Annual report - 2004 - Part 3

Focusing audits on long-term compliance from the 2004 Annual Report

An important part of the community having confidence in the tax administration is for Inland Revenue to have a strong audit function to verify that taxpayers have paid the correct amount of tax. It is also vital that this function is seen to focus on the areas of greatest risk, such as when taxpayers have decided not to comply or do not want to comply.

Inland Revenue recognises that audit work has a key role in the wider process of compliance management. It has strong links to other business areas to support the collection and analysis of compliance risk intelligence and to initiate a range of responses to identified compliance risk so that compliance is improved over time.

This outcome is central to applying our compliance model approaches to our audit strategy. While the focus of our audit activity is on the taxpayer who has decided not to comply, selective verification is carried out among other taxpayers. This helps to maintain confidence in the tax administration by ensuring that the law is applied equally to those who attempt to comply voluntarily, and to those who do not. Our audit strategy helps us to improve our capability to perform audit work as well as achieving a better understanding of those areas that present the greatest risk to revenue.

Focus of audit activity

Our investigation and litigation efforts reflected the overall shift in emphasis to the areas seen as posing the greatest risk to revenue. In 2003-04 our focus was on:

• taxpayers covered by our Corporates group
• aggressive tax issues
• cash economy evasion
• fraud and other tax evasion.

(See also Using the full force of the law.)

Corporates

These are mainly large enterprises with a turnover above $100 million and taxpayers covered by special arrangements. In 2003-04 we assessed $296.5 million in net discrepancies from this customer group. Our focus for the year was on:

• Closely monitoring the top companies and streamlining our risk evaluation process by introducing targeted risk reviews and a formal approach to risk prioritisation.
• High wealth individuals - we have a separate unit targeting 100 high wealth individuals. Analysis performed to date shows that this group of individuals controls approximately 3,500 entities. Detailed questionnaires have been sent to 69 persons seeking information relating to assets, income, and associated entities, including trusts. To date 57 responses have been received. The questionnaire responses are being matched against a range of information. We anticipate that risk profiles will be completed for the 100 cases in 2005.
• Currently 13 cases are subject to full investigations. They involve complex business structures, including numerous companies and trusts both in New Zealand and offshore. The top four cases involve over 100 entities in each case. Issues identified to date include the treatment of: inter-company transactions, trust structures and transactions, capital gains, tax residence and the treatment of lifestyle assets. By their very nature these cases are complex and will take some time to reach conclusive positions.
• Using questionnaires to evaluate foreign and New Zealand-owned multinationals for their transfer pricing and record keeping requirements. We have now received over 350 responses from companies with a turnover above $20 million. Where appropriate, more detailed documentation reviews and audits have been completed, and in some cases companies have been put on notice in relation to their ongoing pricing. Special projects have also been conducted in relation to specific industries and our largest corporates. In addition, advance pricing agreements have been reached with 11 corporates and a further 10 agreements are currently in progress.
• Reviewing structured financial arrangements that have been identified in the banking industry. This review has led to assessments being issued and further investigations being carried out.

Aggressive tax issues

These are schemes designed to reduce a taxpayer's tax liability and are often "marketed" to wealthy investors. For 2003-04 the largest single category of discrepancies was for disallowed depreciation on intangible property relating to aggressive tax avoidance arrangements.

Aggressive tax issues also accounted for a large part of our litigation work in the High Court this year. The test case for New Zealand's second largest alleged tax avoidance case, concerning investments in the ACTONZ joint venture, was heard in July and August 2003. On 14 November 2003 the High Court delivered a judgment which found in favour of Inland Revenue on all issues. The investors have appealed this decision.

In 2003-04, we assessed $181.3 million in net discrepancies concerning aggressive tax issues, 39.6% over target reflecting an increased focus in this area.

Property investigations uncover over $4.7 million in discrepancies

We have been watching transactions involving property development and speculation, particularly at times when the market is expanding. In those areas of rapidly rising prices, we identified an emerging risk to the tax revenue base from a pattern of activity where people, hoping to make quick profits, bought and then on-sold property quickly.

"Many of the people buying up sections in new developments may not be aware of tax implications if they bought properties with the intention of
on-selling them, often within a short time, in order to make a profit", says Peter Consedine, Area Manager, South Island Investigations.

"If people buy property purely to on-sell at a profit, they will be liable for income tax on any profit made.

"We routinely keep our 'eyes and ears open' about a wide range of areas where there may be less than full compliance with tax obligations. During 2004, we looked more closely at developments in the property market, including a focus on Queenstown and Wanaka. As part of our routine activities, staff also looked at associated activities, such as building and construction," says Peter.

"Obviously, Inland Revenue is likely to be initially interested in sales involving properties which have only been held for a very short time. However, the buyer's intention or purpose at the time when they bought the property is the most important indicator when determining a tax liability."

Peter Consedine, Area Manager, South Island Investigations

The law can be complex and people may need to seek professional advice. People need to talk to their tax agent or contact Inland Revenue if they need to clarify the tax situation before they buy or sell property. As at June 2004, Inland Revenue had undertaken 460 investigations in relation to the Queenstown and Wanaka property market, with another 64 investigations ready to go. So far, this work has revealed more than $4.795 million in unaccounted tax involving the property market.

Cash economy evasion

Audits were carried out in high-risk areas and have led to prosecutions - for example in the taxi and contract fruit picking industries (see also Industry Partnership).

Fraud and other tax evasion

Audit activity led to the prosecution of tax agents who had obtained money intended for their clients, a major case involving rebate fraud, and close attention to speculative property transactions where quick profits were being made. During the year, we assessed $48.9 million in net discrepancies (64.6% over target) from fraud and evasion activity. The result reflects improved risk assessment and additional resources being applied to detect tax evasion.

Audit discrepancies

We identified a total of $787 million in audit discrepancies ¹⁷ this year, 4% over our targeted figure. The result of this work is also reflected in the amount of tax in dispute. This is tax generated from current audit activity of businesses, but will generally flow on to future periods as discrepancies when the dispute is resolved. At $386 million, the level of disputed tax is $99 million higher than last year.

^{17 A discrepancy is the difference between the tax previously returned or calculated by the taxpayer and that which is ascertained as a result of an audit (plus penalties and interest if applicable).}

Discrepancies over the years have also reflected the shift in emphasis to corporate taxpayers and those involved in areas of aggressive tax avoidance, or evasion and fraud.

However, not all these adjustments to a taxpayer's return result in an immediate financial liability or additional tax to be paid in the year that was audited. Adjustments to losses have a potential impact on current or future tax obligations and changes to imputation credits are made in anticipation of a future tax liability. Audits that result in adjustments of this kind are important because they protect the future tax revenue base. In 2003-04:

• discrepancies totalled $787 million
• less adjustments to losses of $212 million
• less adjustments to imputation credits of $69 million
• net result 2003-04 was $505 million.

The 10 most commonly occurring discrepancies (by dollar value) in 2003-04 were:

• depreciation, $134 million - mainly arising in aggressive tax avoidance cases where depreciation on intangible property was disallowed
• losses carried forward, $82 million - generally because corporate taxpayers have incorrectly applied losses between years or between related companies
• GST on understated sales, $77 million
• imputation tax adjustments, $69 million - corrections to the taxpayer's account so that it agrees with that of the company's imputation accounts
• treatment of reserves and provisions, $41 million
• incorrect use of branch equivalent tax account, $36 million - relates to the tax on controlled foreign companies owned by New Zealand companies
• GST time of supply adjustments, $28 million
• default assessment, $18 million - issued when taxpayers have failed to file a return
• sales not accounted for, $17 million
• GST time of supply adjustment, $14 million.

Audit-assessed debt is now given higher priority in our debt collection system. This is being done by ensuring that audit-assessed debt is clearly identified in our systems so that we receive a "complete" compliance result.

Voluntary disclosures and refunds

The discrepancy figures above include cases where taxpayers have made voluntary disclosures about under-reported tax. The disclosures can be made by a taxpayer before, or during the course of an audit. The law provides that these disclosures result in lesser penalties being imposed. The disclosures result from a positive approach by taxpayers to getting their affairs right, together with a desire to avoid or reduce exposure to shortfall penalties and to avoid the consequences of detection in an investigation. This year we have had more disclosures, and the value of the corporates disclosures has returned to normal levels.

Audit work may also find that a taxpayer should actually receive a refund or a credit.

This year we identified $37.46 million in refunds compared to $73.46 million in 2002-03. Part of the reason for the difference was that last year two cases accounted for just over $19 million of the refunds. The differences arise because taxpayers have made mathematical errors, overstated sales or have left out expenses that are actually deductible.

Quality and timeliness of audit work

The quality of our audit work showed significant improvement on last year, with 95.4% of surveyed audits meeting the standards. This compares to a target of 85% and last year's result of 87.9%. The survey involves taking samples of audit work from across New Zealand and the different areas of investigation. The results for 2003-04 reflect an increased focus on quality.

We completed our audits more quickly than targeted:

• business audits completed within an average of 2.4 months (target: 4 months)
• investigations completed within an average of 10.5 months (target: 12 months)
• audits by our Corporates group completed within an average of 10 months (target: 17 months).

Industry Partnership

Although audit activity has always been carried out in cash economy industries, this year we have continued to strengthen our focus through our industry partnership approach. Our investigators have been concentrating on partnership industries where there is deliberate non-compliance.

In all, ten industries have been covered, with most of the cases completed being in the agricultural contracting, hairdressing, collision repair and painting and decorating industries. The total value of discrepancies identified was $5.5 million. The most common discrepancies arose from:

• purporting to charge GST
• understating or overstating sales to evade GST payments
• not declaring income
• failing to account for PAYE.

Prosecutions have been taken when appropriate - see section on Using the full force of the law, for some examples of action taken.

In 2004-05 we will set up Industry Partnership assurance teams that focus specifically on issues arising from deliberate non-compliance. The teams will undertake investigations and address the return and debt issues associated with Industry Partnership industries, as well as gathering further community intelligence.

Audit strategy

Work has continued on the implementation of our audit strategy. The strategy is assisting us to change our audit processes to focus on compliance, with an emphasis on the use of gathered intelligence and the range of appropriately targeted responses that can be applied to compliance risk.

The main areas of focus in 2003-04 were:

• Improvements to the way compliance risk is identified and determining the appropriate response
  Dedicated compliance risk analyst positions were established to increase the level of effort and expertise devoted to intelligence gathering and analysis. The positions have been designed to carry out research into compliance levels in specific industries. This helps us to target those who are not complying voluntarily as well as supporting our efforts to reduce compliance costs of those taxpayers who do.
• Strengthening our capability in complex tax areas of high compliance risk corporate taxpayers
  One of the difficult areas of addressing compliance is the complex nature of arrangements made by corporate taxpayers. It requires a high level of technical tax knowledge and legal expertise, especially about international tax arrangements. Our Corporates group received an extra $3.7 million in the 2003 Budget to increase its capability, including establishing a new unit to improve risk analysis.
  Work has also been undertaken to streamline the process for identifying risk issues that may require legislative change.
• Training our audit workforce to a higher level of competence and capability
  We have recently implemented a comprehensive training framework within our audit units. The framework provides a structured two-year learning programme. It is designed to develop auditing skills and tax technical knowledge to the level required to undertake the most demanding and complex types of case work found within our non-corporate areas.
• Improving technology to support audit work
  Besides designing and introducing a number of computer tools to assist investigators in the performance of their work, they are being provided with laptops for use in the field. Greater mobility will lead to greater visibility in the community, with more audit work being completed onsite.
• Developing new ways to measure our audit outcomes
  With the introduction of the compliance-based framework, we recognise the need to change the way we measure our audit performance. We have designed the process to measure the impact of audits on compliance and further work will be carried out in 2004-05.

Progress on OAG Report recommendations

When the Office of the Auditor-General (OAG) reported on our taxpayer audit activities in August 2003, 11 recommendations were made. These have been implemented or incorporated into our audit strategy. Two of the recommendations will take longer to come into operation - the way we manage audit cases and the full implementation of intelligence systems. They are part of long-term projects and will result in future system changes.

The enhancement of our audit processes is a continuous activity and the time for completing the current initiatives is about five years.

Working with the OECD

Inland Revenue has been working to develop relationships with other tax administrations through
the Organisation for Economic Cooperation and Development (OECD). In April 2004, we hosted a meeting of more than 50 specialists who came to Auckland to discuss international tax evasion and avoidance schemes. This is the first time this gathering has been held outside of Paris.

The increasing use of cross-border tax evasion and avoidance schemes is a major challenge for all tax administrations and the meeting looked at legal ways to facilitate cooperation and the effective exchange of information between tax administrations.

In addition, this year Robin Oliver, Deputy Commissioner (Policy), was appointed Vice-Chairman of the Bureau of the OECD's Committee on Fiscal Affairs.

 

 

 

Date published: 15 Nov 2004

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