Benchmarking even when practiced in Australia for tax purposes has its limitations especially when it comes to variations in business practices. The current benchmarking practice has raised certain challenges particularly for small business owners. Still its use helps in the tax compliance and proper payment of taxes.
ATO use of benchmarking causes SME concerns
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The ATO has been using benchmarking for some time in its compliance activities. However, a report by the Inspector-General of Taxation, Ali Noroozi, into the ATO’s use of benchmarking to target the cash economy has flagged business concerns about the ATO’s use of benchmarks.
Under its benchmarking strategy, the ATO uses a business’ financial performance variance from their industry benchmark as the main basis for determining the administrative treatment to which the business will be subjected. The treatments vary from a help and educate letter, to a phone review, or a correspondence audit (see further below).
The Inspector-General conducted his review in response to concerns raised by small businesses and tax practitioners about the ATO’s use of small business benchmarks.
Overall, the review found that stakeholders were supportive of the use of benchmarks as a risk identification tool. They were, however, concerned with the benchmarks themselves in addition to the way the ATO was using them for compliance activities.
In particular, concerns were expressed that the benchmarks did not account for business differences in an industry or for geographic differences. Where this was the case, resultant ATO action could impose time and cost pressures on small businesses that later proved to be unwarranted and unnecessary. There were also concerns about the data integrity of the inputs the ATO was using to develop its benchmarks.
The Inspector-General said he found that many of these concerns related to the transparency of the process and could be addressed by publishing the data inputs and methodology the ATO uses to develop the benchmarks, as well as seeking and publishing independent third party assurance on the methodology.
The Inspector-General also noted there was some confusion during ATO audits about the types of evidence the ATO would take into account in determining whether taxpayers had omitted income.
The IGT found that the ATO could address this confusion by clarifying in its staff instructions and communication with businesses the evidence it is seeking during audits. In particular, the Inspector-General recommended that the ATO publish information regarding how it takes into account business records during an audit and the evidence which a business may adduce should its records not meet the ATO’s requirements.
Noroozi said taxpayers and their advisors also suggested that a greater understanding by the ATO of the pressures experienced by small businesses was needed in designing relevant compliance activities. Although these pressures were not purported to justify non-compliance with the reporting obligations under tax and other laws, they were seen as impacting on the ability of businesses to ensure compliance.
The pressures won’t surprise SMEs and include:
- Regulatory costs, including tax compliance costs, are significant and generally borne regressively by micro and small businesses. Whilst many businesses may use the services of a bookkeeper and tax agent, certain taxpayers could consider the cost prohibitive and seek to manage their own record keeping and return preparation. This has the result of taking the business operator away from carrying on more productive activities.
- Micro and small businesses operate in a more marginal or highly competitive environment that increases pressure to find cost savings. These savings, for some, may include attempts to reduce the overall tax compliance burden. This may be particularly so if they perceive an uneven playing field whereby their competitors are gaining an unfair advantage from tax non-compliance.
- Tax “competency” in the micro and small business market segment is highly variable. Research commissioned by the ATO in 2008 also indicated that 13% of micro businesses had neither engaged an accountant nor a bookkeeper. Of that population, 31% reported not using an electronic record keeping system. In terms of knowledge, 21% of micro businesses rated themselves as knowing only a little about their tax obligations and entitlements. However, the report noted that 93% of micro enterprises use registered tax agents to lodge their tax returns and 50% to lodge their activity statements.
Correspondence audits are a desk-based activity where the ATO officer does not visit the business premises during the course of the audit.
Where the ATO officer is satisfied that the ATO has applied the correct benchmark, he or she will send an “audit confirmation letter” to the business or its representative, notifying them of the commencement of the correspondence audit. This letter requires the business to send sales records to the ATO for a sample quarter, usually April to June. The expected records include cash register reports, bank statements, daily sales summaries and reconciliations.
Seven to 10 days after the letter has been sent the ATO auditor calls the taxpayer or their representative to discuss the audit. Once the ATO receives the records, the auditor assesses their quality and completeness to determine whether the sales figures reported in the BAS and income tax returns are supported.
Where the records do not support the BAS or income tax return figures, the ATO auditor would contact the business to request further documentation to substantiate the sales figures. If the business does not provide any more records to substantiate the sales figures, the ATO officer issues an interim report to the business after it is approved by their team leader. This report informs the business of the likely tax assessment if no further information is provided.
The report usually applies the key benchmark to the reported cost of sales or total expenses of the business to determine a new sales or business income figure and related amended assessment. It also outlines any applicable penalties. The interim report gives the business 14 days to refute the ATO’s position and respond with any further records to substantiate the reported sales.
If at any point, the auditor decides (in consultation with their team leader) that the records adequately evidence the BAS and income tax return figures of the business, the audit can be finalised with no further action.
The Inspector-General made 11 recommendations to improve the use of benchmarks by the ATO. The ATO objected to two of the recommendations in part. The recommendations (and objections) included the following:
- The ATO should improve community confidence in its industry performance benchmarks by publishing material that provides assurance that the methodology to develop the benchmarks is robust and communicating it more broadly. Such material should include: (a) all current benchmarking inputs and methodology, (b) assurance from an independent party with statistical expertise about the benchmarking methodology; and (c) appropriate comparisons of ratios between country and metro businesses and between States and Territories on an aggregated basis. The ATO objected to part (c) on the grounds that publishing large numbers of additional country and metro benchmarks, or benchmarks for comparison between states and territories would not assist and had the potential to cause confusion.
- To minimise compliance costs and improve mixed businesses risk identification, the ATO should consult with tax agents and taxpayers with a view to developing alternative risk models to assess the risk of underreporting by mixed businesses.
- To more accurately target non-compliant taxpayers, the ATO should examine completed correspondence cases to identify whether additional useful predictors of underreporting or compliance exist and use such predictors to refine the risk identification process, and implement strategies to exclude compliant and low risk taxpayers from correspondence audits at the earliest point.
- The ATO should consult with taxpayers, tax practitioners and representative bodies with a view to publishing guidance on what taxpayers and their advisors can expect during cash economy benchmarking compliance activities, including the type of activities and circumstances in which these compliance activities may be used and the manner in which these will be conducted.
- In relation to ATO correspondence audits, such published guidance should include the statement that the ATO considers that the strongest evidence to support reported income are records meeting the ATO’s record keeping requirements and that where the above record keeping requirements may not be met, the ATO will allow taxpayers to provide a cogent explanation supported by appropriate evidence. Where the ATO does not accept the explanation, the guidance should include how the ATO will calculate the amended assessment by taking into account the taxpayer’s personal circumstances.
- The ATO should improve the robustness of correspondence audit penalty decisions by, for example, providing clearer staff guidance on the specific types of evidence which would tend to indicate the application of different penalties.
- To enhance staff capability, the ATO should ensure staff with knowledge or experience in certain industries and businesses are recognised, and have them mentor other less experienced auditors when they are undertaking work in relation to such industries and businesses and ensure that auditors are aware of their own recording and documentation requirements for all compliance activities.
- The ATO should foster better record keeping and accurate reporting of income in a manner that minimises overall costs for small businesses through a variety of means including: (a) the development of industry specific record keeping guidance in consultation with small business owners, industry associations, tax agents and bookkeepers; (b) improvement to promotion of its publications and assistance in relation to record keeping and (c) consultation with relevant tax practitioner representative bodies with a view to establishing a ‘taxpayer record keeping assurance process’ which could be used as a factor in excluding compliant taxpayers from audit selection. The ATO objected to part (c) on the basis that too specific a focus for the suggested consultations may restrict their scope and outcome and that a “taxpayer record keeping assurance process” may not lead to reduced costs for small businesses.
The ATO’s use of benchmarking is here to stay. While SMEs are rightly concerned about aspects of the use of benchmarks, as with all things tax, the keeping of accurate records will help a business to respond to any ATO queries that may arise.
Terry Hayes is the Editor-in-Chief of tax news reporting at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.