ROLE
OF THE CMAS IN CURBING THE BLACK MONEY & TAX EVASION
By K P C Rao,
LLB, FCS, FCMA
kpcrao.india@gmail.com
I.
BACKGROUND
Generation
of black money and its stashing abroad in tax havens and offshore financial centers’
have dominated discussions and debate in public Fora during the last two years.
Members of Parliament, the Supreme Court of India and the public at large have
unequivocally expressed concern on the issue, particularly after some reports
suggested estimates of such unaccounted wealth being held abroad.
Two issues have been highlighted in
this debate. First, several estimates have been floated, often without adequate
factual basis on the magnitude of black money generated in the country and the
unaccounted wealth stashed aboard. Secondly, a perception has been created that
the Government’s response to address this issue has been piecemeal and
inadequate. Thereafter, the then Finance Minister Mr. Pranab Mukherjee has
presented a ‘White Paper on Black Money’ to the Indian parliament on 16th
may, 2012.
This Paper highlights the different
facets of black money and its complex relationship with policy and
administrative regime in the country. It also reflects upon the policy options and
strategies that the Government has been pursuing in the context of recent
initiatives, or need to take up in the near future, to address the issue of
black money and corruption in public life.
According to this paper: “Black money is a term used in
common parlance to refer to money that is not fully legitimate in the hands of
the owner. This could be for two possible reasons. The first is that the money
may have been generated through illegitimate activities not permissible under
the law, like crime, drug trade, terrorism, and corruption, all of which are
punishable under the legal framework of the state. The second and perhaps more
likely reason is that the wealth may have been generated and accumulated by
failing to pay the dues to the public exchequer in one form or other. In this
case, the activities undertaken by the perpetrator could be legitimate and
otherwise permissible under the law of the land but s/he has failed to report
the income so generated, comply with the tax requirements, or pay the dues to
the public exchequer, leading to the generation of this wealth.”
A
comparison of the two ways in which black money is generated is fundamental to
understanding the problem and devising the appropriate policy mix with which it
can be controlled and prevented by the public authorities. At the very outset,
it becomes clear that the first category is one where a strongly intolerant
attitude with adequate participation of all state arms can produce results.
Therefore, as accountants it is important for us to understand the intricacies
of the transactions in the second category where the issue becomes far more
complex and may require modifying, reforming, and redesigning major policies to
promote compliance with laws, regulations, and taxes and deter the active
economic agents of society from generating, hoarding, and illicitly
transferring abroad such unaccounted wealth.
II.
GENERATING BLACK MONEY BY
MANIPULATION OF ACCOUNTS
There can be two different ‘modus
operandi, involved in the generation of black money. The first is the crude
approach of not declaring or reporting the whole of the income or the
activities leading to it. This is the likely approach in all cases of criminal,
illegal, and impermissible activities. The sophistications in such an approach
mostly get introduced subsequently for the purpose of laundering the money so
generated with the objective of making it accountable and converting it into
legitimate reported wealth that can be openly possessed and used.
The same approach of not declaring or reporting activities and the
income generated there from may also be followed in cases of failure to comply
with regulatory obligations or tax evasion on income from legitimate
activities. However, complete evasion or non-compliance may make such incomes
vulnerable to detection by authorities and lead to consequent adverse outcomes
for the generator. Thus a more sophisticated approach for generation of this
kind of black money is often preferred, involving manipulation of financial
records and accounting.
The best way of classifying and understanding the various ways and
means adopted by taxpayers for the generation of black money would be the
financial statement approach, elaborating different means by which the accounts
prepared for reporting and presenting before the authorities are manipulated to
misrepresent and under disclose income, thereby generating unaccounted,
undeclared, and unreported income that amounts to black money.
III. DIFFERENT KINDS OF MANIPULATIONS OF
FINANCIAL STATEMENTS
Diagram
showing the Manipulations of Accounts for Tax Evasion
Some of these manipulations are
explained below:
(a) Out of Book Transactions
This is one of the simplest and most
widely adopted methods of tax evasion and generation of black money. Transactions
that may result in taxation of receipts or income are not entered in the books
of account by the taxpayer. The taxpayer either does not maintain books of account
or maintains two sets or records partial receipts only. This mode is generally
prevalent among the small grocery shops, unskilled or semi-skilled service
providers, etc.
(b) Parallel Books of Accounts
This is a practice usually adopted by
those who are obliged under the law or due to business needs to maintain books
of account. In order to evade reporting activities or the income generated from
them, they may resort to maintaining two sets of books of account – one for
their own consumption with the objective of managing their business and the
other one for the regulatory and tax authorities such as the Income Tax
Department, Sales Tax Department, and Excise and Customs Department. The second
set of books of account, which is maintained for the purpose of satisfying the legal
and regulatory obligations of reporting to different authorities, may be
manipulated by omitting receipts or falsely inflating expenses, for the purpose
of evading taxes or other regulatory requirements.
(c) Manipulation of Books of Account
When
books of accounts are required to be maintained by taxpayers under different
laws, like the Companies Act 1956, the Banking Regulation Act, and the Income Tax
Act, it may become difficult for these taxpayers to indulge in out of books
transactions or to maintain parallel books of accounts. Such parties may resort
to manipulation of the books of accounts to evade taxes.
(d) Manipulation of Sales/Receipts
A
taxpayer is required to pay taxes on profit or income which is the difference
between sale proceeds or receipts and expenditure. Thus manipulation of sales
or receipts is the easiest method of tax evasion. Other innovative means may
include diversion of sales to associated enterprises, which may become more
important if such enterprises are located in different tax jurisdictions and
thereby may also give rise to issues related to international taxation and
transfer pricing.
In
case of use of a dummy / associated entity, there can be a plethora of possible
arrangements entered into by such entities to aid generation of black money. In
its simplest form, the associate entity may not report its activities or income
at all. The main entity may show sales to such a dummy / associate entity at a
lower price, thereby reducing its reported profits.
More
complex scenarios can emerge if the dummy/ associated entity is situated in a low
tax jurisdiction having very low tax rates. Thus the profit of the Indian
entity will be transferred to the low tax jurisdiction and money will be
accumulated by the taxpayer in the books of accounts of the entity in the low tax
jurisdiction.
(e) Under-reporting of Production
Manipulation
of production figure is another means of artificially reducing tax liability.
It may be resorted to for the purpose of evading central excise, sales tax, or income
tax.
(f) Manipulation of Expenses
Since
the income on which taxes are payable is arrived at after deducting the
expenses of the business from the receipts, manipulation of expenses is a
commonly adopted method of tax evasion. The expenses may be manipulated under
different heads and result in under-reporting of income.
It
may involve inflation of expenses, sometimes by obtaining bogus or inflated
invoices from the so called ‘bill masters’, who make bogus vouchers and charge
nominal commission for this facility.
Any
number of more sophisticated versions of manipulation of expenses can also be
resorted to by those intending to generate black money. Sometimes it can also
involve ‘hawala’ operators, who
operate shell entities in the form of proprietorship firms, partnership firms,
companies, and trusts. These operators may accept cheques for payments claimed
as expense and return cash after charging some commission.
There
have been instances of claims of bogus expenses to foreign entities. The
payments can be shown to foreign entities in the form of advertisement and
marketing expenses or commission for purchases or sales. The funds may be
remitted to the account of the foreign taxpayer and the money can either be withdrawn
in cash or remitted back to India in the form of non-taxable receipts. Such money
may also be accumulated in the form of unaccounted assets of the Indian
taxpayer abroad.
(g) Other Manipulations of Accounts
Besides
inflation of purchase / raw material cost, expenses like labour charges,
entertainment expenses, and commission can be inflated or falsely booked to
reduce profits. In these cases, bogus bills may be prepared to show inflated
expenses in the books.
(h) Manipulation by Way of
International Transactions through Associate Enterprises
Another
way of manipulating accounted profits and taxes payable thereon may involve
using associated enterprises in low tax jurisdictions through which goods or
other material may be passed on to the concern. Inter corporate transactions
between these associate enterprises belonging to the same group or owned and controlled
by the same set of parties may be arranged and manipulated in a way that leads
to evasion of taxes. This can often be achieved by arrangements that shift
taxable income to the low tax jurisdictions or tax havens, and may lead to accumulation
of black money earned from within India to another country.
(i)
Manipulation
of Capital
The
statement of affairs or balance sheet of the taxpayer contains details of
assets, liabilities, and capital. The capital of the taxpayer is the
accumulated wealth which is invested in the form of assets or as working
capital of the business. Manipulation of capital can be one of the ways of
laundering and introduction of black money in books of accounts.
(j)
Manipulation
of Closing Stock
Suppression of closing
stock both in terms of quality and value is one of the most common methods of
understating profit. More sophisticated versions of such practice may include
omission of goods in transit paid for and debited to purchases, or omission of
goods sent to the customer for approval. A more common approach is
undervaluation of inventory (stock of unsold goods), which means that while the
expenses are being accounted for in the books, the value being added is not
accounted for, thereby artificially reducing the profits.
(k) Manipulation of Capital Expenses
Over-invoicing
plant and equipment or any capital asset is an approach adopted to claim higher
depreciation and thereby reduce the profit of the business. As already stated,
increase in capital can also be a means of enabling the businessman to borrow
more funds from banks or raise capital from the market. It has been seen that
such measures are sometimes resorted to at the time of bringing out a capital
issue. At the same time, under-invoiced investments, indicating entry of
undeclared wealth, may imply introduction of black money.
(l)
Generation
of Black money in Some Vulnerable Sections of the Economy
While
the source of generation of black money may lie in any sphere of economic
activity, there are certain sectors of the economy or activities, which are
more vulnerable to this menace. These include real estate, the bullion and
jewellery market, financial markets, public procurement, non-profit
organizations, external trade, international transactions involving tax havens,
and the informal service sector.
(m)
Land
and Real Estate Transactions
Due
to rising prices of real estate, the tax incidence applicable on real estate
transactions in the form of stamp duty and capital gains tax can create
incentives for tax evasion through under-reporting of transaction price. This
can lead to both generation and investment of black money. The buyer has the
option of investing his black money by paying cash in addition to the documented
sale consideration. This also leads to generation of black money in the hands
of the recipient. A more sophisticated form occasionally resorted to consists
of cash for the purchase of transferable development rights (TDR)[1].
(n) Bullion and Jewellery Transactions
Cash sales in the gold
and jewellery trade are quite common and serve two purposes. The purchase
allows the buyer the option of converting black money into gold and bullion,
while it gives the trader the option of keeping his unaccounted wealth in the
form of stock, not disclosed in the books or valued at less than market price.
(o) Financial Market Transactions
Financial market
transactions can involve black money in different forms. Initial public offers
(IPOs) offering equity shares to the public at large are also vulnerable to various
manipulations that can generate black money for the promoters or operators.
Rigging of markets by the market operators is one such means. This may involve
use of shell companies and more sophisticated versions of such manipulation may
involve offshore companies or investors in foreign tax jurisdictions who invest
in shares offered by the IPO and through manipulated trading escalate their
price artificially, only to offload them later at the cost of ordinary
investors.
(p) Public Procurement
Public
procurement has grown phenomenally over the years – in volume, scale, and
variety as well as complexity. It often includes sophisticated and hi-tech
items, complex works, and a wide range of services. An OECD (Organisation for
Economic Cooperation and Development) estimate puts the figure for public
procurement in India at 30 per cent of the GDP whereas a WTO (World Trade
Organisation) estimate puts this figure at 20 per cent of the GDP[2].
The Competition Commission of India had estimated in a paper that the annual
public sector procurement in India would be of the order of ` 8 lakh crore while a
rough estimation of direct government procurement is between ` 2.5 and 3 lakh crore.
This puts the total public procurement figure for India at around ` 10 to 11 lakh crore
per year.[3]
(q) Non-profit Sector
Taxation
laws allow certain privileges and incentives for promoting charitable activities.
Misuse of such benefits and manipulations through entities claimed to be
constituted for nonprofit motive are among possible sources of generation of
black money. Such misuse has also been highlighted by the Financial Action Task
Force (FATF), an intergovernmental body which develops and promotes policies to
protect the global financial system against money laundering and financing of
terrorism.
A
Non-profit Organisation (NPO) Sector Assessment Committee constituted under the
Ministry of Finance has reviewed the existing control and legal mechanisms for
the NPO sector and suggested various measures for improvement.
(r)
Informal
Sector and Cash Economy
The
issue of black money is related to the magnitude of cash transactions in the
informal economy. The demand for currency is determined by a number of factors such
as income, price levels, and opportunity cost of holding currency. Factors like
dependence on agriculture, existence of a large informal sector, and
insufficient banking infrastructure with large un-banked and under-banked areas
contribute to the large cash economy in India.
(s)
External
trade and Transfer Pricing
More
than 60 per cent[4]
of global trade is carried out between associated enterprises of multinational
enterprises (MNEs). Since allocation of costs and overheads and fixing of price
of product/services are highly subjective, MNEs enjoy considerable discretion in
allocating costs and prices to particular products/services and geographical
jurisdictions. Such discretion enables them to transfer profit/income to no tax
or low tax jurisdictions. Differing tax rates in different tax jurisdictions can
create perverse incentives for corporations to shift taxable income from
jurisdictions with relatively high tax rates to jurisdictions with relatively
low tax rates as a means of minimising their tax liability. For example, a
foreign parent company could use internal ‘transfer prices’ for overstating the
value of goods and services that it exports to its foreign affiliate in order
to shift taxable income from the operations of the affiliate in a high tax
jurisdiction to its operations in a low-tax jurisdiction. Similarly, the
foreign affiliate might understate the value of goods and services that it
exports to the parent company in order to shift taxable income from its high
tax jurisdiction to the low tax jurisdiction of its parent. Both of these
strategies would shift the company’s profits to the low tax jurisdiction and,
in so doing; reduce its worldwide tax payments. In this context transfer
pricing has emerged as the biggest tool for generation and transfer of black
money. In recent years, after the 9/11 incident in the USA due to intense
scrutiny of banking transactions, enhanced security checks at airports and
ports, and relaxation of exchange controls, transfer of money through hawala
has reduced significantly but now transfer pricing is now being extensively
used to transfer income/profit and avoid taxes at will across countries. Also,
with the relaxation of exchange controls and liberalisation of banking
channels, the popularity of the hawala system for legitimate transfers has
reduced substantially. The increasing pressure on financial operators and banks
to report cash transactions has also helped in curbing hawala transactions. Tax
evasion through transfer pricing is largely invisible to the public and
difficult and expensive for tax officers to detect. Christianaid5 estimates
that developing countries may be losing over US$160billion of tax revenues a
year, primarily through transfer pricing strategies.
The
illicit money transferred outside India may come back to India through various
methods such as hawala, mispricing, foreign direct investment (FDI) through
beneficial tax jurisdictions, raising of capital by Indian companies through
global depository receipts (GDRs), and investment in Indian stock markets through
participatory notes. It is possible that a large amount of money transferred
outside India might actually have returned through these means.
IV.
ROLE
OF THE CMAs
Corruption
and fraud are generally interlinked. In fact corruption is a special type of
fraud and treated as such in many jurisdictions. Fraud and Corruption both pose
serious challenges to audit, as they seek to mislead and distort the true state
of financial and non-financial affairs of the entity. Fraud awareness or
recognition amongst the CMAs is necessary to play a vigilant role in containing
frauds by ensuing correction of system deficiencies and building up effective
system controls and checks in the audited entities.
Fraud is most likely to
involve deliberate misrepresentation of information that is recorded and
summarized by an entity; its impact can be compared to an accounting error and
would involve issues such as measurement, occurrence, and disclosure. Fraud
poses a serious problem from an audit perspective because it is normally
accompanied by efforts to cover/ falsify/ misdirect the entity records and
reporting. Thus, fraud can directly affect the financial statements and records
of the audited entity.
Any transaction entered into by the
taxpayer must be reported in books of account which are summarized at the end
of the year in the form of financial statements. The financial statements
basically comprise statement of income and expenditure which is called by
different names such as ‘Profit and Loss Account’ or ‘Income and Expenditure
Account’ and statement of assets and liabilities which is called ‘Balance
Sheet’ or ‘Statement of Affairs’. Tax evasion involves misreporting or
non-reporting of the transactions in the books of account. Therefore, it is important for the CMAs to
understand the different kinds of manipulations of financial statements
resulting in tax evasion and the generation of black money. Hence, the CMAs
should remain alert, vigilant and develop a nose to smell these manipulations
in the Accounts. It is also desirable to introduce such an orientation to the
Audit.
Therefore, examination of system
for detection and prevention of fraud and corruption will be an integral part of
all regularity audits and also of performance audits. At the commencement of
each audit, information about the fraud and corruption awareness, detection and
prevention policy and related environment should be collected from the audited
entity management. During the course of audit work, the audit teams / officers
should be vigilant and seek explanations.
Though corruption is clandestine and takes
place outside the books, it is likely to leave tell-tale marks here and there.
Even from well-maintained books, a whiff of corruption may rise. Audit can
remain alert to such indirect indications and develop a nose to the smell of
corruption and therefore, it is desirable for the CMAs to introduce such an
orientation to the Audit.
A comprehensive analysis of the factors leading to generation of
black money in India along with the various measures attempted to counter it
till date makes it apparent that there is no single panacea that can rid
society of this menace. At the same time, it is not impossible to curb,
control, and finally prevent the generation of black money in future as well as
repatriation of black money, if a comprehensive mix of well defined strategies
is pursued with patience and perseverance by the central and state governments and
put into practice by all their agencies in a coordinated manner. All
stakeholders who are likely to benefit from prevention and control of black
money generation will welcome and support the important initiative of curbing
the black money and provide needed inputs. Let us play our role as CMAs in
addressing this gigantic task!
[Published in Circuit, Monthly magazine of ICAI, Hyderabad]
Source:
White Paper on Black Money dated 16th May, 2012 of Ministry of
Finance, Department of Revenue, CBDT.
