Tax Rambling

I have been getting asked a lot of questions about travel and accomodation deductions…

They are normally about a contractor or employee who is working away from their home far enough away they can’t just come home each night. They live in Geelong but work in Melbourne, they live in Perth and work in Darwin…

The answer to all these questions is generally found in the 18 example in draft Taxation Ruling TR 2017/D6.

And yes, I know the heading says employees but it applies to employers through the otherwise deductible rule, and the Commissioner uses its reasoning when giving private rulings for contractors…

Lets have a look at one of the 18 examples. This is a reminder that once you are no longer “traveling away from home for work” but a rather “living away from home for work” the accommodation become non deductible…

In “Tax myths busted!”, Commissioner of Taxation, www.ato.gov.au, 30 June 2018 

The Commissioner has identified the top 10 tax myths and misunderstandings that are those involved in preparing individual tax returns have, including tax agents prepared and self-prepared returns. And generally, they relate to substantiation of work related deductions.

MYTH #1: Claim $150 for clothing and laundry, 5,000 kilometres at 66 cents for car related expenses, or $300 for work-related expenses

The first and main myth the Commissioner identifies is that everyone can automatically claim $150 for clothing and laundry, 5,000 kilometres at 66 cents for car related expenses, or $300 for work-related expenses, even if they didn’t spend the money.

The Commissioner states that these are just record-keeping exemptions that provide relief from the need to keep receipts in certain circumstances.

However, they are not an automatic entitlement or a “standard deduction” for everyone.

While you don’t need receipts for claims under $300 for work related expenses, $150 for laundry and 5,000 kilometres, you still must have spent the money, it must be related to earning your income, and you must be able to explain how you calculated your claim.

But let’s look at where these myths come from…

$300 standard deduction???

The rules regarding the required substantiation for work related deductions are found in Division 900 (and Division 28) of the ITAA97.

Division 900 covers substantiation requirements for work expenses (Subdivision 900-B), car expenses (Subdivision 900-C) and business travel expenses (Subdivision 900-D).

These substantiation rules only apply to individuals (section 900-5), and only applies to employees or those who have similar withholding as employees (see list in section 900-12).

Section 900-15 states that even if a “work expense” meets the conditions for a deduction (for example section 8-1), there will be no deduction unless the individual substantiates it “by getting written evidence.”

Under section 900-30, a work expense is a loss or outgoing you incur in producing your salary or wages and includes travel and meal allowance expenses, Division 40 deductions and section 25-60, 25-65 and 25-100 deductions.

The written evidence must be retained for 5 years from the due day for lodging an income tax return or when the return is lodged, whichever is later (section 900-25).

There is a “small total of expenses” exception. Subsection 900-35(1) ITAA97 states:

If the total of all the *work expenses (including *laundry expenses, but excluding *travel allowance expenses and *meal allowance expenses) that you want to deduct is $300 or less, you can deduct them without getting written evidence or keeping travel records.

To be clear, the $300 rule is just a relief of having to have written evidence of a certain type, which are explained in Myth #2 below.

One more time… While you don’t need receipts for claims under $300 for work related expenses, $150 for laundry and 5,000 kilometres, you still must have spent the money, it must be related to earning your income, and you must be able to explain how you calculated your claim.

MYTH #2: “I don’t need a receipt, I can just use my bank or credit card statement”.

The Commissioner states this is only the case if the statement meets the written evidence requirements in Division 900.

What is written evidence is covered in Subdivision 900-E. It states that written evidence can be a document from the supplier of the goods or services the expense is for. The document must set out:

• The name or business name of the supplier; and
• The amount of the expense, expressed in the currency in which it was incurred; and
• The nature of the goods or services (if the document the supplier gave you does not specify the nature of the goods or services, you may write in the missing details yourself); and
• The day the expense was incurred (if the document does not show the day the expense was incurred, you may use a bank statement or other reasonable, independent evidence that shows when it was paid); and
• The day it is made out.

In Practice Statement Law Administration PSLA 2005/7 (as updated to July 2015), the Commissioner states:

Where the above documents are insufficient, we accept the following documents (or combinations of documents) as acceptable evidence of expenses:

• bank statements
• credit card statements
• BPAY reference numbers, combined with bank statements, or
• BPAY reference numbers, combined with tax invoices.

So, if the credit card statement or bank statement does not cover this information then there is no deduction. And in many cases the credit card will not have what the good or service actually is!

I don’t feel like a pathetic tax advisor any more. You see, for the past 10 months I have not been able to answer the question “What is the company tax rate?”

I know I find the answer in the Tax Rates Act. And I know the Tax Rates Act tells me 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).
• From 1 July 2017 the rate stayed at 27.5% but was now available to “base rate entities” and the turnover threshold for a base rate entity was $25 million.
• From 1 July 2018 the rate stayed at 27.5% but was now available to “base rate entities” and the turnover threshold for a base rate entity was $50 million.

This all sounds very easy, except to work out the rate for the 2015/16 year and the 2016/17 year I need to know if the company is carrying on a business. And for the 2017/18 and following years I need to know what is a “base rate entity”. And on top of this I need to not just know what the company tax rate is, but I also need to know how to work out the imputation rate for each of these years.

So, let’s work through each on these questions…

Question #1: Company Tax Rate for 2015/16 and 2016/17 – Am I carrying on a business?

Last year the Commissioner released 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?). In this Draft Ruling the Commissioner states he believes that most companies will be carrying on a business. He states that 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.

This is much broader than any of us would have thought. So, what do we do regarding whether companies are carrying on a business and therefore might get the 28.5% or the 27.5% rate.

The Commissioner has answered this question in Practical Compliance Guideline PCG 2018/D5. In this Guideline the, Commissioner states he 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 unless he 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.

What does this mean? It appears that a company under the turnover threshold in the 2015/16 and 2016/17 year can use either company tax rates as long as it is not unreasonable to do so.

Lesson #1: If a company has a turnover of less than $2 million in the 2015/16 year or less than $10 million in the 2016/17 year you can almost choose which company tax rate.

Question #2: For the 2017/18 and following years, what is a base rate entity?

The Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Act 2018 amends the Rates Act to ensure that, from 1 July 2017, a corporate tax entity will not qualify for the lower corporate tax rate of 27.5% if more than 80% of its assessable income is “base rate passive income”.

Base rate entity passive income is defined as:

• A distribution or dividend by a corporate tax entity, other than a non-portfolio dividend (10% holding). Dividends derived by a holding company which are made by a wholly-owned subsidiary company will not be base rate entity passive income of the holding company;
• Franking credits attached to such a distribution;
• A non-share dividend made by a company;
• Interest or a payment in the nature of interest;
• A royalty;
• Rent;
• A gain on a qualifying security;
• A net capital gain;
• An amount that is included in the assessable income of a partner in a partnership or a beneficiary of a trust estate to the extent that the amount is referable to another amount that is base rate entity passive income. Therefore, an amount that flows through a trust to a corporate tax entity will retain its character for the purposes of determining whether or not the amount is base rate entity passive income of the corporate tax entity.

Lesson #2: If a company has a turnover of less than $25 million in the 2017/18 year or less than $50 million in the 2018/19 year, to work out what tax rate that applies you need to consider the percentage of the income of the company that is base rate passive income. Less than 80% and the company tax rate is 27.5%, more than 80% and the company tax rate is 30%.

Question #3: How does this all work for imputation?

There are three answers to this question.

Lesson #3: For the 2015/16 the imputation rate was always 30%. It did not matter whether the company tax rate for the year for a company was 28.5%, they could still frank dividends at 30%.

Easy.

Lesson #4: For the 2016/17 year the rule was that whatever your company tax rate was, was your imputation rate. If the company tax rate was 27.5% the imputation rate was 27.5%. If the company tax rate was 30% the imputation rate was 30%.

There are new rules that apply from 1 July 2017 that were in the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Act 2018.

Under these rules, as a company will not know its aggregated turnover, the amount of its base rate entity passive income, or the amount of its assessable income for an income year until after the end of that income year, it will not know its company tax rate when it pays a dividend during the year.

Therefore, to calculate the imputation rate, the company must assume that:

• Its aggregated turnover for the income year is equal to its aggregated turnover for the previous income year;
• Its base rate entity passive income for the income year is equal to its base rate entity passive income for the previous income year; and
• Its assessable income for the income year is equal to its assessable income for the previous income year.

Also, if the corporate tax entity did not exist in the previous income year, its corporate tax rate for imputation purposes for an income year will be the lower corporate tax rate of 27.5%.

Lesson #5: From 1 July 2017, to work out the imputation rate the company needs to look at last year’s turnover and the percentage of base rate passive income in the previous year. If the percentage is less than 80% and the turnover is under the threshold the dividend can be franked at 27.5%. Otherwise, it is taxed at 30%.

Given that I have criticised for my recent comments on tax agent prepared returns making inappropriate claims for work related deductions, I decided to put a paper together on the work related deduction rules to help tax agents.

I hope this paper is informative and helpful.

Work and travel deductions

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.