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

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Presentation on theme: "THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Effective Management of SME Taxpayers: The Role of Risk Based Audit Rajul Awasthi."— Presentation transcript:

1 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Effective Management of SME Taxpayers: The Role of Risk Based Audit Rajul Awasthi Global Tax Simplification Team Manila March 2010

2 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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? 2

3 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 1. Why Special Treatment to SMEs? 3

4 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Special characteristics of SMEs Largest number of taxpayers (other than wage earners) Largest number of taxpayers (other than wage earners) Also, major contributors to informal economy operating outside tax net 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 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 Face high costs of compliance relative to their turnover, profits Need to overcome hurdles of formalization Need to overcome hurdles of formalization 4

5 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Strategy: Segment SMEs SMEs segmented according to size (defined by turnover, number of employees, assets, capital base, etc.) 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 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 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 Vast majority of business taxpayers – usually above VAT threshold and under large taxpayer threshold 5 These taxpayers are in the regular tax regime and pose a serious management problem

6 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency A different law of large numbers Large number of SME cases in the tax net Large number of SME cases in the tax net High compliance risk High compliance risk – Effective control and deterrence – Compliance management – Tax audit Good taxpayer service Good taxpayer service – Timely refunds – Help with compliance 6

7 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 2. Principles of Risk Management -risk based audit for SMEs 7

8 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Role of audit Detect and redress individual cases of non-compliance with tax law Detect and redress individual cases of non-compliance with tax law Promote voluntary compliance Promote voluntary compliance Focus on high-risk taxpayers Focus on high-risk taxpayers Attempt to close the tax gap Attempt to close the tax gap 8

9 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency A model of tax compliance 9 Factors influencing taxpayer behavior Business Industry Taxpayer Sociological Economic Psychological Attitude to compliance Have decided not to comply Dont want to comply, but will if we pay attention Try to but dont always succeed Willing to do the right thing Audit strategy aims to create pressure down Compliance strategy Use full force of the law Deterrence by detection Assist to comply Make it easy

10 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 – through provision of good taxpayer service For those SMEs that are willing to do the right thing and try but dont succeed, make it easier to comply – through provision of good taxpayer service For those SMEs that dont want to comply but will if we pay attention provide strong deterrence through effective audit For those SMEs that dont 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 Given large numbers and other characteristics, risk based audit is the most appropriate method 10

11 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Methods of Audit Manual screening – by local officers 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 Random selection –Stratified sampling better representation of taxpayer strata –No bias in audit selection –High opportunity cost of auditing – go errors Risk-based selection Risk-based selection –Identify those taxpayers who are most likely to be non-compliant –Use of risk-scoring techniques and taxpayer profiling 11

12 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Core Principles of Risk Based Audit Trust, but verify Trust, but verify Self-assessment of taxes Self-assessment of taxes Equity – honest, compliant taxpayers treated with respect, non- compliant taxpayers treated with severity Equity – honest, compliant taxpayers treated with respect, non- compliant taxpayers treated with severity Taxpayer service orientation Taxpayer service orientation Promote a tax culture of voluntary compliance Promote a tax culture of voluntary compliance – tax system is based on trust – taxpayers self-assess their taxes 12

13 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Objectives of Risk Based Audit Select the most risky cases for detailed audit – get most bang for the buck 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 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 Reduce interface between tax inspectors and taxpayers Better use of resources of tax authority 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 Lower cost of tax collection 13

14 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 3. Simple Risk Based Audit for SMEs – even in a less sophisticated IT Environment? 14

15 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 15

16 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency State of computerization of tax administration in developing economies The tax administration may be operating in a rudimentary IT environment 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 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 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 The database may only have basic taxpayer information, and can not be used for developing software based applications 16

17 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Core objectives of RBA – Select the most risky cases for detailed audit Select the most risky cases for detailed audit Case selection based on objective criteria Case selection based on objective criteria Better use of resources of tax authority Better use of resources of tax authority Lower cost of tax collection Lower cost of tax collection Promote a tax culture of voluntary compliance 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! 17

18 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency A simple risk based audit system for SMEs in a low-IT-sophistication environment Steps: Lay down objective criteria for case selection Lay down objective criteria for case selection Develop audit capacities in tax inspectors Develop audit capacities in tax inspectors Outreach programs for taxpayers Outreach programs for taxpayers 18

19 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 19

20 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Option 1: Compliance characteristics Irregularity / delays in filing returns Irregularity / delays in filing returns Irregularity / delays in making tax payments 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 20

21 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Option 2: Business characteristics A. 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 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 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 21

22 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Example: Key Risk Sectors Identified AustraliaBelgiumCanadaSwedenUSA Construction Car sales TransportGamblingHospitality sector RestaurantsConstruction RestaurantsTransportAgricultureHairdressersHealth care industry Hairdressing and beauty salons Car salesReal estate agents Taxi companies Medical professions Cleaning services Diamond industry TaxisTrade in used metals Restaurants Clothing and textiles DentistsHairdressingE commerceReal estate agents Motor vehicle retailers E-commerceLabor providers Art and antique dealing Heating oil distributors 22

23 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 23

24 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Example: Performance Benchmark Bakeries Annual Sales Range RatioLow ($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/sales0% - 11%21% - 31%27% - 33% Rent/sales9% - 17%5% - 11%3% - 9% 24 Example contd: Cleaning Services Annual turnover range RatioLow ($50,000 - $150,000) Medium ($150,000 - $300,000) High ( More than $300,000 Labor / Turnover0% - 15%19% - 41%33% - 55%

25 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Example contd: Income Guide for Taxi Drivers Average shifts worked during year225 Average km per shift300 Total km travelled67,500 Cents per km$1.18 Total fares per shift$354 Total fares$79,650 25

26 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 28 Summary

29 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 29 Matching case

30 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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: 30 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 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency A simple score sheet for local tax inspectors 31

32 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 32

33 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 33 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 p ost- intervention offender management Greater prioritisation of compliance debts HMRC Customer Segment Potential Rule Breakers (23% of SMEs) Reduce segment size. Improve record keeping Deter rule breaking. 1-to-many interventions Business assurance visits to improve record keeping (FTRC) Visible d eterrence marketing Tougher debt sanctions for SMEs who dont engage More effective, risk- based debt approach

34 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 34

35 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Develop audit capacities in tax inspectors 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 Analysis of financial statements Financial ratio interpretation and application Financial ratio interpretation and application Knowledge and awareness of complexity and loopholes of tax law Knowledge and awareness of complexity and loopholes of tax law Ability to obtain and use external information sources 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 Knowledge of other relevant laws, e.g., corporate law, customs and VAT regulations, civil and criminal law =>Training and capacity building of tax inspectors 35

36 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Outreach programs for taxpayers and private sector 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 Conduct workshops and seminars illustrating provisions of the system Involve private sector and tax authority in jointly disseminating information 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 36

37 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Thanks for your attention 37

38 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Why Simplify Business Taxation? Tax rates and tax administration constantly ranked across regions among top 3 major constraints for businesses 38 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 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 changes Crisis response work and post-crisis preparedness

39 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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… 39 Tools METR Analysis Tax Admin Process Mapping Standard Cost Model (SCM) Compliance Costs Surveys Inventory of Fees & Charges Incentives Review Profit –Margin Analysis

40 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency Sierra Leone Pilot project All workstreams Pilot project All workstreams Vietnam Yemen Pilot project All 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

41 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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: Sanaa, 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 41

42 THE WORLD BANK World Bank Group Multilateral Investment Guarantee Agency 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 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 42 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


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