Arbitrary Assessment in a Company Tax Audit

The statutory basis for an arbitrary assessment is § 162 AO.  The Tax Authority must arbitrarily assess tax bases, if they cannot be determined or calculated. Arbitrary assessments are in particular indicated in cases, where the taxpayer is unable or unwilling to provide sufficient clarification, or where the taxpayer is unable to furnish the prescribed accounts or documentation. The taxable amounts must also be assessed arbitrarily in cases, where the accounts or records used for establishing the tax bases are rejected in their entirety, which is the most frequent situation occurring in company tax audits. The reasons behind the taxpayers inability to present accounts or records are irrelevant. 

If the accounts or the records are found to be formally deficient, the presumption of accuracy under § 158 AO no longer applies. This situation does however not automatically entitle to an arbitrary assessment, it is rather necessary to establish factual deficiency. An arbitrary assessment is possible, if the Tax Authority is able to establish factual deficiencies based on validations or single-issue audits and thereby establishes, that the accounts are most likely incorrect. A mere suspicion for factual deficiencies does not suffice, only evidenced factual deficiencies entitle the auditor to reject the accounts and make an arbitrary assessment. The law is unambiguous in this respect.

A formal non-compliance alone is no reason to assume a general factual deficiency and make an arbitrary assessment. Vice-versa, a formally compliant set of accounts cannot prevent an arbitrary assessment, if the accounts have been deemed factually deficient. In the view of the Federal Fiscal Court, marginal factual deficiencies do not entitle the Tax Authority to make arbitrary assessments of the tax bases. Factual deficiencies in the accounts do however reflect in the annual result, and deficient cash ledgers may provide justification to perform a full-scope arbitrary assessment in individual cases. This is particularly the case with recurrent deficiencies. These deficiencies indicate the likely presence of more deficiencies. In the case of a limited number of erroneous account entries, the Tax Authority is only permitted to correct the discovered entries, if it is most likely that there are no further erroneous accounting entries. In this case, so-called surcharges due to accounting uncertainty cannot be applied.

The omission to record income or expenditure, calculation errors, incomplete documentation of incoming goods, missing or bogus receipts are the most frequent deficiencies in accounting. All companies with a high cash turnover, such as catering, will be audited on their cash accounting in particular. Typical errors observed:

• The records are incomplete or inaccurate. This means, that the accounting of receipts is incomplete. Each accounting entry must be accompanied by a receipt. This also applies to private disbursements and contributions. Some fiscal courts hold the opinion, that one missing receipt for a private transaction constitutes a significant factual deficiency.
• Cash receipts are retrospectively recorded in the accounts at the end of a year via a private account.
• A verification of cash at hand cannot be performed on a daily basis.
• Frequent overwriting, retrospective changes, significant calculation errors and crossed-out items in the cash ledger.
• The use of incorrect daily cash ledgers.
• The daily tally is rounded to full Euro amounts in the case of so-called cash drawers. All amounts must be recorded and documented precisely, including decimals.
• Cash discrepancies. The amount of cash at hand must never be less than zero. Deficit amounts show, that the accounting was not done properly and no daily cash tally was calculated.
• Income and expenditure is not recorded chronologically. This goes to show, that cash at hand is not accounted on a daily basis and no daily cash verification can be performed.
• Checks are accounted as cash and not recorded separately.
• The optical presentation of the cash reports and other circumstances show that records have not been made in due time (i.e. even handwriting, same pen, etc.)
• Restaurants and pubs frequently omit to separately account the revenue for to-go products and no separate accounts are used to record family or business events.
• Purported theft and embezzlement: If theft or embezzlement are established when drawing a cash balance, this must be recorded. Circumstantial evidence for the credibility of such a claim are demonstrable ramifications, such as report to police or warning letters to employees.
• The date of a transfer from the bank account to the cash account is frequently incorrect. The addition of funds to cash at hand must be accounted for on the day the money was withdrawn, even if the bank’s value date may be later (i.e. public holidays, weekends). In addition, the time noted on the account statements must be considered. This particularly applies to a transfer from the cash account to the bank account that is made earlier than the business opening hours (and thereby takes place earlier than revenue)
• Control slips produced by the cash register are not retained. It is sufficient to retain the control slips (Z-receipt) printed at the end of the day, which must contain the date, the daily cash tally and the name of the company in addition to the sequential number of the control slip.
• Receipts, register slips and other receipts used to calculate the daily cash tally recorded in the cash ledger are not retained. This may only be omitted, if cash tally is immediately recorded in the cash ledger, which is structured as a sequence of daily cash reports.

Cash discrepancies are a classic among the reasons for making an arbitrary assessment. It is based on the thought, that it is not possible to spend more cash funds than have been taken in or deposited. If the expenditure exceeds the initial balance plus the takings and deposits for a certain period, this results in a cash shortfall.  The taxpayer must be able to convincingly explain cash shortfalls.  Deficits in cash at hand may jeopardize the factual accuracy of the accounts and hint at unaccounted operational income based on higher cash balances. If no sufficient explanation, such as a chronologically incorrect account entry or the erroneous recording of a deposit, is given, this may result in an arbitrary assessment.  A dispute about the amount of the arbitrary assessment is inevitable.  

In such cases, the Tax Authority uses the operational result and the concrete withdrawals as determining factors for the arbitrary assessment, e.g. unappropriated and appropriated withdrawals. Unexplained deposits may also be used in an arbitrary assessment. If formal deficiencies, such as non-chronological accounting or erroneous records, are established in relation to deposits, this does not suffice for justification of an arbitrary assessment.   To determine the amount of an arbitrary assessment, it must be evaluated, whether the cause for the cash discrepancy is a one-time event, or if a continuous failure to account for revenues is evident. In the first case, only the highest discrepancy entitles to an arbitrary assessment, possibly with an additional surcharge for uncertainty, while in the case of a continued failure to record revenue, the total of all discrepancies may be considered in making an arbitrary assessment. It is also possible to make a full-scale arbitrary assessment, if the deficiencies in cash accounting are grave enough to justify doubts about the entire revenue accounting.

The frequently practised approach to add up all days with shortfalls and use the result to make an arbitrary assessment does however not lead to proper results, because once-off discrepancies are increased exponentially . Tax advisers who perform their own arbitrary assessments should clearly and openly share them with the Tax Authority. It may otherwise constitute an abetment of tax fraud, if the arbitrary assessments turn out to be too low later down the track.

In real life, hardly any set of accounts will be completely flawless.  The wording of § 158 AO therefore stipulates unequivocally, that only the incorrect parts of the accounts may be rejected. Only minor errors will not result in a complete rejection of the accounts. Insignificant factual error to not affect the compliance of accounts. The error must be corrected or the accounting result must be rectified by a partial arbitrary assessment. In practice, it is frequently problematic to establish conclusive evidence showing that only certain parts of the accounts are flawed. Especially in cases, where an audit of cash at hand has shown numerous flaws, such evidence will have little prospects for success.

The law permits several methods for validation of the the factual accuracy of the accounts (internal benchmarking, post-calculation, time-series comparison, cash flow calculation, capital gains calculation and, in a restricted way, the Chi-Square-Test), others are however not accepted to serve as sole conclusive evidence (external benchmarking, indicative rates schedule).

If a validation method suitable for comparative purposes establishes a deviation from the accounting results, this does not lead to the conclusion that the entire accounts must be rejected. This option is only available, if the deviation falls outside the bandwidth of uncertainty being inherent to the respective validation method. No sequence or valency of the various methods exists. If a certain method employed in a company tax audit concludes, that the accounts are most likely factually wrong, it may be attempted to rebut this with own calculations.  

Important note by the tax law specialist and tax adviser:  The rejection of a formally compliant set of accounts must always follow two steps: The assumption of accuracy as set out in § 158 AO is robust, it does not suffice to justify doubts in respect of the factual accuracy of the accounts by applying the validation methods mentioned above. A mere chance of the accounts being factually inaccurate does not waive the assumption of accuracy. A likelihood bordering on certainty is required. This mean in practice, that the smaller the deviation from the declared numbers is compared to the results of the validation method, the greater the potential for the tax adviser or tax law specialist to contest the authority to make an arbitrary assessment. If it is however certain, that a formally compliant set of accounts is factually inaccurate, then - and only then, may an arbitrary assessment be made in a company tax audit.

If further factual clarification is impossible or unreasonable for the auditor, then he must determine the tax bases by making an arbitrary assessment.  The purpose of an arbitrary assessment is to establish the tax bases by way of stochastic considerations.

The aim of any arbitrary assessment is to determine the most likely tax bases. The result of the arbitrary assessment must be plausible, consistent, economically reasonable and realistic.  Any uncertainties must not be to the detriment of the Tax authority, if and only if, the taxpayer’s conduct has instigated the arbitrary assessment. This is the case, if he has seriously breached his duties to record, retain and cooperate. The company tax audit is then permitted to use the upper limits of the arbitrary assessment. Arbitrary assessments aiming at penalizing or patronizing the taxpayer are expressly prohibited.

According to current jurisprudence, the choice of a method to make an arbitrary assessment is the auditor’s discretion. He must - within his delegated discretion - choose a method, which will warrant the most probable result being obtained with a reasonable effort. The auditor is also obligated, to verify the result of an arbitrary assessment by another method of making arbitrary assessments. The taxation principle of the so-called assessment-period approach authorizes the auditor to use a different method for making arbitrary assessments each year. 

Note:  The instructed tax adviser or tax law specialist should therefore initially scrutinize the method applied in respect of errors and weaknesses. In a second step, he should make his own arbitrary assessment using the same method employed by the auditor and substantiate the result by using another arbitrary assessment methods.

An external company benchmark compares the audited company against other companies. This method may be subject to significant errors. It must frequently be doubted, whether the company used for benchmarking is really comparable and corresponds with the audited company in respect of the material benchmarking values such as number of customers, organisational structure or the size of the company. If this is not the case, an accurate benchmarking of the companies is not possible. Additionally, tax confidentiality usually obstructs the utilisation of the concrete numbers of other companies.  The Tax Authority must disclose the name of the company used for benchmarking in proceedings before the Fiscal Court in order to allow for scrutiny of the comparison.

To alleviate these problems, the Tax Authority regularly compiles indicative rate schedules. These contain benchmarking numbers which the Tax Authority has developed during its auditing history. The indicative rates schedule outlines bandwidths for the following indicative rates: Gross profit margins on materials used, gross profit and net profit. The validation of the gross profit margin of the materials used is the easiest method.  The use of indicative rates schedule for the comparison of values is considered an external company comparison, which must consider the specific individual characteristics of the audited company to address its inherent generalization. It is further not warranted, that the values in the indicative rates schedule are free from inaccuracies themselves.  The benchmarking with external companies therefore holds less evidential value than internal company comparisons.

As deliberated above, the deviation of the audited company’s figures from the bandwidth for the official indicative rates schedule does not justify doubts about the formal compliance of the accounts, even if this is alleged by some company tax auditors.  

In practice, the industry classification of the audited company holds material significance.  Auditors should carefully verify the classification, because the margins vary significantly across the various catering businesses (e.g. pizza restaurant, snack stall).

There are various methods to perform an internal company comparison. One popular method is the so-called time-series comparison. This describes the analysis of company data and their chart analysis. It aims to assess, whether the average operational figures such as goods purchased, materials used, gross profit and gross profit margin are consistent over the audited period - usually 3 years - and remain consistent if looked at in shorter intervals (weeks, months).  The time-series comparison is particularly used in company tax audits of catering businesses. It assumes, that new stock is only purchased when the existing stock has been used up and no inventory is kept. This is justified by the relatively short shelf life of food products. If the time-series comparison yields significant deviations, this allows for inferences pointing to unaccounted revenue.

The so-called yield calculation, which determines the average margin rate for the gross profit for the purpose of post-calculation, is the most commonly used method in post-calculation within the catering industry, which is then examined in a time-series comparison.  

The company tax auditor calculates the annual purchasing amount on the bases of the purchase invoices. Concurrently, rates derived from experience are applied to the menu, which results in the average gross margin rate for a selection of foods and beverages offered and is then allocated to the purchasing account. If the results deviate from the amounts declared in the accounting, arbitrarily assessed amounts are added.  

In order to achieve an overall picture which is realistic at the same time, it is important that the margin rates for the respective foods and beverages are determined in-line with the specific circumstances of the business. The recipes and sizes of servings hold a decisive significance in this respect. It must additionally be determined, which proportion of the purchased goods was actually used in the realisation of revenues. This proportion is often lower due to own consumption, theft or spoilage as well as special events with discounts and free drinks which significantly impact on the respective margin rates. The company tax auditor is an industry outsider and therefore does not possess the necessary industry knowledge to allocate the individual purchased goods to the dishes on the menu or sufficiently consider the special circumstances of the business. This frequently results in significant erroneous allocations, which must be rectified.  

The following applies: If a post-calculation aims at invalidating formally compliant accounts, the post-calculation itself must also be formally compliant. If different margin rates are used by the auditor, he must perform a comprehensive differentiation of the costs of goods sold. This makes post-calculation a very time-consuming effort, which is also problematic and contestable due to the numerous factors to be considered. For this reason, jurisprudence prefers validation methods using cash flow and capital gains, because their results are deemed more reliable.  

The time-series comparison uses the accounts for individual periods as the basis for the calculation of the gross margin rate. This is a relatively new method used in company audits and presents as an advancement of the yield calculation, which is the reason why the time-series comparison is mainly used in the audit of catering businesses. This method aims at verifying, whether a weekly calculation of the gross profit margins also yields the corresponding average gross profit margin for the year, as declared by the business.

Company tax audit reports often mention, that significant fluctuations within the weekly gross profit margins over the year lead to the highest gross profit margin of one or more consecutive weeks to be assessed as the applicable annual gross profit margin, in as far as these fluctuations are not considered usual in the type of business audited, or substantiated reasons are laid down, which explain the fluctuating gross profit margins over the whole year.

This assessment method is well-established and has been used by company auditors for decades. It did however reach its limits in the past practice, which is due to the fact, that a manual calculation is extremely time-consuming in light of the Tax Authority’s insufficient technical equipment. The introduction of audit software in company tax audit departments has changed the situation significantly.

The time-series comparison aims at detecting cases, in which neither the purchased goods nor the proceeds have been correctly accounted for. The Tax Authority considers its own experience that it is virtually impossible for a business owner to entirely omit the purchase costs corresponding to the accounted sales. The annual gross profit margin may oscillate within the usual bandwidth, but telltale abnormalities are detected if looked at on a monthly or weekly basis.

The time-series comparison aims at detecting these abnormalities. The gross profit margin is calculated separately for each calendar week based on the accounted purchases of goods and revenues. The goods purchased and accounted for are allocated to the time between two purchases, separated by type, and then their respective proportion is allocated to the calendar weeks. These costs of goods sold are then compared with the proceeds recorded for that week. If the result shows abnormalities and deviations, it supports the suspicion that the accounts contain factual deficiencies.

In relation to the credibility of this method, the Tax Authority has to be given credit for their exclusive reliance on internal data from the accounts of the respective business in company tax audits. This results in further details about the recipes used and the sizes of dishes being obsolete, and possible sources of errors are thereby eliminated. On the other side, new sources of error eventuate, because not each and any abnormality or deviation observed must inevitably point to accounting abnormalities.

A particularly problematic issue is the question of allocating purchases. The time-series comparison assumes, that new goods are only purchased once the stock at hand has been depleted. If inventory is used for a later creation of revenues, then this will not be considered. This is justified by the notion, that food products have a limited shelf life and older stock is consumed before new purchases are used. An inventory of goods is claimed to be obsolete, because these goods may be delivered at any time, meaning daily, and their prices remain stable.

Practice shows however, that this line of argumentation does in many cases not concur with business reality. It is however difficult, to precisely quantify and assess short-term inventory retrospectively, but this evidence is required for the rebuttal of a time-series comparison. One solution is continuous stocktaking, which is however not a realistic option for smaller companies.

The inventory is of material significance, which is why the annual stocktaking at a specific date is increasingly important. It can frequently be observed in the catering industry, that stocktaking and registration is only done inadequately, which inevitably results in erroneous allocations in time-series comparison, in particular in the first weeks of a new year. If the inventory is recorded at lower than actual level, this leads to inflated gross profit margins and vice versa. The time-series comparison also assumes, that all goods purchased are used for revenue creation in their entirety or in a continuously consistent proportion. Variances remain unconsidered, but are often evident in practice, e.g. due to increased spoilage during the summer months or excessive self consumption in a party by the business owner.

Seasonal variances also remain unconsidered in the time-series comparison. These do however have a significant impact on the gross profit margin in practice. One example is a a beergarden operated in summer: this may result in parts of the revenues of food and beverages to shift in proportion to the total revenues; the higher gross profit margin usually applicable to beverages will then frequently result in an increase of the overall gross profit margin. This is not associated with unaccounted revenues during the other months, but based on what has been described above, the company tax audit will suspect just that. The reasons for seasonal variances are manifold and the difficulty lies in their retrospective assessment and being able to supply corresponding evidence.

Conclusion:  Time-series comparisons are generally highly significant, because they are exclusively based on the data supplied by the audited company. Chart analysis supported by large amount of figures seem convincing on a first glance. Tax advisers and tax law specialists should however carefully analyse the calculation bases used in the comparison.  The weakness of this comparison is, that it can never be assessed with certainty, which goods were actually used in which periods, because intermediate stocktaking, which could in turn refute the results of the comparison, is usually not performed. For the purpose of securing evidence for a defence, intermediate stocktaking and documentation of regular and discounted sales prices, loss and spoilage as well as composition of dishes and consumer purchasing behaviour may be helpful.

The capital gains calculation, the income-expenditure-coverage calculation and the cash flow calculation are other methods of making arbitrary assessments. They are based on the assumption, that a taxpayer can only use funds which are sourced either from income or from assets. If a surplus of used funds is calculated, which cannot be clarified, it allows for the assumption that the source of these funds is undeclared income. The quality of these calculations hinges on the available information on the taxpayer. These also concern his private life, for which no duty to record or retain exists, which may lead to significant sources for error. The basic prerequisite for these types of calculations is the disclosure of private accounts.

Documents not associated with business operations, such as private account transactions, contracts or similar do generally not fall under the duty to disclose in company tax audits. This changes, when a private account is deemed relevant for taxation purposes (§ 200 AO). The company tax auditor needs a concrete reason to request information on private accounts. Formal deficiencies in the accounts suffice for this purpose.  

The cash flow calculation requires private information on the taxpayer. The company tax auditor relies on details and cooperation rendered by the taxpayer, because the auditor himself is not able to obtain the respective documents. As far as the taxpayer does not furnish the requested documents, the auditor is left with the option of enforcement proceedings under §§ 328 et seq AO.  This changes however, when the company tax audit holds a suspicion of criminal tax offences being committed and informs the Tax Authority in charge of criminal tax matters and the tax inspection agency, which will then have investigative authorities and is permitted to approach the bank where the account is held.  If the tax auditor’s request to disclose information is justified in the individual case and the taxpayer fails to comply, the tax auditor may issue a request for information to the bank under § 93 AO. This does not contradict the banking secret. The request for disclosure by the Tax Authority is also not contradicted by the fact, that the taxpayer himself is under no obligation to make or retain records. The only decisive factor is, that the taxpayer did not comply with the request to furnish information and that such a request is reasonable.  Such a request, which must be submitted to the bank in writing and include the required references, is generally limited to a period of one year. If required, it may subsequently be extended to further years.  The request to furnish information directed at the taxpayer under § 200 AO and at the bank under § 93 AO constitute administrative acts under § 118 AO, which may be contested by way of objection or litigation.

Serious objections exist against private cash flow analysis. A comprehensive and meaningful cash flow analysis with the aim of validating income is only possible in cases, in which all bank accounts, including those of the spouse if necessary, can be accessed for verification purposes. The analysis should be carefully examined on a factual basis. It must in particular be assessed, whether the documentation furnished by the taxpayer has been analysed correctly and comprehensively, and if the further explanations provided by the taxpayer have been considered. A detailed analysis of the reasons behind any discrepancies is required.  Discrepancies concerning income may be caused by various reasons. There is further no legal basis for the assumption, that all payments, which were received on a private account and for which no proof of origin can be provided, constitute income subject to income tax. The burden of proof for facts that would increase the tax load lies with the Tax Authority. Taxpayer are not obligated to prove the origin of their private assets.

As explained, the basis for an arbitrary assessment of tax bases must be those tax bases, which yield the most probable result.

Arbitrary assessments are also permissible in criminal tax proceedings, however a completely different set of rules in respect of evidence applies.  The principle of “in dubio pro reo” applies (compare § 261 StPO, defendant is given the benefit of the doubt), which means that remaining doubts about the accuracy of an arbitrary assessment must not held to the detriment of the accused. An arbitrary assessment may only be used in criminal matters, if it has been proven (and not merely asserted), that the taxpayer has committed tax fraud in at least (!) a certain amount. This leads to the outcome in criminal proceedings to usually be significantly below the result of an arbitrary assessment for taxation purposes. Surcharges for uncertainty imposed by the company tax auditor are completely irrelevant in criminal proceedings. Discounts assessed by criminal law judges on the basis of accounting certainty are also problematic.  They evidence the uncertainty of a criminal law judge in respect of the overall result of an arbitrary assessment. It is further not permitted in criminal proceedings, to apply the result of a post-calculation for a certain period, e.g. 6 months, to the entire period in which a tax fraud has been committed.