Should you fess up to the taxman?

The tax law contains provisions which allow for tax penalties to be reduced where the taxpayer makes what is known as a “voluntary disclosure”. The savings can be significant, right up to the base penalty being effectively waived.

But to get a reduction in penalties, taxpayers have to fess up to the taxman before he effectively “catches” them.

In broad terms, an administrative penalty is imposed under the tax laws where a taxpayer (or their agent):

makes a statement to the Tax Commissioner about a taxation law which is false or misleading in a material particular;
makes a statement to the Commissioner which treats an income tax law in a way that is not reasonably arguable; or
fails to make a statement by not lodging a return, notice or other document with the Commissioner by the due date and the statement is necessary for the correct determination of a tax-related liability.

Penalties come in various shades of black, white and grey. If a taxpayer makes a statement which results in tax being underpaid (ie. a shortfall), the amount of what is known as the “base penalty amount” depends on the cause of the shortfall eg:

where there is an intentional disregard of a taxation law, the penalty is 75% of the shortfall amount;
where there is recklessness (ie. gross carelessness or gross negligence) as to the operation of a taxation law, the penalty is 50% of the shortfall amount;
failing to take reasonable care to comply with a taxation law results in a penalty of 25% of the shortfall amount.

The base penalty amount can be reduced in certain circumstances where the taxpayer voluntarily discloses relevant information. For example, it can be reduced by 80% or to nil if the taxpayer voluntarily discloses to the Commissioner a shortfall amount or the false or misleading nature of the statement:

before notification that an examination of their tax affairs (eg. a tax audit) is to be conducted; or
if the Commissioner makes a public statement requesting entities to make a voluntary disclosure about a relevant scheme or transaction – before the deadline for making the disclosure.

The Tax Office recently released a draft tax ruling which discusses the provisions under which an administrative penalty may be reduced if the taxpayer voluntarily discloses there is a tax shortfall or that a statement (eg. in a tax return) is false or misleading.

The base penalty amount can be reduced by 80% if the voluntary disclosure is made before the taxpayer is told their tax affairs will be examined (if the tax shortfall is less than $1,000, the bas penalty is reduced to nil) and by 20% if the voluntary disclosure is made after the taxpayer is told about such an examination. In addition, the 20% reduction only applies if telling the Commissioner can reasonably be estimated to have saved the Commissioner a significant amount of time or significant resources.

What is “an examination… of your affairs relating to a taxation law for a relevant period” is not restricted to the calculation of the taxpayer’s tax-related liabilities and may include an examination of their affairs in relation to debt collection, registration, reporting or other matters to the extent that the issues under examination relate to a taxation law. In addition, an examination is not confined to an audit, although it does not encompass activities that are merely educational in nature.

The meaning of “voluntarily” telling the Tax Commissioner is seen by the ATO as an act done without persuasion or compulsion on the part of the Commissioner.

An issue considered in the draft ruling is what information must be provided to the Commissioner to constitute a voluntary disclosure for the purposes of the relevant law.

Essentially, the taxpayer must disclose the relevant facts and other information to enable the Commissioner to adjust the tax-related liability, but if that is not possible, the taxpayer must do everything reasonably necessary to enable or assist the Commissioner to determine the shortfall amount.

In the context of false or misleading statements that do not result in a shortfall amount, the taxpayer will be required to disclose sufficient information to enable the Commissioner to correct the false or misleading statement and/or rectify any decisions made or action taken as a consequence of the entity making the false or misleading statement.

The Tax Commissioner has a discretion to treat a voluntary disclosure made after the taxpayer is informed about an examination of their tax affairs as if it had been made before being so informed. In such a case, the base penalty will be reduced by 80% (or to nil in certain circumstances). The draft ruling states that, as a general rule, the Commissioner’s discretion will be exercised in the following circumstances:

where the Commissioner is merely identifying and/or assessing risks, for example a risk review, notwithstanding that this is considered to be an examination;
where the disclosure is not within the scope of the examination as notified to the taxpayer (that is, it is outside the risk(s) or issue(s) covered by the examination);
where the tax officer invites the taxpayer to make a voluntary disclosure within a specified period or by a specified date, and the taxpayer makes a full disclosure within that period or by that date;
where, during the initial notification of the examination, the tax officer advises the taxpayer that the examination will commence at a subsequent date (known as the formal date of commencement), and the taxpayer makes a full disclosure on or before that date; or
where a company is undertaking its own review of its affairs (often called “a prudential audit”) at the time the Commissioner notifies the entity of the examination and it could reasonably be concluded that the entity was going to disclose the outcome of its review irrespective of the Commissioner’s examination.

In all cases, the disclosures must still have been made voluntarily.

As a matter of policy, it is likely that the ATO will remit the penalty in full if the taxpayer made an honest mistake and voluntarily discloses the shortfall amount (or the false or misleading nature of a statement) before being notified of an examination of their tax affairs.

Repeated voluntary disclosures however, may indicate that the taxpayer has not made an honest mistake!

The voluntary disclosure rules are an important part of the tax system. With the ATO’s more proactive approach to ensuring tax compliance (eg. through data-matching, data mining, “real time” reviews, etc), the value of making a genuine voluntary disclosure is perhaps greater than it’s ever been.

The basic issue is to ensure the ATO accepts that a taxpayer’s actions meet the voluntary disclosure rules and guidelines, and hence qualify for a reduction in any penalties. This can be something of a minefield, so it is advisable to take professional advice in this regard.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .