Hot topics during a tax audit...Your Achilles heel

Marc-Tell Madl, Partner, Legal Services
/Kyiv Post, 5 February 2009/

Clearly, the tax authorities are going to take a much more proactive approach to tax code enforcement in the coming months. So what should you do when the tax man is coming?

As I have pointed out in this series: preparation is key. Bearing in mind, however, the ocean of tax laws to observe and the vast amount of associated potential pitfalls, preparing for a tax audit is quite challenging. Here, a clear focus is critical.

According to past experience, every taxpayer is acquainted with his or her Achilles heel. This is not a reference to the well-known "skeleton in the closet"; but rather the fact that each industry, each company, and, thus, each Managing Director knows best where his/her firm has structural exposures and shortcomings… and, yes, of course, the skeletons too.

Really, it is best to simulate an audit together with your tax advisor and fix things before the taxman hits the ground. Your advisor knows the typical issues the tax authorities regularly review and, moreover, areas that have become fashionable to investigate in the given fiscal year. The tax authorities not only follow certain patterns, but also are often directed to systematically assess specific things with even more scrutiny. These so called "hot topics" change from time to time. Needless to say, it helps to know them. To give you a head start, let’s reflect on two taxes where many of the most important danger zones dwell: corporate tax and VAT:

Typical dangers in corporate tax stem from a lack of supporting documents (e.g., making payments, supplying goods or rendering services without a proper paper trail) and “mistakes” based on an ambiguous interpretation of the legislation. Hot topics here include the tax authorities’ treatment of any non-sales receipts as “income from other sources”; and intentional tax avoidance / tax evasion schemes, like paying unrecorded salaries or supplying goods/rendering services to related parties at prices that do not correspond with the arm’s length principal.

Another flash point is applying a double tax treaty while withholding repatriation tax without a valid certificate of tax residence. Given the vagueness of the tax law and the resulting high potential for divergence in the interpretation of double tax treaties, tax authorities have begun applying greater focus to this topic. And finally, almost a truism, certain dangers result simply from the predisposed approach of tax officials, like the inappropriate application of tax legislation provisions. Regarding the latter, there are so many examples of course that it would be frankly a bit boring to go into detail.

The ever-controversial application of VAT is always an accounting headache. Here, any disagreement with the authorities is pretty pricy. And, the taxman is almost instructed to disagree, because VAT is – besides personal income tax – the most important source of income for the notoriously short fiscal state. This is where the current downturn in companies' revenues hits the budget most.

The first thing that the taxman checks is the suppliers' invoices. If these documents are absent or issued incorrectly, the authorities reduce the allowable VAT credit. Where there are taxable and exempt supplies, the taxman will check whether input VAT was duly credited based on a direct allocation and prorated. Prorating leaves room for interpretation, thus creating a risk of the tax authorities challenging any VAT credit.

We should not forget that the tax authorities always audit entities claiming VAT refunds and often reject refunds due to incorrect VAT accounting or misinterpretation of the VAT regulations. In checking output VAT, the tax authorities usually focus on: supplies of services to non-residents; agency transactions (cross-border and domestic); leasing operations; returns of goods; liquidation of fixed assets or use of assets in exempt supplies; construction and supply of residential premises; and free of charge supplies during promotional campaigns. The taxman can also adjust output VAT if he concludes that the market value of goods/services sold exceeds their contractual value by more than 20%. All these issues should be properly considered prior to an audit by the authorities and a defence file needs to be in place.

Even though you are likely a “good corporate citizen” it is imperative that before any audit you do your homework, as a good deal of disagreement can still exist between you and the taxman. The authorities' final decision, which closes the audit, will reveal any potential conflicts. Often you can compromise, even change company procedures and – of course – acquiesce to certain fines. But, often you will have a very good point that has not been heard. This is when you have the right to take legal action, which is, at least in statistical terms, much more effective than many taxpayers think.

In the last instalment of this series, we will dive deeper into what the courts have to say and – more importantly – how you should put your troops into place in order to win the battle.