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Selection for tax audit – II

It is important to highlight that in USA, UK, Euro zone, 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. This has created distrust and taxpayers invariably contest audit selection in High Courts invoking Article 199 of the Constitution of Pakistan. 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 2018 117 Tax 17 (H.C. Lah)] 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. Structuring of discretion, liable to be misused, has been ordained by Supreme Court of Pakistan in Amanullah Khan and others v. The Federal Government of Pakistan through Secretary, Ministry of Finance, Islamabad and others (PLD 1990 SC 1092), Government of NWFP through Secretary and 3 others v. Majee Flour Mills (Private) Limited (1997 SCMR 1804), and Muhammad Amin Muhammad Bashir Limited v. Government of Pakistan through Secretary Ministry of Finance, Central Secretariat, Islamabad and others (2015 SCMR 630).

In this judgement, Lahore High Court while giving historic view of selection of a case for audit has made the following significant observations:

“Historic overview of Commissioner’s power to select for audit, the controversy, in backdrop of the changes in relevant law, is necessary. Every attempt to select and audit the tax affairs, after self-assessment, was subjected to litigation since erstwhile Income Tax Ordinance, 1979 (“Repealed Ordinance”). Challenge to selection for total audit, by Regional Commissioner, of returns filed under Self-assessment Scheme was laid to rest through judgment in Commissioner of Income Tax and others v. Messrs Media Network and others (2006) 94 TAX 293 (S.C. Pak.). Policy guidelines, issued by the then CBR, after filing of returns under the Self-assessment Scheme, were challenged, contending that the guidelines should have been issued before filing of returns under Self-assessment Scheme. Single Bench of this Court allowed the writ petitions, however, on appeal, the selection was upheld with the findings that the guidelines, being administrative in nature, had not taken away any vested right. Infringement of the principle of natural justice, claimed by taxpayer’s side was answered by holding that it was not mandatory during the course of preliminary inquiries or investigations. Relevant excerpts are reproduced:

“22. … … The C.B.R. specifically directed that before making a final selection, the Regional Commissioners of Income Tax must confront the assessees, provide them opportunity of being heard and must indicate the basis of their proposed selection in the notices to be communicated to them. These guidelines were administrative in nature meant for the internal consumption of the Income Tax functionaries which did not create any rights nor did they impose any obligations. Those instructions had not taken away any vested right of the assessees and would not govern the adjudicatory proceedings of quasi-judicial in nature. However, it could not be said that the guidelines were, in any way, extraneous, irrelevant or unfair to the object to be achieved by the process of selection of cases for total audit. In our view, the procedure of selection of cases for total audit as provided by paragraphs 9 and 10 of the Scheme was not nullified or whittled down by the policy guidelines, dated 17-12-2002.”

“26. The rules of natural justice are not inflexible. They yield to and change with the exigencies of different’ situations. They do not apply in the same manner to situations which are not alike. These rules are not cast in a rigid mould nor can they be put in a legal strait-jacket. They are not immutable but flexible. They can be adopted and modified by the Statutes. The need to act in an emergency may also exclude at least a prior hearing or where a decision affects so many people that a hearing would be impracticable. In some cases there may be collective right, of hearing, or to be consulted although not necessarily a hearing in individual cases. Depending upon the facts and circumstances of each case, there is no mandatory requirement of natural justice that in every case the other side must be given a notice before preliminary steps are taken. It might suffice if reasonable opportunity of hearing is granted to a person before an adverse action or decision is taken against him. However, it is not possible to lay down an absolute rule of universal application governing all situations as to the exclusion or otherwise of the audi alteram partem rule during the course of preliminary inquiries or investigations.”

Besides providing a transparent audit policy as apparent from above judgment of Lahore High Court, 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 controversies related to selection of cases for audit without any defined parameters through computer ballot or manual selection by the Commissioner have finally been settled by the Supreme Court of Pakistan in its judgement dated 13 March 2018. In this judgement (not approved for reporting), the apex court has held:

“The basic requirement for any scheme of self-assessment and audit is to provide a system of checks and balances and ensure that the taxpayer in whom the system reposes confidence acts justly, fairly and transparently. At the same time upon selection he is dealt in an even-handed, impartial and transparent manner whereunder he shall be granted ample opportunity to justify, substantiate and defend the information provided in the return that he voluntarily filed…..we are also convinced that a general timeframe is necessary to put in place in order to ensure that the tool of the audit is not abused or misused to pester, torment or harass the taxpayer on account of reasons not attributable to him…..Adherence to guidelines and timeframes would enhance confidence of the taxpayers in the system and at the same time act as a check on lethargy and inefficiency on the part of department functionaries”.

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. 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.

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.

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 underway on initiatives that involve both civil actions and criminal investigation.

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.

Huzaima Bukhari and Dr. Ikramul Haq, "Selection for tax audit – II," Business recorder. 2018-09-23.
Keywords: Economics , Large Taxpayers Units , Independent source , Chenone Stores , Policy guidelines , Consecutive selections , Transparent manner , PLD , SCMR , NWFP