Auditing SMEs

							                            Organisation for Economic Co-operation and Development




LOOKING BEYOND THE BORDER

Recent developments in Micro and Small
Business taxation in other regions


                          Matthijs Alink
                  Senior Advisor OECD/CTPA/GR

                 Conference on Taxing Micro and Small Businesses
                  Manila, Philippines, 2 – 5 March 2010



                                              Centre for Tax Policy and Administration
            Economic importance of SME

   SME potentially the most dynamic sector of economy
   SME growth is key for overall economic well-being
   SME represents 99% of all companies in EU
   In China > 10 million SME representing 99% of total enterprises
   Due to their small size and lean structures, SME are potentially
    more dynamic than big enterprises, which make them particularly
    important for job creation
   But SME are also more vulnerable, lacking often access to capital
    and to funding sources
   SME are suffering from the administrative burden, especially SME
    doing cross-border business



2
    Reducing the Compliance Burden for SME


   The compliance burden created by the complexity of tax
    law and administration is of special concern to SME,
    and is considered as one of the important factors
    determining the size of the informal economy
   The fixed component of start-up and compliance costs
    can place SME at a competitive disadvantage, and may
    also have an adverse distributional impact
   Governments must strive to find measures that reduce
    the compliance burden, without undermining the quality
    or availability of the information needed to enforce
    compliance

3
         Measures taken by governments

   Harmonizing/standardisation of definitions and language
    in (tax) legislation
   Use of single (Tax) Identification Number across
    government
   (Electronic) single business information point delivering
    government wide information
   Reuse of information
   Standardisation of electronic information (processes,
    architecture, infrastructure)
   E-filing
   Developing new ways of payment (banks, internet,
    telephone)
4
    Trends likely influencing tax compliance of
                  SME taxpayers

   Also small companies are becoming increasingly global
   International transactions and investments no longer
    mainly limited to large business
   Today even small companies are able to compete and
    exploit global niche markets
   An important driver for this is the internet
   Yet small companies face the same complex regulatory
    tax environment that large companies do, however with
    much less resources to comply
   The scope of the risk of non-harmonized tax regimes
    and administrative procedures is rapidly widening
5
            Micro and Small Businesses

    However in this presentation the main focus will be on
    the traditional domestic issues regarding this group of
    taxpayers

    Key challenges include:
   Large number of taxpayers
   High cost of administration
   Informal economy
   Constantly have new small taxpayers


6
    Micro and Small Businesses form a group
              of particular concern

   Micro and small businesses are the major contributors
    to the cash economy
   Compliance risks in this segment differ from other
    groups of taxpayers such as large business and
    individual taxpayers
   Smaller business are more likely to engage in informal
    economy activities
   Characteristics of this type of non-compliant behaviour
    include no registration as a taxpayer, no filing of returns,
    none or poor payment record, underreporting of
    turnover and profit, and none or poor bookkeeping

7
    A substantial cash economy challenges
       governance in a number of ways


   It reduces the legitimacy of the taxation system
   It puts a disproportionate burden on the formal sector
   It likely has a negative impact on tax compliance in the
    formal sector
   It distorts macroeconomic policy and can reduce
    economic growth in the formal economy
   It threatens the social contract between government and
    the community



8
     Compliance Risk Management approach
    (reflected in tax administration work at the OECD)


   Well-developed compliance risk management
    processes for the identification, assessment and
    treatment of major compliance risks for each of the
    major groupings of taxpayers
   Risk assessment approach entails an element of
    estimating the revenue potential of a particular risk ( e.g.
    undeclared business income of self-employed persons,
    over claimed employee work-related expenses)
   Once the major risk areas are assessed and prioritized,
    treatment strategies are developed



9
        Complexity of taxpayers’ compliance
Academic research……….
 Academic research over last two decades has led to
  increased awareness of the complexity of tax compliant
  and non-compliant behaviour.
   The research has largely shifted from the “persuasion
    versus punishment” (or service versus enforcement)
    debate to what is the right mix of the two.

              SERVICE + ENFORCEMENT = COMPLIANCE

   Emphasis on a regulatory model: Attempting co-operation
    remains the best first choice for achieving compliance in
    most situations.
                                                            10
 The enforcement compliance
 pyramid model- explained

    Many factors influence whether a person chooses to meet
     their obligations:
               ◊ Business
               ◊ Industry
               ◊ Sociological
               ◊ Economic
               ◊ Psychological

    The model shows a continuum of taxpayer attitudes towards
     compliance – from taxpayers who have the desired attitude
     of being willing to do the right thing to taxpayers who have
     decided not to comply by choosing to evade tax or opt out.


11
The enforcement compliance
pyramid model- explained

    The model summarizes the different sorts of support & intervention that
     Tax Administrations need to provide to collect the required revenue.
    The model suggests that Tax Administrations have the ability to
     influence taxpayer behavior through their responses and interaction.
    The model suggests that the challenge for all Tax Administrations is to
     get the right mix or balance of service and enforcement activities across
     the different populations of taxpayers so that the best outcome may be
     achieved.
         ◊ For taxpayers prepared to “willingly comply” this means making it
     as easy as possible for them to comply.
         ◊ For taxpayers “not prepared to comply” at all, it
     means applying the full force of the law.
         ◊ The end goal should be to have as many taxpayers
     as possible in the “willing to comply” category.


12
                 Determining treatment strategies –
                     the compliance pyramide
                           Have decided not to            Use the full force
                           comply                         of the law


                Don’t want to
                                                                    Deter by
                comply but will if we
                                                                    detection
                pay attention



          Tries to but
          don’t always
                                                                               Assist to comply
          succeed


       Willing to do the          Our strategies aim to
       right thing
                                    create pressure
                                      downwards                                         Make it easy
                                                                                        to comply
Attitude to compliance                                    Compliance strategies

 13
      Make it easy to comply by providing services

Market segmentation:

    Delivering taxpayer services:
         - The same services for everyone?
         - Or a more targeted / differentiated approach?

    Fundamental principle of marketing- know your clients!
    Segmentation:
         - aims to improve the knowledge of clients’ behaviour/ preferences.
         - breaks down client populations into smaller groups of clients with
         similar characteristics.
         - is used to target specific approaches/ products.
         - is being adopted by tax bodies world-wide for planning purposes.


14
             Which channels for which services?

        A “channel” is a means of delivering a service (e.g.
         service counter in tax office, phone, Internet).
        Tax Administrations have “”channel” options for their
         service delivery activities.
        Channels vary in their cost and effectiveness, for example:
             - Electronic filing is cheaper and more effective than paper.
             - Call centres are likely to be less costly than counter inquiries

        Technology is providing new and cheaper channels.
        Tax Administrations need to think carefully about how they
         can optimize their use of the different channels.

15
 Measuring satisfaction with taxpayer service

        Tax Administrations need to know:
             - Are we delivering the right services?
             - To the right taxpayers?
             - Are our services having a positive or negative impact?
             - What do we need to improve?
        The best way to find answers to these questions is to
         ask those who need services to properly comply.

        Many Tax Administrations seek feedback from
         taxpayers on their services, often using private research
         firms.

16
       Education and assistance programs
        targeted at new small businesses

     Special education and assistance programs for newly
     registered business aimed at encouraging compliance
     with the laws as well as making it easy to comply.
     Examples include:
    Provision of simple record-keeping tools
    Specialised explanatory materials / guides
    Dedicated seminars for starting business
    Central help desk for inquiries
    Special electronic products



17
            Service provision in summery

    Make it easy to comply and assist to comply
    Self help through use of technology
    Outreach and educational products
    Enquiry functions
    Telephone services
    Industry based approaches
    Life cycle approaches




18
         Identification and registration of
                     taxpayers

    The record-compilation function, comprising
     identification and registration of taxpayers, constitutes
     an important task for the Tax Administration.
    Tax Administrations tend to focus on taxpayers who are
     already known and listed, but they should also make an
     effort to include in their tax-return system all persons
     and companies that have succeeded in escaping their
     notice.
    Management of taxpayers’ records may be divided into
     three basic functions: creation, updating and deletion.


19
       Creating and maintaining registration
                    systems

    Initial registration occurs when the taxpayer voluntarily fulfils his
     legal obligation to file a tax return
    A good tax assessment system encourages taxpayer compliance
     with registration obligations.
    Provide the public with clear and comprehensive descriptions of the
     requirements that lead to registration.
    Establish a system to notify all external events with tax implications
     (setting-up of companies or one-man businesses, transfer of
     registered offices, start of gainful employment for natural persons,
     changes of residence, changes of activity, etc.
    Cooperate and exchange information with chambers of commerce,
     municipalities and other law enforcement agencies
    Use of unique (Tax) Identification Number (TIN)

20
     Actions aimed at detecting non-registration


     Surveys of potential taxpayers for instance by
    physical inspection of business premises and private
     residences in selected areas, by
    visiting starting business,
    on the spot checks at markets and other trade locations,
    inspection of cars
    searching sources of information on economic activities
     such as newspapers and the internet.




21
                   Withholding at source

    Withholding at source arrangements are generally regarded as the
     cornerstone of an effective personal income tax system
    Obligation on third parties to withhold an amount of tax from
     payments of income to taxpayers reduces / eliminates their ability
     to understate such income for tax assessment purposes
    Cost efficient both for taxpayers and Tax Administration
    Reduces the incidence of unpaid taxes by taxpayers who otherwise
     would properly report their income but are unable to pay
    A small number of countries have extended the use of withholding
     arrangements to income tax payable on payments made by
     businesses and others to certain categories of self-
     employed/contractors/SME




22
                      Tax Audit
         General Principles and Approaches

     The audit programme of a Tax Administration performs a number of
     important roles:

    Promote voluntary compliance
    Detect non-compliance at individual taxpayer level
    Gather information on the “health” of the tax system (including
     patterns of taxpayers’ compliance behaviour)
    Gather intelligence
    Educate taxpayers
    Identify areas of the law that require clarification




23
          Key principles audit programmes

    There should be a comprehensive documented set of audit policies
     and procedures that is readily accessible to all audit staff
    Audit policies and procedures should be based on principles of
     accuracy, efficiency, fairness, objectivity, transparency,
     completeness, consistency, and defensibility
    Revenue bodies require a systematic approach to the planning of
     individual audits
    Necessary support tools include industry benchmark data, business
     specific guidance materials, IT facilities, and the use of indirect
     income measurement techniques




24
      Indirect income measurement methods

    For many taxpayers there is a considerable risk that some income
     will not be reported by them in their returns in order to minimise
     their taxable income.
    Especially where it is easy to conceal income, as the income is not
     subject to any systematic third party reporting to the revenue body
     and/or it is difficult for auditors to otherwise directly verify such
     income with third party sources
    There is also a risk that expenses against business income may be
     overstated by taxpayers
    There is also a risk of poor quality, or non-existent, books and
     records




25
     Formal indirect methods used by revenue
            bodies to varying degrees

    Source and application of funds method
     (comparison of expenditures and receipts for the period; the excess
     of expenditures over the sum of reported and non taxable income is
     unreported taxable income)
    Bank deposits and cash expenditure methods
     (computing income by showing what happened to a taxpayer’s
     funds based on the idea that what a taxpayer receives can either
     be deposited or it can be spent)
    Mark-up method
     (reconstruction of income based on the use of percentages or ratios
     considered typical for the business under examination)




26
     Formal indirect methods used by revenue
          bodies to varying degrees(2)

    Unit and volume method
     (gross receipts determined or verified by applying the
     sales price to the volume of business done by the
     taxpayer; volume might be determined from taxpayers
     cost of goods sold or expenses)
    Net worth method
     (increases in a taxpayer’s net worth during a taxable
     year, adjusted for non deductible expenditures and non
     taxable income, indicate taxable income)



27
         When to use a formal indirect method

        A taxpayer’s known business and personal expenses exceed
         the reported income per the return and non-taxable sources of
         funds have not been identified to explain the difference
        Irregularities in a taxpayer’s books and weaknesses in internal
         control
        Gross profit percentages differ significantly from year to year or
         are unusually high or low for that market
        Bank accounts show unexplained items of deposit
        A taxpayer does not make regular deposits of income, but uses
         cash instead
        A significant increase in taxpayer’s net worth not supported by
         reported income
        No book and records available


28
     Enforcement communication targeted on
                  consumers

    Consumers also play a role in cash economy
    Explain to consumers the risks of cash deals hiring
     contractors who don’t issue receipts and don’t prepare
     contracts (accidents, mistakes, losing advance
     payments, poor quality or incomplete work and no
     assurance)
    Explain to consumers that if they participate in the
     underground economy , they affect the governments
     ability to provide services such as education, health
     care, pensions and infrastructure


29
     The Management of Tax Debt Collection
                 Activities
     Growing awareness of importance of the debt collection function
     Tax debt collection is an important and integral part of the overall
      tax administration process
     Where taxpayers have difficulty in paying, arrangements can be
      made to allow taxpayers to pay by instalments.
     By designing arrangements for taxpayers personal circumstances
      and the ability to meet future obligations should be taken into
      account.
     If taxpayers fail too come to an arrangement or fail to comply with
      arrangements, stronger actions will be required.
     These firmer actions include legal proceedings and recovering the
      debt from bank accounts or from other income sources for instance
      by using wage garnishments.
     Finally the tax administration can start action to effect bankruptcy or
      liquidation.
30
                Risk based monitoring

    It is very important for the tax administration to detect
     timely and monitor continuously taxpayers who have
     serious difficulties to pay their debt

    The development and use of a risk – oriented approach
     is recommendable.




31
           Voluntary disclosure programs

    Voluntary Disclosure programmes can be used by tax
     administrations to encourage people to file and pay their
     back taxes.
    The taxpayer must disclose and pay the entire amount
     of taxes due (plus interest) by a certain deadline. The
     taxpayer can (and should) also be asked to sign an
     agreement to pay and file his taxes on time in the future.
    In exchange no penalty or other sanction applied




32
     There is a good reason for this quite unique
                      legal rule.
     A taxpayer, who once started to underreport, is forced to
      continue this behaviour to prevent discovering.
      Voluntary disclosure provides an opportunity for
      taxpayers to step out this forced ongoing pattern of
      underreporting and it turns non-compliant taxpayers into
      compliant taxpayers.
     Up till recently the use of the voluntary disclosure
      regulations was generally initiated by the taxpayer. This
      has changed. The voluntary disclosure regulations have
      become a strategic instrument of Tax Administrations.
      Also in countries where voluntary disclosure is not a
      legal provision (US), but is based on (published) internal
      practice.
33
      Selected other measures taken by Tax
                 Administrations

    Mandatory E-filing for business (Netherlands, US)
    Mandatory registration of employees in certain types of
     business such as restaurants and hairdressers
     (Sweden)
    Electronic invoice systems (Chile)
    Standard Business Reporting (Netherlands, Australia)
    Mandatory Certified Cash Registers for cash payments
     (Sweden)
    Horizontal monitoring - Building a common tax control
     framework (Netherlands)


34
                      In conclusion:

    Challenges are significant
    Essential to know and understand this particular
     category of taxpayers,
     and to have:
     - effective risk management
     - the right mix of strategies to improve compliance
     - cooperation where possible, but also
       confrontation where needed
    To provide tax treatment that is simple and fair.


35