Those who regularly deal with HMRC enquiries into the tax returns and accounts of sole traders and partnerships in particular may well have come across the ‘presumption of continuity’ (sometimes known as ‘spreading’), possibly without realising it.
Presumption of continuity
For example, suppose that an accountancy practice has a self-employed client who operates a cash-based business, such as a market trader or perhaps a fast-food takeaway. The taxpayer’s business records are not particularly good (despite his agent constantly nagging him to improve them). HMRC opens an enquiry into the self-employed individual’s tax return, and the HMRC officer requests the taxpayer’s business records. The HMRC enquiry officer eventually concludes that business profits were understated, and increases the taxpayer’s turnover and profit for the relevant tax year. In addition, the HMRC officer considers that profits for other years have probably been understated as well, and makes discovery assessments for earlier tax years. When the taxpayer’s agent asks what justification HMRC has for reopening early years, the HMRC officer mentions the presumption of continuity, and refers the agent to an earlier tax case, as well as HMRC’s enquiry manual.
The tax case that the HMRC officer will probably refer to is Jonas v Bamford [1973] STC 519. That case broadly involved an enquiry into the tax affairs of an individual, which resulted in additional assessments covering a number of years. It was held in that case that the onus was on the taxpayer to show that the assessments were wrong. Unfortunately for the taxpayer, he was unable to discharge that burden of proof, and his appeal was therefore dismissed. The decision in the High Court by Judge Walton included the following statement, which gave rise to the presumption of continuity:
“… So far as the discovery point is concerned once the inspector comes to the conclusion that, on the facts which he has discovered, the taxpayer has additional income beyond that which he has so far declared to the inspector, then the usual presumption of continuity will apply. The situation will be presumed to go on until there is some change in the situation, the onus of proof of which is clearly on the taxpayer.”
It is interesting to note that Judge Walton was actually referring to the presumption of continuity applying to later years, rather than earlier ones. However, this distinction does not appear to have been taken into account in some tax cases since then.
Limitations
The decision in Jonas v Bamford has been used by HMRC quite extensively. A search for ‘Jonas v Bamford’ on the British and Irish legal Information Institute website, for example (www.bailii.org), reveals that it is mentioned in many other cases. However, not all of these cases have gone HMRC’s way, i.e. the presumption of continuity does have its limitations. This point was illustrated in a recent First-tier tribunal case, Barkham v Revenue & Customs [2012] UKFTT 499 (TC).
In the Barkham case, HMRC opened an enquiry into the taxpayer’s self-assessment return for 2004-05. Mr Barkham operated a car sales and maintenance business. Following the enquiry, HMRC raised an assessment increasing Mr Barkham’s profits for 2004-05, and also raised assessments for 2001-02, 2002-03 and 2003-04. The tribunal had to consider whether the taxpayer’s accounts for the year ended 31 December 2004 were understated, and also whether the discovery assessments were competent for the earlier years.
HMRC’s enquiry into the taxpayer’s accounts resulted in an addition to gross profit which represented a 58% increase in gross receipts for the tax year 2004-05. HMRC then applied the same percentage to increase gross receipts for the three earlier tax years. The dispute between HMRC and the taxpayer via his agent had broadly revolved around the treatment of cash sales in the business. The taxpayer and his agent said that all sales had been declared, and that the accounts were therefore correct. However, HMRC contended that accounts turnover for the year in question omitted cash sales. They also relied on the presumption of continuity to make assessments for the early years.
The tribunal pointed out that the business had not kept proper records and did not have a balance sheet for the year. The tribunal judge said that there was no evidence that the sales figure included the total amount of cash which should have been banked, and therefore dismissed the taxpayer’s appeal against the 2004-05 assessment.
With regard to HMRC’s assessments for earlier years, the tribunal agreed with HMRC in terms of making the discovery assessments. However, on the evidence the tribunal found it hard to accept the figures projected backwards of a 58% increase in the declared turnover for the early years. The tribunal found the rate of 58% to be “unfair and unreasonable”, and that applying the 58% increase to turnover was “unrealistic”. A simple projection of profits on a fixed percentage basis did not strike the tribunal as accurate or fair. The taxpayer and HMRC were therefore asked to provide further written evidence, and suggested that the parties negotiate between themselves.
With regard to the presumption of continuity, the tribunal noted that HMRC had applied this approach in concluding that the under-declaration for 2004-05 pointed to under-declarations in the earlier years, and had raised discovery assessments accordingly. However, the tribunal judge had this to say about the presumption of continuity:
“The presumption of continuity alone does not justify increases in assessments; the initial onus is on HMRC to show evidence in support of the making of the assessments. This would therefore be a limitation of the use of the presumption of continuity where previous year’s accounts are sought to be opened.”
This is not the first time that the tribunal has pointed towards limitations in the presumption of continuity. For example, in Syed v Revenue & Customs [2011] UKFTT 315 (TC), the tribunal referred to the above quote from Jonas v Bamford, stating that it expresses no legal principle, and that it would be quite wrong as a matter of law to say that because something happened in one year, it must be assumed to have happened in a prior year. The tribunal also commented on the presumption of continuity:
“In practice it will generally be reasonable and sensible to conclude that if there was a pattern of behaviour this year then the same behaviour will have been followed last year. Sometimes however that will not be a proper inference: there will be occasions when the behaviour related to a one-off situation, perhaps a particular disposal, or particular expenses; in those circumstances continuity is unlikely to be present.”
Incomplete business records
In cases where the taxpayer’s business records are incomplete, HMRC may seek to assess additional profits using some form of business economics exercise. For example, in Chapman v Revenue & Customs [2011] UKFTT 756 (TC), HMRC opened an enquiry into the taxpayer’s return for 2006-07. In the absence of adequate business records, HMRC conducted a ‘takings build-up’ exercise, which arrived at a shortfall in turnover for 2006-07. HMRC considered that the retail price index should be applied to calculate a shortfall in declared income for 2004-05 and 2005-06, and also the later year 2007-08, on the basis of the presumption of continuity.
However, the tribunal noted that virtually all the evidence related to the period covered by the year of enquiry. The tribunal also noted that HMRC’s takings build-up exercise was only an estimate, and held that the resulting turnover figure was “wholly unrealistic”. The omitted sales figure for 2006-07 was therefore reduced. HMRC had not actually produced a takings build-up for 2004-05 or 2005-06 due to time constraints. The tribunal said that the takings build-up for the enquiry year 2006-07 included a number of transactions peculiar to that year, and concluded that the assessments for 2004-05 and 2005-06 could not stand. In the absence of any alternative basis of assessment, the assessments were reduced to nil. Similarly, the tribunal considered that HMRC’s takings build-up calculation for 2007-08 seemed arbitrary, and the assessment for that year was also reduced to nil.
HMRC does in fact accept that the presumption of continuity needs to be used with some care. For example, in the enquiry manual at EM3309, HMRC states:
“If you have found only one omission in one year and when asked the taxpayer immediately offers a reasonable explanation for its existence, you would not be in a position to argue for additions to other years on that fact alone.”
However, HMRC goes on to say:
“…if you have proven omissions for which there is no ready explanation and the business and way of life of the taxpayer have not changed you will be in a much stronger position to argue for addition to other years.”
At the end of the day, if HMRC wants to use the presumption of continuity to increase a taxpayer’s profits, the onus will initially be on HMRC to provide evidence to support their approach.
Final thoughts
Finally, there are a few further points to bear in mind. Firstly, it might be tempting in an enquiry case to agree additions to business profits with HMRC, in an attempt to bring the enquiry to an early conclusion. However, as we have seen, profit adjustments for the year of enquiry can result in adjustments for other tax years as well, based on the presumption of continuity. So any profit adjustments for the enquiry year need to be considered very carefully.
Secondly, HMRC may refer to the enquiry manual in support of using the presumption of continuity to increase profits for tax years other than the year of enquiry. For example, there is a section of the enquiry manual at EM3310 onwards, which gives details of various cases including Jonas v Bamford in support of reopening early years. However, as noted above, there are other cases which indicate a limitation in the presumption of continuity, and HMRC should be referred to those cases where appropriate.
Thirdly, even if the presumption of continuity is considered to be appropriate and HMRC raises assessments to increase profits for earlier tax years, it should not be automatically assumed that the methodology used by HMRC is correct. If the taxpayer can provide evidence to indicate that, on a balance of probabilities, HMRC’s assessments are excessive, those assessments will need to be adjusted accordingly.
The above article is reproduced from ‘Practice Update’ (January/Febuary 2013), a tax Newsletter produced by Mark McLaughlin Associates Ltd. To download current and past editions of Practice Update, see the Newsletters section.