The vast majority of taxpayers are honest. Everyone is capable of making mistakes; no one is infallible.
It is also difficult (for me at least) not to have some sympathy for those taxpayers who file a complete and correct tax return to the best of their knowledge and belief, only to be subject to a tax return enquiry by HM Revenue and Customs (HMRC). Owners of cash-based businesses (e.g. retail shops, hairdressers, etc.) are a regular target for enquiry, presumably on the basis that it is easier for them to ‘pocket’ takings instead of declaring their takings fully.
Unfortunately, some business owners do not help their cause by keeping inadequate records. However, that alone is insufficient reason for HMRC to assume that business income has been understated in the owner’s accounts and tax returns. Taxpayers who have declared all their business income should not be afraid to challenge attempts by HMRC to estimate increases in turnover and profits for tax purposes, simply because HMRC considers that they ought to be higher. Some taxpayers have successfully challenged such assertions by HMRC (for example, see Newell and Anor (t/a Tanya’s Takeaway) v Commissioners for Revenue & Customs  UKFTT 742 (TC)).
Anything to declare?
If mistakes in the accounts and tax return result in taxable profits being increased, in some cases HMRC could contend that undeclared takings have been deliberately ‘hidden’ by poor record keeping. The implications of HMRC successfully arguing that the taxpayer’s error was ‘deliberate’ as opposed to ‘careless’ are potentially serious. For example:
- Penalties – The maximum penalty for a ‘careless’ error is 30% of the additional tax. By contrast, the maximum penalty is 70% for a ‘deliberate but not concealed’ error, or 100% if the error is ‘deliberate and concealed’ (although in the case of offshore offences penalties are potentially much higher (see FA 2007, Sch 24, para 4; FA 2015, Sch 21, para 6).
- Earlier years – If a loss of income tax or capital gains tax was brought about by an individual taxpayer’s careless behaviour, HMRC can assess the lost tax up to six years after the end of the tax year to which it relates (instead of the ordinary time limit of four years). However, if the loss of tax was brought about deliberately, the time limit is increased to 20 years (TMA 1970, s 36(1A)(a)). Similar extended time limits apply to companies (FA 1998, Sch 18, para 46(2A)).
- Naming and shaming – HMRC may publish information about a deliberate tax defaulter if HMRC has conducted an investigation and the person has been charged one or more penalties for deliberate defaults, where those penalties involve tax of more than £25,000 (although the information will not be published if the person receives the maximum reduction of the penalties by HMRC for fully disclosing details of the defaults) (FA 2009, s 94).
Incomplete (and/or inaccurate) records can result in HMRC conducting their own tests and making assumptions as to what it regards as being the correct amount of sales and profits.
For example, in Dosanjh v Revenue & Customs  UKFTT 973 (TC), the taxpayer was self-employed and ran a newsagent and tobacconist shop. He also had a residential property letting business. Following an enquiry into the taxpayer’s tax return for 2005/06, HMRC issued a closure notice and discovery assessments covering what they alleged were understated shop takings for 1999/00 to 2007/08, and understated rental income for 2004/05 to 2007/08. HMRC contended that the taxpayer deliberately understated his taxable income, and also issued penalties on that basis. The taxpayer appealed.
HMRC considered that the taxpayer’s records were unreliable. The HMRC officer dealing with the enquiry tested the accuracy of the taxpayer’s drawings by considering whether it was consistent with his private expenditure. This identified what was considered to be an unexplained income deficit. HMRC concluded that this represented undeclared income from shop sales and the rental properties, and that the taxpayer had deliberately understated his income from self-employment and rental properties. The taxpayer argued (among other things) that the basis on which HMRC identified and calculated the additional shop takings and rental income was flawed.
The First-tier Tribunal considered the facts, and was satisfied that the taxpayer failed to declare all the profits of the shop and the rental properties. The tribunal concluded that, on the balance of probabilities, he did so deliberately, with a view to evading tax. The tribunal did not accept the taxpayer’s explanation of the shortfall in income, or that his failure to maintain records was an innocent one. Subject to certain adjustments to HMRC’s assessments (see below), the taxpayer’s appeal was dismissed.
Points to note
- It is generally worthwhile checking HMRC’s calculations (e.g. if they produce their own figure for business turnover). The taxpayer in the above case was successful to some degree, on the basis that HMRC’s figures were partly estimated due to missing bank statements. Those statements were provided at the tribunal hearing, and HMRC’s calculation of the shortfall in income was reduced.
- The taxpayer’s day-to-day record keeping for the shop used a similar system as the previous owners (a large chain of newsagents). This included taking ‘z readings’ from the tills at the end of each day. The z readings gave a breakdown of sales between various categories (e.g. newspapers, confectionery and tobacco). The takings for each category were generally noted on a ‘weekly cash summary’. Unfortunately, the taxpayer considered that there was no need to keep the printed z readings, so he threw them (and also the till rolls) away once he noted the information. The tribunal observed that the taxpayer had deliberately destroyed primary records of the shop takings. Interestingly, in Newell t/a Tanya’s Takeaway v Revenue & Customs mentioned above, the First-tier Tribunal considered that the taxpayers had generally met their statutory record keeping obligations by invariably transferring the information from their till rolls to a ‘simplex’ book each day.
- In the Dosanjh case, the tribunal noted that most of the expenditure in the business was paid in cash. Of course, there is nothing wrong with paying cash for business expenses. However, if the business records are inadequate (as the tribunal found in that case), this can cause unnecessary difficulties, particularly if the expenditure cannot be verified or is not evidenced by receipts and invoices.
Not an option!
The taxpayer in the Dosanjh case did not maintain any records at all of his property rental income and expenditure. There is a statutory obligation to keep and preserve records, which applies to individuals (TMA 1970, s 12B) and companies (FA 1998, Sch 18, para 21).
For self-employed taxpayers (i.e. sole traders or partnerships), the records to be kept and preserved broadly include the following (TMA 1970, s 12B(3)):
- Records of all receipts and expenditure, “and the matters in respect of which the receipts and expenditure take place” (this requirement applies not only to trades but to businesses in general. Taxpayers engaged in a property rental business are treated as carrying on a trade (s 12B(6)); and
- Records of all sales and purchases of goods in the course of the trade (for trades involving dealing in goods).The statutory business records of a self-employed individual are generally required to be maintained for at least five years after 31 January following the end of the relevant tax year. Taxpayers who fail to comply with their statutory record keeping obligations potentially face a penalty of up to £3,000. Note that this penalty can apply to each tax year of default (s 12B(3), (5)).Further information about record-keeping for self-employed individuals can be found on the Gov.uk website (https://www.gov.uk/keeping-your-pay-tax-records).
- In the Dosanjh case, the tribunal concluded, on the balance of probabilities, that the taxpayer deliberately failed to declare all the profits of his shop and rental properties, and did not accept that his failure to maintain records was an innocent one. In reaching those conclusions, the tribunal considered various facts and matters. Among them was the taxpayer’s deliberate destruction of the z readings and till rolls, and his failure to maintain any records whatsoever of his rental income and expenditure.
- HMRC guidance in its Enquiry manual 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 importance of maintaining full and complete business records, and keeping them for at least the statutory retention period, should not be underestimated.
The above article was first published by Tax Insider (December 2014) (www.taxinsider.co.uk).