This article was written by a consultant at Solar Tax as a commentary on HMRC enquiry tactics :
Whilst HMRC can launch an investigation into a business at any time within the statutory time limits enquiry notices are usually timed to be issued at specific times of the year in order to control work flow 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 quite intimidating as HMRC tend 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 debtors amounted to £6! When this was gently pointed out to HMRC, the reply rather huffily said that HMRC was entitled to ask for the information and it should therefore be provided! Common sense eventually prevailed and no analysis was provided!
Fridays are another favoured time for issuing enquiry notices – what better way to start a weekend than to open the post on Saturday morning and discover that HMRC is about to investigate your business?
The modern way is for HMRC to impose a non-statutory time limit on the taxpayer for the production of the information requested in the opening letter. 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.
MRC has a variety of techniques which 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 quite 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 whilst 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 of the turnover in the previous year was declared. If it drops significantly then maybe some has been taken by the owner and not declared?
Suspicion is aroused if the claim 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 therefore the officer will 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 proprietors 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 GPR of the business will be examined over a period of up to 6 years to see whether or not it is consistent. It will also be compared to similar businesses and fluctuations of more than 3% will arouse suspicion. HMRC has access to a wealth of information to indicate what the GPR of a particular type of business should be and will be well aware of most of the tricks which the less scrupulous businessman may try in order to disguise the true GPR of his business.
Clients will often be amazed at the depth of knowledge which HMRC may have concerning their business. HMRC has access to information concerning for example the amount of wastage which an experienced butcher would expect from preparing a pig for sale, the wastage which a chef would suffer when grilling a 10 ounce steak. In my previous life as a tax inspector I was present in the kitchen of a Greek restaurant weighing each ingredient as a tray of moussaka was prepared. This enabled me to calculate the profit margin on each serving and led to a rather large adjustment in the accounts!
HMRC will scrutinise invoices carefully. I had a client some years ago who had a Chinese takeaway. HMRC found that when purchasing potatoes the proprietor bought 5 sacks for which he paid by cheque with a further two sacks for which he paid in cash. The two sacks for cash were converted to chips and the sales were not recorded, thus the GPR was unaffected by the unrecorded sale. How did HMRC discover this? – it was written on every invoice “five sacks by cheque plus two by cash”!! This practice had been going on for years and a significant settlement was agreed with HMRC!
HMRC will often target a particular sector because it has become aware of consistent malpractice across the sector. 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 but 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.
Professional footballers and their clubs have been under scrutiny for a few years now mainly because in some cases a player will receive a payment for the exploitation of his “image rights” and HMRC does not approve of this because it reduces or in some cases completely avoids liability to UK tax. HMRC appears to be feeling its way somewhat in this area contending in some cases that there is no such concept in UK law but in other cases seeming to acknowledge that image rights do indeed exist as a concept!
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. I 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.
Another client was the subject of a tip-off to HMRC by a neighbour who became somewhat jealous at seeing a new Porsche parked in the drive every other year. The explanation was again quite simple – once the first Porsche was acquired, it only cost around £20k to exchange it after 2 years for a new model, but again it took a full scale enquiry into the client’s company before HMRC would close the case down.
I knew an accountant who returned a net profit of £5k per annum and he was investigated by HMRC who saw a Rolls Royce with the accountant’s personalised number plate attached to the car! HMRC had a point!!
An on-going case concerns a client who HMRC insists has a number of caravans which he rents out. The information is allegedly from a “reliable source” but the client is adamant that he has only one, and the caravan park has confirmed this. There are no unexplained deposits in the client’s bank account and he lives a modest lifestyle with no indication that there is significant undisclosed income. There is also no indication as to how he could have acquired a number of caravans in the first place. We are now at a stage where HMRC either has to give an idea of where this information has come from or close the case down.
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 check adverts in newsagents’ windows, in supermarkets and DIY stores with the same purpose in mind. Jealous neighbours, relatives and ex-wives will volunteer information to HMRC some of which may be malicious but some may be true and HMRC will usually investigate to see whether or not there is a case to answer.
I knew of a tax inspector many years ago whose 6 year old daughter returned home from a friend’s birthday party asking why she couldn’t go on holiday to Barbados like her friend. My acquaintance knew that the friend’s father was a taxi driver and the following Monday he checked the records of the girl’s father and opened an investigation because the declared profits did not support a holiday in Barbados and sure enough the business takings were grossly understated for a number of years!
So you can see from the above how HMRC can acquire information and use it to investigate a client.
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 which may help to avoid an enquiry or the client can be made aware in advance that his figures pose a risk.
Tax Investigations
Indiana Jones
"Nice try kid, but I think you just brought a knife to a gunfight."
Will I be picked for a Tax Enquiry?
Any system of self-assessment must contain an enquiry power for the tax authorities as part of its mechanism. So HMRC have the right to enquire into any tax return which is filed.
HMRC enquiries may go beyond this and can cover company tax returns, VAT and excise issues and PAYE returns of employers.
HMRC and AI
HMRC says it's Connect AI system has over 55 billion items of data (currently 6100 gigabytes) relating to taxpayers. This data is used to target taxpayers for tax investigations.
The Connect AI system trawls data from many sources to identify potential cases of tax evasion and avoidance. The data is obtained from a wide variety of sources, including :
• Estate agents / rental agents
• Banks
• Investment companies / crypto currency platforms
• Web browsing and email records
• Social media
• Flight sales and passenger information
• DVLA records
• E-retail platforms
• Individual and corporate tax returns
• The Land Registry
• UK Border Agency
• Credit card records
Although the Connect system allows HMRC to analyse billions of data points, it is an incredibly complex system. Using AI to highlight potential investigation cases can easily produce ‘false positives’ and trigger investigations into innocent individuals.
An Increase in Investigations
From 2022 to 2023 HMRC tax investigations into individuals and small businesses have increased by 16,000 additional cases to a total of 232,000 per year. HMRC are reliant on their AI technology to select these cases although the specific criteria used by HMRC for selection are exempted from disclosure under a Freedom of Information Act exemption.
According to a Freedom of Information request made by Thomson Reuters, HMRC opened 23% more inquiries into unpaid VAT, a total of 109,400 in the last financial year.
There was a 21% rise in tax investigations into sole traders and small businesses between the 2020/21 and 2022/23 tax years.
However, a recent Freedom of Information request from UHY Hacker Young found that approximately 267,000 of tax investigations into small businesses and self-employed professionals between 2019/20 and 2021/22 failed to achieve a tax settlement, which suggests that HMRC's AI strategy is putting taxpayers through the stress and cost of an enquiry for no reason.
The Scope of Enquiry
Most often, a tax enquiry into a self-assessment tax return will concentrate on one specific aspect. For example, if you have disclosed a redundancy settlement on your tax return then HMRC may want to check that it has been correctly disclosed as the taxation of severance payments is a complex issue.
Beyond that, if HMRC has information which conflicts with your tax return they may open an enquiry to investigate the issue. If you have made one error in your tax return there could well be others and HMRC have a duty to check that possibility.
In some cases, HMRC may have gathered sufficient intelligence data to believe that the disclosures on your tax return do not match your lifestyle and in these cases they will consider a full enquiry into the whole range of your financial affairs in order to satisfy themselves that the tax returns have been filed correctly.
For the most serious cases, HMRC have the power to take criminal proceedings as they are a prosecuting authority under UK law.
I guess it's not a problem if my tax return is correct?
Tax enquiries are full of traps for the unwary. What might start out as a short meeting with the tax inspector in order to discuss a few points can soon turn into a nightmare with the taxpayer inadvertently giving the inspector ammunition to make assumptions about her lifestyle - and therefore pushing up the potential settlement tax bill.
The unrepresented taxpayer can often inadvertently open up new areas of enquiry thereby prolonging the enquiry and increasing the risk of a tax cost.
The link below relates to a website dedicated to exposing the methodology used by HMRC in tax investigations :
The Burden of Proof
UK criminal law works on the assumption of “innocent until proven guilty”. Unfortunately, in a tax enquiry the opposite is true.
Where HMRC have found an error they will use this as a lever to extrapolate figures which assume that you have committed the same error consistently throughout the period of the enquiry. This can lead to a large tax bill.
It can be difficult to prove that the tax inspector’s figures are wrong and even with a good accountant on your side this can be an expensive and lengthy process.
In recent times a worrying trend has appeared at tax tribunals where the tribunal has found evidence of HMRC officers to be unreliable, inaccurate, or both. In the recent case of Roger Preston Group Ltd v HMRC the judge criticised HMRC’s attempt to change its arguments over issues that had been resolved in two earlier tax enquiries. In the VAT case of Pavan Ltd HMRC made fundamental errors which were reinforced at internal reviews and still decided to take a flawed case to tribunal.
Tax Penalties
When working out a settlement figure to close an enquiry, the starting point is the amount of tax which the inspector has found to be due.
Added to this will be interest charges on the tax due. Interest runs from the date when the tax would originally have been due so, for example, if the tax relates to the 2019 tax return (year ended April 5, 2019) the tax for that year would originally have been payable by January 31, 2020 and so any interest in an enquiry case will be calculated from that date.
The final aspect of the enquiry is the penalty to be charged.
The tax investigation penalties will start at 100% of the tax due in normal tax investigation cases but can be up to 200% of the tax due.
The inspector will often agree a remission of the penalty depending upon the seriousness of the offence, the co-operation received from the person under enquiry (and their accountant) and whether the additional tax is due to a lack of reasonable care or a deliberate act.
Insuring Against the Cost
Although you cannot insure to cover any additional tax, interest or penalties which may be due as a result of a tax enquiry, you can insure the fee cost of professional representation.
A quick online search for "personal tax investigation insurance" will turn up a number of companies who can provide this insurance.
Beyond the original investigation..........
HMRC have a responsibility to look not just at the person under enquiry but also at any associated parties where an indication of wrong doing is suspected.
Also, HMRC are particularly interested in organised criminal activities including money-laundering and where necessary they will withhold conclusion of an enquiry while the scope of the original enquiry is widened.
HMRC Tactics
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