Question: I operate a business supplying and installing solar power systems at residential properties. I am a one man show. I do get help from my wife with the admin side of things though. Occasionally I need to engage some contract labour to help with installations. About 3 months ago I got a letter telling me I am being audited by the ATO. Last week I received some interim audit report saying I’ve earned an extra $180,000 of income. It even says I have to pay a 75% penalty for “intentionally disregarding the tax law”.

To compete with the big players in the market, I sell the hardware for a low markup and rely on the installation cost to get by. The ATO says I’m supposed to use the same markup as everyone else in my industry or I must be defrauding the ATO. Is this right? Or is it some kind of price fixing?

Small Business Owner, Adelaide, SA

Answer: You are definitely not alone in being targeted by an overzealous ATO. We have had many similar tales of woe from all over the country. When I see how some of the ATO Benchmarks are applied, I see red. Not the red haze of anger, but the good old fashioned cold war red of communism. I have to wonder, is the ATO attempting to implement its own policy of state controlled pricing?

The most common question I get from clients subject to benchmark audits is this:
“If I have to use the same markup as everyone else in my industry and we all buy our stock for the same price from the wholesalers, who have to use the same markup as all the other wholesalers in the industry too, then isn’t that price fixing?”

Why do people always ask me this question?

It is because the ATO penalises people for using free market economic theory in their businesses. By that I mean, businesses are penalises for choosing to use a lower markup in order to achieve a greater market share, or to preserve their existing market share. In my view that is very much a legitimate business practice. Indeed it is a practice which has been adopted for centuries to ensure the continued growth of a business’ customer base.

Why is selling stock at a discounted price such a bad thing according to the ATO?

Since the introduction of the self assessment system of taxation, the ATO has struggled to keep pace with its compliance duties. With operating budgets being continually squeezed tighter by Canberra, the poor old ATO is forced to use shortcuts to do its job.

Benchmarks are the flavour of the month as far as shortcuts go at the ATO. The benchmarks allow the ATO to be lazy when selecting businesses or individuals for audits. The benchmarks then assist the overstretched auditors to cut corners and meet performance targets.

How are the benchmarks being used by the ATO?

In my experience with the ATO’s use of the benchmarks – the benchmarks are being treated like ‘black letter law’. The only problem is, the benchmarks are not law at all – rather, the benchmarks are merely policy or a guideline.

A very troubling aspect of the benchmarks is that the cost of goods sold (COGS) ratio is applied very strictly. The problem with that approach is that the ATO is essentially enforcing a policy which encourages price fixing in the market.

Let’s take the scenario from this week’s question. After having examined the business codes produced by the ATO, there is no code for ‘solar panel supply and installation’, so the closest thing is ‘solar hot water system installation’. Then to select the correct benchmark to use, from the ATO website there is again nothing applicable, so there is no option but to select either ‘electrical services’ or ‘plumbing services’ or ‘airconditioning and refrigeration installation’ as being the closest fit.

From that complete mess, the ATO has taken the reported figures from our friend’s income tax return and assessed it against any one of a number of benchmarks that the ATO thinks is closest to the correct business. So from the outset, the ATO is comparing apples with durian.

After comparing our friend’s reported figures with a benchmark that may not be appropriate, the ATO auditor makes two assumptions:

1. There is absolutely nothing flawed in the benchmark system; and
2. The taxpayer must be a fraudster.

The poor taxpayer then gets put to the stress and expense of proving their innocence. This is in instances where the ATO may not have even looked at the taxpayer’s records for the full financial year.

Once the ATO has pretended to consider the response put forward by the taxpayer, an assessment is made that the taxpayer must have not declared all of their income. The ATO says the taxpayer’s record keeping is not good enough and therefore the ATO cannot rely on the reported income amounts. Ironically, the ATO then relies on those very same records to say the COGS are correct. The reported COGS are used to calculate what the ATO says is the true income based on the benchmarks.

Once the ATO has deemed the taxpayer to have earned a truckload more cash, without any evidence that the income was in fact earned, the ATO applies a penalty of 75% on the basis that the taxpayer intentionally lied about their income. Even though the taxpayer never knew they earned the extra money, because they didn’t earn more than they reported.

How do the benchmarks encourage price fixing?

Rather than being at liberty to make legitimate business decisions – the benchmarks enforce a very limited range within which a business can operate. Of course businesses are always free to make their own decisions about what price to sell stock at. However, if a business chooses to sell stock at a lower gross profit margin, they are penalises by the ATO in the form of more frequent audits.

In most cases there is nothing wrong with the business that is targeted by the ATO for a benchmark audit. In most cases the business is healthy and makes a good profit in the eyes of the business owner.

The longer the benchmarks are used as a basis of targeting businesses for ATO audits – and then making default assessments of the business income, the more businesses change their behaviour to report inside the benchmarks. The problem with that is many businesses report outside of the benchmarks for very legitimate reasons. By changing their business strategy and ensuring their COGS is within the benchmarks, the businesses are [perhaps unknowingly] engaging in price fixing conduct.

Price fixing usually involves two or more businesses coming to an agreement to charge a particular price for a particular product or service – with the aim of making each other more profitable. The difference between conventional price fixing and the benchmarks is that businesses are not coming to an agreement with each other – rather the profit margin for their products is forced upon them by the ATO. Although the businesses are not charging the same price for their products by agreement, they are still making a conscious decision to charge the same price as the rest of the market for fear of negative tax consequences.

What do you do if the ATO selects you for an audit?

The first thing you need to do is contact your accountant and tax lawyer immediately. The next thing you need to do is become a Platinum Member to learn our secret tips for ATO audits.

How do you avoid being audited on a regular basis?

The short answer, you can’t. However, once you’ve placated the ATO for a few years – and shown them that you operate legitimately outside the Benchmarks, you should be fine.

The best way to avoid being audited is to stay on top of your book keeping. Keep your accountant busy. Collect up all your invoices, receipts, and payments and hand it all over to your accountant. They need that to double check the figures that you report on your BAS.

Being one step ahead of the game is the best defence when dealing with the ATO.

Can you avoid the Benchmarks altogether?

Unfortunately, there is no avoiding the Benchmarks for your industry. Even if you deal exclusively with electronic transactions – you are still subjected to the Benchmarks.

I know it is not fair. Why should the ATO be allowed to ‘determine’ that you have under-declared your income purely based on some arbitrary number?

The flaw in the system is that it fails to recognise that no two businesses are the same. Not even if they operate in the same industry. The Benchmark system fails to consider:

• the demographic of the client base;
• changing trends towards using electronic payment methods over cash;
• the region the business operates in;
• the payment policies of the business itself; and
• what happens to the business when the main man (or woman) takes extended leave.

Don’t forget to make good use of your team of professionals. Your accountant, advisers and tax lawyers are all there to be utilised. Their job is to make your life easier.

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