What red flags trigger a tax audit? Here are 14 reasons that increase your odds of being selected for tax audit by the Internal Revenue Board (IRB) aka Lembaga Hasil Dalam Negeri (LHDN).
What is a Tax Audit?
The words “tax” already sends a shiver to the man-in-the-street and to add “audit” to it can totally immobilize a person.
Malaysia’s tax is on a self-assessment system since 2001 for companies and 2004 for individuals. The onus to declare tax lies with the taxpayers. A tax audit acts as an enforcement tool conducted by the IRB to check taxpayers’ business records and financial affairs that the tax reported and paid is correct. Being selected for a tax audit is not a suggestion that you have committed a tax offence but it indicates that some figures or information as reported by you in your tax return are not consistent with averages (past, profession, industry) or in conflict with other information filed with IRB.
Tax Audit Selection
A key objective for the IRB is to generate revenue for the government to run the country. Tax audits focus on identifying potential tax revenue that was not reported. This comes generally in two forms:-
- Understated Income
- Overstated deductions
With limited resources available, it is not feasible for IRB to conduct audit on all taxpayers. The IRB selects tax returns that are most likely to generate revenue or that contain the greatest potential for error for review through a tax audit process.
What are the tax audit selection criteria used by IRB? Selection is random through the computerized system based on risk analysis criteria. However, additional reasons for non-computerized selection are taken into account as well. The reason for being selected for audit is not disclosed to the taxpayer selected for tax audit.
The following are some characteristics and red-flags that increase the chances of being selected for a tax audit:-
1. Earning a Higher Income
There is a saying which is “High income, high-risk taxpayer”. A taxpayer with a higher income tends to file a more complicated tax return with complicated tax activities. The odds increase as well on being selected for a tax audit as you reach high median income status.
2. Filing Under Self-Employment
Self-employed taxpayers are also vulnerable to an audit. Self-employed taxpayers are different from earning individuals because the income derived as a result of self-employment is not subject to a standard verification system. However, self-employed taxpayers are still required to report 100 percent of their earnings and are free to deduct all legal expenses. Too many deductions without documentation will eventually subject the self-employed taxpayer to an audit.
3. Operating Cash Businesses
Cash transactions are difficult to track, easily concealed, and difficult to verify. The odds of a business operating predominantly in cash being selected for audit are higher.
4. Reporting Continued Losses or Low Profits
Consecutive periods of losses cast doubt on the business sustainability. The ability to continue business despite several years of losses is questioned. Factors looked into include unreported incomes or excessive expenses deductions.
5. Reporting Huge Losses Compared to Previous Profitability
A red flag is when a business without clear reason shows significant changes in profitability compared to earlier years. Main indicators include underreported income or overinflated expenses.