Selection for and conduct of audit is not ex facie detrimental to the interest of taxpayer, however to exercise such powers; the discretion needs to be structured by framing rules and issuance of policies for ensuring consistency and certainty of procedures; transparency and fairness- Nestle Pakistan Limited etc. Versus Federal Board of Revenue [(2017) 115 TAX 84 (H.C. Lah.)]
Revenue authorities across the world grapple with how to effectively apply their scarce resources to the task of maximizing voluntary tax compliance. The challenge is in knowing where and how to most effectively apply those resources whilst maintaining coverage and visibility in the community - Selecting Cases for Audit-Getting It Right, Margaret E. Cot ton, Asia Pacific Tax Bulletin, International Bureau of Fiscal Documentation (IBFD)
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.
The role of a revenue authority is to collect, and in some cases redistribute, the government's revenue. To maximize collection, the revenue authority is tasked with maintaining and improving voluntary compliance across the taxpaying populace. Rarely do revenue authorities have access to all the resources necessary to achieve this mandate and therefore they make selection and allocation decisions based on a compliance risk management approach. Typically this is achieved through a mix of assistance, education and enforcement activity.
Case selection for audit is about the effective and efficient use of the total resources the revenue authority has determined will be applied to audit or enforcement activity. There is little point auditing the same cases year after year if each year there is no, or a very minor, discrepancy. Similarly there is little point auditing tax returns on a "first in, first audited" basis as the second to last tax return filed might be the " big one".
Simply stated, good case selection leads to more effective audits which lead to more voluntary compliance and ultimately collection of more revenue. Good case selection also assists with maintaining the integrity of the revenue authority by overtly showing that the tax machinery is focusing on the right cases, thereby reducing allegations of corruption and bias. If the wider taxpaying populations consider the revenue authority is acting without fear or favour, voluntary compliance is enhanced. To achieve these aims audit activity should operate in a risk managed environment. This enables those taxpayers who are thought to be high compliance risk to be identified and understood so audit responses can be directed at those risks and tailored in such a way so as to address the risk identified. This requires the revenue authority to build and maintain a good understanding of the taxpaying community taking into account the changing local and international environments.
The revenue authorities in Australia and New Zealand have successfully adopted compliance-based models that rest on the premise that the better the authority understands why taxpayers are not complying with their obligations the better the authority can develop appropriate and proportionate responses. The more that is known about the factors (business, industry, sociological, economic and psychological) that influence the behaviour of a taxpayer or group of taxpayers, the more accurately a revenue authority can apply appropriate resources to that taxpayer or group of taxpayers to influence their compliance behaviour.
Unfortunately, Federal Board of Revenue (FBR) has never bothered to study the models of various countries where the above state approach has been adopted. Thus, it has failed to devise executable tax audit model, efficient operational apparatus, pragmatic educational and enforcement policies, a tax intelligence system and operational framework capable of promoting voluntary compliance and optimizing revenue collection. Resultantly, the number of income tax return filers in Pakistan is not only pathetically low but has steadily declined during the last many years.
FBR needs to understand that compliance strategy recognizes the benefits of economies of scale. The more taxpayers who are in the "willing to do the right thing" category, the less resources proportionately are needed to ensure their continuing voluntary compliance. Thus resource can be deployed at the top of the triangle where there is greater revenue risk and a more expensive one-on-one approach is required to drive voluntary compliance.
Whether there are 200, 2,000 or 2 million taxpayers in a country, the aim of case selection remains the same, ie, to narrow down the possible non-compliers across the entire population that could be audited into a sample of the population most likely to exhibit the highest risk to voluntary compliance. This requires some sort of systematic filtering and prioritizing exercise. Using a systematic selection process provides transparency of process and shows that selection of cases for audit is based on quantifiable evidence and not on an ad hoc or prejudicial basis.
A systematic selection process also enables risks to be better understood thereby allowing more appropriate responses to be tailored to the risk presented. Where risks span fiscal years early identification allows planning opportunities around risk responses and staff development beyond the current financial year. Further, if risks are identified and quantified but current resources do not allow those risks to be addressed approaches can be made to stakeholders and donor agencies supported by this same information.
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, it could not persuade the people towards 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 an unrealized dream. In 2004, the World Bank and other international donors provided funding of over US$ 100 million for various reforms plans. Five-year Tax Administration Reforms Programme (TARP), however, proved to be a great failure despite its extension for one more year (till 31-12-2011). On the completion of TARP, the World Bank admitted that none of the targets set was achieved.
The voluntary tax compliance has been at the core of reform agenda under TARP. But it was disliked by tax officials from the very beginning. They wanted to retain existing discretionary powers for self-aggrandizement. 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 assessments on surmises and conjectures or by indulging in fishing inquiries.
FBR in the past 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, section 25(2) of the Sales Tax Act, 1990 and section 46(1) of the Federal Excise Act, 2005-see judgement of Lahore High Court reported as Chenone v Federal Board of Revenue & Others [2014 PTR 17 (High Court Lahore)=2012 PTD 1815], which is now overruled in ICA 855 of 2014. The order in ICA says: "We are convinced, in light of law laid down by Apex Court in Molasses Trading and Fecto Belarus Cases that meanings given and interpretation made by the Legislature are binding upon the Courts. After the clarification and declaration of Legislative Policy that Commissioner's power to select and conduct audit are independent of FBR's power to select for audit, the binding force of the judgment in Chenone Stores' case has effectively been obliterated".
The issue is not that of powers of FBR and/or Commissioner to concurrently select cases for audit, but finding out a pragmatic model for case selection for meaningful tax audit. 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 several times 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 tax audit work to chartered accountant firms but the experiment failed miserably.
It is important to highlight that in the USA, UK, 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 computerized tax intelligence system or obtained through an independent source.
In Pakistan, FBR did not provide any transparent method for selection of cases for audit under any tax law. It has created distrust and taxpayers invariably contest audit selection in High Courts invoking Article 199 of the Constitution of Pakistan.
(To be continued)
(The writers, lawyers and partners in Huzaima, Ikram & Ijaz, are member Adjunct Faculty of Lahore University of Management Sciences)
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