Tax Rambling

We know that the Commissioner has released some pretty crazy findings that Tax Agent prepared returns are more likely to incorrectly claim work related deductions than self prepared returns.

From the Commissioner’s review of the tax gap for individuals not in business he found the following:

Tax agents get it wrong 78% of the time and self preparers only 57% of the time. By the way, the results show that when tax agents get it wrong, they get it “more wrong”… 85% of the value of mistakes are in tax agent prepared returns…

But what I find most interesting is why these mistakes were made. Have a look at this chart:

51% of all the adjustments were due to, at least in part, substantiation issues.

Immediately the lobbyist for the Tax Agents roll out the excuse that this is not the Tax Agents fault. Poor Tax Agents can only rely on the representations of their clients, they say.

But they would only say that if they did not understand the tax law… Have a look at what section 900-15 of the ITAA97 says:

To deduct a *work expense:

(a) it must qualify as a deduction under some provision of this Act outside this Division; and

(b) you need to substantiate it by getting written evidence.

And for completeness sake the definition of a work expenses is “a loss or outgoing you incur in producing your salary or wages.”

Section 900-15 states that even if there is another provision in any tax act that lets you claim a work expense as a deduction, you still don’t get to claim it until you have the correct documentation. It is not that you can claim a deduction but you need the evidence to prove it, but rather it is if you don’t have the correct documentation THERE IS NO DEDUCTION AT ALL!

So when a client walks into the office of a tax agent and wants to claim a deduction for a work expense, the tax agent should say “but if you don’t have a receipt you can’t claim it and so I won’t include it in your return.”

And when I say “receipt”, I mean “receipt”. Division 900 makes it clear that a credit card or bank statement will generally not be enough… but rather than quote the ITAA97, let me quote the Commissioner…

Myth: I don’t need a receipt, I can just use my bank or credit card statement

Fact: To claim a tax deduction you need to be able to show that you spent the money, what you spent it on, who the supplier was, and when the purchase occurred. Bank or credit card statements usually won’t contain this information. The only time you don’t need these details is if record-keeping exceptions apply.

If you want to claim more than $300 of work expenses as a deduction for your client in a return, you should at least confirm there is and, if you have any professionally at all, sight a receipt.

But how is it then that 78% of tax agent prepared tax returns are wrong and the main reason they are wrong is that when they are audited (within two years as that is the amendment period) 51% of the returns with mistakes don’t have the “substantiation” required – put simply, the receipts that are required!

Its because Tax Agents say… “teacher client, did you buy any sunglasses this year and how much did you buy them for?” without asking “teacher client, do you have a receipt for any sunglasses you bought this year”. They say it this way to “get their client the highest refund” but they are doing this by ignoring the fact that section 900-15 states they are not eligible for the refund at all.

I can get anyone a higher refund if I can just ignore the law and put clients at risk…

Now this should be an easy answer. So tell me what you think it is? I understand that it is a bit harder than it was now that there are two rates, being 30% and 27.5% (28.5% in the 2015/16 year). But can you tell me who gets the lower rate?

Don’t worry if you can’t because neither can the Commissioner…

In Practical Compliance Guideline PCG 2018/D5 Enterprise Tax Plan: small business company tax rate change: compliance and administrative approaches for the 2015-16, 2016-17 and 2017-18 income years the Commissioner states:

1. This draft Guideline sets out the ATO’s compliance and administrative approaches for corporate tax entities that have faced practical difficulties in determining their corporate tax rate and corporate tax rate for imputation purposes in the 2015-16, 2016-17 and 2017-18 income years.

2. The Commissioner acknowledges that uncertainty may have arisen as a result of changes to the tax laws, and changes to these laws still before Parliament, that set out eligibility for the reduced corporate tax rate and the subsequent release of Draft Taxation Ruling TR 2017/D7 Income tax: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986?.

The background in a very quick summary is (the longer summary is in this 9 pager paper I wrote) that from 1 July 2015, corporate entities that were small business entities (less than $2m turnover and carrying on a business) were given the 28.5% tax rate. From 1 July 2016 the rate dropped to 27.5% for these small business entities (but now less than $10m turnover and carrying on a business). For 1 July 2017 the 27.5% rate was available to base rate entities (less than $25m turnover and carrying on a business) and from 1 July 2018 the 27.5% rate was available to base rate entities (less than $50m turnover and carrying on a business).

But what is a business? The Commissioner has some weird understanding of this and even put out a Draft Ruling (Draft Taxation Ruling TR 2017/D7 Income tax: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986?). For example, For example, these are companies carrying on a business according to the draft Ruling:

• A share investment company; and
• A family company with income consisting only of an unpaid trust entitlement, which it reinvests, even if it is just under a loan agreement back to the trust

It is unlikely that any practitioner has considered these companies to be carrying on a business previously.

Although this draft Ruling has never been finalised due to the Bill introduced on the same day, the draft Ruling shows that the Commissioner is considering a major change in his understanding of what can be carrying on a “business” and this could open the door for many more corporate entities claiming the small business concessions that exist.

The Government did not like the Commissioner handing out the 27.5% rate to almost every company so 3 hours after the Draft Ruling came out the Government released the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017. This Bill (still before the Senate) states that, from 1 July 2017, a company will qualify for the lower corporate tax rate for an income year only if:

• No more than 80% of the company’s assessable income for that income year is base rate entity passive income; and
• The aggregated turnover is less than the aggregated turnover threshold for that income year ($25m for the 2018 year and $50 for all subsequent years).

So where does this leave us… We have the law as it is today, we have a Draft Ruling that massively expands the definition of “carrying on a business”, and we have a Bill that throws out the definition of business altogether and replaces it with a passive income test. If I am completing the Company Tax Return for either of:

• A share investment company; and
• A family company with income consisting only of an unpaid trust entitlement from a business trust, which it reinvests under a loan agreement back to the trust;

for the 2017/18 year, do I:

• Use the 30% tax rate for both like I did in previous years as I don’t believe the Company is carrying on a business based on the Commissioner’s finalised positions?
• Use the 27.5% tax rate for both as I believe the Company is carrying on a business based on the Commissioners draft position in the Draft Ruling positions? Or
• Do I use the 80% passive income rule in the Bill before the Senate which means the share investment company uses the 30% rate and the family company gets the 27.5% rate as we look through the trust distribution and see it comes from a business?

And remember, the lower rate might sound good but what if you want to pay out lots of franked dividends? The higher rate might be better.

The Commissioner gives an answer to this question is in Practical Compliance Guideline PCG 2018/D5 Enterprise Tax Plan: small business company tax rate change: compliance and administrative approaches for the 2015-16, 2016-17 and 2017-18 income years. And the answer is DO WHATEVER YOU WANT AS LONG AS IT IS NO UNREASONABLE OR DODGY. What he actually says is…

This means that the Commissioner will not allocate compliance resources specifically to conduct reviews of whether corporate tax entities have applied the correct rate of tax or franked at the correct rate in the 2015-16 and 2016-17 income years. However, this approach will not apply where:

• the Commissioner becomes aware that a corporate tax entity’s assessment of whether they were carrying on a business in the 2015-16 or 2016-17 income years was plainly unreasonable, or
• the corporate tax entity has entered into
  • any artificial or contrived arrangement affecting the characterisation of the company as carrying on a business or not
  • a tax avoidance scheme whose outcome depends, in whole or part, on the characterisation of the company as carrying on a business or not, or
  • arrangements designed to conceal ultimate beneficial or economic ownership of any connected or affiliated entities.

Choose away! Optional tax rates!

Do you know those evil multinational and large companies with all their high paid tax agents incorrectly avoid about $2.5 billion a year in tax. How evil are they, huh? Picking on the little, hard working guy, huh?

Let’s just end that argument now as the Commissioner, the same guy who gave us the $2.5 billion figure, has now worked out what those little, hard working guys are either not declaring as income, or just making up deductions for. And their dodgy claims, with a lot of help from tax agents, means they don’t pay $8.7 billion every year.

And to make it worse, this figure excludes individuals classified as high-wealth who control a net wealth of $5 million or more – this is just your average individual tax returns.

How did the Commissioner get this number? They took a totally random sample of 858 individual tax returns and found that 72% had errors which, when applied across the 13 million individual tax returns, gives $8.7 billion of wrongly avoided tax by these individuals.

But here is the real annoying part of the findings… “agent-prepared returns had a 78 per cent error rate compared to 57 per cent of self-prepared returns.”!!!

Agent prepared returns are wrong 78% of the time and wrong substantially more often than self preparers. Think about what this means. It won’t be that agents make technical breaches as they know this stuff. It will be real mistakes they make… So what are these mistakes?

Of this $8.7 billion, only $1.4 billion relates to unreported income, which is normally due to the client not telling the agent about the income. But the rest of this lost income (over $7 billion) will be incorrectly claimed deductions.

… I’ll just add in $150 for clothing (even though the client does not have eligible work related clothing), $300 for work related expenses (even though the $150 of clothing just reduced this to $150 and they did not have any other expenses), 5,000 x 66 cents for your car (even though they have no record of any work related travel), I won’t ask if you stayed in your rental property (even though they stayed in it for 2 month last year), your a teacher so you can claim sunglasses so I will add them in (even though you did not buy any sunglasses this year), you travelled for work so I will claim a deduction for the reasonable allowances (even though the employer reimbursed all the costs)…

And it is not a surprise how the Commissioner ends his analysis of this information… “500 tax agents were in the ATO’s sights, with 150 of those expected to be closely scrutinised.” I doubt those 500 agents are responsible for $6 billion of dodgy claims…

So who is the biggest tax cheats in this country? Is it the multinationals and the large companies? Even with their high paid tax lawyers they can’t even get close to the dodgy tax agent who makes up deductions for their individual clients or just don’t ask about what they wear to work, what travel they do for work, what they actually purchased, how they used their rental property.

In the Budget we got the following announcement…

From 1 July 2018, companies with turnover of $20 million or more, the rate of the R&D tax offset will depend on the R&D expenditure as a proportion of total expenditure for the year.

The current rate for these entities is 38.5%. As the company tax rate for these guys is generally 30% the actual tax saving is 8.5% of R&D expenditure… but now:

• If less than 2% of an entity’s expenses are R&D expenses, the rate will be 34% (or a 4% benefit);
• If between 2% and 5% of an entity’s expenses are R&D expenses, the rate will be 36.5%;
• If between 5% and 10% of an entity’s expenses are R&D expenses, the rate will be 39%; and
• If more than 10% of an entity’s expenses are R&D expenses, the rate will be 42.5%

This all assumes the company has a tax rate of 30%. If the tax rate is 27.5% all these rates are reduced by 2.5%.

As you can see, if your R&D spend is less than 5% of the company’s total spend this is a substantial reduction in the offset. If the R&D spend is less than 2% of the company’s total spend, the benefit of claiming the R&D Tax Incentive falls to just 4% of the amount the company claims.

But the costing show how few companies spend more than 2% of their expenditure on R&D. The most recent Tax Expenditure Statement that came out two months ago say that the cost of providing the R&D Tax Incentive is a loss of $720 million in tax each year.

The budget costing say this change will increase taxes by between $305million and $395 million a year.

This means these changes reduce the amount handed out through this incentive by half… ouch

The facts…

A taxpayer has a discretionary trust and the trust owns a share in a company that runs an accounting practice. The taxpayer is paid a salary of $250,000 for his work in the accounting practice. The profits of the company are paid to the discretionary trust and are generally around $60,000 but this is distributed to the taxpayer’s spouse and two adult kids at University.

The taxpayer also owns a series of rental properties that are negatively geared with losses of $60,000. The taxpayer sold one of the properties and made a gain of $100,000.

The taxpayer has an SMSF. As the taxpayer has substantial property holdings outside super they hold only listed shares in the SMSF. The fund has $1 million in listed share, returning $50,000 of fully franked dividends. The taxpayer makes a $25,000 deductible super contribution each year.

The taxpayer pays $5,000 for personal tax advice and lodging their return.

The effect if at the next election we get el Presidente Shorten…

The $60,000 profit paid to the discretionary trust was distributed $20,000 to the spouse and the children. Each would pay (almost) no tax now, but under the new tax arrangement proposed by the Opposition the Discretionary Trust Distribution Minimum Tax would apply 30% ($18,000).

$18,000 more Tax

The tax on the $250,000 salary will be increased by the Opposition from 47% to 49%, which is an increase of 2%. But in addition, under the Opposition’s announcements, the taxpayer is denied $2,000 of deductions for tax advice, $25,000 of deductions of super contributions and $60,000 from the losses on the rental properties.

Before these changes, the taxable income was $163,000 ($250,000 – $60,000 – $25,000 – $2,000) but now the taxable income is $250,000. The tax was about $47,000 but it rises to over $87,000.

$40,000 more tax

The sale of the shares for the capital gain of $100,000 was reduced to $50,000 and was (mostly) taxed at 47% so the tax was a bit less than $23,000. But now as the Opposition is reducing the CGT discount from 50% to 25%, the gain is only reduced to $75,000 with tax of $36,750

$14,000 more tax

Finally, under the Opposition’s announcements, the SMSF will lose its refundable tax credits of $15,000 each year.

$15,000 more tax

Total – $87,000 more tax each year

Sent this into a newspaper that will be screaming about unfair tax cuts tomorrow. Let’s see if they publish it. UPDATE… They did (it’s near the bottom of the page – https://www.canberratimes.com.au/national/act/roos-are-a-capital-asset-20180509-p4zecz.html)

Five men decided to split the $100 beer tab based what they earn (one in each 20% grouping based on income) and on the Aussie tax system.

That meant the first paid $0, the second paid $2, the third and fourth paid $14 each, and the fourth paid $70.

The bar owner gave them a $20 refund and based it on what they had paid already.

Therefore, the first got no refund, the second got 40 cents, the third and fourth got $2.4 and the fifth got just under $15.

The media ran headline saying how the refund was inappropriately skewed to the rich and how the refund should be split $4 each. Which is the fairest way to split a refund of this beer tab… or a tax reduction?

So what tax laws are sitting in the Parliament for our hard working MPs to consider in the last sitting week before the May Budget?

1. A bill that has been in the Parliament for 4 days less than a year that supplements the ‘same business test’ with a ‘similar business test’  and to provide taxpayers with the choice to self-assess the effective life of certain intangible depreciating assets they start to hold on or after 1 July 2016… Its not like anyone has completed a 2017 tax return already!!!
2. A Bill to transfer the regulator role for early release of superannuation benefits on compassionate grounds from the Chief Executive Medicare to the Commissioner.
3. A Bill that prohibits the production, distribution, possession and use of sales suppression tools and also requires entities that provide courier or cleaning services to report details of transactions that involve engaging other entities to undertake those courier or cleaning services for them.
4. A Bill that provides that a corporate tax entity will not qualify for the lower 27.5 per cent corporate tax rate if more than 80 per cent of its assessable income is income of a passive nature.
5. A Bill that progressively extends the lower 27.5 per cent corporate tax rate to all corporate tax entities by the 2023-24 financial year; and further reduce the corporate tax rate in stages so that by the 2026-27 financial year, the corporate tax rate for all entities will be 25 per cent.
6. A Bill that removes the entitlement to the capital gains tax main residence exemption for foreign residents.
7. A Bill that requires purchasers of new residential premises and subdivisions of potential residential land to make a payment of part of the purchase price to the ATO.

Add to this some changes to tax concessions for Venture Capital, the Banking Levy, new whistle blower protections, a new Junior Mineral Exploration incentive, tax consolidation fixes, and a lot of minor super changes (can’t use salary sacrificed super to meet SGC requirements and those under EBAs must get a choice of super form)…

As almost all of these were announced in last years budget (some in the budget from the year before), wouldn’t it be great if they finalised these in the last sitting week before we get the next budget with an entirely new set of announcements!!!!