Invalidation of Books

Invalidation of books is a highly significant legal procedure. As part of this process, the tax assessor determines that the accounting records of a business taxpayer are not acceptable in the eyes of the Income Tax Authority. This procedure carries very serious economic implications and can be dangerous for the business and its owners.

Why is the Invalidation of Books So Dangerous for Business Owners?

As a result of book invalidation, the Income Tax Authority is authorized to issue a new assessment based on best judgment. In this process, the tax assessor often disregards the business’s reports on its income and expenses and relies on statistical data available to them. In most cases, the business owner will have to pay more taxes compared to the taxes derived from the reported income for that tax year. Additionally, the business owner will not be allowed to offset taxes with losses from previous years in the same tax year, and various tax credits to which the business owner is entitled will be canceled.

A business whose books are invalidated will lose a significant amount of money, in addition to potential fines, legal representation costs, and any criminal sanctions that may be imposed. For professional advice from a tax consultant or accountant, contact us.

In this article, we will present and detail the process of book invalidation, the possible sanctions, the associated implications, and what can be done to try and assist a taxpayer who has encountered this process.

What is Bookkeeping and Who is Obligated to Maintain It?

The Income Tax Ordinance and the VAT Law require every business and trader, regardless of the type of incorporation, to maintain books according to the type of business. At the core of this requirement are two main obligations:

1. Recording Every Receipt Related to the Business: This includes cash, checks, credit card transactions, bank transfers, and payments through apps such as Bit (Bank Hapoalim), PayPal, and PayBox (Bank Leumi). Receipts include any amount received.
2. Recording the Receipt Immediately Upon Receipt: This means recording the receipt in a timely manner, depending on the type of business. The main idea of this requirement is to prevent any possibility of the business owner “forgetting” the receipt in good faith or intentionally trying to conceal income. The court has broadened the meaning of “immediately upon receipt.”

Improper bookkeeping is seen as an attempt to evade taxes. The business owner must fully understand the bookkeeping regulations relevant to their type of business and instruct their employees accordingly. Even if an employee makes a mistake in recording a receipt or if the professional (accountant or tax consultant) with whom the business owner works misleads them or makes an error in bookkeeping, the responsibility still rests entirely on the business owner and carries significant risk.

Our firm assists business owners in drafting instructions for employees to minimize the chances of issues during bookkeeping audits. In many cases, before starting work with a specific supplier or client, businesses require a “Bookkeeping Management Certificate,” a document showing that the tax authorities have not deemed the taxpayer’s books invalid.

Grounds for Book Invalidation

Book invalidation usually follows a proactive audit, either open or covert, in which the quality of the taxpayer’s reporting is examined. Bookkeeping audits can also be conducted outside the business premises, where the business owner is required to present the business’s accounting records to the tax assessor. During the audit, the tax assessor checks how the business owner manages their books and whether they comply with the specific bookkeeping regulations applicable to their business. The tax assessor may be satisfied with giving instructions for corrections or issuing a warning.

There are several grounds for book invalidation, which can be divided into three main categories:

1. Admission (as stated in Section 1 of the Ordinance): The taxpayer admits that the books are not acceptable and signs off on it after being explained the legal consequences.
2. Book Invalidation Due to Material Deviation or Deficiency in Bookkeeping (Section 130(b) of the Ordinance): The rationale behind enforcing the “proper bookkeeping” section is to give the Income Tax Authority the ability to evaluate the taxpayer’s business activity accurately and thus correctly assess the tax due. Therefore, invalidating the taxpayer’s books is justified when the deviation in bookkeeping is material and affects the tax authority’s ability to determine the business turnover or the tax due. What if the deviations are minor and do not hinder the tax authority’s ability to track the taxpayer’s business activity? While such deviations are undesirable as they complicate the audit, if the tax authority can still track the business activity and accurately determine the business’s scope, the practical significance of the deficiencies is minimal, and there is no justification for invalidating the entire bookkeeping system.

There are three situations in which the tax assessor can invalidate books due to material deviation or deficiency under Section 130(b):

• Use of an invoice issued without a sale or service provided, or where the amount stated does not reflect the actual price of the transfer or service.
• A significant amount of income was not included in the report submitted.
• A private expense or an expense whose purchase amount does not reflect the price was deducted in the report submitted, significantly reducing the reported income.
• Book Invalidation Due to Failure to Record Receipts (Section 145(b) of the Ordinance): As mentioned, every business owner is required to record every receipt received by the business immediately and according to the regulations set forth in the law. There are three situations in which the tax assessor can invalidate books due to failure to record receipts:
• • Section 145b(a)(1): A taxpayer who records receipts in a cash register tape, receipt voucher, invoice, daily income book, or other documentation they are required to maintain according to the ordinance, and did not record a receipt in them. In such a case, the books will be deemed unacceptable unless the tax assessor is convinced that there was a sufficient reason for the non-recording (the burden of proof lies on the taxpayer).
  • Section 145b(a)(2): A taxpayer who, twice or more in one tax year or in twelve consecutive months across two tax years, did not record a receipt they were required to record, with at least one instance after being warned in writing by the tax assessor. In such a case, the books will be deemed unacceptable for both the two preceding tax years and the tax year preceding the first year within the twelve months in which the two instances of non-recording occurred, even if the reports were accepted and the assessments were made accordingly, unless the tax assessor is convinced that there was a sufficient reason for the non-recording (again, the burden of proof lies on the taxpayer).
  • Section 145b(b): Failure to maintain a cash register tape.

Steps in the Process of Book Invalidation

After the tax audit, where deficiencies are discovered, the taxpayer will receive a notice of book invalidation from the tax assessor. This initiates the complex legal process where the business owner must defend themselves.

1. Hearing with the Tax Assessor – A hearing with the tax authority is the first fundamental right of someone accused of maintaining unacceptable books. The hearing is managed by the tax assessor, although the authority may sometimes be delegated to the deputy tax assessor. The tax assessor is the head of the tax office, whose jurisdiction is akin to that of a magistrate judge. It is important to understand that a hearing is a judicial procedure. It is crucial to be represented by an expert (accountant/lawyer/tax consultant) in this process. Appearing before the tax assessor for a hearing before book invalidation should follow significant preparation, where the representative is familiar with all the facts, case law, and legislation in the field to make the correct preliminary arguments and achieve the best result. The emphasis here is on experience in managing such proceedings. The right to appear at the hearing is granted to the taxpayer, who can attend personally with their representative or send the representative alone. The decision on this matter should be made by the representative, who, knowing the tax assessor or deputy tax assessor conducting the hearing, will decide the best course of action under the circumstances. Whether or not a hearing is conducted, after receiving the notice of intent to invalidate books, the taxpayer has 30 days to file an appeal before the Books Acceptance Committee.
2. Books Acceptance Committee – The Books Acceptance Committee consists of three members. The chairman is a public figure expert in accounting, and the other two members are accountants, one of whom must be a state employee or another public institution. The committee’s role is to discuss the tax assessor’s decision in light of the taxpayer’s appeal and decide whether the books are indeed unacceptable or determine that they are acceptable for one of the following reasons:

• There are no deviations or deficiencies from the administrative instructions.
• The deficiencies or deviations are not material.

The committee’s decision is final if it rules in favor of the taxpayer, and the tax assessor must accept it. If the committee rules against the taxpayer, they may appeal to the district court within 60 days.

3. Appeal to the District Court – At this stage, the process moves from the tax authority to the courtroom and the judge’s decision. Naturally, court proceedings are fundamentally different from discussions at the tax office and the Books Acceptance Committee, and the taxpayer must hire lawyers to represent them. Here, too, the burden of proof lies on the taxpayer, who is in a difficult position, with the tax assessor and the negative opinion of the Books Acceptance Committee against them. The procedural rules for such an appeal are set by law and differ from those of the tax authority. Generally, a case reaching this stage is in a dire state. Very few cases result in the district court ruling in favor of the taxpayer in appeals against book invalidation. This is because the likelihood of the court’s judgment being significantly different from the three lower instances is slim. Cases reaching this stage often do so due to inadequate representation in the earlier stages.

Advice Before Book Invalidation

As reviewed in the article, the process of book invalidation is complex and has disastrous consequences for the business owner. Confronting the tax authority is not easy and requires professional knowledge and extensive experience, preferably from within the tax authority system. Moreover, once the books are invalidated, the burden of proof falls entirely on the taxpayer, and their position before the various authorities is unfavorable. It is recommended to hire a firm specializing in tax law, employing lawyers and tax expert accountants familiar with the law and the tax authority inside and out.

It is crucial to have the guidance of a lawyer because this is a judicial procedure. Additionally, firms primarily dealing with other issues (such as bookkeeping or auditing) generally lack sufficient experience to manage bookkeeping discussions. Early advice is essential, as preparatory work for the hearing with the tax assessor is critical to try to resolve the case as early as possible and prevent book invalidation and its associated sanctions.

Sanctions and Risks of Book Invalidation

The Income Tax Ordinance allows enforcement authorities to impose a wide range of administrative and criminal sanctions and punishments. Here are the sanctions and punishments for book invalidation as stipulated in the law:

1. Section 17(11): Expenses related to preparing reports and dealing with tax matters in all assessment and appeal proceedings will not be recognized if the books are not acceptable.

Book Invalidation:

1. Section 33: Limitation on Deductions and Offsets Due to Unacceptable Books

• The tax assessor may refuse to allow the deduction of expenses and assess them based on their best judgment.
• For one year of unacceptable books: No offset of losses from previous years.
• In severe circumstances of book invalidation: No deductions and offsets for doubtful debts and losses, and no recognition of losses for that year.
• Failure to maintain or maintain properly: No deductions and offsets for depreciation, interest, doubtful debts, losses, and no recognition of losses for that year.
• Failure to maintain acceptable books: No tax credits under Section 121a (this section was repealed).

2. Section 121(b)(2): Reduced tax rates for individuals do not apply to those whose books are unacceptable.
3. Section 155: If the books are unacceptable, the burden of proof that the assessment is excessive lies with the appellant.
4. Section 159a(b): Refund of excess tax paid will be delayed. (No obligation within 90 days).
5. Section 164: Higher withholding for those whose books are unacceptable.
6. Section 180(a): The tax assessor is not authorized to exempt advance payments for a taxpayer required to maintain books but failed to do so.
7. Section 191b: Failure to maintain or maintain properly: Additional fine of 10% of the taxable income and 20% for each subsequent year. The advances will be doubled by the fine.
8. Section 20(a) of the Adjustment Law: Capital gains in the tax year will be entirely real; no deductions under Sections 3, 7, 8, 9 of the law.
9. VAT: VAT on transactions will be assessed, but input VAT will be nominal (Abo Khaled Hussein ruling).

Significant Sanctions in the Ordinance:

1. Assessment Based on Best Judgment: If the books are invalidated, the tax assessor can assess expenses based on their best judgment. In practice, this means the tax assessor will issue an assessment not based on the business owner’s income and expense reports, but on unrelated data. Ultimately, the business owner will have to pay a significantly higher amount than in a normal situation. Although the tax assessor must exercise reasonable and logical judgment, the gap between judgment and overassessment narrows significantly.
2. No Recognition of Previous Year’s Losses: Offsetting losses is one of the most important tools for a business owner to reduce their tax liability. A business owner whose books are invalidated will not be able to offset previous years’ losses with profits for the relevant tax year.
3. No Deductions and Offsets: The taxpayer will not be allowed deductions and offsets for depreciation, interest, doubtful debts, and losses from previous years, and no recognition of losses for that year.
4. Loss of Eligibility for Reduced Tax Rates.
5. Delayed Tax Refunds.
6. Imprisonment or Fine or Both: In severe cases, the business owner may face imprisonment, a fine, or both.

Given the above, it is evident that tax advice and consultation with a lawyer/accountant specializing in taxation can be helpful.