Global Experience and Best Practices in Reducing the Tax Gap

Methods for Reducing the Tax Gap

Earlier, we defined the tax gap and identified what elements make it up, understood the importance of this phenomenon, and studied its magnitude using the example of certain states. In this article, we will discuss the practical methods and best practices used by different countries to reduce the tax gap.

VAT, Income Tax, Sales Tax

The Kittel’s Principle

In the EU countries, the UK and Singapore, a VAT fraud scheme through the “Missing Trader Intra Community” (MTIC) is widespread[1]. An October 2018 study by the EU Parliament found carousel frauds to be the most dangerous type of cross-border VAT fraud, with losses estimated at an average of €50 billion annually[2]. The figure below illustrates the fraud’s basic tenets using the EU member states as an example.

The chain shown in the image above can contain an unlimited number of links. If Company C sells goods to Company D, then the missing trader B will have no direct connection to the Company D, which will request a VAT credit from the state. In this case, it is difficult for tax authorities to trace the links in the chain and justify the refusal to refund VAT on sales within the EU countries.

As one measure to combat this phenomenon in the EU countries, the UK and Singapore denied merchants their right to deduct, using the Kittel principle[3], developed in the case law of the EU Court of Justice. The essence of this approach is that the taxpayer may lose the right to a deduction if objective factors show the taxpayer knew or had the opportunity to find out that the purchasing went through the chain associated with VAT evasion.

Transition to Electronic Tax Invoices and Cross-Matching of Seller and Buyer Invoice Data

Electronic declarations and invoices simplify the verification of transactions between counterparties by automatically matching seller and buyer data, while paper declarations require a lot of time and resources for auditing. The transition to electronic document management solves the problem of false invoices to disguise personal expenses as a legal deduction or try to increase its amount.

Argentina

Since 2016, electronic invoices became mandatory for all taxpayers registered as value added tax (VAT) payers. Data received from one party to a transaction is cross-checked with data received from the other party. Based on the results of the inspections, authorities publish lists of unreliable taxpayers on the public website. That limits their right to use an individual taxpayer identification number (TIN) and a temporary suspends the possibility of issuing invoices.

Italy

The introduction of the electronic invoicing began in 2014. Italian authorities implemented data cross-validation to identify discrepancies, potential tax gaps and losses.

Slovakia

Since 2014, taxpayers must submit VAT returns electronically on a monthly or quarterly basis. They include data on all types of transactions: incoming and outgoing deliveries, and receipts, registered by an electronic cash register. Tax administration checks each transaction against the VAT identification numbers of the supplier and the buyer, the invoice number, date, and cost of goods and services.

Introduction of Online Electronic Cash Registers (OECRs)

Online Electronic Cash Registers (OECRs) with built-in fiscal data recording technology limit the ability to manipulate sales or underreport them on the tax return.

They guarantee the preservation of sales data and protection of information from unauthorized access, transmit sales data to tax authorities in near real time, simplify the audit of tax returns and help to better track the work of sales outlets, restaurants.

Argentina, Austria, Belgium, Canada, France, Germany, Sweden

These countries use Online Electronic Cash Registers with storage memory and digital signature for each transaction between point of sale and tax systems. Tax authorities compare taxpayers’ returns with data from cash registers.

Hungary

After the first year of introducing OECRs in certain sectors of the economy, retail VAT revenue in these segments increased by 15%. Income from VAT receipts exceeded the total costs of the project implementation.

Slovakia

Introduced Online Electronic Cash Registers with a unique identification code and a QR code containing all data of the issued receipt and information about the entrepreneur.

Every customer can scan QR-codes using a special application developed by the tax administration and check the data contained in the receipt. If the customer finds a discrepancy, he can appeal to the controlling authorities.

Tax administration receives all transactions and inspectors have full access to them. They can conduct analytical checks of reports, obtain complete information about the financial behavior of the entrepreneur, and detect risky fiscal transactions.

Control Over the Use of Cash in Retail Transactions

Conducting cash transactions or everyday purchases creates favorable conditions for fraud and concealment of data to reduce tax liabilities, since authorities cannot trace such transactions in full. Restricting transactions in cash is an effective way to reduce risks and close loopholes for tax fraud.

Finland

Uses monitoring of ATM cash withdrawals and identification of the person by the number of the credit/debit card. A camera built into an ATM takes photos of the person performing the transaction and sends it to the tax authorities via an online connection that they can use it in audits.

France and Greece

Introduced limits that prohibit cash payments if the value of goods exceeds EUR 1000 and EUR 1500, respectively.

Italy

Implemented real estate cash flow restrictions to help mitigate the risk of untraceable transactions.

Sweden

Companies have begun refusing to accept cash payments. Restaurants, hotels, and public transportation actively use this practice.

Japan

With the help of search robots, authorities collect and analyze information about services over Internet to identify suspicious online companies. They compare collected materials and data to the tax administration database.

Offshore Profits to Reduce the Tax Burden

Countries with a mild tax climate are an ideal haven for individuals or businesses looking for a way to lower their tax deductions. This entails a loss of funds for those countries from which the profit gets offshore, and forces governments to take preventive measures.

Many countries use the concept of the “controlled foreign company” (CFC)[4]. This is a foreign company where a tax resident of another country owns a certain share. There is no single definition as the concept of CFC has different adaptations in different states.

Foreign companies hide their beneficiaries so that host companies can use such legal entities to reduce the tax base in the country of their tax residency. The CFC legislation does not prohibit the incorporation and ownership of companies abroad but requires them to report tax returns and pay taxes in the country of the owner’s tax residency.

To limit the profit shifting to offshore zones with low tax rates, 136 countries have signed an international agreement OECD / G20 Inclusive Framework on BEPS (Base Erosion and Profit Shifting), which comes into force in 2018. It requires that transnational corporations (TNCs) pay taxes at a minimum rate of 15%[5].

Taxes and Insurance Premiums on Wages

Payment of Unofficial Salaries to Employees in Cash in Full or in Part

The control of cash is a critical issue with particular focus on matters of salary payments to employees. Using cash not only reduces the amount of tax paid on wages, but also social and insurance payments. To solve this problem, it is necessary to control the use of cash and track suspicious transactions of legal entities.

Australia

Australia implemented the program for automatic comparison of tax return data with transactions on debit and credit cards of legal entities[6]. This method helps to identify companies that trade for cash currency, which may be the reason for additional verification not only of VAT or income tax returns, but also of the correctness of personal income tax calculation.

Austria

Initially, introduced restrictions on the payment of wages in cash in the construction sector. The employer must pay wages above EUR 500 must not in cash if an employee has a bank account or legitimately requests to have wages transferred to it.

Individual and Self-Employed Income

Hiding Income by the Self-Employed

In many countries, tax legislation requires reporting the additional income if a taxpayer receives it as self-employed. Tracking of such transaction helps to identify tax evaders.

Australia

The tax authority has access to information held by the Australian Transaction Reports and Analysis Centre (AUSTRAC), through which inspectors can track taxpayers’ cash flows and correlate the data with tax returns. For example, it helped to identify drivers (Uber) and tenants who did not report their commercial activities.

Tax evasion in respect of interest (capital gains) on dividends and deposits by shifting savings abroad

International agreements for the transfer of information about foreign citizens—asset holders help countries track the contributions of their taxpayers abroad.

United States (FATCA—Foreign Account Tax Compliance Act)

Foreign Account Tax Compliance Act) requires foreign financial institutions to report to the U.S. Internal Revenue Service on the movement of U.S. taxpayer funds. In case of violation of this requirement, financial institutions will pay fines at the rate of 30% on the working capital of their correspondent accounts in US banks or face closure of such accounts. More than 100 countries have signed the Act[7].

AEOI—Automatic Exchange of Information

An initiative developed by the Organisation for Economic Cooperation and Development (OECD) in 2014. Its members annually exchange information about non-resident accounts (individuals and legal entities) automatically. The basis for the exchange is a concluded bilateral or multilateral agreement.

The difference from FATCA is that the European instrument provides for at least a two-way information exchange about non-resident accounts. As of October 2021, there were over 4500 active bilateral exchange relationships from over 110 jurisdictions[8].

Evasion from Payment of Interest on Transactions in Cryptocurrency

Many countries tax transactions and changes in cryptocurrency assets. For example, profits from investments in bitcoin and other digital assets or holdings in cryptocurrency that have grown in value. Obtaining data on cryptocurrency transactions and other digital assets helps tax authorities track their accounting in tax returns.

Australia

The country receives data related to cryptocurrency transactions and account information from Designated Service Providers (DSPs)[9]. The resulting data help to identify buyers and sellers of crypto assets and quantify related transactions. Further, they compare this information with tax returns submitted by taxpayers.

Real Estate Rental Income

Analyzing the real estate register of taxpayers and obtaining information about property owners and transactions from management companies can help tax authorities control the illegal rental market.

Australia

Authorities analyze data about asset management companies, with the particular attention to information on property owners and completed transactions. They compare this information with tax returns submitted by taxpayers[10].

United Kingdom

Tax authorities analyze corresponding lists of the land cadastre24. If such lists do not indicate rental income, but if a taxpayer has two or more real estate objects, this gives tax inspectors a reason to conduct an audit.

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As we can see, countries are making a lot of efforts to reduce the tax gap. They increase tax collections, help taxpayers file tax returns, and relieve extra burden of tax administration. The fight against tax fraud improves the competitive environment for bona fide businesses with the positive effect on the welfare of society.

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[1] MTIC (Missing Trader Intra Community) fraud. Europol. URL: https://www.europol.europa.eu/crime-areas-and-statistics/crime-areas/economic-crime/mtic-missing-trader-intra-community-fraud

[2] VAT fraud. Economic impact, challenges, and policy issues. Policy Department for Economic, Scientific and Quality of Life Policies. Directorate-General for Internal Policies. Marie LAMENSCH, Emanuele CECI PE 626.076. October 2018. URL: https://www.europarl.europa.eu/cmsdata/156408/VAT%20Fraud%20Study%20publication.pdf

[3] Joined Cases C-439/04 and C-440/04. Axel Kittel v État belge and État belge v Recolta Recycling SPRL. Sixth VAT Directive – Deduction of input tax – ‘Carousel’ fraud – Contract of sale incurably void under domestic law). JUDGMENT OF THE COURT (Third Chamber). 6 July 2006. URL: https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:62004CJ0439&from=EN

[4] Controlled Foreign Company. OECD BEPS Action 3. URL: https://www.oecd.org/tax/beps/beps-actions/action3/

[5] International collaboration to end tax avoidance. OECD. URL: https://www.oecd.org/tax/beps/

[6] Credit and debit card 2015–16 and 2016–17 financial years data matching program protocol. Australian Taxation Office. URL: https://www.ato.gov.au/General/Gen/Credit-and-debit-cards-2015-16-and-2016-17-financial-years-data-matching-program-protocol/

[7] Foreign Account Tax Compliance Act. U.S. Department of The Treasury. URL: https://home.treasury.gov/policy-issues/tax-policy/foreign-account-tax-compliance-act

[8] Activated Exchange Relationships for CRS Information. October 2021. OECD. URL: https://www.oecd.org/tax/automatic-exchange/international-framework-for-the-crs/exchange-relationships/

[9] Crypto assets 2014–15 to 2022–23 data-matching program protocol. Australian Taxation Office. URL: https://www.ato.gov.au/General/Gen/Crypto-assets-2014-15-to-2022-23-data-matching-program-protocol/

[10] Property management – 2018–19 to 2022–23 financial years. Australian Taxation Office. URL: https://www.ato.gov.au/General/Gen/Property-management—2018-19-to-2022-23-financial-years/