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Performance against the 4 key areas of justified trust

How we assess the Top 500 group's performance against 4 key areas of justified trust.

Published 20 November 2023

 Tax governance

Tax governance is a key focus area in our engagements with Top 500 groups.

Ideally, we want the groups in the Top 500 population to create a framework that addresses the main principles of effective tax governance. This includes accountabilities and sign-off points, robust processes to meet the group’s lodgment and payment obligations, and guidelines for when to seek external tax advice.

Within an effective tax governance framework, there will be policies, processes or procedures present that identify and manage business as usual tax issues and mitigate the risk of incorrect reporting. The policies, processes and procedures will also ensure differences in financial accounting and tax principles are recognised and applied correctly, as well as explained in context.

Our engagement teams encourage Top 500 groups to show us their documented tax governance frameworks, processes and procedures. We assess the effectiveness of those controls with the assistance of our internal Tax Governance Tool.

This tool provides a consistent method for our teams to assess the tax governance in place for the active trading entities and non-trading (passive investment) entities within the group. It also helps us evaluate the effectiveness of tax governance processes in place for wealth extraction from those entities (for example, via trust distributions, payments and dividends).

We assess a client’s tax governance framework against the 7 principles of effective tax governance for privately owned groups. When applying the Justified Trust methodology for a Top 500 group, we focus on the following 4 of the 7 principles of effective tax governance:

  • accountable management and oversight
  • recognise tax risks*
  • seek advice
  • integrity in reporting*.

*Note: In GST assurance engagements, the 2 principles of recognise tax risks and integrity in reporting are considered for assessing GST governance.

The 3 remaining principles overlap with the 4 main principles and are not considered on a stand-alone basis to avoid duplication, but their qualitative aspects remain important to how we view each Top 500 group’s engagement with the tax system.

These are:

  • professional and productive relationships
  • timely lodgments and payments
  • ethical and responsible behaviours.

We rate the 4 principles of effective tax governance based on the evidence provided by Top 500 groups to demonstrate the 3 core elements of:

  • existence: a tax control framework exists
  • design effectiveness: the framework, and the processes and procedures within the framework have been designed effectively
  • operational effectiveness: the framework, processes and procedures are operating effectively.

The Top 500 group will obtain the following ratings based on the level of evidence provided.

  • Very high rating – We have obtained a very high level of confidence in a Top 500 group’s tax governance framework. The Top 500 client has provided evidence to demonstrate that they meet all of the following
    • a tax governance framework exists
    • it has been designed effectively
    • it's operating effectively in practice.
  • High rating – We have obtained a high level of confidence in a Top 500 group’s tax governance framework. The Top 500 client provided evidence to demonstrate that that they meet all of the following
    • a tax governance framework exists
    • it has been designed effectively
    • it's operating effectively in practice, with one or more areas requiring improvement.
  • Medium rating – We have obtained a medium level of confidence in a Top 500 group’s tax governance framework. The Top 500 client provided evidence to demonstrate that that they meet all of the following
    • a tax governance framework exists
    • it has been designed effectively, with one or more areas requiring improvement.
  • Low rating – We have obtained a low level of confidence in the Top 500 group’s tax governance framework. The Top 500 client provided evidence to demonstrate that a tax governance framework exists, but there are a significant number of areas requiring improvement.
  • Very low rating – We have obtained a very low level of confidence in the Top 500 group’s tax governance framework. The Top 500 client has not yet provided sufficient evidence to demonstrate a tax governance framework exists or we have significant concerns with the group’s tax risk management and governance.

The engagements completed in the 2023 financial year resulted in the following ratings for Top 500 groups that provided written tax governance policies and procedures (refer to the charts below).

Tax governance ratings for trading entities across 96 groups

Tax governance ratings for trading entities across 96 groups

The Top 500 tax governance ratings for trading entities are:

  • 45% medium confidence
  • 24% high confidence
  • 18% low confidence
  • 13% very high confidence
  • 1% very low confidence.

Tax governance ratings for non-trading entities across 86 groups

Tax governance ratings for non-trading entities across 86 groups

The Top 500 tax governance ratings for non-trading entities are:

  • 42% medium confidence
  • 23% high confidence
  • 19% low confidence
  • 12% very high confidence
  • 5% very low confidence.

Tax governance ratings for wealth extraction across 87 groups

Tax governance ratings for wealth extraction across 87 groups

The Top 500 tax governance ratings for wealth extraction are:

  • 44% medium confidence
  • 25% high confidence
  • 15% low confidence
  • 10% very high confidence
  • 6% very low confidence.

Observations

During the last 12 months, we observed an increase in Top 500 groups that developed or are developing their written tax governance policies and procedures. In our assessments against each of the 4 key principles, the key areas for improvement were identified with respect to recognise tax risks and seek advice. When advising Top 500 groups of their tax governance rating, suggestions for improvement were also provided.

With respect to accountable management and oversight, improvements noted were to:

  • record key responsibilities of the advisor and the Top 500 private group in managing specific tax issues – for example, recording who is responsible for reporting material tax issues identified as requiring management through a process or procedure
  • use a timetable to ensure lodgment and payment obligations are made on time.

With respect to recognise tax risks, we recommended that the Top 500 clients:

  • identify and list all material tax issues that require written tax governance procedures in relation to the way wealth is created by, and extracted from, entities within the Top 500 group
  • have written tax governance procedures for every material tax issue that they identify.

With respect to seek advice, an effective tax governance process:

  • specifies when advice should be sought, who is responsible for seeking that advice and the process for engaging external advisors to provide advice.

With respect to integrity in reporting, we recommended that Top 500 clients ensure written procedures were in place to manage material income tax and GST issues.

Tax risks flagged to market

Public Rulings, Taxpayer Alerts and Practical Compliance Guidelines are how we flag compliance risks to the market. We seek to obtain high levels of assurance that these risks are not present (or have been appropriately mitigated) when undertaking assurance engagements with the Top 500 population.

As part of the engagement process, we seek objective evidence that the tax treatments applied in a Top 500 group accord with our public rulings and don’t exhibit risks flagged in our Taxpayer Alerts program.

We need to assure that the Top 500 group does not have arrangements in place that conflict with our published views and risks flagged to market.

The graph below provides a summary of the categories of Public Rulings, Taxpayer Alerts, and Practical Compliance Guidelines that are present across the Top 500 population.

Summary of risk categories

Summary of risk categories

The top 500 risk categories are:

  • 27% trusts
  • 24% income or deductions
  • 13% other
  • 10% international
  • 7% research and development (R&D)
  • 6% losses
  • 5% residency
  • 4% dividends
  • 2% superannuation
  • 2% GST.

Observations

Broadly, most low ratings provided for Top 500 groups whose affairs were not aligned to our public rulings relate to the misapplication of Division 7A, particularly failing to maintain a complying loan agreement.

Treatments of tax issues from ongoing and atypical transactions

As part of our tax assurance engagements, we seek to understand the tax issues that arise from ongoing income producing activities of the Top 500 group. This includes income from both business and passive investments and the tax treatments applied to significant and atypical transactions.

With the Top 500 population being engaged in business across 141 different industries, we continue to work with groups in assuring the array of tax issues that arise from the ongoing and atypical transactions they undertake.

We seek to obtain a high degree of confidence that the treatments applied to tax issues arising from ongoing and atypical transactions are correct. We apply a consistent rating system when assessing the treatments applied to these tax issues. The categorisations are as follows:

  • high assurance – we have a high level of assurance that the treatment that has been applied to the tax issue is correct
  • medium assurance – more evidence or analysis (or both) is required to obtain a high level of assurance that the treatment applied to the tax issue is correct
  • low assurance – we have insufficient evidence to make an assurance decision about the treatment of the tax issue, or we have concerns that the tax issue has not been treated in accordance with the tax laws.

Observations

As of 30 June 2023, many of the tax issues examined that arise from business as usual and atypical transactions have received a medium or high assurance rating, including those with a Top 500 GST assurance engagement.

The following sections outline specific areas of concerns and items that attracted our attention during the year ended 30 June 2023. We identified these risks in several cases, however they are not endemic in the Top 500 population.

Business as usual income and deductions

Most transactions whose tax treatments we seek to understand in Top 500 engagements are related to ongoing (or ‘business as usual’) activities. Our focus on the basics reflects the purpose of the Top 500 program, to assure that Australia’s largest private groups are paying the correct amount of tax. Accordingly, we need to understand the routine, regular, and ongoing transactions that Top 500 groups engage in and the tax treatments they apply.

In cases where we have finalised our analysis, we provided high levels of assurance to the tax treatments applied in approximately 73% of the tax issues examined.

We are continuing to work with Top 500 groups who have received medium or low assurance ratings to obtain comfort over the tax treatments they have applied. Where necessary, we encourage better practices, particularly through ensuring effectively designed tax governance.

Capital gains tax

Top 500 groups regularly engage in transactions which result in the application of the capital gains tax (CGT) provisions. These transactions involve the disposal of assets, for example real property, shares in a company, units in a trust and rights.

Historically, the misapplication of the CGT provisions to significant, atypical transactions has been a source of tax risk among large privately owned groups. Consequently, during engagements we often review:

  • the accuracy of CGT calculations
  • the correct application of capital losses
  • the availability of CGT concessions
  • rollovers and discounts
  • the pre-CGT status of assets
  • whether the disposal of an asset should be reported on capital or revenue account.

Based on the assurance engagements finalised during the 2023 financial year, most Top 500 groups correctly applied the CGT provisions to the atypical transactions they undertook. A high level of assurance was attained for approximately 76% of the transactions we examined. We are also pleased with the interest Top 500 groups have shown in obtaining tax certainty under our commercial deals program. For the 2023 financial year, certainty was provided on $428.6 million of economic activity reported, and $333.8 million of this related to CGT reporting.

We identified concerns in a small number of cases involving the question of:

  • whether the disposal of a CGT asset should be treated on capital or revenue account
  • whether capital proceeds adjustments in relation to the disposal of a property were made correctly.

Private company loans and benefits

We seek to ensure that benefits obtained from private companies by the controllers of private groups, and their associates, are correctly reported for tax purposes.

Our analysis of these transactions include:

  • verifying that the minimum yearly repayments on loans are correct
  • considering transactions involving debt forgiveness
  • examining whether company property has been used for personal purposes
  • analysing whether unpaid present entitlements have been brought to account.

A high level of assurance has been provided in approximately 64% of instances where we have completed our analysis. Where we provided a low or medium assurance rating in 36% of engagements, the concerns have related to the misapplication of Division 7A.

Although there are instances where we have granted the Commissioner’s discretion to not treat some arrangements as deemed dividends, our view is that the largest private groups have access to the expertise to help them prevent honest mistakes or inadvertent errors.

Use of trusts

Trusts commonly feature in private group structures. During the year, the Top 500 program identified a risk for several Top 500 clients regarding the entitlement of franking credit tax offsets claimed by beneficiaries of non-fixed trusts who had not made a family trust election.

Our approach to the management of this risk was to provide the Top 500 groups with information about the presence of the risk in their group. We asked them to review their entitlements to the franking credit tax offsets within their group and provide the results to the ATO. As a result of the reviews some of the Top 500 groups made a family trust election.

We recommend that Top 500 groups consider the qualified person rules in relation to franked distributions made by trustees of non-fixed trusts and where appropriate make a family trust election.

We also have active audit cases where we are considering the application of the integrity rules in section 100A of the Income Tax Assessment Act 1936. These rules may apply when a trustee make trust distributions to beneficiaries with low marginal rates of tax whilst the economic benefits of the trust income is provided to individuals who would otherwise pay the top marginal rate of tax.

International transactions

We continue to take interest in cross-border transactions and international arrangements entered into by the largest Australian privately owned groups. To date, 147 Top 500 groups have had business or investment activities outside of Australia.

Tax issues arising from international transactions that require verification include:

  • pricing of outbound and in-bound goods and services
  • payment of withholding tax on interest
  • royalties and dividends
  • residency status of entities
  • calculation of foreign exchange gains and losses
  • correct application of provisions relating to controlled foreign entities
  • identifying which entities within the group fall within the significant global entity (SGE) regime.

Several groups have received a medium level of assurance in relation to their cross-border and international activities. This is usually an acceptable level of assurance given the complexities of international tax.

However, we have some concerns with the approach taken by some Top 500 groups in relation to transfer mispricing and residency.

We have also received voluntary disclosures regarding:

  • failure to remit withholding tax from interest paid to a non-resident
  • recognising offshore operations as a permanent establishment
  • omitted attributable foreign income from controlled foreign companies
  • errors in calculations resulting from incorrect foreign exchange rates.

We have also assisted clients with their governance in relation to their international related party dealings, such as:

  • assisting them in country-by-country reporting or preparing new transfer pricing documentation
  • assisting taxpayers in restructuring offshore funding arrangements and resolving corporate residency issues.

Business versus private

As part of our engagement process with the Top 500 population, we seek to obtain confidence that private groups correctly report the extent to which business assets (such as artwork, aircraft, and marine vessels) are used for private purposes – and make the necessary adjustments.

As part of our assurance work, we focus on activities whose costs are expensed through a business, but lack a commercial flavour, or do not exhibit the characteristics of a business. For example, where a Top 500 group’s core business is absorbing the cost of owning lifestyle assets and providing them for the personal enjoyment of the controllers.

Arrangements and characteristics examined include activities:

  • for which there is no formal business plan
  • where the prospect of making a profit is low, or where there has been a history of consistent incurrence of losses (or both)
  • that are speculative in nature, either in their own right, or incidental to the core profit making activities
  • where there does not appear to be a nexus between the cost of the activity borne by the group entity concerned and the production of that entity’s assessable income
  • in the case of horse racing, where the horse racing activities are not sufficiently integrated into a commercially viable breeding business.

In approximately 60% of engagements where this tax issue was examined, high assurance was provided.

Related party transactions

We work with many Top 500 groups who control entities that are not tax consolidated, and as a consequence we have to understand the purpose and pricing of their related party arrangements.

Related party transactions that are common within private groups include, but are not limited to:

  • commercial property leases
  • management fees
  • cost allocations
  • service and administration fees
  • fees related to leasing or hiring equipment.

GST

As part of our collaborative engagement process we sought to obtain confidence that Top 500 groups were correctly reporting their GST.

Some of the areas of concern we found during our GST Top 500 engagements include:

  • adjustments being required due to a change in creditable purpose
  • miscalculating the GST for the sale of property under the margin scheme
  • incorrect GST classification on supplies and acquisitions.

Alignment of tax and accounting outcomes

We seek to ensure that Top 500 groups correctly recognise the differences in the accounting and tax treatments that are applicable to the income producing activities they undertake.

The process of assurance involves obtaining an understanding about each entity’s activities and the tax issues that arise from those activities. We then seek to understand the accounting policy applied in the group’s financial accounts and identify where the accounting treatment differs from the requirements of the tax law. This informs our understanding of the adjustments that are required to ensure the entity’s tax position is reported correctly.

During the 2023 financial year, we examined accounting and tax adjustments in 160 assurance engagements.

The following levels of assurance was obtained:

  • High Assurance – 79%
  • Medium assurance – 16%
  • Low assurance/red flag – 5%

In a large proportion of engagements, we have been able to confirm that the book-to-tax adjustments are correct. This is where:

  • financial statements are prepared in accordance with accounting standards and are audited
  • entities within the group have prepared detailed book-to-tax reconciliations between net profit or loss reported in the financial statements and taxable income or loss reported in their tax returns
  • the Top 500 group’s representatives are forthcoming in providing documents and explanations regarding how their tax reconciliations are mapped to working papers and source documents to ensure they are complete and correct in context
  • the Top 500 group has strong governance processes in place to support the preparation of financial statements and tax returns.

Where there are unresolved concerns during assurance engagements, the issues may be escalated to a review or audit. This has taken place in small number of cases regarding the following reconciliation items:

  • adjustments for trading stock valuations
  • gains or losses from financial arrangements subject to the TOFA rules
  • other income not included in assessable income
  • capital allowances
  • net capital gains
  • capital works deductions
  • net increase in trading stock valuation for tax purposes.

For engagements under the GST Top 500 assurance program, we seek to understand variances between a group’s financial statements and their BAS results.

Monitoring and maintenance phase

When a Top 500 group attains an overall high assurance rating under our justified trust assurance program, we have confidence that they have complied, and will continue to comply, with Australia’s income tax laws and they are placed into Justified Trust. In recognition of the high levels of trust we have in the tax outcomes reported by these Top 500 groups, we scale down our engagement interactions for the following 3 financial years. During this time, we largely rely on the effectiveness of the group’s tax governance framework to ensure correct reporting in tax returns, and that the correct amount of tax is paid.

We continue to engage with the private group during this period. However, our engagements are limited to:

  • understanding any impacts from the group’s operating environment
  • verifying the treatments applied to any new tax issues
  • evaluating the impacts of other material changes to the group.

We also expect that representatives of the group will tell us in real time if the group:

  • has made material changes to the design of its tax governance framework
  • identifies that tax risks that have been newly flagged to market subsist within the group
  • has experienced material changes to the nature of their ongoing transactions
  • enters into new or atypical transactions of a type not previously assured
  • has made material changes in their treatment of book-to-tax adjustments
  • has taken new tax positions or changed tax positions that have previously been assured
  • identifies disclosure issues or errors that should be corrected.

Those Top 500 private groups who have achieved an overall high assurance rating should experience a tangible decrease in the intensity of their engagement during the monitoring and maintenance phase.

 

 

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