1989 Report of the Auditor General of Canada

Main Points

18.1 Federal sales and excise taxes, totalling $17.2 billion in 1987-88, are a significant source of government revenue. Since 1985-86, annual revenue from the federal sales tax has surpassed revenue from corporate income tax. It was equal to about 30 percent of revenue from personal income tax in 1987-88 (paragraphs 18.7 to 18.9).

18.2 In the April 1989 federal budget, the government announced the introduction of the goods and services tax to replace the federal sales tax in January 1991 (18.13 to 18.19).

18.3 The population of taxpayers is expected to increase by at least 13-fold, from 75,000 to over 1 million, and the mechanics of the new tax will be completely different. The Department faces an unprecedented challenge in preparing to implement it. It will need to give it the priority and resources required to ensure the successful delivery of this major government initiative (18.25 to 18.50).

18.4 We found certain weaknesses in the Excise Branch's administration of the federal sales tax, including:

• the level and scope of enforcement activities have been decreasing over time;
• information on performance and compliance has not been adequate, and data have not been used to the best advantage for program administration;
• certain departmental practices have gone beyond legislation; and
• tools and staff training could be improved.

It is important for the Department to analyze and correct the causes of these weaknesses, and not to run the risk of repeating them under the new tax regime (18.23 and 18.24).

18.5 The federal sales tax will continue to be an essential revenue program until it is replaced. During the transitional period, while the Excise Branch plans for the new tax, it must also be vigilant in safeguarding revenue and maintaining the integrity of the system to minimize revenue loss (18.132 to 18.137).

Background

18.6 The Excise Branch of the Department of National Revenue - Customs and Excise administers the Excise Tax Act and the Excise Act and their regulations. The Excise Tax Act and regulations impose federal sales tax (FST) on manufactured goods and excise taxes on goods such as cosmetics, jewelry, wine and gasoline. The same legislation also imposes a tax on certain insurance premiums, the air transportation tax, the telecommunication services tax and the telecommunication programming services tax. The Excise Act and regulations impose excise duty on liquor, beer and tobacco products.

18.7 The federal sales and excise taxes contribute significantly to the total revenue which finances government program delivery. Over a five-year period, this revenue has grown from $7.8 billion to $17.2 billion for 1987-88. The federal sales tax forms a major component of this revenue.

Federal sales tax -- its nature and significance

18.8 The FST is a tax imposed on manufacturers and those who are deemed to be manufacturers under the Excise Tax Act. The tax applies to the manufacturer's sale price for goods produced in Canada and to the customs duty paid value of imported goods.

18.9 In 1987-88, the sales and excise taxes of $17.2 billion represented 17.7 percent of total federal government revenue. The FST component alone was well in excess of the corporate income tax revenue of $10.9 billion and was equal to about 30 percent of the revenue from personal income tax (Exhibit 18.1). Exhibit 18.2 shows the growth of the revenue from FST since 1983-84. It surpassed that from corporate income tax in 1985-86. The general rate of sales tax was set at 12 percent in 1986. In the April 1989 federal budget, the Minister of Finance announced a sales tax rate increase to 13.5 percent, effective 1 June 1989 and forecast an annual revenue increase of $1.6 billion. Many manufacturers will continue to pay more federal sales tax than income tax.

(Exhibits not available)

Organization of the Excise Branch

18.10 The Excise Branch of the Department is responsible for the administration of the sales and excise taxes and duties. The Department of Finance is responsible for tax policy and legislation.

18.11 The Branch identified six sub-activities in its Part III of the Estimates document:

• tax interpretations;
• verification and enforcement;
• revenue accounting and collections;
• appeals;
• policy and systems; and,
• program management and support.

The tax interpretations sub-activity provides rulings and other information to taxpayers. It also identifies and licenses them. The verification and enforcement sub-activity involves verifying and processing refund claims, auditing taxpayers and conducting special investigations and duty surveillance. Revenue accounting and collections deals with depositing and accounting for revenue. In addition, it takes collection actions against delinquent taxpayers. The appeals sub-activity provides an independent system that addresses objections raised by taxpayers. The remaining two sub-activities provide linkage to the Department of Finance and overall support to the Branch. In 1987-88, the Branch had a staff strength of about 1,600 person-years and expenditures of $82 million. The resource allocation among the sub-activities is depicted in Exhibit 18.3.

(Exhibit not available)

18.12 The Branch's administration is decentralized. The functional groups at head office deal with programs, administrative policies and procedures. They provide functional direction and monitor operations in the regions. The regional offices, district and sub-district offices deal directly with the public in a range of activities including licensing, interpretation, audit, refund, tax collection and revenue accounting. The regional directors report directly to the Branch Assistant Deputy Minister. There are 9 regional offices and 27 district and sub-district offices.

Budget announcement to replace federal sales tax

18.13 It has been widely accepted that the FST system is flawed. Since the Excise Tax Act came into force in 1924, there have been numerous studies pointing to its faults.

18.14 In the April 1989 budget documents, the government stated that the FST is limiting economic growth and job creation and that it is impeding the country's ability to compete internationally.

18.15 The archaic structure of FST, coupled with its numerous exemptions, special provisions and administrative practices that have developed over time, is rendering the existing sales tax system increasingly difficult to administer. It is also becoming more difficult to maintain proper safeguards against tax avoidance.

18.16 The June 1987 White Paper on Tax Reform proposed adopting a broad-based multi-stage sales tax system which would extend to the retail level. In the April 1989 federal budget, the Minister of Finance announced the introduction of the goods and services tax (GST) to replace the existing FST effective 1 January 1991.

18.17 According to the budget documents, the GST will be imposed at a nine-percent rate. It is a tax that will ultimately be borne by the final consumer. All businesses throughout the production and distribution chain will charge tax on their domestic sales but will be able to claim a credit for all GST paid on their inputs.

18.18 Unlike the FST, the new tax will apply to most goods and services consumed in Canada. The budget documents indicated that there will be relatively few exceptions. The exceptions announced to date include certain goods such as basic groceries, certain services such as residential rents, as well as special arrangements for certain suppliers such as hospitals, municipalities and registered charities.

18.19 The government planned to release a detailed technical paper on GST in early summer 1989. Following this release, hearings would be held on the proposal. The government also intended to release draft legislation in the summer of 1989 and expected to introduce final legislation in Parliament in the fall of 1989.

Audit Objective and Scope

Audit Objective

18.20 Our audit objective was to review and assess the Branch's operations in key areas of administering the FST system and to identify opportunities for improvement. With tax reform on the horizon, we were also looking at existing problems and weaknesses that could occur in the new sales tax system, with a view to highlighting them so that they can be analyzed and corrected.

Audit Scope

18.21 We examined the two major sub-activities, tax interpretations and verification and enforcement, because they involve about 75 percent of the Branch's resources. Our examination included the functions of licensing, interpretation and rulings, audit and refunds. We also examined performance measurement and human resource management within the Branch, focussing on the same two sub-activities. We reviewed the other sub-activities, such as appeals and policy and systems, only to the extent that they related to issues within the scope of our audit.

18.22 We conducted our audit at head office and visited seven of the nine regional offices. For human resource management issues, we also interviewed staff from the Personnel Administration Branch and the Customs and Excise College in Rigaud, Quebec. In addition, we held discussions with staff from the Corporate Management Branch on matters relating to performance measurement.

Sales Tax Reform -- Its Implications for Tax Administration

Problems and weaknesses in federal sales tax administration need to be analyzed and taken into consideration in planning the administration of the new tax

18.23 Our audit observations centred around the following four areas, which are discussed in the latter part of the chapter:

• The level and scope of enforcement activities have been decreasing over time (paragraphs 18.51 to 18.79)
• Performance and compliance information has not been put to the best use for program administration (paragraphs 18.80 to 18.94).
• Certain departmental practices are beyond the legislation (paragraphs 18.95 to 18.111).
• Tools and training present opportunities to improve the cost-effectiveness of the sub-activities' operations (paragraphs 18.112 to 18.131).

GST Implication

18.24 It is important for the Department to analyze these weaknesses and take measures in planning the GST implementation to minimize the risk of repeating them in the new tax regime.

Tax reform will bring a massive change to the administration

18.25 The new GST differs from the FST in two significant ways -- the greatly increased population of taxpayers and the new mechanics of the tax which will be applied up to, and including, the retail level.

18.26 With the new tax, the tax base will be extended to most goods and services. In addition, it will be charged by all businesses throughout the production and distribution chain. As a result, a massive increase in the number of registered taxpayers is anticipated under GST.

18.27 The FST taxpayers are required to be licensed under the Excise Tax Act. These registered taxpayers are known as licensees. Approximately 75,000 licensees are registered under the existing system. Since the new tax will have to be collected and paid by virtually all businesses, the increase in the number of registered taxpayers will be significant. The final number will depend on the exemption threshold for small traders. Nevertheless, the number of registered businesses is expected to exceed 1 million, representing at least a 13-fold increase in the taxpayer population.

18.28 The budget documents described the new tax as a multi-stage sales tax. The mechanics of the GST will involve all businesses in the production and distribution chain and require them to charge tax on their sales. However, the tax paid on purchases by a company will be offset as an input tax credit against the sales tax collected; the company will only have to remit the net tax. Should the tax credit exceed the sales tax in the reporting period, the company will be entitled to a refund.

18.29 The mechanics of the GST will introduce a new dimension to the sales tax system -- accounting for refundable invoiced-based input tax credits. The volume will be significant, as it applies to all trade levels.

The Department will face an unprecedented challenge in planning and implementing the goods and services tax administration

18.30 The GST is a federal-only, value-added tax. The government proposed it as one of three options in the June 1987 Sales Tax Reform paper. In this paper, the government favoured the option of having a joint federal-provincial national sales tax system because it could offer major gains in efficiency and simplicity to administrators and taxpayers. The April 1989 budget documents stated that after reform at the federal level is complete, the idea of an integrated national tax can be explored once again. However, in the meantime, the Department will have sole responsibility for administering the new tax.

18.31 Under these circumstances, we noted the following aspects of this major challenge to the Department:

• staffing and training;
• information services to taxpayers;
• new population of taxpayers;
• information and system support;
• co-ordination with other organizations; and
• federal sales tax rebates.

18.32 Staffing and training. In order to administer and collect the tax and serve over one million taxpayers, the Department will have to significantly increase its resources. This could result in a two- to three-fold increase in staff strength in the Excise Branch.

18.33 Recruiting and staffing this many positions for a decentralized department like Customs and Excise will be a major undertaking. In addition to the difficulties involved in identifying suitable candidates, many of these positions will be required in the regions which could pose some further staffing problems. New and existing staff will have to be trained to deal with the GST; this will involve a large-scale training program.

18.34 Information services to taxpayers. A self-assessment system demands that taxpayers be made aware of which ones are liable for the tax, what taxes they owe, when the taxes are due, and how they ought to file information returns with the Department. The onus is on the Department to provide information support to taxpayers so that they can voluntarily comply.

18.35 This function becomes even more important with the introduction of a new tax regime. In addition to having to account for the tax paid on inputs to claim credits and refunds, businesses will have to learn to understand exceptions to the GST. Where the exemption status of the sale is different at the federal and provincial levels, retailers will have to contend with a dual system. Further, the multi-stage nature of GST will require payment of tax at the time of input purchases. In some cases, this will increase the burden on cashflow, and all businesses throughout the production and distribution chain will be anxious to know how to claim their tax credits in an expeditious and timely manner.

18.36 The Department will have to educate its own staff as well as the public well before the implementation date of GST.

18.37 New population of taxpayers. Tax reform will bring with it a massive increase in the size of the taxpayer population. The new population will extend far beyond manufacturing activities to the service sector, retailers and non-profit organizations.

18.38 The Department will need to gain knowledge of this new "clientele". In order to provide effective checks and balances in the new regime, it will have to identify areas with high risks and be vigilant to guard against revenue leakage and maintain the integrity of the new tax system.

18.39 Information and system support. The GST administration will require new information and system support. The Department will need to assess its performance measurement system, modify existing performance indicators, and identify and put in place new indicators to provide a compliance monitoring framework and to support management decisions on GST administration.

18.40 In addition to the high volume record-keeping requirements, the Department will have to build a database for the GST taxpayers. It will need to assess its data processing requirements and acquire further computer system capability. The Department was in the process of implementing a comprehensive computerized system for its FST administration. The phased implementation for that system will have to be re-examined as it begins its system development planning for the GST.

18.41 Co-ordination with other organizations. The majority of the population of taxpayers under GST will also be subject to federal corporate income tax. At the retail level, the same businesses will be subject to both GST and provincial retail sales tax.

18.42 This provides an opportunity for the Department to share the experience gained by the other government organizations that manage those tax programs. The Taxation Department has long been developing and maintaining large-scale computerized revenue and tax assessment systems. It also has the groups and systems in place for profiling high risk industries and conducting special investigations. The provinces, on the other hand, have long-standing machinery for interacting with retailers. These retailers, representing the last trade level collecting the GST, form a significant segment of the taxpayer population and are the most susceptible to revenue loss.

18.43 This situation creates a challenge as well as an opportunity. While the Department can benefit from consultation with these organizations, it will have to take a lead role and co-ordinate its activities with them to make administration as efficient as possible and to minimize the burden on taxpayers.

18.44 Federal sales tax rebates. On implementation of GST, many firms will be holding inventories for resale on which FST will have been paid. In the April 1989 federal budget, the government announced that it would provide rebates of FST on these inventories.

18.45 It will be a major task to estimate the FST portion of the inventories held; it is not only a hidden tax but the variation in effective rates of the tax on goods with the same statutory rate is astounding. A 1985 survey conducted on behalf of the Department of Finance showed that the ratio of the highest to the lowest effective FST rate for the same groups of commodities ranged from 1.3 to 3.3. For example, competing small appliances were taxed from a high of 12.4 percent to a low of 4.9 percent -- a spread of 7.5 percentage points, a highest-to-lowest ratio of 2.5. There will also be wide variations in taxpayers' ability to determine for themselves the FST component in their inventories. The Department will have to formulate guidelines to help them and provide a basis for verification and enforcement.

18.46 In principle, all businesses with inventories held for resale could come forward and claim a rebate. The Department is anticipating a significant volume of claims, which will be filed within a relatively short period of time. The Department will have to assemble the machinery to verify and process these claims.

18.47 This major task of converting tax-paid inventories to pre-tax levels will pose threats of revenue leakage. The Department will have to provide proper controls over the conversion process to ensure a fair assessment of the rebates and minimize revenue loss.

Sales tax reform -- making it work

18.48 The reform of the federal sales tax is regarded by the government as a key element of its strategy to safeguard essential programs and strengthen Canada's economy. It also presents an opportunity for Canada to move to a sales tax system comparable with that of many of the other industrialized countries.

18.49 The Department is facing an unprecedented challenge in this reform. We have concerns about the administration of the existing system which need to be considered in planning the delivery of the new tax. However, the implementation timetable will be extremely tight. As of April 1989, the Department had only 20 months to make the system operational. The bill introducing GST legislation in Parliament was not expected until the fall of 1989, which would be about 15 months before the effective date of the new tax. Within that time, the Department has to develop and carry out its implementation strategy. Furthermore, it has to provide information and guidelines to businesses, giving them sufficient lead time to modify and redesign their systems to calculate, account and report the GST by its effective date of 1 January 1991.

GST Implication

18.50 It is imperative that the Department give priority to meeting the challenge, so that the risk of a setback is minimized. A well co-ordinated start would reduce frustration and confusion and would go a long way toward ensuring the future success of this major revenue system. The Department will also require appropriate resources to deliver the new system.

Level and Scope of Enforcement Activities - Decreasing over Time

The changing environment has placed increasing pressure on the existing system

18.51 The federal sales tax was put in place in 1924. Over the years, it has not kept pace with the business environment. Further, with the broadening of the definition of manufacturer and the long list of exemptions, it is becoming increasingly difficult to administer.

18.52 The difficulty is compounded by the growth of the tax consulting industry surrounding the FST. Many consultants offer services, often for contingent fees, to manufacturers and their customers to seek out refunds. The number of refund claims climbed from about 90,000 to almost 140,000 in the five years from 1983-84 to 1987-88. The value of refunds paid over the same period more than doubled to $622 million (Exhibit 18.4).

(Exhibit not available)

18.53 In addition, more and more companies are coming to realize that FST is a significant cost of running a business and are becoming more sophisticated and aggressive in attempting to arrange their affairs to minimize their tax liabilities. This has led them to seek out areas where legislation is weak. It has resulted in actions such as shopping for rulings in different regions and the creation of marketing and distribution companies.

Enforcement levels and activities have been falling behind

18.54 In recent years, in an attempt to encourage voluntary compliance, the Excise Branch increased its emphasis on facilitation through taxpayer visitation and assistance projects. The use of facilitation person-years increased by 45 percent over five years, from 210 PYs in 1983-84 to 306 PYs in 1987-88. During this time, the number of person-years used for enforcement has remained relatively stable. However, in the meantime, the enforcement workload has increased. Over the last five years, the number of licensees increased by 27 percent from 58,000 to 74,000. Also, within the sub-activity, priority has been given to other activities, such as the processing of refund claims and special projects, which has further reduced the availability of enforcement resources for regular sales tax audit.

18.55 The emphasis on service to taxpayers is also shown in the key measures of effectiveness used for the audit function. Audit results are primarily measured using the concept of tax change. Under this concept, both debit and credit assessments are included for measuring audit effectiveness. For example, a $100 debit assessment coupled with a $100 credit assessment on a single audit would yield a $200 tax change measure, although it has no impact on net revenue. Although net revenue measures are also calculated, they are rarely included in management reports.

18.56 It is the mandate of the Department to assess and collect the proper amount of tax. To fulfil this mandate, auditors should grant credits when a taxpayer overpays his taxes. The question becomes where the responsibility of the auditor for identifying that overpayment ends and that of the taxpayer begins. In pointing out the potential exempt area to the taxpayer, the auditor could be considered to have discharged his responsibility. Due to the transaction-oriented nature of the FST, going on to determine the actual amount of the credit usually requires more audit work which would further reduce the availability of scarce enforcement resources. In addition, it is unfair to the taxpayers who compute their credits and bear their own compliance costs. The Branch advised us that in its call letter for 1989-90, auditors were asked, wherever practical, to encourage taxpayers to perform the work involved in establishing credits.

18.57 The Branch's assessment practice for new licensees is a further illustration of its emphasis on service to taxpayers. We noted that in conducting licensee investigations, the auditors would audit and assess back taxes only if they determined that the new licensee was aware of the licensing requirement. The Branch has viewed this practice as a means of providing the taxpayer with the benefit of the doubt of not understanding the licensing implications of the legislation. However, under the Excise Tax Act, the Branch has the authority and responsibility to assess and collect FST for the preceding four years. This assessment practice is not in keeping with the Department's mandate of assessing and collecting the proper amount of tax. It is also a quasi-amnesty program which has not been sanctioned by law and has not been made known to all potential licensees. If the Department wishes to continue this practice, it should seek legislative support and publicize the policy.

18.58 The increase in the number of licensees, coupled with an increasing workload due to refund claims and a changing environment, has had some visible impact on enforcement activities:

• a marked decline in audit coverage; and
• an almost non-existent ongoing licensee identification activity.

It is the Department's objective to collect revenue and foster voluntary compliance. The audit function is very important in providing the proper checks and balances for a self-assessment system. A weakening audit function undermines the deterrent factor and compromises revenue generation.

18.59 Marked decline in audit coverage. The reduction of audit resources has resulted in a marked decline in audit coverage over the years. Departmental data have shown record low rates of audit penetration (Exhibit 18.5). The preliminary figures for 1988-89 indicate a continuing trend of decline, with a penetration rate of less than seven percent.

(Exhibit not available)

18.60 Moreover, the Excise Branch has maintained a similar approach to audit selection over the years in spite of increasing workload. Special projects and the audit of certain groups of licensees, such as large manufacturers, were categorized as mandatory audit workload. The selection of the "jumbo" audits has been adjusted over time. However, these and the special projects continued to erode the ability to conduct discretionary audits of the licensee base at large. To the extent that discretionary audits were done, the selection was made on the basis of risks identified through the computerized Responsible Audit Services Program (RASP) whose database was limited and not up to date. Updating the RASP database is dependent on audit results. The decline in audit coverage has further limited the reliability of RASP to profile the audit risk of licensees.

18.61 The Branch's audit philosophy has been based on revenue payback. The jumbo audits were given priority because they were considered to have the most revenue impact. The RASP selections were made with a view to auditing higher risk licensees. The emphasis on payback was made at the expense of encouraging voluntary compliance and providing a deterrent effect.

18.62 In October 1987, the Branch reported: "In a period characterized by sharply increasing tax rates and an increasing tax scope, reduced audit penetration could result in a steady erosion of the protection of revenue over an extended period of time." In her June 1988 Annual Management Report to the Treasury Board, the Deputy Minister expressed her concern:

With our reliance on voluntary compliance and deterrence through selective enforcement, we are reaching dangerous levels with respect to the risk of non-compliance.

18.63 Since 1987, the Branch has been developing an initiative to increase audit coverage. At the time of our audit, the Department was planning to implement a new audit program in 1989-90. Its stated objective is to increase the audit coverage, update its licensee database and confirm its risk categories.

18.64 However, the Branch has not been able to meet its planned audit coverage in recent years. With the existing resources, we are concerned that the extent of the planned coverage will not be achievable without a significant cutback in audit scope and examination. The Branch's objective of enhancing its audit presence among licensees will not be properly served if these dimensions of the audits are excessively curtailed. The Branch will need to stress the quality and depth of audits to achieve the desired deterrent effect.

18.65 The statement of objectives also included a reference to updating the licensee database and confirming the RASP risk categories. Samples of licensees are to be drawn by the regions on the basis of the existing risk categories. This sampling plan will not be conducive to drawing statistical conclusions. Because of RASP's limitations, it also might not provide the best payback. The Branch could complement its RASP selection with industry-specific or issue-oriented enforcement work.

18.66 Although the Department is less than 20 months away from the implementation of GST, there are statutory provisions allowing for audit and verification up to four years after the date of assessment. During this time, the Department must be vigilant in keeping the system honest and protecting this major source of the government's budgetary revenue.

18.67 The Department should maintain a vigilant enforcement program to promote voluntary compliance and maximize payback. It should make every attempt to meet its new coverage objective, and complement its plan with other enforcement efforts.

Department's response: The Department fully agrees that an enforcement program to promote voluntary compliance and maximize payback is essential. We have tried to maintain an appropriate balance between enforcement and facilitation, compatible with the departmental operating principle that most taxpayers are honest and willing to pay the correct tax when adequately informed. Every effort will be made to meet the new audit coverage objectives, consistent with available resources in the context of the elimination of FST. In this regard, working paper requirements have been modified to permit increased audit efficiency. In addition, specially targeted reviews in high risk industry sectors will continue to be undertaken.

GST Implication

18.68 In administering a revenue system, the Department will always need to strike a balance between facilitation and enforcement. This balance requires evaluation from time to time and adjustment where appropriate. When resources are scarce, it becomes more important to review the approach being taken and to consider alternatives. These principles will continue to apply under sales tax reform.

18.69 Ongoing licensee identification activity was almost non-existent. Under the Excise Tax Act, all manufacturers and producers other than those exempted are required to apply for licenses. The licensing function is part of the tax interpretations sub-activity. It consists of a licensing service, which reviews the applications and issues the licenses, and licensee identification, which seeks out and identifies taxpayers who ought to be licensed. Licensees are periodically required to file returns and remit federal sales tax collected.

18.70 The licensee identification function is significant for a number of reasons. First and foremost, the Excise program objective is to assess and collect the proper amount of taxes due under the legislation. In support of this objective, the Branch has stated as a sub-objective that "eligible taxpayers are identified and licensed". It is an integral part of the Branch's mandate to identify and license taxpayers to maintain the integrity of the system.

18.71 Also, a weak licensee identification function can result in disparity and unfair competition in the affected industries, as well as loss of revenue. Unlicensed manufacturers and producers could avoid charging sales tax on the goods they sell and thereby gain a competitive edge over properly licensed taxpayers.

18.72 Moreover, an unlicensed manufacturer escapes the enforcement function of audit. The Branch's audit coverage and selection are limited to the existing licensee base.

18.73 Identification efforts were made at the time when budget initiatives and legislative changes were introduced. However, ongoing licensee identification was almost non-existent. In our regional visits, we found virtually no ongoing identification activity initiated by the Branch. Licensee investigation normally took place following requests by manufacturers and in response to complaints from competing manufacturers.

18.74 We found that, in 1985, head office had instructed the regions to terminate the licensee identification function beginning in 1986-87. Resources were redeployed to issue rulings to taxpayers. This demonstrates how initiatives and cuts were often at the expense of enforcement.

18.75 However we found that, in two of the smaller regions where the regional directors took the initiative of having their staff conduct some identification work, there have been encouraging results. For example, in Calgary, 212 potential licensees were identified and contacted. This resulted in 18 new licensees, an 8.5 percent success rate. When analyzed according to industries, the success rate ranged from 5.3 percent to 13.3 percent. The new licensees are now subject to filing and remittance requirements and fall within the enforcement net of audit. The regional experience showed that such enforcement actions are feasible and have good potential payback.

18.76 Licensee identification was reinstated for 1988-89. In the call letter for 1989-90, the head office instructed the regions that:

A program of identification of potential licensees is to be maintained to ensure that all persons requiring a license are identified, investigated and licensed.

Although the regions have been instructed to resume the licensee identification function, they have not been given additional resources. The function is considered to be a regional responsibility and there is no national co-ordination.

18.77 While it may not be cost-effective to have a comprehensive identification program in the final days of the existing FST system, we believe that enforcement actions need to be resumed to protect the system and provide fairness to the taxpayers who comply with it.

18.78 The Department should strengthen its licensee identification function by providing more central support such as resourcing, co-ordination and monitoring to ensure the integrity of the sales tax system.

Department's response: As mentioned in the Audit, the regions have been issued instructions on the identification of potential licensees, in the 1988-89 work plan call letter. However, we do not believe it would be cost-effective to divert decreasing FST resources to this function for increased central support. Licensee identification is to be recognized as a special attention area in GST program development.

GST Implication

18.79 The implication of licensing will be different under the new tax. Nevertheless, some businesses would choose not to be registered. With an anticipated increase of over 13-fold in potential taxpayers under GST, it is critical that taxpayer identification become an integral part of the Department's enforcement activity.

Performance and Compliance Information -- Not Adequate and Not Put to the Best Use for Program Administration

18.80 The Excise Branch has established a detailed performance measurement and reporting system to gather information on the Branch's activities. The system has been in operation for a considerable period of time and was one of the contributing factors to the signing of the Memorandum of Understanding with the Treasury Board to participate in the Increased Ministerial Authority and Accountability (IMAA) initiative.

18.81 The system generates data for the monthly performance reports and the Branch Operations Quarterly Reports. These form the basis of the Departmental Performance Reports to senior management. Since 1988, the reports have also been sent to Treasury Board quarterly.

Performance and compliance information has not been adequate to support the Branch's management of the FST system

18.82 We found that there are abundant quantitative measures in the Branch. Every sub-activity has some measures of input, workload and output, and variances from targets based on historical data are reported regularly.

18.83 On the other hand, we found gaps in information on performance and limited analysis for managing Branch activities. In particular, the performance measurement system has fallen short of meeting one of the Branch's objectives -- to determine the degree of compliance. It has not been providing a framework for ongoing monitoring of taxpayers' compliance to support Branch planning and resource deployment. For example, the Branch has not been in a position to know:

• the extent of non-compliance in key industries and the estimated revenue loss;
• the potential effect of a declining audit penetration rate on taxpayers' compliance; and
• the level of service and the adequacy of the information provided to taxpayers by the tax interpretations sub-activity.

18.84 In 1987, a Branch document stated that "it is necessary to have a capacity not only to determine the degree of compliance, but to enforce compliance so as to act as a deterrent to non-compliance".

18.85 We noted that the Department's March 1989 draft Departmental Accountability Regime document included some effectiveness and level-of-service indicators. However, it does not address the need for a compliance monitoring framework or our concerns on weaknesses in other effectiveness measures.

18.86 We also found that there were limited resources for research and analysis within the Branch. Many indicators are influenced by outside factors and without additional analysis do not provide meaningful measures of effectiveness. For example, the tax-change-per-audit-day indicator is heavily influenced by inflation, economic growth and tax rate increases. Departmental data showed a large increase of 150 percent in this indicator from 1974 to 1988. However, when we adjusted it for inflation, one of the many external factors, we found that it had decreased by about 5 percent in that time. There has also been an absence of analysis on the effect of taxpayers' compliance behaviour on this measure. Research and analysis could also be carried out with a view to identifying high-risk industries or commodities, to guide deployment of scarce enforcement resources.

18.87 In the remaining days of the current system, the Department could build on its existing resource base for research and analysis. This research capacity could then be transferred to the new tax regime. It could also serve as the basis for a functional group to develop ongoing qualitative indicators at that time.

18.88 The Department should strengthen the research and analysis capacity within the Excise Branch. The function should research and analyze program data to identify issues that should be brought to management's attention and to support the Branch's resource allocation strategy and other management decisions.

Department's response: The Department agrees that a research and analysis capacity within the Excise Branch is important. Although the Branch did not have a discrete unit, such analysis has been employed to identify issues for resource allocation strategies and decisions. However, it will not be possible to build on the former base at this time. Rather, resources are being deployed to GST implementation, leaving a reduced Headquarters complement to deal with ongoing FST matters.

GST Implication

18.89 Performance information will continue to be a major issue after the introduction of GST. In addition to developing quantitative measures, the Department will need to consider the qualitative dimension. To manage the new tax regime, it will be essential to have the capacity to identify emerging issues and a framework for monitoring compliance and progress of program delivery on an ongoing basis.

Excise program data collection and the sharing of information among functions could be improved to make administration more effective

18.90 We found that certain program data have not been collected; for example, information on refund claims, which represent a major drain on enforcement resources and a vulnerable point for revenue leakage, is very limited. Refund claimants are not required to identify directly whether they are licensed. If the Branch had this basic information, it could identify refund trends for licensees from particular industries to focus verification efforts. Data on non-licensed refund claimants could be screened and referred to the licensee identification function for follow-up if appropriate. In addition, the reason for the refund claim is not categorized. This information would have given the Branch an opportunity to identify possible weaknesses in legislation or interpretation which could result in revenue loss. Where refunds are denied, the reason is not categorized, although this could highlight areas where information services to taxpayers ought to be improved. Furthermore, the refund function is not computerized, making data analysis difficult even if the data had been collected. This would have been done as part of the Excise Commercial System (ECS). However, this part of the ECS development was cancelled as a result of the budget announcement.

18.91 We also found that there has been insufficient sharing of information among functions. The appeals sub-activity, introduced in 1985-86, is a quasi-judicial function which provides an independent review of assessments contested by taxpayers. The sub-activity maintains operating statistics on volume, caseload and cases upheld, varied or overturned. Summary statistics have been provided to the regions; however, information on the reasons for varied or overturned assessments has not. This could provide insight into tax interpretations, rulings weaknesses and vulnerable audit practices and could possibly lead to the policy and system staff discussing amendments to the legislation with the Department of Finance. We also noted that Excise regional directors only receive performance data pertaining to their respective regions and the national statistics. The sharing of information among regions could also highlight issues at the regional level.

18.92 The Branch's mandate is to deliver a single program activity. All sub-activities are directed to achieving the objective of assessing and collecting federal sales and excise taxes and fostering voluntary compliance. It would therefore be logical for these sub-activities to integrate and share program data to enhance the Branch's program delivery.

18.93 The Department should develop better procedures for collecting, analyzing and sharing data for the Excise program to improve the effectiveness of its FST administration.

Department's response: We agree. Collection and analysis of data would be greatly enhanced with the aid of computers. Related enhancements to the recently implemented Excise Commercial System for FST must be withheld in view of the need for redeveloping the system for GST implementation. However, we have plans to develop and implement an Early Warning System within the Tax Interpretations function in 1989-90. This system is intended to analyze reasons for appeal decision and for tax changes made by audits to identify areas where departmental information could be improved.

GST Implication

18.94 With a minimum of a 13-fold increase in the population of taxpayers and only a possible two- to three-fold increase in staff, proper data collection and analysis will be essential for effective delivery of the new GST program. The Department will need to integrate and share information among Excise sub-activities and regions to put the data to the best use. In addition, appropriate computer system support will be required to process the anticipated high volume of FST rebates described in paragraphs 18.44 to 18.46.

Administrative Practices -- They Have Gone Beyond Legislative Authority

18.95 In paragraph 18.51, we pointed out that the FST system, introduced in 1924, has not kept up with the current business environment. Over the years, the Branch has developed a network of administrative practices in an attempt to compensate for this. The April 1989 budget documents indicated that "no fewer than 22,000 special provisions and administrative interpretations have been required to achieve some equity under a basically inequitable tax". Many of these special arrangements have not been supported by legislative authority.

18.96 The Department advised us that the Branch has used these administrative practices for two reasons -- to provide greater taxpayer equity and to facilitate the application of the law in complex situations.

18.97 However, in our opinion, the administration of the statutes should be within legislative authority. When administrative practices and interpretations are beyond the law, the Department operates beyond its mandate and, effectively, sets government policy. In addition, it leads to:

• difficulty in maintaining consistency in rulings and interpretations;
• compromising the government's revenue position and the basis for taxpayer appeal; and
• information on administrative practices not readily available to all taxpayers.

All of these problems could cause unfair treatment of taxpayers, higher compliance costs because of the proliferation and complexity of the special provisions, and revenue loss.

Administrative practices have made it more difficult to maintain consistency in rulings and interpretations

18.98 The FST system has numerous exemptions. This, coupled with the broad definition of manufacturing and producing activities, invites taxpayers and their consultants to challenge borderline cases, to minimize their tax liability. In these circumstances, it is inherently difficult to maintain consistency in the rulings and tax interpretations function.

18.99 We found that administrative practices have exacerbated the problem. Tax interpretation officers have often found themselves interpreting not just the legislation but also the administrative practices, many of which extend beyond the law. Application of these practices has sometimes been arbitrary and inconsistent. At times, the practices have also had to be broadened in an attempt by the Branch to be fair to other taxpayers.

18.100 The aggregation policy on certain construction equipment is an example. The Act exempts certain construction equipment and related repair and replacement parts from tax if the fair sale price by the Canadian manufacturer or the duty paid value of the imported unit exceeds $2,000. In an attempt to provide greater equity to taxpayers, the Department has adopted a policy that extends the exemption to include the aggregated value of component parts forming an assembly designed for the exempt equipment, if it exceeds the $2,000 threshold.

18.101 We found inconsistent applications of this policy by different regions. Some interpreted it liberally and extended the aggregation concept to the costs of repair parts; others did not. The inconsistency did not come to the attention of the Department until a taxpayer complained to the Minister of National Revenue. This led to the announcement of a new departmental policy, which brought about a flurry of refund claims. The policy granted the liberal interpretation for the period during which inconsistent rulings had been issued by different regions, and reverted back to the original position as at the announcement date. The Branch estimated payout totalling some $20 million.

Administrative practices compromise the revenue position and do not provide a basis for taxpayer appeal

18.102 Administrative practices that are outside the legislation may not be defensible in a court of law. Thus, any policy which imposes a tax that is more stringent than the legislated liability will not be viable; the taxpayer can simply comply with the legislation rather than the administrative practice. As a result, such administrative practices are generally a liberalization of the law and effectively compromise the revenue position of the Crown. In addition, taxpayers cannot appeal against unfair treatment and application of the practices.

18.103 The notional values system is a prime example of an administrative practice outside the law. The system has a long history, dating back to the 1920s. It was developed to provide a more equitable tax treatment when a manufacturer sells to more than one trade level and to simplify the method of determining the base for sales tax calculation. The Excise Tax Act sets the sales price as the basis for tax. The system offers two alternatives to this -- established values and determined values. Established values are set by taxpayers on the basis of prices used in regular sales to bona fide independent wholesalers or retailers. Determined values are set by the Branch according to industry, and are usually based on market surveys.

18.104 The application of determined values has benefitted taxpayers, as taxes have been computed on a value that is less than the sales price. Further, the values system has been costly to maintain; it is generally time-consuming to conduct market surveys. To the extent that some of the existing determined values are out of date, this could result in further revenue loss. One of the existing circulars on values dates back to 1959. The Branch has been updating some of its determined values. In view of tax reform, the Branch plans to discontinue other updates.

18.105 Further, since the values system is entirely outside the legislation, taxpayers have no legal recourse. This has resulted in an anomaly in tax administration, as interpretations of legislation are subject to appeal through the courts or an independent tribunal. We noted this in our 1979 Report and recommended that the system be codified. The Branch advised us that there had been several discussions with the Department of Finance on the introduction of legislative amendments but they had not been successful. This anomaly has remained in the FST administration.

Information on administrative practices may not be readily available to all taxpayers

18.106 The Branch's policy statements and administrative practices are promulgated through a wide range of publications, including the Excise News, Excise Communiqués, Excise memoranda on policy statement (ET/PS) and Excise operating memoranda (ET/OM). There is also an electronic database of rulings known as RISE, operated by a private firm which provides on-line access for a fee. In addition, Tariff Board and other court decisions form a valuable source of information. The photograph displays the Excise Tax Act and a number of sources of administrative policy statements.

(Photo not available)

18.107 Most of the departmental publications, especially the Excise memoranda, have been written by technical staff and have not been edited for general consumption. Sometimes the same subjects have been discussed in different publications, which has not facilitated a ready understanding of the most recent departmental position. The same has been true for the RISE database, which contains over 9,000 rulings, many of which are too specific for general use. Some are also inconsistent or outdated.

18.108 The Branch told us that many of the Excise memoranda have been updated and work is under way on the remaining ones to consolidate the policy statements and make them more understandable. We also noted that it has tried to contain the risk of inconsistent rulings and interpretations. During our audit, head office had begun to strengthen its monitoring role. Controls over the input to the RISE system have also improved and recent updates included a more thorough search of the database to purge outdated or conflicting rulings. We support the Branch's initiative to improve its control over maintaining consistency of rulings and interpretations and reduce the risk of tax leakage.

18.109 However, except for large licensees who have in-house expertise, most taxpayers need to rely on expert advisers for information on current practices and the implications these have on their tax liability. For example, despite efforts by the Department, not all taxpayers have known about the notional values system and how to apply it to their business. This has given an unfair competitive edge to those who know and use it.

18.110 Furthermore, the growth of administrative practices has imposed additional compliance costs on FST taxpayers. They need to keep abreast with current practices and comply with them. This requires them to staff more in-house expertise or to use sales tax consultants to help them to comply.

GST Implication

18.111 We noted the high risk of inconsistent treatment of taxpayers, higher compliance costs and revenue loss resulting from administrative practices outside the law. In view of this risk, we are of the opinion that under the new tax regime the Department should restrict its administrative practices to interpretations of the law and keep special arrangements and provisions to a minimum. In addition, it should keep its administration simple to reduce taxpayers' compliance costs.

Tools and Training -- Opportunities for Improvement

18.112 Tools and staff training are important components of an efficient and effective operation. For the tax interpretations and verification and enforcement sub-activities, there are opportunities for improvement.

Technical information support to tax interpretations officers and auditors could be improved

18.113 The on-line RISE system is the database for all policy and precedent setting rulings and thus is a key reference source for the staff. This system was developed in the early 1980s and was intended to serve Excise tax interpretations officers and auditors. Since then, it has also been made available to the public, providing on-line access to rulings information at their own cost.

18.114 We believe that this technical information support to Excise staff requires improvement. In our regional visits, we noted that RISE has been used by most tax interpretations officers but rarely by auditors.

18.115 The RISE system is not user-friendly and requires training and practice before it can be used effectively. Although most tax interpretations officers have had training in conducting searches on the system, most auditors have not been trained. Of those who have had the training, some have not had the opportunity to practise using the system because of equipment shortages. Tax interpretations officers have had more access to the system and are using it more frequently. Although regional offices have the equipment to access the RISE system, it does not appear to be adequate. Moreover, the Branch has not withdrawn the duplicate manual ruling card system, and a large proportion of the staff has continued to refer to it instead of RISE. The photograph below shows the manual system with over 9,000 ruling cards. Although the RISE system has been in place since 1982, there has still not been a plan to phase out the manual system.

(Photo not available)

18.116 Not only is it costly to maintain both the computerized database and a parallel manual system, but the existence of the manual system also detracts from the use of the more efficient information support system. In our opinion, it is also imperative to provide reliable and unrestricted access to the equipment to achieve full benefits from the RISE system. Investments in hardware and improved staff skills in conducting computerized searches will also have payback under the new tax system.

18.117 In internal correspondence dated 2 December 1988, the Department raised the possibility of reducing the number of sets of cards in the manual system or eliminating them entirely. We were advised by the Department that the Halifax and Ottawa offices had withdrawn the card system. Since then, the Department has advised us that it will be reduced to a backup system for RISE. The Department is also acquiring more microcomputers which can be used to access this on-line system.

18.118 The Department should expedite its plan to reduce the use of the manual card system. This should be co-ordinated with an equipment review to ensure that the operational staff will have sufficient access to the RISE system.

Department's response: The Department agrees that the manual system should be eliminated, and indeed this is the intent. However, in view of the continuing needs for the information, the disruption of preparing for GST and the minimal costs of maintaining the card system, it would not seem appropriate to launch a further special initiative at this time. We will continue procedures implemented in September 1988 to speed the input to the automated ruling system. In addition, a comprehensive review of the system is planned to start in October 1989, to recommend improvements and enhancements to ensure accuracy, completeness and relevancy of rulings contained in it. With the continued improvements in and accessibility to RISE, use of the manual system will be gradually eliminated.

Other tools could improve the cost-effectiveness of the audit function

18.119 At the time of our audit, we noted that most of the Excise audit staff had their own "black book" system of files with Excise memoranda, internal correspondence and rulings from other files or cases as their research base. There is a risk that staff files such as these are outdated or incomplete. They arose as a result of a central research facility that was inadequately equipped and indexed. In addition, the audit staff are not supported with commercially available sales tax reporter services which are often used by licensees and their consultants.

18.120 During our regional visits, we reviewed some audit files and observed the extensive use of hand-prepared worksheets and notes and an absence of computerized working papers. The major use of computers in the audit function has been data retrieval for licensees with computerized records and large volumes of transactions. In this highly computerized era, the Branch is falling behind. Many government organizations and the private sector have proven efficiency gains by capitalizing on technological advances.

18.121 In August 1988, the Branch concluded a review on the use of computers in auditing and recommended that computer acquisition initiatives be funded. The Branch distributed four laptop computers for test use in the regions. As a result of its success, it acquired an additional 150 laptops in March 1989 for the audit function. Near the end of our audit, the Branch had started to train regional staff and to plan for the distribution and use of the laptop computers in the regions.

18.122 In our review of the Excise audit files, we observed that the sampling approach used for audit testing had not been standardized. Some files did not contain proper testing conclusions and some did not document sampling decisions and the reasons for them. In our opinion, a standardized sampling approach is more efficient and can improve the quality of audit testing and its conclusions.

18.123 The Department should explore opportunities to improve audit tools for its staff. It should continue to expedite its plan to introduce laptop computers into the audit function.

Department's response: We agree. The Department has every intention of acquiring laptop computers as quickly as resources are available. Furthermore, development of other audit tools is continuing, since these initiatives will be equally applicable to GST auditing.

Roles and responsibilities for training in the Excise Branch are diffused

18.124 In our 1979 report on the Excise Branch, we noted a number of weaknesses in training. Since this 1979 audit, the Branch has developed and started to implement a new Human Resource Management System (HRMS) to integrate the performance appraisal process and the identification of staff training needs. This system has also been used to facilitate the staffing process. It is an innovative initiative and is to our knowledge a unique system in the federal government.

18.125 In the 1979 audit, we also noted that the Department embarked on a project to establish a centralized training college in Rigaud, Quebec to co-ordinate training efforts, eliminate fragmentation, ensure uniform training and reduce the time needed to train staff. Our interviews showed that the college has served primarily as a course site and is functioning as one of many focal points for training Excise Branch staff. The original intent to have the college as the unit responsible for co-ordinating all training matters has not been met and this single co-ordinating role has not been filled elsewhere in the Department.

18.126 The roles and responsibilities for training Excise staff are diffused. In January 1988, Branch management promulgated a statement on training in the Branch. In this statement, training responsibilities were delegated to all head office units and the regions. In particular, the Planning and Administration Division at the Branch's head office was given the responsibility to co-ordinate all Excise training and development activities. It maintains the HRMS system, supports training activities and provides support services to the Human Resource Committee. Although this unit administers the information system and facilitates training, it is essentially an administrative unit and has not been staffed with sufficient pedagogical expertise to assess the adequacy of the Excise training program against changing operational needs.

18.127 There has been no overall task analysis in recent years to enable the Branch to evaluate the adequacy and effectiveness of the existing course curriculum. Updates and development of new courses have been done on an ad hoc basis. The Branch's 1989-90 Training Directive identified that courses representing two-thirds of its training and development expenditures have been in place and operational since 1978, with much of the content and structure unchanged since implementation. The Directive is calling for the review and evaluation of 5 of its 13 core courses in 1989-90.

18.128 We also noted that regional initiatives on orientation and special subject matter sessions are generally not captured by the central unit with a view to sharing them with other regions.

18.129 The Excise Branch has been facing an increasingly complicated environment, with the external pressures which make tax administration more complex. In addition, the Branch has had a high staff turnover rate, particularly the technical staff. In these circumstances, an effective unit to focus training efforts is not only cost-effective but essential.

18.130 The Department should ensure that a functional unit is in place to review existing training courses and regional materials and consolidate training efforts within the Branch with a view to delivering a training program tailored to program activities needed for the remaining days of the FST system.

Department's response: We agree. The Branch has already reviewed training materials to tailor basic modules to remaining FST activities. In addition, a Branch training co-ordination focus has been instituted at Headquarters, to co-ordinate training plans.

GST Implication

18.131 Our audit noted some of the same training weaknesses reported in 1979. We are concerned about the training implications of sales tax reform which will involve both the potential two- to three-fold increase in staff and the existing Excise staff. Under the GST, it will be critical for the Department to ensure that there is a focal point for all training matters; including: identifying training needs; ensuring proper course design and development; co-ordinating course delivery; and; monitoring and evaluating training activities.

Transitional Period -- Maintaining the Old System While Preparing For the New Tax Regime

18.132 The FST system remains in effect for 20 months from the announcement date. During this period, the government will continue to rely on it as a major source of budgetary revenue. In fact, effective 1 June 1989, the FST rate for general taxable goods increased by 1.5 percent to 13.5 percent to provide an additional $1.6 billion of government revenue in 1990. Hence the Department must be vigilant in safeguarding the system, and must not permit the period to be seen as a tax holiday. In our view, in addition to maintaining ongoing Branch operations, there are two issues that the Department should consider during this transitional period -- a major tax avoidance mechanism and a close-out strategy.

The use of marketing and distribution companies has been a major tax avoidance mechanism

18.133 The Branch and the Department of Finance recognize that certain taxpayers have been eroding the tax base by diverting their marketing and distribution (M&D) costs to separate companies. The government brought forward proposals on a number of occasions to deal with the problem. The latest proposal, announced in the February 1988 budget, was withdrawn in April 1989 when the GST announcement was made. In an August 1987 Finance and Economic Affairs Committee hearing, the Department of Finance noted an estimated revenue loss to date of about $1 billion to $1.5 billion. In the April 1989 budget papers, the government estimated annual revenue loss of $350 million as a result of this tax avoidance mechanism.

18.134 The withdrawal of the proposed interim sales tax measures has meant an open invitation to taxpayers to use M&D companies to reduce their tax base. However, there are costs associated with setting up affiliated M&D companies, and potential income tax implications, both of which offer some deterrent effect. Since the Department of Finance has been involved in proposing to amend legislation, we have not seen a concerted effort by the Branch to ensure that such taxpayers have set up their M&D companies properly and have set out defensible transfer pricing. In our opinion, this should be included in the Department's enforcement strategy to provide some deterrent effect against tax avoidance.

A close-out strategy will be necessary

18.135 After the new GST comes into effect, the Department will have up to four years to reassess taxes under the FST system. The Department will have to decide how it chooses to wind down its FST administration.

18.136 The transitional period and the four following years provide the last opportunity for the Branch to audit licensees and assess the amounts of FST that should have been reported and paid. The Branch has a number of options. These include keeping to its regular enforcement program; integrating close-out audits with the verification of FST rebates or the introduction of GST to taxpayers; and conducting stand-alone close-out audits. A strong close-out strategy and efficient deployment of resources will be necessary.

18.137 While the Branch maintains the FST system, it must prepare itself and prospective taxpayers for the new GST implementation. Further, existing weaknesses and problems will have to be analyzed and corrected for the new tax administration. Management and staff must all work together to meet this challenge and support the government's major initiative of sales tax reform.