risk based audit system for smes ifc

8/3/2019 Risk Based Audit System for SMEs IFC

1/27

Effective Management of SME

Taxpayers:The Role of Risk Based Audit

Kigali, Rwanda

April 23, 2009


2/27

Contents

1. Why Special Treatment to SMEs?2. Principles of Risk Management

- risk based tax audit for SMEs

3. Can we set up a Risk Based AuditSystem in a Non-Computerized TaxEnvironment?


3/27

1. Why Special Treatment to SMEs?


4/27

Special characteristics of SMEs

Largest number of taxpayers (other thanwage earners)

Also, major contributors to informal economyoperating outside tax net

Compliance risk: higher likelihood of taxevasion, operating outside tax net, hiding partof business transactions

Face high costs of compliance relative to theirturnover, profits

Need to overcome hurdles of formalization


5/27

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)

0.0%1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0.15 0.3 0.65 3.5 10

Turnover (in R million)

%

ofturnover


6/27

Compliance costs higher for SMEs -

Example Yemen:% of businesses who paid bribes by size


7/27

Strategy: Segment SMEs

SMEs segmented according to size (defined byturnover, number of employees, assets, capitalbase, etc.)

Micro enterprises left out of tax net equivalent to threshold for personal tax

Small businesses in a special Small BusinessTax regime, eg., a turnover tax regime

Vast majority of business taxpayers usuallyabove VAT threshold and under large taxpayerthreshold

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


8/27

A different law of large numbers

Large number of SME cases in the taxnet:

Rwanda: Large taxpayers 300Medium sized 1,200

Small sized 15,000Informal Sector (estimated 60,000)

Effective control and deterrence compliance management

tax audit

Good taxpayer service timely refunds

help with compliance


9/27

2. Principles of Risk Management

- risk based audit for SMEs


10/27

Role of Audit

Detect and redress individual cases ofnon-compliance with tax law

Promote voluntary compliance

Focus on high-risk taxpayers

Help tax administration learn aboutshare of non-compliant taxpayers in total

taxpayer baseEstimate tax gap


11/27

Business Industry

Taxpayer

Sociological Economic

Psychological

Factors influencing taxpayer behaviorAttitude to compliance

Have decided not to comply

Dont want to comply, butwill if we pay attention

Try to but dontalways succeed

Willing to do theright thing

Audit strategy aims tocreate pressure down

Compliance strategy

Use full force of the law

Deterrence by detecti

Assist to compl

Make it ea

A model of tax compliance


12/27

Compliance management in SMEs

For those SMEs that are willing to do theright thing and try but dont succeed, make iteasier to comply

For those SMEs that dont want to complybut will if we pay attention provide strongdeterrence through effective audit

But, given large numbers and othercharacteristics, risk based audit is the most

appropriate method


13/27

Methods of Audit

Manual screening by local officersAuditors decide on cases: high risk of corruption

Not a systematic method, hence some non-compliance can bemissed

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 selectionIdentify those taxpayers who are most likely to be non-compliant

Use of risk-scoring techniques and taxpayer profiling


14/27

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


15/27

Objectives of Risk Based Audit

Select the most risky cases for detailed audit get most bangfor 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

Reduce interface between tax inspectors and taxpayers


16/27

3. Can we set up a Risk Based AuditSystem for SMEs in a Non-Computerized Environment?


17/27

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 auditsystem

Appropriate legal provisions in tax code


18/27

The tax administration may be operating in a rudimentary ITenvironment

The regional offices operate on Local Area Networks, thatmay or may not be linked to the headquarters

Tax returns are not processed online; office audit is done

manually for all tax returns to checkprima facie errors andomissions

The database may only have basic taxpayer information, and

can not be used for developing software based applications

State of computerization of tax administration

in developing economies


19/27

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 anenvironment without a sophisticated IT infrastructure in place

Remember: RBA was invented before computerizationbecame common!


20/27

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


21/27

1. Organizational Arrangements

Set up a Central Audit Committee at the top managementlevel in the tax authority which will lay down objective selection

criteria

Set up an Audit Cell at each tax office mandated to analyzereturns and select those that need to be audited based on objectivecriteria

Audit Cell to prepare a list of cases by business category; list tobe 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


22/27

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

Two options -Criteria can be based on:

Compliance characteristics of taxpayer

- behavior of taxpayer in terms of complying withthe tax law

Business characteristics of taxpayer

- indicators of true declaration of profits / income


23/27

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 asrisky based on compliance characteristics to be laiddown


24/27

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 othertaxes/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


25/27

Option 2: contd

B. For each risky business category, select two or three keybenchmarksof 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 materialconsumption, sales receipts related to fuel consumption,

Amount of tax refund claim

=>Determining benchmarks specific to the country


26/27

3. Develop Audit Capacities in Tax Inspectors

Ability to analyze accounts and taxable transactions to determinetrue 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, customsand VAT regulations, civil and criminal law

=>Training and capacity building of tax inspectors


27/27

4. Outreach programs for taxpayers and privatesector

Publicize tax law and regulations relating to risk based audit

system

Conduct workshops and seminars illustrating provisions of thesystem

Involve private sector and tax authority in jointly disseminatinginformation

=>Knowledge is power: taxpayers must know they can

only be audited if they do not comply with the tax law

risk based audit system for smes ifc

Documents