An ongoing trend in tax is the increasing standards that have to be met by both taxpayers and by tax agents. Long-standing practices are increasingly being questioned by the ATO and both taxpayers and their advisers need to react to this. If they do not then the effective result is that they are both choosing to increase their tax/professional risks. A recent trend which we have noticed in ATO reviews illustrates this.
I’m talking about transactions by journal entry. You know the ones:
- trust distributions which are not physically paid to the beneficiary;
- unpaid distributions which are applied to other loan accounts (whether of that beneficiary or others);
- minimum repayments of Div. 7A complying loans made by application of a dividend;
- loan set offs;
- payment of employee contributions to reduce FBT issues via a journal to a loan account;
- director/family member salaries booked in the accounts without any physical payment (with or without PAYGW being applied);
… and the list goes on.
Whilst many are familiar with the proposition that journal entries do not evidence a transaction, they merely record it, there are still many instances where the only indication a transaction occurred lies in the general ledgers.
In risk reviews and audits the ATO are increasingly asking for information to evidence the transactions which the journals relate to. The ATO are clearly entitled to ask these questions, and it is probably not news to anyone that these questions are being asked. The documents provided (or not provided) are pivotal in whether the ATO accept that the transaction genuinely occurred.
A classic example is the company beneficiary with no bank account. Trusts make distributions to these companies which then flow in later years as dividends to shareholders without the funds ever actually being under the control of the company. The actual cash flowing from the trust may go directly to the shareholder, or even to different taxpayers again.
It is a typical situation which the ATO is sceptical of – third party beneficiaries would not accept non-payment of monies owed to them and would also not pay out an amount they did not have. Without proof that the beneficiary actually received the distribution or that proper documentation was put in place, the ATO may not accept that there was a genuine transaction. In other words, informal undocumented arrangements are rapidly becoming unacceptable.
A typical outcome where contemporaneous documentation is not put in place properly is that accountants and their clients (literally) try to paper over the documentation deficiency whilst under time pressures to answer the ATO’s queries well after the event. Depending on the circumstances, the ATO may not accept the documentation as legitimate, let alone that the journalised transaction actually occurred. Where the ATO does not accept the transaction occurred, the taxpayer may not only be hit with a tax liability but also with a penalty for failing to take reasonable care (or worse). After all, how is it reasonable to not pay what you owe? Or to pay that money to another taxpayer instead? Or not to seek payment of what you are owed? Or even to not document that the indebtedness exists? A lack of evidence for one transaction might be explainable as an oversight, but not when it is a pervasive issue across a group and/or across income years.
So how should accountants (and their clients) approach the issue?
In an ideal world the cash would actually pass in the same way third parties would transact. This gives real evidence of the transaction. Where the client actually pays the trust distribution to the relevant beneficiary there is no argument that it wasn’t paid and no need for complicated loan set-off arrangements later (which will only help if they are done properly and should be prepared by lawyers and not accountants as they are legal documents). If the client can be educated to do this at the time the transaction takes place, any later ATO reviews should be a lot simpler and cheaper to conclude. After all, the client has the cash when it is taken; so, the ATO can hardly argue a distribution was not made if it shows up on the bank statement as having been paid!
The ability to have clients pay cash and/or document contemporaneously is far easier where there is regular client contact, or where the client has a bookkeeper or internal accountant, as any issues should be able to identified readily and addressed in a timely manner.
It is more difficult with annual clients as you are relying on them doing it correctly and you might not see what they have done until many months later. Educating the clients of the risks they are taking is key so that they come to you beforehand and you can help them avoid creating problems for themselves (and you) later.
A less arguable position is to have transactions properly documented/paid for when the annual accounts are prepared. This is not as good as doing this when the transaction occurred, but it at least is done with the intention of properly documenting the decisions taken as a good governance measure, rather than being done in response to an ATO review. In practice, clients may be reluctant to do this as this takes time and so costs money – which is perhaps an argument for having the cash go through the right bank accounts in the first place! It is not an argument for posting the journal without ensuring that there is other evidence that it ever happened.
The worst position to be in is during an ATO review or audit, scrambling to have documents dated and signed today that confirm a verbal direction given ‘back then’, or confirming now that the parties had previously agreed to do something. This is likely to be treated sceptically by the ATO and, as noted earlier, the ATO may take the view that these documents are not proof that the earlier journal entry was an actual transaction. Unfortunately, many taxpayers are in that exact position because they didn’t think to do it properly up-front, often because “this is the way it’s been done for years”.
Taxpayers generally understand that they can’t get a bank loan or sign a property lease without proper documentation done ahead of time and this reality should extend to their own affairs. As a lawyer once said to me – any documentation done after the transaction is over has no evidentiary value at all.
The ATO is holding small business and smaller taxpayers to a higher standard now. Unless taxpayers improve and meet this, more taxpayers will find that they have unexpected (and possibly large) tax bills – and their advisers may also be exposed as well.
This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.