Report on Aspects of Income Tax Self Assessment
This Chapter recommends changes to the rules governing the amendment of assessments to reduce the time that taxpayers are exposed to Tax Office action to increase their liability.
The rules governing the amendment of income tax assessments attempt to balance two competing objectives, namely that:
- A taxpayer should pay the correct amount of tax according to law.
- Whether or not a taxpayer has paid the correct amount, eventually their tax affairs for a particular year should become final, unless they have deliberately sought to evade their responsibilities.
The law seeks to balance these objectives by allowing the Tax Office to amend assessments to correct errors, but only within time limits set out in the law.
The Review has examined this topic with a view to determining whether the current time limits get that balance right. In doing so, we have taken the perspective that, in order to promote certainty, the period permitted for an amendment to increase a taxpayer’s liability should approach the minimum required for the Tax Office to identify the majority of incorrect assessments and take action to correct them.
The standard period now allowed for the Tax Office to amend an assessment (either to increase or reduce a taxpayer's liability) is four years.24 For certain individuals with very simple tax affairs,25 the period is two years. Within these time limits, the Tax Office effectively has an unlimited power of amendment.
There is a special period for amendment where Part IVA (the general anti-avoidance provision) is invoked. As before self assessment, the Tax Office has up to six years (from the date on which tax became due and payable under an assessment) to amend an assessment to cancel a tax benefit under that Part.
There are also numerous specific provisions allowing the Tax Office to amend an assessment to deal with special issues, regardless of the normal time limits. These special cases are discussed in more detail below at subsection 3.2.5.
The law also allows for ‘self amendment’ of assessments (to increase or decrease liability), meaning that the Tax Office can rely on statements made by a taxpayer in a request for amendment in the same way it can rely on a statement in a return.
Finally, if the underpayment of tax was due to fraud or evasion,26 the Tax Office can amend the assessment at any time.
The periods of review that apply in Australia, Canada, New Zealand, the United Kingdom and the United States are broadly comparable.27
The discussion paper proposed that the period permitted for amendment should approach the minimum required for the Tax Office to identify incorrect assessments and take action to correct them. In this way, it was argued that unnecessary delays would be eliminated at no cost or risk to revenue collection.
The Tax Office currently tailors its compliance activities to meet the differing circumstances and characteristics of taxpayers. It does this by adopting a market segment approach that distinguishes between businesses of various sizes, individuals who are not in business and not-for-profit taxpayers (for example, charities and government agencies).28
The length of time that the Tax Office takes to review returns therefore varies according to the compliance activities it undertakes.
For non-business individuals with simple affairs, the compliance activity is primarily based on processes such as income matching.29 If these processes reveal likely non-compliance, the Tax Office may take audit action. Either way, the Tax Office is generally in a position to know whether an amendment should be made to a non-business individual’s assessment in much less than the four years presently allowed.
On the other hand, audits of large business taxpayers with complex (sometimes international) affairs and transactions involving substantial amounts of money will require more time to complete. This reflects the nature of these taxpayers’ affairs and the administrative processes (intended to protect taxpayers’ rights) that accompany these audits.30 Audit actions may be delayed by difficulties with access to the evidence, claims of legal professional privilege,31 delays in responding to requests for information or time to comment on Tax Office statements of facts or position papers.
Consequently, large audits often extend beyond the normal statutory limit, either with the agreement of the taxpayer, or by an order of the Federal Court.32
As canvassed in Chapter 1, the length of time that elapses before a taxpayer’s assessment can no longer be amended represents an aspect of uncertainty for them. If that time can be reduced, the time that people experience the ‘costs’ of uncertainty will also be reduced. The following recommendations explore how this can be achieved without a significant negative impact on compliance behaviour or revenue collection.
Many individuals who are not in business (and some very small businesses) have straightforward tax affairs. The Tax Office generally completes its compliance activity for the vast majority of these taxpayers within two years of the original assessment. Formalising this period will increase certainty for a very large number of people at virtually no cost.
Similar considerations apply to very small business taxpayers.
The amendment period for increasing the liability of individuals and very small businesses should be reduced from four years to two years, subject to certain exclusions dealt with in Recommendation 3.3.
Defining very small business
While there may be no ideal definition of very small business, the discussion paper proposed that the law would be simpler if it used a definition already in existence, and suggested that the current test for a Simplified Tax System (STS) taxpayer was appropriate, as it was designed to identify businesses with simpler income tax affairs.33
In submissions in response, the majority of tax professional bodies said that they would prefer very small businesses to be defined as those eligible to be STS taxpayers rather than those who have elected to be. A difficulty with this approach is that neither the taxpayer nor the Tax Office would be certain about the period for amendment for the taxpayer who may be eligible, but has not elected.
On balance, the Review has concluded that the better approach would be to initially make the shorter review period available to those taxpayers who have elected into STS (rather than those that are eligible). However, a flexible mechanism to give effect to these new rules should be adopted, so that the group of eligible taxpayers can be monitored and increased over time.
For the purposes of the proposed two year amendment rule, a business should be treated as a very small business if it has elected to participate in the Simplified Tax System.
Exclusions from the two year period
The Tax Office cannot complete its compliance activities for all individuals and very small businesses within two years, as some have complex affairs and the relevant information is not always available within that period. Therefore, the Review has concluded that a mechanism to allow the exclusion of high-risk cases from the two year period should be adopted. As the circumstances justifying exclusion are likely to vary over time, a flexible mechanism is needed, such as allowing for future exclusions to be added by regulation.
Examples of exclusions from the two year period are:
- recipients of partnership income or trust distributions where the partnership or trust would not qualify for the shorter amendment period
- taxpayers who enter into or carry out schemes with the dominant purpose of obtaining a tax benefit.
Fraud and evasion cases will continue to have an unlimited period for amendment, as almost all respondents to the discussion paper acknowledged that people who engage in calculated behaviour to evade tax should remain permanently at risk.
The two year amendment period for individuals and very small businesses should exclude:
The two year amendment period may also exclude other high risk cases by regulation.
Audit cycle times for larger businesses are necessarily longer than discussed above. For medium to large businesses, the current four year amendment period is necessary to enable the comprehensive investigations required for taxpayers with complex affairs and to allow administrative procedures to protect taxpayers’ rights.34 Imposing a two year amendment limit for medium and large businesses, while supported by a number of submissions, would risk revenue or put unsustainable strain on the Tax Office’s resources.
While the Review does not recommend a reduction in the statutory timeframe for amendments to larger businesses, steps to hasten audit conclusions and minimise the consequences of Tax Office delays are important. These have been addressed elsewhere in this report, by recommending that Tax Office delay be grounds for remission of shortfall interest (Recommendation 5.3) and that PBR applications be deemed to have been determined if the Tax Office delays finalising them (Recommendation 2.15).
Where an individual taxpayer returns a tax loss in an income year, the Tax Office currently has an unlimited period to review their affairs because the time limitations only start to run from when tax becomes due and payable. The same issue arises in other nil liability cases, for example, where the taxpayer’s taxable income is below the tax-free threshold, or where the taxpayer’s tax offsets reduce their tax payable to nil.
The Tax Office takes the same view for companies and superannuation funds that lodge nil liability returns, but this issue is currently being litigated.35
All submissions agree that there are no compelling reasons to distinguish so drastically between taxpayers who, for example, claim large deductions to reduce tax payable to a very small amount and those who do the same to reduce tax to zero. Taxpayers and practitioners have uniformly responded that it is unfair to face an effectively unlimited period of review in these circumstances.
From the 2004-05 income year, the period of review for loss and nil liability cases should be equivalent to the period for the Tax Office to amend assessments creating liabilities.
The deductibility of a tax loss will be determined in the year that the taxpayer has income against which to offset the loss, in accordance with normal deduction principles. For example, a company returned losses of $10 million in the first year, $12 million in the second year, $5 million in year three and $3 million in year four. In year five, the taxpayer returned a taxable income of $10 million after deducting $30 million for losses of previous years. During year six, the taxpayer is audited with the result that the company's first year return was incorrect and should have returned a taxable income of $8 million. Under Recommendation 3.4, the Tax Office would be unable to issue an assessment of a positive liability for year one. However, the year five assessment can be amended to deny the $10 million deduction claim for a loss in year one.
In addition, there should be transitional arrangements to ensure that nil liability returns from earlier years do not remain open to review indefinitely.
Many of the large number of nil liability returns for earlier years are loss returns. The Tax Office does not currently have complete and accurate information about taxpayers with carry forward losses (which in some cases may be quite old). Furthermore, many of these taxpayers have ceased to earn assessable income and may no longer be lodging returns. To concentrate the transitional arrangements on those taxpayers interested in finalising past years, transitional arrangements should apply to taxpayers with prior year losses who lodge a return for the 2004-05 income year, disclosing relevant loss information.
Other nil liability cases for previous years would generally be more straightforward (for example, individual taxpayers with a taxable income under the tax–free threshold) and could be finalised within four years.
Where a taxpayer’s 2004-05 return discloses relevant loss information about any earlier loss years, the Tax Office should have six years from lodgment of that return to issue an assessment for those prior loss years. For other (non-loss) nil liability returns for years ended 30 June 2004 and earlier, the Tax Office should have until 31 October 2008 (or four years from the date of lodgment, whichever is later) to issue an assessment.
Currently, there is a six year period for amendments to give effect to a determination under Part IVA, the general anti-avoidance provision. This is effectively a 50% extension on the standard time taxpayers are exposed to the risk of an increased assessment.
In an environment where even large and complex cases are generally able to be completed within four years, and records are usually only required to be kept for five years, a six year period is a comparatively long time. Therefore, the discussion paper suggested that the time allowed for amendments relying on anti-avoidance provisions could be reduced to the proposed normal period for larger businesses and complex cases, that is, four years. This has been strongly supported by submissions.
The Tax Office already has the power to require more information in the tax return about areas with a significant revenue risk.36
The present six year period for the Tax Office to amend using the anti-avoidance provisions should be abolished, so that a four year amendment period applies to arrangements entered into or carried out to obtain a tax benefit.
The law sets out over 100 instances where the Tax Office has no time limit on its power to amend. Examples include car expenses, expenditure recoupment schemes, private health insurance offsets, transfer pricing and research and development expenses.
The reasons for these unlimited periods vary. The most common reason is that the primary liability rules contain a condition that might only be satisfied (or cease to be satisfied) outside the normal amendment period. In some cases, the original reason is unclear or no longer relevant.
The Review has concluded that it is undesirable that a taxpayer who is not fraudulent or seeking to evade tax be exposed indefinitely to the possibility that their assessment will be increased to implement a particular provision.
Treasury should conduct a detailed review of the specific provisions with unlimited amendment periods to identify those that could have a set amendment period. Such set periods could be in line with the current general rules, or longer with good reason.
This Review should identify appropriate transitional arrangements so that issues from earlier income years (for which there is currently an unlimited amendment period) become final where a finite amendment period is adopted.
It is already apparent that some unlimited amendment periods are unnecessary. The substantiation and car expenses provisions have an unlimited amendment period although taxpayers are only required to keep the relevant records for five years.
The unlimited amendment periods should be abolished for the substantiation and car expenses provisions, so that the normal amendment limits apply.
Some submissions responding to the discussion paper criticised the Tax Office’s handling of mass marketed investment arrangements because of the apparent delay between the Tax Office becoming aware of the details of the arrangements and taking action to amend assessments to deny deductions.
Having considered the merits of an approach that taxpayers be given a special remedy where the Tax Office has delayed unreasonably in issuing an amended assessment after it received all the relevant information,37 the Review has concluded that recommendations under various headings adequately address that goal. With widespread shorter periods of review, a new framework for relying on Tax Office advice and a lower interest charge on tax shortfalls, the adverse consequences of any Tax Office delays have been significantly
reduced. Moreover, as outlined in the discussion paper, an approach based on ‘unreasonable delay’ has considerable practical problems. 38
Currently, the periods for an amendment reducing a taxpayer’s liability mirror those for amendments increasing a taxpayer’s liability. This approach has been supported in the past on the basis of fairness — if the Tax Office can increase a taxpayer’s liability for a particular period, a taxpayer should be able to request a reduction for the same period.
If there is a shorter review period for individuals and very small businesses as recommended, the question arises whether symmetrical periods should be maintained, or whether a set amendment period of four years for all amendments reducing a taxpayer’s liability is preferable. Submissions were divided on this issue, with some support for each approach. The arguments are finely balanced.
The Review considered a standard four year period for all types of taxpayers because it would allow more time for them to correct their mistakes where they had overstated their liability and would promote certainty through a single rule. However, maintaining the existing formal symmetry of treatment in the law for amended assessments also had appeal from the point of view of balance and fairness. The Tax Office has advised the Review that both goals can be achieved by the Tax Office exercising its present legislative discretion to agree to a request to extend the time for an objection in circumstances where the new shorter review periods might otherwise deprive a taxpayer of a legitimate claim for a credit amendment. Practice Statement PS LA 2003/7 outlines the Tax Office‘s present approach. Many late objections are currently accepted.
The Tax Office should generally accept a request for an extension of time to lodge an objection from individual or very small business taxpayers where the request is received within four years of the original assessment and the taxpayer has at least an arguable case for the objection to be allowed in whole or in part. However, such extensions would not usually be granted where the Commissioner is out of time to amend an assessment of an associated taxpayer to include income which was incorrectly included in the first taxpayer's assessment.
Another way to reduce uncertainty for larger taxpayers would be to extend the Tax Office’s existing pre-assessment agreements to cover a wider range of transactions or circumstances, wherever it is cost effective for both parties to do so.
Currently, taxpayers can enter into pre-assessment agreements with the Tax Office to bring greater certainty to some limited activities covered by the agreement, such as
transactions relating to transfer pricing39 and certain GST activities.40 Other issues that might lend themselves to pre-assessment agreements include the valuation of trading stock and valuation issues under consolidation.
The Tax Office should extend its practice of entering into pre-assessment agreements to a wider range of transactions or circumstances, wherever it is cost effective to do so.
There was widespread support for an idea canvassed in the discussion paper that the Tax Office be required to notify, at an early stage, those taxpayers it selects for further compliance activity. Taxpayers not notified would know that their assessments could only be amended in limited cases. The Tax Office would have, say, half the usual amendment period to notify a taxpayer that they will be subject to further scrutiny.
Although this idea seemed likely to increase taxpayer certainty, the Review has concluded that it has weaknesses making it unsuitable for present implementation.
A statutory notification period of this type may result in a significant loss of revenue, as the Tax Office does not currently identify all compliance risks within the time that would be allowed for notification. This is especially the case for larger businesses and complex cases. Furthermore, it could reduce the substantial number of taxpayers who self amend to increase their liabilities, as the period for amendment would be shorter for taxpayers not notified of further compliance activity.
Nevertheless, the Tax Office has advised that its goal is to make audits more current and it plans to trial a range of process improvements during the next financial year. The early notification of audit action may need to be reconsidered in future.
24 . For individual taxpayers, the amendment period is calculated from the day on which tax became due and payable under an assessment. For full self assessment taxpayers (primarily companies and superannuation funds), the four year period is calculated from the day on which the assessment is deemed to have been made, which is the date the taxpayer lodged its return. Where the Tax Office has begun an audit of a taxpayer’s affairs, but not completed it within the period allowed for amendment, the Tax Office can apply to the Federal Court for an order extending the amendment period, or request the taxpayer to consent to an extension.
25 . To be a Shorter Period of Review (SPOR) taxpayer, the taxpayer must be an individual deriving only salary or wages (or certain other income subject to withholding), interest or public company dividends. The taxpayer must not claim deductions except for gifts, account–keeping fees or government charges on account transactions and expenses of managing tax affairs. There are also disqualifying factors such as having a capital gain or loss. The Tax Office estimates that 1.5 million taxpayers are SPOR taxpayers.
26 . The income tax law defines neither fraud nor evasion. The ordinary legal meaning of fraud is obtaining a material advantage by unfair or wrongful means (Osborn, P 2001, Osborn’s concise law dictionary, 9th ed, Sweet & Maxwell, United Kingdom). It involves the making of a false representation knowingly, without belief in its truth, or recklessly. In Denver Chemical Manufacturing Co v Commissioner of Taxation (NSW)  HCA 25; (1949) 79 CLR 296 at 313, Dixon J said that evasion requires a blameworthy act or omission by the taxpayer (or those for whom the taxpayer is responsible).
27 . See Table 3.1 of the Treasury 2004, Review of Aspects of Income Tax Self Assessment Discussion Paper, Commonwealth of Australia, Canberra.
28 . The range of compliance activities that the Tax Office might adopt will vary according to the compliance profile of the taxpayer and the market segment to which they belong. While most returns are subject to office based analysis, such as risk profiling and data matching, relatively few are selected for comprehensive audit. Selection for audit is generally based on a risk assessment, rather than arising merely by chance, or because it is ‘your turn’.
29 . Income matching means comparing income returned by a taxpayer with information provided by third parties, for example, electronically comparing the database of information about interest paid by financial institutions and dividends paid by public companies with the information in returns.
30 . These processes may involve the Tax Office issuing a statement of facts or a position paper on the legal issues, which a taxpayer can dispute or clarify, and further discussions, negotiations and exchanges of papers. At any stage either or both parties may need time to obtain legal advice, expert advice or valuations, etc. The taxpayer can also request that the Tax Office review its position and has the opportunity to provide a submission on any penalty issues that may arise.
31 . Legal professional privilege is a common law ground upon which a party may object to the disclosure or inspection of confidential communications between a legal adviser and their client in relation to litigation taking place or being contemplated by the client.
32 . The Federal Court can extend the amendment period where, because of any act or omission of the taxpayer, it was inappropriate or not reasonably practicable for the Tax Office to complete an audit within the normal period (see subsections 170(4)-(4C) of the ITAA36).
33 . This test broadly requires that the taxpayer carries on a business in that income year, has an average annual turnover of less than $1 million (ignoring GST credits), has depreciating assets with an end of year value below $3 million and has elected to be an STS taxpayer.
34 . See footnote 30.
35 . For full self assessment taxpayers (primarily companies and superannuation funds) the four year period is calculated from the date on which the assessment is deemed to be made. However, the Tax Office considers that there is no deemed assessment when a full self assessment taxpayer lodges a non-taxable return (Australian Taxation Office 2004, Draft Taxation Determination TD 2004/D2, Australian Taxation Office, Canberra). The Administrative Appeals Tribunal held in BCD Technologies Pty Ltd and Commissioner of Taxation  AATA 496 that there was a deemed assessment where the company lodged a nil liability return. The Commissioner has appealed to the Federal Court.
36 . In this respect, it is noted that, in the United States, corporate taxpayers that enter into ‘reportable transactions’ must (among other things) disclose details of the transactions to the Internal Revenue Service (IRS) in their annual tax return. Reportable transactions are ones identified by the IRS as tax shelter transactions or that have characteristics typically found in tax shelter transactions.
37 . At pages 40-41, the discussion paper explored an approach based on the doctrine of laches.
38 . An ‘estoppel’ approach would not fit comfortably with the long established principle that the law, rather than the Tax Office’s actions, should govern the right to tax collection. (Federal Commissioner of Taxation v Wade  HCA 66; (1951) 84 CLR 105 at 117 per Kitto J: ‘No conduct on the part of the commissioner could operate as an estoppel against the operation of the Act …’) Statutory time limits already attempt to balance the merits of finality against the ideal of all taxpayers paying their correct liability. Superimposing a rule that would require the Tax Office to act within a reasonable time of having all the material facts would add significant complexity.
39 . Transfer pricing agreements set out the transfer pricing methodology to be used in the future apportionment or allocation of income and deductions for income tax purposes. The benefit of these agreements is that the Tax Office will not make any adjustments to the tax liability established under the agreements provided the taxpayer has complied with the terms and conditions of the agreement.
40 . GST pre-assessment agreements apply where the Tax Office is satisfied that businesses have appropriate internal controls in place to meet their full range of GST responsibilities. By obtaining an agreement with the Tax Office, businesses can reduce the risk of audits and penalties, provided they properly implement and maintain the agreed assurance processes.
Next: Chapter 4: Penalties