MANAGING SMALL AND MEDIUM TAXPAYERS (SMTs): TAX ADMINISTRATION VIEW POINT 1. by Seth Terkper

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1 INTRODUCTION MANAGING SMALL AND MEDIUM TAXPAYERS (SMTs): TAX ADMINISTRATION VIEW POINT 1 by Seth Terkper Small and medium taxpayers (SMTs) are grouped with the traditionally hard-to-tax (HTT) group, which may also include large entities such as commercial farmers and retail outlets. Since, recent trends in tax administration reforms in developing countries often place large entities in a large taxpayer unit [LTU] and roughly equate medium entities with VATregistered taxpayers (i.e. outside LTUs), small entities are automatically deemed to fall below VAT registration thresholds. However, these classifications overlap since LTU and VAT thresholds may be set at high levels to ease tax reforms. The reference to SMT-formal and SMT-informal entities in this paper is meant to stress the potential of taxpayers to comply with, and be subject to, formal accounting and enforcement principles. It is not necessarily related to the informal sector in which all SMTs thrive. In general, SMT-formal entities are structured and have the capacity to keep records that conform to the accounting standards and corporate or tax laws. In contrast, SMT-informal entities are not well structured and they may have genuine difficulty in keeping adequate records. SMT BACKGROUND ISSUES There are several reasons why SMTs fail to comply but, at the same time, significant benefits can be derived from making it easy and cost-effective for them to meet their obligations. Many developing countries use presumptive tax regimes to improve SMT compliance but they are often not well managed. While these regimes need significant improvement, developing countries can also use modified or simple accounting, audit and enforcement rules to make SMTs comply better and also improve procedures in tax offices. 2 Why SMTs fail to comply: Apart from factors related to their operations, SMTs also fail to comply because tax agencies often do not have effective mechanisms for controlling them. The poor infrastructure and large informal sector in developing countries (i.e. about 50 and 65 percent) result in informal approaches to setting up, changing and winding up SMT businesses. The sector is characterized by inadequate record-keeping and weak financial or internal controls by a network of close family members, business associates, employees or friends. Often business and private transactions are not separated and there may be no oversight boards or committees. These factors often give rise to malpractices such as 1 This summary is based Managing Small and Medium-Size Taxpayers in Developing Economies, Tax Notes International, January 13, Many parts of the paper are based on two U.K. professional standards: Financial Reporting Standard (FRS) for Smaller Entities [FRSSE], Dec and Practice Note (PN) 13: The Audit of Small Businesses, July 1997

2 - 2 - suppression and falsification of accounting transactions. Finally, the absence of clear SMT tax accounting guidelines tends to increase compliance costs and dissuade them from meeting their tax obligations. Importance of improving SMT compliance: Effective control of SMTs can promote fairness among small taxpayers (e.g. many self-employed persons earn more income but pay less tax than employees subject to wage withholding). Second, administrative decisions often depend on a 20/80 percent rule of thumb that implies that SMTs are many but pay only a small part of total revenue. There is less emphasis on the inverse 80/20 cost rule that implies that management often uses more resources to generate the small SMT revenue. Tax offices can reduce costs and stabilize or increase revenue by improving SMT compliance in small tax offices. Third, the potential revenue from medium entities (i.e percent for most economies) is significant but it can be eroded through non-compliance, despite the fact that medium entities can keep modified accounting records. Fourth, weak SMT methods can undermine compliance among all taxpayers. Perceptions of unfairness and a high tax burden can motivate large entities to evade and avoid taxes with more adverse consequences for the revenue. Finally, while SMT reforms may not increase revenue in the short-term, they can stabilize or even enhance it in the medium-to-long term. Traditional methods of controlling SMTs: As noted, many developing countries depend on presumptive tax systems to enhance SMT compliance. The two broad categories are often used to compare taxpayer declarations and support enforcement: (a) standard assessments applied to groups of taxpayers, businesses or economic sectors; and (b) minimum, often individual, assessments. 3 Most small SMT-informal standard assessments are treated as final (i.e. non-creditable) because these taxpayers do not file tax returns. In principle, however, medium entities expect a credit for the monthly or quarterly installment of minimum taxes paid. The presumptive indicators (e.g. sectors, classes of taxpayers, and estimates of turnover, profit margins and tax rates) are derived from two types of economic or business surveys. The basic surveys are specially-designed field studies that are conducted at 3 5 year intervals and they are used to comprehensively review or establish the indicators. In contrast, secondary surveys are conducted at shorter intervals (e.g. annually or quarterly) to update the basic study. They depend on internally generated (e.g. audit queries and customs) and published economic statistical and financial data (e.g. inflation and profitability ratios). Weak management of presumptive regimes: Presumptive taxes are policy measures but they are also regarded as feasible administrative options for controlling SMTs described as a win-win proposition because they simplify administration and compliance. In practice, the regimes are not well managed for several reasons. The surveys described above are not regularly updated and, therefore, the assessments tend to be arbitrarily applied to vulnerable small entities. They may also be indiscriminately extended through informal negotiations to medium entities that should self-assess. Most presumptive schemes are also not linked to 3 Flat rate or equalization taxes may be imposed on SMTs in lieu of consumption taxes such as VAT.

3 - 3 - general manual or automated accounting systems and they provide little or no feedback for collection enforcement and audits. As discussed below, the procedures tend to be office or desk-based because of the link to tax clearance schemes that compel taxpayers to physically visit local tax offices. Many presumptive regimes are seen as corrupt, unfair and inefficient with processes that offer little or no incentive for businesses and individuals to convert, or graduate to the normal declarative tax regime. IMPROVING SMT ADMINISTRATIVE PROCESSES There are two basic approaches to improving SMT administration and compliance. First, the improvements in presumptive tax processes must be seen as a top tax administration priority. Second, the functional activities (i.e. registration, accounting, collection, enforcement and audit) must be simplified to make it cost-effective for tax offices and taxpayers, especially medium SMT-formal entities. Improvements in presumptive tax procedures It is important not to over-estimate the capacity of SMT-informal entities to apply modified accounting rules. The presumptive taxes may be the only feasible option for controlling many of them and therefore they need to be improved. First, the primary and secondary surveys used to determine standard and minimum assessments should be updated regularly to ensure that they represent a fair and reliable basis for estimating SMT tax liabilities. Second, tax agencies must establish links between the presumptive regimes and their conventional accounting, data gathering/analysis, and enforcement programs. For example, SMTs must be issued with TINs and separate manual or automated ledgers used to record and monitor assessments, payments, penalties and adjustments (credits and refunds). Third, detailed but standard guidelines must be provided to tax offices to ensure uniform application of tax rules, especially collection enforcement activities. Finally, procedures need to be established to ensure that a sample of SMT-formal and informal entities are included in the audit programs of tax agencies. Registration, identification and taxpayer service programs Most SMTs, with the probable exception of medium-sized corporate entities, do not register voluntarily. Once registered, they fold-up or change identity with little or no formality - for example, by simply obtaining a new local or sub-national government license. SMTs must be included in taxpayer identification number (TIN) programs, in close collaboration with the local authorities that have jurisdiction over their operations. SMTs with formal outlets (e.g. retail shops) must display the registration certificate and TIN as required by most tax laws. Tax offices must use routine audit or enforcement programs and special registration drives to check non-registration and assist taxpayers to comply with their obligations.

4 - 4 - Improvements in accounting procedures The purpose of accounting is to ensure that taxpayers keep adequate records to support the tax returns they file. Different methods can be used to make SMT-formal and SMT-informal entities meet this obligation. Tax offices must also improve their accounting procedures to ensure effective control of the financial transactions of taxpayers, including assessments, payments, penalties and adjustments. While significant concessions should be made for small taxpayers, the tax regulations need not be unduly relaxed for SMT-formal entities, especially corporate entities that are required by law to prepare modified audited financial statements. Exclusion from accounting requirements: The majority of SMT-informal entities that pay only standard assessments need not be required to keep records or file tax returns. In this regard, the personal income tax exemption and VAT registration thresholds must be set at high levels to exclude as many small entities as possible from accounting requirements. However, those contesting assessments must keep basic documents (e.g. invoices) and cash records to support their appeals. Cash accounting records: The majority of SMTs need to keep only a cash book to record daily transactions involving purchases, sales and expenses. No ledger records are required but, if desired, assets and liabilities can be listed to track debtors, creditors and assets. Taxpayers must keep copies of purchases and sales invoices and be ready to produce evidence of other payments to support transactions such as apportionments between personal and business expenditure (e.g. splitting fuel and utilities between business and private use). Simple accrual accounting: Medium entities must keep a ledger in addition to the cash book to support simple accrual accounting and audited financial statements. The accounting rules are modified with respect to specific transactions such as depreciation (e.g. pooling of assets and expensing or written-down value of asset), stocks or inventory (e.g. de minimis rules on material values) and expenses (e.g. aggregation, approximation and apportionment rules). Profit and loss accounts (i.e. income statement) and balance sheet are required but in abridged form only thus making it unnecessary to show sub-classifications and detailed notes of assets and liabilities... on grounds of size or relative lack of public interest. Tax office accounting measures: The accounting process in tax offices must be improved to enhance SMT compliance. At a minimum, manual ledgers must be kept for all SMTs even under presumptive regimes. Where feasible, automated ledger records should be kept to reduce tedious manual processes and better augment audit and collection enforcement. Tax agencies must publish guidelines for taxpayers and encourage them to use practitioners in order to reduce the direct involvement of tax officials in preparing taxpayer records. The practitioners must be registered but only non-qualified professionals need to be formally trained and certified by the tax agency. Medium entities must be given incentives (e.g. immediate write-offs) to acquire accounting software and equipment.

5 - 5 - Audit, examination or inspection procedures The purpose of tax audits is to examine an entity s accounting records to ensure that disclosures made in the accounts and tax returns are true, fair, reliable and accurate. The professional accounting standards state explicitly that small and medium entities (SMEs) must not be treated as unauditable. Moreover, auditing is the primary means of controlling tax evasion and avoidance and should be taken seriously for all categories of taxpayers. Nature of SMT audits: SMT audits must follow the conventional view that it is costly and practically unnecessary to examine all taxpayers and their records in given audit cycles. The so-called 100 percent inspections must be replaced with sampling techniques that involve profiling, stratification and risk analysis. The audit plan must follow two broad approaches (a) using simple audit programs to routinely audit an annual sample of SMT-formal entities; and (b) applying audit techniques to review the presumptive regimes (i.e. management assurance), including the records of samples of SMT-informal entities. Planning SMT audits: Audit strategies are contained in working papers made up of audit plans, programs and guidelines. The professional guidelines stress that, while SMTs need to be covered in all plans, the programs and guidelines must be simple and cost-effective. This is suitable from a tax point of view because of the simple nature of SMT records and the general lack of qualified accounting skills in many tax offices. While SMT audit programs must cover all categories of audit desk or clerical audits, simple field (i.e. control or issuesoriented) audits, integrated or comprehensive audits, and investigations the majority are of the simple or control type. A sample of SMT-formal audits must be routinely covered by comprehensive programs. Developing countries must adapt the popular VAT control and verification (CV) programs for designing integrated income and consumption tax audits. To minimize tedious manual desk audits, the returns processing software must be programmed to check the returns for arithmetical accuracy and select exceptional cases for audit. Implementation of SMT audits: The goal of implementation is to obtain audit evidence to confirm the validity of transactions used to process tax returns. Tax offices must be issued with standard audit guidelines to cover background, compliance or control, and transactions or substantive checks. The standard guidelines must ensure that specific procedures are followed and adequate feedback provided to audit managers. As with VAT, the duration and scope of SMT-control audits must be limited to approximately 2-3 days and initially cover only a limited number of returns and records. Given the inadequate recordkeeping culture of SMTs, inspectors must be trained to use indirect audit and single-entry bookkeeping techniques to improve examinations and, if necessary, rewrite the accounts. Complex cases are encountered during desk or control audits should be referred to comprehensive or integrated audit teams. All audit assignments must be properly supervised and adequately covered in the annual budget of tax agencies.

6 - 6 - Collection and enforcement procedures The goal of collection and general enforcement is to control tax arrears and offences. The SMT enforcement strategy must follow a mild-to-aggressive application of powers and sanctions. Priority must be given to debt management procedures because many conventional debt recovery procedures tend to be costly and may involve lengthy procedures and litigation of SMTs that contribute insignificant amounts of revenue. Nonetheless, even SMTs must bear the consequences of persistent non-compliance through stringent measures. Debt management and recovery measures: SMT arrears rapidly accumulate and become irrecoverable. The SMT debt problem is linked to poor liquidity management and the nonseparation of private and business activities. Tax offices must implement recovery plans at an early stage by updating ledger records, sending reminder notices, and enforcing installment payment rules often supported by tax clearance procedures. This will prevent the use of drastic measures with low fiscal yields and with little or no chance of success because they drive SMTs into liquidation or underground. The regular update of ledgers will also ensure effective imposition of interest and penalties as well as collection enforcement. Interventionist measures: Many developing countries require taxpayers to obtain annual tax clearance certificates (TCC) to show that they have settled or made satisfactory arrangements to settle their liabilities. Without the certificates, they cannot engage in specific transactions such as tendering for government contracts or obtaining an operating license from subnational governments. While these measures may be effective, they are often mismanaged and they easily lead to abuse of power and corruption. Another measure which is quite effective against SMTs is the temporary closure of businesses that do not comply. It prompts compliance because of the potential loss of family incomes, contracts and customers. Seizures, sales, levies (destraint or garnishment) and prosecution: Tax agencies must apply stringent measures against persistent SMT non-compliance. The first option is to recover the arrears from third parties, notably commercial banks and debtors. This may be effective against medium-size SMTs but not the majority small SMTs in large informal economies that deal in cash and make little or no use of banks. Tax agencies can also seize and sell personal and business assets to recover tax arrears. Ultimately, SMTs engaged in serious delinquent behavior must be prosecuted to serve as a deterrent against general non-compliance. Simplification of judicial and appeals processes: It is less costly to resolve SMT cases through special schemes like special courts, tribunals, administrative boards, advocates, and ombudspersons. They are suitable for dealing quickly with large numbers of small cases that often slow down operations in regular courts. The rules must be simplified and made flexible to make it easy and cost-effective for small entities to seek redress including representation in their personal capacity or by practitioners who may not be lawyers.

7 - 7 - Strengthening tax office operations The majority of SMTs interact with the tax office where they are registered and many of these offices deal almost exclusively with the presumptive taxes. Tax offices can be organized along the following lines to focus on segments of taxpayers and skills of tax officials as well as improving functional administration. Organization of tax offices Type of office Location Tax/taxpayer focus 1/ Accounting & enforcement measures Large Metropolitan Limited number of large taxpayers; CIT & VAT Full compliance with accounting records; voluntary compliance (self-assessment) techniques. Medium Metropolitan & urban VAT-registered taxpayers; CIT, VAT & a few selfemployed (PIT) Modified accounting records based on simple cash/accrual principles; voluntary compliance; and presumptive measures (i.e. estimated and minimum taxes). Small Urban & rural SMTs below VAT threshold; selfemployed. Simple cash accounting records; presumptive taxes (official or standard assessment); and exemption from filing. 1/ Large and medium entities can file withholding PAYE and other income taxes in their respective offices. All tasks in offices should be judiciously distributed to prevent a single officer dealing with all aspects of an SMT s engagement with tax offices (i.e. from assessment to adjudication). The breakdown of internal control in this type of arrangement is often the main source of corruption and abuse of power. In particular, the tax accounting section should be separated from the audit and enforcement units to make internal control procedures effective. The headquarters must include SMT activities in its planning, control and feedback processes to ensure optimum utilization of scarce resources. In addition to coordinating and supervising operations for a cluster of small offices, regional offices can be used as processing centres and also organize special teams to implement more advanced enforcement programs (e.g. special audits and investigations).