Effective Management of SME Taxpayers: The Role of Risk Based Audit

1. Effective Management of SME Taxpayers:The Role of Risk Based Audit RajulAwasthi Global Tax Simplification Team Manila March 2010

2. Contents • Why Special Treatment to SMEs? • Principles of Risk Management - risk based tax audit for SMEs • Simple Risk Based Audit for SMEs – even in a less sophisticated IT Environment?

3. 1. Why Special Treatment to SMEs?

4. Special characteristics of SMEs • Largest number of taxpayers (other than wage earners) • Also, major contributors to informal economy operating outside tax net • Compliance risk: higher likelihood of tax evasion, operating outside tax net, hiding part of business transactions • Face high costs of compliance relative to their turnover, profits • Need to overcome hurdles of formalization

5. Strategy: Segment SMEs • SMEs segmented according to size (defined by turnover, number of employees, assets, capital base, etc.) • Micro enterprises left out of tax net – equivalent to threshold for personal tax • Small businesses in a special Small Business Tax regime, eg., a turnover tax regime • Vast majority of business taxpayers – usually above VAT threshold and under large taxpayer threshold These taxpayers are in the regular tax regime and pose a serious management problem

6. A different “law of large numbers” • Large number of SME cases in the tax net • High compliance risk • Effective control and deterrence • Compliance management • Tax audit • Good taxpayer service • Timely refunds • Help with compliance

7. Principles of Risk Management - risk based audit for SMEs

8. Role of audit • Detect and redress individual cases of non-compliance with tax law • Promote voluntary compliance • Focus on high-risk taxpayers • Attempt to close the ‘tax gap’

9. A model of tax compliance Factors influencing taxpayer behavior Attitude to compliance Compliance strategy Business Industry Use full force of the law Have decided not to comply Taxpayer Don’t want to comply, but will if we pay attention Deterrence by detection Assist to comply Try to but don’t always succeed Sociological Economic Psychological Willing to do the right thing Make it easy Audit strategy aims to create pressure down

10. Compliance management in SMEs • For those SMEs that are “willing to do the right thing” and “try but don’t succeed”, make it easier to comply – through provision of good taxpayer service • For those SMEs that “don’t want to comply but will if we pay attention” provide strong deterrence through effective audit • Given large numbers and other characteristics, risk based audit is the most appropriate method

11. Methods of Audit • Manual screening – by local officers • Auditors decide on cases: high risk of corruption • Not a systematic method, hence some non-compliance can be missed • Only internal data and local knowledge is used for selection • Random selection • Stratified sampling better representation of taxpayer strata • No bias in audit selection • High opportunity cost of auditing – “go errors” • Risk-based selection • Identify those taxpayers who are most likely to be non-compliant • Use of ‘risk-scoring’ techniques and taxpayer profiling

12. Core Principles of Risk Based Audit • Trust, but verify • Self-assessment of taxes • Equity – honest, compliant taxpayers treated with respect, non-compliant taxpayers treated with severity • Taxpayer service orientation • Promote a tax culture of voluntary compliance • tax system is based on trust • taxpayers self-assess their taxes

13. Objectives of Risk Based Audit • Select the most ‘risky’ cases for detailed audit – get most ‘bang for the buck’ • Case selection based on objective criteria, not left to the discretion of the tax official • reduce opportunities for rent seeking behavior • Reduce interface between tax inspectors and taxpayers • Better use of resources of tax authority • few cases audited • most professionally competent officers can be deputed to tax audit cell • Lower cost of tax collection

14. Simple Risk Based Audit for SMEs – even in a less sophisticated IT Environment?

15. A sophisticated IT based risk-based audit system needs - • High level of data and IT systems capabilities • Data requirements • Hardware and information technology infrastructure • Data management software • Human resource capabilities and training • Skills needed to design and operate objective risk based audit system • Appropriate legal provisions in tax code

16. State of computerization of tax administrationin developing economies • The tax administration may be operating in a rudimentary IT environment • The regional offices operate on Local Area Networks, that may or may not be linked to the headquarters • Tax returns are not processed online; office audit is done manually for all tax returns to check prima facie errors and omissions • The database may only have basic taxpayer information, and can not be used for developing software based applications

17. Core objectives of RBA – • Select the most ‘risky’ cases for detailed audit • Case selection based on objective criteria • Better use of resources of tax authority • Lower cost of tax collection • Promote a tax culture of voluntary compliance • Can all be met in a Risk Based Audit system operating in an environment without a sophisticated IT infrastructure in place • Remember: RBA was invented before computerization became common!

18. A simple risk based audit system for SMEs in a low-IT-sophistication environment Steps: • Lay down objective criteria for case selection • Develop audit capacities in tax inspectors • Outreach programs for taxpayers

19. Simplified risk scoring criteria for SMEs Lay down simple criteria for case selection Key objectives: non-discretionary, informed Two options - Criteria can be based on: Compliance characteristics of taxpayer - behavior of taxpayer in terms of complying with the tax law Business characteristics of taxpayer - indicators of true declaration of profits / income

20. Option 1: Compliance characteristics • Irregularity / delays in filing returns • Irregularity / delays in making tax payments Cases with these characteristics could be taken up for audit => Methodology for categorizing a taxpayer as ‘risky’ based on compliance characteristics to be laid down

21. Option 2: Business characteristics • Identify businesses that are considered most ‘risky’, i.e., prone to tax evasion • For each risky business category, select two or three key benchmarks of ‘non risky tax behavior’ • Businesses most prone tend to vary from economy to economy, but some common examples are: • businesses that have most sales in cash, e.g., restaurants, taxis • businesses that involve underreporting of transaction values to evade other taxes/duties, e.g., real estate (in some countries), imports (where customs duties are high) • professions where individuals control all receipts, e.g., doctors, lawyers, carpenters • Benchmarks would vary across countries, but some examples are • Gross profit margin of a typical non-risky taxpayer • Sales turnover relative to size • Particular Financial Ratios, e.g., production related to key raw material consumption, sales receipts related to fuel consumption, • Amount of tax refund claim

22. Example: Key Risk Sectors Identified

23. Example: Australia: Industry Benchmarks • Developed for 58 SME business segments • Two types of benchmarks: • performance benchmarks based on tax return data and business activity statements; • Input benchmarks based on information from industry and trade associations. • Key elements: • Costs of goods sold to turnover; • Ratio labor to turnover • Ratio rent to turnover

24. Example: Performance Benchmark Bakeries Example cont‘d: Cleaning Services

25. Example cont‘d: Income Guide for Taxi Drivers

26. Example: simple audit selection in Gujarat, India - invoice matching Data Collection • All sale and purchase details, including invoice specific details are provided in the return • Information used to identify • Unregistered dealers • Value of transactions undertaken by unregistered dealers • Commodities transacted by unregistered dealers • Information used to identify prospective dealers for registration • Identify defaulters • Targeted enforcement drives can be undertaken

27. Gujarat: invoice matching (contd.) • Details provided by the buyer and the seller tracked by the IT system, • System identified invoice match/ mis-match between information filed by buyer and seller • Veracity of input tax credit claimed can be checked online

28. Summary

29. Matching case

30. Example: Development of risk scores in a low-capacity environment - Yemen • Approach to inform development of risk scores • Survey of small businesses in key sectors • Correlation analyses conducted between the annual revenue and all variables in the survey • Guiding criteria: Easy to measure, hard to falsify, significant and high correlation with turnover, unlikely to distort business decision • Manufacturing: 4 Indicators selected • Business premises (m2), value of fixed assets, grid costs, and monthly rent • Challenges:

31. A simple score sheet for local tax inspectors

32. A dynamic model with regular “recalibrations” • Survey based analysis is (always) constrained by the sample size and reliability of responses on sensible areas (turnover, profitability, operational cost-structure) • Next step is a trial run testing the score sheets (and fallback indicators) in pilot offices to collect more information • At the initial stage, fact finding/ informational audits are required to gather additional information and refine scores • Subsequently, results of risk based verifications will be analyzed to improve the reliability of the indicators • The use of risk scores generates constant new data, enabling the Tax Authority to “recalibrate” the system on a regular basis

33. The SME Strategy in the UK Willing And Able Hidden Economy Unaware Potential Payment Deferrers Willing But Need Help Potential Rule Breakers Rule Breakers Payment Deferrers HMRC Customer Segment Willing and Able (50% of SMEs) Need Help Around Customer Life Events (20% of SMEs) Rule Breakers (7% of SMEs) (+ HE) Potential Rule Breakers (23% of SMEs) Tax Gap) Negligible Mainly Error + FTRC Evasion and Hidden Economy Grow/sustain segment. Increase voluntary compliance. Serve at lowest cost. Increase likelihood and consequences of being caught evading & in HE Aim Reduce segment size. Reduce error and so encourage voluntary compliance. Reduce segment size. Improve record keeping Deter rule breaking. How • Businesslink.gov main channel for e-guidance and transactions • Increased self-serve through improved online tools • Significantly fewer compliance checks • Time to pay for those who get in touch • Early intervention, education, information and advice • Process redesign to reduce error • Active feedback loops • Proactive mass market help at key lifecycle events • Flexible payment options • Effective use of intermediaries • 1-to-many interventions • Business assurance visits to improve record keeping (FTRC) • Visible deterrence marketing • Tougher debt sanctions for SMEs who don’t engage • More effective, risk-based debt approach • Improved risk assessment identifies more evaders • Increased consequences for evasion & persistent recklessness • Active post-intervention offender management • Greater prioritisation of compliance debts

34. In summary: simpler RBA for SMEs • High levels of efficiency gains for the tax administration • RBA will help select cases that would yield more tax per audit • RBA will ensure time and effort are not wasted on non-productive cases • However, needs to be simple and objective • Few examples of risk scoring outside OECD • May not be possible to use sophisticated IT models for SMEs with limited data availability • Reliance on simple techniques for RBA may be best bet

35. Further key efforts: Develop audit capacities in tax inspectors Ability to analyze accounts and taxable transactions to determine true taxable income • Analysis of financial statements • Financial ratio interpretation and application • Knowledge and awareness of complexity and loopholes of tax law • Ability to obtain and use external information sources • Knowledge of other relevant laws, e.g., corporate law, customs and VAT regulations, civil and criminal law =>Training and capacity building of tax inspectors

36. Further key efforts: Outreach programs for taxpayers and private sector Publicize tax law and regulations relating to risk based audit system • Conduct workshops and seminars illustrating provisions of the system • Involve private sector and tax authority in jointly disseminating information =>Knowledge is power: taxpayers must know they can only be audited if they do not comply with the tax law

37. Thanks for your attention

38. Why Simplify Business Taxation? • Our objective: Smart and simple tax administration and processes to lower the cost of doing business • Tax rates and tax administration constantly ranked across regionsamong top 3 “major constraints” for businesses • Filling the niche: • We bring business perspective • Agenda setters on SME Taxation and Tax Compliance Costs • Collaboration with key players: IMF, PREM, PSD, OECD, ITD Firms identifying issue as “major constraint” [%] Source:Investment Climate Assessments data • Highly responsive to macro economic changes • Crisis response work and post-crisis preparedness

39. Meeting Client Demand with KM and Operations Tools Workstreams Issues addressed Business tax administration is burdensome (CIT, VAT) Misuse of regulatory fees as revenue tools (esp. sub-national) Small business facing high compliance costs Overly complex, cluttered tax laws & appeals system Excessive and discretionary tax audits Tax competition has led to sub-optimal tax incentive structure When “tax cuts” from stimulus packages generate large revenue gaps… • METR Analysis • Tax Admin Process Mapping • Standard Cost Model (SCM) • Compliance Costs Surveys • Inventory of Fees & Charges • Incentives Review • Profit –Margin Analysis • Tax Administration Simplification • Sub-national Taxes & Regulations • Small Business Tax Reform • Tax Legal & Appeals Reform • Risk-based Audit System • Tax Incentives Reform • Crisis Response & Post-crisis Preparedness

40. Central Asia Regional Program • Kyrgyz Republic • Tajikistan • Uzbekistan Nepal Montenegro India Burkina Faso Nigeria Peru Madagascar DRC Diverse Clients. Tailored Advisory Services • Pipeline: • East African Community (EAC) Initiative • Bangladesh Armenia Georgia Vietnam • Pilot project • All workstreams Sierra Leone Lao PDR Pilot project All workstreams Kenya Rwanda Yemen Tanzania • Pilot project • All workstreams

41. The Tax Team in Yemen • Project Brief: Budget: US$1.3mn (Phase I) • Started in Dec 2007:Request from Min Finance, following ICA recommendations • Joint Venture: FIAS and IFC PEP-MENA, in partnership with PREM and IMF • A global team: Sana’a, Cairo, DC • Rationale & Objective: Reduce the very high tax costs of doing business, to facilitate compliance/formalization and address widespread evasion to broaden the tax net • Policy Reforms: Investment Incentives, non-tax revenue instruments, SME regime • Administrative simplification: to reduce compliance costs Results for Phase 1: • New Income Tax Law reflecting best practice (in Parliament) • Lower CIT rate in exchange for incentives • Design of new SME tax regime • Dramatic simplification of GST administration (30% reduction of admin time to date) • Start of risk based audit selection/ self assessment

42. Reforms and Knowledge Management • Recent reforms: • Yemen • Streamlined income tax law rewritten and includes both mining and leasing provisions • Design of “smart” and simplified GST procedures. • Sierra Leone • New VAT rolled out • Incentives reformed • Madagascar • Reduction of number of taxes from 28 to 14 • Tax rates lowered (incl. CIT) • Elimination of redundant taxes • South Africa • Redundant taxes abolished • New SME regime • Reduction in CIT rate => R2 bn in tax relief • Rwanda • First stage of administrative simplification completed Conferences and Workshops: • Regional Tax Practitioners Networks & Conferences • Africa (Rwanda, April 09) • South-East Asia (Philippines, February 10) • South Asia Tax Conference (India, October 09) • Tax Deep Dives in Central Asia and Washington DC for BEE staff Recent publications: Toolkits for Practitioners • Designing a Tax System for Micro and Small Businesses • Tax Simplification Toolkit IN PRACTICE Notes • Local Taxes and Regulations • Small Business Taxation • Business Taxation Reform with Governance • Corruption and Tax Administration Reform • Introducing VAT in Developing Countries Cases: Impact of Tax Incentives on Investment