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Compliance Checks: Making Assumptions?

By Russell Cockburn : taken from “HMRC Enquiries Investigations and Powers “

Russell Cockburn highlights some important issues from his practical experiences when dealing with recent HMRC compliance checks.

This month’s article continues the theme I have developed in recent columns and looks at a couple of HMRC compliance check cases I have had to deal with over the last year.

They are both relatively simple as regards their specific facts and are now settled with the tax authorities, but they serve to illustrate some important points about dealing with such cases on behalf of clients and businesses. They were also a reminder to me when dealing with them that, large or small, there are some important principles at stake when one is dealing with such HMRC ‘enquiries’.

Is it a compliance check?

The first case involved a fairly routine review of the accounts and tax returns of a partnership newsagent and tobacconist business. The accountant dealing with the partnership’s accounts and tax affairs received a letter from HMRC asking for various items of information about the business and the accounts. None of the questions was particularly difficult to answer and could be dealt with fairly straightforwardly, but the letter came without any mention of the case actually being a compliance check.

This is an important point, and should never be overlooked. A compliance check is a formal procedure under the UK’s self-assessment tax system, and both the taxpayer receiving a compliance check notice and the HMRC officer issuing it have formalised rights and obligations. When commencing a compliance check, the HMRC official should normally make it clear that this is indeed what is underway. In this particular case, there was no mention of this being a formal compliance check.

Playing by the rules

Of course, there is normally no particular reason not to answer questions from HMRC, and I am always of the view that one should co-operate fully with the process and will always advise a client to do so. However, the rules and procedures are there for the protection of both the taxpayer and the HMRC officer; so that everyone knows from the outset what is going on and so that the procedure is dealt with under the proper statutory framework. A simple phone call to the officer to clarify the situation and to ask whether or not the letter was, in fact, the commencement of a compliance check served to deal with the issue (which was apparently a simple oversight), and a formal commencement notice was forthcoming almost immediately.

Compliance checks are subject to internal checks and controls within HMRC, so that the department can compile its own statistics for reporting purposes and ensure that matters are being dealt with timeously. It would be unusual for a case to be started without these protocols being followed and this one seemed to have been an accident, but the rules and procedures are important. They serve to ensure that cases are not unduly delayed within the department, and also that compliance checks are not started informally on what some might call ‘fishing expeditions’. In my experience, the latter is very rare indeed these days, but being alert to the possibility is probably a good idea.

Furthermore, once a compliance check has been started and dealt with there are formalities at the end of the process, which again should be adhered to. It is again very rare, but I have encountered the odd case where a ‘closure notice’ has not been formally issued by the HMRC officer at the end of the compliance check process. This should similarly be avoided, as it leaves the taxpayer and their advisers in an uncertain position. Once a case has been properly closed by the issue of a formal notice, then certainty has been obtained about the ‘closed’ year and it should rarely be the case that that year can ever be reopened thereafter!

Business economics exercises

The second case concerns the assumptions about the expected profitability of a business that can be made during a classic ‘back duty’ investigation or compliance check. Most readers will be familiar with the ‘gross profit’ tests that HMRC sometimes applies to businesses. The use of such business economic models is long established and a common feature of the compliance checks environment on businesses of some types, both large and small. As a tax inspector once myself, I spent many happy (sic) hours reviewing the accounts of businesses with a view to testing the veracity of their turnover figure in comparison to the department’s expectations of the level of profitability that some businesses should achieve.

There is little doubt that a well-executed and prepared business economics model can be a very powerful tool in testing the accuracy of a business’s accounts and profitability, but it should not be forgotten that it is just that; a test. It is, in reality, an academic exercise prepared at best from the detailed books and records provided for review by the business and using as much information as can be obtained about the pricing policies, markup rates used and achieved, wastage rates, and a plethora of other features about the operation of the business involved that have to be taken into account when preparing such a review.

Inspectors are usually well versed in such matters and very practised in preparing their calculations, but it should also not be overlooked that the end result is simply an exercise. It may look very convincing and may seem to demonstrate that there is a problem with the accounts for a business; indeed, it may seem to suggest that the turnover of the business has been significantly understated!

When presented with the results of such an exercise, the taxpayer businessman and the adviser can often feel completely flummoxed. The computations will look very convincing and detailed. That is in the nature of these things; however, it is important to remember that the calculations are simply an exercise. They may well have been prepared from detailed records and source accounting books, price lists, etc., but at the end of the process, what has been produced is simply an academic exercise to review the accounts.

Further requirements

Case law precedent demonstrates quite clearly that to persuade a tax tribunal that a set of properly prepared and balanced financial accounts with the results of a business economics exercise, HMRC must do more than just show that something looks wrong. Two other things are required; poor business records and clear evidence that there are either unexplained investments or savings owned by the taxpayer, or a level of personal expenditure which cannot be supported by the income from the business. Without these two extra features, the case for displacing properly prepared financial accounts remains weak.

The courts over the years have supported the view that to replace a properly prepared and balanced set of financial accounts with the results of a business economics exercise, HMRC must do more than just cast doubt on the accounts; they must produce evidence of both poor records and unexplained income or expenditure. Without both of these additional features, it is unusual for a tax tribunal to accept the evidence that a business economics model result usually seems to produce.

I have dealt with many such cases over the years and it is always important to test the assumptions on which such exercises are prepared. They are normally very well executed by HMRC, but their use is limited. Cases such as Scott & Anor t/a Farthings Steak House v McDonald (HMIT) [1996] Sp C 91 provide a clear indication of the limits which can apply to the use of business models, and give some encouragement to the adviser when faced with what can seem overpowering initial evidence that the rise something amiss.

Russell Cockburn is an independent taxation consultant. He was formerly an inspector of taxes.