Updated Handbook on Audit Procedures and Techniques of Property Under Sec. 34 of the Tax Code

October 18, 1995 REVENUE AUDIT MEMORANDUM ORDER NO. 2-95 SUBJECT : Updated Handbook on Audit Procedures and Techniques of Property Under Sec. 34 of the TaxCode TO : All Internal Revenue Officers and Others Concerned I. OBJECTIVE This Order provides the basic procedures and techniques in the audit of tax returns. It has been designated to ensure that the revenue officer acquires useful auditing skills and equip him with the knowledge required for the proper examination of tax returns through the use of the Updated Handbook on Audit Procedural and Techniques. II. QUALITY AUDIT The purpose of auditing a tax return is to determine the taxpayer's substantially correct tax liability. A quality audit is the examination of the taxpayer's books and records in sufficient depth for the purpose of ascertaining the correctness and validity of entries and the propriety of application of tax laws. To ensure quality audit of tax returns, revenue officers are enjoined to utilize their technical skill, training and experience, and follow the minimum audit procedures prescribed by this Order under Annex "A" hereof. III. REPORTING REQUIREMENTS Revenue Officers are required to make a report after the audit has been conducted. All reports should contain the minimum documentary requirements specified under Chapter XIV of Annex "A". IV. EFFECTIVITY All revenue officers and other employees concerned are hereby directed to refer to the aforesaid Handbook in the audit/investigation of tax returns immediately after the approval of this Order. LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue ANNEX A HANDBOOK ON AUDIT PROCEDURES AND TECHNIQUES PREPARED BY THE ASSESSMENT PROGRAMS DIVISION ASSESSMENT SERVICE 1995 PREFACE The updating of this Handbook on Audit Procedures and Techniques was made under the leadership of Commissioner Liwayway Vinzons-Chato and Deputy Commissioners Victor A. Deoferio, Jr., Beethoven L. Rualo and Rene G. Banez. Acknowledgment is extended to the following for their invaluable contribution to the project: Arturo Andino, Luz Barrion, Arnel A. Bernardo, Enrique Bueno, Frederick P. Capitan, Teresita Felipe, Lucina A. Fernando, Alberto R. Paggabao, Evita M. Pantaleon, Arnulfo Romero, Marilou del Rosario, Erlinda Simple, Felix Sumbillo, Esperanza B. Tee, Samuel Veluz, Leonor S. Villalon and Tax Administration Assistance Project (TAAP) Technical Advisors, Steven Bowen, Yassie Hodges and Martin Townsend. ASSESSMENT SERVICE Dominador L. Galura Assistant Commissioner Ofelia B. Ibanez Head Revenue Executive Assistant ASSESSMENT PROGRAMS DIVISION Nora E. Tamayo Division Chief Margaret Mary C. Lauron Assistant Division Chief Leticia C. Batausa Section Chief Ma. Gracia B. Javier Section Chief Cristina T. Billones Section Chief Staff Elenita C. Villareal Marilou L. Servidad Alfredo N. Valeros Gladys M. Aquino Eleanor R. Rudi Edgar C. Espiritu Urania C. Salvacion Ponciana P. Villaruz Teodora V. Enriquez Charlita S. Agarin Table of Contents I. Introduction I-1 Revenue Tax Administration I-1 Purpose I-1 Contents of the Handbook I-2 II. Accounting Methods II-1 Cash II-1 Accrual II-1 Completion of Contract II-1 Percentage of Completion II-2 Installment II-2 Crop Year II-2 III. Bookkeeping Systems III-1 Single Entry System III-1 Double Entry System III-3 IV. Accounting Records IV-1 Journal IV-1 Ledger IV-2 Subsidiary Book IV-3 Computerized Accounting System IV-4 V. Accounting Periods V-1 Calendar Year V-1 Fiscal Year V-1 VI. Financial Statements VI-1 Income Statement VI-1 Balance Sheet VI-2 VII. Purpose and Standards of Audit VII-1 General Standards VII-1 Standards of Preliminary Planning VII-1 Standards of Field Work VII-2 Standards of Reporting VII-2 Standards of Public Relations VII-2 VIII. Preliminary Approach to Examination VIII-1 Pre-audit Analysis of Return VIII-1 Work Planning VIII-2 Contact with Taxpayer VIII-2 Preliminary Evaluation of Miscellaneous Records VIII-4 Initial Examination Techniques VIII-6 Evaluation of Internal Control VIII-7 Sampling Techniques VIII-9 IX. Balance Sheet Approach to Examination IX-1 Cash on Hand and in Bank IX-1 Notes and Account Receivable IX-2 Allowance for Bad Debts IX-3 Inventories IX-4 Advances to Stockholders/Officers IX-5 Investment IX-5 Depreciable Assets IX-6 Allowances for Depreciation, Amortization and Other Valuation Reserves IX-7 Intangible Assets IX-7 Prepaid Expenses and Deferred Charges IX-8 Other Assets IX-8 Exchange, Clearing or Suspense Account IX-8 Current and Accrued Liabilities Including Notes Payable IX-9 Fixed Liabilities IX-9 Deferred Credits IX-10 Loans From Shareholders/Officers/Owners IX-10 Capital Accounts IX-11 Capital or Owner's Equity IX-11 Partners' Capital IX-11 Stockholders' Equity IX-12 Capital Stock IX-12 Retained Earnings IX-14 X. Audit of Income and Expenses X-1 Audit of Income Accounts X-2 Sales X-2 Rent Income X-3 Professional Fees X-4 Income from Sale of Asset X-4 Other Income X-5 Audit of Expense Accounts X-5 Purchases X-5 Cost of Goods Sold X-6 Salaries, Wages and other Employees' Benefits X-7 Rents X-8 Royalties X-8 Interest X-9 Taxes X-9 Repairs X-10 Bad Debts X-10 Losses X-10 Abandonment and Demolition X-10 Casualty or Theft X-11 Depreciation X-11 Depletion X-12 Contribution X-12 Transportation and Travel, Representation and Entertainment X-13 Stationery and Office Equipment X-13 Professional Fees X-14 Insurance Expenses X-14 Light and Power, Telephone and Telegraph X-14 Miscellaneous Expenses X-14 XI. Auditing Computer-Produced Records XI-1 Impact of Computer Records on Audit XI-1 Accounting Software Systems XI-1 Audit Techniques for Computer-Produced Records XI-2 XII. Indirect Approach XII-1 Percentage Method XII-1 Net Worth Method XII-4 Bank Deposit Method XII-6 Cash Expenditure Method XII-9 Unit and Value Method XII-10 Third Party Information (Access to Records) Method XII-12 XIII. Closing Conference XIII-1 XIV. Report Making XIV-1 Document Locator Form XIV-1 Table of Contents XIV-1 Narrative Report XIV-1 Duly Accomplished Revenue Officer's Audit Report XIV-2 Working Papers XIV-3 Attachments to the Docket of the Case XIV-4 XV. Audit Procedures by Kind of Tax XV-1 Value-Added Tax Liabilities XV-1 Withholding Tax XV-21 Estate Tax XV-24 Donor's Tax XV-37 Capital Gains Tax XV-39 XVI. General Policies in the Investigation of Tax Fraud Cases XVI-1 (RMO No. 15-95) Jurisdiction XVI-1 Procedure XVI-1 Civil Fraud XVI-4 Appendix: Guidelines and Investigative Procedures in XVI-5 the Development of Tax Fraud Cases for Internal Revenue Officers I. Introduction A. Revenue Tax Administration The function of the Bureau of Internal Revenue is to administer the provisions of the National Internal Revenue Code. It is the duty of the Bureau to implement the Tax Code and related laws enacted by Congress in a fair and impartial manner. The mission of the Bureau is to enforce internal revenue laws with impartiality, courtesy and consistency, collect the correct amount of taxes at the least cost to the government and least inconvenience to the taxpayer and serve the public honestly and efficiently in a manner that will elicit the highest level of confidence in the Bureau of Internal Revenue. Investigation supports the mission of the Bureau by enhancing a high degree of compliance and encouraging the correct reporting of income, transfer, business and other taxes. This is accomplished by: a. Measuring the degree of voluntary compliance as reflected on filed returns; HITAEC b. Reducing non-compliance by identifying returns and taxpayers that need to be investigated; and c. Conducting quality audits of selected tax returns on a timely basis. The purpose of auditing a tax return is to determine the taxpayer's correct tax liability. A quality audit is the examination of a taxpayer's books and records in sufficient depth so as to ascertain the correctness and validity of entries thereon and the propriety of application of tax laws. B. Purpose The updated Handbook on Audit Procedures and Techniques has been prepared for all revenue officers who make field examinations of tax returns to provide him with confidence in carrying out the investigation. The purpose of the handbook is to equip the revenue officer with the necessary knowledge for the proper examination of tax returns and provide him with confidence in carrying out the investigation. This Handbook is designed to ensure that the revenue officer acquires useful auditing skills, progress from simple audit techniques to more sophisticated procedures and advance in examination procedures from a single proprietorship to a large corporation and from a simple bookkeeping accounting system to a highly sophisticated computerized system. The revenue officer's job is to familiarize with the business activity and/or undertaking of taxpayers assigned to him for audit, evaluate the various methods and procedures used, be imaginative, inquisitive and observant and above all, use common sense. C. Contents of the Handbook The handbook contains guides, instructions and suggestions in the conduct of audit for various taxpayers. The discussions begin with the analysis of tax returns & financial statements, familiarization with accounting methods, bookkeeping systems, books of accounts and other related records. The audit procedures for balance sheet and income statement accounts are laid out together with investigation techniques for each type of tax. This does not preclude, however, the revenue officer from carrying out other audit techniques which are deemed necessary in the circumstances surrounding a particular case. The Handbook is not intended to provide a source of tax law or procedural doctrine nor a reference material of revenue issuances. Each revenue officer is presumed to have a working knowledge of the Tax Code, the latest amendments thereon and an update of existing revenue regulations, revenue rulings, revenue memorandum orders and other issuances. The other contents of the handbook include documentary requirements in the investigation process and proper report making. II. Accounting Methods The methods of accounting regularly employed by the taxpayer in keeping his books are such methods as clearly reflect his income and which are followed at the time items of gross income and deductions are to be accounted for. If the taxpayer does not regularly employ a method of accounting which reasonably shows his correct income, the computation of income shall be made in such manner as in the opinion of the Commissioner of Internal Revenue or his duly authorized representative clearly reflects it. The methods of accounting recognized under the Tax Code are: A. Cash Basis is a method of accounting whereby all items of gross income received during the year shall be accounted for in such taxable year and that only expenses actually paid shall be claimed as deductions during the year. This method of accounting is generally used by taxpayers who do not keep books of accounts. Under this method, income is realized upon receipt of cash or its equivalent including those constructively received (such as deposits for the taxpayer's account by customers) but not including gifts or donations. Users of cash basis accounting are mostly individuals engaged in business and the practice of profession, professional partnerships and professional service organizations. B. Accrual Basis is a method of accounting for income in the period it is earned regardless of whether it has been received or not. In the same manner, expenses are accounted for in the period they are incurred and not in the period they are paid. Under this method, net income is being measured by the excess of income earned during the period over the expenses incurred. Expenses not being claimed as deductions by taxpayers in the current year when they are incurred cannot be claimed as deduction from income for the succeeding year. Thus, a taxpayer who is authorized to deduct certain of his expenses and other allowable deductions for the current year but failed to do so cannot be allowed to deduct the same for the next year. The accrual basis of accounting is being used by taxpayers whose nature of business uses inventories since this method of accounting will correctly reflect income by matching purchases and expenses against sales. This method is being applied by most medium and large corporations. C. Completion of Contract Basis is an accounting method applicable to contractors in the construction of building, installation of equipments and other fixed assets or other construction work covering a period in excess of one year. Under this method, gross income may be reported on the taxable year in which the contract is fully completed and accepted by the contractee if the taxpayers elected it as a consistent practice to treat such income, provided that such method clearly reflects the net income. If this method is adopted there should be deducted from gross income all expenditures during the life of the contract which are properly allocated thereto, taking into consideration any materials and supplies charged to the work under the contract but remaining on hand at the time of the completion. D. Percentage of Completion Basis is a method applicable in the case of a building, installation or construction contract covering a period in excess of one year whereby gross income derived from such contract may be reported upon the basis of percentage of completion. In determining the percentage of completion of a contract, generally one of the following methods is used: a. The costs incurred under the contract as of the end of the tax year are compared with the estimated total contract costs; or b. The work performed on the contract as of the end of the tax year is compared with the estimated work to be performed. HScAEC In such case, the return should be accompanied by a certificate of the architect or engineer showing the percentage of completion during the taxable year of the entire work performed under contract. There should be deducted from such gross income all expenditures made during the taxable year on account of the contract, account being taken of the materials and supplies on hand at the beginning and end of the taxable period for use in connection with the work under the contract but not yet so applied. E. Installment Basis is a method considered appropriate when collections extend over relatively long periods of time and there is a strong possibility that full collection will not be made. As customers make installment payments, the seller recognizes the gross profit on sale in proportion to the cash collected. F. Crop Year Basis is a method applicable only for farmers engaged in the production of crops which take more than a year from the time of planting to the process of gathering and disposal. Expenses paid or incurred are deductible in the year the gross income from the sale of the crops are realized. In relation to the foregoing accounting methods, the Tax Code provides for a tax credit system in computing the tax payable by certain taxpayers. While the tax credit system is not an accounting system, it is discussed here for the proper understanding of the computation of taxes due from taxpayers. The tax credit system is a method used to account for the creditable taxes deducted by the withholding agents from the income payments due to certain payees (as in the case of withholding tax at source pursuant to RR 6-85) or the creditable tax added to the sales price (as in the case of value-added tax). The creditable taxes should be clearly identified in the books of the taxpayer; such as: 1. Creditable income tax (asset) 2. VAT input tax (asset) 3. Withholding tax payable - Compensation (liability) 4. Withholding tax payable - Expanded Withholding Tax (EWT) (liability) 5. VAT output tax (liability) III. Bookkeeping Systems Bookkeeping may be made according to two systems, namely, (1) the single entry and (2) the double entry. The single entry system of bookkeeping is basically a type of "net worth" method of arriving at net income. It records only the debit or credit of each transaction, or an account with the debtor or creditor and a simple record of cash receipts and disbursements. Whenever a system of records keeping does not include equal debit and credit to asset, liability, proprietorship, income and expense accounts, it is referred to as a "single entry system". The single entry is often used by comparatively simple ventures such as small retail or commission merchants, professional firms, estates and trusts. In many cases, the only record of income and deductions consists of entries on the stubs of their checkbooks. Some taxpayers maintain an income tax folder in which they place documents to support their income tax deductions. A single entry system may be merely a chronological record of transactions posted in a notebook or journal. Sometimes, the records consist of a complete set of journals (cash, sales, purchases and general journal) and general ledger providing important accounts. The accounting cycle starts with source documents (invoices, bills, paid checks, vouchers, receipts, register tapes, loan documents, bank deposit slips, and bank statements) proceeding to the cash receipts and cash disbursements journal, working paper summary and ending with the tax return. Reconciliation of the taxpayer's books, working paper summary and records to the return is a very important audit step. In this way, the revenue officer will become familiar with the taxpayer's accounting system, policies and control procedures. If the records available are organized, this will lend more credibility to the tax return, but if they are inadequate, then the revenue officer should closely scrutinize the information on the income tax return. Therefore, when encountered with the lack of formal books and records, the revenue officer must use source documents and other available documents to construct the taxpayer's financial position in order to compare it with the taxpayer's standard of living and business activity. Double Entry System Under this system of bookkeeping, accounting recognizes the two-fold effects of every recorded event, the debit and the credit or the object of the event and the equitable interest in that object. Every recorded event affecting one side must necessarily affect the other side. This can be presented in an equation: Assets = Liabilities + Capital This can be analyzed into its component elements which show that there are two distinct parties that have rights in the assets of the business, the creditors and the owners. The rights of the creditors are the claims of such creditors on the assets of the business which are referred to as liabilities and the rights of the owners on the business are referred to as capital. In the double entry method, any net increase and net decrease in asset has a corresponding increase and decrease in either liabilities or capital. Audit of accounting records under this system shall be detailed as presented in the following discussions of audit of real and nominal accounts. IV. Accounting Records Taxpayers are required by law and regulation to keep and maintain accounting records in sufficient detail to enable them to make a proper return of income. The Commissioner of Internal Revenue is authorized to examine such records or other data which may be relevant material for the purpose of ascertaining the correctness of the tax returns. The books and records kept must be sufficient to establish the amount of the gross income and the deductions, credits and other matters required to be shown in the tax return. The primary records commonly used by all types of businesses, considering the accounting systems and reporting methods of the business are those documents such as invoices, vouchers, bills, receipts and other source documents which are also the supporting documents in the selling and buying of merchandise, services and assets used in the business. For companies which require the use of inventories, the primary records include the detailed inventory list. Other primary records used in financial transactions are the cancelled checks, duplicate deposit slips bank statements and notes. HcDaAI The secondary records, regardless of the accounting method used by the taxpayer include permanent books and working papers which summarize and list the individual documents including adjustments, when necessary. These records are properly classified in such a way that the taxpayer will determine the financial status of his business in a given period of time and the profit and loss for the period. All records required to be kept by the taxpayers should be preserved by them for proper administration of any internal revenue law. Below are the accounting records being used by taxpayers: A. Journal is a book of original entry in which transactions affecting the business of a taxpayer are recorded consecutively day by day as they occur. Journal consists of the following: a. Sales Journal . This is a book whereby sales an account are recorded which are supported by sales invoices and which are also the documents that will serve as the basis of recording the transactions in the books of accounts. Cash sales are usually recorded in the cash book although it may be posted in both books representing a debit to cash in the cash book and a credit to sales in the sales book. Every entry in the sales journal represents a debit to a customer's account and a credit to sales to be posted in the general ledger. Sales returns and allowances are also recorded in the sales book which represents a debit to Sales Returns and Allowances and a credit to Accounts Receivable to be posted in the general ledger. This would mean a decrease in Sales and eventually a decrease in an asset account. b. Purchase Journal . This is a book used to record exclusively all transactions involving the purchase or acquisition of merchandise on account. The business document that serves as evidence of a purchase transaction is the purchase invoice. An entry to record charge purchases is a debit to Purchases and a credit to Accounts Payable to be posted in the general ledger. Purchase returns and allowances are also recorded in this book and posted in the general ledger representing a debit to Accounts Payable and a credit to Purchase Returns and Allowances which would mean a decrease in the purchases account. In certain instances such as where the volume of business is large under the value-added tax system, taxpayers maintain subsidiary sales and purchase journals where details of daily sales and purchases are recorded. c. Cash Book is a book whereby all transactions involving cash whether cash receipts or cash disbursements are recorded. Under this book are the following: c.1. Cash receipts book a book whereby all transactions involving cash receipts of whatever source are recorded. c.2. Cash disbursements book a book whereby all transactions involving cash or check disbursements are recorded. B. Ledger is a book of final entry to which are posted the classified accounts or items of all transactions entered in the journal. All entries in the journal must be posted to the ledger and shall be classified in the ledger so as to show the assets, liabilities, capital and the operating accounts from which a balance sheet and a profit and loss statement covering the operation of the business can be prepared. No entry shall be made in the ledger unless said entry originates from the journal. The accounts contained in the general ledger provide the revenue officer with insight into the operations of the business. When pertinent, the chart of accounts should be requested from the taxpayer. If a private ledger is maintained, it should also be requested. As the revenue officer goes through the ledger, unusual or non-recurring items should be noted and verified. Most of these items are classified as follows: a. Unusual in amount The revenue officer should be alert for month-end entries with significant amounts which may affect income and expenses. b. Unusual by source source means the books of accounts from where the entry to the ledger account originates. Hence, expenses or adjustments to income which do not ordinarily originate from the cash journals, sales and purchase books should be investigated. Such adjustments originating from the general journal or journal vouchers should be thoroughly examined as to supporting documents and proper authorization. c. Unusual by nature An entry in a ledger account may be unusual by nature as well as by an account itself. Accounts with abnormal balances such as receivable accounts with credit balances may indicate income which is credited to receivables instead of sales. Unusual accounts such as suspense, other receivables and due to stockholders and such other unusual liability accounts should be analyzed as there may be income components lodged in these accounts. EISCaD C. Subsidiary Book . In the general ledger, accounts are usually transferred and grouped into certain accounts to a subsidiary book. This general ledger account is called control account. Control accounts in the general ledger contain summarized information that is recorded in detail in a subsidiary book or ledger. It is therefore the control account which contains summarized information and the subsidiary ledger contains the same information but in detail. Thus, in order to relieve the general ledger of too many individual accounts, business concerns having numerous accounts with customers and creditors will transfer said accounts to separate ledgers one for customers and another for creditor's. For example, the control account for the customer's subsidiary book will be called "Accounts Receivable", while the control account for the creditors' subsidiary book will be called "Accounts Payable". All corporations, companies, partnerships or persons required by law to pay internal revenue taxes have the option to keep this kind of book depending on the need of their business, provided that where such subsidiaries are kept, they shall form part of the accounting records of the taxpayer and shall be subject to the same rules and regulations as to their keeping, translation, production and inspection as are applicable to the journal and the ledger. D. Computerized Accounting System . This method of accounting is now being used by most companies. It is a system whereby information are fed into the computer thus providing uniformity in the processing of transactions. Types of System under this method: a. Simple System . Transactions are easily traced in a small computer system where the primary function performed is the sorting and manipulation of input data and the printing of output reports. There is no loss of audit trail. Audit of this type of system requires little training and background in Information Systems (IS). An example of this type of system are shipping data that are encoded and processed throughout the system along with accounts receivable ledgers. The output is a multicopy sales invoice for each sale, an updated subsidiary ledger and a sales journal. b. Complex System . This is characterized by the batch processing mode, the existence of one Central Processing Unit (CPU) and the extensive use of master files on magnetic media in processing. In this type of system, processing is usually confined to calculations, extensions, summarizations and the like. There is some loss of audit trail but the same is not significant. The audit of such system can be done by auditors with limited specialized training in IS auditing. Because of the extent of a printed audit trail, the auditors have the option of performing audit tests with or without the use of the computer based on his experience. c. Sophisticated System . In this type of system, transactions are initiated within the computer. There is extensive data processing and consequently, a substantial loss of audit trail. Most of the output is in machine-readable form. Heavy reliance must be placed on internal control in the audit of said system. Since many of these tests require IS skills beyond the knowledge of most auditors, IS specialists are usually called upon by the auditors. Careful advance planning is necessary because records needed in audit and the approach to be used in testing must be made before data are processed. V. Accounting Periods Accounting periods are classified into two, they are: 1. Calendar year; and 2. Fiscal year. Calendar year is an accounting period which starts from January 1 and ends on December 31. This is generally used by most taxpayers who elect the calendar year as their accounting period. However, the calendar year shall be the basis of computing the net income in the following cases: a. when the taxpayer is an individual; b. when the taxpayer does not keep books of accounts; and c. when the taxpayer has no annual accounting period. Fiscal Year is an accounting period for twelve months ending on the last day of any month other than December. Corporations and duly registered general co-partnerships are allowed to use this type of accounting period. A taxpayer may have a taxable period of less than twelve (12) months in the following cases: a. When a corporation is newly organized; b. When a corporation changes its accounting period; c. When a corporation is dissolved; d. When the Commissioner of Internal Revenue, by authority, terminates the tax period of a taxpayer; and e. In case of final return for the decedent. Change in Accounting Period An individual cannot change his accounting period from the calendar year to the fiscal year. He is only allowed to use the calendar year. The corporation and general co-partnership have the option to choose between the calendar year and the fiscal year. The application for a change in accounting period should be filed in writing with the Commissioner of Internal Revenue, through the Revenue District Office, within thirty (30) days prior to the date fixed for filing of the return on the basis of the original accounting period designating therein the proposed date for the closing of its new taxable year. VI. Financial Statements Financial Statements are reports signifying the end product of the financial accounting process. These reports are as follows: A. Income Statement it is a report that summarizes the business activities for a given period and reports the net income or loss resulting from operations and from certain other activities. It is variously called the earnings statement, the statement of profit and loss and the statement of operations. It normally consists of the following sections or items: a. Sales reports the total sales to customers and fees received from clients for the period. Transactions deemed sale, except goods out for consignment, must have been properly recorded as sales. All sales transactions should be recorded and invoiced. b. Cost of goods sold refers to cost of goods relating to sales when merchandise is acquired from outsiders. This is the sum of the beginning inventory, purchases and all other buying, freight and storage costs relating to the acquisition of goods and subtracting the ending inventory thereof. When the goods are manufactured by the seller, the cost of goods manufactured must first be calculated. This is the sum of the cost of goods in process at the beginning, the cost of materials put into production, the cost of labor applied and factory overhead incurred. The total cost as thus obtained represents the cost of both completed work and uncompleted work still in production. The ending goods in process inventory, then, must be subtracted from this total in arriving at the cost of the product completed and made available for sale. c. Operating expenses are expenses incurred or utilized in the course of business or pursuant to the practice of profession. They are generally reported in two categories: a. selling expenses and b. general and administrative expenses . In case of self employed individual taxpayers, professionals, non-resident aliens, estates and trusts engaged in trade or business, general professional partnerships and their individual partners, expenses claimed are subject to the provisions of RR 2-93. d. Other Income and Expenses include items identified with financial management and miscellaneous recurring activities. Other income include interest and dividend income and income from rentals, royalties and service fees. Other expenses include interest expense and expenses related to the miscellaneous income items reported. B. Balance Sheet is a report that shows the financial position of the business unit as of a specified moment of time. It is a status report rather than a flow report. It is variously called statement of financial position, statement of condition, statement of resources and liabilities and the statement of net worth. The balance sheet is the fundamental accounting statement in the sense that every accounting transaction can be analyzed in terms of its effect on the balance sheet. In order to understand the information a balance sheet conveys and how economic events affect the balance sheet, it is essential that the reader be absolutely clear as to the meaning of its two sides, the equation DSHTaC ASSETS = LIABILITIES + OWNER'S EQUITY a. Assets are economic benefits obtained or controlled by a particular entity as a result of past transactions or events. They include those costs that have not been matched with revenues in the past and are expected to afford economic utility in the production of revenues in the future. It includes both monetary assets, such as cash, marketable securities and receivables and non-monetary assets, those costs recognized as recoverable and hence properly assignable to revenues of future periods, such as inventories, prepaid insurance, equipment and patents. b. Liabilities measure the claims of creditors against entity resources. The method for settlement of liabilities varies. Liabilities may call for settlement by cash payment or settlement through goods to be delivered or services to be performed. c. Owner's Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. It measures the interest of the ownership group in the total resources of the enterprise. Such equities originally arise as the result of contributions by the owners and the equities change with the change in net assets resulting from operations. VII. Purpose and Standards of Audit The basic purpose of tax examination is the determination of correct taxable income as defined by the National Internal Revenue Code and the determination of the correct income and other internal revenue tax liabilities of the person or entity whose return is being examined. In making the examination, the revenue officer's responsibility is two-fold: to the taxpayer and to the Philippine Government. Minimum standards of examination may be extended beyond the originally intended scope, or beyond minimum requirements because of situations or facts not apparent at the outset. The amount of verification to be done in any single tax examination is a matter of auditing judgment for which no rigid guide can be established. The degree of checking or scope of a tax examination may be influenced by an analysis of the taxpayer's accounting procedures and the results achieved thereby insofar as they evidence the credibility of the records and the degree of the existing system of internal control of the taxpayer. Standard refers to the criteria by which the quality of performance of auditing examinations are measured. A. General Standards a. An impartial mental attitude must be maintained in all affairs relating to an examination in order to assure a fair application of tax laws, regulations and rulings. b. Professional skill and ingenuity must be exercised in the performance of the examination and the preparation of the report. c. Issues should be raised only when in the revenue officer's opinion they have real merit and only when they will contribute in the proper determination of tax liability. d. The confidential nature of all information pertaining to any assignment must be rigidly observed. B. Standards Of Preliminary Planning a. Sound judgment should be exercised in selecting from assigned returns those which are most likely to contain areas of non-compliance and, where otherwise permissible, survey procedures should be employed to dispose of those which do not warrant further consideration. b. Advance planning of work schedules with reasonable accuracy is essential for the effective use of time. c. A general work plan should be formulated in each case prior to contacting the taxpayer which includes the development of issues suggested by the return and other information. The following steps may be included in the work plan: c.1. Prepare a list of items which suggest a need for special consideration. c.2. A list of questions to be asked from the taxpayer. c.3 A list of other agencies or offices where the revenue officer can have access to their records if the taxpayer cannot present the documents requested. C. Standards of Field Work a. Audits should normally be performed at the taxpayer's place of business because of the accessibility of the books and records and to permit actual observation of taxpayer's facilities and scope of operation. Otherwise, it should be performed in the office of the Bureau of Internal Revenue. b. The use of accounting skills, tax knowledge and ingenuity should be directed toward recognizing and raising issues which relate to non-compliance areas. c. Adequate evidential matter should be obtained through inspection, observation, inquiry, analysis and documentation to afford a reasonable basis for consideration of each issue with regard to the position of both the Government and the taxpayer. d. The position taken with respect to each issue should be supported by adequate authority. D. Standards Of Reporting a. Reports are to be prepared in a complete, clear, concise, and legible manner in order that they may be easily read and understood. b. Working papers should be legible, in the revenue officer's own handwriting, properly headed, indexed, signed and arranged in a logical and orderly manner. c. Working papers should be used as a practical and professional tool to aid the revenue officer in the discussion of issues or questions with the taxpayer or his authorized representative. It also generally provides a record of the audit procedures undertaken by the revenue officer. E. Standards of Public Relations a. Initial contact for audit arrangements should be made with the taxpayer and care should be exercised in explaining the type of records required. b. Revenue Officers must be fully cognizant of the proper sources for gathering information and of the rights of the taxpayer and his representatives. c. Necessary time and patience should be devoted to a discussion of any proposed adjustments to ensure that the taxpayer has a proper understanding of the issues. d. Tact and discretion are required in pointing out errors in books and records in order to avoid discrediting an employee or representative of the taxpayer. cAISTC VIII. Preliminary Approach To Examination A. Pre-Audit Analysis Of Return Analysis of the return is essential to an effective audit. Preliminary analysis is used to identify potential issues which will be developed further after contacting the taxpayer. All information contained in any attachment to the tax return should be thoroughly and completely scrutinized to ascertain whether or not all of the information is adequately reflected on the tax return. Before contacting the taxpayer the revenue officer should familiarize himself with the following: a. The business organization of the taxpayer and whether it has business establishments other than its main or head office; b. The location of the business and its branches as this has a relation to the volume of business; c. The economic activity in which the taxpayer is engaged in; d. The accounting books and records that would ordinarily be kept; e. The accounting methods and policies and the degree of internal control; f. The overall composition of the tax return; g. The types of income reported; h. The reasonableness of deductions; i. Unusual or unfamiliar items; j. Apparently questionable or unallowable items; k. Gross profit and selling expense percentage as well as significant variations between prior and current years; l. Inconsistencies between items and also in the treatment with respect to bad debts, inventory valuation methods, depreciation rates methods, etc.; m. Prior year's entries in the reconciliation schedules of retained earnings on a corporate return and of a partner's capital account in a partnership return which affect the year under examination; n. The status of the retained earnings account as well as basis of assets and depreciation allowed or allowable; and o. The report of the tax liabilities of the taxpayer for the immediately preceding period in order to be aware of the deficiencies that were reported. Review of prior year's examination records will clarify some doubts or questions in the revenue officer's mind regarding certain items or bring light to situations that otherwise would have remained concealed on the basis of the return alone. B. Work Planning Work properly planned achieves good results. a. Returns or cases where the statute of limitations is about to prescribe should be given first priority. Prescriptive period is three (3) years counted from the date prescribed by law for the filing of the return, provided that in case a return is filed beyond the prescribed period, the three-year period shall be counted from the day the return was filed. b. Claims for refund should be given the next priority in order to develop good BIR-taxpayer relationship. c. Cases assigned for reinvestigation should follow. d. Returns which would be more productive in point of revenues should be given precedence over the less productive ones. In work planning, an Audit Program should be prepared for each and every case. An Audit Program is a checklist of the various auditing procedures to be undertaken and the various books of accounts, records, documents and business forms to be verified in order to assess the correct tax due from a taxpayer. This checklist would serve as a guide for the revenue officer to conduct a "Quality Audit" within the time frame allowed to conclude a tax audit. It is also a tool of the tax administrators to check on the progress of the tax audit and for proper evaluation of the performance of the revenue officer. C. Contact With Taxpayer a. Arranging for an appointment . A telephone or a personal call by the revenue officer should be made to the taxpayer and not to his representative. b. Serving of Letter of Authority b.1. On the first opportunity of the revenue officer to have personal contact with the taxpayer, he should present the Letter of Authority together with a copy of the Taxpayer's Bill of Rights. The LA should be served by the revenue officer assigned to the case and no one else. He should have the proper identification card and should be in proper attire. b.2. A Letter of Authority (LA) authorizes or empowers a designated revenue officer (RO) to examine, verify and scrutinize a taxpayer's books and records in relation to internal revenue tax liabilities for a particular period. b.3. A Letter of Authority must be served or presented to the taxpayer within 30 days from its date of issue, otherwise, it becomes null and void unless revalidated and the taxpayer has all the right to refuse its service if presented beyond the 30-day period. Revalidation is done by serving a new Letter of Authority. AaIDCS c. Request for Accounting Records The revenue officer should clearly specify the records he desires to be assembled for his examination. Among the books and records that may be required are: c.1. receipts c.2. invoices c.3. vouchers c.4. bills c.5. contracts c.6. journals c.7. ledgers d. Initial Interview The initial interview is the most important part of the examination process and should be conducted in all audits. Request should be made for a personal interview with the taxpayer himself. The interrogation should be so conducted as to encourage the taxpayer to contribute willingly useful information which will assist in the proper determination of his tax liability. The information developed by this method will determine the eventual outcome of the case. The preliminary interview should, as far as practicable, cover the following: d.1. Discussion of sources of income This may uncover possible sources of income which has not been reported such as interests on investments and deposits, dividends, rents, sales of properties as well as information on financial history and standard of living. d.2. Records kept for each source of income; d.3. Handling and recording of cash transactions; d.4. Records of loans from banks and/or loans to others; d.5. Real or personal properties bought or sold in current year; d.6. Correctness of personal and additional exemptions claimed; and d.7. Other items that would be relevant in the examination, to wit: d.7.1. The responsible officers of the firm in order to facilitate acquisition of information/data; d.7.2. Place and time of audit; d.7.3. Ocular inspection of the factory, branches, outlets, etc.; d.7.4. Officers to whom the tax audit findings will be discussed; d.7.5. Financial history and standard of living of the owner/owners. D. Preliminary Evaluation Of Miscellaneous Records The investigation on the taxpayer's office may begin with miscellaneous records other than accounting ledgers and journals. Mostly, scrutiny of these records may reveal items which the revenue officer should take into consideration as the examination progresses. The records and information to be obtained are the following: a. Minute Book The review of the minute book should not be confined to the taxable year under audit but should cover at least some period immediately before or after. As the revenue officer scans the minute book, he should note appropriate transactions and items of significance, such as contracts entered into by the taxpayer, stock issuance, dividend declaration and compensation of officers. b. Stock Transfer Book This book contains the names of stockholders, past and present, with the number of shares cancelled and issued. This book is vital also in computing documentary stamp tax liabilities. A general knowledge of the names of large shareholders is also of value when checking the salary expense. When the stock and transfer book is not available, the record of dividend payment is an alternative source of similar information. c. Partnership agreement A copy of the partnership agreement should be obtained and certain provisions affecting partner's salaries, profit and loss sharing, interest on capital, other allowances and other matters which may have tax consequences should be noted. d. Audit report of independent auditors The revenue officer should read the auditor's report accompanying the financial statements. Sometimes, revenue officers fail to evaluate the auditor's report. However, there are cases when auditors do not issue an unqualified opinion. Any qualification or unusual comments in the auditor's report or certificate such as expression of opinion as to taxpayer's depreciation policy, inventory and cost valuation, adequacy of reserves, status of collectibility of receivables and the like should be noted for consideration and should be related to the examination of accounts. In cases where the auditor issues two reports, one for management and the other for attachment to the tax return, the former should be studied and compared with the latter. Income and net worth in both reports may differ from income and net worth per books due to the auditor's adjusting entries not reflected in the books. Thus, the adjusting entries and supporting documents should be examined. If needed, the auditor's working papers should be looked into to explain these entries. e. Auditor 's working papers Audits, particularly of large companies, may frequently be simplified and facilitated, if the examining revenue officers are given access to the auditor's working papers. Where necessary, authorization from the taxpayer or requests for access to said working papers signed by duly authorized officials shall be secured to be able to scrutinize the working papers of auditors, particularly the year-end adjustments, intercompany transactions, nature of receivables and other peculiar accounts. TCAHES f. Statements and schedules filed with government regulatory agencies Certain taxpayers are required to file financial statements and other reports with government bodies such as the Securities and Exchange Commission for corporate taxpayers, the Garments and Textile Export Board for garments exporters, the Board Of Investments for exporters and other similar government offices. The revenue officer should compare the statements filed with the Bureau of Internal Revenue against those filed with other government offices Any discrepancy should be inquired into and material differences should undergo an in-depth investigation. g. Appraisal reports Appraisal reports, particularly real estate appraisals, are important in many cases such as for estate tax valuation of properties, capita] gains tax verification and donor's tax investigation. E. Initial Examination Techniques a. Understanding the taxpayer's books and records . One technique that should be commonly used is for the revenue officer to interview the taxpayer or his representative to walk him through the book recording of a sale, purchase and expense transaction and to have a thorough understanding of the taxpayer's accounting system and records. b. Reconciliation -of books and returns . Another step in understanding the records is to perform a reconciliation of the books with the return. The following actions are recommended to assist the revenue officer in the reconciliation process: b.1. Request for a Chart of Accounts and identify account numbers and account titles. b.2. Identify unusual accounts. b.3. Scan the general ledger to pursue unusual account entries. b.4. Ask the taxpayer for the tax working papers or any other type of working papers that were used to prepare the return. If the working papers are in the hands of the external auditor, the taxpayer should be advised to secure a copy thereof from their auditor. If no working papers are available, request the taxpayer to prepare the reconciliation and supporting schedules used to arrive at the reconciliation. b.5. Inspect the Statement of Changes in Financial Position, if the taxpayer has one, to identify sales and purchases of fixed assets, investments made and disposed, loan and debt payments, capital contributions and other transactions that might not be readily apparent on the balance sheet and income statement. c. Performance of compliance tests . The revenue officer should establish the level of reliance that can be laced on the books and records and determine whether the books show all the transactions which occurred. To accomplish this, a compliance test should be performed on some transactions through the backward approach and the forward approach as follows: c.1. In the backward approach, the figures per tax return are traced to the trial balance, then to the general ledger, the various journals and ultimately to the source documents such as sales invoice or official receipt. c.2. In the forward approach, the revenue officer should select a supporting document, say a sales invoice, and trace it through the sales journal, general ledger, trial balance and finally to the tax return. The backward approach is effective in checking unsupported expenses while the forward approach is used in uncovering unreported income. d. Analysis of adjusting journal entries . It is important that the revenue officer understands adjusting journal entries because tax issues are frequently discovered in the adjusting journal entries. These adjusting journal entries are usually accruals, deferrals, corrections or reclassification of accounts. d.1. Accruals are normally entries to record certain known and fixed amount obligations or liabilities. Accruals are also used to book uncertain, contingent liabilities. Contingent liabilities are not fixed in amount or date and are not deductible for tax purposes. d.2. Deferrals are typically used to defer or postpone recognition of income or expenses. An inspection of the deferred income account may reflect amounts representing services already performed. It may also show goods already shipped and received by the customer. In both of these situations, a referral of income is not proper. IEDaAc d.3. Corrections of prior year's earnings, other adjustments and reclassifications are made through adjusting journal entries which are recorded in the general journal or in the journal vouchers. Usually, these entries are taken from the auditor's working papers. The examining revenue officer should scrutinize these entries, specially those credited directly to retained earnings, analyze the tax issues involved and note down possible-tax assessments. d.4. Also, when scanning adjusting journal entries, the following should be looked into closely: d..4.1 Unusual, nonrecurring entries. d..4.2 Entries reducing assets as there could possibly be unreported gain on sale, incorrectly computed gain on sale, incorrectly computed installment sale, non-taxable exchange or withdrawal of goods by the owner. d..4.3 Entries increasing liabilities as these could represent fictitious or contingent liabilities, fictitious expenses, invalid loans to shareholders or undeclared income credited to liability accounts. F. Evaluation Of Internal Control Internal Control is a system of procedures in place to ensure that all business transactions are properly recorded and assets are adequately safeguarded. It is mandatory for the revenue officer to evaluate internal control to decide to what extent the system can be relied upon, which in turn determines the nature, extent and timing of audit tests to be applied in the examination and to plan subsequent audit procedures. a. Principles of Internal Control Good internal control assures good record keeping and the inability of the employees and the owner from misappropriating the assets. Some broad principles of internal control are: a.1. Responsibilities should be clearly established. a.2. Adequate records should be maintained. a.3. Assets should be insured and employees bonded. a.4. Record keeping and custody should be separated. a.5. Responsibility for related transactions should be divided. a.6. Personnel should be rotated. cCaIET a.7. Automation should be used whenever practical. a.8. Employees should be informed of prescribed procedures. a.9. The system should be under constant review. b. Elements of Internal Control Internal control can be divided into three elements: b.1. Control environment This includes the entity's organizational structure, methods of assigning authority and responsibility, engagement in related party transactions and compliance with various laws. b.2. Accounting system This consists of the methods and records established to capture financial transactions such as sales, purchases, investments and payment of expenses and liabilities. This element is important to the revenue officer for him to understand how transactions are initiated and recorded and to determine the degree of reliability to be placed in the taxpayer's books and records. b.3. Control procedures These include the adequate use of documents to ensure the proper recording, valuation and timing of transactions. Reconciliations of accounts should be done periodically and management should review reports for accuracy and completeness. c. Standard Procedures in Evaluating Internal Control To establish the scope of the audit and degree of compliance tests to be performed, internal control should first be evaluated based on the following techniques: c.1. Identify the personnel responsible for record keeping and determine their responsibilities and authority in the business operation. c.2 Reconcile the return with the books and records. Difficulty in reconciling the return with the books and records may be an indication of inadequate internal control in either financial or tax accounting. c.3. Interview responsible company personnel and observe business operations . c.4. Review the chart of accounts and identify unusual accounts or note those accounts which should be included but are absent. c.5. Secure and study copies of operating manuals or instructional booklets that may lead to an easy understanding of the taxpayer's business operations. c.6. Determine if the taxpayer's personal transactions are segregated from business operations or if separate bank accounts are maintained by the owner and the business. c.7. Determine if bank accounts are reconciled monthly. c.8. Determine the books and records maintained and the frequency of recording transactions. c.9. Determine if pre-numbered documents are being used. c.10. Determine the extent of involvement of auditors and other third parties in the business. c.11. Determine if certified audits for any reason were prepared. If so, copies of these documents should be secured. c.12. Determine if the income reported by the taxpayer reflects his lifestyle. The effective evaluation of internal control is dependent upon a very good interview, observation of the business operation and testing of the system. G. Sampling Techniques Sampling is a large and important part of the examination of a tax return. It is the application of examination procedures to less than 100% of the items in an account to evaluate its accuracy. a. Two Basic Types of Sampling a.1. Statistical sampling a.2. Judgmental sampling In selecting accounts and transactions to be tested, judgmental sampling should be applied as it involves the use of professional judgment in planning and performing the sampling and analyzing the results. ASDCaI Judgmental sampling may include any or both of the following methods: a.2.1. Block sampling uses groups of continuous items selected from an account balance or class of transactions. An example is a revenue officer's decision to sample one month of travel expense to reach a conclusion for the year. a.2.2. Peso limitation sampling or cut-off sampling selects a minimum peso amount and transactions in excess of the said amount are verified. b. Factors to be Considered in Planning the Sample b.1. Internal Control The extent of sampling to be done is dependent on the degree of internal control. Thus, a small sample size is required if internal control can be greatly relied upon. b.2. Accounting System Large errors or high frequency of errors in the accounting system may require a large sample size. b.3. Materiality In choosing appropriate material limits, the absolute size of an item, the relative size and the nature of the business and industry/business practice should be considered. Materiality of an item should be related to its tax consequence. b.4. Analytical Review In analytical review, the following considerations should be studied: b.4.1. Taxpayer's standard of living TcDIEH b.4.2 Interest in closely held companies b.4.3. Transactions between related parties b.4.4. Transactions involving questions of fraud b.4.5 Significant increases or decreases in taxable income from year to year b.4.6. Significant adjustments on previous revenue officer's reports c. Sampling Techniques to be Applied in Testing Accounts and Transactions There are as many sampling techniques as there are cases. The revenue officer is not precluded from discovering and applying new techniques as may be needed in each particular case. Listed below are the suggested sampling techniques in testing income statement and balance sheet items: c.1. Select the first and last months of sales to ensure that income was not deferred to an improper year. c.2. The last month of the period under examination should be tested because of the likelihood of errors and unallowable adjustments made before the end of the year. c.3. Selection of the largest three months of an expense account may reveal expenses that should be capitalized, personal expenses or padded expenses. c.4. Scan the cash disbursements journal and general ledger for unusual or very large entries. This step also familiarizes the revenue officer with the accounts, payees, suppliers and clients of the taxpayer. c.5. Select at least one month's (or one week for a large corporation) issuance of cancelled checks. Thoroughly analyze each check together with the endorsement at the back. This could lead to the discovery of fictitious payees, unusual transactions, personal items charged to expense and other potential disallowances. c.6. Inspection of the corporate minutes and the articles of incorporation could lead to a revenue officer's determination to sample a particular account. c.7. Examine certain accounts in the income statement in relation to the balance sheet accounts. Thus, Accounts Receivable should be analyzed together with Sales, Bad Debts Expense should be verified together with the Allowance for Bad Debts. Likewise, Accounts Payable should be examined together with Purchases and other related expenses. c.8. Test check source documents and related transactions by considering the persons involved, nature of the contract, mode of payment and other important aspects. c.9. Rounded figures should be checked as they may be estimates. c.10. Utilize results of analytical review in selecting the sample. c.11. Contract or limit the scope of the sample if the majority of the samples are completed and there are still no discrepancies. d. Examining the Sample Items The sample items, as selected, should be verified as follows: d.1. Analyze and determine the validity of the source documents. d.2. Examine collaborating documents. d.3. Check with third parties. d.4. Inspect and observe inventory flow, fixed assets acquired, sales transaction and other transactions which may require ocular inspection. e. Analyzing the Results Analyzing the results of a sample is an important yet commonly missed step. The sample taken should be evaluated and considered in relation to any peculiar situation, such as related party transactions or economically unsound transactions. One example would be purchases made at unusually high or low prices. If the results of the sampling indicates potential tax assessment, an in-depth analysis should be conducted as follows: e.1. Verify the account showing the discrepancy or possible source of tax deficiency. cADaIH e.2. Trace the audit trail involving the transaction. e.3. Perform a 100% verification of such account. e.4. Consider performing third party checks to substantiate transactions. e.5. Take a close look at how the taxpayer handled the entire transaction. e.6. Consider the adjustments associated to other accounts. e.7. Discuss the problems or discrepancies with the taxpayer or his authorized representative. f. Concluding the Sampling Results The audit samples should be clearly documented in the working papers from which a conclusion shall be drawn. If a quality sample analysis has been performed, it will be easy to form a conclusion from the sample results. The conclusion reached should be clear, concise and final. IX. Balance Sheet Approach To Examination A series of suggestions on the procedures of commencing the examination of tax returns and appropriate accounting records have already been presented. The initial phase includes a verification of the net income per books with the reconciling items reflected in the tax return. After the foregoing process, the revenue officer should turn his attention primarily to the books and records bearing in mind that there are some reconciling items which affect the net income per books. The following offer guides to the techniques in examining asset, liability and net worth accounts. The revenue officer, however, is not precluded from applying other techniques which are required in each particular case. A. Cash on Hand and in Bank a. Compare deposits shown by the bank statement against entries in the cash receipts book and official receipts. Note down any unrecorded or unreceipted deposit and investigate the source. b. Test check cash sales with the cash receipts book if they have been correctly recorded. Also check cash sales made at the beginning and end of the period under examination to determine if year-end sales have been recorded in the proper accounting period. c. Investigate entries in the general ledger cash account. Look for unusual items which do not originate from cash receipts or disbursements journals . These entries may indicate unauthorized withdrawals or expenditures, sales of capital assets, omitted sales, undisclosed bank accounts, etc. d. Review cash receipts journal for items not identified with ordinary business sales, being alert to such items as sales of assets, miscellaneous income, sale of scrap, income received in advance, proceeds from issuance of capital stock and other taxable transactions. e. Review cash on hand and cash in bank accounts to determine if there are any credit balances during the period under examination. This may indicate unrecorded receipts. f. Review cash disbursements journal for a representative period. Note any missing check numbers, checks payable to cash, large or unusual items and determine propriety thereof through a comparison with vouchers, journal entries and other related accounting records. g. If the taxpayer is on cash basis, ascertain if checks were written and recorded at the close of the period under audit but were issued thereafter. Verify checks issued during the latter part of the year to check the authenticity of expenses claimed. h. Give special consideration to checks issued for cashier's checks, sight drafts and other similar bank instruments where the payees and nature of the disbursements are clearly shown. i. Obtain bank statements and cancelled checks for each bank account for one or more months, including the last month of the period under examination. j. Note year-end bank overdrafts. This may indicate expenses which are fictitious or unallowable since funds were not available for payment. k. Determine if there are checks which have remained outstanding for an unreasonable period of time. This may indicate improper, fictitious or duplication of disbursements . Old outstanding checks could possibly be restored to income. AHSaTI l. Determine whether voided checks have been properly adjusted in the books and credited to the appropriate expense accounts, if applicable. m. For a test period, check endorsements to verify if they are the same as that of the payees', noting any endorsements by the owner, or any questionable endorsement. n. If records appear unreliable or have not been subjected to a competent independent audit, tests of footings and postings should be made for a representative period. o. Test check disbursements from petty cash to determine if there are any unallowable items included. p. Scrutinize cash overages and shortages, being alert to irregularities. q. Tally debits and credits to the cash accounts per month against sales credits, and other sources of cash based on the worksheet of real and nominal accounts submitted by the taxpayer. Note down discrepancies and substantial accumulation of cash without reasonable credits. B. Notes And Accounts Receivable a. Secure a breakdown of the receivables by class, whether notes or accounts and by debtors, such as customers, affiliated companies, officers, stockholders, employees and others. b. Check entries in the general ledger control accounts Look for unusual items, especially those which do not originate from the sales or cash receipts journals. c. Determine if subsidiary ledgers are in agreement with control accounts, and if not, ascertain the reasons for any differences. d. Note any credit balances in the general ledger or subsidiary accounts. This may indicate deposits or overpayments which could be considered as additional income or unrecorded sales. Also, credit balances may indicate a bad debt recovery misapplied or deposits received for so long a time that there is little likelihood that they will ever be refunded. Whatever the cause, the credits, if material, should be isolated for consideration. e. Some credit sales invoices and postings should be test checked from the sales journal to the subsidiary and control account. f. Compare balances of accounts receivable and sales with preceding year's. Investigate significant changes. g. Investigate large and/or unusual balances classified as other accounts receivable. h. In case of notes receivable, determine whether accrued income on interest bearing notes or accounts has been included in income. i. Investigate the sources of notes receivable as there may be instances when the taxpayer has other sources of income other than his regular business. j. Determine whether accrued income on interest bearing notes or accounts has been included in income. k. If needed, check the detailed listing of beginning receivables to cash collected as reflected in the cash receipts book. This may disclose diversion of funds and other irregularities. C. Allowance For Bad Debts a. Ascertain the company policy of providing for allowance for bad debts by examining minutes of meeting and other documents. b. Compare balances in the allowance account with the preceding year's. Investigate significant changes. c. Evaluate the reasonableness of the allowance by computing the ratio of the balance of allowance for bad debts to the trade accounts receivable balance. d. Compute the ratio of bad debts expense over sales. Analyze if such is reasonable. e. Review the aging schedule of accounts receivable. f. For accounts written off which were charged to expense, examine minute book for authorization to write off accounts. g. Ascertain that accounts written off are worthless by examining supporting documents such as reports of collection agencies, correspondence with said customers and documents ISAaTH g. Ascertain that accounts written off are worthless by examining supporting documents such as reports of collection agencies, correspondence with said customers and documents filed in court and court decisions on collection cases. h. If possible, check the financial status of the customers for which allowance for bad debts were provided. i. Check entries to the allowance account for possible bad debt recoveries and trace if the same were declared as income at the time of recovery. D. Inventories a. Determine what cost to include in the inventory. The cost used in determining inventory depend on whether the business is of a service, merchandising or manufacturing nature. b. Verify the inventory valuation method being applied if such is acceptable for tax purposes and consistently applied from year to year. c. Compare inventory balances in the return under examination with the balances for the prior and subsequent year's returns and financial statements and verify these with the taxpayer's records. d. Check authorization for changes in inventory valuation method. e. Check gross profit percentage variations. f. Determine the significance of any notes or qualifying statements on financial reports prepared by independent accounting firms. g. Determine the taxpayer's computation of standard rates if standard rates are applied. h. Verify cost of production reports and test check certain costs reflected therein to supporting documents. i. Determine if year-end purchases were included in the closing inventory. j. Analyze unusual entries to cost of sales account for materials, labor and overhead charges not directly related to sales or transfers of finished goods, if applicable. k. Determine if there have been write-downs for "excess" inventory to below cost. Verify authorization and supporting document/report for such write down. l. When items have been removed from inventory for the owner's or shareholders' use, check of this is properly recorded as part of sales. E. Advances To Stockholders/Officers This receivable account may represent an outright advance of money by the corporation to officers and/or stockholders. Usually, these advances vary in amounts over a period of time, building up to the current amount. The following verification procedures on this account should be conducted, if warranted: a. Verify authorization from Board of Directors for advances and loans to stockholders and officers by checking duly approved minutes of meetings. b. Identify company officers and stockholders who are granted advances regularly. c. Check payments of advances to the company if such earned interest for which no withholding tax was deducted. d. Verify entries on cancellation of advances if the same do not originate from cash receipts. F. Investment The investments most commonly found on the books are stocks and bonds and, in some cases, real estate not used in actual business operations. The following procedures should be conducted in the examination of investments, if such are material assets of the taxpayer: a. Become familiar with the nature of investments, utilizing any records maintained by the taxpayers such as the investment ledgers, worksheets showing the breakdown of investments and other investment records. b. Analyze sales and other credit entries. If stocks sold are listed in the stock market, test check selling price of stocks sold at the prevailing "close" price at the Philippine Stock Exchange during the date of sale. Real properties sold should not fall below fair market value and/or zonal value where the zonal value has been established, whichever is higher. c. Verify journal entries to ascertain the selling price and gain on sale of investments. Vouch supporting documents such as deeds of sale, proof of remittance of taxes withheld, payment of documentary stamp tax and other relevant records. d. Investigate sales to related parties and/or to officers or stockholders below fair market value. e. All investments during the year should be cross-checked to the interest, dividend or rental income accounts. f. If investments or bonds were acquired at a premium or discount, determine whether the premium/discount is amortized. G. Depreciable Assets This group includes tangible properties of relatively long life which are used in the operation of the business. Natural resources such as oil or mineral lands are not included in this group. The following verification procedures should be undertaken on these accounts: a. Compare the asset and related reserve amounts as they appear on the tax return, balance sheet, depreciation schedule and taxpayer's books and schedules. Compare the beginning and ending figures for the taxable year and reconcile differences or ask the taxpayer to make a reconciliation. Verify such reconciliation. b. Review depreciation schedule of fixed assets and ascertain propriety of depreciation expense claimed. Watch out for depreciation that may have been taken on assets which are fully depreciated or charged off to expense. c. Review asset additions during the year by reference to invoices, contracts and other documents and determine if the proper basis was used. c.1. Note items which appear to have originated from unusual sources such as appraisal increases, transfers and exchanges, and determine propriety thereof. Ascertain if prior earnings were adequate to cover acquisitions. c.2. Determine if acquisition and installation costs of fixed assets and leasehold improvements have been capitalized. c.3. Ascertain if assets include items of a personal nature. If the assets are used by the officers for their personal use, the depreciation should be disallowed. c.4. Where construction or another work of a capital nature is performed with the taxpayer's own labor, equipment and other assets for its own use, be certain that the basis of such asset includes materials, labor and overhead including depreciation. c.5. With regard to the basis of assets, consider such items as trade-ins, acquisitions from related taxpayers, allocation of cost between land and building and other basis. d. Decreases in the asset accounts during the year should be noted. Gains or losses resulting therefrom should be verified and ascertain that the appropriate tax, such as value-added tax, if applicable, has been paid. e. Ascertain if the taxpayer has transferred assets to the owner, officers, stockholders or to a controlled domestic or foreign corporation for less than fair consideration. H. Allowances For Depreciation, Amortization And Other Valuation Reserves a. Review the nature and source of all accounts and ascertain if they are being used to claim unallowable deductions. b. With regard to depreciation, determine the correctness of the amount being depreciated. No depreciation is allowable on the appraisal increase of fixed assets. Any foreseeable salvage is to be deducted from the cost of the asset in determining the basis of depreciation. b.1. No depreciation is allowable on a building until it is completed or on a machine until it is installed. Expenditures which are properly includible as an element of cost are freight-in, installation cost, title cost, and legal or brokerage fees in connection with acquisition. b.2. Where land and building are acquired on lump-sum, the following formula should be used in computing the building cost for depreciation computation: FMV or Zonal value of land x FMV or Zonal value of land and building Total acquisition cost = Cost of Land Total acquisition cost of land and building P xxx Less: Cost of land per above computation xxx Cost of building P xxx c. Consider the depreciation and amortization policies: c.1. Whether the methods applied by the taxpayer are in compliance with the Tax Code and existing revenue regulations; CSHEAI c.2. Whether the depreciation rates used by the taxpayer are fair and reasonable; c.3. Whether the taxpayer has applied the same method consistently from period to period; and d. Check authorization from minutes of meetings, fixed asset reports, etc. on credits for allowance for obsolescence and/or asset write-offs. If necessary, inspect assets claimed as obsolete and/or written off. I. Intangible Assets a. Investigate the nature of the intangible whether leases, patents, licenses, trademarks, goodwill, copyright, franchise and others. b. Costs of acquiring the intangible should be capitalized when useful lives can be estimated. If not, no amortization is allowable for tax purposes. c. Determine if the cost and cost of current additions includes proper elements such as legal fees, application fees and other costs of acquisition. Examine contracts and other legal documents. d. Verify correctness of deductions claimed as follows: d.1. Leasehold costs are subject to amortization over the term of the lease. d.2. Goodwill cannot be amortized if it is for an indefinite period of time. d.3. Research and development expenditures may be capitalized or treated as deductible expense. d.4. Patents sold with the exclusive right to make, use and sell an article constitutes ordinary income. d.5. Organization expenses are not deductible in the year incurred. Check the reasonableness of the taxpayer's amortization policy on original expense. e. Determine if there have been transactions with related taxpayers. If so, consider arms length features. f. Determine if income applicable to intangibles has been included as income, e.g. subleases, over-riding royalties, franchises and other sources. g. Analyze any transaction involving transfer of foreign rights to any foreign entity for an equity interest or for nominal consideration. h. Be alert to transactions which could have given rise to intangibles which may have been recorded as expense. J. Prepaid Expenses And Deferred Charges a. Verify the nature and source of these assets and the manner in which they are charged off to expense. b. When prepaid expenses are not present in the balance sheet, verify charges to expenses which entail advance payments such as insurance, rent, supplies, repairs and maintenance as covered by contracts. K. Other Assets a. When material in amount, obtain a schedule of other assets b. Investigate sources of charges to the account; verify entries and supporting documents to check if the other assets are results of income generating activities not reported in the financial statements. L. Exchange, Clearing or Suspense Account a. If significant in amount, obtain a schedule to determine the nature and purpose of the account. b. Test check debit-and credit entries, being aware of the possibility that such account may be used as a means for diverting sales, padding expenses and other irregularities. M. Current And Accrued Liabilities Including Notes Payable These liabilities are found on business records under various titles, such as accounts payable, vouchers payable, notes payable, accrued expenses and other current liabilities. The procedures are as follows: a. Reconcile subsidiary ledgers with the control accounts. Request the taxpayer for explanation for any discrepancies. SDEHCc b. Note debit balances in the general ledger or subsidiary accounts. This may indicate diversion of funds and other underdeclaration of income. c. Note accounts which have long overdue balances. This may indicate contested liabilities or accounts which no longer exist such as unclaimed wages or unclaimed deposits which should be reverted to income. d. Review computation of year-end accruals with respect to their deductibility as expenses or purchases. e. Examine legitimacy of accounts payable to affiliates or related taxpayers. Test check payments made. f. Investigate entries in the general ledger control accounts. Check unusual items such as those that do not originate from the voucher register or disbursement book. This may disclose unreported income, improper or overstated expense. g. Be aware of any contingent liability by reading minutes or annual reports. Although this is not reflected in the return, an accrual may have been made for the item. To be deductible, an expense cannot be contingent. It must be reasonably determinable in amount and the liability must be fixed. h. If payables include security deposits, read the lease term to determine application of the deposits. They are taxable when received. N. Fixed Liabilities a. Acquaint with the pertinent provisions of loan contracts, mortgage agreements, certificates of indebtedness, financing arrangements and consider possible adjustment areas as follows: a.1. determination of expenses, e.g. interest and bank charges a.2. refunding of debt a.3. legal, professional and other expenses of issuance b. Scrutinize any long-term outstanding liability to the owner, shareholders, officers or to a related taxpayer as this may be accumulated unreported income. c. When the liability is secured by pledged collateral or mortgage, ascertain that income has been reported from such collateral. d. Verify if funds were borrowed for use of affiliates as the interest expense thereon shall not be deductible on the part of the borrowing taxpayer. This must be shifted to the affiliate. e. Determine if loans were borrowed to finance tax exempt securities. If so, the interest expense is not deductible. O. Deferred Credits a. Check all payments received in the cash receipts book., i.e. date of receipt and other entries. b. Check if payments received were included in the gross income for the year payments were received. Amounts are generally includible in gross income for tax purposes not later than the time of receipt if they are subject to free and unrestricted used by the taxpayer. (Advance rents, legal retainer and the like, advance sales of transportation tokens or communications tickets and other advances are income when received under this theory). c. Look for credit balance accounts which fall in these categories. They may be clearly labeled as advance rents, deferred service income or may be shown as a reserve mixed with true liability accounts, or as a contra-balance in receivables. d. If the taxpayer used the completed contract method of accounting, income and expenses attributable to a particular job or project are properly deferred until substantial completion. The contracts and progress reports should be inspected to determine whether income has been delayed beyond the completion of the project. e. When a taxpayer uses the installment method of reporting income, the unrecognized gain for tax purposes should be recorded as a deferred credit. This particular account should be checked to determine if the year-end balance remaining in the account reconciles with the gross profit to be reported on the subsequent payments. A difference would indicate that the current or prior installment computations of the taxpayer were erroneous. ISTECA P. Loans from Shareholders/Officers/Owners a. Determine whether there is a true debtor-creditor relationship. Excessively large liabilities in relation to capital stock (especially in the case of a new company) may indicate a thin capitalization situation. b. Check the financial statements of the corporation as well as that of the shareholders. If there is an interest expense account on the part of the corporation from such loan, there should also be an interest income account on the part of the shareholder. There are certain advantages to the corporation or shareholder for an equity investment to be treated as a loan. See that the taxpayer gets these benefits only when the facts of the case show that a true loan exists. If "loans" are found to be equity capital, then: b.1. Disallow interest expense; treat as dividends. b.2. Treat repayments as dividends. b.3. Disallow bad debts deductions by the shareholders. c. Check supporting loan documents issued in favor of the shareholders, officers or owners. If unsupported or if support is doubtful, the unreported income may be lodged in this account. d. Test check payments of loans against check vouchers and paid checks. e. Verify the debit and credit entries in the general ledger account and watch out for unusual sources other than the cash receipts and disbursements book. f. Examine adjustments, specially increases in the account, at the end of the year as this may constitute shifting of taxable income to this liability account. Verify general journal entries, journal vouchers and related documents supporting the entries. Q. Capital Accounts a. Capital or Owner's Equity for sole proprietorship a.1. Review debits and credits to the account during the period under audit and check supporting entries to the account. Increases which originate from sources other than profit and loss may indicate omitted income. a.2 Reconcile amount appearing on the books, return and financial statements. Verify discrepancies, if any. a.3. Relate the account balance and withdrawals with the owner's standard of living. Where owners report no other sources of income and withdrawals appear insufficient to maintain personal living expenses there may be underreporting or diversion of income. b. Partners' Capital for partnerships b.1. Review debits and credits to the account during the period under audit. Verify increases and decreases and check for unusual sources other than profit and loss. b.2. Reconcile amount appearing on the tax return, books and financial statements. Verify any differences noted. b.3. Examine pertinent provisions of partnership contract and check correctness of distribution of partnership income and expenses. b.4. Ascertain that the correct tax has been withheld on distribution of partnership profits. b.5. If the taxpayer claims that it is a general professional partnership, examine partnership contract and registration with the Securities and Exchange Commission. c. Stockholders ' Equity for corporations c.1. Capital Stock c.1.1. Review entries in the capital stock account and verify increases and decreases. c.1.2. Verify correctness of all items appearing on the return, books and financial statements. Investigate discrepancies, if any. c.1.3. In case of additions to capital stock out of new issues during the period under audit, ascertain that the correct amount of documentary stamp tax has been paid. Secure a photocopy of the proof of payment. c.1.4. Compare data from minute book with items recorded on the books of accounts to determine if entries have been made. c.1.5. Determine if expenses relating to stock issuance have been properly handled (legal fees, registration fees, broker's commission and other expenses). c.1.6. Determine during the examination of a recapitalization of the stock in a closely held company if the fair market value of the stock to be received by each exchanging shareholder is equal to the fair market value of the stock surrendered in the exchange. If there is a significant difference, the revenue officer should consider the possibility of considering the difference as a donation, and therefore subject to donor's tax. c.1.7. If a reorganization has taken place, examine the following documents: c.1.7.1 The reorganization plan AcTHCE c.1.7.2 Journal entries giving effect to the reorganization c.1.7.3. Notes of all minute book references to it c.1.7.4. Notes of pertinent information from the correspondence file with other parties to the reorganization c.1.8. Examine by-laws, articles of incorporation or other documents in stocks; and support of other transactions affecting capital stock. c.1.9. Determine if the increase in capital stock is the direct consequence of an exchange of property under Section 34(c)(2) of the Tax Code. If so, confirm compliance with the conditions set for the non-recognition of gain or loss by performing the following audit procedures: c.1.9.1. In case of merger or consolidation c.1.9.1.1. Verify if the plan of reorganization has been adopted by each of the parties to the reorganization. c.1.9.1.2. Check if the income tax return filed for the taxable year in which the exchange took place incorporated all the facts pertinent to the non-recognition of gain or loss upon such exchange, such as: c.1.9.1.2.1. the historical cost or other basis of valuation of all properties, including all stocks or securities, transferred incident to the plan; and c.1.9.1.2.2. the nature and amount of liability assumed upon the exchange and the amount and nature of any liabilities to which any of the property acquired in the exchange is subject. c.1.9.1.3. Verify Deed of Assignment of property for shares of stocks; and c.1.9.1.4. Check if Documentary Stamp tax has been paid. c.1.9.2 In case of transfer of property to a controlled corporation c.1.9.2.1 Verify if the transferor and the transferee filed an income tax return for the taxable year in which the exchange was consummated with a complete statement of all facts pertinent to the exchange; c.1.9.2.2. Verify Deed of Assignment; c.1.9.2.3. Determine if transferor of property acquired at least 51% of the total voting stock, alone or together with others, not exceeding four persons of the transferee-corporation; and c.1.9.2.4. Determine if the Documentary stamp tax was paid. c.1.9.3. In both cases, ascertain if the following information has been annotated at the back of the Transfer Certificates of Title or certificates of stock: c.1.9.3.1. Date the deed of exchange was executed; c.1.9.3.2. The original or historical cost of property; and c.1.9.3.3. The fact that no gain or less was recognized as a result of such exchange. c.2. Retained Earnings The investigation of the retained earnings (or deficit, in case of accumulated losses), is a very important part of the audit process as this is related to the net worth method of investigation. It is the account to which the net income or net loss from operations is transferred and accumulated. The minimum audit procedures that should be undertaken in analyzing this account are as follows: c.2.1. Compare the amount shown on the return, financial statements, books of accounts and the schedule of reconciliation of net income per books and per return. Verify differences, if any. c.2.2. Verify correctness of all items, both increases and decreases appearing on the books or return. Trace opening retained earnings balance to the balance sheet of the prior period. c.2.3. Check increases which do not originate from net income. Verify entries from the general journal/journal vouchers, specially those recorded other than as year-end adjustments as these may indicate sales or income directly posted to the retained earnings account. c.2.4. Determine if declared and unpaid dividends are properly recorded. Compare paid dividends to Directors' minutes. c.2.5. For taxpayers incurring continuous losses and deficit balance, investigate the real status of the business. Tour company premises, evaluate the volume of business and compare the information gathered with the financial data reported. There may be underreporting of sales as there is very little reason for a business to exist if it is continuously incurring losses. c.2.6. Examine supporting documents and authorization for all other transactions in retained earnings to determine conformity with existing tax laws. X. Audit Of Income And Expenses This Chapter discusses the books of accounts, accounting records and documents used to record income and expense transactions. It enumerates the audit procedures and techniques for income and expenses. The audit of income or revenues are applicable to resident and non-resident individuals engaged in business and the practice of profession, estates and trusts engaged in trade or business, general professional and business partnerships and corporations. Expenses chargeable against income are allowable in their entirety only for business partnerships and corporations. Self-employed resident citizens and aliens engaged in business or the practice of profession, non-resident aliens engaged in business, estates and trusts engaged in trade or business and general professional partnerships as defined under Section 20 (b) of the Tax Code, as amended, and their individual partners can claim expenses subject to certain limitations under Republic Act. No. 7496 adopting the Simplified Net Income Taxation Scheme (SNITS), as implemented by Revenue Regulations No. 2-93. SCHcaT Under the SNITS, a taxpayer can claim itemized deductions as follows: a. Raw materials, supplies and direct labor; b. Salaries of employees directly performing services for the taxpayer in the course of or pursuant to his business or practice of his profession; c. Telecommunication, electricity, fuel, light and water; d. Business rental; e. Depreciation; f. Contribution made to the Government and accredited relief organizations for the rehabilitation of calamity-stricken areas declared by the President; and g. Interest paid or accrued within a taxable year on loans contracted from accredited financial institutions which must be proven to have been paid or incurred in connection with the conduct of a taxpayer's profession, trade or business. However, Sec. 29, NIRC, as amended by R.A. No. 7496, provides a maximum of forty percent allowable deduction based on gross sales, in the case of seller of goods, or gross revenue in the case of seller of services when the cost of goods sold and deductions are difficult to determine. Such 40% allowable deduction shall answer for business or professional expenses. A taxpayer who elected to claim the itemized deduction under SNITS, but who upon subsequent audit by the BIR cannot substantiate any or all of the expenses with the proper receipts shall not be allowed to revert to and claim the 40% maximum deduction. The subsequent discussions on the procedures and techniques in the investigation of income and expense accounts are general audit guides. The revenue officer should not be hindered in applying additional procedures and techniques which he deems necessary based on his initial findings, evaluation of internal control, reliability of accounting records and analytical review of operations. a. Sales a.1. Review the taxpayer's accounting method of revenue recognition if acceptable and consistent with prior years. a.2. Ascertain that all sales were reported as of the cut-off date. Cut-off refers to the point at which entries from one accounting period stop and entries for the next period begins. This is typically the last day of a taxable year. If the last day of the taxable year is not used, the taxpayer must substantiate his choice. a.3. Verify revenues/sales recorded and deposited near the end of the tax year and immediately during the subsequent month to determine if these pertain to income earned for the tax year under examination. a.4. Account for all sales invoices issued. Match delivery receipts, gate passes, if any, against sales invoices issued. a.5. Compare totals of sales invoices, sales summary, entries in subsidiary sales and sales journals and general ledger accounts. Inquire and investigate discrepancies between book entries and returns filed. a.6. Reconcile credits to sales with debits to accounts receivable and debits to cash receipts book. Test check monthly entries. a.7. Research unusual and unfamiliar issuances of goods or goods which are not normally sold by the taxpayer. a.8. Conduct interviews to secure information regarding the taxpayer's business, financial history, number of employees and other information which may lead to sales estimation. a.9. Determine inventory method applied if acceptable and consistently followed. a.10. Determine if merchandise is being withdrawn for personal use or for any other purpose not in relation to normal sales process. a.11. Scan credit memo issued to customers and test check entries to Sales Returns & Allowances and Sales Discounts to insure proper recording of credits. a.12. Verify cancelled sales invoices by test checking deposits made and withdrawal of goods on the day of cancellation. a.13. Tour the business premises to obtain information on: a.13.1. Sales volume a.13.2. Volume of sales return and method of handling sales returns a.13.3. Major products a.13.4. Other by-products and scrap sales, if any a.13.5. Equipments used in operation a.13.6. Nature, quality and size of facilities a.13.7. Inventory level In touring the premises, be observant and ask questions. a.14. Review sales contracts, consignment agreements and other documents relative to sales. CcADHI a.15. On installment sales, ascertain that collections have been properly segregated as to the year of sales and that the proper gross profit ratios have been applied. Review unearned or deferred income accounts for any uncollected balances which have been outstanding for an unreasonable period of time. a.16. Determine whether sales on consigned goods are taken up at the time of shipment or after 60 days from date goods were consigned. a.17. Where the internal control is weak and records are unreliable or inadequate, apply other approaches to audit revenue such as cash analysis, net-worth analysis, third party verification and other indirect approaches. b. Rent Income b.1. Obtain copies and review lease contracts. b.2. Tour the premises under lease. Identify tenants and monthly or annual rentals. Conduct interviews if necessary. b.3. Relate real properties under lease agreement to assets declared in the balance sheet. Note inconsistencies between asset values and income generated. b.4. Where the rental income is based on a percentage of sales of the lessee, the sales of the lessee should be tested for a representative period, say one month, to get a proper approximation of the lessee's sales during the taxable year under audit and the rental income received by the lessor. In such cases, proper authorization from the lessee should be obtained before conducting the test verification. b.5. Research on rental of neighboring properties and compare with rent income reported. b.6. Scrutinize official receipts. Compare total with general ledger balance, tax return declaration and financial statements. Account for discrepancies. b.7. Ascertain acceptability and consistency of accounting methods. For cash-basis taxpayers, prepaid rent and rental deposits constitute income during the year of receipt. b.8. The revenue officer should be alert on lease contracts which are actually conditional sales. b.9. Where necessary, obtain copies of Transfer Certificates of Title, tax declarations, mayor's or municipal permits and real property tax receipts to determine properties which may be hidden by the taxpayer. c. Professional Fees c.1. Determine the taxpayer's accounting methods of recognizing income, whether cash or accrual. Most professionals, however, adopt the cash basis of accounting. c.2. Examine contracts with clients and other correspondence/documents in relation to professional services rendered. c.3. Check copies of BIR forms on taxes withheld on professional fees. Tally with the income declared per return. c.4. Compare income reported on the tax return with the books of accounts, creditable withholding tax forms, financial statements and official receipts issued. Verify discrepancies, if any. c.5. Account for official receipts issued. Note any missing receipt or break in the series. c.6. Analyze the reasonableness of expenses claimed in relation to income declared. c.7. Conduct interviews and third party verification, if necessary. c.8. Relate the income reported per tax return to the lifestyle and assets owned by the taxpayer. If the assets of the taxpayer and estimated cost of living expenses are beyond the income earned, verify and compute for possible underdeclaration of income. d. Income from Sale of Asset d.1. Identify in the tax returns and financial statements any sale, exchange or disposal of assets other than inventories. d.2. Obtain copies of deeds of sale and other documents relating to the sale. d.3. Determine zonal values, fair market values or appraisal values and compare with the selling price. d.4. Compute any underdeclaration of sales by comparing the selling price with the existing fair market value, zonal value or value of similar properties sold. d.5. In case of disposal of capital assets, ascertain compliance with the provisions of the Tax Code on capital gains and losses. d.6. Verify sales of property reported on the installment basis and determine if all requirements pertaining thereto have been complied with. d.7. Determine if proper accounting for depreciation, book value and salvage value was taken up. d.8. Inquire from certain company personnel on possible sales of assets which may not have been recorded. DECcAS e. Other Income e.1. Scrutinize the general ledger and general journal for any other income or other receivables recorded. e.2. Test check entries in intercompany accounts for shifting income or management fees that may have been charged to affiliates. e.3. Investigate suspense accounts and unusual liability accounts, such as due to affiliates/due to stockholders and other payables to uncover possible income not recorded in the income accounts. B. Audit Of Expense Accounts a. Purchases For taxpayers engaged in trading and manufacturing, purchases is one of the largest accounts in the income statement. Thus, there is a possibility that taxpayers may hide a number of non-deductible expenditures in this account due to the volume of transactions posted to it. The following principal audit procedures should be followed in examining purchases: a.1. Account for all purchase invoices and receiving reports as of the cut-off date. Determine if year-end purchases have been recorded in the proper accounting period. a.2. Compare totals of purchases in the return, income statement, purchase book, subsidiary purchases book, if any, and general ledger. Determine any discrepancy and investigate its nature as well as the nature of year-end adjustments. a.3. Determine that the purchases declared are neither overstated nor understated by vouching the supporting documents, test-checking footings of invoices, purchase books and ledger accounts. Understatement of purchases may also mean underdeclared sales. a.4. Tour the premises where inventory items are kept and correlate actual inventory level against purchases reported. a.5. Scan the purchase book and look for items unusual in amount and payee. Take note of suppliers not generally associated with the products or services handled by the taxpayer. a.6. Verify entries in the general ledger account which originate from unusual sources such as journal entries, debit and credit memoranda and other accounting records. a.7. Test check recorded purchases for a representative period with suppliers' invoices and cancelled checks. Note if these are personal expenditures, withdrawals of merchandise by the owners, fictitious or duplicate invoices, cancelled purchase invoices, excessive rebates discounts and allowances and purchases not received. a.8. Where there are only a few major suppliers, conduct third party verification to ascertain the correctness of purchases declared if there is suspicion of fraud. a.9. If purchases are from suppliers related to the owners or from affiliates, conduct a review of a number of transactions to uncover prices in excess of market value, excessive rebates and allowances and other similar schemes. b. Cost Of Goods Sold b.1. Verify the inventory valuation method applied by the taxpayer whether first-in, first-out, last-in, first-out, specific identification, weighted average or simple average. Last-in, first-out is not acceptable for income tax purposes. Determine consistency of application of method from year to year. b.2. Obtain an understanding of the production process by familiarization with the taxpayer's business, tour of the premises, conducting interviews and analyzing cost of production report. b.3. Compare inventory balances in the return under examination with the balances for the prior and subsequent years' returns, and verify these with the general ledger and the physical inventory summary. b.4. Check unauthorized changes in inventory valuation method from period to period. Take samples from the summary inventory sheets and determine if the taxpayer has not improperly valued any item. b.5. Check gross profit variations. Any significant variation should be discussed with the taxpayer and a reasonable explanation obtained. A material decrease in gross profit from one year to the next could be due to understated ending inventory. b.6. Determine the significance of notes or qualifying statements on financial reports prepared by external auditors. Any unusual comments or qualifying statements about the inventories or cost of sales that have a material tax effect should be discussed with the taxpayer and, if necessary, with a representative of the external auditor. b.7. If the taxpayer applies standard or predetermined cost in costing goods manufactured, the revenue officer should inspect the working papers and production report used to calculate the cost per unit and insure that expenses included are allowable. b.8. Analyze unusual entries to cost of sales; account for labor, materials and overhead charges not directly related to sales or transfers of finished goods The taxpayer may be trying to include in the cost of sales a non-deductible item. b.9. Determine that year-end purchases are included in closing inventory. Review purchase invoices at the last month of the taxable year under audit and compare quantities on the inventory summary for classes of goods purchased with the quantity in the ending inventory list and quantity of sales recorded at year's end for such goods. Thus, if a specific item or a certain quantity of goods were purchased on the last day of the year, it should be included in the ending inventory unless sold that same day. b.10. Determine reductions in ending inventory values by reviewing authorization for write-downs and provision for obsolescence or decline in market values. Check minutes of meetings for such authorization, analyze journal entries for the write-down or provision of allowance for obsolescence/decline in value, check itemized inventory summary sheet and test-check the list with actual inventory observation. SaCIAE c. Salaries, Wages and Other Employees' Benefits c.1. Evaluate the expense initially by comparing the ratio of salaries and wages to sales and the percentage of taxes withheld to total salaries, allowances, bonus and other compensations. Low ratios might indicate that the company hires sub-contractors or an understatement of the expenses which may be a lead underdeclared-sales. High ratios may mean also an understatement of sales or padded payroll with fictitious or terminated employees. c.2. Review payroll sheets. All expenses claimed having the semblance of a compensation payment should be verified together. c.3. Interview personnel assigned to prepare payroll and inquire if family members are included in the payroll. If so, check legitimacy of the work assignment and reasonableness of compensation. c.4. Compare payroll costs with industry standards and other independent data. Require explanations for significant deviations. c.5. Observe the number of employees and relate this to declared sales. Inquire if independent contractors are hired. c.6. Perform a comparative analysis of salaries, wages and other employee benefits with prior and subsequent years. Material changes may indicate a change in the volume of business or in the policy of classifying manpower employed. c.7. Determine if the taxpayer is properly withholding the correct amount of taxes on compensation by test-checking actual pay slips against employee records and BIR Form W-4 (Employees Compensation and Withholding Exemption Certificate). Determine also if taxes withheld are remitted completely and promptly per BIR Form 1743 W. Cross check BIR Form W-4 with BIR Form 1743 IR (Annual Alpha List of Employees from whom Withholding Tax has been deducted). c.8. Reconcile totals of wages paid which were subjected to withholding tax and total of compensation paid which were not subjected to withholding tax with payroll expense claimed. c.9. Verify Social Security System Premium Remittance List to cross check the list of employees to whom compensation was paid. d. Rents d.1. Verify pertinent provisions of the lease contract with the lessor. d.2. Verify reasonableness of rentals paid by the lessee, particularly if the lessor is related directly or indirectly to the taxpayer. d.3. Verify whether the corporation is renting property for which it has no actual business use. Any rentals in that case would be unreasonable. d.4. Determine the terms of the lease. If the lessee may take or acquire the title to the property, rental should be disallowed. d.5. Determine if there are any capital expenditures included in the accounts. d.6. Determine whether the proper amount of expanded withholding tax has been withheld and remitted. e. Royalties e.1. Verify minute book and pertinent provisions of the contract with the lessor. e.2. Determine whether the proper amount of final withholding tax has been withheld and remitted. e.3. If the recipient is a non-resident alien or other foreign entity, determine whether the proper amount of tax has been withheld and remitted. f. Interest f.1. Verify sources of interest expenses such as actual notes, loans, mortgage or bond instruments. Check whether the indebtedness is business related. f.2. Determine the accounting method used by the taxpayer. If he uses accrual basis, only the interest accruing during the taxable year is deductible. f.3. Determine if interest paid or accrued applies to obligations due to related taxpayers. Consider such items as: f.3.1. Arm's length features f.3.1.1. Bona fide obligations f.3.1.2. Interest in excess of the prevailing rates in unrelated transactions f.3.2. Accrual of items payable to related taxpayers which are not paid within the prescribed time limit. f.4. Determine if deductions claimed relate to interest incurred in carrying tax free obligations. If so, then the interest claimed is not deductible. f.5. Determine if the interest deduction includes any principal amount. f.6. If the recipient is a non-resident alien or other foreign entity, determine if the proper amount of tax has been withheld. f.7. Ascertain if the loans acquired were not utilized but were loaned out to affiliates. If so, disallow interest expense claimed. g. Taxes g.1. Determine that only the taxes properly paid or accrued during the year have been claimed. aSACED g.2. Determine that no protested taxes or reserves for deficiencies upon audit of taxes are claimed. g.3. Determine taxes not allowable as deductions such as: g.3.1. Income tax provided for under the Tax Code; g.3.2. Income, war profits and excess profits taxes imposed by authority of any foreign country; g.3.3. Estate and gift taxes; g.3.4. Taxes assessed against local benefits of a kind tending to increase the value of the property assessed; and g.3.5. Electric energy consumption tax imposed by Batas Pambansa Blg. 36. g.4. Determine if the-taxpayer has title to the real and personal property being taxed. g.5. Determine if there are any taxes on the purchase of capital assets that have been capitalized as well as expensed. h. Repairs h.1. Determine depreciation policy of the taxpayer. A conservative depreciation policy often contemplates a high degree of current repair expenditures. h.2. Verify nature of expenditures. If the expenditure prolongs the life or enhances the value of the existing assets, then it is not deductible but should be capitalized and depreciated over the years. h.3. Check repair accounts for the possibility that personal expenses of owners or others are included. i. Bad Debts i.1. Determine with a reasonable degree of certainty the uncollectibility of the debt. i.2. Determine if the charge-off is based on worthlessness of the debt within the year. i.3. Determine if there are repossessed merchandise. If so, verify if the value of repossessed merchandise has been correctly assigned. i.4. Verify losses on installment receivable if consideration on any merchandise repossessed had been taken into account and if portion of the losses had been charged to the unrealized gross profit account. i.5. Determine if the method of deducting bad debts is acceptable and consistent with the preceding year. i.6. Obtain and review list of accounts charged off. i.7. Verify bad debts expense in relation with the examination of the allowance for doubtful accounts. j. Losses j.1. Abandonment and Demolition: j.1.1. Verify if the amount of the abandonment loss is the adjusted basis of the asset abandoned. j.1.2. Determine if the loss or missing fixed assets really occurred with within the taxable year. j.1.3. Determine if the retirement or abandonment loss is specifically allowable under the taxpayer's method of accounting for depreciable property. j.1.4. Determine the reason for the demolition of a building. If it was the taxpayer's intention to demolish the building when the property was first acquired, abandonment loss is not allowable. It should form part of the cost of the building. j.2. Casualty or Theft Casualty loss refers to loss of property connected with trade or business. In the verification of casualty or theft losses, the following pointers should be observed. j.2.1. Ascertain that a loss has actually been incurred. j.2.2. Ascertain that the loss is claimed in the proper year. Casualty loss, generally, is claimed in the year incurred, while theft or embezzlement is claimed in the year discovered. j.2.3. Ascertain that insurance proceeds or claims, salvage proceeds, or salvage value have been properly taken into account. j.2.4. Ascertain that the adjusted basis has been properly computed. Consider reasonableness of values used in the computation and ascertain that the loss claimed does not exceed the adjusted basis. j.2.5 Ascertain that the rule as to the manner of deductibility have been complied with (type of asset, whether insured or not, time held, and other factors). j.2.6. In cash basis cases, be alert on the possibility that cash stolen may not have been included in income. j.2.7. Trace handling of losses involving inventory or stock in trade to ascertain that a double deduction is not claimed. IcCATD j.2.8. Analyze any loss claimed for assets located in a foreign country. j.2.9. Verify police blotters, fire department records and other independent documents in support of the claim. k. Depreciation k.1 Compare total depreciation as shown by the depreciation schedule with the deduction claimed on the return. Reconcile any differences. Be alert for duplication of deductions. k.2. Review the rates of depreciation used to determine if they are reasonable. k.3. Test check a representative number of items listed on the depreciation schedule to determine if the accumulated depreciation at the end of the accounting period exceeds the depreciable basis of the asset. k.4. Test check extensions and prove footings to determine if current depreciation has been correctly computed. k.5. Determine if there is any personal use of cars and other depreciable assets. k.6. Ascertain if proper allocation has been made on bulk purchase of depreciable and non-depreciable assets. 1. Depletion l.1 Determine if the taxpayer has an economic interest in the property. l.2. Determine if the taxpayer has acquired, at least by investment, any interest in oil or gas or mineral in place, and secures, by any form of legal relationship, income derived from the extraction of oil, gas or mineral to which he must look for a return of his capital. l.3. The following guidelines should be followed in the verification of the deduction for depletion: l.3.1. Determine that any aggregation of mineral interest are proper; l.3.2. Ascertain that the sales reported in regard to each property do not include sales applicable to another property, sales of purchased minerals, non-minerals sales or other income items. l.3.3. Ascertain, where applicable, if mineral sales have been adjusted to "gross income from the property" by reduction of such factors as unallowable treatment cost, unallowable transportation costs, rents and royalties including a proportionate part of lease bonuses, amounts paid to others in contract mining or similar operations where the other party has acquired an economic interest and is entitled to depletion, certain excise taxes, trade discounts allowed and other deductions. l.3.4. In situations where the basis for percentage depletion is not the actual sales price of a finished product but a value of the mineral at the point at which it has passed through the last allowable treatment process applicable thereto, determine if the value used is the correct representative market or field price. l.3.5. Ascertain that mineral sales made to a business controlled by the taxpayer are not inflated to gain a tax advantage through depletion. l.3.6. Ascertain that all expenses applicable to a property have been charged to that property including a proper allocation of general, administrative and overhead expenses. l.3.7. Be alert on possible reduction of expenses by improper offsets such as income from scrap sales, cash discounts earned, sales of assets, and other income. m. Contributions m.1. Determine if the donee or recipient is the government or an accredited relief organization. m.2. Determine if the contribution is to be utilized for the rehabilitation of calamity stricken areas declared by the President. m.3. Verify if the claim is actually paid within the taxable year. n. Transportation and Travel, Representation and Entertainment n.1. Determine if the expenditures have been incurred to enhance the business and not for personal use. n.2. For transportation and travel expenses, the following information are necessary to properly determine deductibility: n.2.1. Date of travel n.2.2. Purpose of the travel n.2.3. The person or persons who incurred the expenditure n.2.4. Place or places travelled n.2.5. Amount of expenditure n.2.6. Means of transportation or travel caCTHI n.3. Determine if taxpayer's travel and transportation and representation and entertainment expenses are recorded in a daily diary and if such expenses appear to be disproportionate to the taxpayer's income and business activities, the taxpayer should be required to corroborate the book entries by furnishing documentary proof or collateral evidence. n.4. The following techniques should be observed in the verification of travel and transportation expenses and representation and entertainment expenses: n.4.1. Determine the policy with respect to reimbursing or giving allowances to employees. n.4.2. Ascertain the specific amount in which these items are recorded. n.4.3. Prepare a summary of the totals posted to the account containing items of these expenses and identify the same with the deductions for these expenses in the return. n.4.4. Select a representative test period or periods. n.4.5. Determine from the analysis and verification of supporting documents the reliability of the records. n.5. Determine company-owned vehicles and the expenses incurred in connection with these vehicles. o. Stationery and Office Equipment o.1. Determine if the expenses claimed are not capitalizable office furniture and equipment. o.2. Verify if personal purchases by taxpayer/owner are included in the account. o.3. Determine the reasonableness of the expenditures. o.4. Compare receipts with the amounts claimed and investigate significant discrepancies. p. Professional Fees p.1. Determine if the charge includes amounts incurred for legal, accounting, engineering, appraisal, surveying and other similar services. p.2. Verify if the amount is material and check the detailed description of the exact professional services rendered by examining contracts. p.3. Check legal expenses or representation expenses as it might at times be political contributions. p.4. Determine research and experimental expenses, in which case, the item should form part of the cost of patents, trade-marks and copyrights and other intangible assets. q. Insurance Expenses q.1 Verify insurance policies. Premiums paid by employers on individual life insurance policies of their employees are not deductible if the employer is a direct or indirect beneficiary. q.2. Determine if the employee is the beneficiary. Otherwise, the premiums paid shall be treated as an additional salary provided that it is reasonable. q.3. Check the account if it includes fire insurance, burglary insurance and other policies on officer-stockholder's personal and real properties. r. Light and Power, Telephone and Telegraph r.1. Determine sizeable amounts claimed as it may include capitalizable electrical equipment or purchases of capital items from utility companies. r.2. Examine the receipts issued by the utility companies. Compare the same with the amounts claimed per return. Investigate material discrepancies. r.3. Determine if there are personal expenses included in the expense account. r.4. Relate the expense consumption against sales and production to determine any possible underdeclaration of sales. s. Miscellaneous Expenses s.1. Check the validity of the individual charges. s.2. Determine if deductions claimed are adequately substantiated. s.3. Ascertain if the miscellaneous expenses claimed do not contain any personal items. XI. Auditing Computer - Produced Records A. Impact of Computer Records on Audit The use of computers to process accounting data has a significant effect on the audit skills of the revenue officer. The ability to understand and evaluate the automated data processing (ADP) system is important. The revenue officer must understand the flow of accounting data or audit trails on an ADP system to conduct a quality audit. B. Accounting Software Systems Auditing computer records require basic techniques used in auditing manual books and records. There is still a need to: a. Perform an effective pre-audit; b. Interview the taxpayer; c. Tour the business; d. Evaluate internal controls; e. Reconcile the books to the return; f. Reevaluate your previous pre-audit; g. Set the scope of the audit; h. Test the amounts you have identified as questionable; i. Ask questions about the data you have examined; and j. Apply accounting principles and tax law to reach the proper conclusion regarding the data examined. As part of the initial interview, the revenue officer should ask questions to achieve a clear understanding of the taxpayer's books and records, such as: Find out what type of system software is being utilized. TAECSD Determine who authorizes the debit and credit of certain accounts. Determine who encodes the accounting transactions. If the same person enters both the payables and the receivables, there is no segregation of functions. This would allow one person to perpetuate or conceal errors by controlling the offsetting debits and credits. Internal control should be made for all business returns. Find out how often reports are generated and what reports are generated. The taxpayer may not utilize reports that the software system can generate. In addition to asking the taxpayer about the particular accounting system, the revenue officer may briefly skim the software manual. The manual will tell how the system works and the types of reports available. The revenue officer shall use judgment to determine the time to spend reviewing the software capabilities. C. Audit Techniques For Computer- Produced Records a. Auditing hardcopy records The traditional audit approach to double-entry books and records is to scan through the general ledger noting any unusual entries. The purpose of this scanning is to identify entries which are unusual due to the amount, source or nature of the entry. When an audit trail is not clear, have the taxpayer prepare a schedule substantiating deductions. Have the taxpayer demonstrate the trail through computerized records. b. Identify unusual entries in the Computerized General Ledger b.1 Unusual in Amount The basic technique for identifying large changes to accounts in a computerized system consists of securing the monthly statements. Usually, these will be retained by the taxpayer. The monthly balances are reviewed for changes. Changes in the monthly account balances are then explored by reviewing the monthly detail and scanning the check register. The revenue officer considers if the change could be expected, is reasonable and in the expected direction, and is material enough to warrant investigation. For example, if monthly trial balances showed rent expense of P500 and one month showed P1,500, you would ask the taxpayer about the P1,500 rent expense. b.2. Unusual by Source The basic technique for detecting entries to accounts from unusual sources consists of comparing monthly posting summaries from each source with the chart of accounts. A computerized system will utilize monthly posting summaries. These summaries will show monthly changes to an account, most often by account number and originating journal. By comparing the accounts which show monthly changes with the chart of accounts, posting to unusual accounts can be detected. Scan the accounts payable listings for vendors that appear personal. b.3. Unusual by Nature The basic technique for detecting entries to accounts which are unusual by nature involves the same process as shown for detecting entries from unusual sources. You are looking for debit posting to accounts which normally contain only credit posting and vice versa. An example would be a debit to a sales account which could be a bad debt written-off. Accounts which exist at the beginning of the year and not at the end might indicate unauthorized accounting changes. XII. Indirect Approach Reconstruction of income is generally employed where the taxpayer keeps no record or inadequate records, or where there is strong suspicion that the taxpayer has received income from undisclosed sources. Over the years, the Bureau of Internal Revenue has developed the following general methods for reconstructing a taxpayer's income: A. Percentage method B. Net worth method C. Bank deposits method D. Cash expenditure method E. Unit and value method F. Third party information or access to records method G. Surveillance and assessment method A. Percentage Method This method is the equivalent of a ratio analysis of percentages considered typical of the business under investigation to indicate potential areas of revenue adjustment in examination where revenue records do not exist. The computed amount of revenues based on the percentage computation is compared to the amount of revenues reflected on the return. The percentages used may be obtained by an industry publication, prior years' results, the taxpayer or third parties. The comparison will provide an indication on the possibility of revenue being understated. The extent of investigation required should be based on the degree of variance. It must, however, be emphasized that in comparing transactions of similarly situated businesses, the name of the particular taxpayer used as the model must not be divulged to the taxpayer under investigation nor in the report as this would constitute a violation by an internal revenue officer of the provisions of Section 269, National Internal Revenue Code (NIRC)on unlawful divulgence of trade secrets. Significant ratios and trends to be analyzed are as follows: a. Percentage Mark-up This is effective on businesses whose purchases can be readily broken down in groups with approximately the same percentage of mark-up. The purchases should be grouped in items with the same percentage of mark-up. The appropriate percentage of mark-up would then be applied to each group of items to arrive at the gross receipts. The percentage of mark-up can be determined from selling prices obtained from the taxpayer. However, if cooperation from the taxpayer is lacking, the information should be obtained from competitive business establishments in the same industry. Once the gross receipts are determined the taxpayer should be given the opportunity to explain the discrepancy noted between the reconstructed gross receipts and the amounts indicated by the records and the tax returns. The taxpayer may argue that the percentage mark-up should not be applied to purchases which were stolen, broken or spoiled. When reconstructing income using the mark-up method, possible unrecorded purchases should be considered. b. Gross Profit Ratio or Gross Margin Percentage The gross profit is expressed as a percentage of sales. GROSS PROFIT GROSS PROFIT RATIO = (SALES-COST OF GOODS SOLD) SALES NOTE: Sales should be net of Sales Discounts, Returns and Allowances Comparisons should be made with prior period ratios to evaluate the taxpayer's own performance in previous years or with other firm's in the same industry. c. Profit Margin Net Income = Profit Margin Net Sales If the profit margin is low, this will indicate that the firms' sales prices are relatively low or that its costs are relatively high or both. d. Total Assets Turnover Sales = Total Assets Turnover Total Assets A high rate compared to the industry would signify sufficient volume of business and if a net loss is declared, questions must be raised or further investigation and analysis should be performed. e. Inventory Turnover = Sales or Inventory Cost of Sales Beg. Invty. + End Invty. / 2 If the turnover is low, the company could be holding damaged or obsolete materials not actually worth their stated volume. Average Inventory at a given point x turnover rate = total purchases during the year AcSEHT B. Net Worth Method The fact that the taxpayer's books and records accurately reflect the figures on the income and business tax returns does not prevent the use of the net worth method of proof. The Revenue Officer can still look beyond the "self-serving declarations" in the taxpayer's books and records and use any evidences available to contravene their accuracy. However, this net worth method is most often used when one or more of the following conditions prevail: 1. The taxpayer maintains no books and records. 2. The taxpayer's books and records are not available. 3. The taxpayer's books and records are inadequate. 4. The taxpayer withholds books and records. This is a method of reconstructing income which is based on the theory that if the taxpayer's net worth has increased in a given year in an amount larger than his reported income, he had understated his income for that year. In applying this method, it is important to establish the net worth on a fixed starting date. This is to erase doubts that the increase in net worth or the excess of expenditures over reported income did not originate from prior accumulated funds (i.e. hoarded cash or undisclosed assets which do not represent income during the tax year). a. Net Worth Computation Assets xxx Less: Liabilities (xxx) Net Worth xxx Less: Prior Year's Net Worth xxx Increase (Decrease) in Net Worth xxx Add: Non-deductible items Personal, living and family expenses xxx Income Tax payments xxx Insurance Premiums xxx Gifts xxx Non-deductible contributions xxx Net Capital loss xxx Amnesty tax payments xxx Estate and Donor's taxes xxx Other non-deductible items xxx xxx Net Income before further adjustments xxx Less: Non-taxable items Gifts, donations and inheritance received xxx Non-taxable capital gains xxx Proceeds of life insurance policy xxx Non-taxable stock dividends (provided reflected in Assets) xxx Retirement pay from SSS xxx Non-recognized gains from exchange of property under Sec. 34 of the TaxCode xxx Social Security benefits received from foreign government and institutions (PD 220) xxx Other non-taxable items xxx Total Non-Taxable Items xxx Adjusted Net Income per investigation xxx Less: Statutory Exemptions: 1. Exemption of Working Wife xxx 2. Personal and additional exemption xxx 3. Special additional exemption xxx Total Statutory Exemption xxx NET INCOME SUBJECT TO TAX xxx ==== b. Burden of Proof The "Net Worth" method to be acceptable must establish with reasonable certainty an opening net worth, to serve as a starting point from which to compute future increases in the taxpayer's assets. It must also introduce evidence to support the inference that the taxpayer's net increases are attributable to currently taxable income. In computing the increase, the taxpayer's assets are totaled and net worth as determined at the close of the previous taxable year is subtracted from the total at the close of the taxable year in question. The remainder, if any, is the increase for the taxable year, and if no adjustments are required, constitutes taxable income. However, where net worth increase is the income determinant, the Revenue Officer may, in making the final computation upon which to base the tax, add to the increase estimated living expenses incurred by the taxpayer since such expenditures are presumed to be made from income. The taxpayer on the other hand is entitled to have the income, as thus reconstructed, reduced by the amount of depreciation allowable on assets which are not considered in determining net worth. The factors to be considered in reconstructing net worth are variable like availability of evidence and facts of the individual case control. But, generally speaking, net worth has been computed on the basis of some, all or a combination of the following: a. bank records b. securities c. financial statements d. physical assets e. inventory f. all available records c. Determination of Opening Net Worth : The COHAN Rule The difficulty of establishing the opening net worth of a taxpayer has led to the use of the Cohan rule to estimate or approximate the amount of cash at that time. The Cohan rule (established by the US Seventh Circuit Court of Appeals in Cohan vs. Commissioner) allows the use of estimates where the taxpayer lacks adequate records. C. Bank Deposit Method When the taxpayer's records are patently inaccurate or manifestly incomplete, the Revenue Officer (RO) may look to the bank deposits of the taxpayer as evidence income. Under the bank deposit method, the bank records of the taxpayer are analyzed and the Revenue Officer estimates income on the basis of the total bank deposits after eliminating non-income items. This method stands on the premise that deposits represent taxable income unless otherwise explained as being non-taxable items. While the mere making of a bank deposit does not prove the receipt of taxable income, once the Revenue Officer has made his determination, the burden is on the taxpayer to prove that various deposits did not stem from the receipt of taxable income. The passage of time makes it difficult for the taxpayer to meet this burden but this does not relieve him from showing the non-taxable source to contradict the Revenue Officer's determination. If the bank deposit method is used in support of a determination of fraud, however, the burden of proof is on the Revenue Officer. ADHcTE A showing that the deposits were made with frequency and regularity and that was a source of income from which deposits might have been derived, strengthens the use of the bank deposit method of reconstructing income. Expert testimony as to the maximum income the taxpayer could earn has been held insufficient to prevent the use of the bank deposit method. When computing taxable income under this method, it is appropriate to add to the bank deposit the amount of cash expenditures from unbanked funds for personal non-deductible purpose. Withdrawals which can be identified as deductible are allowed against the taxable income so determined. In using the method, it is proper to prove the existence of a business and the practice of making deposit of business income into one or more bank accounts and then to adjust the total deposits for transfers, redeposits, deposits otherwise explained and finally to allow for ascertainable expenses, deductions and exemptions. a. Analysis of Bank Deposits The Revenue Officer's careful analysis of the taxpayer's bank deposits could well constitute the most important phase of his/her investigation. A review of the taxpayer's personal and business bank records for several months should be made. The following information/questions could be obtained from inspecting the taxpayer's deposits: a.1. Are deposits made on a basis consistent with the information secured during the initial interview? a.2. Are there any large or unusual deposits? a.3. Are there any deposits from sources not reflected on the tax return? a.4. The taxpayer's cancelled checks may reveal additional bank accounts not previously disclosed by the taxpayer. a.5. Are there checks endorsed by the taxpayer and deposited into an account not previously disclosed? a.6. Are there checks for assets or personal expenses that affect the taxpayer's-standard of living? b. Computation of Gross Receipts Through Bank Deposit Method Total Reconciled Bank Deposits xxx Less: Non-Taxable Receipts Deposited (sch. 1) (xxx) Net Deposits That Resulted From Taxable Receipts xxx Add: a. Business Expenses Paid By Cash (sch. 2) xxx b. Capital Items Paid By Cash xxx c. Personal Expenses Paid By Cash (sch. 3) xxx d. Cash Accumulated During The Year From Receipts xxx e. Increase in Accounts Receivable xxx f. Decrease in Accounts Payable xxx Total xxx Less: Non-taxable cash used in (a) thru (d) (xxx) Decrease in Accounts Receivable (xxx) Increase in Accounts Payable (xxx) Gross Receipts xxx ==== Schedule 1 Non-Taxable Receipts include: Checks drawn to cash that was redeposited Second deposits of NSF checks Transfers between accounts Proceeds from loans, social security, tax exempt interest Schedule 2 Business Expenses Paid By Cash Total business cash outlays per returns xxx Less: Total checks written xxx Less: Non-business expenses paid by check (xxx) Business expenses paid by check (xxx) Business expenses paid by cash xxx ==== Schedule 3 Personal Expenses Paid By Cash Total personal expenses xxx Less: Non-business expenses paid by check (xxx) Personal expenses paid by cash xxx === Deposits may represent redeposited items and loans, in which event, taxable income as determined by the Revenue Officer should be reduced by such amounts. When there is evidence that some of the deposits were for non-taxable items and as such, there is no proof of the precise amount of taxable income, the Cohan principle may be resorted to. Deposits may also be shown to represent amounts on hand at the start of the year in which they are deposited rather than income in that year. The bank deposit method like the net worth method, encompasses an area of uncertainty, thus though the taxpayer's records are inadequate for precise and complete verification of its return, a determination of income by the bank deposit method will be rejected if it is inconsistent with surrounding circumstances and gives an absurd result. D. Cash Expenditure Method An outgrowth of the net worth method of determining income is the "excess cash expenditure method". This method assumes that the excess of a taxpayer's expenditures during a tax period over his reported income for that period is taxable to the extent not proved otherwise. The taxpayer may show that this excess resulted from non-taxable items such as loans, gifts, inheritance or assets on hand at the beginning of the period. AHaDSI While it has been said that no opening net worth is needed, when the cash expenditure method is used, the more impressive authority is to the contrary. The two steps involved in the cash expenditure method are: a) valuation of the taxpayer's assets at the beginning of the taxable period in order to determine the taxpayer's funds available for expenditure during the ensuing taxable period and b) determination of the amount by which expenditures exceeds reported income for the taxable period. To show a failure to report the full amount of income by the use of this method, it must be demonstrated that the expenditures made during the taxable year were in excess of the available funds during the year which were reported on the tax return. Total expenditures may not include checks drawn to cash and items for which the taxpayer has paid cash, unless the cash bank withdrawals were not used to pay for the cash expenditure. The burden is on the taxpayer to establish the relationship between the cash withdrawal and individual items. Expenditures may not necessarily come from income, but very large expenditures for personal purposes each year may be interpreted as an indication that the income being reported was too small. Consideration must be given to non-taxable sources of cash. Here, too, the difficulty of establishing the amount of cash at the starting point has led to the use of Cohan rule to estimate the cash available at the opening of the taxable period. The method has to be rejected when it gives an unrealistic result. Proof in cash expenditure case may be difficult, for it is highly unusual for anyone to keep accurate records of personal living expenses. However, once the Revenue Officer has made a determination as to the amount of cash expenditures, the burden of proof to establish a different amount is on the taxpayer. E. Unit And Value Method This is not considered as a primary method proof. The determination or verification of gross receipts may be computed by applying price and profit figures to the known ascertainable quality of business of the taxpayer. In addition, there are existing regulatory bodies to which the taxpayer reports units of production or service, some of which are: a. records of sugar milled by a sugar central b. records of fish production to the Bureau of Fishery and Aquatic Resources c. records of production by pioneer and non-pioneer industries to the Board of Investments. E.1. Examples Using Unit and Value Method Industry Item Being Variables for Estimate of Tested Item Being Tested Pizza Parlor Sales Pounds of flour used multiply by number of pizzas per pound multiply by average price per pizza Gas Station Gasoline Sales Number of gallons sold per suppliers' invoices multiply by average price per gallon Exercise Patronage Membership statistics, Clubs individual membership fees, or monthly dues Hotels Room Revenue Number of rooms multiply by occupancy rate multiply by average room rate Laundry Washer and Cost per machine load Dryer multiply by number of times machine was used during business hours and number of machines Professional Fees billed Number of employees multiply by utilization rate multiply by hours a year multiply by average billing rate Real Estate Rental Revenue Number of rental units multiply occupancy rate multiply by average rent F. Third Party Information (Access to Records) Method Third party contracts are a source of information that should not be forgotten. The revenue officer determines when to make third party inquiries. The decision to make a third party inquiry is shaped by the size of the peso amount involved and the volume of the transaction. Third party inquiry through access to records can be time consuming. The revenue officer must weigh the benefits to be realized from this work against the time required to make an access to records and the availability of the needed information through other methods. The need for the revenue officer to obtain third party information is most often involved in our attempts to verify gross receipts. ANNEX A-1 PRO-FORMA STATEMENT OF ASSETS, LIABILITIES AND NETWORTH (Revised to conform to recent laws) PARTICULARS Dec. 31, 1993 Dec. 31, 1994 ASSETS (Net of Depreciation) 1. Cash on Hand ** Pxxxx Pxxxx 2. Cash in Banks xxxx xxxx 3. Accounts, Notes & Loans Receivable xxxx xxxx 4. Mortgage Receivable xxxx xxxx 5. Investments xxxx xxxx 6. Real Property - Land xxxx xxxx 7. Real Property - Improvements xxxx xxxx 8. Motor Vehicles xxxx xxxx 9. Inventory at the end xxxx xxxx 10. Furnitures/Fixtures xxxx xxxx 11. Personal Properties xxxx xxxx 12. Other Assets xxxx xxxx Total Assets xxxx xxxx LIABILITIES 1. Accounts, Notes & Loans Payable Pxxxx Pxxxx 2. Mortgage Payable xxxx xxxx 3. Other Liabilities. xxxx xxxx Total Liabilities xxxx xxxx Net Worth at the End Pxxxx Pxxxx ===== ===== Less: Net Worth at the Beginning xxxx Increase (Decrease) in Net Worth xxxx ** Supported by accompanying Cash Analysis Schedule Add: Non-deductible Items 1. Personal, living and family expenses Pxxxxx 2. Insurance premiums xxxx 3. Income tax payments xxxx 4. Gifts to others xxxx 5. Non-deductible expenses, taxes and contributions not directly connected with business of taxpayer xxxx 6. Net capital loss xxxx 7. Estate and Donor's taxes xxxx 9. Final tax payments xxxx 10. Other expenses which are non-deductible xxxx Total Non-deductible Items Pxxxx Net Income before further adjustments Pxxxx Less: Non-taxable items and income and proceeds subjected to final tax 1. Gifts, donations & Inheritance received Pxxxx 2. Non-taxable capital gains xxxx 3. Backpay/Pensions non-taxable xxxx 4. Proceeds of Life Insurance Policy xxxx 5. Non-taxable stock dividends (provided stocks are reflected in Assets) xxxx 6. Pensions received under RA 4917 (private firms) xxxx 7. Retirement pay from GSIS and SSS xxxx 8. Non-recognized gains from exchange of property under Sec. 34(c)(2) of the TaxCodeof 1988 xxxx 9. GSIS Cash Dividends xxxx 10. Social Security benefits received from foreign government and institution (per PD 220) xxxx 11. Other non-taxable items (such as those excluded under Sec. 28(b) of NIRC of 1988, those subjected to final tax such as foreign earnings by a non-resident, Filipino, royalties, prizes, yields on deposits, dividends, share in profits of taxable partnership, etc., per Sec. 21(b), Sec. 21(c), Sec. 22(2) of NIRC of 1988.) xxxx 12. Other exempt income xxxx 13. Proceeds of Sale of Real Estate subjected to final tax under Sec. 21(e) of the TaxCodeof 1988 xxxx Total Non-taxable items Pxxxx CASH ANALYSIS (Revised to conform with provisions of recent laws) -1994- Sources of Funds Cash on hand and in bank at the beginning Pxxxx Add: 1 Cash received from business (sales) Pxxxx 2. Collection of receivables xxxx 3. Proceeds of loans and mortgages xxxx 4. Proceeds of life insurance policies xxxx 5. Proceeds from sale of property, real or personal xxxx 6. Cash gifts, bequests and inheritance received xxxx *7. Non-fund deductions (depreciation and provision for bad debts) xxxx 8. Backpay, pensions, benefits, gratuities received xxxx 9. Cash dividends & interest income 10. Wagering gains xxxx 11. Receipt of cash from any other source xxxx xxxx Total Available Funds for the Year Pxxxx Less: Application of Funds *1. Cash purchases & business expenses Pxxxx 2. Cash paid for assets/property, real or personal (in payment of installment) xxxx 3. Payments of loans, notes & mortgage payable xxxx 4. Section 30(c) (1) (A to D) (non- deductible items) xxxx 5. Section 31(a) cash disbursement a. Personal living or family expenses xxxx b. Capital expenditures xxxx c. Premiums paid on life insurance xxxx 6. Cash disbursement of any kind xxxx 7. Cash on hand and in bank at the end xxxx xxxx CASH ON HAND AT THE END AS RECONSTRUCTED Pxxxx ===== *7 Sources: This item should be included as a contra account to Item No. 1 of Application of Funds if it includes non-cash deductions such as depreciation, bad debts, application of deferred items. Thus, if Item I of Application of Funds does not reflect non-cash deductions, there is no necessity to include Item 7 to Sources of Funds. Adjusted Net Income as per Investigation Pxxxx Less:- Statutory exemptions: Personal & additional exemption xxxx NET INCOME SUBJECT TO TAX Pxxxx Income tax due thereon Pxxxx Less: Amount previously paid xxxx Deficiency income tax still due Pxxxx Add: 50% surcharges, if fraud can be proven xxxx 25% surcharges for late payment xxxx Total amount due, exclusive of interest Pxxxx ====== XIII. Closing Conference Essential to an effective audit of internal revenue tax liabilities is the holding of a closing conference with the taxpayer before the preparation of the final report of investigation by the Revenue Officer assigned to the tax case. During this time, the Revenue Officer and his Supervisor explains to the taxpayer how the assessment of his tax liability was arrived at. If necessary, the records of the case shall be presented to the taxpayer to document the Revenue Officer's findings. The taxpayer shall then be allowed to examine such records and to present his arguments. If the taxpayer agrees with the audit findings, he shall be made to sign an Agreement Form, if not, the Revenue Officer shall give the taxpayer enough time to document his objections to the proposed assessment. In both cases, the report of investigation shall be prepared and submitted to the Revenue District Officer for review and approval. Upon receipt of the report of investigation, the Revenue District Officer (RDO) shall send to the taxpayer a notice for informal conference. The notice should be accompanied by a summary of the Revenue Officer's (RO) findings. The notice shall be made in writing and sent to the taxpayer at the address indicated in his return or at his last known address. This notice, however, may be dispensed with in case the taxpayer agrees in writing to the proposed assessment, or where such proposed assessment has been paid. In case the taxpayer responds to the notice within the period prescribed in the informal conference letter, he or his duly authorized representative shall again be allowed to examine the records of the case and to present his arguments in writing protesting the proposed assessment. Thereafter, the RDO shall, on the basis of the evidence on record, decide whether or not to approve the report before forwarding it to the Assessment Division for approval and issuance of the corresponding Termination Letter or Assessment Notice, as the case may be. In the event the taxpayer fails to respond to the notice for informal conference within the prescribed period, or when the RDO finds the response to be without merit, the report of investigation shall be given due course and shall be forwarded to the Assessment Division for review. XIV. Report Making The revenue officers are required to make a report after the investigation/audit has been conducted. Before starting to write a report, the revenue officer should have in mind a definite outline of the arrangement in which the facts and evidence may be presented in the most effective manner. A good general plan is to state the problem, present the results of the investigation and set forth the conclusions and recommendations. The report to be prepared by the revenue officer in the conduct of his investigation shall contain the following: A Document Locator Form duly accomplished by the Revenue Officer wherein the dates when the docket was received and acted upon are indicated (BIR Form 23.02) B. Table of Contents The table of contents shall indicate the description and page number of each and every document attached to the report. aAHDIc C. Narrative Report This is a memorandum report prepared and submitted by revenue officers. The narrative report shall contain the following: a. A preliminary statement indicating : a.1 the basis of the authority to investigate, specifically the Letter of Authority number, or referral number, date issued/served and details of referrals or revalidations, if any; a.2. type of investigation/verification undertaken; and a.3. profile of the taxpayer, particularly the type of business organization, nature of business, product line, other sources of income, information of its registration with the SEC, BOI, EPZA, etc., identification of major owners/stockholders and subsidiaries/affiliates, if relevant, brief description of accounting system/method used, description of any extraordinary business activity and kinds and amounts of incentives availed of, if any. b. A brief description of approach in investigation stating : b.1. the books of accounts, records and documents verified; b.2. the audit procedures adopted; b.3. access to records undertaken; b.4. the authorized representative of the taxpayer; and b.5. the dates and results of conferences. c. Results of investigation summarizing : c.1. the audit findings; c.2. discrepancies discovered, disallowances made and other relevant facts uncovered during the examination; c.3. basis of computation of recommended deficiency taxes/tax credit or refund, if any; and c.4. comparative results of findings/deficiency taxes collected/assessed with prior year's audit. d. A recommendation as to : d.1. the review/approval of the report of investigation and issuance of termination letter after collection of the deficiency tax; d.2. assessment of deficiency taxes indicating the prescription of the case; d.3. issuance of tax credit/refund; d.4 such other recommendation as may be necessary under the circumstances. D. Duly Accomplished Revenue Officer's Audit Report These forms are used by the Revenue Officers in the preparation of reports of investigation: BIR Form 1717 A This shall be accomplished by all Revenue Officers in reporting results of investigation of the income tax liabilities of taxpayers. It will reflect the nature and amount of the determined discrepancies, if any, as well as the result and verification of the taxpayer's delinquent account. BIR Form 1717 C This form is to be used in reporting results of investigation on Capital Gains Tax on real property transactions. BIR Form 1717 C-1 This form is to be used in reporting results of investigation on Capital Gains Tax on stock transactions not traded thru a Local Stock Exchange. BIR Form 1717-D This form is to be used in reporting results of investigation on Donor's Tax. BIR Form 1717-E This form is to be used in reporting results of investigation on Estate Taxes BIR Form 1717-P This form is to be used in reporting results of investigation on Percentage Taxes. BIR Form 1717-S This form is to be used in reporting results of investigation on Documentary Stamp Taxes. BIR Form 1717-V This form is to be used in reporting results of investigation on Value-Added Tax (VAT). BIR Form 1717-W This form is to be used in reporting results of investigation on Withholding Taxes. BIR Form 1717-X This form is to be used in reporting results of investigation on Excise Taxes. E. Working Papers Working papers from the most important portion of a report as they provide all the information on the investigation conducted. They are the best evidence of the scope of the investigation and the diligence with which it was completed. They further constitute the background for the revenue officers determination of tax liability. The working papers should include all notes made before, during and after a tax investigation which relates to his findings on a particular tax return and shall include items raised during the analysis of the return as possible issues. It should also include explanations on the various observations and analysis of pertinent schedules and information. Working papers prepared by the revenue officer are used as sources of a more detailed information which he may use later on as witness in court. The properly completed examination should therefore be reflected by adequate working papers. Memory should not be relied upon in reciting facts determined in the investigation. There is no better way to substantiate the fact that an item or issue has been extensively explored except to have suitable notes in the working papers. TEcCHD Each of the working papers should be headed clearly showing the name of the taxpayer, year of examination, date prepared and the signature of the revenue officer on each page. The pages should be numbered and prepared in the revenue officer's handwriting. The minimum requirements as to the inclusion of specific schedules or analysis in the working papers would vary in every case depending upon the type of return, nature of the business, sources of income, etc. The requirement is that the working papers contain evidence of what was done during the examination. This would include summaries or transcript of accounts analyzed, schedule of specific items checked, reconciliation of accounts, analysis of reserves and all other pertinent notes of the work performed. The basic working papers consist of, but are not limited, to the following: a. Working papers showing real and nominal accounts b. Working papers showing discrepancies, disallowances, adjustments and computation of deficiency taxes c. Reconciliation of net income per financial statements with the net income per income tax return d. Schedule of income producing property, if applicable e. Schedule of taxes and licenses f. Schedule of depreciation g. Schedule of loans/notes/accounts payable and interest expense/advances from officers/stockholders h. Schedule of miscellaneous income, if material i. Schedule of bad debts j. Schedule of Accounts Receivable and advances to accounts k. Schedule of miscellaneous expense, if material F. Attachments to the Docket of the Case These consist of documents which are necessary to the proper understanding and substantiation of results of the investigation. The documents to be attached to the dockets are composed of but no limited to: a. General Requirements a.1. All tax returns for the year/period under audit a.2. Duplicate copy of letter of authority duly received by the taxpayer or his representative a.3 Audited financial statements with supporting schedules and reconciliation statements for the period under investigation a.4. Narrative memorandum report a.5. Table of contents a.6. Checklist of audit procedures undertaken (Schedule RM-1) a.7. Working paper showing computation of deficiency tax payment a.8. Duly signed Agreement form, if applicable a.9. BIR: Form 1717 a.10. Photocopy of ATAP for deficiency tax payment a.11. Comparative report of deficiency tax paid/assessed a.12. Post reporting notice a.13. Logsheet/record of time spent by Revenue Officers a.14. Proof of exemption under Special Law b. Specific Requirements b.1. Income Tax b.1.1. Working papers showing breakdown of real and nominal accounts THEDCA b.1.2. Proof(s) of payment of tax claimed as tax credit (e.g. 1743IR, income tax paid in foreign country) b.2. Value-added tax (See Reporting Requirements on Audit Procedures on VAT) b.3. Percentage tax b.3.1. Summary of gross receipts and percentage tax due b.3.2. Proof(s) of payment of tax claimed as tax credit b.3.3. Reconciliation of Percentage Tax Returns figures with income tax returns and financial statements figures. b.4 Estate Tax b.4.1. Certificate of barangay chairman as to the domicile of the decedent (if family home is claimed as deduction) b.4.2. Certificate of the Certified Public Accountant, together with the itemized assets and deductions of the decedent, where the gross estate exceeds P50,000.00 b.4.3. Notice of death duly received by the BIR b.4.4. Death Certificate b.4.5. Statement of the name of executor/administrator/heirs ( with their respective addresses) who may be made liable for assessments/findings per review b.4.6. Verified copies of Transfer Certificates of Title (front and back) b.4.7. Certified true copy of the latest tax declaration at the time of death of the decedent b.4.8. Copy of judicial or extrajudicial partition b.4.9. Working papers showing composition of the gross estate and deductions claimed stating the exact location, area and valuation used for real properties b.4.10. Certificate of no improvement from Assessor's Office as verified by RO b.4.11. Affidavit of no improvement executed by the administrator b.4.12. Proof(s) of payment of tax claimed as tax credit, if any b.4.13. Proof(s) of claims against the estate (Sec. 79, NIRC) b.4.14. Proof(s) of valuation of shares of stock b.4.14.1. if listed newspaper clipping at the time of death b.4.14.2. if not listed Financial statements of the issuing corporation b.4.15. Proof of exempt transfer under Sec. 80, NIRC. b.5. Donor's Tax b.5.1. Verified copy of transfer certificate of title, if real property is the subject of donation (front and back) b.5.2. Certified true copy of latest tax declaration at the time of donation b.5.3. Copy of deed of donation b.5.4. Financial Statements of issuing corporation, if donation involves shares of stock not listed with the stock exchange. If listed newspaper clipping at the time of donation. b.5.5. Proof of exemption for exempt donation under Sec. 94, NIRC b.5.6. Sworn Statement of relationship of the donor to the donee b.5.7. Certificate of no improvement from the Assessor's Office as verified by Revenue Officer b.5.8. Proof of claimed tax credit, if any b.5.9. Working papers showing composition of gross donation and deductions claimed and details of previous donations for the same calendar year. AcaEDC b.6. Withholding Tax b.6.1. Withholding tax on Compensation Form 1743 W (monthly) Form 1743 IR (annual) with Alpha List of employees Form 1701B - income payments of P1,800 above not subject to withholding tax b.6.2. Expanded Withholding Tax Form 1743 W (monthly) Form 1743 IR (annual) with List of Income Recipients b.6.3. Final Withholding Tax Form 1743 W (monthly) Form 1745 (quarterly) Form 1743 IR (annual) Form 1745 A (Annual Information Return of Final Income Taxes Withheld on Interest Paid on Deposits and Yield on Deposit Substitutes/ Trust/etc.) b.6.4. Withholding Tax on Government Money Payments Form 750 AV (monthly) b.6.5. Working papers or reconciliation of amounts per Financial Statements with the amounts subject to withholding tax. b.7. Documentary Stamp Tax b.7.1. Proofs of Purchases b.7.2. Worksheets showing the following: b.7.2.1. Computations of time deposits, sale of acquired assets, promissory notes and other instruments requiring the affixture of documentary stamp tax by banks b.7.2.2. Computation of policy insurance transacted by life insurance companies during the year b.7.2.3. Computation of Gross Premiums from Direct Writings transacted during the year by non-life insurance companies b.7.2.4. Other transactions/documents subject to documentary stamp tax b.8. Excise Tax b.8.1. Official Receipts showing/evidencing payment b.8.2. Schedule of tax deposits and excise tax applied, if applicable b.8.3. Other requirements based on item subject to excise tax b.8.4. Schedule of importation subject to excise tax b.8.5. Report of Production and Withdrawals during the year XV. Audit Procedures by Kind of Tax Value-Added Tax Liabilities (Ref. RAMO 1-90 and 1-91 and RMO 40-94) a. Preliminary Approach to Investigation Prior to actual field investigation, the revenue officer should perform the following analytical procedures: a.1. Familiarize with the business of the taxpayer and determine the economic activity in which it is engaged in, whether sale of goods or services. a.2. Ascertain if the taxpayer maintains branches or other business establishments other than its main office. TCAScE a.3. Determine if the taxpayer is engaged in other lines of business aside from its principal undertaking. a.4. Study the accounting methods and peculiarities in the industry group where the taxpayer belongs. a.5. If possible, conduct interviews with responsible accounting and sales personnel to determine the degree of internal control. a.6. Examine the quarterly value-added tax returns and monthly VAT declarations filed and check if all information are provided for. a.7. Scrutinize the validation of payment on the VAT declaration/returns. Watch out for fake validations. a.8. Refer to the report of the audit of the value-added tax liabilities of the taxpayer for the immediately preceding period to be aware of the deficiencies noted that may also be relevant in the audit of the current period. a.9. Check reasonableness of sales and purchases together with output and input taxes declared. Verify mathematical computations. a.10. Tally input tax carried over against the VAT return for the prior period. a.11. Identify significant changes in sales and purchases and VAT payment from the immediately preceding period with the period under audit. a.12. Obtain documentary requirements enumerated under Schedule V-6 hereto for claims for VAT credit/refund. a.13. Request for the books of accounts and accounting records to be examined per Schedule V-7 hereof. b. Audit of Sales and Output Tax b.1. Gross Taxable Sale of Goods and Services b.1.1. Reconcile the amount of each category of sales per monthly VAT declarations, quarterly VAT returns and financial statements with the recorded amount of sales per general ledger, sales journal, including the control subsidiary sales ledger and any subsidiary sales journal for each branch. b.1.2. Review the composition of the sales account in the journals and ledgers and ascertain that: b.1.2.1. Only those transactions which are specifically exempted under Sec. 103 of the NIRC, are treated as exempt sales. b.1.2.2. "Deemed" sales of goods are recorded as taxable transactions: b.1.2.2.1. Transfer, use or consumption not in the course of business of goods or properties originally intended for sale or for use in the course of business. Transfer of goods or properties not in the course of business can take place when a VAT-registered person withdraws goods from his business for his personal use; b.1.2.2.2. Distribution or transfer to shareholders or investors as share in the profits of the VAT-registered person. Property dividends which are distributed to shareholders and declared out of retained earnings shall be subject to VAT based on the market value at the time of receipt; b.1.2.2.3. Transfer to creditors in payment of debt or obligation; b.1.2.2.4. Consignment of goods if actual sale is not made within 60 days following the date when such goods were consigned. Consigned goods returned by the consignee within the 60-day period is not deemed sold; b.1.2.2.5. Retirement from or cessation of business with respect to all goods on hand, whether capital goods, stock-in-trade, supplies or materials as of the date of such retirement or cessation, whether or not the business is continued by the new owner or successor. The following circumstances shall, among others, give rise to transactions "deemed sale": (1) change of ownership of the business; (2) dissolution of a partnership other than a general professional partnership and creation of a new partnership which takes over the business; (3) death of an individual who is a VAT-registered person, even if the estate or heirs of the decedent shall continue to operate the business; and aDACcH (4) incorporation of the business in the case of a single proprietorship. b.1.3. Verify and compare entries appearing in the subsidiary and/or sales journal and compare the same with information shown in the sales invoices. b.1.4. Test the accuracy of the sales summary against the source documents. b.1.5. Determine compliance with invoicing requirements and procedures. b.1.5.1. Ascertain that invoices bear all necessary information as required under Sec. 108(a) and 238 of the NIRC. b.1.5.2. Verify authority to print receipts/invoices. b.1.6. Ensure that the sales invoices issued for sales transactions are all accounted for. Account for any break in the sequence of serial numbers of sales invoices and official receipts issued and invoices assigned to branches. In case of cancelled sales invoices, the original copy should be on file. b.1.7. For those using loose-leaf invoices/cash register machines, require presentation of authority to use the same. b.1.8. Be alert on the use of double or multiple set of invoices bearing identical serial numbers. b.1.9. Verify if the transactions covered by "Statement of Account", "Delivery Receipt", "Debit Notes" and other similar documents are properly recorded as sales. The mere issuance of these documents without the corresponding sales invoice is a violation of the bookkeeping regulations and an indication of unrecorded sales, except in the case of bona fide consignment sales. b.1.10. When confronted with a delivery receipt, ascertain whether it covers a consummated sale or consignment sale. Consignment sale shall be considered as taxable sale after sixty (60) days following the date of consignment. b.1.11. If the taxpayer is engaged in both taxable and exempt transactions, ascertain that only VAT invoices are issued for VAT taxable transactions and separate invoices are issued for exempt transactions. Any person whose sale of goods or services which are otherwise not subject to VAT but who issues a VAT invoice or receipt therefore shall, in addition to his liability to other applicable percentage tax, if any, be liable to VAT without benefit of any input credit. b.1.12. Test check footings in the sales and subsidiary sales journals and posting to the general ledger. b.1.13. Verify sales contracts, marketing agreements, consignment terms and other sales related documents. b.1.14. Scrutinize miscellaneous and other income accounts and ascertain if such accounts are taxable. b.1.15. Examine the cash receipts book and official receipts issued to uncover any collection which may not have been included in the taxable sale. b.1.16. Tour the company and plant premises and relate the equipments in use and the volume of business with the amount of sales declared for tax purposes. b.1.17. Be resourceful in discovering underdeclaration of sales. Abnormal levels of inventories, sales, purchases, accounts receivables, including manipulation of interbranch transactions, among others, may suggest instances of underdeclaration. b.1.18. If necessary, analyze all the accounts affecting total sales, particularly cash account, accounts and/or notes receivable, collections from receivables, sales discounts and sales returns, bad debts written off and other relevant accounts. ICAcHE In the case of sale of service, include in the analysis other accounts such as advances, retention receivables, mobilization fees and other accounts. (See illustrations on Schedules V1-V4). b.1.19. Identify instances where the gross selling price of goods and services are unreasonably lower than the actual market value and make the necessary adjustments. b.1.20. If the accounting records are unreliable, look into gatepasses, purchase order registers and other records used by the taxpayer in its day-to-day transactions. b.1.21. Ascertain the correctness of output tax computation. b.1.22. Verify whether other charges such as excise tax, packaging, insurance, freight and delivery expenses are treated as part of the gross taxable sales. The excise tax, if any, shall form part of taxable sales. b.1.23. Account for deductions from sales such as: b.1.23.1. Discounts granted and determined at the time of sale which do not depend upon the happening of a future event expressly indicated on the face of the invoice and previously recorded in the books of accounts; and b.1.23.2. Sales returns and allowances for which proper credit or refund was made during the month or quarter to the buyer for sales previously recorded. b.1.24. In case the taxpayer enjoys full or partial exemption pursuant to special laws, verify the extent of exemption and compliance with the conditions set for the enjoyment of such exemptions. Compute the output tax by applying the factors prescribed under Executive Order No. 273. b.2. Zero-Rated and Foreign Currency Denominated Sales Determine whether sales declared as zero-rated actually emanate from export sales or foreign currency denominated sales and other transactions that may qualify as zero-rated or effectively zero-rated sales. b.2.1. For actual export sales, review invoices, bills of lading, inward letters of credit, lending certificates and other commercial documents. Ascertain if the proceeds were paid for in acceptable foreign currency and inwardly remitted or its equivalent in goods or services in accordance with the rules and regulations of the Bangko Sentral ng Pilipinas (BSP). Obtain schedule with the following information and check against supporting documents: b.2.1.1. Date of Export b.2.1.2. Sales Invoice No. b.2.1.3. Name of Consignee b.2.1.4. AWB/BL No. DacASC b.2.1.5. Shipment Date b.2.1.6. Amount of Sales in Foreign Currency Per Invoice b.2.1.7. Amount of Foreign Currency Remitted b.2.1.8. Conversion Rate b.2.1.9. Amount of Remittance in Pesos b.2.1.10. Date of Remittance b.2.1.11. Accredited Bank b.2.1.12. Bank Credit Memo No. b.2.1.13. Sales per Books b.2.1.14. Discrepancy Between b.2.1.6 & b.2.1.7 b.2.1.15. Discrepancy Between b.2.1.9 & b.2.1.13 V-1 Apply the following pro-forma computation to arrive at the total sale of goods Cash Sales Pxxx Add: Collections on accounts receivable Pxx Collection on notes receivable xx (if it pertains to sale of goods) Sales discounts granted xx Sales returns and allowances from sales on account xx Bad debts written off xx Accounts receivable, ending xx Notes receivable, ending xx Total receivables during the period Pxx Less: Accounts receivable, beginning Pxx Notes receivable, beginning xx xx Sales on account xx Total Sales during the period Pxxx ==== V-2 Account for the quantity of goods actually sold in appropriate cases, as a tool to further audit Finished goods, beginning xxx Add: Production or purchases xxx Total available for sale xxx Less: Finished goods inventory, end xxx Number of units issued xxx Less: Samples, destroyed or lost items xxx Number of units sold during the period xxx Multiply by average selling price per unit xxx Total sales per audit Pxxx ==== V-3 Determine the taxable sale by computing: Total sales during the period Pxxx Add: Deemed sales per audit xxx Total Sales per audit xxx Less: Zero-rated sales Pxxx Exempt Sales xxx xxx Gross Taxable Sales Pxxx Less: Sales returns and allowances xxx Taxable Sales Pxxx ==== V-4 Apply the following pro-forma computation to arrive at the gross taxable receipts during the period: Income or billings during the period Pxxx Add: Accounts receivable, beginning xxx Retention receivable, beginning xxx Total Available for Collection xxx Less: Accounts receivable, ending xxx Retention receivable, ending xxx xxx Collection from receivable xxx Add: Deposits or advances and mobilization fee xxx Gross receipts during the period xxx Less: Gross receipts from exempt service xxx Gross receipts from zero-rated service xxx xxx Taxable Gross Receipts Pxxx ==== b.2.2. Secure approval for zero-rating on export sales other than actual exports. b.2.3. For "foreign currency denominated sales", review the transactions and ascertain if: b.2.3.1. the buyer is a non-resident; b.2.3.2. the goods are assembled or manufactured in the Philippines; b.2.3.3. the goods are to be delivered to a resident in the Philippines; and b.2.3.4. The goods are paid for and inwardly remitted in acceptable foreign currency and accounted for in accordance with the rules and regulations of the Bangko Sentral ng Pilipinas (BSP). b.2.4. For zero-rated sale of services, verify contract agreement to ascertain the person for whom the services were rendered, amount of consideration, description of the services, and documents evidencing actual payments. Determine if proceeds of sale in foreign currency were inwardly remitted in accordance with the rules and regulations of the Bangko Sentral ng Pilipinas. Prepare schedule with the following information: b.2.4.1. Name of Contractee b.2.4.2. Contract Price b.2.4.3. Amount Billed in Foreign Currency b.2.4.4. Amount Received in Foreign Currency b.2.4.5. Official Receipt No. b.2.4.6. Date of Receipt b.2.4.7. Conversion Rate b.2.4.8. Amount Received in Pesos b.2.4.9. Name of Bank b.2.4.10. Bank Credit Memo No. b.2.4.11. Discrepancy between b.2.3.3 and b.2.3.4 b.2.5. For other effectively zero-rated transactions, secure copy of the application approved by the Revenue District Office. Without an approved application, the transaction otherwise entitled to zero-rating shall be considered taxable. c. Audit of Purchases and Input Tax c.1. Reconcile the amount of each category of purchases per VAT declarations and returns with the amount of purchases per subsidiary purchases journal. Check if all the information required are maintained in the purchase journal. c.2. Analyze and compare the summary of purchases with entries appearing in the subsidiary purchase journals, purchase journal, purchase invoices and other source documents. c.3. Review the composition of the purchase accounts in the journals and ledgers and ascertain that: c.3.1. Purchases from non-VAT and/or exempt persons do not result in any input tax credit. c.3.2. Effectively zero-rated purchases do not result in any input tax credit. c.3.3. Purchases from VAT persons, which are personal in nature, shall not give rise to input tax credit. c.4. Determine substantiation of claims for input tax credits. c.4.1. For domestic purchases of goods and services in the course of trade or business, these must be supported by VAT invoices or receipts showing the information required in Sec. 108 (a) and 238 of the Code. The printer's authority to print must likewise be indicated on the face of the invoice or receipt. A cash register machine tape shall not constitute valid proof of input tax credit. c.4.2. Credit for input tax on importation shall be supported with import entries or other equivalent documents showing actual payment of VAT on the imported goods. VAT payment must be based on the total value used by the Bureau of Customs in determining tariff and customs duties, plus customs duties, excise taxes, if any, and other charges prior to the release of the goods from customs custody, such as postage, commissions and similar charges. In case the valuation used is by volume or quantity, the landed cost which consists of the invoice amount, customs duties, freight, insurance and other charges and excise taxes, if any, shall be the basis for computing the value-added tax. c.4.3. VAT invoices issued for exempt and zero-rated transactions will not generate input credits to the purchaser. c.5. Determine correctness of computation of claims for input tax credits. c.6. Check the authenticity of substantial claims of input tax credits by confirming purchase transactions through, but not limited to: c.6.1. Access to supplier's records c.6.2. Comparing purchases of other taxpayers belonging to the same industry. c.6.3. Test checking payments of representative sample of purchases against check vouchers and cancelled checks. c.7. Ascertain that purchase returns or allowances granted to the taxpayer and input tax attributable to exempt sales results in a corresponding reduction in the input tax credit balance. (See illustration on Schedule V-5.) If a VAT-registered person is also engaged in exempt activities, the input taxes paid for purchase of goods or services which cannot be attributed to either operation shall be allocated between the VAT taxable operation and the non-VAT operation using the above computation. The amount allocated to the exempt transaction should reduce the input tax credit balance. c.8. Applications for the issuance of tax credit certificates and refund affecting the input tax credit accounts must reduce the input tax credit available at the time of application. These shall include not only applications filed with the Bureau of Internal Revenue but also those filed with the Department of Finance, the Board of Investments and the Bureau of Customs. c.9. Reconcile the amounts of input tax claimed in the VAT return for the portion carried over from previous quarters and the balance carried to succeeding quarters with the amounts recorded in the books of accounts. c.10. Ascertain that the recorded amount of the purchase of goods or services are net of VAT. d. Reporting Requirements The audit report should be brief and concise but complete in all details necessary to its understanding. It must have the following contents: d.1. Copy of the Letter of Authority d.2. VAT declarations and VAT returns for the audited period with proper validation of payment by the bank d.3. Worksheets showing the following schedules: d.3.1. Analysis of sales and output tax d.3.2. Analysis of purchases and input tax d..3.3. Analysis of relevant accounts such as cash, receivables, payables, advances, etc. (if necessary) d.3.4. Adjustments to sales and output tax d.3.5. Adjustments to purchases and input tax d.3.6. Computation of deficiency value-added tax V-5 For instance: Sales: From VAT operation P300,000 From non-VAT or exempt activity 200,000 Purchases which cannot be directly attributed to taxable and exempt activity 60,000 Input tax 6,000 Input tax on VAT taxable operation Sales on VAT Taxable Operations Total Input Tax x Input = Creditable to Total Sales (VAT Taxable + Tax VAT operation non-VAT or exempt activity) P300,000 x P6,000 = P3,600 500,000 ====== Thus: Input tax P6,000 Less: Unallowable input tax credit attributable to exempt activity 2,400 Allowable input tax credit P3,600 ====== d.4. Revenue officer's memorandum report stating the nature of business, audit findings and other relevant information uncovered during the investigation and his recommendation thereon. d.5. Revenue officer's VAT audit report (BIR Form 1717V) d.6. One copy of the BIR's Authority to Accept Payment form duly validated by the bank where the deficiency tax was paid d.7. Approved application for zero-rate, if applicable d.8. Photocopies of certificate of registration with other government agencies evidencing exemption from value added tax, if applicable d.9. Copy of audited financial statements for the period under audit d.10. A copy of "Access to Records" letter, if third party verification was conducted and documents gathered due to this procedure d.11. Other general and specific requirements as stated in Schedule V-6 hereof d.12. Checklist of duly accomplished Audit Procedures Undertaken (Schedule V-8) V-7 BOOKS OF ACCOUNTS AND OTHER ACCOUNTING RECORDS TO BE EXAMINED I. BOOKS OF ACCOUNTS 1. General ledger a. Subsidiary ledgers for branches, if any 2. General journal/journal vouchers 3. Sales journal a. Subsidiary sales journal for control account b. Subsidiary sales journals for branches, if any 4. Purchase journal a. Subsidiary purchase journals, if any 5. Cash receipts book 6. Cash disbursements book II. ACCOUNTABLE FORMS/SOURCE DOCUMENTS 1. Sales invoices of head office and branches, if any 2. Purchase invoices 3. Purchase orders 4. Official receipts 5. Receiving reports 6. Delivery receipts 7. Sales contracts 8. Import entry documents, if applicable III. OTHER ACCOUNTING RECORDS (if necessary) 1. Gate pass 2. Purchase order register 3. Check vouchers 4. Cancelled checks V-6 BUREAU OF INTERNAL REVENUE Revenue District Office No. _______ CHECKLIST OF REQUIREMENTS IN FILING VAT CREDIT/REFUND CLAIMS I. GENERAL REQUIREMENTS. ____1. 3 copies of application for VAT Credit/Refund (Form 2552). ____2. Photo copy of approved Application for Zero-Rate (for effectively zero-rated sales). ____3. For local purchases: In lieu of the second copy required to be attached to the VAT return under RR-6-89, photo copies of VAT purchase invoices for purchase of goods and official receipts (supported by statement of account of bill invoice) for purchase of services with the corresponding summary of purchase of goods and services and input tax claimed. The invoices must be arranged according to the summary list. The summary list should contain the details specified below. (Prepare separate list and documents for input tax within the period but not previously claimed.) Total Name of VAT Invoice Date of OR Date Input Invoice Supplier Number Number Invoice No. of OR Amount Tax Amount Importations: A) Photo copies of invoices, import declaration, import entry document, official receipt or confirmation receipts evidencing payment of VAT (segregate payments made by cash or tax credit). B) Summary of importation made during the period with the following details: Date of AWB/ Date of Total Date of O.R. Invoice Supplier Item BL No. Arrival Value Payment No. VAT ____ 4. VAT return(s) filed for the quarter showing that the tax credited on purchases of zero-rated sales were not applied against output tax for a certain quarter(s) and VAT return for the succeeding quarter. ____ 5. Certificate of taxpayer showing the amount of zero-rated, taxable and exempt sales, where applicable. ____ 6. Where the applicant's zero-rated transactions are regulated by certain government agencies, a statement therefrom showing the amount and description of sale of goods and services, name of persons or entities (except in case of exports) to whom the goods or services were sold and date of transaction. ____ 7. Authority to maintain Special Dollar Account. ____ 8. Other Documents (if applicable): (A.) Articles of Incorporation for first time filers. (B.) Sales contract/agreement. (C.) Beginning and ending inventory of raw materials, work-in-process, finished goods, supplies and materials. (D.) BOI Registration. (E.) VAT Registration for those claiming refund/TCC for the first time. (F.) Certification from BOI, BOC, EPZA that subject taxpayer has not filed similar claims for the period. (G.) If 100% exporter, sworn statement that ending inventory as the close of the period being claimed has been used directly or indirectly in the products subsequently exported as supported by export documents. (RR 9-89). (H.) For indirect exporters documents of liquidation evidencing the actual utilization of the raw materials in the manufacture of goods at least 70% of which have been actually exported. (RR 2-88) (I.) Audited financial statements, if applicable. (J.) In case of constructive inward remittance: 1) Central Bank approval of offsetting arrangement. 2) Schedule of monthly offsetting of receivables and payables in accordance with Central Bank rules and regulations. 3) Certification from CB on the amount constructively remitted under the off-setting arrangement. (K.) CB Clearance on non-violation of any CB rules or regulations. II. SPECIFIC REQUIREMENTS ____ 1. For Export sales (Semi-conductor companies, garments, food, etc.) ___ a) Summary of export sales stating the date of exportation, sales invoice number, name of buyer, airway bill/bill of lading number, lading date, amount of sales in foreign currency, peso value of sales, date of remittance, bank credit memo number and amount remitted in pesos. ___ b) Photo copies of export documents: 1. Invoices/receipts evidencing sale of goods, as well as the name of the person to whom the goods were delivered with respect to foreign currency, denominated sales. 2. export declaration/permit. ___ c) bank credit memoranda and certificate from the Central bank or any accredited agent bank showing that the proceeds of the sale in acceptable foreign currency had been inwardly remitted and accounted for in accordance with applicable banking regulations. The statement should also show the amount in foreign currency of the export proceeds or consideration, date of export, date of inward remittance, conversion rate into Philippine currency and the total peso value thereof. ____ 2. For zero-rated Sale of Service (contractors, mining, etc.) ____ a) Authenticated copy of the contract showing the person for whom the services were rendered, amount of consideration, description of the services and documents evidencing actual payments. ____ b) Photo copies of official receipts and billings, together with a summary of the date of billing, name of principal, official receipt number, date of receipt, amount in foreign currency and the corresponding peso value thereof, date of remittance, name of bank, bank credit memo number and amount remitted in pesos. ____ c) Bank credit memoranda and certificate from the Central Bank with information similar to 1-c (export sales). ____ d) Reconciliation of billings against inward remittances. Additional Requirements for Manning services: ____ 2A. Monthly Central Bank report on income of agency received. ____ 2B. Breakdown of gross foreign receipts specifying the nature of foreign currency received (e.g. Commission, allotment, manning fee, agency fee, advances, etc.) showing the total foreign currency value with its peso equivalent, bank credit memo number, name of bank and date of remittance. ____3. Effectively zero-rated sale of goods (mining, etc.)/services (contractors, etc.) ____ a) Summary of Sales invoices/receipts showing the name of the person entity to whom the sale of goods or services were delivered, dates of delivery, amount of consideration, and description of goods or services delivered. (RR 6-89 and RMC 2-90) ____ b) Reconciliation of billings against payment. ____ c) Evidence of actual receipt of goods or services. Additional Requirements for mining companies: ____ 1. Reconciliation of billings against actual collection. ____ 2. Operating agreement with owner of mining claims(s), if applicable. ____4. Purchase of Capital Goods. ____ a) Original copies of invoices/receipts showing the date of purchase, purchase price, amount of value-added tax paid and description of the capital equipment locally purchased. ____ b) On imported capital equipment: 1. Photo copy of import entry document and confirmation receipt of payment issued by the Bureau of Customs for value-added tax paid. V-8 CHECKLIST OF AUDIT PROCEDURES UNDERTAKEN IN THE VERIFICATION OF VAT RETURNS (Prescribed Under RAMO No. _____) Name of Taxpayer: _________________ Taxable Period: _________ Business Name or Style: _____________ TAX Acct. No. _________ Address: Principal Branch/es (Attach additional list, if necessary) 1. TAXPAYER'S GENERAL PROFILE 1.1 Type of Organization /_/ Single Proprietorship /_/ Partnership /_/ Corporation /_/ Others (specify) ____________ 1.2 Business Activity/ies /_/ Sale of Goods /_/ Manufacturing /_/ Importing /_/Local Trading Principal products/items sold _________________________________ /_/ Sale of Services Type of service/s (specify) ___________________________________ /_/ Activity exempt from VAT (specify) _________________________ 1.3. Maintenance of books /_/ Centralized /_/. Not centralized /_/ General ledger /_/ General Journal /_/ Sales journal /_/ Cash receipts Book /_/ Purchase journal /_/ Disbursements journal /_/ VAT Subsidiary Sales Journal /_/ VAT Subsidiary Purchase Journal 1.4. Method of Recording in the Books /_/ Manual /_/ Computerized /_/ Mixed 1.5. Manner of Invoicing/Issuance of Receipts: /_/ Manual /_/ Computerized /_/ Cash register receipts /_/ Mixed 1.6. Maintenance of branch/es /_/ Yes /_/ No How many? ________ 1.7 BIR Permits for: /_/ Printer's authority to print invoices/receipts /_/ Cash register machines, and for how many? _________ /_/ Loose-leaf invoices/receipts 1.8 Period Last Audited _________________________________ Nature of discrepancy/ies ___________________________________ Deficiency tax paid, if any ___________________________________ 1.9 Existence of affiliated/associated companies /_/ Yes /_/ No If yes, prepare an enumeration in a separate list. 1.10. VAT Registration Number /_/ Prominently displayed /_/ Not displayed /_/ Printed /_/ Rubber Stamped /_/ Handwritten /_/ Typewritten 1.11. Manner of Billing the VAT /_/ Separately /_/ Not separately billed 1.12. Registration under Special Laws (BOI, EPZA, etc.) /_/ Yes /_/ No If yes, specify ___________________________________________ Extent exemption _________________________________________ /_/ shown in invoice /_/ not shown 1.13. Number of sales invoices/receipts issued during the taxable period ________________________________ 2. AUDIT OF SALES AND OUTPUT TAX Done Not Done Remarks 2.1 Reconciliation of sales per books versus VAT return/s /_/ /_/ ________ 2.2 Review of the composition of sales accounts /_/ /_/ ________ 2.3 Analysis of all accounts affecting total sales 2.3.1 Prepared reconstruction of sales using accounts receivable /_/ /_/ ________ 2.3.2 Prepared reconstruction of sales using the inventory method /_/ /_/ ________ 2.3.3 Prepared reconstruction of gross taxable receipts using accounts/billings receivable /_/ /_/ ________ 2.4. Scrutiny and comparison of information in the sales invoices and subsidiary sales journal /_/ /_/ ________ 2.5. Determination of compliance with invoicing requirements /_/ /_/ ________ 2.6. Determination of the correct taxable base and output tax /_/ /_/ ________ 2.7. Determination of compliance with the conditions prescribed in the transitory provisions of the VAT law. /_/ /_/ ________ 2.8. Conduct of third-party verification of recorded transactions /_/ /_/ ________ 3. AUDIT OF SALES AND OUTPUT TAX Done Not Done Remarks 3.1 Reconciliation of purchases per books versus VAT return/s /_/ /_/ ________ 3.2. Review of the composition of purchase accounts /_/ /_/ ________ 3.3 Scrutiny and comparison of information in the suppliers' invoices/receipts and subsidiary purchase journals /_/ /_/ ________ 3.4. Determination of propriety of claims for input tax credits /_/ /_/ ________ 3.5. Determination of correct purchases and corresponding input taxes /_/ /_/ ________ 3.6. Determination of the correct input tax credits carried over from previous quarters /_/ /_/ ________ 3.7 Determination of compliance with the conditions prescribed in the transitory provisions of the VAT law /_/ /_/ ________ 3.8 Conduct of third-party verification of recorded transactions /_/ /_/ ________ I/We hereby certify to the correctness of the foregoing information. ____________________________ ____________________________ ____________________________ REVENUE OFFICER(S) Attested By: ____________________________________ SECTION CHIEF(or GROUP SUPERVISOR ____________________________________________ DIVISION CHIEF (or REVENUE DISTRICT OFFICER Withholding Taxes (Ref. RAMO 5-86) The following audit procedures outlines the steps to be performed by a Revenue Officer in the determination of the correct amount of withholding taxes due from withholding agents. The audit procedures are classified according to the classification of withholding taxes, to wit: 1. Withholding Tax on Compensation 2. Expanded Withholding Tax 3. Final Withholding Tax 4. Withholding Tax on Government Money Payments a. Verify records of payments to resident or non-resident payees or employees to ascertain if: a.1. The income payment is subject to withholding taxes. a.2. The rate of tax and the amount of tax withheld is correct. a.3. The tax withheld is remitted within the due dates. b. Audit procedures for the different kinds of withholding taxes. b.1. Withholding Tax on Compensation b.1.1. Determine the correctness of the amount of personal and additional exemptions claimed in the certificate of exemption (W-4) as accomplished and filed by the employee. This will be the basis for the computation of the withholding tax to be deducted from the compensation of the employee per payroll period. b.1.2. Verify the number and list of employees per payroll records and the list of employees submitted to the Social Security System and the Department of Labor and Employment as against the alpha list of employees from whom taxes have been withheld which is attached to the annual information return (1743-IR). b.1.3. Reconcile the aggregate gross compensation income stated in the withholding certificate (W-2) with the total amount indicated in the gross compensation income column of the alpha list. b.2. Expanded Withholding Tax b.2.1. Check amount payable or paid per income statement and information return (1701 or 1701Q) against those declared in the monthly and annual returns (1743W and 1743 IR). b.2.2. Determine the correctness of the rate of withholding tax applied. b.2.3. Ascertain payments by and to prime contractors, and subcontractors, professionals, brokers, sub-brokers, agents of entertainers, etc. b.2.4. Determine the dates of payment or the period when the obligation to pay the amount subject to withholding is due. The time to withhold is fixed at the time the obligation is due irrespective of the actual payment. b.3. Final Withholding Taxes b.3.1. Check documents to ascertain the type of income payments, the due date of the obligation and the residence of payee. b.3.2. Ascertain if the income payment was subjected to withholding in the year it was accrued, irrespective of whether or not it was actually paid, and whether the taxes withheld were remitted within 10 days following the month in which the payment was accrued. In the case of interest on bank deposits, the remittance shall be made quarterly within 25 days after the end of each quarter. b.3.3. Determine the correctness of the basis and rate of withholding tax applied. b.3.4. Ascertain the date of accrual of the income payment, to fix the time withhold, irrespective of the actual remittance or non-remittance of the tax withheld by reason of official restriction. b.4. Withholding Tax on Government Money Payments b.4.1. Determine the correctness of bases and rates of tax applied. b.4.2. Check money payments from voucher billing records, records of purchases, COA audit reports, etc. against monthly returns (7.50 AV), books of accounts/accounting records maintained. b.4.3. Verify records on withholding tax. b.4.3.1. Withholding Tax on Compensation Check the exemption certificates (W-4), payroll records, particularly confidential payrolls, if any, list of employees submitted by employer to the Government Service Insurance System and/or to the Department of Labor and Employment, employment contracts, supporting vouchers/receipts for advances/reimbursements of transportation and representation expenses, receipts for payment of compensation and financial statements. b.4.3.2. Expanded Withholding Tax Scrutinize the contracts and subcontracts between contractees and prime contractors and between the latter and subcontractors, and contracts between payees and payors, vouchers, receipts and billings indicating payments to professionals, brokers and sub-brokers, lease agreements, information returns (1701B) and financial statements. b.4.3.3. Final Withholding Tax Review the contracts for payment of certain items of income to resident and non-resident payees of interest and rent, Central Bank approval papers, commercial papers, employment contracts, contract for payment of royalties, records of prizes or winnings and financial statements. b.4.3.4. Withholding Tax on Government Money payments Examine the government contracts with the suppliers, the purchase records, payment orders, billing records, receipts, vouchers, cash book and reports of COA auditors. c. Check whether the correct amount of tax has been withheld and remitted within the prescribed period. Otherwise, impose appropriate penalties for non-withholding or non-remittance of the tax, as the case may be. ESTATE TAX (Ref. - RR 17-93, RAMO 2-82, RAMO 1-82, RAMO 1-80) The following audit procedures were culled from existing revenue issuances. They enumerate the steps to be taken by a Revenue Officer in the processing, verification and investigation of estate tax returns and unverified income tax returns of resident and non-resident decedents subject to estate tax. However, these do not preclude the application of other audit procedures as warranted by the circumstances surrounding each case. 1. The estate tax return of a decedent and all his unverified income tax returns for the last three years prior to his death shall be simultaneously investigated by a revenue officer or a group of revenue officers. The revenue officer should see to it that an income tax return covering the income and deductions of the decedent from January 1 to the date of his death has been filed. Although the period covered by the return consists of less than twelve (12) months, such period shall be considered as a "taxable year". 2. If the settlement of the estate of the decedent is the object of judicial testamentary or intestate proceedings, ascertain if: aDcTHE a. An income tax return for the estate as a taxable person has been filed by the fiduciary or administrator. The estate's income tax return shall cover the income and deductions of the estate for the period from the date immediately following the death of the decedent to the end of the taxable year. Thereafter, annually a return for the estate shall be filed until the estate is terminated. or b. An individual return for each of the spouses, heirs/beneficiaries has been filed covering their respective income and deductions for the period from the date immediately following the death of the decedent to the end of the taxable year. Such individual income tax returns shall include the income received by them from the estate. If the settlement of the estate is not the object of judicial testamentary or intestate proceedings, verify if the income of the properties left by the decedent is included in the income tax return of each heir or beneficiary according to his distributive share in the net income of the estate or co-ownership. 3. Verify if a Notice of Death was filed within two (2) months after the decedent's death where the gross value of the estate exceeds three thousand pesos (P3,000.00). In case of failure to file the notice, impose the appropriate penalty provided by the Tax Code. However, the Notice of Death may also be filed without penalty within two (2) months after the qualification of the executor or administrator. This contemplates the filing of estate proceedings in court and the appointment of the executor or administrator by the court. 4. Determine if the value of the gross estate is fifty thousand pesos (P50,000.00) or more. If in the affirmative, check whether the estate tax return is accompanied by a certified statement of an independent Certified Public Accountant showing the following information: a. Itemized assets of the decedent with their corresponding gross value at the time of his death, or in the case of a non-resident alien, of that part of his gross estate situated in the Philippines; and b. Itemized deductions from gross estate allowed under Sec. 79 of the Tax Code. After which, thoroughly examine the inventory of assets and liabilities submitted with the estate tax return to determine whether there are assets and/or liabilities not reported in the said return. Prepare an adjusted schedule of assets and liabilities as basis in computing the yearly increase in the net worth of the taxpayer up to the time of his death. 5. Inquire into the historical acquisition of the property left by the decedent, whether it was acquired by purchase, donation or inheritance, for the purpose of ascertaining if such property is conjugal, exclusive or the paraphernal property of the deceased. 6. Scrutinize the provisions of the insurance policies taken out by the deceased upon his own life as to whether the designation of the beneficiary is revocable or irrevocable. If revocable, the proceeds of the life insurance shall be included in the gross estate. If irrevocable, the proceeds thereof shall be excluded from the gross estate. However, the proceeds of the life insurance shall be included in the gross estate, irrespective of whether or not the insured retained the power of revocation, if the beneficiary named in the policy is the estate of the decedent. 7. Verify if the land, specially urban land, includes improvements and buildings. Secure a certification from the Assessor's Office as to the existence or non-existence of improvements on the land. If possible, an ocular inspection of the land should be undertaken. 8. Conduct third party verification an certain government agencies such as the Office of the Register of Deeds, Securities and Exchange Commission, Land Transportation Office, Office of the Provincial, City or Municipal Assessor for possible properties listed and registered in the name of the decedent which have not been included in the estate tax return. 9. Inquire into the bank deposits or other investments of the decedent. The Commissioner is authorized under Section 16 of the Tax Code to look into the bank deposits of a decedent for estate tax purposes, the provisions of Republic Act No. 1405 notwithstanding. Foreign currency, if any, shall be valued at their current foreign exchange rate. 10. Ascertain if the shares of stocks are properly valued. In doing so, observe the following rules on valuation pursuant to RAMO 1-82: a. For stocks listed or traded in the stock market a.1. The selling price shall be used where there are sales made on the valuation date. The mean between the highest and lowest selling prices on valuation dates shall be the fair market value per share. a.2. If there were no sales on the valuation date but there were sales on dates within a reasonable period both before and after the valuation date, the fair market value is determined by taking the weighted average of the mean between the highest and the lowest sales in the nearest trading date after the valuation date. The average is to be weighted inversely by the respective number of trading days between the selling dates and the valuation date. The reasonable period of valuation must not exceed six months before or after the valuation date. Example: The valuation date is January 15, Friday. Sales of stock occurred on January 13, Wednesday or two trading days before valuation date at P10.00 and on Wednesday, January 20, three days after valuation date at P15.00, the fair market value of the shares to be taken is P12.00 computed as follows: (3 x P10) + (2 x P15) = P30 + P30 = 60 = P12.00 5 5 5 a.3. If actual sales of the shares are not available during a reasonable period beginning before and ending after the valuation date, the fair market value may be determined by taking the mean between the bona fide bid and asked prices on the valuation date, or if none, by taking the weighted average of the mean between the bona fide bid and asked prices on the nearest trading date before and after the valuation date within a reasonable period in accordance with the formula in the preceding paragraph. a.4. If there are no sales or bona fide bid and asked prices available on a date within a reasonable period before the valuation date, but such prices are available on a date within a reasonable period after the valuation date, or vice versa, then the mean between the highest and lowest available sale prices or bid and asked prices nearest the valuation date may be taken as the value of the shares. a.5. If it is established that the selling or bid and asked prices as provided in the foregoing paragraphs do not reflect the fair market value thereof, some reasonable modification of that basis or other relevant facts and element of value may be considered. In certain exceptional cases, the size of the block of the stock to be valued in relation to the number of shares changing hands in sales may affect adversely the fair market value of the stocks to be valued. b. For unlisted stocks or stocks not quoted or traded in the stock market b.1. In general, the unlisted shares shall be valued at their book value nearest the valuation date. The book value of these unlisted shares of stock shall be prima facie considered as their fair market value. b.2. In case the shares are valued on a basis lower than their book values, a justification for the deviation from the book value, together with the evidences in support thereof, should be submitted. The following factors are considered relevant in the valuation of shares of stock of closed corporations: b.2.1. The nature of the business and the financial history of the enterprise, from the date of the incorporation. b.2.2. The economic outlook in general and the business condition and outcome of the specific industry in particular. b.2.3. The financial condition of the business b.2.4. The earning capacity of the company b.2.5. The dividend paying capacity b.2.6. Goodwill b.2.7. Sales of stocks and size of the block of stock to be valued b.2.8. Market price of stocks of corporations engaged in the same or similar line of business to be valued b.2.9. Existence of corporate debts in favor of the family of the principal shareholder b.2.10. Restrictive agreements impairing the alienability of the stock b.2.11. Investments in business or property maintained at a deficit b.2.12. Dividend arrearages b.2.13. Voting rights of stockholders b.2.14. Difficulty in liquidating the assets. If such lower fair market valuation is not clearly established and documented, the book value of the unlisted shares of stocks shall be adopted. If there have been previous bona fide sales/exchanges of the unlisted shares of stock, the price at which these shares exchange hands should be taken/considered as its fair market value/s. c. Preferred shares of stocks shall always be valued at par. 11. Audit of itemized deductions under Section 79 of the Tax Code: a. Funeral Expenses Require the submission of invoices or official receipts evidencing actual funeral expenses. Only actual funeral expenses in an amount equal to 5% of the gross estate or P100,000.00, whichever is lower, may be allowed as a deduction from gross estate. b. Judicial Expenses Check if the settlement of the estate is the object of judicial testamentary or intestate proceedings. If not, no deduction for judicial expenses shall be allowed. However, a reasonable amount for legal fees and accounting expenses incurred in the settlement of the estate of the decedent may be allowed. Scrutinize legal fees deducted in the estate tax return by checking the nature of the payment, the person to whom it was paid and the date of payment. c. Claims Against The Estate c.1. Verify if the claim is subject to Mortgage Redemption Insurance (MRI). If in the affirmative, disallow deduction claimed c.2. In the verification of claims against the estate, secure certified true copies of the following documents and scrutinize them: c.2.1. duly notarized promissory notes or contract of loan signed by the debtor if the loan was contracted within three years before the death of the decedent. Check the statement submitted by the administrator or executor regarding the disposition of the proceeds of the loan. If the administrator or executor fails to satisfactorily explain, in whole or in part, the disposition of the proceeds of the loan contracted within three (3) years before the death of the decedent, such proceeds or a portion thereof may be included as cash in the gross estate; c.2.2. vouchers, cancelled checks or other documents evidencing the advances made by individuals or corporations to the deceased; c.2.3. latest balance sheet of the corporation; and HCSDca c.2.4. other documents or evidences relevant to the grant of the loan, i.e., real estate or chattel mortgage, a copy of the Transfer Certificate of Title to show annotations thereof. c.2.4.1. Where the settlement is made through the court in a testate or intestate proceeding, scrutinize pertinent documents filed with the court evidencing claims against the estate or the court order approving the said claims if already issued. c.2.4.2. Obtain a sworn certification from the creditor as to the exact balance of the liability of the deceased. The certification must be duly signed by the president, vice-president or other principal officer of the corporation in case the creditor is a corporation. Ensure that the creditor agrees in writing allowing the verification by the Revenue Officer of his pertinent records for the purpose of substantiating the claims against the estate of the deceased. d. Claims Against Insolvent Persons d.1. Determine if the Account or Notes Receivable has been included as part of the gross estate. If not, disallow deduction. d.2. Find out if the claims against insolvent persons may be considered as conjugal or separate property of the decedent. In case the claim is the exclusive or paraphernal property of the decedent, the same should not be considered in the computation of the share of the surviving spouse. e. Vanishing Deduction (Property Previously Taxed) Ascertain compliance with all of the following conditions in order that the claim for vanishing deduction may be allowed: e.1. The prior decedent must have died or the donation was made within five (5) years before the decedent's death. e.2. The property subject of the vanishing deduction must be the same property inherited or donated from the prior decedent or donor. e.3. The vanishing deduction is based on the value of the property at the time of the donation or death of the prior decedent or at the time of the death of the present decedent, whichever is lower. The deduction is based on the value of each individual property. e.4. The estate tax or donor's tax due on the donation or estate of the prior decedent must have been paid. f. Transfers For Public Use f.1. Failure to comply with any of the following requisites will result in the disallowance of the deduction: f.1.1. The transferee is the government or any political subdivision thereof and the transfer is exclusively for public purpose. f.1.2. The transfer must be by way of a last will and testament or donation mortis causa executed by the deceased before his death. g. Losses Examine closely the losses being claimed as a deduction from gross estate. Disallow the deduction if any of the following conditions is absent: g.1. The property lost must have been included in the gross estate. g.2. The loss must not have been compensated for by insurance, in whole or in part. g.3. The loss must not have been claimed as a deduction for income tax purposes. g.4. The loss must have been incurred not later than six (6) months (last day for payment of the estate tax) after the decedent's death. 12. Check computation for the allowance of Family Home as a deduction from the gross estate and its corresponding valuation in accordance with RR No. 17-93, to wit: a. Valuation of Family Home. The decedent's family home shall be appraised as of the time of his death, at its current or fair market value or zonal value, whichever is higher. b. Conditions for the allowance of Family Home as a deduction from the gross estate: b.1. The family home must be the actual residential home of the decedent and his family at the time of his death, as certified to by the Barangay Captain of the locality where the family home is situated; b.2. The total value of the family home must be included as part of the gross estate of a person who died on or after July 28, 1992, the date of effectivity of R.A. 7499; and b.3. Allowable deduction must be in an amount equivalent to the fair market value or zonal value of the family home as declared or included in the gross estate but not exceeding P1,000,000. To illustrate: a. Real and personal properties P5,000,000 Family home 2,000,000 Gross Estate P7,000,000 Less: Deductions: Family home P1,000,000 Other deductions 3,000,000 4,000,000 Net Taxable Estate P3,000,000 ========== Note: Although the family home is valued at P2 million, the maximum allowable deduction for the family home is P1 million only. b. Real and personal properties P5,000,000 Family home 800,000 Gross Estate P5,800,000 Less: Deductions Family home P800,000 Other deductions 3,000,000 3,800,000 Net Taxable Estate P2,000,000 =========== Note: Deduction for family home is allowed for P800,000 only which is the declared value of the home. 2. Decedent is a married man with surviving spouse: a. The family home is his exclusive property Exclusive Conjugal Total Conjugal Properties: Real Properties P5,000,000 P5,000,000 Exclusive properties: Family Home P2,000,000 Other Exclusive Properties 2,500,000 P4,500,000 Gross Estate P4,500,000 P5,000,000 P9,500,000 Less: Conjugal Deductions: Other Deductions (2,000,000) (2,000,000) Share of surviving spouse: Conjugal Properties P5,000,000 Less: Conjugal Deductions 2,000,000 Net Conjugal-Estate P3,000,000 share of surviving spouse (1,500,000) (1,500,000) Family Home (1,000,000) (1,000,000) Net Taxable Estate P3,500,000 P1,500,000 P5,000,000 =========== =========== ========== b. Family home is a conjugal or community property. Exclusive Conjugal Total Conjugal Properties: Family Home P2,000,000 Other Real Properties P5,000,000 P7,000,000 Exclusive Real properties P2,000,000 2,000,000 Gross Estate P2,000,000 P7,000,000 P9,000,000 Less Deductions: Conjugal Deductions (2,000,000) (2,000,000) Share of surviving spouse: Conjugal Property P7,000,000 Less: Conjugal Deductions 2,000,000 Net Conjugal-Estate P5,000,000 share of surviving spouse (2,500,000) (2,500,000) Family Home (1,000,000) (1,000,000) Net Taxable Estate P2,000,000 P1,500,000 P3,500,000 =========== =========== =========== Note: Family home allowance of P1,000,000 is considered as one item of deduction after the computation and deduction of the net share of the surviving spouse in the conjugal property. c. Same facts and figures as in (b) except for family home which has a fair market value/zonal value of only P1,500,000. Exclusive Conjugal Total Conjugal Properties: Family Home P1,500,000 Other Real Properties P5,000,000 P6,500,000 Exclusive Real properties P2,000,000 2,000,000 Gross Estate P2,000,000 P6,500,000 P8,500,000 Less Deductions: Conjugal Deductions (2,000,000) (2,000,000) Share of surviving spouse: Conjugal Property P6,500,000 Less: Conjugal Deductions 2,000,000 Net Conjugal-Estate P4,500,000 share of surviving spouse (2,250,000) (2,250,000) Family Home (750,000) (750,000) Net Taxable Estate P2,000,000 P1,500,000 P3,500,000 =========== ============ =========== Note: Since the fair market value/zonal value of Family home (Conjugal) in the above example is P1,500,000, the Family home deduction corresponding to of such fair market value/zonal value is P750,000 only. CTIDcA d. Family home is conjugal property, but lot on which it stands is exclusive property. Exclusive Conjugal Total Conjugal Properties: Family Home P3,000,000 Other Real Properties P1,000,000 P4,000,000 Exclusive Real properties: Other real properties P2,000,000 Family lot 400,000 2,400,000 Gross Estate P2,400,000 P4,000,000 P6,400,000 Less Deductions: Other Deductions (2,000,000) (2,000,000) Share of surviving spouse: Conjugal Property P4,000,000 Less: Conjugal Deductions 2,000,000 Net Conjugal-Estate P2,000,000 share of surviving spouse (1,000,000) (1,000,000) Family Home and lot (P500,000 + 400,000) P400,000 (500,000) (900,000) Net Taxable Estate P2,000,000 P500,000 P2,500,000 ========= ========= ========= 3. Family home is conjugal property and both spouses died in the same year, leaving THREE (3) children: a. Estate of HUSBAND: Exclusive Community/ Total Conjugal Conjugal Properties: Real Properties P6,000,000 P6,000,000 Personal Properties P4,000,000 P4,000,000 Family Home 2,000,000 2,000,000 Exclusive properties: Real properties P4,000,000 4,000,000 Personal Properties 1,000,000 1,000,000 Gross Estate P5,000,000 P12,000,000 P17,000,000 Less Deductions: Conjugal Deductions (4,000,000) (4,000,000) Net Estate P5,000,000 P8,000,000 P13,000,000 Less: Share of surviving spouse (4,000,000) (4,000,000) Family Home (1,000,000) (1,000,000) Net Taxable Estate P5,000,000 P3,000,000 P8,000,000 ========== ========== ========= b. Estate of WIFE Inheritance Conjugal Share Share Total Conjugal Real Properties P750,000 P3,000,000 P3,750,000 Conjugal Personal Properties 500,000 2,000,000 2,500,000 Family Home 250,000 1,000,000 1,250,000 Exclusive Real Properties 1,000,000 - 1,000,000 Exclusive Personal Properties 250,000 - 250,000 Gross Estate P2,750,000 P6,000,000 P8,750,000 Less Deductions: Other deductions (500,000) (2,000,000) (2,500,000) Family Home (1,000,000) (1,000,000) Vanishing deductions* (1,964,286) (1,964,286) Net Taxable Estate P285,714 P3,000,000 P3,285,714 ========== =========== =========== *Vanishing deductions: Inherited properties P2,750,000 Less: 2,750,000 x P2,500,000 = 785,714 8,750,000 Amount subject to vanishing deductions P1,964,286 100% Vanishing deduction P1,964,286 ======== 13. In case of death of an individual who is a VAT-registered person, verify if the value-added tax (VAT) has been paid or imposed on the transfer or transmission of the business assets to the heirs, even if the estate or the heirs of the decedent continue to operate the business. If the business assets are conjugal, only one-half (), representing the share of the deceased, is subject to value-added tax. CTcSIA DONOR'S TAX (Ref. RAMO 1-82) An outline of the audit procedures which may be followed by a Revenue Officer for the immediate processing and proper verification of donor's tax returns is provided hereunder. a. Determine whether the donor's tax return has been filed within thirty (30) days from the date of donation. If not, impose penalties incident to late filing and late payment of the tax. b. Verify if the donor has made previous donations during the same taxable year from existing records available in the Revenue District Office or the Assessment Division for the purpose of determining how much is the gross gift to date. c. Ascertain authenticity of the following documents: c.1 Deed of Donation c.2 Transfer Certificate of Title (TCT)/Condominium Certificate of Title (CCT)/Original Certificate of Title (OCT), for real properties c.3 Latest Tax Declaration, for real properties d. If donation involves shares of stocks, verify proper valuation thereof by following the procedures prescribed under RAMO 1-82 (see procedure No. 10 in the .investigation of the estate tax liabilities of the decedent). e. Determine whether the essential elements of a gift are present. f. Ascertain whether the gross gift has been valued either at adjusted fair market value or zonal value, whichever is higher, at the time of the donation. g. Determine the relation between the donor and the donee for the imposition of the proper donor's tax rate. h. Verify if the donation of the land includes improvements and buildings. Secure a certification from the Assessor's Office as to the existence or non-existence of improvements on the land subject of the donation. Donation of the land ordinarily includes the improvements unless specifically excluded in the Deed of Donation. i. If a deduction is claimed, like liabilities or mortgage required to be assumed by the donee as a condition of the donation: a. Ascertain the balance of the indebtedness as of the time of the gift. b. Verify the genuineness of the deduction claimed and require the submission of pertinent documents in support of the deduction. c. Verify if the assumption of the liability is expressly stipulated in the Deed of Donation and is duly accepted by the donee. Otherwise, the claimed deduction should be disallowed. CAPITAL GAINS TAX ON SALE, TRANSFER OR EXCHANGE OF REAL PROPERTY UNDER SECTION 21 (e) OF THE TAXCODE (Ref. - RAMO 2-91, RR 13-85) This section equips the Revenue Officer with the minimum audit steps prescribed by existing revenue issuances in the proper determination of the correct capital gains tax due on the sale, transfer or exchange of real properties. Additional audit techniques may be employed by the Revenue Officer depending on the complexity and materiality of the transactions involved. a. Ascertain authenticity of the following documents: a.1 Deed of Sale/Transfer or Exchange a 2 Transfer Certificate of Title (TCT)/Condominium Certificate of Title (CCT)/Original Certificate of Title (OCT) a.3 Latest Tax Declaration b. For disposition of real property without any improvement, authenticate the certificate executed by the City/Provincial/Municipal Assessor on the non-existence of improvement on the real property being sold, transferred or exchanged. c. Corroborate value of property subject of sale by conducting an ocular inspection. d. Review computation of the tax base for land and improvement in accordance with the following schedules d.1 When the zonal value of land has been established d.1.1. Determine value of improvements by using the formulas shown below: d.1.1.1 Total Selling Price/Consideration per Deed of Sale (Land and Improvements) xxx Less: Zonal value of land xxx Value of improvements xxx === d.1.1.2 Improvements introduced from 1991 to present: Construction cost per building permit and/or occupancy permit xxx === Improvements introduced in 1986 to 1990: (Construction cost per building permit and/or occupancy permit xxx Add: 10% thereof per year after year of construction xxx Value of Improvements xxx === Improvements introduced in 1985 and prior years, and in cases of improvements in places other than NCR and chartered cities where there is no building permit and/or occupancy permit, use the following formula: Fair Market Value (FMV) per latest tax declaration xxx Add: 10% of the FMV of the improvements per latest tax declaration. if classified as residential or agricultural other than fishpond/ prawn farm. or 150% of FMV of the improvements per latest tax declaration, if classified as commercial, industrial and/or agricultural devoted to fishpond/ prawn farm xxx Value of Improvements xxx === d.1.2. Tax base of land and improvements Zonal value of land xxx Add: Value of improvement under d.1.1 or d.1.2, whichever is higher xxx Tax base of land and improvements xxx === d.2 When the zonal value of land has not been established d.2.1 Total Selling Price/Consideration per Deed of Sale (Land and Improvements) xxx === d.2.2 Determine value of land and improvements by using the following formula: FMV of land per latest tax declaration xxx Add: 100% of FMV of land per latest tax declaration if classified as residential or agricultural other than fishpond/prawn farm or 150% of FMV of land per latest tax declaration, if classified as commercial, industrial, and agricultural devoted to fishpond/prawn farm xxx Value of land xxx Add. Value of improvements (see d.1.1) xxx Value of Land and Improvements xxx === d.2.3 Tax base of land and improvements Selling Price d.2.1 or total market value of land and improvements d.2.2, whichever is higher xxx === e. In case of installment sales, determine whether the taxpayer is qualified to report his gain under the installment basis. An individual is qualified to account for his gain on installment basis if the initial payment does not exceed 25% of the selling price. The term "initial payment" means the payment or payments which the seller receives before or upon execution of the instrument of sale and payments which he expects or is scheduled to receive in cash or property (other than evidence of indebtedness of the purchaser) during the taxable year of sale or disposition. Example: Assume that on October 15, 1986, an individual sold for P100,000 a real property with an adjusted basis of P60,000 under the following terms: P10,000 upon execution of sale; the balance of P90,000 in 18 equal monthly installments of P5,000 each beginning November 15, 1986. The taxpayer qualifies to pay the capital gains tax on installment because the initial payment consisting of the amount of P10,000 he received upon sale and the amount he expects or is scheduled to receive P5,000 on November 15, 1986 and P5,000 on December 15, 1986, or a total of P20,000 during the year of sale do not exceed 25% of the selling price. e.1. Computation of amount of tax payable on installments. If the taxpayer qualifies and elects to pay the capital gains tax in installments, the tax may be paid in installments, the amount of each installment of which shall be the proportion of the tax so determined which e.1.1. on the date of sale or disposition, first payment (amount received, including the excess of the mortgage, if any, assumed by the purchaser over the basis of the property sold) and e.1.2. in succeeding payments, the installment payment received by the seller bears to the total contract price. Illustrations: Example 1. Assume that on October 1, 1986 an individual sold a piece of real property with an adjusted basis of P60,000 for P100,000 under the following terms: P20,000 down payment; balance in five annual installments beginning 1987. Taxpayer elects and is qualified to pay the tax in installments. The periodic payment of the tax is computed as follows: Computation of total tax due: Selling price P100,000 Total Tax Due at 5% thereof P5,000 Portion of the tax payable upon sale or upon receipt of first payment is determined as follows: [First payment/Contract price] X Total Tax Due = Portion of Tax Payable or [P20,000/P100,000] X P5,000 = P1,000 Portion of the tax payable annually for five years beginning 1987 is computed as follows a. Installment payment received P16,000 b. Total selling price P100,000 c. Total capital gains tax P5,000 d. Amount payable annually (a) divided by (b) multiplied by (c) P800 Example 2: Assume that in 1969, an individual acquired a property for P60,000. In 1986, he sold the property for P100,000. Terms of sale: Down payment, October 1, 1986, P10,000; mortgage assumed, P40,000; balance payable in four annual installments beginning January 2, 1987. The taxpayer elects to pay the tax on the gain in installments. The tax payments on installments received is computed as follows: Computation of total tax due: Selling Price P100,000 Total Tax Due at 5% thereof P5,000 Computation of taxes payable on installments (i) Upon receipt of first payment: (a) First payments received P10,000 (b) Total contract price: Selling Price P100,000 Less: mortgage assumed by buyer P40,000 P60,000 (c) Total capital gains tax due P5,000 (d) Amount of tax payable: [P10,000(a)/P60,000(b)] x P5,000(c) = P833.33 ====== (ii) Amount of succeeding tax payments (a) Annual installment receipts P12,500 (b) Total contract price P60,000 (c) Total capital gains tax P5,000 (d) Annual tax payable on installments [P12,500(a)/P60,000(b)] X P5,000(c) = P1,041.67 ======= Example 3. Assume that in 1986, an individual sold for P100,000 a piece of real property which he bought in 1980 for P40,000. Prior to sale, the property was mortgaged for P60,000 The terms of sale are as follows: Down payment, P10,000; assumption of unpaid mortgage, P50,000; balance of P40,000 payable in four semi-annual payments beginning January 15, 1987. The taxpayer elects to pay the tax in installments. Amount of tax payable in installments is computed follows: Computation of total capital gains tax: Selling price P100,000 Total Tax Due at 5% thereof 5,000 Computation of tax payment in the year of sale: First payment: Cash P10,000 Excess of mortgage assumed by buyer over the acquisition cost (P50,000 - P40,000) P10,000 Total first payment P20,000 ======= Total Contract Price: Selling Price P100,000 Less: mortgage assumed P50,000 P50,000 Add: Excess of mortgage assumed over basis of property sold P10,000 Total contract price P60,000 ====== Tax payable on first payment First payment P20,000 Contract price P60,000 Total capital gains tax P5,000 Amount of tax payable on first payment: P20,000/P60,000 x 5,000 = P1,667.00 ======== Semi-Annual tax payable on succeeding payments Installment received P10,000 Total contract price P60,000 Total tax due P5,000 Amount of tax payable semi-annually: [P10,000 / P60,000] x P5,000 = P833.00 ====== f. Confirm payment of Capital Gains Tax by cross-checking the payment thereof with the Batch Control Sheet prepared by the bank or the Collection Officer, as the case may be. g. When there is delay in the presentation of sales documents, require the taxpayer to submit documents such as cancelled checks, official receipts or certification of the archive official to show that there is no ante-dating of public instrument. The rules and regulations applicable at the date of execution of the contract shall be applied and the increments for late filing and payment of tax shall be imposed. If the taxpayer cannot show proofs that-the-same is not ante-dated, the rules applicable at the time of presentation of the document shall be applied. XVI General Policies in the Investigation of Tax Fraud Cases A. Jurisdiction 1. Tax Fraud Division 1.1 The Tax Fraud Division (TFD) shall have jurisdiction to conduct or undertake the investigation and/or reinvestigation of cases referred to or developed by the Division, and those assigned, referred or approved by the Commissioner of Internal Revenue. 2. Special Investigation Division (SID) 2.1 The SID shall have jurisdiction over the following cases: 2.1.1. Tax fraud cases referred to it by the Intelligence and Investigation Service (IIS). 2.1.2 Tax fraud cases initiated and developed by the SID. 2.1.3 Tax fraud cases referred to it by the RDO. 3. Revenue District Offices 3.1. If in the course of the regular examination of returns, indications of fraud were discovered, the RDO must transmit the records of the case immediately to the SID and provide assistance in the formal investigation thereof. This shall be considered sufficient compliance with RMO 44-93. B. Procedure A Preliminary Investigation must first be conducted to establish the prima facie existence of fraud. This shall include the verification of the allegations on the confidential informations and/or complaints filed, and the determination of the schemes and extent of fraud perpetrated by the denounced taxpayers. The Formal Fraud Investigation, which includes the examination of the taxpayers' books of accounts through the issuance of Letters of Authority, shall be conducted only after the prima facie existence of fraud has been established. 1. Tax Fraud Division 1.1 Where indications of fraud have been established in a preliminary investigation, the TFD through the Assistant Commissioner, Intelligence and Investigation Service (IIS), shall request/recommend the issuance of the corresponding Letter of Authority by the Commissioner which will automatically supersede all previously issued Letters of Authority with respect thereto. 1.2 Thereafter, a copy thereof shall be immediately furnished the RDO and/or the SID of the Revenue Region having jurisdiction over the taxpayer, who, upon receipt thereof, must immediately transmit to the TFD all the documents in their possession relative thereto and must withdraw and cancel any issued Letter of Authority therefor. No Letter of Authority shall be issued for any taxpayer already covered by a Letter of Authority issued by the Commissioner. 1.3 Reports on cases recommended for criminal prosecution shall be forwarded to the Assistant Commissioner, Legal Service, Attn: Litigation and Prosecution Division, through the IIS. However, if after evaluation the Litigation and Prosecution Division resolves that the evidence is not sufficient to warrant the filing of a criminal action against subject taxpayer, the case shall be referred back to the TFD through the IIS, for further documentation and/or appropriate action. 1.4. No Assessment Notice shall be served upon any taxpayer recommended for criminal prosecution for tax evasion, following the Supreme Court's ruling in the case of Ungab vs. Cusi, 97 SCRA 877. HAaECD 1.5. All other reports on cases not recommended for criminal prosecution shall be forwarded to the Commissioner, through the IIS, for approval. 2. Special Investigation Division 2.1. The Chief of the SID shall issue the corresponding Letter of Authority if the prima facie existence of fraud has been established, and the same has been confirmed by the Regional Tax Fraud Committee (RTFC), composed of the following: a. Regional Director Chairman b. Chief SID Member c. RDO having jurisdiction over the taxpayer Member d. Chief, Assessment Division Member e. Chief, Legal Division Member The RDO shall then desist from issuing any Letter of Authority to the taxpayer concerned, and shall transmit to the SID all the documents in its possession relative thereto. However, the RDO may assign one Revenue Officer, whose name shall be included in the Letter of Authority as the "RDO Assisting Revenue Officer'' (RARO), to assist and coordinate with the SID in the formal investigation. 2.2. Where the SID has established the prima facie existence of fraud against a taxpayer who has been the subject of an on-going or terminated investigation by the RDO, the SID shall nevertheless forward the records of the case for evaluation to the RTFC. If after evaluation the RTFC confirms to the SID the prima facie existence of fraud, the following procedures shall followed: 2.2.1 Where the investigation is on-going the RDO concerned shall withdraw its Letter of Authority and immediately cease and desist from further investigation. The records of the case shall then be forwarded to the SID concerned which, thereafter, shall issue a Letter of Authority and proceed with the formal fraud investigation. 2.2.2 Where investigation is already terminated the office who has the possession of the records shall upon written request, immediately forward the records to the SID concerned. If a re-investigation is necessary, the SID shall forwarded the same to the IIS with a recommendation for the issuance of the corresponding Letter of Authority by the Commissioner of Internal Revenue. 2.3. Where the business activities and/or establishments are situated in more than one revenue region, the tax fraud case must be referred to the TFD through the IIS. ACIDTE 2.4. If after conducting the preliminary investigation the prima facie existence of fraud cannot be established, but a potential deficiency tax assessment exists, the case shall be referred to the RDO concerned for appropriate action. 2.5. Reports on cases recommended for criminal prosecution shall be forwarded to the Legal Division of the Revenue Region. If after evaluation the Legal Division resolves that the evidence is not sufficient to warrant the filing of a criminal action against subject taxpayer, the case shall be referred back to the SID, for further documentation and/or appropriate action. 2.6. Reports on cases not recommended for criminal prosecution shall be forwarded to the Assessment Division of the Region. 3. Revenue District Offices 3.1 Upon discovery of the indication(s) of fraud during the regular examination of the returns, the Revenue Officer should make a detailed report thereof to Revenue District Officer who shall immediately transmit the records of the case to the SID. 3.2. The RDO shall then assign a RARO to assist and coordinate with the SID in the investigation of the said case. C. Civil Fraud In case the quantum of evidence gathered does not warrant a criminal prosecution because it is not sufficient to prove the guilt of the taxpayer beyond reasonable doubt, but there exists a clear and convincing evidence that fraud has been committed, a corresponding 50% surcharge shall nevertheless be imposed. A P P E N D I X GUIDELINES AND INVESTIGATIVE PROCEDURES IN THE DEVELOPMENT OF TAX FRAUD CASES FOR INTERNAL REVENUE OFFICERS A. OBJECTIVES : The substantial revenue collections of the government derived from the series of tax amnesties signify to a large degree that the BIR has not effectively tapped a great number of potential sources of revenues. The tremendous shortfall in revenue collections for the preceding year should spur the BIR on the need for a more systematic and vigorous tax campaign by instilling more awareness and tax consciousness among our taxpayers, more especially those who have continuously flaunted our revenue laws with impunity. To provide a strong deterrent to the commission of fraud against the revenues for the purpose of increasing and enhancing our revenue collections, the imposition of criminal sanctions, in addition to the civil liabilities, on erring taxpayers should be implemented to the fullest extent of the law in line with the pronouncement of the President of the Philippines. These guidelines are, therefore, presented to guide and to refresh all internal revenue officers with the necessary know-how in the investigation, evaluation, and submission of reports of fraud cases envisioned to withstand judicial scrutiny. B. NATURE AND TYPES OF FRAUD Definition fraud or evasion Tax fraud or evasion means the elimination or reduction of one's correct and proper tax by fraudulent means. "The fraud contemplated by law is actual and not constructive. It must be intentional fraud, consisting of deception, willfully and deliberately done or resorted to in order to induce another to give some legal right. . . . " Aznar vs. CTA and Collector, Gr#L-20569,. Aug. 25, 1974. Factors in Fraud or Evasion All the following elements must be proven by competent evidences to establish the existence of fraud: 1. The end to be achieved the payment of less tax than that known by the taxpayer to be legally due. 2. The accompanying state of mind which is variously described as being; evil", "in bad faith", "deliberate and not accidental", or "willful" the exact term used is not too important. 3. The overt act done or scheme used by the taxpayer to achieve the non-payment of taxes known to be due. The act or scheme must be tinged with some elements of deceit, misrepresentation, trick, device, concealment or dishonesty. Fraud under Tax Law, Balter . Burden of Proof in Establishing Fraud A tax fraud or evasion case is basically a criminal case. In the establishment of fraud, the burden of proof is on the Bureau of Internal Revenue. The presumption that an officer of the government has performed his duty regularly (.Section 5, Rule 131 of the New Rules of Court), as in the case of the correctness of deficiency assessments, is not applicable in fraud cases. "In criminal cases, the burden of proof as to the offense charged lies on the prosecution."(Section 2, Rule 131, New Rules of Court). Mere suspicions and mere doubts on the intention of the taxpayer are not sufficient proof of fraud. Fraud is never presumed; it must be proved. Types of Tax Fraud Cases Criminal Fraud A criminal tax fraud case results when all the elements of fraud can be proven beyond reasonable doubt. Proof beyond reasonable doubt does not mean such a degree of proof as, excluding possibility of error, produces absolute certainty. Moral certainty is only required, or that degree of proof which produces conviction in an unprejudiced mind. Here, the taxpayer upon conviction shall be liable aside from the deficiency taxes, to both criminal and civil penalties. Civil Fraud A civil tax fraud case results when all the elements of fraud cannot be proven beyond reasonable doubt, but rather by clear and convincing evidence amounting to more than a mere preponderance, and cannot be justified by mere speculation. "Preponderance of evidence" means that the testimony adduced by one side is more creditable and conclusive than that of the other. "Clear and convincing" need not rise to proof beyond reasonable doubt as in a criminal case but yet must be stronger than mere preponderance of evidence. Here, the taxpayer shall be liable aside from the deficiency taxes only to the civil penalties. Effects of Fraud under the National Internal Revenue Code (NIRC) 1. Civil penalties giving rise to the imposition of the 50%, surcharge; to be imposed by the BIR; 2. Criminal penalties involving the imposition of penal sanctions imprisonment and/or fine to be imposed by the Regional Trial Court (RTC) upon conviction; 3. Power of the Commissioner to assess and collect the tax is extended to 10 years from date of discovery, however, Sec. 280 provides the five year prescription on the filing of criminal action; 4. Cases involving fraud cannot be the subject of compromise as mandated by Section 204, NIRC; 5. Suspension and temporary closure of the business operations of a taxpayer under Sections 111 of Tax Code for violation of the VAT provisions. C. METHODS OF PROVING FRAUD IN CRIMINAL AND CIVIL TAX FRAUD CASES 1. The Direct Approach Method or by Direct Evidence, also called Specific item Cases Proof of fraudulent acts are adduced by specific items of fraudulent transactions. It is that one, if the allegations are believed, the existence of the principal or ultimate fact is proven without any inference or presumption. Specific Item Cases determined by the direct approach method . The following are mere examples of fraudulent act which can be adduced without the necessity of any inference or presumption: 1.1 Income tax 1.1.1 Omission or understatement of taxable income 1.1.1.1 Failure to file income tax return; 1.1.1.2 Items of income and expenses, or assets or liabilities have been omitted, or falsely claimed in the accounting records or return in order to minimize or reduce taxes; 1.1.1.3 Misclassification of accounts Income taken up and classified as liabilities; erroneous classification of income from taxable to exempt; ordinary gains classified as capital gains; non-deductible expenses disguised as deductible items; and capital expenditures classified as deductible items. 1.1.1.4 Sales/Income of domestic branches purportedly shown as income of the foreign head office; 1.1.1.5 Keeping two sets of invoice or receipts one set registered with the BIR and sales or income recorded thereon are the ones posted in the accounting records; whereas the other set is not reported for tax purposes. 1.1.1.6 Keeping two sets of books of accounts/ records one set registered with the BIR and the other set reflects the correct transactions and not registered and reported to the BIR. 1.1.1.7 Non-issuance of receipts to customers; and 1.1.1.8 Sales invoices or receipts issued to customers reflect the correct transactions, but invoices or receipts recorded for tax purposes reflect much smaller amounts. 1.1.2 Utilization of other persons or entities 1.1.2.1 Establishment of several entities corporations, partnerships, or proprietorships, by a person making it appear that sales are made by the different entities created when in fact such sales are only made by one person; 1.1.2.2 Allocating income and expenses to other persons in order to reduce or minimize taxes by a controlling person; and 1.1.2.3 Establishment of a registered partnership or corporation, using dummy partners or stockholders. 1.1.3 Improper claims of costs of sales and deductible expenses 1.1.3.1 Fictitious purchases, or padding of purchases, or that proceeds are diverted to the personal benefit of the taxpayer or his assign. 1.1.3.2 False or fictitious claims of deductions. 1.1.3.3 Misclassification of deductions Investments or major repairs or improvements claimed as nominal expenses; 1.1.3.4 Dividend declarations classified as expenses or salaries. 1.1.3.5 Withdrawals claimed as expenses or compensation. 1.1.3.6 Claim of depreciation of non-existing assets or already fully depreciated, or on assets which were appraised higher for credit purposes. 1.1.3.7 Claim of purchases from non-VAT sources as VAT purchases and claiming tax credits thereon; and 1.1.3.8 Improper claims of tax credits without having paid the input taxes passed on by the seller. 1.1.4 Claims of false personal exemption Claiming exemptions as married by an unmarried individuals or head of the family by single persons who do not actually support their parents; and Claiming false additional exemptions of alleged children, or children who are already of age or who are not physically incapacitated. 1.2. Business Taxes VAT and Percentage Taxes 1.2.1 Omission or understatement of taxable sales/income 1.2.1.1 Non-filing of VAT returns or Percentage Tax Returns; 1.2.1.2 Keeping of falsified books of accounts; 1.2.1.3 Non-issuance of sales invoices, or under-recording of sales or non-recording of true sales or income; 1.2.1.4 Claiming fictitious tax credits; 1.2.1.5 Crediting sales against items of expenses or costs of sales to conceal the amount of sales subject to business taxes on VAT; 1.2.1.6 Deducting against sales or income discounts which were granted subsequently and not in the sales invoice; 1.2.1.7 Deducting returned sales which were not actually returned. 1.2.2 Misclassification of sales or income 1.2.2.1 Classifying sales as exempt when in fact they are taxable; 1.2.2.2 Misclassification of sales of goods subject to VAT as only subject to percentage taxes; 1.2.2.3 Claiming domestic sales as export sales when in fact the goods were sold in the domestic market; and 1.2.2.4 Sales in the local market which are made to appear as sales by the foreign head office. 1.2.3 Claims of fictitious tax credits 1.2.3.1 Claiming tax credits on purchases of goods from Non-VAT registered enterprises; and 1.2.3.2 Claiming fictitious tax credits on non-existing invoices. CacHES 1.2.4 Non-payment of VAT on materials imported for re-export Materials were applied against goods originally imported for re-export, but which were used instead on goods sold in the local market. 1.3. Estate Tax 1.3.1 Failure to file estate tax return; 1.3.2 Filing of estate tax returns on different jurisdictions to avoid payment of the higher graduated tax, as in the case where the deceased-owned properties in various places; 1.3.3 Willful under-valuation of the market values of the properties of the estate; 1.3.4 Willful omission of some properties especially those located in places other than the residence of the deceased; and 1.3.5 Claim of fictitious items funeral expenses, claims against the estate, judicial and testamentary expenses. 1.4. Donor's Tax 1.4.1 Failure to file donor's tax return; 1.4.2 Filing of returns within the same year in various jurisdictions to evade the payment of the higher graduated tax; 1.4.3 Willful omissions of prior donations made during the same taxable year; 1.4.4 Willful undervaluation of the market value of the property donated; and 1.4.5 Insufficient consideration on sales of property, the difference between the market value from the consideration agreed upon, considered as subject to the donor's tax. 1.5 Excise Taxes 1.5.1 Misclassification of articles subject to excise tax by making it appear that a particular manufactured article falls within a lower tax classification; 1.5.2 Illegal manufacture of articles subject to excise tax; 1.5.3 Unlawful possession or removal of articles subject to excise tax, and for which no tax has been paid; 1.5.4 Unlawful use of denatured alcohol; 1.5.5 Unlawful possession of cigarette paper in bobbins, etc. and 1.5.6 Shipment or removal of liquor or tobacco products under false names or brands or as an imitation of any existing or otherwise known product name or brand. 1.6. Documentary Stamps Non-affixture of the correct documentary stamps on pertinent documents or papers. 1.7. Withholding Taxes Failure to withhold the correct taxes as withholding agent under the pertinent provisions of the Tax Code. 2. Indirect Approach or by Indirect Method This relies upon circumstantial evidence of determining the correct income or transaction of a taxpayer. Circumstantial evidence is that which tends to prove the existence of the disputed facts by proof of other facts which have a legitimate tendency to lead the mind to a conclusion that the fact exists which is sought to be established. However, where circumstantial evidence is relied upon to prove a fact, the circumstances must be proved by direct evidence and cannot themselves be inferred. The legal bases for an indirect approach in the determination of the correct income or transactions of a taxpayer are anchored on Sections 16 and 37 of NIRC of 1988. Principal Types of Indirect Approach or Indirect Methods Used 1. Net Worth Methods or Inventory Method or Net Worth & Expenditures Method This is a method of reconstructing income based on the theory that if the taxpayer's net worth has increased in a given year in an amount larger than his reported income, he had understated his income for that year. Formula: The mathematical formula for this method may be laid down as follows: a. Increase in net worth, plus b. Non-deductible items, less c. Non-taxable income or receipts subjected to final tax or transfer taxes, equals d. Taxable net income, less e. Personal and additional exemptions equals f. Net income subject to tax The Commissioner's determination of taxpayer's unreported income through the net worth expenditure method usually involves the following steps: (1) The net worth on a fixed starting date is established (excess of assets over liabilities). This starting date is usually the beginning of the first tax year under examination. The amount of such net worth is considered of vital importance in order to foreclose the possibility than an increase in net worth during the tax year, or an excess of expenditures over reported income, did not originate from prior accumulated funds (i.e. hoarded cash or undisclosed assets which would not represent income during the tax year); (2) The net worth at the close of each tax year under examination is established; (3) Comparison is made of the net worth at the beginning and end of each year, to determine the increase, if any; (4) The increase in net worth for each year is adjusted to eliminate items accounting for such increases which arise from non-taxable sources (i.e., gifts, bequests, other receipts exempt from tax, etc.) and adjustment is made where property is sold at a profit but the entire profit is not taxable because of long-term capital gain provisions. The increase in net worth for the year, after these eliminations and adjustments, is presumed to be income realized in that year; (5) The amount of non-deductible expenditures is determined or estimated. These items usually consist of personal, family and living expenses; and (6) The reconstructed income under the net worth expenditure method is the sum of items (4) and (5) and this amount is then compared with the income reported, if any, by the taxpayer. (Id., par. 6059; see also Perez vs. Araneta, L-10507, May 30, 1958, Reyes vs. Col. of Internal Rev., L-11534 and L-11558, Nov. 25, 1958; Jamir vs. Col. of Int. Rev. L-16552, Mar 30, 1962; Avelino vs. Col. of Int. Rev., L-17715, July 31, 1963). Circumstances and conditions necessary to warrant the use of the Indirect method in establishing a prima facie case of fraud : (1) That the taxpayer's accounting records are inadequate and do not clearly reflect his income; or that the taxpayer maintains no books and records; or that the taxpayer's accounting records are available, but he refuses to produce them; (2) That there is a fixed starting point or opening net worth, i.e., a date beginning of a taxable year or prior year to it, at which time the taxpayer's financial conditions can be affirmatively established with some definiteness; (Statements of net worth of taxpayers who availed of the tax amnesty under the provisions of Executive Order No. 41, may be used as the starting point as at December 31, 1985, pursuant to the authority given to the BIR under section 7 of said Executive Order); (3) That the circumstances are such that the method does reflect the taxpayer's income with reasonable accuracy and certainty, and proper and just additions of personal expenses and other non-deductible expenditures were made and correct; fair and equitable credit adjustments were given by way of eliminating non-taxable items or receipts or taxable income which have been subjected to final tax. (4) The need for evidence of the source of income under this method: "In all leading cases on this matter, courts are unanimous in holding that when the tax case is civil in nature, direct proof of sources of income is not essential. . . . However, when a taxpayer is criminally prosecuted for tax evasion, the need for evidence of a likely source of income becomes a prerequisite for a successful prosecution. . . ." RMC No. 43-74 This proof of a likely source of income may be shown by any of the following: (1) Demonstrating that there were specific omissions of income items by the taxpayer in his income tax return; (2) A showing that the nature of the taxpayer's business is such that it has the capacity of generating a substantial income; (3) Proofs of underdeclaration of income by the existence of unregistered sales invoices, which were not recorded in the books; (4) Findings of unrecorded purchases; (5) Existence of business permits, license from government agencies as to the types of businesses the taxpayer is engaged in; (6) Keeping separate sets of books one registered and the other reflecting the correct transactions of a business; (7) Use of false invoices or documents; and (8) Willful destruction of accounting records. 2. Expenditures Method or Excess Cash Expenditures Method : The expenditures method proceeds on the theory that where the amount of money which a taxpayer spends during a given year exceeds his reported income, and the source of such money is otherwise unexplained, it may be inferred that such expenditures represent unreported income. The discussions on when and how the net worth method should be used are equally applicable to the expenditures method. In a case where the taxpayer has several assets (and liabilities) whose cost bases remain the same throughout the period under investigation, the expenditures method may be preferred over the net worth method because a more laconic presentation can be made of the computation of taxable income. This is because assets and liabilities which do not change during the period under investigation may be omitted from the expenditures statement. The expenditures method is used often on a taxpayer who spends his income on lavish living and has little, if any, net worth. THcEaS Formula: The expenditures method of determining income should be applied by deducting the aggregate yearly expenditures from the declared yearly income (Col. of Int. Rev. vs. Jamir, 4 SCRA 718, March 30, 1962). Under this formula enunciated by the court in the above-cited case, the particulars in the use of this method are shown below: A. Expenditures for a given taxable year: (1) All expenses and deductions claimed per return filed with the BIR (Exclude non-cash items, such as amortization of goodwill, depreciation of assets, application of deferred expenses from prior period, etc.) Pxxx (2) Expenses, personal and non-deductible or deductible for tax purposes, as determined per investigation (Exclude non-cash items) xxx (3) Payments of debts, payables, accruals, and other liabilities taken up in the ITR and those not taken up, such as personal and other liabilities xxx (4) Payment of taxes xxx (5) Acquisition of assets per ITR and personal acquisitions such as cars, appliances, even real estate xxx Total Expenditures per Investigation Pxxx B. Sources of Cash (1) Declared income per Income Tax Return Pxxx Deduct: Account Receivables if taxpayer is on cash basis method of accounting (xxx) Add: Collections from receivables xxx (2) Non-taxable receipts, prizes, royalties, etc. xxx (3) Non-taxable receipts, such as dividends, donations from abroad xxx (4) Receipts subjected to transfer such as donations, inheritance xxx (5) Cash loans, if any xxx (6) Cash at the beginning of the period xxx xxx Excess Cash as determined per Investigation Pxxx As in the case of the Net Worth Method, when a tax case is civil in nature, direct proof of sources of income is not essential. However, when a criminal case is filed against the taxpayer, the need for evidence of a likely source of income becomes a prerequisite. 3. Percentage Methods Although the use of this method is of little value in criminal cases, it is useful in test-checking or corroborating the results obtained by some other means of proof such as specific items, net worth, and expenditures methods, and for evaluating allegations from informants regarding unreported profits or income. The percentage method is a computation whereby determinations are made by the use of percentages or ratios considered typical of the business under investigation. By reference to similar businesses or situations, percentage computations are secured to determine sales, gross profit, or even net profit. Likewise, by the use of some known base and the typical percentage applicable, individual items of income or expenses may be determined. ITScHa These percentages may be externally derived or they may in some instances be internally derived from the taxpayers accounts for other periods or from an analysis of subsidiary records. Gross profit percentages may be determined by comparing purchase invoices with sales invoices, price list, and other similar data. Also other years not covered by the investigation or portion of years under investigation may indicate typical percentages applicable to the entire year or years under investigation. It must, however, be emphasized that in comparing transactions of similarly situated businesses, the name of the particular taxpayer used as the model must not be divulged to the taxpayer under investigation nor in the report as this would constitute as a violation by an internal revenue officer of the provision of Section 269, NIRC of 1988 on unlawful divulgence of trade secrets. 4. Unit and Value Method This is not a prime method of proof. The determination or verification of gross receipts may be computed by applying price and profit figures to the known ascertainable quality of business done by the taxpayer. This method is feasible when the investigation can ascertain the number of units handled by the taxpayer and also when he knows the price or profit charged per unit. There may be regulatory body to which the taxpayer reports units of production or service. Examples are: (a) Records of sugar milled by a sugar central; (b) Records of fish production to the Bureau of Fishery and Aquatic Resources; (c) Records of production by pioneer and non-pioneer industries to the Board of Investments; and (d) Records of logs exported to the Forest Management Bureau. D. SOURCES OF FRAUD CASES 1. From routine examination of returns: a. Keeping no records or inadequate records despite substantial transactions reflected in the returns; b. Standard of living of the taxpayer, such as the possession of expensive cars and jewelry, or staying in a luxurious mansion, and ownership of properties whose values far exceed his probable sources of income as declared per return. c. Records, verified, were not properly declared for tax purposes; d. False vouchers and receipts which were verified in the course of the routine examination. 2. From information furnished by: a. An informant who has knowledge of the transactions of the taxpayers which were not properly declared for tax purposes; b. Referrals from other government offices or from other investigating units of the BIR. 3. Through the initiative of the investigating officers: a. From newspaper reports; b. Through research of available government records such as from offices of the Register of Deeds, Bureau of Highways, and other government offices; and c. In relation to an investigation of another taxpayer, where he suspects certain transactions were not declared for tax purposes. E. INDICATIONS OF FRAUD 1. Maintaining two sets of books and records; 2. Concealment of Assets 3. Destruction of books and records; 4. Large or frequent currency transactions; 5. Payments to fictitious companies or persons; 6. False or altered entries and documents; 7. Overdeclaration of purchases or under declaration of sales; 8. Use of false names or nominees; 9. Large company loans to employees or other persons; 10. Payee names on checks left blank and inserted at a later date; 11. Excessive billing accounts; 12. Excessive spoilage or defects; 13. Double payment on billing; TSIDaH 14. An individual negotiating checks made payable to a corporation; 15. Second or third party endorsement on corporate checks; 16. Excessive use of exchange checks or clearing accounts; 17. Personal expenses paid with corporate fund; 18. An understatement of income attributable to specific transactions and denial by the taxpayer of the receipt of the income or inability to provide a satisfactory explanation for its omission; 19. Substantial unexplained increases in networth over a period of years; 20. Failure to file a return, especially for a period of several years although substantial amount of income were received; 21. Concealment of bank accounts, brokerage accounts, and other property; 22. Inadequate explanation for dealing in large sums of currency, or the unexplained expenditure of currency, (especially when in a business not calling for large amount of cash); 23. Failure to deposit receipt to business account contrary to normal practices; 24. Claiming fictitious or improper deductions; 25. Substantial amount of personal expenditures deducted as business expenses; 26. False entries or alterations made on the books and records, backdated or postdated documents, false entries or invoices or statements, or other false documents; 27. Failure to keep records, especially if put on notice by the BIR as a result of prior examination, concealment of records or refusal to make certain records available. 28. Distribution of profits to fictitious partners; 29. False statements, especially if made under oath about a material fact involved in the investigation; 30. Attempts to hinder the investigation; Failure to answer pertinent questions or repeated cancellations of appointments. Avoiding the investigator; 31. The taxpayers knowledge of taxes and business practices where numerous questionable items appear on the returns; 32. Destruction of books and records, especially after the investigation was started; 33. Transfer of assets for purposes of concealment; 34. Involvement in illegal activity (illegal income); 35. Failure to disclose all relevance facts; 36. Unsubstantial or unexplained wealth; 37. Mental handling of ones affair to avoid keeping records usual in transactions of the same kind. 38. Keeping no records or inadequate records despite substantial transactions in the return; and 39. Any conduct, the likely effect of which would be to mislead or to conceal material facts. F. PROCESSING OF A TAX FRAUD CASE 1. Preliminary Investigation: The purpose of preliminary investigation is to establish the existence of a prima facie indications of fraud. To gather evidences therefor the courses of action that may be conducted pursuant to the pertinent Tax Code provision, are but not limited to the following: a. Sec. 7 Access to records of private persons or entities, and government offices and agencies; and Interview potential witnesses. b. Sec. 15 Arrest persons and seize documents and instruments, if the violations of the Tax Code are done within the view of a revenue officer. c. Sec. 16C Conduct inventory taking or surveillance. d. Sec. 171 Conduct as search for excise taxable articles. 2. Preparation of a preliminary investigation report with a recommendation for the Issuance of a Letter of Authority: The examiner or revenue official who discovers a potential tax fraud case must submit a memorandum report to his immediate superior stating the facts and circumstances which constitute the indication of fraud, and the evidence at hand to be verified and confirmed. The issuances and approvals of Letters of Authority for fraud cases shall be in accordance with existing rules and regulations on such issuances. The issuance of Letters of Authority, in the case of the Tax Fraud Division, may be dispensed with when so warranted by the circumstance of the case; provided that the taxpayer shall be notified by the Commissioner of Internal Revenue that his internal revenue tax liabilities are under investigation or that the report thereon has been submitted. 3. Formal Fraud Investigation: (a) Whenever there appears to be a need for a formal tax fraud investigation of a particular taxpayer, a work plan must be prepared in accordance with the following guidelines: (1) Review all available information; (2) Determine the objectives of the investigation; (a) Development of criminal tax case; (b) Deciding the particular provision of the NIRC allegedly violated and asking by whom, when, where, and by what means. Were Revenue Regulations, Revenue Memorandum Circulars or BIR Rulings and issuances also violated or involved; (c) Understanding clearly the elements of the offense. (3) If it is an investigation referred by an informant, recontact and obtain detailed information about the origin of the case, who has been talked to, what was said, available records, etc. Re-interview the person who initially provided the information or made the allegation. (4) Determine the following: (a) Information that is needed; (b) Relative importance of the desired information; (c) Best sources of information; and (d) Best sequence for making the necessary inquiries. (5) Gather background information: (a) Obtain as much information as possible on the suspect; (b) Obtain tax returns from Revenue District Offices concerned; (c) Obtain pertinent records such as General Information Sheet, Articles of Incorporation, Constitution and By-Laws, Financial Statements from Securities and Exchange Commission and other information from Bureau of Domestic Trade, Department of Trade and Industry and other government agencies. (6) In conclusion, decide if an examination of the taxpayer's books of accounts is warranted and the best method of proof. G. PREPARATION AND ASSEMBLY OF REPORTS FOR TAX FRAUD CASES (1) Planning the report: Before starting to write a report, the examiner should have in mind a definite outline of the arrangement in which the facts and evidence may be presented in the most effective manner. A good general plan is to state the problem, present the results of the investigation, and set forth the conclusions and recommendations. (2) Assembly of a report: A report should be assembled in the following manner: (a) Table of Contents The table of contents should indicate the subject matter, and page number in the docket, to provide quick reference to important features of the case. (b) Body of the Report The format of the report must more or less contain the following information and presentation whenever it is necessary: b-1 Name and Address of Taxpayer b-2 Tax periods involved in the investigation b-3 Returns filed and statute of limitations b-4 Type of violation indicate the pertinent provision of the Tax Code violated b-5 Origin of the case b-6 Name and Titles of cooperating BIR officers b-7 Letter of Authority number, date issued, issuing officer b-8 Date the taxpayer was first contacted by the examiners b-9 Representative of the taxpayer b-10 Brief description of the method used in the evasion or other violation b-11 Related cases b-12 Summary of facts determined during the investigation Explanations on the evidence in support of the tax deficiency Explanations on the evidence in support of the criminal aspect b-13 Explanation and defense of taxpayer b-14 Conclusions and recommendations The body of the report should contain a reference to the appendices or worksheets and schedules, the appendices should contain a reference to exhibits which consist of supporting documents. For example: "Appendix A is a summary of the unreported receipts from sales, and Exhibits 8 to 25 are copies of documents in support thereof." Important matters in the exhibits generally should be explained in the report. However, if a document is of the nature that it is adequately described in an appendix, no further explanation is necessary. When mentioning or referring to a document that is submitted as an exhibit, including the written statement of a witness, insert the exhibit number in parenthesis immediately following the reference. ADaECI The examiner, before beginning his report, should arrange the proposed appendices and exhibits in the order of his planned presentation of facts and evidence, and then he prepares his report discussing the appendices and exhibits in that order. When the report is completed, the exhibits should be assembled in the order in which they are originally mentioned in the report, and they should be numbered for easy reference. ANNEX A-2 SAMPLE LIST OF WITNESSES and EXHIBITS SING and FURR, INC. No. 24 Changi Street, Manila EXHIBIT REF. W1 Atty. ROBY CAPULON 1 PP. 66-72 1990 ITR and Bureau of Internal Revenue Attachments Revenue District Officer 2 PP. 73-80 1991 ITR and RDO No. XX, Manila Attachments Tel. No. 315-62-22 W2 Atty. CARLS MIRANDA JR. 1 PP. 81-83 Memorandum of Bureau of Internal Revenue Interview with Joel Intelligence Officer Cruz, accountant of Special Investigation Div. SING and FURR INC. Revenue Region X, Manila dated July 12, 1994 Tel. No. 61-24-08 2 P. 84 APPENDIX A - Computation of unreported Gross Receipts-1990, 1991 3 P. 85 APPENDIX B - Computation of Adjusted Taxable Income-1990, 1991 4 P. 86 APPENDIX C - Computation of Deficiency Taxes- 1990, 1991 W3 ANJIE FARUMOG 1 P. 12 Affidavit dated Manager FLORR, INC. August 4, 1994 125 ABC St., QC 2 P. 13 Confirmation letter Tel. No. 40-15-24 dated June 6, 1994 Computation of Unreported Gross Receipts - 1990, 1991 SING and FURR, INC. Computation of Adjusted Taxable Income 1990 & 1991 SING and FURR, INC.