| The author, a Principal Director of Audit (Direct Taxes), was engaged in conceptualizing strategies for revenue audit for the period 1997-2001, their implementation and monitoring. These efforts resulted in improved public accountability of the internal revenue department, widening of tax base, changes in the successive finance Act, increased revenue realization besides superior audit capabilities of the revenue auditors. As many countries are yet to embark on revenue audit, the reports of the Comptroller & Auditor General of India for revenue receipts submitted to the national General of India for revenue receipts submitted to the national Parliament could provide a framework for undertaking such audits by other countries. |
This paper outlines the strategies for conducting revenue audit in the public sector. Revenue audit assumes great importance for most developing countries and could not be ignored anymore as taxation as an instrument of growth is increasingly used by all. There is a growing realization that tax policies must be tuned for equity and generation of financial resources for development. Role of Auditor General, under such circumstances, cannot be restricted to that of expenditure audit alone. Revenue audit strategies and their implementation in India resulted in substantial changes in the successive Finance Acts, Rules and regulations, prevention of tax evasion and plugging of loopholes in the legislations. The audit reports of the Comptroller & Auditor General of India (C&AG) pointed out tax leakages of more than US$300 billions, conservatively estimated, during last five years. Several billions would be recovered in taxes in future because of audit suggestions and recommendations.
Apart from regularity, compliance and VFM audits, a number of audit investigations were taken up with forensic implications. Innovative use of the information technology was a prime mover in such investigative audits. Audit programmes were designed to uncover several cases of manipulation of legislative intent, unexplained issue of executive circulars and notifications that enabled large-scale evasion of taxes. The findings provided the Government with the opportunities for corrective actions in the tax assessments, tax reforms and improve public governance.
These strategies were developed over a period of time to respond to the changing scenario in the country. This paper states revenue audit strategies with specifics from direct taxation.
Most developed countries have fine-tuned their long term taxation policies and therefore their taxpayers are generally not subjected to frequent changes in the tax rates. For them, whether dynamic scoring should be adopted as against static scoring to determine effect of changes in the tax rates are paramount public issues for debate. The developing countries, on the other hand, have to grapple with issues that could possibly result in increased tax augmentation. 'Frequent change in the tax rates' is definitely not an important issue for them. Typically, the ratio of direct to indirect tax collection in these countries would depend on the stage of development of the economy. It is observed that a less developed country would mostly collect its taxes indirectly, i.e., on production, distribution and transactions, whereas direct taxes, i.e., income tax, corporate tax and wealth tax, are relatively given more importance in developed countries. It may be noted that most of the developing countries have a colonial past. Their colonial rulers, understandably, never attempted to build adequate systems of transparency as regards revenue collection. As a result, these countries have inherited some systems to monitor the expenditure but practically little for the revenue function. The government audit also developed on predictable lines to emphasize accountability of the executive largely for the expenditure. Revenue audit in most developing countries have thus either not started or is only at the nascent stage.
The revenue audit function in developed countries is largely restricted to obtain assurances as to the reliability of the computerized data base management systems. The income tax returns and assessments by the revenue authorities are not as such audited by the Auditor General in most developed countries, but left to the audit wing of the revenue department. However, public debates on tax rates and tax administration is very intense in developed countries while this is absent in developing countries. In the USA, the 'Greenspan debates' on whether excess tax amounts should be refunded to the tax payers and how the refunds be made had full scale discussions in the senate and various public forums.
Broadly speaking, revenue audit strategies would be dependent on the stage of development of respective countries. Indian experience is particularly meaningful in the development of revenue strategies as it is not only relevant for developing countries, but also the developed countries.
The Revenue Audit wing of the Comptroller & Auditor General of India was functional since the early 1970s mainly for assessment based audit. Since each assessment file contained the Income tax return of an individual, corporate entity, trusts, etc., as also the assessment orders of the tax authorities, audit reported on deficiencies noticed in individual files. In the 1980s the limitation of this approach became apparent due to the marginal impact of such audit objections and the partial response of executive to correct only those cases which were taken up in audit. To be fair, revenue officers exerted on timely completion of large number of assessments rather than look at broader perspective of national tax policies.
For them, a few audit objections and that too on a few sections of the Act meant audit validation for their good work. The structure of the revenue department and the public accountability framework, therefore, could not effectively utilize the audit objections for changes in the tax policies. The audit responded to this challenge by introducing systems audit which could effectively utilize assessment based expertise of revenue auditors. It also enabled them to relegate earlier work which was essentially an internal audit function. Several system reviews conducted during the eighties received appreciation for their usefulness.
Shift in strategy: However, 1990s saw emergence of new paradigms in the Indian economy. The country witnessed large scale economic reforms that were accompanied by host of fiscal options being tried out for getting the maximum mileage for rapid economic development. The economy was truly opened up for global interaction whereby predictably importance of traditional sectors was quickly but positively diminished. Multi-national companies, global trade and commerce certainly brought in winds of change but also gave rise to several issues including their taxability. These reforms, evidently, could not bring in increased tax collection. In fact, growth of tax collection when compared to the growth of GDP of the country showed stagnant trend. Similar was the case as regards tax base. Contrary to the perceptions, massive corporate frauds, tax frauds and wide spread tax evasions became nagging issues for the executive. Even Voluntary Disclosure of Income Scheme, an amnesty scheme to unearth unaccounted income, offered in 1997 to the tax dodgers could not achieve its objectives. The circumstances warranted quick changes in the revenue audit strategies to respond to these new developments. And changes could be effected in the backdrop of following major issues.
Intensive planning in establishing revenue audit strategies reinforced and enabled the direct tax wing to address almost all taxation issues during the nineties. A Matrix at Chart no. 1 broadly indicates revenue audit strategies for direct taxation.
CHART 1: MATRIX FOR REVENUE AUDIT STRATEGIES
The strategic proactive revenue audit resulted in reports that generated intense debate in the media and the official circles and examination by the Public Accounts Committee of the Parliament of India. Several legislations were introduced, acts modified, notifications and circulars withdrawn by the government on the basis of the audit reports. The reports also showed the way to widen the tax base and plug revenue leakages.
Laffer curve, simply put, states that no revenues can be generated at either zero% or 100% tax rates. It is no wonder that the whole exercise the world over is on what should be the tax rate between these two extremes. The added concerns of developing countries are many and diverse such as how to use taxation policies for balanced regional growth, ways to ensure equity in taxation tuned to ability to pay taxes, sector specific incentives. The result is a plethora of deductions, incentives in terms of preferential tax rates, concessions for industries, rebates for social service sector such as insurance, transportation, banking, education and exports. These may rightly be called State induced leakages in revenue stream. These are essential elements in growth models and it is difficult to wish them away. However, at the macro level, the main concern of the policy makers is as regards what has been allowed as legitimate 'leakage' and what actually got leaked. This gap is difficult to fathom particularly in developing countries where data collection and analysis are never back-to-back affair with state induced 'leakages'. Revenue department usually never consider these as mainline functions and ignore the need or pay little attention for such analysis. A study of such incentives, exemptions, and deductions is an indispensable strategy in revenue audit.
The revenue authorities in all countries are vested with certain statutory powers for effective tax administration. A number of discretions are contemporaneous with the level of authority and the responsibilities attached to the assessing officers. What one would wish to assess is the impartiality and sagacity with which such discretions are used. Strategies for conducting revenue audit should aim at assessing whether major discretions have been exercised fairly, judiciously and pass the test of reasonableness and prudence.
Keeping in view staff constraints and the need for focused approach in audit, strategies could be finalized. Chart no.2 shows the essential planning that could be attempted for thematic countrywide reviews.
Chart No.2: Selection of topics for thematic countrywide reviews
3.1 Sector analysis
Many developing countries are afflicted by a strong parallel economy where unaccounted income and money distorts the calculation of national income. A recent analysis of amnesty scheme in India revealed that financial sector followed by textile and construction industry had the highest propensity to generate unaccounted income. If one goes by the experience, certain industries do have inherent tendency to evade taxes. For instance, there is a huge unorganized financial market in India which accounts for the large share of unaccounted income in that sector. Different countries may have different experiences depending upon the prevailing circumstances. Even so, it would always pay rich dividends if the revenue audit strategy could be built on these crucial aspects of tax administration through analysis of behaviour of such sectors in tax matters. Whereas precise strategy would be country specific, a few general steps could be as follows:
Study the usual pre-budget Economic Survey for the relevant 'previous year'.
Study the industrial surveys by Chambers of Commerce or other such organizations.
Select the top sectors that have registered high growth. If database available, compare aggregate tax payments with earlier previous years to see if the growth is consistent with the sectoral growth.
Determine the locations that have concentration of such sectors to build evidence of under collection of taxes or under assessment of taxable income.
Select the companies, firms, individuals within such sectors for in-depth study of their tax returns.
A spin off from the implementation of this strategy lies in added assurance to the public auditors that those sectors having the highest audit risk could be adequately examined in audit.
3.2 Growth parameters
National economy of any country could broadly be divided into agriculture, industry, export-import and the services. It's routine for the government to analyze growth parameters for each of them. Revenue audit strategy should also be dovetailed to the study of those segments of economy that have registered considerable growth. Sharp growth in any sector presents not only more possibilities for increased amount of taxes but also more opportunities for tax evasion. Understanding of growth parameters would equip the revenue auditors with clear roadmap for planning for relevant audit strategy. Some of the growth parameters could be found in the following analysis.
Segmental growth analysis of select components of the economy could be attempted. A phenomenal growth of private banking companies and non-banking financial companies in India, for example, was determined through this exercise and revenue audit led to excellent conclusions that occasioned wide spread changes in the Act and also investigations into malpractices in areas other than income tax.
Study of tax growth in select industries particularly for negative trends would lead to firming up audit strategies designed to unearth evasions or innovative tax planning by specific industries using loopholes in the text of the Act or Rules. An excellent example in the Indian scenario was the ingenious case of foreign direct investment in India through the Mauritius based shell investment companies. The Double Taxation Avoidance Agreement between India and Mauritius was effectively used to completely avoid payment of taxes.
Existence of growth of profits should normally accompany higher amounts of taxes payable, and this fact could be the basis for revenue audit exercise. Declining profits, on the other hand, may suggest revenue auditors to keep off such attempts.
Employment growth rate is a useful indicator for devising revenue audit strategies. However, this indicator must be analyzed sufficiently before reaching any conclusions. A declining growth, for example, may indicate recession in that part of the economy or conversely may point towards greater automation.
Growth in exports / imports may indicate yet another area for revenue audit strategies. Most developing countries, for instance, have poor legislations in regard to joint ventures with the companies, firms or association of persons located in other countries. The combined effect of country specific legislations normally results in confusion. Evasion of taxes through mind-boggling tax planning maneuvers in almost all countries is perhaps a rule rather than an exception. Audit of joint ventures in any country, for instance, could beneficially lead to preventing revenue leakages.
3.3 Corporate analysis
Revenue realizations from the corporate world in India almost equal the income tax collections from the individuals. In most countries, few groups generally control the business activities. Mineral rich countries, illustratively, may be dominated by the mining companies, whereas trading companies may hold sway in countries with excellent ports. Reviews aimed at determining taxability issues of such prominent corporate groups would throw up excellent audit results.
Since most of the companies are listed on the stock exchanges, their performance is regularly available quarterly, half-yearly and annually. Several computerized database in the public domain are also available which substantially detail all aspects of individual companies, their inter-corporate comparison, industry ratings, production figures, sales and inventory. Tax provisions and tax payments are also available on such databases. Trend analysis for 5-10 years for each company with reference to industry or group would present important clues on taxability matters. Following additional exercises, if done regularly, may be helpful in the revenue audit.
Individual company profile analysis
Financial newspapers / journals analysis
Central Bank bulletins and statistics.
Stock exchange performance
Figures of sales, inventory, raw materials, power consumption, production and profits when analysed in conjunction with each other for several years, could provide excellent conclusions as to tax evasion or tax avoidance. This strategy, when implemented in India, resulted in recovery of several millions in taxes.
3.4 Database analysis
Emergence of e-governance has shrunk the world to a great extent. Wealth of information is lying today in the electronic form in government organizations, corporate world and with individuals. Data warehouses have been set up in several countries that take care of storage of e-information. Auditors in the public sector need to take due interest in this information. Data mining tools that are simple and user friendly would help in attempting this exercise. Computerized database analysis is an important strategy in conducting the revenue audit as it facilitates intelligent shuffle through the vast information on tax payers and their tax returns.
Corporate database in the public domain is most common and easily available source of information for quick analysis.
Specific computerized database on assesses could be created in the audit department or downloaded from the revenue department. A review on the assessment of Private Hospitals and Nursing Homes in India was done by creating a database through scanning the information available in yellow pages of different cities, registers of Medical Associations, and records of Municipal authorities. The resultant audit findings led to widening the tax base by more than 400,000 assessees.
Database on criminals and those involved in money laundering was effectively used by revenue auditors in India to segregate ineligible declaration forms under tax amnesty scheme.
It is usual for any Commissioner of tax to maintain a well defined database on high tax payers, either manually or in electronic format. This database could be made use of in sampling the cases for audit so as to ensure adequate resource planning and effective audit coverage of major revenues.
Linkages with global databases through data warehouses could be created for effective audit. A known case of tax evader could be linked to several of his associates. For example, directors in a defaulting company could be examined in relation to other companies where they may be associated. Possession of relevant database or adequate access to such database by the auditors would prove immensely useful in finalizing audit strategies.
3.5 Market survey
Market survey may appear illogical at first sight in the quest for better revenue audit. Uncharacteristically, it provides one with excellent tax policy statements that would be readily acceptable. There is no need for the auditors to undertake such surveys, as there are reliable publications from reputed agencies with balanced views. It is no longer a rarity to find good research works on taxation. These are invaluable sources of information to understand tax evasions, growth rates, extent of parallel economy in various sectors, thinking of tax consultants, tax avoidance measures, etc.
Direct surveys conducted by research organizations are precious generic data sources. In India, National Council of Applied Economic Research (NCAER), MARG, National Institute of Public Finance and Policy (NIPFP) are some of the independent organizations that have extensively dealt with issues of public finance including taxation. For example, NCAER conducted direct survey of household incomes, rural and urban, in India. The data generated by this survey could be juxtaposed by the revenue auditors with the data on income tax paid by households. This exercise led to determination of what could be the approximate incomes of households in different income groups and the scale of tax evasion. Having determined the potential tax evasion, a suggestion was made to the Executive to frame appropriate policies to plug the revenue leakages.
Surveys by authors for their books, articles are useful sources of information. For example, assessment of black economy in the country provides important clues on where to concentrate audit efforts.
Surveys by the IT department under the Act are designed to collect information for effective assessment. Usually the department concentrates on 'Business Houses' that control certain industries. Managing agents constitute another group that may be collectively controlling certain companies. The results of such surveys are always useful in deciding revenue audit strategies.
3.6 Revenue department statistics
Revenue departments, generally, maintain statistical wing for preparation of statistics and dissemination of conclusions to field formations and the top management for making policy decisions. Revenue auditors can profitably utilize this source of information, which will go unchallenged by the revenue authorities. Some sources for immediate reference are as follows:
Income Tax department's division for statistics, research and analysis
MIS reports to the top management
Statistical information submitted to the Parliament or Legislative bodies.
One would like to believe that all citizens are honest taxpayers. But unfortunately there is a big gap between reality and belief. It is no wonder that income tax returns are the most imaginative fictions being written today. Inefficient auditing of these tax returns could result in non-detection of fraud, mistakes and leakages of revenues. Whereas reviews on certain broad topics could provide a platform for making changes in the policies and legislation, it is the in depth audit of tax returns that would assure the Legislature of the revenues being collected efficiently, effectively and economically.
In today's environment, this assurance is difficult to provide without adequate expertise. An auditor is expected to know not only the Tax Acts, Rules and Procedures but also be able to relate them to the plethora of case-laws, judgements of the Tax Appellate Authorities, High Courts, and Supreme Court. Divergent views of tax experts, commentaries on legal issues and judgements are other issues that need to be focused for leading-edge audit of assessments.
Characteristically, assessment based audits provide the auditor with validation as to sustainability of his observation. The objection could be relating to either 'over-assessment' or 'under-assessment' of income and consequent effect on taxes. Whatever be the scenario, either the revenue authorities or the taxpayer would be ever ready to contest the audit objection. There is, therefore, no doubt that only professionally conducted audit would result in more revenues for the State and enhance the scope for better response to audit from the executive.
It is the customary function of the Legislative bodies to lay down the Act, and approve the Rules and Procedures framed by the Executive based on such Acts. An elaborate structure of tax administration is normally a part of such legislations. Since all eventualities in the administration of tax laws are difficult to visualize while framing legislations, certain flexibility is always provided for in the Act so that the Executive may ease the rigours of law in deserving cases. These discretions are implemented through the circulars, notifications and clarifications issued by the Board of Revenues and they carry the force of law. Circulars are internal instructions (but in the public domain) from the Board of Revenue to the assessing officers and lay down orders, generally in keeping with the stated statutory provisions, to assess the taxpayers in a particular manner.
Notifications, on the other hand, are issued by the Board of Revenue that may exempt from or include for taxation, certain category, class or types of assesses. They have the legal standing and could be insisted upon by the tax payers in finalizing their tax obligations.
Clarifications are issued by the revenue department to sort out ambiguity in the Act, Rules or Procedures.
Should the Parliament have a right to know about these circulars, notifications and clarifications? Due to the tax implications attached to every circular, notification and clarification, Parliamentary control on the implementation of legislations is an absolute and fundamental right in the scheme of governance. It is therefore imperative that the Legislative body has the option to meaningfully review these circulars, etc. Revenue auditors could provide the legislative body with this important analysis for parliamentary control over executive actions.
Indian Audit experience in the scrutiny of these circulars, notifications, etc., is replete with examples that resulted in prevention of revenue leakages and amendment of Act and Rules. For instance, a circular issued by the Board of Revenue exempted the Foreign Telecasting Companies from the rigours of law and laid down effective rate of tax at 3.65% as against 33% payable by domestic channels. Revenue audit changed all that and the circular was withdrawn, without further leakage of millions of dollars in taxes.
Strategies for auditing the circulars, notifications and clarifications should however, consider certain precautions. These are as follows:
5.1 Relevance: It is not necessary that all circulars have been issued without adequate consideration of facts, disregard for lack of details or with malafide intentions. Analysis of the relevance and the need for such circulars is paramount before challenging them.
5.2 Legality: It is important to check whether notifications or circulars were necessary in the first place and is not covered by existing legislation. If the existing legislation was adequate to deal with the stated situations, there is a case for challenging the circulars, etc.
5.3 Administration issue: Revenue department relies heavily on building up public perception of impartiality of tax administration. Hence, every audit objection suggesting withdrawal, modification or clarification as regards the circulars and notifications is a direct blow on such perceptions. Conversely, audit may receive serious setback if the objections could not be sustained subsequently.
5.4 Scope: The strategy to include this type of audit must be carefully planned based on detailed scrutiny. It may be remembered that the whole edifice of circulars, notifications and clarifications is perched on the fence that sets apart what could be audited and what is beyond the scope of the public auditor. National laws empowering the Auditor General may have to be kept in view.
Tax proposals contained in the Annual Budget are elaborate exercises at balancing the projected revenues and expenditure for the next year. Annual budgets provide the auditors with an excellent roadmap for critical examination of taxation strategies of government. In most countries, annual budget is also critically commented upon by the tax experts, economists and the politicians immediately on release of the papers in the parliament or legislative assembly. Reactions from the specific industry associations, Chambers of Commerce and people at large are important inputs in framing revenue audit strategies.
An interesting example in India was the recent imposition of dividend tax with effect from 1st April 2002 following audit recommendations. Since the budget was presented in Parliament on the 28th February 2002, the Companies could get a clear one month to declare dividends without payment of taxes. A host of other tax planning instruments sprung up overnight to avoid payment of taxes on dividends. The Board of Revenue could deal with the loophole in time thanks to such analysis in their department.
It is worthwhile to keep tab on all provisions in the annual budget that lay down applicability of laws with retrospective effect. In all such cases, there are strong possibilities that these dispensations may be industry group specific or 'house' specific. Additionally, a number of provisions may favour certain group companies at the cost of other groups in the same business.
New forward looking tax proposals normally find place in the annual budget so that the reactions from interest groups could be had by the Executive before these are converted into Act. Issue of transfer pricing in intra-group transactions of Multi National Companies, for example, was debated upon extensively in India before it was introduced as part of the Act. Revenue audit strategy entails evaluation of all such new tax proposals in conjunction with the reactions and their tax impact.
Equity, efficiency and simplicity are the hallmarks of good taxation policy. Inequitable tax rates and policies for their implementation for example could result in large scale litigations and consequent choking of grievance redressal system or flooding of courts with petitions. Such decisions could hardly be called good tax initiatives. Fortunately, since all tax litigations are Section-specific, it is not difficult to measure the impact of changes in the Act. What a revenue auditor needs is reliable and complete statistics for his analysis.
A word of caution is in order with reference to audit of tax policies. It may not be in the realm of Auditor General to question the Policy per se as laid down by the Legislature or Executive. What, however, can be questioned is the failure of the Executive to place before the Legislature, or to consider itself, all relevant facts necessary for framing the policy. Taxation policy issues are many and have different connotations for different countries.
Revenue audit strategies and implementation are important issues in ensuring that taxation laws, policies and their implementation enable revenue collection in an efficient, effective and economical manner through thematic horizontal countrywide audit reviews, assessment based scrutiny of tax returns, evaluation of taxation policies and in-depth study of discretionary circulars, notifications and clarifications. Unlike the expenditure audit, the audit tools are different and have to be proactively employed for effective revenue audit.
Revenue audit presents an awful potential for the Auditor General to secure public accountability of revenue executives through innovative use of computerized database linked audit tools. Excellent conceptualization of strategies and their implementation could enhance audit scope and may result in fine tuning the taxation system of any country. Pioneering work has been carried out by the Comptroller & Auditor General of India and the reports represent high standards through well defined strategies.