Ministry of Revenues

Tax Audit Manual

May 2019
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 Table of Contents

Definition of terms................................................................................................................ 5
1. Introduction ................................................................................................................... 15
1.1 Country Tax Policy ................................................................................................... 15
1.2 MoR Vision, Mission and Values .............................................................................. 15
1.3 Introduction to tax audit – the legal framework.......................................................... 16
1.4 Purpose of tax audits ................................................................................................ 19
1.5 Scope of tax audit ..................................................................................................... 20
1.6 Nature of tax audit .................................................................................................... 22
1.7 Types of Tax Audit.................................................................................................... 22
1.8 Validity and Interpretation of the manual................................................................... 27
1.9 Effective Date ........................................................................................................... 27
2 Professional Ethics and code of conduct for auditors .................................................... 28
2.1 The need for an Ethical code of conduct................................................................... 28
2.2 The fundamental ethical principles ........................................................................... 30
2.3 Other measures that promote ethical behavior among the auditors .......................... 32
2.4 Conflict of interest ..................................................................................................... 34
2.5 Auditors code of conduct .......................................................................................... 34
3 Internal audit and tax audit operations .......................................................................... 37
3.1 The role of internal audit in audit operations ............................................................. 37
3.2 The role tax audit staff in facilitating internal audit work ............................................ 39
4 The role of tax auditors and the HQ function ................................................................. 41
4.1 The HQ function ....................................................................................................... 41
4.2 Role of audit operations at the branches .................................................................. 41
4.3 Audit team’s alignment to specialized sectors and their roles ................................... 42
4.3.1 Alignment of audit teams to specialized sectors ....................................................... 42
4.3.2 Role of auditors under specialized sectors ............................................................... 43
5 Performance evaluation ................................................................................................ 48
5.1 Introduction .............................................................................................................. 48
5.2 Audit quality .............................................................................................................. 48
5.3 Audit yield ................................................................................................................. 50
5.4 Audit coverage ......................................................................................................... 50
5.5 National audit plan .................................................................................................... 51

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5.6 Cascading national audit plan targets to individual scorecards ................................. 52
6 The tax legal framework in Ethiopia .............................................................................. 53
6.1 Introduction .............................................................................................................. 53
6.2 Income Tax .............................................................................................................. 53
6.3 Employment income ................................................................................................. 61
6.4 Business Income tax ................................................................................................ 69
6.5 Value Added Tax ...................................................................................................... 82
6.5.1 Introduction .............................................................................................................. 82
6.5.2 Imposition of Value Added Tax ................................................................................. 83
6.5.3 Computation of tax payable ...................................................................................... 89
6.5.4 Understatement of VAT by taxpayers, key pointers for auditors’ ............................... 90
7 Business structures ....................................................................................................... 91
7.1 Introduction .............................................................................................................. 91
7.2 Company .................................................................................................................. 91
7.3 Partnerships ............................................................................................................. 93
7.4 Sole proprietorship ................................................................................................... 94
7.5 Franchise ................................................................................................................. 95
7.6 Joint Venture ............................................................................................................ 97
8 Taxation Accounting ................................................................................................... 100
8.1 Introduction ............................................................................................................ 100
8.2 Taxation accounting for a company, partnership and sole proprietor ...................... 101
8.3 Taxation accounting for a branch of a non-resident company ................................. 105
9 Audit planning ............................................................................................................. 110
9.1 Introduction ............................................................................................................ 110
9.2 The responsibility of the audit team during the audit planning phase ...................... 110
9.3 Audit planning process flow .................................................................................... 111
9.4 Analytical review of financial statements to identify tax risks ................................... 111
9.5 Risk Assessments .................................................................................................. 124
9.6 Materiality ............................................................................................................... 133
9.7 Audit Sampling ....................................................................................................... 138
9.8 The audit plan......................................................................................................... 145
10 Audit execution ........................................................................................................... 147
10.1 Introduction ............................................................................................................ 147
10.2 Initiating the audit ................................................................................................... 148
10.3 Entry conference .................................................................................................... 149
10.4 Audit procedures for obtaining appropriate audit evidence during audit execution .. 151

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10.5 Audit methods ........................................................................................................ 161
10.6 Audit working papers .............................................................................................. 164
10.7 Reconciliation and communication of audit findings ................................................ 166
11 Audit completion ......................................................................................................... 167
11.1 Introduction ............................................................................................................ 167
11.2 Exit conference....................................................................................................... 167
11.3 Communicating the final audit findings ................................................................... 168
11.4 The Audit report...................................................................................................... 168
11.5 The audit file ........................................................................................................... 170
11.6 Referencing and cross referencing ......................................................................... 170
12 Objection and Appeals ................................................................................................ 171
12.1 Introduction ............................................................................................................ 171
12.2 Applicable law for adjudicating tax appeals ............................................................ 171
12.3 Grounds for appeal, the role of the auditor and independent review team .............. 173
12.4 Lessons drawn from objections and court precedents, the role of Audit HQ ........... 174
13 Sector based auditing ................................................................................................. 176
13.1 Introduction ............................................................................................................ 176
13.2 Key considerations of the tax legal framework for specialized sectors .................... 176
13.3 Construction sector................................................................................................. 177
13.4 Manufacturing sector .............................................................................................. 184
13.5 Finance .................................................................................................................. 187
13.6 Import and Export ................................................................................................... 192
13.7 Insurance services.................................................................................................. 195
13.8 Agriculture .............................................................................................................. 201
13.9 Mining and mineral ................................................................................................. 206
13.9.1Introduction ............................................................................................................ 206
13.9.2Tax law aspects ..................................................................................................... 207
14 International Taxation.................................................................................................. 209
14.1 Introduction ............................................................................................................ 209
14.2 International tax law aspects of domestic laws ....................................................... 209
14.3 Income sourced in Ethiopia by non-residents ......................................................... 210
14.4 International aspects of domestic legislation (Proclamation) and treaty law ............ 210
14.5 Principles of taxation of non-residents in Ethiopia ................................................... 211
14.6 Principles of taxation of residents in Ethiopia .......................................................... 212
14.7 International tax treaties ......................................................................................... 214
14.8 International tax planning and anti-avoidance provisions ........................................ 216

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14.8.1.1 Transactions subject to Transfer pricing ........................................................ 218
14.8.1.2 Purposes of Transfer Pricing ......................................................................... 219
14.8.1.3 An Illustration of Transfer Pricing .................................................................. 219
15 Tax Investigation Audit ................................................................................................ 222
15.1 Introduction ............................................................................................................ 222
15.2 Purpose, nature and scope of an investigations audit ............................................. 222
15.3 Tax audit investigations procedures and tools used................................................ 223
15.4 Duty of care to the taxpayer .................................................................................... 224
16 References ................................................................................................................. 226
17 Annexes ...................................................................................................................... 227

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Definition of terms
 Audit: an examination of a tax return or certain items on a tax return to ensure
accuracy.
 Auditing: The process or action of undertaking an audit.
 Audit evidence: Facts gathered during the audit procedures that provide a
reasonable basis for forming an opinion regarding the financial statements under
audit.
 Audit objective: In obtaining evidence in support of financial statement assertions,
the auditor develops specific audit objectives in light of those assertions. For
example, an objective related to the completeness assertion for inventory balances
is that inventory quantities include all products, materials, and supplies on hand.
 Audit planning: is developing an overall strategy for the audit. The nature, extent,
and timing of planning vary with size and complexity of the entity, experience with
the entity, and knowledge of the entity’s business.
 Audit risk: A combination of the risk that material errors will occur in the accounting
process and the risk the errors will not be discovered by audit tests. Audit risk
includes uncertainties due to sampling (sampling risk) and to other factors (no
sampling risk).
 Accounting data: includes journals, ledgers and other records, such as
spreadsheets, that support financial statements. It may be in computer readable form
or on paper.
 Accounts receivable: Debts due from customers from sales of products and
services reported as a current asset.
 Adjusting entries: are accounting entries made at the end of an accounting period
to allocate items between accounting periods.
 Analytical procedure: A comparison of financial statement amounts with an
auditor’s expectation. An example is to compare actual interest expense for the year
(a financial statement amount) with an estimate of what that interest expense should
be. If actual interest expense differs significantly from the expectation, the auditor
explains the difference in audit documentation.

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 Analytical review: An auditing technique that focuses on analysis of the movements
in account balances over time, and on assessing the reasonableness of financial
statement items.
 Arm’s length transactions are transactions between people who have no
relationship other than that of buyer and seller. The price is the true fair market
value of the goods or services sold.
 Assertion: Management asserts financial statements are correct with regard to
existence or occurrence of assets, liabilities or transactions, completeness of
information in the financial statements, rights and obligations at a point in time,
appropriate valuation or allocation, presentation, and disclosure.
 Assess: To determine the value, significance, or extent of.
 Assessed: Determined. The level of control risk determined by the auditor, based on
tests of controls, is the assessed level of control risk.
 Assurance: The level of confidence one has.
 Audit adjustment: is a correction of a financial information misstatement identified
by the auditor, whether recorded or not.
 Audit documentation: (working papers) are records kept by the auditor of
procedures applied, tests performed, information obtained, and pertinent conclusions
reached in the engagement. The documentation provides the principal support for
the auditor’s report.
 Accountant: An individual who performs accounting duties
 Acquisition cost: The purchase price of an asset, service, legal right, or entity.
 Adjustment: A change or modification to an account, transaction, or financial
Statement.
 Advance A prepayment toward the purchase of goods or services, or toward the
costs of expenses like salaries.
 Audit approach: The strategy for an audit, or the manner of conducting an audit.
 Audit assignment: A discrete, separately identifiable audit. Compare special
Assignment.
 Audit cycle: The process of conducting an audit or a series of audits over time.
 Audit engagement: An alternative term for audit assignment.
 Audit guide: An alternative term for audit program.

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 Auditing standard: Formal rules and guidance for tax auditing.
 Audit opinion: An auditor’s conclusion on the extent to which audit evidence refutes
or confirms an audit objective.
 Audit program: An audit program is a listing of audit procedures to be performed in
completing the audit.
 Audit quality: The good performance and positive characteristics of an audit.
 Audit recommendation: In an audit report, a proposed action to remedy a problem
or potential problem.
 Audit report: A document that summarizes the findings of an audit.
 Audit schedule: A formal list of auditing assignments determined by an audit
function’s planning process.
 Audit step: An alternative term for audit test. or An individual measure or action
within an audit test.
 Audit test: An action or procedure to gather and evaluate audit evidence. Audit tests
are normally formalized in audit programs, and they may be classified in to
substantive and compliance testing.
 Audit trail: An information flow that allows an auditor to trace the evolution of a
transaction.
 Bill of loading: A document issued by a carrier to a shipper, listing and
acknowledging receipt of goods for transport and specifying terms of delivery.
 Bad debt: an accounts receivable balance whose collection is doubtful.
 Balance the net total of debit and credit entries in a general ledger account.
 Balance sheet: an accounting summary of the financial position of an organization
or individual at a specific date.
 Balance sheet equation: the alternative term for the accounting equation.
 Bank reconciliation: A periodic internal control procedure to identify differences
between bank statements and corresponding bank balances stated in general ledger
accounts.
 Bank statement: A summary of transactions in a bank account prepared for a bank
customer.
 Book value: The historical cost of an asset recorded in a general ledger

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 Control risk: The risk that a company’s internal controls won’t detect or prevent
mistakes.
 Comparability: Users evaluate accounting information by comparison. Similar
companies account for similar transactions in similar ways. Another goal is
comparison of one company’s information from one period to the next (consistency).
 Comparative: Financial statements of a prior period shown with those of the current
period to aid in comparisons between periods.
 Compare (comparison): An audit procedure, the auditor observes similarities and
differences between items such as an account from one year to the next.
 Completeness: Assertions about completeness deal with whether all transactions
and accounts that should be in the financial statements are included.
 Consignment: Transfer of possession but not title to goods. Title stays with the
consignor, while the consignee has possession.
 Consistency: To achieve comparability of information over time, the same
accounting methods must be followed. If accounting methods are changed from
period to period, the effects must be disclosed.
 Capital: Ownership interest in the equity of an organization.
 Capital expenditure: The purchase or betterment of long-term assets like property,
plant, and equipment.
 Capitalization: The inclusion or reclassification of a cost to an asset account.
 Cash: Tangible units of money
 Cash basis accounting: The recognition of revenues and expenses in line with
related cash movements.
 Cash equivalent value: The amount of cash that can be received in an arm’s length
transaction for the sale of an asset.
 Cash flow statement: An accounting summary of cash movements arising from the
operations of an organization or individual.
 Chart of accounts: A sequentially numbered list of general ledger accounts.
 Common stock: A share of ownership in a corporation.
 Comprehensive auditing: An alternative term for operational auditing.
 Contra account: A general ledger account that offsets another account.
 Contract: An agreement between two or more parties that is enforceable in law.

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 Corporation: An organization recognized as a legal entity separate from its owners.
 Cost of goods sold (COGS): An alternative term for cost of sales.
 Due professional care: Taking the time to gather reasonable audit evidence to
support the fact that the financial statements are free of material misstatement.
 Deferred income: An alternative term for unearned revenue.
 Engagement letter: A letter that represents the understanding about the
engagement between the client and the audit.
 Estimation sampling: is sampling to estimate the actual value of a population
characteristic within a range of tolerable misstatement.
 Examine (examining): As an audit procedure to examine something is to look at it
critically.
 Existence: Assertions about existence deal with whether assets or liabilities exist at
a given date.
 Field work: The performance of audit procedures outside the tax office.
 Fraud: A deliberate deception to secure unfair or unlawful gain. False representation
intended to deceive relied on by another to that person’s injury. Fraud includes
fraudulent financial reporting undertaken to render financial statements misleading or
Illegal, dishonest, or improper activity.
 Going concern assumption: assumes the company will continue in operation long
enough to realize its investment in assets through operations (as opposed to sale).
Presenting assets at historical cost is justified by assuming productive assets will be
used rather than sold.
 Gross margin percentage: The gross margin from an income statement divided by
net sales revenue.
 Internal controls: The operating standards a client uses to prevent or uncover
mistakes.
 Inherent risk: The susceptibility of a balance or transaction class to error that could
be material, when aggregated with other errors, assuming no related internal
controls.
 Interim audit: A preliminary or intermediate audit performed in advance of a main
audit.

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 Internal audit: A branch of auditing developed as a means of monitoring an
organization’s risks, internal controls, procedures, and management accounting.
 Inventory: Supplies used and goods manufactured in production processes.
Inventory is normally categorized into (i) raw materials, (ii) work-in-process, and (iii)
finished goods.
 Investigation: A formal enquiry, or the undertaking of research. Investigation is
central to the gathering of audit evidence, especially in the context of fraud or other
irregularities. See also forensic auditing.
 Invoice: A document that formally records, quantifies, and requests payment for the
sale of goods or services.
 Judgmental sampling: The selection of a sample of data from a population on the
basis of subjective decisions.
 Limited audit: An audit with restricted scope. Agreed limitations on audit work may
be determined in reference to (i) specific time periods, (ii) specific activities, or (iii)
high materiality thresholds.
 Materiality: The importance placed on an area of financial reporting based on its
overall significance.
 Misstatement: is a difference between the amount, classification, presentation, or
disclosure of a reported financial statement item and the amount, classification,
presentation, or disclosure that is required for the item to be in accordance with the
applicable financial reporting framework.
 Objectivity: The ability to evaluate client records with no preconceived notions or
prejudices.
 Observe (observation): Watch and test a client action (such as taking inventory).
 Operating income: from continuing operations is reported on an income statement.
 Observation: A systematic examination or analysis of an activity or procedure.
Observation is a key method of obtaining and evaluating audit evidence, and it
includes inspections of the performance of internal control procedures. The following
or obeying of laws, rules, and regulations.
 Obsolescence: A reduction or ending of an asset’s useful economic life (or sales
value) through technological or other changes.
 Professional skepticism: Approaching an audit with a questioning mind-set.

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 Payroll: Department that determines amounts of wage or salary due to each
employee.
 Quick ratio: Quick assets divided by current liabilities. Quick assets are current
assets less inventories and prepaid expenses.
 Quality audit: The auditing of activities and operations with focus on adherence to
the principles of total quality management.
 Random sample (random-number sampling): Identical probability of each
population item being selected for a sample. Also, the use of random numbers to
select a random sample from a population.
 Ratio: The relation between two quantities expressed as the quotient of one divided
by the other.
 Related parties: are those with whom the client has a relationship that might destroy
the self-interest of one of the parties (accounting is based on measurement of arm’s
length transactions). Related parties include affiliates of the client, principle owners,
management (decision makers who control business policy) and members of their
immediate families.
 Reliable (reliability): Different audit evidence provides different degrees of
assurance to the auditor. When evidence can be obtained from independent sources
outside an entity it provides greater assurance of reliability for an independent audit
than that secured solely in the entity.
 Revenue cycle: The portion of a company that fills customer orders, accounts for
receivables, and collects those receivables.
 Review: To examine again. The overall review of audit documentation is completed
after field work.
 Review evidence: is information used by the accountant to provide a reasonable
basis for the obtaining of limited assurance.
 Risk assessment procedures: are the audit procedures performed to obtain an
understanding of the entity and its environment, including the entity’s internal control,
to identify and assess the risks of material misstatement, whether due to fraud or
error, at the financial statement and relevant assertion levels.
 Risk assessment: The identification, analysis, and measurement of risks relating to
an activity or organization.

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 Sample size: The number of population items selected when a sample is drawn
from a population.
 Sampling error: Unless the auditor examines 100% of the population, there is some
chance the sample results will mislead the auditor.
 Sampling risk: The possibility that conclusions drawn from the sample may not
represent correct conclusions for the entire population.
 Transfer price: The price of a good or service used in transactions between parts of
a decentralized organization.
 Translation: The process of converting financial data from one currency to another.

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Preface

In developing countries like Ethiopia, promoting development and creating a well-

fare system for people is a huge responsibility of the government. These huge
responsibilities require a huge amount of money and this money mainly comes from
different kinds of taxes. That is why tax is considered to be the backbone of a
country. Tax is a system in which the government collects money from the public in
many different ways and then distributes it to the public in different forms.

The tax audit process is expected to play its role to realize the vision the Ministry in
accordance with the values Ministry of Revenues has set. If it deviates from these
anchors, it will be malicious to the system and will play a negative role for the overall
success of the tax administration. Insufficient and ineffective audit program leads to
a number of challenges in the tax collection process and administration. Weak tax
audit may make the tax system unfair in that honest taxpayers may bear heavier and
disproportional burden. It, in turn, may have a huge impact on the efficiency of tax
operation. If not managed well, tax audit may also lead to lack of good auditing
processes and corruption.

This manual is a guide for Auditors conducting audits of taxpayers. It outlines the
procedures to be followed. It provides a framework for planning, preparation,
carrying out an audit and preparing reports. It is particularly important in that it sets
out a different and more professional approach to audit. It describes many of the
standard techniques used to check or assess the correctness of a tax payer’s liability
to direct & indirect tax.

This manual seeks to be comprehensive and it covers most of the recognized means
of detecting errors and underreported tax. Techniques used can often vary but the
results are usually very similar. Auditors need a sound understanding of tax law and
audits should be seen as routine activity.

The manual is a reference book for those auditors who are conducting audits of
taxpayers. Not everything in the manual will be applicable to all tax payers. In fact, it

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is doubtful if everything included in the manual will be applicable to any one
taxpayer. Auditors may give their valuable suggestions based on their experience
which will help to make further improvement of this manual.

As part of a project undertaken by MoR, this manual has been collectively developed
by a working group team:
 Joseph Kateregga
 Etaferahu Sisay
 Meseret W/Mariam
 Kiros Debesu
 Agegnechew Sisay

MoR expresses its sincere gratitude to the working group, for their tireless effort.

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1. Introduction

1.1 Country Tax Policy

Ethiopian tax policy is based on taxpayers’ voluntary compliance i.e. self-

assessment. It is geared towards promoting investment, supporting industrial
development; and broadening the tax base and decreasing the tax rate, at least
maintaining the current reduced tax rates compared to most other countries, in view
of financing the ever-growing needs of the government expenditure. Ministry of
Revenues (MoR) has the mission for accomplishment of these policy objectives.

1.2 MoR Vision, Mission and Values

Vision

By 2025 the Ministry aspires to build a world class customer-centric tax

administration that will finance government expenditure through tax revenue
collection.

Mission

Our mission is to build overall capability of workforce and using modern technology
so as to build harmonized tax administration system, to provide easy, simple and fair
services to improve culture of voluntary compliance, to enforce tax and customs laws,
and to collect tax revenue to be generated from the economy.

Values

 Customer centricity

 Professionalism

 Teamwork

 Commitment

 Innovation

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1.3 Introduction to tax audit – the legal framework

Tax audit is an examination of whether a taxpayer has correctly assessed and

reported their tax liability and fulfilled their obligations (OECD - Strengthening Tax
Audit Capabilities; General principles and Approaches).This examination can only
proceed if it is supported by a robust legal framework, otherwise, it would be subject
to challenge.

In this regard, Article 28(1) of the Federal Tax Administration Proclamation, 983 of
2016, provides the legal basis for audit activity in Ethiopia and can be said to be the
foundation upon which tax audits are premised and conducted. It provides that
subject to this Article, the Ministry may amend a tax assessment (referred to in this
Article as the “original assessment”) by making such alteration, reductions, or
additions, based on such evidence as may be available, to the original assessment of
a taxpayer for a tax period to ensure that:

i. in the case of a loss under Schedule ‘B’ or ‘C’ of the Federal Income Tax
Proclamation, the taxpayer is assessed in respect of the correct amount of the
loss for the tax period;

ii. in the case of an excess amount of input tax under the Value Added Tax
Proclamation, the taxpayer is assessed in respect of the correct amount of
excess input tax for the tax period;

iii. in any other case, the taxpayer is liable for the correct amount of tax payable
(including a nil amount) in respect of the tax period. Emphasis added.

It is through tax audit activity, that the object of Article 28(1) of the Federal Tax
Administration proclamation in particular amending the “original assessment” can be
achieved. Accordingly, tax audit activity seeks to assess taxpayer compliance with
the tax laws (Proclamations).

The assessment of taxpayer compliance with the tax laws (Proclamations) during
audit activity for a given tax period demands of the auditor superior working
knowledge of tax law and its connection (interface) with the accounting framework

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relevant to the taxpayer if fair & accurate tax assessments are to be issued.
Exercising fairness in the course of duty (audit activity) is a cardinal obligation
required of the auditor as envisaged by article 6(2) of the Federal Tax Administration
Proclamation. Fair tax assessments reduce the incidences of tax appeals which in
turn increase taxpayer confidence in the Ministry reflected in improved compliance.

Article (28(1)) envisages evidence based audit activity and requires the use of robust
audit procedures to collect appropriate audit evidence. This implies that the use of
arbitrary methods to raise tax assessment would be outside the premises of the law
(tax) and are subject to litigation. Accordingly, auditors are required at all times to use
credible information from trusted sources for example declarations by consumers
(inputs), IFMS etc. Taxpayers are equally under obligation to maintain records for
purposes of the tax law (Article 17 of the Federal Tax Administration Proclamation),
to ensure that the evidence required by the auditors is availed.

Obtaining appropriate audit evidence during audit activity is not expected to be

challenging as there is a sufficient legal framework to ensure that this information is
provided to the auditors. This includes the right to inspect taxpayer’s documents
at all reasonable times pursuant to article 18 and to at all times and without notice,
full and free access to any premises, place, goods, or property, any document,
and data storage device, make an extract or copy of any document, seizure of
documents in the terms of Article 66 of the said proclamation. However, the powers
under article 66are vested only in the Director General or any officer specifically
authorized by the Director General to exercise such powers (Article 66(2)).
Accordingly, express permission of the Director General must be sought. That said,
officers will be required to treat the taxpayers with courtesy and respect even when
this involves seizure of documents (Article 6(2)).

Further, article 28(1) above alludes to amendment of the “original assessment”.

This in accordance with article 25 read together with articles 2(29) and 2(30) of the
said proclamation is a self-assessment of the taxpayer pursuant to article 2(28) in
respect to Value Added Tax, Excise Tax, Turnover Tax, Advance Tax and Income
Tax.

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Following the above, it is envisioned that tax audit activity starts with the
taxpayer’s declaration (self-assessment) and any subsequent amendments must
be anchored on such submissions. The tax assessments thereof are referred to as
“amended assessments” in the terms of article 28 of the Federal Tax Administration
Proclamation.

The above notwithstanding, it is possible for audit activity to commence in the

circumstances were the taxpayer fails to file a tax declaration. Article 25 is
instructive and provides that when a taxpayer has failed to file a tax declaration for a
tax period as required under a tax a law, the Ministry may based on such evidence
as may be available and at any time, make an assessment (referred to as an
“estimated assessment”) of:

a) in the case of a loss under Schedule ‘B’ or ‘C’ of the Federal Income Tax
Proclamation, the amount of the loss for the tax period;

b) in the case of an excess amount of input tax under the Value Added Tax
Proclamation, the amount of the excess input tax for the tax period;

c) in any other case, the amount of tax payable (including a nil amount) for the
tax period.

In this case i.e. where the taxpayer fails to submit documents, adjustments may be
based on evidence available. This could include substantiated third party information
from sources like IFMIS, Report Portal, ECX, input tax claimed by other taxpayer.
That said, the article uses the word, ‘’may” and not “shall”, implying that the auditor is
not prevented from making adjustments or issuing estimated assessments even in
the absence of evidence, although, it is good practice to rely on evidence, for
instance industry averages to avoid costly litigation arising out of unjustifiable
assessments.

The requirement to rely on evidence as envisaged by article 28 and 25 during audit

activity underpins best practice which requires that tax audit activity must be
occasioned by a sound risk management system that identifies and flags non
complying taxpayers. This is possible if risk management is evidence based and

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corroborates all data sources in its domain. It is on the basis of the identified risks
that a robust audit program is developed for greater returns (audit yield and
coverage).

1.4 Purpose of tax audits

The OECD attributes six grounds to taxpayer audits. These are:

a. Promotion of voluntary compliance.

b. Detection of non-compliance at the taxpayer level.

c. Gathering information on the “health” of the tax system (including patterns of

taxpayer’s compliance behavior).

d. Gathering intelligence information.

e. Educating the taxpayer.

f. Identifying areas of the law that require clarification or amendment.

1.4.1 Promotion of voluntary compliance

Promotion of voluntary compliance by the taxpayers with the tax laws is envisaged as
the primary role of the audit program. This is achieved by:

i. Reminding the taxpayers of the risks associated with non-compliance that

serious abuses of the tax law will be detected and appropriately penalized.

ii. Taxpayer education provided by the auditors during the audit creates
awareness among the taxpayers of their obligations.

1.4.2 Detection of non- compliance at the taxpayer level

This is achieved by concentrating on major areas of risk relevant to taxpayers likely

to be evading their responsibilities. This may bring to light significant
understatements of tax liabilities and additional tax revenue collections.

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1.4.3 Gathering information on the “health” of the tax system (including
patterns of taxpayers’ compliance behavior)

Audit results may provide information on the general well-being of the tax system.
Audits conducted on a random basis can assist overall revenue administration by
gathering critical information required to form judgements on overall levels of tax
compliance. This information can over time be used to identify trends in overall
organizational effectiveness and to gather more precise information that can be used
to inform decision making on future compliance improvement strategies, to refine
automated risk based case selection processes and even support changes to tax
legislation.

1.4.4 Gathering intelligence information

Audits may bring to light information on evasion and avoidance schemes involving
large number of taxpayers that can be used to mount major counter abuse projects.

1.4.5 Educating the taxpayers

The tax audit process is expected to play its role to continuously engage in
awareness creation programs that target on creating compliant taxpayers during the
course of the audit. In addition, tax audit is very essential to minimizing the degree of
tax avoidance and evasion, and thereby to increase voluntary compliance through
providing input for taxpayer education programs of the Ministry.

1.4.6 Identifying areas of the law that require clarification/ amendment

Audits may bring to light areas of the tax law that are grey and problematic to
taxpayers and thus require further efforts by the revenue body to clarify the law
requirements and to better educate taxpayers on what they must do to comply into
the future.

1.5 Scope of tax audit

The scope of tax audit is determined by:

a. Risk level of the individual taxpayer

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 b. Legal framework

1.5.1 Risk level of the taxpayer

i. Where the risk parameters indicate that the taxpayer is risky across the
different tax types (Corporate, VAT and Excise duty), it is expected that the
scope will be comprehensive (Comprehensive audit). However, it is
apparent that comprehensive audits are costly since they require a lot of
investment in person audit hours and may require extensive tax and specific
industry knowledge that the tax authorities may not possess.

ii. Where the risk parameters point to an isolated aspect of the taxpayer’s tax
account, then it would be naturally expected that the tax audit focuses on that
single issue (single issue audit). These audits are usually information based,
take relatively little time to complete compared to comprehensive audits.

1.5.2 Legal framework

The Federal Tax Administration Proclamation (article 28(2) and article 26(1) read
together) determine the scope or period of audit as follows:

a. In case of fraud, or gross or willful neglect by, or on behalf of the taxpayer

and were the taxpayer fails to file a tax declaration at any time. This implies
that audit coverage is not limited in terms of scope (period). For instance, a
taxpayer who is found to have committed fraud 10(ten) years back, will have
their declarations audited for the same period (10 years).

b. In any other case, within 5 (five) years of the date that the self-assessment
taxpayer filed the self-assessment declaration to which the self-assessment
relates or within 5 (five) years from the date on which the Ministry served the
notice of the assessment on the taxpayer in the circumstances were the
auditor failed to submit their declaration. This implies that for the category of
taxpayers who are not found to be fraudulent, negligent or failed to make their
declaration, the audit scope is restricted to a five-year period. Audit activity
and assessments that span over 5 years for this category of taxpayers are a
nullity and cannot be enforced in law.

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It is important audits especially at the national planning level (national audit plan)
adhere to the statutory time lines to avoid incidences where audit activity may be time
barred.

1.6 Nature of tax audit

Tax audit like any other audit is a compliance check. The difference is that it seeks to
confirm whether the taxpayer has complied with tax legislation and the obligations
provided thereof. Accordingly, audit procedures must be planned in manner that
seeks to assess the level of taxpayer compliance with the tax laws.

That said, tax law sits on an accounting framework which is what taxpayers use to
provide the financial position of their enterprises. Accordingly, tax audit envisages an
in-depth understanding of the taxpayer’s accounting system in order to determine
whether the tax account fully complies with the provisions of tax law since any
adjustments during audit will be made on the basis of the taxpayer’s declaration.

1.7 Types of Tax Audit

The types of audits are defined by three major factors, namely:- The audit scope and
intensity, the period(s) under examination and the location of the audit activity. The
major types of audit in MoR are described below:

1.7.1 Comprehensive Audit

A comprehensive audit is all-encompassing in scope and entails an in-depth

examination of all information relevant to the calculation of a taxpayer’s tax liability
for all tax type for a given period. Given the broad scope, comprehensive audit is
typically costly to undertake in terms of time and resources, and thus reduces the
rate coverage of taxpayers that could otherwise be audited.

Comprehensive audit is classified into Very Complex, Complex and simple. This
classification will depend on a number of factors ranging from size, group, trade or
profession, volume of records or transactions, nature of business to location. In
practice, the scope and nature of any comprehensive audit activity to be undertaken
will depend on the available evidence pointing to the likely risks of non-compliance

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and a taxpayer’s history. An audit may also be classified and justified as complex or
very complex because of the taxpayer’s financial and/or business activities which are
unusually complex.

1.7.2 Desk Audit

A Desk audit is used as a preliminary examination of declarations analyzing

accuracy, completeness, ratios and crosschecking information to determine if further
audit or investigation is warranted. By implication, returns which are stated on certain
level of risk.

According to Adediran, Alade and Oshode, 2010, and audit takes place within the
confines of the office of the tax officials. In this situation the tax official may simply
request the taxpayers to provide some additional documents to his office to enable
him clear some issues in the returns submitted. In this type of audit, no official notice
is given to the taxpayer of the impending desk audit exercise. He only gets to know
when letters are written to him requesting for certain documents or explanations. The
essence is to ensure some level of compliance with tax laws, rules and regulations as
well as performing the administrative checks on returns submitted. Basic checks
conducted at the tax office when the auditor is confident that all necessary
information can be ascertained through in-office examination.

1.7.3 Issue Audit

This is a limited scope audit that may be confined to specific issues in a tax return
and/or a particular tax type. The objective here is to examine key potential risk
areas of non-compliance. This type of audit is recommended because it consumes
relatively fewer resources than comprehensive audits and allows for an increased
coverage of the taxpayer population. The audit will normally focus on a single tax
type, period or item. Where an issue audit is escalated into a comprehensive audit,
the team coordinator`s concurrence must be sought and the procedures prescribed
for comprehensive audits adhered to.

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1.7.3.1 Desk Issue Audit

This can be conducted in relation to specific issue(s) of a taxpayer or enterprise when

the auditor is confident that all the necessary information can be ascertained by
conducting an examination in the office. All the required or relevant information or
data may be accessed from internal sources or official reference without the need to
contact the taxpayer. Issue audits may be conducted either on the Desk or in the
Field.

1.7.3.2 Field Issue Audit

This is the escalation of a desk issue audit into a field activity or exercise. It is
important to remember that the audit is limited to key issues of compliance or to a tax
type or period. Field issue audit is commonly used in examining whether a taxpayer
has met his/her obligations in respect of PAYE, VAT/TOT and Excise tax,
Withholding Tax or Income Tax normally for a specified tax period. Care should
always be taken to guard against being derails and thus progressing field issue
audits into comprehensive audits. The objective of the field issue audit is to focus
on a shorter period for a single tax item for a faster and effective outcome. This
audit type should therefore be the commonest and most effective audit type to be
utilized for faster results.

1.7.4 Distinction between Comprehensive and Field Issue audits

In order for an audit to be classified as Comprehensive, the following factors

must be considered - The audit must be detailed and involve an in-depth inquiry
into all aspects of compliance; The audit must cover all tax types to which the
taxpayer is liable; The audit must cover a period of at least one accounting year; The
audit process involving all procedures outlined under Pre-engagement activities,
Planning and Evaluation activities, Execution or Performance of the audit activities,
and Audit conclusion activities; The relevant documentation in respect of the audit
assignment i.e. from initiation to conclusion must be kept in an Audit Box File.

In the case of Field-Issue Audits, the requirements are as follows:– A Field

Issue audit will ordinarily emanate from a desk review of returns and disclosures

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made by the taxpayer in financial statements, together with any privileged third party
information; will normally target an issue in a particular tax head and cover a
specified period, depending on the tax head under review; A specific issue(s) must
be identified and the field activity must be sanctioned by the Team coordinator; must
involve a review of the taxpayer’s primary records relating to the identified subject
matter at the taxpayer’s premises or in the tax office, as the case may be;
Documentation in respect of the specific review must be kept in a separate file folder;
The Standard Audit Working Papers must be used to report the specific review
activity. Additional reporting on the field assignment may be provided where the case
warrants.

1.7.5 Special Audit Projects

Audits can be organized as a separate project for a targeted or specific group of

taxpayers in a given period to verify compliance in the sector. These audit projects
may cover an industry, trade, profession or a line of businesses. They will consist of
specific checks and are used to address a particular risk or to establish the degree of
non-compliance in a particular sector, industry or trade. For this audit type to be
effective, all taxpayers in the targeted sector must be considered and handled within
the shortest time possible.

1.7.6 Advisory Visit Audits

All registered taxpayers or businesses need to be visited with the aim of offering
advice on tax obligations and the taxpayer’s rights, and any other developments
pertinent to the tax system and administration. It is highly recommended that auditors
carry out these audits to keep abreast with compliance trends of their taxpayers and
offer timely advice so as to improve compliance. These audits are expected to be
spontaneous and hence should not take more than a day.

According to IMF, 2010 advisory audit visit to newly established businesses

advising obligations in terms of tax types, filing of returns, payment of amounts due,
records to be maintained. It is very appropriate when introducing new laws.

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1.7.7 Refund Audits

This is the verification of a taxpayer’s claim for a tax refund prior to processing the
refund. The predominant claim for refund is VAT and/or WHT which is submitted
monthly. The details are specified in the Refund Guidelines.

1.7.8 Investigation Audit

Involve the most serious cases of non-compliance with Criminal implications. Require
special skills in investigation and evidentiary requirements as they often involve
seizure of records, taking testimonies from witnesses and preparing briefs for courts.
Require special skills in investigation and evidentiary requirements

1.7.9 De-Registration Audits

In order to establish outstanding obligations or liabilities, a de-registration audit will be

conducted for all reported cases of cessation of business, winding up or uncertainty.
The audit will focus on determining taxes due and any other pertinent issues. The
objective of de-registration audit is to ensure orderly exit from the tax register with the
attendant obligations and liabilities sorted out.

1.7.10 Field Audit

Adediran, Alade and Oshode, By the nature and scope of their work, regular
assessing officers can only carry out limited desk audit through examination of
accounts and returns. It is in a bid to check this handicap as well as to improve on tax
compliance that tax authorities carry out field audit exercise on taxpayers by
physically conducting the exercise in the office of the taxpayer. The taxpayers are
however formally notified of the arrival of the auditor prior to the commencement of
the audit and the requirements of the auditors in terms of documents to be audited
will also be requested for in advance. Field audit involves physical verification of
documentary evidence and materials at the premises of a taxpayer so as to confirm
the facts and figures of the tax returns filed by corporate taxpayers.

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1.8 Validity and Interpretation of the manual

i. Once approved by the Senior Management Team and formally issued by the
Audit Directorate, this manual shall remain valid.

ii. The power to interpret any provision in this manual shall be vested on the
Audit Directorate.

iii. Questions from staff members on policy interpretation, application and

procedures should be addressed to the Audit Directorate for clarification.

iv. In case of dispute or lack of clarity, the final interpretation and application of
the contents of the manual shall rest upon the Minister. The Minister in
consultation with the Senior Management Team is responsible for final
interpretation and will decide on the necessity for reviews, interpretations or
possible revisions of the policies and procedures.

1.9 Effective Date

This manual shall enter into force on the date of __________________.

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2 Professional Ethics and code of conduct for
auditors

2.1 The need for an Ethical code of conduct

Auditors whether conducting statutory or tax audits are expected to conform to a

minimum ethical behavior and remain impartial (independent) in their dealings with
audit clients. This is because, the public depends on their esteemed opinion
regarding the reliability of financial statements prepared by the entity’s directors to
make key important decisions. For instance, a company interested in acquiring
another would be concerned about its tax health status. Tax audit (by the tax
authorities) is naturally a source of such information and its reliability enables good
decision making.

Taxpayers consider taxation as a liability and will go an extra mile to reduce its
impact on profitability in order to post a greater return on investment. This could
involve tax planning that is considered legal and evasion which is not. Conversely,
the tax authorities are under obligation to review taxpayers’ submissions and raise
fair tax assessments within the realm of the law (tax) that reflect taxpayer activity for
a given period.

On account of the above, it is naturally expected that there will never be goal
congruence especially where the taxpayer seeks to maximize profits by reducing or
evading tax liability and the tax Ministry on the other hand mandated to collect
through audit any taxes that remain unaccounted. This conflict sometimes places the
auditors in a very compromising situation especially where appropriate safeguards
are not well positioned to deter unethical behavior, noting that any “successful” tax
evasion scheme is propagated by taxpayers and abetted by the auditors.

It is worth of mention that aiding or abetting a tax offence is an offence under the
terms of the Article 128 of the Federal Tax Administration Proclamation and is
punishable. The said article provides that, a person who aids, abets, assists,

28
incites, or conspires with another person to commit an offence under a tax law
referred to as the “principle offence” shall be punishable by the same sanction
as imposed for the principal offence. Emphasis added. Accordingly, where the
offence involves tax evasion, the officer (auditor) will be punishable with a fine of birr
100,000 (One hundred thousand Birr) to 200,000 (Two hundred thousand Birr) and
rigorous imprisonment for a term of three to five years in the terms of article 125 of
the said proclamation.

Auditors are likely to abet tax evasion through:

a. Self- review. This arises when an auditor prepares and reviews their own
audit working papers. In this case, it is possible for an auditor to abet a tax
evasion scheme propagated by the taxpayer and this will go undetected
especially where the oversight internal review mechanism expected of a
robust independent internal audit function is nonexistent.

b. Advocacy. This is when an auditor acts as an advocate of the taxpayer in

situations where especially there is self-interest driven by personal gain. For
instance, an auditor may influence colleagues undertaking an audit to
conclude the audit case in the interest of the taxpayer for personal gain. In this
case, the audit staff external to the audit assignment becomes an accomplice
by influencing colleagues to circumvent the law in exchange for financial
rewards (bribes).

c. Intimidation. This arises especially were the political class or the auditor’s
superiors assert undue influence on the auditors to circumvent the law or even
back off certain transactions during the audit. In this case, while the auditor
may not receive a financial reward, they trade off their independence in return
for job security.

d. Familiarity. Tax evasion through facilitating illicit taxpayer behavior is likely to

happen when the auditor becomes quite familiar with a particular taxpayer
either through trade relations or through continuous engagement with the audit
client to the extent that they establish unethical ties that are likely to impair the
independence of the auditor.

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e. Conflict of interest. Conflict of interest arises in circumstances where the
auditor undertakes the review of an audit client/taxpayer in which they have an
interest. An example is where an auditor undertakes to audit records of a
taxpayer where they are a shareholder or a director. In this case, the
independence of the auditor is put to the test and there is a good chance that
they may abet evasion.

It is on the basis of the above, that the need to establish a sound ethical code of
conduct is not only important but must be entrenched as part of the auditors (tax)
user guide and point of reference to deter unethical behavior. The discussion below
espouses the different schemes that may be employed to keep the auditor’s ethical
behavior in check.

2.2 The fundamental ethical principles

These are drawn from IESBA/ ACCA code of conduct and the legal framework in
Ethiopia (Federal Tax Administration Proclamation).

The IESBA and the ACCA publish a code of conduct for their members based on five
fundamental principles. The said principles are universal and may be adopted to
create a strong ethical culture among the auditors. Interestingly, the Federal Tax
Administration Proclamation under article 6 and 8 entrenches these five principles as
part of the legal framework. Accordingly, the said principles cease being principles
but an obligation or set of rules for the tax auditors. The discussion below
espouses the said principles/ legal obligation that audit staff are required to uphold
during the execution of their duties.

2.2.1 Professional competence and due care

Audit staff have a continuing duty to maintain professional knowledge and skill at a
level required to ensure that audits executed depict high professional standards.
Among the objects of the Ministry is the enforcement of tax laws by preventing and
controlling tax fraud and evasion. Noting that tax evasion is usually done by high
level unscrupulous taxpayers, requires an equally well trained tax professional to
unearth these schemes and deliver on the Ministry’s mandate.

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Additionally, staff are required to act diligently as they go about their audit activity.
Article 6(2) of the Federal Tax Administration Proclamation requires tax officers, in
this case auditors to treat each taxpayer with courtesy and respect.

2.2.2 Integrity

Auditors are required to be straightforward and honest in furtherance of their

duties. Article 6(2) obliges tax officers (auditors) to be honest and fair in the exercise
of any power, or performance of any duty or function, under a tax law. Chapter one
considered tax audit as a creature of statute (function of the law) in the terms of
article 28(1) and 26(1) of the Federal Tax Administration Proclamation which must be
exercised fairly and with due regard to honesty by the auditors.

2.2.3 Professional behavior

Auditors are required to comply with the relevant laws and regulations (MOR). This
applies to laws on integrity (article 6(2)), confidentiality (article 8), and objectivity
(article 6(3)). Further, the auditor is expected to exude acceptable behavior in all their
dealings to avoid bringing the Ministry and the audit profession under disrepute.

2.2.4 Confidentiality

Auditors are expected to respect confidentiality of information acquired as a result of

audit activity and should not disclose any such information to third parties without
proper or specific authority or unless there is a legal or professional right or duty to
disclose. Confidential information acquired as a result of professional relationship
should not be used for the personal advantage of auditors or third parties.

Article 8(1) of the tax administration proclamation provides that any tax officer shall
maintain the secrecy of documents and information received in his capacity. The
obligation to maintain secrecy notwithstanding, article 8(2) permits disclosure of
information to another officer for the purpose of carrying out official duties, a law
enforcement agency for the purpose of prosecution of a person for an offence under
a tax law, the commission or a court proceeding, the competent authority, the Auditor
General, Attorney General and the Regional Tax Authority. However, the supply of
confidential information shall be made only when a written request is

31
submitted to the Director General or his representatives and the provision of
the document or information is authorized in the terms of Article 3 of the council
of ministers’ regulation no.407/2017.

2.2.5 Objectivity

Auditors should not allow bias, conflict of interest or undue influence of others to
override professional judgements. Article 6(3) of the Federal Tax Administration
Proclamation provides that a tax officer shall not exercise a power, or perform a duty
or function, under a tax law that;

a. relates to a person in respect of which the tax officer has or had a personal,
family, business, professional, employment, or financial relationship;

b. otherwise involves a conflict of interest.

Further, article 6(4) provides that a tax officer or any officer of the Ministry who is
directly involved in tax matters shall not act as a tax accountant or consultant, or
accept employment from any person preparing tax declarations or giving tax
advice.

It is therefore expected that an auditor who believes his independence is likely to be

compromised on account of conflict of interest to make sufficient disclosure to their
audit seniors and request to be precluded from the audit activity. Audit seniors on
receiving this request shall ensure that the auditor is excluded from the audit and that
he/she does not assert undue influence on his/her colleague/s to conclude the audit
in a given manner.

2.3 Other measures that promote ethical behavior among the auditors

2.3.1 Review of audit workings by auditor seniors

One of the biggest threats to auditor independence and unethical behavior is self-
review or no review at all of audit assignments by the audit seniors. This encourages
staff to abet evasion for personal gain knowing that their actions will never be

32
detected. It is therefore good practice that all audit working papers completed by
auditors are reviewed and signed off by audit seniors.

Additionally, it is good practice that all audit plans prepared by the auditors are
reviewed by audit team leaders and approved by process owners prior to
execution of audit activity. This ensures that an audit plan which takes account of
all the key risks is prepared prior to audit execution. A well prepared audit plan
guarantees maximum tax returns delivered efficiently without compromising the
quality of audit. It is at audit planning that an unsuspecting auditor(tax) may connive
with the taxpayer to abet tax evasion schemes by excluding from the audit plan
transactions for audit that were hitherto understated/overstated/ omitted as the case
may be in exchange for personal rewards. Accordingly, audit seniors are required to
confirm that all key risks have been included in the audit plan.

Further, there is need for a coherent review by team leader’s / process owners of
audit findings against the audit plan to ensure that no single aspect of the plan has
been omitted during the audit execution and that the findings reflect a true picture of
the taxpayer’s business activity.

Lastly, it should be expected that an independent and competent internal audit

function would review compliance to audit procedures by auditors and bring to the
attention of management unethical behavior unearthed during their audit review. This
ensures that auditors are kept in check knowing that an independent party would
review their work. The role of internal audit is espoused in the next chapter.

2.3.2 Rewards for exemplary staff

Article 135(1) of the Federal Tax Administration Proclamation provides that the
Ministry shall reward a tax officer for outstanding performance. It is good practice to
sandwich penalties with rewards to promote ethical behavior. Accordingly,
management should institute a committee that investigates and rewards staff that
have demonstrated excellent ethical behavior.

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2.4 Conflict of interest

Conflict of interest is among the factors that impact on auditors’ impartially/

independence and is a stimulus for unethical behavior. In order to avoid un ethical
behavior arising from conflict of interest, auditors will be required to disclose any
conflict of interest that may exist or is expected to arise during the audit.

The management of the audit team should immediately find a suitable replacement
as soon as the officer discloses that they are conflicted. There should also be
sufficient safeguards to ensure that the officer does not unduly influence the auditors
assigned to the case in order to conclude the audit outside the premises of the law.

At the beginning of every audit, all auditors will be required to complete a conflict of
interest declaration form as per the sample provided below.

I……………………... (name of auditor) declare that I am not conflicted /conflicted by

virtue of my personal, family business, professional, employment or financial
relationships with…………………………. (name of taxpayer) pursuant to article 6(3) of
the Federal Tax Administration Proclamation.

Further that while I step aside from the audit assignment, I will not (if conflicted) impose
any undue influence on my colleagues engaged on the audit in manner that suits
…………………. (taxpayer name). I also undertake to keep in confidence any
information within my domain either before or during the audit and to refrain from
supplying the said information to …………………………………. (taxpayer name) in the
terms of article 8(1) of the Federal Tax Administration Proclamation.

Note; Imposing undue influence amounts to obstruction of a tax officer in the

performance of their duties and is punishable with simple imprisonment for a term of
one to three years (Article 126(1))

2.5 Auditors code of conduct

Auditors will be required to adhere to the code of conduct below. Branch

management is expected to sensitize the auditors and ensure that each auditor
receives and endorses a copy acknowledging their full understanding and
unreserved adherence to the code. A copy (signed) will be sent to human resource
and kept on the auditor’s personal file.

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 2.5.1 Rules of conduct

i. Integrity

Auditors:

a. shall perform their work with honesty, diligence, and responsibility;

b. shall observe the law and make disclosures expected by the law;

c. shall not knowingly be a party to any illegal activity, or engage in acts that are
discreditable to the profession or to MoR;

d. Shall respect and contribute to the legitimate and ethical objectives of MoR.

ii. Objectivity

Auditors:

a. shall not participate in any activity or relationship that may impair or be

presumed to impair their unbiased assessment. This participation includes
those activities or relationships that may be in conflict with the interests of
MoR;

b. shall disclose all material facts known to them that, if not disclosed, may
influence the tax audit findings.

iii. Confidentiality

Auditors:

a. shall be prudent in the use and protection of information acquired in the course
of their duties;

b. shall not use information for any personal gain or in any manner that would be
contrary to the law or detrimental to the legitimate and ethical objectives of the
organization;

35
 c. shall maintain the secrecy of documents and information received in their
official capacity except to persons specifically mentioned by article 8(2) of the
Federal Tax Administration Proclamation and when a written request is
submitted to the Director General or his representative and the provision of the
document is authorized.

iv. Competency

Auditors:

a. shall engage only in those audits for which they have the necessary
knowledge, skill and experience, except under guidance and supervision of an
audit senior who ensures that work of the auditor is quality assured.

b. shall perform tax audit services in accordance with the tax laws and tax audit
manual and procedures thereof.

c. Shall continually improve their proficiency and the effectiveness and quality of
their audits.

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3 Internal audit and tax audit operations

3.1 The role of internal audit in audit operations

The objective of internal audit is to provide an independent and objective

consultancy service specifically to help management improve the MoR’s tax
administration, control and governance. Internal audit applies professional skills
through a systematic and disciplined evaluation of the policies, procedures and
operations that management put in place to ensure the achievement of the public
body’s objectives. In addition to the evaluation, internal audit makes
recommendations to improve procedures and policies.

In order to realize the above object, the internal audit manual spells out a range of
activities required of its staff. This manual (tax audit) considers those activities that
are relevant and pertinent to tax audit operations so as to create awareness among
tax audit staff of the oversight role of the internal audit function. The following are the
activities that may be relevant and specific to tax audit.

Internal Audit Directorate will execute its responsibility stated here as per its own
manual/ guideline.

3.1.1 Deterrence, detection, investigation and reporting fraud

3.1.1.1 Deterrence of fraud

The internal audit is responsible for assisting the deterrence of fraud, by examining
and evaluating the adequacy and effectiveness of control commensurate with the
extent of the potential exposure in the tax audit operations or with individual audits.
Internal audit will accordingly, examine the effectiveness of the tax audit procedures
and make recommendations where the control environment is weak and insufficient
to deter fraud among tax auditors.

37
3.1.1.2 Detection of fraud

The internal audit is required to identify indicators of fraud and recommend an

inquest (investigation) to management, where there is sufficient evidence. These
indicators may arise as a result of controls established by management, tests
conducted by auditors and other sources both within and outside MoR.

3.1.1.3 Investigating and reporting fraud

When indicators suggest that fraud has been committed, the internal audit is
expected to perform extended procedures necessary to determine whether the fraud
was actually committed. In this case, auditors are required to cooperate with the
internal audit function whenever information is sought.

A written report is required to be issued to the Minister of MOR at the conclusion of

the investigation phase. It should include all findings and conclusions and
recommendations for corrective action to be taken.

3.1.2 Audit compliance with policies, plans, procedures, laws and regulations

Internal audit is required to review the systems established by management to

ensure compliance with applicable policies, plans, procedures, laws and regulations
and should determine whether the audit staff are in compliance.

Internal audit is also mandated to report the existence of significant non-compliance

or an unreasonable exposure to significant instances of non-compliance.

3.1.3 Follow up on reported audit findings

Internal audit is mandated to establish a time frame within which management’s

response to the audit findings is required. Management’s response is expected to
include sufficient information to enable the internal auditor to evaluate the adequacy
and timeliness of corrective action.

38
The internal audit is mandated to receive periodic updates from management in order
to evaluate the status of management efforts to correct previously reported
conditions.

In addition, the internal audit is mandated to develop escalation procedures for any
management response, which are found to be inadequate in relation to the identified
risk. These procedures ensure that the risk of failure to take action have been
understood and accepted at a sufficiently senior management level.

3.2 The role tax audit staff in facilitating internal audit work

The role of internal audit in ensuring that auditors conduct their audits within the
premises of the legal frame and laid down procedures cannot be over emphasized.
Internal audit will expect of the tax auditors the following;

i. Provision of information. This includes the tax audit files and any information
that the auditors may have considered during the audit. The auditors usually
give prior notice ahead of the audit review. Accordingly, auditors should not
give all sorts of excuses for failure to comply with information requests by
Internal Audit.

Further, auditors cannot claim that the tax audit information requested by the
internal auditors is confidential and cannot be shared in the terms of article
8(1) of the proclamation. Article 8(2) (a) provides that the provision of sub-
article (1) of this article (confidentiality of tax information) shall not prevent
a tax officer from disclosing a document or information to the following,
another tax officer for the purpose of carrying out official duties. This is also
extended to the Auditor –General when the disclosure is necessary for the
performance of official duties by the Auditor General in the terms of article
8(2)(e).

ii. Response to audit queries raised by the internal auditors. It is expected

that the auditors will be required to provide responses to queries raised by the
internal audit function. The responses must be timely and qualitative in nature.
This implies that the branch administration particularly the audit process owner

39
 should take lead in quality assuring the responses prior to their release to the
internal audit function. Auditors are reminded of their duty of honesty under the
ethical code as they provide responses to the internal audit team.

iii. Participate in pre-audit, pre-exit and exit conferences with internal audit
teams. Pre-entry conferences set the tune and direction for the audit review
process. Pre-exit conferences give the auditors an opportunity to respond and
reconcile audit findings while the exit conference communicates the final
outstanding matters that are captured in the audit report for the attention of
management. It is important that key audit staff at the branch including the
process owner and audit team leader are in attendance especially during the
entry and pre-exit conference to insure that all queries raised by internal audit
are sufficiently and adequately addressed. This also presents an opportunity
to the audit teams to improve their processes.

40
4 The role of tax auditors and the HQ function

4.1 The HQ function

The Headquarter (HQ) function is expected to provide strategic direction to the audit
operations resident at the branches. This involves:

i. Setting objectives, priorities and strategies for the audit program

ii. Setting annual, quarterly and monthly targets (performance indicators) for the
branches under the national audit plan including audit types to be conducted.

iii. Monitoring and evaluation of key performance indicators for audit (Quality,
coverage & yield) for better performance.

iv. Analyzing and evaluating audit results and other data for future planning.

v. Identifying and communicating staff training needs assessment to Human

resource and the Tax Training Centre for further management.

vi. Research and provide guidance to audit staff on current trends in the economy
that may impact on audit activity.

vii. Conduct quality assurance checks on operational offices to ensure that audit
policies and procedures are applied professionally and consistently.

viii. Communicate legislative changes and policy decisions and procedures to

audit operational staff.

ix. Provide manuals, tax legal assistance, forms / documentation, and other
support to auditors.

4.2 Role of audit operations at the branches

Branch audit operations are expected to:

i. Comply with laid down tax audit procedures and policies at all times during
planning and execution of audits.

41
 ii. Comply with legislation (proclamations), treaty law and financial reporting
standards where the law makes specific reference.

iii. Adhere to set targets (monthly, quarterly and annual) by Headquarters.

iv. Provide input to headquarters in the development of plans and performance

targets.

v. Identifying training needs for staff and communicate with Headquarters for
further management.

vi. Monitoring achievement of plans, and providing regular reports to

headquarters regarding any deviations against plan.

vii. Maintaining data on taxpayer’s profiles, undertaking research and analysis of

compliance behavior, and provide feedback to Taxpayer Compliance Risk
Process at Branches and Tax Audit Directorate at HQ.

viii. Comply with internal audit operations and requests.

4.3 Audit team’s alignment to specialized sectors and their roles

4.3.1 Alignment of audit teams to specialized sectors

It is good practice to align audit staff to specialized sectors owing to the following
benefits;

i. Guaranteed specialization among audit staff. This ensures audit quality and
increased audit yield arising from obtaining industry knowledge through
repetitive audits of the same nature.

ii. Specialist sector enable meaningful comparison (vertical and horizontal)

among the taxpayers in same sectors. This comparison could provide answers
to why specific taxpayers in the same sector with the same level of investment
post different tax returns. This could be a source for risk identification and
design of appropriate audit procedures to establish the variation.

42
iii. Better understanding of taxpayer business and behavior which helps auditors
to draw robust audit plans for effective and efficient delivery. The basic
requirement for any robust audit program/plan is sound knowledge of the
taxpayer’s business. Audit is about verification of assertions and this can be
best done if the auditor has a good understanding of the taxpayer’s business.
Specialist sectors guarantee this knowledge.

iv. Improved taxpayer compliance. When taxpayers are aware that they have
been segmented according to specialist sectors, they are likely to improve
their compliance levels following targeted audit activity. In addition, taxpayers
may provide information (whistle blowing) about their competitors in the same
industry engaged in unfair competition anchored on tax evasion to the
Ministry.

4.3.2 Role of auditors under specialized sectors

Auditors are expected to:

i. Comply with the audit procedures and polices laid down for the various
specialized sectors.

ii. Plan audits and tailor tax audit activity in a manner that reflects the economic
activity of the given or specialized sector.

iii. Consider and appropriately tax legislation pertaining to the specific industry.

iv. Complete audit working papers for all adjustments or accounts affected during
audit activity and that audit seniors review the audit working papers.

v. Adhere to the auditor’s ethical code of conduct at all times during audit activity.

vi. Disclose any conflict of interest that is present or expected to occur during
audit activity of a particular audit assignment.

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4.3.2.1 Understanding business (sector) dynamics

Understanding the business dynamics and work processes of a particular tax audit
client is pivotal in the design of any robust audit plan. It is worthy of note that a robust
audit plan is expected to set the tone for high yielding audits. Akin to a doctor who
requests clinical information about a patient prior to any medical procedure, tax
auditors are expected to have an excellent understanding of their audit client in order
to align suitable audit techniques and procedures to obtain appropriate audit
evidence as a basis for sound and fair tax assessments.

It is through knowledge of the taxpayer’s business that auditors are able to perform
relevant audit procedures (inspection, observation, external confirmation,
recalculation, re-performance, analytical procedures and inquiry) in order to obtain
sufficient appropriate audit evidence to be able to draw reasonable conclusions about
the compliance of the taxpayers.

In order to understand the business dynamics of a particular taxpayer it is important

to consider the following:

i. Nature of business activity. Business activity refers to the trade in which the
tax payer is engaged, for example, construction. Here it is important to take
stock of the associated risks to tax revenue that the particular business activity
presents and how appropriate audit evidence for such a business activity may
be obtained. Considering the construction sector, risks associated with
understating income from contracts is likely to emerge and through validation
with third party information from government data bases like IFMIS, such risks
may be mitigated.

It would also be important to establish for instance the nature of transactions,

i.e. whether the transactions are cross border and between associated
enterprises. In this case, transfer pricing issues or matters of treaty law may
then be considered.

ii. Vehicle used for trading. In this case whether the entity is trading through a
branch or a subsidiary of a non-resident company are very important aspects

44
 for consideration. A branch of a non-resident is liable to tax to the extent that
its income is sourced in Ethiopia while a resident company is subject to its
worldwide income.

iii. Sector in which the taxpayer is engaged. This is the broad umbrella in
which the taxpayer is engaged. For instance, manufacturing. Various sectors
of the economy present different and or specific risks to tax. Understanding
the sector dynamics provides the tax auditor with an opportunity to plan
relevant audit procedures in order to obtain sufficient appropriate audit
evidence.

iv. Industry regulatory and financial reporting framework. The regulatory

framework provides good insights. The proclamation variously refers to
financial reporting standards and it is good practice to make special reference
where this is required. For instance, in the determination loss reserves of
banks, trading stock, and taxable income, there is need to make reference to
financial reporting standards.

v. Global and local trends affecting or likely to affect specific industry. It

would be very important to keep a keen eye on global and local trends
affecting a particular industry in order to identify the associated tax risks. For
instance, the impact of the e commerce.

4.3.2.2 Sector comparability analysis

Segmentation along specialized sectors enables greater understanding of the

taxpayer’s operations and provides better insights into the nature of audit procedures
relevant to a given audit assignment. Auditors are required to maintain a certain level
of professional skepticism in order to exercise professional judgement and draw
conclusions. Comparability analysis enables the skeptic to clear their mind or confirm
that the taxpayer could have understated or overstated declarations as the case may
be.

Tax auditors will be required to review data of key indicators for specialized sectors in
which they are assigned to inform a robust risk management system. For instance,

45
auditors handling the beverages subsector under manufacturing would be interested
in running a comparability analysis on sales among different players and level of
investment in capital goods etc.

Case study

ABC Limited is a member of the Coca-Cola Plc group and is resident in the Ethiopia.
ABC manufactures the favorite Coca-Cola brand. During the last financial year, the
company purchased equipment to improve its production efficiency as a reaction from
cost cutting by a DEF Limited a manufacturer of Pepsi believed to be substitute product
that is trying to claim coca cola’s market share in Ethiopia.

DEF Limited invested in a like equipment a few years ago and has declared the cost on
their financial statements as well as the tax returns. ABC’s profit after tax have declined
due to an increase in depreciation allowance arising from the recently acquired capital
investments.

In the example above, a comparability analysis can useful in validating the cost of the
equip against which ABC Limited is claiming huge capital allowances in comparison to
a similar investment that DEF acquired a year ago.

4.3.2.3 Compliance initiatives

Auditors are expected to drive compliance through audit activity as follows;

i. Adjustments (assessments inclusive of penalties) made especially if they are not

contested, are within the realm of the law and are fair usually impact on the
compliance level of the taxpayers. This implies that tax auditors are required at all
times to consider the relevant provisions of tax law in regard to any adjustment
made to the taxpayer’s declaration.

ii. Tax education provided inadvertently during audit. Audit presents an opportunity
for auditors to educate their auditees on matters of tax law and especially the
correct treatment of various accounts. Where this information is supplied to
taxpayers who file inappropriate tax returns for lack of the requisite tax knowledge,

46
 their compliance levels are likely to improve provided that tact and respect for the
audit client is adhered by the auditor.

4.3.2.4 Relationship management

Auditors are expected to manage their clients in a manner that will enhance
compliance. Auditors are usually the first point of contact for taxpayers especially
regarding their tax position and another other adjustment to the tax assessments.
Accordingly, auditors are well positioned to engage as relationship managers to
advise their audit clients on matters of taxation and their obligations/rights.
Relationship management involves:

a. Follow-up on the status of debt collection after audit assessment with debt
management team.

b. Providing taxpayer education during the audit. This involves educating taxpayers
on the technical aspects of tax law and how these affect their particular
businesses.

c. Engaging clients on their rights but importantly, their obligations under the tax
laws/ Proclamations. This implies that auditors will be required to send out
reminders to their audit clients to file their returns and pay the attendant taxes
promptly.

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5 Performance evaluation

5.1 Introduction

The words of Peter Drucker, “what gets measured gets managed”, suit
performance evaluation for the audit staff. Others have expressed it as “what gets
measured, gets done.” It is therefore important to determine performance indicators
for audit staff as enablers for productivity.

In order to set robust performance indicators for the audit staff, there is need to
appreciate why tax audits are conducted. The principle purpose for tax audits is the
enhancement of voluntary compliance of the taxpayers which is achieved by
reminding taxpayers of the risks of non-compliance and by signaling the broader
community that serious abuses of the tax law will detected and appropriately
penalized.

Audit activity improves taxpayer compliance if the audit clients view the auditors’ as a
competent lot capable of unearthing their tax schemes and issuing fair tax
assessments within the realm of tax legislation. In addition, the national audit plan
should consider a sizeable portion of the tax payer register that is considered high
risk in order to drive the required compliance levels among the taxpayers. This
speaks to audit coverage.

Arising from the above, audit performance evaluation seeks to consider:

i. Audit quality
ii. Audit yield
iii. Audit coverage

5.2 Audit quality

Measuring audit quality can be very problematic, since quality measures are very
subjective in nature. However, audit quality may be measured from the stand view
point of an independent party who participates in the review process. Audit reviews
are occasioned by internal audit and taxpayers’ objections to the tax audit
assessments.

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Article 55(1) of the Federal Tax Administration Proclamation requires the Ministry to
establish a review department as a permanent office within the Ministry to provide
an independent review of objections and to make recommendations to the
Ministry as to the decision to be taken on an objection.

The review process by an independent office within the tax body can be used to
validate the quality of audits executed by the tax audit teams. For instance, audit
quality may be measured as a proportion of appeal cases concluded in the favor of
the Ministry. Where the taxpayer has appealed against a number of issues within a
particular audit assignment, as in the case of a comprehensive audit, then the
measure of audit quality would be the proportion of audit value adjusted after the
objection.

Case study 1
During the financial year ended 10/07/2017, the large taxpayer office (LTO) completed
180 cases out of which fifty percent (50%) were objected and reviewed by the
independent review department. Ninety percent of the objections were concluded in favor
of the tax payers. Arising from the above, the quality of the audits in percentage terms is
55% (50% + 50% x 10%).

Accordingly, if one were to appraise the branch performance on audit quality, the score
would be 55%.

Case study 2
Assume all factors remain constant except that 90% of the cases were ruled in favor of
the Ministry. This would imply that the performance evaluation of the branch on the audit
quality aspect is 95% (50%+ 50% x 90%)

Case study 3
MTO audited 100 cases with an audit value of Birr 5billion. These were all comprehensive
audits. 50 cases were objected with a value of Birr 3billion. The grounds for objection
were several for each case. The appeals committee adjusted the audit value by Birr
1billion.

In this case the score on audit quality is 83% (50% +0.5(2/3) x100%)).

49
The above performance evaluation at the branch level may then be cascaded to
individual audit teams. Where it is the intention to improve the quality of audits, this
measure may then be given a higher weight relative to audit yield and coverage
performance indicators.

5.3 Audit yield

This considers audit as a means for revenue generation. It assesses the auditor’s
ability to generate revenue through audit. While this is not the main reason for tax
audits, maintaining a keen eye on revenue collected directly from audits ensures that
auditors plan their audits in a manner that generates additional tax revenue. It is
expected that an audit program anchored on a robust risk assessment guarantees
high tax returns.

Determining the score card depends on the potential revenue yield (projected tax
revenue) for a particular sector/ taxpayer and growth trends in the economy. It would
also be important to consider the contribution to GDP of various sectors and the
growth trends in order to project expected tax revenues for a particular sector.

5.4 Audit coverage

Audit coverage considers the proportion of the taxpayer register audited during a
given period (financial/fiscal year and month). In order to cause the desired level of
compliance through audit activity, and based on the level of risk indicators, it is
imperative that the audit coverage is considered a key performance indicator.

Except where the taxpayer is found to be fraudulent or grossly/willfully negligent,

audit activity is restricted to a five-year period from the date the self-assessment
taxpayer filed the self-assessment declaration, in the terms of article 28(2) of the
Federal Tax Administration Proclamation. Accordingly, the national audit plan should
consider to audit twenty percent (20%) of the taxpayer register annually to safeguard
against being locked out on account of statutory time limits, if all (100%) the
taxpayers are found to be risky. The twenty percent or another percentage, as
appropriate, would then constitute the upper limit.

50
Following from the above, the actual percentile for audit activity would then be
determined by the level of risk that the taxpayer register postulates. For instance, if
eighty percent of the taxpayers (total taxpayer register) are found to be risky, the
national audit plan should consider audit of sixteen percent (16%) (20% of 80%).

Care should be taken to avoid auditing the same taxpayers annually to avoid audit
fatigue. There is usually a tendency for tax authorities motivated by revenue
generation from audit activity to concentrate on the same taxpayer’s year on year.
This is likely to be misconceived as witch hunt and it impairs taxpayer’s compliance
levels considering that audit activity is an expensive process. Audit requires the
taxpayer to engage external consultants to response to tax audit findings which
usually takes significant resources depending on the complexity of issues identified.

5.5 National audit plan

The national audit plan is expected to consider at the minimum audit yield and
coverage as key quantitative performance indicators. However, it should include the
qualitative aspects, i.e., Audit quality. This will ensure that the quantitative
performance outcome of audit activity is qualitative. This guarantees taxpayer
confidence in the tax audit function, an ingredient for taxpayer compliance. A wrong
signal is likely to be sent where a sizeable portion of the audits are objected and
concluded in favor of the taxpayers.

It is the collective responsibility of the branch management supported by the HQ

function to deliver on the national audit plan as cascaded to the respective branches.
The HQ function will be required to monitor performance targets against actual
outputs for each branch.

Monitoring by the HQ function includes requiring branches to give an account of

unsatisfactory performance and a comprehensive corrective plan. This should be
done on a monthly, quarterly, half yearly and annual basis. It would also be good to
compare performance for the same period for different years in order to run a trend
analysis and identify areas for improvement.

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5.6 Cascading national audit plan targets to individual scorecards

In order to ensure that performance targets at the national level (national audit plan)
are implemented and delivered at the branch level, these must be cascaded into staff
individual performance appraisals. Accordingly, staff should be appraised on audit
coverage (number), yield and quality.

Cascading national targets to individual scorecards ensures accountability at the

individual audit staff level. The appraisal should include rewards for outstanding
performance, e.g. cash bonus or promotion in accordance with the Human Resource
guidelines.

Conversely, audit staff who fail to meet audit performance targets should be identified
and corrective action undertaken. For instance, such staff may undergo a
performance improvement plan (PIP) drawn and managed by their supervisors.
Continuous failure by individual staff to meet the set targets should be penalized in
accordance with the Human Resource guidelines especially after undergoing a
rigorous PIP.

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6 The tax legal framework in Ethiopia

6.1 Introduction

Chapter one established that the nature and scope of tax audit differs from other
audit types. Tax audit being an examination of whether a taxpayer has correctly
assessed and reported their tax liability and fulfilled their obligations, requires
the auditor to have sound working knowledge of the taxpayers’ business model,
accounting system but importantly the tax legislative structure in order determine
whether the taxpayer is in compliance with the applicable legislation.

This chapter highlights the key aspects of the tax legal framework (Income Tax,
Value Added Tax and Excise Tax) in a style that aids its comprehension and
usability. Auditors are expected to approach tax audits from a tax law point of
knowledge in order to make correct and fair tax adjustments. This chapter seeks to
provide auditors with the requisite tax law knowledge. However, the reader is advised
to refer to the proclamations as this manual does not purport to replace them. This
chapter is expected to be a guide and a point of first call to aid ease interpretation
and application of the different articles relevant to tax audit.

6.2 Income Tax

6.2.1 Introduction
The Federal Income Tax Proclamation, 979/2016, is the primary legislation for
income tax in Ethiopia. Further, article 99 of the said proclamation mandates the
Council of Ministers to issue Regulations necessary for the proper implementation of
the principal law. The said regulations are cited as Council of Ministers Federal
Income Tax Regulation No.410/2017 and are subsidiary (legislation) to the Principal
tax law, cited as the “Federal Income Tax Proclamation No. 979/2016.”

Auditors or any other user of the Federal Income Tax Proclamation are required at all
times to make reference to the Regulations (No.410/2017) for clarity and proper
implementation of the Proclamation.

53
Further, the Federal Income Tax Proclamation severally makes reference to the Tax
Administration Proclamation. Auditors will be required to make this special reference
wherever the Income Tax Proclamations requires. For instance, the preamble to
article 2 of the Federal Income Tax Proclamation provides that a term used in the Tax
Administration Proclamation shall have the meaning in the Tax Administration
Proclamation unless defined otherwise in this proclamation. In this respect, terms like
person, body among others derive their meaning from the Tax Administration
Proclamation.

Income Tax in Ethiopia follows a scheduler system of taxation. A scheduler income

tax is one in which taxes are imposed on different categories of income. This differs
from a global income tax in which a single tax is imposed on all income, whatever its
nature.

In a scheduler system, gross income and deductible expenses are determined

separately for each type of income; in some cases, limited deductions or no
deductions may be allowed. The rates of applicable to each category of income are
then applied to the taxable amount of the income. The rates of tax may vary from
category to category. Different procedures may apply to each category of income for
the reporting, assessment, and collection of tax. Some types of income may be
taxable only through withholding; others may involve the filing of returns. Lee Burns
and Richard Krever, Tax law design and drafting, IMF, 1998.

The Federal Income Tax Proclamation (article 8) provides for the taxation of income
in accordance with the following schedules

a) Schedule ‘A’, income from employment;

b) Schedule ‘B’, income from rental of buildings;

c) Schedule ‘C’ income from business;

d) Schedule ‘D’, other income;

e) Schedule ‘E’, exempt income.

54
Except where a taxpayer derives “other income” under schedule ‘D’, income derived
from different sources subject to tax under the same Schedule for a tax year shall be
taxable under the Schedule on the total income for the year (Article 8(2) and 64(2)).

6.2.2 Principles of income tax in Ethiopia

Schedular system of taxation: Income tax follows a schedular system of taxation

and income tax is separately imposed for each income category. Accordingly, the
Federal Income Tax Proclamation (article 8) provides for the taxation of income in
accordance with the following schedules

a) Schedule ‘A’, income from employment

b) Schedule ‘B’, income from rental of buildings

c) Schedule ‘C’ income from business

d) Schedule ‘D’, other income

e) Schedule ‘E’, exempt income

Except where a taxpayer derives “other income” under schedule ‘D’, income derived
from different sources subject to tax under the same Schedule for a tax year shall be
taxable under the Schedule on the total income for the year (Article 8(2) and 64(2)).

6.2.3 Payment of income tax

The obligation to pay income tax rests on every person (an individual, body,
government, local government, or international organization- article 2(26) of the
Federal Tax Administration Proclamation) deriving income in accordance with the
Income Tax Proclamation, in the terms of article 9 of the Income Tax Proclamation.
Derivation in reference to income denotes timing of recognition of income by the
taxpayer. In other words, the obligation to pay income tax arises when income is
recognized by the taxpayer.

In the case of business and rental income tax, where the taxpayer is accounting for
tax on an accrual basis, when the right to receive the income arises. Conversely,

55
if the said taxpayer is accounting for tax on a cash basis, on receipt of cash (Article
2(5) a of the Income Tax Proclamation).

Tax is due for other tax types other than business and rental, i.e., say employment
tax, when the income by the person is received. This presupposes a cash basis. In
other words, an employee is liable for tax when they have received their salary and
not when it accrues and is not paid.

6.2.4 Scope of taxation in Ethiopia

The imposition of Income Tax applies to:

a) Residents of Ethiopia on their worldwide income. This implies the both

Ethiopian source income and foreign income sourced by a resident of Ethiopia
is taxable under the Proclamation.

b) Non-residents with respect to their Ethiopian source income. Article 6,

provides the source rules. In other words, it determines when income is said to
be sourced in Ethiopia. Auditors are encouraged to read this article for details.
This implies that foreign income sourced by a non-resident is outside the
scope of taxation in Ethiopia.

Residence

Income Tax applies to residents and non-residents distinctively. Residents are

subject to worldwide income while nonresidents to Ethiopian sourced income. This is
a potential area for tax planning with substantial revenue leakage. Auditors are
accordingly required to have a sound understanding and application of the residence
rules in order to mitigate their associated risks.

The law as quoted above requires that the income of a non-resident subject to tax
is restricted to their Ethiopian source income. This implies that the foreign
sourced income of a non-resident is outside the scope of taxation in Ethiopia.
Accordingly, taxpayers are likely to structure their business affairs in a manner that
may seemingly present them as non-residents so as to lessen their tax burden. For
instance, a company may decide to incorporate and conduct business offshore in a

56
low tax haven but with presence in Ethiopia. This entity would easily pass for a
nonresident whereas not especially if its effective management takes place in
Ethiopia thereby substantially reducing its exposure to taxation (in Ethiopia).

Due to its importance and given that unsuspecting taxpayers may take advantage to
tax plan or evade taxability in Ethiopia, the auditor is required to have sound working
knowledge and application of the residence rules in order to mitigate the risk of
avoidance or evasion. The paragraphs below, simplify these rather complex rules;

In the terms of article 5(1), the following are residents of Ethiopia:

i. A body

While the proclamation does not define the term “body”, the Federal Tax
Administration Proclamation in the terms of article 2(5) does and it provides that
“Body” means a company, partnership, public enterprise or public financial agency, or
other body of persons whether formed in Ethiopia or elsewhere. The preamble to
article 2 of the Income Tax Proclamation permits the meaning of the terms given by
the Federal Tax Administration Proclamation.

Pursuant to article 5(5), a resident body is a body that meets either of the two criteria:

a. Is incorporated or formed in Ethiopia; or

b. Has its place of effective management in Ethiopia.

Further, Article 5(6) provides that a resident company is a company that is a resident
body. This would apply to a partnership and other entities under the definition of the
term body.

Effective management is not defined by the proclamation, but there is a wealth of

jurisprudence (case law) that may be relied upon. The question of exercise of
management and control of a company was the subject of De Beers Consolidated
Mines Ltd v. Howe. There the House of Lords held that a company resides for the
purpose of income tax where its real business is carried on, and a company’s
real business is carried on where the effective management bides. Similarly, in
Unit Construction Co Ltd v. Bullock, the court found that the central management and

57
control of three African subsidiary companies of a United Kingdom parent company
was in London because the parent company exercised the central management and
control of those companies in London.

Place of effective management can be said to be the state where key management
decisions are made. This could include for instance where the board of directors sits
to direct the affairs of the entity. Therefore, a body that is not incorporated or formed
in Ethiopia, may be a resident if it is found that it’s effective management is in
Ethiopia. Auditors are therefore required to be vigilant of foreign incorporated
bodies, as such may be resident of Ethiopia.

Case study

ABC limited was incorporated in UAE in 2008. The company manufactures Techno mobile
phones which a have great market potential in Africa. The sales by their main distributor in
Ethiopia, TM Limited encouraged ABC to commission a multibillion factory in order reap from
the benefits of cheap labor and proximity to the market. Accordingly, a branch of ABC
Limited was registered in Ethiopia for this purpose on the advice of their tax consultant that
this vehicle would guarantee enormous tax savings since it would be seen as a branch of a
non-resident company. This would imply that the branch would be taxable only on the
income through its branch in Ethiopia.

During the extraordinary meeting held on 31/12/2014, the directors approved a proposal to
have the effective management of the company in Ethiopia with effect from 01/01/2015 in
order to direct the affairs of the company from their new strategic base.

ABC Limited sales 40% of its products through its branch in Ethiopia and 60% through it the
head office in UAE.

Required: Is the advice of the tax consultant tenable?

Solution

ABC is not incorporated in Ethiopia and on this basis would be treated as nonresident. Its
registered branch in Ethiopia would be a branch of a nonresident company. However, ABC
limited has its effective management in Ethiopia. This makes the ABC resident and subject to
tax on its worldwide income (Ethiopian source (40%) and the foreign sourced income (60%)).
ABC should disregard the advice of their consultant and account for all (100%) its income in
Ethiopia.
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 ii. The Government of the Federal Democratic Republic of Ethiopia, and any
Regional State or City Government in Ethiopia.

iii. An individual who:

a. Has a domicile in Ethiopia

b. Is a citizen of Ethiopia who is a consular, diplomatic, or similar official

posted abroad

c. Is present in Ethiopia, continuously or intermittently, for more than 183 days

in one-year period.

In determining the number of days (183) above, a part of the day that an individual is
present in Ethiopia (including the day of arrival in, and the day of departure from,
Ethiopia) shall count as a whole day. Further, public holidays, leave days including
sick leave, a day in which the individual’s activity in Ethiopia is interrupted because of
strike, lock-out, delay in the receipt of supplies, adverse weather conditions/seasonal
factors, days spent by the individual on holiday in Ethiopia before, during, or after any
activity conducted by the individual in Ethiopia shall be included in the count of the
183days.

The above notwithstanding, a day or part of a day when an individual is Ethiopia

solely by reason of being in transit between two different places outside Ethiopia
shall not count as a day present in Ethiopia.

Note that the conditions provided for individuals are not mutually exclusive. In other
words, one doesn’t need to satisfy all the conditions to be a resident.
Satisfaction of any one of the conditions is sufficient to be resident. For instance,
while a citizen who is a diplomat posted abroad may be absent in Ethiopia for more
than 183 days during a twelve-month period (one year), this person a resident.

Further, the above conditions assume that an individual is a resident for the entire tax
year even when they have been in the country for only 184 days. However, Article
5(3) and 5(4) read together permit for partial residence during a tax year.

59
Article 5(3) provides that, an individual who is a resident individual under sub-article
(2) of this Article for a tax year (referred to as the “current tax year”), but who was not
a resident individual for the preceding tax year shall be treated as a resident
individual in the current tax year only for the period commencing on the day on
which the individual was first present in Ethiopia.

Further, Article 5(4) provides that, an individual who is a resident individual under
sub-article (2) of this Article for the current tax year, but who was not a resident
individual for the following tax year shall be treated as a resident individual in the
current tax year only for the period ending on the last day on which the
individual was present in Ethiopia.

These conditions are illustrated in the example below:

Case Study

Allan a Kenyan Citizen was contracted by DFID as an independent contractor (Business

Income) to support the Tax transformation office as an audit Advisor for a period of nine
(9) months commencing 12/07/2017 and ending 11/04/2018. He was previously engaged
with the world bank in Uganda until 30/06/2017. Allan returned to Kenya after his nine
months’ contract and he is not expected to return to Ethiopia as he has been appointed as
the internal audit director at KCB with effect from 15/04/2018.

Required;

Determine Allan’s residence status during the tax year ended 30/06/2018 and the
treatment of income earned from Kenya as the Internal Audit Director and Uganda with
the world bank.

Solution;

Allan is a partial resident, effective 12/07/2017 to 11/04/2018. In the terms of article 5(3),
Allan is resident during the tax year ended 30/06/2018, i.e. with effect from 12/07/2017
since he was nonresident during the tax year ended 30/06/2017. His residence expires on
11/04/2018, i.e., effective 12/04/2018, Allan is nonresident.

The income earned from the world bank in Uganda is foreign sourced pursuant to article
6(5) and accrued was he was nonresident in the terms of article 5(3). Accordingly, this
income is outside the scope the proclamation pursuant to article 7(1) and is not taxable in
Ethiopia.

Further, the income earned in Kenya arises when Allan is nonresident, in the terms of
article 5(4) and 5(7). This amount is equally outside the scope of taxation in Ethiopia. Allan
will therefore be subject to tax on income he earned in Ethiopia while he was resident. If
he has earned foreign source income during his residence, this income would have been
brought to the scope of taxation in Ethiopia

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6.3 Employment income

Employment income under Schedule “A” is one of the main sources of direct taxation
and a major contributor to tax revenue. Tax imposed (levied) on employment income
is referred to as employment income tax.

Article 10(1) provides that without to Article 84 of this proclamation, Employment

income tax shall be imposed for each calendar month or part thereof at the rate or
rates specified in Article 11 of this proclamation on an employee who receives
employment income during the month or part thereof.

This article lays down three fundamental principles for imposition of employment
income tax. These are discussed below:

a. Imposition of tax on employment income tax is on the employee, the person

receiving employment income. The employer is simply a withholding agent.
Article 2(7) defines an employee to mean an individual engaged, whether on a
permanent or temporary basis, to perform services under the direction and
control of another person, other than as an independent contractor, and
includes a director or other holder of an office in the management of a body,
and government appointees and elected persons holding public offices.

It is important that the auditors distinguish between an independent contractor

and an employee because these are taxed differently. An employee is liable to
employment income tax while an independent contractor is liable to business
income tax under article 8. Taxation under business income tax comes with
greater tax privileges. For instance, business income is imposed on taxable
business income (total business income less total deduction) whereas under
article 10(3), a tax on employment income is on gross receipts (deductions are
not allowed). This implies that if the taxpayer posted a loss, they are not liable
to tax instead the loss is carried forward and allowed as a deduction in
determining the taxpayer’s taxable income for the subsequent year (article
26(2) of the Federal Income Tax Proclamation).

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 Although there is usually a very thin line between the two, an independent
contractor is one who provides their own tools, is not controlled by the
employer, can assign part or all the assignment to another person, is not
under a regular form of remuneration (salary).

b. Period of taxability is a calendar month or part thereof. This is unlike rental

and business income taxes which are imposed for a tax year. Accordingly,
auditors are required to check if the employer has deducted withholding tax
from the employees on a monthly basis in the terms of article 88 and such
amounts are paid in accordance with article 97 of the Federal Income Tax
Proclamation.

c. Tax is on the basis of receipt of employment income. This implies a cash

based method of accounting. In other words, employment income tax can
only be imposed at the time of payment and not when it accrues. This
means that an employer who has not paid employment income will not be
required to withhold tax on accrued employment income in the terms of article
88(1). Taxpayers are likely to use this as scheme to evade or delay
payment of tax on employment income by purportedly accruing salaries and
wages. Auditors are there required to run a cash flow statement to check cash
payments and bring to tax unaccounted tax on employment income.

Employment income is defined in accordance with article 2(9) and article 12

and broadly includes cash and non-cash benefits (fringe benefits- details
contained in the Council of Ministers Regulation No. 410/2017) received in
respect of a past, current or future employment. However, this does not
include exempt employment income (article 12(2))). Exempt amounts are
spelt out in article 65 of the Federal Income Tax Proclamation.

Fringe benefits provide a platform for tax planning/evasion under this tax
head. This is because they are tax allowable expenses for the employer, i.e.,
deductible from business income but may remain discreet for employment
income tax. Employees may decide to provide non cash benefits such as
vehicle, housing, house hold property which are not disclosed on the payroll.

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 This is potential for tax leakage which calls for auditor’s vigilance during
audit activity.

Importantly, where the employer pays employment income tax for the
employee, the amount of tax is treated as employment income in the terms of
article 12(3) and is taxable on the employee. Auditors are expected to check
employment contracts of employees to the pay roll to determine if
employment income is paid gross and raise appropriate assessments.

d. The principles of taxability of residents apply to employees. In this case, a

resident employee who earns foreign employment tax is still subject to tax on
their worldwide income (foreign employment income) in the terms of article
7(1) read together with 10(1). The taxability of such foreign employment
income is as follows:

Foreign employment income (FEI) xxxx

Tax payable on FEL xxxx
Less: Tax credit; the lessor of
Foreign tax (paid) on FEI xxxx
Tax on FEI x (Average rate of employment tax) xxxx
(xxxx)

Tax payable xxxx

Note that where the tax credit exceeds the tax on FEI the excess is not refundable,
carried back to the preceding year or carried forward to the following year, in the
terms article 45(5) of the Federal Income Tax Proclamation read together with
article 20(3) of the Regulation No. 410/2017. This is illustrated in the case study
below.

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Case study

Biruk works for ABC LTD a multinational. For the months of July, he was posted to Nairobi to
fill in for the auditor who was on leave. He returned to Ethiopia after the short stint in Nairobi.
During this period, he received a monthly salary of Birr 108,000(FEI), equivalent of which his
employer deducted and remitted tax of Birr 32,400 to KRA.

Determine Biruk’s tax liability in Ethiopia if any.

Issues

i. The average rate of employment income tax is 34.8% (Tax on FEI /FEI) in the terms
of article 20(4) of the Regulations. (108,000-600) x 35% / 108,000)
ii. Biruk is a resident in the terms of article 5(2) of the Federal Income Tax Proclamation
and is accordingly taxable on worldwide income (Kenyan and Ethiopian in this case)
in the terms of article 7(1) and 5(1) of the said Proclamation despite the Kenyan
despite impost of tax of Birr 32,400 in Kenya.
iii. Biruk is entitled to a tax credit on tax paid in Kenya. This is determined as the lower
of;
a. Foreign income tax paid, 32,400
b. Tax on FEI, determined as, 37,584 (108,000 x 34.8% (average rate of
employment income))
In this, the tax credit is Birr 32,400
iv. Tax payable is computed as follows

Tax on FEI (108,000-600) x 35%) 37,590

Less tax credit 32,400
Tax payable 5,190

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6.3.1 Valuation of fringe benefits

Fringe benefits are usually given in the form of non-cash benefits and fall under the
scope of employment income in the terms of article 12(1)(b) of the Proclamation.
Provision of fringe benefits is likely to fall below the tax radar and could be a source
of revenue leakage under employment income tax.

Article 12(4) provides that the Council of Ministers shall make Regulations for
determining the value and taxation of fringe benefits. Fringe benefits are clustered
under nine (9) different categories with the tenth as a residual fringe benefits that is
not specifically included among the said categories.

6.3.2 General principles of taxation (fringe benefits)

i. Tax on fringe benefits shall not exceed 10% of the employee’s salary (Article
19(1)) and for this purpose salary doesn’t include other employment related
benefits, such as allowances.
ii. The employee is deemed to have received a fringe benefit if it is provided to
the employee by the employer, a related person to the employer (e.g. a
parent company and its subsidiary) and a third party to the employer acting
under an arrangement with an employer or a related person of the employer.

iii. The employee is deemed to have received a fringe benefit if it is provided to

the relative of the employee (spouse/children) by the employer, a related
party to the employer and a third party to the employer acting under an
arrangement with an employer or a related person of the employer.

iv. Specific benefits enumerated by article 8(4) of the regulations shall not be
treated as benefits provided to the employee and are therefore not taxable.

6.3.3 Summary of taxation of fringe benefits

Below is a glossary of the different fringe benefits and their taxation. In the table
below:

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i. a reference to an “employer” includes a related person of the employer and a
third party acting under an arrangement with an employer or a related person
of the employer.

ii. a reference to an “employee’’ includes a related person of the employee.

Benefit Value of the benefit

Debt waiver: Amount of debt waived.

Arises where the employer waives a debt

owed by the employee

Household personnel’s Fringe benefit Total employment income paid to the

domestic workers less any payments
This is where the employer provides made by the employee.
domestic worker/s to the employee

However, the provision of a security

guard for the benefit of the employee is
not a fringe benefit and is not taxable
on the employee

Housing or Accommodation a. Fair market rent of the

accommodation less payments
Arises where the employer provides by the employee if the premises
housing or accommodation to the employee are owned by the employer.
or their relative. b. Rent paid by the employer less
any payments by the employee

Discounted Interest loan Difference between interest at market

lending rate on the loan and actual
Arises where the employer provides to interest paid by the employee.
the employee a loan at interest rate lower
than the market rate. If the employer is a commercial bank,
the market lending rate is the lending
rate on loans and rediscount facilities
granted by the National Bank of
Ethiopia to commercial banks
prevailing in Ethiopia during the
month.

For any other employer, the lowest

lending interest rate of commercial
banks prevailing in Ethiopia during
the month.

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 Benefit Value of the benefit
Vehicle fringe benefit Determined according to the formula

Arises where the employer provides a (A x 5%)/ 12

vehicle to the employee wholly or partly
for the private use of the employee.
Where A is the;

Note i. Cost to the employer of acquiring

the vehicle plus duty and taxes if
Provision of motor vehicle for private the vehicle was imported tax/duty
use includes a vehicle that is made free, reduced by 50%(of cost +
available to an employee for private use duty/taxes) if the employer has
even if the employee did not actually held the vehicle for more than
use the vehicle for private use at any five years
time.
OR

Reference to vehicle means a motor ii. Fair market value of the vehicle at
vehicle designed to carry a load of less the commencement of the lease if
than one tonne and fewer than nine the vehicle is on lease reduced by
passengers. 50% (of the fair market value) if the
employer has held the vehicle for
more than five years

iii. Amounts in (i) and (ii) above are

further reduced by the following;

a. Payments made by the

employee for use of the vehicle
or maintenance or running
costs;
b. Proportion of use of vehicle for
conduct of employment;
c. Proportion of the month that the
vehicle was not provided for
private use.
Private expenditure fringe benefit The cost paid by the employer.

Arises where the employer makes a

payment that gives rise to a private
benefit of the employee.

Meals or refreshment fringe benefitTotal cost to the employer of

providing the meal reduced by any
Note that subsidy to meal or amounts paid by the employee.
refreshment provided in a canteen,

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 Benefit Value of the benefit
cafeteria, or dining room operated by, or
on behalf of, an employer solely for the
benefit of employees and that is
available to all non-casual employee
on equal terms is not a fringe benefit
and is not taxable.

Property or services fringe benefit Two conditions apply:

Arises when the employer transfers Where the property or services

property to an employee provided to an employee comprises
of the employers’ ordinary business
Or undertakings, then the value if the
benefit is 75% of the normal selling
Provides a service/s to an employee price of the property or services,
less any payment made by the
employee. In the case of airline
providing free or subsidized air
transport for its employees, the
normal selling price is the standard
economy fare.

Where the property or services

provided to an employee does not
constitute the employers’ ordinary
business undertakings, then the value
if the benefit is the cost to the
employer of acquiring the property
of the service less any payments
made by the employee.

Employees’ share scheme benefit Value is the fair market value of the
shares at the date of allotment
Defined as an agreement or arrangement reduced by the employees
under which an employer company or a contribution (sum of consideration
related company may allot shares to an given by the employee).
employee of the employer company.

The benefit arises when the employee

exercises the right to acquire shares.
Therefore, provision of the right to acquire
share doesn’t constitute a fringe benefit.
This also applies where the employee
disposes the right or option to acquire
shares, in this case, the provisions of
article 59 of the proclamation apply.

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6.4 Business Income tax

Business income tax is imposed under article 18(1) of the Federal Income Tax
Proclamation and provides that, subject to provisions of this part, business income
tax shall be imposed for each tax year at the rate or rates specified in Article 19 of
this Proclamation on a person conducting business that has taxable income for
the year.

Article 2(2) a defines business to mean any industrial, commercial, professional, or

vocational activity conducted for profit and whether conducted continuously or short
term but does not include the rendering of services as an employee or the
rental of buildings. Auditors are required to be keen as taxpayers involved in the
rental of buildings may opt to declare under business income to partake of the
numerous deductions available under that tax head.

Article 18(1) lays down three fundamental principles for imposition of business
income tax. These are discussed below:

a. Imposition of tax on business income is on the person conducting business

The preamble to article 2 of the Federal Income Tax Proclamation read together with
article 2(26) of the Federal Tax Administration Proclamation define a person to
mean, an individual, body, government, local government, or international
organization. Article 2(5) of the Federal Tax Administration Proclamation defines a
body to mean, a company, partnership, public enterprise or public financial agency,
or other body of persons whether formed in Ethiopia or elsewhere.

Further, article 2(2) of the Federal Income Tax Proclamation defines business to
mean:

i. Any industrial, commercial, professional, or vocational activity conducted for

profit and whether conducted continuously or short-term, but does not include
the rendering of services as an employee or the rental of buildings
ii. Any other activity recognized as a trade under the commercial code; or

69
 iii. Any activity, other than the rental of buildings, of a share company or private
limited company whatever the objects of the company.

Accordingly, persons conducting business (subject to item b below) are liable to

business income tax. This includes a partnership. In this case, a partnership is
treated for business income tax as the taxable person and not the partners on
its (partnership’s) taxable business income. This would imply that where the
partnership appropriates profits to the partners in accordance with its established
profit sharing ratios, the appropriated amounts would be treated as a dividend
income in the terms of article 2(6) of the Federal Income Tax Proclamation and
imposed to tax at a rate of 10% of the gross dividend in accordance with article 55 of
the Proclamation (Schedule D). Article 2(6) defines in part, a dividend to mean a
distribution of profits by a body to a member. In this case the individual partner
would be liable for tax.

Auditors are accordingly required to pay particular attention to the tax treatment of
partnerships/partners as there is a likely hood that tax on the share of profits to
partners may fall through the cracks as withholding of tax on dividends at 10% in the
terms of article 90(2) by the partnership may be omitted. Further, article 61 of the
Proclamation imposes tax at a rate of 10% on the net undistributed profits of a
body (read partnership) in a tax year to the extent that the undistributed profits are
not re-invested in accordance with the Minister’s Directive. In this case auditors are
equally required to check if tax (10%) has been withheld by the partnership in
accordance with article 90(1) where the profits are not shared out among the partners
(undistributed profits).

b. The business conducted by the person must give rise taxable business
income for the year.

Taxable business income is the total business income (excluding an amount that is
exempt income) of the taxpayer for the year reduced by total deductions allowed to
the taxpayer for the year. This implies that where deductions exceed total business
income (loss), no tax will be payable.

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Business income is defined by 2(4) and article 18 of the Proclamation. Deductions
are provided under article 22, 23, 24, 25, 26 and 30. Article 27 specifically spells out
the non-deductible expenditures and losses in determining the taxable business
income of a person. The rules espoused by the foregoing articles will be considered
in detail under chapter 8 (taxation accounting).

Business income takes the three broad forms

i. Proceeds (gross) derived from ordinary course of business. This includes

disposal of trading stock and gross proceeds from fees arising from the
provision of services, other than employment.

Where the taxpayer is accounting for tax on an accrual basis, business income
arises when the right to receive the income occurs and conversely when the
income is received if the taxpayer is accounting on a cash basis.

ii. Capital gains. This arises on a disposal of business assets other than trading
stock subject to deferral of capital gains under Article 71 of the Proclamation.
The implication is that there is no gain or loss on the disposal of assets spelt
out under Article 71. Auditors are required to check that gains that have not
been brought to tax are those covered by the said Article.

iii. Any other amount included in business income of the taxpayer for the tax year
under the Proclamation. This includes foreign currency exchange gains
(Article 44(1) of the Regulation No. 410/2017); see also Article 77(3) of the
proclamation.

c. The tax is imposed for each tax year.

Unlike employment income tax, business income tax is imposed for a tax year
in accordance with the rates provided by Article 19. This distinction is
important in the sense that rates applicable for employment income tax are
monthly while those applicable for business income tax are annual with regard
to individuals.

71
While 30% is the rate applicable to a body on its taxable business income (Article
19(1)) of the proclamation, Micro Enterprises are required pay tax in accordance with
rates prescribed for individual taxpayers in accordance with Article 19(2) of the
Proclamation. Micro Enterprises are prescribed by the Federal Urban Job Creation
and Food Security Agency Establishment Council of Ministers Regulations
No.374/2016.

Tax year is defined by article 2(21) to mean

i. For an individual, the one-year period from 1stHamle (July) to 30thSene

(June), unless the Ministry has granted permission, by notice in writing and
subject to such conditions as may be specified by the Ministry in the notice, for
the individual to use its accounting year as the individual’s tax year:

ii. For a body, the accounting year of the body; or

iii. A transitional accounting year as determined under Article 28 of the

proclamation.

Article 2(a) and (b) envisage that the tax year is a twelve months’ period. However,
Article 2(c) provides for a shorter than twelve months’ period in the case of a
transitional accounting year which potentially arises when the accounting year of a
taxpayer changes either as a result of approval by the Ministry (Article 28(3)) or a
revocation of the approval by the Ministry (Article 28(4)). The period between the last
full accounting year prior to the change and the date on which the new accounting
year commences is treated as a separate accounting year referred to as a
“transitional accounting year” This is illustrated in the scenario below; Auditors are
therefore required to ensure that taxpayers fully account for tax during those periods
of transition.

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Scenario

B Limited incorporated in Ethiopia and has an accounting year ending 31/12/….and is a

subsidiary of A Limited incorporated in Kenya whose accounting date is 30/06/…. The
parent company A Limited, is required to prepare consolidated financial statements to
include its subsidiary (B Limited) in accordance with IFRS. This will require the subsidiary B
Limited to align its accounting year to that of its parent, A limited.

As a result of the above requirement, B limited applies under Article 28(3) of the
Proclamation to change its accounting year to 30/06/…. from 31/12…The application is
granted effective 01/07/2018. B Limited’s first accounting year after the change is
01/07/2018 to 30/06/2019.

Determine the transitional accounting year and its implication for tax purposes.

Solution;

The transitional accounting year is the period of six months from 01/01/2018 to
30/06/2018. This is the period between the last full accounting year (01/01/2017 to
31/12/2018) prior to the change and the date on which the new accounting year commences
(01/07/2018).

This six months’ period is treated as a separate tax year and B limited will be subject to tax
during the six months’ period.

6.1.1 Rental Income Tax

Rental Income Tax is imposed under article 13(1) of the Federal Income Tax
Proclamation and provides that, rental income tax shall be imposed for each tax
year at the rate or rates specified in Article 14 of this proclamation on a person
renting out a building or buildings who has taxable rental income for the year.

Article 13(1) lays down four fundamental principles for imposition of rental income
tax. These are discussed below:

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a. Imposition of tax is on the person renting a building or buildings.

The preamble to article 2 of the Federal Income Tax Proclamation read together with
article 2(26) of the Federal Tax Administration Proclamation define a person to
mean, an individual, body, government, local government, or international
organization. Article 2(5) of the Federal Tax Administration Proclamation defines a
body to mean, a company, partnership, public enterprise or public financial agency,
or other body of persons whether formed in Ethiopia or elsewhere.

Auditors are therefore required to look out for entities other than natural persons to
determine if they have accounted for rental income tax.

b. The person referred to in (a) above should have taxable rental income.
Article 15(1) provides that the taxable rental income of a taxpayer for a tax year is
the gross amount of income derived by the taxpayer from the rental of a building
for the year reduced by the total amount of deductions allowed to the taxpayer
for the year.

Article 15(2) and 15(3) define gross income (rental). Of particular importance is that
the gross income excludes exempt income in the terms of article 15(4).

Derivation in reference to rental income means for a taxpayer accounting for tax on
accrual basis, the arising of the right to receive or for a taxpayer accounting for tax
on a cash basis, received in the terms of article 2(5) of the Proclamation.

Article 15(5) determines deductions available for taxpayers who are not required
to maintain books of account (article 15(6)). These are:

a. Any fees and charges, but not tax, levied by a State or City Administration in
respect of the land or building leased and paid by the taxpayer during the year.

b. An amount equal to fifty percent (50%) of the gross rental income derived by
the taxpayer for the year as an allowance for the repair, maintenance, and
depreciation of the building, furniture and equipment.

On the other hand, where the taxpayer is required to maintain books of

account, article 16(7) provide for deductions as; cost of the lease of land on

74
 which the building is situated; repairs and maintenance; depreciation of the
building, furniture and equipment; interest and insurance premiums; and fees
and charges, but not tax, levied by a State or City Administration in respect of
the land or buildings leased.

c. The tax is imposed for each tax year.

Unlike employment income tax, rental income tax is imposed for a tax year in
accordance with the rates provided by Article 14. A body is liable to tax 30% while
individuals are liable to rates provided in the schedule to article 14(2).

Tax year is defined by article 2(21). See discussion under business income tax head
for details. In addition, Article 21(1) of the regulations provide for prorating of rental
income received by a lessor or sub-lessor for a period exceeding one year. In this
case, the rental income shall be that amount that relates to a particular tax year.

Scenario

Peter rents his commercial premises to X Limited. During the year ended 30/06/2016, his
tenant paid rent for 2.5 years of 100,000bir. Determine the amount of rental income to be
included in Peter’s tax computation for year ended 30/06/2017.

100,000/2.5= 40,000 birr (Is the amount that will be subject to tax during the tax year
ended 30/06/2017 and not 100,000.

d. Rental tax is imposed on residents on their worldwide rental income. This

implies that foreign rental income derived from a building(s) located outside Ethiopia
will be subject to tax in Ethiopia where they are rented by a resident in accordance
with article 7(1) of the Proclamation.

Accordingly, should the person pay tax on foreign rental income, a credit of the tax
paid will be allowed on the rental income tax payable on the foreign rental income in
the terms of Article 25 of the Regulations. Auditors are required to check taxpayer
details to establish especially through interviews whether they have rental properties

75
located outside the country in order to bring to charge the income arising therefrom.
The principles of taxation of foreign rental income are illustrated in the scenario
below:

Scenario

Moses a resident (tax) of Ethiopia has rental property on plot 44 King George Street
Kololo, an upscale residential area in Kampala (Uganda). He receives an annual taxable
rental income (after deductions) of 3,240,000 Birr on which he pays rental tax in Uganda
of 518,400 Birr (A)

Determine his rental tax liability in Ethiopia for the year ended 30/06/2017.

Taxable rental income 3,240,000

Tax due (3,240,000*35%) (B) 1,134,000

Less tax credit (Lessor of A & B) 518,400

Tax payable in Ethiopia 615,600

e. Others- treatment of subleases: Rental income tax includes income received

from sublease of buildings. In other words, a lessee who undertakes to sub-lease, is
liable for rental income tax on the difference between the income sublease income
and rentals paid to the owner of the building in the terms of Article 16(1) of the
Proclamation. Where the sub- lesser fails to account for rental income tax, the owner
of the building shall be liable in accordance with Article 16(2).

Auditors are accordingly required to check if the premises are subleased and
determine rental tax on the sub-lease. This could be a potential source of tax
leakage.

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6.1.2 Other Income, Schedule D

6.1.2.1 Income of non – residents

A non-resident who has derived an Ethiopian source dividend, interest, royalty,

management fee, technical fee, or insurance premium shall be liable for non-resident
tax at the rate specified bellow and in case of a permanent establishment in Ethiopia
it is not apply to a dividend, interest, royalty, management fee, technical fee, or
insurance premium that is attributable to a business carried on by the non-resident
through a permanent establishment in Ethiopia and, in that case, the amount shall be
taxable under Schedule ‘C” or ‘D”, as the case may be.

The rate of non-resident tax is:

a. for an insurance premium or royalty , 5% of the gross amount of the premium

or royalty;
b. for a dividend or interest, 10% of the gross amount of the dividend or interest;
c. for a management or technical fee, 15 % of the gross amount of the fee.

6.1.2.2 Taxation of recharged Technical fees and Royalties

“Technical fee” means a fee for technical, professional, or consultancy services,

including a fee for the provision of services of technical or other personnel.

1) the tax proclamation shall apply when the following conditions are satisfied:

a. a non-resident supplies technical services or the lease of equipment other

than through a permanent establishment in Ethiopia;

b. the technical services are supplied, or equipment leased, to a person

(referred to as the “recipient”) who is:
i. a resident of Ethiopia, other than in relation to a business conducted by
the resident through a permanent establishment outside Ethiopia; or
ii. a non-resident conducting business in Ethiopia through a permanent
establishment;

c. the technical fee or royalty in respect of the supply or lease is paid to the
non-resident by another non-resident that is a related person of the
recipient;

77
 d. the technical fee or royalty is recharged by the related person to the
recipient.

2) the Proclamation shall apply as if the related person is supplying the technical
services or leased equipment to the recipient and the recharged amount is the
technical fee for the services or royalty for the leased equipment.

6.1.2.3 Taxation of non-resident Entertainers

1) A non-resident entertainer or group of non-resident entertainers who has

derived income from the participation by the entertainer or group in a
performance taking place in Ethiopia shall be liable for income tax at the rate
of 10% on the gross income derived from the performance without deduction
of expenditures.

2) When the income for a performance by an entertainer, including as member of

a group, is derived not by the entertainer but by another person, this shall
apply to the gross income derived by that other person.

3) In this:

a. “entertainer” includes musician and sports person;

b. “group” includes a sporting team; and

c. “performance” includes a sporting event.

6.1.2.4 Royalties

“Royalty” is defined broadly. The definition follows international norms and is

consistent with the definition commonly found in tax treaties.

In this:

A resident of Ethiopia who derives a royalty shall be liable for income tax at the rate
of 5% on the gross amount of the royalty.

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A non-resident who derives an Ethiopian source royalty that is attributable to a
permanent establishment of the non- resident in Ethiopia shall be liable for income
tax at the rate of 5% on the gross amount of the royalty.

6.1.2.5 Dividends

“Dividend is defined to mean a distribution of profits by a body to a member. “Body” is

defined in Article 2(5) of TAP and includes a company, partnership, or other body of
persons. “Member” is defined in Article 2(20) of TAP and means a shareholder in
company, partner in a partnership, and any other person with a membership interest
(i.e. ownership interest) in a body.

The rate is:

1) A resident of Ethiopia who derives a dividend shall be liable for income tax at
the rate of 10% of the gross amount of the dividend.

2) A non-resident who derives an Ethiopian source dividend that is attributable to

a permanent establishment of the non- resident in Ethiopia shall be liable for
income tax at the rate of 10% on the gross amount of the dividend.

6.1.2.6 Interest

Interest is defined to mean an amount that is consideration for the use of money or
for being given time to pay. The main examples are interest paid by a financial
institution on deposits with the institution or paid by a company on debentures issued
by the company. However, the definition is broad and includes interest paid on any
loan no matter who the lender is. The focus is on the character of the return derived
on a transaction as interest and not on the character of the recipient.

In this:

1) A resident of Ethiopia who derives interest shall be liable for

income tax at the rate of:

a. in the case a savings deposit with a financial institution that is a resident of

Ethiopia, 5% of the gross amount of the interest; or

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 b. in any other case, 10% of the gross amount of the interest.

2) A non-resident who derives Ethiopian source interest that is

attributable to a permanent establishment of the non-resident in
Ethiopia shall be liable for income tax at the rate of:

a. in the case a savings deposit with a financial institution that is a resident of

Ethiopia, 5% of the gross amount of the interest; or
b. in any other case, 10% of the gross amount of the interest.

6.1.2.7 Income from games of chance

“Games of chance” means a game whose outcome depends primarily on chance

rather than the skill of the participant, including a lottery or tombola.

1) A person who derives income from winning at games of chance held in Ethiopia
shall be liable for income tax at the rate of 15% on the gross amount of the
winnings.

2) In computing the gross amount of winnings no deduction shall be allowed for

any loss incurred by the person from games of chance.

3) This shall not apply when the winnings are less than 1000 Birr.

6.1.2.8 Income from casual rentals

1) A person who derives income from the casual rental of asset in Ethiopia
(including any land, building, or movable asset) shall be liable for income tax
on the annual gross rental income at the rate of 15% of the gross amount of
the rental income.

2) This Article shall not apply to income that is a royalty taxable

under Article 51 or 54 of the income tax Proclamation.

6.1.2.9 Gain on disposal of certain investment assets

1) A person who derives a gain on the disposal of immovable asset, a share, or

bond (referred to as a “taxable asset’) shall be liable to pay income tax at the
rate specified bellow;

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2) The rate of income tax shall be:

a. for a class ‘A’ taxable asset, 15%;

b. for a class ‘B’ taxable asset, 30%.
3) The amount of a gain on disposal of a taxable asset by a person shall be the
amount by which the consideration for the disposal of the asset exceeds the
cost of the asset at the time of disposal.

4) If a person makes a loss on disposal of a taxable asset during a tax year, the
loss shall be recognized and be available to offset a gain on disposal of a
taxable asset of the same class during the year subject to the following:

a. the loss may be used only to offset gains.

b. the unused amount of a loss can be carried forward indefinitely for
offset against gains on disposal of taxable assets of the same class
until fully offset;
c. no loss is recognized on the disposal of a taxable asset by a person to
a related person;
d. the person has substantiated the amount of the loss to the satisfaction
of the Ministry.
5) The amount of a loss on disposal of a taxable asset is the amount by which
the cost of the asset at the time of disposal exceeds the consideration for the
disposal.

6) Article 35 of the income tax Proclamation shall apply when the taxable asset
transferred is also a business asset.

7) Subject to, the gain on disposal of a business asset included in business

income is the amount by which the consideration for the disposal of the asset
exceeds the net book value of the asset at the time of disposal.

8) If a business asset is a taxable asset under Article 59 of the income tax

Proclamation:

a. the gain on disposal of the asset included in business income is the

amount by which the cost of the asset exceeds the net book value of
the asset at the time of disposal; and

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 b. any gain above cost is taxable under Article 59 of the income tax
Proclamation:

In this:

a. “immovable asset” shall not include a building held and wholly used as a
private residence for 2 years prior to the disposal of the asset;

b. “Class ‘A’ taxable asset” means immovable asset; and

c. “Class ‘B’ taxable asset” means shares and bonds.

6.5 Value Added Tax

6.5.1 Introduction

Value Added Tax (VAT) is administered by the Value Added Tax Proclamation No.
285/2002 as the primary legislation and Regulations thereof (No. 79/2002) the
subsidiary legislation. Article 64 of the VAT proclamation requires the Council of
Ministers to issue regulations for the proper interpretation of the Proclamation.
Accordingly, auditors are required at all times to make reference to the said
regulations for interpretation of the relevant articles of the Proclamation.

VAT is tax on value addition/ turnover (not on profits) and is imposed at every stage
of the value chain. It is expected to be charged on a markup (cost plus). VAT is an
indirect tax that is naturally borne by the consumer with the registered taxable
persons as a collecting agent for government.

VAT therefore unlike income tax, is not charged on profits but on taxable
transactions made by registered persons. This is a very important distinction in
the sense that traders cannot claim not to have made profits as an excuse for failure
to account for VAT. This implies that a taxpayer making business losses and has no
taxable profits would be required to account for VAT provided that they have made
taxable sales (transactions).

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6.5.2 Imposition of Value Added Tax

Article 7 of the VAT Proclamation provides that subject to the provisions of this
proclamation and subject to Sub-Article (2), there shall be levied and paid a tax,
to be known as value added tax, at the rate of 15 percent of the value of-

a) every taxable transaction by a registered person; and

b) every import of goods, other than an exempt import; and

c) an import of services as provided in Article 23.

This Article is the foundation on which Value Added Tax is premised. The discussion
below highlights the principles laid down by the said Article.

6.5.2.1 Taxable transaction

Imposition of tax is on a taxable transaction and not on a person as is in the case

of income tax (Business, Rental and Employment) and it therefore underpins the
concept that VAT is a transactional tax. This means that the tax burden is borne by
the consumer of the transaction/service and the registered person is simply an
intermediary for Government as a collection agent.

A taxable transaction is a supply of goods or a rendition of services in Ethiopia

in the course or furtherance of a taxable activity other than an exempt supply, in
the terms of Article 7(3).

Arising from the above, not all supply of goods and rendition of services by a
registered person are taxable transaction unless they are made or rendered in
Ethiopia. Article 9 and 10 of the Proclamation sets out rules on the supplies made in
Ethiopia and are summarized as hereunder.

The supply (goods and rendition of services) occurs in Ethiopia if:

a. It is a supply of goods that involves transportation provided the goods are

located in Ethiopia when their transportation commences. This implies that
where a supply is made by a registered person of goods located outside

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 Ethiopia that require transportation to a location outside Ethiopia, this
supply is outside the scope of VAT and is not a taxable transaction.
Conversely, where the supply is made by a registered person of goods
located in Ethiopia that require transportation to a location outside Ethiopia,
this supply is a taxable transaction and is charged at zero percent as an
export of goods in the terms of article 7(2)(a) of the proclamation.

b. It is a supply of goods that does not require transportation, provided the

goods are transferred in Ethiopia by the registered person. Transfer of the
goods occurs for instance at the point of sale, say at the trader’s premises.

c. It is a supply of electric or thermal energy, gas, or water, provided these

supplies are received in Ethiopia.

d. It is a supply of services (rendition of services), provided the supplier renders

the services from a location in Ethiopia. See details under article 10 of the
proclamation.

Time of supply rules: It is a requirement that the supply of goods or rendition of

services occurs (place of supply rules) in Ethiopia for the supply to pass as a taxable
transaction. However, the timing of the supply is important in determining when
(accounting period- Calendar month) it should be accounted for by the registered
person. Article 11 of the Proclamation and Article 6 of the regulation determine when
a supply is made.

Supply of goods and rendition of services has meaning assigned to it by Article 4

of the Proclamation. Auditors are accordingly required to study the rules governing
supply of goods and services in order to ascertain whether the transaction should be
brought to the tax bracket. Importantly, the supply (goods/ services) should be made
in the course or furtherance of a taxable activity. This means that a supply of goods
or services which is not made in the furtherance of a taxable activity should not be
brought to tax.

Article 6 defines a taxable activity to mean an activity which is carried on

continuously or regularly by any person in Ethiopia, or partly in Ethiopia

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whether or not for a pecuniary profit, that involves or is intended to involve, in
whole or in part, the supply of goods or services to another person for
consideration. Article 4 of the Proclamation determines when there is a supply of
services or goods.

Article 4(2) of the Regulation excludes the following from taxable activity:

a. An activity carried on by a natural person essentially as a private

recreational pursuit or hobby or an activity carried on by a person other
than a natural person which would, if carried on a by a natural person, be
carried on essentially as a private recreational pursuit or hobby; or

b. An activity to the extent that the activity involves the making of exempt
supplies.

However, anything done in connection with the commencement or termination of a

taxable activity is treated as carried out in the furtherance of that taxable activity
(Article 4(1) of the Regulations).

It is on the above basis that a taxpayer cannot claim to be liable for VAT for of lack of
profit on a particular transaction or on existence of business losses. Auditors are
therefore particularly required to confirm that loss making entities account for VAT,
where it is due.

In addition, the foregoing article envisages that VAT only accrues on an activity
that occurs in Ethiopia. This is unlike income tax that considers taxation of
global business activity especially for resident persons (taxpayers). For instance,
while a resident of Ethiopia is liable for rental tax on properties outside Ethiopia (see
discussion on rental income tax above), VAT would be out of scope (the rental
income is not subject to VAT in Ethiopia) since the rent of property (activity) is
outside Ethiopia.

Lastly, the article requires that for VAT to arise the taxable transaction must be
made by a registered person. The proclamation does not define a registered
person although it variously refers to it. However, section 5 of the Proclamation that
deals with “registration of persons” could in essence allude to a person (natural

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person, sole proprietor, body, joint venture, or association of persons including a
business representative residing and doing business in Ethiopia on behalf of the
principal) registered for VAT.

6.5.2.2 6.5.2.2 Imposition (levy)

The imposition (levy) of tax at the rate of 15% under this Article is subject to the
Proclamation and in particular to sub article 2 which prescribes at rate of Zero
percent (0%) on particular transactions. This implies that VAT is charged/ levied at a
standard rate of 15% or 0% as the case may be. It should be noted that a zero rate
of tax is not the same as no tax. This implies that a person who for instance deals in
zero rated supplies will account for VAT at zero percent but will be entitled to claim
inputs incurred. This would perceptually put this person in a refundable position.
Auditors are particularly required to examine the transactions to verify if they
qualify for zero rating as this is a potentially an area for revenue leakage.

6.5.2.3 Import of goods

VAT is imposed on an import of goods. Import means bringing goods in Ethiopia

according to the customs legislation (Article 2(9)). However, VAT does not arise on
exempt imports. Article 8(2) of the Proclamation spells out the imports that are
treated as exempt.

6.5.2.4 Import of services

Lastly, VAT is imposed on the import of services (except exempt services). This is
charged under the reverse taxation regime. Under reverse taxation, it is the receipt
of the services that accounts for VAT, i.e. deemed to be the taxpayer. Ordinarily,
VAT is accounted for by the supplier. Article 23 provides a set of comprehensive
rules that this manual simplifies as hereunder;

a. The services should have been rendered in Ethiopia by a non-resident

supplier who is not registered for VAT in Ethiopia. Where the non-resident
supplier is registered for VAT, the normal rules will apply. In other words, they
will be required to charge their customers VAT on the supply and account for
the VAT on their tax returns.

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b. Where the imported services are made by a nonresident person (supplier)
to any registered person in Ethiopia (customer) the registered person shall
withhold the tax from the amount payable to the non-resident. In other words,
the registered person (recipient) shall charge the supplier and account for the
VAT (reverse taxation). However, the payment (tax withheld) is a credit to the
registered person (recipient) and gives the person the right to VAT credit
under Article 21 of the Proclamation.

c. Where the imported services are made by a non-resident person (supplier) to

resident legal person (customer), the customer is required to withhold tax
and pay the amount withheld within 30days of the date of payment to the non-
resident. This implies that even unregistered resident legal persons are
required to account for tax imported services. However, this non-registered
person cannot claim a refund of the VAT but the amount is included in the
cost and is claimed as a business expense.

d. Where the import of services is attributable to lease rentals of imported

property, the lessee (importer) will be liable for VAT at importation of the
leased property. The VAT paid by the lessee can be claimed as input VAT.
The lessee is treated as the taxpayer and is responsible for VAT payable
upon the subsequent supply of the property. However, the lease rentals will
be subject to tax taxation as in b and c above.

e. Where the non-resident supplier of services pays the tax, the customer
(recipient) of the services is not required to withhold tax. This could be an area
for fraudulent dealings by the taxpayers. A taxpayer may decide to claim input
tax paid by their non-resident supplier on the imported goods and this would
certainly be fraudulent. Auditors are particularly required to examine
documents that involve imported services to ensure that taxpayers are
not claiming amounts they have not paid.

f. Where the service is rendered by a related party, the value of the import for
purposes of VAT payable is the market value (Article 12(1) of the regulations).
This is an anti-tax avoidance provision intended to reduce tax leakage through

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 tax planning schemes where a related party under or over invoices to claim
tax benefits.

Scenario- Reverse taxation

A limited is incorporated and resident in Kenya. The company offers management
consultancy services and lease of road construction equipment. The company will
supply consultancy services and lease of equipment to B limited a 100% subsidiary
resident in Ethiopia.

A Limited Charges Birr 200,000 for the services and lease rental of Birr 100,000. The
market value of similar services is 300,000 and 150,000 for management charge and
lease rentals.

Required:
Determine the tax treatment of the above if B limited is

a. VAT registered
b. Is not VAT registered and
c. The construction equipment is imported and VAT at importation is Birr 15,000.

Solution

a. B is VAT registered. B will charge VAT on Birr 300,000 and 150,000 for the
services and lease rentals respectively. The VAT charged is a creditable input for
B Limited and will be offset from their output VAT. VAT paid of Birr 15,000 at
customs (import) is creditable to B limited.
b. B is Not VAT registered. B is still required to charge VAT as in a and b above but
will not be required to claim the said VAT and VAT on importation of the
construction equipment.

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6.5.3 Computation of tax payable

The determination of tax payable for an accounting period is the difference between
the tax charged on taxable transactions and creditable amount (tax credit). (VAT on
sales less VAT on purchases).

It is important to note that for an amount to be creditable, it should be in respect of

goods and services used or are to be used for the purpose of the registered
person’s taxable transactions. Accordingly, where the registered person uses the
good or services for private expenditure, no credit will be allowable for such inputs.

Further note that creditable tax will be apportioned where only part of the registered
persons supplies (sales) are taxable transactions as follows;

a. Where the supply (purchase) can be directly attributable to a taxable

transaction (sales), the full amount of the supply /import is allowed.

b. Where the supply (purchase) is directly attributable to an exempt transaction,

no amount of VAT on the purchase shall be creditable.

c. Where the supply is attributable to both taxable and exempt transactions

(sales), the tax on the purchases shall be apportioned. Article 21(2)(c),
requires that the minister to issue a directive on the methodology of
apportionment.

Article 21(3) includes items for which VAT is NOT creditable. Auditors are
particularly required to examine whether the amount of VAT claimed is
creditable. This is an area where taxpayers either knowingly or unknowingly
evade taxation (VAT) reduce VAT liability by claiming uncreditable tax.

Further auditors are required to examine rules pertaining to “value of a supply”

provided by article 12 of the Proclamations and 7 of the regulations to ensure that
the correct value is taken into account. This includes rules on adjustments made to
taxable transactions under Article 13 of the proclamation. This is potentially a
technical area that taxpayers are likely use to fraudulently reduce their liability. For
instance, a taxpayer who purchases goods and later returns part of the said goods to

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the supplier, may deliberately refuse to adjust the input tax previously claimed even
when the supplier has issued a credit note.

6.5.4 Understatement of VAT by taxpayers, key pointers for auditors’

VAT is one tax head that taxpayer easily evade to reduce their exposure. Auditors
are accordingly required to be extra cautious while conducting tax audits. Below are
some of the tools taxpayers deploy to evade VAT.

a. Understatement of sales by traders. This happens especially where sales are

made to final consumers who have no interest in claiming VAT. However,
where cash registers are effectively deployed, used and monitored, the risk
may be significantly reduced.

b. Overstatement of creditable tax (inputs). This is likely to occurs when the

taxpayer claims;

i. VAT attributable to exempt sales.

ii. Other non-creditable inputs highlighted by article 21(3).

iii. VAT in full that is attributable to both taxable and exempt transactions.
Taxpayers are required to apportion the VAT on purchases.

iv. VAT attributable to non-business use, for instance groceries purchased for
home consumption.

v. VAT in full even where credit notes are issued following a cancellation of a
transaction, alteration of the supply or issuance of discounts.

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7 Business structures

7.1 Introduction

The purpose of this chapter is to introduce the different vehicles that taxpayers use
in trade. These include incorporated bodies, Partnerships, Joint ventures, branch of
a non-resident company, sole proprietor ships among others.

The accounting framework for each of these vehicles differs. Noting that taxation sits
on an accounting framework, it is important that auditors are introduced to the
features of each of these business structures in order to lay a foundation for
appropriate audit procedures.

Furthermore, chapter eight deals with taxation accounting(practical aspects of how

different business structures are expected to account for tax) of the various
business structures and introducing the business structures a head of this simplifies
the complexities associated with taxation accounting for each of the said structures.

7.2 Company

These may either be private or public limited companies difference being in the
minimum number of shareholders required by each company type. Importantly is that
they are limited by shares as opposed to companies limited by guarantee, which are
likely not to be trading entities.

The shareholders are the owners of the company and appoint directors (stewards) to
manage the day to day running of the business. This is an important distinction in the
sense that a shareholder is not taxed on company proceeds unless they receive a
dividend. However, company directors are essentially employees of the company
and will be entitled to emoluments of employment and are subject to employment
income tax.

A trading company unlike a business run by a sole proprietor cannot be seen to have
incurred a private expenditure even when it finances say a private expenditure of an
employee. Such costs would naturally be allowable deductions to the company for

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tax and accounting purposes but would be taxable on the recipient of the benefit as
an emolument of employment.

The shares of the company are capital and should not be brought to the ambit of
taxation and they should neither be treated as an allowable expense. Article 27(1)(b)
provides that an increase in share capital of a company is not an allowable expense.
However, the auditor would be interested in establishing the source of financing of
the shareholding held by the individual shareholders. The auditor would then assess
whether the sources from which the shareholding is sourced were taxed and if not
should bring the capital contribution to taxation in the hands of the individual
shareholder and not the company.

A company as reflected on its balance sheet owns assets but may also lease assets
for its trade. The assets held (owned) by the company are reflected on its balance
sheet. This is not the case for assets leased or rented except in the case of a finance
lease. The assets held by the company are entitled to wear and tear (depreciation)
which is an allowable expense for both financial and taxation reporting, with variation
in the rates of depreciation applied during the year.

Since depreciation of assets is expected to reduce the company tax through

deduction of depreciated amounts, auditors are required to confirm whether assets
on the balance sheet exist, are owned by the company and the cost declared is
ascertainable before grant of deduction of depreciation allowances.

A company will have liabilities on its balance sheet. These are obtained for the
purpose of running the company’s business for example trade creditors and long
term loans. These amounts are also capital in nature and should not be brought to
the ambit if taxation. However, care should be taken to establish that sales are not
disguised as creditors since they both have credit balances. The trail balance and
the balance sheet will “balance” whether the sales are recorded as sales or creditors.
Accordingly, auditors are required to check that no sales are hidden under creditors.

Creditors will usually come with a cost to the company, say interest and this is an
allowable deduction. Auditors are accordingly, required to confirm that the company
is not holding fictitious creditors just to claim undue interest expenses. It is also likely

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that the company may disguise shareholding as loans to partake of interest
expenses. Auditors are required to check that shareholding is not disguised as loans
by requesting for loan agreements.

A company especially a non-resident (see chapter 6 above) may operate through a

branch, technically known as a permanent establishment. While the branch and the
company are technically one person, for taxation purposes, branch in Ethiopia would
be treated as a separate entity from the company and is liable for taxation on income
sourced in Ethiopia.

Conversely, an Ethiopian resident company that operates through a branch in

another tax jurisdiction, is liable for tax on its global income. This implies that the
profits of the branch accruing from another tax jurisdiction would be brought to the
ambit of taxation in Ethiopia.

7.3 Partnerships

A partnership is an association of two or more individuals pooling resources to

finance business interests with a view to profit. Partners’ capital in the business is
the basis for share of the profits earned or losses made and is equally non allowable
as an expense in the terms of Article 27(1)(b).

In some tax jurisdictions, Partnerships are tax transparent. In other words, they are
not subject to taxation on the Partnerships profits. Instead, the individual partners are
liable for taxation. This is not the case in Ethiopia. Partnerships are liable to taxation
as in the case of companies. This implies that appropriation of the partnerships’
income is after accounting for tax. Auditors are particularly required to take this into
account. Article 27(1) (d) is instructive and provides that, except as provided for in
this Proclamation, no deduction is allowed for the following, dividends and paid-out
profit shares.

The implication of the above is that the share of the partnerships’ residual profits
after tax is a dividend taxable on the partners. Article 2(6)(b) of the Income Tax
Proclamation provides that, dividend means a distribution of profits by a body to a
member… Article 2(5) defines a body to mean a company, partnership public

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enterprise or public financial agency, or other body of persons whether formed in
Ethiopia or otherwise.

7.4 Sole proprietorship

This is where a business is neither incorporated as a company nor trading as a

partnership. The owner of the business trades under their name. This is a very
common business practice and often times accounts for the majority of business
structures.

There is often a very thin line between the owner and the business. Unlike
incorporated bodies that have shareholders as separate from the company, this is
not the case for a sole proprietor.

In dealing with the company as a form of business structure, it was noted that the
company is not envisaged to have private expenditures. This is not the case with a
sole trader as private expenses are not tax deductible expenses. Article 27(1)(i)
provides that, except as provided for in this Proclamation, no deduction is allowed for
personal consumption expenditure. A body, unlike an individual would have, does
not have personal consumption expenditure.

Arising from the above, private expenditure is expected to be an area where sole
traders evade taxation by claiming personal consumption expenses. This is in
addition to suppressing their income. Accordingly, auditors are expected to check
expenses of the sole trader to ensure that they are incurred in furtherance of the
business.

It would therefore be common to have private assets such as a motor vehicle

running personal errands of the business owner reflected on the balance sheet and
claiming undue depreciation allowances.

One uncommon method of checking that the sole trader is correctly accounting for
income and expenses is through a life style audit. It would be worthwhile checking to
verify that the private life style of the sole trader such cost of vehicle, housing and
the type of schools the children attend among others is commensurate with the
business tax returns of the individual taxpayer.

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7.5 Franchise

Franchising is simply a method for expanding a business and distributing goods and
services through a licensing relationship. In franchising, franchisors (a person or
company that grants the license to a third party for the conducting of a business
under their marks) not only specify the products and services that will be offered by
the franchisees (a person or company who is granted the license to do business
under the trademark and trade name by the franchisor), but also provide them with
an operating system, brand and support.

Business Format Franchising

There are two different types of franchising relationships. Business Format

Franchising is the type most identifiable to the average person. In a business format
franchise relationship the franchisor provides to the franchisee not just its trade
name, products and services, but an entire system for operating the business. The
franchisee generally receives site selection and development support, operating
manuals, training, brand standards, quality control, a marketing strategy and
business advisory support from the franchisor.

Traditional or Product Distribution

While less identified with franchising, traditional or product distribution franchising is

actually larger in total sales than business format franchising. In a traditional
franchise, the focus is not on the system of doing business, but mainly on the
products manufactured or supplied by the franchisor to the franchisee. In most, but
not in all situations, the manufactured products generally need pre- and post-sale
service as found in the automobile industry. Examples of traditional or product
distribution franchising can be found in the bottling, gasoline, automotive and other
manufacturers.

Franchising is about Brands

A franchisor’s brand is its most valuable asset and consumers decide which
business to shop at and how often to frequent that business based on what they

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know, or think they know, about the brand. To a certain extent consumers really
don’t care who owns the business so long as their brand expectations are met. If you
become a franchisee, you will certainly be developing a relationship with your
customers to maintain their loyalty, and most certainly customers will choose to
purchase from you because of the quality of your services and the personal
relationship you establish with them.

Franchising is about Systems and Support

Great franchisors provide systems, tools and support so that their franchisees have
the ability to live up to the systems brand standards and ensure customer
satisfaction. And, franchisors and all of the other franchisees expect that you will
independently manage the day-to-day operation of your businesses so that you will
enhance the reputation of the company in your market area. Some of the more
common services that franchisors provide to franchisees include: A recognized
brand name, Site selection and site development assistance, Training and
management team, Research and development of new products and services,
Headquarters and field support, Initial and continuing marketing and advertising.

Franchising is also a Contractual Relationship

While from the public’s vantage point, franchises look like any other chain of branded
businesses, they are very different. In a franchise system, the owner of the brand
does not manage and operate the locations that serve consumers their products and
services on a day-to-day basis. Serving the consumer is the role and responsibility
of the franchisee.

Franchising is a contractual relationship between a licensor (franchisor) and a

licensee (franchisee) that allows the business owner to use the licensor’s brand and
method of doing business to distribute products or services to consumers. While
every franchise is a license, not every license is a franchise under the law.
Sometimes that can be very confusing.

In exchange, the franchisee usually pays the franchisor a one-time initial fee (the
franchise fee) and a continuing fee (known as a royalty) for the use of the

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franchisor’s trade name and operating methods. The franchisee is responsible for
the day-to-day management of its independently owned business and benefits or
risks loss based on its own performance and capabilities.

7.6 Joint Venture

A joint venture is a grouping of people arising out of a partnership agreement, which

is also known as a joint venture agreement in which two or more persons combine
their labor and/or capital for the purpose of carrying out economic activities and
participating in the profits and losses arising according to proclamation number 166
of 1960 (Art.271 cum 211). The joint venture is the simplest form of business
organization. Joint ventures, more often than not, are used for a single transaction or
project, or a related series of transaction or project. Although joint ventures can
hardly be adapted to industrial enterprises, commercial transactions in which great
amount of capital are involved are often dealt with by joint ventures. Large
organizations often investigate new markets or new ideas by forming joint ventures.
Joint ventures have the following merits:
1. Transactions or projects can remain secret by virtue of the secretive nature of the
organization;

2. Joint ventures are exempted from registration, unlike the remaining legal forms of
business organizations.

Characteristics of joint ventures

A joint venture, being one variant of partnerships, is subject to the general principles
of law relating to partnerships [Art.271]. Exceptions to the application of partnership
principles to joint ventures include the following:

1. A joint venture is not made known to third parties. What is more, a joint
venture agreement need not be in writing and is not subject to registration
(Art. 272)

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 2. A joint venture does not have legal personality [Art. 272(3)]. Thus, it is not
going to be considered as a legal entity. That is to say, a joint venture may not
have a firm-name; may not enjoy ownership right over the capital; may not
incur liabilities; may not have a head office; cannot sue or be sued in its firm-
name; cannot be declared bankrupt.

One general principle of law relating to partnership is such that any business
organization other than a joint venture must not be made known to third parties.
[Art.219 (1)]. Also, sub-article (1) of art. 272 provide that a joint venture is not made
known to third parties. Nevertheless, where a joint venture is made known to third
parties, it shall be deemed, insofar as such parties are concerned, to be an actual
partnership [ art. 272(4)].

The joint ventures may conclude a contrary agreement as regards ownership of their
contributions. First, they may provide for transfer of title over their contributions to the
manager. Therefore, the manager will become the owner from the moment the
venturers explicitly or implicitly show that they want to transfer ownership. In case of
cash contributions, the manager becomes owner thereof. Anyway, the manager is
duty-bound to use the goods placed at his disposal exclusively for the business
purposes of the joint venture. Second, the joint venturers are at liberty to provide for
a regime of co-ownership pertaining to their contributions, thereby rendering each
venture a co-owner of the common property.

The transfer of capital assets into a joint venture company will potentially give rise to
a charge to capital gains tax or corporation tax on chargeable gains for the
shareholder making the transfer. Depending upon the nature of the assets
transferred and the tax position of the shareholder making the transfer, exemptions
or reliefs from tax or deferrals of the tax liability may be available.

The transfer could also give rise to a VAT liability. If the asset transferred is a
business or a let property it may be treated as a transfer of a going concern for VAT
purposes which would mean that VAT would not be payable by the joint venture
company.

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If the joint venture company is to be funded by way of loans from the shareholders,
various anti avoidance provisions could prevent the joint venture company obtaining
a tax deduction for the interest paid. These include the transfer pricing provisions,
which restrict tax reliefs for payments between connected parties to the amount that
would have been payable on an arm's length basis. The transfer pricing provisions
can apply in relation to loans even if the interest rate is what an independent third
party lender would have charged. They can apply if a loan between connected
parties exceeds the amount that would have been lent to the joint venture company
by an independent third party.

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8 Taxation Accounting

8.1 Introduction

This chapter builds on chapters six and seven. It aims to illustrate from a practical
perspective how a taxpayer is expected to account for tax in accordance with the
Proclamations and the regulations thereof.

Additionally, this chapter is a launch pad to chapter nine, ten and eleven (audit
planning, execution and completion). A robust tax audit plan is informed by a
thorough understanding of the taxpayers’ obligation to tax, in order to identify key tax
risks presented by the financial statements and other relevant information. Inevitably
a robust audit plan sets the stage for a meaningful audit program (execution and
conclusion).

Reference to taxpayer in this chapter means a person who is required to pay tax
either through withholding, for instance employment income tax, by direct
imposition on income, such a business income tax, on transaction such as Value
Added Tax (VAT) and Excise Tax. In this case, the person may be a sole
proprietorship (natural person), a company, a partnership or a branch of a non-
resident company.

Depending on the nature of transactions (Vatable or Excisable), volume and nature

of business, all the above mentioned persons (taxpayer’s/trading vehicles) will be
required to account for income tax (Business, Employment and Rental Income Tax),
VAT and Excise tax.

Cognizant of the obligation to account for Income Tax, VAT and Excise by each of
the above mentioned persons’/ business vehicles/taxpayers, this chapter
comprehensively covers taxation accounting under the umbrella of “company” as the
business vehicle or taxpayer and where aspects of taxation accounting are unique to
the other vehicles (sole proprietorship, a branch of non-resident company and
partnership) only those aspects are considered in detail under that vehicle.

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8.2 Taxation accounting for a company, partnership and sole proprietor

Each of the above vehicles will account for tax (VAT, Income Tax and Excise duty) in
the same way. Partnerships in Ethiopia are not opaque and are required to account
and pay tax on their business, rental and other income as in the case of a company
or a sole proprietor. In other tax jurisdictions, Partnerships are not taxable persons
but the business profits are taxable to the partners in their profit and loss sharing
ratios.

On account of the above, an appropriation of profits by a partnership to its partners is

treated as a dividend (Article 2(6) of the Income Tax Proclamation) and is not an
allowable deduction in accordance with Article 27(1) d of the Income Tax
Proclamation. Accordingly, the tax computation for a partnership and company are
similar in all aspects.

The owners (Partners and shareholders) of the Partnerships and companies are
treated for tax purposes as separate persons from the entities that they own.
Accordingly, expenses incurred by the aforementioned persons on behalf of their
owners whether they relate to business or not cannot be disallowed under Article
27(1)(i) of the Income Tax Proclamation on account that they are expenses of a
personal nature (consumption).

However, where the expenses referred to above are not incurred in deriving,
securing and maintaining amounts included in business income, such expenses are
not deductible expenses to the Company or Partnership pursuant to Article, 22(1)
(a) of the said Proclamation.

Unlike a shareholder in a company, a sole proprietor is not distinct from their

business. In actual sense the sole proprietor is the taxpayer and not the business
that they own as in the case of company and partnership. In this case, any expenses
made by the business for the benefit of the owner is treated as a personal
consumption expenditure and is not tax admissible pursuant to article 27(1)(i) of the
Income Tax Proclamation. This reasoning holds true even if the expense were a
“salary” because, the sole proprietor cannot be an employee in their own business
so as to consider employee costs under Article 22(1) (a) as an allowable deduction

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in order to bring the purported employment income to tax under Article 10(1) of the
Proclamation.

Article 10(1) of the Proclamation imposes Employment Income Tax on an employee

who receives employment income. Article 2(7) defines in part an employee to mean
an individual engaged, whether in a permanent or temporary basis, to perform
services under the direction and control of another person. It is therefore
unconceivable that the sole proprietor will be under the direction and control of
another person in their own business and cannot therefore pass for an employee in
the terms of Article 2(7).

Therefore, where the business meets the sole proprietor’s remuneration, the
expense should be disallowed. Disallowing such an expense implies that the
remuneration has been brought to the tax net and has paid tax.

However, unlike a company or a partnership, the distribution of profits to the sole

proprietor is not a dividend and no further taxation will be imposed on the after tax
profit distribution. Article 2(6) defines a dividend to mean a distribution of
profits by a body to a member. Article 2(5) of the Tax Administration Proclamation
read together with the preamble to article 2 of the Income Tax Proclamation defines
body to mean, a company, partnership, public enterprise or public financial agency,
or other body of persons whether formed in Ethiopia or elsewhere. The individual
(sole proprietor) is excluded from the above definition.

Finally, the residence of the company, partnership or sole proprietor is key in

determining the extent of its taxability in Ethiopia. Where company, partnership or
sole proprietor is a resident, they are taxable on their worldwide income. This
potentially means their income derived both in Ethiopia and other tax jurisdictions
(countries). However, where these persons are non- residents, they are taxable to
the extent that they could have sourced income in Ethiopia.

Following from the above, a resident person is likely to suffer tax twice. Their foreign
sourced income will be taxed in Ethiopia and in the state where the income is
sourced, but Article 45 of the Income Tax Proclamation will provide a relief from
double taxation.

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Further, if Ethiopia and the country in which it sources its foreign income have a
double taxation agreement, then provisions of that treaty will supersede Article 45
(especially where they are in conflict with the double taxation agreement) and will
determine the methodology for eliminating the effects of double taxation. Article
48(2) is instructive and provides that, if there is a conflict between the terms of a tax
treaty having legal effect in Ethiopia and this Proclamation, with the exception of sub
–article (3) of this Article and part eight of this Proclamation, the tax treaty shall
prevail over the provisions of this Proclamation.

Having pointed out that taxation accounting for a company, partnership and sole
proprietorship is similar in all aspects except for treatment of personal expenses and
dividends, the example below illustrates these principles using a limited liability
company as a case study.

Illustration

A limited incorporated in Ethiopia owns 100% shares in B Limited incorporated in

Eritrea. A Limited is a trading company that procures its supplies from China, with a
distribution outlet in Uganda and commenced business in 2010. The company owns
a commercial building in Addis Ababa from which it derives rental income. It’s tax
year commences 08/07/….

During the year ended 07/07/2016, the company incurred a loss of 4,000,0000 Birr,
Further, during the year ended 07/07/2017 the company recovered bad debts of
500,000 written off during the year ended 07/07/2015.

Below is an extract of the income and expenses for the year ended 07/07/2017

a. Sales made by its Kenya branch of 40,000,000 and allowable expenses

attributable to the branch (Permanent establishment) in Uganda, 10,000,000.
The expense includes a 4,000,000 of foreign losses incurred in the previous
year. Uganda has subjected the income of the branch at 30% (9,000,000) and
A limited has a receipt evidencing payment from Uganda Revenue Authority.
This tax was paid in Uganda. Ethiopia and Kenya don’t have a double taxation

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 agreement. The cost of trading stock was 15,000,000 and withholding tax of
300,000 paid at importation.

b. Sales made by its Ethiopian operations of 100,000,000

c. Dividends paid by the B limited 1,000,000. Tax at 15% (150,000) was withheld
by the Eritrean Tax Authority.

d. Bad debts (800,000), Depreciation (4000,000), Interest expense (300,000),

Employment costs (10,000,000), Repairs (5,000,000) and other allowable
expenses (3,000,000)

e. Rental income and expenses broken down as follow

i. Gross rental 1,000,000

ii. Renovations paid by the lessee 100,000

iii. Lease of furniture 50,000

iv. Sublease 20,000

v. Repairs 50,000

vi. Cost of lease 100,000

The tax pro forma below summarizes the tax payable by A limited.

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8.3 Taxation accounting for a branch of a non-resident company

Except for its treatment as a non-resident and the requirement to account for
additional tax on repatriated profits, the taxation of a branch of a non-resident
company is similar in all respects to taxation of a company. Accordingly, the
illustration provided above applies to the branch except for these differences. Below
is the detailed discussion.

8.3.1 The branch as non- resident and its taxation

A branch of a non-resident company is not a separate legal entity from its

headquarters, the company or body incorporated in different tax jurisdiction. It is
simply an extension of the company’s operations in a different tax jurisdiction in this
case Ethiopia. It is effectively the non-resident company (person) incorporated
elsewhere but operates in Ethiopia through a permanent establishment. This branch

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(Permanent establishment) is liable to business, rental and schedule D income tax
as though it were a separate legal entity from its headquarters. Accordingly, and
in accordance with Article 7(2) of the Income Tax Proclamation, it shall be subject to
tax in Ethiopia only in respect to its Ethiopian Sourced income. This implies that
where the branch sources foreign income, Ethiopia will not have jurisdiction to tax
such income.

Arising from the above, any deductions allowable to the branch in determining its
taxable business income should be restricted to expenses incurred in deriving such
income. Article 22(1) a provides that, subject to Provisions of this Proclamation, in
determining the taxable income of a taxpayer for a tax year, the deductions allowed
to a taxpayer shall include the following, any expenditure to the extent necessarily
incurred by the taxpayer during the year in deriving, securing, and maintaining
amounts included in business income. Since the branch of a non- resident
company includes only income sourced in Ethiopia any expenses incurred that don’t
give raise to such income should be disallowed.

This is likely to be an area of potential tax evasion since the branch sits in a unique
position that could be used as vehicle for fraud. The head office (the company) may
recharge fees to its branch in Ethiopia which have no relationship to income derived
from sources in Ethiopia in order to reduce its tax exposure. Auditors are required to
verify that the costs are in respect to income sourced in Ethiopia which is included in
the business income.

The above notwithstanding, a branch of a company incorporated outside Ethiopia

may at times be resident in Ethiopia if the branch in Ethiopia is the place of
effective management of the company, in accordance with article 5(5) b of the
Income Tax Proclamation. In this case, the company would be taxed in Ethiopia on
its worldwide income. Place of effective management is where the high level
management, commercial, and financial decisions necessary for the conduct of the
body’s business as a whole are taken. This is determined having regard to all the
facts and circumstances of the body. In this case, the effective management would
ordinarily be the place where the board meets and takes day to day decisions.

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Given that residence in Ethiopia implies taxation on worldwide income, it is important
that auditors assess the documents available especially minutes of board meetings
to determine the effective management of the company, noting that companies may
open up branches as vehicle to avoid or reduce the incidence of taxation.

8.3.2 Repatriated profits

Where the branch (Permanent establishment) repatriate’s profits to the company (its
headquarters), it is liable to tax on the repatriated profits at a rate of 10%, in the
terms of article 62 of the Income Tax Proclamation. The tax on repatriated profits is
in addition to tax imposed on its taxable business income pursuant to article 18 of
the Proclamation. It is included under schedule D.

The purpose of the repatriated profits tax is to equate the taxation of a branch of a
non-resident company to that of a non-resident parent company operating in Ethiopia
through a subsidiary company. Article 55 (2) provides that a non-resident who
derives an Ethiopian source dividend that is attributable to a permanent
establishment of the non-resident in Ethiopia shall be liable for income tax at the rate
of 10% on the gross amount of the dividend.

In the absence of taxation on repatriated profits, it would be possible for entities to

use a branch as a vehicle to avoid taxation of dividends which would arise if they had
operated through a subsidiary.

Article 51 of the regulations provides for the taxation of repatriated profits of the
branch (Permanent establishment) in accordance with the following formula:

A+ (B – C) – D

Where:

A - is the total cost of assets, net of liabilities, of the permanent establishment at the
commencement of the tax year

B - is the net profit of the permanent establishment for the tax year calculated in
accordance with the financial reporting standards

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C - is the business income tax payable on the taxable income of the permanent
establishment for the tax year, and

D - is the total cost of assets, net of liabilities, of the permanent establishment at the
end of the tax year.

Example

A Limited incorporated in the UK operates through a branch in Ethiopia. The

statement of financial position of A Limited as at 31/12/2017 is as follows:

31/12/2017 31/12/2016
Assets
3,000,000,000 2,000,000,000
Plant and Machinery
1,000,000,000 1,500,000,000
Debtors
1,000,000,000 2,500,000,000
Stock
5,000,000,000 6,000,000,000
Total assets

Equity & Liabilities

1,000,000,000 1,000,000,000
Share capital
2,000,000,000 400,000,000
Reserves
3,000,000,000 1,400,000,000
Total Equity

Liabilities
2,000,000,000 4,600,000,000
Loans

Total equity & Liabilities 5,000,000,000 6,000,000,000

Additional information

During the period ended 31/12 2017, the company made reported an accounting
profit of shillings 1,000,000,000 determined in accordance with financial report
standards. However, PWC tax consultants have adjusted the chargeable income to
2,000,000,000. Tax payable at 30% for the period ended 31/12/2018 is 600,000,000.

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Question

 Determine the income repatriated by the Branch to UK.

 Interpret your answer.

Solution

Repatriated income is determined as follows;

A = 3,000,000,000
B= 1,000,000,000
C= 600,000,000
D= 1,400,000,000

A+(B-C)-D
3,000,000,000 +(1,000,000,000-600,000,000)-1,400,000,000 = 2,000,000,000
Tax at 10% of 2,000,000,000 = 200,000,000

Interpretation of results

Repatriated income is 2,000,000,000. The following explains this result.

This is largely an adjustment in the company’s net assets. It is noted that under the
net assets, the only variable that changed was reserves. Share capital remained
constant and therefore is ignored in the analysis.

Reserves at commencement 2,000,000,000

Add profits for year after tax 400,000,000
Total 2,400,000,000
Less
Reserves at the end (400,000,000)
Repatriated income 2,000,000,000

Owing to the above, the entire reserves at the commencement of the period were
repatriated retaining reserves for the current period.

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9 Audit planning
9.1 Introduction

The audit program follows a three stage phase; Audit planning, execution and
completion. Audit planning is a vital stage of the audit program primarily conducted
at the beginning of the audit process to ensure that:

a. Potential tax risks are promptly identified.

b. Appropriate attention is devoted to key tax risks.

c. Audit work is completed expeditiously and is properly coordinated.

d. Audit is carried out efficiently and effectively.

e. Adequate and proper resource allocation for the proper conduct of the audit.

Audit planning sets the scope, timing and direction of the audit. This places audit
planning at the most critical phase of the audit program. Accordingly, a robust audit
plan requires superior audit resources (experienced auditors) to ensure that the
correct tax risks are identified and resources are properly allocated for the efficient
and effective conduct of the audit program.

9.2 The responsibility of the audit team during the audit planning phase

The sensitivity and importance of audit planning cannot be over emphasized and as
noted under 9.1 above, is required to be done by the best of the audit team. The
assigned auditors are required to prepare the audit plan on the basis of a sound
analytical review of the financial statements and other relevant information of the
taxpayer.

On the other hand, the audit team leader is expected to review and ensure that the
risks identified reflect the financial position of the taxpayer. It is further expected that
the team leader will provide direction to the audit team members and should not
allow an audit to commence unless they are satisfied that the audit plan

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addresses all the key risks and is appropriately drawn to optimally utilize the
available resources (time and human capital).

9.3 Audit planning process flow

Where the taxpayer prepares and furnishes financial statements, audit planning
involves the following:

a. Analytical review (vertical and horizontal) of financial statements in light of;

i. the taxpayer’s business and sector performance.

ii. intelligence or third party information.

iii. other relevant information, for instance, sector contribution to GDP,

comparison with industry averages.

b. Developing a robust plan that determines;

i. the scope, nature and extent of audit procedures during the execution stage of
the audit.

ii. resources allocation clearly spelling out who, how and when audit procedures
will be carried out during audit execution.

9.4 Analytical review of financial statements to identify tax risks

A robust tax audit considers the analysis of financial information of the taxpayer in
order to identify key tax risks and develop appropriate audit procedures. This
requirement is statutory derived. Accordingly, Article 20(2) of the Income Tax
Proclamation provides that the taxable business income of a taxpayer for a tax year
shall be determined in accordance with the profit and loss, or income
statement, of the taxpayer for the year prepared in accordance with the financial
reporting standards. Article 18 of the now repealed Income Tax Proclamation no.
286/2002 applicable for tax periods up to 07/07/2016 is drafted along the same
theme.

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The above provision implies that the taxpayers’ financial statements, particularly the
income statement are the point of first reference in determining their taxable
income. It is important to note that the income statement doesn’t exist in isolation,
but depends on the items of statement of financial position (balance sheet) to derive
income or incur expenses. The balance sheet is for instance a record of assets and
liabilities that are necessary for generating business income reflected in the income
statement. These assets and liabilities are serviced through depreciation and interest
posted to the income statement as expenses. The closing balance on the income
statement (Profit or loss) is posted to the balance sheet under the heading, Capital,
reserves and liabilities.

On the other hand, the cash flow statement describes how cash was generated and
used during the year to produce in part taxable income (Business Income). For
instance, an increase in debtors for a business that largely extends credit facilities to
its clients is should ordinarily reflect in the gross proceeds from the disposal of
trading stock or fees for the provision of services.

Owing to the above interdependency, the process of identification of key tax risks
requires not only relies on the income statement but a comprehensive interpretation
of the entire set of financial statements; the balance sheet, statement of cash flow
and income statement.

9.4.1 Creative/manipulative accounting

In order to analyze the taxpayers’ financial statements for the purpose of

identification of key tax risks and design of appropriate audit procedures, it is
necessary for the auditor to imagine how the taxpayer could have developed and
presented the financial statements in a manner that reduces their tax exposure. The
auditor is expected to exercise a degree of professional skepticism that the taxpayer
could have manipulated financial statements in order to under declare taxable
income.

As a matter of principle, taxpayers or businesses exist to profit. Profit maximization is

achieved either through reduction in costs or generation of income. Tax, especially

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income tax (direct tax) is a cost to the business and any taxpayer/ business driven by
the motive to profit will attempt to reduce its impact to the business in manner that
increases the profitability of their business.

To achieve the above object (reduction in the tax burden in order to maximize
profits), the taxpayer will, either inflate costs or under declare income to reduce
the taxable business income in a manner that is likely to go unnoticed by an
inexperienced tax auditor. This is because tax is imposed on taxable business
income, which in accordance with Article 20(1) of the Income Tax Proclamation is
the total business income of the taxpayer for the year reduced by the total
deductions allowed to the taxpayer for the year.

This subchapter considers the various accounts manipulated by taxpayers in order to

inflate costs and or reduce income. The auditor is required to review the taxpayers
accounts with a degree of professional skepticism that the taxpayer could have
understated income or inflated expenses.

9.4.1.1 How taxpayers suppress income

The statement of financial position (balance sheet) is actively used to reduce the
taxable income through accounts that directly impact on the income statement. The
balance sheet is drawn on the basis of the accounting equation; Assets = Capital +
Liabilities. Capital in the equation includes the “profit or loss” balance for the year.

The equation aids the manipulation of financial statements in manner that

suppresses taxable income, through adjustment to assets or liabilities with the contra
(corresponding) entries posted to the profit and loss account whose balance is part
of the balance sheet. This ensure that the balance sheet is balanced at all times. In
so doing, the cash flow statement is equally manipulated, particularly the cash/bank
balances posted to the balance sheet. Accordingly, where the cash flow
statement must be re-constructed during audit, it should be done after other
balance sheets accounts such as fixed assets, debtors, creditors etc. have
been adjusted to reflect their correct amounts with any positive variations on
the cash flow statement added back as undeclared income.

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Assets and liabilities are used to suppress taxable income as follows:

a) Assets

i. Fictitious assets (fixed) are introduced (increased) to the financial statements

as debit entries. To complete the transaction, contra entries are created on
the credit side of the balance sheet. These include an adjustment to the P&L
account balance (through depreciation) and loans with or without an interest
component. This way, the balance sheet balances. The effect of the above is
to reduce taxable business income through:

a) Depreciation allowance which is an allowable deduction in accordance with

Article 22(1)(c), 25 and the attendant Articles of the Regulations.

b) Interest expense if the fictitious “loan” is interest bearing. The expense is in

accordance with Article 23 of the Income Tax Proclamation.

ii. Reduction in current assets especially debtors on the debit side of the balance
sheet with a corresponding contra entry passed on the credit side of the
balance sheet through made up (fictitious) expenses. These expenses would
be ordinarily allowable in the terms of Article 22(1)(a). Debtors represent
unpaid income and a reduction is ordinarily expected to result into receipt of
cash or bad debts written off. However, as discussed above, instead of
increasing cash balances/write offs the contra adjustment could still be posted
to the P&L account as a fictitious expense.

iii. Closing stock is understated. This increases the cost of goods sold which
reduces the profit by the same amount. The balance sheet will balance since
there would be reduction on the assets side followed by a corresponding
reduction under the capital and reserves account of the balance sheet.

b) Liabilities

i. Trade creditors are usually interchanged for sales. They both have a credit
balance. The trial balance will balance and so will the balance sheet. In this

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 case, trade creditors are increased with a corresponding entry passed to the
P&L account as reduction in income through concealed/hidden sales.

ii. Creation of fictitious loans to claim undue interest expenses.

9.4.1.2 Key learning points for auditors

a) Auditors are expected to exercise a degree of professional skepticism at all

times when considering taxpayer’s financial statements that the taxpayers’
could have understated taxable income.

b) Creditors are a conduit vehicle for hidden sales

c) Debtors are a conduit for inflated expenses

d) Fixed assets are a conduit for undue depreciation allowances

e) Loans (fictitious) are a vehicle for undue interest expenses

f) Stocks (closing inventory) are undervalued to increase cost of goods sold.

g) Where ever the taxpayer refuses to provide bank statements, this could imply
that cash balances reported on the balance sheet are made up to conceal the
fictitious adjustments in b, c, d, e & f above.

9.4.2 Interpretation/analytical review of financial statements for tax purposes

Financial statements include a lot of valuable information about the performance of

the taxpayer’s business and should be analyzed in detail with a view to identify
potential tax risks. In order to make the best out of the analysis, the following points
are worth considering:

a) Knowledge of the taxpayers’ business and the sector in which they operate. This
is important in determining the nature of transactions expected to appear on the
financial statements of the taxpayer or those that would not be ordinarily
expected to appear. For instance, where the taxpayer is an importer of
pharmaceuticals products but claims capital deductions on equipment used for

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 the manufacture of medicines, such an asset should be queried and the
attendant depreciation disallowed.

Other expenses appearing on the profit and loss account should always be
examined in light of the taxpayers’ business.

b) Business trends

This is achieved through a trend analysis. Year on year comparatives are done to
study the business trends and any outliers should be questioned. Where sector
trends are available, a comparison with sector averages could be done to check for
inconsistencies.

c) Balance sheet analysis

This should be done in light of the taxpayers’ business and with regard to accounts
that have an impact on the income statement, particularly fixed assets, loans,
debtors and creditors. The auditor is expected to exercise a degree of professional
skepticism that the taxpayer could have understated taxable business income.

d) Related transactions

These are transactions between connected persons, for instance between the
headquarters and the branch of a non-resident company or parent and subsidiary.
Such transactions are vehicles for tax avoidance schemes and should be examined
to confirm that applicable legislation is adequately followed.

e) Auditors opinion

Auditor’s opinion especially where the accounts are audited with reputable firms and
have qualified the financial statements. Most important is a qualification that has an
impact on the taxable business income, for instance where the auditor is unable to
ascertain existence and value of key assets used in the business or is unable to
obtain confirmation from the bankers as to the correct value of the bank balances,
such a qualification would be prima facie evidence for understated taxable income.

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f) Other considerations that impact on other tax heads other than that of the
business in question.

These include particularly loans and shareholding. While these are not taxable to the
business, it is important to examine the capability of the shareholders in light of the
amounts introduced to the business. Where they have personal income tax files,
their financial statements should be examined for adequacy in light of the
contributions made with any unsupported amounts taxed to the shareholders.

g) Timing of transactions

This applies especially in regard to prepayments. Consider only amounts due for the
period.

h) Comparison with VAT and other tax heads

It is important that declarations made by the tax payer in their tax returns are
compared with VAT and Excise tax where applicable for completeness. However,
this should be carefully done since time of supply rules (recognition of sales) under
VAT may be different from those under Income Tax in some respects.

i) Third party information

Credible third party information should at all times be used during audit planning. For
instance, IFMIS information on government funded construction projects should
always be considered to examine the completeness of construction income declared
by the business.

j) The income statement should always be considered in light of the nature of the
taxpayer’s business, especially with regard to expenses.

9.4.3 Analysis of financial statements, case study (ABC PLC)

In this part, we consider analysis of the financial statements of ABC PLC for a four-
year period commencing 08/07/2013 to 07/07/2017.

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9.4.3.1 Nature of business

The company derives income from the rental of construction/ civil engineering
machinery and in addition provides catering services.

9.4.3.2 Auditors/ Auditors opinion

The auditors are XYZ Audit Services General Partnership, Chartered Certified
Accountants (UK) and Authorized Auditors (Ethiopia). These are auditors of
reputable standing on account of the certification and affiliation to credible bodies.

During the four years under review, all the financial statements were qualified by the
auditors on account of various material items. On the basis of the credibility of the
auditors, we shall consider the items for further investigation during the audit, but
also in the analysis of the financial statements below.

9.4.3.3 Statement of financial position (balance sheet) analysis

Below is the extract of the statement of financial position (Balance sheet) for ABC
PLC for the four years under review and an analytical review.

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 2013 2014 2015 2016 2017
Fixed Assets
Property plant & Equipment 3,341,863 6,321,208 36,245,502 36,359,834 30,236,992
Pre - operational cost 96,000 546,952 712,054 769,726 9,876,078
Current Assets
Goods in transit 1,252,649 4,282,524 4,047,941
Debtors & prepayments 11,067,726 9,531,720 17,562,043 31,494,756 25,465,363
Related parties- receivable 2,225,165 2,737,636 3,727,180 3,793,707 11,573,644
Shareholder's account 2,740,341 8,858,840 17,970,900 21,960,613 22,761,609
Cash and bank balance 195,783 1,698,712 357,016 1,269,562 186,737

19,666,878 30,947,717 80,857,219 99,696,139 100,100,423

Current liabilities
Bank overdraft - 2,165,820 7,173,915 11,620,087 19,683,439
Bank loan - Current - - 5,136,001 11,200,738 17,824,118
Creditors & accruals 9,112,737 16,638,913 23,905,750 32,148,545 43,329,290
Profit tax payable 1,316,088 2,548,377 8,289,791 2,776,042 -
Shareholders' account 1,547,894
10,428,825 21,353,110 44,505,457 57,745,412 82,384,741
Non-current liabilities
Bank loan - non current - 216,298 5,999,856 8,712,588

Represented By
Paid up Capital 5,000,000 5,000,000 5,000,000 17,000,000 25,400,000
Legal reserve 211,903 229,579 500,000 984,672 984,672
Customs DPV Variance 5,042,328 5,171,337 5,171,337
profit & loss account 4,026,150 4,365,028 25,593,136 12,794,862 (22,552,915)

19,666,878 30,947,717 80,857,219 99,696,139 100,100,423

i. Property, plant and equipment

a. On page 3 of the financial statements for the year ended 07/07/2017, there is
a note to the effect that other business assets acquired after 08/07/2016 will
be depreciated at 25%, contrary to Article 39 of the regulation that provides a
rate of 15%. The audit team should verify and make adjustments where
appropriate.

b. During years ended 07/07/2014, 07/07/2015, 07/07/2016 there were additions

of motor vehicles of 3,744,558.2, 14,100,398 and 1,869,565 respectively. This
is in addition to machinery, which we assume is used in the rental business.
The business of the company is the rental of construction/ civil

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 engineering machinery and provision of catering services. There is need to
investigate the purpose of the motor vehicles. There is a possibility that these
are included to claim depreciation whereas they don’t exist.

c. Article 23(11) of the repealed Income Tax Proclamation applicable to income

for the period up 07/07/2016, caps (limits) repairs and maintenance
allowances to 20% of the depreciation base. While the repairs and
maintenance account under administrative expenses are lower than 20% of
the depreciation base, operating costs whose break down is not provided
exceeds 20% of the depreciation base. In the event that this account includes
repairs, they should be examined further and any amount that exceeds 20%
of the depreciation base should be disallowed, capitalized and depreciated.

d. Ownership, cost and usage should be verified.

ii. Debtors

2013 2014 2015 2016 2017

Trade Debtors 5,113,484.08 4,758,125.09 3,709,723.20 6,173,859.17 10,243,026.78
Staff Debtors 183,547.93 900,101.18 1,163,594.20 1,961,065.96 2,093,296.63
VAT Receivable(Net) - - 1,147,738.05 - -
Prepayments 162,820.14 154,937.38 420,372.26 490,767.26 696,792.72
sundry Debtors 5,597,873.86 3,718,555.97 11,120,612.84 22,869,064.04 12,432,247.33
Total 11,057,726.01 9,531,719.62 17,562,040.55 31,494,756.43 25,465,363.46
Change in Total
Debtors - 1,526,006.39 8,030,320.93 13,932,715.88 6,029,392.97
Income 50,296,679.90 72,147,099.37 97,230,204.06 119,115,710.31 44,351,333.40

Trade debtors are unpaid invoices. The account includes in addition to trade debtor’s
sundry debtors. There is need to investigate the details and whether the
corresponding entry is booked under the income/sales ledger.

While there has been a general increase in the total debtors account, 2017 recorded
a reduction by 6,029,392. It should be noted that this was the year in which a loss of
22 million was posted and yet we have noted that taxpayers use debtors as a vehicle
for inflating costs especially when there is a reduction which is neither matched with
cash or write offs of bad debtors. There is need to investigate and establish
whether the fall in debtors during the year ended 2017 is attributable to a cash
inflow /bad debts and not inflated costs.

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iii. Related parties

2013 2014 2015 2016 2017

Related Party Receivable 2,225,165 2,737,636 3,727,180 3,793,707 11,573,644

There is need to establish whether these receivables due from related parties have
corresponding sales entries. In addition, there is need to establish if they were
provided at market value.

iv. Creditors and accruals

2013 2014 2015 2016 2017

Trade Creditors 2,808,184.90 8,979,494.97 14,182,868.22 14,144,260.71 22,067,890.73
Dividend Payable - - - 6,967,780.45 6,994,636.09
Value Added Tax(Net) 439,118.84 991,264.72 - 4,809,563.31 633,761.05
Payroll Tax 852,150.93 172,661.62 338,398.42 179,782.53 542,870.28
Pension 117,692.83 51,015.94 150,271.43 80,330.96 725,084.59
Pension-DMT Project - - - 318,040.85 318,040.85
Profit Tax - - - - 573,790.66
Dividend Tax - - - - 230,358.87
Withholding Tax 21,039.27 31,763.77 146,009.76 33,361.52 10,836.11
Accruals 1,392,353.48 3,110,641.72 152,341.57 956,701.53 6,483,164.74
sundry Creditors 3,487,196.97 3,302,070.26 8,938,960.62 4,658,722.76 4,748,856.16
Total 9,112,737.22 16,638,913.00 23,905,750.02 32,148,544.62 43,329,290.13

This account includes accruals during the 2017 of 6,483,164.74 when the company
posted huge losses. Accruals are unpaid expenses. There is need to establish the
nature of the corresponding expenses and whether they were incurred for the
purpose of the business or are not part of the scheme to inflate costs.

Trade creditors and sundry creditors are used a concealment for undeclared income.
These accounts need to be examined especially during 2014 where the auditors
issued a qualification on account of sales posted as creditors.

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v. Bank loans and over drafts

The company is significantly borrowed. The interest expense is claimed as an

allowable deduction. There is need to receive loan agreements to confirm existence
of the loan and interest payments.

There is need to ascertain whether the lending banks are financial institutions
recognized by the National bank of Ethiopia for purposes of Article 23(2) (a) which
caps interest expense to an additional 2 percentage points between the rate used by
the National Bank of Ethiopia and commercial banks.

vi. Shareholders account

The auditors issued a qualification on the above account. Importantly, is that the
account represents shareholders as debtors to the company which may represent a
withdrawal of profits or dividends taxable at 10%. Article 34 of the Income Tax
Proclamation applicable to years ended 07/07/2016 is instructive and states that,
every person deriving income from a share company or withdrawals of profit from
a private limited company shall be subject to tax at the rate of 10%. The period
2014 to 2017 recorded profits. Accordingly, this account could represent withdrawal
of profits subject to tax at 10%.

vii. Income statement

a. Operating cost

The company has significant operating costs of 46,906,889.90, 40,291,843.48,

65,924,178.16 and 32,718,905.74 for the years 2014, 2015, 2016 and 2017
respectively. These values account for more than 50% of the operating income.
Considering that the business of the company is rental of machinery/ catering
services and the expenses that would ordinarily be incurred in maintaining the said
business such as depreciation of machinery, repair & maintenance, salaries and
wages among others are already included under administrative expenses, there is
need to investigate the claim to operating cost.

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In addition, there is no breakdown of the said account despite carrying significant
values. There is a possibility that this account could have been used as a vehicle for
inflating expenses not incurred in the production of business income.

b. Income and expenses

2013 2014 2015 2016 2017

Income 50,296,679.90 72,147,099.37 97,230,204.06 119,115,710.31 44,351,333.40
Operating Cost 34,412,139.25 46,906,889.90 40,291,843.48 65,924,178.16 32,718,905.74
Operating cost/Income 68.42 65.02 41.44 55.34 73.77

Administration Cost 12,446,296.40 23,059,624.62 29,664,272.91 39,041,255.47 29,251,175.85

Profit 4,026,150.00 4,365,028.00 25,593,136.00 12,794,862.00 -22,552,915.00

Property, Plant and

Equipment 3,341,863.00 6,321,208.00 36,245,502.00 36,359,834.00 30,236,992.00
Creditors 9,112,737.00 16,638,913.00 23,905,750.00 32,148,545.00 43,329,290.00
Increase in Creditors - 7,526,176.00 7,266,837.00 8,242,795.00 11,180,745.00

The above table points to the following:

1) The nature of business being rental of machinery, one would expect a linear
relationship between income and expenses. This means that where the
equipment is not leased, there would no direct (operating) expense. However,
this is not true especially during 2017 where proportionately operating costs to
income is highest at 73%.

During the said period (2017), a loss of 22,552,915 was recorded. There is
need to investigate the direct expenses to determine if they not inflated.

2) There has been a significant growth increase in trade creditors during each of
the four years, particularly by 11,180,745 in 2017, when the company
recorded a loss. Trade creditors are potentially undeclared sales and should
be investigated to ensure that they don’t include undeclared income. The
auditor’s report for 2014 indicates that a balance of 5,065,745.21
included in trade payables should have been recognized as sales.

3) The auditor’s report for 2014 alludes to a variance of 20million between an

invoice to Omega for services rendered and the income recognized from

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 this invoice. This transaction should be investigated and the said undisclosed
income brought to tax.

4) The auditor’s report for 2015 indicates that operating cost of Omega totaling
2,746,935.63 did not have supporting documentation. This should be
investigated and disallowed.

5) The auditors noted (for the year 2016) that included in the operating cost of
MT Account are expenses without documents totaling 1,799,894.09. These
should be investigated and disallowed if they are not incurred in deriving
income.

6) There are significant variations between VAT returns and income declared in
the income tax returns. These variances need to be examined and
adjustments made to the tax computation as appropriate.

7) Employment costs should be examined for employment tax. In particular,

where the employee receives benefits in kind this should be brought to tax.

9.5 Risk Assessments

9.5.1 Definition

Risk is the potential for non-compliance and the possibility of events or activities that
will have a negative impact upon MoR objectives.

Risk Analysis is the systematic use of available information to determine how often
defined risk may occur (likely hood of occurrence) and the magnitude of their
consequences.

i. Risk Assessment is the systematic determination of risk management priorities

by evaluating and comparing the level of risk against predetermined standards,
target risks levels or other criteria.
ii. Compliance means stakeholders meet all their obligations in accordance with
legal requirements. Stakeholders will meet their compliance obligations through
education and voluntary disclosure of all tax matters to MoR.

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iii. Compliance Management is the holistic recognition of the level of conformity with
laws, regulations, and obligations used as a tool for granting privileges and as
input to risk management.

Risks are those events that could negatively impact on an organization’s ability to
deliver on its mission. Risk assessment must therefore be an integral part of
the entire audit process and should involve:

 a review of the economy to identify risk-prone sectors

 a review of the sectors to profile the various operators therein; and
 a profile of the operators in order to identify risky trends or behavior.

9.5.2 Understanding Risk from a Taxpayer`s Perspective

Taxpayers can use a number of options to avoid paying the correct amount of
tax. For instance, they can decide to:

 stay out of the system by not registering

 not maintain books and records (those who are obliged by law)
 not submit declarations on time
 submit incorrect declarations
 not pay outstanding taxes
 make aggressive interpretation of the law
 enter into schemes or tax avoidance arrangements that hide or alter the
commercial reality of their dealings; and
 Negotiate a compromised assessment or payment.

9.5.3 Analyzing Risk and Potential for Collection of Assessment/

Reassessment
Selecting files for audit should always be based on sound risk assessment.
Sound risk assessment includes evaluating the potential collectability of a debt
that could arise as a result of an audit action. Difficulty to collect a potential debt is
only one aspect to consider in selecting a file for audit or closing a file early. The
collection of an assessment is an important final step in the audit process.
While the Branch does not intend to overemphasize the collection of an

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assessment, it must be recognized that uncollectible assessments are not in the
best interests of the MoR.

9.5.4 Audit File Assignment

Audit files are assigned from the inventory of files selected by the concerned
team and from other sources. The team coordinator generally assigns audit files
to the individual auditors based on gross revenue of the taxpayers and categories
established for each group and level of auditors.

In addition to gross revenue, the following factors must be considered when

assigning audit files in order to be transparent:

 the nature of the audit

 rotation or specialization of auditors
 training and development of auditors
 Idle or on duty of auditors (work in process)

9.5.5 Types Audit Risk

Audit risk can be categories on the following risk components.

1. Inherent risk (IR)

Inherent Risk is the susceptibility of a relevant assertion to a mis-statement that

could be material, either individually or when aggregated with other misstatements,
assuming that there are no related controls.

The risk of such misstatement is greater for some assertions and related account
balances, classes of transactions, and disclosures than for others. For example,
complex calculations are more likely to be misstated than simple calculations. Cash
is more susceptible to theft than an inventory of coal. Accounts consisting of
amounts derived from accounting estimates that are subject to significant
measurement uncertainty pose greater risks than do accounts consisting of relatively
routine, factual data.

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External circumstances giving rise to business risks also influence inherent risk. For
example, technological developments might make a particular product obsolete,
thereby causing inventory to be more susceptible to overstatement. In addition to
those circumstances that are peculiar to a specific relevant assertion, factors in the
entity and its environment that relate to several or all of the classes of transaction,
account balances, or disclosures may influence the inherent risk related to a specific
relevant assertion. These latter factors include, for example, a lack of sufficient
working capital to continue operations or a declining industry characterized by a
large number of business failures.

2. Control Risk (CR)

Control Risk (CR) is the risk that a misstatement that could occur in a relevant
assertion and that could be material, either individually or when aggregated with
other misstatements, will not be prevented or detected on a timely basis by the
entity's internal control. That risk is a function of the effectiveness of the design and
operation of internal control in achieving the entity's objectives relevant to
preparation of the entity's financial statements. Some control risk will always exist
because of the inherent limitations of internal control. Inherent risk and control risk
are the entity's risks, that is, they exist independently of the audit of financial
statements.

The risk of material misstatement (RMM) as the auditor's combined assessment of

inherent risk and control risk; however, the auditor may make separate assessments
of inherent risk and control risk. Furthermore, auditors may implement the concepts
surrounding the assessment of inherent and control risks and responding to the risk
of material misstatement in different ways as long as they achieve the same result.

 The auditor should assess the risk of material misstatement at the relevant
assertion level as a basis for further audit procedures. Although that
assessment is a judgment rather than a precise measurement of risk

 The auditor should have an appropriate basis for that assessment. This
basis may be obtained through the risk assessment procedures performed
to obtain an understanding of the entity and its environment, including its
internal control, and through the performance of suitable tests of controls

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 to obtain audit evidence about the operating effectiveness of controls,
where appropriate. The risk that a misstatement that could occur in an
assertion about a class of transaction, account balance, or disclosure and
that could be material, either individually or when aggregated with other
misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity’s internal control.

Internal control consists of five components:

1. The control environment sets the tone of an organization, influencing the

control consciousness of its people. It is the foundation for all other
components of internal control, providing discipline and structure.
2. Risk assessment is the entity's identification and analysis of relevant risks
to achievement of its objectives, forming a basis for determining how the
risks should be managed.
3. Information and communication are the identification, capture, and
exchange of information in a form and time frame that enable
employees to carry out their responsibilities.
4. Monitoring is a process that assesses the quality of internal control
performance over time.
5. Control activities are the policies and procedures that help ensure that
management directives are carried out.

3. Audit Risk

Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately
modify an opinion on financial statements that are materially misstated. Audit risk is
the risk that auditors issued the incorrect audit opinion to the audited financial
statements. For example, auditor issued unqualified opinion to the audited financial
statements even though the financial statements are materially misstated. Or the
qualified opinion is issued as the result of immateriality found in financial statements
which the correct opinion should be unqualified.

The auditor must consider audit risk and must determine a materiality level for the
financial statements taken as a whole for the purpose of:

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  Determining the extent and nature of risk assessment procedures
 Identifying and assessing the risks of material misstatement
 Determining the nature, timing, and extent of further audit procedures
 Evaluating whether the financial statements taken as a whole are presented
fairly, in all material respects, in conformity with generally accepted
accounting principles

Audit risk is a function of the risk that the financial statements prepared by
management are materially misstated and the risk that the auditor will not detect
such material misstatement. The auditor may reduce audit risk by determining
overall responses and designing the nature, timing, and extent of further audit
procedures based on those assessments. During identifying audit risks:

 The auditor should consider audit risk in relation to the relevant assertions
related to individual account balances, classes of transactions, and
disclosures and at the overall financial statement level.
 The auditor should perform risk assessment procedures to assess the risks of
material misstatement both at the financial statement and the relevant
assertion levels. The auditor may reduce audit risk by determining overall
responses and designing the nature, timing, and extent of further audit
procedures based on those assessments.
 The auditor should perform the audit to reduce audit risk to a low level that is,
in the auditor's professional judgment, appropriate for expressing an opinion
on the financial statements.

The considerations of audit risk and materiality are affected by the size and
complexity of the entity and the auditor's experience with and knowledge of the entity
and its environment, including its internal control. Entity-related factors also affect the
nature, timing, and extent of further audit procedures with respect to relevant
assertions related to specific account balances, classes of transactions, and dis-
closures. In considering audit risk at the overall financial statement level, the auditor
should consider risks of material misstatement that relate pervasively to the financial
statements taken as a whole and potentially affect many relevant assertions.

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4. Detection risk (DR)

Detection Risk (DR) is the risk that the auditor will not detect a misstatement that
exists in a relevant assertion that could be material, either individually or when
aggregated with other misstatements. Detection risk is a function of the effectiveness
of an audit procedure and of its application by the auditor. Detection risk cannot be
reduced to zero because the auditor does not examine 100 percent of an account
balance or a class of transactions and because of other factors. Detection risk
relates to the substantive audit procedures and is man- aged by the auditor's
response to risk of material misstatement.

For a given level of audit risk, detection risk should bear an inverse relationship to
the risk of material misstatement at the relevant assertion level. The greater the risk
of material misstatement, the less the detection risk that can be accepted by the
auditor. Conversely, the lower the risk of material misstatement, the greater the
detection risk that can be accepted by the auditor.

 The auditor should perform substantive procedures for all relevant assertions
related to material classes of transactions, account balances, and disclosures.
 Detection risk relates to the substantive audit procedures and is man- aged by
the auditor's response to risk of material misstatement. For a given level of
audit risk, detection risk should bear an inverse relationship to the risk of
material misstatement at the relevant assertion level. The greater the risk of
material misstatement, the less the detection risk that can be accepted by the
auditor. Conversely, the lower the risk of material misstatement, the greater
the detection risk that can be accepted by the auditor.
 The auditor should perform substantive procedures for all relevant assertions
related to material classes of transactions, account balances, and disclosures.

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The relationship between Inherent Risk, Control Risk, Detection Risk and Audit Risk

Susceptibility of an assertion
to material misstatement
Inherent Risk (IR)
Total Misstatement assuming no related internal
controls
Less (-)

Caught by internal Risk of misstatements not

Control Risk (CR) being detected by system of
controls
internal control.
Less (-) Risk of misstatements not
being detected by the auditor.
Caught by auditors Detection Risk (DR)

Equals (=)
Misstatement that remains
Undetected misstatement Audit Risk (AR) undetected by the auditor.

9.5.6 Identification of Risk Factors

The auditor's consideration of inherent risk, fraud risk, control environment, risk
assessment, communication, and monitoring (parts of internal control) affects the
nature, timing, and extent of substantive and control tests. This section describes:

1. The impact of risk factors identified during this consideration on

substantive and control tests
2. The process for identifying these risk factors

9.5.7 Impact on Substantive Testing

Based on the level of audit risk and an assessment of the entity's inherent and
control risk, including the consideration of fraud risk, the auditor determines the
nature, timing, and extent of substantive audit procedures necessary to achieve
the resultant detection risk. For example, in response to a high level of inherent
and control risk, the auditor may perform:

1. additional audit procedures that provide more competent evidential

matter (nature of procedures);

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 2. substantive tests at or closer to the financial statement date (timing of
procedures); or
3. more extensive substantive tests (extent of procedures)

Control Assessment- Effectiveness and efficiency of operations. These controls

include policies and procedures to carry out organizational objectives, such as
planning, productivity, programmatic, quality, economy, efficiency, and
effectiveness objectives. Management uses these controls to provide reasonable
assurance that the entity:

a. Achieves its mission

b. Maintains quality standards, and
c. Does what management direct it to do?

(Note that performance measures controls (those designed to provide

reasonable assurance about reliability of performance reporting transactions and
other data that support reported performance measures are properly
recorded, processed, and summarized to permit the preparation of performance
information in accordance with criteria stated by management) are included in
operations controls.) The auditor considers factors in identifying such risks and
weaknesses. These factors are general in nature and require the auditor's
judgment in determining:

1. The extent of procedures (testing) to identify the risks and weaknesses and
2. The impact of such risks and weaknesses on the entity and its financial
statements. Because this risk consideration requires the exercise of
significant audit judgment, it should be performed by experienced audit team
personnel.

The auditor considers the implications of these risk factors on related operations
controls. Therefore, the need for operations controls in a particular area or the
awareness of operations control weaknesses related to these risk factors should
be identified and considered for further review.

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The auditor identifies and documents any significant risk factors after considering:

1. his/her knowledge of the entity (obtained in previous steps in the planning

phase)

2. the risk factors

3. other relevant factors.

These risks and weaknesses and their impact on proposed audit procedures
should be documented on the General Risk Analysis (GRA) or equivalent. The
auditor also should summarize and document any account-specific risks. For
each risk factor identified, the auditor documents the nature and extent of the risk
or weakness; the condition(s) that gave rise to that risk or weakness; and the
specific cycles, accounts, line items, and related assertions affected (if not
pervasive). Also in an overall response, the nature, timing, and extent of
procedures related to certain accounts and assertions may be modified as follows:

 The nature may be changed to obtain more reliable evidence or further

corroboration, such as from independent sources outside the entity. For
example, physical observation of certain assets may become more
important.
 The timing of substantive tests may be closer to or at year end.
 The extent of procedures may involve larger sample sizes or more
extensive analytical procedures.

The auditor may determine that a specific response is required due to the types
of risk factors identified and the accounts and assertions that may be affected.

9.6 Materiality

The auditor’s judgment as to matters that are considered to be material in the

context of an audit is based on a consideration of the nature of the intended users of
the financial statements and an assessment of the matters that could influence their
economic decisions. Materiality can be defined in the following terms.

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“Omissions or misstatements of items are material if they could individually or
collectively influence the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size and nature of the omission or
misstatement judged in the surrounding circumstances. Materiality is one of several
tools the auditor uses to determine that the planned nature, timing, and extent of
procedures are appropriate. As defined in Financial Accounting Standards Board
(FASB).

 Materiality represents the magnitude of an omission or misstatement of an

item in a financial report that, in light of surrounding circumstances, makes it
probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the inclusion or
correction of the item.

 Materiality is based on the concept that items of little importance, which do

not affect the judgment or conduct of a reasonable user, do not require
auditor investigation. Materiality has both quantitative and qualitative
aspects. Even though quantitatively immaterial, certain types of
misstatements could have a material impact on or warrant disclosure in the
financial statements for qualitative reasons.

The auditor should determine a materiality level for the financial statements as a
whole for the purpose of:

 Determining the extent and nature of risk assessment procedures

 Identifying and assessing the risks of material misstatement; and

 Determining the nature, timing and extent of further audit procedures

 The determination of what is material to the users is a matter of professional

judgment.

The auditor often may apply a percentage to a chosen benchmark as a step in

determining materiality for the financial statements taken as a whole. When
identifying an appropriate benchmark, the auditor may consider factors such as:

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 a. The elements of the financial statements (for example, assets, liabilities,
equity, income, and expenses) and the financial statement measures
defined in generally accepted accounting principles (for example, financial
position, financial performance, and cash flows), or other specific
requirements.
b. Whether there are financial statement items on which, for the particular
entity, users' attention tends to be focused (for example, for the purpose of
evaluating financial performance).
c. The nature of the entity and the industry in which it operates.
d. The size of the entity, nature of its ownership, and the way it is financed.

Examples of benchmarks that might be appropriate, depending on the nature and

circumstances of the entity, include total revenues, gross profit, and other categories
of reported income, such as profit before tax from continuing operations. Profit
before tax from continuing operations may be a suitable benchmark for profit-
oriented entities but may not be an appropriate benchmark for the determination of
materiality when, for example, the entity's earnings are volatile, when the entity is a
not-for-profit entity, or when it is an owner-managed business where the owner takes
much of the pretax income out of the business in the form of remuneration. For
asset-based entities (for example, an investment fund) an appropriate benchmark
might be net assets. Other entities (for example, banks and insurance companies)
might use other benchmarks.

When determining materiality, the auditor should consider prior periods' financial
results and financial positions, the period-to-date financial results and financial
position, and budgets or forecasts for the current period, taking account of significant
changes in the entity's circumstances (for example, a significant business
acquisition) and relevant changes of conditions in the economy as a whole or the
industry in which the entity operates. For example, when the auditor usually
determines materiality for a particular entity based on a percentage of profit,
circumstances that give rise to an exceptional decrease or increase in profit may
lead the auditor to conclude that materiality is more appropriately determined using a
normalized profit figure based on past results.

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Once materiality is established, the auditor should consider materiality when
planning and evaluating the same way regardless of the inherent business
characteristics of the entity being audited. Materiality is determined based on the
auditor's understanding of the user needs and expectations. User expectations may
differ based on the degree of inherent uncertainty associated with the measurement
of particular items in the financial statements, among other considerations. For
example, the fact that the financial statements include very large provisions with a
high degree of estimation uncertainty (for example, provisions for insurance claims
in the case of an insurance company, oil rig decommissioning costs in the case of an
oil company, or, more generally, legal claims against an entity) may influence the
user's assessment of materiality. However, for audit purposes, this factor does not
cause the auditor to follow different procedures for planning or evaluating
misstatements than those outlined for other entities.

Misstatements can result from errors or fraud and may consist of any of the
following:

 An inaccuracy in gathering or processing data from which financial

statements are prepared
 A difference between the amount, classification, or presentation of a re-
ported financial statement element, account, or item and the amount,
classification, or presentation that would have been reported under generally
accepted accounting principles
 The omission of a financial statement element, account, or item
 A financial statement disclosure that is not presented in conformity with
generally accepted accounting principles
 The omission of information required to be disclosed in conformity with
generally accepted accounting principles
 An incorrect accounting estimate arising, for example, from an over- sight or
misinterpretation of facts; and management’s judgments concerning an
accounting estimate or the selection or application of accounting policies that
the auditor may consider unreasonable or inappropriate.

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The auditor must consider audit risk and must determine a materiality level for the
financial statements taken as a whole for the purpose of:

 Determining the extent and nature of risk assessment procedures

 Identifying and assessing the risks of material misstatement
 Determining the nature, timing, and extent of further audit procedures
 Evaluating whether the financial statements taken as a whole are presented
fairly, in all material respects, in conformity with generally accepted
accounting principles

For example, intentional misstatements or omissions (fraud) usually are more critical
to the financial statement users than are unintentional errors of equal amounts.
This is because the users generally consider an intentional misstatement more
serious than clerical errors of the same amount.

Materiality is determined in the following stages:

a. Planning materiality is a preliminary estimate of materiality, in relation to

the financial statements taken as a whole, used to determine the nature,
timing, and extent of substantive audit procedures and to identify
significant laws and regulations for compliance testing.

b. Design Materiality is the portion of planning materiality that has been

allocated to line items, accounts, or classes of transactions (such as
disbursements).

c. Test materiality is the materiality actually used by the auditor in testing a

specific line item, account, or class of transactions. Based on the auditor's
judgment, test materiality can be equal to or less than design materiality.
Test materiality may be different for different line items or accounts.

Generally, the materiality level will vary depending up on the level of audit risk
assessed. When the level of risk assessed is high the materiality level will be set at
lower level, and when the risk assessed is low, it will be set at a higher level.

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9.7 Audit Sampling

The application of audit procedures to less than 100% of items within a population of
audit relevance such that all sampling units have a chance of selection in order to
provide the auditor with a reasonable basis on which to draw conclusions about the
entire population.’

In other words, the standard recognizes that auditors will not ordinarily test all the
information available to them because this would be impractical as well as
uneconomical. Instead, the auditor will use sampling as an audit technique in order to
form their conclusions. It is important at the outset to understand that some
procedures that the auditor may adopt do not involve audit sampling, 100% testing of
items within a population, for example. Auditors may deem 100% testing appropriate
where there are a small number of high value items that make up a population, or
when there is a significant risk of material misstatement and other audit procedures
will not provide sufficient appropriate audit evidence.

Sampling is used to test the information and transactions to increase the efficiency
and effectiveness of the audit. Cost and time constraints do not usually permit 100%
verification of the taxpayer's information nor does the relative risk warrant 100%
verification. However, in rare situations 100% verification may be required.

The use of sampling is widely adopted in auditing because it offers the opportunity for
the auditor to obtain the minimum amount of audit evidence, which is both sufficient
and appropriate, in order to form valid conclusions on the population. Audit sampling
is also widely known to reduce the risk of ‘over-auditing’ in certain areas, and enables
a much more efficient review of the working papers at the review stage of the audit.

Population

Is defined as, the entire set of data from which a sample is selected and about which
the auditor wishes to draw conclusions.

Sampling unit

The individual items constituting a population.

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 Sample Risk

 Is the probability that the sample results are not representative of the entire
population?
 This risk can be controlled by adjusting the sample size using an
appropriate method of selecting sample items.

TARGET TEST

Selection method When applicable Type of test

▪ The balance has a small number of large value items;
Select all items ▪ There is a significant risk and other means do not
(100% provide sufficient appropriate audit evidence; or
examination) ▪ The repetitive nature of a calculation or other
process performed automatically by a software.

▪ High value or key items. Selection of specific items Targeted test

because they are of high value, or for example, items
that are suspicious, unusual or that have a history of
Select specific
error;
items
▪ All items over a certain amount. Selection of all
items whose recorded values exceed a certain
amount (e.g. all transactions above materiality).

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9.7.1 Purpose of Audit Sampling

Sampling is performed because it is more efficient than testing 100% of a

population. In tax audits a representative sample can save both parties time and
money. So the auditors should select the appropriate audit sampling method during
their audit planning stage.

When Not to Sample

There are many audit procedures which do not involve sampling.

a) Inquiry and Observation:

 Reviewing records for the method of accounting and other information.

 Observing accounting procedures.
 Discussing methods of accounting and reporting with taxpayer.
 Scanning documents for possible issues.

b) Analytical Review Procedures:

 Comparing records, reports and other information.

 Re-computing or estimating amounts.
 Reviewing trends in reporting.
 Comparing similar businesses.

c) One-Hundred Percent Examination:

 Reviewing all fixed asset purchases, where appropriate.

 Examining all contracts, where there are a small number.
 Reconciling each year`s gross receipts to VAT/TOT declaration and
Financial statements.
 If the assessment of risk by the auditor is high.

d) Zero Percent Examination:

 This occurs when the auditor determines that a type of receipt, deduction,

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 exemption or other item does not need to be tested.

Sampling Risk is the probability that the sample results are not representative of
the entire population.

9.7.2 Methods of Sampling

There are many methods of selecting a sample, but it considers five principal
methods of audit sampling as follows:
 Random selection/Judgmental
 Stratified sampling
 Cluster sampling
 Systematic selection
 Monetary unit sampling
 Haphazard selection

Sampling may be non-statistical or statistical.

1. Statistical sampling

a. Judgmental sampling /Random Sampling

The process of selecting samples in random & without any particular order or
classification. All elements of the population have equal chances of getting picked.
This can be done either with the use of random number generators, example
random number tables. This is the most used method of all methods.

This method of sampling ensures that all items within a population stand an equal
chance of selection by the use of random number tables or random number
generators. The sampling units could be physical items, such as sales invoices or
monetary units in which a bias is placed on the sample (e.g. all sampling units over
a certain value). A judgmental sample is not probably representative of the
population. Indeed, it is biased by whatever judgment was used in order to select
the sample.

Analysis of a haphazard or judgmental sample may not be relied upon to form a

conclusion on the population. The only conclusion that can be drawn from errors

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detected by these techniques is that at least the detected errors exist in the
population and the value of errors is no less than the value detected in the sample.
This may lead the auditor to a legitimate and useful conclusion (e.g. when
considering a judgmental sample of invoices over a certain material value) but it is
essential that care is taken to avoid misleading conclusions when using these
techniques.

 The process of selecting samples in random & without any particular order
or classification.
 All elements of the population have equal chances of getting picked.
 This can be done either with the use of random number generators,
example random number tables.
 This is the most used method of all methods.

Disadvantages of Simple Random Sampling:

 Costly and time-consuming for large transaction.

 Gives us large sample size

b. Stratified sampling

It is used to segregate the entire population into subgroups. Then random sampling
or systematic sampling is applied within each sub group. Example:
departmentization, production group.

Advantage of Stratified sampling

 Free from auditor bias

 beyond the influence of the Auditor
 produces a representative sample

c. Cluster sampling

The total population is divided into these groups (known as clusters) and a simple
random sample of the groups is selected. The elements in each cluster are then
sampled.

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d. Systematic selection

The method divides the number of sampling units within a population into the
sample size to generate a sampling interval.

Example 1

You are the auditor of Yohan Co. and are undertaking substantive testing on
the sales for the year ended 31 December 2010. You have established that
the ‘source’ documentation that initiates a sales transaction is the goods
dispatch note and you have obtained details of the first and last goods
dispatched notes raised in the year to 31 December 2010, which are
numbered 10,000 to 15,000 respectively.

The random number generator has suggested a start of 42 and the sample
size is 50. You will therefore start from goods dispatch note number (10,000 +
42) 10,042 and then sample every 100th goods dispatch notes thereafter until
your sample size reaches 50.

Example 2

You decide to sample a fixed percent of the population using a random

starting point and you select every nth individual `n` in this case is determined
by calculating the sampling interval (population size ÷ sample size) example:
you decide to sample 20% of 100 Transaction. n = 100 ÷ 20 = 5,(interval) so
generate a random number between 1 and 5, start at this number and sample
each 5th Transaction.

Advantage of Systematic Random sampling: It ensures a high degree of

representativeness, and no need to use a table of random numbers

e. Monetary unit sampling

The method of sampling is a value-weighted selection whereby sample size,

selection and evaluation will result in a conclusion in monetary amounts. The

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objective of monetary unit sampling (MUS) is to determine the accuracy of
financial accounts. The steps involved in monetary unit sampling are to: -

 determine a sample size

 select the sample
 perform the audit procedures
 evaluate the results and arriving at a conclusion about the population.

For example: a receivable balance of $50 contains 50 sampling units. Monetary

balances can also be subject to varying degrees of exception – for example, a
payables balance of $7,000 can be understated by $7, $70, $700 or $7,000 and
the auditor will clearly be interested in the larger misstatement.

2. Non-statistical sampling

Haphazard sampling

When the auditor uses this method of sampling, he does so without following a
structured technique. Care must be taken by the auditor when adopting haphazard
sampling to avoid any conscious bias or predictability. The objective of audit
sampling is to ensure that all items that make up a population stand an equal
chance of selection. This objective cannot be achieved if the auditor deliberately
avoids items that are difficult to locate or deliberately avoids certain items.

Designing a Sampling Application

There are several steps in designing a sampling application for an audit. The steps
are listed below:

 Define the objectives of the test

 Determine the type of test to be performed
 Define the deviation conditions
 Define the population
 Determine the method of selecting the sample
 Determine the sample size
 Perform the sample

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  Evaluate the sample results
 Document the sampling procedure

Documentation of each test should include the following:

 stating the audit objective of the test conducted

 description of the document(s) selected for examination
 disclosing the size of the population from which the sample will be selected
 determine the number of items selected for detailed examination from
the population
 disclosure of the method of selecting the sample
 disclosure of all exceptions to the expected results – where full disclosure is
required all items tested should be listed on the working paper and the test
results of each item noted – in most cases 'exceptions only' disclosure is
adequate.

Generally, the materiality level and sample size will vary depending up on the
sector based level of audit risk assessed. When the level of risk assessed is high
the materiality level will be set at lower level and sample size taken will be
high, while the risk assessed is low, materiality level will be set at a higher level
and sample size will be taken low.

9.8 The audit plan

After conducting the analytical review of the financial statements the auditor may if
need be conduct a pre-entry interview with the taxpayer to ascertain further
information and will then draw an audit plan to be followed during the execution of
the audit.

During audit planning, the auditor has to also take in to consideration the risk level
indicators for each audit case, which is obtained from Risk and Taxpayer
Compliance Directorate.

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