Managing Tax Audits in Afghanistan

Author: Matt Nissley, CPA

Introduction

There is no single article in the tax law that directly deals with the legal basis for tax audits, how such audits shall be conducted, etc., though there are many references to the audit process scattered throughout the 2009 Income Tax Manual.  The ARD has an Audit Manual which contains details about audit processes and procedures, but this document is not publicly available. The clearest information in the law about tax audits comes from Article 8 of the 2015 Tax Administration Law:

While the text of the law above does not directly mention tax audits, the primary way by which the taxation administration receives “new information based on which the tax liability is affected” is by conducting tax audits.

The law originally established a 5-year statute of limitations for conducting tax audits and issuing amended tax assessments, though this statute of limitations is removed in the case of taxpayers who are guilty of tax evasion.[1] However, an internal ARD regulation signed in June 2024 changed the statute of limitations from five years to one year,[2] meaning that tax audits can now only be conducted for the last year for which tax clearance was obtained.

In past years, the ARD did not attempt to audit every single organization. Organizations were audited on a sample basis based on various criteria (size of the organization, volume of financial transactions, whether or not taxes were paid on time, and other risk factors). Some organizations were never audited at all, while those that were audited were usually audited for a five-year period. However, the ARD’s current approach is to audit as many organizations as possible, seemingly with a goal of auditing every year of every organization (though auditing every single tax return filed is likely not possible). Since the statute of limitations is now one year, organizations should not be surprised if their tax return is audited on an annual basis from this point going forward.

The Tax Audit Process

This section provides a summary of the key steps in the audit process. This summary is not intended to be comprehensive, but rather to give an overview of the process. It should be noted that sometimes the exact order of these steps may vary or overlap with each other, and that the ARD also regularly changes the procedures for conducting tax audits. Further, there are different types of tax audits, and the scope and objectives of one audit may vary significantly from another.

1. Organization is placed under audit. The organization’s name will be recorded on an internal list at ARD along with a record of the date they were placed under audit.
2. ARD preparations. The ARD will request the Tax Office to send over all the taxpayer’s files and records, assign an audit team, and prepare several standard questionnaires for the organization under audit.
3. Taxpayer is notified. The audit team will contact the organization under audit, usually by phone but sometimes by email. The taxpayer must visit the ARD to receive the official audit notice letter, a letter introducing the audit team, and the questionnaire forms. The official notice letter specifies that the taxpayer has either 10, 20, or 30 days to amend the tax return for the year(s) under audit depending on the size of the organization. The audit team generally requests the taxpayer to provide responses to the questionnaires as soon as possible, often within one week.
4. Kickoff meeting. The audit team will usually visit the organization’s office to meet key personnel and discuss the upcoming audit.
5. Audit procedures initiated. Standard audit procedures include a review of all documents provided in the document request list (including bank statements, general ledgers, payroll records, rent contracts, etc.), reconciling tax payments, selecting sample transactions in every line item on the tax return to review supporting documentation, sending audit confirmations to third parties to verify transaction data, etc.
6. Draft tax assessment. The auditors calculate a draft tax assessment based on their audit findings.
7. Negotiation/defense. The auditors usually verbally inform the organization what the audit findings are along with the amount of the draft tax assessment. The organization can defend its case and negotiate the amount of the draft assessment with the auditors.  
8. Tax assessment finalized. After the audit team has concluded their audit, they send their findings to an audit committee which will review the case and review the assessment amount. After the committee has finished its review, the relevant deputy audit director must sign off on the final tax assessment. The audit team will then amend relevant tax returns to match their final audit assessment.
9. Payment made. The auditors notify the organization to collect all amended tax returns and make the required payment. Payment is generally required within a week, though it is possible to negotiate the due date and even request an installment plan if needed.
10. Tax audit clearance letter. After payment is made, the ARD will issue a tax audit clearance letter along with a written summary of the result of the audit.

Preparing for Tax Audits

Tax audits are stressful for all parties involved. Tax auditors are often under pressure to complete their audits quickly, usually within 1-3 months depending on the industry of the taxpayer (though it should be noted that it is not unusual for tax audits to drag out for many months before completion). This pressure is then transferred to the organization under audit. Organizations must provide an extensive amount of information to auditors, and it is often difficult to find and provide all requested information and documents in a timely manner. Organizations scrambling to deal with a tax audit they were not prepared for will struggle to find time to think strategically about how to reduce their tax audit risk. Therefore, the groundwork for undergoing a tax audit with a minimal tax assessment must be laid long before the tax audit starts.

One important point to understand upfront is that the burden of proof falls to the taxpayer to prove the incorrectness of any tax assessment issued by the auditors. Consider Article 14(1) of the 2015 Tax Administration Law:

While the above article from the law technically applies to a formal dispute process, experience shows that this concept is applied to the process of arriving at a tax audit assessment. Auditors will often make general assumptions to calculate a draft tax assessment, such as estimating what percentage of NGO operating expenses should be subject to contractor tax or applying findings from a haphazard sample to an entire population of transactions. The auditors do their work on a sample basis and will generally not provide a comprehensive list of specific non-compliant transactions, the sum of which reconciles to the draft tax assessment. It therefore depends on the taxpayer to provide evidence if they believe that the auditors’ general calculation is not fully correct.

This brings us to the next important point. Most tax audit assessments are negotiated amounts rather than exact calculations. These negotiated amounts must be reasonable considering whatever evidence is available, but most of the time neither party wants or is able to take the time to calculate and defend a precise tax assessment based on a detailed and comprehensive review of transactions.

A major takeaway from the above is that the better prepared an organization is to defend its case with detailed evidence, reconciliations, etc., the better its chances to lower the tax audit assessment. Without a detailed and strategic defense, an organization may have to settle for a tax assessment that exceeds what is actually owed under the law.

The following lists provides some specific action steps a taxpayer can take to prepare for tax audits before they happen:

Managing Tax Audits

When an organization receives notice that it has been placed under audit, the following steps should be following to facilitate a smooth audit with a fair result:

1. General first steps.
   1. Respect the government’s right to audit the taxpayer and commit to cooperating in full with all lawful audit procedures. It is important for taxpayers to be honest in their dealings with the Afghanistan Revenue Department and to never present any false documents or information.
   2. Carefully review the official audit notice letter to ensure that the organization has indeed been placed under audit. Article 26 of the 2015 Tax Administration Law gives the taxation administration the right to request and obtain information from the taxpayer, but the taxation administration is required to give the taxpayer written notice and to give at least six working days for the taxpayer to provide information. If the auditors do not provide an official audit notice letter upfront, ask them to do so before proceeding further.
   3. Review the period under audit and ensure that it falls within the statute of limitations. If the period under audit is outside the statute of limitations, the taxpayer is within their rights to request an explanation from the auditors, and may even request a written explanation from the ARD if desired.[4]
   4. Consider amending the tax returns. The taxpayer should perform a review of its tax returns for the year(s) under audit and determine if it would be appropriate to amend its annual tax returns or associated monthly/quarterly tax filings within the amount of time granted by the official audit notice letter. If deficiencies are noted on the original tax returns, filing an amended tax return may lead to a smoother audit process.
   5. Assign a focal point to liaise with the auditors. It is important for this focal point to have a strong grasp of the tax law and a deep understanding of the organization and its activities.
2. Risk analysis. If organizations have not yet reviewed and analyzed their tax risks, it is helpful to do so immediately at the start of an audit. As part of the risk analysis process, taxpayers should identity the 5-10 biggest transactions in each line item of the annual tax return(s) under audit and conduct a careful review of all relevant supporting documentation to ensure everything is in order. The same process should be done for all fixed asset purchases during the year(s) under audit, particularly in the case of for-profit business entities. Further, taxpayers should review the “risky” line items on their annual tax returns (as noted above) to ensure that a proper defense of these accounts can be presented. Refer to the sub-sections below to understand the most common risks faced by businesses and NGOs.
3. Document review. It is important to review all documents in detail before submitting them to auditors. Taxpayers should give all requested documents but generally not more than what is requested. Original documents can be shown to the auditors but never handed over – all documents handed over to auditors should be copies. It is also helpful to keep a written record of all documents shown or given to the auditors.
4. Kickoff meeting. While tax auditors occasionally skip a kickoff meeting for sake of expediency, in most cases they will request a kickoff meeting after a review of the initial documents provided in response to the audit questionnaires. The auditors usually prepare well for this meeting and ask important questions, the responses to which will greatly impact the audit process. Organizations should designate experienced senior management personnel to handle this meeting along with the focal point to ensure that the case is well-presented.
5. Interacting with auditors.
   1. Always show respect and seek to establish a professional relationship. This is important and generally helpful for the audit process.
   2. If the auditors ask a question to which is answer is not known, ask for time to find the proper answer rather than providing a speculative answer.
   3. Always stay calm; avoid emotional reactions even if you disagree with the auditors.
   4. Take written notes from all interactions with auditors. Having a record of what has (and has not) been said is often useful at the stage of negotiating and defending the audit assessment.
6. Negotiate. Be prepared to negotiate a final settlement. Taxpayers should design their entire defense to reduce the tax audit assessment. Organizations should carefully prepare a negotiation strategy that can be executed by skillful negotiators. At this stage, the skill of the negotiator and strength of relationship with the auditors can be equally if not more important than the actual technical defense of the case.
7. Payment. After the tax audit assessment is finalized, organizations will be required to make the payment within a week or so. If an organization needs more time to come up with the cash, it is possible to request an installment plan.
8. Dispute. If taxpayers disagree with the result of a tax audit, they may file a formal dispute with the ARD within 45 days of receiving the auditors’ decision. The process for filing a dispute can be found in Articles 11-14 of the 2015 Tax Administration Law. One notable point is that the initiation of a formal dispute process by a taxpayer cannot be used to fully postpone the payment of tax, as Article 14(2) (as amended) of the 2015 Tax Administration Law says that up to 30% of the tax assessment may be collected [before the dispute is resolved].

Most Common Business Tax Risks

Tax auditors often work on the assumption that all businesses are profitable every year. If a business has a legitimate net loss in a down year, auditors will try to find ways to disallow expenses (or increase income) so that the business will have a taxable profit. And even when businesses report taxable profit, auditors will try to increase the profit margin percentage during their audit. Businesses should be aware of and develop processes to mitigate risk in the following two areas:

1. Expense disallowance. Article 18 of the 2009 Income Tax Law says that the “Deduction of all ordinary and necessary expenses of production, collection, and preservation of income of natural and legal persons shall be allowed in accordance with the provisions of this Law…,” then goes on to provide additional detail on deductible and non-deductible expenses. Tax auditors will aggressively disallow any expense claimed as a business deduction that they believe cannot be properly substantiated or is not necessary to the generation of income. In addition to the “risky line items” previously mentioned in this article, please also note that the ARD considers all unrealized foreign exchange losses to be nondeductible. Disallowed expenses will result in an additional tax audit assessment of 20% (the corporate income tax rate) of the disallowed amount. Businesses can support the deductibility of legitimate business expenses in the following ways:
   1. Ensure that every expense transaction has acceptable third-party documentation. As many informal vendors in Afghanistan cannot provide proper documentation, businesses should plan to procure goods and services from more professional vendors if they want to prioritize the substantiation of expenses for tax audit purposes.
   2. Ensure that contractor tax is properly withheld as per the law. If a business fails to withhold contractor tax in cases where it is required by the law, the tax auditors will not subsequently collect the applicable 2% or 7% contractor tax at the time of audit; instead, they will completely disallow the expense, costing the taxpayer 20% of the disallowed amount.
   3. Pay vendors via check or bank transfer whenever possible. Whereas cash payments are primarily substantiated by third-party documentation (as per point “a” above), payments made by bank are undisputed proof that a payment happened. Tax auditors will always accept expenses paid through bank if the relevant contractor tax was paid and the connection between the transferred funds and the transaction can be established.
2. Revenue recognition. Since revenue is subject to both BRT (4% for most entities) and 20% corporate net income tax (after legitimate expense deductions are considered), tax auditors will carefully audit revenue to ensure that businesses are not hiding revenue. Auditors will generally examine “revenue” from four different perspectives:
   1. Revenue as reported on the annual income tax return.
   2. The sum of all credits in the business’ bank statements.
   3. Audit confirmations received from the taxpayer’s clients.
   4. Income as stated in the business’ accounting records/general ledger.

If any of these four perspectives indicate that the business generated more revenue than reported on the annual tax return, auditors will adjust taxable revenue accordingly.

Assuming the business has accurately reported its revenue on the annual income tax return, there should be no basis for auditors to adjust/increase taxable revenue at the time of audit. However, the above-mentioned audit approach may easily lead the auditors to believe that a taxpayer had more revenue than what was reported. This risk is particularly acute with method “b” of summing credits in bank accounts. Not only would an accrual-basis taxpayer not recognize revenue as per cash receipts from customers, but even for cash-basis taxpayers there are some transactions that are simply not revenue-related (i.e. internal transfers from one bank account to another, loan repayments, etc.). Therefore, businesses are advised to prepare their own internal reconciliations to be able to prove that revenue is correctly stated on the annual income tax return.

Most Common NGO Tax Risks

NGOs are not subject to tax on their revenue or net income. Therefore, the two above-mentioned areas of audit risk for businesses are not applicable for NGOs. Despite being exempt from BRT and corporate income tax, NGOs are still responsible for applicable withholding taxes. While auditors will carefully examine all types of withholding taxes, tax-compliant NGOs typically find that contractor tax poses far greater tax audit risk than salary or rent tax.

Tax auditors will often review the annual tax return of an NGO and add up all expense line items that may be subject to contractor tax (excluding line items such as wages and rent that are clearly not subject to contractor tax) to determine a theoretical “taxable base” for contractor tax. Then the 12 monthly contractor tax forms will be reviewed to determine the total amount of expenses upon which contractor tax was paid. This amount will be divided by the “taxable base” to determine the percentage of expenses upon which contractor tax was paid. While there is no fixed standard for the percentage of expenses upon which contractor tax should be paid, anecdotal evidence suggests that the ARD often expects contractor tax to have been paid on at least 70% of the “taxable base.” While this is a very rough figure and may vary from auditor to auditor and entity to entity depending on the nature of their operations, it is still helpful for understanding the ARD’s perspective. 

If the tax auditors find that the percentage of expenses upon which contractor tax was paid is lower than their expectation, one common strategy employed by the auditors to simply calculate the difference and make a general contractor tax assessment on that amount. While this method of calculating a tax assessment is efficient, it can be a deeply flawed approach because it does not require the auditors to specifically identify any non-compliant transactions (i.e., transactions upon which contractor tax should have been withheld but wasn’t). If the NGO believes this general tax assessment is incorrect, it bears the burden of proof to demonstrate that it has in fact paid all contractor tax as required by law.

NGOs should take the following points into consideration to mitigate this tax audit risk:

1. Ensure compliance with contractor tax requirements. Taxpayers should ensure that their policies and procedures for withholding and remitting contractor tax are in full compliance. There are several commonly misunderstood facets of the contractor tax law as well as some gray areas which may need to be clarified by the taxpayer by obtaining a private ruling. See Quest’s article on contractor tax for more information.
2. List expenses by vendor. The single most effective strategy to prove the correctness of contractor tax withholding is to create a list of expenses by vendor for the year(s) under audit, with the total reconciling to the aforementioned “taxable base.” The taxpayer can then use this list of expenses by vendor to prove that it withheld and paid contractor tax on every eligible vendor to whom annual payments exceeded the AFN 500,000 threshold in the law. Taxpayers who can convincingly present evidence in this manner may be able to significantly reduce or eliminate any draft tax assessment that was calculated based on a percentage of taxable expenses.
3. Pay more contractor tax. Taxpayers may want to consider increasing contractor tax withholding as part of the procurement process by working with contracted/professional vendors rather than informal vendors as much as possible, including possibly withholding contractor tax on payments to vendors even if they do not exceed the annual AFN 500,000 threshold.
4. Negotiate the rate. Tax auditors who make a general assessment of contractor tax may start by assessing contractor tax at a 7% rate (the rate for non-licensed vendors). Taxpayers should try to negotiate this rate down to 2% (the rate for licensed vendors), which is possible if taxpayers can demonstrate doing a high volume of business with licensed vendors.

It is worth noting that businesses also face this exact same tax risk, and they also should be prepared to employ the four risk mitigation strategies mentioned above for contractor tax. However, while this risk is usually forefront in the audits of NGOs, it is usually a lower-tier risk for businesses.

Conclusion

Dealing with tax audits in Afghanistan is indeed challenging, but this article should help taxpayers navigate the process. The ideal outcome of tax audits is increased mutual confidence and trust between the ARD and the taxpayer that all taxes are being paid correctly and that that law is being fairly applied by both parties. Approaching the tax audit process with both knowledge and integrity will help to achieve this outcome.

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[1] Article 3 subsection 1 (13) of the Tax Administration Law defines tax evasion as “when the taxpayer acts deliberately and unlawfully, resulting in tax evasion, or partial payment of taxes.”

[2] This new regulation reducing the statute of limitations for tax audits to one year was the direct result of new tax rules announced in May 2023 by the highest levels of leadership of the Islamic Emirate of Afghanistan.

[3] The ARD may not even accept receipts printed from a cash register unless the vendor signs and stamps the receipt after printing.

[4] Article 5 of the 2015 Tax Administration Law gives taxpayers the right to receive written information from the taxation administration regarding their tax situation.