What is Tax Compliance?

"Compliance" is defined as strategically designed and executed legal conformity with a protection and control system intended to protect against violations of law and the consequences resulting from such. With reference to active compliance with the tax obligations of a company and the avoidance of liability and penalty risks accompanying such, we generally speak of "tax compliance".

What are the purpose and the objective of a tax compliance management system (tax CMS)?

With the help of an effectively structured tax CMS, awareness of structures, work processes and matters within the company which have, or might have tax effects, is indicated, checked and, if required, these are adjusted. This is intended to create framework conditions for correct taxation-related conduct and actions and, at the same time, to raise awareness of tax-relevant data. As a result, retroactive tax payments and liability risks are avoided or, at least, reduced.

For example, it is a suitable instrument to support compliance with deadlines in the framework of deadline management and, as a result, it contributes to the prevention of default fines (art. 152 AO), late payment fines (art. 240 AO) or, in individual cases, arbitrary assessment (art. 162 AO). Moreover, the risk of liabilities can be reduced, or even avoided. Complicated, controversial or incomplete matters can be detected early on and even before the submission of the tax return and taken into account with regard to taxation matters so that, for example, criminal investigations on grounds of tax evasion (art. 370 AO) or non-compliance procedures on grounds of reckless tax evasion (art. 378 AO) can be avoided. Last but not least, a functioning tax CMS will also have positive effects on the type and extent of audits. As a result of the main matters of internal control and documentation being dealt with separately, the administration can focus on those matters which are actually under dispute in the framework of the audit.

Is a fiscally optimal alignment of my company still possible when a tax compliance management system is used?

The establishment of a tax compliance management system does not mean that companies have to forego possibilities for tax-optimised procedures. Instead, tax compliance is intended to provide support with regard to the aim of reducing the tax burden, under consideration of the legal requirements. In addition, non-compliant behaviour can be avoided. Therefore, legal opinions deviating from those of the state fiscal administration can also be expressed. However, this is subject to the premise that these are identified and disclosed.

 Do I need a tax compliance system?

A tax CMS offers advantages in many respects: It ensures that there are systems in place that give you the certainty that the requisite structures and processes have been created for the appropriate consideration of all matters which are relevant for taxation. This gives you certainty. Moreover, a tax CMS system provides protection against the accusation of disorganisation of the company (Administrative Offences Act) or even the personal charge of premeditated tax evasion (Criminal Tax Law). Even though an existing tax CMS system can only be seen as indication that no premeditated or reckless action is likely to have been taken (cf. art. 153 AO), reputable companies, in particular, have an interest in a tax CMS since it helps them to document this tax “open and honest” approach. Therefore, the subject of "tax compliance" is relevant in principle for all companies.

 Does the usage of a tax compliance system provide advantages in working with the tax office?

An established and documented tax CMS is regarded as being positive by the fiscal administration, in particular, in the case of tax return corrections. This is because if you succeed in establishing a holistic approach to tax CMS in your tax department, you do not only build more trust within the company - but also with the relevant tax office. If, e.g., there is an error in the tax returns, a tax CMS can help to disprove the accusation of premeditation or recklessness in the incorrect tax declaration and create the opportunity to effect a correction of the tax return as a correction instead of a voluntary self-disclosure. As a result, criminal law investigations on grounds of tax evasion (art. 370 AO) or a non-compliance procedure on grounds of reckless tax reduction (art. 378 AO) can perhaps be avoided. However, a functioning tax CMS will also have positive effects on the type and extent of audits.

 How do I design a tax compliance management system?

There are no general specifications or rules as to how a tax compliance management system should be designed. Since the respective conditions of a company need to be addressed, an individual design is required in almost every case. Nonetheless, background information regarding the design requirements can be derived from several sources. In this context, according to IDW, a tax compliance system is considered as being adequate "if it is suited to identify both risks of essential violations and to detect such violations of rules in due time with sufficient certainty." This means preventative and identifying measures are required. A tax compliance management system is effective if these principles and measures are considered and complied with – and, in short, "implemented" - by the parties concerned in the current business process in line with their respective responsibilities. Furthermore, continuous monitoring, updating, improvement and training of the parties concerned are required.

 Is the use of a tax compliance system also possible for individual functions?

A tax CMS is certainly also conceivable for certain functions. For example, compliance guidelines could be developed for sales tax, which constitutes the main risk factor for many companies. However, this design is not really advisable. The term "tax" should be interpreted so as to include all taxes and expenses. Therefore, in addition to the fulfilment of the requirement to submit tax returns for the different taxes and charges, the tax CMS can also extend to compliance with retention, accounting and recording requirements as well as to rules regarding deadline management, responsibilities for checking assessments and objection procedures, as well as restructuring measures, border-crossing matters and audits. Moreover, this list is not exhaustive.

 Tax compliance and sales tax: What are the main aspects of an audit?

In recent years, sales tax has emerged as the biggest tax risk for many companies. This is e.g. due to the fact that because of existing system issues it is prone to fraud, while it is also of essential importance for tax revenue and, therefore, it is often a focus of the audit by the fiscal administration.

Therefore, in the field of sales tax, the fiscal administration regularly checks the correctness of invoicing, the authorisation to deduct input tax and - in particular, in the border-crossing exchange of goods, purchase invoices management and proper accounting in the framework of special VAT audits.

In these fields, special attention is paid to the question of whether the business partners have convinced themselves of the existence and entrepreneurial status of the respective business partner. Therefore, the sales tax assessment of every performance relationship in terms of contents requires a high degree of tax legislation expertise and places high requirements on the relevant employees.

 In the framework of a tax CMS for the sales tax segment these aspects, in particular, should be considered:

• Do the invoices contain the characteristics required under art. 15 UStG [German Sales Tax Act]?
• Are periodic invoices issued correctly?
• Do the performance relationships correspond to the invoices issued?
• Are sales tax training and further training measures carried out?
• Are new business relationships checked?

 Tax compliance and tax accounting and recording obligations – 

Where does it start?

Moreover, an effective tax compliance management system also comprises the fulfilment of the tax accounting and recording obligations within the meaning of art. 140 ff AO. This area of responsibility should not be underestimated. Certain taxable entities have to keep books and records. In this context, the principle of complete, correct, timely and orderly accounting applies (art. 146 AO). In its letter dated 14th November 2014, the Federal Ministry of Finance published comprehensive amendments for proper accounting with effect from 1st January 2015. This concerns, in particular, companies fulfilling their accounting, recording and retention obligations in an electronic format with the help of IT systems. If the auditability and verifiability of compliance with the compliance procedures of art. 146 AO cannot be ensured through procedural documentation, the fiscal administration can consider this a defect of substance. This would, e.g., result in the risk of an assessment of the taxation bases according to art. 162 section 2 sentence 2 AO.

 How can a tax CMS system help me with regard to the requirement to file my tax returns or with regard to the obligations to cooperate with the tax office?

Every taxpayer is required to submit a tax return. This also includes sales or income tax statements. The tax laws specify who has to submit which returns. However, the returns have to be submitted in line with certain tax declaration periods. The compliance system should, e.g., delineate internal competences for the preparation and submission of tax returns in order to avoid a non-submission or a delayed submission. Of course, the specific deadlines for submission should be clear at an early date to ensure this. Likewise, a tax compliance system can help to prevent the submission of tax returns the content of which is incorrect (principle of dual control).

Generally, every taxpayer is subject to a duty to cooperate with the tax office. This applies, in particular, also in the case of matters involving foreign transactions or field audits. A tax CMS helps to avoid any violations of duties to cooperate. Here compliance guidelines are created which provide a clear documentation in order to avoid conflicts with the fiscal administration.

 Does your cash management comply with tax provisions?

If cash management is non-compliant, this results in the loss of the correctness of the entire accounting. Therefore, in such a case, the tax office can assess the taxation bases in accordance with art. 162 section 2 sentence 2 AO. If it is assumed that the incorrect records are intended to hide the actual situation and to evade taxes, this will also result in addition to the initiation of criminal tax law investigation proceedings.

Therefore, a tax CMS can provide support in ensuring that the accounting and recording requirements are properly fulfilled. Companies with cash receipts usually use cash registers, computer cash register systems or open cash registers. As part of accounting, these systems are subject to the same recording and retention requirements as accounting systems. The fiscal administration differentiates between the types of cash register system in use. The requirements regarding recording of data are based on this. Generally, the following applies: Data which are recorded and can be provided technically also have to be preserved in a reasonable manner. In this context it has to be cited that the law provides for a so-called individual record obligation (cf. art. 238 HGB, art. 140 to 148 AO and art. 22 UStG, i.e. all revenues and expenses have to be recorded individually in principle) and with a retention period of ten years.

 Tax compliance and hidden profit distribution - what needs to be considered?

The subject of hidden profit distributions often becomes an issue in limited liability companies and other corporations. The fiscal administration checks, in particular, the performance relationships between companies and their shareholders or close relatives. Risks regarding the acceptance of a hidden distribution of profits arise wherever excessive advantages are granted - in the opinion of the fiscal administration.

 The following has to be complied with to avoid a hidden distribution of profits:

• The agreements between the shareholder (controlling party) and the company must be clear, made in advance and recorded in writing. Moreover, they must be carried out as agreed.
• Performances between the company and the shareholder must stand up to scrutiny in compliance with the arm's length principle.

 What support can a tax adviser provide?

A tax adviser can support the company in analysing the situation as-is. However, it is a fallacy to assume that the implementation of a tax compliance management system constitutes a complete overhaul of the current work procedures. As a rule, there are already numerous principles and measures regarding compliance with the tax obligations. As a first step, therefore, these principles and measures are to be documented and compiled in order to develop check lists from the existing work procedures and guidelines as a second step. However, it is also conceivable for the tax adviser to provide support in drafting and filling in so-called risk matrices with the help of which a risk analysis and evaluation is to be carried out.

After the status quo has been recorded, a tax adviser can also help to design a strategic tax CMS from the existing elements and to use this system to implement the objectives to be established and the requirements of the management board under consideration of risk aspects.

In addition to the written documentation of guidelines, check lists and work procedures, however, control provisions are also to be developed. Parts of these control activities can be outsourced to an external consultant. This could serve as a further protection mechanism since a circumvention of the system is less likely with control by an external third party than with control by an internal party.

Ultimately, however, responsibility for the tax compliance management system rests with the legal representatives of the company even if the tax adviser retained can carry out a multitude of services and support measures in connection with the analysis, implementation and documentation of a control system.

 Conclusion by LHP Lawyers:

At present, the subject of "tax compliance" is at the focus of the tax debate - not only in the technical literature. Specifically, this was triggered by the letter by the Federal Ministry of Finance dated 23/05/2016 and amending the application decree for the tax code regarding art. 153 AO and in which the Federal Ministry of Finance outlines the evidence effect of a working tax compliance management system. Of course, all clients want to secure their commercial success in terms of tax law; as a result, the establishment of a tax compliance management system is advisable. We offer you individual and intensive consultancy by a tax adviser or tax law expert on the subject of "tax compliance". We create check lists for you and provide instructions and assistance in their day-to-day use. Our law firm has extensive knowledge and the necessary practical experience as tax attorneys and tax advisers to assist each individual case in the best possible way. This profound knowledge is brought together in our law firm by the continuous professional education of our partners and team members. 

Co-author of this article:
Linda Konken
Employed Tax Adviser, M.Sc. Business