SME tax issues in the firing line

The tax office’s compliance program is at least a chance to get your house in order before that knock on the door. By TERRY HAYES of Thomson Legal & Regulatory.

By Terry Hayes

The tax office’s compliance program is a very important document and, as it has done for the last several years, provides opportunities for SMEs to get their tax houses in order.

 

Last week the tax commissioner Michael D’Ascenzo announced the 2007/08 compliance program, which puts all taxpayers on notice of the sorts of things the tax office will be looking at in the coming year.

And as “forewarned is forearmed”, let’s look in depth at what SMEs can take from the commissioner’s message. D’Ascenzo says one of the themes of this year’s compliance program is providing greater assistance for small businesses, especially concerning the newly revised small business CGT concessions as well as GST changes.

The commissioner says that given that many SMEs represent groups of closely-related entities, the tax office focuses on the economic group rather than the individual taxpaying entity. D’Ascenzo says that around 90% of SME business entities are privately owned, and many of these are part of larger groups controlled by one or a few individuals.

The tax office believes this can give rise to issues around the transparency of the decisions and actions of the controlling individuals that affect the tax affairs of the businesses they own.

I’ve spoken about data-matching in several of my columns, and the commissioner has flagged its use and that of information-sharing systems to enable the tax office to develop far more sophisticated tax risk profiles of individuals, firms, companies and institutions.

This year, D’Ascenzo says the tax office will identity match over 220 million records. The message, he says, is clear; the tax office’s capacity to identify tax risk is being progressively enhanced.

The tax office will also continue to use statistical analysis to help identify what it calls “tax risks” based on business results that are outside industry norms or expected economic performance. Factors that may indicate higher risk include the extent to which a business makes losses and engages in related-party and international transactions, particularly where the transactions involve tax havens.

SME audits

In 2007/08, the tax office plans to undertake 390 audits and 460 reviews of SMEs, focusing on issues including capital gains tax, losses and extracting wealth from businesses. In the previous year, the tax office conducted some 990 audits and 760 reviews, so while the number is down in the current year, it is the issues the tax office will look at that are important.

The tax office will contact 2500 SMEs to verify FBT and income tax issues and undertake 6000 checks of income tax returns where claims for refunds appear excessively large or unusual. This means SMEs have to get their tax basics right. Be sure FBT is correctly reported and be aware that if a large tax refund is expected. The tax office is likely to query it first – so be sure the refund position is justifiable.

Capital gains tax

Always a key issue for attention – don’t ever doubt that. With many SME owners entertaining thoughts of retirement, they may consider selling their businesses. The tax office is keen to ensure such owners are aware of tax risks associated with that.

This could include making sure capital gains tax is correctly accounted for in any sale, whether it be to a relative (in a succession planning exercise) or to an arm’s length party. What is being sold – the business itself or just shares in the business?

The tax office is also concerned about:

• Situations where a capital is arranged to be reduced where a business is sold.
• Where significant capital losses are artificially created to offset capital gains.
• The misclassifying of income to obtain the most advantageous capital position.
• SMEs claiming small business CGT concessions when they are not eligible, or incorrectly calculating the claim.
• Failing to account for capital gains arising from the sale of assets where the proceeds have been transferred into a superannuation fund.

The tax office has for years been concerned that capital gains in general have not been correctly reported, or not reported at all. This is another area where its data-matching capabilities are important, for example via checking property sales, etc.

Losses

The tax office says its compliance focus concerning losses is on larger SMEs. Issues it will examine include:

• Recouping losses without taking into account changed ownership or the fact that a different business is being conducted.
• Misclassifying losses as capital or revenue.
• Having revenue losses where the origin of the losses is artificial and has no economic or legal basis.
• Attempting to use related-party losses outside of a consolidated group.
• Incorrectly applying the consolidation loss rules.

GST

The tax office continues to be concerned about SME real property transactions, including unreported sales, the correct application of the margin scheme, incorrect reporting of adjustments and incorrect treatment of supplies to associates.

The margin scheme basically involves calculating the GST liability on real property transactions on the difference between the consideration for the supply and the cost of the acquisition (that is, the margin on the sale). This can produce a lower GST cost to the supplier, so is an area the tax office looks at closely. It also plans to increase its use of data-matching to identify taxpayers who fail to disclose or significantly under-report GST on real property transactions.

The tax office’s GST compliance activities will also examine what it calls serious tax evasion risks, for example arrangements involving alleged exports of services where actual consumption occurs in Australia, and whether the non-resident entities providing those services are required to register and pay GST.

Extracting wealth from businesses and business exit strategies

The tax office says it will closely examine business owners trying to extract value from their business without paying the correct tax. There is a clear overlap with capital gains tax issues here, but many income tax issues are relevant as well, for example valuing trading stock, etc.

Arrangements flagged by the tax office for “close examination” include:

• Loans, payments and debts forgiven by private companies that in effect, distribute company profits to shareholders in a non-taxable form. The tax law concerning the use of private companies is complex and tax traps abound, so it’s essential to get good professional advice here.
• Divestment of business assets via mechanisms such as share buy-backs, capital reductions, the sale of shares. The tax treatment of the use of such mechanisms can be tricky and, while they are not necessarily illegal, care is needed to get this right.

As always, there are many tax issues that SMEs have to deal with – and get right. The tax office’s compliance program at least signposts what issues it will look at. It’s not the whole story by any means, and the tax office will obviously examine other issues than those highlighted in its program.

But the program does represent a window into the tax office’s thinking – and SMEs should take advantage of that window.

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

For more Terry Hayes features, click here .