Prioritising tax audit

Voluntary compliance under the self assessment system is supervised through the process of audit. Hence audit is an objective exercise with the specific purpose to assess and supervise the universal self assessment scheme at work. Selection for audit is, therefore, a neutral, impartial and equitable function and is dependent on a reliable tax intelligence system-Chenone Stores Ltd v. Federal Board of Revenue etc [2012 PTR 17 High Court Lahore]
Since the promulgation of Income Tax Ordinance, 2001, the Federal Board of Revenue (FBR) has 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 the 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 & Training at Lahore.
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.
There is no innovative audit strategy at national level that can nab the non-filers and counter the underreporting on the part of filers. FBR while maintaining core tax administration responsibilities needs to concentrate on the following key areas for the new audit initiatives:
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 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.
In fiscal year 2016-17, the FBR must start utilising a combination of filters to identify high-risk, high-income returns. The returns selected for desk examination for tax year 2016 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 so far bothered to conduct audit on these lines?
Abusive schemes and promoter investigations FBR must accelerate efforts to combat abusive schemes and scams on the rises that include:
-- Schemes, reducing a person's tax liability by claiming inflated expenses, false deductions, unallowable credits or excessive exemptions.
-- Abusive shelters and trusts, investments established for the purpose of hiding income from taxation. Recent disclosures through Panama and Bahamas Leaks containing names of many Pakistanis confirm the abuse of offshore shelters.
-- Employment tax schemes, employee leasing, paying in cash and filing false payroll tax returns.
FBR must have 'Anti Abusive' and 'Fraud Specialist' teams to systematically monitor the Internet to identify promoters of abusive activities and develops 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 centralized automated enforcement.
-- Outreach and education efforts.
Unreported income Unreported income represents the largest component of the tax gap. FBR must develop a new tool for identifying returns with a high probability of unreported income. The new tool can be known as Unreported Income Discriminant Index Formula (UI DIF). Its details can be seen at the website of Inland Revenue Service (IRS) of USA. All individual returns in USA have traditionally been assigned a DIF score rating the probability of inaccurate information on the return. The new UI DIF score rates the probability of income being omitted from the return. The IRS has customarily used indirect examination methods to identify unreported income but until now has had no systemic method for selecting the returns at highest risk for unreported income. The same method can be used in Pakistan.
UI DIF will give the FBR the ability to systemically identify returns at high risk for unreported income and beginning this fall all returns will receive a UI DIF score in addition to the traditional DIF score.
National Research Programme National Research Programme (NRP) has enabled the IRS to improve the examination selection process. NRP is very different from its predecessor, the Taxpayer Compliance Measurement Program (TCMP) used by IRS earlier. NRP no longer relies heavily on time-intensive, "line-by-line" audits for establishing a baseline measure of reporting compliance. The FBR must learn from IRS experience in this regards.
The FBR has never conducted research on the distribution of errors on returns. Without the information that needs to be gathered through NRP, the FBR will have no ability to direct examinations and other compliance activities with accuracy and precision. With updated information, the NRP effort will prevent thousands of "no change" audits each year. The NRP effort could have reviewed a small, statistically valid sample of individual returns for tax year 2016, less than 50,000 returns business returns filed. The FBR has never thought of such techniques that are prevalent in other parts of the world.
The NRP process should have four main categories:
-- No FBR contact. About 10,000 returns may be checked relying solely on information already available to FBR.
-- Correspondence. These may be less intrusive correspondence exchanges with taxpayers-rather than the old standard of sit-down audits. About 15,000 returns can be included in this process.
-- Less intrusive audits. Instead of the old "line-by-line" examination approach, the FBR may gather more information beforehand and focus only on selected parts of approximately 20,000 returns.
(The writers, lawyers and partners in HUZAIMA IKRAM & IJAZ, are Adjunct Faculty at Lahore University of Management Sciences (LUMS)