PREFACE. Mario de Zamaróczy East AFRITAC Coordinator

Transcription

1 PREFACE This is the first of the East AFRITAC series of Field Manuals. The purpose of this new initiative is to disseminate international best practice more widely, and to distill the lessons learnt during the implementation of specific capacity-building initiatives. The objective is to draw broad lessons for countries that plan to implement similar reforms. Each year, East AFRITAC supports local capacity building through its professional attachment programs by exposing regional staff to practical on-the-job learning and experience sharing in sister organizations which are more advanced in relevant areas of expertise. Participants in this program are subsequently required to prepare an endof-attachment report detailing their experience, identifying the gaps that exist in their home agency, and making recommendations on how to address them. The objective of such reports is to draw lessons and derive guidelines that can be used by similar agencies in the region to strengthen capacity. I am happy to note that this objective is now realized through the publication of this Field Manual. During the fiscal year, East AFRITAC offered sponsorship to Messrs. Patrick Kassera (Tanzania Revenue Authority) and David Sserebe (Uganda Revenue Authority) to attend a professional attachment on risk management and tax audit methodologies at the South Africa Revenue Service (SARS). The duo successfully completed the program and prepared a thoughtful report on their findings. The report was subsequently refined and enriched by Mr. Edmund Biber, an IMF Fiscal Affairs Department tax administration expert, and resulted in this Field Manual. Tax audits are a critical tool, and an integral part of any compliance management program. However, tax administrations in the region have not fully exploited the vast potential tax audits present for enhancing compliance. This Field Manual is East AFRITAC s contribution towards sharing information on tax audit best practices, and the audit process by using risk management methodologies. I hope that this Field Manual will go a long way in assisting tax administrations in implementing best practices in the area of tax audits. I would like to thank the following for successfully putting together this important document: (i) SARS management and staff for hosting the attachment program; (ii) Messrs. Patrick Kassera and David Sserebe for the end-of-attachment report they prepared; and (iii) Mr. Edmund Biber for his editorial and refining services. I would also like to thank the East AFRITAC Revenue Administration Advisor and his colleagues at the IMF Fiscal Affairs Department for all the hard work that went into producing this Field Manual. Mario de Zamaróczy East AFRITAC Coordinator

2 ii Foreword by the Commissioner General of Uganda Revenue Authority Like all tax administrations in the region, the Uganda Revenue Authority (URA) is continuously challenged to improve tax administration performance. To achieve this objective, the URA strives to achieve high levels of taxpayer voluntary compliance as the best way to optimize revenue collection and minimize collection costs. This is being pursued through strategic and tactical compliance interventions, an integral part of which is an effective taxpayer audit program. Experience in the URA, but equally applicable in the East AFRITAC region, suggests that taxpayer audit still poses a challenge to our revenue administrations and a lot more can be done in using this compliance tool to improve taxpayer voluntary compliance. For instance, some of the current audit approaches are still akin to an administrative assessment regime that is more focused on re-assessing the taxpayer s self-declaration, than on detecting and deterring non-compliance. I have also observed general weaknesses in all stages of the audit program, right from the setting of audit objectives to case selection, planning, execution and finalization of the audit; and also in the use of key performance indicators to evaluate the audit program. The publication of this Taxpayer Audit Improvement Guide by the East AFRITAC therefore comes at an opportune time. I gladly note that while the Guide is structured to focus on the common components and features of an effective tax audit program, it also recognizes that an audit program cannot operate in isolation, and therefore goes further to address other complementary programs such as effective taxpayer services, a robust appeals process, and collection enforcement programs. Ultimately an effective audit program requires capable staff. I therefore urge the East AFRITAC to complement publication and dissemination of this Guide with targeted regional and in-country training programs. The URA, and I personally, are proud to be associated with this important capacitybuilding endeavor. Allen Kagina Commissioner General Uganda Revenue Authority

3 iii Selected Acronyms CMF CRLM GDP IP IMF ISQ IT KPIs LTO MTO RRM Rwf SAR SARS SLA TRA URA VAT Compliance Management Framework Compliance Risk Likelihood Matrix Gross Domestic Product Incident Report International Monetary Fund Inspection Survey Questionnaire Information Technology Key Performance Indicators Large Taxpayers Office Medium Taxpayers Office Risk Rating Matrix Rwanda Francs Suspicious Activity Report South African Revenue Service Service Level Agreement Tanzania Revenue Authority Uganda Revenue Authority Value Added Tax

4 iv Contents Preface..... i Foreword by the Commissioner General of Uganda Revenue Authority ii Selected Acronyms..... iii Contents.. iv 1 ROLE AND FUNCTION OF A TAXPAYER AUDIT PROGRAM Role beyond verification Information and intelligence Addressing deficiencies in the law Law clarification and education Organization and Structure Resource management and the audit plan RISK ASSESSMENT Need for risk based approaches Risk Identification Understanding Risk from a Taxpayer s Perspective Internal Risks RISK PROFILING Risk Profiling Activities PRIORITIZING RISKS Assessing Relative Risk Assigning Responsibility of Risk Treatment Risk and Audit Case Selection Features of an Effective Audit Case Selection System PREPARING FOR THE AUDIT Pre Contact Analysis Planning the Audit Starting the Audit CONDUCTING THE AUDIT Technical Ability... 24

5 v 6.2 Scope of Audit Inappropriate Auditors Audit Cycle/ Audit Turnaround Time Materiality Testing the Correctness of the Return Testing and Sampling Information analysis and examination Risk Assessment Working Papers Concluding the audit case Audit Work Process Flow Chart QUALITY OF AUDITS Quality Assurance Quality Reviews AUDIT WORK FORCE MANAGEMENT Competency/Capability Models Identifying Required Competencies Assessing Competencies Addressing Capacity Gaps AUDIT PERFORMANCE Defining Work Content Setting Performance Standards Work Load Versus Quality Key Performance Indicators Service Level Agreements Measuring Compliance improvement AUTOMATED AUDIT MANAGEMENT Profile The Risks Allocate Audit Cases... 42

6 vi 10.3 Track / Monitor Case Progress Computer Assisted Auditing Prepare reports Catalogue Incidents and Findings DISPUTE RESOLUTION Minimizing Disputes Dispute Resolution Dispute Resolution Procedure Meeting The Aggrieved Taxpayer Due Dates For Objections Un resolved Objections INVESTIGATION GUIDELINES Purpose of Investigation Investigator Competency Referral guidelines Preparations for the Investigation The Investigation/Taxpayer Inspection Process Documenting Investigation Cases The Suspicious Activity Report The Incident Report The Inspection Survey Questionnaire The Investigation File... 49

7 1 ROLE AND FUNCTION OF A TAXPAYER AUDIT PROGRAM 1.1 ROLE BEYOND VERIFICATION Tax administrations carry out audits so as to verify that the taxpayer has complied with provisions of the tax legislation. However, the role of an audit program in a modern tax administration goes beyond verifying a taxpayer s reported obligations and detection of discrepancies between a taxpayer s declaration and supporting documentation. Audit can play a major role in improving tax administration and overall taxpayer compliance by impacting on taxpayer behavior. In addition to raising revenue directly from audit activities, by selecting the highest risk cases, efficiently detecting non-compliant taxpayers, applying appropriate sanctions, and publicizing results of audit activity (either generally or specifically), taxpayers get the message that any attempt to avoid tax presents a high risk of detection and the penalty for non-compliant taxpayers is substantial. Tax audits therefore provide the tax administration with significant leverage across the community rather than only impacting on the taxpayer selected for audit and collecting the tax that should have been paid in the first place. Additionally, a tax system that is perceived to be fair and equitable, and punishing taxpayers who do not comply, builds community confidence and encourages compliance from the broader population. The impact of an effective audit program should be seen in terms of the following effects: Corrective Making adjustments to detected instances of non-compliance. Deterrent Influencing the behavior of the audited taxpayer or sending warning signals to potential non-compliant taxpayers to be compliant in future. Preventive The leverage effect of an efficient audit program on broader community compliance. In a self assessment system, taxpayers should be induced to comply by being: (1) provided with information and assistance to enable them assess themselves; (2) informed that not everyone will be audited but rather that cases will be selected for audit on the basis of risk; (3) convinced that if they understate their tax liability there is a high probability that they will be audited; and (4) convinced that if they do not meet their basic obligations they will be penalized. 1.2 INFORMATION AND INTELLIGENCE By having extensive access to the business community, the audit program is in a position to gain a wide range of information and intelligence that can inform the tax administration of practices that could be jeopardizing compliance and revenue collection. This information is critical to the development of appropriate treatment strategies in other parts of the tax administration, for example, taxpayer service, policy and legislation, collection, filing and payment enforcement, and informs the selection of future audit and investigation cases. 1.3 ADDRESSING DEFICIENCIES IN THE LAW Tax auditors detect, in their daily work, weaknesses in law that are being exploited by taxpayers, and this information is normally escalated to the tax administration s policy and legislation program so as to address the loopholes through amending the tax legislation. If auditors observe recurring patterns of avoidance, this may indicate, for example, that the penalty provisions are inadequate and require amendment to provide sufficient deterrence.

8 2 1.4 LAW CLARIFICATION AND EDUCATION The tax audit program also plays an important part in clarifying the law and educating taxpayers on appropriate compliance measures, such as filing and payment requirements, record keeping practices, relevant interpretation of the law, and legislative changes. This can be done directly by the auditors either interacting directly with taxpayers, or by influencing the taxpayer services program in the development of strategies to address areas of non-compliance detected during audits. 1.5 ORGANIZATION AND STRUCTURE HEADQUARTERS AND OPERATIONS There needs to be clear accountability for strategic management and support of the audit program at headquarters level and delivery of the program at operational offices (e.g. the large taxpayers office (LTO), and regional and district offices). The distinction between the role of headquarters and operational offices is described below. Role of the headquarters Set objectives, policies, priorities and strategies for the audit program. Establish national audit targets and allocate them to field offices. Allocate financial and staff resources to field offices. Monitor and evaluate performance against budgets and targets. Develop a case selection criteria. Develop and maintain computer systems to aid audit and reporting. Provide training materials, manuals, legal assistance, forms, and other support to auditors. Design structures at all levels and assign responsibility to positions. Communicate legislative changes, policy decisions and procedures to field offices. Conduct quality assurance programs to ensure consistency in policy and procedures. Develop and disseminate industry/sector trends to guide audit operations. Identify training needs, and facilitate both refresher and specialized training. Role of the operations office Develop operational plans aligned to corporate goals and objectives. Select cases for audit based on criteria established by headquarters. Allocate audit cases to staff according to experience and skills. Implement internal systems to ensure quality audits. Identify training needs and inform headquarters. Monitor achievement of operational plans on a daily basis. Maintain data on taxpayer in their office and undertake analysis of compliance. Implement compliance projects that are appropriate to the office SEGMENTATION AND SPECIALIZATION As the sophistication and complexity of taxpayers financial affairs and compliance practices will usually vary according to the nature and size of their enterprise, many tax authorities have moved to institute taxpayer segmentation to organize resources according to industry specializations (e.g. banking and finance, insurance, oil and petroleum) and size of taxpayers (for example: large, medium, small). Reasons for non-compliance will often vary between taxpayer segments and therefore audit strategies and practices should be designed to complement compliance risks. For instance, LTO audit teams should also

9 3 comprise of experts in telecommunications, banking, finance and insurance, e.t.c. There should also be expert teams in the taxation of international transactions, tax avoidance arrangements, and computer aided audits to assist and support auditors in dealing with taxpayers who have these unique features in their enterprises. Whilst the establishment of the LTO and medium taxpayers office (MTO) may be seen to address these matters, it is necessary to go beyond mere structure and align strategies with the compliance issues in particular segments. Profiling taxpayers in respective segments will aid in the determination of appropriate structures and strategies. 1.6 RESOURCE MANAGEMENT AND THE AUDIT PLAN In order to optimize use of resources to effectively meet the audit objectives, it is necessary to strategically plan the allocation of available resources to areas likely to have the greatest impact on compliance, while maintaining a balanced program across the taxpaying population. Intelligence, research, and analysis need to be used to define risk areas and audits need to be tailored to address the identified risks. It is essential that audit plans are developed in an integrated fashion with the involvement of audit management to ensure that there is a matching of the number of case targets to resource availability. There is no point selecting 1000 cases for audit in a period when audit capacity will only allow the execution of 100 cases. Priority needs to be given to high-risk cases. An audit plan should be developed annually, and reviewed quarterly, to ensure that the planned audits: Correspond to strategic direction; Are reflective of the compliance risks being observed; Provide prioritization to cases of highest risk; Provide adequate but realistic coverage of taxpayer segments, industry sectors, geographic regions, entity types and tax types; Include a range of audit products, e.g. desk, specific issue, comprehensive; Can realistically be completed by the audit resources available, i.e. the number of audits and the time requirements are reasonable given the available audit competency, capacity, and the expected quality standards; and Include performance objectives.

10 4 2 RISK ASSESSMENT 2.1 NEED FOR RISK-BASED APPROACHES No tax administration has, nor should have the resources to control 100 percent of their client and transaction base. Instead, they increasingly rely on risk management methodologies to allocate better the available scarce resources in order to achieve an optimal compliance strategy. Risks are those events that could negatively impact on an organization s ability to deliver on its mission. Risk assessment must therefore be an integral part of the entire audit process and should involve: (i) a review of the economy to identify risk-prone sectors; (ii) a review of the sectors to profile the various operators therein; and (iii) a profile of the operators in order to discern risky trends or behavior. Risk assessment should also involve a review of the internal systems within an organization to obtain a picture of any in-house factors that influence the non-attainment of audit objectives. The adoption of risk-based approaches goes beyond audit case selection and applies to more than direct revenue risk. A tax administration will usually have as part of its objectives, the need to deliver a certain amount of revenue to the government to meet budget objectives, but this will usually be supplemented by other objectives such as: improving compliance; maintaining expenditure within a specific budget; minimizing taxpayer compliance costs; and maintaining community confidence in the tax system (often an important political objective). The administration therefore has to manage the risks of failing to achieve each of these objectives and not just the risk of non-compliance. From an audit perspective, management needs to complement the administration s objectives. This requires a review of all activities related to the audit program, and to assess the value they add to meeting the administration s objective. Only by having a clear understanding of the objectives, is it possible to formulate a risk-based approach. As resources are limited, the administration needs to allocate resources to activities that will provide the greatest impact on the achievement of objectives this usually means gaining the biggest improvements in voluntary compliance at the lowest cost to both the taxpayer and the administration, while maintaining community confidence in the tax system. If activities performed do not contribute to the attainment of these objectives, management needs to reconsider the performance of such activities. As there are likely to be more risks identified than can be adequately addressed by the administration, it is necessary to rank and prioritize the risks according to the likelihood and consequence of their impact on the objectives. 2.2 RISK IDENTIFICATION It is necessary that functional units are established with a mandate to gather, collate and analyze data collected by the tax administration, and to liaise with other government and private sector organizations both within the country and abroad. These units would have the following roles:-

11 INFORMATION (DATA) GATHERING This involves collecting data on the economy, sectors within the economy and the players/operators in the respective sectors. The data can be obtained from within the tax administration, other government or public depositories, the media, and foreign sources. Third party sources, such as property registers, civil courts, and stock exchanges should also be used to gather information that can be used to compare publicly declared income and returns to the tax authorities. At international level, the exchange of information articles contained in tax treaties should be used effectively to obtain information from tax administrations in other jurisdictions INFORMATION ANALYSIS The data collected should be analyzed and simulated to provide estimates of the total tax base and tax liability. The analysis should also break down these estimates into estimated contribution by sector or key players. A comparison of these estimates with the actual performance of the respective sectors will reflect the gap, for example, registration gap, filing gap, payment gap, etc RESEARCH AND STATISTICAL MODELING A database of macro-economic data, obtained from the national statistics office or the Ministry responsible for economic planning, should also be compiled and maintained. Using statistical modeling techniques, the relationship between the performance of the economy and the tax base/tax collection can be simulated to enable the tax administration observe patterns, trends, and developments. Any significant outlier observation should be tagged for further analysis such as correcting for exemptions trends, timing or accounting differences, etc. The ultimate objective of the review is to ascertain the cause of any discrepancies, and implementation of appropriate remedial action. 2.3 UNDERSTANDING RISK FROM A TAXPAYER S PERSPECTIVE Taxpayers can use a number of options, both legal and illegal to avoid paying the correct amount of tax. For instance they can decide to: (1) stay out of the system by not registering; (2) not maintain books and records; (3) not submit declarations on time; (4) submit incorrect declarations; (5) not pay outstanding taxes; (6) make aggressive interpretation of the law; (7) enter into schemes or tax avoidance arrangements that hide or alter the commercial reality of their dealings; and (8) negotiate a compromised assessment or payment. Non-compliance and tax avoidance therefore can take many forms and, for this reason, the tax administration needs to develop a range of strategies to treat particular risks and have the flexibility to apply them, rather than being constrained by standardized and mandatory processes. It is imperative that the audit programs seek to understand taxpayers behavior and adopt appropriate treatment strategies, including a range of audit methods and techniques. Hence, risk identification is more than selecting a case for audit. It should involve identifying and articulating the nature of the risk so that the case is appropriately allocated and acted upon.

12 6 2.4 INTERNAL RISKS Risks to the achievement of audit objectives are not only in the domain of taxpayer behavior. There are also risks manifested internally within the administration. These also need to be addressed by the administration s management if it is to take a risk-based approach. To minimize internal risks, a tax audit program requires: Professional staff of high integrity; Well structured planning systems that set objective plans and targets; A risk-based case selection system; A range of audit methods, techniques, and strategies; A functional case management system; A monitoring and evaluation framework; A clear legal framework; The support of a robust taxpayer education program; and A fair dispute resolution framework.

13 7 3 RISK PROFILING 3.1 RISK PROFILING ACTIVITIES An understanding of the characteristics of taxpayers, their behaviors, and areas of noncompliance, is necessary so as to be in a position to identify, assess and prioritize risks. The determination and execution of appropriate treatment strategies, e.g. the particular types of audit, resources allocated, and sanctions imposed, must have a strong correlation to the nature of the risk. The table below illustrates the different characteristics of taxpayer segments and the appropriate responses from an audit program. Profiling the taxpayer population will aid an understanding of features, compliance risks and the development of appropriate treatment strategies. Table 3.1: Characteristics of taxpayer sectors and audit approaches Business Size Small and Micro Medium Large Number of taxpayers Revenue at risk per taxpayer Large Moderate Small Small amounts Moderate amounts Large amounts Areas of noncompliance Receiving cash without tax withheld, poor records, not registering, not filing. Understating sales, overstating purchases and expenses, falsification of documents, creative accounting. Diversion of income to wealthy owners. Tax treated as an expense to be minimized through: complex and dynamic structures, involving financial products, global and local nonarms length and non commercial transactions; and aggressive interpretation of the law. Audit Treatment Selective, simple auditing using education and penalties as a leverage tool to gain compliance through the broader community. Single issue audits focusing on areas of non-compliance and using sampling and computer audit techniques. Tailored audits by teams comprising specialists in specific taxes, industry sectors, international and computerized audit.

14 TAXPAYER PROFILING The mere collection of disparate data about taxpayers or taxpayer sectors is of little use to the administration. It is necessary to turn the information into strategic intelligence that can effectively support selection of the right audit targets. Many administrations have taken steps to improve their knowledge of taxpayer behavior by maintaining profiles of individual taxpayers, economic groups, market segments, and industry sectors. Profiling allows the systematic analysis of tax performance and development of indicators of tax avoidance. Once tax avoidance is detected in one taxpayer, the characteristics of that taxpayer, for example, their specific profession and financial ratios, can be used to frame the parameters for selection of other taxpayers for audit. The profiles also aid comparison of tax performance over successive periods, and in establishing patterns and trends that may not be visible through the examination of an individual tax file. The investment required in developing taxpayer profiles is particularly worthwhile in the large business sector where contribution to revenue is so critical and where the highlighting of anomalies in accounts and tax performance provides the administration with a strong indicator of where any audit activity should be focused. Without such analysis, the auditor is often left to fish for information, take time-consuming approaches such as checking every record, or take a hit or miss approach to detect avoidance. Profiling permits the establishment of industry benchmarks, which can be used to rate taxpayers performance against industry averages and peers. The comparison serves only as an indicator of risk and not as a measure of tax avoided. However, in cases of incomplete records, some jurisdictions use industry benchmarks to make estimations of income. By profiling tax performance of individual taxpayers or sectors, the administration is able to evaluate the effectiveness of its audit activity. For instance if a project on the legal profession detected avoidance by 80 percent of lawyers and action was then taken to have more intensive audit activity and apply heavier sanctions to this group, at a later date one could measure the compliance level of the sector and hopefully detect an improvement in compliance. Profiling also allows the administration to identify those taxpayers or sectors that have a good compliance record and hence defer them from consideration for audit, while focusing on areas of poor compliance. For instance, it should not be difficult to establish the sectors more prone to non-filing, nil filing, or repeat offenders. A graduated effort to profile taxpayers should be taken, starting with say the top 100 taxpayers, and then progressively moving through the LTO. At other levels of the organization, the profiling of individual taxpayers will be less comprehensive and should focus on their profession or industry sector. The nature of information to be captured in taxpayer profiles will be guided by the availability of data, the capacity to capture the data, the integrity of the data, and the choice of selection criteria. The profiles of LTO taxpayers should consolidate the data of individual entities into a picture of the group where there is common ownership of the separate entities. In principle, all value added tax (VAT) registered taxpayers should also be registered for income tax, the data captured from VAT registration documentation, declarations, audit results and collection records is equally relevant to income tax. The data can readily be

15 9 used to build individual case profiles, stratify the population into meaningful groups and develop business sector profiles. Any third party information indicating VAT avoidance will almost certainly be relevant to income tax THE RISK REPORT A risk report should be compiled, containing the following: Taxpayer s name and identification number; The tax segment and economic sector; Audit type and periods audited or to be audited; Names of persons preparing, reviewing and approving the report; Comparative financial analysis, highlighting patterns, trends, and variations; The perceived risk (reason for audit); and Estimated results from the audit A SUMMARY OF THE TAX HEALTH OF THE TARGET TAXPAYER The record/summary of the taxpayer tax health could include: REGISTRATION DETAILS PER TAX TYPE SUCH AS: Whether the taxpayer is required to be registered; Taxpayers registration number; Outstanding returns (if any); and Outstanding tax periods-with comments on extensions and summons EXPIRATION DATES OF ASSESSMENTS, SHOWING: Tax years; Due dates for the outstanding taxes; Date(s) when assessments were prescribed; and Required further action LIST OF OUTSTANDING RETURNS, SHOWING: Tax type (head);

16 10 Period; Applicable section(s) of the law; and Contact person s details STRATEGIC TOP DOWN COMPLIANCE RISK EVALUATION The tax administration should establish a systematic way to identify the key compliance risks by: Reviewing, on a quarterly or bi-annual basis, the tax law for loopholes and possible avoidance schemes; Recording and monitoring the groups of taxpayers in the high-risk category; Providing specialist training to staff in key economic activities including attachments to the taxpayers, other tax administrations, etc.; and Allocating organizational resources across the various functions in a way that enables the tax administration to achieve the best possible outcomes in terms of taxpayers compliance STRATEGIC BOTTOM UP COMPLIANCE RISK EVALUATION Systematic capture of data on audit results and analysis of the causes of noncompliance will provide the administration with valuable information to develop parameters for future case selection based on the profiles of those taxpayers known to avoid tax COMPLIANCE MANAGEMENT FRAMEWORK(CMF) A CMF should be developed and continuously reviewed to provide a systematic approach to monitoring and measuring compliance. The monitoring should be at four levels: registration; filing (lodging returns on time); reporting (complete and accurate information); and payment of the tax liability on time. The CMF enables the tax administration to respond to changing circumstances, ensure that treatment strategies are applied to activities of the highest priority, leverages the impact of interventions, and is cost effective. An example of a CMF is shown in Chart 3.1 below.

17 11 Chart 3.1 Compliance Management Framework OPERATING CONTEXT Identify Risks Assess and prioritize risks Monitor performance against plan Evaluate compliance outcomes Registration Analyze compliance behavior (causes and options for treatment) Determine treatment strategies Filing Reporting Payment Plan and implement strategies

18 CORROBORATIVE MEASURES Proxy measures should also be derived to track compliance trends. These include: Macro-economic indicators such as GDP, inflation, imports, exports, exchange rates, etc can be used to benchmark revenue collection. Non-compliance indicators (derived from financial data) can be used to flag taxpayers suspected of not conforming to expectations. Public opinion indicators (derived from public surveys on the professionalism and fairness of the tax administration) can provide information on possible sources of non-compliance. Program impact indicators (such as the effects of compliance interventions undertaken by the revenue authorities) can provide an insight into their consequences on compliance.

19 ASSESSING RELATIVE RISK 4 PRIORITIZING RISKS Prioritizing risks requires a relative weighting system. Tax administrations should therefore develop a mechanism that will enable them to objectively assess the relative size of compliance risks based on likelihood and consequence parameters. Consequence is measured in terms of the impact that a risk would have on the achievement of organizational objectives. Likelihood, on the other hand, is measured in terms of the probability of the risk occurring at all. Both measures can be expressed in either qualitative or quantitative terms. Table 4.1 below is an illustration of a Compliance Risk Likelihood Matrix (CRLM) and a range of ratings that can be applied. Table 4.1: Probability of Non-compliance Risk Occurring Risk Rating Description Subjective Definition of Likelihood Objective 1 Rare May occur only in exceptional circumstances Likely to occur in 10 years 2 Unlikely Could occur at some time Likely to occur in 5 years 3 Moderately likely Might occur at sometime Likely to occur in 3 years 4 Likely Will probably occur in most circumstances 5 Almost certain Is expected to occur in most circumstances Likely to occur in the next year Likely to occur this year or at frequent intervals In order to determine the relative rating of risks, the perceived likelihood of an event occurring should then be combined with the perceived consequence of an event through the construction of a Risk Rating Matrix (RRM). Table 4.2 below is a guide to building a RRM. The RRM compares the assessed compliance risks against the objectives of the tax administration; and helps prioritize the risks to signal appropriate treatment. For example, the shaded severe risk should be dealt with, with some urgency.

20 14 Table 4.2: Compliance Risk Rating Grid Likelihood Rare Unlikely Possible Likely Almost certain Extreme High High Severe Severe Severe Consequence Very high High High High Severe Severe High Significant High High High High Medium Moderate Moderate Significant Significant Significant Low Low Low Moderate Moderate Significant 4.2 ASSIGNING RESPONSIBILITY OF RISK TREATMENT After construction of the RRM and placing sectors and taxpayers in appropriate ranking grid boxes, responsibility for specific sectors or taxpayer should be allocated within the tax administration as follows: Severe - Executive management and other relevant government agencies; High - Executive management; Significant - Senior management; Moderate - Middle management; and Low - Routine procedures. 4.3 RISK AND AUDIT CASE SELECTION A well-targeted audit program is necessary to ensure that resources are not wasted on unproductive activities and that taxpayers are not unnecessarily inconvenienced. Selecting the right targets for audit requires accurate taxpayer data, application of meaningful criteria based on a series of risk indicators and prioritization of risks. 4.4 FEATURES OF AN EFFECTIVE AUDIT CASE SELECTION SYSTEM ACCURATE AND USEABLE DATA AND INFORMATION The ability to capture and maintain data that can be usefully manipulated and interrogated is the foundation of a good case selection system. This, however, does not mean that onerous reporting requirements need to be imposed on taxpayers and other institutions. As with any investment, the costs and benefits need to be considered. The challenge is to

21 15 collect data that can be related to risk indicators and be built into databases that can be used to support analysis and development of inferences about non-compliance. Data is usually readily available from taxpayers at various stages of tax administration, including: (1) registration; (2) filing; (3) audit; and (4) collection enforcement. The data can be used to build individual case histories or profiles, stratify the population into meaningful groups and develop business sector profiles. This enables the tax administration to score taxpayer characteristics as well as relate the compliance history of one taxpayer to others in comparative circumstances. Attempts are often made to supplement internal data by obtaining information from third parties. However, unless matching of the taxpayer identity is reasonably straightforward, the use of these data is limited in bulk systematic case selection activities. It can, however, be useful for specific projects, for example, a project on a particular industry using association membership data, or following up individual compliance where specific information is received on incidences of non-compliance ANALYSIS AND ASSESSMENT Data alone does not make a good case selection system. It must be analyzed to facilitate application of an objective risk criteria to select audit cases. Analysis can take the form of: Applying objective risk factors across the data sets Assessment of filing and paying compliance; level of deviation in reported figures across periods and/or different revenue declarations from group averages; relationship between sales and cost of sales, gross profit, expenses, payroll, net profit, tax payable, and refunds claimed; etc. Automation allows the variables to be changed rapidly and also the bulk processing of data across the risk indicators. Review of files by experienced auditors This is used where there is limited computerization. It can also be utilized to supplement, enhance, or refine an automated case selection system by way of local knowledge, which can provide credibility to the selection process. This is particularly useful if the examiner has specialized knowledge of a particular sector. Data mining Once a risk is identified and the characteristics of the risk can be described in terms of variables captured in a database, it is possible to select all taxpayers meeting well-defined parameters. Audit results can be used to model the characteristics of non-compliance and the resultant criteria can be used to identify taxpayers with similar characteristics. An example is as follows select property developers in district X with turnover between Rwanda francs (Rwf) million and payroll in excess of Rwf 5 million where the net profit margin is less than 10 percent. Drilling through data in this way provides a very effective way of selecting a precise group of taxpayers for review. Data matching This is valuable only if comparable data fields and taxpayer identifiers are available. For example, the tax administrations can match a taxpayer s declarations of VAT turnover against income tax turnover or match customs data with tax declaration data.

22 RESOURCES AND COMMITMENT Case selection systems require investment of resources and organizational strategies to develop, maintain, and refine the systems. Some important elements in this regard are: Information technology (IT) capacity Automation will support processing of large volumes of data. Skilled staff Specialized staff with research and analytical skills are required to turn data into intelligence, develop appropriate prioritization criteria, regularly refine case selection criteria, and disseminate intelligence to appropriate areas of the organization. Evaluation and improvement Analysis of audit results is essential to evaluate the effectiveness of the case selection system. Improvements should always be made in obtaining new data sources, enhancing data integrity, reviewing taxpayer stratification, refining risk indicators, sharing intelligence, and developing new treatment strategies.

23 PRE-CONTACT ANALYSIS 5 PREPARING FOR THE AUDIT When a case has been selected for audit, auditors should undertake a pre-contact analysis so as to better understand the taxpayer s business and behavior, and to establish the appropriate type, scope, and period of audit, as well as the resources and strategy to be employed. This analysis should include: BASIC TAX INFORMATION (CHECK LIST) This should include, as a minimum, information on whether: Tax returns were filed on time; Tax schedules were completed; Tax was paid on time; and Financial statements were filed with the tax administration and other statutory authorities. (A checklist with Yes/No ticks should be completed and placed in the audit file) REVIEW OF THE CALCULATION OF TAX AMOUNT AND TAXABLE INCOME The auditor should determine, for example, whether: Carry over losses, exempt income and deductible income were properly applied; Accumulated income was properly calculated; and The tax amount or tax credit was properly calculated. (A checklist with Yes/No ticks and any variances should be noted) FINANCIAL STATEMENTS REVIEW A trend analysis on major accounts should be done to identify any significant departure from the norm. (These should be noted and kept in the audit file) CAPITAL AND SHAREHOLDING CHANGES Any significant changes in capital or shareholding structure since the last audit cycle should be identified and documented. (These should be noted and kept in the audit file).

24 THE TAXPAYER S ORGANIGRAM AND BUSINESS TRENDS A review of the taxpayer s setup should be carried out with regard to: Organization chart; Business products or activities; Functions of each part of the enterprise; and Offshore assets holdings (The auditor should obtain copies of appropriate documents and attach in the audit file) REVIEW OF PRIOR COMPLIANCE RECORD Tax returns from multiple tax years should be examined by comparing income, expense or balance sheet issues, including some verification of income to establish whether there is any unreported income (This record should be attached in the audit file) REVIEW OF RETURNS PREPARER S PERFORMANCE A compliance check of the firm or individual who prepared the returns for back record, past tax offences, etc. should be performed (Key observations should be recorded and attached in the audit file) ANALYSIS OF RETURNS TO DETECT INDICATORS OF NON-COMPLIANCE Relevant figures should be compared to provide means by which business and industry trends can be identified. This should be done by deriving essential and supplementary ratios ESSENTIAL RATIOS These include: Profitability ratios- which indicate profitability and financial strength of the taxpayer by comparing profits with sales, expenses or assets; Capital structure ratios- which indicate whether the business will be able to meet its debts in the short term; and Income/corporate tax ratios which compare a business tax payments with its income, taxable income or profits to establish the adequacy of tax payments.

25 SUPPLEMENTARY RATIOS Supplementary ratios can be used to refine and test the conclusions drawn from the essential ratios. Examples of supplementary ratios include- liquidity ratios, gross profit ratios, inventory turnover ratios, etc. (All these ratios must be indexed and placed in the audit file) THIRD PARTY INFORMATION/COUNTERPART EXAMINATIONS Additional information to verify the taxpayer s income should be obtained and also placed in the audit file. Key information sources include: Financial institutions information on interest; Public institutions information on dividends; Social security and pension fund benefits payments; Offshore or foreign companies (where a taxpayer is engaged in crossborder trade); and Entities with whom the taxpayer usually deals such as real estate agents, local authorities and utility suppliers NO AUDIT DECISION Where a decision has been taken not to audit a taxpayer, the grounds for such a decision must be comprehensively documented and placed in the audit file. 5.2 PLANNING THE AUDIT An audit should start with a written plan containing: A list of the prioritized risks; Issues identified at the risk profiling stage; The data needed to test the risks; A questionnaire listing inquiries with the taxpayer, his/her tax agent or other parties; The sequence of activities to be followed/undertaken during the audit; The type of audit and the methodology and techniques to be employed; The audit team to carry out the audit and time management plan; The expected duration/audit turnaround time; Special resources required such as computer facilities (hardware and software), special type stationery and other items not readily available; and Appropriate authority to audit, such as endorsement or approval by supervisor.

26 20 Copies of the relevant laws and regulations should also be obtained for reference purposes and put together with the other documents comprising the audit plan. Further, any relevant literature regarding the taxpayer, such as brochures, pamphlets, newspaper cuttings, and internet downloads should also be obtained and put together with the other documents TYPES OF AUDIT The auditor should not embark on a comprehensive audit unless there is sufficient indication of the probability of avoidance to warrant thorough examination. For example, it would not be appropriate to undertake a comprehensive joint audit of income tax and VAT if the risk only pertains to the incorrect characterization of a supply/sale, or there is a discrepancy in withholding of taxes from salaries and wages. On the other hand, if a taxpayer is suspected of inflating costs of purchases and understating sales, it would be appropriate to utilize all available information and examine the impact across VAT and income tax. However, when developing the scope of the audit, the consequences of the risks identified must be considered across all tax types and therefore, an integrated approach to profiling, risk assessment, and audit is recommended. Most audits should proceed based on sample checks of specific issues and cover a limited timeframe to establish the credibility of the taxpayers accounts and claims. If the auditor uncovers anomalies during a single tax (or issue) audit, the scope of the audit can then be expanded to include more issues and a broader timeframe. For small and medium-size businesses, an approach often adopted is to commence with a focus on VAT and expand to a full income tax audit if irregularities are detected. As the focus of the audit program is on influencing future behavior, it is preferable to have the audit initially focused on the latest declaration or reporting period. If this is found to be satisfactory and there is no obvious reason to audit previous periods, the auditor should conclude the audit at that stage. If however, there are discrepancies detected, the auditor should expand the scope of the audit to previous periods. It will often not be necessary to undertake a comprehensive examination of the prior periods if the nature of the discrepancy in the period examined is such that it can be applied or extrapolated for prior periods. The nature of a joint audit and make-up of audit teams should vary depending on the characteristics of the taxpayer and segment. Comprehensive large taxpayer audits will usually require a team approach that may include experts on particular aspects of the law, specialized sectors such as banking or petroleum, international trade, and computer analysts as well as proficient accountants. Conversely, it is possible to conduct a small enterprise audit using one auditor familiar with each of the laws and possessing good investigative skills, or a single issue audit, for example withholding tax on salary, using basic inspection techniques. Rather than taking a one size fits all approach, modern tax administrations have developed a range of audit products to provide a more tailored response to the risk being addressed through the audit activity. A typical range of audit activity includes: Registration checks. This type of audit is a quick check on businesses to establish that they are correctly registered for all their taxpaying obligations. Information

27 21 from the business license office, customs, third parties or other audit activities may alert the administration that a check is necessary. Advisory audits. A visit to newly established businesses advising them of their obligations in terms of tax types, filing of declarations, payment of amounts due, and records to be maintained may be appropriate. This is particularly necessary when introducing new laws. Record keeping audits. A check on enterprises that may have a reputation of not keeping adequate records. The visit would point out the obligations of the taxpayer with regard to keeping of records and the consequences of failing to do so. These audits should be followed up and penalties imposed if the taxpayer continues to disregard record keeping requirements. Desk audits. Audits will generally require field visits, however it may be possible to undertake some basic checks from the tax office. These can be conducted in relation to specific issue audits of a small enterprise or employee when the auditor is confident that all necessary information can be ascertained by conducting the examination in the office. They can also be used as a preliminary examination of declarations, analyzing ratios and cross checking information to determine if further investigation is warranted Single issue audits. Focusing on a single tax type, single aspect or a single period. For instance the auditor may be only examining whether the taxpayer has met obligations in respect of employment tax, VAT, or examining a specific expense claim. VAT refund audits. Verifying the taxpayer s right to a refund prior to processing the refund. Usually undertaken for first refund claims as well as where the refund claim varies significantly from established patterns and trends. Audit projects. Audits can be organized as a separate project for specific groups of taxpayers. These audit projects may cover an industry (e.g., construction) or a line of business (e.g., retail) and/ or certain items from the declaration or profit and loss account (e.g., depreciation). They will consist of specific checks and are used to address a particular risk or to establish the degree of non-compliance in a particular sector. Comprehensive (or full) audits. An examination of all tax obligations over a number of tax periods is preferred when major discrepancies are uncovered during single issue audits. Comprehensive audits are usually time consuming and therefore should only be applied to taxpayers where there is evidence of under reporting that impacts across taxes. Fraud Investigations. Involve the most serious cases of non-compliance with criminal implications. Require special skills in investigation and evidentiary requirements as they often involve seizure of records, taking testimonies from witnesses and preparing briefs for courts. 5.3 STARTING THE AUDIT NOTIFICATION The audit is deemed to have commenced once a letter of engagement informing the taxpayer of the audit has been delivered. The taxpayer should be advised of the scope of