Use Of Indirect Audit Procedures, Sampling and Sample Projections Limited
On Wednesday, March 20, 2013 I will be testifying before the House Taxation Committee on five bills currently before the committee. This Blog is the first of three which will discuss the proposed legislation. I urge CPAs, your clients and others to become familiar with the bills and to support their enactment with your local legislators. Today I will discuss House Bill 4288 - Sales Tax, House Bill 4292 - Use Tax and House Bill 4289 - Unclaimed Property.
Michigan is making great strides to improve the tax climate; however, while it is critically important to get the tax structure correct, and the tax rate competitive, it is also very important that the actual "administration" of taxes is simple, fair and efficient, and with an emphasis on compliance rather than other factors.
Taxpayers deserve a clear understanding of what to expect when audited. Unfortunately, there is no clear statutory guidance of what audit methods are acceptable and when. Auditors are increasingly reliant on the use of indirect methods and projection sampling (extrapolation). HB 4288-Sales Tax, HB 4292-Use Tax and HB 4289-Unclaimed Property would provide Treasury auditors with clearer guidance on conducting audits. At the same time, taxpayers would have a better understanding of what to expect while under audit. Better guidance equals less confusion, less costly litigation, and more good will.
The bills would codify standards and procedures for conducting an audit and prohibit the Michigan Department of Treasury from using any "indirect audit procedure", which is defined as a procedure which relies on circumstantial evidence and therefore more than one possible conclusion exists, unless the Department has documented reason to believe that any records or returns filed are inaccurate or incomplete and that additional taxes are due.
Further, the bills attempt to eliminate "arbitrary" audits by codifying that an audit must include a review of the taxpayer's books and records, require written approval from the taxpayer to use an indirect audit procedure or sampling, and require the Department to provide to the taxpayer the evidence they used in determining tax liability.
There are many real-life examples which illustrate how the use of an indirect audit procedure combined with a sample and sample projection (extrapolation) resulted in arbitrary conclusions. Without formal procedures, taxpayers are left with audit assessments that do not accurately reflect their business activities or transactions.
In two 2011 Tax Tribunal decisions [Fradco, Inc. v Dep't of Treasury and SMK, LLC v Dep't of Treasury] the Tax Tribunal found in favor of both taxpayers. The Tribunal stated: "The process and procedures followed by Respondent's auditor cannot be relied upon. ...Respondent's calculations and methodologies result in imperfect estimates because they are based on an incomplete sample of purchases invoices for two months, extrapolated over an almost four-year period, using an estimated "average" mark-up."
The sad fact in regard to both of these cases, although decided in 2011, the Department of Treasury; 1) is appealing both cases to the Supreme Court on jurisdictional issues, and 2) continues to use indirect audit procedures combined with an inadequate sample and biased sample projections. There are also two cases pending before the Tax Tribunal where the Department picked two months, both winter months for a seasonal business, and used an indirect audit procedure to project the results for four years. In short, the Department is not following good, reasonable audit procedures in their use of indirect audit procedures, sampling and sample projections and the courts are agreeing.