Indirect Tax and Audits: Internal Audits and Tax Authority Inquiries
Learn how internal audits and Tax Authority inquiries test your Indirect Tax Control Framework (ITCF). Understand audit risk, triggers, and best practices for readiness.
The phrase 'tax audit' is one that taxable persons do not want to hear about or be part of. However, this situation need not be painful nor unpleasant for those who plan. Moreover, tax audits, whether conducted internally or by the Tax Authority, are a key test for any mature indirect tax control framework (ITCF).Â
Internal audits, on the one hand, are a company's proactive mechanism for testing whether processes, tax positions, and supporting evidence withstand scrutiny. Tax audits conducted by the Tax Authority, on the other hand, are the external stress test that exposes gaps, confirms strengths, and can produce financial exposure if controls are weak. In either case, audit-readiness is a continuous showcase of a company's discipline that must be embedded into everyday tax operations.
Audit Risk in Indirect Tax
Essentially, audit risk refers to the likelihood, or even the company's vulnerability, that an error or issue in a company’s tax reporting could lead to a tax audit or issues during an audit. The risk arises from three interconnected factors: the likelihood that a return or transaction contains an error, how easily that error can be detected, and the potential consequence if the error is discovered.
The likelihood that a return or transaction contains an error depends on the complexity of the company’s business operations and the strength of its internal controls and tax knowledge. The ease with which an error can be detected includes both the company’s own review processes and the Tax Authority’s analytical tools and audit techniques. The third factor includes consequences such as financial penalties, interest charges, and reputational damage.
Some of the most common tax audit triggers are unusual refund patterns, large or irregular cross-border transactions, sudden changes in margins or tax treatment, and discrepancies between transactional systems and filed VAT returns. Due to the current tax environment, where Tax Authorities increasingly use data analytics and electronic reporting and adopt a risk-based approach, even minor anomalies can attract disproportionate attention if they align with a higher-risk profile.Â
Internal Audit as a Risk Detection Mechanism
Internal audits are scheduled and targeted reviews designed to detect control weaknesses, test the application of tax rules, and validate the integrity of tax-related data flows. This is one of the key testing and monitoring mechanisms for determining the effectiveness of the ITCF. Therefore, a well-structured internal audit process concentrates on high-risk areas identified through periodic risk assessments, samples transactions across end-to-end processes, and validates supporting evidence against filings.
Furthermore, companies can adopt a hybrid model that combines periodic deep-dive reviews with ongoing monitoring of the key data. By doing so, companies can ensure that any error, which may ultimately expose the company to tax audit, is detected early, thus reducing the likelihood of surprises during an external inquiry.
Integrating Internal Audit Findings into the Control Framework
Conducting an internal audit has two purposes. The first is to ensure that errors are detected early. However, these findings from the internal audits have additional purposes and value. First, each finding must be assessed for root cause analysis. This analysis should provide answers to questions about whether the error stems from process design, is a human error, is caused by system configuration, or is due to poor data integrity.Â
Once this task is completed, the findings should be mapped to a corrective action that includes ownership, timelines, and measurable outcomes. Generally, the most effective systems translate recurring audit observations into policy amendments, standard operating procedures updates, technical fixes in ERP and other tax engines, and role-based training.
Integration of internal audit findings also means adjusting the risk register and prioritizing fixes that materially reduce exposure. As a result of replicating these practices, there should be fewer repeat findings, improved documentation standards, and more defensible tax positions if challenged by external parties, such as the Tax Authority.Â
Tax Authority Audits and Inquiries: What to Expect
The reality is that, even with a more comprehensive and practical ITCF, companies, particularly large and international companies, are subject to regular tax audits over one to three-year periods. However, the practices and requirements vary from one jurisdiction to another, making the whole process complex. Nevertheless, some steps are common among many jurisdictions.
Therefore, the tax audit process is typically initiated by a notification and a formal data request, often specifying the periods under review, the documents to be produced, and a timeframe for response. Additionally, the notifications can also include the time and date of the scheduled visit to the company's premises, and requests for electronic extracts.
Even though the trend of transitioning to data-driven analytics, in most cases in real time, is apparent, many Tax Authorities often conduct complementary manual inquiries and checks to verify data completeness, rates, and VAT registration validation.Â
To successfully pass the tax audit and limit any further escalation, companies should consider a prompt, organized, and evidence-focused response. Some key steps in this process include clear internal delegation for handling external inquiries, centralized document repositories, and a pre-agreed communication plan with external tax advisers.
Conclusion
Internal tax audits are a complementary mechanism within an indirect tax control framework for revealing internal weaknesses early and allowing time for remediation. Nevertheless, even the Tax Authority inquiries or tax audits, often viewed as control processes, can be viewed as a complementary mechanism, or even proof of effectiveness, as they confirm whether the framework is genuinely practical under scrutiny.
In the era of data-driven tax administration and digital reporting, companies should emphasize continuous detection, transparent governance of remediation, and technology-enabled evidence management. By embedding the audit-readiness approach into everyday processes and operations, it transforms tax audits from crises into opportunities to strengthen controls and demonstrate compliance maturity.
Source: UK HM Revenue and Customs (HMRC), PwC, Deloitte, Thomson Reuters, OECD
A tax audit in indirect tax is a review conducted either internally or by the Tax Authority to verify that a company’s tax returns, processes, and documentation comply with applicable VAT, GST, or Sales and Use Tax rules and regulations.
Internal tax audits are crucial because they test the effectiveness of a company’s internal controls, identify errors or weaknesses, and help ensure compliance with tax obligations before external authorities intervene.
Tax audit risk increases with business complexity, weak internal controls, inconsistent data quality, and poor documentation. Irregular refund claims or sudden changes in tax treatment can also raise red flags for Tax Authorities.
Common audit triggers include unusual refund patterns, significant cross-border transactions, rapid margin changes, discrepancies between accounting and tax systems, or data anomalies detected through electronic reporting tools.
Frequency depends on the company’s risk profile, transaction volume, and operational complexity. However, most mature organizations conduct periodic reviews, e.g., annually or semi-annually, in combination with continuous monitoring of key data.
Preparation involves maintaining a central repository for documents, defining clear internal roles for managing inquiries, maintaining strong communication with advisors, and consistently documenting all tax positions.
