ATO Disputes and Audits: Compliance Preparation and Prevention

ATO TAX DISPUTES: Tax Audits and Evasion / Avoidance in business: Prevention and Preparation for ATO Compliance

As presented by Nathan Thomson at the recent Legalwise Tax Essentials conference 13 June 2017 and published on LinkedIn.

1. Introduction

The Australian taxation system and the ATO revolves around and depends on the concept of self-assessment.

Most individuals and businesses know only that they lodge returns, either personally or through an accountant. Then they receive a refund or a bill and that is the end of it – little or no actual interaction with an actual person at the ATO and certainly nothing like a dispute.

We normally identify anything outside this process as a dispute, certainly clients do. Any contact directly from the ATO is enough to give most ordinary people serious concern.

What lawyers and accountants term a dispute may also involve other things. For example, if the taxpay is unhappy with the answer given in a private ruling, that may also lead to a disagreement or dispute with the ATO.

The ATO review or audit process starts with risk. If the ATO identify a taxpayer (or a transaction) as a compliance risk, they may choose to review or audit the transaction or the taxpayer’s affairs generally. The ATO also undertake compliance action on specific taxpayers if they are a member of a particular class – for example high net wealth individuals.

Given any ATO action depletes resources (which translates into money), all ATO action comes down to a rather mercenary cost benefit calculation. If the risk is not high enough or the potential payoff not high enough, any compliance action is less likely that it might have been otherwise.

This paper and accompanying presentation focus on the time prior to full-blown dispute with the ATO. We note some strategies to avoid ATO disputes and how you might wish to approach a situation where a dispute is inevitable.

2. ATO Review and ATO Audit.

What is an ATO Review, and what is an Audit. Is there a difference?

The Commissioner’s audit powers are not governed by specific provisions in the law. Rather, the Commissioner has the power of general administration of taxation legislation.[1] In addition, the Commission has broad information gathering powers (information can be gathered and from various sources, not just the taxpayer).

“Audit” is not defined in the TAA[2]. Tax Audit is, however, defined in the ITAA97[3] as: “an examination by the Commissioner of an entity’s financial affairs for the purposes of a *taxation law.”[4]

The word “review” is used throughout the TAA, but not in the context of the ATO reviewing a taxpayer’s affairs.[5] This means that – for the purposes of tax legislation and in this context, review has no distinct or important meaning.

The concept of review is important, though. Not because of legislation, but rather because of ATO policy and procedures.

In the ATO’s risk review and audit processes, the ATO advises as follows:

“Generally, when we identify a compliance risk we will review your tax affairs. This may result in an audit if we identify areas of concern requiring closer examination.”.

In this way, the ATO distinguishes between review and audit. The distinction is interesting as it has no basis in legislation (both likely constitute the ATO examining a taxpayer’s affairs) but critical because of how the ATO administer that difference. Similarly to other administrative concessions from the ATO[6] it has no basis in legislation and critically, the courts are not bound by those concessions.

Voluntary Disclosure

The ATO’s practical application of the Voluntary Disclosure provisions is a good example of the importance of this distinction.

If a taxpayer’s return is amended and increased (whether by taxpayer request or ATO compliance action), the increase is potentially subject to potential legislative administrative penalty.[7] That penalty varies depending on the nature of the shortfall and is subject to increase or decrease, pursuant to the TAA.

However, if a taxpayer voluntarily discloses a shortfall amount to the Commissioner before being notified of an examination of the taxpayer’s tax affairs, the base penalty amount is reduced by 80%.[8]

Practitioners should note that this provision was changed in 2010. Prior to that, the taxpayer had to be notified of an audit, rather than just an examination. This change to Section 284-26 potentially makes it harder for a taxpayer to have the base penalty amount reduced by 80%. In fact, the ATO takes a broad view as to what might constitute an examination – including using the phrase ‘under review’.[9]

Whilst examining a taxpayer’s affairs, the Commissioner has been known to write to the taxpayer, advising them:

  • that their taxation affairs are under review;
  • possibly the transaction or return that is of interest to the ATO;
  • of the ATO’s reply deadline;
  • that the Commissioner will treat any disclosure of a tax shortfall as qualifying for a voluntary disclosure.[10]

The courts would consider this sort of letter an examination of the taxpayer’s affairs and that the voluntary disclosure provisions would no longer be available.

The Commissioner in making the offer to allow voluntary disclosure shows a willingness to bend the rules. This flexibility is only often available at this early stage of ATO compliance and has good policy behind it. Early compliance by at-risk taxpayers with a shortfall costs less ATO money.

Note that the legislation provides a possible voluntary disclosure base penalty discount of 20% in some circumstances after an examination has commenced.[11]

3. How to prepare for an ATO Review / Audit

General Preparation

Preparing for ATO compliance action can be intimidating for both client and accountant, even for an experienced practitioner. The issue at the heart of that intimidation is that every contact with the ATO (audit or otherwise) is different for many reasons, including:

  • every ATO officer is different and conducts themselves and their matters in slightly unique ways subject to their personality;
  • every client of yours is different (if even so slightly);
  • every transaction is different and applies differently to individual taxpayers.

For these reasons, a definitive guide on how to prepare for every audit is impossible. An exhaustive guide would be more harm than good as when the facts inevitably fall outside the guide, you are left with nothing. Rather, it is more useful to have general guidelines which you must adapt depending on your circumstances. In addition, once the audit commences (that is, once preparation is over), you must maintain that flexibility.

The following guide is one option (and in no order):

  • Find out what the ATO wants and why.

This may not be as simple as it sounds and may take some time. It is important however and will dictate the remainder of your preparation.

From the initial ATO contact and any further information you have from the ATO, try to ascertain:

  1. What risk the ATO have identified.
  2. What the issue is at the core of that risk – is there a transaction or series of transactions that has the ATO’s interest.
  • Is there a problem – is there the potential somewhere for a tax shortfall or other taxation issue.
  1. Is the resolution to an identified problem clear or is it likely to be contentious?
  2. If there is a problem, the scale of the problem and the potential fallout.
  3. If there is a problem, whether you, professionally, can continue to act and even if you can, if you should.
  • Do not panic.

Panic is the pathway to audit disaster.

We see examples of both client and accountant panic and it can be the accountant’s job to manage both. That is why it is critically important that the professional adviser acts in that way – professionally. Panic is never an option.

Panic can lead to hasty decisions that have not been properly considered.

Balancing client emotions can be difficult. Your client must be fully informed and realistic and at the same time not panicky.

  • Avoid emotional responses.

“It’s not fair” has no value to you and your clients, and yet we hear it way too often.

  • Do not make (more) mistakes.

Has someone in your firm potentially created the problem, or made it worse.

If that is the case, you should consider whether you can and should continue to act. You may also have to advise your insurers – consult your professional indemnity policy. Your insurers may instruct you to cease acting for that client.

Whether your firm has contributed to the audit, mistakes at this point can have terrible consequences. Common mistakes include technical (understanding the law) mistakes, underestimating the ATO and panicking.

  • Consider avoiding direct client – ATO contact.
  • Communicate with the ATO.

Communication is essential. A ‘review’ can swiftly change into an ‘audit’ and despite the difference in legislation, there is a difference at the ATO. Any opportunities available at review stage can be swiftly lost if you miss deadlines or are generally unhelpful.

  • Ensure the ATO are operating within their powers.
  • Communicate with your client.

Burying an ATO letter under the pile of things to do on your desk will not make it go away. Delaying any discussion with your client is unlikely to help.

If you cannot deal with the problem, let your client know that, close your file and move on.

  • Get help if needed.

Experts are available and across all areas. If your client needs one, tell them that. There is no shame in admitting that you are not the be all and end all of every possible taxation issue.

  • Try to look forward to a possible conclusion.

If there is a problem, there are opportunities now which may not be available for long, particularly if the ATO commence an ‘audit’.

  1. Is there the possibility for an early negotiated settlement.
  2. Is voluntary disclosure available.
  • Are there legislative possibilities available which might allow you to minimise any shortfall.

Returning to an earlier point (panic), you are unlikely to properly consider these possibilities will occur to you if you panic. In addition, you may need an expert to look at the possibility in enough detail.

Example: Section 109RB ITAA36

Consider a problem created under Section 109D[12] which we see all too frequently. Section 109D is a deeming provision – if certain things have happened, then there is a deemed outcome. This outcome – a deemed dividend, is unfranked and often unfrankable (depending on who received the payment and therefore the deemed dividend).

Division 7A is also a common cause concern from a lawyer’s perspective due to when and why we get called. More often than could be considered comfortable, an instruction comes down to this:

  • there is a Division 7A deemed dividend problem;
  • that is ok, we can declare a dividend (in the past…) to fix the problem;
  • we need a loan agreement (which we are going to backdate), please prepare it.

Other than it being simple, there is nothing good about that solution.

There is a better solution to the initial problem. Pursuant to Section 109RB[13], the taxpayer and Commissioner can mitigate this problem.

Firstly, note that the Commissioner has a discretion[14] to make (or to not make) this decision. Secondly, the result could be the deemed dividend is disregarded or, that it is frankable.[15] Thirdly – and this is not intended to be an exhaustive look at Section 109RB, the Commissioner must have regard to corrective action that the taxpayer has taken in relation to the Division 7A problem[16].

So, a taxpayer and their account in these circumstances may like to consider 3 alternatives:

  • Bury their head in the sand, nobody will ever find out.

If a review has commenced, this is not a good plan.

  • Backdate the dividend and loan agreement.

When considering this option, please also consider the very serious consequences that go with backdating a transaction.

  • Put a loan agreement in place (with a current date), make corrective repayments and apply to the Commissioner to exercise his discretion.

4. Consequences of Backdating

This is not intended to be a complete analysis on the consequences of what is commonly called backdating. Unfortunately, “commonly” is certainly the case. Even in 2017, it is at least once a week that a lawyer in our firm has to spend time writing file notes confirming that they advised a client who proposed backdating a document that they should not do it, and the potential consequences of doing so.

Backdating, in all its forms is a bad plan.

Lose your liberty – Criminal Consequences

Backdating has the potential to be a conspiracy to defraud the Commissioner of taxation revenue.[17] If you think this is an idle threat, accountants and advisers have gone and will go to jail for backdating.[18] The ATO take this sort of action very seriously.

There do not need to be any other reasons, but there are.

Lose most of everything else – Civil Consequences

We accept that a (supposedly compelling) reason to comply with a backdating request (or worse, you might have come up with the plan in the first place) may be to cover up a mistake made by you or your firm in the first place.

That is, you are concerned that you might be sued for negligence. If you lose, the financial impact could be serious.

Every accountant should, though, have professional indemnity insurance. The purpose of that insurance is to cover you in exactly those circumstances. PI insurance is designed to cover negligence. This means that the direct impact of a negligence claim is likely limited to the extent of your per-claim excess.

PI Insurance almost inevitably excludes claims connected with a criminal act. This means that any negligence connected to the criminal act (the backdating) will not be insured.

5.  Example of tax disputes

Well Managed Dispute – Division 7A

 A real client had these circumstances:

  • 10 loans from a company to related individuals and trusts.
  • Loans totalling more than $10,000,000.
  • Each of the loans had already triggered an automatic deemed divided under Division 7A.
  • The ATO commenced a review of the client with no specifically identified areas of interest.

 The client did this:

  • Put complying Section 109N loan agreements in place.
  • Put mortgages over real property, allowing the loans to extend to 25 years.
  • Made payments to ensure payments of principle and interest had been made as if the loan agreements had been in place for each loan from the beginning.
  • A voluntary disclosure and application under Section 109RB.

The Commissioner:

  • Accepted the client’s application under Section 109RB.
  • Did nothing else.

This is a good example of compliance action which worked in favour of the taxpayer.

Badly Managed Dispute – Controlled Foreign Trust

An overseas resident client did this:

  • Transferred property in another country to a foreign trust through a series of transactions.
  • Moved to Australia.
  • Presuming the trust now had nothing to do with him, ignored any income generated in or around the trust.

The ATO did this:

  • Commenced an audit.
  • Issued assessments.
  • Seized assets.
  • Made an error which doubled the shortfall in the re-assessed return.

The client and advisers:

  • Objected to the assessment and were partially successful, leading to a massive reduction in the assessment.
  • Failed to make a reasonable settlement offer to the ATO.

The taxpayer is now:

  • Out of Australia and likely unable to return.
  • Being hounded across the world for money that likely does not exist.

There was a point in time when this taxpayer had the opportunity to try to end the dispute. A reasonable settlement offer could have stopped the entire compliance process.

On the other hand, the unreasonable offer that was made got the taxpayer nowhere. Given the amount of money then spent by the ATO chasing this client, it likely made someone in the ATO fairly unhappy. Unhappy enough to spend a lot of money chasing a taxpayer all over the world for money which is likely to never be recovered.

This is also a good example of how compliance action can accelerate in circumstances where the Commissioner’s view is that the taxpayer has deliberately avoided tax.

  1. How to reduce incidences of compliance action

Of course, it is almost impossible to completely reduce this possibility. Even if every one of your clients submits completely accurate and fair returns, they may be subject to review. Other than not having any clients, there is no way to completely eliminate ATO review from your practice.

Also, it depends on the sort of practice that you want. You may be in the business of working for clients notionally at high risk of audit, which is completely fine.

Of course, there are also those practitioners who invite audit by working with high individuals and businesses and/or adopting high risk practices. These include practitioners who, over the years tended to shop around to their clients and benefit from very borderline tax minimisation schemes.[19]

Do you want to be a practitioner identified as a possible promoter of tax exploitation schemes? Do your clients want to be associated with that sort of practitioner.

New Clients

  •  Do Your Due Diligence.

If you have new client, do everyone (not only them and your practice) the courtesy of reading their papers. Review returns, working papers, trust deeds and anything else you are given.

 Check to make sure work done in the past has been done to your satisfaction. If not, you need to give it further consideration. New accounting work done on top of a mistake (inadvertent or deliberate) will potentially perpetuate the problem.

 If there is something you do not understand, get help. Help from an expert or help from the ATO.

  •  Check and cross-check (doubt everything).
  •  If there is a problem – do something about it.

Firstly, tell the client. A shortfall (or other problem) identified early can be properly considered and either fixed or mitigated before ATO action. At worst, no audit having commenced, voluntary disclosure should be available to mitigate any damage.

At this early stage of client engagement, you have that option. You also have the option to refuse the client engagement altogether. If a new client refuses to accept that there is an issue, which may have adverse consequences,

 Similarly to that outlined above at 3.1, this is a suggested set of procedures you might consider at this point – potential problem identified, no ATO compliance action.

  • In relation to the identified transaction:
  1. Is the resolution to an identified problem clear or is it likely to be contentious.
  2. The scale of the problem and the potential fallout.
  • If there is a problem, whether you, professionally, can continue to act and even if you can, if you should.
  • Do not panic.
  • Do not make (more) mistakes.
  • Consider Communicating with the ATO.

No matter how much you might hate the idea of a private binding ruling, at least consider the option.

  • Communicate with your client.
  • Get help if needed.
  • Try to look forward to a possible conclusion.

Similarly to above, if there is a problem, there are opportunities now which may not be available if the ATO find out about the problem.

  1. Is there the possibility for an early negotiated settlement.
  2. Is voluntary disclosure available.
  • Are there legislative possibilities available which might allow you to minimise any shortfall.
  1. Aggression is not the answer.

Covering up the initial transaction is not a good option.

Existing Clients

  • Avoid transactions that make you uncomfortable.
  • Avoid transactions that are too good to be true.
  • Avoid ‘experts’ and ‘promoters’ selling schemes to your clients.
  • Work within your level of expertise and get help when necessary.
  • Identify problems early and act accordingly.

If and when you identify a problem, consider the procedures at 6.1 above.

 7. CONCLUSION

Avoiding and preparing for ATO compliance action is something you have done and will do for your entire career in tax. The purpose of this paper was not to provide a definitive resource. Rather, the author hopes to have given some practical insights into strategies which have served well over the years and also into some which have not.

[1] Section 8 Income Tax Assessment Act 1936 (“ITAA36″), Section 3A Taxation Administration Act 1953, Section 1-7 Income Tax Assessment Act 1997 (“ITAA97″). Similar provisions exist in other taxing Acts, giving the Commissioner identical powers.

[2] Taxation Administration Act 1953

[3] Income Tax Assessment Act 1997

[4] Section 995-1 ITAA97

[5] It is used rather, in the context of reviewing a decision of the Commissioner as in Division 3 of Part IVA

[6] For example, the Commissioner’s practice until recent legislative changes to the taxation of trusts that trust distribution minutes could be prepared well past 30 June.

[7] Subdivision 284-C of Part 4-25 of the TAA.

[8] Section 284-225 TAA.

[9] MT 2012/3 at 71.

[10] For Section 284-225 TAA.

[11] Section 284-225(1)(a) TAA but only if the disclosure saves the Commissioner a significant amount of time or resources. See also MT 2012/3.

[12] More commonly known as Division 7A, particularly Section 109D of the ITAA36, contained in Division 7A of Part III of the ITAA36.

[13] Please also refer to the Commissioner’s PS LA 2011/29

[14] Section 109RB(1) ITAA36.

[15] Section 109RB(2) ITAA36.

[16] Section 109RB(3)(b) ITAA36.

[17] Section 135 Criminal Code Act 1995 Cth

[18] R v Dunn [2014] WASC 61

[19] These practitioners should be aware of the civil penalty provisions contained within Division 290 ITAA97, PS LA 2008/7 and PS LA 2008/8. Also note that Division 290 also applies extra-territorially.

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