Preparing for an ATO Tax Audit: Part 1 - Strategies for getting the house in order

ATO Tax Audits can be daunting for both clients and advisers. They can have serious implications. Consequently, you need to prepare. Anna Tang

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Regulatory Background

The Commissioner of Taxation (Commissioner):

• has the general administration of the taxing acts; and
• is required to report to the Commonwealth Treasurer on any breaches or evasions of the taxing acts of which he is aware.[1]

In 2005/2006, the ATO's compliance activities raised $6,244 million including tax, penalties and interest.[2]

The ATO's Compliance Activities

ATO compliance activities include telephone calls, letters to taxpayers as well as audits.

During an audit, the ATO:

• examines the tax affairs and records of a taxpayer to ensure that reported information is accurate and to confirm the taxpayer's tax liability[3];
• may examine the tax records of other persons which may shed light on the taxpayer's tax position; and
• may cross-check data against different sources (for example, interest payment records forwarded by financial institutions) may send ATO officers to visit the taxpayer's (or third party's) premises to examine records.

Tax audits sometimes last months or even years.

Risks to the Taxpayer

A taxpayer involved in a tax audit faces the following risks:

• the risk of discovery of breaches in tax obligations and the imposition of penalties and interest; and
• the risk of adverse affects on business operations.

Reducing the risks - Audit Strategy

All taxpayers need an appropriate audit strategy to minimise these risks. An audit strategy should cover actions for the taxpayer:

• to take before the ATO selects them for an audit; and
• to take during an audit.

This article examines the pre-audit strategy. The March 2007 edition of ClearLaw will examine the strategies for dealing with audits.

Pre-Audit Strategy

All taxpayers should conduct their affairs in anticipation of an ATO audit. Accordingly, a taxpayer should:

• take great care in entering transactions with taxation implications; and
• assume that the Commissioner will scrutinise the transaction.

The taxpayer's care needs to extend throughout documenting, executing and recording the transaction. If possible, the taxpayer should obtain ATO rulings (both private and public) if a particular transaction is in doubt.

1. Private and public rulings

An ATO ruling binds the Commissioner if the ruling applies to a taxpayer and the taxpayer relies on the ruling and acts in accordance with it. Significantly, a taxpayer's exposure to administrative penalties is reduced if a ruling applies.[4] Generally, there are two types of rulings - public rulings and private rulings.

Public rulings - on how a provision would apply

The Commissioner's written public rulings are the Commissioner's opinion on how a relevant provision applies or would apply. They:

• bind the Commissioner;
• are useful to show whether a taxpayer's position is reasonably arguable[5]; and
• apply from the time they are published until they are withdrawn (unless specified otherwise). A public ruling that is withdrawn will continue to apply to a taxpayer after its withdrawal if the taxpayer is involved in an arrangement and that arrangement had already begun to be carried out at the time of the withdrawal.

Private rulings - on a particular scheme

The Commissioner's written private rulings are the Commissioner's opinion on how a relevant provision applies or would apply to a particular scheme. They also bind the Commissioner and they bind the relevant taxpayer. A taxpayer or the taxpayer's agent may apply to the Commissioner for a private ruling.

The Commissioner may decline to make a private ruling if:

• the Commissioner considers that making the ruling would prejudice or unduly restrict the administration of a taxation law; or
• the matter sought to be ruled on is already being, or has been, considered by the Commissioner; or
• the matter sought to be ruled on is how the Commissioner would exercise a power under a relevant provision and instead, the Commissioner's decision is only as to whether to exercise the power; or
• the Commissioner considers further information is required and it has not been provided in a reasonable time; or
• the Commissioner considers that the private ruling's correctness would depend on assumptions about a future event or other matter.

If the Commissioner declines to make a private ruling, he must supply written reasons for that decision. A taxpayer can apply to have that decision reviewed under the Administrative Decisions (Judicial Review) Act 1977 (Cth).

2. Document retention policy

Taxpayers should implement an appropriate document retention policy and administrative filing system to enable them to retrieve records efficiently during an audit.

The tax laws impose a positive obligation on taxpayers to maintain records that document and explain all transactions and other acts engaged by the taxpayer that are relevant for the purposes of the taxation laws.[6] Taxpayers should determine which documents are protected by "privilege", mark them as privileged and arrange for them to be kept separate from "non-privileged" documents. This enables the taxpayer to minimise the risk of privilege being inadvertently waived.

Which documents are privileged?

Generally, if a taxpayer has a document that is privileged, then it usually does not have to show that document to the ATO or to a court.

The types of privilege available to a taxpayer include legal professional privilege, accountants' privilege and corporate board document privilege.

Legal professional privilege

Legal professional privilege protects:

• confidential communications between a client and the client's legal advisor for the dominant purpose of obtaining or giving legal advice; and
• confidential communications between a client, the client's legal advisor and third parties, for the dominant purpose of use in relation to pending litigation or contemplated litigation.[7]

A document is not protected by privilege if it is part of preparing for, or furthering, a crime or fraud.[8]- including a 'sham contrivance'.[9]

Accountants' privilege

Although Legal professional privilege does not protect communications between a client and their accountant[10], the Commissioner has voluntarily respected the confidentiality of some documents prepared by external professional accountants.[11]

The Commissioner distinguishes between 3 categories of documents:

• Source documents. The Commissioner seeks access to source documents which are papers:

  • prepared in connection with the conception, implementation and formal recording of a transaction or arrangement; and
  • which explain the setting, context and purpose of the transaction or arrangement - for example accounting ledgers.

• Restricted source documents. The Commissioner usually respects the confidentiality of restricted source documents which include:

  • advice prepared by an external accountant solely for the purpose of advising a client on matters associated with taxation, and
  • created by, or contemporaneously with, a relevant transaction or arrangement.

• Non-source documents. The Commissioner usually respects the confidentiality of restricted source documents which include advice papers provided after a transaction has been completed and included in a current audit file.

However, the Commissioner will seek access to restricted source documents and non-source documents in exceptional circumstances and after an internal approval process has been complied with. Generally, for the Commissioner to seek access to these documents:

• there must be reasonable grounds to suspect fraud or evasion or other illegal activity;
• the source documents have not been provided or have been lost or destroyed;
• neither the taxpayer nor the taxpayer's records can be located; or
• some or all of the taxpayer's records are located overseas.

The accountants' privilege is merely an administrative privilege with no legal basis. Accordingly, the Commissioner is not legally obliged to comply with the internal approval process. However, it is likely that a court would prevent the Commissioner from exercising his investigative powers unless there is an urgent basis to investigate - for example, if there are fears that the documents will be destroyed.[12]

Corporate board document privilege

Corporate board documents are documents created by advisors (either a qualified in-house or independent advisor) for the sole purpose of providing advice to the board of directors on tax compliance risks. The Commissioner has stated that he will not seek access to corporate board documents except in exceptional circumstances.[13] As this is an administrative privilege and not legally binding on the Commissioner, taxpayers should note that the issues in relation to non-compliance with the accountants' guidelines also apply here.

3. Internal audit rules

Taxpayers should create internal rules for handling documents and handling a tax audit. This ensures that taxpayers and their personnel are prepared for the audit process. Taxpayers and their staff should be familiar with the Taxpayer's Charter - www.ato.gov.au/content/charter.htm. It sets out:

• a taxpayers rights and obligations under the law; and
• the service and standards the taxpayer can expect from the ATO and its officers.

March 2007 ClearLaw

The next edition of ClearLaw will go beyond strategies for preparing for an ATO Audit, to explore strategies for dealing with an ATO Audit.

More Information

For more information, please call Maddocks on 03 9288 0555 and ask for Anna Tang.

[1] Sections 8 and 14 of the Income Tax Assessment Act 1936 (Cth) (ITAA36) and sections 3 and 3B of the Taxation Administration Act 1953 (Cth) (TAA).
[2] Commissioner of Taxation Annual Report 2005-06, Australian Taxation Office, 2006, p.127.
[3] Industrial Equity Limited v DFC of T (1990) 170 CLR 649.
[4] Section 284-215 of the TAA.
[5] Section 284-15 of the TAA.
[6] Section 262A of the ITAA36.
[7] Commissioner of Taxation v Pratt Holdings Pty Ltd (2003) 195 ALR 717.
[8] Attorney-General (NT) v Kearney (1985) 158 CLR 500.
[9] Crescent Farm (Sicup) Sports Ltd v Sterling Offices Ltd [1972] Ch 553 per Goff J at 565.
[10] Baker v Campbell (1983) 153 CLR 52 per Dawson J at 128.
[11] ATO's Internal Access and Information Gathering Manual.
[12] OneTel Ltd v Deputy Commissioner of Taxation (2000) 101 FCR 548.
[13] In PSLA 2004/14