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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The audit plan must be reviewed by the team leader and approved by the process
owner or the team leader to ensure completeness. Further that, the audit plan is not
cast in stone, is expected to be flexible and should be reviewed after the entry
conference or during audit execution as and when addition information or
clarification is obtained.

Below is a pro forma of an audit plan matrix with an illustration.

Item Scope Objective Audit procedure Information Auditor Time log

during audit required in for audit
charge activity
Plant & 2014 to Verify: Verify:  Log book/ Amon 1 day
Equip 2017 registration
Accuracy and  Existence detail of
validity of  Cost taxpayer
depreciation  Ownership  Loan
allowances  Extent of use in agreements
claimed the business  Import
 Re-compute documents
depreciation
allowances in
accordance with
the
proclamations
and regulations
thereof

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10 Audit execution
10.1 Introduction

Audit execution chronologically follows the audit planning phase. It seeks to

implement the audit plan in order to obtain sufficient and appropriate audit
evidence regarding aspects of tax leakage (risk) identified during planning phase.

Obtaining sufficient and appropriate audit evidence is an important aspect of the

audit execution phase because tax audits are expected to result into a tax
assessment which in accordance with Article 25(1) and 26(1) of the Federal Tax
Administration Proclamation (the legal basis for a tax audit) is expected to evidence
based.

Further, the Federal Tax Administration Proclamation provides the taxpayer with a
window for appeal to a tax assessment. Article 59 of the said Proclamation provides
that the burden of proof lies with the taxpayer to prove that the tax decision is
incorrect. Accordingly, where the tax assessment is evidence based, it is unlikely
that the taxpayer will choose for arbitration because they will have nothing to prove
to the adjudicators that the assessment is incorrect and ensures that collections from
audits are expedited.

On account of the foregoing, auditors are expected at all times to obtain sufficient
appropriate audit evidence in relation to audit activity giving raise to estimated tax
assessments pursuant to Article 26(1) to mitigate incidences of appeal.

Key aspects of the audit execution phase: The audit execution phase is made up
of the following stages:

1) Initiating the tax audit.

2) Entry conference.

3) Audit procedures for obtaining audit evidence and the relevant audit working
papers.

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 4) Communication of preliminary audit findings in the form of queries. These
queries will be cleared based on additional evidence from the taxpayer.

5) Reconciliation and communication of reconciled audit findings with the

taxpayer.

10.2 Initiating the audit

a. A tax audit shall be derived from an annual audit plan on the basis of tax
risks identified during the plan stage through detailed analysis of financial
statements and risks flagged by the risk engine.

b. A notification to the taxpayer of an impending audit shall be hand delivered

to the taxpayer not later than 10 working days prior to the date of
commencement of the audit and shall be written in a manner that affords
courtesy to the taxpayer.

c. Where a notification could endanger the aim of the audit, particularly

investigative audits, no fore warning shall be given.

d. A notification to a taxpayer of an impending audit shall contain:

i. The tax identification number and address of the taxpayer

ii. Scope of the audit

iii. Membership of offices to perform the audit

iv. The effective date of the audit (including appointed date for the entry
conference) and the requirement of senior leadership/owners of the
business to attend the said conference.

v. List of documentation that may be required based on identified risks.

vi. Duration of the audit drawn from the audit planning matrix.

e. A tax audit shall be conducted during the working hours of the taxpayer.

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 f. A taxpayer or a delegated tax representative shall be under obligation to
participate during the audit and provide information or records at the verbal
request of the auditors.

10.3 Entry conference

This is the first meeting with the taxpayer or his designated representative prior to
commencing the examination of their records. It aims to obtain additional information
regarding the taxpayer’s business, answers questions from the taxpayer, discusses
records required and any other issues relevant for the conduct of the audit. It sets
the tone and direction for the audit.

Attendance of senior auditors at the entry conference (Team leaders or process

owners) is mandatory for better understanding of the taxpayer’s operations and to
provide leadership to the audit team from an informed standpoint.

Further, the branch audit leadership is required to engage the taxpayer to secure
their attendance or designated key management staff who is in a position to provide
key relevant information of the business and transactions to the audit team
unrestricted.

The following is expected of the auditors during the entry conference.

1) List all the taxpayer’s representatives who attend the entry conference.

2) Make the taxpayer aware of the purpose of the audit and what is expected of
the taxpayer, as well as what the taxpayer may expect of the auditors, what
taxes heads are to be audited and the audit period.

3) Discuss the taxpayer’s business operations, activities and administrative

organization including;

i. Nature of business

ii. Product lines

iii. Clientele

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 iv. Availability and location of records

v. Related parties and nature of transactions.

vi. Accounting system, methods and reporting channels.

vii. Obtain company literature if available – brochures, pamphlets, annual

reports, management accounts, etc.

4) Determine the taxpayer’s method of compiling and reporting taxable

amounts, including the following:

i. Are records computerized or manual

ii. Are records centralized in one location or kept separately for each
division

iii. Records available and how they are filed

iv. Who prepares the tax returns, and whether there have been any
changes in personnel.

v. Review step-by-step procedures used to prepare the return

5) Discuss the audit procedures that may be used and determine if the
organization of records is such that a sample or projection is feasible.

6) Verify historical information with the taxpayer and note any changes in
ownership, business growth, mergers, plant expansion etc.

7) Seek understanding of the following

i. Key suppliers and customers including trade terms (credit days and
collection period)

ii. Bankers including loan obligation.

iii. Nature of employment benefits for staff, e.g. use of motor vehicles or
provision of accommodation.

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 iv. Whether the premises are rented and existence of outlets/ branches.

8) Tour the business operations of the taxpayer and note the following

i. Assets maintained and actively deployed in the business.

ii. Idle assets (plant) if any.

iii. New construction or construction in progress and obtain agreements.

iv. Services provided and/or products sold

v. Accounting process

vi. Level of business activity in relation to financial information

9) Document proceedings and secure endorsement from the taxpayer.

Following the audit conference, the audit plan should be reviewed to reflect
additional information or clarification obtained from the taxpayer during the
conference and tour of the business operations.

10.4 Audit procedures for obtaining appropriate audit evidence during audit
execution

The audit procedures (largely substantive) considered here are those expected to
aid the tax auditor to obtain sufficient appropriate audit evidence for assumptions
made and risks identified during the audit planning phase, through analytical reviews
of the financial statements and other relevant information. The procedures
particularly examine whether the taxpayer has overstated expenses or under
declared income.

Below are the procedures relevant to the various accounts;

10.4.1 Tangible fixed assets

Objective is to confirm:

i. Existence of assets. Fictitious assets are not legible for depreciation.

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ii. Ownership of assets as depreciation is due to the owner of the asset.
iii. Valuation of assets is not inflated with undue costs so as to claim excessive
depreciation.
iv. Disposal of assets giving raise to gains/ losses are properly accounted for.
v. Depreciation is in accordance with the law.

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1) Existence of assets and use in the business

 Inspect assets and check that they are included in

fixed assets register.
 Any assets that cannot be accounted for should be
removed from the register and the depreciation
hitherto claimed disallowed in the tax computation.
 Extent to which the asset is used in the business of
the taxpayer
 Where the asset is provided for the private use of the
employee, such as a vehicle, check if employment
tax has been computed on the benefit.

2) Ownership of assets

 Verify ownership by inspecting title deeds, car log

books and transfer / sale agreements
 Remove from the fixed asset schedule any assets
not owned by the taxpayer and any previously
claimed depreciation disallowed.

3) Valuation

 Check purchase documents and invoices issued

from the suppliers and trace to the assets schedule
for completeness.
 Where the assets are constructed, check
agreements with the contractor and invoices thereof
issued.
 Ensure that interest on funds borrowed to finance a
purchase or construction are not capitalized after the
asset has been brought to use.
 Any assets whose value cannot be substantiated
should be removed from the fixed asset schedule
and the depreciation allowance reduced accordingly.

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 Where the assets are imported and have paid VAT at
importation which is claimed as input Tax, audit
should check whether the costs build up does not
include VAT claimed.
 Check that withholding taxes imposed at importation
which are claimed as tax credits have not been
included in the cost build up.
 Revaluation of assets is not included in the
depreciation base.

4) Disposal

 Check that the disposed amounts have been deleted

from the fixed assets schedule in the year of
disposal. Where the disposed assets are removed
from the fixed assets schedule during the year after
disposal, depreciation claimed after the disposal
should be disallowed.
 Confirm that computation of loss or gain on the
disposal of assets is done in accordance with the
proclamation and that the correct amounts posted to
expenses or income account respectively.
 Where the asset disposed was partly used for other
purposes other than the business, gain or loss
should relate to the fair proportional part of business
use- Article 25(5) of the Income Tax Pro.
 Where the disposal involves taxable asset, that the
gain or loss is considered under schedule D, other
income and not schedule C, Business income and
that the correct rates of tax have been applied in
accordance with Article 59 of the Proclamation.

5) Depreciation

 Adjustments are made where the asset is either

partly used during the year or used for other
purposes other than that of the business.
 Check that the correct rates applicable to each
category of assets are used and applied.
 Re-compute the depreciation allowances and make
appropriate adjustments.
 For additions check that the assets are depreciated
only when they are ready and available for use in
deriving business income. For instance, in the case
of plant that is assembled, depreciation commences

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after assembly in accordance with Article 25(6).
 Where the assets were acquired during the repealed
proclamation, the provisions of the repealed
legislation on depreciation continue to apply and the
audit should check compliance with the said
legislation.

10.4.2 Debtors and prepayments

Objectives

i. Trade debtors reasonably match sales revenue

ii. Prepayments are not expensed during the year of payment.
iii. Whether write offs follow the provisions of the law and recouped write offs
are included in income.

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1) Debtors match sales / revenue

 Agree debtor’s ledger to sales to check for any unrecorded

sales

2) Bad debt write offs and amounts recouped.

 Review procedures for bad debt write off and confirm that
the amounts claimed were included in income. Any write offs
not included in income should be disallowed.
 Check whether write offs arise from trade debtors, any write
offs which are not business related should be disallowed.

3) Prepayments are not expensed

 Prepayments are not deductible in the year of payment and

accordingly, a review to confirm that these have not been
deducted should be undertaken.

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10.4.3 Bank and cash balances

Objectives

i. Cash flow statement reconciles to cash and cash equivalents at the year end
ii. Revenue through the cash and bank is recorded and accounted for in the tax
returns

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1) Cash flow statement reconciles to year end cash

balances

 Re-compute the cash flow statement with any

unexplained variances brought to the tax bracket.
 Use of the indirect method should be done after
adjusting other balance sheet accounts, if they are
found to be incorrectly stated or manipulated. In
other words, a cash flow statement considered after
reconstructing other account balances.

2) Revenue through cash and bank is declared

 Obtain bank statements and match credits to

revenue declared with any variances representing
undeclared income.
 Bring to tax any undeclared banked income.

10.4.4 Inventories

Objectives: Determine that:

i. Inventories are not understated (valuation) to increase cost of sales.

ii. Inventories exist for the purpose of the business and are not simply used to
claim expenses.

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1) Inventories are not understated (valuation)

 Sample invoices of material stock items to the

purchases ledger and check out for any variations.
 Consider year end stock count documents especially
when they are attended by auditors of repute.
 Compare inventory value brought forward with
previous yearend balances to trace for any
variations.

2) Existence of inventories for the purpose of the business

 Inspect the inventories and check that they exist.

 Inspect inventories (sample) on the basis of the
taxpayer’s business type to determine whether
stocks held are consumed in the business. For
instance, a company that sales computers would not
be expected to keep car spare parts as stock. If this
happens, then it indicates that the taxpayer has not
fully disclosed other business dealings.
 Inspect production lines to confirm whether the
taxpayer is a manufacturer or an agent of a
manufacturer especially where they claim costs of
raw materials.

10.4.5 Revenue

Objectives: To check

i. Completeness of the sales/revenue with regard to understatement.

ii. Classification of income in accordance with the prescribed schedules (A, B,
C & D)
iii. Accuracy of declaration especially where sales are made to related parties.

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1) Completeness of revenue with regard to understatement
 Inspect the sales ledger using CAAT s (e.g. Idea,

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Advanced Excel) to detect any missing invoices in the
sales ledger.
 Inspect VAT tax returns particularly input in relation to
sales made by this client and check whether
corresponding sales have been declared.
 Where the taxpayer is a construction company,
reconcile the contract documents to the certificates
issued and income declared.
 Use third party information especially IFMIS where the
taxpayer is a supplier to government to verify
declarations and exports under Ascyuda.
 Where the taxpayer is a contract manufacturer, check
agreements for supplies and reconcile them to the
sales ledger.
 Inspect creditors for any hidden sales. Creditors are
known to be vehicles for hidden income.
 Reconcile VAT and Income Tax returns for any
variances.

2) Classification of income in accordance with prescribed

schedules ( A, B, C & D)
 Inspect the income records to ensure that income is
classified as per the prescribed schedules. This
particularly applies to income under schedule D with
most inflows taxed on the gross proceeds without
providing for expenses.
 Confirm that the correct tax rates have been applied to
the respective incomes.

3) Accuracy of declaration especially where supplies are

made to related parties
 Where supplies are made to related parties check the
rates used in relation to similar goods and services by
the same taxpayer and make adjustments to reflect
market valuation. This applies to both VAT and Income
Tax.

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10.4.6 Expenses/ Purchases

Objectives

i. Purchases are made (occurrence), to sieve out fictitious purchases.

ii. Purchases claimed relate to the business
iii. Expenses/purchases are recorded at their true value, not overstated.

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1) Purchases are made to sieve out fictitious invoices.

 Check stock cards, bank statements and invoices or

delivery notes of material purchases to confirm that they
were supplied.
 Check suppliers (sales) for declaration in the VAT returns
to confirm existence of purchase through the sales
system of the supplier.

2) Purchases/expenses claimed relate to the business

 Purchases/expenses should be inspected to confirm that

they relate to the business.
 Disallow purchases/expenses that are not related to sales
of the enterprise.

3) Expenses/purchases are recorded at their true value, not

overstated

 Inspect the purchases ledger on sample basis especially

those of a material value to check that they don’t include
VAT where it is recoverable.
 Inspect imported items for inclusion of withhold tax at
importation that is deducted as a tax credit.
 Where the goods are supplied by a related party, check
confirm that they are supplied at arm’s length.

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10.4.7 Creditors and accruals

Objectives

i. Whether trade creditors relate to un paid business expenses

ii. Whether expenses accrued relate to the year of accrual
iii. Whether creditors don’t include sales

Work Work
Audit procedures done paper
by ref
1) Whether creditors relate to unpaid business expenses

 Inspect trade creditors to confirm that they relate to

business.
 Personal expenses especially where the enterprise is a
sole proprietorship should be disallowed.
 Where the enterprise is a body, these could be allowed
but taxed to the recipient, such the director as
employment benefits.

2) Whether expenses accrued relate to the year of accrual

 Confirm that expenses accrued especially material items

relate to the year of accrual.
 Study agreements e.g. rental agreements and prorate
expenses that are consumed during the year.
 Disallow any accrued expenses that relate have not
accrued.

3) Whether creditors don’t include sales amounts

 Review creditors ledger to trace out for any amounts

included as sales revenue
 Adjust the tax computation to include undeclared sales.

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10.4.8 Long term liabilities

Objectives

i. Existence of long term liabilities

ii. Interest rates charged

Work Work
Audit procedures done paper
by ref
1) Existence of long term liabilities and use in the business

 Confirm from loan agreements existence of loan

agreements.
 Where the taxpayer is unable to substantiate existence
of liabilities, this could mean that the said loans are
financed from undeclared income and should be brought
to the tax net.
 Where the nonexistent loan is used to finance
nonexistent assets, remove from the depreciable base
the said assets and disallow the depreciation expense
accordingly.
 Disallow interest expenses in relation to unsupported
loans.
 Check loan agreements to confirm use in business of
the taxpayer. Disallow interest claimed if the loan is not
in relation to the business.
2) Interest rates charged

 Review loan agreements for interest rate.

 Disallow interest paid or payable to a related person
who is not a resident of Ethiopia except when the
interest is included in the schedule D of the related
person.
 Disallow interest in excess of 2 percentage points
between the national bank of Ethiopia and commercial
banks unless the lender is a financial institution
recognized by the central bank.

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10.4.9 Share capital

Objectives

i. Source of share capital, the increases are not sourced out of undeclared
sales.
ii. Shareholder capital and dividends.

Work Work
Audit procedures done paper
by ref
1) Source of share capital, especially increases

 Examine the ability of the shareholders to introduce

additional shareholding to the company.
 Where the shareholders are unable to account for the
increase from credible sources say loans, salary, etc..,
this could imply that the purported shares capital is
internally generated and should be treated as sales.
 In the alternative, where the source is a different
business which is outside the tax radar, this income
should be treated as dividends and taxed on the
shareholder(s).

2) Shareholder capital and dividends

 Confirm that dividends paid are not deducted against

income.
 Confirm that the increase in share capital is of the
company is not expensed.

10.5 Audit methods

The audit of a taxpayer comprises both financial and compliance audit. The
compliance aspect of auditing is to ensure that the taxpayer is adhering to the
provision of tax laws. The financial audit may take the form of either a direct or
indirect method as explained below.

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10.5.1 Direct method

This method involves the review of a taxpayer’s transactions and financial records
available and consists of a systematic examination and evaluation of financial and
accounting systems, transactions and accounts of the taxpayer, in order to attest to
“truthfulness” and “fairness” of the financial statements in regard to taxation.

10.5.2 Indirect method

Indirect method is the determination of a taxpayer’s liability by use of partial

accounting records and other available information about the taxpayer. What is key
is the fact that money leaves tracks and a diligent tax auditor or investigator will
always look out for the money trail.

The success of the indirect method hinges on third party information and
interviewing/investigative skills of the audit staff. If indirect income measurement
methods are to be adopted, the audit will need to question the taxpayer on personal
expenditure and receipts comprehensively early in the interview process. It is often
useful to obtain signed statements from a taxpayer in this regard.

The approach to the interview will vary according to the type of case. In a small
business operation, the matters discussed will be to do with the nature of the
business, the accounting and bookkeeping procedures used in the business and the
financial affairs of the taxpayer and associated persons. In a large business
enterprise, the focus will be on the accounting system and the interpretation if the
law in specific instances.

Types of indirect methods include the following:

1. Expenditure method/source and application of funds.

a) This method focuses on expenses and compares sources and

application of funds.
b) The basic formula is: All expenditure less funds from known sources
(declared income) EQUALS funds from Unknown sources (Undeclared
income)

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 c) Sources of funds are represented by decreases in assets and/or
increases in liabilities, plus legitimate known sources items like wages,
salaries, business profits, rent, gifts, inheritance etc.
d) Application of funds are represented by increase in assets and/or
decrease in liabilities, plus known expenditures for living expenses.

2. Bank deposit method

a) This method operates on the premise that there are only three things a
person can do with money, i.e. spend it. Deposit it or hoard it (ina which
case cash on hand increases). The focus therefore is on bank deposits,
cash expenditure and cash on hand increases.
b) A vital component of this method is analysis of deposits to ensure
accuracy of figures and to eliminate non-income items by determining
the nature of deposit (income, capital proceeds etc.), making
adjustments for transfers out and into other accounts and determining
actual amounts deposited, composition of deposits, source of items
deposited and classification of deposited items.
c) Unidentified deposits should be deemed income of the taxpayer if he is
involved income generating business or he makes regular or periodic
deposits.
d) It is important to ascertain cash on hand at the beginning of the year and
determining the increase in cash in hand, if any for the year in question.
e) The basic formula for this method is Total Deposit PLUS Increase in
cash on hand, PLUS Cash Expenditure, LESS Non-income deposits and
items EQUALS Total funds; LESS Funds from Known sources; EQUALS
funds from Unknown sources (Omitted/undeclared income)
3. Means test

a) This is a test to determine a taxpayer’s resources. The underlying

principle is that one cannot spend more than what is available, i.e.
income must equal expenditure over a fixed period of time. The basic

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 formula in this case is “Known Incomings LESS Known Outgoings
EQUALS Balance Available”
b) A low balance indicates insufficiency to meet day to day living expenses,
thereby implying the taxpayer’s information is incorrect and further
analysis is required. A means Test is not an end in itself.

4. Asset betterment/capital statement/net worth/capital accretion method.

a) This method identifies items of capital and how it was financed by

following the money trail.
b) The basic principle behind this method is the income must equal
spending and saving. If there is no omitted income, then savings and
expenses must equal available income or known income.

5. Percentage method (mark-up/mark-down)

This involves a comparative analysis of businesses trading in similar items

within the same environment and time frame. The idea is to establish market
trends for purposes of assessing the reliability of a taxpayer’s disclosures.

6. Unit and volume calculations/ Input-output ratios

The input/output ratios help to compare firms in the same industry to confirm
whether sales are being understated. It establishes units of inputs required to
produce a specified quantity of outputs, taking into account wastage at
acceptable percentages.

10.6 Audit working papers

Once the audit program is drawn, audit working papers are required to be completed
by the auditors indicating adjustments made during audit execution. They are
required to be reviewed and approved by the senior team members, preferable the
audit team leader.

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It is essential that the entire audit process is documented, because;

i. Documents show that the audit work has been done properly
ii. It enables senior staff to review the work of junior auditors.
iii. It will help the audit team in future audits.
iv. It encourages a methodical, high-quality approach.

10.6.1 Importance of audit working papers

Audit working papers are necessary because they;

i. Are necessary for audit quality control purposes.

ii. Provide assurance that the work delegated by the audit senior/team leader
has been properly completed.
iii. Provide evidence that an effective audit has been carried out.
iv. Increase the economy, efficiency and effectiveness of the audit.
v. Contain sufficient detailed and up-to-date facts which justify the
reasonableness of the auditor’s conclusions.
vi. Retain a record of matters continuing significance to future audits.

10.6.2 Content of audit working papers

The following are the essential content that all audit working papers should have

i. The name of the person who prepared it, and their signature
ii. The date it was prepared
iii. The name of the person who reviewed it, and their signature
iv. The date it was reviewed
v. The name of the client and their tax identification number
vi. The tax year/ accounting year
vii. A file reference, and cross-reference to other pages in the file
viii. Account audited, e.g. depreciation.
ix. Some explanation of the aim of the work that was done, how it was done.
x. The conclusions of the work

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 xi. If a sample was selected, which items were tested and how the sample was
chosen. Audit evidence (documented) gathered shall be included in the audit
working paper with a cross reference to the evidence on the audit file.

10.7 Reconciliation and communication of audit findings

When the audit preliminary findings are in place, it is good practice for the auditors to
share with the taxpayer. This sets the stage for reconciliation meetings to agree
findings of the audit team and reduces on the incidences of appeal.

The said engages are to be attended by senior audit team members, particularly the
audit team leader and key personnel of the taxpayer preferably the accounts staff or
their tax representative.

Once the audit findings have been reviewed and agreed with the taxpayer, a
management letter is issued communicating the final audit findings and their
implication to tax. Chapter 11, Audit completion considers the next steps.

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11 Audit completion
11.1 Introduction

Audit completion is the final phase of the audit program and is as important as the
audit planning and audit execution phase. It is at this stage that the audit is
concluded notwithstanding that the taxpayer may appeal the outcome and will
require a review of the audit findings and assessments thereof.

Prior to engaging the taxpayer at the exit conference, the taxpayer should have
received a copy of the final audit findings with potential adjustments reconciled by
both parties and is given an opportunity to express their disagreement or agreement
on any outstanding matter.

Senior members of the audit team, preferably the audit team leader and process
owner are required to attend in person in order to manage any unresolved issues
with the taxpayer during the reconciliation meetings. This calls for adequate
preparation, ahead of the exit meeting.

Conversely, the taxpayers or their trusted representatives are required to attend the
exit meeting to commit on the outcomes of the audit. Accordingly, notification for the
exit meeting is required to be sent out at least 3 (three) days in advance.

Auditors are expected to treat the taxpayer with courtesy and respect and should
exercise restraint even when the taxpayer is clearly upset with audit findings.

At time of completion, auditors should complete the template shared by Risk and
Taxpayer Compliance Directorate to provide feedback on the risk level information
provided for the audit case.

11.2 Exit conference

Upon completion of the field work, the auditors are expected to meet with the
taxpayer and explain the audit procedures and findings with regard to -

i. All records examined;

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 ii. A detailed description of audit procedures used and audit adjustments
supported with evidence where appropriate;

iii. Minor errors for which no adjustments were made;

iv. Applicable law and procedures;

v. Any additional information the taxpayer may provide within a set time to
reduce the tax liability;

vi. Taxpayer’s objection and disagreements with the audit;

vii. Proposed tax adjustments;

viii. Payment procedures;

ix. Policies and procedures pertaining to penalty and interest imposition waiver.

At exit meeting, the audit staff are required to document areas of disagreement
which originate from application of tax law, audit procedures and methods used, and
the non-availability of records.

Auditors are required to educate the taxpayer as to the proper procedures to follow
in future, and make recommendations on proper reporting methods without
attempting to redesign the taxpayer’s accounting system.

11.3 Communicating the final audit findings

After the exit meeting, the audit team is expected to communicate the final audit
findings to the taxpayer in a letter, making reference to the assessment notice
issued.

11.4 The Audit report

The audit report details the audit outcomes and features the following-

a. Cover page

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 i. Taxpayer information- Name, TIN, Postal and Physical address, Auditor’s/
Tax Representative, Nature of Business.

ii. Members of the Audit team

iii. Tax periods under audit

iv. Previous audit period

v. Audit commencement date

vi. Audit completion date

b. Background/ overview of taxpayer

A brief description of the taxpayer including commencement and nature of business,

activities conducted under the business, directorship and ownership of the business,
related companies or businesses, significant changes over the years etc.

c. Scope of the Audit

A brief description of what activities were conducted during the audit and to what
extent, including limitation in scope

d. Records availed and examined

e. Findings, adjustments and justification, preferably in a tabular form.

f. Summary of findings

g. Taxpayer concurrence and recommendations

i. Overall view of the audit exercise

ii. Reconciliation and agreement/ disagreement reached with the taxpayer

iii. Observations and recommendations for future audits

h. Endorsement by audit team and process owner

i. Remarks/ observations by team leader

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 ii. Remarks/ observations by process owner

iii. Signatures-Audit team members

11.5 The audit file

Audit findings, report and evidence collected during the audit are required to be filed
in a coherent manner that aids reference. In order to make it readable, the audit file
is expected to be referenced and cross referenced. A well referenced file simplifies
audit reviews.

Further, the audit file is expected to kept under lock and key for future reference
especially during arbitration.

11.6 Referencing and cross referencing

A reference identifies the document while a cross reference indicates the source of
the issue or refers you to a subsequent document where the same issue is being
addressed.

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12 Objection and Appeals
12.1 Introduction

An objection or appeal naturally follows audit activity where the taxpayer for certain
reasons is dissatisfied with a tax assessment arising from audit.

The right to appeal is statutory and in this regard, Article 54(1) of the Federal Tax
Administration Proclamation provides that, a taxpayer dissatisfied with a tax
decision may file a notice of objection, in writing, with the Ministry within 21
(Twenty-one) days after service of the notice of the decision.

Article 2(34) (a) of the Proclamation defines a tax decision to mean among others a
tax assessment, other than a self-assessment.

Cognizant of the taxpayer’s right of appeal, the notice of assessment is required to

specify among others, the manner of objecting to the amended or estimated
assessment, including the time limit for lodging an objection to the assessment
pursuant to Article 28(5)(g) and 26(2)(f) of the Federal Tax Administration
Proclamation.

This chapter explores the role of tax auditors and the independent review team in the
management of tax appeals.

12.2 Applicable law for adjudicating tax appeals

The enactment of the Federal Tax Administration Proclamation harmonized

particular Articles including among others, the appeals and objections procedures
separately provided for in the Income Tax, Value Added Tax and the Excise Tax
Proclamations.

The Federal Tax Administration Proclamation currently in force provides for appeals
procedures in respect to tax assessments made prior to its entry into force (Article
137(1)) except an appeal that has been pending in the tax appeal commission
when the said Proclamation became effective. In this case, such an appeal shall be

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adjudicated in accordance with the tax laws in force prior to the Federal Tax
Administration Proclamation (Article 137(2) (b) of the said Proclamation).

Scenario 1

A limited is audited in October, 2018 for the tax year ending 31/12/2014. Business
Income Tax Assessments issued are appealed.

Determine the applicable Proclamation.

Solution

While the assessment relates to income for the period ended 31/12/2014 when the
Income Tax Proclamation, 286/2002 was inforce, the appeal will be adjudicated by
the Federal Tax Administration Proclamation in the terms of Article 137 (1).

Scenario 2

A Limited is audited in June, 2015 for the tax year ending 31/12/2014. Business
income tax assessments are issued. At the time of enactment of the Federal Tax
Administration Proclamation, the appeal is still pending in the tax appeal commission.

Determine the applicable Proclamation

Solution
\
In this case, the assessment was issued and objected to prior to the enactment of the
Federal Tax Administration Proclamation but the matter is still pending in the tax
appeal commission.

The appeal will be adjudicated in accordance with the repealed Income Tax
Proclamation, 286/2002.

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12.3 Grounds for appeal, the role of the auditor and independent review team

The grounds for appeal before the independent review team within the Ministry of
Revenues (MOR), may be on issues of fact or a question of law or both. This is
unlike an appeal before the Federal High Court which is strictly on a question of
law only.

In addition to the above, the burden of proof that the assessment is incorrect
rests with the taxpayer in accordance with Article 59 of the Proclamation. Further
that a notice of objection decision shall contain a statement of findings on the
material facts, the reasons for the decision and the right to appeal to the
commission (Article 55(6)).

In light of the above and article 55, the review team (department) is expected to:

a. Consider the facts of the objection on its own merits based on evidences
provided by the taxpayer. Such evidences must be in writing as is required
by article 54(1). This means that where the taxpayer is unable to
substantiate their claim (objection), the review committee cannot assume
that the assessment is incorrect, even if it is.

b. Notwithstanding (a) above, where they (review team) are of the view that the
amount of tax assessed should be increased, to recommend to the Authority
(Ministry of Revenues) that the tax assessment be referred to the tax officer
who issued the assessment for reconsideration (Article 55(3)).

c. Provide recommendations to the Ministry of Revenues (Authority) which will

provide the basis for issuance of an objection decision to allow in whole or in
part or entirely disallow it the taxpayer’s objection.

The threshold rule is that a member of the review team shall not partake of a
review (objection) that relates to a taxpayer in respect of which the tax officer
has or had a personal, family, business, professional, employment or financial
relationship or others wise involves a conflict of interest. (Article 6(3)).

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In this case, the member of the review team shall disclosure their conflict of interest
in the matter and step aside from the assignment.

The auditor is expected to:

a. Consider a recommendation by the review team to increase an

assessment, in the terms of Article 55(3). However, the review team will be
required to provide the basis for the recommendation since amended
assessments are expected to be evidence based, pursuant to Article 28(1) of
the Proclamation. Note a recommendation does not in itself create an
obligation for the auditor especially where evidences are not provided.

b. Issue and serve an objection decision to the taxpayer on the basis of the
recommendations given by review department. This decision is expected to
contain a statement of findings on the material facts, the reasons for the
decision and the right to appeal to the Commission.

c. Arrange and provide all relevant facts of the audit to the review team. In
providing this information, the auditor is not bound by the rules of
confidentiality in the terms of Article 8(2) (a) of the Proclamation.

d. Prepare and attend court proceedings as key witnesses in any court

proceedings relating to an appeal where they participated and issued an
assessment of tax.

e. Keep a log of all cases referred to the review team, including

recommendations by the review team and action taken.

f. Update the audit file with the objection decision including a re-computation
and amended assessments as the case may be.

12.4 Lessons drawn from objections and court precedents, the role of Audit
HQ

Appeals and the objection decisions made thereof could be a source of knowledge
to the audit teams to improve their approach to audit assignments. While the review
department is expected to build Chinese walls to enhance their independence with

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the audit teams, the review team, will be expected to share their findings and
experiences with the Audit Support Directorate (HQ) on a periodic basis in regard to
recurring areas of objection.

On the basis of this periodic report, Audit Support Directorate (HQ) is expected to
sensitize auditors on areas of audit weakness identified by the review team and
issue departmental guidelines to improve auditor capability in order to reduce the
incidences of objections arising out of the recurring objections.

Further, the Audit Support Directorate in liaison with the review and the legal
department is expected to keep a log of decided cases and rulings thereof given by
the appeal commission, Federal High Court and Federal Supreme Court.

The decisions of court are a source of law and provide important precedents (Case
law) which should be considered in interpreting tax law provisions (Articles). The
threshold rule being that a decision of a higher court overrides a decision of a lower
court. For instance, a ruling of the supreme court overrides a ruling by the high court
and a ruling of the high court overrides another given by the appeal commission.

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13 Sector based auditing
13.1 Introduction

This chapter considers tax audit of seven (7) specialized sectors - Construction,
Manufacturing, Finance (banking), Insurance, Import/export, Mining and Agriculture.

Sector based auditing directs tax audit activity to specialized sectors. This inevitably
requires auditors to develop capacity and skill to direct audit activity with precision.

Sound knowledge of the sector dynamics in which the taxpayer operates and the
legal framework (Accounting/IFRS and Tax law) that regulates financial and tax
compliance of the specific sector are a basic requirement for an auditor undertaking
review of a specialized nature (sector based auditing).

This chapter considers the accounting standards, tax legal framework and audit
procedures specific to the above sectors. The general provisions that apply to any
other sector will be assumed knowledge and are also covered under chapter 6, 7, 8,
9 and 10 of the audit manual. Auditors are encouraged to make reference where
applicable.

13.2 Key considerations of the tax legal framework for specialized sectors

Income tax

Article 20(2) 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, subject to other provisions of this Proclamation,
Regulations issued by the Council of Ministers, and Directives issued by the
Minister.

The above provision requires that financial reporting standards are the basis for
determination of taxable income except where a particular provision of tax law
specifies otherwise.

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Accordingly, in determining the taxable business income of the taxpayer under a
specialized sector, the auditor is required to evaluate its compliance with accounting
standards and tax law provisions specific to the sector. Audit procedures are
expected to identify aspects of taxpayer noncompliance with assigned tax law and
accounting provisions.

VAT & Excise Tax

Unlike income tax which prescribes financial reporting standards as the basis for
determining taxable income, this does not arise for VAT and Excise Tax.

13.3 Construction sector

This sector incorporates establishments primarily engaged in the construction

buildings, roads and other public infrastructure. Construction activities may include
new projects, additions, alterations, reconstruction, installation, maintenance and
repairs. Also included are demolition activities, clearing of sites and sale of materials
from demolished structures, blasting, drilling, land fill or leveling, earth moving,
excavation, draining and other land preparation.

Activities of these establishments are generally managed at a fixed place of

business, but construction activities are normally performed at multiple project sites
with responsibilities specified in contracts with the owners of the construction
projects for prime contacts with other construction establishments for sub-contracts.

13.3.1 Vehicle used for trade and its taxability

Arising from the above, most construction enterprises especially non- resident
companies operate through branches which are effectively permanent
establishments in the terms of article 4(3) of the Income Tax Proclamation.

Article 4(3) provides that, a building site, or a construction, assembly, or installation

project, or supervisory activities connected with such site or project shall be a
permanent establishment only when the site, project, or activities continue for more
than one hundred eighty-three days.

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This business structure (branch/PE of a non-resident) will be liable for business
income tax on income sourced in Ethiopia. In addition, where the branch repatriate’s
income, it will be liable for tax on repatriated profits in accordance with Article 62 of
the Income Tax Proclamation. See details on branch repatriated profits under
chapter 8 of this manual.

13.3.2 Tax legal framework

13.3.2.1 Income Tax

Effective 01/01/2018, IFRS 15 superseded IAS 11. Under IFRS 15, construction
contracts are treated just the same way as any other contracts with customers.

Article 32 of the Income Tax Proclamation which provides for long term contracts is
line with IFRS 15 on revenue recognition and cost allocation arising under
construction contracts, except that it excludes the output method (Work
certified/Total contract revenue) in determining the percentage of work completed
and has a differing approach to treatment of losses. The said Article only considers
the input method (costs to incurred/Total estimated costs) in the terms of Article
32(2).

As a result of the above, except where the taxpayer uses the output method in the
determination of the percentage of contract completed and the treatment of losses, it
will be expected that the taxable business income arising from their computation will
align with income determined in accordance with Article 32. Accordingly, auditors
are expected to check and make adjustments should the taxpayer use the
output method and has returned a loss since this is likely to contravene Article
32(1), 32(3), 32(4) and 32(5) of the Income Tax Proclamation.

The following steps are expected to be followed by the taxpayer in determining the
taxable business income/ loss arising under construction contracts which span more
than one tax year and are estimated to be completed in more than twelve months
(Long term contracts- Article 32(6) of the Income Tax Proclamation).

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a. Determine the percentage of work completed by the taxpayer during the
year. This determine by; (total costs incurred/total estimated contract
costs including any variations)

b. Establish the total contract price and the estimate costs to completion
multiplying each with the percentage of works completed as determined
in (a) above. The resulting figures should provide the income and
expenses attributable to the period and the taxable income.

c. Determine if the final year of the project is loss making. This happens if
the following conditions are met;

i. the taxable income(in (b) above) estimated to be made under the

contract for the purposes of the percentage of completion method
in ((a) above) exceeds the actual taxable income and

ii. the amount of the excess determined in (i) above exceeds the
difference between the business income and deductible
expenditures (taxable income) computed in (a) above for the tax
year in which the contract was completed.

The implication of the above is that a final year loss can only
arise if the difference between the actual income and
expenses over the life time of the project is a loss.

It should be noted that loss under IFRS 15 is estimated at the

commencement of the project as the excess of estimated
costs over the projected income. If this happens, this loss is
recognized immediately. This is clearly a divergent procedure
from Article 32 that determines the loss at the close of the
contract but allows for a carry back of the said losses for a
maximum of two tax years.

Arising from the above, Auditors are required at all times to

examine loss making contracts and whether they are correctly
treated in accordance with the law.

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 d. The loss determined in (c) above is utilized as follows

i. the loss is carried forward but if the taxpayer is unable able to do

so for the reason that the they cease to carry on business in
Ethiopia at the end the contract, the taxpayer may carry the loss
back to the preceding tax year. Where the preceding years taxable
income is unable to exhaust the loss, it is further carried back to the
next preceding tax year.

The implication of the above is that the loss can only be

carried back for no more than two tax periods (years).

ii. where the loss is incurred by a taxpayer other than one winding up
business, the loss is permitted to be carried forward for tax period
not exceeding five years. In this case, Article 26(3) applies.

13.3.2.2 VAT

The determination of VAT for construction businesses does not follow unique
procedures as in the case of Income Tax. However, the following are worth
mentioning;

When to account for VAT arising from construction services

VAT is a monthly tax and is dependent on when (time of supply) a supply is made.
However, in the case of construction services, these may not be made monthly.
Article 11(5) of the VAT Proclamation provides that, if services are rendered on a
regular or continuing basis, a rendering of services is treated as taking place on
each occasion when a VAT invoice is issued in connection with such services
or, if payment is made earlier, at the time when payment is made for any part of
such services.

The implication of the above provision is that construction enterprises will account for
VAT either on issuance of invoices or on receipt of payment for services. However,
advance payments for services to be rendered in the future will not attract VAT since
there are no services rendered. Article 4(1) b is instructive in this regard and

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provides that a rendition of services means anything done which is not a supply
of goods or money. At the time of receiving the advance payment, there is no supply.

Taxation of residents for construction services rendered outside Ethiopia

Construction services rendered by a resident outside Ethiopia are outside the scope
of VAT, i.e. not taxable in Ethiopia. Below is why.

VAT is naturally imposed on a taxable transaction in the terms of Article 7(1) a.

Article 7(3) defines a taxable transaction to mean 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. Further Article 10(2) a provides that the place of rendering of
services is the place where immovable property is located, if the services are
directly connected with the property. Therefore, where the construction site
(immovable property) is located outside Ethiopia, the rendition of construction
services will be deemed to be outside Ethiopia and such a transaction would be
outside the scope of VAT in Ethiopia (Not a taxable transaction).

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 whether
or not for 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.

Arising from the above, where a resident construction enterprise renders

construction services outside Ethiopia, by say A Limited to a consumer outside
Ethiopia say the Government of Uganda on the Owen falls dam located in Uganda,
these services would be outside the scope of VAT since they are not rendered
in Ethiopia. The place of rendition of services is Uganda where Owen falls dam is
located.

13.3.3 Taxation of construction services by non-residents

Unlike residents who provide construction services outside Ethiopia which are said
to be outside the scope of VAT, non-residents (not VAT registered) who supply
construction services to VAT registered or any resident legal person are taxed on
these services through VAT withholding.

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The consumers of these services are required to withhold the tax from the amount
payable to the non–residents in accordance with Article 23(1). In this case the
requirement to account for the tax is lies with the consumer of the service.

13.3.4 Glossary of issues for consideration during audit

13.3.4.1 Income

a. Where the construction firm has written contracts, the auditors are required
to obtain the said agreements to:

 Determine the contract price and duration of the contract.

 The duration of the project determines whether it is a long term

contract the extent to which article 32 of the Proclamation applies in
determining the taxable income of the construction enterprise.

 Reconcile the contract price to the revenue declared during the period
and whether they have been considered in the correct tax periods for
both VAT and Income Tax.

 Determine whether revenue recognition based on the input method

discussed above has been correctly applied for purposes of income
tax. Where the output method is used, the auditors are expected to
re-compute the income and expenses recognized using in the input
method.

 Whether the contract was varied, and whether the additional income
arising from the additional works is fully accounted in the tax returns.

 Reconcile the contract price with third party sources especially IFMIS
to ensure validity and completeness of the contract /amounts declared
by the taxpayer.

 Reconcile contract price with capitalized assets of the taxpayer’s

client/s to ensure completeness of income.

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 b. Other considerations

 Where the taxpayer is a branch of a non-resident company, whether

repatriated profits have been properly accounted in accordance with
article 62 of the Income Tax Proclamation and tax thereon is paid.

13.3.4.2 Expenses

Auditor are expected to examine the contracts and other relevant information to
determine whether

 Computation of final year loss is in accordance with Article 32(5) of the

Income Tax Proclamation.

 Final year losses have been properly applied either as a carry back for a
maximum of two tax years for entities closing business especially non-
residents or a carry forward for a maximum of five years for entities
whose business are ongoing in accordance with article 32(3&4) and 26(3) of
the Income Tax Proclamation.

 Inputs used match outputs declared from their suppliers. This can be done
by examining substantial claims of inputs obtained from registered taxpayers
to determine whether such supplies where made.

 Claim for depreciation is adjusted (reduced) for equipment which is not fully
deployed during the tax year in accordance with Article 25(3) of the Income
Tax Proclamation.

 Costs of assets especially used by branches of non-resident companies are

not inflated to so as to claim undue depreciation allowances.
Multinational entities run projects in different countries and will likely transfer
the same equipment to Ethiopia from another project. Considering that these
items move into the country duty free creates a window for inflating cost
value at customs for purposes of reducing their tax exposure through undue
depreciation claims.

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 Auditors are accordingly required to examine the purchase documents of the
taxpayer and not simply the customs value declared as these are likely to be
different. Article 68(1) of the Income Tax Proclamation determines the cost
base of a depreciable asset.

 Extent of use labor and whether employment tax is accounted for. In regard
to foreign branches employing expatriate staff, the remuneration paid should
be examined for reasonableness as most of these will receive the bulk of
their payments in their home countries to avoid employment tax in Ethiopia.

 Computation of employment tax on fringe benefits. These construction

projects especially those run by the foreign firms provide free
accommodation, transport and a host of other non-cash benefits. These
should be examined to confirm payment of employment tax.

 Thin capitalization rules provided by Article 47 of the Income Tax

Proclamation should be applied where the taxpayer is a foreign controlled
resident company or a permanent establishment of a foreign entity and the
loan is advanced by it’s the parent. Auditors are required to check
compliance with these laws.

13.4 Manufacturing sector

13.4.1 Introduction

The manufacturing sector features the following;

a. The manufacturing sector includes businesses engaged in the mechanical,

physical, or chemical transformation of materials, substances, or
components into new products and ate usually described as plants, factories
or mills. They characteristically use power driven material handling
equipment.

b. Materials, substances or components transformed by manufacturing

establishments are raw materials that are products of agriculture, forestry,

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 mining, or quarrying, as well as products of other manufacturing
establishments.

c. Materials used in the manufacturing may be purchases directly from

producers, obtained through normal trade/market channels or secured by
transferring the product from one establishment or another under the same
ownership.

d. The products of a manufacturing entity may be finished in the sense that it is

ready for utilization or consumption, or it may be semi-finished so as to
become an input for another establishment engaged in further
manufacturing.

e. As a general rule, establishments in the manufacturing sector are engaged

in the transformation of materials into new products. Their output is a new
product.

13.4.2 Tax law aspects

Unlike the finance, insurance and construction sectors, there are no specific tax law
provisions governing this sector. Accordingly, the tax law provisions applicable to
other business of a non-specialized nature apply to manufacturing.

13.4.3 List of issues for consideration during audit

Auditors are required to pay attention to the following areas during audit of
manufacturing entities.

a. Industry averages of a similar and comparable level on sales, production that

may be used to evaluate performance of the particular audit case.

b. Assets used. Manufacturing entities are usually capital intensive in nature.

This implies huge capital deductions through depreciation allowances.
Auditors are particularly required to establish existence, cost and
ownership of the said assets before grant of depreciation allowances.

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 For manufacturing entities that are newly established during the course of
the year of income, depreciation will be computed when the assets are ready
and available for use in accordance with Article 25(6) of the Income Tax
Proclamation. Accordingly, where assets have not been used for the entire
period, depreciation will be apportioned for the time the assets were used or
available.

c. Input output ratios. This requires scientific research into inputs used and
expected outputs. Auditors in this case will be supported by experts who are
able to determine through the use of given inputs, expected outputs. Use of
this method is common with investigative audits where a taxpayer is
suspected to be fraudulent. While MoR does not have in house experts
(chemists) to conduct laboratory research, other bodies of government such
as the bureau of standards, are equipped to handle such assignments.
Article 7 of the Federal Tax Administration requires all Federal and state
government authorities and their agencies to cooperate with the Ministry in
the enforcement of the tax laws. Accordingly, the Ministry may liaise with
such bodies to establish input output ratios for particular clients suspected of
fraud.

d. Sales.

Auditors are required to conduct a gap detection to determine whether sales

register is complete. This could be done using Computer Assisted Audit
Techniques (CAATS) like advanced excel and IDEA Audit Software. Gaps
on the sales register should be investigated.

e. Excise tax

Ensure that Excise Tax has been accounted for in respect of goods
(excisable) produced at the rates provided in the Excise Tax Proclamation.

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13.5 Finance

13.5.1 Introduction

This sector comprises establishments of firms which primarily engage in financial

transactions involving the creation, liquidation or change in ownership of financial
assets; and / or in facilitating or monitoring financial transactions.

Three principal types of activities can be identified-

a. Raising funds by taking deposits and/ or issuing securities and in the

process incurring liabilities. These firms use raised funds to acquire financial
assets by giving loans and / or purchasing securities. They channel funds
from lenders to borrowers, transforming or repackaging the funds in terms of
maturity, scale and risk. This is known as “financial intermediation’’.

b. Providing specialized services to support or facilitate financial intermediation,

insurance and employee programs.

c. Other include; Treasury, asset management, leasing, factoring.

Financial industries are extensive users if electronic means for facilitating the
verification of financial balances, authorizing transactions, transferring funds to and
from clients’ accounts, notifying banks of individual transactions and providing daily
summaries

13.5.2 Taxes imposed on financial institutions

Financial institutions are largely bodies that account for income tax on their business
income. In addition, they are expected to withhold tax on employment income tax
imposed on their employees. The rendering of financial services is exempt in the
terms of article 8(2)b of the Value added Tax Proclamation and accordingly financial
institutions are not expected to account for VAT except specific services listed under
Article 20(6) of the Value Added Tax Regulation which are taxable at 15%. These
include

 Safe custody for cash

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  Debt collection and factoring services
 Leases, licenses, and similar arrangements relating to property other than a
financial instrument.

13.5.3 A list of issues for consideration during audit of financial institutions

The following areas should be considered during audit planning and execution as
potential for risk in regard to financial institutions.

a. Provision for bad debts

 Auditors are required to re-calculate the loss reverse deducted to

determine it is in accordance with the prudential requirements
prescribed by the National Bank of Ethiopia and are consistent with
financial reporting standards (Article 45 of the Income Tax
Regulation). The deducted loss should not exceed eighty percent (80%)
of the loss reserves for the year. Any excess should be disallowed.
Note that the 80% is applied to the reserves for the year and not the total
reserves.

b. Foreign currency exchange gains and losses

 Foreign currency exchange losses are permitted subject to the financial

institution substantiating the loss to the Ministry in the terms of Article
44(3) of the Income Tax Regulation. This loss should be disallowed
unless the taxpayer has provided satisfactory evidence in support.

 Foreign exchange gains should be included in the business income of

the financial institution. These largely arise out of forex trading.

c. Bank fees and commission income

 Check that all fees and commission income are booked.

d. Intergroup loans

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  The loans do not exist and the local bank is claiming an interest charge
which is not ordinarily deductible.

 The loans are not used by the bank to derive business income in
accordance with Article 23(1). Such interest expense should be
disallowed. Here the financial institution should prove that the borrowed
funds are invested in revenue generating activities or assets.

 Where the loan is advanced by a foreign bank (parent), the interest

deducted will not be permitted unless the foreign bank is permitted to
lend to persons in Ethiopia in the terms of Article 23(2) a.

e. Leasing income

 Lease income is VATABLE and is often disguised as a financial service.

However, Article 20(6)g of the VAT regulation explicitly brings leasing
income under the ambit of Value Added Tax. Auditors are expected to
check compliance with this provision.

 The financial institution has claimed depreciation on assets leased under

a finance leasing arrangement. IFRS 16 requires determines a finance
lease as one that transfers substantially all the risks and rewards
incidental to ownership of the underlying asset to the lessee. Such an
asset is treated as owned by the lessee. Article 25(1) read together with
20(1) will grant depreciation to the lessee and where the bank claims this
depreciation, such amounts should be disallowed.

The following situations would normally lead to a lease being classified

as a finance lease;

o The lease transfers ownership of the underlying asset to the

lessee by the end of the lease term.

o The lessee has the option to purchase the underlying asset at a

price expected to be sufficiently lower than fair value at the

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 exercise date, that it is reasonably certain, at the inception date,
that the option will be exercised.

o The lease term is for a major part of the economic life of the
underlying asset even if title is not transferred.

o The present value of the lease payments at the inception date

amounts to at least substantially all of the fair value of the
underlying asset.

o The underlying asset is of such specialized nature that only the

lessee can it without major modifications.

o Any losses on cancellation are borne by the lessee

o Gains/losses on changes in residual value accrue to the lessee

o The lessee can continue to lease for a secondary term at a

rent substantially lower than the market value.

 In calculating the loss on the lease, the financial institution does not
include any resale consideration, guarantee or insurance taken. Article
27((1) (e) of the Income Tax Proclamation disallows an expenditure or
loss to the extent recovered or recoverable under a policy of insurance,
or a contract of indemnity, guarantee, or surety.

f. Written off loans

 Written off loans did not exit. Auditors are expected to review all loan
write-offs to confirm that the loans where advanced and that interest
income had been previously included in the business income of the
financial institution.

g. General service charges

 The services received are not used by the financial institution in the
course of its trade.

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  Where the bank is part of a group, recharges made by the parent that do
not support the production of income of the local financial institution
should be identified and disallowed.

h. Hybrid financial instruments

 This arises where the bank has raised funds through equity, but
classified it as debt in order to take undue credit for fictitious interest
costs.

i. Treasury transactions

 Fee income charged by treasury is not reflected in the profit and loss
account.

j. Others

 Apportionment of input VAT. This arises where the financial institution

has both taxable and exempt sales but does not apportion over heads
attributable to both supplies.

 Employment income tax on benefits in kind. Financial institutions will

usually provide fringe benefits inform of motor vehicles or
accommodation to their senior staff. Auditors are particularly required to
check monthly employment income tax returns for inclusion of these
amounts.

 Banks publish audited financial statements in the print media. These

financial statements should be compared with those provided to the
Ministry for consistency of reporting. Any variations should be
investigated further and where they have an impact on tax, appropriate
adjustments should be made.

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13.6 Import and Export

This sector involves the importation of finished commercial goods for resale on the
local market in Ethiopia and the export of finished, semi processed or unprocessed
raw items.

List of issues for consideration during audit of import based business.

a. VAT build up in costs

 Auditors are expected on a sample basis to check whether VAT at

importation is not included in the cost of goods sold, where the taxpayer
is VAT registered.

 VAT included in the cost of goods should be disallowed in determining

taxable business income.

b. Foreign exchange gains/ losses (Article 44 of the Income Tax Regulations)

 Audit should determine that the losses deducted are not foreign
exchange translation losses, which are not ordinarily part of the cost of
goods. Any foreign exchange translation losses in relation to this should
be disallowed.

 Where the taxpayer has a hedging contract with the supplier, the
exchange losses shall be discounted by amounts hedged.

 Losses arise where the taxpayer has a debt obligation. Any losses
outside this scope should be disallowed in determining taxable business
income.

 Gains arise where amount in Birr paid arising from a debt obligation is
lower than the amount in Birr payable at the time the debt obligation was
booked.

 The foreign exchange losses should have been realized, i.e. at the time
of payment of the foreign debt obligation when the amount payable in

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 Birr exceeds the amounts of the debt obligation in Birr at the time it was
booked on the accounts of the trader.

 Foreign exchange gains shall be included in business income of the

taxpayer.

 Foreign exchange losses are not directly deductible against business

income, but against foreign exchanges gains.

 Where during the tax year a trader incurs foreign exchange losses
without corresponding deriving foreign exchange gains, the losses will
not be deductible against business income but will be carried forward
indefinitely for offset when the next exchange gains are realized.

c. Under declared sales

 Unreceipted and unrecorded sales is a popular window taxpayers exploit

to evade taxation.

 Where the taxpayer uses an electronic accounting system, auditors can

detect missing transactions by conducting a gap detection methodology.
This could be supported by advanced excel or other CAAT’s like IDEA
Audit Software. Where gap in the sales is detected, taxpayers should be
held to account.

 Where the goods are imported, using information from Asycuda, a

markup could be obtained and compared with the declarations in the tax
returns and adjustments made to the tax computation.

 Reconcile VAT returns to sales declared for variances. Where the

enterprise operates sales registers, information on this platform should
be reconciled to sales declared.

d. Over stated cost of goods sold.

 This could arise as a result of incorporating fictitious purchases. These

could be validated from the Ascyuda data bases.

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  VAT returns for input could be compared with purchases during the year
for any variation.

e. Life style audits (using indirect methods)

 Auditors are expected to know their clients. Knowledge of the client can
be leveraged in determining un disclosed income. In this case using the
known expenditure pattern of the taxpayer (Tuition for children,
nature/cost of vehicle, assets owned etc..), can be compared with the
income declared in the tax returns. The difference could be attributable
to undisclosed income.

f. Interest expense

 Where the interest is due to a foreign lender, the auditors should obtain
confirmation that the loan was authorized by the National Bank of
Ethiopia (Article 28 of the Income Tax Regulation)

 The auditors should ascertain whether the loan was obtained for the
purpose of the business. Interest accruing to a loan which is not
exclusively for the business should be disallowed.

 Thin capitalization rules provided by Article 47 of the Income Tax

Proclamation should be applied where the taxpayer is a foreign
controlled resident company or a permanent establishment of a foreign
entity and the loan is advanced by it’s the parent. Auditors are required
to check compliance with these laws.

g. Employment tax and employee costs

 Auditors pay less attention to employment tax.

 Employment costs should always be examined to determine whether

employees within the threshold for employment tax are included on the
payee return and tax withheld and remitted to MOR/MOR.

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13.7 Insurance services

13.7.1 Introduction

This involves pooling of risk by underwriting insurance and annuities. These firms
collect fees, insurance premiums or annuity considerations; build up reserves; invest
those reserves; and make contractual payments.

Article 31 of the Income Tax Proclamation read together with Article 46 and 47 of the
Income Tax Regulation, provide for taxation of general insurance and life insurance.
Auditors are encouraged to read the said Articles when considering the tax legal
framework for Insurance business.

Importantly, where a taxpayer derives income from life insurance and any other
business (including general insurance services), the taxpayer will not aggregate
taxable income from life insurance with taxable income from other businesses.

The determination of taxable income of life insurance business shall be in

accordance with Article 47 of the Income Tax Regulation. Therefore, where the
taxpayer’s returns are not incompliance with the said Article, the Auditors are
required to adjust the computation and determine the correct tax position in
accordance with the said Article.

13.7.2 Audit Issues for Insurance Companies

13.7.2.1 Premium income and commissions

Premium is the primary source of income for insurance companies.

Commission is paid to agents/brokers (% of business received).

a) Risk to tax

 Understatement of premium income

 Overstatement of commissions paid

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b) Proposed audit procedures:

Premium income

 Obtain premium account for the particular class of business to be audited.

 Select a sample of entries and trace them from source documents

(registers/cover notes) to debit notes to ledger accounts to ensure
completeness.

 Use of registers for new, recurring business and endorsements.

 Ensure the sequential recording of all debit notes and authorisation of

credit notes.

 Ensure cut-off procedures are adhered to.

Commission paid

 Obtain commission paid account for the particular class of business to be

audited.

 Ensure commissions are paid to only licensed intermediaries.

 Ensure commissions are paid to only brokers who have brought in

business and a policy underwritten

 Establish whether the approved commission rate has been used in the
payment of commissions

13.7.2.2 Unearned Premium Reserves (UPR)

Unearned premium is income not relating to the current year but to the following
year. This is due to the fact that the debit notes are not raised at the start of the
year but throughout the year. The unearned premium income brought forward is
added to the premiums underwritten for the year and the earned income as at the
end of the next year.

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 a) Risk to tax

 UPR may be used to manipulate profitability

 Regulatory compliance – rate of calculation

b) Proposed audit procedures

 Re-compute UPR reserves at the yearend to ensure correct calculation,

ensuring that all premium underwritten in the year is taken up
(completeness)

 Review policy of accounting for UPR to ensure correctness

 Ensure prior year reserves are realised in the detailed revenue account and
the current year reserves taken up correctly.

13.7.2.3 Claims Paid

This is the main expenditure of the company – ‘cost of sales’.

a) Risk to tax

 Claim paid for may actually not be in existence

 Recoveries from the re-insurer may not be correctly done

 Claims may be paid for policies that are not in existence (mismatch of
income and expenditure)

 Claims may be paid when there is no cover in a particular class of business

 Large claims presented

b) Proposed audit procedures

 Ensure that there is adequate documentation to support the claim, i.e.

assessor’s/investigators’ reports, authorisation, approval and vetting of all
large claims for existence.

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  Select a sample of claims and trace them from the ledger to supporting
documents including the loss adjuster’s reports

 Use of analytical review procedures – technical ratios, market trends and

loss ratios.

 Ensure that insurance policies exist for all claims paid, especially the large
ones.

13.7.2.4 Claims Outstanding

This is a provision for claims reported and assessed but not paid at the financial
yearend.

a) Risk to tax

 May be used to manipulate profitability

 Re-insurers’ portion may not be debited to them correctly

b) Proposed audit procedures

 Ensure that once a claim is reported adequate reserves are maintained

after assessment. This can be done vis a vis claims paid.

 Select a sample and validate claims outstanding at the yearend to

supporting documents including loss adjusters’ reports/investigation
reports, correspondence and review post yearend payments.

 Review the claims outstanding register – sequential claim numbers and

enquire into missing claims.

 Use of analytical review procedures – market trends and loss ratio

 Ensure reinsurers’ portions have been correctly debited to them

 Review of lawyer’s responses and internal management meeting expenses

 Ensure cut off procedures adhered to.

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13.7.2.5 Reserves

This is a general reserve maintained for claims incurred.

a) Risk to task

 May be used to manipulate profitability

 Reserves maintained by the company may not be adequate or may be

excessive

 Regulatory compliance – the reserve has to be calculated in accordance

with Article 46 of the Income Tax Regulation.

b) Proposed audit procedures

 Ensure correct calculation of the reserve as at the year-end in line with

Article 46 of the Income Tax Regulation.

13.7.2.6 Reinsurance

 In order to minimise its exposure and spreading its risk, the insurance
company passes on part of its risks to a reinsurer. In doing this an amount
of premium will be ‘ceded’ out based on the treaty between the insurance
company and the reinsurer. Upon crystallisation of a claim the reinsurer
shall pay part of the claim again based on the treaty.

a) Types of reinsurance

 Treaty – reinsurance with reinsurance companies which could be both local

and overseas companies

 Facultative- reinsurance with local insurance companies (occurs when an

insurance company underwrites a risk that is over and above what the
company can retain plus what the treaty reinsurance can accommodate)

b) Risk to tax

 Claims may not be correctly accounted for i.e. reinsurers portion

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  Completeness, valuation and accuracy are the key assertions for balances
due to reinsurers

c) Proposed audit procedures

 Ensure correct ceding of premiums, booking of commissions, correct splits

of claims incurred and paid.

 Review of reinsurance statements:

 Quarterly – shows quarterly position i.e. receivable / payable as a

result of transactions in the quarter

 Premium adjustment – this is for non-proportional treaties whereby

we pay the reinsurer a proportion of the premiums not yet given to
the reinsurer for the year based on the computations indicated in
the treaty agreement

 Portfolio withdrawal – shows how much of the balances due to

reinsurers should be held for a period of 1 year to cater for any
calamities that may arise for premiums underwritten and ceded in
the year. This is reversed in the following year

 Review correspondence with the reinsurer

 Review of reinsurance committee meeting minutes

 Ensure premium tax returns are completed

 Validate material facultative balances to statements

13.7.2.7 Premium Receivable

These are actually trade debtors.

a) Risk to tax

 All premium receivable as per the books of account may not be receivable
due to the nature of the business.

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 b) Proposed audit procedures

 Ensure aged analysis provided is correct

 Review of correspondence between the company and the debtor

 Review of material amounts outstanding over one year

13.8 Agriculture

This sector involves the biological transformation of biological assets for sale, into
agricultural produce or into additional biological assets

The two elements that form part of, or result from, agricultural activity can be
defined;

a) Biological assets: living animals and plants with an innate capacity of biological
transformation which are dependent upon a combination of natural resources
(sunlight, water, etc)
b) Agricultural produce: harvested produce of the entity’s biological assets, at the
point of harvest

Auditors required to understand that biological assets are the core income-producing
assets of agricultural activities, held for their transformative capabilities. Biological
transformation leads to various different outcomes:

a. asset changes through (i) growth (an increase in quantity or improvement in

quality of an animal or plant), (ii) degeneration (a decrease in the quantity or
deterioration in quality of an animal or plant), or (iii) procreation (creation of
additional living animals or plants); or
b. production of agricultural produce such as latex, tea leaf, wool, and milk.

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 Example

Examples of biological assets, agricultural produce, and products that are the
result of processing after harvest are stated as follows;
Biological assets Agricultural Products that are the
produce result of processing
after harvest

Sheep Wool Yarn, carpet

Trees in a timber Felled trees Logs, lumber

plantation

Dairy cattle Milk Cheese

Pigs Carcass Sausages, cured hams

Cotton plants Harvested cotton Thread, clothing

Sugarcane Harvested cane Sugar

Tobacco plants Picked leaves Cured tobacco

Tax law aspects

Unlike other business sectors, there are no specific tax low provision governing this
sector. Article 2(240 of income tax proclamation provides trading stock includes
livestock, but not including animals used as beasts of burden or working beasts.
Nevertheless, it is not appropriate provision for biological assets since biological
assets has transformative capability and it has changed through growth,
degeneration and procreation. the value of asset has changed accordingly in
continuous manner.

Due to specialized nature of a business, the tax low provisions applicable to other
business of a non- specialized nature has not been applied to agricultural business
sector.

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It is quite difficult to apply traditional accounting method to agricultural activities.
Even though it does not have legal backing in any tax lows, it is essential to use the
provision of IFRS developed for agriculture business (IAS 41). Currently, IAS 41
helps the world to develop consistent and effective practice in accounting for
agriculture.

Therefore, the government need to issue a legal provision for agriculture business
that makes provisions of IAS has a legal base.

List of issues for consideration during audit of agriculture business sector

Auditors are required to pay attention to the following areas during audit of
agricultural entities.

13.8.1 Biological asset

1. Recognition of biological asset

 In agricultural activity, control may be evidenced by, for example, legal
ownership of cattle and the branding or otherwise marking of the cattle on
acquisition, birth, or weaning. Article 66 of income tax proclamation provides
that person acquires an asset when legal title to the asset passes to the
person, including, in the case of an asset that is a right or option, the
granting of the right or option to the person. Nevertheless, it is not applicable
to use it as a criteria to recognize biological asset since biological assets are
transformative capabilities like growth and procreation.
 The significant physical attributes of biological assets can be measured
using various methods (which are used by markets to measure value) and
generally indicate the source of future economic benefits

2. Measurement of biological assets

 The auditors should ascertain whether a tax payer has measured a
biological asset on initial recognition and at the end of each reporting period
at its fair value less costs to sell, except for the case where the fair value
cannot be measured reliably.

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 Auditors required to evaluate the fair value measurement process of tax
payers and need to ascertain whether fair value measurement process is
according to fair value measurement provisions of IFRS (IFRS 13)
 The fair value measurement of a biological asset facilitated by grouping
biological assets according to significant attributes; for example, by age or
quality
 Entities often enter into contracts to sell their biological assets at a future
date. Nevertheless the auditor should determine whether contract prices are
not used in measuring fair value, because fair value reflects the current
market conditions in which market participant buyers and sellers would enter
into a transaction
 When the tax payer has not measured a biological asset on initial recognition
and at the end of each reporting period at its fair value less costs to sell, the
auditor should make certain that:
 little biological transformation has taken place since initial cost
incurrence (for example, for seedlings planted immediately prior to
the end of a reporting period or newly acquired livestock); or
 the impact of the biological transformation on price is not expected
to be material (for example, for the initial growth in a 30-year pine
plantation production cycle)
 A gain or loss arising on initial recognition of a biological asset at fair value
less costs to sell and from a change in fair value less costs to sell of a
biological asset shall be included in profit or loss for the period in which it
arises. Auditors required to confirm that a gain or loss has included in profit
and loss statement in determining taxable business income of the tax payer.
 A loss may arise on initial recognition of a biological asset, because costs to
sell are deducted in determining fair value less costs to sell of a biological
asset. A gain may arise on initial recognition of a biological asset, such as
when a calf is born.
 If a fair value cannot be determined because market determined prices or
values are not available. Then the biological asset can be measured at cost
less accumulated depreciation and impairment losses. This alternative basis
is only allowed on initial recognition.

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13.8.2 Agricultural produce

13.8.2.1 Recognition of agricultural produce

 It is recognized at the point of harvest (eg detachment from the biological

asset).
 The auditor should ascertain that recognition of agricultural produce ends
once the produce enters trading activities or production processes within
integrated agribusinesses, although processing activities that are incidental
to agricultural activities and that do not materially alter the form of the
produce (e.g. drying or cleaning) are not counted as processing.
 The auditor should check that following harvest, the agricultural produce
treated as inventory.

13.8.2.2 Measurement of agricultural produce

 Auditors are required to confirm that the tax payers has measured
agricultural produce at each year end at fair value less estimated point-of-
sale costs, to the extent that it is sourced from an entity's biological assets,
which are also valued at fair value.
 The fair value measurement of a biological asset facilitated by grouping
agricultural produce according to significant attributes; for example, by age
or quality.
 Entities often enter into contracts to sell their agricultural produce at a future
date. Nevertheless the auditor should determine whether contract prices are
not used in measuring fair value, because fair value reflects the current
market conditions in which market participant buyers and sellers would enter
into a transaction.
 The change in the carrying amount of the agricultural produce held at year
end should be recognized as income or expense in profit or loss statement
of the tax payers in determining taxable income.
 A gain or loss may arise on initial recognition of agricultural produce as a
result of harvesting

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  The auditor should determine that Agricultural produce that is harvested for
trading or processing activities within integrated agricultural/agribusiness
operations measured at fair value at the date of harvest and this amount
taken as deemed cost by tax payer in treating it as inventories.

13.9 Mining and mineral

13.9.1 Introduction

Generally mining can be defined as the extraction of valuable minerals or other

geological materials from the earth, usually from an ore body, vein or (coal) seam.
Materials recovered by mining include base metals, precious metals, iron, uranium,
coal, diamonds, limestone, oil shale, rock salt and potash. Any material that cannot
be grown through agricultural processes, or created artificially in a laboratory or
factory, is usually mined. Mining in a wider sense comprises extraction of any non-
renewable resource (e.g., petroleum, natural gas, or even
water).http://en.wikipedia.org/wiki/Mining

Mining operations are easily recognizable. By nature of what mining means –

digging, removing soil and overburden, and separating out ores and non-metal
minerals –these operations leave behind environmental “footprints”. Such
’’footprints’’ can have a number of different effects –at worst seriously limiting the
ability of surrounding communities to earn and sustain their livelihood, particularly in
areas where communities rely on their natural environment to provide food, shelter,
transport, and other opportunities.

By its inherent nature, mining impacts on land, water and air which are the essential
components of the environment. Among the Environmental issues associated with
mining can includes erosion, formation of sinkholes, loss of biodiversity, and
contamination of ground water and surface water by chemicals from the mining
process, contamination of the areas surrounding the mines due to the various
chemicals used in the mining process as well as damaging compounds and metal
removed from the ground with ores, water produced from mine drainage, mine
cooling, aqueous extraction and other mining process increase the potential for
these chemicals to contaminate the ground and surface water

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13.9.2 Tax law aspects

13.9.2.1 Development expenditure

This term is relevant to Income Tax proclamation 979/2008 Article 40 (which

provides for the deductibility of development expenditure incurred by a licensee or
contractor).

 “Development expenditure” means capital expenditure incurred by a licensee or

contractor in undertaking development operations. For mining, “development
operations” is defined in Article 36(5)(a) to mean authorized operations under a
mining license. A “mining license is granted under the Mining Operations
Proclamation. For petroleum, “development operations” is defined in Article
36(5)(b) to mean authorized operations relating to development and production
under a petroleum agreement.

13.9.2.2 Social infrastructure expenditure

This term is relevant to the Article36 definitions of “development expenditure” and

“exploration expenditure”.

“Social infrastructure expenditure” is defined to mean capital expenditure incurred by

a licensee or contractor on the construction of a public school, hospital, road or any
similar social infrastructure. A licensee or contractor may be required to incur such
expenditure under a mining right or petroleum agreement.

The deductibility of social infrastructure expenditure depends on the phase of

operations in respect of which it is incurred. Social infrastructure expenditure that a
licensee is required to incur under an exploration right is treated as exploration
expenditure and, therefore, allowed as a deduction in the tax year in which the
expenditure is incurred under Article39(1). Similarly, social infrastructure expenditure
that a licensee is required to incur under a mining license or petroleum agreement in
relation to development and production operations is treated as development
expenditure and, therefore, is depreciated for business income tax purposes over
four years (Article40).

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13.9.2.3 Subcontractor

This term is relevant to Article 37(4).

A “subcontractor” is defined to mean a person supplying services to a licensee or

contractor in respect of mining or petroleum operations undertaken by the licensee
or contractor. It is expressly provided that a person supplying services to a licensee
or contractor as an employee is not a subcontractor. The employment income tax
applies to employment income paid by a licensee or contractor to an employee.

13.9.2.4 Exploration Expenditure

This Article provides for the tax treatment of exploration expenditure.

Sub-article (1) provides that exploration expenditure incurred by a licensee or

contractor is treated as a business intangible with a useful life of one year. In other
words, the depreciation rate applicable to exploration expenditure is 100%.

13.9.2.5 Development Expenditure

This Article provides for the tax treatment of development expenditure.

Sub-article (1) provides that Article 25 applies to development expenditure incurred

by a licensee or contractor on the basis that it is a business intangible with a useful
life of four years.

13.9.2.6 Rehabilitation Expenditure

This Article provides for the tax treatment of rehabilitation expenditure, including
contributions made to a rehabilitation fund established for the purposes of funding
rehabilitation of a mine site or oil well.

Sub-article (1) provides that a contribution made by a licensee or contractor to a

rehabilitation fund under the terms of an approved rehabilitation plan in relation to
mining or petroleum operations is allowed as a deduction in the tax year in which the
contribution was made.

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14 International Taxation
14.1 Introduction

Kelvin Holmes, International Tax policy and double tax treaties in the following
paragraphs highlights the cardinal principles of international taxation/ law.

International tax is best regarded as the body of legal provisions of different

countries that covers the tax aspects of cross border transactions. International
tax, in this sense, is concerned with direct taxes and indirect taxes. It can also be
regarded as the international tax laws of a particular country including its tax
treaties.

The generally accepted convention under international law is that, while a

country is free to levy tax however it chooses, it cannot enforce its tax claims on
the territory of another country. In other words, its taxing jurisdiction cannot
extend to imposing its tax on taxable objects that arise in another country. For
example, France cannot levy its tax on Germanys who derive all of their income from
Germany. Therefore, typically a country’s tax laws are confined to taxable
subjects and objects that have some sort of connection with the country.
Those tax laws normally cover two kinds of activities:

a. The activities of a resident of that country in foreign countries; and

b. The activities of a non-resident in that country.

On the basis of the above, this chapter seeks to highlight the aspects of international
tax law aspects of domestic laws (Proclamations) and treaty law that the auditors are
expected to be aware in regard to the taxation of activities of a resident of
Ethiopia in foreign countries and activities of non-residents in Ethiopia.

14.2 International tax law aspects of domestic laws

This is a set of domestic tax laws that imposes tax on activities of residents in a
foreign country and activities of a non-resident in Ethiopia. The Income Tax
Proclamation defines a resident under Article 5. The discussion on residents was
elaborately covered under chapter 6 of this manual.

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Importantly, the Income Tax Proclamation applies or imposes tax on residents of
Ethiopia in respect to their worldwide income and to nonresidents with respect
to their Ethiopian source income in the terms of Article 7. This implies that income
arising from taxable activities of residents outside Ethiopia and the taxable activities
of non-residents in Ethiopia is subject to tax in Ethiopia. Conversely, the taxable
activities of a non-resident earned outside Ethiopia are outside Ethiopia’s tax
jurisdiction. This is an important concept that auditors are expected to be aware of.

14.3 Income sourced in Ethiopia by non-residents

Article 6 determines when a taxable activity of a non-resident gives rise to Ethiopian

source income. This implies that not all taxable activities earned by non-residents
are subject to tax in Ethiopia unless they are listed under the source rules provided
by Article 6. For instance, not all business income earned in Ethiopia by a non-
resident person is Ethiopian sourced unless the business of the non-resident
is conducted through a permanent establishment in Ethiopia (Article 6(3)). This
is also in line with tax treaty law that requires income to be attributable to a
permanent establishment for it to be taxable in the state where it is derived. The
Article 4 defines a permanent establishment.

14.4 International aspects of domestic legislation (Proclamation) and treaty

law

a. The Income Tax Proclamation imposes tax on incomes of non-residents where

the income is sourced in Ethiopia and for residents on their worldwide
income (Ethiopian and beyond her borders).

b. Tax treaties do not impose tax on persons. They simply allocate taxing rights
among member states on incomes of their residents.

c. Arising from (a) and (b) above, domestic legislation (Proclamation) may claim
taxing rights over income of a person which on the other hand is allocated to the
other member state by treaty law (Double Taxation Agreement). This certainly
causes conflict between Domestic and Treaty tax law.

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d. Where tax treaty and domestic law conflict as in c above, treaty law shall prevail
over domestic law with the exception of Article 48(3) and Part Eight of the
Proclamation in accordance with Article 48(2).

e. In dealing with cross border transactions, auditors are required to determine

whether a double taxation treaty between two member states exists before
relying on the provision of the Income Tax Proclamation to determine the
taxation of the said transaction.

14.5 Principles of taxation of non-residents in Ethiopia

a. A non-resident is subject to income tax to the extent of their taxable activities

that give rise to Ethiopian sourced income.

b. Article 6 defines when a non-resident has derived Ethiopia sourced income.

c. Where a non-resident is operating through a permanent establishment located in

Ethiopia, the business income of the permanent establishment is subjected to
tax first on its taxable business income as a resident body and then at a rate of
10% provided it repatriates its profits. See details under Chapter 8 of this
manual.

d. A non-resident is liable to tax on schedule “D’’ other income. This is taxed

separately from business profits under Schedule “C’’. However, where the
income is a royalty, dividend or interest and is paid to resident of a country
with which Ethiopia has a double taxation agreement, the provisions of the treaty
prevail over taxation of such income. In this case they determine whether or not
Ethiopia has a taxing right over the said income.

e. Where the non-resident is an employee, the non-resident employee is liable to

employment income tax provided the employment income is Ethiopian sourced
in the terms of Article 6(1) of the Income Tax Proclamation. However, where the
employee is a resident of treaty state, i.e., with which Ethiopia has concluded a
double taxation agreement, the provisions of treaty law will determine whether
such income will be taxable in Ethiopia or in the other state where the recipient is
a resident.

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 For instance, if the employee (non-resident) a resident of India is in Ethiopia for
less than 183 days, is employed by ABC Limited a resident of Kenya and the
salary received is not borne by a Permanent Establishment or fixed base of ABC
Limited in Ethiopia, the employment income earned by the employee will be
taxable in India. Accordingly, Ethiopia losses grip of the right to tax the said
income under Article 10, 7(2) and 6(1)(a) of the Income Tax Proclamation.

f. Thin capitalization. Where the permanent establishment is treated as a foreign

controlled resident company with an average debt to average equity ratio in
excess of 2 to 1, interest paid to its headquarters will be disallowed in
accordance with the formula provided by Article 47 (3) of the Income Tax
Proclamation.

14.6 Principles of taxation of residents in Ethiopia

a. Residents of Ethiopia are subject to tax on their worldwide income (income from
Ethiopian sources and outside Ethiopia).

b. A resident of Ethiopia is effectively a non-resident in another country and will be

taxed in that other country on the income sourced therefrom.

c. As a result of (a) and (b) above, the resident of Ethiopia is taxed twice on the
same income from foreign sources. First, through global taxation of their income
as a resident of Ethiopia and second as a non-resident on income sourced in the
other country. This effectively results into juridical double taxation.

d. There is adequate relief for juridical double taxation under domestic law (Income
Tax Proclamation) and treaty law should a double taxation agreement arise.

e. Relief for double taxation suffered by the resident in respect of tax paid on
foreign business income is provided for under Article 45 of the Income Tax
Proclamation. The auditor is required to consider in detail the said article to
determine the modalities of the relief.

f. Where the foreign income is earned and taxed in a country that has concluded a
double taxation treaty with Ethiopia, relevant article of the treaty will be

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 considered in providing relief for double taxation. Any relevant article of the tax
treaty law will take precedence over the Article 45 of the Income Tax
Proclamation.

g. In determining the taxable income of a resident from foreign income, a deduction

is allowed for foreign losses carried forward from the previous year/s in respect
of foreign business activity of the taxpayer, in accordance with Article 46 of the
Income Tax Proclamation. This implies that foreign losses can never be
offset against Ethiopian business income. Auditors are therefore particularly
required to check whether such losses are offset against Ethiopian sourced
income and pass the relevant adjustments.

h. The above treatment implies that taxable business income of the resident from
Ethiopian and foreign sources shall not be aggregated. The taxpayer is
expected to account for the taxable business income from domestic and foreign
sources separately.

i. Where the resident earns schedule D income from foreign sources, part five of
the Income Tax Proclamation will apply in determining the taxation of such
income. However, where the schedule D income includes dividend, royalties
and interest income earned from a country where Ethiopia has a double
taxation treaty, the provisions of that treaty will determine the country with
the taxing right and rate of tax applicable.

j. Where as a result of a double taxation agreement, interest, dividends and

royalties are taxed in both Ethiopia and another country; any relevant treaty will
provide the modalities for relief of double taxation. Auditors are particularly
encouraged to review the provisions of the relevant article of treaty law.

k. Thin capitalization. Where the resident company is a foreign controlled resident

company with an average debt to average equity ratio in excess of 2 to 1,
interest paid to the parent will be disallowed in accordance with the formula
provided by Article 47 (1) of the Income Tax Proclamation.

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14.7 International tax treaties

Ethiopia has Double Taxation Treaties in force with different countries. This implies
that each of those countries that have concluded double taxation agreements have
substantial trade dealings with Ethiopia. Double taxation agreements are intended
to:

a. To provide relief for double taxation or the avoidance of double taxation.

b. Prevent tax evasion in a cross border context.

Application of double taxation agreements during tax audits

Auditors are more likely than not to encounter scenarios where their audit clients
have cross border transactions with tax residents of a country that has concluded a
double taxation agreement with Ethiopia.

Double taxation agreements are applied as follows during tax audit of cross border
transactions.

a. Profile parties to a cross border transaction, i.e. the payer and payee of
the income.

b. Determine whether both parties are residents of either parties (countries)

to the double taxation agreement.

c. Where one of the parties to the transaction is not a tax resident of the
other state that Ethiopia has concluded a DTA, then the treaty benefits will
not apply. In this case, Ethiopia will invoke the relevant articles of its
Income Tax Proclamation unrestricted.

d. Where one of the parties to the transaction is not in a state that has
concluded a double taxation agreement, there will be no treaty to invoke.
In this case, the Income Tax Proclamation will apply unrestricted.

e. In determining whether the taxpayer is resident, the relevant Article of the

DTA determines residence must be considered over the Article 5 of the
Income Tax Proclamation.

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f. Once the parties have been identified and are found to be residents, the
auditor is expected to determine the nature of the transaction between the
two parties, for instance dividend payments.

g. The auditor is then required to study the relevant article of the double
taxation agreement in order to determine which country (state) has a
taxing right over the transaction. Where the treaty specifies the rate of tax,
this should be applied in determining the tax payable. Note that the
double taxation agreement does not impose tax even where it specifies a
rate of tax. Tax is imposed by the domestic legislation in this case, the
Income Tax Proclamation.

h. Where the DTA allocates taxing rights to Ethiopia, the auditor should
invoke the relevant provision of the Income Tax Proclamation to impose
tax on the said income. For instance, where the income is a dividend, the
imposition of tax will be in accordance with article 55 of the Income Tax
Proclamation.

i. Where the DTA allocates tax to both countries, the Auditor should ensure
that Ethiopia has taxed the said income but shall provide for double
taxation relief where the other member state has taxed the same income,
in case of a resident. Where the income is derived by a nonresident,
Ethiopia, is not required to provide for double taxation relief as this will be
provided in the country where the taxpayer is resident.

j. Where the auditor requires further information regarding a taxpayer who is

a resident of the other country/state, any relevant double taxation
agreement will be invoked. This Article prescribes the information that
may be requested and the modalities of the information request.

k. In the event of tax dispute, treaty law provides a window for mutual
agreement procedures. Auditors should refer to the relevant clauses of
the double taxation agreement.

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14.8 International tax planning and anti-avoidance provisions

Taxpayers take advantage of differences in tax regimes between countries to

engage in schemes for avoidance of taxation. This is done by establishing related
enterprises in more than one tax jurisdiction and transaction among themselves in a
manner that compromises taxation in Ethiopia. The following schemes may be used
by the taxpayer to avoid or reduce the incidence of taxation.

a. Transfer pricing. This arises when goods or services are transferred by an

enterprise to its associate at less than their true value. In this case the
associated enterprise in a high tax jurisdiction will receive goods or services at
inflated prices from its associate in the low tax jurisdiction. This ensures that
the enterprise in the high tax jurisdiction pays less or no tax arising from
inflated cost of goods or nonexistent services (recharges). On the other hand,
the enterprise in the low tax jurisdiction will pay a lower rate of tax on inflated
goods, but this will be compensated by a low or no taxes in the high tax
jurisdiction.

Article 9 of treaty law provides for a robust mechanism to avoid transfer pricing.
This is reinforced with transfer pricing guidelines issued by the OECD that
detail how this vice can be dealt with. Auditors are specifically required to read
in detail these guidelines when dealing with transfer pricing audits – refer
section 14.8 for details of transfer pricing.

b. Base companies

Base companies are predominantly situated in a low-tax jurisdiction, typically a tax

haven. They are used to shelter income that would otherwise accrue directly to a tax
payer, which is a resident of a country that taxes its residents on their worldwide
income. A base company shelter income from the normal taxation of worldwide
income in the taxpayer’s residence state. There, a base company is used to keep
the taxpayer’s income outside the country’s jurisdiction in order to avoid tax on that
income in the country.

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c. Treaty shopping

Treaty shopping is the situation where a person who is not entitled to the benefits of
a tax treaty makes use- in the widest meaning of the word or of a legal person in
order to obtain those treaty benefits that are not available directly. This could be
achieved through use of conduit companies.

d. Hybrid entities

The use of Hybrid entities allows the international tax planner to take advantage of
different definitions, and tax treatments, of certain entities in different countries.

A hybrid entity is defined as an entity that is characterized as transparent for tax

purposes (e.g., as a partnership) in one jurisdiction and non-transparent (e.g. as a
corporation) in another jurisdiction.

For tax purposes, a transparent entity itself is not a taxable subject, but we look
through the entity to its underlying owners, and attribute the entity’s income to, and
tax, them. Hence, the term, “transparent’’. By contracts, non-transparent entities are
standalone entities, which are taxed on their income in their own right. They are legal
and taxable subjects, which are taxed separately from the owners.

Tax arbitrage in the context of hybrid entities arises because one country treats the
entity as transparent, and does not tax it, while another country treats the same
entity as non-transparent and does not tax its partners. For instance, in Ethiopia,
partnerships are treated as non-transparent and therefore will not tax the partners.

e. Hybrid financial instruments

Hybrid financial instruments used in cross-border transactions can also produce a

characterization mismatch in different jurisdictions, which give rise to international
tax avoidance. A hybrid financial instrument has features of debt and equity.
Convertible notes are a good example. They are interest bearing notes, exhibiting

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the features of debt, which convert into share capital after a specified period, thus
also exhibiting the features of equity.

If the country in which the company that issues the notes is resident treats the notes
as debt instruments for tax purposes, the company would normally obtain a tax
deduction in the country for the interest paid to the note holders. However, if a note
holder’s country of residence treats the notes as equity and does not tax (foreign
source) dividends, the resultant tax benefit is the deduction in one country without a
corresponding assessment of income of the noteholder in another country.

14.8 Transfer Pricing

14.8.1 Introduction - The Basic Concept of Transfer Pricing

Although the basic concept of maximizing business profits by taking advantage of a

countries tax law can be viewed as good management practice, the problem occurs
when a company intentionally over or under values the price of goods and services
sold by one division in a company to another (a transaction referred to as not at
arm’s length – e.g. not the same price charged to a completely unrelated party). The
prices are then used to determine the individual companies’ profit or loss. The range
of corporate tax rates in different countries can be viewed as an incentive for
companies to lawfully shift profits from highly taxed countries to more lightly taxed
locations.

However, it is the practice of multinational companies’ arbitrarily establishing prices

for goods and services for the sole purpose of minimizing tax payments in the
countries in which they operate which has caught the attention of tax administrators
worldwide. This practice has been referred to as ‘transfer pricing’.

14.8.1.1 Transactions subject to Transfer pricing

The following are some of the typical international transactions which are governed
by the transfer pricing rules:

 Sale of finished goods;

 Purchase of raw material;

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  Purchase of fixed assets;
 Sale or purchase of machinery etc.
 Sale or purchase of Intangibles.
 Reimbursement of expenses paid/received;
 IT Enabled services;
 Support services;
 Software Development services;
 Technical Service fees;
 Management fees;
 Royalty fee;
 Corporate Guarantee fees;
 Loan received or paid.

14.8.1.2 Purposes of Transfer Pricing

The key objectives behind having transfer pricing are:

 Generating separate profit for each of the divisions and enabling performance
evaluation of each division separately.
 Transfer prices would affect not just the reported profits of every center, but
would also affect the allocation of a company’s resources (Cost incurred by
one center will be considered as the resources utilized by them).

14.8.1.3 An Illustration of Transfer Pricing

In short, internationally, transfer pricing is defined as shifting profits from one country
to another country. Consider a profitable parent company, Y, located in a tax haven
country (a location where either rate of taxation or levels of enforcement are low)
which has subsidiary companies in countries B and C respectively.

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 ILLUSTRATION OF MNE TRANSFER PRICING

COUNTRY A – TAX HAVEN COUNTRY B – HIGH TAX RATE

Company Y – Parent Company X - Subsidiary

 Sells Finished Goods ABOVE Arm’s  Sells raw material BELOW Arm’s
Length Price to Z (Subsidiary) Length price to Y (Parent Company)
 Sales generates a profit  Sale creates a loss or reduced profit
 Because of location - pays little to  Resulting in payment oflittle to no
no taxes taxes
COUNTRY C – HIGH TAX RATE

Company Z– Subsidiary

 Buys Goods ABOVE Arm’s Length Price

from Y (Parent Company)
 Creates a loss or reduced profit
 Pays Little to no taxes
 Citizens pays higher price for good and
service

Overall Tax impact:

 Parent Company Y: Since company Y acquired the raw materials BELOW

arm’s length price and sold manufactured goods ABOVE arm’s length price, Y
would be accumulating profits. However, because it is in a tax haven country,
they will pay little or no taxes.
 Subsidiary Company X: Since X sold the raw material BELOW the arm’s length
price thereby reducing its income, it will incur a loss or show little profit.
Therefore, it will pay little or no taxes.
 Subsidiary Company Z: Since Z purchased the finished products ABOVE the
arm’s length price thereby increasing its cost of goods sold, it will also incur a
loss or show little profit. Therefore, it too will pay little or no taxes.

The same scenario is often used for providing management services, the licensing of
patents and know-how, granting of loan (interest rate charged), etc.

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The major challenge tax administrator’s face in addressing the above scenarios is
determining the correct prices which should be used.

14.8.2 Connection Between Base Erosion and Profit Shifting (BEP’s) and
Transfer Pricing

Base erosion is the use of financial measures and tax planning to reduce the size of
a company’s taxable profits in a country. It is often achieved by structuring income
to have more favorable tax treatment or by finding ways to write off certain
expenditure against taxable income. This has the effect of reducing a company’s tax
bill below what it would otherwise be expected to pay.

Profit shifting involves making payments to other companies within a controlled

group in order to move profits from high-tax jurisdictions to low-tax regimes. This
serves to increase the overall profits available to group shareholders. As previously
indicated, these intra-group payments are known as “transfer pricing.”

14.8.3 Ethiopia transfer pricing rules

Ethiopia transfer pricing rules in the form of Directive 43/2015 issued by the Ministry
of Finance and Economic Development became effective 12 October 2015. The
Directive provides detailed guidance as to the application of Article 79 of the Income
Tax Proclamation (ITP) 979/2016, which requires taxpayers to ensure transactions
between related persons are conducted at arm's length. The Directive is largely
consistent with international standards and provides MNE doing business in Ethiopia
with clarity concerning the application of transfer pricing rules.

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15 Tax Investigation Audit
15.1 Introduction

This manual considers tax audit procedures carried out during a compliance audit.
While there are differences in procedure and approach between compliance and
investigation audits, they both end up with a tax assessment that has to be
supported by tax law provisions. Additionally, compliance audits may be escalated
into tax investigations audits for a deeper analysis of tax issues.

Owing to the above, all the aspects of the tax audit manual covered up to the
preceding chapter (14) are relevant to an investigations audit. This chapter, therefore
considers only those procedures unique to tax investigations audits.

15.2 Purpose, nature and scope of an investigations audit

Tax investigation audit is a detailed analysis of the taxpayer’s declaration to obtain

sufficient appropriate audit evidence in order to raise additional tax
assessments and prosecute fraudulent taxpayers in court to send a strong
deterrent message to the public.

Tax investigation audits focus on taxpayers suspected to be fraudulent and engaged

in tax evasion schemes, which involve deliberate concealment of revenue or
falsification of expenses to suppress taxable income or transactions as the case may
be. Information regarding such offences may be supplied by competitors, whistle
blowers and recommendations of a compliance audit.

Investigative audits are usually very comprehensive, intense and rely a lot on work of
experts to obtain sufficient appropriate audit evidence. This could include use of
input out ratios obtained through a laboratory analysis of taxpayer’s manufactured
goods and a data matching through use of Computer Assisted Audit Techniques
(CAATs,) like IDEA Audit Software and others.

Investigative audits are not limited by time. The amended assessments arising from
such audit activity where the taxpayer is found to have been fraudulent may be
issued at any time, in accordance with Article 28(2)(a) of the Federal Tax

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Administration Proclamation. This is unlike audit activity arising from compliance
audits that is restricted to a five-year period.

15.3 Tax audit investigations procedures and tools used

Taxpayers engage in fraudulent activities in order to understate income or inflate/

claim fictitious expenses. Investigations procedures aim to unearth fraudulent
schemes and bring the taxpayer to account through criminal proceedings. This
requires audit procedures to focus on obtaining appropriate audit evidence which will
be adduced in court.

Tax audit investigations consider the following procedures:

a. Search taxpayer’s premises and seize taxpayer’s accounting

records, data storage facilities to conduct deeper analysis to obtain
sufficient appropriate audit evidence. Article 66(1) of the Federal Tax
Administration Proclamation supports this approach and provides that for
the purposes of administering any tax law, the Ministry shall have, at all
times and without notice, full and free access to any premises,
place, goods, or property, any document and any data storage
device.yu

Further Article 66(1)(b) provides that the Authority may seize any
document in the opinion of the Ministry, affords evidence that may be
material in determining the tax liability of a taxpayer and may retain
the document for as long as the document may be required for
determining a taxpayer’s tax liability or for any proceeding under a tax
law.

b. Obtain relevant third party information on sales and purchases of the

taxpayer through corresponding analysis of tax returns of other taxpayers
they have supplied or those that have supplied them and whose returns
are filed electronically.

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 c. Obtain an understanding of the taxpayer’s operations and conduct an
analytical review of the financial statements to detect further risk to direct
the investigation.

d. Once the information is obtained, the investigator is expected to conduct

deeper analysis using CAAT’s (Computer Audit Aided Techniques) to
establish missing invoices from the sales ledgers of the taxpayer, conduct
a bank reconciliation and agree deposits on the banks statements to the
sales ledger to establish any missing sales among others.

e. Where the taxpayer is a manufacturer or a construction firm, samples may

be obtained and provided to government chemists to determine input-
output ratios. These ratios are then used to project production or costs
incurred. Where the costs reported are greater than the derived value
from the input-output ratios used, such costs will then be disallowed as a
claim to the taxpayer. While MOR/ MOR does not have in house scientists
capable of undertaking this analysis, government agencies with the
requisite skill and equipment may be directed to provide the required
support. Article 7 of the Federal Tax Administration Proclamation requires
all Federal and State government authorities and their agencies, bodies to
co-operate with the Ministry in the enforcement of the tax laws.

f. As a rule of thumb, tax adjustments arising from investigations should be

made in accordance with the tax laws.

15.4 Duty of care to the taxpayer

a. Tax investigation officers are required at all times to obtain written

permission from the Minister of Revenue before exercise of powers to
enter and search taxpayer’s premises and accounting systems. This
written authorization should be provided to the taxpayer at time of the
search.

b. Further, the investigator shall at all times be required to treat the taxpayer
under investigation with courtesy and respect in accordance with Article
6(2) of the Federal Tax Administration Proclamation. In the process of

224
 seizing vital information, the taxpayer may go physical, in this case, the
investigator is expected to exercise restraint.

c. Taxpayer’s information should be kept confidential in accordance with

Article 8 of the Tax Administration Proclamation except where the
investigator is required to present the information as evidence before a
competent court.

225
16 References

1. Minster of revenue (2005) profit tax manual, Addis Ababa

2. MOR,2014 , Domestic tax audit manual , Addis Ababa
3. Federal income tax proclamation 979/2016, tax administration proclamation
983/2016 and each regulations and all indirect tax proclamations and
regulations
4. Commercial code of Ethiopia ,1960 ,
5. IMF, 2010 Technical manual, www.imf.org.
6. OECD,2006 : Strengthening Tax Audit Capabilities: General Principles and
Approaches
7. Adediran, Alade and Oshode, 2010 ,Application of Tax Audit and
Investigation on Tax Evasion Control in Nigeria, Journal of Accounting,
Finance and Auditing Studies, 4/1 (2018) 79-92
8. Audits of Financial Institutions Fort Worth, Texas (800) 431_9025
trainingcpe.thomson.com
9. Business Tax and Fee Division California Department of Tax and Fee
Administration.
10. Construction Industry Audit Technique Guide (ATG) from internet citation
11. Revenue Administration: Taxpayer Audit—Development of Effective Plans,
Edmund Biber, Fiscal Affairs Department
12. https://www.franchise.org/what-is-a-franchise
13. https://smallbusiness.chron.com/audit-checklist-manufacturing-58076.html

226
17 Annexes

Annex 1 - Audit Working Paper

Date: -----------------------------

Taxpayer’s name: -----------------------------

TIN: -----------------------------

Business Sector: -----------------------------

Audited Period: -----------------------------

Tax Auditors’ Name:

1 ………………………………………………………

2 …………………………………………………….. .

Team Coordinator Name: … … … … … … … … … … …

227
Planning Phase

228
Annex 2 : Audit Planning Form

1. Case Number 2. AUDIT TYPES

A. Issue Audit _____
B. Comprehensive Audit _ _ _ _ _ _
C. R efund Audit ______
3. Taxpayers Identification and Address: 4. Activities
Taxpayer’s name: ____________________ Main Business Activity: Secondary Business
TIN No. ______________________________ Activity: ________________________________
Location: ____________________________ Date of commencement of audit: -------------------------
Telephone: __________________________ Estimated days of audit: -----------------------------
Estimated completion date: -----------------------------
Mobile: ____________________________
P.O. Box: __________________________

5. Related parties 6. Tax Auditors names

Branches and locations: ______________ 1. ______________________________________
Subsidiary/ Associated Co’s and locations: 2. ______________________________________
__________________________________ Team Coordinator:
Other related businesses/Co’s: __________________________________________
____________________________________
7. Person to contact and period to be
audited
Accountant’s name and addresses:
_________________________________

Tax type(s) under review:

_________________________________
Tax period to be audited:
_________________________________
Previous periods audited:
_________________________________
Reason’s for selection:
_________________________________

229
 Action Plan Est. Actual Variatio Remark
No Day/ Day/ n
. Time Time
1 Review the tax payer`s business activity
and financial statements
2 Analytical review (vertical and horizontal)
of financial statements in light of; the
taxpayer’s business and sector
performance; intelligence or third party
information; other relevant information, for
instance, sector contribution to GDP,
comparison with industry averages.

3 Interpretation/analytical review of financial

statements for tax purposes
4 Compare profit tax returns with VAT/TOT,
Withholding Receivable
5 Interview the tax payer about the business
activity and its Internal Control System.
6 Obtain a summary of Revenue and verify
its correctness.
7 Verifications of Purchase/ inventory &
COGS, Cost of Manufacturing, Cost of
Construction, WIP, FG etc.
8 Confirm Expenses are accounted using
appropriate reliable supporting documents
9 Check the Income Tax Computation On
payroll Sheet And other allowances are
treated as per the P/ tax Proclamation
And its regulation.
10 Check for deductions of withholding Tax for
entitled expenditures.
11 Obtain Fixed Asset Summary and
supporting schedules containing
additions, disposals and depreciations
12 Test the depreciation calculations on
the group of individual assets; compare
the results within the depreciation
expenses .on the F/S
13 Obtain any Bank Loan agreements and
check for Interest expenses and
repayment of loan to source of Cash.
14 Obtain list of Collateral for the bank loan
both from the company and outside;
Inspect the inclusion of properties into
the financial records

230
15 Reconcile the Balances to the General
Ledger entries to the FS.
16 Examine the General Ledger for any
unusual entries and trace back to the
source document.
17 Check accrued liabilities to journal entries
to source documents for their
appropriateness.
18 Discuss findings with the T/ Leader
and Conduct additional Examinations
and make corrections based on the T/.
Leader comment.
Organize Findings and conduct Exit-
19 Conference with Team Leader
Prepare and submit Draft Assessment
20 report and when approved by Team
Leader Capture Final Report to SIGTAS.
Prepare Final Report and Assessment
21 Notice.

Total Time To be Taken

Tax Auditors Name: _____________

Signature

Tax Audit Team Coordinator

Signature

231
Annex 3 - Notice of Intention to Audit

Comp /Tax payer Name

TIN
Address: Region Sub City Woreda House No. Tel. No.

Subject: - Notice of Intention to audit under Income tax proclamation 983/2016 article
18, VAT proclamation 285/2002 article 30 sub article 2(b), Turnover tax proclamation
308/2002 article 12 sub article 2(b), Excise tax proclamation 307/2002 article 9 sub article
2

Notice is hereby given under the above legislations of an intention to carry out an audit
on your operations for the years of ……………...

The audit will cover Accounts, Business income tax; VAT, Payee, Withholding tax, Excise
tax, and others schedule D taxes.

You are therefore required to avail for examination the records, books of accounts
and other documents on or before ……………………. If this is not done, the Ministry
will assess the tax based on the available information.

The required books/ records/ documents should include, but are not limited to the
following:-
 Sales and Purchases invoices, Receipts, Credit Notes, Debit Notes
 Journals
 Ledgers/soft copy backup
 Cash Books
 VAT Records and Returns
 Excise Records and Returns
 Other relevant documents

The audit will be conducted mainly at Tax office and at your business premises when it’s
necessary. In order to perform the audit, the under named auditors are assigned.

1. Ato/W/r…………………..
2. Ato/W/r…………….........

With

regards

Notice received by: Name

Position/title
Date

232
Annex 4: Entrance Interview Questionnaire

General guideline for all business sectors

a. Income cash
 How are cash receipts reconciled?
 Who is responsible for reconciling them?
 What supporting records are available?
 Are receipts banked entire? If not what records are kept of gross
takings and payments made?
 How was the sales figure in the accounts arrived at? Is same agreed with
above records?
b. Payments
 Are all payments made by cheque?
 Who draws cheque?
 If there are cash payments including private items how are these recorded
dealt with in the accounts? Are invoices and receipts available for
verification?
c. Debtors
 Are there credit sales
 What records are kept?
 Is a debtors control account maintained?
 Is a list of balances available?
 If not how is end-of-year figure arrived at
d. Creditors
 End of year figure
 How arrived at. What records? Obtain copy.
e. Stock
 Is there any stock or works in progress.
 What stock records are kept?
 Obtain copy of stock sheets
 What is the basis of valuation?

233
Annex 5: Interview formats – All business sectors

1. Comp/Tax payer Name: ………………TIN No.…………………

2. Business sector--------------------------------
3. Address: …………………………………………………..
4. Name and position of those present at interview:
On behalf of the taxpayer On behalf of the Ministry
1. 1.
2. 2. .
5. Date and time of interview _____________ Place____________________
6. Reasons for interview:_______________________
7. Explain Scope of Audit: _________________________
8. Agenda:______________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
9. How Many years have you been in the business Industry?
_____________________________________________________________________

10. What type of business activities do you perform

_____________________________________________________________________

11. What are the major suppliers of the company and origins of your company suppliers?
_____________________________________________________________________
_____________________________________________________________________

12. What are the major customers of the company and addresses?
_____________________________________________________________________
_____________________________________________________________________

13. Specify the Value Added Taxable, Tax-exempted and Zero Rated supply of goods and
services of your company.
_____________________________________________________________________

14. Explain other sources of Income your company earned other than the main operations.
_____________________________________________________________________

234
 _____________________________________________________________________

15. Describe the locations of your company, Ware Houses, sales outlets, etc both for
Raw Material, inventory and Finished Goods.
_____________________________________________________________________

16. Provide all your company Bank Names and Account Numbers.
_____________________________________________________________________
_____________________________________________________________________

17. Explain the amount and source of any loans from Financial Institutions.
_____________________________________________________________________

18. Explain the type and ownership of properties your company use as a collateral for loan
applications.
_____________________________________________________________________

19. Explain the amount and source of any loans from Owners of the company.
_____________________________________________________________________

20. Explain the names and amounts of any loan from Individuals, Business Organizations,
Affiliated Companies, Relatives or employees of your company.
_____________________________________________________________________
_____________________________________________________________________

21. Describe the costing systems of your company follows for cost allocation purposes of
either standard costing or actual costing and for Services rendered.
_____________________________________________________________________

22. Provide the names of cheque signatories for various payments.

___________________________________________________________________

23. Describe the roles of the General Manager in the preparations of financial documents
and financial statements.
_____________________________________________________________________

235
24. Describe the roles of the General Manager and Owners’ of the company in purchase
activities.
_____________________________________________________________________

25. Who prepares and maintains books of accounts of your company?

_____________________________________________________________________

26. Describe how you treat Sales Returns.

_____________________________________________________________________

27. Describe how you determine Selling Price for your goods and/or services.
_____________________________________________________________________

28. If your company accounting system is computerized, provide the type of Software you
use and the Organization whom install and customized it for your company’s business.
_____________________________________________________________________

29. Explain the type of financial documents you use such as Cash Payment Vouchers,
Credit Sales Invoices, Cash Receipt Vouchers and others.
_____________________________________________________________________

30. Who approves payments for various purchases/ expenses?

_____________________________________________________________________

31. Provide the name of your company External Auditors

_____________________________________________________________________

32. Describe the responsibilities of Owners’ relatives in the preparations and maintenance
of financial documents and financial statements.
_____________________________________________________________________

33. Are there related parties with transactions under the definition of related party under
Income Tax proclamation 979/08 and Tax Administration 983/08? If yes, state the
names, nature of relationship and amounts of transactions.
_______________________________________________________________________
_______________________________________________________________________

236
34. Please provide us any additional issues and information that might be relevant for our
assessment of your tax liability for the above mentioned Tax Periods.
_______________________________________________________________________
_______________________________________________________________________

237
Annex 6: Interview formats – Import and Export sector

1. Describe the type of products your company is importing/exporting abroad.

_____________________________________________________________________
_____________________________________________________________________

2. Describe the name of organizations with which your company has an agency
relationship for selling of your products on a commission basis abroad/do you have a
consignment agreement.

_____________________________________________________________________

_____________________________________________________________________

3. How do you treat your imported /exported services in regard to the treatment of costs
and revenue?

_____________________________________________________________________

_____________________________________________________________________

4. How do you record/ treat the products which are spoiled, physical deterioration,
expired, etc?

_____________________________________________________________________

_____________________________________________________________________

238
Annex 7: Interview formats – Manufacturing sector

1. Describe the locations of your company Ware Houses both for Raw Materials and
Finished Goods.
_____________________________________________________________________
_____________________________________________________________________
2. Describe the locations of your company manufacturing sites.
_____________________________________________________________________

3. Describe the locations of your company sales outlets.

_____________________________________________________________________

4. What is your Company Policy as per the percentage of overhead, general and
administration cost, and profit margin for the services you rendered?
_____________________________________________________________________

5. Describe the names of your company products’ distributors.

_____________________________________________________________________
_____________________________________________________________________

6. Describe the name of organizations with which your company has an agency
relationship for selling of your products on a consignment basis.
_____________________________________________________________________

7. Explain the name companies abroad that have an association with your company and
the nature of business relationship.
_____________________________________________________________________
_____________________________________________________________________

8. Describe the costing systems of your company follows for cost allocation purposes of
manufactured goods; either standard costing or actual costing.
_____________________________________________________________________
_____________________________________________________________________
9. How do you record/ treat the cost of by products which are spoiled, expired, etc
_____________________________________________________________________

239
Annex 8: Interview formats – Construction sector

1. How Many years have you been in the Construction Industry?

_________________________________________________________________

2. What Type of construction do you perform? Where?

_________________________________________________________________

3. What type of contracts do you perform?

__________________________________________________________________

__________________________________________________________________

4. Describe the Services you rendered to Clients outside Ethiopia.

__________________________________________________________________

___________________________________________________________________

5. Describe how you do account Retention from Certified Payments.

___________________________________________________________________

___________________________________________________________________

6. If you are working with subcontractors describe how you determine their fee.
___________________________________________________________________

___________________________________________________________________

7. Describe whether your contract agreement with subcontractors includes any direct and
indirect material costs.
___________________________________________________________________

___________________________________________________________________

8. Describe whether Materials will be shipped directly to cite or issued from Warehouses.
___________________________________________________________________

240
Annex 9: Interview formats – Agriculture sector

1. Describe the locations of your company Ware Houses both for Raw Materials and
Finished Goods.
_____________________________________________________________________
2. Describe the locations of your company agricultural sites.
_____________________________________________________________________
3. Describe the locations of your company sales outlets.
_____________________________________________________________________
4. What is your Company Policy as per the measured, record & grouping of a biological
asset on initial recognition and according to fair value measurement provisions and
how the company measures and records all direct and indirect costs of little biological
transformation or growing?
_____________________________________________________________________
_____________________________________________________________________
5. Describe the names of your company products’ distributors.
_____________________________________________________________________
_____________________________________________________________________
6. Describe the name of organizations with which your company has an agency
relationship for selling of your products on a consignment basis, abroad or Local.
_____________________________________________________________________
_____________________________________________________________________
7. Explain the name companies abroad that have an association with your company and
the nature of business relationship.
_____________________________________________________________________
_____________________________________________________________________
8. Describe the costing systems of your company follows for cost allocation purposes of
Agricultural products; either standard costing or actual costing.
_____________________________________________________________________
9. How do you record/ treat the cost of by products which are spoiled, expired, etc.
_____________________________________________________________________

241
Annex 10: Interview formats – Mining sector

1. Describe the locations of your company Ware Houses both for Raw Materials and
Finished Goods.
_________________________________________________________________

2. Describe the locations of your company mining site.

_________________________________________________________________

3. Describe the locations of your company sales outlets.

__________________________________________________________________

4. What is your Company Policy as per the measured, record & recognize and treat all
the direct or indirect costs incurred during Exploration, Development, Social
infrastructure, Rehabilitation Expenditure?
___________________________________________________________________
___________________________________________________________________

5. Describe the names of your company products’ distributors.

____________________________________________________________________
____________________________________________________________________

6. Describe the name of organizations with which your company has an agency
relationship for selling of your products on a consignment basis, abroad or Local.
_____________________________________________________________________
_____________________________________________________________________

7. Explain the name companies abroad that have an association with your company and
the nature of business relationship.
_____________________________________________________________________

8. Describe the costing systems of your company follows for cost allocation purposes of
Agricultural products; either standard costing or actual costing.
_____________________________________________________________________

9. How do you record/ treat the cost of by products which are broken, low quality etc.
_____________________________________________________________________

242
Execution Phase

243
 Annex 11: Audit Program – Cash/ Bank Balances

AUDIT PROGRAM

Cash /Bank Balances

Tax Payer Name: Auditor:
TIN:
Tax Year Date:
Audit Objectives Financial Statements
Assertions
 Cash collected or deposited is recognized as income or Revenue of
the company.
 Cash receipts and cash disbursements are recorded correctly as
to account, amount, and period.
 Cash balances include funds at all locations, funds with custodians
and deposits in transit.
 Cash is properly classified and presented in the financial
statements, and adequate disclosures are made with
respect to restricted cash.
Audit Steps Prepared by Working
(Document audit steps taken or to be taken) paper
Reference
Cash on Hand and at Bank
 Obtain all bank Accounts of the Company both Savings and
Checking
 Compare the Balance in the ledger and Bank Statement to
the FS reported
 Perform a Cash Flow Statement to check the correctness
cash movements and Cash balances
 Check the preparations of Bank Reconciliation to control
Bank Deposits
 Check all collection of Credit Sales are accounted to Cash or Bank of
the company

244
 Cash/ Bank Balances

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

245
Annex 12: Audit Program – Debtors and Pre-payments

AUDIT PROGRAM

DEBTORS AND PRE-PAYMENTS

Tax Payer Name: Auditor:

TIN:
Tax Year Date:
Audit Objectives Financial Statements
Assertions
 Trade debtors reasonably match sales revenue
 Prepayments are not expensed during the year of payment.
 Whether write offs follow the provisions of the law and recouped write
offs are included in income
Working
Audit Steps Prepared by paper
Reference

(Documentaudit steps taken or to betaken)

Debtors and Pre-payments

 Compare beginning general ledger balance to ending general

ledger balance. Investigate significant changes.
 Review the subsidiary receivable ledgers or a trial balance based on
these ledgers. They should agree in total with the control accounts.
Any unusual credit entries, in real amount; by source (posting
reference), in nature (descriptions), or a credit balance should be
investigated. Credit entries may indicate deposits or overpayments
which could be considered as additional income or unrecorded sales.
Accounts Receivable postings are usually from sales journal & cash
receipts journal. Unusual entry would be credit entry not from cash
receipts journal.
 the
Obtain Trial Balance of accounts receivable & compare total to the
FS reported
controlling accounts receivable general ledger account. Investigate any
differences e.g. diversion of funds, large credit balances. Income? e.g.
deposits, overpayments received.
 cash movements
Sample and Cashinbalances
debit entries accounts receivable subsidiary ledger
(individual customers) and trace to sales journal for unreported sales in
accounts receivable ledger & trace to cash receipts journal. If no entry
in cash receipts journal did company write off as bad debt? Debit
Sales? Diversion of funds?
 Bank Deposits

246
 In cash receipts journal, sample credit entries to accounts receivable
where Debit is to cash & verify sale was previously recorded.
 Ask company what percentage of sales represents cash (vs. sales on
account). Then review cash receipts journal for a month or two &
compare total cash sales to sales for same two months in sales journal
(sales on account).
 Review procedures for bad debt write off and confirm that the amounts
claimed were included in income. Any write offs not included in income
should be disallowed.
 Check whether write offs arise from trade debtors, any write offs which
are not business related should be disallowed.
 Prepayments are not deductible in the year of payment and accordingly,
a review to confirm that these have not been deducted should be
undertaken

247
 DEBTORS AND PRE-PAYMENTS

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

248
 Annex 13: Audit Program – Inventory

AUDIT PROGRAM

INVENTORY

Tax Payer Name: Auditor:

TIN:
Tax Year Date:
Financial
Audit Objectives Statements
Assertions
 Inventories are not understated (valuation) to increase cost of sales.
 Inventories exist for the purpose of the business and are not simply used
to claim expenses.
 Inventories are not understated (valuation) to increase cost of sales.
 Inventories exist for the purpose of the business and are not simply used
to claim expenses.
Working
 Audit Steps Prepared by paper
Reference
Inventory(Cost of Goods sold)audit
(Document for merchandise/Import –Export Business
steps taken or to be taken)
 Determine the extent of the verification performed by the independent
external auditor
 Compare the taxpayer’s inventory records (or year-end inventory list)
with the books of account, financial statements and tax declaration.
Note the locations, costing method and any provisions made for
obsolescence.
 Test the costs from the suppliers invoices, import entries etc. for the
items that comprise the majority of the reported inventory.
 Determine the inventory valuation method used by the taxpayer and
its acceptability.
 If the taxpayer maintains perpetual inventory records, compare the
physical inventory stock taking record, on a test basis, and review any
adjustments made by the taxpayer with respect to shortages, values and
the like

 In the event that the auditor suspects that the taxpayer may be
suppressing sales or income, identify the personnel who have
knowledge of the taxpayers inventory management practices and
procedures for the purposes of obtaining information.

249
 Issues for consideration during audit of import based business.
a. VAT build up in costs

.  Auditors are expected on a sample basis to check whether VAT at

importation is not included in the cost of goods sold, where the taxpayer
is VAT registered.

 VAT included in the cost of goods should be disallowed in determining

taxable business income.

b. Foreign exchange gains/ losses (Article 44 of the Income Tax

Regulations)

 Audit should determine that the losses deducted are not foreign
exchange translation losses, which are ordinarily part if the cost of goods.
 Any foreign exchange translation losses should be disallowed.
 Where the taxpayer has a hedging contract with the supplier, the
exchange losses shall be discounted by amounts hedged.
 Losses arise where the taxpayer has a debt obligation. Any losses outside
this scope should be disallowed in determining taxable business income.
 The foreign exchange losses should have been realized, i.e. at the time of
payment of the foreign debt obligation when the amount payable in Birr
exceeds the amounts of the debt obligation in Birr at the time it was
booked on the accounts of the trader.
 Foreign exchange gains shall be included in business income of the
taxpayer.

 Foreign exchange losses are not directly deductible against business

income, but against foreign exchanges gains.
 Where during the tax year a trader incurs foreign exchange losses
without corresponding deriving foreign exchange gains, the losses will
not be deductible against business income but will be carried forward
indefinitely for offset when the next exchange gains are realized.

Inventory for manufacturing

Goods of the taxpayer’s own manufacture should be valued on the basis of

the aggregate of the cost of material, direct labor and overhead.

 Match the physical inventory records with the perpetual inventory or

warehousing records (if maintained) to the general ledger, financial
statements and tax declaration


250
 Determine the extent of the verification conducted by the independent
external auditor

 Review the costing methods used by the taxpayer to value closing

inventories, work in process and sales of finished goods. Review the
periodic or annual adjustments made by the taxpayer to update standard
costs and the adjustments made to the values of inventories and cost of
goods sold. Ensure that the excise tax is treated as part of the cost of
production and not as an operating expense. Ensure that custom work
provided by third parties, such as specialized machining of the product,
are include in the production costs and not as an expense

 Review the method and basis used by the taxpayer to value goods below
cost, due to such matters as product obsolescence, faulty production
runs and the like. Determine if some of these products have been sold
subsequent to the year-end and the sale value thereof;

 Determine if the inventories have been pledged as security for loans and
review the insurance coverage.
 Determine the raw materials and components that may be supplied by
the foreign parent for subsequent review under the transfer pricing
considerations;

 Compare the established selling prices of the major items in the
inventory to the manufacturing costs, and subsequently to the financial
statements and tax declaration for reasonableness and consistency

251
 INVENTORY

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

252
 Annex 14: Audit Program – Fixed Assets

AUDIT PROGRAM

FIXED ASSETS

Tax Payer Name: Auditor:

TIN:
Tax Year Date:
Financial Statements
Audit Objectives Assertions

 Existence of assets. Fictitious assets are not legible for depreciation.

 .Ownership of assets as depreciation is due to the owner of the asset.

 Valuation of assets is not inflated with undue costs so as to claim excessive
depreciation.
 Disposal of assets giving raise to gains/ losses are properly accounted for.
 Depreciation is in accordance with the law.
Working
Audit Steps Prepared by paper
Reference

(Document audit steps taken or to be taken)

FIXEDASSETS
1) Existence of assets and use in the business
 Inspect assets and check that they are included in fixed assets register.

 Any assets that cannot be accounted for should be removed from the register
and the depreciation hitherto claimed disallowed in the tax computation.
 Extent to which the asset is used in the business of the taxpayer
 Where the asset is provided for the private use of the employee, such as a
vehicle, check if employment tax has been computed on the benefit.

2) Ownership of assets

 Verify ownership by inspecting title deeds, car log books and transfer / sale
agreements

 Remove from the fixed asset schedule any assets not owned by the taxpayer
and any previously claimed depreciation disallowed.

3) Valuation

.  Check purchase documents and invoices issued from the suppliers and trace
to the assets schedule for completeness.

253
 Where the assets are constructed, check agreements with the contractor and
invoices thereof issued.
 Ensure that interest on funds borrowed to finance a purchase or construction
are not capitalized after the asset has been brought to use.

 Any assets whose value cannot be substantiated should be removed from the
fixed asset schedule and the depreciation allowance reduced accordingly.
 Where the assets are imported and have paid VAT at importation which is
claimed as input Tax, audit should check whether the costs build up does not
include VAT claimed.

 Check that withholding taxes imposed at importation which are claimed as

tax credits have not been included in the cost build up.

 Revaluation of assets is not included in the depreciation base.

4) Disposal
 Check that the disposed amounts have been deleted from the fixed assets
schedule in the year of disposal. Where the disposed assets are removed
from the fixed assets schedule during the year after disposal, depreciation
claimed after the disposal should be disallowed.

 Confirm that computation of loss or gain on the disposal of assets is done in

accordance with the proclamation and that the correct amounts posted to
expenses or income account respectively.

 Where the asset disposed was partly used for other purposes other than the
business, gain or loss should relate to the fair proportional part of business
use- Article 25(5) of the Income Tax Pro.

 Where the disposal involves taxable asset, that the gain or loss is considered
under schedule D, other income and not schedule C , Business income and
that the correct rates of tax have been applied in accordance with Article 59
of the Proclamation

5) Depreciation
 Adjustments are made where the asset is either partly used during the year
or used for other purposes other than that of the business.

 Check that the correct rates applicable to each category of assets are used
and applied.

 Re-compute the depreciation allowances and make appropriate adjustments.

 For additions check that the assets are depreciated only when they are ready
and available for use in deriving business income. For instance, in the case of
plant that is assembled, depreciation commences after assembly in
accordance with Article 25(6).

254
 Where the assets were acquired during the repealed proclamation, the
provisions of the repealed legislation on depreciation continue to apply and
the audit should check compliance with the said legislation.

FIXED ASSETS

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

255
 Annex 15: Audit Program – Cost of goods sold

AUDIT PROGRAM

COST OF GOODS SOLD

Tax Payer Name: Auditor:

TIN:

Tax Year Date:

Audit Objectives Financial Statements

 Purchases are made (occurrence), to sieve out fictitious purchases. Assertions

 Purchases claimed relate to the business


 Purchases are recorded at their true value, not overstated.
Audit Steps Working
Prepared paper
(Document audit steps taken or to be taken) by
Reference
Purchases/ Costs of Goods Sold-Import/Export

 Study and understand the internal control procedures of the taxpayer over
Inventories
 Obtain list of Inventory Items and their related Stock Control Card

 Inspect all Balances Brought Forward have been recorded in the opening balances

 Obtain the ending Inventory Count Sheet

 Check the Balance reported on FS and the Purchase Ledger balance are in
agreement
 Re-perform the cost build-up of all purchases and check all foreign purchases
have been maintained based on Customs Cost Valuations or Commercial Value
whichever is higher

 Confirm all purchases have been accounted and recorded in all GRN, stock card
and purchase accounts
 .
 Confirm the purchase amounts against Bank payments, and against Value Added
Tax Declarations
 Confirm the purchase amounts against Accounts Payable ledger

 Check whether all local purchase are supported with reliable source documents,
recorded in purchase accounts and their related stock cards

256
 Understand the pricing methods of the Company and obtain Price List for all the
Items

 Forecast the yearly sales for each Inventory Items using the Price provided and
compare the result with the reported Revenue amounts

 For selected Items substantiate the recording and deduction of Items sold on the
Stock Card

 Confirm the correctness of selected Inventory movement against Sales Invoices

 Confirm ending quantity balance against Inventory Sheet and determination of

Ending Inventory value; any adjustments made (for both overage and shortage)
on the Inventory amount should be critically Investigated

 This could arise as a result of incorporating fictitious purchases. These could be

validated from the Ascyuda data bases.

 VAT returns for input could be compared with purchases during the year for any
variation.

Cost of Construction
 Determine the percentage of work completed by the taxpayer during the year. This
determine by; (total costs incurred/total estimated contract costs including any
variations)

 Establish the total contract price and the estimate costs to completion multiplying
each with the percentage of works completed as determined in above. The
resulting figures should provide the income and expenses attributable to the period
and the taxable income.

 Determine if the final year of the project loss is making. This happens if the
following conditions are met
 The taxable income estimated to be made under the contract for the
purposes of the percentage of completion method in exceeds the actual
taxable income and
 The amount of the excess determined exceeds the difference between the
business income and deductible expenditures (taxable income) computed
in the tax year in which the contract was completed.

 Computation of final year loss is in accordance with Article 32(5) of the Income Tax
Proclamation.
 Final year losses have been properly applied either as a carry back for a maximum
of two tax years for entities closing business especially non-residents or a carry
forward for a maximum of five years for entities whose business are ongoing in
accordance with article 32(3&4) and 26(3) of the Income Tax Proclamation.

 Inputs used match outputs declared from their suppliers. This can be done by
examining substantial claims of inputs obtained from registered taxpayers to
determine whether such supplies were made.

257
 Claim for depreciation is adjusted (reduced) for equipment which is not fully
deployed during the tax year in accordance with Article 25(3) of the Income Tax
Proclamation.

 Cost of assets especially used by branches of non-resident companies is not inflated

to so as to claim undue depreciation allowances.
 Extent of use labor and whether employment tax is accounted for. In regard to
foreign branches employing expatriate staff, the remuneration paid should be
examined for reasonableness as most of these will receive the bulk of their
payments in their home countries to avoid employment tax in Ethiopia.

 Computation of employment tax on fringe benefits. These construction projects

especially those run by the foreign firms provide free accommodation, transport
and a host of other non-cash benefits. These should be examined to confirm
payment of employment tax.

 Thin capitalization rules provided by Article 47 of the Income Tax Proclamation

should be applied where the taxpayer is a foreign controlled resident company or a
permanent establishment of a foreign entity and the loan is advanced by it’s the
parent. Auditors are required to check compliance with these laws.

Cost of manufacturing
 Goods of the taxpayer’s own manufacture should be valued on the basis of the
aggregate of the cost of material, direct labor and overhead.
 Match the physical inventory records with the perpetual inventory or warehousing
records (if maintained) to the general ledger, financial statements and tax
declaration;
 Determine the extent of the verification conducted by the independent external
auditor
 Review the costing methods used by the taxpayer to value closing inventories,
work in process and sales of finished goods.
 Review the periodic or annual adjustments made by the taxpayer to update
standard costs and the adjustments made to the values of inventories and cost of
goods sold.
 Ensure that the excise tax is treated as part of the cost of production and not as an
operating expense.
 Ensure that custom work provided by third parties, such as specialized machining
of the product, are include in the production costs and not as an expense;
 Review the method and basis used by the taxpayer to value goods below cost, due
to such matters as product obsolescence, faulty production runs and the like

 Determine if some of these products have been sold subsequent to the year-end
and the sale value thereof
 Determine if the inventories have been pledged as security for loans and review
the insurance coverage

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 Determine the raw materials and components that may be supplied by the foreign
parent for subsequent review under the transfer pricing considerations

Auditors are required to pay attention to the following areas during audit of
manufacturing entities
 Industry averages of a similar and comparable level on sales, production that may
be used to evaluate performance of the particular audit case.

 Assets used. Manufacturing entities are usually capital intensive in nature. This
implies huge capital deductions through depreciation allowances. Auditors are
particularly required to establish existence, cost and ownership of the said assets
before grant of depreciation allowances.
 Input out ratios. This requires scientific research into inputs used and expected
outputs. Auditors in this case will be supported by experts who are able to
determine through the use of given inputs, expected outputs.

 Auditing standards require auditors to physically observe the company's inventory

count procedures and make their own independent tests of the physical count of
inventory.

 This requirement is in response to the multitude of accounting frauds that have

been perpetuated through falsification of inventory records.

 Often, when the auditor tests the inventory count, use a technique called "floor-to-
sheet" and "sheet-to-floor." Floor-to-sheet is when the auditor selects items from
the inventory warehouse and makes sure that they are included on the count
sheet.
 Then, the auditor selects items from the count sheet and ensures that they are in
the warehouse, which tests for the existence of inventory.
 Cutoff analysis. The auditors will examine your procedures for halting any further
receiving into the warehouse or shipments from it at the time of the physical
inventory count
 Reconcile the inventory count to the general ledger. They will trace the valuation
compiled from the physical inventory count to the company's general ledger, to
verify that the counted balance was carried forward into the company's
accounting records.

 Test high-value items. If there are items in the inventory that are of unusually
high value, the auditors will likely spend extra time counting them in inventory,
ensuring that they are valued correctly, and tracing them into the valuation report
that carries forward into the inventory balance in the general ledger.
 Test error-prone items. If the auditors have noticed an error trend in prior years
for specific inventory items, they will be more likely to test these items again.

 Test inventory in transit. There is a risk that you have inventory in transit from

one storage location to another at the time of the physical count. Auditors test for
this by reviewing your transfer documentation.

259
 Test item costs. The auditors need to know where purchased costs in your
accounting records come from, so they will compare the amounts in recent
supplier invoices to the costs listed in your inventory valuation.

 Review freight costs. You can either include freight costs in inventory or charge it

to expense in the period incurred, but you need to be consistent in your
treatment - so the auditors will trace a selection of freight invoices through your
accounting system to see how they are handled.
 Test for lower of cost or market. The auditors must follow the lower of cost or
market rule, and will do so by comparing a selection of market prices to their
recorded costs.

 Finished goods cost analysis. If a significant proportion of the inventory valuation


is comprised of finished goods, then the auditors will want to review the bill of
materials for a selection of finished goods items, and test them to see if they
show an accurate compilation of the components in the finished goods items, as
well as correct costs.
 Direct labor analysis. If direct labor is included in the cost of inventory, then the
auditors will want to trace the labor charged during production on time cards or
labor routings to the cost of the inventory. They will also investigate whether the
labor costs listed in the valuation are supported by payroll records.

 Overhead analysis. If you apply overhead costs to the inventory valuation, then
the auditors will verify that you are consistently using the same general ledger
accounts as the source for your overhead costs, whether overhead includes any
abnormal costs (which should be charged to expense as incurred), and test the
validity and consistency of the method you use to apply overhead costs to
inventory.
 Work-in-process testing. If you have a significant amount of work-in-process
(WIP) inventory, the auditors will test how you determine a percentage of
completion for WIP items.

 Inventory allowances. The auditors will determine whether the amounts you

have recorded as allowances for obsolete inventory or scrap are adequate, based
on your procedures for doing so, historical patterns, "where used" reports, and
reports of inventory usage (as well as by physical observation during the physical
count).
 Inventory ownership. The auditors will review purchase records to ensure that
the inventory in your warehouse is actually owned by the company (as opposed
to customer-owned inventory or inventory on consignment from suppliers).

 Inventory layers. If you are using average, inventory valuation system, the
auditors will test the inventory layers that you have recorded to verify that they
are valid.

d. Cost of Agriculture
Measurement of biological assets

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 The auditors should ascertain whether a tax payer has measured a biological asset
on initial recognition and at the end of each reporting period at its fair value less
costs to sell, except for the case where the fair value cannot be measured reliably.

 Auditors required to evaluate the fair value measurement process of tax payers
and need to ascertain whether fair value measurement process is according to fair
value measurement provisions of IFRS (IFRS 13)

 The fair value measurement of a biological asset facilitated by grouping biological

assets according to significant attributes; for example, by age or quality
 Entities often enter into contracts to sell their biological assets at a future date.
Nevertheless the auditor should determine whether contract prices are not used in
measuring fair value, because fair value reflects the current market conditions in
which market participant buyers and sellers would enter into a transaction

 When the tax payer has not measured a biological asset on initial recognition and
at the end of each reporting period at its fair value less costs to sell, the auditor
should make certain that;

 little biological transformation has taken place since initial cost incurrence
(for example, for seedlings planted immediately prior to the end of a
reporting period or newly acquired livestock); or
 the impact of the biological transformation on price is not expected to be
material (for example, for the initial growth in a 30-year pine plantation
production cycle)
 A gain or loss arising on initial recognition of a biological asset at fair value less
costs to sell and from a change in fair value less costs to sell of a biological asset
shall be included in profit or loss for the period in which it arises. Auditors are
required to confirm that a gain or loss has included in profit and loss statement in
determining taxable business income of the tax payer.

 A loss may arise on initial recognition of a biological asset, because costs to sell are
deducted in determining fair value less costs to sell of a biological asset. A gain may
arise on initial recognition of a biological asset, such as when a calf is born.

 If a fair value cannot be determined because market determined prices or values

are not available. Then the biological asset can be measured at cost less
accumulated depreciation and impairment losses. This alternative basis is only
allowed on initial recognition.

 all direct and indirect costs of growing crops should be accumulated and growing
crops should be (reported at the) lower of cost or market” In the case of annual
crops, for analysis purposes, that it is allowable to accumulate direct costs only and
report this “Investment in Growing Crops” on a cost basis counting” these same
direct costs in prepaid expenses.)

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 An agricultural producer should report inventories of harvested crops held for sale
at (1) the lower of cost or market or (2) in accordance with established industry
Practice, at sales price less estimated costs of disposal, when all the following
conditions exist:
 The product has a reliable, readily determinable and realizable market price.
 The product has relatively insignificant and predictable costs of disposal.
 The product is available for immediate delivery

e. Cost of Mining
1. Exploration Expenditure

 An exploration expenditure incurred by a licensee or contractor is treated as a

business intangible with a useful life of one year. In other words, the depreciation
rate applicable to exploration expenditure is 100%. So the Auditor should verify the
check lists in accordance with the Income Tax proclamation 979/2008 Article 39

2. Development expenditure
 Construction costs that relate to more than one mineral Account for them in the
same way as other property, cost centre plant and equipment.
 According to Income Tax proclamation 979/2008 Article 40 (which provides for the
deductibility of development expenditure incurred by a licensee or contractor).
Auditors should consider development expenditure incurred by a licensee or
contractor on the basis that it is a business intangible with a useful life of four
years.

 Development costs Recognize as an asset, Construction costs that relate to a single

mineral cost centre Capitalize as part of the costs of that cost centre.
 Post-production exploration and development costs Treat the same way as any
other exploration or development costs
3. Social infrastructure expenditure

 Is defined to mean capital expenditure incurred by a licensee or contractor on the

construction of a public school, hospital, road or any similar social infrastructure.

 The auditors should ascertain whether a tax payer has measured those expenses as
per the following conditions when:
 The deductibility of social infrastructure expenditure depends on the phase
of operations in respect of which it is incurred.
 Social infrastructure expenditure that a licensee is required to incur under an
exploration right is treated as exploration expenditure and, therefore,
allowed as a deduction in the tax year in which the expenditure is incurred
under Article39 (1).
 Similarly, social infrastructure expenditure that a licensee is required to incur
under a mining license or petroleum agreement in relation to development
and production operations is treated as development expenditure and,
therefore, is depreciated for business income tax purposes over four years
(Article40).

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4. Rehabilitation Expenditure

 This Article provides for the tax treatment of rehabilitation expenditure, including
contributions made to a rehabilitation fund established for the purposes of funding
rehabilitation of a mine site or oil well.

 The auditors should consider a contribution made by a licensee or contractor to a

rehabilitation fund under the terms of an approved rehabilitation plan in relation to
mining or petroleum operations is allowed as a deduction in the tax year in which
the contribution was made.

5. Subcontractor

 The auditors should verify A “subcontractor” supplying services to a licensee or

contractor in respect of mining or petroleum operations undertaken by the
licensee or contractor. And its related costs or expenses that addressed in the
contract.

 It is expressly provided that a person supplying services to a licensee or contractor

as an employee is not a subcontractor. The employment income tax applies to
employment income paid by a licensee or contractor to an employee.

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 COST OF GOODS SOLD

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

264
Annex 16: Audit Program – Accounts Payable and Other Liabilities

AUDIT PROGRAM

ACCOUNTS PAYABLE & OTHER LIABILITIES

Tax Payer Name: Auditor:
TIN:
Tax Year Date:
Financial Statements
Audit Objectives Assertions

Whether trade creditors relate to un paid business expenses

Whether expenses accrued relate to the year of accrual

Whether creditors don’t include sales

Existence of long term liabilities

Interest rates charged

Audit Steps Prepared by Working

(Document audit steps taken or to be taken) paper
Reference

ACCOUNTS PAYABLE & OTHER LIABILITIES

Reconcile the taxpayer’s list of accounts payable with the subsidiary ledger,
general ledger, financial statements and tax declaration.
Compare beginning & ending balances and investigate significant changes.
Review general ledger for unusual entries.
Accrued expenses:
 Determine how accruals were computed; ask company; review
amortization schedule where applicable; review agreements/contracts if
necessary.
 Determine if accruals are deductible. E.g. Related parties - accrued
bonuses not deductible until paid.
 Test subsequent year for payments, were reversing entries properly made?

Check for Inter-company Loans

Review Deferred Income Taxes

Deferred Credits- investigate all significant credit balances. Deferred income

265
Contingent & estimated liabilities:
 Determine if estimated, contingent, disputed liabilities are present.
 Determine if company is deducting.
 Determine nature & purpose of contingent liabilities, how amount
determined, how long liability outstanding, & subsequent payment

Other liabilities: Any liability that is not included in the above categories.
 Examine any large/unusual accounts or entries within account.
 Look for items that should be included/brought back into income such
as, deposits, unclaimed wages (longer than 12 Mo.), unclaimed sales
allowances, and rebate to customers who can’t be located.

Determine the degree of verification of the balances by the independent external

auditor

Confirm the balances of the major individual creditor accounts, either to monthly
statements of account or directly with the supplier;
Review the long outstanding balances owing to specific creditors, and supporting
correspondence between the taxpayer and the creditor, to determine the validity
and reason for non-payment (i.e. goods returned for credit but not recorded,
payment dispute etc.). Pay particular attention to these accounts if the creditor is a
VAT supplier.

Identify non-trade debts that may represent advances to shareholders and, if so,
review the terms, accounting treatment, business and personal income tax
implications etc

Identify the trade accounts for the parent or associated company which will
require subsequent examination during the tests of purchases and expenses;
Audit procedures

1) Whether creditors relate to unpaid business expenses

Inspect trade creditors to confirm that they relate to business.

Personal expenses especially where the enterprise is a sole proprietorship should
be disallowed.

Where the enterprise is a body, these could be allowed but taxed to the recipient,
such the director as employment benefits.

2) Whether expenses accrued relate to the year of accrual

Confirm that expenses accrued especially material items relate to the year of
accrual.
Study agreements e.g. rental agreements and prorate expenses that are
consumed during the year.
Disallow any accrued expenses that relate have not accrued.

3) Whether creditors don’t include sales amounts

266
Review creditors ledger to trace out for any amounts included as sales revenue

Adjust the tax computation to include undeclared sales

4) Existence of long term liabilities and use in the business

Confirm from loan agreements existence of loan agreements.

Where the taxpayer is unable to substantiate existence of liabilities, this could

mean that the said loans are financed from undeclared income and should be
brought to the tax net.
Where the nonexistent loan is used to finance nonexistent assets, remove from
the depreciable base the said assets and disallow the depreciation expense
accordingly.
Disallow interest expenses in relation to unsupported loans.
Check loan agreements to confirm use in business of the taxpayer. Disallow
interest claimed if the loan is not in relation to the business.
5) Interest rates charged

Review loan agreements for interest rate.

Disallow interest paid or payable to a related person who is not a resident of
Ethiopia except when the interest is included in the schedule D of the related
person.
Disallow interest in excess of 2 percentage points between the national bank of
Ethiopia and commercial banks unless the lender is a financial institution
recognized by the central bank
Obtain any Bank Loan agreements and check for Interest expense and repayment
of loan to source of Cash, and outside; Inspect the inclusion of properties into the
financial records
6) Shareholders Accounts
Determine Loans made to the Company by the Shareholders and the extent of
Interest payment,
For any Owner’s Account balances check for the Fund flow to the Company and
vise versa against any source document,
Check for any Dividend declarations and Payments to the Shareholders of the
Company


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 ACCOUNTS PAYABLE and OTHER LIABILITIES

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

268
Annex 17: Audit Program – Expenses

AUDIT PROGRAM
EXPENSE

Tax Payer Name: Auditor:

TIN:
Tax Year Date:
Financial Statements
Audit Objectives Assertions
Expenses are made (occurrence), to sieve out fictitious expenses.
Expenses claimed relate to the business
Expenses are recorded at their true value, not overstated.
 Purchases are made (occurrence), to sieve out fictitious purchases.
Audit Steps Prepared by Working
 ii. Purchases claimed relate
(Document audittosteps
the business
taken or to be taken) paper
Reference

EXPENSE
 iii. Expenses/purchases are recorded at their true value, not overstated
General and Administrative Expenses /Only for selected expense
accounts

Confirm expenses are accounted using appropriate reliable supporting

documents
Check the expenses incurred are only for the business purpose and are allowable
as per the Profit Tax Proclamation

Check the Income Tax computations on Payroll Sheet and other allowances are
treated as per the Profit Tax Proclamation and its related Regulation
Check for deductions of Withholding Tax for entitled expenditures,

Check weather expenses incurred in relation to Fixed Assets for their Ownership
title
Check expenditures on repair to confirm they are going to be capitalized as per
the Profit tax Proclamation

Confirm the availability of contractual agreement for Rent expense,

Reconcile all the expense account totals to FS balances

Any amounts entered into expenses with Gift and Entertainment nature should
be identified

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 EXPENSE

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

270
Annex 18: Audit Program – Shareholders’ Equity

AUDIT PROGRAM

SHAREHOLDERS’ EQUITY

Tax Payer Name: Auditor:

TIN:
Tax Year Date:
Financial Statements
Audit Objectives Assertions

Source of share capital, the increases are not sourced out of undeclared

Shareholder capital and dividends.

Audit Steps Prepared by Working

(Document audit steps taken or to be taken) paper
Reference

SHAREHOLDERS’ EQUITY

1) Source of share capital, especially increases.

Examine the ability of the shareholders to introduce additional shareholding to

the company.

Where the shareholders are unable to account for the increase from credible
sources say loans, salary, etc.., this could imply that the purported

Share capital is internally generated and should be treated as sales.

In the alternative, where the source is a different business which is outside the
tax radar, this income should be treated as dividends and taxed on the
shareholder(s).

2) Shareholder capital and dividends

Confirm that dividends paid are not deducted against income

Confirm that the increase in share capital is of the company is not expensed.

271
 SHAREHOLDERS’ EQUITY

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

272
Annex 19: Audit Program – Income/ Revenue

AUDIT PROGRAM
INCOME/REVENUE

Tax Payer Name: Auditor:

TIN:

Financial Statements
Audit Objectives Assertions

Completeness of the sales/revenue with regard to understatement.

Classification of income in accordance with the prescribed schedules (A, B, C &
D)
Accuracy of declaration especially where sales are made to related parties.

Audit Steps Prepared by Working

(Document audit steps taken or to be taken) paper
Reference

INCOME/REVENUE
General Guide lines
Study and understand the Internal Control procedures of the taxpayer over
sales and related trade debtors,
Obtain list of approvals granted to the taxpayer for printing both Credit and
Cash Sales Invoices, and Cash Receipt Vouchers,
Obtain the beginning and ending sequential numbers of both the Cash and
Tax Year
Credit Sales Invoices for the Tax Period, Date:

Obtain a summary of the goods and/or services sold by the taxpayer that are
taxable, exempted for VAT and/or Zero rated

Obtain the monthly VAT declarations and compare the sum sales amount
with a revenue amount reported on the financial statements, any differences
should be critically investigated.

Confirm the monthly sales amount from the sales day book to subsidiary
sales ledgers, to sales ledger and to the monthly VAT statements, and
revenue amount reported on the financial statements. Any differences
should be critically investigated declarations, and any difference should
critically need to be investigated
Confirm the completeness of sales amount by sequential check or account
 the numerical sequences of all Invoices and credit Sales,
for

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Obtain the Taxpayer’s official price lists for pricing of Invoices,

Select a sample of sales transactions. Check the copies of the relevant

Invoices with dispatch notes for dates of dispatch, quantities, descriptions
and computations,
For each VAT Tax Periods confirm the correctness of Output VAT
computations,

Vouch the Invoices selected to the sales day book and check the postings to
the nominal and sales ledger,

Select a sample of Sales Invoices and Dispatch Notes towards the end of the
accounting period and carry out cutoff tests to ensure that sales and debtors
are recorded in the correct period,
Examine all the debit balances on the sales ledger together with supporting
evidences,

Review the bank deposit patterns in relation to the sales and cash collection
patterns,

Compare the sales ledger balance at the year end with the schedule of
balances provided by the taxpayer. Any discrepancy discovered should be
noted and investigated,
Audit procedures

1. Completeness of the sales/revenue with regard to understatement

Inspect the sales ledger using CAAT s (e.g. Idea, Advanced Excel) to detect
any missing invoices in the sales ledger
Inspect VAT tax returns particularly input in relation to sales made by this
client and check whether corresponding sales have been declared.
Where the taxpayer is a construction company, reconcile the contract
documents to the certificates issued and income declared.

Use third party information especially IFMIS where the taxpayer is a supplier
to government to verify declarations and exports under Ascyuda.
Where the taxpayer is a contract manufacturer, check agreements for
supplies and reconcile them to the sales ledger.
Inspect creditors for any hidden sales. Creditors are known to be vehicles for
hidden income.
Reconcile V AT and Income Tax returns for any variances.
2) Classification of income in accordance with prescribed schedules ( A, B, C
& D)

Inspect the income records to ensure that income is classified as per the
prescribed schedules. This particularly applies to income under schedule D
with most inflows taxed on the gross proceeds without providing for
expenses.

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Confirm that the correct tax rates have been applied to the respective
incomes.
3) Accuracy of declaration especially where supplies are made to related
parties

Where supplies are made to related parties check the rates used in relation
to similar goods and services by the same taxpayer and make adjustments to
reflect market valuation. This applies to both VAT and Income Tax.
 Income from Import and Export sectors

Under declared sales

UN receipted and unrecorded sales are a popular window taxpayer’s exploit
to evade taxation.

Where the taxpayer uses an electronic accounting system, auditors can

detect missing transactions by conducting a gap detection methodology. This
could be supported by advanced Excel or other CAAT’s like IDEA. Where gaps
in the sales are detected, taxpayers should be held to account.

Where the goods are imported/exported using information from Ascycuda, a

markup could be obtained and compared with the declarations in the tax
returns and adjustments made to the tax computation.

Reconcile VAT returns to sales declared for variances. Where the enterprise
operates sales registers, information on this platform should be reconciled to
sales declared.

 Income from Construction

Determine the contract price and duration of the contract.
The duration of the project determines whether it is a long term contract the
extent to which article 32 of the Proclamation applies in determining the
taxable income of the construction enterprise.

Reconcile the contract price to the revenue declared during the period and
whether they have been considered in the correct tax periods for both VAT
and Income Tax.

Determine whether revenue recognition based on the input method

discussed above has been correctly applied for purposes of income tax.
Where the output method is used, the auditors are expected to re-compute
the income and expenses recognized using in the input method.

Whether the contract was varied, and whether the additional income arising
from the additional works is fully accounted in the tax returns.
Reconcile the contract price with third party sources especially IFMIS to
ensure validity and completeness of the contract /amounts declared by the
taxpayer.

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Reconcile contract price with capitalized assets of the taxpayer’s client/s to
ensure completeness of income.

 Income from Finance sector

The following areas should be considered during audit planning and
execution as potential for risk in regard to financial institutions.
a. Provision for bad debts

Auditors are required to re-calculate the loss reverse deducted to determine

it is in accordance with the prudential requirements prescribed by the
National Bank of Ethiopia and are consistent with financial reporting
standards (Article 45 of the Income Tax Regulation).

b. Foreign currency exchange gains and losses

Foreign currency exchange losses are permitted subject to the financial
institution substantiating the loss to the Ministry in the terms of Article 44(3)
of the Income Tax Regulation. This loss should be disallowed unless the
taxpayer has provided satisfactory evidence in support.

c. Bank fees and commission income

Check that all fees and commission income are booked.

d. Intergroup loans

The loans do not exist and the local bank is claiming an interest charge which
is not ordinarily deductible.

The loans are not used by the bank to derive business income in accordance
with Article 23(1). Such interest expense should be disallowed. Here the
financial institution should prove that the borrowed funds are invested in
revenue generating activities or assets.

Where the loan is advanced by a foreign bank (parent), the interest deducted
will not be permitted unless the foreign bank is permitted to lend to persons
in Ethiopia in the terms of Article 23(2).

e. Leasing income
Lease income is VATABLE and is often disguised as a financial service.
However, Article 20(6) g of the VAT regulation explicitly brings leasing
income under the ambit of Value Added Tax. Auditors are expected to check
compliance with this provision.
The financial institution has claimed depreciation on assets leased under a
finance leasing arrangement. Article 25(1) read together with 20(1) will grant
depreciation to the lessee and where the bank claims this depreciation, such
amounts should be disallowed.

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The following situations would normally lead to a lease being classified as a
finance lease

The lease transfers ownership of the underlying asset to the lessee by the
end of the lease term.

The lessee has the option to purchase the underlying asset at a price
expected to be sufficiently lower than fair value at the exercise date, that it is
reasonably certain, at the inception date, that the option will be exercised.

The lease term is for a major part of the economic life of the underlying asset
even if title is not transferred.
The present value of the lease payments at the inception date amounts to at
least substantially all of the fair value of the underlying asset.
The underlying asset is of such specialized nature that only the lessee cans it
without major modifications.

Any losses on cancellation are borne by the lessee

Gains/losses on changes in residual value accrue to the lessee

The lessee can continue to lease for a secondary term at a rent substantially
lower than the market value.

f. Written off loans

Auditors are expected to review all loan write-offs to confirm that the loans
where advanced and that interest income had been previously included in
the business income of the financial institution.

g. General service charges

The services received are not used by the financial institution in the course of
its trade.
Where the bank is part of a group, recharges made by the parent that do not
support the production of income of the local financial institution should be
identified and disallowed.

h. Hybrid financial instruments

This arises where the bank has raised funds through equity, but classified it
as debt in order to take undue credit for fictitious interest costs.

i. Treasury transactions
Fee income charged by treasury is not reflected in the profit and loss
account.

j. Others

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Apportionment of input VATS. This arises where the financial institution has
both taxable and exempt sales but does not apportion over heads
attributable to both supplies.
Employment income tax on benefits in kind. Financial institutions will usually
provide fringe benefits inform of motor vehicles or accommodation to their
senior staff. Auditors are particularly required to check monthly employment
income tax returns for inclusion of these amounts.

Banks publish audited financial statements in the print media. These financial
statements should be compared with those provided to the Ministry for
consistency of reporting.
 Income from Insurance Companies
a. Premium income and commissions

Premium is the primary source of income for insurance companies.

Commission is paid to agents/brokers (% of business received).

Proposed audit procedures:

Premium income
Obtain premium account for the particular class of business to be audited.

Select a sample of entries and trace them from source documents

(registers/cover notes) to debit notes to ledger accounts to ensure
completeness.
Ensure the sequential recording of all debit notes and authorization of credit
notes
Use of registers for new, recurring business and endorsements.
Ensure cut-off procedures are adhered to.

Commission paid
Obtain commission paid account for the particular class of business to be
audited.
Ensure commissions are paid to only licensed intermediaries.

Ensure commissions are paid to only brokers who have brought in business
and a policy under written

Establish whether the approved commission rate has been used in the
payment of commissions

b. Unearned Premium Reserves (UPR)

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Unearned premium is income not relating to the current year but to the
following year. This is due to the fact that the debit notes are not raised at
the start of the year but throughout the year. The unearned premium income
brought forward is added to the premiums underwritten for the year and the
earned income as at the end of the next year.

Proposed audit procedures:

Re-compute UPR reserves at the yearend to ensure correct calculation,
ensuring that all premium underwritten in the year is taken up
(completeness)

Review policy of accounting for UPR to ensure correctness

Ensure prior year reserves are realized in the detailed revenue account and
the current year reserves taken up correctly.

c. Claims Paid
This is the main expenditure of the company – ‘cost of sales’.

Proposed audit procedures:

Ensure that there is adequate documentation to support the claim, i.e.

assessor’s/investigators’ reports, authorization, approval and vetting of all
large claims for existence.

Select a sample of claims and trace them from the ledger to supporting
documents including the loss adjuster’s reports

Use of analytical review procedures – technical ratios, market trends and loss
ratios.
Ensure that insurance policies exist for all claims paid, especially the large
ones.

d. Claims Outstanding

This is a provision for claims reported and assessed but not paid at the
financial yearend.

Proposed audit procedures:

Ensure that once a claim is reported adequate reserves are maintained after
assessment.

Select a sample and validate claims outstanding at the yearend to supporting

documents including loss adjusters’ reports/investigation reports,
correspondence and review post yearend payments.

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Review the claims outstanding register – sequential claim numbers and
enquire into missing claims.

Use of analytical review procedures – market trends and loss ratio

Ensure reinsurers’ portions have been correctly debited to them

Review of lawyer’s responses and internal management meeting expenses

Ensure cut off procedures adhered to.

e. Reserves

This is a general reserve maintained for claims incurred.


Proposed audit procedures:


Ensure correct calculation of the reserve as at the year-end in line with
Article 46 of the Income Tax Regulation.

f. Reinsurance

In order to minimize its exposure and spreading its risk, the insurance
company passes on part of its risks to a reinsurer. In doing this an amount of
premium will be ‘ceded’ out based on the treaty between the insurance
company and the reinsurer. Upon crystallization of a claim the reinsurer shall
pay part of the claim again based on the treaty.

Proposed audit procedures:


Ensure correct ceding of premiums, booking of commissions, correct splits of
claims incurred and paid.

Review of reinsurance statements:

Review correspondence with the reinsurer

Review of reinsurance committee meeting minutes

Ensure premium tax returns are completed
Validate material facultative balances to statements
g. Premium Receivable

All premium receivable as per the books of account may not be receivable
due to the nature of the business.

Proposed audit procedures:

Ensure aged analysis provided is correct

Review of correspondence between the company and the debtor
Review of material amounts outstanding over one year

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 INCOME/REVENUE

Tax Period Per Return Per Audit Adjustment

Conclusion: (Reflects the final determination on the issue)

Based on the procedures performed and the results obtained, it is my opinion that
the objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by
Signature Date

Approved by
Signature Date

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 Annex 20: Stock Sheet/ Stock Count

Stock Sheet/ Stock Count

Company/Tax payer name: _________________________

Stock count: As at _______________________

Quantity
S. Item Description Shortage/ Unit Total Remark
As per As per stock
No. Unit of Overage cost cost
measure physical count card

Total

Store keeper (Custodian) Counted by:

Name: _________________________ Name: _______________________
Signature: _______________________ Signature: ____________________
Date: ___________________________ Date: ________________________

Witnesses
Name: ____________________________
Signature: _________________________
Date: _____________________________

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Annex 21: Query Sheet

Tax payer Name Prepared by

TIN No. Date
Audit year(s)

No. Queries Dispositions Initials & Date

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 Annex 22: Time Sheet (Case Activity Sheet)

Tax payer Name Sector

TIN No. Month
Audit year(s)

Tax Audit Daily case activity Record

Time taken
Week Date Day Activities Team Name Auditors Name
to perform
Monday
Tuesday
1st week

Wednesday
Thursday
Friday
Saturday
Sunday
Monday
Tuesday
2nd week

Wednesday
Thursday
Friday
Saturday
Sunday
Monday
Tuesday
3rd week

Wednesday
Thursday
Friday
Saturday
Sunday
Monday
Tuesday
Wednesday
4th week

Thursday
Friday
Saturday
Sunday
Monday
Tuesday

Prepared by ______________ Date Approved by _______________ Date _____________

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Annex 23: Individual Accounts Working Papers

Tax payer Name Tax Date

TIN No. Auditor
Audit year(s)

Account Name: Account No.

Date Reference Amount

document Description
No Dr. Cr. Remark

Findings:

Conclusion:

Based on the procedures performed and the results obtained, it is my opinion that the
objectives listed in this audit program have been achieved.

Performed by Signature Date

Reviewed by Signature Date

Approved by Signature Date

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Completion Phase

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 Annex 24: Report Format (BIT)

Company / Taxpayer Name

Business Profit Tax Audit Report
For the years __________________________

TIN ______________________
VAT No.___________________
Business Sector _____________
Address: City _______________ Sub city ______________ Woreda _____ H. No. _______
Tel. No _______________________
Previous Audit Period ____________________________
Audit Commencement date:___________________
Audit Completion Date:______________________

Background

X-PLC has been established on E.C with a register paid up

capital of birr ___________consisting of shares with par contributed by
____________ shareholders. Later on Sep 30,19xx the company increased its capital to
_____________________and still the company is engaged in the
______________________. The Company has been registered for VAT on December 23,
1995 E.C.

Audit Objective
The audit objective is to verify the company’s book of accounts, records and other
related documents so as to ascertain the taxpayer’s compliance with existing tax laws and
regulations.

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Audit Scope

The audit covers from 20xx to 20xy tax periods only. And brief description of what activities
were conducted during the audit and to what extent, including limitation in scope.

Methodology
As the taxpayer’s business transaction is wide and bulky and making a detail examination
of all accounts is infeasible, we conduct our audit on a test basis. We
used ____________ sampling methods when selecting accounts for test and determining
our sample size.

Documents Verified
We have examined the company’s book of accounts, records and other documents
that we considered relevant to the assessment of tax returns. Below are some of
documents we have verified in the course of audit.

 VAT and profit tax declarations

 Financial statements
 General ledger, Accounts Receivable ledger, fixed asset Subsidiary ledger etc
 General Journal, Sales Journal, Cash receipt Journal, Purchase/or expenditure/
Journal etc
 Other source documents that support those financial statements.
 Third party Information.

Findings, Adjustments and Justification

During our audit engagement we have observed that the taxpayer has maintained its
financial and other aspects in line with Ethiopian tax laws except the adjustments listed
below. We have added back the adjustments to the taxpayer’s taxable income to
determine its tax liability

1. Undeclared sales: - It is an Income recorded as unearned but service is delivered

to customer, debit balance of unearned income that must be credited by sales unless
otherwise the sales agreement is canceled, un posted sales to the general ledger,
understated sales based on undeclared purchase and understated purchase is adjusted

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to taxable income of Birr _______ , ________ ,and ______ for the tax years of _______ ,-
__________ and __________ respectively.

2. Over stated Cost of goods sold:- the Company over states the cost of goods sold
by recording of overage of stock, unofficial receipt, double and over recording of cost is
as adjusted to taxable income of Birr , , and for
the tax years of ______ ,________and respectively.

3. No source document: when we are examining the company’s disbursements & cost,
we come across with entries that are not properly backed with reliable evidence, and we
are not sure it is really incurred then finally adjusted to taxable income of Birr______,
______, and _______ for the tax years of _____ , ______ and __________ respectively.

4. Unofficial receipt: - It is transaction entries supported with illegal invoices as per

directive no. xxxxxxx and xx/20xxxx expense incurred without official receipt is adjusted
to taxable income of Birr_____,_______ and _______for the tax years of________
,________ and _______ respectively.

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 Summary of Findings and adjustment

Company /Taxpayer Name

Business Profit Tax Computation
For the years from 20xx to 20xz

COMPANY NAME
BUSINESS PROFIT TAX COMPUTATION
FOR THE YEARS FROM 20xx -20xx E.C
DESCRIPTIONS 20xx 20xy 20xz TOTAL
Declare taxable income as per F/Statement
Add:-Adjustments
Undeclared income/Sales
Disallowed overstated cost
No source Document
Unofficial Receipts
Total Adjustments
Total adjusted taxable income
Tax (30%)
Payments: - by Receipt (a)
- Withholding tax claimed (b)
- Refund /c/
Total Payments (a+b-c)
Balance due
Interest
Penalties
Total Tax, Interest and Penalties

Performed by Signature Date

Signature Date
Verified by

Signature Date
Approved by

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Annex 25: Report Format (VAT)

Company / Taxpayer Name

Value Added Tax Audit Report
For the years 20XX - 20XY E.C

TIN: ______________________
VAT No. ___________________
Business Sector: _____________
Address: Region: _______________ Sub City ____________ Woreda _______ H. No. ______
Tel. No_______________________
Previous Audit Period: ____________________________
Audit Commencement date: ______________ Audit Completion Date: ______________

Background

X-PLC has been established on E.C with a register paid up

capital of birr ___________consisting of shares with par contributed
by____________ shareholders. Later on Sep. 30, 19xx the company increased its capital
to_____________________ and still the company is engaged in the __________________.
The Company has been registered for VAT on December 23, 1995 E.C.

Audit Objective
The audit objective is to verify the company’s book of accounts, records and other
related documents so as to ascertain the taxpayer’s compliance with existing tax laws and
regulations.

Audit Scope

The audit covers from 20xx to 20xy tax periods only. And brief description of what activities
were conducted during the audit and to what extent, including limitation in scope.

Methodology

As the taxpayer’s business transaction is wide and bulky and making a detail examination
of all accounts is infeasible, we conduct our audit on a test basis. We

291
used ____________ sampling methods when selecting accounts for test and determining
our sample size.

Documents Verified

We have examined the company’s book of accounts, records and other documents
that we considered relevant to the assessment of tax returns. Below are some of
documents we have verified in the course of audit.

 VAT and profit tax declarations

 Financial statements
 General ledger and
 All source documents that support those VAT declarations.
 Third party Information

Findings, Adjustments and Justification

During our audit engagement we have observed that the taxpayer has maintained its
financial aspects in line with Ethiopian tax laws except the adjustments listed below.
We have made adjustments to output and input amounts to determine its tax liability.

1. Undeclared income: when we are comparing the financial statement and General
ledger, agreement of the taxpayer with different customers and foreign purchase, we
have got undeclared income recorded as unearned income and under stated sales. As
a result we adjusted to taxable output of Birr ________ , ________, ________ for the
years of 20xx, 20xy and 20xz respectively.

2. Undeclared commission income:- When we verify the company’s sales the company is
not collected vat on commission income as a result we adjusted to taxable output
of Birr ,_____ , for the years of 20xx, 20xy and 20xz respectively.

3. Rejected input: - Input tax incurred without sufficient supporting document like
custom declaration and declaration not invoice in the name of the company is rejected
and as a result we adjusted to taxable output of Birr _________ ,_________ , and
__________ for the years of 20xx, 20xy and 20xz respectively.

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 Summary of Findings and adjustment
Company / Taxpayer Name
Value Added Tax Computation
For the years from Hamle , 20xx – 20xx

Description 20xx 20xy 20xz TOTAL

Declared Vatable sales as per VAT
Declaration
Add:- Undeclared income
Undeclared vatable commission income

Assessed output
Output VAT (15%)
Declared input
Less: - Rejected Input
Assessed input
Input VAT (15%)
Add: - Credit brought from previous
period
Less: - Credit carried forward
Adjusted Input VAT for the period
VAT to be paid
Less:- Payment(receipt )
Government voucher(withholding)
Balance due
Interest
Penalty
Total tax, interest and penalty

Performed by Signature Date

Signature Date
Verified by

Signature Date
Approved by

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Annex 26: Exit Conference Format

Ethiopian Ministry of Revenues

__________________ Branch
Audit Exit Conference

Place of meeting
Taxpayers/ Company Name:
TIN
VAT No.
Company’s phone No.
Business type
Audit coverage from to _ _____
Reason why the company selected for audit
Audited tax type
Auditor’s name
Team coordinator name

Name of participant Position signature

1. _____________ __________________ ______________

2. _____________ __________________ ______________
3. _____________ __________________ ______________
4. _____________ __________________ ______________

Discussion Agenda:

 About All records examined

 A detailed description of audit procedures used and audit adjustments supported with evidence
where appropriate;
 Minor errors for which no adjustments were made;
 Applicable law and procedures;
 Any additional information the taxpayer may provide within a set time to reduce the tax liability;
 Taxpayer’s objection and disagreements with the audit;
 Proposed tax adjustments;
 Payment procedures;
 Policies and procedures pertaining to penalty and interest imposition waiver
 Also Auditors are required to educate the taxpayer as to the proper procedures to follow in future,
and make recommendations on proper reporting methods without attempting to redesign the
taxpayer’s accounting system.

294
1. Audit Methodology for

a) Revenue/Sales
____________________________________________________________________
____________________________________________________________________
_________________________________________

b) Cost of good sales/Purchase

____________________________________________________________________
____________________________________________________________________
____________________________________________________________________
________________________________

c) Expenses
____________________________________________________________________
____________________________________________________________________
_________________________________________

2. Findings on

a) Revenue/sales
____________________________________________________________________
____________________________________________________________________
_______________________________________

Reason of findings
____________________________________________________________________
____________________________________________________________________
_________________________________________

b) Cost of good sales

____________________________________________________________________
____________________________________________________________________
_________________________________________

Reason of findings
____________________________________________________________________
____________________________________________________________________
_________________________________________

c) Expenses
____________________________________________________________________
____________________________________________________________________
________________________________________________________

Reason of findings

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 ____________________________________________________________________
____________________________________________________________________
_________________________________________

3. Total due for the period

No. Description Amount in birr

1 Tax
2 Interest
3 Penalty penalty
Total due

4. Taxpayers response on audit methodology and findings

4.1 According to tax regulation points/issues/findings that taxpayers agreed.

4.1.1 ___________________________________________________________________
4.1.2 ___________________________________________________________________
4.1.3 ___________________________________________________________________
4.1.4 ___________________________________________________________________

4.2 Findings that Taxpayers disagree

4.2.1 ___________________________________________________________________
4.2.2 ___________________________________________________________________
4.2.3 ___________________________________________________________________
4.2.4 ___________________________________________________________________

Reason of disagreement
_______________________________________________________________________
_______________________________________________________________________

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Annex 27: Business Income Tax Assessment Notice

THE FEDRAL DEMOCRATIC REPUBLIC OF ETHIOPIA

ETHIOPIAN MINISTRY OF REVENUES
BUSINESS INCOME TAX ASSESSMENT

Ref. No. ___________________

Date ______________________

To: ______________________________
TIN ______________________________ Assessment No. ___________________
Address: _____________________ Sub City ___________________ Woreda __________
House No ___________ Tel. No: _____________________
Business Sector: ___________________________
Audit Coverage Period: _____________________ Tax type: ________________________

The Ministry examined your books of accounts and produced this reassessment in
accordance with the provision of Income Tax Proclamation 979/08 and the Tax
Administration No. 983/08. Therefore the Ministry notifies you to pay additional tax
of Birr ___________ in word/________________________/
Payment Summary

Description Amount due in Birr

Tax to be paid
Less: Total Paid tax
Outstanding tax
Interest
Penalty
Total Due for the Period (Tax + Penalties + interest)

With regards,

Received by: Name: _________________________ Signature ___________

Date: __________________ Position ____________________
Delivered by __________________
CC ፡
 Tax Debt Administration process
Branch office
(The tax computation is on the reverse side)

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 Tax Computation
Tax years
Descriptions Total
20xx 20xy 20xz
Declared Income/Loss

Adjustments:-

Total Adjustments

Total Taxable Income

Tax /30%/
Less:- Tax paid

Withholding

Refund

Total deductions

Total Tax due

Interest

Penalties: Late payment

Understatement
Other
Total Penalties

Total Tax, interest & penalty

Note:

1. We examined your Books of Accounts and produced this reassessment in accordance with the provision
of the Income Tax Proclamation No.979/2008. Therefore you must pay the said amount within thirty (30)
days of the issuance of this assessment notification.
2. If you have any objection to the assessment, you have the right to appeal to the Review Committee of the
Tax Ministry within Twenty one (21) days or to the Tax Appeal Commission within thirty (30) days of
receiving the Assessment Notice as per Tax Administration No.983/08 Article 54 and 88.
3. If the taxpayer has failed to pay the tax due within the time specified in a notice served under (1) of this
note or note (2) of this is not applies, as per Tax Administration No.983/08 Article 41the Ministry may issue
a seizure order on the taxpayer and any person having possession of the taxpayer’s property.

4. As per Income Tax Proclamation 979/08 Article 37,105 the Taxpayer is required to pay penalty and
interest on Late, Late Payment and failure to pay Tax due.
5. The Tax Office is authorized by law to demand additional Tax with penalty upon further information
6. If necessary, you can get further explanation on the assessment at our office.

298
Annex 27: VAT Assessment Notice

THE FEDRAL DEMOCRATIC REPUBLIC OF ETHIOPIA

ETHIOPIAN MINISTRY OF REVENUES
VAT ASSESSMENT

Ref. No. ___________________

Date ______________________

To: ______________________________
TIN ______________________________ Assessment No. ___________________
Address: _____________________ Sub City ___________________ Woreda __________ House No
___________ Tel. No: _____________________
Business Sector: ___________________________
Audit Coverage Period: _____________________ Tax type: ________________________

The Ministry examined your books of accounts and produced this reassessment in accordance with
the provision of the Value Added Tax Proclamation No.285/2002 and the Tax Administration No.
983/08. Therefore, the Ministry notifies you to pay additional tax of Birr__________________
in words /__________________________________/.

Payment Summary

With regards,

Received by Name: _________________________________ Signature _______________

Date ___________ Position _____________________________________
Delivered by Name ____________________________________

CC ፡
 Tax Debt Administration process
Branch office
(The tax computation is on the reverse side)

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 Tax Computation
Description 2007 E.C. 2008 E.C. 2009 E.C. Total
Declaredasper declaration
Undeclared Income
Undeclared Commission Income
Adjusted Taxable Income
VAT (15%)
Purchases ('Inputs)
Rejected Purchases (Inputs)
Adjusted Input
Input tax (15%)
Credit Brought Forward
Credit Carried Forward
Total Adjusted Input tax
Tax to be paid
Less:-Paid tax
Total outstanding Tax/Credit
Interest
Penalty
Total Tax, Interest and Penalty

Note:

1. We examined your Books of Accounts and produced this reassessment in accordance with the provision
of the Income Tax Proclamation No.979/2008. Therefore you must pay the said amount within thirty (30)
days of the issuance of this assessment notification.
2. If you have any objection to the assessment, you have the right to appeal to the Review Committee of the
Tax Ministry within Twenty one (21) days or to the Tax Appeal Commission within thirty (30) days of
receiving the Assessment Notice as per Tax Administration No.983/08 Article 54 and 88.
3. If the taxpayer has failed to pay the tax due within the time specified in a notice served under (1) of this
note or note (2) of this is not applies, as per Tax Administration No.983/08 Article 41the Ministry may issue
a seizure order on the taxpayer and any person having possession of the taxpayer’s property.

4. As per Income Tax Proclamation 979/08 Article 37,105 the Taxpayer is required to pay penalty and
interest on Late, Late Payment and failure to pay Tax due.
5. The Tax Office is authorized by law to demand additional Tax with penalty upon further information
6. If necessary, you can get further explanation on the assessment at our office.

300
Annex 29: Audit Findings and Recommendations (Management)
Letter Format

Company /Taxpayer Name ____________________________________

TIN No. _____________________________________
Address: Region ________ S/City ___________ Woreda ______ House No.________

Telephone No.________________

Dear sir/madam,

The audit, covering periods of ..........................................has now been completed.

Attached is a schedule detailing the findings of the audit and associated recommendations? It
should be noted, however, that not all of the taxable events relating to the system were
examined and, therefore, the results should not be seen as a complete assessment of the integrity
of the system.

Please advise us as to whether any changes have been, or will be, made to the system as a result
of our audit and also whether any of the recommendations have been or are to be adopted.

We identified the following controls, which appear to be in place and which are seen as critical
to the accurate reporting of revenue. Every effort should be made to ensure these controls
continue to operate correctly [list the controls].

Please acknowledge receipt of this letter. If you have any queries regarding the content of this
letter, please do not hesitate to contact us.

Finally, we would like to take this opportunity to thank you and your staff for the assistance and
co-operation we received during the course of this audit.

With regards,

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Annex 30: Criminal Case Transfer Form

______________________ Branch office

Domestic Tax Audit

1. Tax payers name: __________________________________________

2. Name of the Company: __________________________________________
3. TIN No. _____________________________
4. Taxpayer address: Tel. ______________________ Mob. _______________________
5. Business Sector: ___________________________________
6. Company address: ____________________________________________
7. Indication of evasion or criminal case
a) Undeclared income
b) Not issuing receipt
c) Over or under invoicing
d) Transfer of price between related party
e) Administrative expenses
f) Others (specify)
________________________________________________________________
_______________________________________________________________ .
8. Expressed the case and attach all the necessary document
________________________________________________________________________
________________________________________________________________________

9. The case forward to domestic investigation audit by:

Team Team Coordinator Process Coordinator

Name: Name: Name:

Signature: Signature: Signature:

Date: Date: Date:

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10. Case received

 Investigation Audit Team Coordinator _____________________

 Signature ___________________________________________
 Date ______________________________________________

The case is assigned to:

 Name ___________________________
 Position __________________________
 Signature________________________
 Date ___________________________
 Decision given date ________________

303