Performance audit, Department of Revenue,Taxation Division and Hearing Office

              PERFORMANCE AUDIT
DEPARTMENT OF REVENUE
TAXATION DIVISION AND HEARING OFFICE
Report to the Arizona Legislature
By the Auditor General
April 1985
85- 5
DOUGLAS R. NORTON. CPA
AUDITOR GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
April 22, 1985
Members of the Arizona Legislature
The Honorable Bruce Babbitt, Governor
Mr. J. Elliott Hibbs, Director
Arizona Department of Revenue
Transmitted herewith i s a report of the Auditor General, A Performance
Audit of the Arizona Department of Revenue, Taxation Division and Hearing
Office. This report is i n response to an April 27, 1983, resolution of
the Joint Legislative Oversight Committee. The performance audit was
conducted as a part of the Sunset Review set forth i n A. R. S. § § 41- 2351
through 41 - 2379.
The report addresses the adequacy of the Department's sales tax audit
effort, and the need to improve audit selection systems and controls over
the quality and integrity of audit work. Implementation of
recommendations contained i n the report could generate well over $ 20
mi 11 ion annual ly i n additional revenue.
My staff and I will be pleased to discuss or clarify items i n the report.
Respectful ly submitted,
DOU~ IYRS. Norton
Auditor General
Staff: William Thomson
Peter N. Francis
Brent L. Nelson
Kimberly S. H i 1 debrand
Cindy G. Whi taker
Kurt L. Schul te
1 1 1 WEST MONROE SUITE 600 PHOENIX. ARIZONA 85003 ( 602) 255- 4385
SUMMARY
The Office o f the . Auditor General has conducted a performance audit o f
the Department of Revenue ( DOR), Taxation Division and Hearing Office i n
response t o an A p r i l 27, 1983, resolution o f the J o i n t Legislative
Oversight Committee. This report, the f i r s t i n a series on the
Department of Revenue, was completed as p a r t o f the Sunset Review set
forth i n A. R. S. § § 41- 2351 through 41 - 2379.
The Taxation Division o f DOR i s responsible f o r administering Arizona' s
tax laws and regulations r e l a t i n g t o income, sales and use, luxury,
bingo, fiduciary, estate taxes, and unclaimed property. I t s primary
function i s t o conduct audits of taxpayers and assess taxpayers for
amounts owed. The Department's Hearing Office i s organized under the
d i r e c t o r of the Department o f Revenue and i s responsible f o r r e g i s t e r i n g
and monitoring a l l protests related t o audit assessments.
The Department O f Revenue Could Collect Up To $ 18 M i l l ion Annually I n
Additional Revenue By Increasing I t s Sales Tax Audit E f f o r t ( See Page 5)
Although the sales tax i s the State's best revenue producer and a
productive audit area, the Department maintains a r e l a t i v e l y low coverage
of the sales tax base. A national study, based on 1979 data, computed
DOR's sales tax audit coverage a t 2.4 percent, we1 1 below the 4 percent
coverage o f sales tax accounts considered near optimal by authorities.
Increasing DOR's sales tax audit coverage would substantially increase
audit collections. Hiring additional auditors would be cost effective.
If 24 more auditors were hired, a t a cost o f about $ 996,500, up t o $ 18.8
m i l l ion i n additional revenue would be generated. Because o f the
inexperience of i t s s t a f f and t h e l a c k o f t r a i n i n g programs, DOR may not
wish t o absorb 24 additional auditors a t once. Instead, increases i n
audit staff could be phased i n over 2 or 3 f i s c a l years.
The Department Could Significantly Increase Revenue By Improving I t s
Audit Selection Svstems ( See Daae 11 1
The Department of Revenue needs to improve i t s audit selection systems.
Currently, the S t a t e ' s major taxpayers, which generally offer the
greatest potential to generate additional audit assessments and
collections, are not being audited. Analysis of a random sample of the
S t a t e ' s major sales taxpayers indicated that about 20 percent had been
audited between January 1981 and August 1984. If all large accounts were
audited, we estimate that an additional $ 1.8 million to $ 3.6 million i n
revenue coul d be generated yearly.
DOR has not implemented systems to identify major taxpayers for audit.
I t has not placed major taxpayers on a cyclical audit schedule, which i s
common practice i n several states, nor has i t implemented a computerized
system to help identify major taxpayers for audit. However, even i f DOR
selected major taxpayers for audit, DOR auditors may not currently have
sufficient experience and training to handle audits of these more complex
accounts. To address t h i s problem, DOR needs to improve both i n i t i a l and
in- service training programs offered to i t s audit s t a f f .
In addition, many accounts DOR does select for audit are unproductive,
suggesting other selection system weaknesses. A significant number of
sales tax audits are terminated, some because they were not appropriately
selected for audit. DOR has apparently used inaccurate or outdated
records for selection purposes and has not adequately tracked audit
activity. Unproductive audits also occur partly because DOR lacks clear
selection c r i t e r i a . DOR should develop and apply clear c r i t e r i a i n using
various sources of information for audit selection.
The Audit Section of the Department of Revenue does not have adequate
controls to ensure quality audit work and equitable treatment of
taxpayers. A1 though auditors exercise consi derabl e responsi bil i ty and
authority on behalf of the State, their decisions are not adequately
checked. Controls over audit decisions made by supervisory personnel are
minimal, although these decisions may involve hundreds of thousands of
dollars. To improve controls over audit decisions, DOR needs to
strengthen i t s review of audit work, improve documentation i n case f i l e s ,
and upgrade and improve training of personnel. Review of audit work
could be further improved if DOR implemented a qual i t y control review
u n i t . Several other states have made effective use of t h i s type of u n i t
and consider i t an integral part of their review process. We recommend
that the Legislature consider appropriating $ 116,000 for t h i s purpose.
Additional controls are also needed to minimize the potential for
collusion, bribery and other abuses. Specific instances of abuse were
uncovered by the Department i n 1983, and two o f f i c i a l s were dismissed
from their positions as a result. Implementation of a centralized
qual i t y control u n i t would help reduce the potential for such abuses. In
addition, we recommend that DOR consider implementing other control s such
as routine rotation of auditors.
Finally, DOR needs to improve i t s review of audit working papers. A
review of audit f i 1 es disclosed mi nimal and inconsistent supervisory
review. Because audit review i s lax, auditor errors can go undiscovered
or necessitate subsequent modifications or amendments to original audit
assessments. The Department needs to develop written standards and
policies governing audit work techniques and audit review.
Protested Assessments Are Not Processed Efficiently; Consequently The
Potential For Loss Of Revenue Exists ( See Paqe 37)
The Department of Revenue does not process protested assessments
efficiently. As a result, the potential for loss of revenue exists.
Under Arizona law, those taxpayers who are assessed additional taxes may
petition for a hearing, correction or redetermination. Procedures for
processing protests, however, are cumbersome and 1 ack adequate control s.
The current system re1 ies extensively on manual operations. Our analysis
of the process showed excessive transferring of documents among sections
and duplication of effort. For example, 59 documents involving 14
personnel are used i n the sales tax assessment and formal protest
process. Each audit f i l e i s handled by a t l e a s t e i g h t d i f f e r e n t people
and transferred a t l e a s t 16 times between employees and eight times
between sections.. The number o f documents involved could be reduced and
ef f i c i enci es coul d be real i zed.
Excessive manual processing and dupl i c a t i o n increases the r i s k o f errors
and mishandling. We noted several instances i n which audit f i l e s were
requested but could not be located. Other cases have been l o s t i n the
system and hearings have never been scheduled. DOR's a b i l i t y t o monitor
and control the protest process i s hampered by a lack o f management
reports, a deficiency i d e n t i f i e d i n our 1981 DOR a u d i t report. A1 though
the Department has been working t o develop a protest tracking system
since a t l e a s t March 1983, the system i s s t i l l not operational.
I n addition, the Department's Hearing Office has a backlog o f cases that
are not being e f f i c i e n t l y resolved. As o f October 1984, the Office had
63 pending cases f o r which hearings had been held but decisions had not
y e t been rendered. I n 19 o f these cases, more than a year had passed
since the hearing had been held. A l l o f these cases had been assigned t o
the same hearing o f f i c e r . The Department needs t o implement a system t o
ensure timely f o l l ow- up o f cases awaiting decisions. I n addition, the
Department needs t o take more timely action t o resolve cases informally.
Many cases are resolved informally on the day of the scheduled hearing,
thus wasting the time and resources of the Hearing Office.
TABLE OF CONTENTS
INTRODUCTION AND BACKGROUND . . . . . . . . . . . . . . . . . . . . .
FINDING I: THE DEPARTMENT OF REVENUE COULD COLLECT
UP TO $ 18 MILLION ANNUALLY IN ADDITIONAL REVENUE BY INCREASING ITS SALES TAX AUDIT EFFORT . . . . . . . . . . . . . .
Current Auditor A l l o c a t i o n . . . . . . . . . . . . . . . . . . .
Sales Tax Audit Coverage I s Low . . . . . . . . . . . . . . . . .
Increasing Audit S t a f f Would Generate Substantial Additional Revenue . . . . . . . . . . . . . . . . .
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . .
FINDING 11: THE DEPARTMENT COULD INCREASE REVENUES
BY IMPROVING ITS AUDIT SELECTION SYSTEMS . . . . . . . . . . . .
Taxation D i v i s i o n Purpose And
Current Selection Systems . . . . . . . . . . . . . . . . . . . .
Major Taxpayer Accounts Are Not Being Audited . . . . . . . . . .
Major Taxpayers Are Not I d e n t i f i e d
I n A Systematic Way . . . . . . . . . . . . . . . . . . . . . . .
Unproductive Audits Suggest Other Selection System Weaknesses . . . . . . . . . . . . . . . . . . .
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . .
FINDING 111: THE DEPARTMENT OF REVENUE LACKS ADEQUATE CONTROLS
TO ENSURE THE QUALITY AND INTEGRITY OF AUDIT ASSESSMENTS.
MODIFICATIONS AND AMENDMENTS . . . . . . . . . . . . . . . . . .
Impact O f Audit Assessments.
Modifications and Amendments . . . . . . . . . . . . . . . . . .
Important Controls Are Lacking . . . . . . . . . . . . . . . . .
Q u a l i t y O f Audit Review Needs To Be Improved . . . . . . . . . .
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . .
Page
1
TABLE OF CONTENTS ( Cont. 1
Page
FINDING IV: PROTESTED ASSESSMENTS ARE NOT PROCESSED
EFFICIENTLY; CONSEQUENTLY, THE POTENTIAL
FOR LOSS OF REVENUE EXISTS . . . . . . . . . . . . . . . . . . . 3 7
The Protest Process. . . . . . . . . . . . . . . . . . . . . . . 37
Procedures Are Cumbersome And Lack
Adequate Control s. . . . . . . . . . . . . . . . . . . . . . . . 38
UHnedareicnidge dO fCfiacsees . H a. s B. a. ck. log. O. f . . . . . . . . . . . . . . . . . . 42
Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . 48
AREAS FOR FURTHER AUDIT WORK . . . . . . . . . . . . . . . . . . . . 51
AGENCY RESPONSE. . . . . . . . . . . . . . . . . . . . . . . . . . . 55
LIST OF TABLES
Page
TABLE 1 - DOR Estimated And Actual Expenditures
For Auditing/ Compliance Programs
Fiscal Years 1982- 83 Through 1984- 85 . . . . . . . . . . .
TABLE 2 - Sales and Use Tax Audit Coverage I n Arizona
And Five Western States. . . . . . . . . . . . . . . . . .
TABLE 3 - Auditor A1 l o c a t i o n Among Tax Types:
Sales And Use, And Income Taxes. . . . . . . . . . . . . .
TABLE 4 - E f f e c t Of Increasing Sales Tax Audit S t a f f :
Estimated Additional Annual Coll e c t i ons. . . . . . . . . .
TABLE 5 - Corporate Income Tax: Average D o l l a r s
Assessed Per Audit Hour
For Ten Assessment Ranges. . . . . . . . . . . . . . . . .
TABLE 6 - HDeataer inOgf OHef faircineg C Aanseds DPaeten dOinfg P Bryo test. . . . . . . . . . . .
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a performance audit of
the Department of Revenue ( D O R ) , Taxation Division and Hearing Office i n
response to an April 27, 1983, resolution of the Joint Legislative
Oversight Committee. This report, the f i r s t i n a series on the
Department of Revenue, was completed as part of the Sunset Review set
forth i n Arizona Revised Statutes ( A. R. S.) § § 41- 2351 through 41- 2379.
Taxation Division
The Taxation Division of DOR i s responsible for administering Arizona's
tax laws and regulations relating to income, sales and use, luxury,
bingo, fiduciary and estate taxes, and unclaimed property. I t s primary
function i s to conduct audits of taxpayers and assess taxpayers for
amounts owed.
The Division of Taxation consists of four sections: Audit, Compl iance,
Estate Tax and Tax Policy. The Audit Section contains four units: Sales
and Use Tax, Individual Income Tax, Corporate Income Tax, and Audit
Services. The Audit Section i s responsibl e for selecting accounts for
audit and analyzing statutes applicable to the various tax types. The
Compl iance Section is responsibl e for securing compl iance with State
taxation 1 aws through criminal prosecution of violators when criminal
intent i s found. The Estate Tax Section audits and collects State
revenue from taxable estates and fiduciary returns. I t i s also
responsible for administering the State's unclaimed property laws. The
Tax Policy Section develops rules and regulations for the Taxation
Division.
The Audit Section conducts in- house audits of taxpayer returns and field
audits of taxpayer records to ascertain that taxpayers accurately report
and pay tax 1 iabil i t i e s . Thus, revenue i s generated from additional tax
assessments based on audit fi ndi ngs. According to Department records,
auditing has resul ted i n the foll owing additional assessments for fiscal
years 1981 - 82 through 1983- 84.
Year Assessments Col 1 ections
Staffing And Budget - Auditing a c t i v i t i e s consume 27 percent o f the
Department's resources. One hundred seventy- two o f the Department' s 640
authorized f u l l - time employee positions ( FTE) were a1 1 ocated t o auditing
and compl iance programs i n f i s c a l year 1983- 84. Table 1 shows actual and
estimated expenditures f o r auditing a c t i v i t i e s i n f i s c a l years 1982- 83
through 1984- 85.
TABLE 1
DOR ESTIMATED AND ACTUAL EXPENDITURES
FOR AUDITING/ COMPLIANCE PROGRAMS
FISCAL YEARS 1982- 83 THROUGH 1984- 85
Actual Actual Estimated
1 982- 83 1 983- 84 FY 1984- 85
FTE Positions 163 172 180
Expenditures:
Personal Services $ 3,327,000 $ 2,825,600 $ 3,306,800
Employee Re1 ated 695,300 594,200 757,900
Professional And
Outside Services 2,900 5,000 14,200
Travel
I n State 80,000 41,300 69,000
Out O f State 136,600 171,000 252,100
Other Operating 56 ; 200 44 1000 741 800
Equipment 66,100 22,300 0
Total Expenditures $ 4.364.100
Source: Department of Revenue budget requests
* Includes one large case involving more than $ 20 m i l l i o n , which i s i n
court.
Heari ng Office
The Hearing Office o f the Department o f Revenue i s organized under the
d i r e c t o r o f the Department o f Revenue. It operates with one hearing
o f f i c e r and two c l e r i c a l s t a f f . The Office i s responsible f o r
r e g i s t e r i n g and monitoring a1 1 protests re1 ated t o audit assessments.
Sco~ e O f Audit
Our audit of the Department o f Revenue Taxation Division and Hearing
Office was l i m i t e d t o the Audit Section o f the D i v i s i o n o f Taxation and
the Hearing Office. The operations o f the Tucson Office, except where
noted, were not included i n t h i s audit. The Tucson o f f i c e operates
independently from the Taxation Division i n Phoenix ( see page 51 ).
Detailed work was conducted on the f o l l owing issues:
a Whether sales tax audit coverage i s adequate,
a Whether audit selection systems need t o be improved,
a Whether review o f audit work i s adequate and controls s u f f i c i e n t
t o deter and prevent abuse, and
a Whether the appeals process i s e f f i c i e n t and timely.
I n addition, 1 imited work was done t o address the 12 statutory Sunset
Factors. Departmentwi de responses t o these factors w i 11 be prepared
f o l l owing completion o f our other Department o f Revenue audits.
I n some cases, work was delayed due t o d i f f i c u l t y i n obtaining accurate
and re1 iabl e information. This d i f f i c u l t y resulted from data and systems
problems and was not due t o lack o f cooperation by the Department.
The Auditor General and s t a f f express appreciation t o the assistant
d i r e c t o r and s t a f f o f the Taxation Division and the Hearing Office for
t h e i r cooperation and assistance during the course o f our audit.
FINDING I
THE DEPARTMENT OF REVENUE COULD COLLECT UP TO $ 18 MILLION ANNUALLY IN
ADDITIONAL REVENUE BY INCREASING ITS SALES TAX AUDIT EFFORT
The Department of Revenue ( DOR) does not conduct enough sales tax audits.
A1 though sales tax i s t h e S t a t e ' s highest revenue producer, audit coverage
of the sales tax base i s low compared with other states or standard
ratios. I n addition t o providing f o r more favorable tax base coverage,
assigning more audit s t a f f t o sales tax audits would s i g n i f i c a n t l y
increase audit c o l l ections.
Current Auditor A1 1 ocation
At the time o f our audit, 39.5 auditors ( both Phoenix and Tucson s t a f f )
were assigned t o the Sales and Use Tax Unit, and 56.5 t o the Income Tax
Unit. Within the Income Tax Unit, 28.5 auditors were assigned t o f i e l d
audits and 28 t o o f f i c e audits.* Income f i e l d audits are p r i m a r i l y
corporate audits conducted a t the taxpayers' place o f business. These
a u d i t s i n v o l ve detai 1 ed review o f f i nancial records supporting the
taxpayer's return. Income o f f i c e audits are p r i m a r i l y i n d i v i d u a l income
tax a u d i t s i n v o l v i n g a desk review o f tax returns and available IRS
revenue agent reports.
Sales Tax Audit
Coverage I s Low
A1 though sales tax i s t h e S t a t e ' s best revenue producer and a productive
audit area, the Department maintains a re1 a t i v e l y 1 ow audit coverage of
* Total k I t s include temporary and i n t e r n ( part- time) s t a f f .
the sales tax base. This i s evidenced by: 1 comparing Arizona with other
states, 2) analyzing auditor allocation based on a percentage o f revenue
collected, and 3) . examining standard r a t i o s of auditors t o numbers of
accounts.
Other States - DOR does not conduct as many sales tax audits as other
states. A national study based on 1979 data, which included Tucson audits
and accounts, computed DOR's sales tax audit coverage a t 2.4 percent, well
below the 4 percent level considered near optimal by authorities.* AS
shown i n Table 2, Arizona's audit coverage was we1 1 below coverage o f f i v e
other western states considered t o have reasonably adequate sales tax
audit programs. **
TABLE 2
SALES AND USE TAX AUDIT COVERAGE IN ARIZONA
AND FIVE WESTERN STATES
State Audit Coverage
ARIZONA 2.4%
Cal i f o r n i a
Colorado
Nevada
Utah
Washington
Source: Due and M ik esell , 2.- c it ., p. 238
* John F. Due and John L. Mikesell, Sales Taxation: State and Local
Structure And Administration ( Baltimore, The Johns Hopkins University a
Press, 1983). ** Other states with adequate audit coverage are Alabama, Arkansas,
Mississippi , Okl ahoma, Rhode Is1 and and Tennessee.
Precise comparisons between states are not possible due to differences i n
state tax structures and record keeping systems. However, the differences
are substantial enough to conclude that Arizona's audit coverage is
re1 atively 1 ow.
Percentage Of Revenue Collected - DOR's sales tax audit coverage i s also
low when auditor allocation i s compared to revenue collected. As shown i n
Table 3, State sales tax will generate 57 percent of total sales and use,
and income tax revenue expected to be collected for fiscal year 1984- 85.
Yet only 41 percent of audit resources are assigned to the Sales and Use
Tax U n i t . If audit resources were assigned based on percentage of revenue
collected, 55 auditors would be assigned to audit sales and use taxes,
which i s 15.5 more than are currently assigned.
TABLE 3
AUDITOR ALLOCATION AMONG TAX TYPES
SALES AND USE, AND INCOME TAXES
Allocation Based On Percentage of
1984- 85 Anticipated Revenue Coll ections Current A1 location
Tax Type Number % of Total( 1) Number % of Total
Sal es/ Use 55
Income - Fi el d 2 5
Income - Office - 16
Total -- 96 m-% 9 6 1- 00%
Source: Prepared by Auditor General staff from informati on compi 1 ed by
the assistant director of taxation
( 1) Column percentages represent the proportion of revenue expected by DOR
to be contributed by each tax type to total sales and use, and income
tax collections for fiscal year 1984- 85.
Some states have reallocated audit resources based on similar analyses.
For example, the New York State Department of Taxation and Finance
discovered several years ago that i t s corporate tax field audit program
accounted for 35 percent of total fiel d audit revenue. However, the
program was allocated only 10 percent of audit s t a f f ; while the income tax
program, w i t h 22 percent of the audit s t a f f , accounted for 8 percent of
total revenue. Income tax auditors were transferred to the programs
producing more revenue, such as corporate tax fiel d audit.
Standard Ratios - Finally, DOR sales tax audit coverage is 1 ow based on
the number of auditors compared to accounts. DOR has assigned 39.5
auditors to audit a sales tax base of approximately 95,000 active
accounts, a ratio of one auditor per 2,400 accounts. Studies i n various
states indicate that one auditor per 1,000 accounts may be an adequate
sales tax audit s t a f f . Some states meeting t h i s standard are Rhode
Island, Utah, Vermont, Wisconsin and Texas. Others close t o t h i s staffing
level are Connecticut, Iowa, Nevada, Oklahoma and Virginia. DOR would
need to assign 95 auditors to the Sales and Use Units to meet this ratio.
If only monthly sales tax accounts ( 63,538), which are considered by DOR
to be the best audit prospects, were included i n the analysis of sales tax
coverage, 63.5 auditors woul d be needed.
Increasing Audit Staff Woul d Generate
Substantial Additional Revenue
Increasing DOR's current sales tax audit coverage to the near optimal 4
percent level woul d substantial ly increase audit col lections. Hiring
additional sales tax auditors would be cost effective.
DOR could increase revenue collections substantially by h i r i n g additional
sales tax auditors. If 24 additional auditors were hired and assigned to
sales tax audits, bringing the total to 63.5 positions, a total estimated
increase of more than $ 18 mill ion could be collected.
TABLE 4
EFFECT OF INCREASING SALES TAX AUDIT STAFF
ESTIMATED ADDITIONAL ANNUAL COLLECTIONS
Tax
- TY pe
Current A1 1 ocation Adding Staff
Number of Estimated Number of Estimated
Auditors Collections( 1) Auditors Collections
Sal es/ Use 39.5 $ 31,101,800 63.5 $ 49,999,074
Income - Fi el d 28.5 14,152,200 28.5 14,152,200
Income, - Office
Total 96 $ 54.768.000 120 $ 73.665.274
Increase Over
Current A1 location
Source: Auditor General analysi s of information compiled by the Division
of Taxation
These estimates are based on the assumption that DOR would generate the
same average collections per audit as the number of sales tax audits
increased. Sales taxation authorities note that i f audit selection
systems are working effectively, do1 l a r s generated per audit will decl ine
as tax base audit coverage increases. This occurs because the largest and
most productive accounts are audited f i r s t , 1 eaving 1 ess productive
accounts for subsequent selection. As noted i n Finding I1 ( page 11 ),
however, DOR i s not currently selecting the largest and most productive
accounts for audit. Thus, improvement i n audit selection may offset any
expected decl ines i n average coll ections per audit.
DOR could increase i t s sales tax audit effort by reallocating existing
s t a f f , however, this would not be desirable for two reasons. F i r s t ,
reduction i n income f i e l d audits would not be feasible or cost effective.
These audits are primarily corporate audits and are relatively productive
audits based on historical data. Further audit work i s needed to
determine whether current corporate audit coverage i s adequate. In
addition, for a1 1 tax types, regard1 ess of productivity, the Department
needs to mai ntai n adequate audit coverage for compl i ance purposes.
Hiring additional audit staff would be cost effective based on the
expected return. .. DOR estimates that adding 24 auditors to the sales tax
audit program would cost approximately $ 996,500 annually. If the full
$ 1 8.8 mil 1 ion i n additional coll ections coul d be real ized, each additional
dollar spent would return more than $ 18 i n revenue. Even i f only
one- fourth of the expected return were generated, the cost of additional
auditors woul d be we1 1 worth the investment.
DOR may not wish to absorb 24 additional auditors all a t once. Instead,
increases i n audit staff could be implemented i n phases over 2 or 3 fiscal
years. The Department has neither adequate management, supervisory nor
support staff to absorb a large staff increase, nor controls needed to
minimize errors and the potential for abuse ( see Finding 111, page 26).
Moreover, as noted i n Finding I1 ( page 16), training and experience of
existing auditors needs to be improved so audit resources can be more
efficiently and effectively util i zed.
CONCLUSION
DOR does not conduct enough sales tax audits. Increasing coverage of the
sales tax audit base could generate as much as $ 18 million i n additional
revenue.
RECOMMENDATIONS
1. The Department of Revenue should develop a comprehensive plan to
increase sales tax audit coverage. T h i s plan should address the
actions that would be taken to provide training, supervision, etc.
before additional audit staff were hired.
2. The Legisl ature shoul d consider appropriating the necessary funds over
the next 3 fiscal years for a phased increase of sales tax auditors.
3. DOR should conduct a study to determine whether corporate income tax
audit coverage needs to be increased.
FINDING I1
THE DEPARTMENT COULD INCREASE REVENUES BY IMPROVING ITS AUDIT SELECTION
SYSTEMS
The Department o f Revenue ( DOR) needs t o improve i t s audit selection
systems. Most of t h e S t a t e ' s major taxpayers, some o f the most productive
accounts, are not being selected f o r audit. Estimated additional sales
tax revenue o f more than $ 1 .8 m i 11 ion t o $ 3.6 m i 11 ion coul d resul t each
year i f these accounts were audited. DOR has not placed these taxpayers
on a c y c l i c a l audit schedule nor implemented a computerized system t h a t
would automatically i d e n t i f y major taxpayers. I n addition, many audits
DOR does perform are unproductive, suggesting other selection system
weaknesses.
Taxation Division Purpose And
Current Selection Svstems
One purpose o f the audit function i s t o increase tax revenue through audit
assessments.* During the l a s t few years t h i s has been a major emphasis of
the Department because o f potential State budget d e f i c i t s . To accompl i sh
t h i s , t h e Division o f Taxation attempts t o i d e n t i f y taxable accounts and
decide which of these w i l l be audited. Currently, selection i s performed
manually by s t a f f experienced i n each tax type audit unit. Both
i n t e r n a l l y generated and externally derived information i s used i n the
selection process.
The Sales and Use Tax U n i t selects accounts f o r audit throughout the year
from about 20 sources. Some sources are the McGraw H i l l Dodge Reports
( which provide information on current construction w i t h i n the State), and
outside party r e f e r r a l s, i ncl uding compl a i nts from concerned individual s.
* The Division o f Taxation i s responsible f o r administering sales and
use, i ncame, w i thhol ding, 1 uxury , severance, estate, f i d u c i a r y and
bingo taxes. Due t o the time l i m i t a t i o n s of t h i s audit, only sales
and corporate i ncome t a x s e l e c t i o n methods were examined. These
accounted f o r 83 percent and 84 percent of gross revenue collected by
DOR i n f i s c a l years 1982- 83 and 1983- 84, respectively.
The auditors themselves identify potential audits through newspapers and
periodicals, or by observing new entities or construction on the way to or
during engagements.
Corporate income tax selection of reporting corporations i s based on
auditor experience and judgment, and prior audit information on a
corporation. DOR sometimes uses a zip code report prepared by Data
Processing, listing corporate name, zip code and amount of tax remitted a t
a particular time to aid i n selection. Another source of audits i s the
Internal Revenue Service revenue agent reports. * Many audits are
performed using these because they usually require minimal audit time t o
determine what State tax assessment, i f any, can occur as a resul t of a
Federal income tax assessment.
Major Taxpayer Accounts
Are Not Being Audited
DOR is not selecting major taxpaying accounts for audit. Although they
are among the most productive accounts, most major taxpayers have not been
audited w i t h i n the l a s t 3 years. Significantly more revenue could be
generated if more of these accounts were selected for audit.
Major taxpayers generally offer the greatest potential to generate
additional audit assessments and coll ections. Various systems to select
audits, such as California's cell system, place substantial emphasis on
large firms because the dollar productivity of such audits i s likely to be
high. Several other states, i ncl uding Wisconsin, Washington, Tennessee,
Texas, and Nebraska emphasize audits of major taxpayers because of their
revenue potential.
Arizona's actual audit experience indicates that audits of 1 arger firms
and taxpayers are more productive. According to our analysis of a random
sample of 100 of the 490 sales tax audits performed by Phoenix audit staff
resulting i n additional tax due i n fiscal year 1983- 84, there i s a very
* Federal revenue agent reports contain Federal i ncome tax adjustments
to individual and corporate income tax return amounts. State auditors
can often determine if additional state tax i s due from the taxpayer
by examining these reports.
12
high correlation between net taxable amount and audit assessment.* This
v e r i f i e s t h a t the. larger the firm, the greater the audit assessment.
Despite their potential, many major taxpayers are not being audited.
Fewer than 2 percent of DOR's ongoing sales tax accounts ( 1,798 out of
103,913 accounts) account for 70 percent of t o t a l s a l e s taxes paid.**
Analysis of a random sample of 300 of the 1,798 large taxpaying accounts
( using Phoenix Office records) revealed that only 20 percent had been
audited between January 1981 and August 1984. Only 36 percent had been
audited i n the previous 8 years.
A similar result was found i n further review of both Phoenix and Tucson
audit a c t i v i t y f o r the 100 largest accounts. Ninety- seven of these 100
taxpayers remitted a t l e a s t $ 500,000 i n sales taxes i n each of the 1 a s t 3
fiscal years. About one- fourth ( 24 percent) were audited between 1981 and
1984. Because the State statute of 1 imitations 1 imi t s DOR to auditing and
collecting sales accounts for the preceding 39 months, many years of
potential additional tax revenue could be 1 ost because of this failure to
identify and audit potenti a1 ly productive 1 arge accounts.
Additional Revenue Could Be Generated - DOR could generate from $ 1.8
mill ion to more than $ 3.6 mill ion in additional sales tax revenue yearly
i f the Department audited more 1 arge firms. Of the 24 1 argest sales tax
accounts audited between 1981 and 1984, 19 owed additional taxes. The
average audit assessment over t h i s period for these major taxpayers was
$ 1 26,561. If DOR audited one- third of the taxpayers remitting more than
* The actual correlation is .9407 w i t h a significance level of .001.
** Because sales taxes generate the most State revenue, and because of
difficul ty i n getting accurate data, our analysis focused primarily on
audit selection systems i n the Sales tax u n i t . Three separate master
sales tax f i l e tapes, prepared by the DOR Data Processing Center, were
sent to our Office. Each was different than the previous tape and
each contained inaccuracies. Our comparison of the 1 ast two tapes
received indicate that although certain percentages derived i n our
analyses may change depending on which tape i s used, we can s t i l l
conclude that potentially productive 1 arge tax accounts are not always
audited.
$ 500,000 i n sales tax each year ( which would coincide w i t h the 39- month
s t a t u t e of 1 imitations) about $ 3,658,000 i n additional revenue coul d be
realized. Using the DOR 5- year audit cycle of such accounts, nearly
$ 1,868,000 of increased coll ections coul d occur.*
In addition to generating additional revenue, audits of major taxpayers
increases auditor productivity . We examined actual do1 l a r s generated per
audit hour invested by DOR Phoenix Office corporate income tax auditors.
Comparing audits that r e s u l t i n assessments of $ 1 t o $ 500 w i t h those
resulting i n assessments of $ 50,001 to $ 100,000, per hour average audit
return is increased by more than $ 3,700. For assessment cases of more ( I
than $ 1,000,000, additional average tax due i s i ncreased by about $ 59,000
per average audit hour. Table 5 i l l u s t r a t e s average audit assessment due
per audit hour for ten assessment ranges.
TABLE 5
CORPORATE INCOME TAX:
Average Assessment
AVERAGE DOLLARS ASSESSED PER AUDIT HOUR
FOR TEN ASSESSMENT RANGES
Per Audit Hour
$ 60,000 7
$ 1- 500 $ 501- $ 1,001- $ 5,001- 510,001- $ 25.001- 550, COl- $ 100,001- $ 500.001- Over
1,000 5,000 10,000 25,000 50,000 100.000 500,000 1,000,000 $ 1.000,000
Assessment Range
Source: Prepared by Auditor General s t a f f using Phoenix Office Corporate
Income Tax audit log for the period July 1983 through May 1984
x These estimates are based on sales tax data indicating that 221
accounts paid more than $ 500,000 i n sales taxes i n fiscal year
1983- 84, and includes allowances for unproductive accounts and for
productive audits currently performed. Actual col 1 ections potential
may be greater. In addition, more recent sales tax data ( the t h i r d
sales tax tape we analyzed) showed 273 accounts paying more than
$ 500,000 i n fiscal year 1983- 84, which i f audited woul d increase
coll ections.
Based on that analysis, i f DOR performed one more audit i n each of the
three highest assessment ranges, estimated coll ections from those audit
assessments would total nearly $ 1,750,000.*
Major Taxpayers Are Not
Identified In A Systematic Way
DOR is not identifying major sales- tax payers for audit i n a systematic
way. Although it plans to do so, the Department has not placed major
taxpayers on a cyclical audit schedule. Nor has i t successfully
imp1 emented the Marginal Analysis Audit Selection System ( MAASS), an
automated system that is designed partly to emphasize selection of large,
productive sales tax accounts. Even i f large accounts were selected for
audit, DOR's current capability to audit these acounts may be limited
because auditors are not adequately trained to audit complex firms.
Cyclical Selection Not Performed - DOR has not placed the S t a t e ' s major
sal es- tax payers, those paying more than $ 500,000 i n sales taxes per year,
on a cyclical audit schedule. According to DOR, there were 221 accounts
w i t h a tax l i a b i l i t y greater than $ 500,000 i n fiscal year 1983- 84. The
number of such accounts has increased i n each of the 1 a s t 3 fiscal years.
From fiscal year 1981- 82 through 1983- 84 these accounts have increased by
about 42 percent.
The Phoenix Office plans to place a l l major taxpayers on a cyclical audit
schedule, but its plan may not be adequate due to the s t a t u t e of
limitations. The Sales Tax Audit Selection Group is i n the process of
implementing a formal , manual , cycl i c a l audit selection system for a1 1
accounts paying $ 100,000 to $ 500,000 yearly i n taxes, and for those
remitting more than $ 500,000 i n taxes. The group expects cycles of 8- 10
and 5 years respectively, for the two groups. Again, this will not allow
even the highest dollar accounts to be audited w i t h i n the 39 month statute
of 1 imitations. As a resul t, undetermined audi t- re1 ated revenue will be
lost.
* tstimated collections are based on fiscal year 1984- 85 collection
objectives.
Several states audit major taxpayers on a cyclical basis w i t h i n their
respective statutes of limitations. Cycles range from 3 years i n
Tennessee to 4 years i n Washington. Texas, which has a 4- year statute of
1 imitations, considers as its priority taxpayers those cumulatively
accounting for 65 percent of the reported taxable amount ( 2 calendar
years of reported amounts are used). Texas audit division pol icy
stipulates that 25 percent of these accounts be examined each year,
resulting i n virtually 100 percent audit coverage every 4 years.
MAASS System Has Not Been Implemented - In addition, DOR has not
successfully imp1 emented an automated system to he1 p identify major
taxpayers for audit. The now defunct MAASS system was obtained by the
Department i n February 1982 from the City of Scottsdale. The system,
similar to California's cell system, is designed to select sales tax
audits to be selected based on audit assessment potential. The system
groups Standard Industrial C l assi f ication* ( SIC) codes into categories and
assigns each sales account a number, one through 16, based on amount of
tax paid each year. The c e l l s are then grouped into three categories:
most productive, productive, and 1 east productive. The " most productive"
category usually contains the 1 argest and most complex business operations.
The MAASS system has several known program problems, which since i t s
i n i ti a1 operation i n June, 1982, have rendered the system unusable.
First, the system i s not accepting a l l audit maintenance i n p u t forms, and a
thus, a l l audit information does not get on the history f i l e . For
example, " l a s t audit date" i s missing from most accounts. Secondly, some
SIC codes needed for account assignments are not on the system. Lastly,
some " undefined" SIC codes ( and accounts) show up erroneously i n the
l i s t i n g of the " most productive accounts." These problems have not been
corrected because MAASS i s not a priority w i t h the Department's Data
Processing Center and the Division i t s e l f does not have the programming
expertise to correct known problems.
Auditor Experience And Training Are Lacking - Even i f DOR selected major
* SIC is the abbreviation for Standard Industrial Classification. These
codes group businesses into industry categories.
taxpayers for audit, DOR auditors may not have sufficient experience and
training to handle audits of these more complex accounts. DOR auditors
lack experience due to high staff turnover. In addition, the auditors
w i t h i n both the Phoenix Office Sales and Corporate Income Tax Units
receive 1 i ttl e training.
A1 though qual i fied f o r t h e i r positions, DOR auditors 1 ack experience a t
some levels.* A survey of audit staff qual ifications indicated that most
entry- 1 evel field auditors ( 81 percent) and many journey- 1 evel auditors
( 40 percent) had less than 1 year experience i n their positions.
Moreover, a l l b u t one of DOR's audit supervisors ( f i e l d and office) had
less than 1 year experience i n their supervisory positions a t the time of
our audit.
DOR has experienced re1 atively high turnover i n recent years, making i t
d i f f i c u l t for i t to build more experience w i t h i n its audit ranks. Field
auditor turnover was 27 percent i n fiscal year 1982- 83, and climbed to 65
percent i n fiscal year 1983- 84, according to the Department. High
turnover i n fiscal year 1983- 84 i s attributable partly to the early
retirement option that was offered to State employees during that year.
Turnover may decline once DOR's new auditor classification series is fully
implemented. As a result of a 3- year DOA- Personnel study, most auditors
will be reclassified and upgraded retroactive to January 1, 1985. D O R ' s
audit staff salaries, a1 though s t i l l of concern to Department management,
now appear to be more competitive w i t h salaries of comparable positions i n
industry and other governmental settings. Even i f turnover decl ines,
however, i t will take time to develop staff experience w i t h i n the audit
section.
* Audit staff come to DOR well qualified. In the Phoenix Office, of the
16 entry- level field auditors responding to our survey, a l l b u t one
had a bachelor's degree, usually i n accounting or business
administration. Entry- level auditors have an average of more than 24
credit hours i n accounting. Eleven of the 25 journey- level auditors
surveyed had bachelor's degrees, and 4 had associate degrees.
Journey- level auditors had an average of 25 hours i n academic
accounting course work. In addition, many of the auditors had related
auditing and financial accounting experience before joining the DOR
staff.
17
I n addition, the sales tax auditors do not receive much formal training.
The Units' t r a i n e r r e t i r e d from the Department i n l a t e 1982. Because of
Division reorganization and the p r i o r i t y given t o revenue acceleration
there has been l i t t l e formal, structured t r a i n i n g since t h a t time. I n
l a t e 1983 new auditors received 8 hours o f t r a i n i n g i n sales and use tax
problems, research material s, and the protest and appeal s process.
According t o a supervisor, however, about h a l f o f the current s t a f f has
had no formal technical classroom training, and only about eight of the 29
auditors have enough t r a i n i n g and experience t o perform compl ex audits.
Auditors i n the Corporate Income Tax U n i t a l s o l a c k structured technical
training. A l l auditors attended a t r a i n i n g series from October 1981
through February 1982, which ranged from basic t o very technical aspects
of corporate income tax auditing. Again, due t o the same problems and
events t h a t occurred i n the Sales and Use Tax Audit Unit, very 1 i t t l e
structured t r a i n i n g has occurred since t h a t time. I n f i s c a l year 1983- 84,
for example, technical audit t r a i n i n g totaled about 10 hours f o r new
auditors. Only about half t h e c u r r e n t s t a f f are prepared t o do large,
complex audits.
Supervisors i n both audit Sales and Use and Corporate Income Tax Units use
on- the- job auditor devel opment programs t o he1 p t r a i n auditors. However,
some supervisors i n both u n i t s stated t h a t more formal, structured,
technical t r a i n i n g woul d he1 p prepare auditors t o examine 1 arge, compl ex
accounts. *
The best s t a t e t a x administration agencies such as the Texas Office o f the
Comptroller of Public Accounts and the California Franchise Tax Board have
we1 1 devel oped t r a i n i ng programs. Texas states t h a t auditor t r a i n i n g has
been the major c o n t r i b u t i n g f a c t o r t o job efficiency and high- qua1 i ty
* The lack of t r a i n i n g also a f f e c t s even the routine audit a c t i v i t i e s .
I n a February 6, 1985, memo the Department's hearing o f f i c e r c i t e d
several examples i n which auditors and col lectors 1 acked knowledge of
fundamental p o l i c i e s and procedures. I n h i s memo he stated ". . .
v i r t u a l l y every day an auditor e i t h e r c a l l s me or comes t o my office
with a question( s1 t h a t r e f l e c t s a basic lack of understanding of how
the system works which, i n my opinion, i s the r e s u l t o f inadequate
training. "
audits. In the f i r s t 3 months of employment, new sales tax auditors
receive up to 5 weeks ( 200 hours) of intensive classroom training, and
on- the- job training w i t h an office training coordinator. Subject areas
covered incl ude tax 1 aw, preaudit research, audit control, audit
procedures, evidence and working paper f i 1 e, and report writing.
Additional ly, penalty and interest procedures, and administrative
procedures are taught. As auditors gain experience they attend additional
classroom training for sales tax. Senior auditors receive an average of
40 hours of continuing classroom training yearly to maintain and expand
their expertise.
The California Franchise Tax Board offers substantially more corporate
income tax training than DOR. I t s formal, classroom training plan
accounts for approximately 16 percent of a new auditor's time during the
f i r s t year. This training begins w i t h 200 hours of personal income tax
law and auditing techniques. The second training phase consists of about
120 hours of corporate income tax auditing methods, techniques and
procedures. Thus, i n the f i r s t year, Cal ifornia gives about 320 hours- of
classroom training to new corporate income tax auditors vs. 10 hours i n
Arizona.
Unproductive Audits Suggest Other
Selection System Weaknesses
Many accounts selected by DOR for audit are unproductive, suggesting other
selection system weaknesses. A number of sales tax accounts selected for
audit are terminated, and about one- fourth of all corporate income tax
audits performed result i n no subsequent assessment or in a refund to the
taxpayer. This appears to occur i n part because DOR lacks clear selection
c r i t e r i a .
Numerous Unproductive Audits - A1 though even good audit selection systems
produce some unproductive audit accounts, both the Sales Tax and Corporate
Income Tax Units have initiated numerous unproductive audits. Sales tax
audits that are started and then closed are documented on individual
report forms. Individual reports are used: 1 ) to document that an account
has been reviewed for the current audit period and no known additional tax
is due or overpayments have occurred, 2) t o document reasons an account
was selected for audit b u t never audited, or 3) to provide information for
potential audits that is gained while conducting other audits. According
to available DOR records, which may not be complete, 450 individual
reports were completed for the 2- year ending audit period of July 1982
through September 1984. Our analysis shows that during about the same
period, 974 audits were completed. A comparison of individual reports and
completed audits shows that slightly less than one- third of a1 1 selected
accounts are terminated.*
The f 01 l owing case exampl es i 11 ustrate some of the unproductive audit
activity that is documented i n these reports.
e A report dated September 26, 1984, indicated that the firm
selected for audit had canceled its 1 icense i n February 1984 and
was apparently no longer i n business. The audit was canceled.
0 A report dated October 1, 1984, noted that the firm selected for
audit had recently been audited and no audit was necessary. The
audit was canceled.
a A report dated September 11, 1984, said the firm selected for
audit had been audited approximately 2 months previously for
sales and use taxes. No audit was necessary and i t was canceled.
0 A report dated March 7, 1984, indicated that a f t e r 2 weeks' work,
the auditor determined the company's sales were exempt. The
audit was discontinued a f t e r 86 hours of audit time was expended.
None of the above accounts appear to have been appropriate for selection.
DOR has apparently used inaccurate or outdated records for selection
purposes, and has not adequately tracked audit activity. Val uabl e time
that could have been spent on productive accounts was wasted.
x The actual percentage is 31.6 percent, which may be high because some
individual reports may not record terminated audits.
Because documentation i s sometimes inadequate, we were unable to determine
why DOR began and then terminated some audits. For example, in February
1983, DOR started , audits of several sales 1 icense accounts of a 1 arge
resort. The audits were never completed, however, individual reports
documenting the reasons could not be found.
The Corporate Income Tax U n i t also conducts many unproductive audits. Of
the 428 audits completed i n fiscal year 1983- 84, about 18 percent resulted
i n no additional tax due, and 11 percent resulted in refunds to
taxpayers. Together, these audits that d i d not generate revenue accounted
for more than one- fourth of a1 1 audits performed. For audits completed i n
fiscal year 1982- 83, the percentages were similar, although refunds were 3
percent lower. S t i l l , approximately 25 to 29 percent of all audits for
each of those 2 years were unproductive.
Unclear Selection Criteria - Unproductive audits also occur, a t least i n
part, because DOR lacks clear selection criteria.* Although both the
Sales and Corporate Income Tax Units have identified and documented
sources of potential audits, neither has well developed criteria for
selecting accounts for audit from those sources.
The Sales Tax Audit Unit does not have clear, specific criteria with which
to select accounts for audit w i t h i n identified sources. For example, for
the source " request for refund," a dollar amount of refund ( or some other
criteria) i s not specified as an indicator for whether an account should
be audited. When the Department uses the Dodge Reports, a floor amount of
additional tax due ( or other appropriate c r i t e r i a ) is not used. Another
exampl e concerns " property val uati on" information. The extent of
discrepancies noted as a result of certain comparisons i s not specified as
to when an audit should occur. In other words, there are no documented,
clear- cut criteria with which to accept or reject an account for audit,
again resul ting i n unsystematic selections.
* Implementation of the computerized MAASS system may also help reduce
the number of unproductive audits.
Corporate Income Tax Audit also lacks clear c r i t e r i a . Selection i s
performed mainly on a judgmental basis. The Department i s attempting to
address t h i s deficiency. Starting i n fiscal year 1984- 85, tax year 1983
tax returns are being entered into the Department's computer system.
Various reports will be produced from this data; some will a1 1 ow selectors
to request 1 istings w i t h certain c r i t e r i a , such as all corporations w i t h
tax 1 i a b i l i t y greater than X amount or all corporations w i t h a net
operating loss of X amount. These reports will be helpful but of 1 imi ted
use because they will originally contain data for only 1 tax year ( 1 983).
A t the time of our audit report, the corporate system was not producing
any reports.
CONCLUSION
Audit selection systems w i t h i n the Department need to be improved.
Currently, major taxpayers are not being audited. In addition, many
audits performed are unproductive, indicating other selection system
weaknesses.
RECOMMENDATIONS
1. DOR should implement a cyclical audit selection program for large
sales and corporate income tax accounts to provide 100 percent audit
coverage of major taxpayer accounts within the current statute of
1 imitations.
2. DOR should make implementation of MASS a priority and devote
necessary data processing resources to correct program problems.
3. DOR should provide formal training to all new auditors and improve
in- service training of i t s audit staff.
4. DOR should ensure that the Audit Section has updated and accurate
audit activity and general account records for use in selecting audits.
5. DOR shoul d improve documentation of reasons audits are terminated.
6. DOR should develop and apply clear c r i t e r i a to use various sources of
information for audit selection.
FINDING I11
THE DEPARTMENT LACKS ADEQUATE CONTROLS TO ENSURE THE QUALITY AND INTEGRITY
OF AUDIT ASSESSMENTS, MODIFICATIONS AND AMENDMENTS
The Audit Section o f the Department o f Revenue ( DOR) does not have
adequate controls t o ensure qua1 i t y audit work and equitable treatment of
taxpayers. Technical review o f decisions on a u d i t assessments,
modifications and amendments i s weak, and controls are needed t o prevent
c o l l usion, bribery and other abuses. I n addition, supervisory review o f
audit working papers i s minimal and needs t o be improved.
Impact O f Audit Assessments,
Modifications And Amendments
DOR audits i n f i s c a l year 1983- 84 generated approximately $ 55.5 m i l l i o n i n
additional tax revenue assessments. Many o f these assessments involve
substantial sums o f money and can have a s i g n i f i c a n t f i n a n c i a l impact on
both i n d i v i d u a l and corporate taxpayers i n Arizona. Thus, it i s important
t o ensure t h a t audit assessments are accurately determined and f a i r t o
taxpayers.
I n addition, Arizona Revised Statutes allow each taxpayer who i s audited
the r i g h t t o protest the r e s u l t i n g tax l i a b i l i t y assessment.
Consequently, a s i g n i f i c a n t number o f assessments we reviewed were
modified or amended, usually decreased, based on the outcome o f protests.
Many of these modifications and amendments are made informally, a f t e r
contact o r p r i v a t e meetings with the taxpayer. I n the case of
modifications and amendments, assurances are needed t h a t loss o f revenue
i s minimized and t h a t taxpayers are t r e a t e d f a i r l y and equitably.
The reasons f o r changing o r i g i n a l a u d i t assessments are many and varied.
Some reasons f o r changes made t o corporate income tax assessments include
adjustments t o the apportionment f a c t o r , the Federal i ncome tax deduction,
and net operating loss carry- overs. For i n d i v i d u a l income tax
assessments, changes may resul t from additional information suppl ied by
the taxpayer or the taxpayer not being required to f i l e a return. Changes
i n sales and use tax assessments may result from allowances for exempt
purchases and sales, and from adjustments to taxable income and tax
collected. Changes i n assessments may also be necessary due to auditor
errors.
A study done by the DOR Audit Section showed that the dollar amount of
these modifications i s significant. The Corporate Income Tax U n i t
modified eight cases for a total of $ 487,650 during a recent 4- month
period. The Sales and Use Tax U n i t modified 44 cases for a total of
$ 394,711 during a 6- month period. The Individual Income Tax U n i t modified
59 cases for a total of $ 48,053 during a 1- month period.
Important Control s
Are Lackinq
The Department currently does not have adequate controls to ensure the
integrity of audit decisions. A1 though auditors exerci se considerabl e
responsibility and authority on behalf of the State, their decisions are
not adequately checked. Unlike several other states, DOR does not have an
independent qua1 i ty control u n i t . In addition, control s necessary to
reduce the risk of collusion, bribery and other abuses need to be
strengthened.
Checks On Audit Decisions - Review of decisions made by audit personnel i s
not adequate to ensure quality, consistency, and fairness to taxpayers. A
review of audit cases shows that technical review of decisions needs to be
strengthened and documentation i n case f i l e s needs to be improved.
Presently, control s over audit decisions made by supervisory personnel are
minimal , a1 though these decisions may i nvol ve hundreds of thousands of
dollars. Audit Section procedures call for review of audit work by the
auditors' immediate supervisor. The audit f i l e s may also be reviewed
again a t higher levels. For example, the chief auditor i n the Income Tax
Audit U n i t attempts to review all cases involving assessments of more than
$ 500,000. Cases including sizeable modifications to assessments may a1 so
be reviewed by the chief auditor i n the Sales Tax Unit. However, f i l e s
are r a r e l y reviewed above the chief auditor level by the audit
administrator, and the Department does not have an independent u n i t o f
auditors t o conduct qua1 i ty control reviews."
Because checks on audit decisions are 1 acki ng, technical or judgmental
errors can be made. For example, errors may be made i n applying statutes,
rules and Department policies. These errors may r e s u l t i n incorrect
assessments, inconsistencies among auditors and unfairness t o taxpayers.
Errors could lead t o taxpayers paying more or less money than l e g a l l y
required. I n addition, Department auditors who exerci se considerabl e
authority on behalf o f the State could make a r b i t r a r y or biased audit
judgments.
The following case examples i l l u s t r a t e the need f o r adequate controls t o
minimize these problems.
Case 1
A large in- State corporation was audited f o r corporate income tax f o r
f i s c a l years 1979, 1980 and 1981. This corporation has many
out- of- State operations. The t o t a l tax l i a b i l i t y as determined by the
audit was more than $ 4 m i l l i o n . However, the corporation protested
t h i s amount on the grounds t h a t it questioned DOR's position on i t s
f i l i n g status. The taxpayer had been given permission by a DOR
o f f i c i a l t o f i l e a consolidated rather than a separate return. The
taxpayer had suffered major f i n a n c i a l losses and wanted t o f i l e an
Arizona tax return r e f l e c t i n g those losses. The audit, however, had
been conducted on the basis t h a t the corporation should have f i l e d a
separate, not a consolidated return.** Four d i f f e r e n t negotiating
positions were determined by DOR. These ranged i n t o t a l l i a b i l i t y
from $ 3,081,243 down t o $ 1,571,065 f o r consol idated f i l ing.
Eventually, a f t e r a lengthy negotiating process t h a t ended a t the
d i r e c t o r ' s o f f i c e , t h i s assessment was lowered t o $ 550,000 - more than
$ 1 m i l l i o n less than the amount of DOR's lowest negotiating position.
The f i n a l settlement was based on a settlement o f f e r made by the
corporation.
' R I he audit administrator i s responsible f o r managing the e n t i r e a u d i t
function, i n c l uding pl anning, organizing and coordinating a1 1 work,
and developing DOR pol i c y on tax administration. Technical review o f
** Faui ldi nitg f iolne sa ssheopualrda tne obt absei sn emceeasnssa rtyh aatt etahcihs sleuvbeslid. iary i n a corporation
f i l e s a return r e f l e c t i n g only i t s income. A consolidated return
means t h a t a l l tax data from each subsidiary i s combined i n t o one
return. The r e s u l t i s one tax assessment for the coruoration as a
Comment
According t o the Department's Attorney General representative, the DOR
o f f i c i a l may have erred i n granting the company permission t o f i l e a
consol idated return." State law and Department pol i c y on fili ng
status are vague and allow considerable discretion i n deciding such
issues. Even i f the manager had erred, however, the Department was
not prevented from seeking the additional taxes, a1 though i t s case may
have been weakened.
This case i l l u s t r a t e s the need f o r review o f audit decisions. The
case was not subjected t o independent technical review, which would
have served as some check on c r i t i c a l discretionary decisions such as
the U n i t manager's decision t o allow a consolidated f i l i n g . Further,
a1 though meetings were he1 d between DOR and corporati on o f f i c i a1 s,
neither the meetings nor the reasons and j u s t i f i c a t i o n s supporting the
f i n a l settlement agreement are documented i n the case f i l e .
Department o f f i c i a l s stated t h a t judgmental errors and mi shandl i ng
l e f t the Department i n such a weak position t h a t it could not have
acted more aggressively.
Case 2
I n 1983, DOR audited three large p r i v a t e clubs f o r use tax. DOR
assumed t h a t these clubs d i d not s e l l food and l i q u o r as p a r t o f t h e i r
regular business operations. This would make them 1 iable f o r use tax
on these food and l i q u o r purchases, since these clubs usually
purchased t h i s food and l i q u o r a t wholesale prices without paying
sales tax.
Upon completion o f these audits, these three clubs had a combined tax
l i a b i l i t y o f more than $ 169,000. The clubs adamantly protested these
assessments. They had never been audited f o r use tax before, and they
questioned the l e g a l i t y of t h e i r use tax 1 i a b i l ity.
Attorneys f o r these clubs met with DOR o f f i c i a l s and argued t h a t they
were not l i a b l e f o r the tax. The outcome o f t h i s meeting was t h a t the
additional tax 1 i a b i l i t i e s f o r these c l ubs was decreased considerably
t o a 1 i t t l e less than $ 10,000.
Comment
The documentation f o r these sizable modifications was inadequate. The
combined modification was more than $ 160,000, and the only explanation
i n the f i l e s was a statement t h a t the modification had resulted from a
meeting between DOR o f f i c i a l s and the attorneys f o r the clubs. No
f u r t h e r d e t a i l s were given. A DOR o f f i c i a l o r a l l y said t h a t the law
was somewhat vague, thus a decision was made t o enforce it
prospectively. However, the f a c t t h a t a high level meeting resulted
i n a sizable modification with only minimal documentation i n the audit
f i l e again demonstrates the need f o r review o f audit decisions f o r
consistency, fairness and compliance with law.
* Th i s empl oyee resigned i n September 1 979.
To improve controls over audit decisions, DOR needs t o strengthen i t s
review of audit work, improve documentation i n case f i l e s supporting audit
decisions, and upgrade and improve t r a i n i n g o f personnel ( see Finding 11,
page 19). Better t r a i n i n g and communication of Department p o l i c i e s and
standards f o r conducting audits should improve both the q u a l i t y and
consi stency of audit decisions.
Quality Control Unit - Review of audit work could be strengthened by
imp1 ementing a central ized qual i ty control review unit. Several other
states have made effective use o f t h i s type o f unit, and consider it an
i n t e g r a l p a r t of t h e i r review process.
Washington, Indiana and Connecticut are among the states t h a t have a
separate audit review unit.* I n Washington, the u n i t i s composed of
highly qual i f i ed auditors with extensive experience and good performance
records. Positions i n t h i s u n i t are highly competitive, and are viewed by
the r e s t of the s t a f f as a stepping stone t o higher management positions.
I n Indiana, the u n i t i s made up o f f i e 1 d auditors c a l l e d i n t o t h e c e n t r a l
office f o r 3- month periods. This method gives the auditors exposure t o
reports other than t h e i r own, and allows them t o judge qual i t y by reading
both good and bad reports. F i n a l l y , the Connecticut Department o f Revenue
has a qual i ty control d i v i s i o n t h a t reviews a selected sample o f reports
quarterly. Any of these methods could be used by DOR t o provide the
independent technical review needed. Establ i s h i ng a u n i t o f three
auditors and support s t a f f would require an additional appropriation of
approximately $ 1 16,000.**
DOR d i d attempt centralized audit review i n 1982, however the e f f o r t was
unsuccessful due t o personal i ty c o n f l i c t s t h a t developed among the
reviewers. The reviewers i n t e r p r e t e d s t a t u t e s and the audit issues
differently, which made it d i f f i c u l t t o review the audits i n a timely
manner. The u n i t may have been further hampered by i t s placement i n the
* The review units i n Indiana and Connecticut are described i n a
t r a i n i n g manual of the National Association of Tax Administrators. ** This amount i s based on salaries and employee related expenditures f o r
two auditor I Is, an audit u n i t supervisor I I, and a t y p i s t I1 I.
0
Audit Services Section rather than t h e A u d i t Section. Eventually, such a
sizable back1 og of cases developed t h a t the u n i t had t o be disbanded.
Control s Over Abuses - Additional controls are a1 so needed t o minimize the
potential f o r collusion, bribery and other abuses. Other states and the
IRS have implemented procedures t o reduce the r i s k o f such abuses.
Control s are needed because audit personnel can potential ly abuse t h e i r
responsi b i 1 i ty and authority i n several ways. For exampl e, auditors might
compromi se thei r work by knowingly i ssui ng an i n c o r r e c t a u d i t assessment,
which may require a taxpayer t o pay more or less than i s l e g a l l y
required. I n the f i r s t case, the auditor may bear a personal grudge or
d i s l i k e f o r the taxpayer, i n the l a t t e r t h e a u d i t o r may have been
improperly influenced by the taxpayer through some type o f monetary or
other offer. I n addition, audit personnel may decide t o collude i n e i t h e r
s o l i c i t i n g o r accepting a bribe from a taxpayer. Because audit decisions
can involve hundreds o f thousands o f do1 lars, the r i s k and opportunity f o r
such abuses i s real.
I n fact, specific instances o f abuse were recently uncovered by the
Department following a taxpayer complaint. I n June 1983 two members of
the Audit Section ( a chief income t a x a u d i t o r and an audit supervisor)
were dismissed from State service f o r several v i o l a t i o n s of State
Personnel Board rules and the Arizona Revised Statutes. The dismissal s
were appealed t o the State Personnel Board and hearings were held.
According t o the Personnel Board Hearing O f f i c e r ' s Findings o f Fact, the
chief income tax auditor was aware of a possible bribery attempt, but did
not report it t o h i s supervisors. I n 1981, an employee i n the Estate Tax
U n i t found a $ 300 check t h a t a company had made out t o her supervisor f o r
" D i r e c t o r ' s Fees." The employee was concerned because the company, which
speci a1 ized i n f i n d i n g hei r s t o uncl aimed property, had submitted more
than $ 200,000 i n claims t o DOR over a short period of time. She brought
the matter t o the attention of the c h i e f income t a x a u d i t o r and an audit
supervisor. With the chief auditor's agreement, the audit supervisor
conducted a withholding audit of the company and found the stub f o r the
$ 300 check. However, the chief income t a x a u d i t o r did not report h i s
knowledge of the check o r anything else regarding the matter t o h i s
superiors.
After reviewing the facts surrounding t h i s incident, the hearing o f f i c e r
concluded:
"( The chief income tax auditor's) actions i n
authorizing a withholding audit o f a company receiving
money from the State from claims f i l e d by it with the
Estate Tax section where a1 1 egations o f possible
bribery had been made against such company upon the
discovery o f a $ 300.00 check made out ( t o ) the section
manager constitutes abuse o f the audit function o f the
Department and as such, constitutes incompetence,
neglect of duty and improper a t t i t u d e .
. . . ( His) actions i n not informing h i s supervisors
about the $ 300.00 check a f t e r hearing about the check
from ( an employee) and after ( t h e a u d i t supervisor)
reported t h a t the check stub was found i n a withholding
audit constitutes incompetence, inefficiency, neglect
o f duty and improper attitude."
I n the case of the audit supervisor, the hearing o f f i c e r found t h a t the
supervisor had directed an a r b i t r a r y assessment o f a taxpayer. The s t a f f
auditor, hand picked by the supervisor t o do the audit because he
considered her " aggressive" and " n i t- picky," complained t h a t she 1 acked
sufficient information t o make a proper assessment. The supervi sor
advised using an estimated mean average method t o c a l c u l a t e t h e
assessment. The taxpayer protested the assessment and appealed. A f t e r
the taxpayer complained t o the Governor's Office and a f t e r an
i n v e s t i g a t i o n by the Attorney General ' s Office, the assessment was
adjusted and the appeal hearing canceled. A f t e r reviewing the f a c t s
surrounding the matter, the hearing o f f i c e r concluded:
" ( The supervi sor) made fundamental errors i n judgment,
thereby neglecting h i s duties, causing distress t o a
taxpayer u n j u s t i f i a b l y and demonstrated an improper
a t t i t u d e toward the audit powers o f the State . . . I n
d i r e c t i n g an a r b i t r a r y assessment of the taxpayer ( the
psuug e l ircvi saourd) i tovrsio, lattheadt ifusn, dafmaiernnteasl s raens B o inmspi bairlt iita ilei tsy ot of
a l l members o f the public. The power o f the State t o
harass and demean persons through the audit power i s
awesome; it i s only the i n t e g r i t y o f the audit process
t h a t prevents massive disobedience o f the tax laws. By
v i o l a t i ng , t h i s precept ( the supervi sor) jeopardized the
State from c o l l e c t i n g taxes from a l l o f the c i t i z e n s o f
t h i s State."
After reviewing the facts surrounding these incidents and several other
serious matters involving the c h i e f income tax auditor and t h e a u d i t
supervisor, the hearing o f f i c e r recommended t h a t t h e i r appeal s be denied
and t h e i r dismissals be upheld. Both employees have appealed the
Personnel Board decision t o Superior Court.
These examples p o i n t out circumstances t h a t can resul t from 1 ack o f proper
control over the audit function. I n our opinion, DOR s t i l l does not have
adequate means o f preventing future abuses o f t h i s type.
Implementation o f a centralized q u a l i t y control u n i t would help reduce the
potential f o r abuse. Audits involving substantial amounts o f money, and
other audits on a sample basis, could be reviewed by an independent group
of auditors not involved i n the audit. The review u n i t could determine
whether audits were conducted properly and whether audit decisions were
j u s t i f i e d and supported by adequate evidence. Any problems or abuses
could be reported d i r e c t l y t o the audit administrator or the assistant
director f o r taxation.
I n addition, some states and the U. S. Internal Revenue Service ( IRS) have
imp1 emented other control s. For example, the Indiana Department of
Revenue has a long- standing pol i c y o f r o t a t i n g auditors. An auditor may
n o t a u d i t the same taxpayer consecutively. The Connecticut Department of
Revenue and the IRS have s i m i l a r pol i c i e s . Rotating auditors minimizes
the r i s k o f collusion and abuse. The IRS has also adopted a reporting
policy on bribery. This policy requires auditors t o be a l e r t t o and
report a l l instances, subtle or otherwise, t h a t may represent an attempt
t o bribe an IRS o f f i c i a l . Currently, DOR does not rotate auditors nor
does it have a r e p o r t i n g p o l i c y on bribery.
Quality O f Audit Review
Needs To Be Improved
The q u a l i t y of DOR's review of s t a f f working papers i s also not adequate.
A review o f audit f i l e s showed minimal and inconsistent supervisory
review. As a r e s u l t , a u d i t o r errors t h a t necessitate subsequent
modification and amendments can occur. Unlike some other states, DOR
lacks good audit review procedures and techniques.
Our review o f audit f i l e s indicated t h a t the q u a l i t y of working paper
review i s poor. I n addition t o other f i l e s reviewed during the course o f
t h i s audit, we judgmental ly sampled ten recent sales tax audit f i l e s and
eight corporate income tax f i l e s , focusing p r i m a r i l y on those with
modifications or amendments t o the i n i t i a l audit assessment. The f i l e s
contained minimal and inconsistent evidence o f review. I n most cases,
there was no evidence, such as i n i t i a l s or sign- offs, i n d i c a t i n g
supervisory review o f backup working papers. Many o f those working papers
were sloppy, had no headings or sources of information l i s t e d , and had not
been signed or dated by the auditor. V i r t u a l l y none o f the f i l e s
contained supervisory comments on the q u a l i t y o f working papers or the
audit work, nor any' other evidence such as point sheets o f meaningful,
substantive review.
Some review was evident, although i t s depth and scope was unclear. A few
corporate income tax audit f i l e s we reviewed contained backup working
papers i n i t i a l e d by supervisors. I n addition, most f i l e s contained
evidence t h a t math calculations had been checked, although it was not
always clear what specific calculations had been v e r i f i e d . Most f i l e s
also contained assessment summary sheets or lead schedules with a
supervisor' s signature. It could not be determined from these s i gn- offs,
however, whether any backup working papers were reviewed.
Errors Not Discovered - Because audit review i s lax, auditor errors can go
undiscovered and necessitate subsequent modifications or amendments t o the
o r i g i n a l a u d i t assessment. An i n t e r n a l study by DOR audit management
found t h a t some modifications were required due t o auditor errors. O f the
eight corporate audit cases reviewed, three i nvol ved auditor e r r o r s t h a t
necessitated amendments t o t a l i ng almost $ 35,000.
We also found a u d i t o r e r r o r s i n a separate review o f sales and use tax
cases involving modifications of more than $ 25,000. O f the 34 cases
examined, eight had amended assessments as the r e s u l t o f auditor error.
The effects of these errors may have been minimized had they been
d i scovered during review.
Review i s also needed t o ensure t h a t documentation meets miminum
standards. If the Department were challenged i n court, evidence i n the
case f i l e s would need t o be adequate t o support Department actions.
DOR Lacks Review Standards - The Department does not have specific working
paper standards, or guidelines or p o l i c i e s governing supervisory review.
Because DOR w i l l be conducting more sales t a x a u d i t s j o i n t l y and i n
coordination with municipalities, it pl ans t o develop such standards and
procedures i n the future. I n addition, establishment o f an independent
review u n i t would help improve the q u a l i t y of audit review. Any
inconsistencies, patterns of e r r o r or other problems could be reported to
supervisory personnel f o r corrective action.
Indiana and Connecticut have s t r i c t and e f f e c t i v e standards f o r working
paper technique, documentation, and audit review. The Indiana Department
of Revenue requires t h a t a l l audit reports be checked f o r neatness,
composition, substantiation and documentation, l o g i c a l arrangement, and
accounting t r a i l . Also, the review u n i t t h a t checks for compliance with
these standards provides a monthly record of reporting errors so
management can determine what s k i l l s the auditing s t a f f i s weak in, and
what additional t r a i n i n g they may need.
Ttie Connecticut Department o f Revenue has a standards handbook t h a t i s
used by audit examiners and audit supervisors throughout the audit
process. The handbook contains procedures and techniques f o r working
paper format and referencing, f o r summarizing reports, and f o r arranging
the audit package. Compliance with these standards r e s u l t s i n a uniform
audit presentation.
CONCLUSION
The Department o f Revenue needs t o improve controls over the a u d i t
function. Audit decisions need t o be checked f o r q u a l i t y and consistency,
and controls are needed t o minimize the r i s k o f abuses. Supervisory
review of audit working papers also needs t o be strengthened.
RECOMMENDATIONS
1. The Legislature should consider funding an audit review unit. The
Department should establish the audit review u n i t as an independent
u n i t w i t h i n the Taxation Division. The u n i t should be staffed wth a
minimum of three auditors and should report d i r e c t l y t o the audit
administrator or t h e a s s i s t a n t director f o r taxation.
2. Reasons supporting modifications and amendments made t o a u d i t
assessments should be documented i n case f i l e s .
3. DOR should consider adopting a policy on r o t a t i o n o f auditors and on
reporting of bribery.
4. The Department of Revenue should develop w r i t t e n standards and
p o l i c i e s governing audit workpaper techniques and audit review.
5. Audit review should be conducted consistently and i n accordance with
standards and p o l i c i e s developed by the Department.
FINDING I V
PROTESTED ASSESSMENTS ARE NOT PROCESSED EFFICIENTLY; CONSEQUENTLY, THE
POTENTIAL FOR LOSS OF REVENUE EXISTS
The Department of Revenue ( DOR) does not process protested assessments
e f f i c i e n t l y ; as a r e s u l t t h e p o t e n t i a l f o r loss o f revenue exists.
Procedures f o r handling protests are cumbersome and lack adequate
controls. I n addition, the Hearing Office has a backlog o f cases
awaiting decisions, and a large and increasing work load.
The Protest Process
DOR conducted more than 25,000 audits i n f i s c a l year 1983- 84, generating
approximately $ 55.5 m i l 1 i o n i n additional tax assessments. Under Arizona
law, taxpayers who are assessed additional taxes may p e t i t i o n f o r a
hearing, correction or redetermination. During the 2- year period t h a t
ended June 30, 1984, an indeterminable number o f appeals resulted i n 31 2
hearings.
The processing of protests involves three separate sections of the
Department. These are the Audit Section, t h e A u d i t Services Section
w i t h i n the Taxation Division, and the Hearing Office. The Audit Section
conducts audits, determines assessments, and pursues i nformal resolution
of protests. The Audit Services Section i s responsible f o r typing and
mailing the assessments and monitoring the status o f assessments and
related protests. The Hearing Office i s responsible f o r r e g i s t e r i n g a1 1
protests, ensuring t h a t action i s taken on protests w i t h i n reasonable
time 1 imits, and schedul ing and conducting formal hearings.
Taxpayers have 30 days t o protest f o r sales tax audits with the option t o
request an extension. Taxpayers have 90 days t o protest f o r income tax
audits with no extensions allowed. Taxpayers are not b i l l e d u n t i l
protests are resolved. The Audit Section attempts t o resolve protests
informally, thus saving the time and expense of a formal hearing. If
informal r e s u l t s are unsatisfactory , however, a formal hearing may be
held a t the taxpayers' request. Taxpayers may f u r t h e r appeal t o the
d i r e c t o r o f the Department o f Revenue and subsequently t o the Board o f
Tax Appeals and the courts.
Procedures Are Cumbersome And
Lack Adequate Control s
Procedures f o r handling p r o t e s t s are cumbersome and lack adequate
control s. The protest system re1 ies on excessive manual processing of
documents, which r e s u l t s i n errors and mishandling o f cases. I n
addition, 1 ack o f management information p r o h i b i t s the Department from
i d e n t i f y i n g and control 1 ing problems. Implementation o f an automated
system would stream1 i ne processing and improve control s.
Reliance on Manual Processing - The current system r e l i e s extensively on
manual operati on. Our analysis of the process revealed excessive
transferring o f documents among sections and i n e f f i c i e n t dupl i c a t i o n o f
e f f o r t .
m Fifty- nine documents ( 24 o r i g i n a l s and 35 copies) involving 14
personnel are used i n the sales tax assessment and formal protest
process. Each audit f i l e i s handled by a t l e a s t eight d i f f e r e n t
people and transferred a t l e a s t 16 times between employees and
eight times between sections.
e Five separate index card f i l e s are maintained on income and sales
tax assessments and protests.* Four o f these index f i l e s are
maintained by three d i f f e r e n t empl oyees w i t h i n t h e A u d i t Services a
Section and one f i l e i s maintained by the Hearing Office. Each
index card f i l e contains s i m i l a r information regarding protested
audits.
* During our audit, questions raised by Auditor General s t a f f regarding
the necessity of one o f the card f i l e s resulted i n the card f i l e
being eliminated - therefore, there are now a t o t a l of f i v e index
card f i l e s .
0 Both the Hearing Office and Audit Services monitor the status o f
protested audit assessments, and i n several cases t h e i r records do
not agree on the status of a protest. Several instances were
noted i n which the Hearing Office had a protest registered y e t
Audit Services d i d not.
@ Eight l o g s are maintained f o r the assessment and protest process
indicating where audit f i l e s are and when they should be
returned. However, t h i s information i s a1 so recorded on several
of the index cards.
The Sales Tax Audit Section, i n an e f f o r t t o keep control over
those audit f i l e s logged out t o the Section, had i n s t i t u t e d i t s
own l o g book. However, personnel involved with hand1 ing the audit
f i l e s were not aware o f t h i s control procedure and consequently,
it was bypassed i n many instances. I n fact, the supervisor o f the
employee keeping the l o g was not even aware t h a t the employee was
keeping the 1 og, and the employee d i d not know where the idea t o
keep the log had originated.
DOR could reduce the number o f documents involved i n the protest
process. While documenting t h e p r o t e s t process we i d e n t i f i e d some areas
i n which e f f i c i e n c i e s could be realized. An analysis could be undertaken
t o determine other areas i n which e f f i c i e n c i e s are possible. This could
a1 so allow e i t h e r a reduction i n s t a f f o r assignment o f s t a f f t o other
functions.
Excessive manual processing and dupl i c a t i on o f e f f o r t increases the ri sk
of errors and mi shandl i ng. Furthermore, we observed several probl ems i n
the processing of protested assessments. I n addition, the potential f o r
loss of revenue exists, as evidenced by the following examples.
0 Some audit f i l e s were missing or could not be located. I n several
instances audit f i l e s were requested and could not be located. I n
one case 45 income audit f i l e s were requested from Audit Services,
and only 9 were found. Because an audit f i l e i s the only record
of how an assessment was determined and what taxes are owed, it i s
c r u c i a l t o adequately safeguard against it being l o s t or
misplaced. ,. In addition, the audit f i l e s and t h e i r contents are
confidential , and i f they are misplaced the ri sk o f someone other
than authorized personnel having access t o the f i 1 es i s i ncreased.
For instance, a taxpayer protested an income assessment of
$ 52,288.72 i n August 1982. A subsequent hearing was held and the
taxpayer and auditor were given time t o attempt resolution
informally. At the time of our audit, the Hearing Office
indicated t h a t the case was s t i l l open, therefore we attempted t o
f i n d the audit f i l e t o determine the status o f the case. However,
as of November 29, 1984, the audit f i l e could not be found and the
$ 52,288.72 assessment remained i n 1 imbo.*
e Auditors make amendments t o protested assessments without
n o t i f y i n g Audit Services and the Hearing Office o f the protest.
Auditors did not always n o t i f y the Hearing Office when they
received protests. It was discovered t h a t auditors were receiving
protests and amending assessments without n o t i f y i n g the Hearing
Office or Audit Services of the protests. Consequently, a
taxpayer i n protest could be b i l l e d i n error. I n fact, 396 income
a u d i t cases t h a t had been protested were put on b i l l i n g . This
e r r o r may cause f r u s t r a t i o n on the part o f the taxpayers and
possibly damage t h e reputation and i n t e g r i t y o f the Department
among those involved.
e F a i l u r e t o schedule hearings i n a timely manner. Some cases have
been l o s t i n the system, and hearings have never been scheduled.
The following cases i l l u s t r a t e a potential loss of revenue as a
r e s u l t of the apparent lack o f a timely hearing.
* Hearing Office records l i s t the amount owed a t more than $ 52,000,
however, the Audit Services Unit indicates the protested amount i s
$ 24,327.00.
40
Case 1
A taxpayer protested tax assessments of $ 53,726.84 i n March 1982.
An informal. hearing was requested for July 1982. There is no
documentation i n the f i l e that a hearing, formal or informal, was
he1 d. As of November 1984, 2 1/ 2 years later, a formal hearing
had n o t been held on this case.
Case 2
A taxpayer protested and a hearing was held i n December 1980. The
audit was subsequently amended. The taxpayer protested the
amended assessment of $ 37,315.73 i n September 1981. As of
November 1984, no subsequent hearing had been he1 d on this case.
Some of these problems occurred because DOR lacks adequate written
procedures to guide staff involved i n processing protested assessments.
In other instances, however, Department procedures were not followed.
DOR's inefficient process results i n audit f i l e s being lost or misplaced,
dupl ication of efforts, potential frustration w i t h the Department by the
taxpayers, and potential loss of revenue as the result of delayed
heari ngs.
Inadequate Management In formati on System - DOR' s abi 1 i ty to monitor and
control the protest and appeals process i s inhibited by a lack of
meaningful and periodic management reports. Thi s deficiency has not been
corrected since f i r s t identified in our 1981 audit report. As a result,
DOR management is unsure of and cannot readily verify:
1. The identity of each outstanding audit ,*
2. The age of each outstanding audit,
3. The causes for 1 ong- outstandi ng cases,
4. Whether assessments were amended before hearing,
5. How many assessments were corrected for mathematical or technical
errors,
6. The time required to process assessments through current
procedures, and
7. What stage of the protest process an account i s in.
* An outstanding audit i s one that has been assessed b u t not paid i n
full.
i3)
An effective monitoring system would enable the Department to identify
and resolve processing errors i n a more timely manner. The lack of this
information currently impacts the efficiency and effectiveness of the
system.
The Department of Revenue has been planning to implement an automated
system to monitor assessments and protests through the process since a t
least March 1983. A t the time of our audit the system was not yet
operational, A combination of factors contributed to the delay in
getting the system operational. First, DOR originally planned to use i t s
Data Processing Section to develop a protest tracking system on the
Department's main frame computer. However, this was later determined not
to be feasible due to Data Processing's turnaround time for requests for
service. Second, plans were made to develop the protest tracking system
on a word processor. This was determined to be impractical. Third, the
acquisition of a personal computer prompted the decision to develop the
system on this personal computer. However, other projects took priority
over the protest tracking system.
The protest tracking system i s projected to be fully operational by May
1 , 1985. When operational , this automated system should provide DOR with
the necessary management reports needed to evaluate the assessment and
protest process, providing the data i n p u t is accurate. A t the time of
our audit, i t was impossible t o determine what effect this automation
will ultimately have on improving the process. The Department has
planned some changes to the protest tracking system, however, they have
not yet been implemented. Furthermore, the Department has 21 other areas
prioritized for automation that will also impact on the efficiencies of
the system.
Hearing Office Has Backlog
Of Undecided Cases
The Hearing Office of the Department of Revenue has a backlog of cases
that are not being efficiently processed and resolved. In some
instances, the Hearing Office has not rendered timely decisions. In
addition, informal resolution o f protested cases has not been pursued i n
a timely manner by the Audit Section.
The Hearing Office has one hearing o f f i c e r and two c l e r i c a l s t a f f . The
O f f ice i s responsible f o r r e g i s t e r i n g and monitoring a1 1 protests re1 ated
t o audit assessments. If a taxpayer wants a formal hearing t o protest an
assessment the Office sets the hearing date, n o t i f i e s a l l involved
parties, conducts the hearing, and renders a decision.
I n the future, the Hearing Office may need additional s t a f f t o handle i t s
growing work load. The number o f hearings being scheduled has increased,
and as of November 20, 1984, the Hearing Office calendar was booked i n t o
March with two hearings scheduled each day. A September 1984 i n t e r n a l
report on the Hearing Office performed by Management Services determined
t h a t the Hearing O f f i c e ' s work load has increased an estimated 22 percent
within the l a s t year. This report also i d e n t i f i e d a trend showing an
average increase o f 19 percent each year from 1981 through m i d- July 1984.*
Timely Decisions Not Rendered - The Hearing Office has a backlog o f cases
awaiting decisions. As of October 25, 1984, the o f f i c e had 63 pending
cases for which hearings had been held but decisions had not y e t been
rendered. The d o l l a r amount associated with these 63 pending cases i s
approximately $ 6.7 m i l l ion. 45 o f those cases pending are the backlog of
a hearing o f f i c e r who was recently suspended and subsequently f i r e d . I n
19 of those 45 cases, more than a year has passed since the hearing was
held, although hearing o f f i c e r s are expected t o resolve cases w i t h i n 60
t o 90 days of a hearing.** Table 6 categorizes the cases by time between
the date o f the hearing and the date the protest was received.
* The report recommended a f u l l - t i m e permanent p o s i t i o n be created t o
a s s i s t w i t h secretarial duties. As of December 4, 1984, t h i s
position was created and f i l l e d with a temporary employee who had
been with the Hearing Office f o r a year. ** This i s a standard on employees' Performance, Planning and Evaluation
Reports.
TABLE 6
Months Since
Protest Received
HEARING OFFICE CASES PENDING
BY DATE OF HEARING AND DATE OF PROTEST
Pending
Cases
Tax Months Since
Assessment Date o f Hearing
16- 18
19- 21
22- 24
25- 30
31 - 48
49- 73
No hearing
dates set ( 3)
Pending Tax
Cases Assessment
Average 16.44 months Average 9.3 months ( 4) ( I
( 1 ) Tax assessment based on three cases
( 2) Tax assessment based on 15 cases
( 3) Protest dates - 9- 81, 9- 83, 4- 84
( 4) Based on 60 pending cases
The following cases i l l u s t r a t e delays i n the decision rendering process.
Case 1
A hearing was held August 30, 1978, on a taxpayer assessed $ 195,566.
The taxpayer had f a i l e d t o f i l e t a x r e t u r n s f o r the years 1973
through 1978. The hearing o f f i c e r gave the taxpayer 90 days t o f i l e
these tax returns. However, no returns were subsequently f i l e d .
Comments
It appears t h a t a decision should have been rendered based on the
information available a f t e r the extended 90 days t o f i l e returns had
passed. Instead, 3 years passed with no action whatsoever taken on
the case and as o f the time o f our audit, 6 years l a t e r , no decision
had been rendered.
Case 2
A hearing was held on June 7, 1983, a f t e r the taxpayer had requested
several extensions. The amount protested i s $ 1 0,166. The taxpayer
did not attend the hearing and the hearing o f f i c e r documented i n the
case f i l e t h a t the taxpayer would be allowed 2 weeks t o explain why
he d i d not appear a t the hearing.
More than a year passed with no action taken. On June 26, 1984, the
hearing o f f i c e r received a memo from an audit supervisor requesting a
decision i n favor o f the Department since the taxpayer f o r f e i t e d h i s
p o s i t i o n by not appearing a t the hearing. On June 27, 1984, the
hearing o f f i c e r sent the taxpayer a l e t t e r giving the taxpayer 30
days t o respond. The l e t t e r stated t h a t i f no response was received
a decision would be rendered based on the information avail able.
Comments
This case has l i n g e r e d f o r more than a year past the date o f the
hearing f o r no i d e n t i f i a b l e reason. As o f October 31, 1984, the
taxpayer had not responded and no decision had been rendered. I n
addition, administrative hearing o f f i c e s i n other State agencies do
not contact i n d i v i d u a l s who do not appear a t hearings.
Case 3
A taxpayer's protest was received on June 22, 1983, apparently 1 day
past t h e allowed 30- day protest period. The amount i n protest i s
$ 1 74,042. The taxpayer submitted memorandum on September 16, 1983,
and the hearing was held September 27, 1983. The hearing o f f i c e r
requested t h a t the taxpayer's attorney f i n d out if the Attorney
General's Office wanted t o submit a response memorandum t o the
taxpayer's memorandum. On October 10, 1983, the hearing o f f i c e r was
informed t h a t the Attorney General's Office did n o t intend t o
f i l e a memorandum and t h a t the matter was ready f o r the hearing
o f f i c e r t o take under advisement.
Comment
From the documentation i n the f i l e s it appears t h a t t h i s was not a
v a l i d protest because it was not submitted w i t h i n t h e s p e c i f i e d
30- day period. However, a hearing was held. No documentation has
been added t o the f i l e since October 10, 1983, and no decision has
been rendered.
A l l o f these cases were assigned t o the same hearing o f f i c e r . The
hearing o f f i c e r a t t r i b u t e s delays t o the complexity o f the cases. Some
cases require more research and consequently, more time i s needed t o
render a decision. However, there i s no evidence i n the f i l e s t o support
why no action has been taken on some cases for years. I n fact, there i s
no documentation i n the f i l e s indicating t h a t any subsequent research has
been undertaken on these cases.
An adequate system t o ensure follow- up on cases awaiting decisions has
not been developed. Taxpayers may be given additional time t o submit
supporting documents or post hearing memoranda, however, procedures have
not been developed t o ensure t h a t action i s taken w i t h i n the extended
time.*
Due Process May Be Affected - Taxpayers may be deprived o f due process by
unnecessary delays i n the appeals procedures, and thus the whole
proceeding may be void. An August 15, 1980,** Legislative Council
Memorandum states:
* Since January 1984 the Hearing Office has been assigned the added
r e s p o n s i b i l i t y o f monitoring a l l protests i n an e f f o r t t o ensure t h a t
t i m e l y a c t i o n i s taken. As a r e s u l t , i t s paperwork has increased
tremendously. However, the Hearing Office has no d i r e c t authority or
control over the process unless a formal hearing i s requested or
conducted. ** According t o Legislative Council, t h i s opinion i s s t i l l v a l i d as of
November 1984.
". . . a requirement for reasonable promptness i n
resolving the appeal may be imp1 ied from the nature of
the appeal and hearing before the department. . . . To
inhibit or delay these further hearings i s a denial 3
due process of law under the United states
Constitution. Due process requires botn a prompt
hearing and a prompt conclusion. . . . There i s l i t t l e
conceivable state interest i n delaying the decision on
an appeal of sales or use taxes. On the contrary, i t
would be in the interest of both the state and the
taxpayer to provide for a timely and reasonably prompt
resolution of the matter i n order to either collect the
tax or move the action on to the next forum. Moreover. ~ - ~ ~ - ~ if due process i s not afforded by the hearing and
appeal , the who1 e proceeding may be void. " ( emphasis
added)
Consequently, a taxpayer could chall enge a Hearing Office decision i n
court. In addition, the age of cases hinders the collection of revenue
owed. Subsequently, cases pending for extended periods of time are
difficult to collect once decisions have been rendered.
Efforts To Resolve Protests A t Informal Levels Are Not Timely - Efforts
to resolve protests through informal methods are not pursued in a timely
manner. Many cases are resolved informally on the day of the scheduled
hearing, thus wasting Hearing Office time and resources.
Protests may be resolved a t an informal 1 eve1 eliminating the need for a
formal hearing. In fact, auditors are encouraged by the Hearing Office
to contact taxpayers to attempt informal resolution ( even i f a formal
hearing is requested).
The director of the Department of Revenue supports and encourages
informal resolution of protests, as evidenced by a 1981 memo.
" When a taxpayer f i l e s a protest, i t should be reviewed
by members of the Taxation Division and if they feel
the taxpayer i s correct, they should take care of
resolving the matter themselves. If i t appears the
taxpayer might be correct, additional information
should be obtained from the taxpayer prior to the
hearing to determine whether or not the hearing might
be unnecessary."
Many cases are not resolved informally, however, until the day of the
scheduled hearing. In an 11- month period from January 1984 through
November 1984, 30 cases scheduled for hearing were resol ved informal ly ,
or the taxpayer and auditor attempted to resolve the case informally
immediately before the hearing. For example, a taxpayer protested an
assessment of $ 13,436 on July 9, 1984, and requested a formal hearing. A
hearing was set for September 19, 1984. However, the hearing was never
held. The taxpayer brought in documents supporting his position and the
assessment was amended informally. The protest was closed on September
19, 1984, the same day as the scheduled hearing.*
Schedul ing a formal hearing involves considerable time and effort, as
we1 1 as various personnel. Subsequently, i f a hearing i s canceled
immediately before it is to begin, efforts involving the scheduling of
the hearing become nonproductive and increase the work load
unnecessarily. This problem occurs because DOR does not adequately
monitor and control actions on cases i n the protest process.
CONCLUSIONS
Protested assessments are not being resolved efficiently and
consequently, potential revenue may be lost. Protest procedures are
cumbersome and control s are i nadequate. Thus, errors and i neff iciencies
occur i n the handling of cases. In addition, the Hearing Office has a
backlog of undecided cases and an increasing work load.
RECOMMENDATIONS
The Department of Revenue should:
1. Conduct a work simplification and methods improvement study of the
protest process.
* As of October 12, 1984, the Hearing Office had not been notified of
the action taken by the A u d i t Section and consequently, s t i l l
indicated the protest as open.
2. Continue to develop and implement the automated tracking system.
3. Devel op and imp1 ement written procedures regarding:
a. taxpayer no shows for hearings,
b. appropriate and timely follow- up on hearings held,
c. notification to the Hearing Office of attempted informal
resol uti on, and
d. specific and consi stent dead1 i nes for submitting post hearing
memoranda.
Procedures developed should ensure consistent hand1 i ng of protests,
equi tab1 e treatment of taxpayers and timely resol u t i on of pending cases.
AREAS FOR FURTHER AUDIT WORK
During the course o f our audit, we i d e n t i f i e d potential areas f o r f u r t h e r
audit work t h a t we could not pursue due t o time constraints. These areas
include the following.
o Should the Tucson Office continue t o function as an autonomous
d i v i s i o n w i t h i n the Department?
The Department o f Revenue's Tucson Office i s an organizational ly
autonomous d i v i s i o n w i t h i n the Department. The Tucson Office Audit
U n i t reports t o the Tucson Office d i r e c t o r rather than t o the
assistant d i r e c t o r f o r taxation i n t h e c e n t r a l Phoenix Office.
Although the Tucson Office follows standard DOR p o l i c i e s and
procedures, the Taxation Division has no l i n e control over the
a c t i v i t i e s o f the Tucson a u d i t u n i t . Further work i s a1 so needed t o
determine whether t h i s organizational structure promotes the most
e f f i c i e n t and e f f e c t i v e Statewide admini s t r a t i o n of DOR's tax audit
program.
e Does the De~ artment ade~ uatelv serve the needs o f local . j u r i s d i c t i o n s
and coordinate i t s sales t a x a u d i t program e f f e c t i v e l y w i t h
municipal i ties?
The Department currently c o l l e c t s sales taxes f o r over 60 l o c a l
j u r i s d i c t i o n s i n Arizona, and cooperates with the 11 l a r g e r
m u n i c i p a l i t i e s t h a t c o l l e c t t h e i r own sales taxes. DOR's e f f o r t t o
service the needs o f the local j u r i s d i c t i o n s may not be adequate since
only two employees are assigned t o t h i s function. I n addition, DOR
may be able t o coordinate i t s e f f o r t s more e f f e c t i v e l y with the
municipal i t i e s t h a t col l e c t t h e i r own sal es taxes. Current
coordination i s p r i m a r i l y l i m i t e d t o sharing of information t h a t could
be used more e f f e c t i v e l y . A special State Commission i s studying ways
t o better manage and administer sales tax c o l l e c t i o n Statewide, and
the feasi b i l i ty of imp1 ementing a central ized, State- operated
program. Depending upon the outcome o f the Commission's study,
f u r t h e r work i s needed t o determine whether DOR needs t o commit more
resources t o i t s local Sales Tax Audit Unit.
e Should Arizona's contracting law be changed?
Arizona i s the only state t h a t does not c o l l e c t sales tax from
contractors a t t h e i r point o f purchase. Instead, contractors pay
sales tax when construction i s complete or a sale i s made. For
example, when b u i l d i n g a house contractors do not pay sales tax on the
purchase of 1 umber and other building materials. Rather, sales tax i s
paid when the house i s sold. According t o DOR personnel, out- of- State
contractors may not be aware o f Arizona's law and consequently DOR
conducts sales tax audits o f many contractors. This law may not be
providing the State with any additional revenue and furthermore, i s
hard t o enforce. Further work i s needed t o v e r i f y the extent o f t h i s
problem and determine whether any statutory changes are needed.
e Are auditors i d e n t i f y i n g those accounts with potential f o r criminal
prosecution?
The Compliance Section o f DOR has received no r e f e r r a l s from sales tax
auditors since August 1983. Fai 1 ure t o recognize and pursue potenti a1
noncompliance may cause a loss o f revenue and provides l i t t l e
incentive f o r taxpayers t o comply with sales tax laws. Further audit
work i s needed t o determine whether accounts with potential f o r
criminal prosecution are being adequately i d e n t i f i e d and pursued.
e Should the 90- day protest period f o r corporate income tax audit
assessments be shortened?
DOR deemphasizes corporate income tax audits, as opposed t o sales tax
audits, because the longer 90- day income t a x p r o t e s t period ( vs. the
30- day period for sales tax) causes collection delays for both cases
that are protested and those that are not. Further audit work i s
necessary to determine i f the 90- day income tax protest period i s too
lengthy.
Are out- of- State corporations taking advantage of the Federal income
tax deduction and improperly 1 oweri ng their Arizona tax 1 i abil i ty?
Current statute a1 1 ows both individual and corporate income- tax payers
to deduct their Federal income tax paid from their State tax
l i a b i l i t y . According to a DOR o f f i c i a l , Arizona i s one of only five
states that s t i l l allows t h i s deduction. Out- of- State corporations
may take advantage of t h i s deduction and i n f l a t e t h e i r Federal tax
paid to lower their State tax 1 iabil ity. DOR i s not able to audit
many of these out- of- State taxpayers to make sure they are properly
using t h i s deduction. Further work i s needed to determine whether
t h i s deduction is being abused and i f i t should be continued.
/ ARIZONA
DEPARTMENT OF
RWEMUE %
J. Elliott Hibbs Bruce Babb~ tt
Dlrector Governor
April 19, 1985
Mr. Douglas R. Norton, Auditor General
Auditor General's Office
111 W. Monroe, Suite 600
Phoenix, AZ 85003
HAND DELIVER
Dear Mr. Norton:
The Department of Revenue has completed its review of the draft report on the
performance audit of the Taxation Division. I believe the following points
put into perspective our performance over this audit period and are relative
in this evaluation:
o We initiated aggressive audit enforcement programs thereby increasing the
fairness of our tax system. This has resulted because tens of thousands
of non- filers have been detected and brought into compliance. Untold
others have filed back returns voluntarily as we obtained and publicized
the first prosecutions of income tax non- filers and evaders. Likewise, we
conducted the first amnesty program in the country which brought in
millions of dollars in unpaid taxes.
o The productivity of department auditors has substantially increased the
last five years. We more than doubled the $ 200,000 in collections per
auditor recorded in 1981- 82 due to such improvements as:
I) Initiating training to improve auditor techniques. In fact, our
statistical sampling course was adopted by the Internal Revenue
Service.
2) Increasing number of audits that can be done by automating some of
the tasks, e. g. sales tax audit work sheets and calculating state
income tax changes from federal audit report adjustments.
3 ) Establishing accountability leading to higher quality audits by
evaluating programs and managers based on the amount collected rather
than assessed.
4) Reorganizing audit functions to free auditors from non- audit tasks.
Mailing address CCapitoll:
1700 W. Washington
Phoenix, AZ 85007
Other locations:
Phoenix Uptown
5555 N. 7th Avenue
Tucson
402 W. Congress
Page 2
5) Documenting criteria and procedures to be used for manual audit
selection and review to maximize return on audits conducted.
o We also devoted audit staff to assist in the development of new processing
systems that prevent millions of dollars in unpaid taxes escaping
detection.
We recognize there is still substantial progress that can and should be made
in our audit programs. We generally concur with the findings and
recommendations. Specific comments for each finding are attached for your
information and inclusion in the final report.
Your staff has been very cooperative and helpful in the conduct of the
performance audit. Their findings and recommendations will help us improve
the administration of the audit functions.
Please contact me if you have any questions concerning our written reply.
Sincerely,
ARIZONA DEPARTMENT OF REVENUE
-
Director
attch.
ch/ 3
DEPARTMENT OF REVENUE COMMENTS
PRELIMINARY REPORT OF THE AUDITOR GENERAL
PERFORMANCE AUDIT - TAXATION DIVISION
In general, we concur with the findings of the performance audit and have
already adopted, are implementing or are planning implementation of most of
the recommendations.
Our comments are offered in the sequence of the findings in the report.
FINDING I
The Department of Revenue could collect up to $ 18 million annually in
additional revenue by increasing its sales tax audit coverage.
Audit Recommendation 1:
The Department of Revenue should develop a comprehensive plan to increase
sales tax audit coverage. This plan should address the actions that would be
taken to provide training, supervision, etc. before additional staff were
hired.
DOR RESPONSE:
The division is hiring a training specialist, who will specifically address
audit training needs by the end of this fiscal year. In addition, our new
supervisors are scheduled to attend the state's management development
program. During the upcoming budget and objective- setting processes, we will
develop a plan for supplemental training of existing staff, future training
for new staff and other activities that will be covered under Finding 11.
Audit Recommendation 2:
The Legislature should consider appropriating the necessary funds over the
next three fiscal years for a phased increase of sales tax auditors.
DOR RESPONSE:
We concur with this recommendation as the preferred method of expanding sales
tax audit coverage as opposed to reassignment of auditors from other tax
types. In our budget process, we will explore the optimum approach for adding
staff, given our floor space limitations.
Audit Recommendation 3:
DOR should conduct a study to determine whether corporate income tax audit
coverage needs to be increased.
DOR RESPONSE:
We agree. We have been increasing the corporate audit staff by reclassifying
other positions because these audits generate a higher return. We plan on
comparing our staff size with the staff in comparable states and the audit
coverage mix in those states. Given the recent changes in corporate tax law,
we feel the average audit of a multinational business will take longer due to
greater complexity, and we will consider that when making corporate staff
projections.
Page Two
FINDING I1
The Department could increase revenues by improving its audit selection
systems.
Audit Recommendation 1:
DOR should implement a cyclical audit selection program for large sales and
corporate income tax accounts to provide 100 percent audit coverage of major
taxpayer accounts within the current statute of limitations.
DOR RESPONSE:
While improvement can always be made in any program, we have made major
improvements worthy of recognition in our selection methods. For example, the
report does not review dollar recovery per audit dollar spent. If it had, our
achievements would have been obvious. In FY 1982- 83, the recovery per dollar
spent was $ 4.73; for FY 1983- 84, it more than doubled to $ 10.54.
The report also does not cover revenue generated per auditor. A comparison
with two major states cited in the report, Texas and California, shows the
following data for FY 1983- 84:
State
Texas
California
Arizona
Sales Tax Revenue Per Auditor
It is obvious that, although our audit selection techniques are not perfect,
they have resulted in significant revenue production.
We agree that audit selection should continue to be improved; but we see some
problems in a reliance on cyclical audits to the exclusion of other methods.
Many large sales taxpayers are put on a cyclical audit schedule if audit
productivity is demonstrated. While we have not covered them all, it is not
necessarily true that they will all be productive. For example, we audited a
large retailer with 19 separate divisions, spent over 200 hours of auditor
time and produced additional tax less than $ 10,000.
Because of the unusual nature of Arizona's tax on contracting and a general
taxpayer ignorance of use tax, we have found contracting and use tax audits to
be very productive.
In corporate audit, most large taxpayers are audited on a three- year cycle.
It may not be cost effective to audit all of them because some are in
substantial compliance with the statutes or in a perpetual paper loss position
due to the subtraction for controlled corporation dividends.
Page 3
Audit Recommendation 2:
DOR should make implementation of MAASS a priority and devote necessary data
processing resources to correct program problems.
DOR RESPONSE:
The Department is rewriting the sales tax processing system, which will
generate reports useful for audit selection. We agree, however, that MAASS is
necessary and will make it a higher priority ( contingent upon the impacts of
legislative changes).
Audit Recommendation 3:
DOR should provide formal training to all new auditors and improve in- service
training of its audit staff.
DOR RESPONSE:
We concur and, as mentioned under Finding I, are implementing a structured
training program. The need to increase revenue during the state's financial
squeeze delayed the program, but we are bringing it back into priority.
Because we do not have a training staff of the size of Texas and California
( nor an audit staff of that size), we will be looking to other states and IRS
for adaptable courses.
Audit Recommendation 4:
DOR should ensure that the Audit Section has updated and accurate audit
activity and general account records for use in selecting audits.
DOR RESPONSE:
Generally, we agree with this recommendation in that our audit history records
need to be both automated and readily available to both Phoenix and Tucson
audit staffs. As far as questions raised about non- profitable audits,
however, we want to stress that just because an audit is a refund, net
operating loss adjustment or no change does not mean it was unproductive.
The purpose of an audit is to determine a taxpayer's correct tax liability.
Many times, the tax impact of the audit cannot be truly gauged until the
taxpayer's books are examined. A substantial adjustment of a net operating
loss can result in payment of more taxes in future years. A refund caused by
a certain adjustment in one year can also cause more taxes to be paid in
future years.
Since audit change rates : ompared with coverage rates vary considerably among
the states, we have not yet been able to determine the optimum change rate.
For example, Illinois, with a 3 . 7 percent sales tax coverage rate, generates
additional revenue on 66 percent of its audits. New Mexico, which has only a
.9 percent coverage rate, has a 66.9 percent change rate. Even Texas, which
is cited as one of the best states, considers both return on audit cost and
exposure for enforcement purposes in its selection process.
Page Four
Audit Recommendation 5:
DOR should improve documentation of reasons audits are terminated.
DOR RESPONSE:
We agree and will do so immediately.
Audit Recommendation 6:
DOR should develop and apply clear criteria to use various sources of
information for audit selection.
DOR RESPONSE :
We concur with this recommendation, and, as mentioned in the report, are
already addressing this area in the corporate income tax system. Criteria
will be developed fully as the selection systems are automated.
FINDING I11
The Department lacks adequate controls to ensure the quality and integrity of
audit assessments, modifications and amendments.
Audit Recommendation 1:
The Legislature should consider funding an audit review unit. The Department
should establish the audit review unit as an independent unit within the
Taxation Division. The unit should be staffed with a minimum of three
auditors and should report directly to the audit administrator or the
Assistant Director for Taxation.
DOR RESPONSE:
We will create such a unit in the tax policy section, reporting to the
Assistant Director. Until the unit can be fully staffed, we will tighten both
technical and math review reporting, documentation and change criteria in the
different sections.
Audit Recommendation 2:
Reasons supporting modifications and amendments made to audit assessments
should be documented in case files.
DOR RESPONSE:
Since amendments to audits can be caused by many things other than error ( such
as decisions in appeals, the provision of additional information by the
taxpayer, retroactive law changes, penalty abatements and settlement), we
agree that better documentation of the reasons for changes is needed to
protect both the department and the auditor. We already are implementing this
recommendation.
Page Five
Audit Recommendation 3 :
DOR should consider a policy on rotation of auditors and on reporting of
bribery.
DOR RESPONSE:
Given our high turnover rate, we have not felt the need for a rotation policy.
We have designated audit territories for large, out- of- state audits which will
be rotated every three years to minimize repetition. With the inception of a
more formal cyclical audit program, however, a rotation policy will be
necessary.
Audit Recommendation 4:
The Department of Revenue should develop written standards and policies
governing audit workpaper techniques and audit review.
DOR RESPONSE:
With the use of portable computers, audit work papers are being standardized.
We plan to present work paper training for non- computer audits.
Audit Recommendation 5:
Audit review should be conducted consistently and in accordance with standards
and policies developed by the Department.
DOR RESPONSE:
As mentioned in number one above, we concur and will be establishing stricter
guidelines for audit review.
FINDING IV:
Protested assessments are not processed efficiently; consequently, the
potential for loss of revenue exists.
Audit Recommendation 1:
The Department of Revenue should conduct a work simplification and methods
improvement study of the protest process.
DOR RESPONSE:
The division is already looking at methods to streamline the protest control
process in the audit services unit in conjunction with the development of the
protest tracking system. In addition to that system, we will be looking at
other aspects of the process that can be automated to handle the more than
1,000 assessments generated weekly. The increase in assessment volume caused
by the use of personal computers in audit necessitates elimination of as many
manual control processes as possible.
Page Six
Audit Recommendation 2:
The Department of Revenue should continue to develop and implement the
automated tracking system.
DOR RESPONSE:
We are doing so and are on target for the May 1, 1985, implementation date.
Audit Recommendation 3:
The Department of Revenue should develop and implement written procedures
regarding:
a. taxpayer no shows for hearings,
b. appropriate and timely follow- up on hearings held,
c. notification to the Hearing Office of attempted information
resolutions, and
d. specific and consistent deadlines for submitting post hearing
memoranda.
DOR RESPONSE:
We agree and will document the unwritten procedures as soon as possible. The
procedures being utilized by the present hearing officer are:
a. If a taxpayer does not appear for a hearing, but the record shows
that he or she received proper notice of the hearing and has not
contacted us, the hearing proceeds as scheduled on the presumption
that the taxpayer has simply chosen, for whatever reason, not to
attend. If nothing more is heard from the taxpayer, a written
decision will be rendered based on all of the information then
available, which, of course, includes the audit section's
testimony at the hearing.
Sometimes a taxpayer will call later in the day, or within a day
or two, with his reason why the hearing was missed. If the excuse
is reasonable, the hearing officer will usually set the matter for
hearing again, but the taxpayer is informed that the second
scheduling is a firm date.
b. This is done by keeping a list of the hearings that have been
held, in chronological order. That way, the hearing officer
always knows where he stands regarding the 60- 90 day deadline.
When an old decision is rendered, that name is crossed off the
list and when a new hearing is held that name is added to the
list.
c. A three- copy form indicating results of informal conferences has
been developed in sales tax and will be used for all tax types.
One copy of the form is for the taxpayer, one for the audit file
and one for the hearing officer.
Page Seven
d. The procedure is that the taxpayer has 30 days from the date of
the hearing to submit a post hearing memorandum, the section has
30 days from the date of receipt of taxpayer's memorandum within
which to file its responsive memo, and the taxpayer then has 15
days to file a reply memo, if necessary. If either party needs
additional time, it is routinely granted. Those deadlines are
also written down on the hearing officer's pending decision list
so they can be monitored.