Unexplained Income: The Practical Implications for Taxpayers

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

The ATO's data matching net has never been tighter. Overseas transfers, cash deposits, crypto transactions, property, you name it, they all leave a trail.

0:22
When the ATO comes knocking and asks you to prove what something is, that's where the trouble really begins.

Today's topic is about unexplained income and the tax trouble with unexplained income.

To unpack this topic, I'm joined by Rajan Verma, who's the director in Velocity Legal's tax practice.

0:39
Welcome, Rajan.

Thanks very much, Andrew. Good to be here. Thank you.

So what is unexplained income and why is it a problem?

So unexplained income, as the name suggests, is really income that doesn't have a readily identifiable source.

0:56
So it can come in the form of random cash deposits in the bank account or money that's come from overseas or transfers that don't have an appropriate description behind them.

But as the name suggests, it is income that doesn't have a clear source. And the reason that that income is very problematic is because when the ATO sees it, they need to know where it's come from.

1:20
They need to know, well, is this income? Is it not income?

And they don't know what is it.

Yeah, well, they don't know, they can't tell. So it's very different. Like if you receive salary and wages, for example, it's very clear what that is. You know where that's come from.

But when it's a random cash deposit in your bank account or an amount of money that's come from overseas, for example, the ATO is not to know what was this income or is it a gift?

1:45
What is it?

And in that situation, the taxpayer is then the one under the obligation to actually demonstrate what that is.

So if the ATO comes knocking and they ask the question, well, you know, is this income, you as a taxpayer have to demonstrate whether it is or isn't.

2:04
Yeah. And I mean, things that could be income could be, you know, someone's conducting a business and taking cash amounts and not recording it, for example, or they've done some sort of overseas ventures and then just bringing the money back and not recording it.

2:21
All right, countless other examples as well.

Absolutely. Yeah, it can include those things. It could even include things like criminal proceeds from crime, for example.

Yeah.

So there's all sorts of different things, all sorts of different places where unexplained income can come from.

2:38
Why are these so problematic for taxpayers? You know, the ATO has immense power. And is it really because of those powers that these are so difficult as cases?

Yeah, absolutely.

I suppose just taking a bit of a step back, we're under a self-assessment system in Australia, which means that people lodge their own returns.

3:01
They are the ones that make their declarations around what their income is. They lodge that, the ATO accepts it on its face, and they issue a notice of assessment.

When the ATO sees some sort of discrepancy, or they have a reason to look into a person's taxation affairs, and they find that, well, hang on, there's something here that doesn't make sense.

3:23
There's money in your bank account or there's something that we see here that doesn't quite stack up. It's not for the ATO to prove whether that's income or not.

The thing is, the ATO is a stranger to all transactions, and the position is very much taken by the tax system that the taxpayer knows their own affairs.

3:44
Who better to explain what this is than the taxpayer themself?

So the entire burden and the entire onus of proof is put on the taxpayer. They must demonstrate what it is. The ATO doesn't need to prove anything, and because of that reverse onus of proof, effectively the ATO can say whatever it is.

4:03
So the ATO can say, look, you've received an amount of money in your account. We don't know where this is from, so we will assume that this is income until you prove that it isn't.

And if you can't prove that it isn't, it's income.

And it ties into also, I guess, your asset betterment type methodology, things where they do an assessment based on assets where it doesn't line up with income and things like that.

4:25
But the ATO is given a pretty wide berth to, so long as they say it is, you need to say that it isn't.

Absolutely. And there's a lot of mechanisms within the tax legislation that support that.

So in the Tax Act, for example, there's the due and conclusive evidence rule that says that once an assessment's issued, that is due and conclusive evidence of the debt.

4:47
So which means that it stands.

It's like me writing a piece of paper, you owe me $1 million.

That's legally enforceable.

Yes, yes.

The only time that rule doesn't apply is when you can test it in proceedings for a tribunal or court.

But until you do that, what the ATO says goes from a legal point of view.

5:07
It's a very strong amount of power that they have.

Absolutely. And so it puts an enormous burden on taxpayers.

The taxpayer is the one that needs to demonstrate where did the money come from? Is it from a taxable source or is it not taxable?

5:28
Why is it not taxable? All of that needs to be proven by the taxpayer. And if they can't prove it, they're going to pay tax on it.

And Rajan, why are we seeing more and more of these cases? Now we're going to go into some of the reported decisions, but in your practice, in my practice, we are seeing more of these cases. But I'm interested in your views about why we're seeing more and more of these cases.

5:51
I think there's a few reasons why.

So first of all, I suppose just in terms of revenue and the needs of the government, the ATO recently published its tax gap data. It lags behind a few years. It was for the 2022 year, but they've identified an almost $50 billion tax gap.

6:10
Now, when I say tax gap, what that is, it's the government's estimate, it's the ATO's estimate of how much tax they think is legally collectible and how much are they actually collecting.

Yeah.

And what they've also identified is 60% of that sits in the private market, SMEs and private individuals.

6:28
So from the ATO's perspective and the government's perspective, there's a belief that there's a lot of money on the table here.

So that's the first part of it.

The second part of it is, I think the ATO is finding it a lot more easily than they used to.

I mean, I've been in practice almost 20 years and I know in the early days there were always things that sort of, you know, the ATO never quite picked up or never quite noticed.

6:52
But nowadays they have so much access to information. The data matching is just incredible.

In fact, in a lot of these unexplained income cases, the ATO has already collected all of your bank statements and gone through them, and they've found it.

7:08
Sometimes without even telling you.

Sometimes without even telling you, they've got all your bank account details, all the data, and you didn't even know they had that or that they were even looking at it.

There's also a lot of information sharing that happens between the bodies, so different government bodies, state governments, SRO, titles office, they all share data with the ATO.

7:29
AUSTRAC shares data with the ATO. AUSTRAC tracks the money that comes into and out of the country.

So if you've got people transferring large sums or even intermediate sums of money into the country, the ATO sees that and the ATO will investigate that.

7:47
And then I think the computer systems are a lot better too. The computer systems are identifying the gaps, and they use AI.

The ATO is using AI also, which is probably helping them speed up their investigations and identifying those gaps.

8:04
The other thing too that the ATO will often look at is when there's sort of mismatches in a person's lifestyle and living expenses versus what they're declaring as income.

So I always say, look, you know, the fastest way to get an audit is go buy a Ferrari.

8:21
Yeah, because if you go buy one of those really expensive vehicles, or you buy a property and you buy it all cash, for example.

Or a boat.

Yeah, you know, a yacht or something, you know, the ATO is going to find out about that because it gets reported.

The next thing the ATO then does is they then check your income tax return and say, oh, well, you know, how much is Andrew declaring in his tax return?

8:43
Does that make sense, that he could go buy such an expensive property or car or boat or whatever it is?

And if it doesn't stack up, I mean, if you're declaring 50 grand of income but you just bought a Lambo, for example, you're going to get an audit, guaranteed.

8:59
Yeah.

So it's those sort of things also that the ATO picks up on.

And there's been also, I guess, a focus on budgetary sort of compliance with the ATO as well, with Treasury and federal governments giving money to the ATO for such compliance programs as well.

9:18
Oh, absolutely.

I mean, the most recent federal budget, there was $999 million that was allocated to the ATO. Why it wasn't a billion, I don't know.

But 999 million, yeah, that was allocated to the ATO to assist in its compliance programs.

9:34
So the ATO is obviously being well funded, but they're being given that money because the government obviously believes they're going to get a return on that investment.

Yeah, it's really interesting, I suppose even with cash deposits. I mean, another thing is that we're getting into a society where cash is becoming less and less of the overall transactions, it's becoming much smaller.

9:57
So, you know, there's always going to be an element of cash where people operate in the grey. And perhaps that's now becoming a larger percentage of all cash transactions as well.

Yeah. Well, absolutely. I mean, I think, you know, for a lot of people, who really deals with cash that much anymore?

It's a lot of things are done through bank transfers or credit cards or that sort of thing.

10:18
And those sorts of transactions are really easy to track. You can see where they've come from. You can see the other side of it.

Yes.

When it's cash, it's a bit unusual, and particularly when it's large sums.

And one thing that I do find is that the people who typically deal with cash transactions tend to be people who have come from other countries.

10:36
The money has come from other countries, and they're the ones that typically get into a lot of trouble in this space.

It tends to be people who have come from overseas, who have brought money from overseas. They're the ones who typically get into a lot of trouble in this space.

Well, let's unpack a bit more of the key legal framework.

10:53
So you said, we mentioned before the due and conclusive evidence rule, that if the ATO issues an assessment, then that is it, unless you challenge it in a certain way.

I want to just get into sort of default assessments versus other assessments.

11:12
What is the difference between the ATO issuing a default assessment and your regular assessment from the ATO?

Yeah, certainly.

So when you lodge your tax return, you're obviously making declarations and you're providing information to the ATO.

11:28
You're making statements that, you know, this is what your income is and this is what your expenses are, etcetera.

And then that results in an assessment being issued, and that's an original assessment.

Now, if the ATO is dissatisfied with that assessment or if they see that there's been an error with that assessment, they can respond to that in one of two ways.

11:47
They can either issue an amended assessment to say, look, you've overclaimed deductions or you haven't declared this, and so they amend the original assessment.

That's in the sort of less extreme.

I failed to put it. I put a deduction in I wasn't entitled to.

12:02
They'd knock it out.

I forgot to put in the sale of an investment property.

They add it in.

Yep, exactly. Exactly right.

Then you get the default assessments, the dreaded default assessment.

So the default assessment is basically a situation where the ATO just doesn't trust anything that you've said.

12:18
So they've either completely thrown out the original assessment because they found that all the declarations, statements you've made are completely incorrect, or you haven't even made a statement. You didn't even lodge a return.

So the ATO is now having to guess what it thinks your income is because they just can't rely on anything you've told them or you haven't told them anything.

12:36
So in that situation, the ATO can issue what's called a default assessment.

So that's just based on what the ATO thinks your income is.

Now, those default assessments will usually be incorrect, but again, because of the due and conclusive evidence rules, it doesn't matter. They stand.

And to make matters worse, if a default assessment is issued, it's an automatic 75% penalty.

75% of the tax that would be payable.

13:01
Correct. Yeah. So if you had a $100,000 tax debt, it turns into $175,000 and then you've got interest on top.

Yeah.

So your $100,000 tax bill very quickly turns into $200,000 plus.

Yeah, and that's before you've done anything.

Yes. So default assessments are nasty, and we find that they are very, very commonly issued in these unexplained income situations.

13:24
Yes. So going to, I guess the ATO has had a pretty high, at least from reported decisions, the ATO has had a pretty high recent success rate with these types of cases, which is understandable given these barriers.

What does a taxpayer firstly need to do to overcome a default assessment or something approximating a default assessment?

13:48
And why have a lot of taxpayers lost in this space?

Yeah, certainly.

So if a default assessment's issued, or even if it's an amended assessment, doesn't matter which one it is, the process from there will be to object to it.

So that will mean obviously making submissions to the ATO around why the assessment's incorrect, why the default assessment's incorrect and what it ought to have been.

14:15
Now that's part of the difficulty actually with default assessments, that it's not enough to just say the ATO is wrong.

You can't just say that figure in there is wrong, because how could it possibly be right?

Correct.

You can't say that. What you have to do is you have to go further to actually positively prove what it actually was.

14:33
Right. And that's a really, really hard thing to do.

So it's not about proving the ATO wrong. It's about proving that you're right. And to prove that you're right, you need documentation, you need contemporaneous information, you need evidence, and it needs to be at a certain standard.

14:49
It needs to be a degree that the tax officer would look at that and say, yep, I can clearly see where this has come from. This is clearly income or not income. It needs to be at that sort of level.

Now, in our experience, when it's unexplained income, the taxpayer typically doesn't make that standard of proof, or they have difficulties.

15:13
And there can be many reasons why that's the case. It could be that money, like cash, has come from overseas. It could be gifts within family members, so undocumented.

And usually things that happened a couple of years ago, so everyone's kind of fuzzy about why it happened and when it happened.

15:30
Exactly. There's not much of a paper trail that explains why the transaction happened. So you can go back to the ATO and say, oh, I got the money from here. It came from my parents, it came from my friend, it was a gift, whatever it was.

But if you don't have a paper trail to evidence that.

15:46
Becomes really hard, doesn't it?

Becomes very hard and the ATO will likely look at that with a degree of suspicion and scepticism and say, look, we don't buy it. This doesn't make sense to us. We're going to put you to the proof.

And then from there, the taxpayer doesn't have a choice but to then go to the Administrative Review Tribunal or the court to then prosecute their case in front of an independent tribunal member or judge.

16:15
But then you need to convince them.

Yes, because all those rules around the burden of proof and the standard of proof that needs to be met, they apply at that level too.

So you need to demonstrate to the courts that, well, you know, this is what it is and this is the reasons why.

16:35
What are the common sort of arguments or reasons why people would say that it's not income? Would it be that there's sort of family gifts, loans? Are they the typical ones?

They're very much the typical ones.

It's usually a gift from a family member, that's the main explanation, or it's an amount that's possibly tax free from some other jurisdiction or something like that.

16:59
But most of the time it's gifts.

In fact, most of the cases I've seen, it's been a gift from a relative overseas.

Yeah. I wanted to get into the cases a little bit because there's been a lot of them in this space.

And I want to start with the positive, which was the case called Chung.

17:19
I understand this case is on appeal, so it may not be the final word, but jump in at any time.

My understanding is there were very significant repeated transactions from Vanuatu to Australia involving family members that were siblings, and the ATO was essentially saying these were all income, and it was held that they were not income and they met that onus of proof.

17:46
Yeah, that's right. That's a very good description of the case.

So the taxpayer had family members that lived in Vanuatu and they ran a supermarket, obviously very successful.

There were numerous payments that were made to the taxpayer in Australia, and I believe over time it was around $30 million.

18:06
It was an enormous amount of money.

The ATO obviously got wind of it and they basically said, look, we think that this is income, that you had some sort of interest in the supermarket and effectively it was income.

The taxpayer's position was that, no, no, this was a gift from family members overseas.

18:25
The matter went to the Federal Court and it was considered, and the judge of the Federal Court basically said that, look, if you look at all the different possible categories of what forms ordinary income, this doesn't really fall into any of those categories.

18:41
It's not income from services, not income from rent, it's not dividends, it's not any of those categories of income that we're familiar with.

So in a sense, what the judge did is effectively, by negating all the possible categories of assessable income, all you've got left was, well, it must be non.

19:02
It's not income, it's not assessable.

Yeah, yeah.

So the taxpayer won in that case, and it's one of the few cases where the taxpayer did win.

But as you said, the matter's been appealed to the Full Federal Court.

And there's all kinds of losses that we're not going to go through the details, but I mean from your highlights reel, there's gambling winnings, there's sole traders, there's business people, there's family businesses, there's cash deposits, there's all sorts of transactions.

19:32
And I think all types of transactions, but the takeaway is that in each of them, they essentially didn't meet that high onus of proof that the amounts were not income, or couldn't prove what the income actually was.

19:47
Yeah, well, that's absolutely right.

One of the cases I could talk about is HWFX, and this one's an interesting case because I think it kind of highlights the problem.

So HWFX, that's not the person's name. It's been anonymised to protect the identity of the individual.

20:05
But the individual in that case, she worked as an escort, and what happened is she bought two properties in Sydney.

So one of them she actually borrowed money from a bank, but she pretty much paid down the entire loan within a few months. There's only 770 grand left.

20:21
She then bought a second property in Sydney entirely with cash, no bank debt whatsoever.

So that is obviously going to raise alarm bells to the ATO, because who's buying Sydney property straight cash, right?

So the ATO naturally, they looked at her tax records, how much tax she had been declaring, and it obviously didn't stack up.

20:43
Like, how can someone declaring the level of income she was declaring purchase almost million dollar property in Sydney, straight cash, two of them in fact?

Her position was that these were gifts basically from family members overseas, but again, cash gifts.

21:03
So the paper trail was no records.

No records, couldn't really be evidenced with contemporaneous or third-party information. And so the burden of proof couldn't be satisfied.

But to be honest, that is a very, very typical example of what happens with these cases where there's an extreme mismatch in the asset position of the person and their income.

21:25
And then when you look under the hood, it's like, well, no, it's being bankrolled by some other source.

And then when you try and track through that source, you can't track it properly.

Can't have records.

Yeah, yeah.

Well, it brings me, I guess, to a question. What should taxpayers do?

21:40
We know that a gift is not assessable, at least usually not assessable.

But what should taxpayers do if they're in the very fortunate position to be receiving substantial gifts?

21:57
Look, prevention is always better than cure, and you can't necessarily avoid the fact that the ATO might come knocking and asking questions, but I think really it's about setting yourself up in the best possible way to answer those questions and to prove your position.

22:14
The best way to prove your position is with contemporaneous third-party information. That is always the highest form of evidence that you can provide.

So what is an example of that? Things like bank records, bank statements, you know, try not to deal with cash because cash can't be tracked very easily.

22:30
If money can be put into bank accounts and then transferred, then you can obviously keep bank records and you can track that, and that is third-party evidence.

That can be very useful, very helpful.

If it is being done in cash and if that can't be avoided for whatever reason, then consider having things like deeds of gift or documentation to document that gift at the time it's being made, not when you've got the ATO audit, but at the time it's being made.

22:58
Now, I appreciate that between family members, having deeds of gift or having a loan, it can be quite offensive and it can be quite improper when it's within family, particularly in other cultures.

But to be honest, let the lawyer, let the accountant be the bad guy and say, look, you know, it's for tax purposes that we need to have this information on hand.

23:20
Better than having the whole thing assessed, plus penalties, plus audit, plus plus plus.

100%, absolutely.

So I think that's the first thing.

If you've got business taxpayers, so for example, if it's a situation where it's a trust or if it's a company that's receiving the money, then things like keeping accurate business records.

23:42
So in the Corporations Act, there's rules around business records and effectively they're seen as true on their face unless there's of course evidence to say that they've been improperly prepared.

But business records actually carry a fair degree of evidentiary value.

23:59
So making sure that, you know, obviously it doesn't apply to individuals, but for companies and trusts, making sure that they have accurate business records in place that are prepared on time, prepared properly.

And I suppose even for the accountants who are preparing those records, sometimes there can be a bit of a tendency that the client will just sort of say, oh, well, it's a gift.

24:22
And then you just put it down as a gift, and you don't really ask too many questions about that.

I think it's important to ask the question and to really forensically test, well, you're saying it's a gift. Do you have any documentation around that?

Something that the accountant can put on their return file for the year.

24:41
Because that evidence can be incredibly valuable.

And it's a lot better that the adviser asks the question and sort of pushes the taxpayer on that point than get pushed in three years' time by the ATO with an assessment in hand.

24:56
Yes. So that can be something that can be done by an accountant or an adviser.

And the benefit of that advice is potential protection against penalties.

One thing we haven't talked about is that the ATO does have the ability to go back further than four years where they say there's fraud or evasion.

25:15
And having professional advice goes a long way to negating that.

So, yeah, the point around the professional advice is very important.

Oh, absolutely.

And look, it can be worth its weight in gold. I mean, as you correctly mentioned, if the taxpayer seeks advice, it's less likely going to be an inference that they have acted recklessly or that there's been any sort of fraud or evasion.

25:41
Because you've asked the question and you've worked through that information and those details.

So that can be very important.

And even then, even just the process of asking the question can identify the gaps in the information and the evidence that you can deal with at the time.

25:57
Because it's a lot easier to deal with things like a gift of money or whatever when you've received it than it is five years later.

Yeah, when everyone's forgotten about it and it's hard to get records and all this type of stuff.

Exactly right, etcetera. Exactly right.

Rajan, I wanted to thank you for being part of this discussion about unexplained income.

26:17
The ATO's success in these unexplained income cases shows that record keeping wins and that taxpayers face a very uphill battle without those records to overcome the onus of proof issues.

But put simply, if you can't prove where your money came from, it'll be taxed as income.

26:35
If you or someone you know encounters an issue in this space, I'd recommend reaching out to Rajan Verma or the Tax team at Velocity Legal more generally, about how you could protect yourself before the ATO comes knocking.

Thanks again.

Thanks very much, Andrew.