THE susceptibility of VAT/GST to frequent unethical practices is considered a daunting challenge for the Inland Revenue tax administration.

Largely, a person commits sales tax fraud if taxable supplies are made without getting registered under the GST Act and, or, involves false sales tax invoices for either understating tax liability or overstating the eligible tax credit or refunds. Loss of revenue also occurs where businesses remit to the government less sales tax amount than they have charged their customers or where they claim deductible input tax on the basis of fake invoices.

A ‘taxable supply’ takes place when an importer, manufacturer, wholesaler (including dealer), distributor, or retailer supplies goods other than those exempt in section 13 of the Act.

Supply of goods chargeable at the rate of zero per cent is also considered taxable supply under section 4 of the Act.

All such persons engaged in making taxable supplies are required to be registered under the Act. Manufacturers are required to be registered if the value of their supplies in the last twelve months exceeds Rs5m, now Rs10m from July 1, 2016, or if their annual utility (electricity, gas, and telephone) expenses exceed Rs700,000 in the last twelve months.

Retailers must register if the value of their supplies in the last twelve months reaches Rs5m. There is no registration threshold for importers, wholesalers (including dealers) and distributors.

A considerable part of the economy is informal, because among other things, taxable supplies are being made without getting registration. Discovery of unregistered businesses gives rise to a windfall for the tax authorities.

For example, tax authorities visited the business premises of non-registered manufacturer ‘A’, which was engaged in manufacturing and supplying wooden furniture.

They found that ‘A’s unremitted sales tax liability for the last five years was Rs176m and assessed ‘A’ for that amount, without allowing ‘A’ to deduct any input tax. ‘A’ disputed the assessment on the ground that it could not have manufactured the furniture without the purchase of wood.

Consequently, even though ‘A’ could not produce any purchase invoices, the assessment should be reduced by the VAT on ‘A’s inputs. Besides, even if ‘A’ would liquidate the entire business, the proceeds would not be sufficient to pay the tax debt. Where ‘A’ produces and supplies furniture for a value of over Rs1,000m, it must logically be assumed that ‘A’ must have purchased a considerable amount of wood, even if ‘A’ is not registered and cannot produce any purchase invoices. So, it would be fair if the tax authorities would limit the assessment to, say, 70pc of ‘A’s turnover. Is it likely that the High Court will grant ‘A’ such a flat-rate deduction? The answer is NO, because such a flat-rate deduction would put a bomb under the entire sales tax system, which is based on invoices.

The sales tax system is not based on an estimated value added. Sales tax is based on actual turnover minus the sales tax actually paid on inputs. It is clear that ‘A’ will never be able to pay the assessment unless its profit margin is much higher than 17pc.

It is very common that non-registered businesses go bankrupt after the tax authorities have discovered their unlawful activities and have assessed them for unremitted VAT.

In another case, the department conducted action under section 38 of the Sales Tax Act, 1990 on the manufacturing premises of ‘B’ who manufactured and supplied wheat threshers and other agricultural machinery.

On the basis of record resumed, its sales tax liability worked out at Rs38m as output tax without giving the benefit of input tax adjustment. ‘B’ agitated that it is beyond its capacity to pay this hefty amount. Furthermore, ‘B’ produced record of inputs.

About 70pc inputs used in manufacturing of taxable supply were imported items subject to sales tax at the import stage as the same are not produced /available in Pakistan. But ‘B’ failed to produce ‘invoices’ as per relevant provisions of the Act. [If B actually produced evidence (customs documents) on the imported goods, including the amount of sales tax remitted to the customs authorities on importation, the tax authorities should reduce the assessment accordingly].

Holding an invoice is normally only an administrative requirement, which should not have the effect that the importer loses the right to deduct input tax, if there is alternative evidence.

The most common form of sales tax fraud on the part of registered businesses is understating the value of supplies or overstating the value of purchases, or both.

The objective is to reduce the business’s tax liability or to claim a refund of sales tax as flying invoices only make it more difficult for the tax authorities to trace the real supplier and assess the supplier for unremitted sales tax.

Many dummy firms register just for the purpose of issuing sales tax invoices to enable other businesses to reduce their tax liability or to claim refunds. These firms register in the name of employees or persons having no connection with any business activity, on the basis of fake documents.

The magnitude of the problem is illustrated by the number of bogus companies that were busted by the Intelligence and Investigation department.

A company misused SRO 1125 and out of a demand of Rs439m, an amount of Rs150m was recovered. Another group misused SRO 1125 and committed tax fraud to the tone of R796m.

In Pakistan’s informal economy, which predominantly consists of small and medium-sized enterprises, legitimate businesses have difficulties in purchasing inputs from registered suppliers because they are difficult to find.

Purchases from legitimate suppliers do include sales tax but that sales tax can be deducted by the customer, which means that the sales tax is not an actual burden on the purchaser, unless the purchaser is not registered.

Non-registered suppliers commonly offer inputs of similar quality for lower tax-exclusive prices. The prices are lower, not because non-registered suppliers evade sales tax, but because they evade other taxes, such as income tax and social security contributions.

However, even registered businesses do not always operate within the limits of the sales tax legislation because, in order to boost deductible input tax, they frequently purchase fake purchase invoices.

Analysis of data of some registered businesses indicated that they claimed input tax in relation to purchases that were not even related to their business activity. For example, a manufacturer in the tea sector has claimed input tax on the invoices issued by other registered persons engaged in supply of tyres and aerated water.

There are registered businesses with dormant businesses that file ‘nil’ returns for many years but, in reality, issue fake invoices enabling other registered businesses to deduct large amounts of input tax. Like in many economies, it is a daunting challenge to tackle the issue of fake and flying invoices in this country.

There are also cases in which registered businesses have claimed sales tax in relation to invoices which were connected with fake/non-verifiable customs import declarations.

Published in Dawn, Business & Finance weekly, July 18th, 2016