Banking Fraud- where were the auditors?

The banking sector has seen NRB taking control over several problematic banks in past and recent times, including decisions of liquidation.  Conflicts within management, related party transactions and credit issues are increasingly coming into news which are the outcomes of ineffective control systems and poor corporate governance practices. Such poor practices have widespread affect and also provide ground for frauds by the employees and management or those charged with governance. Here we look at what will be the role of auditor in this regard.

The term “fraud” refers to an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. When the fraud involves one or more members of management or those charged with governance, it is termed as management fraud.

Banking Offense and Punishment Act 2064 has instead used the term ‘banking offense’ which is broad in definition, including instances of frauds.  The activities defined as offense is so comprehensive that it even includes third person who deals with the bank in any transactions, for e.g. if somebody provides falsified details to the bank while availing loan is doing an offence. So, offense or fraud (as auditor’s say) could be anything- like granting loan to a personally related party and then diverting the fund for own’s purpose, misuse of loan by the borrower in collusion with bank management and directors, other cases of fraudulent loans, falsification of loan applications and credit appraisals or even abuse of electronic cards etc.

The responsibility for preventing and detecting fraud rests with the directors. But whenever corporate governance problems or instances of banking fraud are identified, one of the first question asked is “How wasn’t it known earlier and where were the auditors?”

Bank auditors- responsibility without boundaries

Bank and Financial Institution Act 2063 requires the external auditor to separately report to NRB through its ‘Long form Audit Report’ on risk management systems and fraud identification, on the status of legal compliance and overall functioning of the bank and financial institution. Though the provisions are not explicitly concerned with fraud, these reporting widen the scope of auditor’s responsibility. The auditor should also disclose in its report to shareholders whether any staff or directors have acted fraudulently or have not acted in best interest of the bank.

The stringent reporting requirement for auditors of commercial banks is a globally accepted practice, however, the auditors in Nepalese context are more vulnerable to these practice, as the possible risk for an audit failure is not limited to financial liability or reputation risk but stretch towards exposure to high risk of facing legal charges even before being provided adequate opportunity to prove their point. This threat is always more serious in countries like ours where disciplinary proceedings and judiciary processes are lengthy and often not transparent, and where law enforcement authorities themselves lack good governance.

Should frauds be identified in normal audit?

The primary objective of an audit of a bank by an external auditor is to enable an independent auditor to express an opinion as to whether the published financial statements of the bank are prepared, in all material respects, in accordance with the identified financial reporting framework. The auditor should maintain an attitude of professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist.

However, the auditor cannot be held responsible for not detecting frauds. Fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Such attempts at concealment may be even more difficult to detect when accompanied by collusion. Collusion may cause the auditor to believe that audit evidence is persuasive when it is, in fact, false.

The auditor is always concerned with fraud that causes a material misstatement in the financial statements. But the subsequent discovery of a material misstatement of the financial statements resulting from fraud does not, in and of itself, indicate a failure to comply with ISAs.

The two differing angles

Auditors do not make subjective judgments to identify frauds, nor do they make legal determinations of whether fraud has actually occurred. This is a principle accepted worldwide. Let’s understand it with an example.

Suppose the bank management has sold an NBA at a price lower than NBA value to a person without going through tender process to a related person of bank’s directors. But the auditor cannot go beyond the records available at the bank to identify whether the purchaser is related to management or directors. He can only indicate and identify the process loophole in the transaction and risk arising from such practices with a recommendation for the future. But in contrast to that NRB might have information and details with it to confirm that the purchaser is a close relative of one of the director and the NBA has been sold at lower price without tender process intentionally, thus terming it a fraud.

Auditors- Challenges and limitations

There are also certain limitations on what an auditor can verify.

• The reporting requirements involve plenty of subjective judgment and the understanding of the auditors and of NRB supervisors might differ at places.
• Banking Offense Act 2064 considers that providing loans to any close relatives of the person who have financial interest in the bank, e.g. promoter, director, shareholder or to CEO or employees is an offence. Close relatives is very widely defined in the Act and even includes separated family members. So, it can be impracticable for an auditor to verify these details and he might have to limit himself to obtaining a declaration from the management and the board regarding such compliance.
• A detailed audit of all transactions of a bank and forming an informed opinion in all the factors to be reported to NRB would not only be time-consuming and extremely expensive but also wholly impracticable.
• The audits are carried out at intervals and not continuously. So, it cannot be possible for an auditor at year end to carry out a complete evaluation of internal control and to monitor a bank’s compliance with all NRB rules.
• There is not transparency in selection of auditors by audit committee as the reasons for selecting an auditor or changing auditors before statutory period of three years is never disclosed. Legal provisions are taken more as formalities. So, a good relationship with promoters and bank management is often necessary for an audit assignment which in turn can affect auditor’s independence while disclosing all relevant matters to shareholders and NRB.
• Auditors even face resource constraint while audit of large banks because of low fee structure, for which they themselves are responsible. In AGM, Shareholders always make hue and cry on appointment and fee issues and management make it their excuse while considering fee request of auditors.

Though principally it is agreed that the auditor has a much more difficult role in detecting misstatements when fraud is involved, the risk is always there that the auditors are even made responsible for supervisory failures in identifying irregularities in bank and financial institutions. NRB in its own is able to exercise a more persuasive influence over banks in achieving stringent control system, strong corporate governance and fraud control measures because of its regulatory powers, which is not the case with auditors they can only monitor the actual application of such practices. So, it is for the auditors to come forward to make their perception of the responsibility towards fraud as perception of NRB and the other stakeholders at large.

Tax Compliance for NGO and INGO

 IRD came up with clarified provisions for Not-for-Profit sector (NGO and INGO) though its Income Tax Directives 2066. INGOs, bilateral agencies and other organizations who make payment to tax exempt organizations (TEO) now have additional responsibility to ensure that the payment relates to intended objective of the TEOs and that they have complied with all relevant Income Tax  regulations.

While making payment to the tax exempt organization, the new tax directives effective February 2010 requires the donor organization to confirm that:

• The activity of the TEO for which the payment is being made is within the permitted activity as per constitution of the TEO.
• The fund being disbursed has not been used for any personal use by the TEO.
• The TEO has expended the fund complying with the provisions of Income Tax Act and Regulations.
• All other provisions of Income Tax Act and Regulations have been duly complied with.

For e.g. if the donor is making payment to a TEO for a training program it has sponsored, the donor has to ensure that:

• The  TEO has deducted tax on all payments made during the training like trainer fees, hall rents etc. and
• The TDS has been duly deposited in IRD.
• The payment does not relate to an income earned by the TEO by competing with organizations that are not exempt.

The directives have also clarified on how the definition of “Service Fee” (and TDS on such fees) is attracted for payments that are made by donor organizations to TEO or any other organizations. For e.g. the donor may select a private company for a field based research with condition that the company submits the detail of expenditures to the donor. In another case, appointment may be made for a stipulated amount without condition of submission of expenditure details. In both cases, service is calculated differently.

These additional responsibilities means that the concerned program staffs of the donor organization should be well informed about the payments that require TDS as per Income Tax Act and the appropriate TDS rates and provisions of Income Tax Act applicable to TEO.

In several INGOs and bilateral agencies, review of program expenditures and assessment of program effectiveness are looked upon by program staffs who have limited knowledge on taxation matters and the finance departments simply limit itself to accounting of the fund disbursed and its settlement.

Clearly, IRD wants to regulate the Not-for-profit sector by assigning more responsibilities to auditors and the donors, however the control mechanism still lacks in cases where the donor themselves do not have obligation to submit their audit reports and financial statements to IRD because of treaty provisions that override the provisions applicable for tax exempt organizations.

A part of donor’s responsibility is shared if robust audit of NGO/Projects is conducted regularly and timely, because  the auditors are also required to clearly state in their report if the organization has functioned as per its objectives and if Income Tax provisions are complied with.

But the reliance can weaken if the level of reliance in audit report is itself doubtful, as in many cases, the audit of the concerned tax exempt organization is more a formality considered essential for renewal purpose and for submission to donor. It is for donors to ensure that it is not the case.

Summary- NGO/INGO & Not-for-profit sector in Tax Directives

• Not for Profit companies registered as per Company Act not to get tax exempt status
• Tax not exempt if income is earned through competitive bidding with taxable organizations
• Only income covered by Sec.10 Chha exempt for tax purpose
• Donor and auditors to ensure confirmation of activities with organization’s main objective compliance with  Income tax regulations
• Service fee clarified for TDS purpose.
• Donors to obtain TDS deposit vouchers from the recipient organizations

Be sure on your tax deductions…check these tips

When it comes to calculating your tax deductible expenses, there are plenty of reasons for you to panic. In the first sight Nepalese tax law may not appear too complex or large to be grasped by any professional; however there are ambiguities in tax law that results in differing opinions between you, your consultant and the tax office. Once you submit your tax returns, there is no opportunity for you to revise it even in case you identified an error. So, often lack of proper tax knowledge can lead you to unintentional non compliance with tax laws, ultimately leading to undesired penalties and interest. Therefore, it is important to get it right at the very beginning.

So, the only way for you to minimize your tax risks, is to be sure on your tax deductions. Here are some tips that could be useful for you.

Complete your Statutory Audit in time

Sounds simple! But having extra time to prepare and review your tax returns and tax related documents means you will have time to extract additional details from your branches to ensure correct figures are claimed and to make additional consultation in tax office or with your tax consultants for any confusions. As it goes with the proverb ‘Hurry Burry spoils the curry’, piling up your tax works for ultimate deadline may lead up to possible errors in your tax returns.

Obtain written opinion on complex matters

Opinion over phone may be cheap for you, but acting on them may be costly. So, if you are consulting with your tax consultant on tax deduction that is not clear from plain reading of tax law, ask your consultant to give his written opinion. Remember, your tax auditor has certified your tax return doesn’t mean he agrees to deductions that you have claimed. Written opinions are not given without adequate homework and it will help you to defend your case in tax office or in revenue tribunal.

Go for advance ruling

Just the way it applies for opinion from consultants, asking a tax officer may not be sufficient. You need an advance ruling to be sure of tax treatment proposed to be undertaken. Advance ruling is a ruling issued by the tax department to a taxpayer in anticipation of a proposed transaction. The ruling provided to you is binding on the tax department if you have made a full and true disclosure to the Department of all aspects of the arrangement relevant to the ruling; and the arrangement proceeds in all material respects as described in your application for the ruling. The procedure for it is simple- you just have to write an application to tax department giving the details of tax related confusions or the arrangement proposed or entered into. Rulings are normally issued unless the matter is before court or have already been decided by the court.

Foreign Permanent Establishments

The concept of Foreign Permanent Establishments (FPE) is relatively new in Nepalese context. Though Income Tax Act 2058 introduced it more than 6 years back, the provision is yet to be properly explained and implemented. Here we try to explain what FPE means, concept underlying it and its responsibilities under the IT law.

The existence of a “Permanent Establishment” (PE) in a country as per Tax law is analogous to the concept of branch under Company law.

As per Sec 2 (ka da) of IT Act, Permanent Establishment means a place from where a person fully or partially conducts his business. The term also includes place of fully or partially conducting business through agents (other than independent agents),  place where main equipment or machinery is kept or installed or used, places where a person has provided any technical, professional, or consultancy service through his employees or otherwise for more than 90 days (at once or severally) in a 12 months period and a place where a person is engaged in a construction, assembly, or establishment project for 90 days or more, and the place of supervision of such project.

If the permanent establishment is of a foreign entity, it becomes ‘Foreign Permanent Establishment’ (Sec. 2 (Bha) of IT Act). Such FPE is treated as an entity for income tax purpose. So, all the provisions applicable to entity as per Income Tax Act apply to FPE. The income earned through such FPE in Nepal is taxed as an entity and the income that it repatriates to its controlling foreign person  is taxed as if it is dividend distributed.

 PE- International Concept

As per international tax law concept, all countries assert jurisdiction to tax persons where the source of income, profits or gains or the location of assets fall in their territory. Called “source concept”, it gives first right to tax an income in the country where its source is located. When an overseas resident has substantive presence in a country, he meets the threshold of having a permanent establishment (PE). If the person is carrying on business through such PE, than tax may be due in the country where PE is established, on “source concept” as well as in the country of his residence on “resident concept”. So, the provision of PE is widely accepted around the globe and is incorporated in OECD and UN Model conventions. These conventions are internationally accepted models for conducting bilateral Double Tax Avoidance Treaties and are also authoritative text for interpreting PE.

 Interpreting FPE with Examples

 As we have defined FPE as PE of a foreign entity, to establish a FPE, the point first is to determine whether PE exists on not.

The basic definition of PE given in IT Act simply means “a place from where a person fully or partially conducts his business”. This gives three basic conditions to decide the existence of PE.

• • Existence of place of business
• • This place of business must be fixed and
• • Carrying of business through this fixed place.

Though the term ‘fixed’ is not clearly mentioned in this definition, we use it here because the intention of law is not to term an isolated transaction of short term nature as PE, hence the criteria of 90 days for specified transactions. Besides, in OECD & UN Model conventions, fixed place of business is the most basic condition used for determining the existence of PE. The mere fact that an enterprise has certain amount of space at its disposal which is used for business activities is sufficient to constitute a place of business. No formal right to use that place is therefore required.

1.  Suppose an employee of a company who for a long period of time, is allowed to use an office in the headquarters of another company (e.g. a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In such case the employee is carrying out business of the former company and the space at his disposal in the latter company will constitute PE. (See Commentary to Article 5 OECD Model Treaty).
2. Beta Bank of Nepal did a technical service agreement (TSA) with Alpha Bank whereby Alpha Bank provided three managerial level staff to Beta for a whole year to provide technical assistance. In return, Beta Bank reimburses all the salary and other cost of staffs and a separate fee to Alpha Bank. In such a case, Alpha Bank is said to have FPE in Nepal.
3. Suppose a Malaysian company wins a contract to undertake construction of a bridge in Nepal. A construction team of the company works in Nepal for 175 days to construct the bridge and returns to Malaysia. Though the Malaysian company does not have any separate legal status here, it is regarded as having FPE in Nepal because it was involving in construction project for more than 90 days.

 FPE- Liabilities as per IT Act

Once we conclude that FPE exists, many provisions of the IT Act is attracted, as the FPE is regarded as entity. FPE are regarded as “Residents” for Nepal and so are required to comply with the provisions applicable to resident persons, like deducting TDS when it makes payment attracting Sec. 87, 88 & 89.

The FPE should file its tax return under self assessment basis by including all income of the FPE and deducting all relevant expenses. Any expenses of the foreign person in its respective country that is exclusively incurred for the purpose of such FPE can be claimed as expense. The profit is taxed as if it were an entity.

The Profit after tax so derived, is taxed at 5% when it is repatriated to the nonresident foreign person. This is a form of dividend tax and ensures that domestic companies are not at disadvantaged position compared to FPE.

Such tax paid by FPE here could again be taxed in the country of residence of the foreign person. In that case, the foreign resident claims tax credit for the tax that is paid in Nepal by his FPE as per the law of the country of his residence. So, in example “1” above, from Beta Bank perspective it is sufficient if it makes TDS on service fee it pays to Alpha Bank and on employee remuneration. However, if FPE of Alpha Bank does not submit its tax return here, it is avoiding tax in Nepal because higher tax rate applies as an entity and additional tax on repatriation. This avoided tax indirectly goes to the country of residence of Alpha Bank, instead of Nepal who has the first right to tax the income on “Source concept” basis.