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Effective Management of SME Taxpayers:

The Role of Risk Based Audit


Kigali, Rwanda April 23, 2009

Contents
1.

2.
3.

Why Special Treatment to SMEs? Principles of Risk Management


- risk based tax audit for SMEs

Can we set up a Risk Based Audit System in a Non-Computerized Tax Environment?

1. Why Special Treatment to SMEs?

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

Compliance costs higher for SMEs Example South Africa:


Compliance Burden for preparation of tax returns as a percent of turnover (firms registered/not registered for VAT; mandatory at R300,000)
6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 0.15 0.3 0.65 3.5 10 Turnover (in R million)

% of turnover

Compliance costs higher for SMEs Example Yemen:


% of businesses who paid bribes by size

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 are a management problem

A different law of large numbers Large number of SME cases in the tax net:

Rwanda: Large taxpayers 300 Medium sized 1,200 Small sized 15,000 Informal Sector (estimated 60,000)

Effective control and deterrence


compliance management tax audit

Good taxpayer service


timely refunds help with compliance

2.

Principles of Risk Management - risk based audit for SMEs

Role of Audit
Detect and redress individual cases of non-compliance with tax law Promote voluntary compliance Focus on high-risk taxpayers Help tax administration learn about share of non-compliant taxpayers in total taxpayer base Estimate tax gap

A model of tax compliance


Factors influencing taxpayer behavior
Attitude to compliance
Have decided not to comply

Compliance strategy
Use full force of the law

Business

Industry
Dont want to comply, but will if we pay attention

Deterrence by detectio

Taxpayer
Sociological Economic Psychological
Try to but dont always succeed

Assist to comply

Willing to do the right thing

Make it eas

Audit strategy aims to create pressure down

Compliance management in SMEs


For those SMEs that are willing to do the right thing and try but dont succeed, make it easier to comply

For those SMEs that dont want to comply but will if we pay attention provide strong deterrence through effective audit

But, given large numbers and other characteristics, risk based audit is the most appropriate method

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 noncompliant Use of risk-scoring techniques and taxpayer profiling

Core Principles of Risk Based Audit

Trust, but verify of taxes

Self-assessment

Equity honest, compliant taxpayers treated with respect, noncompliant 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

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

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 interface between tax inspectors and taxpayers

Reduce

3.

Can we set up a Risk Based Audit System for SMEs in a NonComputerized Environment?

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

State of computerization of tax administration in 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

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!

A simple risk based audit system for SMEs in a non-computerized environment

Steps:

Set up appropriate organization arrangements Lay down objective criteria for case selection Develop audit capacities in tax inspectors Outreach programs for taxpayers

1.

Organizational Arrangements

Set up a Central Audit Committee at the top management level in the tax authority which will lay down objective selection criteria Set up an Audit Cell at each tax office mandated to analyze returns and select those that need to be audited based on objective criteria

Audit Cell to prepare a list of cases by business category; list to be approved by the head of the tax office

Make publicly known the cases finally approved for audit by prominently displaying the list on a notice board in the tax office

2. Lay down objective criteria for case selection (to be done by Central Audit Committee) 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

Option 1: Compliance characteristics


Irregularity / delays in filing returns Irregularity / delays in making tax payments

Cases with these characteristics to be taken up for audit Detailed methodology for categorizing a taxpayer as risky based on compliance characteristics to be laid down

Option 2: Business characteristics


A. Identify businesses that are considered most risky, i.e., prone to tax evasion 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

=>Identification of tax evasion prone businesses

Option 2: contd
B. For each risky business category, select two or three key benchmarks of non risky tax behavior

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

=>Determining benchmarks specific to the country

3.

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

4.

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