Full Audit Controversy Resurfaces Amidst Economic Slowdown

Kathmandu. Amidst an economic slowdown and a declining investment climate, the old dispute between tax administration and businesses has resurfaced. The center of the dispute is full audit, or complete tax examination.

Finance Minister Rameshwor Khanal of the interim government formed after the Janji movement had stopped the full tax audit, citing business complaints and aiming to remove irregularities in tax administration. His decision was to adopt a risk-based tax audit method.

However, the current Finance Minister Dr. Swarnim Wagle recently instructed to move forward with the stopped audit and complete pending files. Accordingly, the Inland Revenue Department a few days ago issued a circular to its subordinate tax offices directing them to immediately complete the work on pending files.

Businesses view this effort as the government trying to revive tax terrorism and the culture of commission. An official from the Federation of Nepalese Chambers of Commerce and Industry says, 'We had accepted the risk-based tax audit, but by repeating the old practice, the government has shown distrust towards the private sector. This will not boost investor morale.'

But, has the government truly revived full audit out of distrust towards businesses, or with the intention of intimidating and collecting?

This is an attempt to analyze based on conversations with senior tax administration officials and experts, and available facts.

What is the root of the dispute?

According to Inland Revenue Department employees, the decision to revive full audit was not made arbitrarily; the department's circular is within administrative and legal provisions. It is primarily focused on the settlement of files whose deadlines are expiring.

Once any taxpayer is selected for audit, legally, it must be completed within a certain period. In the past, the legal provision was that such an examination had to be completed within 4 years. However, the new Economic Act recently reduced that deadline to 3 years.

'With this provision, files that had to be completed within 4 years now must be completed within 3 years, creating a legal compulsion. Since the work has to be completed a year earlier, tax offices are under double the pressure of work,' says the department employee. 'The department has now directed the offices to complete the old files whose deadlines are about to expire within the time limit. However, a narrative has been created in the market that the government has restarted the full audit, which was already stopped, and is harassing businesses.'

Moreover, according to the official, there was no decision not to conduct full audits on files already selected, and therefore, according to legal procedures, these files must be examined.

With the department's circular, it is now difficult to even work on files whose deadlines are expiring. The official states that tax officers are facing a situation of non-cooperation from businesses, saying, 'The state has already said it won't do full audits, so why should we provide you with details?' This, according to the official, has lowered the morale of tax officers.

Why did the previous government stop full audit?

Former Finance Minister Rameshwor Khanal, during his tenure, abolished the traditional style of full audit and put forward the concept of risk-based and faceless online audit.

The reason behind Khanal's action was serious and long-standing complaints from businesses. According to businesses, under the guise of full audit, tax offices would not look into anything in the initial years but would flip through files in the fourth year, i.e., at the eleventh hour. By showing minor technical errors at the last moment, businesses would have to pay heavy interest, fees, and penalties for four years.

Tax administrators say that although Khanal's move to stop the traditional full audit to address business complaints sounded revolutionary, it was a hasty and ill-studied fatal decision.

'If the examination had been done at the beginning, the work would have been completed with a small penalty, but the work was done by delaying for 4 years, burdening them with interest and penalties,' is the common complaint of businesses.

Similarly, there were equal complaints that full audit had become a means for bargaining and collecting commissions through collusion between tax officers and some auditors in the name of settling files. To stop this irregularity, Khanal had tried to create a system that would analyze based only on documents submitted through faceless and online submission.

'Stopping full audit was an even bigger mistake'

Although Khanal's move to stop the traditional full audit to address business complaints sounded revolutionary, tax administrators say it was a hasty and ill-studied fatal decision.

'Yesterday, one person came and stopped it; he did not do the right thing. He should not have stopped it hastily without proper study. Today, for another person to talk about reopening it without reforming the system is also not entirely right,' says an administrator who also served as the Director General of the Inland Revenue Department. 'This is an irregularity that has arisen from trying to find a solution from elsewhere without addressing the problem at its root.'

The problem with the self-assessment system

Nepal's tax system is based on self-assessment. This means the state trusts that taxpayers are honest, they maintain proper accounting of their transactions, and submit correct returns. Because of this trust, the state considers the returns submitted by about 98 to 99 percent of taxpayers as final and does not raise any questions about them.

However, to ensure a check and balance so that this leniency and trust given by the state are not misused, only the files of 1 to 2 percent of taxpayers are randomly selected for full examination.

When the former finance minister stopped the full audit altogether, tax officers say it had an adverse effect in the market.

'When there is no tax audit, and the state is not looking, a mentality developed among businesses: why comply? Why issue bills? Why submit correct returns?' the officers say. 'This has led to an increase in tax evasion and non-compliance. There is a risk that the taxes that should be collected according to the law will not be collected.'

According to him, abolishing the entire system because an employee misbehaved or took a bribe is like cutting off the head because of a headache.

How are files selected for full audit?

Many businesses think that a tax officer can select any company's file for full audit if they don't like them or want to harass them, but the reality is a bit different. The audit of any individual or company primarily occurs in three stages.

In the first stage, the taxpayer themselves gets a tax audit done by hiring a chartered accountant or a registered auditor. This is part of self-assessment. Here, the chartered accountant or registered auditor examines whether the expenses claimed in the accounts kept by the accountant are legally admissible or not.

In the second stage, those returns reach the Inland Revenue Department. 99 percent of files are approved as they are.

However, the department has a risk indicator software. This software contains indicators such as suspicious transactions, unusual purchases and sales, continuous losses, or large transactions. This system screens the details of taxpayers across Nepal and flags risky files.

In the third stage, the department selects 70 percent of the files flagged by the software and sends them to the concerned tax office for further investigation. Only the remaining 30 percent are selected by the tax office for examination during their investigation if they seem suspicious.

Thus, only about 1 to 1.5 percent of taxpayers are investigated each year. The main objective is not to harass businesses but to maintain a demonstration effect.

'If a taxpayer goes down the wrong path, they are caught and punished. This sends a message to other taxpayers that this cannot be done, and they might be punished too. This increases voluntary tax compliance. This is how tax administration works worldwide,' says the official.