Conclusions and Recommendations

• Introduction
• The Context for Our Conclusions
• Overall Conclusions
• Setting a Strategic Direction for Taxpayer Audit
• What Specific Changes are Required?
• Managing the Changes

Introduction

The Inland Revenue Department’s (the IRD) strategic business plan The Way Forward 2001 Onwards includes a Taxpayer Compliance Model that is the cornerstone of the IRD’s aim to ensure that all taxpayers pay the correct amount of tax that is due. The strategic business plan is ambitious and challenging, and the audit of taxpayers’ reporting of income tax and other amounts liable for tax is a crucial component of the Taxpayer Compliance Model. It is vital that the IRD undertakes audits to detect non-compliance with tax laws and to deter potential non-compliance.

The cost of taxpayer audit is 23% of the total cost of running the IRD and is the largest single activity undertaken. For the year to 30 June 2003, the planned cost of taxpayer audit as described in this report (excluding Litigation Management) was $91 million excluding GST – representing $73 million for the audit work done in the IRD’s service centres, and $18 million in its Corporates Division.

In this audit, we have examined the IRD’s taxpayer audit function in the context of the Compliance Model to establish whether taxpayer audit is in a position to deliver the IRD’s vision to improve taxpayer compliance.

The Context for Our Conclusions

Our conclusions on pages 11 to 20 need to be seen in the context of:

• important current developments in public sector management; and
• the IRD as a large and complex organisation that has a range of major priorities competing for resources and management attention.

Current Developments in Public Sector Management

The current public sector management system is based on an output-contracting model. Under this system, the IRD’s taxpayer audit is delivering against the targets that the IRD has agreed with the Government. The IRD’s annual report, the quarterly reports to the Minister, and monthly internal reports show that, over time, the performance of taxpayer audit is consistently in line with the IRD’s Purchase Agreement. Central agencies have confirmed that the IRD has consistently delivered on its taxpayer audit outputs.

In recent years it has been recognised that the output-contracting model is not, on its own, an adequate model for measuring public sector performance. The IRD has been one of the departments involved from the outset in identifying the changes required to expand the model to include outcome measures. It has participated in the Pathfinder Project¹, and was an early adopter of the Statement of Intent. The IRD, together with central agencies, has begun reviewing its performance measures and making changes to ensure that the measures are meaningful and include a clear focus on outcomes.

The IRD’s review of performance measures has not yet focused fully on taxpayer audit. The current performance targets for taxpayer audit are still focused on output measures such as audit hours performed and the value of discrepancies identified on individual audits. The IRD recognises that these measures are not capable of demonstrating the performance of taxpayer audit in meeting the IRD’s vision – to improve taxpayer compliance – that it set out in The Way Forward 2001 Onwards.

Major Recent Developments in the IRD

Though taxpayer audit is a substantial part of what it does, the IRD has a number of other substantial activities that have been subject to a high level of public attention in recent years.

During 1999-2000, the Finance and Expenditure Committee completed an inquiry into the IRD’s powers and operations. The inquiry found that, during the late 1990s, public confidence in tax administration had been eroded. Since then, the IRD has embarked on a major programme of change aimed at restoring public confidence and improving its efficiency and effectiveness. It has identified a two-pronged approach:

• building the internal foundations required to underpin the changes; and
• addressing immediate known priorities.

The Way Forward 2001 Onwards is a key document and sets out the IRD’s goals over a five-year period. Major externally focused initiatives have included the development of a Taxpayer Charter, and the introduction of a complaints management service. Key initiatives to improve the internal foundations across the IRD have included revision of the IRD’s Code of Conduct, focus on service delivery training, and implementation of a performance management system linking desired competencies, behaviours, and achievement of results to staff performance, remuneration, and strategic initiatives.

Operational priorities have concentrated on systems that have replaced the need for most salary and wage earners to file a tax return, and initiatives aimed at reducing compliance costs for small businesses. The IRD has also been increasing its emphasis on tax evasion and aggressive tax issues (avoidance), as well as its focus on particular sectors through, for example, its Industry Partnerships² project. The IRD has secured additional funding to address aggressive tax issues as part of the Government’s 2003 budget.

Overall Conclusions

Taxpayer audit is a difficult task. It involves highly technical issues, and audits are undertaken in often stressful, and occasionally confrontational, circumstances.

Taxpayer audit is under-developed – much of what is needed for taxpayer audit to play its full part in the Taxpayer Compliance Model and to enable the IRD to meet its strategic direction is not yet in place. The IRD agrees that the time has come for taxpayer audit to be improved and has already initiated a number of projects. The scale of change needed is substantial and requires a significant programme to manage the change.

Our more detailed conclusions and recommendations are set out below, under the following headings:

• Setting a Strategic Direction for Taxpayer Audit;
• What Specific Changes are Required?; and
• Managing the Changes.

Setting a Strategic Direction for Taxpayer Audit

During our audit, we spoke to many tax practitioners who deal regularly with the IRD’s investigators. These practitioners gave us a range of views about the performance of the taxpayer audit function. This enabled us to direct our audit at areas where improvements were seen to be required. Many of these practitioners supported the thrust of the IRD’s vision in The Way Forward 2001 Onwards.

The IRD is in the process of preparing its strategy for taxpayer audit to support this vision. Many projects related to taxpayer audit are under way, and a detailed framework is needed to bring together the large amount of important work that needs to be done to ensure that taxpayer audit can play its part in achieving the IRD’s aims.

What Specific Changes Are Required?

Improving Case Selection and the Conduct of Audits

The management of taxpayer audit is currently highly devolved, with most of the decisions about how the work should be done being taken in the five service centres and the Corporates Division where the audit staff are based. Within general categories of identified compliance risks, audit staff have substantial discretion over the individual audits selected and the techniques they use, leading to the following circumstances and results:

• There is no standard practice or policy that binds investigators to proven methods of case selection.
• The practices of investigators vary widely – for example, case plans are not always prepared.
• Audit manuals are out of date and not being consistently used – investigators refer mainly to their team leader for advice, but he or she may have differences in approach and practices from colleagues.
• Best-practice case management techniques have not been identified and shared among service centres in a systematic manner.

The IRD has recognised the need for greater consistency in the application of taxpayer audit methodologies, and is setting up a number of projects to achieve this.

Strengthening Capability

As part of the strategy being prepared for taxpayer audit, the IRD is identifying the changes in capability that audit staff will need to match the requirements of The Way Forward 2001 Onwards. These changes will require its investigators to acquire some capabilities they do not currently have. We endorse the identification of the changes required to fill the capability gap.

The IRD will need to prepare detailed plans to bridge the gap – covering, for example, aspects of investigator training, availability and use of technology, and the collection and use of intelligence about taxpayer compliance behaviour. This work will be a major challenge for the IRD.

Investigator Training

Investigators’ take-up of IRD’s formal auditing training is low. The IRD does not have a standard audit induction programme for new investigators. In addition, the performance management system is not being systematically used to identify the training and development needs of audit staff, tailor courses and opportunities to meet these identified needs, and follow up to check that the training is done.

Availability and Use of Information Technology

Appropriate availability and use of information technology is central to the effectiveness of taxpayer audit. It is also an important feature of a good working environment that helps to attract and retain quality audit staff. As our benchmark for assessing the status of information technology in taxpayer audit, we used the availability and use of information technology in the audit division of large accountancy firms.

Measured against this benchmark, some aspects of information technology for taxpayer audit are substantially under-developed. Individual investigators have not historically had access to the computer audit tools they need to do their job – such as laptop computers and electronic working papers.

In October 2002, the IRD began an audit technology project that envisages substantial change to the technologies that auditors will use and the skills required to facilitate the increased use of technology in the audit process. This project aims to ensure that all investigators that need to use audit technology tools are able to do so effectively by June 2004.

The audit technology project forms part of the IRD’s wider technology strategy that was launched in December 2002. The inter-relationships between the technology and audit strategies and the audit technology project need to be clearly identified.

Collection and Use of Intelligence in Taxpayer Audit

The IRD’s strategic direction recognises the need for more intelligence about the tax base. Such intelligence underpins the effective operation of taxpayer audit – for example, to support risk-based selection of cases to be audited. However, for some years, industry profiles that were created in the 1980s have not been systematically updated, and no formal method exists to collect and use the intelligence that is available to audit staff.

While a number of commendable intelligence-related projects – such as the ongoing development of the Data Warehouse – are well advanced, the IRD does not yet have a comprehensive plan for all the intelligence it needs to collect – and some projects are likely to take years to complete. For example, Industry Partnerships is a long-term programme with plans for work on 15 industry sectors to be under way by December 2003.

Five Compliance Risk Analysts (CRAs) based in service centres have the primary responsibility for collecting and collating information to improve targeting of case selection for audits. Individual investigators can choose whether or not to use the results of the CRAs’ analysis. More effective and consistent use should be made of their work.

Measuring and Reporting the Performance of Taxpayer Audit

We identified instances where performance measures currently being reported could be having unintended effects. Some investigators tended to select cases that would easily achieve targets. For example, because the targets do not measure tax actually collected as a result of audits, an investigator may prefer a case with a likelihood of a large assessable but uncollectable discrepancy over a case where a smaller discrepancy, if identified, is ultimately likely to be collected.

As explained on page 75, the IRD has started to establish outcome measures – in order to bring its performance reporting into line with its strategic focus on improving taxpayer compliance, and to measure the extent to which it is meeting its statutory responsibility of protecting the tax base.

The IRD is aware that this work will not be straightforward, because effective measurement will not be achievable solely through the kinds of output measures that are currently being used. The performance reporting model will have to cope with difficult apparent contradictions for taxpayer auditors. For example, in the future, audits that detect discrepancies will continue to be seen as positive outcomes, as will those that do not detect discrepancies where they demonstrate that the compliance model is working.

As part of its move towards reporting outcomes, the IRD intends to focus more on qualitative measures. A Quality Measurement System (QMS) designed to measure audit quality and to lift the overall standard of taxpayer audit through monitoring and learning was piloted from October 2001 and formally introduced from July 2002. We identified problems with the QMS that relate to:

• the level of its acceptance by taxpayer audit staff;
• delays in feedback to investigators; and
• insufficient training for those who perform the reviews.

A review of the QMS to address these problems is in progress and a number of initiatives to improve its effectiveness are being considered.

The IRD is currently considering options for measures of taxpayer compliance post-audit, the quality of the audit from the taxpayer’s perspective, and public perceptions of the likelihood of the IRD identifying under-declarations of tax liability.

Managing the Changes

Adoption of the Taxpayer Compliance Model emphasises the need to manage not only on a geographical basis but also on a functional, customer, and tax-type basis. Securing the changes needed for taxpayer audit to support The Way Forward 2001 Onwards will require management of change through clear allocation of roles and responsibilities, and agreed accountabilities.

Currently, there is insufficient accountability for ensuring that good practices and new initiatives are taken up – initiatives are not always mandatory, and this reduces the scope for calling a particular service centre to account for not adopting them.

Responsibilities for the taxpayer audit function are therefore diffuse:

• Service centre managers are responsible for those investigators in their own service centre – as well as for a range of other staff and functions. Service centre managers’ exposure to and knowledge of taxpayer audit varies according to their own career history.
• The senior manager responsible for taxpayer audit field delivery activities also covers all other service centre staff, comprising 2359 people (or just under half of the IRD’s workforce).
• The taxpayer audit “portfolio holder” is a third-tier manager and also the manager of a service centre.
• The IRD’s Design and Monitoring Group – which is responsible for devising new initiatives for a range of functions, including taxpayer audit – has a separate reporting line from taxpayer audit delivery, and the two only come together managerially at Commissioner level. The Group’s initiatives are not always mandatory – its staff sometimes have to persuade Field Delivery Staff to take up the initiatives, resulting in variable levels of implementation, because much of the value of an initiative usually comes from the wholehearted commitment of the very people being persuaded.

Principles for Managing the Changes

In presenting our findings to the IRD, our primary concern was that the IRD needed to establish sound arrangements to promote and allocate accountabilities for the changes required for taxpayer audit. In order to ensure that the changes required to fulfil the IRD’s strategy for achieving its aims for taxpayer audit are comprehensively achieved, any change programme must include:

• agreement and commitment to the project timeline, and resources for the changes;
• commitment of investigators to the changes – through a combination of leadership, firm and fair management, application of best practice, and well-targeted training, so that investigators understand the changes and see how they fit into the IRD’s overall strategic direction;
• oversight of and accountability for implementation of the changes; and
• on completion of the change programme, an assessment of whether the changes can be sustained into the future.

We describe on the next page the proposals that the IRD has drawn up for managing the changes.

The IRD’s Proposals for Managing the Changes

The IRD has already set up a Business Initiatives Governance Board to oversee further development of the audit strategy and the implementation of strategic initiatives. The Governance Board:

• is modelled on the IRD’s Information Technology Governance Board, which is well established and has been providing leadership and a focus for its technology strategy and oversight of all technology projects and operations;
• is a subcommittee of the IRD’s Senior Management Team;
• is chaired by the General Manager – Service Delivery;
• includes as members the Commissioner, the General Manager – Business Development and Systems, and the General Manager – Strategic Design; and
• meets monthly.

The responsibilities of the Business Initiatives Governance Board include:

• ensuring that the IRD’s business strategies are aligned with its strategic business plan;
• ensuring that business initiatives deliver against the strategy;
• ensuring that business initiatives deliver value to the IRD;
• managing the risks associated with business initiatives; and
• monitoring the performance of the business initiatives governance process.

Specifically in relation to the taxpayer audit strategy, the Board’s role will include scrutiny of all key projects – including their prioritisation, approval to initiate, allocation of resources, monitoring progress, and resource and financial reporting.

The IRD has invited us to monitor progress against the audit strategy on a regular basis. We intend to do so, and propose to test the IRD’s management of the changes against the principles set out on page 19. We will report publicly on the IRD’s progress towards the end of 2005.

1: The Pathfinder Project is leading the way for adoption of management for enhanced outcomes. It is developing a range of basic techniques, together with practical guidance on outcome-based management systems. The project is supported by the Treasury and the SSC, but is voluntary for the departments involved.

2: This project is described in paragraphs 5.46-5.51 on pages 67-68.