THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Effective Management of SME Taxpayers: The Role of Risk Based Audit Rajul Awasthi

THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency

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

Rajul Awasthi

Global Tax Simplification TeamManila

March 2010


Contents

1. Why Special Treatment to SMEs?

2. Principles of Risk Management- risk based tax audit for SMEs

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

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1. Why Special Treatment to SMEs?

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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

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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

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These taxpayers are in the regular tax regime and pose a serious management problem


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

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2. Principles of Risk Management

- risk based audit for SMEs

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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’

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A model of tax compliance

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Factors influencing taxpayer behavior

Business Industry

Taxpayer

Sociological Economic

Psychological

Attitude to compliance

Have decided not to comply

Don’t want to comply, butwill if we pay attention

Try to but don’t always succeed

Willing to do the right thing

Audit strategy aims tocreate pressure down

Compliance strategy

Use full force of the law

Deterrence by detection

Assist to comply

Make it easy


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

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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

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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

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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

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

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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

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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

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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!

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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

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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

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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

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Option 2: Business characteristicsA. Identify businesses that are considered most ‘risky’, i.e., prone to tax

evasion

B. 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

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Example: Key Risk Sectors Identified

Australia Belgium Canada Sweden USA

Construction Construction Construction Construction Car sales

Transport Gambling Hospitality sector

Restaurants Construction

Restaurants Transport Agriculture Hairdressers Health care industry

Hairdressing and beauty salons

Car sales Real estate agents

Taxi companies

Medical professions

Cleaning services

Diamond industry

Taxis Trade in used metals

Restaurants

Clothing and textiles

Dentists Hairdressing E commerce Real estate agents

Motor vehicle retailers

E-commerce Labor providers

Art and antique dealing

Heating oil distributors

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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

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Example: Performance Benchmark Bakeries

Annual Sales Range

Ratio Low ($75,000 - $400,000)

Medium ($400,000 - $750,000)

High (More than $750,000)

Cost of goods sold/sales

38% - 46% 32% - 40% 28% - 36%

Labor/sales 0% - 11% 21% - 31% 27% - 33%

Rent/sales 9% - 17% 5% - 11% 3% - 9%

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Example cont‘d: Cleaning ServicesAnnual turnover range

Ratio Low ($50,000 - $150,000)

Medium ($150,000 - $300,000)

High ( More than $300,000

Labor / Turnover 0% - 15% 19% - 41% 33% - 55%


Example cont‘d: Income Guide for Taxi Drivers

Average shifts worked during year 225

Average km per shift 300

Total km travelled 67,500

Cents per km $1.18

Total fares per shift $354

Total fares $79,650

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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


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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


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Summary


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Matching case


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:

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Data reliability

Technical challenges

Small sample size

→ Exclusion of doubtful respondents from the sample

→ “working” with data, red-flag approach for different turnover groups


A simple score sheet for local tax inspectors

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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

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Willing And Able

Payment Deferrers

Potential Payment Deferrers

Potential Rule Breakers

Willing But Need Help

Unaware

Willing and Able(50% of SMEs)

Negligible

Grow/sustain segment. Increase voluntary compliance. Serve at lowest cost.

• 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

Need Help Around Customer Life Events(20% of SMEs)

Mainly Error + FTRC

Reduce segment size. Reduce error and so encourage voluntary compliance.

• 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

Tax Gap)

Aim

How

Hidden Economy

Rule Breakers

The SME Strategy in the UK

Evasion and Hidden Economy

Rule Breakers(7% of SMEs) (+ HE)

Increase likelihood and consequences of being caught evading & in HE

• Improved risk assessment identifies more evaders• Increased consequences for evasion & persistent recklessness• Active post-intervention offender management• Greater prioritisation of compliance debts

HMRC Customer Segment

Potential Rule Breakers (23% of SMEs)

Reduce segment size. Improve record keepingDeter rule breaking.

• 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


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

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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

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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

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Thanks for your attention

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Why Simplify Business Taxation?

Tax rates and tax administration constantly ranked across regions among top 3 “major constraints” for businesses

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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

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Tax Rates Access toFin

Tax Admin. Labor SkillLevel

Transport. BizLicensing &

Permits

LaborRegulations

Firms identifying issue as “major constraint” [%]

Source: Investment Climate Assessments data

Our objective: Smart and simple tax administration and processes to lower the cost of doing business

Highly responsive to macro economic changesCrisis response work and post-crisis preparedness


Meeting Client Demand with KM and Operations

Workstreams

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

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…

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Tools

METR Analysis

Tax Admin Process Mapping

Standard Cost Model (SCM)

Compliance Costs Surveys

Inventory of Fees & Charges

Incentives Review

Profit –Margin Analysis


Sierra Leone

Pilot projectAll workstreams

Pilot projectAll workstreams

Vietnam

YemenPilot projectAll workstreams

Diverse Clients. Tailored Advisory Services

Nigeria

Peru

Nepal

DRC

Burkina Faso

Central Asia Regional Program• Kyrgyz Republic

• Tajikistan

• Uzbekistan

Montenegro

Madagascar

India

Kenya

Rwanda

Tanzania

Lao PDR

Pipeline:• East African Community

(EAC) Initiative

• Bangladesh

Armenia

Georgia


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

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Reforms and Knowledge Management

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 NotesLocal 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

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Recent reforms:

Yemen Streamlined income tax law rewritten and includes both mining and leasing provisions

Design of “smart” and simplified GST procedures.

Sierra LeoneNew VAT rolled out

Incentives reformed

MadagascarReduction of number of taxes from 28 to 14

Tax rates lowered (incl. CIT)

Elimination of redundant taxes

South AfricaRedundant taxes abolished

New SME regime

Reduction in CIT rate => R2 bn in tax relief

RwandaFirst stage of administrative simplification completed

Documents

THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Effective Management of SME Taxpayers: The Role of Risk Based Audit Rajul Awasthi