8 Jan 2020
Tax investigations should be avoided – they are not something that many welcome or would want to endure, as they are stressful and can be costly. And if HMRC finds misbehaviour, that taxpayer is bound to receive “special” attention in the future.
Adam Bernstein
Job Title
Image © ink drop / Adobe Stock
According to HMRC’s Annual Report and Accounts for 2018-19, the tax authority brought in £627.9 billion in tax revenue for the Government.
More importantly, HMRC protected its revenues to the tune of £34.1 billion – and specifically through litigation activity, to the value of £17.5 billion.
The recent clampdown by HMRC on dishonest dog breeders (Veterinary Times, 20 May issue) saw a wide range of powers used to claw back about £5.4 million in unpaid taxes from 257 cases.
Checks and investigations are a key part of HMRC’s armoury. Indeed, investigations and penalties are, by definition, the backbone of any state-run organisation – for without a punitive regime, minimal compliance would occur.
HMRC oversees 45 million individuals (of which 500,000 are officially wealthy), more than 5.7 million small firms, 207,000 mid-sized firms, charities and public bodies, and 2,000 large businesses – and it’s because of this that it has had to up its game. Technology and online data sources have made it much easier for the body to search for tax it is due.
According to Money Donut, tax audits can be expected every five years, while just a few per cent of income and corporation tax returns are investigated. But some sectors are more likely to be closely examined – especially those that handle cash.
HMRC tax investigations are, reckons the Federation of Small Businesses (FSB) – to a small business organisation – expensive, time-consuming and stressful. They can last 16 months, on average, and cost from £5,000 in accountancy fees plus management time and penalties if HMRC finds anything wrong.
Fee protection insurance can cover the cost of an HMRC investigation. Offered to members by the FSB, other insurers also operate in this market – often at discount via a taxpayer’s accountant compared to a stand-alone purchase.
A key problem for taxpayers is that while investigation risk can be minimised through compliance, it cannot be eliminated as some investigations are conducted at random. However, by understanding what triggers an investigation – what the red flags are – taxpayers can lower the risk of trouble.
HMRC requires compliance and any mistakes – however simple – may lead to questions being asked of the taxpayer.
Of course, one small error – especially if voluntarily corrected by the taxpayer – is not going to raise the hackles of an investigator. But a series of regular mistakes will suggest to HMRC the taxpayer is either keeping poor records or unable to follow processes set down by law. It may also suggest the taxpayer is attempting to commit fraud or evade tax.
The only viable option to lower the risk of a mistake-related investigation is to engage a qualified accountant – one who is a member of a professional body. While a taxpayer will always be responsible for his or her tax affairs, the accountant will at least advise on processes and statutory returns.
While it’s very tempting for a taxpayer to complete tax returns without professional help, a good accountant lowers the risk – in HMRC’s eyes – of hidden monies and transactions, as well as reducing the risk of mistakes caused by inexperience and a general lack of knowledge of the tax system. It’s important to remember that good record-keeping is a legal requirement. Furthermore, a lack of understanding or knowledge is no excuse.
Of course, accountants charge for their services. But the right one will save far more in tax and time than he or she will cost.
Some businesses, but not many, will see wildly fluctuating figures during a period of time. However, most will see a gentle series of peaks and troughs over time. But if one year the profits are reported at, say, £200,000, but the following at £20,000, HMRC would be within its rights to ask why such a variation exists. The response may be simple and reasonable, but taxpayers should expect HMRC to ask. To forestall the chance of an investigation, the taxpayer would be advised to tell HMRC – via the notes box in the tax return – why profits fell so dramatically; the report should be honest, and the excuse will need to be proven.
Similarly, it’s quite reasonable for a business to take time to get off the ground. But if the business is considered to be well established, it’s also reasonable for HMRC to ask where the profit is – no business can run for long without a profit – and, after all, businesses not earning a profit will pay no tax. Again, where this situation arises, the taxpayer would be advised to pre-empt HMRC’s questions and state on the tax return the reasons for no profits after several years of trading.
With HMRC having a long and storied history, it’s obvious it’s going to have statistics on what the average business in any given sector should be declaring, in terms of expenses and profit.
It will know, for example, what the average Chinese takeaway sells, and what it buys as raw ingredients and packaging. Investigators have been known to sit outside restaurants counting customers and extrapolating information to see if this tallies with what has been declared. Clearly then, if the business’ declared numbers are well off the mark of the sector norm then HMRC may seek answers via an investigation.
Avoiding this scenario isn’t easy. Being honest is the first step, but also trading via the right form of business entity may help, too. Sole traders often earn less than limited companies – businesses likely to earn little would be best advised not incorporating.
It should be apparent to anyone with a grain of common sense that management and owners should be earning more than those they employ. While the super rich can afford to give away blocks of shares or work for a token £1, the majority in business cannot. So to declare an almost non-existent income is likely to lead to interest from HMRC; it will suspect some form of tax avoidance scheme is being employed – and not many are permitted.
Taxpayers should aim to not rock the boat; they should maintain the employment hierarchy, which is best illustrated by expected pay structures.
Employers wanting to give staff a little extra should take advice about giving some form of tax-exempt bonus – trivial gifts (that are not contractually due, given with no tie to performance, not convertible into cash and below £50 in value) are a good example.
In the modern age, it shouldn’t come as a surprise that HMRC uses technology to help it check on taxpayers. In 2010, it started developing its Connect database, which cross-references the tax records of individuals and businesses against other databases, looking for evidence of fraudulent or undisclosed activity. In 2016, the system was connected to British Overseas Territories databases; and in 2017, it was linked to systems in some 60 countries.
HMRC doesn’t just look at taxpayers or businesses in isolation; it’s actively comparing and linking records of anyone that’s linked to taxpayers, too. Any temptation to “forget” payments or receipts should be resisted as transaction records, by definition, have two sides – payer and payee. Whether a client, supplier or bank, HMRC can trace these through. The odd record on its own may not lead to an investigation, but, over time, the risk of discovery will rise.
Finally, it may seem obvious, but it does need pointing out: HMRC does, from time to time, receive information about dishonest taxpayers breaking the law. While it hasn’t the resources to investigate everything it is told, situations considered serious will merit attention.
As to who may tip-off HMRC, it’s fair to include upset partners (personal or professional), irritated (former) employees wanting revenge, someone with knowledge of a cash-only business, or someone who is jealous that an individual is living beyond his or her declared means.
While living beyond declared means can be easy to disprove if private unearned wealth exists from, say, an inheritance or investments, this private wealth still needs reporting – especially if non-cash assets are involved. Taxpayers should be above board in tax matters and, where possible, avoid taking cash – cash carries cost to deposit and carries risk of loss, while card payments can carry relatively little cost and remove the risk of cash loss in transit.
HMRC uses technology to gather in tax it is entitled to. But it’s important to not lose sight of the fact it’s run by people. Using just a modicum of common sense is key to having inspectors give a taxpayer the benefit of the doubt. But ultimately, complying with the law is the safest way to avoid an investigation.
