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Auditing SMEs

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					                            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


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    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
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       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
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          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


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     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
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    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.

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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.
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                  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

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       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.
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              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
15       how they can optimize their use of the different
         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



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         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.
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     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)
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     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
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                  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)


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     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
30    bankruptcy or liquidation.
               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



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     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)
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                    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.


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