Tax return enquiries by HM Revenue & Customs (HMRC) are an unwelcome prospect for any taxpayer. In fact, HMRC enquiries can be very worrying, stressful and time consuming. Taxpayers who run their own business (e.g. as sole traders or partners) face the prospect of HMRC scrutinising the accounts and examining the business records.
Cash based businesses (e.g. taxi drivers, market traders, etc) can often appear to be an easy target for HMRC, in terms of challenging the accounts of the business if turnover and profits are considered to be too low compared to similar businesses.
HMRC’s approach to examining business records is explained in its Enquiry manual (www.hmrc.gov.uk/manuals/emmanual/index.htm). The guidance states (at EM2795): “The credibility of the return and the supporting accounts can be challenged by showing that the books and records upon which they are based are inaccurate and incomplete”. The manual lists possible ways in which HMRC can challenge the business records and accounts, such as “a business model based on all the available facts which shows an apparently much greater level of profits.” HMRC’s guidance also includes lists of questions which may be asked of taxpayers about the business (EM2915) and its accounting records (EM2916).
With regard to small businesses, HMRC states (at EM2851): “Taxpayers running small businesses may not always keep comprehensive records and in those cases where the taxpayer maintains records mistakes may be made.”
If additional profits are assessed for the tax year of enquiry on the basis that disclosed profits were understated, HMRC may seek to assess other years as well. This approach is often referred to as ‘spreading’. It is based on a principle known as the ‘presumption of continuity’, which was established some time ago (Jonas v Bamford  STC 519), although the courts and tribunals have not always accepted this approach (see for example Chapman v Revenue & Customs  UKFTT 756 (TC) and Barkham v Revenue & Customs  UKFTT 499 (TC)).
Challenging HMRC’s figures
However, business owners should not be afraid of challenging HMRC’s figures if additional profits are assessed, particularly if HMRC’s methods of calculation are flawed (e.g. their assessments are unfair, unreasonable or unrealistic).
In Newell & Anor (t/a Tanya’s Takeaway) v Commissioners for Revenue and Customs  UKFTT 742 (TC)*, Mr and Mrs Newell were partners in a takeaway business selling West Indian food. HMRC opened an enquiry into the partnership’s 2006/07 tax return. This resulted in HMRC increasing the partnership profits, not only for the tax year of enquiry, but also for the following four tax years up to and including 2010/11 (in fact, HMRC originally went back ten years and amended partnership profits from 1996/97 as well, but later withdrew those earlier year amendments). Penalties were added. The partners appealed against HMRC’s assessments and penalty notices, on the basis that the profits originally declared were correct.
HMRC contended that the business records were ‘broken‘, and that the profits declared by the partners could therefore not be relied upon. Mr and Mrs Newell argued that it was impossible for their small takeaway business to have generated the extra profits assessed by HMRC (see below). Fortunately, the tribunal agreed with the taxpayers. HMRC’s figures were found to be unreliable. The tribunal concluded that the partnership’s reported profits did not require any amendment. The taxpayers’ appeal was allowed for all tax years, and their appeal against the penalties was also allowed.
Is HMRC being unrealistic?
The importance of checking HMRC’s figures, and the logic behind them, cannot be overstated where additional profits are assessed. An HMRC enquiry can potentially damage, or even destroy, a business in terms of the extra tax (and penalties) which HMRC considers to be due.
For example, in the Tanya’s Takeway case:
- The business profits correctly reported on the partnership’s tax return for 2006/07 was £7,088. HMRC assessed additional profits of £54,475 (i.e. £61,563 profit in total) – an increase of almost 870%!
- In addition to 2006/07, HMRC assessed further profits for the tax years 2007/08 to 2010/11 as well. The total profits declared by the partnership for all five tax years (i.e. 2006/07 to 2010/11) amounted to £36,508. HMRC tried to increase total profits by an eye watering £289,618 to £326,126 – an overall increase of 893%!
- If HMRC had been successful in assessing the additional profits and penalties, Mr and Mrs Newell would have been faced with a further tax bill of £87,643.73, plus penalties of £45,255.96 – a total of £132,899.69 – none of which was due, based on the tribunal’s decision.
Interestingly, the tribunal in Tanya’s Takeaway noted a flaw in HMRC’s logic in its argument that the business profits were understated. HMRC noted that a number of unidentified cheques had been deposited in Mr and Mrs Newell’s bank accounts. This apparently resulted in HMRC concluding that the unidentified deposits formed part of the additional business profits assessed.
However, Tanya’s Takeaway was purely a cash business. It had no facility to take credit cards, and did not accept cheques, so all receipts were in cash. The tribunal noted that the business did not accept cheques, and concluded that the cheques deposited in Mr and Mrs Newell’s bank account could not have come from the takeaway.
Here are two practical tips. First, prevention is better than cure. So keep good business records – and keep them up to date. HMRC states in its guidance (at EM2851): “Sometimes, things will go wrong because the books are simply not written up regularly.” There is a statutory obligation to keep and preserve records for the purposes of preparing a complete and correct tax return, subject to possible penalties for non-compliance (TMA 1970, s 12B).
In Tanya’s takeaway, HMRC criticised Mrs Newell for not keeping till rolls. Fortunately, the tribunal did not find that this meant the business records kept by Mr and Mrs Newell were incorrect, or that the accounts were incomplete. Mr and Mrs Newell normally transferred the information from the till rolls to the accounting book of the business each day. The tribunal considered that Mrs Newell had met her statutory record keeping obligation by preserving the till roll figures in the accounting book each day.
Secondly, if HMRC enquires into your tax return and undertakes a ‘takings build-up’ or other exercise resulting in an estimated assessment of profit and a further tax bill for that year (and possibly other years as well, under the ‘presumption of continuity’), be prepared to stand your ground if you consider that HMRC’s assessment is incorrect and unrealistic. Expert professional help is strongly recommended. In the Tanya’s takeaway case, the taxpayers’ representative identified a number of errors in HMRC’s figures at the tribunal hearing.
Newell & Anor (t/a Tanya’s Takeaway) v Commissioners for Revenue and Customs  UKFTT 742 (TC)* (http://www.bailii.org/uk/cases/UKFTT/TC/2013/TC03120.html)
The above article was first published by Tax Insider (www.taxinsider.co.uk).