Tax loss claims: Government concerns send a warning

Correctly claiming tax losses or returning capital gains are two very basic elements of the tax system that continue to cause problems. The Government knows this and the 2011-12 Federal budget on 10 May 10, 2011 effectively sent a warning to businesses which, by the way, won’t go unnoticed by the Tax Office.

The global financial crisis has apparently seen such a large increase in the stock of capital losses on hand that the Government is concerned about the effects those losses will have on its revenues. And when the Government is concerned about this, the Tax Office won’t be far behind.

The size of the problem

Given the economic circumstances that have applied in recent years, the 2011-12 Federal budget papers say the outlook for tax receipts has been “significantly revised down” in the near-term. The Government says there is increasing evidence that the effects of the subdued economy on receipts have been exacerbated by what are “larger than previously anticipated losses” incurred during the global financial crisis.

The Government estimates the stock of capital losses in 2008-09 has risen to over 20% of GDP, or more than double 2007-08 levels. The utilisation of these losses, as well as operating losses, has driven significant downward revisions to revenue receipts, primarily in company tax and other individuals’ tax receipts.

The larger amount of losses means it will take longer for them to be recouped, and the Government expects these losses will continue to exert a larger and more significant influence in 2011-12 on company tax receipts, and CGT receipts more broadly, than had previously been anticipated. In addition, gains from the property market have also been lower and this further exacerbates the weakness in CGT receipts.

Capital gains tax receipts affected

The Government says past losses and slow recovery in wealth suggest capital gains tax (CGT) receipts will not return to earlier pre-crisis levels for some years. Capital gains tax is expected to be $3.2 billion lower in 2010-11, and $3 billion lower in 2011-12, than previously anticipated.

Net capital gains were $30 billion for 2008-09, which is $60 billion lower than for 2007-08. The stock of capital losses more than doubled from $104 billion in 2007-08 to $260 billion in 2008-09.

The full impact of these losses on future CGT receipts depends on when the stock of accumulated losses is claimed against future gains. The Government says two factors suggest “continued softness” in CGT receipts:

Features of the tax system (such as CGT only being levelled on realised gains) mean that, like company tax, CGT is partly paid in the years after capital income is earned. A major proportion of capital gains earned during the 2009-10 and 2010-11 income years will be offset by the utilisation of the large stock of losses.
History shows that existing losses in the system take a considerable time to be run down. This suggests a much longer period of strong asset price growth will be needed to draw down the large 2008-09 stock of losses.

The Government said the global financial crisis had the biggest impact on taxes from profits, capital gains and consumption (eg. GST) and it is these taxes that still remain below their pre-crisis levels.

Tax Office already “on the case”

All of the above can only suggest that the Tax Office is likely to scrutinise tax loss claims and capital gains even more closely in the next few years. Of course, losses and capital gains have been on the ATO’s compliance radar for many years and its latest Compliance Program flagged them again.

Last year, the ATO data-matched over 500 million transaction records reported to it by third parties and this year expects to analyse a similar volume of records, including details of property and share ownership and disposals. This, of course, helps it in checking on capital gains (and losses) claimed by taxpayers. The ATO is also concerned that investors are failing to declare capital gains on the sale of their investments. It says it may alert taxpayers to their CGT reporting obligations where they have had capital gains events from the sale of shares or property (which the ATO will know from its data-matching activities).

As part of the ATO’s current compliance activities, where micro enterprises incurred a loss for the first time in 2009, the ATO will contact them and provide information about incurring and using losses. It will also review the tax affairs of businesses using losses to ensure that tax payable is not incorrectly reduced in current or future years.

The ATO says most CGT issues centre on the incorrect reporting of a capital gain in assessable income. This can occur as a result of not including a capital gain, inflating the cost base to reduce the amount of a capital gain, or incorrectly accessing one of the various concessions or rollovers.

Get the tax concessions right

The most difficult to understand, but potentially one of the most beneficial, tax concessions for SMEs are the small business tax concessions. They are complex but can provide great tax benefits where they are used effectively. To assist, the ATO has published three practical tips designed to help with the correct application of the concessions.

Market valuations: when considering the valuation records that must be keep, the ATO says:

where the CGT event (most commonly, the disposal of an asset) is a result of a non-arm’s length transaction (eg. transfers of real estate or shares between related parties, such as husband and wife, or family members), taxpayers must obtain evidence of the asset’s market value just before the CGT event;
to be eligible for the concessions under the $6 million maximum net asset value test, taxpayers must work out the following just before the CGT event: (i) the market value of all relevant assets and liabilities; (ii) the market value of all the relevant assets and liabilities owned by any entities with whom the taxpayer is either connected or affiliated.

Aggregated turnover test: aggregated turnover is a taxpayer’s annual turnover plus the annual turnovers of any businesses that are connected or affiliated with them. Their aggregated turnover must be less than $2 million. There are three alternate methods taxpayers can use to work out whether they are a small business entity for the current year: (i) the previous year turnover method; (ii) the estimate of current year turnover method; (iii) the actual current year turnover method.
Record keeping: the most important records taxpayers must keep are:

financial statements prepared just before the CGT event for taxpayers and entities connected or affiliated with them;
evidence of the market value of the following in order to demonstrate eligibility for the $6 million maximum net asset value test: (i) the taxpayer’s assets just before the CGT event; (ii) assets belonging to any entities connected or affiliated with the taxpayer;
evidence of the following to demonstrate the taxpayer’s eligibility for the small business entity test: (i) they are carrying on a business; (ii) their turnover calculations and those of any entities connected or affiliated with them;
records supporting how any capital losses have been calculated and carried forward to later years.

The close scrutiny by the ATO of loss claims in general, and the correct treatment of capital gains (and losses), must be expected to continue, or even increase. SMEs might take note.

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