How does HMRC go about investigating a taxpayer?
While HMRC can launch an investigation into a business at any time within the statutory time limits, enquiry notices are usually timed at specific times of the year in order to control workflow within the department.
Most practitioners will be aware that a favoured time of the year is the end of January. Accountants are hoping that their problem clients may have avoided an enquiry, only to have those hopes dashed by an enquiry notice dated right at the very end of the month.
The initial letter from HMRC can be intimidating, as the Revenue tends to throw the kitchen sink at it. The letter will often embrace every single aspect of the business and will often be a standard template padded out in parts by reference to the particular client.
This can be evidenced by a request for an analysis of debtors in a case where debts amounted to £6! When this was gently pointed out to HMRC, the reply rather huffily said that it was entitled to ask for the information and it should therefore be provided. Common sense eventually prevailed and no analysis was provided.
HMRC has a variety of techniques that are employed in deciding whether or not a business should be investigated. This ‘risk assessment’ process can be very informative as it will compare the results of the business to other similar businesses; it will produce statistics such as gross profit margin, mark-up rate and comparisons to earlier years. The problem is that if a case is ‘risk assessed’ the officer cannot decline the invitation to investigate. Officers have openly admitted that they had no choice but to open an enquiry, even though they knew that there was nothing in it for them, because the risk assessment process had identified the case as warranting an enquiry.
Accountants do not have access to the risk assessment software used by HMRC, so what are the trigger points to look out for? The simple answer is patterns.
HMRC loves to see consistency across a business, both within the business itself and also across similar businesses. It will expect turnover to be fairly level while accepting modest fluctuations in either direction. If turnover goes down it will expect expenses to decrease. If profit goes down HMRC will raise an eyebrow if proprietors’ drawings/directors remuneration goes up.
If turnover increases substantially it begs the thought that maybe not all the turnover in the previous year was declared. If it drops significantly then perhaps some has been taken by the owner and not declared?
Suspicion is aroused if the expense in respect of power and light increases well beyond what would be expected comparing it with the previous year (and bearing in mind known increases in tariff). The HMRC officer will wonder whether working hours have increased (hence the increase in power/light) and will therefore wonder why turnover has gone down.
Proprietors’ drawings will be similarly scrutinised. A substantial increase could mean that drawings may have been understated in the past, leading HMRC to wonder whether any cash takings have found their way into the proprietor’s pocket rather than the company’s books. If the drawings are less than the salary paid to the highest-paid employee HMRC will be very uneasy. Business owners are expected to be the highest earners in the business.
Gross profit margins are a favourite barometer for judging whether or not a businessman is declaring all of his income to HMRC. The GP margin of the business will be examined over a period of up to six years to see whether or not it is consistent. It will also be compared with similar businesses and fluctuations of more than 3% will arouse suspicion. HMRC has access to a wealth of information to indicate what the GP of a particular type of business should be and will be well aware of most of the tricks that the less scrupulous businessman may try in order to disguise the true GP of his business.
HMRC will often target a particular sector because it has become aware of consistent malpractice across it. Security companies have been under the microscope for a while now, mainly because it is known that many of them engage guards as ‘self-employed’ workers when the reality is that they are employees. Medical practices, dentists and vets are targeted because they engage locums as self-employed workers, whereas in reality it is nigh on impossible for a locum to be self-employed.
HMRC will be concerned as to whether or not an individual has the means to finance his standard of living. Information will be gained in this regard from a variety of sources, giving HMRC details of property owned, cars, boats, bank accounts, horses, etc. There will often be perfectly sound explanations as to how such assets may have been acquired. We had one client who was investigated because HMRC drove past his house and saw half a dozen boats in the client’s drive. The explanation was that he was allowing fellow yacht club members to store their boats there during the winter, but it still took HMRC the best part of 18 months to accept that the enquiry should be closed without any adjustment.
Some HMRC officers will scour the weekly adverts in the free local paper to see who is advertising their services and will then check to ensure that they are all registered with HMRC. They may scrutinise adverts in newsagents’ windows, in supermarkets and DIY stores with the same purpose in mind. Jealous neighbours, relatives and ex-spouses will volunteer information to HMRC, some of which may be malicious but some may be true, and HMRC will usually investigate to see whether there is a case to answer.
So while accountants do not have access to HMRC’s risk assessment software, with experience it is possible to risk assess your own clients and at least address possible inconsistencies in advance of submitting self-assessment returns to HMRC. In this way explanations can be provided that may help to avoid an enquiry or the client can be made aware in advance that his figures pose a risk.
White Space Disclosures provide an obvious means of communicating such explanations, for example to explain why there have been fluctuations in business profits, or to provide further details on figures where there is no option to provide further information. In terms of the amount of information provided it is of course always a fine line. Ideally, the disclosure should give HMRC enough information so that they do not need to ask generic questions into the return but not provide too much information that they can find fault. If they feel that they need to ask further questions for clarification then they will still raise an enquiry.
While such risk assessment and disclosures will help to avoid enquiries, with HMRC activity at record levels, it is clearly not going to always be possible to avoid Revenue attention. Where your client is subject to an enquiry HMRC should look to work the enquiry in a collaborative and non-confrontational manner and we, of course, recommend that taxpayers and their agents take the same approach. Indeed, HMRC updated the Enquiries and Settlement Strategy used by them in November 2013 from this point of view. In the past, where HMRC considered that their opinion was correct, enquiry cases were pursued without compromise or a negotiated settlement. However, following the failure at Tribunal of a number of cases where this approach has been taken the guidance now suggests that HMRC should take a more collaborative approach. HMRC should therefore always be clear when requesting documentation, detailing what is required and why and giving an expected date for its provision. If there is any doubt then the other party is entitled to ask for an explanation regarding the relevance of the request. The modern way is for HMRC to impose a non-statutory time limit on the taxpayer for the production of information. It will often not be possible to provide this within the time frame specified, and it is advisable to make contact very quickly with HMRC if this is the case and agree an extended deadline. This can be useful in both getting some sort of relationship started with the officer dealing with the enquiry and also gaining maximum penalty mitigation relating to cooperation if the worst happens and there is culpability.
HMRC are trying to foster a more proportional response to the risks identified, including more on site record reviews and a culture of early and open dialogue. They want to be more transparent from the outset with regards to the aim of the enquiry. So where you feel that HMRC are not we would recommend that you approach them and ask why they have requested the information or more specifically what their concerns are. This will, hopefully, give you an opportunity to address the concerns at an earlier stage. Also remember that there is always room for compromise and co-operation – unless the enquiry is conducted under COP 8 or COP 9 or is likely to result in a significant change to a large number of cases. Even cases that appear to have reached an impasse may still be referred for independent review or progressed under the Alternative Dispute Resolution, before recourse to Tribunal or litigation becomes necessary.
With HMRC recently announcing a record Compliance Yield it is clear that the potential for your client to be subject to an enquiry has never been so high. It has never been so important to understand how help avoid enquiries or mitigate the costs when they are unavoidable.
Not only does Taxwise Fee Protection Insurance protect against your fees incurred dealing with the enquiry but it also gives unlimited telephone access to our tax and VAT consultants.
This article is taken from “Accounting Practice” the ICPA quarterly magazine. Dedicated to supporting and promoting the needs of the general practitioner.