Improving voluntary tax compliance - I

The Inland Revenue is here to ensure that everyone understands and receives what they are entitled to and understands and pays what they owe, so that everyone contributes to the UK's needs - slogan on website of Inland Revenue Service of United Kingdom. Unlike many other countries of the world, Pakistan's apex revenue authority Federal Board of Revenue (FBR) has never bothered to launch a well-designed voluntary tax compliance programme.
It also failed in creating an effective deterrence in the form of a reliable tax intelligence system - a prerequisite for the success of voluntary tax compliance regime. Resultantly, the number of persons filing income tax returns in Pakistan is pathetically low. During the last many years, FBR has miserably failed to broaden the tax base, counter tax evasion and avoidance, increase the number of return-filers, use modern tax audit tools and tap the real tax potential. The failure of FBR is on two counts; firstly it has failed to collect taxes from where these are actually due thus paving the way for enormous black economy and secondly could not persuade the people for voluntary tax compliance. This has created a malevolent social malady ie social injustice where the rich and mighty are enjoying life whereas the overwhelming majority is being pushed below poverty line.
An effective tax audit system is essential to maximize voluntary tax compliance. All the developed tax administrations possess sophisticated tax intelligence systems in place enabling them to enforce voluntary tax compliance. Duplicating a similar system for developing administrations is not optimum due to the lack of basic systems and skilled staff. Countries like Pakistan need a model that combines the best of a developed administration's practices with the flexibility that allows it to be used regardless of the size of an administration and skill of staff.
In Pakistan, the tax reform process remains unrealized dream. In 2004, the World Bank and other international donors provided funding of over US $100 million for various reform plans. Five-year Tax Administration Reforms Programme (TARP), however, proved to be a great failure despite its extension till 31-12-2011 and more money pouring in from abroad. On the completion of TARP, the World Bank admitted that none of the targets set was completed.
The voluntary tax compliance has been at the core of reform agenda under TARP. But it was disliked by the tax officials from the very beginning. They wanted to retain existing discretionary powers for self-aggrandisement. They were not ready to accept the idea of voluntary compliance backed by strong deterrence audit and tax intelligence system. Therefore, instead of creating an effective tax intelligence system to enforce voluntary tax regime, they resorted to discretionary audits and frequent amendments.
They tried to unsettle the declared versions of taxpayers without having any definite information. They amended the assessments on surmises and conjectures or by indulging in fishing inquiries. They lost a large number of cases in courts as taxpayers successfully challenged abuse of powers under sections 177, 122(5) and 122(5A) of the Income Tax Ordinance, 2001.
Global comparison of tax audit provisions, procedures and practices with those adopted in Pakistan shows that FBR has never bothered to provide a transparent selection process based on any intelligible differentia to provide benchmarks that are intrinsically linked with risk areas. From tax year 2003 onwards, FBR selected cases under section 177 (this section was amended numerously and substantially since its inception) of the Income Tax Ordinance, 2001 without any regard to law and established international principles relating to tax audit.
FBR also tried to outsource the tax audit work to chartered accountant firms but the experiment failed miserably. It is important to highlight that in the US, the UK, the Eurozone, Scandinavia, Japan, Singapore and many other developed tax administrations, the main emphasis is on selecting cases for audit on the following two bases:
1. Benchmarks are provided for each year on websites before the filing of returns. Any case falling in any of the benchmarks is automatically selected for audit. There is neither any discretion nor any discrimination involved in the audit selection process. It makes the selection process universally acceptable and transparent.
2. Special audit is done in cases where any definite information is generated by computerised tax intelligence system or obtained through an independent source. In Pakistan, FBR did not provide any transparent method for selection of cases for audit. It created distrust and taxpayers contested audit selection in High Courts invoking Article 199 of the Constitution of Pakistan. In these writ petitions, the vires of law as well as administrative arbitrariness were successfully challenged.
FBR also miserably failed to prioritise its audit resources to focus on key areas of tax non-compliance, tax fraud, high-risk, high-income taxpayers and unreported income. On the contrary, its audit selection criteria aimed at harassing existing taxpayers without having any tenable evidence of tax fraud, underreporting or non-compliance against them. Their only fault is that they have claimed refunds, which FBR does not like to pay as it has negative impact on its so-called "record" revenue collection.
The purpose behind any tax audit is always to check potential cases of non-compliance or tax fraud rather than threatening the existing taxpayers or to penalise the persons claiming refunds. The FBR has yet not come out of conventional methodology of ignoring or protecting the tax evaders and punishing those who file returns though may not be reporting their correct incomes. The priority should have been to first nab the non-filers and then go after those who underreport their incomes. Audit, if not backed by a reliable 'Tax Information Integrated System', will never be effective. The FBR needs to adopt a rational audit strategy representing a new direction for its compliance effort. The FBR must conduct research and planning to work out a new approach that could focus on high-risk areas of non-compliance.
The audit policy of apex revenue authority must aim at new and enhanced efforts on several priority areas, including:
--- High-risk, high-income taxpayers.
--- Abusive schemes and promoter investigations.
--- High-income non-filers.
--- Unreported income.
--- The National Tax Research Programme.
Increased resources for audits - also known as examinations - should be devoted to these areas, which should be declared as a year of transition and training as new audit cases to be selected from returns accepted under section 120 of Income Tax Ordinance, 2001. The Regional Tax Offices (RTOs) and Large Taxpayers Units (LTUs) must be equipped to handle the new audit assignments in these key areas affecting individuals and businesses. Compliance and widening of tax base efforts should also be reconsidered with starting a national tax research programme at the Directorate General of Research and training.
The FBR can learn a lot from recent initiative on the part of Internal Revenue Service (IRS) of United States in this direction that reflects part of a broader, agency-wide plan. This strategy places a top priority on pursuing promoters of abusive schemes, shelters and trusts and then identifying participants in these efforts to evade taxes. To address these problems, the IRS has revamped its compliance programs to refocus on problem areas. The IRS is using a full scope of tools and techniques ranging from summons enforcement, injunctions and criminal investigation of promoters to civil audits of participants.
The new audit strategy must reflect the new way of doing business at the FBR as well, but till today it is completely missing. Several of these efforts - such as the National Research Programme and the credit card initiative - need to reflect innovative approaches to tackle long-standing tax problems. And the FBR's reorganization must allow key parts of the organisation to work together in ways they didn't previously. For example, the new audit initiative must include similar emphasis for the FBR's collection area. And new levels of co-operation and coordination should be under way on initiatives that involve both civil actions and criminal investigation.
For the five new areas mentioned above, the FBR may direct more examination resources to address these issues. However, the FBR may maintain a presence in other audit areas to maintain core tax administration responsibilities. Additional exam resources can help meet this requirement.
Key areas for the new initiative must include:
HIGH-RISK, HIGH-INCOME TAXPAYERS High-income returns are often more complex and, generally, upper income taxpayers have resources to engage in pass-through entities such as partnerships, trusts and corporations. Even utilising FBR's various matching programmes, income and deductions from such activities are more difficult to verify.
FBR needs to match returns from pass-through entities, the technique does not provide any verification of income reported by the entity itself. Verifying the income on these returns requires an examination. The FBR must start utilising a combination of filters to identify high-risk, high-income returns. The returns selected for desk examination should be those most likely to have unreported income or structured transactions. The idea to examine all of them will be sheer wastage of resources. A structured transaction is one with limited economic benefit and whose primary purpose is to reduce or eliminate a tax liability. Structured transactions are generally done through one or more pass-through returns. The pass-through returns create paper losses that flow back to individual income tax returns offsetting income from other sources. FBR has not even bothered to conduct audit on these lines.
ABUSIVE SCHEMES AND PROMOTER INVESTIGATIONS FBR must accelerate efforts to combat abusive schemes and scams on the rise that include:
--- Schemes, reducing a person's tax liability by claiming inflated expenses, false deductions, unallowable credits or excessive exemptions.
--- Frivolous return arguments, telling taxpayers that compliance is voluntary or the Constitution does not provide for tax collection.
--- Abusive shelters and trusts, investments established for the purpose of hiding income from taxation.
--- Employment tax schemes, employee leasing, paying in cash and filing false payroll tax returns.
Abusive Scheme Groups are being established in each Area and the use of Fraud Specialists must increase. To identify and address promoter activity, a Promoter Lead Development Center needs to be created. The Center must systematically monitor the Internet to identify promoters of abusive activities and develop cases for injunctive investigations.
HIGH-INCOME NON-FILERS The FBR's efforts to address non-filers must focus on the most egregious and high-risk segments of the population. The non-filer strategy should be pursued on many fronts:
--- Re-engineered processes and work streams to improve efficiency and productivity.
--- Identification and expedited assignment of the most egregious non-filers.
--- Expanded and centralised automated enforcement. Outreach and education efforts.
(To be continued)