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  • Small business random enquiry program findings

    For the purposes of estimating the small business income tax gap, we review the income tax affairs of randomly selected small business taxpayers. This is called the random enquiry program.

    The small business income tax gap estimate for 2018–19 is a preliminary estimate. It will be revised and released with updated findings from our random enquiry program in 2022.

    The small business income tax gap estimate for 2017–18 is based on the outcome of reviews and audits of around 2,000 taxpayers across the 2015–16, 2016–17 and 2017–18 financial years.

    Of the taxpayers sampled, we found that:

    • 64.3% reported correctly
    • 25.5% tried to report correctly but made mistakes. These were usually caused by one or more of the following
      • poor record keeping
      • lack of reconciliation processes
      • carelessness (for example, transposition errors or small one-off omissions)
      • complexity (business owners not understanding the law)
    • 6.7% under-reported income or exaggerated expenses and were considered to be non-compliant. While there was no definitive evidence of shadow economy (previously known as black economy) activities, these taxpayers often made little effort to keep records or substantiate claims
    • 3.5% under-reported income or exaggerated expenses. This group were clearly identified as deliberately avoiding paying the right tax. They were considered to be operating in the shadow economy.

    While only 3.5% of the taxpayers in the sample were clearly identified as exhibiting shadow economy behaviour, the adjustments made to their tax returns accounted for over a third of the missing revenue identified across the sample.

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    Small businesses getting it right

    When we see businesses operating well and complying with their tax obligations, we see they have the basics right. These businesses:

    • keep good records and conduct thorough reconciliation processes
    • seek advice when they need it
    • have the support of someone who understands their business (for example, their tax or BAS agent, a bookkeeper or accountant)
    • use technology to help run their business – from point of sale software, to cloud-based accounting systems, or mobile apps.

    Small businesses getting it wrong

    Mistakes with tax can cost businesses time and money. It’s worth investing the time upfront to get it right.

    When small businesses are getting their tax wrong, it's usually in one of four ways:

    • making errors as a result of poor record keeping
    • not declaring all of their business income
    • failing to account for private use of business assets or funds
    • making mistakes because they don't understand their tax obligations

    Not keeping proper records

    Poor record keeping can be the result of a lack of business acumen. We've also seen examples where records are not kept as a tactic to mask deliberate tax avoidance.

    Poor record-keeping habits make it hard for tax professionals to ensure that their clients are reporting accurately.

    Some of the record keeping issues we've seen include:

    • no source records kept for business income
    • errors due to manual recording or transposing of figures
    • expenses claimed (e.g. motor vehicle, travel expenses, home office) without the necessary substantiation
    • poorly maintained documentation (e.g. logbooks not kept up to date)
    • poor storage of documents (faded receipts)
    • bank account statements used to determine income and expenses (instead of being reconciled against).

    Digital record keeping solutions are the ideal way to keep records, but care is required to ensure they are fit for purpose and set up correctly. In the random enquiry program, we saw coding and software errors including:

    • miscoding of transactions (e.g. distributions, interest, sales, expenses)
    • double-counting of records
    • software limitations (e.g. software didn’t allow use of sales codes for any payments made from a bank account).

    Not declaring all income

    Undeclared business income can be unintentional or deliberate. When it's deliberate, the amounts are usually larger.

    Through the random enquiry program, we saw businesses deliberately hiding income in a variety of ways, including:

    • depositing income into private accounts or mortgages
    • receiving cash and not declaring it
    • not reporting all electronic transactions
    • not declaring coupon or voucher sales.

    Some tax agents knowingly participate in these activities. But we also saw many examples where tax agents were not given the information they needed to report correctly.

    Not accounting for private use of business assets or funds

    Claiming private expenses within the business can also be unintentional or deliberate.

    Unintentional errors are often the result of insufficient record keeping and reconciliation processes. In the program, we saw business owners:

    • failing to keep a logbook to account for the business use of motor vehicles
    • guessing whether expenses were business expenses or personal expenses.

    Where the behaviour is deliberate, the taxpayer has often attempted to exploit the rules. Examples we saw include:

    • personal expenses claimed as a business expense (for example, rent, travel, fines, meals, alcohol)
    • an excessive business portion claimed for things used personally and for business purposes (for example, home office expenses)
    • director's fees or drawings not recorded correctly.

    Not understanding tax obligations

    Tax law in Australia can be complex, leaving some taxpayers unsure of their tax obligations.

    The obligations a small business taxpayer is required to meet can differ depending on the business structure they have chosen. Unnecessarily complex business structures can over-complicate their tax obligations.

    No matter which structure they operate under, business owners are responsible for ensuring they pay the right amount of tax.

    Most small businesses are not structurally complex. Around 80% are owned and operated by one or two people, using a base structure of company, trust, partnership or sole trader. But a range of concessions can apply to small businesses. Sometimes a one-off or unusual event such as a business restructure can add a level of complexity.

    We saw several examples of business owners making mistakes because they didn't understand their obligations, including:

    • company owners using company assets for private purposes, or private assets for company purposes. The consequences of this can include
      • over-claimed or incorrectly claimed business expenses
      • undeclared profits and dividends
      • misapplication of loan accounts
    • sole traders transitioning to a company or trust structure, without understanding that
      • business assets are now owned by a separate entity (that is, the company or trust)
      • personal use of these assets can result in a fringe benefits tax obligation
    • business owners incorrectly splitting income with other family members – this is referred to as the alienation of personal services income (PSI)
    • business owners incorrectly claiming private expenses (e.g. rental expenses, legal/litigation costs), including the travel costs associated with those expenses
    • company directors borrowing company or trust funds for personal reasons (e.g. large purchases or day-to-day expenses) without maintaining the appropriate loan documentation or records required. This has implications under Division 7A of the of the Income Tax Assessment Act 1936.

    While some business owners are making genuine errors in these areas, others are deliberately breaking the rules to avoid paying the right amount of tax.

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    The shadow economy

    The shadow economy (formerly known as the black economy) impact on the small business income tax gap is estimated to be around $6.3 billion, or around 47% of the gross income tax gap. This is mainly due to businesses deliberately hiding or under-reporting their income. To a lesser extent, it is also due to businesses deliberately over-claiming business expenses.

    The shadow economy refers to economic activities that are unrecorded and untaxed, but the behaviour is not limited to tax issues. It is a complex, multi-faceted phenomenon operating across Australia’s workplace relations, financial, welfare, procurement and migration systems. Activities include dishonest or opportunistic behaviour carried out to misuse or abuse these systems, as well as criminal activities.

    Common shadow economy activities for small businesses include:

    • deliberately hiding income or overclaiming expenses
    • underpaying wages or paying cash wages to avoid a range of government obligations
    • not meeting reporting obligations on payments to contractors and others
    • liquidating and reforming a business to avoid obligations (known as 'phoenixing')
    • illegal activities, such as money laundering and unregulated gambling.

    Some examples of activity that we observed included:

    • business owners deliberately under-reporting income to finance their lifestyle
    • claiming expenses that have no link to business activities
    • paying staff or contractors in cash and not reporting it.

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    Tax professionals working with small businesses

    Australian small businesses use tax professionals more than those in countries that have reported a larger tax gap.

    The role of tax professionals and their relationships with their clients vary significantly. Most small businesses engage a tax professional to help prepare and lodge their annual tax return. We saw many cases demonstrating how more regular contact with a tax professional-enabled small businesses to correctly meet their obligations and report correctly.

    In these cases, the tax agent (through regular contact with the business owner, accounts person or bookkeeper) developed a good understanding of what was happening in the business. This ongoing relationship provided a platform for the tax agent to identify obligations the business owner may have overlooked. It also enabled them to provide the right advice at the right time.

    Areas to focus on

    During the random enquiry program, we also identified instances where tax practitioners:

    • made mistakes as a result of bookkeeping and accounting system errors
    • provided incorrect advice
    • failed to show reasonable care.

    While they rely on the information their clients provide, tax professionals are expected to show reasonable care and perform some basic checks. They should ask additional questions to ensure their clients are reporting accurately.

    Some examples of situations where tax professionals failed to show reasonable care included:

    • not checking whether all relevant information had been provided by the client
    • not questioning ambiguous or seemingly far-fetched information
    • not providing the level of support the client needed when setting up a new business structure or when business activities changed.

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    Last modified: 20 Oct 2021QC 59962