Medium business income tax gap 2018-19

This information is for historical purposes only. If you require previously published content for past estimates, please email taxgap@ato.gov.au.

This estimate for the medium business income tax gap relates to the 2018-19 financial year.

On this page

• Trends and latest findings
• ATO action to reduce the gap
• Methodology
• Reliability

This gap forms a part of our overall tax performance program.

For the purposes of estimating this gap, we define the medium business population as companies with a group turnover of between $10 million and $250 million, as well as the individuals controlling these companies. Most companies in our analysis had a turnover of less than $50 million.

Entities linked to a high wealth group are excluded from this analysis and are included in the High wealth income tax gap. Where income earned from trusts and partnerships is distributed to companies or individuals in the medium business population, we recognise the tax effect here.

For 2018–19, we estimate the net income tax gap for medium business to be $814 million or 6.2%. We estimate that medium businesses paid around 94% of the total theoretical tax payable for 2018-19.

See more about:

• the concept of tax gaps, including why and how we measure them and a summary of the latest available tax gap data in Australian tax gaps – overview
• our research methodology, data sources and analysis used for our tax gap estimates in Principles and approaches to measuring gaps.

Trends and latest findings

The net medium business income tax gap estimate for the latest year increased slightly to 6.2%, but over time, this gap has remained steady.

The data in this table has been refreshed as part of producing the tax gap for 2018-19.

Figure 1 displays a trend of the medium business tax gap as a percentage over the same period.

Figure 1: Gross and net tax gap (percentage) – medium business, 2013–14 to 2018–19 

Medium business population

The medium business population represents a diverse group of businesses. As a result, the risks and behaviours driving tax errors differ greatly across the population.

Historically we have focussed on specific tax risks, but this may shift as we take a more holistic approach to the compliance of medium business.

The medium business population includes a mix of:

• publicly-listed businesses
• internationally-controlled businesses
• privately-owned businesses
• not-for-profit organisations.

Medium businesses cover a wide turnover range between $10 million and $250 million. However, approximately 80% of medium businesses have a turnover of less than $50 million.

Some medium businesses are well established and closely resemble large businesses in their structure and behaviour. Publicly-listed companies have additional regulatory and governance requirements that influence their tax decisions.

For medium businesses with international dealings, incorrect tax outcomes may be the result of how they interpret tax law or navigating complex international transactions.

Others were small businesses that experienced recent growth into a medium business. Their systems, controls and governance may no longer provide sufficient support for their expanding business. We see this manifest in simple errors and mistakes, including inadvertent omission of income, overstated expenses or miscalculation of capital gains.

Only a very small proportion of medium businesses deliberately avoid paying tax. It is this group that contributes significantly to the tax gap. Often, we see opportunistic behaviour, carelessness in meeting tax obligations, or failure to report income. Some may operate outside of the system by entering into tax evasion arrangements.

With improved data analytics, it is becoming increasingly difficult for taxpayers to evade tax without detection.

What's driving the gap

The majority of medium businesses pay the right amount of tax and they pay it on time. When they make mistakes, they readily correct them. When we identify errors during a review, they often make a voluntary disclosure.

Where medium businesses make mistakes, it is generally in how they interpret tax law or because they do not understand their tax obligations.

The most common issues we see from taxpayers are:

• incorrectly recording transactions or not reporting transactions that are outside the normal course of business
• not accounting for private use of business funds or assets
• omitting domestic or foreign-sourced income.

A very small number of medium businesses seek to evade paying the right amount of tax. These groups take advantage of the closely-held nature of their structures. We see these groups undertaking artificial and non-commercial arrangements that are intentionally designed to evade tax. Where we detect deliberate tax evasion, we apply correction strategies such as penalties and prosecutions.

ATO action to reduce the gap

Over 92% of tax paid by medium businesses is paid voluntarily, without any intervention by us. Our engagement activities increases this to approximately 94%.

Our primary strategy for reducing the tax gap is increasing voluntary compliance by making it easy for medium businesses to get their tax right and keeping the system fair by tackling tax avoidance.

We make it easier for medium businesses to get their tax right by:

• Helping navigate complex tax law with advice and guidance that is clear and practical. Our practical compliance guidelines and taxpayer alerts give businesses certainty on our view of the law so they can make decisions with confidence.
• Providing timely access to tailored support, including our early engagement and commercial deals services. Businesses can talk to us when transactions get complex, so they can get it right up front.
• Supporting transition and growth by providing the right tools for growing businesses. We provide information on good tax governance and record-keeping for managing obligations with less chance of error and mistake.

We keep the system fair by taking firm action against tax avoidance and those who deliberately evade their obligations.

Our Tax Avoidance Taskforce programs improve the tax performance across both the high wealth and medium business populations. Through our engagement and assurance and risk-based strategies across the Top 500, Next 5,000, Medium and Emerging, and Abusive Use of Trust programs, we seek to improve voluntary compliance in the tax and super system.

Through our programs, we:

• use risk models and data analytics to identify trends and behaviours, and design strategies to mitigate risks across the population
• engage one-to-one with taxpayers to influence behaviour towards voluntary compliance
• work with businesses experiencing rapid growth or looking to expand offshore
• encourage compliance by informing medium business of what current tax risks and behaviours attract our attention so they can make informed decisions.

Where we detect evasion, we apply corrective action such as penalties and prosecution. This keeps the system fair for everyone.

Through our engagement under the tax avoidance taskforce, we have seen steady increase in the number of medium businesses willingly participating in the tax and superannuation system as evidenced in Table 2.

See more about:

• Tax control frameworks for medium and small corporations
• Early engagement for advice
• Commercial deals
• What attracts our attention
• Medium and emerging private groups tax performance program

Methodology

The medium business income tax gap estimate is derived through applying two bottom-up statistical methods:

• the 'extreme value theorem' regression model for individuals
• a two-stage logistic and linear regressions for companies – we refer to this as the 'logistic linear regressions' model.

The steps we used are detailed below followed by a summary table for each population. Overall results for the combined estimate are shown in Table 1.

Calculation – medium business individuals

We used four steps in applying the extreme value theorem regression model to the individual's population. The steps are explained in more detail below:

• Step 1: Identify the extreme population
• Step 2: Estimate the unreported tax amount
• Step 3: Apply a non-detection uplift and non-pursuable debt
• Step 4: Consolidate the gap estimates

Step 1: Identify the extreme population

Amendments for medium individual taxpayers follow a power law distribution, with the majority of total tax amendments in value terms represented by a small number of amended income tax returns.

We rank the amendments in descending order and identify the point where the cumulative sum of positive amendments is equal to or less than the total negative amendments. We remove all these small amendments, which together have no impact on the net value of total amendments. The remaining amendments are referred to as the 'extreme values'. Based on this, we calculate the number of extreme values as a ratio of all amendments to be used for extrapolation purposes in Step 2 below.

Step 2: Estimate the unreported tax amount

We transform the amendment data of the extreme population to estimate a linear relationship between the value and rank of the amendments using a regression approach. To estimate the unreported tax amount, we then extrapolate the regression outcomes to the number of taxpayers expected to contribute to the extreme values in the wider population.

Step 3: Apply a non-detection uplift and non-pursuable debt

We need to account for imperfections in the process that could lead to the final gap estimate not reflecting the true tax gap. To account for non-detection, we apply an uplift factor to the unreported tax amount in Step 2.

Step 4: Consolidate the gap estimates

The gross gap is calculated by adding the unreported amounts from Step 2 to the non-detection uplift and non-pursuable debt from Step 3. The net gap is calculated by subtracting the total amendment amount from the gross gap. The net gap is then added to the tax paid to estimate the total theoretical liability.

Calculation – medium business companies

We used five steps in applying logistic linear regressions to the company population. The steps are described in more detail below:

• Step 1: Establish a logistic regression trend
• Step 2: Establish a linear regression trend
• Step 3: Combine the results from the two regressions
• Step 4: Apply a non-detection uplift factor and non-pursuable debt
• Step 5: Consolidate the tax gap estimates

Step 1: Establish a logistic regression trend

We analyse the income tax return data of companies that have been subject to amendment activities. We apply weights to the data to account for selection bias in our data. Using a logistic regression approach, we identify the relevant characteristics of businesses in general that would contribute to the prediction of whether or not a business has a tax gap.

Based on these characteristics, each company taxpayer is assigned a unique probability of having a tax gap. Each company is then modelled to be either compliant or non-compliant through a Monte Carlo simulation.

Step 2: Establish a linear regression trend

We analyse the income tax return data of companies known to be non-compliant, to identify relevant characteristics of businesses that would contribute to the prediction of the size of a tax gap, if the company is found to be non-compliant. Weights are applied to account for selection bias. The linear regression is then applied to each company to estimate the potential size of the tax gap.

The key difference between Step 1 and Step 2 is that Step 1 calculates the likelihood of a company having a tax gap, while Step 2 calculates the size of each company's potential tax gap.

Step 3: Combine the results from the two regressions

The estimated unreported tax amount for each simulation is calculated by adding together the non-compliance amounts from Step 2 for all non-compliant businesses predicted in Step 1. We estimate total unreported tax (including amendments) by taking an average of the results from the 20,000 simulations.

Step 4: Apply a non-detection uplift factor and non-pursuable debt

We uplift the estimates preceding this step to account for non-compliance that is not detected. This ensures the final estimate is not understated.

We also add in the value of non-pursuable debt. This is debt that the Commissioner of Taxation has assessed as being not legally recoverable, uneconomical to pursue, or unable to be pursued due to another Act.

Step 5: Consolidate the tax gap estimates

The gross gap is calculated by adding up the unreported amounts from Step 3 to the non-detection uplift and non-pursuable debt from Step 4. The net gap is calculated by subtracting the total amendment amount from the gross gap. The net gap is then added to the tax paid to estimate the total theoretical liability.

Limitations

The following caveats and limitations apply when interpreting the medium business income tax gap estimate:

• There is considerable lag between an income year and the completion of our compliance activities relating to that year. This means that gap estimates may remain subject to revision for a considerable period. Results for 2016–17 onwards are projected and are expected to be subject to revision.
• The true extent of non‑detection is unknown and is extremely challenging to measure. There is no international proxy that can be applied to the individuals or companies in this population. We assume that there will be errors and omissions in our compliance activities due to factors outside our control and limitations in operational capability and capacity.

Updates and revisions to previous estimates

Each year we refresh our estimates in line with the annual report. Changes from previously published estimates occur for a variety of reasons, including:

• improvements in methodology
• revisions to data
• additional information becoming available.

The updated net gap percentages for this year are marginally lower than previous estimates due to natural population churn between tax gap populations.

Figure 2: Comparison of previous and current net tax gap estimates (%), 2012–13 to 2018–19

This data is presented in Table 4 as a percentage.

Table 4: Current and previous net medium business income tax gap estimates, 2012–13 to 2018–19

Reliability

We seek feedback and advice about the methods we use to estimate the gap from our external and internal subject matter experts. Based on the advice and assessment, the reliability for this estimate is medium (with a score of 20).

While the current method is considered acceptable, it is possible to use a random enquiry model on this population. This would provide more granular insights into the gap estimate and overall compliance for this population.

Figure 3: Reliability rating scale from very low to very high – medium business income tax gap