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

2. Why Special Treatment to SMEs? Principles of Risk Management
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
Have decided not to comply
Use full force of the law
Taxpayer
Don’t want to comply, but
will if we pay attention
Deterrence by detection
Try to but don’t
always succeed
Assist to comply
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 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

17. Remember: RBA was invented before computerization became common!
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
Australia
Belgium
Canada
Sweden
USA
Construction
Car sales
Transport
Gambling
Hospitality sector
Restaurants
Agriculture
Hairdressers
Health care industry
Hairdressing and beauty salons
Real estate agents
Taxi companies
Medical professions
Cleaning services
Diamond industry
Taxis
Trade in used metals
Clothing and textiles
Dentists
Hairdressing
E commerce
Motor vehicle retailers
E-commerce
Labor providers
Art and antique dealing
Heating oil distributors

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
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%
Example cont‘d: Cleaning Services
Annual 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%

25. 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

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:
The choice of indicators ultimately depends on the degree of fairness desired for the system. While the value of assets and rent paid are less reliable and more prone to negotiations than the other two indicators, they do capture regional and sectoral differences of businesses and thereby help ensure a higher degree of fairness in the system.
Data reliability
Technical challenges
Small sample size
→ Exclusion of doubtful respondents from the sample
→ “working” with data, red-flag approach for different turnover groups

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
Potential
Payment
Deferrers
Unaware
Hidden Economy
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)
Potential Rule Breakers
(23% of SMEs)
Rule Breakers
(7% of SMEs) (+ HE)
Tax Gap)
Negligible
Mainly Error + FTRC
Evasion and Hidden Economy
Aim
Grow/sustain segment. Increase voluntary compliance.
Serve at lowest cost.
Reduce segment size. Reduce error and so encourage voluntary compliance.
Reduce segment size. Improve record keeping
Deter rule breaking.
Increase likelihood and consequences of being caught evading & in HE
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
Firms identifying issue as “major constraint” [%]
Tax rates and tax administration constantly ranked across regions among 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
Short Term:
Reducing of compliance costs (time and financial)
Lowering barriers to formalization
Reducing avenues for corruption
Building capacity of taxpayers and tax administrators
Long Term:
Encouraging formalization and job creation
Widening the tax net, spreading the tax burden
Tax systems that foster good governance
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
Workstreams
Issues addressed
Tools
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
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

40. 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
Vietnam
Pilot project
All workstreams
Sierra Leone
Pilot project
All workstreams
Yemen
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