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Pragmatic case selection model for audit  

Huzaima Bukhari & Dr. Ikramul Haq

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— Nestle Pakistan Limited etc. Versus Federal Board of Revenue [(2017) 115 TAX 84 (H.C. Lah.)]

Revenue authorities  across  the  world grapple  with  how to effectively   apply  their  scarce resources  to  the  task  of maximizing voluntary  tax compliance.  The challenge  is in knowing  where  and  how  to  most effectively  apply those resources  whilst maintaining coverage  and visibility in  the community— Selecting Cases  for  Audit–Getting  It  Right, Margaret  E. Cot ton, Asia Pacific Tax Bulletin, International Bureau of Fiscal Documentation (IBFD)

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—slogan on website of Inland Revenue Service of United Kingdom.

The role of a revenue authority is to collect the government’s revenue. To maximize collection, the revenue authority is tasked with maintaining and improving voluntary compliance across the taxpaying populace. Rarely do revenue authorities have access to all the resources necessary to achieve this mandate and therefore they make selection and allocation decisions based on a compliance risk management approach. Typically this is achieved through a mix of assistance, education and enforcement activity.

Case selection for audit is about the effective and efficient use of the total resources the revenue authority has determined will be applied to audit or enforcement activity. There is little point auditing the same cases year after year if each year there is no, or a very minor, discrepancy. Similarly there is little point auditing tax returns on a “first in, first audited”  basis  as  the second  to  last  tax  return  filed  might be  the “ big  one”.

Simply stated,  good  case selection  leads  to more effective  audits which  lead  to  more voluntary compliance and ultimately collection of more revenue. Good case selection also assists with maintaining the integrity of the revenue authority by overtly showing that the tax machinery is focusing on the right cases, thereby reducing allegations of corruption and bias. If the wider taxpaying populations consider the revenue authority is acting without fear or favour, voluntary compliance is enhanced. To achieve these aims audit activity should operate in a risk managed environment. This enables those tax payers who are thought to be high compliance risk to be identified and understood so audit responses can be directed at those risks and tailored in such a way so as to address the risk identified. This requires the revenue authority to build and maintain a good understanding of the taxpaying community taking into account the changing local and international environments.

The revenue authorities in Australia and New Zealand have successfully adopted compliance-based models that rest on the premise that the better the authority understands why taxpayers are not complying with their obligations the better the authority can develop appropriate and proportionate responses. The more that is known about the factors (business, industry, sociological, economic and psychological) that influence  the behaviour of a taxpayer or group of taxpayers, the more accurately a revenue authority can apply appropriate resources to that taxpayer or group of taxpayers to influence their compliance behaviour.

Unfortunately, Federal Board of Revenue (FBR) has never bothered to study the models of various countries where the above state approach has been adopted. Thus, it has failed to devise executable tax audit model, efficient operational apparatus, pragmatic educational and enforcement policies, a tax intelligence system and 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 have steadily declined during the last many years.

FBR needs to understand that compliance strategy recognizes the benefits of economies of scale. The more taxpayers who are in the “willing to do the right thing” category, the less resources proportionately are needed to ensure their continuing voluntary compliance. Thus resource can be deployed at the top of the triangle where there is greater revenue risk and a more expensive one-on-one approach is required to drive voluntary compliance.

Whether there are 200, 2,000 or 2 million taxpayers in a country, the aim of case selection remains the same, i.e. to narrow down the possible non-compliers across the entire population that could be audited into a sample of the population most likely to exhibit the highest risk to voluntary compliance. This requires some sort of systematic filtering and prioritizing exercise. Using a systematic selection process provides transparency of process and shows that selection of cases for audit is based on quantifiable evidence and not on an adhoc or prejudicial basis.

A systematic selection process also enables risks to be better understood thereby allowing more appropriate responses to be tailored to the risk presented. Where risks span fiscal years early identification allows planning opportunities around risk responses and staff development beyond the current financial year. Further, if risks are identified and quantified but current resources do not allow those risks to be addressed approaches can be made to stakeholders and donor agencies supported by this same information.

During the last many years, FBR has miserably failed to broaden the tax base, counter tax evasion and avoidance, increase the number of return-filers, use modern tax audit tools and tap the real tax potential. The failure of FBR is on two counts; firstly it has failed to collect taxes from where these are actually due thus paving the way for enormous black economy and secondly, it could not persuade the people towards voluntary tax compliance. This has created a malevolent social malady i.e. social injustice where the rich and mighty are enjoying life whereas the overwhelming majority is being pushed below poverty line.

An effective tax audit system is essential to maximize voluntary tax compliance. All the developed tax administrations possess sophisticated tax intelligence systems in place enabling them to enforce voluntary tax compliance. Duplicating a similar system for developing administrations is not optimum due to the lack of basic systems and skilled staff. Countries like Pakistan need a model that combines the best of a developed administration’s practices with the flexibility that allows it to be used regardless of the size of an administration and skill of staff.

In Pakistan, the tax reform process remains an unrealized dream. In 2004, the World Bank and other international donors provided funding of over US$ 100 million for various reforms plans. Five-year Tax Administration Reforms Programme (TARP), however, proved to be a great failure despite its extension for one more year (till 31-12-2011). On the completion of TARP, the World Bank admitted that none of the targets set was achieved. 

The voluntary tax compliance has been at the core of reform agenda under TARP. But it was disliked by tax officials from the very beginning. They wanted to retain existing discretionary powers for self-aggrandizement. They were not ready to accept the idea of voluntary compliance backed by strong deterrence audit and tax intelligence system. Therefore, instead of creating an effective tax intelligence system to enforce voluntary tax regime, they resorted to discretionary audits and frequent amendments. They tried to unsettle the declared versions of taxpayers without having any definite information. They amended assessments on surmises and conjectures or by indulging in fishing inquiries.

FBR in the past lost a large number of cases in courts as taxpayers successfully challenged abuse of powers under sections 177, 122(5) and 122(5A) of the Income Tax Ordinance, 2001, section 25(2) of the Sales Tax Act, 1990 and section 46(1) of the Federal Excise Act, 2005—see judgement of Lahore High Court reported as Chenone v Federal Board of Revenue & Others [2014 PTR 17 (High Court Lahore)=2012 PTD 1815], which is now overruled in ICA 855 of 2014. The order in ICA says: “We are convinced, in light of law laid down by Apex Court in Molasses Trading and Fecto Belarus Cases that meanings given and interpretation made by the Legislature are binding upon the Courts. After the clarification and declaration of Legislative Policy that Commissioner’s power to select and conduct audit are independent of FBR’s power to select for audit, the binding force of the judgment in Chenone Stores’ Case has effectively been obliterated”.

The issue is not that of powers of FBR and/or Commissioner to concurrently select cases for audit, but finding out a pragmatic model for case selection for meaningful tax audit.  Global comparison of tax audit provisions, procedures and practices with those adopted in Pakistan shows that FBR has never bothered to provide a transparent selection process based on any intelligible differentia to provide benchmarks that are intrinsically linked with risk areas.

From tax year 2003 onwards, FBR selected cases under section 177 (this section was amended several times and substantially since its inception) of the Income Tax Ordinance, 2001 without any regard to law and established international principles relating to tax audit. FBR also tried to outsource tax audit work to chartered accountant firms but the experiment failed miserably.

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. It 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:

      n    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.

      n    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.

      n    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.

      n    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.

      n    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.

      n    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)] has once 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 Khanand 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 BashirLimited 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 seletion 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, yet reported by Pakistan Tax Digest as CIR Sialkot v Messers Allah Din Steel & Rolling Mills and Others 2018 PTD 1444), the Supreme Court has held:

 “The basis requirement for any scheme of self-assessment an 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.

Key areas for the new initiative must include:

High-Risk, High-Income Taxpayers

High-income returns are often more complex and, generally, upper income taxpayers have resources to engage in pass-through entities such as partnerships, trusts and corporations. Even utilising FBR’s various matching programmes, income and deductions from such activities are more difficult to verify.

FBR needs to match returns from pass-through entities, the technique does not provide any verification of income reported by the entity itself. Verifying income on these returns requires an examination. FBR must start utilising a combination of filters to identify high-risk, high-income returns. The returns selected for desk examination should be those most likely to have unreported income or structured transactions. The idea to examine all of them will be sheer wastage of resources. A structured transaction is one with limited economic benefit and the primary purpose is to reduce or eliminate a tax liability. Structured transactions are generally done through one or more pass-through returns. The pass-through returns create paper losses that flow back to individual income tax returns offsetting income from other sources. FBR has not even bothered to conduct audit on these lines.

Abusive Schemes and Promoter Investigations

FBR must accelerate efforts to combat abusive schemes and scams on the rise that include:

  • Schemes, reducing a person’s tax liability by claiming inflated expenses, false deductions, unallowable credits or excessive exemptions.
  • Frivolous return arguments, telling taxpayers that compliance is voluntary or the Constitution does not provide for tax collection.
  • Abusive shelters and trusts, investments established for the purpose of hiding income from taxation.
  • Employment tax schemes, employee leasing, paying in cash and filing false payroll tax returns.

Abusive Scheme Groups are being established in each Area and the use of Fraud Specialists must increase. To identify and address promoter activity, a Promoter Lead Development Center needs to be created. The Center must systematically monitor the internet to identify promoters of abusive activities and develop cases for injunctive investigations.

High-Income Non-Filers

FBR’s efforts to address non-filers must focus on the most egregious and high-risk segments of the population. The non-filer strategy should be pursued on many fronts:

  • Re-engineered processes and work streams to improve efficiency and productivity.
  • Identification and expedited assignment of the most egregious non-filers.
  • Expanded and centralized automated enforcement.
  • Outreach and education efforts.
Unreported Income

Unreported income represents the largest component of the tax gap. FBR must develop a new tool for identifying returns with a high probability of unreported income. The new tool can be called Unreported Income Discriminant Index Formula (UI DIF). Its details can be seen at the website of Internal Revenue Service (IRS) of USA.

All individual returns in USA have traditionally been assigned a DIF score rating the probability of inaccurate information on the return. The new UI DIF score rates the probability of income being omitted from the return. The IRS has customarily used indirect examination methods to identify unreported income but until now has had no systemic method for selecting the returns at highest risk for unreported income.  The same method can be used in Pakistan.

UI DIF will give FBR the ability to systemically identify returns at high risk for unreported income and beginning this fall all returns will receive a UI DIF score in addition to the traditional DIF score.

National Research Programme

National Research Programme (NRP) examinations measure reporting compliance and identify compliance issues. NRP has enabled the IRS to improve the examination selection process. NRP is very different from its predecessor, the Taxpayer Compliance Measurement Program (TCMP) used by IRS earlier. NRP no longer relies heavily on time-intensive, “line-by-line” audits for establishing a baseline measure of reporting compliance. FBR must learn from IRS experience in this regards.

FBR has never conducted research on the distribution of errors on returns. Without the information that needs to be gathered through NRP, FBR will have no ability to direct examinations and other compliance activities with accuracy and precision. With updated information, the NRP effort will prevent thousands of “no change” audits each year. The FBR has never thought of such techniques that are prevalent in other parts of the world.

The NRP process should have four main categories:

  • No FBR contact. About 8,000 returns may be checked relying solely on information already available.
  • Correspondence. These may be less intrusive correspondence exchanges with taxpayers – rather than the old standard of sit-down audits. About 9,000 returns can be included in this process.
  • Less intrusive audits. Instead of the old “line-by-line” examination approach, the FBR may gather more information beforehand and focus only on selected parts of approximately 20,000 returns.

Vice Chairman Senate, Saleem Mandviwalla in a statement [Mandviwalla terms FBR’s audit policy disaster for tax system, Business Recorder, January 7, 2017] said that FBR had failed “to squeeze the neck of 0.7 million high net wealth individuals, despite having their complete records”. While lambasting the audit policy of FBR, he said that it was unfortunate that out of 0.9 million taxpayers, only 0.1 million would be on FBR’s radar through its audit exercise.

Mr. Mandviwalla termed FBR’s audit policy “a disaster for 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 FBR was busy in threatening and harassing taxpayers as they were raiding their offices and issuing notices to them almost every day. He further said: “FBR has completely failed to increase the tax net of the country and through this inaction they are restraining unregistered persons to get enrolled in tax net. FBR has done nothing on the data of 0.7 million high net wealth individuals attained from NADRA in the tenure of PPP-led government rather it has put the said classified information in the dustbin”.

Mr. Saleem Mandviwalla said that due to inefficiency of FBR, the rich and mighty “are enjoying every facility in the country, they are living in luxury villas, travelling abroad every month, their children are studying abroad and they have a bank balance of billions”. He urged the FBR to revisit its audit policy in order to provide maximum relief to the registered persons, who were being neglected since long.

This year, despite spending huge money on media campaign “threatening non-filers” instead of “public awareness campaigns” and extending the deadline for filing income tax returns up to February 28, 2018, the FBR received 1,260,181 returns, half the number of returns it received in 2008. The position of returns filed during the last 10 years is as under:

Income Tax filers (2008 to 2018) in Pakistan

Tax YearReturns (in millions)
20181.56 as of 15 September 2018


Dawn, January 7, 2017: https://www.dawn.com/news/1306870

The Express Tribune, February 21, 2018: https://tribune.com.pk/story/1640236/2-tax-year-2013-2017-except-salaried-class-number-tax-return-filers-shrinks/

February 14, 2018: https://tribune.com.pk/story/1546446/2-number-income-tax-return-filers-drops-less-half/

The latest figure up to September 15, 2018 is also below 1.6 million whereas ten years back total returns filed were 2.5 million.  In a decade, there is decrease of 100% in filers of returns. One wonders if our policymakers have ever studied the approach of Inland Revenue, UK 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 co-operative 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 co-operative 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 business community and tax bars rejected FBR’s Audit Policies for all the years, there are serious apprehensions about competence and capacity of tax officials to conduct scrutiny of 93,277 cases selected through parametric computer balloting on January 6, 2017. It was claimed that these “audit cases would 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”.

In 2016, FBR claimed: “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”.

Record of FBR speaks poor performance in the field of audit as officers could not increase collection through audit or creating demand otherwise. Collection on demand in 2017-18 was only 9% of total collection. In the last 10 years, the tax collected by field officers through audit never went near 7% of total collection.

The Lahore High Court in its judgement dated 09.01.2017 in the case of Nestle Pakistan Limited etc. Versus Federal Board of Revenue [[(2017) 115 TAX 84 (H.C. Lah.)] 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”. This judgement is upheld by the Supreme Court in its order dated March 18, 2018 (not approved for reporting)—see summary above.

According to a report, “It is not surprising that an overwhelming number of tax audits are conducted in haste and are perfunctory,” noted the Tax Reforms Commission (TRC). It said that there was a serious lack of capacity to perform any type of meaningful tax audit both at the Head Quarters and at field formations. The TRC has recommended that a specialised but an independent unit should be created to conduct the audit. The government did not implement this recommendation”.

FBR has miserably failed to introduce any tax intelligent computerized system, despite the fact that it has a market-wage oriented company, Pakistan Revenue Automation Limited (PRAL), at its disposal, to monitor the economic activities of corporate/business sectors. Meaningful audit policy cannot 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 a Tax Intelligence System.

For intelligence purposes, whether the expenditure or income (exincome) is of 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 exincome 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 exincome 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 boards etc. set up by government, can provide information to track rental, transport or agricultural exincome 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 exincome 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 exincome 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)

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