October 3, 2009

HOW EFFECTIVE ARE TAX AUDITORS?

No one wants to get audited. Not even the tax auditors. But they get audited too.

The Auditor General, Sheila Fraser, looked at how the Canada Revenue Agency (CRA) audits Small and Medium Enterprises (SMEs). Despite 5,600 staff focusing on these businesses, earlier problems remain. As taxpayers, we want compliance with the rules to ease our tax burdens, which vary considerably by province, especially for entrepreneurs.

We're talking about big dollars. The CRA estimates there aren't many tax cheaters but those abusers cost us plenty. About $12.7 billion in unpaid tax according to their 2006-07 Annual Report. Of that, about $2.5 billion relates to SMEs.
Overall, the Canada Revenue Agency (the Agency) has made unsatisfactory progress in addressing the recommendations we selected from our previous reports for follow-up.
--- Auditor General, March 2009 Status Report
Sheila found the "taxman" fares poorly in
  • taxing the underground cash economy (targeted by 1,000 CRA staff): "about half of its underground economy audits over the past five years did not detect unreported income"
  • auditing too many low-risk files
Auditing The Wrong Files
The CRA "has difficulty demonstrating that it is selecting and auditing small and medium enterprises of high risk or priority."
--- Auditor General, March 2009 Status Report
The CRA uses computerized risk assessment to classify tax returns by the potential tax recovery into four categories from low to high. That makes sense.

However, the CRA focuses on low-risk files where they expect a $0 tax recovery. This is like targeting drivers going 0-10 above the speed limit but ignoring drivers zooming past at 50+.

In the last two fiscal years, the CRA audited 87,000 SMEs. Of these, 13% were tagged as high-risk and brought in 41% of the total tax recoveries. However, 56% of the audits were on zero or low-risk files and brought in 39% of the total tax recoveries.
"Available auditors may lack the experience necessary to do complex high-risk files and therefore audit lower-risk files."
--- Auditor General, March 2009 Status Report
What's going on? Among other explanations, CRA says their auditors are better suited to doing low risk audits. Also, audits do turn up problems even where tax recoveries are low. This is like a "broken windows" approach: tackle minor crimes like speeding and littering to prevent bigger crimes.

The CRA does not know why high-risk files bypass audits because the human screeners who make the ultimate decisions aren't required to document their reasons. Screeners favour their own judgement over computerized risk assessments. Human judgement leads to inconsistencies.

The Right Staff
During the Tax Roundtable in the 2008 CALU conference, a CRA official reported difficulties filling two senior vacancies in the Ontario audit unit. Why? The pay scale starts at $40,973 and caps out at $110,779. The private sector pays better. Also, tax auditors would rank among the least prestigious professions. Want proof?

At a party, announce that you're an actuary and people will leave you for fear of boredom. Say you're a tax auditor and watch them bolt even faster and go further away.

Cheaters
The study found that most people know little about the implications of tax cheating, and concluded that more communication would encourage better compliance.
--- 2007 public opinion research by the CRA
Honest taxpayers suffer. Cheaters prosper and encourage others to follow. Until they're caught. Let's see what happens.
3 comments Posted by Promod
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September 26, 2009

Three Steps To Keeping Financially Solvent

It is hard for us without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.
--- Joseph Cassano of AIG on their credit default swap business (Aug 2007)

Well, a house of cards was never built for shock
You could blow it down in any kind of weather.
--- Dire Straits, Solid Rock

Julie Dickson addressed a sold-out audience at the Actuaries' Club of Toronto this week. She's the Superintendent of Canada's most important regulator, the Office of the Superintendent of Financial Institutions (OSFI). Her remarks were informative, interesting and have relevance for you. OSFI oversees the federally-regulated banks, trust companies, insurance companies and pension plans.
Julie was accompanied by my first actuarial boss, Stuart Wason, now a Senior Director at OSFI. We haven't met in years. During my summer job at Crown Life, I learned plenty from Stuart and Henry Essert. They inspired me to pursue my actuarial career. I'm in their debt and haven't thanked them enough.
Offend the tax department and you can appeal all the way to the Supreme Court. Offend OSFI and your company risks swift intervention. Don't expect much sympathy either.
Actuaries would be well served to sit up and take notice of the speed at which risk management expectations are changing.
--- Julie Dickson
OSFI's mandate is solvency: ensuring that financial institutions have enough capital to weather financial storms. How? By predicting the unthinkable, setting high standards, and intervening early. This process works wells in protecting the public and the politicians. Here only one financial services company cuts dividends (but they cut them in half).

You can protect your own financial solvency as you follow the four steps in wealth management. Let's look at three ways
  1. predict the unthinkable
  2. follow high standards
  3. forget bailouts
Predict The Unthinkable
Your challenge as actuaries is to learn from the past but like your motto says, you need to "see beyond risk".
--- Julie Dickson
We underestimate risk, especially during periods of stability. Also, we fear the wrong risks. So we don't prepare for storms and get shocked when the tide reminds us that our castle was made of sand.

We can't predict and prepare for every disaster but we still benefit from planning.

We can look at different "what if" scenarios, especially the bad ones we like to ignore.
  1. Suppose a car accident confines you to a wheelchair for life. What happens to your savings, your ability to work and your future earnings?
  2. Suppose you're forced to retire five years early due to a layoff or ill health. What happens to your retirement income?
  3. Suppose you live an extra 10 years or earn lower returns after tax and inflation. Would your money last?
You can examine your current and projected financial situation more regularly with your financial advisor. Ideally one who know how to stress-test your plans. Maybe you're following simple "rules of thumb". Changing conditions can make them obsolete. In Dumb Money, Daniel Gross identifies four simple but incorrect assumptions that leading to the financial crisis in the US.

Yes, we can over-prepare but we're more likely to do too little.

Follow High Standards
Life is going to be more challenging for "experts", and a premium will be placed on how well you can explain such things as actuarial reserves and capital.
--- Julie Dickson
Raise the bar on your risk management. Picking better quality investments does dampen the returns (the perennial risk vs reward quandary) but the chances of potential problems drops too. Diversification helps diminish risk too.

Canada trusts actuaries to apply principles, which requires judgement. The US prefers rules, which makes compliance easier to monitor. Since rules don't change quickly, companies can follow the letter of the law without following the spirit.

Forget Bailouts
You can take on extra risk if you've got someone to bail you out. Maybe you've got a kind rich aunt. The financial sector turns to us taxpayers. Without market discipline, companies can take undue risks with impunity. That's where we rely on the regulators.

We face four key financial risks: outliving your savings, dying too soon, getting sick and getting disabled. What are you doing about them now while you can? You are your own regulator (unless you have a spouse).

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2 comments Posted by Promod
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