CA Srikantha Rao T

CA Srikantha Rao TIndirect taxes compliance has posed problems to assessees over the years and more so since the introduction of service tax and negative list based taxation from 2012. A parallel development has been the introduction of new Companies Act 2013 along with changes in reporting requirements for auditors thereunder. A reference to Section 143(3)(i) of the Act reveals the need for the auditor to comment on internal financial controls system of the auditee as well as operating effectiveness of the same. The Institute of Chartered Accountants of India has come out with a detailed Guidance Note on Audit of Internal Financial Controls over Financial Reporting which indicates the steps to be taken by auditors. The auditor going by the Guidance Note, has to express an opinion on the effectiveness of the auditee’s internal financial controls over financial reporting.

Since the auditor would be required to look at the internal financial controls from the point of view of financial reporting, he would not be in a position to ignore controls operating within the organisation which would facilitate reporting on matters pertaining to indirect taxes compliance. A review of these controls would assume significance in light of the fact that the Guidance Note requires the auditor to evaluate the control environment, the risk assessment processes, IT environment and controls thereunder, control activities established by the Management as well as monitoring thereof. While these would seem easy in terms of regular business processes, there would be considerable challenges when it comes to carrying out these tests in the field of indirect taxes. This would be mainly due to issues on legal interpretation as well as frequent legislative changes. Added to this is the fact that the auditor would not be dealing with one single law but a combination of laws with taxing jurisdiction split between Union and States i.e. Central Excise, Customs and Service Tax levied by the Central Government and VAT by the States. The auditor however could look at certain key points in trying to form a view on control system in place.

Multi locational units

The nature of operations undertaken by the auditee as a service provider or manufacturer or both and whether in one single unit or across multiple units would be indicative of complexities involved in establishing controls. This is on account of the fact that while individual units at various locations would be separately registered under Central Excise, they could all be covered by central registration under service tax as long as units involved happen to provide or receive services. This would require review of controls pertaining to availing and utilizing of cenvat credits in the central premises under service tax as well as of duties of excise at individual locations engaged in manufacturing activity. The possibility here of the credits on services being distributed to concerned units cannot be ruled out. The added complexity here could be that of units being located across States in which case, there could be stock transfers impacting input tax set off under VAT at consignor end.

Product or service profile

The auditee could also have a combination of goods and services being provided i.e. for instance a supplier of machinery also following supply with installation services. This would have to be seen in light of structuring of contracts with the customer to see whether one would have a contract for supply of machinery/goods with installation following the supply or one of works contract where there would be transfer of property in goods involved in works contract execution. This would not only impact liability under central excise (where a manufacturer is liable on excisable goods manufactured) in terms of valuation but also impact liability under service tax in respect of services provided. Needless to say here that one would have to look at the timing of transfer of ownership of goods to the customer and the form in which it is transferred in order to assess the true nature of the contract.

An auditee which is predominantly a service provider, would be required to ensure controls which would help in confirming timing of provision of service and accrual of service tax liability based on earlier of receipt of consideration or on completion of service and billing thereof as indicated in Point of Taxation Rules 2011. This would have to be seen in context of those services where billing milestone details are to be sought viz., construction services, erection and installation services, software services etc. This would be in addition to controls to determine nature of service provided or received where cross-border services are involved as the taxability thereof would have to be determined with reference to Place of Provision of Service Rules 2012.

A proper understanding of the product and its nature would be essential to ensure proper classification for the purpose of taxation. Multiple products being handled with some of them being different from the other in terms of product features and characteristics would increase risk of improper classification unless classification is based on expert review or undertaken by personnel of auditee well versed in Indirect Tax matters and having sound knowledge about product features. Improper classification could not only impact liability under Central Excise but also under VAT for products manufactured by auditee. Depending on the nature of product involved and investment required for the productive facility, there could be possibility of customer supplying tools/components or machinery or even advancing money which in turn could impact valuation especially under Central Excise at auditee end.

Customer profile

The customer profile of the auditee could also be indicative of the risks involved in terms of controls. Where B2C transactions are involved, there could be possibility of the products being subjected to MRP based levy especially with regard to Central Excise. Where the products happen to be covered by Third Schedule to the Central Excise Act 1944, packing or repacking processes undertaken on goods along with labelling or relabelling of containers could be deemed to amount to manufacture making an auditee prima facie appearing to be trader, also liable as a manufacturer. B2B transactions would have to be analysed to review the possible end use of the products in question which could sometimes impact classification of products under Harmonised System of Nomenclature and consequent liability where certain products of specific use are exempted from duties but items manufactured by auditee happen to be capable of dual use. The trade or commercial parlance test here would be relevant.

Processes involved

The exact processes undertaken would have relevance under Central Excise considering the concept of manufacture and deemed manufacture under the said law. The auditor here would have to assess the points at which processes are split by the auditee so as to undertake sub-contracting through third parties and find whether the manufacturing test would be satisfied at all before any split off. He would also be required to check whether the auditee has assumed responsibility to pay off duty of central excise on any processes undertaken by the sub-contractor where the products are directly cleared/sold to customers which would have to be duly factored in while furnishing returns for the period. In such cases, the auditor would have to ensure existence of proper controls over despatches by sub-contractors and invoicing by auditee to ensure that revenue is not short accounted or duty/tax liability thereon not remaining unpaid.

Services or goods being exempted

One issue which could confront the auditor here is of the possibility of some of the services handled by auditee or some of the goods produced being exempted under service tax (or not covered under definition of service itself) or central excise as the case may be which would require auditee to forego credits in relation thereto. This scenario could also arise in case of pure trading where the auditee would simply buy products from the vendor and sell the same without any processing involved thereon. Recent trends have revealed that assessees generally ignore input service credits in relation to trading or exempted turnover while reversing cenvat credits leading to objections from Authorities. The question of input tax set off segregation could arise even in respect of State level VAT where goods are exempted from tax or certain sales exempted from tax based on end use/consumption at customer end.


Issues often arise when there is transfer of ownership of goods by auditee to his customer located inter-state especially where either goods do not move inter-state or sales undertaken through a depot/consignment agent or warehouse of auditee located in the State where consignee/customer is located. Unless there is actual movement of goods from one State to another by virtue of such sale or goods transferred other than by way of sale happen to be of specific nature/ascertained and meant for use only by the end customer in the other State, local VAT in the concerned State would be applicable. Unless the auditee has controls in place to correctly identify the nature, time and place of sale, chances of wrong payment of tax would be high which could lead to demands from tax authorities.

Related party transactions

The quantum of transactions with entities falling within the Group or controlled by the same management could also be indicative of the risk factors involved. There could be transactions within entities located in India or between the auditee in India and an entity outside India. The impact would mainly be in terms of valuation of goods under Central Excise (when goods manufactured) and Customs (when goods are imported into India). The auditor should ensure that goods are not undervalued by virtue of related party relationship. Goods manufactured and sold between entities having holding-subsidiary relationship or goods imported into India from an entity within the Group would have to be subjected to price comparison with those goods sold to unrelated buyers.

The SVB (Special Valuation Branch) officer under Customs would have access to published data within and outside India to undertake comparison with prices prevailing on goods imported into India at or around the same time the goods in question are imported into India. This comparison would be on goods which are identical or similar to the ones being reviewed with due adjustments allowable for any difference in product characteristics. Where these are not available, the cost details or price chargeable by the foreign vendor on sales to unrelated buyer in India are sought. Past trends have revealed that declared prices are adjusted to the extent of undervaluation noticed leading to additional demands on importers. The auditee consequently should have a process in place to review the value in this regard and to close matters pending before SVB based on data readily available.

Inward-outward movement of stocks

The auditor should ensure that the auditee has sufficient controls to monitor inward and outward movement of stocks. This would be critical for a manufacturer as cenvat credit on goods would generally be allowed on receipt thereof at factory with duty being payable on removal of finished product. The controls in respect of credit availment and utilisation including required reversals under Cenvat Credit Rules 2004 would have to be tested based on evaluation of operations during the audit period as well as disclosures in returns. The methodology followed for recording outward movement of stocks needs to be reviewed to ensure that there is no movement without a valid invoice or a delivery challan depending on the purpose for which stocks are moved out of the premises. This would involve confirming that all dutiable goods are cleared under a valid excise invoice which would be considered for duty payment at the end of the relevant month for which returns are to be furnished as well as fact of goods moving out for processing to sub-contractors under the cover of challan where these are to be received back into factory before despatch of finally manufactured product. The tracking of goods moving out to sub-contractors as well as of stocks lying thereat would need to be reviewed as this would have a bearing on cenvat credit eligibility (cenvat to be reversed where goods sent out not received back within stipulated period which is 180 days in general (two years for capital goods)).

Cenvat Credit & Input Tax

One of the main challenges that the auditor is likely to face is with regard to cenvat credits availment by auditee under central excise and service tax and input tax under State VAT. While the set off under State VAT would be simpler to comprehend, set off under cenvat scheme has been subject matter of considerable litigation in recent years. This is on account of interpretational issues regarding scope of the definition of capital goods, inputs and input services as well as extremely conservative stances being taken by Departmental audit teams. The auditor would be required to ensure that where credits on capital goods and inputs are concerned, these are availed only on items qualifying as goods in the first place. The next issue would be one of identifying goods which would be eligible for set off under the relevant definitions under Cenvat Credit Rules 2004. Similar approach is needed for input services i.e. services received to confirm these are eligible services within the definition of input service. Here, services received should be capable of being classified properly based on bills of service provider and contracts available. The eligibility test would have to be applied in light of the goods manufactured as a manufacturer and service provided by a service provider. Since there could be interpretational issues involved, it would be preferable to consult a legal expert who could confirm credit admissibility. Within the auditee organisation, the decision for credit availment should be taken by someone with requisite experience and/or qualification.

Reverse Charge liability

The auditor should ensure that the auditee is able to correctly identify services received for liability on reverse charge basis based on nature and description of services received, status of receiving entity as well as timing of liability. The exact liability could be appreciated by going through Notification 30/2012 ST which would enable him to confirm liability on each service set out thereunder. Complexities could arise in cases where services are provided by agents as intermediaries to principals (involving cross border transactions) which would require correct identification of liability. These services received in turn could qualify for credit availment post payment of service tax thereon.

Return filing exercise

The auditor should also review the return filing exercise to confirm that the filing is based on proper registers maintained for the period covered by the return. These include the cenvat registers/input tax registers for recording of credits with linkages to bills from vendors/input service providers, job work registers for tracking material movement to and from sub-contractors with credit reversals thereon if any, Daily Stock Account which would indicate invoices issued for clearance of manufactured goods and duty payable thereon, sales registers for quantifying the output tax payable, service register indicating service invoices issued for services provided along with tax payable thereon. It can be seen from experience that most of the auditees have these registers maintained outside the ERP involving manual controls rather than system generated ones which could increase audit risk possible due to omissions and errors in return filing process.

Management Philosophy and duty segregation

The auditor would be required to look at the management philosophy which could be evident based on reports of tax authorities pursuant to audits conducted in the past by them as these would highlight issues if any in terms of legal compliance and consequent demands thereon. The nature of errors noticed here and the manner of identification of issues by tax authorities i.e. third party confirmations, audits or investigations etc would indicate the extent of management involvement and extent that could be placed on assertions.

The presence/absence of competent personnel at the individual unit level, the tasks handled by the HO/Corporate Office under a centralized environment as well as the level of automation in record keeping with due customization of the software (in ERP environment) to handle reporting requirements under Central Excise, Service Tax and VAT in particular would also indicate likely risks in terms of establishment and operation of controls.

In this article the author has sought to capture issues likely to be faced frequently by auditors which could be flagged as concern areas. There could be other areas as well depending on operations of the auditee. Readers who may have queries on this article could reach the author at

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0 responses to “Internal Financial Controls and Indirect Taxes”

  1. SRIKANTHA RAO T says:

    The IFC is mainly from point of view of financial reporting rather than from operating effectiveness from a business perspective. However such analysis will be part of overall risk based internal audit which is wider in scope as compared to review of IFC.

  2. CMA ASIM SAHA says:

    Earlier also there were internal control but CA Act 2013 made a significant mandate that IFC and its quality to assess the genuineness of any expenditure, on CFO vis-a-vis audit committee and Fin Auditor and finally BOD must give recognition on its efficiency.But whether IFC can evaluate the Cost Benefit analysis of any expenses and finally called as ” COST”

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