Purpose, nature and scope of tax audit

1.1 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 Authority 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, which the OECD refers to as, “an examination of whether
a taxpayer has correctly assessed and reported their tax liability” 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 juxtaposition (interface) with the accounting framework 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 increases taxpayer confidence in the
tax authority reflected in improved compliance.

The article (28(1)) envisages an 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 66 are 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.

Following the above, it is envisioned that tax audit activity starts with the taxpayer’s
declaration (self-assessment) and any subsequent amendments (alterations, reductions or
additions) 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 Authority may base 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 IFMS, input tax claimed by other taxpayer. That said, the article uses the
word, ‘’may” and not “shall”, implying that the auditor is not estopped 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 unpins 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 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).

1.2 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.

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.

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.

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.

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.

Educating the taxpayers

Audits can assist clarify the application of the tax law for individual taxpayers.

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.

1.3 Scope of tax audit

The scope of tax audit is determined by

a. Risk level of the individual taxpayer.

b. Legal framework

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, studies by the IMF observe
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.

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 Authority 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.

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.

1.4 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.
 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.

That said, 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 authority 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, 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.

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 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.

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 Ethiopian Revenues and Customs Authority 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 authority’s mandate.

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.

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.

Professional behavior

Auditors are required to comply with the relevant laws and regulations (ERCA). 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 authority and the audit profession under disrepute.

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 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.
 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.

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 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.

Rewards for exemplary staff.

Article 135(1) of the Federal Tax Administration Proclamation provides that the
authority 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.

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 auditors personal file.

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 ERCA;

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

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
ERCA;

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;
 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.
 Internal audit and tax audit operations

3.1 The role of internal audit in audit operations.

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

service specifically to help management improve the ERCA’s risk management, 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;

i. Deterrence, detection, investigation and reporting fraud

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.

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 ERCA.
 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 Director General ERCA at the

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

ii. 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

iii. 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.

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
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.
 The role of 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.
 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, and undertaking research and analysis of
compliance behavior.

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.
 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
tax authority.

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.

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.

Chapter one established that tax audits are required to be evidence based. Article 28
of the Federal Tax Administration proclamation is instructive and provides that,
subject to this article, the Authority may amend a tax assessment (referred to in this
Article as the “original assessment”) by making such alterations, reductions, or
additions, based on such evidence as may be available, to the original assessment of
a taxpayer for a tax period….

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. On obtaining the relevant pieces of evidence, the
auditor is best placed to raise a fair tax assessment as required by article 6(2) of the
Federal Tax Administration Proclamation.

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
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, 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,
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, 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. Sending reminders to their audit clients to pay up the assessment amounts,

especially arising out of audit to ensure that taxpayers do not accumulate
uncollectable arears (debt).

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.
 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 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.
Article 55(1) of the Federal Tax Administration Proclamation requires the Authority to
establish a review department as a permanent office within the Authority to provide an
independent review of objections and to make recommendations to the Authority 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 tax authority.
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 taxpayer. 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%)).
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 the highest 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 would then constitute the upper limit.
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.

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.
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
manuscript 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, 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.
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.

 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 scheduler 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)).

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(25) 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, 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.

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 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 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.
 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.

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

6.2.3 Summary (See also article 8(2) in the summary

6.2.4 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).

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 tax 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. 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, n 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.
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 entitle 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
e. 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.

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.

Summary of taxation of fringe benefits

Below is a grocery of the different fringe benefits and their taxation.

In the table below;

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

Discounted Interest loan Difference between interest at market

Arises where the employer provides to the interest paid by the employee.
employee a loan at interest rate lower than the
market rate.
lending rate on the loan and actual
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.

Vehicle fringe benefit
Arises where the employer provides a vehicle to
the employee wholly or partly for the private use
of the employee.
Note
Provision of motor vehicle for private use
includes a vehicle that is made available to an
employee for private use even if the employee
did not actually use the vehicle for private use at
any time.
ii. Fair market value of the vehicle at
Reference to vehicle means a motor vehicle
designed to carry a load of less than one tonne
and fewer than nine passengers.
iii. Amounts in (i) and (ii) above are
Private expenditure fringe benefit
Arises where the employer makes a payment that
gives rise to a private benefit of the employee.
Meals or refreshment fringe benefit
For any other employer, the lowest
lending interest rate of commercial
banks prevailing in Ethiopia during the
month.
Determined according to the formula
(A x 5%)/ 12
Where A is the;
i. Cost to the employer of acquiring
the vehicle plus duty and taxes if the
vehicle was imported tax/duty free,
reduced by 50% (of cost +
duty/taxes) if the employer has held
the vehicle for more than five years
OR
the commencement of the lease if
the vehicle is on lease reduced by
50% (of the fair market value) if the
employer has held the vehicle for
more than five years,
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.
The cost paid by the employer.
Total cost to the employer of providing
the meal reduced by any amounts paid
by the employee.
Note that subsidy to meal or refreshment
provided in a canteen, 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;

Where the property or services
Arises when the employer transfers property to provided to an employee comprises of
an employee the employers’ ordinary business
undertakings, then the value if the
Or benefit is 75% of the normal selling
price of the property or services, less
Provides a service/s to an employee 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 reduced
Defined as an agreement or arrangement under by the employees contribution ( sum
which an employer company or a related of consideration given by the
company may allot shares to an employee of the employee).
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.
6.2.5 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
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.
 Business income is defined by 2(4) and article 18 of the Proclamation. Deduction
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.
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 1st Hamle (July) to 30th Sene
(June), unless the Authority has granted permission, by notice in writing
and subject to such conditions as may be specified by the Authority 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 authority (Article 28(3))
or a revocation of the approval by the Authority (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.
 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.

6.2.6 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;

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 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 located outside the country in order to bring to charge the
income arising therefrom. The principle 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 sublease, 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.

6.2.7 Other Income, Schedule D

6.3 VALUE ADDED TAX

6.3.1 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).
6.3.2 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.

i. 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 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
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 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.

ii. 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.

iii. VAT is imposed on an import of goods. Import of 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.

iv. 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.

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 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.

6.3.3 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
 the supplier, may deliberately refuse to adjust the input tax previously claimed even
when the supplier has issued a credit note.

6.3.4 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.
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 these vehicle 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 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 that 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 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 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 the following,
personal consumption expenditure. A body unlike an individual would have 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.
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 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.

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 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.

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 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 proforma below summarizes the tax payable by A limited

 Schedule B Schedule C Schedule D Tax law reference
"Rental Income "Business Income "Other Income tax"
Amount Amount Amount Tax rate Tax payable Procl. Reg.
Income
Gross rental income from building 1,000,000 15(2)
Renovations by lessee 100,000 15(2)d
Lease of furniture & equipment 50,000 15(3)
Sublease 200,000 16(1)
Proceeds on disoposal of trading stock (Ethiopia) 100,000,000 21(1)a
Proceeds on disoposal of trading stock (Uganda) 40,000,000 21(1)a & 7(1)
Gain on disposal of business assets 21(1)b
Gain on disposal of taxable assets 21(4)a , 59(3)
Recovered expenditure (bad debts) 500,000 73, 21(1)c, 101(3)
Royalties - 5% - 54
Dividends- Eriteria sourced 1,000,000 10% 100,000 55
Interest - 5% - 56
undistributed profit - - 10% - 61
Gain on disposal of taxable asset - 59
a. Class " A" taxble asset- Immovable - - 15% - 59(1,2,3 &4)
a. Class " B" taxble asset- Shares & bonds - - 30% - 59(1,2,3 &4)
Total income 1,350,000 140,500,000 1,000,000

Allowable deductions
Cost of trading stock 15,000,000 22(1)b
Loss on disposal of business assets - 22(1)d
Loss on disposal of taxable assets - 59(4)
Depreciation 4,000,000 22(1)c , 25 36- 40
Charitable donations - 24, 24(3) 33
Carry forward losses 4,000,000 26 42-43
Baddebts 800,000 30
Interest expense 300,000 23
Employments costs 10,000,000 22(1)a
Repairs and maintaince 50,000 5,000,000 22(1)a
Expenses attributable to the branch in Uganda 10,000,000 22(1)a & 46
Other allowable expenses 3,000,000 15(7)
Cost of lease 100,000 15(7)

Total deductions 150,000 52,100,000 -

Taxable income ( Rental & Business) 1,200,000 88,400,000 1,000,000 13(1),15(1), 20(1)
Taxpayable before tax credits 360,000 26,520,000
Less tax credits
Foreign sourced 9,000,000 100,000 45, 64
WHT on imports 300,000 85(1)
Taxpayable (Buiness, Rental & Other Income) 360,000 17,220,000 - - - 13(2) 14(1), 18(2),19 (1)

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.

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 (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.
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.

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
branches 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;

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;
Assets
Plant and Machinery 3,000,000,000 2,000,000,000
Debtors 1,000,000,000 1,500,000,000
Stock 1,000,000,000 2,500,000,000
Total assets 5,000,000,000 6,000,000,000
Equity & Liabilities
Share capital 1,000,000,000 1,000,000,000
Reserves 2,000,000,000 400,000,000
Total Equity 3,000,000,000 1,400,000,000
Liabilities
Loans 2,000,000,000 4,600,000,000
Total equity & Liabilities 5,000,000,000 6,000,000,000
Additional information
During the period ended 31/12 2012, 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.
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.
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 creme de la creme (best of 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 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.

i. intelligence or third party information.

ii. 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.
 The above provision implies that the taxpayers’ financial statements, particularly the
income statement is 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 exists to profit. Profit maximization

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

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.
Assets and liabilities are used to suppress taxable income as follows;

i. 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 represents 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.

ii. 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 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.

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 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

Auditors 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.

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 (Quadrant Investment PLC)

In this part, we consider analysis of the financial statements of Quadrant Investment

PLC (existing client) for a four-year period commencing 08/07/2013 to 07/07/2017.

Nature of business

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

Auditors/ Auditors opinion

The auditors are TIGIST & EYOB 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.

Statement of financial position (balance sheet) analysis.

Below is the extract of the statement of financial position (Balance sheet) for
Quadrant Investment PLC for the four years under review and an analytical review.
 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 17,562,042 31,494,756 25,465,363
Related parties- recievable 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 & bank balances 195,781 1,698,712 357,016 1,269,561 186,737
19,666,877 30,947,716 80,857,218 99,696,137 100,100,424

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 1,547,894

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 211,903 229,577 500,000 984,672 984,672
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
19,666,877 30,947,716 80,857,218 101,244,031 100,100,424
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 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 Recievable (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.

iii. Related parties

2013 2014 2015 2016 2017

Related parties- recievable 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 2,803,184.90 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 852,150.93 172,661.62 338,298.42 179,782.53 542,870.28
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
Witholding tax 21,039.27 31,763.77 143,009.76 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 examined especially during 2014 where the
auditors issued a qualification on account of sales posted as creditors.

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
withdraw of profits subject to tax at 10%.

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.
 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

Adminstrative expenses 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 & Equip 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 Exalo for services rendered and the income recognized
from 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 Exalo
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 DMT/Delonex are expenses without documents totaling 1,799,894.09.
These should be investigated and disallowed of 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 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 them draw an audit plan to be followed during the execution of the audit.

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 proforma of an audit plan matrix with an illustration.

Item Scope Objective Audit Information Auditor Time
procedure required in charge log for
during audit audit
activity

Plant 2014 Verify Verify; Log book/ Amon 1 day

& to accuracy registration
Equip 2017 and validity Existence detail of
of taxpayer
depreciation Cost
allowances Loan
claimed Ownership agreements
Extent of use Import
in the documents
business

Re-compute
depreciation
allowances in
accordance
with the
proclamations
and
regulations
thereof
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.

This article (25(1) is instructive in this regard and provides (in part) that, subject to this
Article, the Authority may amend a tax assessment (referred to in this Article as the
“original assessment’’) by making such alterations, reductions, or additions, based on
such evidence as may be available, to the original assessment of a taxpayer for a tax
period.

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 opt 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.

10.1.2 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.

4) Communication of preliminary audit findings.

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 15days 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.

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.

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. 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

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.

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.

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. Tax assessments are expected to
emerge out of adjustments that are evidence based, in accordance with article 28(1)
and 26(1) of the Federal Tax Administration Proclamation. The procedures
particularly examine whether the taxpayer has overstated expenses or under declared
income.

Below are the procedures relevant to the various accounts;

Tangible fixed assets

Objective is to confirm;

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

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.

Work Work
Audit procedures done by paper ref

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.
 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).
 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.

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.

Work Work
Audit procedures done by paper ref

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.

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
.
Work Work
Audit procedures done by paper ref

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.

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.

.
Work Work
Audit procedures done by paper ref

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 year end 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.

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.

.
Work Work
Audit procedures done by paper ref

1) Completeness of 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 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.

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.

Work Work
Audit procedures done by paper ref

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.

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 by paper 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.

Long term liabilities

Objectives

i. Existence of long term liabilities

ii. Interest rates charged

.
Work Work
Audit procedures done by paper 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.

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 by paper 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

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.

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.

i. This method focuses on expenses and compares sources and
application of funds.
ii. The basic formula is: All expenditure less funds from known
sources (declared income) EQUALS funds from Unknown
sources (Undeclared income)
iii. 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…
iv. Application of funds are represented by increase in assets and/or
decrease in liabilities, plus known expenditures for living
expenses.
2. Bank deposit method
i. 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 (in a which case cash on hand increases). The focus
therefore is on bank deposits, cash expenditure and cash on hand
increases.
ii. 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.
iii. Unidentified deposits should be deemed income of the taxpayer
if he is involved income generating business or he makes regular
or periodic deposits.
iv. 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.
v. 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
i. 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 formula in this case is “Known Incomings LESS
Known Outgoings EQUALS Balance Available”
ii. 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.
i. This method identifies items of capital and how it was financed
by following the money trail.
ii. 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.

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.

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.

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
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.
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 reconciled by both parties and is given an opportunity
to express their disagreement 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 taxpayer or their trusted representative are required to attend the said
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.

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;

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 said 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

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

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.

11.5.1 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.

Find details of a referenced and cross referenced file in the appendix.

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 Authority 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 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.
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 Revenue (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)).

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 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.
Sector based auditing

13.1 Introduction

This chapter considers tax audit of five (5) specialized sectors. Construction,
Manufacturing, Finance(banking), Insurance and import/export.

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.

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.

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.
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.

Tax legal framework

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
rhyme 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).
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.

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.

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 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.

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.

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.

Grocery of issues for consideration during audit.

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.

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.

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.
  Cost 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.

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.

VAT

The following are worthy of note;

 In the case the construction company is a non-resident and is not VAT registered,
that the recipient of the services (customer) has fully withheld the VAT and
remitted the same in accordance with Article 23 of the VAT Proclamation.
  VAT for construction entities is accounted for when the invoice is issued or
payment is received after provision of the construction services which ever comes
earlier.

13.4 Manufacturing sector

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, mining, or quarrying, s
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.

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.
Grocery 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.

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 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. Use of this method
is common with investigative audits where a taxpayer is suspected to be
fraudulent. While ERCA now the Ministry of Finance 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 Authority in the enforcement
of the tax laws. Accordingly, the Authority 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 CAATS like advanced excel and
IDEA. 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.

13.5 Finance

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

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

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

Grocery 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 Tax Authority 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

 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 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.

 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 tax authority for
 consistency of reporting. Any variations should be investigated further and
where they have an impact on tax, appropriate adjustments should be made.

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.

Grocery 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 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.

 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 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

 Un receipted 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. Where
gaps in the sales is detected, taxpayers should be held to account.

 Where the goods are imported, using information from Ascuda, 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.

 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

 Auditor 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 ERCA/MOR.

13.7 Insurance services

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.

Audit Issues for 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).

Risk to tax:
  Understatement of premium income

 Overstatement of commissions paid

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

b. 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.

Risk to tax:

 UPR may be used to manipulate profitability

 Regulatory compliance – rate of calculation

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.

c. Claims Paid

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

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

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.

 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.

Risk to tax:

 May be used to manipulate profitability

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

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.

e. Reserves

This is a general reserve maintained for claims incurred.

Risk:

• 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.

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 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.

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)

Risk to tax:

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

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

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

g. Premium Receivable

These are actually trade debtors.

Risk:

 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

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 (income taxes) and indirect taxes (value added and excise
tax). 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 6. The discussion on residents was elaborately covered
under chapter 6 of this manual.
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.

Income sourced in Ethiopia by non-residents.

Article 6 determines when a taxable activity of a nonresident 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.

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.
 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.

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.

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.

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, Article 23 of the relevant treaty will be
considered in providing relief for double taxation. This article of 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, article 23 of the 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.

14.3 International tax treaties.

Ethiopia has… treaties in force. 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.

The threshold rule is that DTA’s don’t impose taxation.

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

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, Article 26 of the 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.

14.4 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.

b. Conduit companies.
c. 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.

d. 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.

e. 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.

f. 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 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.
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 audit aided techniques (CAATs,) like IDEA
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 Administration
 Proclamation. This is unlike audit activity arising from compliance audits that is restrict
to a five-year period.

15.3 Legal framework

The Ethiopian Revenues and Customs Authority Establishment Proclamation, No.

587/2008 provides the legal framework for investigative audits. In particular, Article
6(10) of the said proclamation provides for powers and duties of the Authority to
investigate and follow up criminal proceeding in court, for the discharge of such
responsibilities, organize its own prosecution and investigation units and supervise their
performance.

Further, the Proclamation provides for powers and duties of the investigator under
Article 16(2) (a) to investigate criminal offences committed against federal government
revenue and social securities in violation of customs and tax laws, and deliver the
criminal investigation file to the prosecutor.

Article 2(5) defines an investigator as an intelligence officer and investigation officer of

the Authority who investigates criminal cases in relation to tax and customs offences.
Further Article 16(1) of the Proclamation extents powers given to the Federal police to
investigate to ERCA investigators.

15.4 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 considers the follow 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
Authority 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.

Further Article 66(1)(b) provides that the Authority may seize any document in
the opinion of the Authority, 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.

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 ERCA/
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 Authority 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.

15.5 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 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 adduce the information as evidence before a competent court.