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Pragmatic case selection model for audit – II

In Nestle Pakistan Limited etc. v Federal Board of Revenue [(2017) 115 TAX 84 (H.C. Lah.)], Lahore High Court held that “FBR shall rectify the defects pointed out, hereinbefore, in the impugned Audit Policy 2015 and in the policies to be issued in future. Following directions shall be read and incorporated in the rules or policies:

* A taxpayer selected and audited in preceding tax year/period shall not be selected and audited without giving reasons for such selection. FBR shall enhance its capacity to audit a selected taxpayer for last five years to give respite from consecutive selections.

* Audit, being administrative proceedings, shall be completed on issuance of Audit Report. If audit is not completed within the given time frame, the selection shall be deemed to have been dropped. After issuance of Audit Report; adjudication proceedings shall be carried out by some other taxation officer to satisfy command of the Constitution under Article 10A.

* After selection for audit, any demand for increase in payable tax to drop audit proceedings is not only against the scope and spirit of audit but is in violation of the provisions relating to audit under the Federal Taxing Statutes as well.

* The audit shall be conducted in accordance with “Income Tax Manual Part V” and “Sales Tax Audit Hand Book” and such procedure for conduct of audit shall be incorporated in the Rules for Selection and Conduct of Audit.

* Remedy against any grievance, regarding selection or conduct of audit, under Section 7 of FBR Act, 2007 shall, henceforth, be read as part of every Audit Policy and its procedure is directed to be incorporated in the Rules for Selection and Conduct of Audit.

* The decision, directions and observations made in this judgment shall be followed while implementing the impugned Audit Policy 2015 and future audit policies”.

The Lahore High Court in its order of November 17, 2017 in ICA 855 of 2014 [Federal Board of Revenue v Chenone Stores Ltd and Others] has once again cautioned the FBR that:

* We are in agreement with the observation in Chenone Stores’ judgment that ‘even though the Commissioner may be the best person in the system to identify a tax default, he cannot enjoy unguided discretion’.

* It has already been declared in Media Network’s Case [(2006) 94 TAX 293(S.C. Pak)] that Commissioner shall give criteria/reasons in the notice for selection.

* Following the laid down law, first proviso to the Section 177(1) requires that reasons shall be given by the Commissioner before calling the record for audit. Yet in our opinion, his discretion to call for record to conduct audit need to be structured for avoiding its potential misuse. This discretion should not be used to call a taxpayer consecutively to meet budgetary targets of collecting tax. In subsection (7) of the Section 177, though the legislature has authorized audit of a taxpayer in the next and following tax years but only where there are reasonable grounds for doing so. These reasonable grounds need to be confronted, in addition to the reasons for selection required under the first proviso.

* Commissioner can call for last six years record for audit, as is deducible from the second proviso, therefore, collective reading would show that the Legislature deprecates, as a rule, selection or calling for record of a taxpayer every year. Calling for record in the next or following year should be in exceptional circumstances on very sound reasons.

* Commissioner’s discretionary power to select cases for audit must be structured.

Besides providing a transparent audit policy, FBR has also miserably failed to prioritize 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 penalizing persons claiming refunds. FBR has yet not come out of conventional methodology of ignoring or protecting tax evaders and punishing those who file returns though may not be reporting their correct incomes. Priority should have been to first nab 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.

FBR needs to adopt a rational audit strategy representing a new direction for its compliance effort. It 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.

FBR can learn a lot from recent initiative on the part of Internal Revenue Service (IRS) of the 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 programmes 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 a new way of doing business at 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 organization 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 cooperation and coordination should be under way on initiatives that involve both civil actions and criminal investigations.

For the five new areas mentioned above, FBR may direct more examination resources to address these issues. However, FBR may maintain a presence in other audit areas to maintain core tax administrative 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 income on these returns requires an examination. 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 the 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

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 called Unreported Income Discriminant Index Formula (UI DIF). Its details can be seen at the website of Internal Revenue Service (IRS) of USA.

All individual returns in the US 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 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) examinations measure reporting compliance and identify compliance issues. 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. FBR must learn from IRS experience in this regards.

FBR has never conducted research on the distribution of errors on returns. Without the information that needs to be gathered through NRP, 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 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 8,000 returns may be checked relying solely on information already available.

* Correspondence. These may be less intrusive correspondence exchanges with taxpayers – rather than the old standard of sit-down audits. About 9,000 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.

Senator Saleem Mandviwalla in a statement [Mandviwalla terms FBR’s audit policy disaster for tax system, Business Recorder, January 7, 2017] said that FBR had failed “to squeeze the neck of 0.7 million high net wealth individuals, despite having their complete records”. While lambasting the audit policy of FBR, he said that it was unfortunate that out of 0.9 million taxpayers, only 0.1 million would be on FBR’s radar through its audit exercise.

He said that FBR’s audit policy would prove a tool to harass honest taxpayers of the country, which would encourage more taxpayers to escape from the tax net. He alleged that FBR was busy in threatening and harassing existing taxpayers through raiding their offices and issuing notices to them almost every day.

He further said that due to inefficiency of FBR, the rich and mighty “are enjoying every facility in the country, they are living in luxury villas, travelling abroad every month, their children are studying abroad and they have a bank balance of billions”. He urged the FBR to revisit its audit policy in order to provide maximum relief to the registered persons, who were being neglected since long.

This year, despite spending huge money on media campaigns “threatening non-filers” instead of “public awareness campaigns” and extending the deadline for filing income tax returns up to December 15, 2016, the FBR received about 850,000 returns, half the number of returns it received in 2008. The latest figure is also below 1.25 million whereas ten years back total returns filed were 2.5 million. In a decade, there is decrease of 100% in filers of returns. One wonders if our policymakers have ever studied the approach of Inland Revenue, UK that involves community participation. The following methodology and brief review of their voluntary compliance programme can be an eye-opener for FBR high-ups:

Voluntary compliance

A developing and important aspect of our relationship with the businesses for which we are responsible is the support we can provide to help them to comply with their responsibility to submit accurate returns. Where businesses or partners experience compliance problems, for instance the need for repeated, and maybe extensive, enquiries and amendments to their tax computations, we want to work with them to correct the problems. This sort of co-operative work can be extremely beneficial to businesses, partners and the Inland Revenue alike by limiting the number of enquiries raised, reducing the risk of unexpected and possibly significant extra tax liability and ensuring that attention is properly focused on the most complex and significant issues. By working with groups in this way, we aim to foster a more positive working relationship and reduce the areas of disagreement between business and the Inland Revenue. We wish to encourage businesses and partners to raise and discuss with us any area where they wish to develop their compliance performance. We aim for our part to let businesses know when we see compliance problems we think can be solved by working together.

Our compliance review process

We build on the success of our pilot programme that promotes real-time working and is based on establishing open and co-operative working methods between groups and Large Business Office [LBO] case teams by agreeing timetables and protocols with over 50 more groups. We now work with around 75 groups in this way. We aim to continue to put in place this type of approach with appropriate groups as it is clear there are real benefits to both parties. If you would like to explore whether this approach is right for your business contact your case team who will be able to provide more details. In addition, LBO case teams will be looking at how groups approach the various aspects of tax compliance and discussing their conclusions with the groups to see if it is possible to agree areas for improvement, by either the group, or the case team as appropriate. This may in some cases lead to working arrangements on a more real-time basis along the lines discussed above, but may also be the catalyst for both sides tackling a specific area of difficulty or dispute that has not been resolved by the normal exchanges.

While business community and tax bars have rejected FBR’s Audit Policy for 2016, there are serious apprehensions about competence and capacity of tax officials to conduct scrutiny of 93,277 cases selected through parametric computer balloting on January 6, 2017. It is reported that these “audit cases will be handled by an officer cadre in the grade of 17 and 18, in addition to dealing with those pending of the previous years, according to officials in the FBR. At present, there are only 755 sanctioned posts in the grades 17 and 18 and out of them 651 are filled”.

According to FBR, “The ‘Audit Policy’ 2016, has proposed a paradigm shift from the past. Its focus has been realigned from random to parametric selection and from general to risk based approach. This approach will minimize chances of selection of compliant tax payers resulting in increased confidence in the system. This new trend in taxpayers’ audit will not only promote compliance with the existing tax laws but will also generate increased revenues through better declarations for better public spending by the Government. The right audit approach will help FBR in broadening the tax base and in focusing on high risk areas. This can be assured though equitable tax policies where a taxpayer knows that good citizens are appreciated”.

Record of FBR speaks poor performance in the last fiscal year, as officers could not increase collection through audit or creating demand otherwise. Collection on demand in 2015-16 was just Rs 87.9 billion, which was Rs 27.6 billion less than the immediately preceding year.

Scope and purpose of audit

Under the Audit Policy 2016, for tax year 2015, 93,277 cases have been selected for audit in respect of six categories, namely, Income tax (Corporate) 2,173, Income Tax (Non-Corporate) 82,090, Sales Tax (Corporate) 987, Sales Tax (Non-Corporate) 7,976, Federal Excise Duty (Corporate) 30.

The Lahore High Court in its judgement dated 09.01.2017 in the case of Nestle Pakistan Limited etc. Versus Federal Board of Revenue [[(2017) 115 TAX 84 (H.C. Lah.)] for Audit Policy 2015 has held that “State has a right to audit; corresponding to taxpayer’s duty to make correct declarations and comply with the statutory commands under three Federal Taxing Statutes. 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”.

According to a report, “It is not surprising that an overwhelming number of tax audits are conducted in haste and are perfunctory,” noted the Tax Reforms Commission (TRC). It said that there was a serious lack of capacity to perform any type of meaningful tax audit both at the Head Quarters and at field formations. The TRC has recommended that a specialised but an independent unit should be created to conduct the audit. The government did not implement this recommendation”.

FBR has miserably failed to introduce any tax intelligent computerized system, despite the fact that it has a market-wage oriented company, Pakistan Revenue Automation Limited (PRAL), at its disposal, to monitor the economic activities of corporate/business sectors. Meaningful audit policy cannot be enforced without establishing automated Tax Intelligence System. The widest possible taxpayer base has to be identified for any tax to be equitably spread across the whole taxpayer population. Even a small tax at a lower rate spread over a wide taxpayer base will invariably yield more revenue than a higher tax on a narrow base. How can Pakistan succeed in raising the number of return filers and encouraging voluntary compliance when it has no information/intelligence system/unit to maintain the taxpayer roll?

Tax Intelligence System is the area that should be given the first priority in improving tax compliance and efficacy of audit. As far back as 1958, Professor Stanley S. Surrey of the Harvard Law School pointed out the advantages of building up a comprehensive taxpayer roll:

The beginning of tax administration lies in seeing that the taxpayers are on the tax rolls. Unless the tax authorities know who are the individuals or units subject to the tax, the whole machinery of administration must necessarily function with incomplete coverage of the taxable area… The important tasks are to select among the various sources only those which promise to be productive of names likely to be taxpayers under the tax in question (thus in some places telephone books may be very useful, while elsewhere these lists may contain only more non-taxpayers than taxpayers); to gather only so much information as can be efficiently processed; and to devise an efficient system for correlating the selected information in a continuously current form usable for enforcement purposes.

A concept of expenditure-income (“ex-income”) flows should be developed to create a system that can collect and process information needed by field formations rather than work with what they passively receive. The concept of flows of income, capital, goods, services, etc. within an economy is common in economic theory. It is the basis of the value added tax system, whereas in Pakistan we are implementing it without the support of reliable Tax Intelligence System. Goods and services are monitored as they flow from one person to another and one person’s expenditure becomes another’s income. This concept is at the core of building a Tax Intelligence System.

For intelligence purposes, whether the expenditure or income (ex-income) is of revenue or capital nature, is not significant. What is important is the ability to trace one person’s income from another’s expenditure or vice versa by identifying both sides of a financial transaction. These flows could be recorded by monitoring streams of activity like that which cascades from governmental capital expenditure down to private contractors, subcontractors, employees, wholesalers, importers and finally out of the country to foreign suppliers. Once the main flows of ex-income in the economy are identified it is possible to select points at which the information relating to persons and their transactions in that flow could be gathered.

In Pakistan, the major flows are relatively easy to map, as its main source of economic activity is “imports”. The flow of “imports” can be monitored through the computerization of all points of customs where “imports” are handled. Once the exincome stream reaches the contractors, it is a little more difficult to trace. It spreads out through many channels in a wide delta of economic activity. Tax Intelligence system should be able to track some sections of this flow by examining the records of government departments and other large institutions, for which statutory amendments are required in various laws, especially the Banking Laws protecting even criminal financial transactions.

From the Department of Customs, it is possible to monitor the imports of goods that enter the country and travel up this delta to wholesalers and retailers that service the large pool of householders and others that are active in the economy. Intangible imports such as management or professional services by offshore companies can also be traced independently through bank records wherever necessary.

Income flowing into the hands of employees can be recorded through the Tax Withholding System. Other centres of information like that of the Registrar of Motor Vehicles, the Registrar of Deeds, and various agricultural authorities and revenue boards etc. set up by government, can provide information to track rental, transport or agricultural ex-income that are not part of the major flows. Information in respect of offshore transactions and suppliers could be accessed using double tax agreements where possible and appropriate.

One important feature of the Tax Intelligence System should be its recognition of ex-income flows. Under the existing system, each piece of information received is followed up without checking whether the data is significant. This is a reactive approach that leads to an enormous amount of unsolicited, uncontrollable and unmanageable work. Once the main sources of ex-income are identified the scarce resources of FBR can be deployed fruitfully in areas that have the greatest chance of producing positive results. Voluntary compliance can only be ensured through ways and means discussed above. The reliability of tax machinery, stability of tax laws, low cost of compliance, timely dispensation of justice and respect of taxpayers’ rights are prerequisites of this process.


(The writers, lawyers and partners in Huzaima, Ikram & Ijaz, are member Adjunct Faculty of Lahore University of Management Sciences)

Huzaima Bukhari and Dr Ikramul Haq, "Pragmatic case selection model for audit – II," Business Recorder. 2017-12-17.
Keywords: Tax