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.
6. Conflicting Tax Information
Conflicting entries on a return where a tax return does not match other information filed previously with the IRB may trigger a tax audit.
7. History of Tax Audits
Prior tax audits which resulted in additional taxes being assessed increase your likelihood for future tax audits.
8. Relation to Audited Company
Companies within a group of which some entities are audited may result in other related entities being selected for a tax audit.
9. Relation to Third Party
An examination of third-party records, normally arising from audit or investigation of other taxpayers may trigger a tax audit. For example, an expense to taxpayer A is an income to taxpayer B. The link between both parties may be investigated and verified.
10. Complaint by Third Party
A third-party who may have information on a tax defaulter may write to IRB. IRB will reviewing the complaint if there is merit and investigate.
11. Making Extravagant Cash Purchases or Assets
Suddenly showing increased signs of wealth and affluence by buying assets such as houses or cars may trigger an audit. Income or income tax reported is not proportionate or prove the ability for full cash purchases. It may be indicative of unreported incomes.
12. Giving Large Donations
Donations to charities are used to reduce tax liability. It will attract scrutiny if the proportion compares to income is unusually high. You should keep the receipts as proof.
13. Owed Large Tax Refunds
A significant tax refund due to taxpayer increases the odds of a tax audit. Large refunds are indicative of large losses or excessive deductions on a taxpayer’s return or something that has offset a large amount of tax that the taxpayer would have had to pay. This may trigger additional scrutiny from the IRB.
14. Frequent International Transactions
Having foreign bank accounts and frequent cross-border transactions increase your likelihood for a tax audit. Cross-border transactions and hiding assets and foreign countries are often used method to evade taxes. Such activities traditionally make the IRB nervous as the abilities to demand records from 3rd parties (banks, financial institutions) in foreign countries (some strong secrecy law) is extremely limited.
Avoiding a Tax Audit
How can a taxpayer reduce the likelihood of a tax audit? Simple. Ask yourself these questions
“Does my income tax return make sense?”
“Is all my income accounted for and reported correctly?”
“Do the deductions or business expenses make sense?”
The key takeaway is to take time to check everything and not rush before you submit your tax filing. If everything can be explained and substantiated, you should have no worries at all even if you are selected for a tax audit.