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

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?

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

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

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

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 Attempt to close the ‘tax gap’

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

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

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

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

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

Simple Risk Based Audit for SMEs – even in a less sophisticated IT 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

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!

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

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

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

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

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

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

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%

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

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

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

Summary

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: 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

A simple score sheet for local tax inspectors

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

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

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

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

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

Thanks for your attention

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

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

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

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

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