If you’ve been notified that your tax affairs are under “investigation”, “review” or “audit” by the Australian Taxation Office ("ATO") or by Revenue NSW, you may be wondering how to respond and what is likely to happen next.  This blogpost tries to address those questions.  The post considers a situation where it is the ATO who has contacted you, but if you are under investigation by Revenue NSW, much of the content should still be relevant. 

Key recommendation

The initial letter from the ATO notifying that you are under “review” or audit” will likely ask you to provide certain documents (eg, financial statements, contracts etc); and state that if you make a “voluntary disclosure” the ATO will reduce any penalties by 80%.

My key recommendation is:  Don’t respond “unthinkingly” to the letter by mindlessly providing the documents the ATO has asked for.  If you do: 

• the documents you provide to the ATO may, on their face, present the wrong impression to the ATO. If so, you may squander the opportunity to show the ATO, at the initial stage of investigation, that your tax affairs are in order – meaning that you will have to spend additional costs and effort in challenging the ATO as the matter escalates; and/or

• you may miss out on the valuable 80% penalty reduction.

More detail

So what is the “thoughtful” way to respond to the ATO’s initial letter and what will happen after you respond? 

1. First, you should try to understand what concerns the ATO has about your tax affairs. The ATO rarely conducts wholly random investigations so if the ATO has decided to “review” or “audit” you, they probably have some concern about your tax affairs.  Understanding why the ATO is investigating you will help you with paragraphs 2 and 3 below.

2.  Once you know why the ATO is investigating you, you should assess whether the ATO’s concerns have any basis.  If you realise you have clearly made an error in your tax affairs then making a “voluntary disclosure” about the error to the ATO at this early stage of the investigation may well be the optimal way to respond.  Doing so will mean you can pay the tax you should have paid and move on with your life.  The alternative is to continue “fighting” the ATO, which will likely result in your having to: (a) pay the unpaid tax as well as penalties imposed by the ATO; and (b) spend money, time and effort in fighting the ATO.

3. If, after analysis, you believe the ATO’s concerns are unfounded, then your key objective in responding to the ATO’s letter should be to persuade the ATO of this.  You want to do this to avoid the matter being escalated by the ATO to the next stage (because escalation will only result in more costs/hassle for you).  Therefore:

(a) Before you provide the ATO with the documents they have asked for, you should carefully review and consider the significance of the content of each document.  This is because there may be something in a document which inadvertently presents the wrong impression about what has occurred; or, alternatively, there may be something in a document which is very helpful in showing why the ATO’s concerns are unjustified.  In either case, you should provide an explanation to the ATO when you submit the document to help the ATO understand the significance of the document.  So, for example, if there is something helpful to your case in the footnote on page 89 of a 200 page document, draw the ATO’s attention to it – otherwise they might miss it.  Alternatively, if there is something in a document that might inadvertently provide a misleading impression, then you should  address it, upfront, in your response to the ATO.

(b) Also, consider whether you should provide any additional documents or explanation (ie, beyond what the ATO has expressly requested) when you respond.   You are in a lot better position to know what documents and information in your possession will be helpful to address the ATO’s concerns than the ATO will.  More specifically:

(i)  In relation to documents – To some degree the ATO is “floundering in the dark” when deciding what documents to ask you for.  So there may be documents, which the ATO has not thought to ask for, that would alleviate the ATO’s concerns.  Just for example, let’s say the ATO is auditing you to investigate whether the GST exemption for “sale of a going concern” validly applied to your sale of a property.  Assume a situation where there was no lease in place at the time the contract for sale was entered into but, prior to settlement, you commenced leasing out the property and you and the purchaser agreed, at that time, that the sale would be the supply of a going concern.  The letter from the ATO may have asked only for a copy of the sale contract.  If you simply provide the ATO with the sale contract it will appear to the ATO that the sale does not qualify for the GST exemption because the sale contract will show that the property was untenanted at the time the contract was executed. However, if (even though the ATO has not asked for it) you also provide evidence of the lease and evidence that you agreed with the purchaser, after the sale contract was executed, but before settlement, that the sale would be the supply of a going concern, then you will go a long way to alleviating the ATO’s concerns about why you claimed the exemption.

(ii) In relation to additional explanation – Sometimes the history of what has occurred is complicated.  If so, it can be helpful to provide the ATO with a clear, easy to understand chronological narrative of what has occurred (even though the ATO has not specifically asked you for this.)  Also, don’t fall into the trap of thinking that the ATO knows as much as you do about how your business or industry operates – they probably don’t.  So if there is any industry background that is relevant to your case, you may want to explain it upfront.   

(c) Try to write clearly and in plain English.  This will make it easier for the ATO to understand the points you are trying to get across and thereby increase the likelihood of the ATO agreeing with you.    

4. After you submit your response to the ATO's letter, the ATO will consider it and then may have some follow up questions or requests for information.  If you are asked to provide further responses or information, when doing so, keep in mind the recommendations in paragraph 3 above.

5. The ATO will then either (a) end the investigation favourably (or assess you based on the voluntary disclosure you have made) or (b) “escalate” the matter to the next stage.  If you were initially under “review”, then the next stage will likely be an “audit” – this means the ATO will be asking you significantly more questions and for significantly more information.  After the “audit” stage, the next stage is for the ATO to issue a “position paper”.

6. The position paper will set out the ATO’s preliminary (unfavourable) findings and an explanation for why the ATO has made those preliminary findings.  You should carefully review the position paper to make sure you understand what the ATO is saying and why they have determined what they have.  Then, if you still think the ATO is wrong, you should prepare a response making sure to address all the concerns the ATO has raised in their position paper.  It is worthwhile taking the time to provide a comprehensive and considered explanation about why the ATO’s preliminary findings are wrong because, in my experience, the ATO is open to changing its position if presented with compelling arguments in response to their position paper.  And if you can persuade the ATO to change its mind at this stage, then you can avoid having to go to the next stage.

7. If your response to the position paper persuades the ATO that their preliminary adverse findings were wrong, then that will be the end of the matter.  If not, the ATO will assess you to tax based on their adverse findings and may also impose penalties.  

8. If, after receiving the adverse assessment, you wish to keep “fighting” the ATO, then the next stage is to prepare and lodge an “objection” against the adverse assessment.  Note that there are time limits for lodging an objection.  The “objection” is another chance for you to make a submission (to a different department in the ATO) about why the ATO is wrong.  Again, you should aim to present your case as comprehensively and persuasively as possible with all relevant evidence.  The better your objection submission, the more likely you can avoid having to go to the next stage.

9.  If the ATO decides against you at the objection stage then the next stage is to fight the ATO in court – either in the Administrative Appeals Tribunal (“AAT”) or in the Federal Court.  There are pros and cons to each option.  It is generally undesirable to still be fighting the ATO at this stage because if you engage proper legal representation it can be very expensive to run a case in the AAT or the Federal Court.

10. At any point in your dispute with the ATO, you can try to settle the matter.  In other words, you can offer the ATO an amount that is less than the amount the ATO insists is payable but more than you think is payable.  And in some cases, the ATO will themselves initiate a settlement offer.  However, the ATO is unlikely to agree to a settlement if there is no merit to your case – in other words, if the ATO believes that a court will very likely side with the ATO if the matter ends up in court, then the ATO has little incentive to settle the matter for less than the amount the ATO thinks is properly payable.