Benefits and Methods of Implementing Tax Monitoring

Table of Contents

Goals and Objectives of Tax Monitoring

Tax monitoring provides a direct line of communication between taxpayers and tax authorities. The taxpayer discloses the accounting data to the tax authorities together with the tax return.

Traditional desk and field audits assess the correctness of the tax base in the taxpayers’ returns. The audits use up to 50% of the tax authorities staff and consume taxpayers’ time and resources.

The purpose of tax monitoring is to reduce the amount of control work for the tax authorities. In exchange, taxpayers get some relief, such as a freeze on the requests for documents or on field audits.

The taxpayer’s task is to disclose the calculation of the tax base with transactions and primary documents, along with the submission of the return. To implement tax monitoring, tax authorities should develop a control system that:

Standardizes the tax authorities’ approaches to inspections.
Allows taxpayers to implement an internal control system that considers the standards and requirements of the tax authorities.

Taxpayer’s Internal Control System

COSO framework defines internal control as “a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance”^[1].

The internal control system based on the COSO model includes five components:

Control Environment.
Risk assessment.
Control activities.
Information and Communications.
Monitoring.

Control Environment

The control environment includes a set of standards, processes, and structures that establish the basis for carrying out internal control across the organization.

The control environment comprises:

The integrity and ethical values of the organization.
The parameters enabling the board of directors to fulfill its governance oversight responsibilities.
The organizational structure and assignment of authority and responsibility.
The process for attracting, developing, and keeping competent individuals.
The rigor around performance measures, incentives, and rewards to drive accountability for performance.

The resulting control environment of an organization provides the basis for the development of the other components of internal control.

Risk Assessment

Every organization faces external and internal risks. Risk is a probability of a future event negatively affecting the achievement of desired goals and outcomes. An ongoing iterative process for identifying and assessing risk forms the basis for managing risk in an organization.

Control Activities

Control activities are the actions established through policies and procedures that help ensure that management’s directives to mitigate risks to the achievement of objectives are carried out. Control activities are performed at all levels of the entity and affect departments, business processes, and information systems. They compromise approvals, authorizations, checks, reconciliations, and performance reviews.

Information and Communications

Organizations use the information to achieve goals. Management receives, creates, and uses information from internal and external sources for internal control.

Communication is the continual, iterative process of providing, sharing, and getting information.

Internal communication conveys information within the entity upward to management, downward to employees, and across organizations. It communicates a coherent message from top management to employees about taking the goals and objectives of internal control seriously.

External communication provides external information within the organization and provides internal information to external parties in response to requests and demands.

Monitoring Activities

Monitoring verifies the existence and operation of each of the five components of internal control, including the controls of each component. Business process monitoring at various levels of the organization provides the controlling information. Conclusions based on this information should be evaluated for compliance with the requirements and criteria of regulators, standards, management, and the board of directors.

Tax Monitoring Implementation Methods

Violation of tax laws is a risk that a taxpayer’s internal control system should manage. Tax monitoring helps reduce tax risks and administrative costs for bona fide taxpayers.

The tax code and bylaws do not always provide an exact answer on how to interpret a particular transaction to calculate the tax base and taxes. As part of tax monitoring, the tax authority gives the taxpayer a reasonable opinion on the calculation of taxes and eliminates the ambiguity of interpretation.

Tax monitoring requires the deployment of these essential components:

Taxpayer registration. The set of documents that the taxpayer sends to the tax authorities and the registration in the tax monitoring system.
Data presentation. The taxpayer sees the calculation of the tax base and taxes made by the tax authority based on the received returns, accounting data, and primary documents.
Data transmission. The taxpayer sends a certain set of data to the tax authority to process and calculate taxes. This may result from the internal control system.
Electronic communications between taxpayers and tax authorities to request and receive reasonable opinions.

The key problem in implementing tax monitoring is finding a balance between manual and automated controls.

Tax monitoring with a taxpayer-side module collects accounting system data and electronic documents, and provides access to tax officers. This approach offers only manual control by the tax authorities. It is possible to facilitate the work of inspectors with built-in tips. However, manual control does not scale well, because one inspector can only work with a few taxpayers.

The automated approach includes the creation of a single centralized tax monitoring system. Taxpayers upload tax returns and accompanying information to calculate the tax base with the confirmation through primary documents. Inspectors use the system to verify the information and accept submissions.

The inspector works with the results of processing, not with the primary data. The tax monitoring system is integrated with the taxpayer’s tax reporting system and synchronized by tax returns.

To implement tax monitoring, it is important to standardize accounting and tax accounting regulations. Tax authorities also need to work with independent software developers of accounting systems. Tax monitoring functions should become a standard built-in feature and do not require additional costs and efforts of taxpayers to implement tax monitoring on their side and integrate it with the tax administration systems.

From experience, there are some common issues with implementing tax monitoring.

Tax authorities poorly understand taxpayers’ needs for transparent rules of the game and elimination of ambiguous interpretations of tax legislation. Without standards and requirements transparency, automation is impossible. Manual monitoring will be required but cannot be extended to tens of thousands of taxpayers.
Scaling of tax monitoring is possible by creating obvious benefits for taxpayers. In the absence of direct benefit, taxpayers will refuse to be involved.
Implementing tax monitoring does not consider the costs to taxpayers. Additional costs, months of implementation, and lack of expertise for implementation will smash the taxpayers’ interest against the wall.

Ideal Implementation of the Tax Monitoring

Ideally, tax monitoring automatically discloses taxpayer data to the tax authorities with minimal cost and rework in taxpayers’ accounting and internal control systems. Tax authorities get a holistic picture of taxpayers’ tax accounting and improved performance of tax control.

Tax monitoring should become a standard part of commercial accounting software. It should issue a standard tax monitoring file with a tax return, transcripts, and primary documents available to tax administration as electronic copies or download links.

Tax authorities create unambiguous tax monitoring requirements, including transaction registers, rules to calculate taxes, and documents to confirm transactions.

The tax monitoring file is transmitted to the tax administration according to the same rules as filing tax returns. Files are uploaded to the central tax accounting and monitoring system, which is integrated with the core tax administration information system. The tax monitoring and accounting system supports multiple taxpayers, maintains accounting and tax records, and generates tax returns based on taxpayers’ transactions and primary documents.

The basic tax administration information system processes tax returns following standard procedures and legal requirements.

The tax monitoring and accounting system visualizes and transcribes tax returns, uses control ratios that verify data integrity, and cross-checks with data from other taxpayers and tax authorities.

Documents are transmitted to the tax authorities as electronic copies or links to the primary document in the taxpayer’s accounting system.

So, the ideal implementation of a tax monitoring system looks like this:

A taxpayer uses a popular accounting system, such as SAP, Microsoft, SAP, Oracle, and others.
The accounting system uses the built-in tax monitoring module and generates a tax monitoring file for each return.
The accounting system sends the tax monitoring file to the tax authorities via electronic communication channels.
Central Tax Monitoring Accounting System is an accounting system developed for accounting outsourcing providers servicing multiple taxpayers, including auditing returns. The central system receives tax monitoring files from taxpayers and controls the completeness, integrity, and correctness of tax returns.

[1] Committee of Sponsoring Organizations of the Treadway Commission (COSO). Guidance on Internal Control. URL: https://www.coso.org/sitepages/internal-control.aspx?web=1