What documentation do small businesses really need?

Many tax disputes before the Administrative Appeals Tribunal (AAT) involve default assessments where the Commissioner determines the assessable income of the taxpayer or assessments that have been amended as the result of an ATO audit. As outlined in a previous article here, the onus is on the taxpayer to prove that the Commissioner’s assessment is excessive and to prove what the correct taxable income should be. Overwhelmingly, the Commissioner wins these types of disputes, with a lack of contemporaneous documentation often being a fatal weakness in taxpayers’ cases.

A recent AAT decision, WYVW and FCT [2023] AATA 4242, provides some interesting commentary regarding the type and extent of documentation that should be maintained by taxpayers, particularly those involved in operating small businesses. Administrative penalties and the application of the safe harbour rule were also dealt with in this case. These will be discussed in a subsequent article.

Background

The taxpayer’s group consisted of a large number of entities, including companies, discretionary trusts, unit trusts, SMSFs and a partnership. Like many small business owners, the taxpayer held multiple roles within the group, including director, shareholder, and beneficiary.

The taxpayer held a bookkeeping and related administrative role, but due to her accounting inexperience, the taxpayer engaged a tax agent for tax compliance and accounting assistance, and a lawyer to provide legal advice. The taxpayer maintained MYOB records of transactions that went through the bank. The tax agent prepared ledgers based on the MYOB files and additional information provided by the taxpayer in relation to non-bank transactions. In addition, the tax agent prepared financial statements and income tax returns, and performed corporate secretarial services for the taxpayer’s group.

The dispute with the ATO primarily related to 23 different unexplained deposits, totalling $9.3 million, that had not been dealt with in the taxpayer’s 2009-13 income tax returns. The taxable income included in the taxpayer’s returns for these income years originally totalled $9,969 but, on audit, was increased to $9.8 million due to the unexplained deposits in addition to deductions denied by the ATO. On objection, the taxable income was reduced by $3.4 million but was still significantly different from the original assessments.

These relevant transactions primarily fell into 3 categories: loans, unpaid present entitlements (UPEs) and the CGT consequences of various redemptions of units in unit trusts.

Although the taxpayer was unsuccessful in showing the Commissioner’s amended assessments were excessive, the AAT’s decision provides insightful comments. In particular, the AAT discussed the documentary and evidentiary expectations of the relevant transactions, within the context of the size and complexity of the taxpayer’s group.

Evidence of the taxpayer

Interestingly, the taxpayer was the only witness, with her husband, who was heavily involved in the group, not appearing to give evidence. In addition, the tax agent and the lawyer who had been retained by the taxpayer to fulfil significant accounting and corporate secretarial functions did not appear and were not subpoenaed to provide documents or evidence. This is unsurprising as the taxpayer told the AAT that she and the former tax agent had not parted on good terms. Given she was attempting to utilise the safe harbour provisions, there may have been a concern the tax agent might have given a different version of events.  However, that left the taxpayer at risk that the AAT would infer that the decision to not call these additional witnesses was because their testimony would not have helped (and perhaps would have harmed) their case.

Contemporaneous documentation

The various transactions had been initially recorded by the taxpayer into MYOB based on bank statements. The MYOB files were then provided to the tax agent who entered the transactions into their preferred accounting software. Non-bank transactions were also processed by the tax agent. The taxpayer argued the recording of the transaction, for example by journal entry, evidenced the transaction. However, this was found to be insufficient, with Senior Member Grigg stating that accounting entries do not provide conclusive evidence of a transaction, and a witness merely explaining what the journals were is not of itself evidence. As such, in addition to accounting entries, contemporaneous records and/or witnesses were required to verify the taxpayer’s claims.

Loans

The group did not have loan agreements in place. The taxpayer sought to argue journal entries (and presumably therefore the financial statements derived from those journals) evidenced the loans.

According to paragraphs 245 and 246 of the decision:

There is no evidence to support the Applicant’s assertion that the purported loans are genuine loan arrangements. All that is known is that there was a book transfer or accounting entries made.

There is no loan agreement in place and no corroboration of any loan. At the hearing the Applicant acknowledged that she did not keep a written record of any agreement between the parties to the various “loan” transactions. She says her accountant never advised her to have formal written loan agreements. The Tribunal finds this implausible. These sums that are the subject of the purported loans are not “trivial”. It is reasonable to expect there would be very likely be some record of the decision to loan this money.

 The decision states that some form of documentation or contemporaneous recognition would be expected, in addition to a journal entry, to confirm whether a loan was genuinely in place. Loan terms such as whether or not the loan is secured, whether or not interest is payable, the loan term and the repayment obligations need to be documented.

The AAT did accept that there may not be formal loan agreements within a family group:

While a formal loan agreement may not be found in such a familial group, some documentation or contemporaneous recognition (other than journal entries) should be available. No other witness was called to verify the Applicant’s claim.

The most persuasive evidence of the existence of a loan is a written loan agreement. If that does not exist, other written communications between the parties to the loan (such as email correspondence or text messages) can be supportive of the existence of a loan. Here there are no loan agreements, no other written documentation to confirm loan agreements were entered into, and no corroborative evidence of any oral arrangement. [emphasis added]

It is always recommended that a formal loan agreement is entered into, particularly where Division 7A would otherwise apply or where parties do not want the loan to be treated as equity for tax purposes. However, based on the above, it would appear that if a formal loan agreement has not been entered into but there is other evidence in writing that documents that a loan exists, that may be sufficient for the taxpayer to satisfy its burden of proof.

The importance of retaining copies of advice obtained by advisors was also discussed. That is:

There is no corroborating evidence of consultations with lawyers and tax advisers. If advice was received, acted and relied upon, which would explain why the Group and the Applicant undertook such transactions, why was this advice … not kept?  Why is there no other record, no other evidence proffered, of the circumstances surrounding these transactions? This was not addressed in the evidence.

In addition to the lack of evidence, the AAT considered there was a lack of “commercial reality” about the purported loan transaction. For significant borrowings, in this case $2 million, the AAT would also expect some corroborating documentation on what the funds were being used for.

Unpaid present entitlements

The AAT stated that the documents you would expect to have recorded for a UPE include minutes of trustee meetings, distributions resolution or loan agreements.

Redemption of units

The taxpayer was unable to provide evidence that she owned the units in the relevant trust and there was no evidence regarding the redemption process.

The AAT also commented that these transactions happened under the:

… supervision and guidance of tax accountants and solicitors. It is reasonable to expect that documentation would have been prepared. Again, no corroborating witnesses were called.

Taxation advice on transactions

The taxpayer had applied the small business CGT concessions to a capital gain in the 2011 income year. The AAT said it would expect that the taxpayer had obtained advice provided by the lawyers or tax advisers in relation to this issue. The taxpayer was unable to provide copies of any such advice.

These comments suggest that it is expected taxpayers seek advice on something as complex as the SBCGT concessions, and that any advice received is maintained.

Key Takeaways

Ultimately, the AAT’s decision illustrates that the size and complexity of a taxpayer group may be relevant when considering the type of documentation required to be maintained for different transactions. However, while small businesses may not prepare formal agreements, there is still an expectation that there is sufficient, contemporaneous documentation of transactions. The recording of transactions in journals for accounting purposes is not enough, as the journals merely record the transaction, and do not provide the required evidence. In reality, due to time pressure or the assumption that parties would remember details, transactions might not be documented as well as they could or should be. But it is important to take a step back while undertaking a transaction and think about what documentation is required to properly substantiate a transaction, to minimise the risk of a dispute with the Commissioner. And remember that it might take the ATO more than 5 years to come back to you about a transaction that happened over a decade ago!

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