[Tax Series: 06] Understanding Tax Audits: Why You Might Be Selected

The word audit can strike fear into the heart of even the most meticulous taxpayer—but understanding what a tax audit is and why it happens can help ease some of that anxiety. While being selected for an audit doesn't necessarily mean you've done something wrong, it does mean the tax authorities want to take a closer look at your tax return. 

Don't let tax audits intimidate you. This blog will walk you through everything you need to know to stay informed and prepared.

Let’s dive in.

What is a Tax Audit?

A tax audit is an official examination conducted by tax authorities to verify the accuracy of a taxpayer’s reported tax base and tax amount. Under internal administrative guidance/regulation, officials have the right to question taxpayers, inspect documents, ledgers, or goods, and request submissions to ensure compliance (Investigation Management Regulations Article 3).

This process often begins with a tax audit advance notice or formal notice, based on a predefined investigation plan. Whether you’re a business owner or an individual, understanding why you might be selected for a tax audit can help you stay prepared.

Types of Tax Audits: Regular vs. Irregular

Tax audits are broadly categorized into two types: regular and irregular. Each serves a distinct purpose and provides clues about why a taxpayer might be selected.

Regular Tax Audit:

These audits occur periodically to verify the accuracy of reported details, even without specific suspicions of tax evasion. They aim to encourage diligent reporting and ensure compliance across industries.

Irregular Tax Audit:

Triggered by clear suspicions of tax evasion, these audits are more targeted. They often follow specific reports or evidence suggesting discrepancies in tax filings.

Receiving an irregular audit notice suggests that the NTS has identified red flags or received reports that warrant further investigation.

Are Tax Audits Arbitrary?

You might wonder if the National Tax Service (NTS) conducts tax audits at its discretion. The answer is no. The National Tax Basic Act regulates tax audits to protect taxpayers’ rights, incorporating safeguards like the principle of prohibiting duplicate investigations (Article 81-4) and specific tax audit selection criteria (Article 81-6). These laws ensure audits are conducted methodically, based on an investigation plan, preventing arbitrary or excessive use of audit powers. However, once selected, taxpayers often face extensive questioning and multifaceted investigations, which can lead to additional tax assessments and potential losses.

 

Reasons for Selection: Regular Tax Audits

Regular tax audits are conducted systematically, often based on data analysis or predefined criteria. Here are the key reasons you might be selected:

• Suspicion of Non-Compliance: The NTS Commissioner analyzes tax data, external audit reports, and accounting integrity details. If reported information raises suspicions of non-compliance, a tax audit may be initiated.

• Long Audit Gap: If a taxpayer hasn’t been audited for the same tax item in four or more recent tax periods, the NTS may select them to verify reporting accuracy, considering factors like industry, scale, and economic influence.

• Random Sampling: In rare cases, the NTS may conduct sample-based audits for statistical or industry research purposes, which may include compliant taxpayers.

Reasons for Selection: Irregular Tax Audits

Irregular tax audits are more targeted and typically arise from specific red flags. Common triggers include:

• Failure to Meet Tax Obligations: Not filing required reports, issuing tax invoices, or submitting payment statements can prompt an audit.

  
  

• Discrepancies in Transactions: Suspicion of unreported transactions, fabricated transactions, or transactions without proper documentation may lead to an irregular tax audit.

  
  

• Tax Evasion Reports: A specific tip-off or report about tax evasion can trigger an investigation.

  
  

• Clear Evidence of Errors: Obvious omissions or errors in reported content can warrant an audit.

  
  

• Improper Conduct: Providing money or goods to a tax official about their duties can immediately trigger an irregular tax audit.

The NTS’s Information Powerhouse: PCI System and FIU

The NTS leverages advanced systems and data to identify potential audit targets, maximizing efficiency with limited resources. Two key tools are the Property, Consumption, and Income Analysis System (PCI) and the Financial Intelligence Unit (FIU).

PCI System: Tracking Income and Assets

The PCI system analyzes five years of tax data, comparing reported income against asset acquisitions and consumption expenditures. For example, if an individual’s reported income is low but they’ve acquired high-value assets or incurred significant credit card expenses, the NTS may suspect tax evasion, flagging them for a tax audit. This income-expenditure analysis is a cornerstone of the NTS’s ability to detect discrepancies.

Financial Intelligence Unit (FIU): Monitoring Cash Transactions

The Financial Intelligence Unit (FIU) plays a critical role by collecting data from financial institutions, which the NTS uses to select audit targets. Two key reports from the FIU are:

• Cash Transaction Report (CTR): Financial institutions must report cash transactions exceeding 10 million won to the FIU. Known as a cash transaction report, this system helps detect illegal fund flows or money laundering by tracking high-value cash movements.

  
  

• Suspicious Transaction Report (STR): If a transaction appears unusual—such as excessive deposit turnover, large transaction volumes, or deviations from normal account activity—financial institutions report it to the FIU. These reports raise red flags for potential tax evasion or illicit activities.

  
  

• The NTS integrates cash transaction reports, STRs, tax evasion tips, and other data to build a comprehensive profile of a taxpayer’s financial behavior, enabling precise audit targeting.

  
  

While the FIU operates under Korea’s Financial Services Commission for anti-money laundering, relevant data may be shared with the NTS when deemed necessary.

How to Stay Prepared

Understanding the reasons for tax audit selection empowers taxpayers to take proactive steps. Maintaining accurate records, ensuring timely compliance with tax obligations, and being mindful of high-value transactions reported via cash transaction reports can reduce the likelihood of an audit. Regularly reviewing your financial activities and consulting with tax professionals can also help you align with NTS expectations.

What’s Next?

The Lee Ha-nee case highlights the importance of being informed about tax audits. Stay tuned for more insights, and feel free to reach out with any questions about tax audits, the Financial Intelligence Unit, or navigating tax compliance. At J&J, we guide you through the complexities of tax law as well as offer reliable taxation services. Contact us to learn more about staying compliant and prepared.