Countering sales tax frauds

Globally, tax crimes have always been a significant threat to economic stability and governance. These offences that include tax evasion, fake invoicing, refund fraud, and misreporting of income, lead to substantial revenue losses undermining the effective functioning of public institutions.

Governments are deprived of essential resources required for investment in infrastructure, education, healthcare, and other critical public services. Besides direct financial impact, when these illicit practices are widespread or unchecked, they erode public confidence in fairness of the tax system thus discouraging voluntary compliance and increasing the overall cost of tax administration.

Pakistan has made some progress in combating tax crimes. The Federal Board of Revenue (FBR) has undertaken initiatives to modernize tax administration, including digitizing processes and using automated systems to reduce opportunities for fraud. However, challenges persist, particularly in managing the large informal sector and enhancing coordination among agencies involved in tax enforcement.

Real-time monitoring systems and rigorous auditing practices have yielded some success, but sustained efforts are required to close loopholes and ensure compliance. To maximize effectiveness, Pakistan’s strategy must continue to focus on technology-driven solutions and foster collaboration with international partners to combat tax evasion and fraud comprehensively. Building a transparent, resilient, and responsive tax system is pivotal to ensuring sustained economic growth and equitable development.

Eliminating fake/flying invoices and addressing sham carry-forward input tax is critical to improving tax compliance and revenue collection in Pakistan. A multi-faceted approach is required to tackle these problems effectively. Firstly, implementing advanced data analytics and Artificial Intelligence (AI) can help detect unusual or suspicious patterns in invoices.

By comparing transaction data with known benchmarks and using algorithms to flag inconsistencies, tax authorities can quickly detect fraud. Secondly, integrating a comprehensive electronic invoice system that requires real-time reporting of sales transactions to FBR can significantly curb the issuance of fake invoices. This system ensures that all transactions are recorded and traceable, minimizing opportunities for manipulation.

Stricter Know Your Customer (KYC) policies for businesses registering for sales tax purposes should also be enforced by ensuring through vetting companies that only legitimate entities can generate tax invoices. Furthermore, penalties for issuing or using fake invoices should be more stringent. These could include heavy fines, suspension of tax privileges, or even criminal prosecution for repeat offenders.

Regular audits and surprise inspections by tax officials should be conducted to ascertain compliance. Public awareness campaigns could help in educating businesses and the public about risks and consequences of fraudulent practices. Collaboration with financial institutions to monitor and trace payments linked to fake invoices could add another layer of accountability. If effectively enforced, all these combined measures could substantially reduce tax frauds in Pakistan.

Sales tax frauds, particularly within developing economies, are responsible for inefficiencies in regulatory oversight and gaps in digital integration. Fraud schemes, including the creation of fictitious companies, manipulation of invoice values, and the use of “flying invoices”, emphasize the need for advanced digital systems that ensure transparency, traceability, and authenticity of tax records.

In Pakistan, there is increasing use of shell companies/entities for generating fake invoices for claim of input tax credits and reduce legitimate tax liabilities. These entities do not conduct actual businesses but exist solely to facilitate fraudulent activities.

Real-time digital invoicing with integrated reporting mechanisms is essential to combat such entities. By requiring businesses to submit invoices electronically and in real-time, tax authorities can immediately verify the legitimacy of transactions, with unique QR codes, each invoice can be tracked back to its origin, providing an immediate verification tool for businesses and consumers.

Similarly, businesses underreport their taxable revenue by issuing invoices at lower values than the actual sale price, a practice known as under-invoicing that can be countered through automatic data cross-verification systems that compare invoices with buyer and seller records in real-time. In case of discrepancies, alerts can be triggered for further investigation. E-Invoicing systems can validate price points against standard market values, preventing businesses from undervaluing goods or services.

Another form of fraud involves invoices that do not correspond to actual transactions—flying invoices. This occurs when a business uses legitimate invoices from other entities to claim tax deductions without engaging in any real business transaction.

Prevention requires direct confirmation of the transaction between the buyer and the seller via an online portal and implementing a buyer acknowledgment process to confirm receipt of goods and services. Additionally, a system that tracks each invoice uniquely will prevent it from being used multiple times or “flown” between different entities, ensuring that each invoice is only processed once.

Fabricating input claims is another prevalent form of fraud, where businesses create fake purchase records to claim tax deductions. This can be mitigated through a two-way verification system ensuring that both the buyer’s and seller’s records align with the submitted invoices. To prevent such claims, it is critical that tax authorities only allow deductions for invoices issued by verified, registered suppliers, with transactions tracked along the entire supply chain.

A particularly insidious fraud involves withholding of invoices from filing, allowing businesses to evade sales tax obligations by failing to submit some invoices. Real-time invoices address this issue by making sure that all invoices are automatically submitted to tax authorities.

Failure to report an invoice triggers an alert, preventing businesses from withholding sales from tax filing. Additionally, inventory audits can cross-reference reported sales against stock levels to detect discrepancies indicative of unreported transactions.

The key to mitigating fraudulent activities lies in the integration of digital invoicing systems with licensed integrators, which provides a transparent, auditable record of each transaction, making it difficult for businesses to engage in fraud.

The real-time nature of these systems, combined with automatic validation and verification protocols, greatly enhance tax authorities’ ability to detect and prevent fraud at an early stage. Expanding the use of these systems and ensuring that businesses comply with digital invoicing requirements could significantly reduce opportunities for fraud.

Countries such as India and Turkey have successfully implemented digital invoicing systems to combat sales tax fraud. In India, the Goods and Services Tax (GST) system integrates e-invoicing for real-instantaneous reporting and verification of transactions. This has drastically reduced tax fraud as tax authorities can cross-check invoices with taxpayers’ records and identify inconsistencies.

Similarly, Turkey’s robust e-invoicing system integrates with other tax reporting systems, providing a comprehensive view of business transactions. These systems have proven highly effective in minimizing fraudulent activities by making it more difficult for businesses to falsify records or engage in deceptive tax practices.

On the contrary, Pakistan’s approach to digital invoicing remains underdeveloped. Despite introduction of three key Statutory Regulatory Orders (SROs) to promote E-invoicing for sales tax, implementation has been sluggish, and the system lacks full integration for real-time, automated verification of transactions. FBR’s reliance on its 100 percent owned company, Pakistan Revenue Automation Limited (PRAL) has proven ineffective due to inefficiency, incompetence, corruption, and lack of modern infrastructure. PRAL’s capacity to monitor and enforce tax compliance remains limited.

Licensing requirements for digital invoicing systems in India and Pakistan reflect distinct regulatory frameworks and operational challenges. India’s licensing requirements are stringent, focusing on technical capabilities and financial stability. Service providers must meet performance benchmarks, demonstrate compliance with data security laws, and ensure customer support infrastructure. In contrast, Pakistan’s licensing requirements are less prescriptive, focusing mainly on technical capacity and basic regulatory compliance.

Reliance on PRAL highlights a fundamental problem with FBR’s approach to digital invoicing. The system is overly centralized and lacks flexibility and scalability required to accommodate the growing demands of a digital economy. The solution lies in expanding the digital invoicing ecosystem by incorporating licensed integrators capable of handling actual reporting, validation, and cross-verification.

These integrators would serve as intermediaries between businesses and tax authorities, ensuring that all transactions are legitimate, traceable, and compliant with tax laws. Integrators should be held accountable for any lapses in their systems, with penalties for non-compliance or failure to detect fraud.

Copyright Business Recorder, 2024