports an income figure different to that indicated on their tax return. The ATO would then move to adjust the taxpayer's income tax liability to align with the evidence. In these circumstances, whilst underreported income is detected, the ATO does not apply the benchmark to calculate it.

5.19 There may be other occasions where the taxpayer does not provide any acceptable evidence to substantiate any particular income amount. In such cases, the ATO advises they do not rely on taxpayer specific information and would instead move to apply the benchmark as a basis for assessment. As indicated in chapter 2, where the ATO applies the benchmark, it applies the highest percentage in the relevant benchmark range for that industry and that turnover range. This has the effect of amending the taxpayer's income to the lowest amount available within the benchmark range. In the case of applying the cost of sales benchmark, the percentage is applied to the taxpayer's cost of sales as reported on their tax return. The assumption here is that the cost of sales figure is correct as taxpayers tend to have a greater incentive to keep good records of expenses which may be tax deductible.

5.20 By applying the benchmark percentage to the taxpayer's actual reported cost of sales, the ATO considers that this takes into account the particular circumstances of the business and is thus a reasonable basis for assessment. The ATO has also advised that in the case of correspondence audits, it does not seek to use personal living expenses or asset betterment methods as a basis for assessment as it is more resource intensive and the combination of the taxpayer's reported cost of sales and the benchmark already suffices. This can be compared to the ATO's approach in cash economy audits where obtaining personal living expenses and third party data verification is part of the audit process.116

5.21 Nevertheless, the ATO advises that the taxpayer may undertake such an analysis of their own volition to rebut the ATO income figure based on the benchmark.

5.22 The ATO provides the following guidance to the auditor about the reason for the correspondence audit and how it should be conducted:

Assessments must take into account the individual circumstances of the taxpayer. For instance if the taxpayer can provide evidence of their actual cost of sales ratios, and can satisfy record keeping requirements of PSLA 2005/2, use the taxpayer's figures rather than a benchmark ratio as the basis for the assessment. ...

The records requested are to test the integrity of the record keeping system of the taxpayer in order to support their claims. The other information and evidence requested leaves it open to the taxpayer to provide whatever they consider relevant to their situation.117

5.23 The following is an extract from a Best Practice Guide circulated via email in October 2010 to Cash Economy staff conducting correspondence audits:

We should also seek to obtain contentions in relation to benchmarks and any other relevant contentions relating to profit margins. Clients should be advised to support their contentions with physical evidence rather than making general broad statements about what may be affecting their margins.

We should also attempt to obtain information in relation to supplies and COGS [that is Cost of Goods Sold] calculations, particularly where the client appears to have a mixed business.

Goods for own use and wastage should also be discussed.118

5.24 The above requires auditors to seek information not just relating to sales figures, but also relating to margins. Evidence requested for cost of sales ratios is not indicated in any correspondence to taxpayers and it is up to the auditor to ask for that information. For example, if a takeaway shop had records relating to sales that gave rise to some concern, but was able to show their cost of sales ratios (for example their margins), by comparing the cost of acquiring food and the sale prices as indicated by their menus, then that ratio could be used to reconstruct a new business turnover. However, a review of audit confirmation letters119 shows that none of the audit letters provide any guidance as to other evidence that the taxpayer might be able to provide in support of the taxpayer's original assessment should the business records not meet ATO expectations.

The evidentiary basis for default assessments

5.25 Under subsection 167(b) of the ITAA 1936, where the Commissioner is not satisfied with the return furnished by any person:

the Commissioner may make an assessment of the amount upon which in his or her judgment income tax ought to be levied, and that amount shall be the taxable income of that person.

5.26 These are commonly referred to as 'default assessments'.

5.27 As discussed above, where the ATO is not satisfied with the records or other evidence provided by the taxpayer during an audit, it will 'use the benchmarks as a reasonable basis for making a revision assessment'. That is, the ATO will issue a default assessment.

5.28 Concerns were raised by stakeholders that the use of benchmarks for a default assessment is unreasonable since the benchmark is a generalised statistic. It was submitted that the figure estimated may not resemble reality for the taxpayer (being too high or even too low in some cases).

5.29 A key stakeholder contention underlying this position was the concern that the ATO was effectively 'making up' or 'creating income' that taxpayers did not have. This is a particularly difficult situation as it may act to create taxpayer resistance in certain circumstances by instilling a sense that the ATO is telling the business they are not making enough money or that the taxpayer is not a good business operator.

5.30 It was suggested in submissions that if the ATO wants to effect default assessments, it needs to apply more rigour in the process to understand the specific financial circumstances of the taxpayer (as it does with other default assessment processes such as betterment assessments) before using the benchmark. The ATO policies and processes for issuing default assessments is discussed below.

ATO policies on default assessments

5.31 When issuing default assessments, ATO staff are required to follow Law Administration Practice Statement, PSLA 2007/24 Making default assessments: section 167 of the Income Tax Assessment Act 1936 and similar provisions. This instruction applies to all ATO officers, not just those in the Cash Economy or TPALS areas who conduct benchmarking compliance activities. Paragraph 8 states that:

Section 167 allows the Commissioner to make an assessment of the amount upon which, in his or her judgment, income tax ought to be levied. Given the objective nature of this judgment, tax officers must ensure that their decisions are fair, that they are made on reasonable grounds (see paragraph 9 of this practice statement), that there is sufficient information available to them to make a genuine judgement, and that they consider the relevant individual circumstances in accordance with the law, the commitments made in the taxpayers' charter and the principles of the compliance model.

5.32 Paragraph 9 of the Practice Statement lists the following as being reasonable grounds:

  • information provided by third parties,
  • any internal or external data matching information,
  • indirect audit methodologies (such as sources and application of funds, 'T' accounts or asset betterment assessments),
  • relevant economic statistics, or
  • extrapolation from previous years returns.

5.33 In 2010, the ATO's Active Compliance Steering Committee issued a Default Assessment — End to End Process document which gives greater guidance to its compliance staff about the context, policy framework and procedures to be followed when considering default assessments. In particular:

The Commissioner may use a rationally-based process to make a genuine ascertainment of the taxpayer's taxable income. Any basis used must be reasonable, credible and defensible. The basis must, as much as practical, take into account the taxpayer's particular circumstances. The information taken into account in making an assessment must have a rational connection to the taxpayer's individual situation.120

5.34 This document indicates that it is the norm for default assessments across the ATO to be based on information pertaining to the taxpayer's individual circumstances.

5.35 In relation to the benchmarking strategy, such an approach is supported in the ATO's funding bid for the strategy:

In conducting audits and making default assessments business taxpayers will be given every opportunity to provide evidence. Benchmarks will only be used in the absence of other evidence. For instance where the ATO has third party data that identifies trading stock purchases but the taxpayer is unable to provide records of sales; mark-up benchmarks could be used to determine sales. Even so, this would take into account any reasonable contentions made by the taxpayer.121

5.36 In this respect, most default assessments arise during correspondence audits. Of the 228 default assessments issued, 223 were the result of these audits.

5.37 As previously discussed, the ATO considers that applying the benchmark to a taxpayer's cost of sales is a reasonable basis on which to issue default assessments, where the taxpayer has inadequate evidence to support their reported income.

IGT observations

5.38 There may be circumstances where the ATO does not give the taxpayer a reasonable opportunity to provide information to augment or otherwise contest a potential default assessment. This runs the risk of prolonging a dispute that may not have a sound basis, may run up costs and possibly even require taxpayers to pay tax on income not earned. That is, even if a taxpayer has records that do not meet ATO expectations, they may have an alternative basis to support their reported income level. The importance of the ATO applying greater rigour to the default assessment process in avoiding the potential for perceptions of unfairness or oppression is critical.

5.39 An analysis of objection outcomes and their reasons may indicate the degree to which evidentiary issues arise during audit, default assessment and objection processes.

Default assessments and objections

5.40 The table below indicates that out of 2420 outcome cases from July 2010 to April 2012, 228 cases were classified as default assessments. Of the 228 cases, 185 were cases where the only outcome was an income tax default assessment. The other 43 cases contained an income tax default assessment outcome as well as another outcome. The rest of the outcome cases were the results of ATO activity statement revisions, amendments of previously lodged returns, lodging outstanding returns or making voluntary disclosures.

Table 16: Revenue outcomes for benchmarking activities July 2010 to April 2012
  Cases % of cases Tax liabilities raised ($ million) % of tax liabilities raised Penalties raised ($ million) % of penalties raised Objections lodged
Cases where the outcome is a default assessment only 185 7.6% $18.6 27.9% $13.6 41.8% 39
Cases where the outcome includes a default assessment and another outcome(a) 43 1.7% $4.1 6.2% $2.6 8% 13
Cases where the outcome does NOT include a default assessment 1707 70.5% $40.9 61.5% $14.8 45.5% 179
Cases where information was not available as to any outcome 485 20% $2.8 4.2% $1.5 4.5% 38
Total(b) 2402 99.8% $66.5 99.8% $32.7 99.8% 269

Source: Table compiled by IGT case data supplied by ATO 23 December 2011 and 31 May 2012.

Note (a): Cases may have multiple outcomes, for example, a default assessment for income tax, and an ATO activity statement revision.

Note (b): Totals may not equal due to rounding.

Note: Where the field value for 'Amendment' and 'Voluntary disclosure' was recorded as 'unavailable' or 'not available', but the other three fields have values such as 'yes' or 'no', Amendment and Voluntary disclosure was converted to 'no'.

5.41 The table above demonstrates that although default assessments accounted for 9 per cent of benchmarking compliance cases, they represent 34 per cent and 49 per cent of taxes and penalties raised respectively under the benchmarking strategy.122

5.42 Where a taxpayer is dissatisfied with an assessment, including a default assessment, they may lodge an objection against it.123 In information provided by the ATO, 269 objections relating to benchmarking were lodged between July 2010 and April 2012. Of these, 259 have been finalised with 10 remaining on hand.124 The results of these objections are summarised in the table below.

Table 17: Results of objections
Allowed in full 61
Allowed in part 120
Disallowed 61
Withdrawn 7
Invalid 7
Other 3

5.43 The following table indicates the types of cases that generated these objections, and the rate at which the objections are allowed, either in full or in part.

Table 18: Rate of disputation for benchmarking activities
  Cases Objections lodged Percentage of cases to which were objected Objections allowed in full Objections allowed in part Objections disallowed Allowance rate(a)
Cases where the outcome is default assessment only 185 39 21.1% 8 23 3 79%
Cases where the outcome includes a default assessment and another outcome(b) 43 13 30.2% 1 9 1 76%
Cases where the outcome does NOT include a default assessment 1707 179 10.5% 39 74 47 63%
Cases where information was not available as to any outcome 485 38 7.8% 13 14 10 71%
Total 2420 269(c)   61(c) 120(c) 61(c) 67%

Source: IGT compiled table from ATO data supplied on 7 June 2012.

Note (a): Objections allowed in full and in part / Objections lodged

Note (b) Other outcomes may include ATO activity statement revision, or lodgment of outstanding returns.

Note (c): Objections allowed in full, in part and disallowed do not add up to 269 since there are other types of objection outcomes, such as withdrawal or an invalid objection.

5.44 The table above shows that cases involving a default assessment had a higher rate of disputation compared to other case outcomes. Furthermore, these objections had a higher proportion of which resulted in the objection being allowed in full or allowed in part (79 per cent and 76 per cent) compared to other objections not involving a default assessment (63 per cent and 71 per cent).

5.45 The following table shows the reasons for those objections which were allowed in full and those which were allowed in part. Where the reason outcome relates to objections involving default assessments, the number of these objections is shown brackets.

Table 19: Reasons for objection outcomes — July 2010 to March 2012125
  Allowed in full Allowed in part
1. Additional information provided 1 3
2. Evidence — Incomplete supporting evidence provided by taxpayer 11 (1) 28 (9)
3. Evidence — Audit adjustment not supported due to incomplete research, error in calculation, supporting evidence not used or requested by auditor 18 (2) 16 (1)
4. Evidence — Audit evidence incomplete to support audit decision 7 (1) 8 (2)
5. Evidence- Evidence is outside the scope of the audit so not used by auditor as part of decision making process 6 (2) 10 (4)
6. Evidence- Evidence penalty not supported - 8 (3)
7. Interpretation — Auditor interpreted ATO view incorrectly or did not apply ATO view 1 -
8. Interpretation — Auditor behaviour not supported 3 7 (1)
9. Interpretation — Auditor interpreted application of penalty incorrectly 1 4
10. Interpretation — Auditor interpreted [penalty] remission provisions incorrectly - 1
11. Procedural — Auditor calculated penalty and/or adjustment incorrectly 2 7 (2)
12. Procedural — Auditor did not apply procedures correctly - 1
13. Unknown 11 (3) 23 (7)
Total 61(9) 116(29)(a)

Note (a): Total differs from Table 17 above since four objections allowed in part had 'disallowed' type reason codes against them.

IGT observations

5.46 The above table shows that the most common reason for an objection involving a default assessment to be allowed in full or allowed in part relates to the completeness of the evidence that was provided by the taxpayer during the course of the audit. The above list of outcome reasons seek to make a distinction between instances where the taxpayer has not provided sufficient evidence during the audit, despite being requested to do so (reason 2), and instances where such evidence was not provided because the auditor did not use or request it (reason 3).

5.47 As discussed previously, the ATO will accept 'records' as well as 'other evidence' during a correspondence audit. The IGT is of the view that this distinction between records and other evidence may be a source of mismatched expectations between auditors and taxpayers as to what information is being requested of the taxpayer. This mismatch may be a reason why evidentiary issues are prevalent in the objections outcomes outlined above.

The distinction between 'records' and 'other evidence'

5.48 The IGT believes that there is a distinction to be drawn between a taxpayer's compliance with their record keeping obligations under section 262A of the ITAA 1936 and their ability to substantiate their income during an audit.

5.49 Income can be substantiated through the provision of a range of evidence. The strongest evidence a taxpayer can provide in the ATO's view is outlined in Taxation Ruling TR 96/7 Income tax: record keeping — section 262A — general principles and the ATO's guide, Record keeping for small business.

5.50 Non-compliance with record keeping obligations in itself, however, is not conclusive evidence of underreported income. A taxpayer still has open to them the opportunity to provide other evidence (not necessarily 'records' in the strict sense contemplated above) to substantiate their income. This evidence may be used to indicate the assessable income or taxable income for a business.

5.51 Alternatively, the taxpayer may adduce other evidence to refute an ATO contention. For example, where the ATO proposes to apply the industry benchmark to establish a revised business income figure, the taxpayer may submit evidence, such as personal living expenses or asset betterment, to indicate that the revised income figure is not reasonable since the purported extra income is inconsistent with the taxpayer's consumption or accretion to wealth.

5.52 The distinction between the different types of evidence sought by the ATO, and that may be adduced by the taxpayer, are summarised in the diagram below.

Figure 9: Evidence to substantiate income

Chart summarising the distinction between the different types of evidence sought by the ATO, and that may be adduced by the taxpayer.

5.53 The ATO has directed the IGT to a number of cases in which the ATO considered the taxpayer records to give rise to some concerns but the ATO did not use the benchmark to make an adjustment. For example, in a case involving a clothing retailer, it was found that the taxpayer did not produce or keep basic documentation, such as sales summaries or reconciliations. However, other documentation such as bank statements and ledger reports were submitted, along with written explanations of how the business operated.

5.54 Whilst the ATO auditor initially determined126 that the taxpayer did not keep their records 'in a such a manner as to enable us to readily ascertain your tax liability', the case did not result in an adjustment since the taxpayer's low business income figure was better explained, not by the underreporting of cash income, but rather by the fact that the taxpayer had taken out a loan against their home to keep the business afloat.

5.55 At the conclusion of the audit, the taxpayer was sent a letter indicating the ATO had finalised the audit with no further action. The letter also advised the taxpayer:

However, your record keeping practices were inefficient and lacked the level of detail required of a business that has a significant sales turnover and deals in cash transactions. As such, we have included some information below in this report to assist you with record keeping requirements.

Please note that you need to keep your business records for five years, including all records examined as part of this audit.

5.56 The letter then makes specific recommendations with respect to the production and maintenance of certain types of source documents.

5.57 It is the IGT's view that the ATO justifiably asks for records at first instance in the audit confirmation letter since this is the strongest evidence that taxpayers can produce to substantiate their reported business income. However, it is also important, as can be seen in the case above, that the ATO inform the taxpayer that it will accept other appropriate evidence to assist it in making a judgement about the likelihood of underreported income.

5.58 Compliance with record keeping obligations requires an investment of time and money on the part of the taxpayer which may be regarded as part of the baseline compliance cost that all taxpayers are expected to incur in a self assessment taxation system. Not complying with record keeping obligations exposes them to the possibility of greater compliance costs should the ATO ask them to substantiate their income in the event of an audit. In such situations, the taxpayer is then in the tenuous position of having to produce alternative evidence which may or may not satisfy the ATO that the income figure reported in the tax return is correct. Taxpayers may incur significant compliance costs in engaging the services of tax and/or legal practitioners to help reconstruct records or compile other evidence to support the income tax return figures.

5.59 The IGT also notes that the ATO's inclusion of record keeping advice in audit finalisation letters even where there is no adjustment, as in the case above, complements the ATO's help and education approach to addressing the record keeping risk in the tax system.127

Awareness of opportunities to provide alternative evidence

5.60 During consultations with stakeholders, however, the IGT noted there was confusion among taxpayers and their tax agents about whether correspondence audits were, in effect, record keeping audits. In particular, certain stakeholders submitted that they felt that non-compliance with record keeping obligations of itself was evidence of underreported income and was thus a threshold that the ATO used to determine whether to apply the benchmark in a default assessment.

5.61 Certain stakeholders asserted that ATO auditors appeared focussed on the quality of the records submitted almost to the exclusion of other evidence. In other cases drawn to the IGT's attention, taxpayers voluntarily completed a personal living expenses analyses or personal financial position statements, which were accepted by the ATO. Importantly, such analyses and statements were not requested or performed by the auditors.

5.62 Furthermore, notwithstanding it is ATO policy to give taxpayers an opportunity to produce other evidence besides business records to substantiate the income figures in the tax return, stakeholders submitted that they did not think that such an opportunity was available or was consistently communicated by the ATO.

IGT observations

5.63 In the IGT's view, the misalignment between ATO and taxpayer expectations of the audit process, especially with regard to the role of 'records' and 'other evidence,' can be addressed by the ATO better communicating the audit process to taxpayers and tax agents.

5.64 The IGT believes there are aspects of the written communication which may have caused some confusion about the nature of correspondence audits. For example, it may not be immediately clear in the audit confirmation letter that the ATO is seeking to establish whether the taxpayer has underreported their income. Where it does mention the reporting of income, the same sentence also indicates the taxpayer is required to effectively demonstrate compliance with their record keeping obligations.

5.65 The same letter then lists (helpfully) the types of records the ATO is requesting, followed by the comment that the taxpayer is required to keep these records. The letter also indicates that, 'If your records do not support your reported income or you fail to provide the information requested, we will use the benchmark figures as a reasonable basis for making a revision assessment'. It may not be immediately apparent to some taxpayers that the ATO also mentions 'information' as well as 'records'.

5.66 For example, an auditor may ask for cash register tapes and the taxpayer may focus on answering that question, rather than considering other evidence to support reported income. If the auditor had asked how the cash takings were evidenced and recorded, then the taxpayer may have provided different evidence. Such a miscommunication could be avoided by ensuring that the taxpayer is aware that, although the auditor is looking for the strongest evidence of income which complies with the record keeping requirements, there may be other means to evidence their income.

5.67 Where the ATO is initially not satisfied with the records and information provided, it will issue an interim report to the taxpayer outlining its findings. The interim report effectively indicates the judgment made by the ATO officer about the quality of the taxpayer's records or record keeping processes. The interim report commonly includes the phrase:

We have analysed the records you provided and it is determined that these records were not kept in such a manner as to enable us to readily ascertain your tax liability due to the following reasons.

5.68 However, an examination of a sample of interim reports, including those provided by the ATO, show that ATO auditors have been including factors which do not relate to record keeping. For example, factors considered in this judgment included:

  • Not providing an explanation of why the business is reporting outside the benchmarks.
  • The taxpayer has provided an explanation of why the business is reporting outside the benchmarks, but the ATO does not accept the explanation since it is too general in nature.
  • The reported income figure does not appear consistent with the apparent lifestyle of the taxpayer, that is, the income would be insufficient to meet the cost of living for their household.

5.69 Thus, whilst the ATO may have taken into consideration the 'other information' provided by the taxpayer, they are included under what appears to be a judgment about the manner in which the taxpayer kept their records, and not an overall judgement about whether the taxpayer has discharged the onus to substantiate the income reported in their tax return. In this sense the distinction between complying with the record keeping obligations and disproving the existence of omitted income is in the IGT's view being blurred.

5.70 One may get the impression, therefore, that the ATO uses compliance with record keeping obligations as the threshold for deciding to issue a default assessment.

5.71 Despite the fact that there are staff instructions, stakeholders have raised concerns that ATO auditors do not consistently communicate the fact that additional evidence may be useful in substantiating the reported income tax return figures, or at least providing an alternative basis for default assessment. The IGT considers that there are some aspects of ATO staff instructions128 that may not adequately support auditors in making the distinction between records and other evidence and communicating it to taxpayers.

5.72 Furthermore, there is a mismatch of expectations in relation to the types of evidence the ATO would rely on. In particular, certain stakeholders have expressed that the ATO has, in the past, proactively used asset betterment and personal living expenses as a basis for default assessment. The view of those stakeholders was that the ATO should continue to do that in the case of correspondence audits, in preference to the benchmark. As noted above, it is ATO policy not to proactively pursue this type of evidence in correspondence audits.

5.73 The IGT considers that, even where objection outcome reasons list 'incomplete supporting evidence provided by taxpayer' (where it is implied that such evidence was properly requested by the auditor), certain cases may be attributable to taxpayers not understanding the distinction between records and other evidence since ATO documents themselves do not consistently make such a distinction.

5.74 It is the IGT's view that taxpayers would receive more consistent treatment, and have a greater understanding of the intended ATO process, if the ATO:

  • produced clear guidelines to ATO staff about the correspondence audit process, in particular, the distinction between records as 'strongest evidence' and other information as 'other evidence', and the role they both play in relation to substantiating income;
  • instructed ATO officers to make the taxpayer aware that they have the opportunity to provide 'other information' besides records, including examples of what that other information may entail;
  • clearly communicated to taxpayers in the audit confirmation letter the process of the audit, including that the focus is on 'omitted income' and that the request for records is just a means to that end (this should include how the ATO treats 'records' and 'other evidence');
  • made taxpayers aware in the same letter of other information the ATO seeks (for example information relating to margins or cash flows, etc.); and
  • informed taxpayers that they have an opportunity to provide asset betterment or personal living expenses information of their own volition even though the ATO does not proactively seek such information.

Default assessments and potential small business regulatory costs

5.75 Certain stakeholders contended that situations arose where taxpayers did not object to default assessments, although they considered them excessive.

5.76 The ATO considers that taxpayers who comply with their record keeping obligations would be in a better position to prove they had not omitted income and therefore not be subject to default assessments. In this sense, the ATO considers that the taxpayer has deferred their baseline compliance costs by not keeping adequate records.

5.77 The IGT is of the view that the ATO should also consider the pressures faced by small businesses, such as the regulatory burden (including that imposed by non-tax compliance obligations) have a highly regressive effect. These are not tendered as an excuse for taxpayers not complying with their obligations under the law. However, it is important that the ATO distinguish between taxpayers who have made a deliberate choice not to comply with the record keeping obligations under the law and those that need assistance and have not had reasonable opportunity to explain the figure reported in their return. Therefore, there is a need to clearly establish at outset of an audit what the audit is seeking to test, what the ATO will consider the strongest evidence (that is compliance with record keeping requirements) and, in the event such evidence does not exist, that the ATO requires a cogent explanation based on appropriate evidence. The importance of clearly establishing these evidence requirements at the outset of an audit is highlighted in the above discussion on objection outcomes.

5.78 Whilst default assessments can be challenged through the objection process, the IGT is concerned that, in an increasingly complex tax system and regulatory environment, the costs involved in small businesses lodging objections is regressive and may in certain cases be practically prohibitive. In this regard, it is worthwhile noting the following:

  • the cost of engaging tax professionals in a low margin business may make it uneconomical;
  • it may require the personal attention and time of the business owner, who may be the main person running the business and cannot afford to be away from the business;
  • it may take a substantial emotional toll on business owners;
  • the taxpayer will be unable to recover their costs in successful appeals to the Administrative Appeals Tribunal, as the costs in that forum fall upon each party directly — there is no sharing or directing on costs; and
  • the high cost of litigating the issue in the Federal Court of Australia.

5.79 During the course of the IGT review, the ATO did acknowledge that in the very early period of the use of benchmarks that certain taxpayers were subject to default assessment prematurely. The ATO has subsequently sought to improve their processes by developing a '5-point process'. This process is reflected in the ATO 'end to end process' document supplied to the IGT and is included in Appendix 8.

5.80 Given the importance of the issue and the relatively small number of default assessment cases, the IGT considers that the ATO's revised approach in conjunction with the recommendations below should ensure future default assessments are subject to appropriate rigour by providing taxpayers and their representatives the means to hold ATO auditors to account and promote consistent practice.

Encouraging better record keeping

5.81 As mentioned above, where a correspondence audit results in no adjustment to the taxpayer's reported income, but the records still give rise to certain concerns, the auditor may include recommendations for the business to improve their record keeping. That is, it is possible for a taxpayer to have not met the ATO's record keeping expectations but still, by virtue of other evidence they have provided, substantiate their reported income.

5.82 The IGT is of the view that taxpayers with inadequate record keeping practices in these situations may be encouraged to improve their future record keeping simply by virtue of the fact that these taxpayers have already borne the higher compliance of an audit which may have been mitigated had the taxpayer been keeping adequate records at first instance. This will assist tax practitioners to persuade their clients to maintain better records and thereby reduce some of the practitioners' unrecoverable costs.

5.83 Nevertheless, the IGT also believes that some taxpayers may continue to attempt to defer their compliance costs and decide not to improve their record keeping practices. It is appropriate in these circumstances that the ATO continue to apply pressure to these taxpayers to improve their record keeping.

5.84 As indicated in chapter 2, the ATO currently uses record keeping audits as a combined education and verification tool to improve record keeping standards. The IGT believes that correspondence audits, to the extent that they examine the records and record keeping practices of the business, present an education opportunity. The ATO already takes advantage of this opportunity by providing record keeping recommendations.

5.85 It is the IGT's view that the ATO should reserve the right to apply its record keeping penalties consistent with practice statement PSLA 2005/2 — that is where the taxpayer has been given an opportunity to improve their record keeping, but fails to do so upon future verification activity, a record keeping penalty may apply.

Recommendation 5.1

  1. The ATO should consult with taxpayers, tax practitioners and their representative bodies with a view to publishing guidance on what taxpayers and their advisors can expect during cash economy benchmarking compliance activities, including:
    1. the type of activities and circumstances in which these compliance activities may be used and the manner in which these will be conducted; and
    2. more effective escalation processes where the ATO's officers do not meet the expectations set out in the guidance.
  2. In relation to ATO correspondence audits such published guidance should include the following:
    1. the ATO considers that the strongest evidence to support reported income are records meeting the ATO's record keeping requirements;
    2. where the above record keeping requirements may not be met, the ATO will allow taxpayers to provide a cogent explanation supported by appropriate evidence;
    3. where the ATO accepts such an explanation as supporting the taxpayer's reported income, the ATO may still impose record keeping penalties if the taxpayer has been previously given an opportunity to improve their record keeping; and
    4. where the ATO does not accept the explanation, how the ATO will calculate the amended assessment by taking into account the taxpayer's personal circumstances.

ATO response: Agree

The ATO will consult with taxpayers, tax practitioners and their representative bodies with a view to publishing enhanced guidance about the ATO conduct of cash economy compliance activities and escalation processes for taxpayers and their advisers.

109 Tax Practitioners Board, Explanatory Paper TPB 01/2010 Code of Professional Conduct, Tax Practitioners Board, 16 December 2010, viewed 2 July 2012.

110 ATO Strategic Risk Register: Compliance; Risk SR2/2 - Issued August 2011

111 Australian Taxation Office, The Cash Economy under the New Tax System, Australian Taxatio Office, Canberra, September 2003, page 17.

112 Australian Taxation Office, Penalties for not keeping records: what is our approach to record keeping and penalties?, Australian Taxation Office, Canberra, 25 August 2010, viewed 2 July 2012.

113 Australian Taxation Office, Compliance Program 2011-12, page 12

114 Australian Taxation Office, Small business benchmarks - Overview, Australian Taxation Office, Canberra, 22 May 2012, viewed 30 May 2012.

115 A sample audit confirmation letter is attached as Appendix 6. Letter supplied by ATO, 7 June 2012.

116 Australian Taxation Office, Small business benchmarks: how we use the benchmarks, Australian Taxation Office, Canberra, 22 May 2012, viewed 30 May 2012.

117 ATO communication to IGT, 23 February 2012.

118 'Cash Economy Update Issue 5' email to Cash Economy staff, dated October 2010, supplied to IGT 23 February 2012.

119 Audit Letters supplied by ATO, 23 December 2011.

120 ATO Default Assessment End to End Process, April 2010, Page 7, supplied by ATO 27 January 2012.

121 Australian Taxation Office, Promoting a level playing field for Australian small business: funding bid, March 2009, supplied by ATO 22 March 2012.

122 Default assessment only cases + Default assessment with other outcomes cases.

123 Section 175A of the Income Tax Assessment Act 1936 and Part IVC of the Taxation Administration Act 1953

124 IGT compiled figures from ATO case data of objection outcomes supplied 7 June 2012.

125 IGT compiled figures from ATO case data of objection outcomes supplied 7 June 2012.

126 This finding is in the interim report that was never sent to the taxpayer since the decision was made to NFA the case. The reason for closing the case, however, was not related to record keeping.

127 ATO Strategic Risk Register: Compliance; Risk SR2/2 - Issued August 2011.

128 ATO communication to IGT, 31 May 2012.