Income Tax Assessment Hearings — Prepare in Advance

By: CPA Hanoch Hager and CPA Zvika Alperowitz

Tax law is one of the most intricate areas of law. It changes frequently, and every rule comes with exceptions, reliefs, exemptions and sub-rules — which makes dealing with tax questions especially complex and demands a great deal of expertise. The law requires every item of income to be reported, and tax to be paid according to how the income is classified and how large it is. When questions or reservations arise about a report, or suspicions emerge of under-reporting or under-payment, the Tax Authority may demand an additional payment beyond what was reported and paid — and may even summon the taxpayer to a hearing to give explanations.

When you attend the hearing, which is held before the tax inspector, it is essential to arrive prepared. You need to know the taxpayer's particular facts thoroughly against the rules, provisions and procedures the Authority applies, and to know how to raise the arguments and present the taxpayer's position in the right light. That is how an unfair or excessive payment demand can be avoided — or at least reduced significantly, by agreement with the assessment inspector.

Who Pays Income Tax, and How Much?

As noted, every person must pay income tax on the income they produced, subject to conditions — whether it is income from a vocation, ordinary (revenue) income, rental income, a prize, a dividend, interest, or any income from any source. Under the Income Tax Ordinance and the Value Added Tax Law, every business or corporation must open a file with Income Tax and with VAT as soon as it begins operating, and keep books of account according to the specific rules for its business classification, including a record of all the business's income and expenses. The business must report monthly or bi-monthly (depending on its registration) and pay Income Tax and VAT their share. At the end of each calendar year, an annual return must be filed, summarizing in detail all of the business's expenses and income from every source.

In broad and rough terms, income tax is a tax at a given percentage, according to the tax brackets, derived from total income after deducting recognized expenses. A recognized expense is any expense incurred to produce income, as well as further expenses recognized at a certain rate and in a proportionate part (such as vehicle expenses, pension contributions, donations and more). Whether a particular expense will be recognized for deduction is a question that comes up for discussion more than once.

The Summons to a Hearing

Sometimes — after the annual return is filed, following a surprise audit, or because of information that reached the Authority from another outside source — questions arise about the assessment, and the Tax Authority sees fit to demand an amount beyond what the taxpayer paid and to summon them to a hearing.

For example, when a company in a particular industry reports income that is low relative to what is usual in that field, a suspicion may arise that some income was not reported in full. The same applies when expenses are especially high and there is a suspicion that they were inflated in order to reduce the tax, or when there is doubt whether the expenses really belong to the business.

Assessment Based on the Economic Guideline

An argument that recurs in many assessment hearings is that the income is not reasonable. Income Tax has an economics department that estimates, on the basis of industry data, the expected income of each business according to its type and its scale of activity. When a business reports income that is low relative to the industry norm, the owner will be summoned to a hearing to explain the gap, and will be required to pay the tax derived from it.

Take, for example, a garage owner summoned to a hearing because his income was significantly lower than the industry norm. It may be, for instance, that he serves weaker populations and charges especially low prices, or that in that year he launched a new and innovative service that caused expenses to multiply. In every such case, one must know in depth how the business is run and what caused profits to fall, and present in the best possible way the relevant arguments that justify treating the situation as an exception to the rigid rules of the economic guideline.

The taxpayer must show that, because of the business's particular circumstances, a departure from the economic guideline is warranted, and that the taxpayer's own calculation should prevail over the assessing officer's calculation — which is deficient, unreasonable, or does not reflect the actual state of affairs. The entries in the books of account that support the report must be located, and their truth vouched for.

It should be noted that someone who worked for many years at Income Tax and knows the system well has an enormous advantage: familiarity with Income Tax's working methods, dealing in the best way with the arguments raised, and giving satisfactory explanations for the amounts stated.

Support from the First Step

Before opening a file with the tax authorities, it is advisable to consult a professional who is expert in the field and up to date with the frequent changes in legislation. Before opening a business, when selling a business, or at any other stage, legitimate tax planning can be carried out that will present the figures in a different light from a professional point of view, and so save tax. For example, the Capital Investment Encouragement Law grants certain benefits to investors under certain conditions, and different, more lenient tax rules apply to selling products abroad or to product-development work.

Representation in Assessment Hearings

The representative must justify the reports and argue, in the taxpayer's defense, that the taxpayer's position is the better one. Where expenses are alleged to be excessive or unrelated to the business, it must be proved that the expense is connected to the business and should be recognized. For example, a taxpayer travelled abroad and reported the travel costs as a recognized expense — in that case the Income Tax officials argued that travel abroad should not be recognized as an expense incurred to produce income. In such a case, it must be proved that the trip abroad was made in connection with the work — for instance, to examine a new product, an additional market segment, import transactions from abroad, or another business justification that ties the travel costs to the business.

Another example — embezzlement in a business, and the concealment of money by employees. This is a very borderline case, and through negotiation the assessing officer can be persuaded to recognize at least part of it as an expense. In any event, fair negotiation can lead to a compromise with the Tax Authority. In many cases, waging all-out war against the Tax Authority does not bring the desired results, and can cause a needless waste of time and resources. Knowing the system — its limits and the flexibility possible within it — carries great weight in dealing with it and in the ability to reach the best results.

Summary

Opening the file, filing the monthly reports and the annual returns, and representation before the tax authorities — above all in assessment hearings — will bring peace of mind in dealing with the tax authorities and the greatest possible saving in tax. CPA Hanoch Hager and CPA Zvika Alperowitz, formerly income tax assessment inspectors at the Tax Authority, are the owners of the accounting firm Hager-Alperowitz & Co., which specializes in representation before the tax authorities.

The above article does not constitute a recommendation, professional advice or a legal opinion. If you have any questions, you are welcome to contact us — we will be happy to advise, accompany and represent you before the Israeli tax authorities.

Kind regards,
Hager-Alperowitz & Co. — Certified Public Accountants