A substantial reorganization of the way VAT audits are conducted, including the development of an annual program based on documented risk criteria and the strengthening of on-site audits, is recommended by the Audit Service, in a special report on VAT audits by the Tax Department, which was released on Thursday.

As noted, based on an audit conducted on a random sample of VAT tax files, the Audit Office identified significant weaknesses in the Tax Department’s audit procedures, as well as in the degree of compliance with the regulatory framework for both indirect taxation—which was the main focus of our audit—and direct taxation.

See the full Audit Report here.

Specifically, it states that in a number of cases, delays of several years were identified in the conduct of substantive audits, audits were limited to desk-based reviews, incomplete documentation regarding the place of service provision, and doubts regarding the correct tax treatment of complex transactions, such as intra-Community transactions and gold trading.

“These weaknesses resulted in the payment of significant VAT refunds without adequate verification, the inability to assess taxes in a timely manner due to the expiration of the six-year statute of limitations, and an increased risk of loss of public revenue. Furthermore, discrepancies were found between VAT and income tax returns, failure to file financial statements, as well as cases where the liability of professionals who submitted inaccurate returns was not investigated,” he further notes, noting that the above demonstrate that the existing procedures for case selection, monitoring of refunds, and cross-checking of data do not provide adequate safeguards for public revenue.

In the preface to the report, Auditor General Andreas Papakonstantinou states, among other things, that the initial results of the newly established Pan-Cyprus VAT Audit Unit are quite encouraging, demonstrating that the Commissioner’s decision to create the Unit was a step in the right direction, laying the groundwork for specialized audits that can make a substantial contribution to the protection of public revenue.

“Of course, the effectiveness of a tax audit system cannot be assessed solely on the basis of the amount of taxes assessed. It is also essential that available (audit) resources be allocated based on a documented risk assessment, covering the entire spectrum of economic activity—not just sectors already under systematic monitoring—as well as identifying undeclared economic activity and individuals who remain outside the tax system,” he states.

It notes that “beyond the SME, the findings of this Report demonstrate that in certain cases, despite audits conducted by the Tax Department and serious indications of tax risk, these do not appear to have been given due weight or to have been subject to the necessary investigation. At the same time, instances of significant delays in completing audits were identified, as well as a lack of clear and adequately documented procedures and guidelines, a fact that appears to have affected the uniform and consistent handling of similar tax issues,” he adds.

He further notes that “strengthening tax compliance requires a holistic and continuously evolving approach to tax risk management, with an emphasis on their timely identification and effective resolution.”

According to the Audit Office, the report concerns audits conducted by the Audit Office at the Limassol District Office, the Limassol Large Taxpayers Division, and the Cyprus-wide VAT Audit Unit (PME).

As noted, the audit—based on a random sample of tax files—focused on indirect taxation issues (VAT) and the related audits conducted by the Taxation Department, as well as a review of the main activities and results of the VAT PMU.

It should be added that in cases where it was deemed necessary, the audit was extended to cover direct taxation issues, while the audit was conducted using data obtained from the Tax Department, its computerized systems, and the website of the Department of the Registrar of Companies and Intellectual Property (TEEDI).

Specifically, it is reported that the Pancyprian VAT Audit Unit (PME) conducted 175 audits in 2024, of which 112 (64%) resulted in tax assessments totaling approximately €10 million, while the total number of audits conducted island-wide during the same year amounted to 3,609, of which VAT assessments totaled approximately €30 million.

It should be added that, as a result, the PME audits—which represent 5% of the total number of audits—resulted in the assessment of VAT amounting to 33% of the total VAT assessed through all audits; furthermore, and despite the fact that SME audits covered only 0.07% of the 261,077 VAT-registered entities, their results were particularly significant.

Subsequently, the Audit Office refers to the Tax Commissioner’s decision to establish the PME as a targeted measure aimed at ensuring greater specialization and more effective management of higher-risk cases, adding that from the early stages of the PME’s operation, it appears to have been a necessary step which, if implemented correctly, will maximize the state’s revenue from tax assessments in relation to the number of audits conducted.

“Based on our audit, and despite the PME’s generally successful operation, we found that the selection of PME audits for 2024 focused primarily on taxable entities (to be continued) operating in the construction industry and in consulting services, without providing evidence of how they were selected. “We believe that, as a general rule, the selection should be targeted and based on specific criteria, but there should also be flexibility to examine issues based on their significance and the circumstances,” the EY continues.

She adds that, furthermore, the Internal Audit Unit does not have an annual audit plan, and it appears to be burdened from time to time with other tasks as well, a fact that hinders the effective performance of its duties.

“In our view, the PME appears to have the potential to contribute substantially to the objectives of the Tax Department, so it should focus on its work and be provided with the necessary resources and tools to carry out its duties without distraction and effectively,” the report notes.

The Audit Office recommends a substantial reorganization of the way VAT audits are conducted, by establishing an annual program based on documented risk criteria and strengthening on-site audits.

It adds that the Tax Department should proceed with a targeted review of cases involving high fiscal risk, particularly where intra-Community transactions, special regimes, or significant discrepancies between direct and indirect taxation, and to make use of the provisions of the law to extend the audit period where there are grounds for fraud or willful omissions.

It adds that, at the same time, uniform guidelines must be issued to ensure consistent application of the law, strengthening cooperation with the Central Bank and other competent authorities, as well as establishing mechanisms for cross-checking data from the TFA and TEEDI systems.

It also recommends the immediate investigation of liability in cases where inaccurate declarations were submitted or required information was not provided, as well as the establishment of procedures for timely communication between the Department’s divisions. “The implementation of the above measures is deemed necessary to strengthen control procedures and effectively protect public revenue,” the report states.