Tax time is here again, and the ATO has been reminding taxpayers of their obligations and warning of the issues it will be particularly looking at this year.
Among the many areas that the ATO looks at is its focus on detecting the omission of cash income by individuals and businesses. It can do this in various ways (eg by data matching), but one major way is to examine a household’s expenditure to see if taxpayers are spending more than they return as income in their tax returns. Sounds pretty obvious, but it does happen.
In selecting taxpayers for reviews and audits, the ATO uses data matched from other government agencies and suppliers, including state government registration records of cars and boats, financial institutions and trade suppliers. Tax returns and activity statements are also used by the ATO to identify taxpayers who appear to be spending beyond their means and may not be reporting all their income.
The ATO then compares this information with the lodgement and income history of the business. Any discrepancies identified are then followed up. Comparison with the information provided by similar businesses can also identify a business for potential audit.
During an audit or review, the ATO often contacts third parties to gather information about the taxpayer or business. Data collected includes credit card records, overseas travel, bank account details and overseas money transfers. Customers and suppliers of the business may also be contacted by the ATO to request invoices, receipts, delivery addresses and payment details.
The ATO has, over the years, developed quite sophisticated techniques for reviewing and identifying businesses that it may wish to review or audit. So, it is not surprising to learn that, during an audit process, the ATO often asks taxpayers to complete a questionnaire detailing the living expenses for their household.
What have personal living expenses got to do with a business? Perhaps nothing, but examining those expenses can provide the ATO with background information that could indicate that a business has not returned all its income for tax purposes or at least points to further questions being asked.
At least part of the ATO rationale is that, by self-reviewing their personal living expenses, taxpayers have the opportunity to evaluate their record keeping practices and consider if anything has been missed from either their personal income tax return, or the tax return of their business.
To assist with these reviews, the ATO has created personal living expenses worksheets that provide analysis of all household income inflows and outflows. By comparing annual household funds and expenditure, the ATO believes taxpayers can self-assess whether their declared income is enough to support their actual lifestyle. Does A – B = C? Any differences may well be explainable but the taxpayer may be called on do provide that explanation to the ATO.
The ATO gave the example of a concreter who runs his own business and meets his tax agent to discuss his annual tax return. Because the concreter’s business records are not complete, the agent suggests they look at his personal living expenses using one of the ATO’s worksheets.
The business owner is married and has two school-age children. He lives with his wife and children in a home they are paying off. He recently obtained a mortgage to purchase a second home where his parents, who are pensioners, live rent-free. He also provides assistance to his brother who lives overseas.
Using both business and personal records, the business owner completes a personal living expenses worksheet with the help of his tax agent. Their analysis shows a reported annual household income (husband and wife, after tax and including Family Tax Benefit) of $50,829 for both the business owner and his wife.
The family’s outgoings are $65,900 (including the two mortgage payments, private school fees, health insurance, credit card and money transferred overseas) which exceeds their reported income by $15,071, without taking into account basic household expenses such as food, clothing and entertainment.
As the concreter’s household outgoings significantly exceed his incoming funds, he will need to look at his records and be prepared to explain the difference if asked to do so by the ATO. Non-cash tax return items like depreciation can be part of the explanation for the difference, but the difference itself can at least prompt the business owner to review his invoices and business expenses to ensure nothing has been missed.
In another example, the owner of a small painting business visits his tax agent to discuss his annual tax returns. The business owner has recently purchased a boat and is concerned about being selected for audit as a result of the ATO’s data matching program. Don’t forget that ATO matches data from state government registration records of cars and boats.
His tax agent advises him that his reported income is low when compared to other similar painting businesses and suggests the business owner complete a worksheet about his family, their income, assets and expenses.
The business owner lives with his wife, who does not work, in a home they paid off some years ago. They have three children – aged 17, 22 and 25 years-old. The youngest lives at home, while the eldest lives in a property his parents purchased with an interest-only mortgage.
Using both business and personal records, including bank and credit card statements, the business owner completes the personal living expenses worksheet and records a household income of $36,275 for the year (which includes his and his wife’s after-tax income plus some Family Tax Benefit). The family’s expenses are $81,275, which exceeds their reported income by $45,000.
The expenses recorded on the worksheet included rates, food, power and water, phone, eating out, newspapers, clothing and footwear, fuel and registration on motor vehicles, health insurance, superannuation, loan repayments on the boat, mortgage payments on the second property, a family trip overseas and private school fees. As can be seen, these worksheets produce detailed figures (essentially a cash-flow analysis) that readily provide a comparison to the figures included in the tax return.
As with the concreter, this business owner’s household outgoings exceed incoming funds, so he needs to look at his records and be prepared to explain the difference. His tax agent calculates that some of the difference is due to non-cash items in the painter’s tax return such as depreciation. However, a significant difference still needs to be explained.
If the ATO asked the business owner to complete a personal living expenses questionnaire during an audit, it would question him about the accuracy of his reported income and household expenses. Among other things, the ATO says it would query the claimed $600 spent on clothing and footwear as it considers that, for a household of two adults and a teenager, this is a low amount. This is how detailed and specific the queries can be.
If the business owner was audited by the ATO, he would be required to produce detailed documentary evidence in support of his explanation. If he could not fully explain the difference and was unable to produce suitable supporting evidence, the ATO would re-assess him and increase his income figure. He would then have to pay tax on any shortfall of omitted income plus penalties and interest.
The foregoing paints a picture of the scope and extent of the ATO’s powers and efforts in detecting omitted income. However, the very fact that it has prepared worksheets that business owners can use to set out these income and expenses, and see how that compares with figures declared in their tax returns, gives taxpayers the opportunity to determine whether they need to make adjustments to their business and record keeping practices before the ATO comes calling. The worksheets can also help improve the efficiency of a business.
These are relatively simple things to do, but illustrate the value of keeping a close eye on income and expenses – both business and private.
Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
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