What is Tax Compliance: Meaning, Types, Procedures, Examples

‘Tax compliance’ is a simple-to-understand compound in English, but in legal parlance, it can have far-fetched implications for businesses. This article discusses everything that you need to know to stay on the right side of the tax laws. 

What is tax compliance?

People often confuse tax compliance meaning using it interchangeably with tax payment. They think that paying tax is equivalent to complying with tax laws; but it may not be true in most of the cases. Any government aiming to mobilise tax revenues legislates a set of laws regarding applicability and levying of taxes on businesses. 

Tax compliance means the willingness of a taxpayer to abide by the applicable tax laws, file tax returns and pay due taxes within the stipulated time period. In this context, it is important to remember that tax compliance requires people to follow any tax law with its spirit and text.  

Importance of tax compliance 

Tax compliance for businesses is crucial for the below reasons:

Legal necessity:

It is legally obligatory for any business to comply with the tax laws as per the jurisdiction in which the business is operational. Intentional or unintentional, any failure to abide by the applicable tax laws is tantamount to a breach of law. It may attract legal ramifications, like penalties, fines, and, in certain cases, imprisonment. 

Managing company reputation:

Information on legal proceedings against a company for tax avoidance can tarnish its business reputation. This can cause a serious deficit of trust among investors, vendors and customers. Lack of investors’ trust may dry up the flow of fresh capital into the company.   

Avoiding disruptions to business operations:

Legal ramifications for any non-compliance of tax laws can increase the cost of doing business. The tax authority may seize business assets and block the company’s bank accounts. The cost of fighting complex tax litigations in courts can be prohibitively high. It can disrupt the regular business operations of small companies. So, tax compliance always leads to cost savings for businesses. 

Corporate Social Responsibility:

Every company is responsible for making contributions to the societal goals of the region it is serving. Voluntary tax compliance portrays a company’s commitment to its corporate social responsibilities as the government uses tax revenue to fund developmental programmes. 

Business growth and expansion:

An established practice of voluntary tax compliance may help a company build a reliable tax forecasting mechanism and minimise being overly concerned about tax implications. Ultimately, it facilitates business growth and smooth expansion into new territories. 

Objectives of tax compliance

For a company, the major objectives of tax compliance are: 

• Monitor taxation laws and interpret the effects of changes in rules and regulation for the business. 
• Implement company-wide practice of following tax compliance procedures. 
• Document and maintain records of business transactions for tax estimation purpose.  
• File tax returns and pay taxes within the stipulated time limits for avoiding legal repercussions. 
• Assess and improve tax compliance practices through regular internal audits. 

Types of tax compliances in India

India being a fast-developing country with a population over a billion, governments require mobilising significant amounts of tax revenue to finance developmental programmes. So, the central and the state governments impose taxes on various economic activities. Companies are required to comply with each of these tax laws. 

The major tax laws under the jurisdiction of the central government of India are: 

• Income Tax Act.
• Customs Act.
• Central Goods & Services Tax Act.
• Integrated Goods & Services Tax Act.

The major taxes, fees and duties imposed by the state governments are:

• Professional Tax Act.
• Stamp Duty and Registration Fees Act.
• Road Tax and Motor Vehicles Act.
• Excise Duty on Alcohol.

What is direct tax compliance?

Taxes that an entity must pay directly to the respective governments are categorised as direct taxes. The liability of paying such taxes cannot be shifted to any other entity. These are progressive taxes, which means the amount of tax increases as the taxable income goes up.  

Common examples of direct taxes in India are:

• Income taxes on individuals and corporates. 
• Capital gain tax.
• Security transaction tax.
• Dividend distribution tax.
• Gift tax.
• Wealth tax.

Each of these taxes is applied and levied based on the respective tax legislations. Direct tax compliance means:

1. Following applicable direct tax laws by their texts and spirits. 
2. Voluntary disclosure of taxable income and activities.  
3. Payment of legitimate tax within the stipulated time as per the laws. 
4. Regular tax audits and documentation 

What is indirect tax compliance?

Compared to direct taxes, governments levy indirect taxes on the consumption of goods and services. The value of such taxes has no direct linkage with personal income or business profits. Rich and poor pay the same amount of tax despite differences in their earning capacities. It’s the reason such taxes are regressive. 

The most common indirect taxes in India are: 

• Goods and Services taxes (GST).
• Services tax.
• Excise tax.
• Entertainment tax.

For indirect tax compliance, entities need to follow underlying tax legislations, disclose taxable activities voluntarily, make tax payments within the stipulated time limits, tax audits, and documentation.   

What are the tax compliance procedures?

Companies should not practise voluntary tax compliance on an ad hoc basis; it causes more problems than it can solve. Tax laws are constantly evolving with changes in regulations and legislation. A lack of standard procedures in tax compliance complicates monitoring, interpreting, and adhering tax laws. 

Actual steps of voluntary tax compliance may vary depending on the business and the industry. However, we can outline the standard tax compliance procedures. They are: 

1. Monitor, identify and interpret applicable tax laws and regulation - Tax legislations and regulations are changing. It is essential for businesses to stay updated on the latest tax laws and their implications. It’s a full-time job and requires the support of expert minds.    
2. Document and maintain financial records for taxation - Every transaction in business can have tax implications. So, it’s important to document business transactions and maintain those records judiciously. This is an integral part of the tax compliance procedure. 
3. Calculate the tax liability accurately and file necessary tax returns - Based on your interpretation of existing tax laws, it is now time to calculate taxes you owe to the government. File tax returns and make the payment within the time limits.   
4. Conduct internal tax audits for identifying gap areas in tax compliance - Internal examination of tax accounting and returns is important for voluntarily maintaining tax compliance. It helps businesses to find out gap areas in the above-mentioned steps of tax compliance procedure. It is also essential to implement suggestions made in tax audit reports.  
5. Reply to tax notices and orders - Tax notices and orders are ways to maintain communications between the tax authority and taxpayers. Failure to reply to tax notices within a stipulated timeline may attract legal complications. 

Examples of tax compliance

To understand the meaning of tax compliance, let us discuss a tax compliance example: 

As per CGST Act, a competent tax officer can issue a show cause notice in a DRC-01 format to a taxpayer if a short payment of GST is found. As per the Act, the taxpayer must reply to DRC-01 within 7 working days from the date of receiving the notice. Otherwise, the tax authority can block the facility to file GSTR-1/IFF in the GST portal for the subsequent GST period. Besides, the reply to DRC-01 must be made in DRC-06 format. It should precisely describe the taxpayer’s perspective and necessary documents as attachments. 

These are all part of adhering to the CGST Act.    

What are the challenges in Indian tax compliance?

Some of the major challenges that businesses face in ensuring tax compliance in India are: 

• Complex tax structure.
• Frequent changes in tax legislation and regulations. 
• High cost of tax compliance. 
• Inter-state differences in tax laws.
• Risk of tax frauds. 

How to ensure proper tax compliance?

Tax compliance has serious implications on businesses and following the standard practices of tax compliance is a full-time responsibility. So, it is important to take help from expert professionals to establish and implement company-wide tax compliance procedures.