Matthijs Alink Senior Advisor OECD/CTPA/GR Conference on Taxing Micro and Small Businesses

1. LOOKING BEYOND THE BORDER Recent developments in Micro and Small Business taxation in other regions Matthijs Alink Senior Advisor OECD/CTPA/GR Conference on Taxing Micro and Small Businesses Manila, Philippines, 2 – 5 March 2010

2. Economic importance of SME • SME potentially the most dynamic sector of economy • SME growth is key for overall economic well-being • SME represents 99% of all companies in EU • In China > 10 million SME representing 99% of total enterprises • Due to their small size and lean structures, SME are potentially more dynamic than big enterprises, which make them particularly important for job creation • But SME are also more vulnerable, lacking often access to capital and to funding sources • SME are suffering from the administrative burden, especially SME doing cross-border business

3. Reducing the Compliance Burden for SME • The compliance burden created by the complexity of tax law and administration is of special concern to SME, and is considered as one of the important factors determining the size of the informal economy • The fixed component of start-up and compliance costs can place SME at a competitive disadvantage, and may also have an adverse distributional impact • Governments must strive to find measures that reduce the compliance burden, without undermining the quality or availability of the information needed to enforce compliance

4. Measures taken by governments • Harmonizing/standardisation of definitions and language in (tax) legislation • Use of single (Tax) Identification Number across government • (Electronic) single business information point delivering government wide information • Reuse of information • Standardisation of electronic information (processes, architecture, infrastructure) • E-filing • Developing new ways of payment (banks, internet, telephone)

5. Trends likely influencing tax compliance of SME taxpayers • Also small companies are becoming increasingly global • International transactions and investments no longer mainly limited to large business • Today even small companies are able to compete and exploit global niche markets • An important driver for this is the internet • Yet small companies face the same complex regulatory tax environment that large companies do, however with much less resources to comply • The scope of the risk of non-harmonized tax regimes and administrative procedures is rapidly widening

6. Micro and Small Businesses However in this presentation the main focus will be on the traditional domestic issues regarding this group of taxpayers Key challenges include: • Large number of taxpayers • High cost of administration • Informal economy • Constantly have new small taxpayers

7. Micro and Small Businesses form a group of particular concern • Micro and small businesses are the major contributors to the cash economy • Compliance risks in this segment differ from other groups of taxpayers such as large business and individual taxpayers • Smaller business are more likely to engage in informal economy activities • Characteristics of this type of non-compliant behaviour include no registration as a taxpayer, no filing of returns, none or poor payment record, underreporting of turnover and profit, and none or poor bookkeeping

8. A substantial cash economy challenges governance in a number of ways • It reduces the legitimacy of the taxation system • It puts a disproportionate burden on the formal sector • It likely has a negative impact on tax compliance in the formal sector • It distorts macroeconomic policy and can reduce economic growth in the formal economy • It threatens the social contract between government and the community

9. Compliance Risk Management approach (reflected in tax administration work at the OECD) • Well-developed compliance risk management processes for the identification, assessment and treatment of major compliance risks for each of the major groupings of taxpayers • Risk assessment approach entails an element of estimating the revenue potential of a particular risk ( e.g. undeclared business income of self-employed persons, over claimed employee work-related expenses) • Once the major risk areas are assessed and prioritized, treatment strategies are developed

10. Complexity of taxpayers’ compliance Academic research………. • Academic research over last two decades has led to increased awareness of the complexity of tax compliant and non-compliant behaviour. • The research has largely shifted from the “persuasion versus punishment” (or service versus enforcement) debate to what is the right mix of the two. SERVICE + ENFORCEMENT = COMPLIANCE • Emphasis on a regulatory model: Attempting co-operation remains the best first choice for achieving compliance in most situations.

11. The enforcement compliance pyramid model- explained • Many factors influence whether a person chooses to meet their obligations: ◊ Business ◊ Industry ◊ Sociological ◊ Economic ◊ Psychological • The model shows a continuum of taxpayer attitudes towards compliance – from taxpayers who have the desired attitude of being willing to do the right thing to taxpayers who have decided not to comply by choosing to evade tax or opt out.

12. The enforcement compliance pyramid model- explained • The model summarizes the different sorts of support & intervention that Tax Administrations need to provide to collect the required revenue. • The model suggests that Tax Administrations have the ability to influence taxpayer behavior through their responses and interaction. • The model suggests that the challenge for all Tax Administrations is to get the right mix or balance of service and enforcement activities across the different populations of taxpayers so that the best outcome may be achieved. ◊ For taxpayers prepared to “willingly comply” this means making it as easy as possible for them to comply. ◊ For taxpayers “not prepared to comply” at all, it means applying the full force of the law. ◊ The end goal should be to have as many taxpayers as possible in the “willing to comply” category.

13. 10 9 8 7 6 5 4 3 2 1 0 Determining treatment strategies –the compliance pyramide Have decided not to comply Use the full force of the law Don’t want to comply but will if we pay attention Deter by detection Level of compliance costs Tries to but don’t always succeed Assist to comply Our strategies aim to create pressure downwards Willing to do the right thing Make it easy to comply Attitude to compliance Compliance strategies

14. Make it easy to comply by providing services Market segmentation: • Delivering taxpayer services: - The same services for everyone? - Or a more targeted / differentiated approach? • Fundamental principle of marketing- know your clients! • Segmentation: - aims to improve the knowledge of clients’ behaviour/ preferences. - breaks down client populations into smaller groups of clients with similar characteristics. - is used to target specific approaches/ products. - is being adopted by tax bodies world-wide for planning purposes.

15. Which channels for which services? • A “channel” is a means of delivering a service (e.g. service counter in tax office, phone, Internet). • Tax Administrations have “”channel” options for their service delivery activities. • Channels vary in their cost and effectiveness, for example: - Electronic filing is cheaper and more effective than paper. - Call centres are likely to be less costly than counter inquiries • Technology is providing new and cheaper channels. • Tax Administrations need to think carefully about how they can optimize their use of the different channels.

16. Measuring satisfaction with taxpayer service • Tax Administrations need to know: - Are we delivering the right services? - To the right taxpayers? - Are our services having a positive or negative impact? - What do we need to improve? • The best way to find answers to these questions is to ask those who need services to properly comply. • Many Tax Administrations seek feedback from taxpayers on their services, often using private research firms.

17. Education and assistance programs targeted at new small businesses Special education and assistance programs for newly registered business aimed at encouraging compliance with the laws as well as making it easy to comply. Examples include: • Provision of simple record-keeping tools • Specialised explanatory materials / guides • Dedicated seminars for starting business • Central help desk for inquiries • Special electronic products

18. Service provision in summery • Make it easy to comply and assist to comply • Self help through use of technology • Outreach and educational products • Enquiry functions • Telephone services • Industry based approaches • Life cycle approaches

19. Identification and registration of taxpayers • The record-compilation function, comprising identification and registration of taxpayers, constitutes an important task for the Tax Administration. • Tax Administrations tend to focus on taxpayers who are already known and listed, but they should also make an effort to include in their tax-return system all persons and companies that have succeeded in escaping their notice. • Management of taxpayers’ records may be divided into three basic functions: creation, updating and deletion.

20. Creating and maintaining registration systems • Initial registration occurs when the taxpayer voluntarily fulfils his legal obligation to file a tax return • A good tax assessment system encourages taxpayer compliance with registration obligations. • Provide the public with clear and comprehensive descriptions of the requirements that lead to registration. • Establish a system to notify all external events with tax implications (setting-up of companies or one-man businesses, transfer of registered offices, start of gainful employment for natural persons, changes of residence, changes of activity, etc. • Cooperate and exchange information with chambers of commerce, municipalities and other law enforcement agencies • Use of unique (Tax) Identification Number (TIN)

21. Actions aimed at detecting non-registration Surveys of potential taxpayers for instance by • physical inspection of business premises and private residences in selected areas, by • visiting starting business, • on the spot checks at markets and other trade locations, • inspection of cars • searching sources of information on economic activities such as newspapers and the internet.

22. Withholding at source • Withholding at source arrangements are generally regarded as the cornerstone of an effective personal income tax system • Obligation on third parties to withhold an amount of tax from payments of income to taxpayers reduces / eliminates their ability to understate such income for tax assessment purposes • Cost efficient both for taxpayers and Tax Administration • Reduces the incidence of unpaid taxes by taxpayers who otherwise would properly report their income but are unable to pay • A small number of countries have extended the use of withholding arrangements to income tax payable on payments made by businesses and others to certain categories of self-employed/contractors/SME

23. Tax Audit General Principles and Approaches The audit programme of a Tax Administration performs a number of important roles: • Promote voluntary compliance • Detect non-compliance at individual taxpayer level • Gather information on the “health” of the tax system (including patterns of taxpayers’ compliance behaviour) • Gather intelligence • Educate taxpayers • Identify areas of the law that require clarification

24. Key principles audit programmes • There should be a comprehensive documented set of audit policies and procedures that is readily accessible to all audit staff • Audit policies and procedures should be based on principles of accuracy, efficiency, fairness, objectivity, transparency, completeness, consistency, and defensibility • Revenue bodies require a systematic approach to the planning of individual audits • Necessary support tools include industry benchmark data, business specific guidance materials, IT facilities, and the use of indirect income measurement techniques

25. Indirect income measurement methods • For many taxpayers there is a considerable risk that some income will not be reported by them in their returns in order to minimise their taxable income. • Especially where it is easy to conceal income, as the income is not subject to any systematic third party reporting to the revenue body and/or it is difficult for auditors to otherwise directly verify such income with third party sources • There is also a risk that expenses against business income may be overstated by taxpayers • There is also a risk of poor quality, or non-existent, books and records

26. Formal indirect methods used by revenue bodies to varying degrees • Source and application of funds method (comparison of expenditures and receipts for the period; the excess of expenditures over the sum of reported and non taxable income is unreported taxable income) • Bank deposits and cash expenditure methods (computing income by showing what happened to a taxpayer’s funds based on the idea that what a taxpayer receives can either be deposited or it can be spent) • Mark-up method (reconstruction of income based on the use of percentages or ratios considered typical for the business under examination)

27. Formal indirect methods used by revenue bodies to varying degrees(2) • Unit and volume method (gross receipts determined or verified by applying the sales price to the volume of business done by the taxpayer; volume might be determined from taxpayers cost of goods sold or expenses) • Net worth method (increases in a taxpayer’s net worth during a taxable year, adjusted for non deductible expenditures and non taxable income, indicate taxable income)

28. When to use a formal indirect method • A taxpayer’s known business and personal expenses exceed the reported income per the return and non-taxable sources of funds have not been identified to explain the difference • Irregularities in a taxpayer’s books and weaknesses in internal control • Gross profit percentages differ significantly from year to year or are unusually high or low for that market • Bank accounts show unexplained items of deposit • A taxpayer does not make regular deposits of income, but uses cash instead • A significant increase in taxpayer’s net worth not supported by reported income • No book and records available

29. Enforcement communication targeted on consumers • Consumers also play a role in cash economy • Explain to consumers the risks of cash deals hiring contractors who don’t issue receipts and don’t prepare contracts (accidents, mistakes, losing advance payments, poor quality or incomplete work and no assurance) • Explain to consumers that if they participate in the underground economy , they affect the governments ability to provide services such as education, health care, pensions and infrastructure

30. The Management of Tax Debt Collection Activities • Growing awareness of importance of the debt collection function • Tax debt collection is an important and integral part of the overall tax administration process • Where taxpayers have difficulty in paying, arrangements can be made to allow taxpayers to pay by instalments. • By designing arrangements for taxpayers personal circumstances and the ability to meet future obligations should be taken into account. • If taxpayers fail too come to an arrangement or fail to comply with arrangements, stronger actions will be required. • These firmer actions include legal proceedings and recovering the debt from bank accounts or from other income sources for instance by using wage garnishments. • Finally the tax administration can start action to effect bankruptcy or liquidation.

31. Risk based monitoring • It is very important for the tax administration to detect timely and monitor continuously taxpayers who have serious difficulties to pay their debt • The development and use of a risk – oriented approach is recommendable.

32. Voluntary disclosure programs • Voluntary Disclosure programmes can be used by tax administrations to encourage people to file and pay their back taxes. • The taxpayer must disclose and pay the entire amount of taxes due (plus interest) by a certain deadline. The taxpayer can (and should) also be asked to sign an agreement to pay and file his taxes on time in the future. • In exchange no penalty or other sanction applied

33. There is a good reason for this quite unique legal rule. • A taxpayer, who once started to underreport, is forced to continue this behaviour to prevent discovering. Voluntary disclosure provides an opportunity for taxpayers to step out this forced ongoing pattern of underreporting and it turns non-compliant taxpayers into compliant taxpayers. • Up till recently the use of the voluntary disclosure regulations was generally initiated by the taxpayer. This has changed. The voluntary disclosure regulations have become a strategic instrument of Tax Administrations. Also in countries where voluntary disclosure is not a legal provision (US), but is based on (published) internal practice.

34. Selected other measures taken by Tax Administrations • Mandatory E-filing for business (Netherlands, US) • Mandatory registration of employees in certain types of business such as restaurants and hairdressers (Sweden) • Electronic invoice systems (Chile) • Standard Business Reporting (Netherlands, Australia) • Mandatory Certified Cash Registers for cash payments (Sweden) • Horizontal monitoring - Building a common tax control framework (Netherlands)

35. In conclusion: • Challenges are significant • Essential to know and understand this particular category of taxpayers, and to have: - effective risk management - the right mix of strategies to improve compliance - cooperation where possible, but also confrontation where needed • To provide tax treatment that is simple and fair.