Construction tax fraud detection methods

Construction tax fraud detection methods

One of the main ways to detect fraudulent activities of a subcontractor, is (besides the site observations or visits) the practice of analyzing data (digital and on paper) in the possession of the tax administration.

There exists a wide variety of sources and types of information and in the way the information is stored and used by the tax analysts. Thus, this part of the inquiry is closely related to the problem of risk analysis.

When attempting to establish the tax liability of a taxpayer who is operating in the construction industry, the tax administration, as well as the individual auditor, will be required to make the best use of all sources of information available. These sources of information will either prompt the commencement of an audit or will assist the auditor in computing the tax liability. Information can be received from several sources, internal and external, some of which are listed below.

Internal and external sources of information

Classified into internal and external sources of information, relevant and useful information remains as follows:

  • Data acquired from the tax police;
  • Data from state authorities are used;
  • VAT data;
  • Data extracted from the VIES system;
  • Data obtained from the international exchange of information;
  • Data from income tax and corporate tax returns;
  • Data from suppliers and clients/customers.

The different types of data have been grouped and summarised according to their sources along with a comprehensive explanation as to their value.

  1. Types of internal sources

From different tax regimes

All taxes tend to interact to a greater or lesser extent. The tax officer auditing a company for VAT purpose should realize the impact of employment taxes on the turnover for VAT purposes and of the effect of VAT on the published profits for income tax payments. The cost of other tax payments is usually a deductible expense when calculating the income tax liability of the business. However, when deducting the tax payment this deduction must equal the actual payment of the tax, e.g. the deduction for one tax regime must equal the payment for the other. A typical example of the mismatch between tax declarations is where the turnover declared for income tax purposes does not equal the turnover declared for VAT purposes.

In the field of VAT we can specify the following list of indicators that can be useful in the detection process of non-compliant taxpayers (principals and subcontractors in the construction industry):

  • Amount of credit notes on outgoing transactions in comparison to all the positive outgoing transactions;
  • Amount of received credit notes in comparison to the total turnover;
  • Amount of investments;
  • Difference between paid VAT and deducted VAT;
  • Difference between VAT on purchases according to the customers’ accounts of the taxpayer and the amount of net VAT on the sales according to declaration (some countries having liabilities that impose declaration of these data by the taxpayers);
  • Difference between national acquisitions and the amount reported by the suppliers (some countries having liabilities that impose declaration of these data by the taxpayers);
  • Proportion of the purchases of commercial goods and services versus the total turnover (gross benefit margin);
  • Difference between the net Intra-Community acquisition of goods on the declaration and in the VIES system;
  • VAT due against the lowest rate in comparison to the total turnover;
  • VAT due against the normal rate in comparison to the total turnover;
  • Difference between the base of the list of customers and the total turnover;
  • Proportional turnover in the last trimester or month in comparison to the total turnover;
  • VAT on the list of customers in comparison to the difference between the base on the list of customers and transactions where VAT due by the other person of the contract (checks on domestic reverse charge application (some countries having liabilities that impose declaration of these data by the taxpayers));
  • VAT due against the normal rate and VAT due by the other person of the contract in comparison to the acquisitions with reverse charge mechanism.

Specific references from other tax offices

Other tax offices may send routine transaction verification requests based on the premise that one person’s sale is another person’s purchase. In addition, an audit carried out on a business in one tax district will often generate a suspicion about the customers or suppliers of that business which in turn will generate a specific reference.

Ratio analysis

Virtually all businesses operate in a sector that has certain characteristics. These characteristics usually form the basis for commercial or governmental analysis of key ratios and trends. Examination of the key sector trends and comparison to the business under review may reveal unexpected variances that will call for further enquiry and explanation.

The auditor should carry out specific ratio analysis of the business under audit to search for anomalies both when carrying out the pre-visit inspection and during the authorized audit programme. The industries liable to payment of VAT on their sales are classified into groups of industries under the Standard Industrial Classification Code. Each classification has certain characteristics in the business operations, from which a picture of the average business can be built up.

Direct observation

Direct observation of the business premises can reveal unexplained economic activity that may lead to fruitful areas of inquiry. For instance, observed deliveries from manufacturing premises may be matched to dispatch notes and invoices (establishing the completeness of records that are used to compile financial statements).

Another aspect of direct observation is to evaluate the lifestyle of the directors/owners of the company under audit. A reconciliation of the cost of the observed lifestyle with the declared profits may reveal understatement, especially in owner-managed companies.

Annual accounts and management accounts

A business limited in liability must publish annual accounts which must be lodged with the authorities. Matter of public record, the annual accounts are prepared by the management and audited by a reputable firm of accountants they can be an invaluable source of information for items such as sales, purchases, additions and disposals of assets, and expenditure items.

Most management, when not directly involved in the running of a business on a day-to-day basis (small businesses for example) will require reports of the activities of the various parts of a business. These reports can be extremely revealing, especially if prepared in isolation from the system that prepares official accounts and tax returns.

Example from Hungary on the use of internal sources of information is presented below:

– In case of a fictitious company the tax authority launches the procedure for tax number suspension; finally the tax number is deleted from registration. The relevant data is published on the tax office website and is available for everybody to see.

– The tax authority publishes quarterly the list of those, whose outstanding tax liability exceeds, for instance, EUR 400,000 in case of companies, and EUR 40,000 in case of individuals. This is a useful piece of information for other taxpayers who may enter into a business contact with these tax debtors.

It is obvious that not every tax administration will have the legal possibility to implement the measures as described above. This example from Hungary only aims at showing how internal sources can be used as a deterrent.

  1. Types of external sources

Informers’ letters

It is not unusual for the tax authority to use information received from informers but this information should be treated carefully. As a general rule, specific attributable information should be treated as reliable and action should be taken to verify the information given. Un-attributable or vague information should be treated as unreliable and the reference left on the taxpayer’s file to be dealt with at the next routine audit.

Supplier and customer businesses

Direct inquiries of suppliers and customers may reveal differences in declared and actual transactions.

Gathering information about subcontractors during interviews with main contractors is a source that may help to analyse the supplier chain for construction work. The contracts between the main contractor and the subcontractor have to be checked and also the list of people working that day on the site. Based on those lists, the inspectors can check ID documents.

The purpose of checking is to know the person as a taxpayer. Based on the outcome of those checks tax administrations can select companies for audit purpose.

Media and Internet

Sales, acquisitions and other important information are reported in areas such as the financial and fiscal press, trade and tax magazines, statistical bulletins, websites on Internet, search engines, etc. This can be a valuable source of information when building up the background of the company. Tax administrations use specific software for the collection a variety of economic and non-economic data which is available on the Internet.

Non tax-related records

Other records, unconnected or only loosely connected with financial statements can be used to obtain ratios that can then be used to check the accuracy and completeness of tax declarations, which are originally based on the financial records of the company.

The auditor should use his/her judgement to select interrelated areas of the business then:

  • Calculate the effect of one ratio against the other;
  • Compute an expectancy based on the calculation;
  • Assess the expectancy against the actual reported figures;
  • Make enquiries to establish the reasons for any variance;
  • Adjust the expectancy utilising the reasons given; and
  • Continue to establish the reasons for any variances from the adjusted expectancy.

Exchange of information with third parties as a useful external source of information

Exchange of information with third parties, institutions or organizations is of vital importance to the accuracy of establishing tax obligations. In this context, it is of primary importance to use information from domestic and foreign institutions, associations, organisations, similar organisations from other countries, third parties, etc., which, under the terms of signed agreements, among others, also have obligations to exchange information.

Exchange of Information is taking place with:

  • Customs authorities;
  • Treasury branches
  • Territory plan administration;
  • Real estate registration offices;
  • Constructors association;
  • Authorities that administers vehicles register;
  • Authorities that administers population register;
  • Authorities in charge of the social and work inspection.

Other external sources are:

  • Commercial banks that are required to report suspicious bank transactions to the police; tax inspectors also receive reports from the police based on the information from banks;
  • Different records & information from other authorities (state/communal) which are involved with labour, crime, and construction, eg.; unemployment records, etc.;
  • Confidential calls;
  • Information provided by the general public.

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