Audit Employment Income Tax

1. Introduction
Just like any other country, in Ethiopia also, anyone who derives income from
employment and employment related activities are expected to pay Employment Income
Tax.
Individuals may receive various types of income such as wages or salary from
employment, commission, bonus, fringe benefits, rent from letting houses or buildings,
interest from lending/saving money, and profit from their trading activities or
business. These individuals are required to pay income tax. They are ordered to do so by
income tax proclamations, regulation and directives. The law specifies how and when
these individuals have to pay the required tax. This paper deals especially with the aspect
of the law and audit which applies to individuals who earn income from employment.
2. Definitions
2.1. What is an Employee?
“Employee” means an individual engaged, whether on a permanent or temporary basis, to
perform services under the direction and control of another person, other than as an
independent contractor, and includes a director or other holder of an office in the
management of a body, and government appointees and elected persons holding public
offices.
2.2. What is an Employment Income?
Employment income is any payment or gain in cash or in kind received from employment
by the employee subject to certain exemptions. i.e.; employment income shall not include
exempt income. Employment income means the following:
 Salary, wages, an allowance, bonus, commission, gratuity, or other remuneration
received by an employee in respect of a past, current, or future employment;

2.3. What is an Employment Income Tax?

Employment income tax is a kind of tax on the earnings of an employee. Employees who
earn birr 601 per month and above are liable to pay employment income tax. The
government collects this tax from any individual employees, other than contractors,
engaged whether on a permanent or temporary basis to perform services under the

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direction and control of the employer. Employment income is one of the most well
known forms of tax in Ethiopia
2.4. What is an Employment income tax audit?
An Employment income tax audit is an inspection conducted by a government
representative to confirm that the employees’ taxes were prepared correctly.
3. Employment Income Tax in Ethiopia Context
Employment income under Schedule “A” is one of the main sources of direct taxation
and a major contributor to tax revenue. Tax imposed (levied) on employment income is
referred to as employment income tax.
Article 10(1) provides that without to Article 84 of this proclamation, Employment
income tax shall be imposed for each calendar month or part thereof at the rate or
rates specified in Article 11 of this proclamation on an employee who receives
employment income during the month or part thereof.
This article lays down three fundamental principles for imposition of employment
income tax. These are discussed below:
a) Imposition of tax on employment income tax is on the employee, the person
receiving employment income. The employer is simply a withholding agent.
Article 2(7) defines an employee to mean an individual engaged, whether on a
permanent or temporary basis, to perform services under the direction and
control of another person, other than as an independent contractor, and
includes a director or other holder of an office in the management of a body, and
government appointees and elected persons holding public offices.

It is important that the auditors distinguish between an independent contractor and

an employee because these are taxed differently. An employee is liable to
employment income tax while an independent contractor is liable to business
income tax under article 8. Taxation under business income tax comes with
greater tax privileges. For instance, business income is imposed on taxable
business income (total business income less total deduction) whereas under
article 10(3), a tax on employment income is on gross receipts (deductions are not
allowed). This implies that if the taxpayer posted a loss, they are not liable to tax
instead the loss is carried forward and allowed as a deduction in determining the

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 taxpayer’s taxable income for the subsequent year (article 26(2) of the Federal
Income Tax Proclamation).
Although there is usually a very thin line between the two, an independent
contractor is one who provides their own tools, is not controlled by the employer,
can assign part or all the assignment to another person, is not under a regular form
of remuneration (salary).
b) Period of taxability is a calendar month or part thereof. This is unlike rental and
business income taxes which are imposed for a tax year. Accordingly, auditors are
required to check if the employer has deducted withholding tax from the
employees on a monthly basis in the terms of article 88 and such amounts are paid
in accordance with article 97 of the Federal Income Tax Proclamation.

c) Tax is on the basis of receipt of employment income. This implies cash based
method of accounting. In other words, employment income tax can only be
imposed at the time of payment and not when it accrues. This means that an
employer who has not paid employment income will not be required to
withhold tax on accrued employment income in the terms of article 88(1).
Taxpayers are likely to use this as scheme to evade or delay payment of tax
on employment income by purportedly accruing salaries and wages. Auditors are
there required to run a cash flow statement to check cash payments and bring to
tax unaccounted tax on employment income.

Employment income is defined in accordance with article 2(9) and article 12 and
broadly includes cash and non-cash benefits (fringe benefits- details contained in
the Council of Ministers Regulation No. 410/2017) received in respect of a past,
current or future employment. However, this does not include exempt
employment income (article 12(2)). Exempt amounts are spelt out in article 65 of
the Federal Income Tax Proclamation.

Fringe benefits provide a platform for tax planning/evasion under this tax head.
This is because they are tax allowable expenses for the employer, i.e., deductible
from business income but may remain discreet for employment income tax.
Employees may decide to provide non cash benefits such as vehicle, housing,
house hold property which are not disclosed on the payroll.

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 This is potential for tax leakage which calls for auditor’s vigilance during
audit activity. Importantly, where the employer pays employment income tax for
the employee, the amount of tax is treated as employment income in the terms of
article 12(3) and is taxable on the employee. Auditors are expected to check
employment contracts of employees to the pay roll to determine if
employment income is paid gross and raise appropriate assessments.

d) The principles of taxability of residents apply to employees. In this case, a

resident employee who earns foreign employment tax is still subject to tax on
their worldwide income (foreign employment income) in the terms of article 7(1)
read together with 10(1). The taxability of such foreign employment income is as
follows:

Foreign employment income (FEI) xxxx

Tax payable on FEL xxxx
Less: Tax credit; the lessor of
Foreign tax (paid) on FEI xxxx
Tax on FEI x (Average rate of employment tax) xxxx
(xxxx)
Tax payable xxxx

Note that where the tax credit exceeds the tax on FEI the excess is not refundable,
carried back to the preceding year or carried forward to the following year, in the
terms article 45(5) of the Federal Income Tax Proclamation read together with
article 20(3) of the Regulation No. 410/2017.
Valuation of fringe benefits
Fringe benefits are usually given in the form of non-cash benefits and fall under the scope
of employment income in the terms of article 12(1) (b) of the Proclamation. Provision of
fringe benefits is likely to fall below the tax radar and could be a source of revenue
leakage under employment income tax.

Article 12(4) provides that the Council of Ministers shall make Regulations for
determining the value and taxation of fringe benefits. Fringe benefits are clustered under
nine (9) different categories with the tenth as a residual fringe benefits that is not
specifically included among the said categories.

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General principles of taxation (fringe benefits)
i) Tax on fringe benefits shall not exceed 10% of the employee’s salary (Article
19(1)) and for this purpose salary doesn’t include other employment related
benefits, such as allowances.
ii) The employee is deemed to have received a fringe benefit if it is provided to the
employee by the employer, a related person to the employer (e.g. a parent
company and its subsidiary) and a third party to the employer acting under an
arrangement with an employer or a related person of the employer.
iii) The employee is deemed to have received a fringe benefit if it is provided to the
relative of the employee (spouse/children) by the employer, a related party to the
employer and a third party to the employer acting under an arrangement with an
employer or a related person of the employer.
iv) Specific benefits enumerated by article 8(4) of the regulations shall not be treated
as benefits provided to the employee and are therefore not taxable.
4. Planning of Employment Income Tax Audit
The auditor is required to plan and perform their work in order to form an opinion on the
financial statements and in doing so to obtain reasonable assurance that the financial
statements are free from material misstatement, whether due to fraud or error. And also
the auditor performs planning to determine an effective and efficient way to obtain the
evidential matter necessary to report on the taxpayer`s tax returns. The followings are
some of audit planning for employment income tax.
 Review the tax payer payroll, and document findings.
 Interview the tax payer in the organization by field audit about the employees
 Confirm employment income, expenses and liabilities are accounted using
appropriate reliable supporting documents
 Check the income tax computation on payroll sheet and other allowances are
treated as per the tax proclamation and its regulation.
 Check for deductions of withholding tax for entitled expenditures.
 Discuss findings with the payroll and conduct additional examinations and make
corrections based on the payroll comment.
 Organize Findings and conduct Exit-Conference with team leader.

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  Prepare and submit draft assessment report and when approved by team leader
capture final report to SIGTAS.
 Prepare final report and assessment notice.

5. Techniques or Approaches of Employment Income Tax Audit

During an audit, testing payroll transactions includes sniffing out employees paid who
shouldn’t have been and making sure valid employees are paid the correct amount.
Auditors also need to make sure the payroll transactions are reflected in the correct
financial statement accounts.
Tax audit activity starts with the taxpayer’s employment income tax declaration. Thus,
the employment income tax audit is required to determine whether the taxpayer has
properly disclosed all employee income tax regardless of the type of audit.
The Employment income tax audit verifies compliance workers are properly classified,
payments made to employees is properly reported, and protects workers’ rights to receive
benefits.
5.1. Entrance Interview
Before reviewing your records, the auditor will conduct an entrance interview with you or
your designated representative to explain the purpose of the audit and the audit process,
gather general information about the operation and organization of your business and
accounting records, and answer any of your questions.
The information obtained from entrance interview questionnaire will support the
development of the detailed audit plan. The auditor should compile the following basic
information:-
 The business entity, i.e. sole proprietorship private limited company, public
share company government owned enterprise etc.;
 The trade name(s) under which the taxpayer operates, if applicable;
 The addresses of the business outlets operated by the taxpayer;
 The names and responsibilities of the key officers, directors and controlling
shareholders of the company who are directly involved in the management of
the taxpayer’s operations. Include the TIN’s of the individuals
 The names, locations and account numbers of the financial institutions used
by the taxpayer and related other.

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 5.2. Audit employees income
The following are the basic audit employee’s income tests that the auditor should conduct
that are expanded upon in the Audit Program:-
 Confirm that the taxpayer has accurately disclosed all income for the purpose of
determining the taxable income.
 Confirm that the taxpayer has correctly declared employment income, and
accounted for tax accordance to the income tax proclamation and regulation,
inclusive.
 Confirm that tax was paid in accordance with income tax proclamation
 Prior to the beginning of the audit, if possible and practical, vist the
company/taxpayer’s business premises and informally observe the
company/taxpayer’s employers.
 Select a representative sample of Me/He/1/1 receipt voucher or invoices for
various periods in the taxation year, to evaluate the reliability of the taxpayer’s
accounting system and internal controls/checks. Pay particular attention to the
periods in which changes in personnel or systems occurred.
 Test the accuracy and classification of the recording of payroll transactions and
exemptions taken are properly agreed with income tax proclamation.
 Observe when reporting takes place to ensure that payroll transactions are
recorded on a timely basis. (Timing)
 Find out the names of the employee’s or family members of the
shareholders/taxpayer’s who may be involved in the retention of the records for
interview.
 Match information to other computer-based procedures, such as match the
accounts payable file to the employee master file to check for payments to
employees outside the payroll system.
 Examine the recorded payroll payments are for work actually performed by
existing employees and agree the income reported on the employment income tax
declaration with the payroll.

Under this the auditor will examine the following supporting documents and records:

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 a) Cancelled payroll checks for employee name, authorized signature and proper
endorsement, watching specifically for unusual or recurring second
endorsements.
b) Payroll journal or listing, tracing transactions to the personnel files to
determine whether the employees were actually employed during the payroll
period.
c) Payroll journal or listing and individual payroll records, selecting terminated
employees to determine whether each terminated employee received his or her
termination pay in accordance with company policy and whether each
employee was paid in the subsequent payroll period.
d) Payroll checks, observing each employee as he or she picks up and signs for
his or her check.

5.3. Audit employees expense

During your audit, you need to test management financial statement assertions. For
payroll expense transactions test these five assertions:
1. Occurrence: Occurrence tests if the payment transactions actually took place.
Check that payroll expenses and payroll tax expenses the company records are
for employees who exist and work during the pay period. Also, all accrued
payroll and payroll tax liability balances should represent amounts the company
owes at the date of the balance sheet. To test this assertion, you regularly
perform two procedures:
 Testing for terminated employees: To make sure no terminated
employees are being paid, select a sample of the client’s terminated
employees and trace them back to the payroll register.
 Verifying new employee information: Select a sample of employees
hired in the year under audit. Review the personnel file and make sure
each new employee has appropriate documentation according to the audit
client’s human resources procedure and policy manual.
2. Completeness: In the payroll process, understatement isn’t a major concern
because most employees will notify employers if they don’t get a paycheck.
Regardless, you do need to perform some testing to make sure the audit client
isn’t understating payroll expense.

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 Test the completeness assertion by securing a list of current employees from
human resources. Select a sample of current employees and trace them to the
payroll register, making sure each current employee has been paid.
3. Authorization: This step addresses whether your audit client management and
staff follow proper internal control or other company authorization procedures
when handling payroll transactions. You need to make sure that personnel file
updates and time sheets have proper authorization.
To test authorizations for both, select a sample of employees from the payroll
register. Inspect time sheets, checking that an appropriate level of management
approves hours for which the employee is paid. Trace employees back to their
personnel file to make sure the facts reflecting in the payroll register are the
same as in the personnel folder. These facts include both rates of pay and
appropriate payroll deductions.
4. Accuracy: Testing accuracy addresses whether transactions are free from error.
For payroll, you must check the amount paid and account classifications to
make sure they’re correct.
5. Cutoff: Clients may try to move accounting transactions from one year to
another to show more positive results. Your job as an auditor is to have
reasonable assurance the company records all payroll-related transactions when
they are incurred. The best way to check for proper cutoffs is to test accruals.
5.4. Audit employees Liabilities
The following are the basic audit employee’s liabilities tests that the auditor should
conduct that are expanded upon in the Audit Program:-
 Accrued wages or bonuses to key shareholders and management personnel for
which expenses deductions have been claimed. Confirm that the withholding
tax on employment income has been deducted. Since the recipient will need to
declare the income in the current year, even if not actually paid, the auditor
should notify the respective City/Regional tax authority for consideration of
the income aggregating provision.
5.5. Audit employees asset accounts
The following are the basic audit employee’s asset account tests that the auditor should
conduct that are expanded upon in the Audit Program:-

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  Examine all bank debit and credit memos. An unusual number of errors
corrected may indicate several bank accounts with similar or identical names
that employees and bank employees are getting confused.
 Some employees may be paid cash under the table to avoid paying benefits.
Most often this cash is from unrecorded cash sales. Analyze the payroll
journal, collective bargaining agreement, and other documents to identify
inconsistencies.
6. Scope of Employment Income Tax Audit
Payroll systems can be as basic as a manual system with only a check register and
individual earnings records or as complex as a computerized double entry system on an
accrual basis.
The auditor will review your books and records to:
 Verify the business ownership and type of entity (sole proprietorship, partnership,
corporation, etc.).
 Verify that all individuals paid for services have been properly classified as either
employees or independent contractors in accordance with the proclamations,
regulations and directives.
 Discuss any questionable payments made for personal services and the nature of
the working relationships with you and the workers. Based on the facts obtained
from the records, input from you, and discussions with the workers, the auditor
will determine whether the workers are employees or independent contractors.
In addition, if your account has been selected for a complete audit, the following tests
will be performed:
 Verification that your acknowledged gross and taxable wages, cash direct labor,
inventory salary expense, construction in progress commission expense, wages
payable payroll tax expense, payroll taxes withheld, and accrued payroll taxes
have been properly reported.
 Verification that you have correctly withheld and reported personal income tax
for wages paid to your employees.
7. Examination of Employment Income Tax Records
An audit begins with the examination of records for a test year. The test year is generally
the most recent completed calendar year. If differences are found in the test year, then the

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examination may be expanded to include the records for the entire period covered by the
audit.
All employing units to make business records available during normal business hours.
These records include:
• Check registers, check stubs, canceled checks, and bank statements
• General ledger and general journal
• Annual financial statements (income and expense statements, balance
sheet, etc.)
• Cash payments records (pay out slips and vouchers)
• Ownership verification (City business license, Taxpayer identification
number, Any license required to operate your business, Written
agreements)
• Federal/State income tax returns
• Worksheets
Additional records required useful for verification of acknowledged payroll
 Payroll records such as payroll journal, individual earnings records, payroll
summaries, etc.
 Federal employment tax reports (Wage and Tax Statement, Employee’s
Withholding Allowance Certificate, Employer’s Quarterly Federal Tax Return,
Employer’s Annual Federal Unemployment Tax Return).
 State employment tax reports (Quarterly Contribution Return and Report of
Wages, Quarterly Contribution Return and Report of Wages (Continuation),
Quarterly Contribution and Wage Adjustment Form, Tax and Wage Adjustment
Form, Employee’s Withholding Allowance Certificate).

8. Findings of Employment Income Tax Audit

Upon the completion of the audit, the auditor will arrange for an exit interview, either in
person or by phone, to review the audit findings, identify any other information that
should be considered, and attempt to resolve disputed issues, if any. If you do not reach
an agreement with the auditor, you may request a pre-assessment conference with the
supervisor of the auditor.
The audit will result in one of the following:
 No change audit, where no differences are found.

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  An overpayment, where a credit or refund will be issued.
 An underpayment, where the differences will be assessed.
 Both an underpayment and overpayment.
In general, one way auditors test employee payroll-related items is to make sure the
related employer expenses are properly accounted for on the books. It’s the auditor’s
responsibility during the audit to sample and test employer payroll taxes, accrued
employee payroll taxes, and employe.

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