Audit sans sensibility

The Inland Revenue is here to ensure that everyone understands and receives what they are entitled to and understands and pays what they owe, so that everyone contributes to the UK's needs, says a slogan on the website of Britain's Inland Revenue Service.Unlike tax agencies of many other countries of the world, the Federal Board of Revenue (FBR) has never bothered to devise an efficient operational apparatus, pragmatic audit policies, a tax intelligence system and an operational framework capable of promoting voluntary compliance and optimizing revenue collection. Resultantly, the number of income tax return filers in Pakistan is not only pathetically low but has steadily declined for the last many years.
The FBR has failed to broaden the tax base, increase the number of return-filers and tap the real tax potential. The failure of the FBR is on two counts: firstly, it has been unable to collect taxes from where these are actually due, thus paving the way for the country's enormous black economy; and secondly, it could not persuade people to adopt voluntary tax compliance. This has created a malevolent social malady; i.e., social injustice where the rich and mighty are enjoying life while the majority is being pushed below the poverty line. Adding insult to injury every now and then amnesties are given that also fail to produce desired results.
Senator Saleem Mandviwalla said in a statement (Mandviwalla terms FBR's audit policy disaster for tax system, Business Recorder, January 7) that the FBR had failed "to squeeze the neck" of the 700,000 high net wealth individuals, the this despite of its having their complete records. Lambasting the audit policy of the FBR, he said that it was unfortunate that out of 900,000 taxpayers, only 100,000 would be on the FBR's radar through its audit exercise.
Mandviwalla termed the FBR's audit policy "a disaster for the tax system of the country". This audit policy, he said, 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 the FBR was busy threatening and harassing taxpayers, raiding their offices and issuing notices to them almost every day.
This year, despite spending a huge amount of the money on media campaign threatening non-filers instead of public awareness campaigns and extending the deadline for filing income tax returns up to December 15, the FBR received about 850,000 returns, half the number of returns it received in 2008. In eight years, there is a decrease of 100 percent in filers of returns, yet the Finance Minister makes claims of the FBR's "extraordinary performance". One wonders if our policymakers have ever studied the approach of Britain's Inland Revenue 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 cooperative 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 focussed 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 cooperative 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 the business community and tax bars have rejected the FBR's Audit Policy for 2016, there are serious apprehensions about the competence and capacity of tax officials to conduct scrutiny of 93,277 cases selected through parametric computer balloting on January 6. 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".
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 [Writ Petition 32597 of 2015] 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 the 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".
In 2016, FBR officers could not increase collection through audit or creating demand. Collection on demand in 2015-16 was just Rs 87.9 billion, which was Rs 27.6 billion less than in the preceding year.
"It is not surprising that an overwhelming number of tax audits are conducted in haste and are perfunctory," noted the Tax Reforms Commission. It said that there was serious lack of capacity to perform any type of meaningful tax audit both at the headquarters and at field formations.
The FBR, according to available data and indicators, is one of the most inefficient, incompetent and corrupt arms of the government. Responsible for the collection of federal taxes, the FBR has failed to introduce a computerized intelligent system, despite the fact that it has a market-wage oriented company, Pakistan Revenue Automation Limited, at its disposal, for monitoring of the economic activities of corporate/business sectors.
On the policy level, the government always seems to be keen to protect tax evaders, not to provide effective deterrence to the evasion. According to reports, the Finance Minister wants to extend a "facility" to those who have their assets stashed abroad. This soft corner towards tax evaders in the wake of the Panama Leaks is astonishing when the case is sub judice in the Supreme Court.
While large-scale tax evasion and the existence of a large black economy result in colossal loss of revenue to the State, it tends to reduce the built-in elasticity of a fiscal system, to the extent that the tax evaded income is spent on goods and services that raise prices of real estate. In the context of the prevailing grave challenges such as terrorism, money-laundering and the ever-growing black money, there is an urgent need to enact asset seizure legislation to prevent this black money becoming a lethal weapon in the hands of the mafias now in control of the economy as well as the government. Before the promulgation of such a law, it is important to identify the sources generating black money. Black money will keep thriving, if such sources are not blocked, notwithstanding the existence of stringent laws. We will not be able to promote voluntary tax compliance unless sources leading to black money are eliminated.
A conservative estimate is that Rs 600 billion is generated every year in Pakistan by the parallel economy. Add to this the black money generated through smuggling in the goods and narcotics trade that is between Rs 300 billion and Rs 500 billion. This amounts to a whooping Rs 1000 billion. When the presence of black money is so apparent, why its criminal accumulation and generation not revealed and the offenders punished, is a question which has been baffling the minds of honest citizens. They ask, whether it is on account of lack of political will, or rampant corruption, or collusion of tax dodgers and the tax administrators at defrauding the revenue, or the political system or the ineffectiveness and defectiveness of laws, or the pervasive stubborn indifference of the citizens towards their duties?
The recurrent appearance of amnesty schemes and money whitening instruments/modes show that the State has conceded the failure of its tax machinery in performing its main function of collection of taxes. This nation has become addicted to easy money and such schemes/instruments have become a routine matter for them. The people hooked on ill-gotten wealth/income for the last many years know for certain that after every two or three years, there will be an amnesty scheme giving them a chance to get their income/assets whitened by paying far less an amount than what they would have been required to pay under the normal income tax/wealth tax regime. It is a tragic situation where the entire State apparatus is subservient to those who blatantly manage to hide their income and wealth. It is an ugly joke with those who are paying their taxes honestly at much higher rates than those offered to tax evaders at 3% under such schemes. Can we think of voluntary tax compliance in the face of these ugly realities?
No meaningful audit policy can 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 ("exincome") 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 Tax Intelligence System.
For intelligence purposes whether the expenditure or income (ex-income) of a 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 ex-income 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 etc. boards 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 Adjunct Faculty at Lahore University of Management Sciences (LUMS).)