Summary of findings
For the purposes of estimating the small business income tax gap, we examine the income tax affairs of a sample of small business taxpayers. This is called the random enquiry program.
Our latest completed sample comprises of 1,795 small business taxpayers across the 2018–19, 2019–20 and 2020–21 financial years. We refer to this as our 2021 bundled sample.
Of the taxpayers sampled, we found that:
- 61% reported correctly.
- 30% tried to report correctly but made mistakes – these were usually caused by one or more of the following:
- poor record keeping
- lack of reconciliation processes
- carelessness (for example, transposition errors or small one-off omissions)
- complexity (business owners not understanding the law or how their tax obligations apply for their chosen business structure).
- 4% under-reported income or exaggerated expenses and were considered to be non-compliant. While there was no clear evidence that the behaviour was deliberate, these taxpayers often made little effort to keep records or substantiate claims.
- 5% were clearly avoiding paying the right tax by deliberately under-reporting income or overclaiming expenses – this group were operating in the shadow economy.
The taxpayers found to be operating in the shadow economy had the biggest impact on the tax gap. They made up 5% of the sample but were responsible for around 55% of the missing revenue identified across the sample.
Behaviours observed in the random enquiry program
The random enquiry program has been operating for 8 years. Over this time, we have analysed the behaviour of small business taxpayers and gained some key insights into how we can better assist taxpayers to lodge and pay the correct amount of tax.
The observed behaviours can be broken down into 3 broad categories:
- small businesses getting it right
- small businesses getting it wrong (as a result of mistakes, complexity, poor record keeping or opportunistic behaviour)
- small businesses operating in the shadow economy.
Figure 1 shows the observed behaviours since the random enquiry program started. Over time, a slight increase in instances of small business taxpayers getting it wrong can be observed. The percentage of entities operating within the shadow economy appears to be relatively stable over the years.
Figure 1: Proportion of bundled sample population by behaviour, 2017–2021
Small businesses getting it right
When we see businesses operating well and complying with their tax obligations, we see they have the basics right. As observed through the random enquiry program, we can see that these businesses:
- have good record keeping practices and undertake regular reconciliation processes (such as ensuring cash deposits match total sales)
- understand their tax obligations and seek advice when they need it
- have the support of someone who understands their business (for example, a registered tax or BAS agent, a bookkeeper or accountant)
- use technology that is appropriate for the size and scale of their business (for example, point of sale software, cloud-based accounting systems, mobile apps).
Small businesses getting it wrong
Where we observe small businesses getting it wrong, we see 4 main types of behaviours:
- Simple mistakes - these entities are generally doing the right thing but make a genuine, isolated error.
- Complex mistakes - these entities generally demonstrate a degree of willingness and effort to comply with their tax obligations, however complex issues such as misunderstanding how the law applies to their circumstances drive errors.
- Poor record keeping - these entities generally don't fully understand their record keeping obligations, are unaware of problems with their record keeping systems or had minimal controls in place to prevent errors.
- Opportunistic - these entities don't exhibit a clear intention to avoid their tax liabilities, but appear to take advantage of ambiguous circumstances or rely on social norms to justify their actions.
Simple mistakes
In the 2021 bundled sample, we can see an increase in the number of small businesses who make mistakes along with an increase in the shortfall amount.
The reasons for the mistakes are similar to previous bundled samples. The most commonly observed simple mistakes are:
- Clerical errors - bookkeeping errors such as errors made during reconciliation processes, typographical errors, transposition errors, missing substantiation, apportionment issues or an incorrect calculation.
- Non-deductable expenses - these types of errors can occur when incorrectly claiming a non-deductable expense such as a late superannuation payment or a donation to a non-deductable recipient.
- Immaterial variations - these types of errors are typically misreported income or expense amounts that are small and either forgotten or not properly verified, such as omitted bank interest.
Complex mistakes
Our analysis of the 2021 bundled sample shows errors due to complexity were often related to the business structure used by the taxpayer or incorrect application of the law. Complex mistakes observed in the sample included:
- Division 7A - businesses failing to consider loan implications for personal use of assets, missing loan repayments or using the incorrect interest rate in non-arm's length loan arrangements.
- Fringe benefits - errors regarding fringe benefits arise mainly from a result of private use of motor vehicles.
- Personal services income - underreporting or misreporting income from personal services.
- Business structure - errors made due to a misunderstanding of how tax obligations apply for the chosen business structure, a change in business structure, mistreatment of franchising costs, or an existing complex reporting structure with multiple entities.
- Capital gains - these errors can include incorrectly calculating a cost base for the sale of a business, property, or shares.
- Income - these errors are made due to misreported foreign or rental income, or complex errors related to loan income, or cash and accrual entries.
Poor record keeping
Poor record keeping can be the result of a lack of business acumen, however, it can also be a tax avoidance strategy. Taxpayers who deliberately avoid keeping the right records to hide income are engaging in shadow economy behaviour.
Unintentional record keeping issues observed in the 2021 bundled sample included:
- no source records kept for business income
- errors due to manual recording or transposing of figures
- limited or no reconciliation practices in place
- failure to separate business and personal transactions
- expenses claimed without the necessary substantiation, such as motor vehicle, travel and home office expenses
- poorly maintained documentation, such as partially completed logbooks
- poor storage of documents, such as faded receipts or no digital backups
- bank account statements used to determine income and expenses (instead of being reconciled against).
Digital record keeping solutions are the ideal way to keep records, but care is required to ensure they are fit for purpose and set up correctly. In the random enquiry program, we saw coding and software errors primarily caused by accidental miscoding of transactions or limitations from software that did not allow for business-specific transactional coding.
Opportunistic
These businesses don't exhibit a clear intention to avoid their tax liabilities like those operating within the shadow economy, however they appear to take advantage of the self-assessment system. It's reasonable to expect errors could have been rectified by the business owner or tax professional with proper due diligence.
In our analysis of the 2021 bundled sample, small business engaging in opportunistic behaviours were typically observed to be:
- taking advantage of ambiguous circumstances
- relying on social norms to justify their actions
- claiming private expenses that could not be linked to business operations
- exaggerating the apportionment of business use for services or assets that are also privately used.
The shadow economy
The shadow economy refers to economic activities that are unrecorded and untaxed, but the behaviour isn't limited to tax issues. Activities include dishonest behaviour carried out to misuse or abuse government systems, as well as criminal activities. Shadow economy activity accounts for around 59% of the gross small business income tax gap (around $11.2 billion).
Common shadow economy activities for small businesses include:
- deliberately hiding income or overclaiming expenses to avoid paying the right tax
- underpaying wages or paying cash wages to avoid a range of government obligations
- not meeting reporting obligations on payments to contractors and others
- liquidating and reforming a business to avoid obligations (known as 'phoenixing')
- illegal activities, such as money laundering and unregulated gambling.
Through our analysis of the 2021 bundled sample, we have observed that 5.4% of the entities in the sample were engaged in shadow economy behaviour. This behaviour contributed around 55% of the overall tax shortfall amount across the sample. Figure 2 shows the percentage of missing revenue attributable to each non-compliant behaviour.
Figure 2: Percentage of missing revenue attributable to behaviour 2017–2021
Some examples of activity that we observed included:
- business owners deliberately hiding income in personal accounts or not declaring cash income, which was then used to finance their lifestyle
- intentionally claiming expenses that have no link to business activities
- paying staff or contractors in cash and not reporting it.
Undeclared business income can be unintentional or deliberate. When it's deliberate, the amounts we observe are usually larger.
We observe small business taxpayers deliberately hiding income in a variety of ways, including:
- depositing business income into private accounts or mortgages
- receiving cash and not declaring it
- not reporting income received from an associate entity (for example director's fees).