W Accountancy Fact Sheets  -  Tax Investigations

Introduction

A recent survey found that one of the greatest worries for businessmen and women was being investigated by the Inland Revenue. The introduction of self-assessment gave the Revenue greater powers to carry out investigations including:

• an absolute right to investigate without giving any reason for doing so; and

• the power to demand information needed to help them carry out their investigation.

The Revenue say that these powers are necessary to enable them to police the self-assessment regime.

One of the effects of these new powers is that the Revenue can select a business for investigation at random, so it is now true to say that no-one can be certain of avoiding an investigation. However, the very great majority of investigations will still be carried out because the Revenue has identified a risk that profits might have been understated.

By knowing how the Revenue make their risk-assessment it is possible to avoid unnecessary selection for investigation. Also, the steps taken to avoid unnecessary selection will help to avoid a random selection leading to an unnecessarily prolonged (and possibly expensive) investigation.

Stages of an enquiry

The first step is to know what are the stages of an investigation so that you can identify the points at which you can take action to avoid selection or help bring an investigation to an end as quickly as possible. The stages are:

• selection

• detailed review

• opening the investigation

• obtaining information

• business economics exercise

• private side review

• settlement

Selection

The selection process takes place entirely within the Revenue and the first you will know about it is when the enquiry notice is issued. To influence the process, however, you should know what are the main reasons for selection and what you can do to allay any concerns the Revenue might have about a particular matter. The main reasons for selection are:

Information held by the Revenue

The Revenue is provided with a lot of information, some of it automatically, some of it at their own request and some of it unsolicited. It helps to be aware of this so that any enquiries based on it can be quickly answered.

It should be assumed that all bank and building society interest details are sent to the Revenue by the institution concerned. Care should be taken to ensure that no account is overlooked and that a full summary of all interest received is kept. If the interest increases or decreases suddenly and substantially, this will trigger an enquiry unless the return includes an explanation of where deposits came from or how withdrawals were used.

If the business has to have any contact with another public body, such as the local authority to obtain a licence, take into account the possibility that the Revenue will hold full details either because it has been decided to investigate a person’s return for some other reason or because they have made a general request for information as part of an investigation project. Information would include details of grants given, licences granted, housing benefit paid etc. It can remove a person from the list of possible selections if the return has enough information to show that the third party information does not indicate omissions from the return. An example might be a detailed capital allowances computation for a taxi business identifying every taxi run by the business, showing its registration number. Information might not relate directly to the business and might have come not from a public source but from another business, either by use of the Revenue’s information powers or from investigating that other business. Information about moorings in a marina might make the Revenue decide to investigate how a business with an apparently modest profit can support an apparently expensive lifestyle. More difficult to counter is information provided by an informer which is incorrect and provided maliciously. Perhaps all that can be done is to warn readers that the Revenue receives a big mailbag from informers. If you think you are the victim of a malicious informer who has provided false information to the Revenue, you should challenge the inspector on this immediately the investigation is opened. Unfortunately, even if it can be proved that the information is false, the inspector is still instructed to carry on with a full enquiry, but at least you will have removed one area of concern about your return.

Inadequate drawings

If your drawings from the business appear to be inadequate, you will be selected for investigation. This often does not occur to people because they think:

The best protection from in-depth enquiries into your private affairs is keeping excellent and comprehensive business records. Unless the inspector can show that the return is incorrect or is liable to be incorrect, a request for information about a person’s private affairs cannot be justified. If, however, it is clear that the business records are not robust and effectively operated, with adequate supporting documentation, or if omissions from the records have been proved, the inspector will be justified in extending the investigation into your private affairs. Another point to watch is that you should not use your private bank accounts for business purposes. If you pay business money (other than your drawings) into a private account or pay business expenses out of it, the Revenue can ask to see this in the same way they can ask to see any documentation used to complete the return.

So, how you live your life away from the business can be a matter of concern to the Revenue in an investigation, but what will they look for?

• they will try to find out as much about your lifestyle as possible, often looking at your property, its state and what is kept on it, to see if the drawings are enough to pay for your apparent lifestyle and account for your known investments;

• they will look to see if your drawings, taking one year with another, keep up with inflation; and

• they will look at the wages paid to your highest paid employee to see if you draw less.

What can you do about this? As with every other way of avoiding an unnecessary investigation you need to recognise the problem and then provide the information with your tax return which explains it.

Look at your drawings figure. Would an unconnected third party have difficulty in seeing how you manage to live on this? If so, make sure an explanation is provided of any money available to you which the Revenue will not know about. You might receive regular gifts from a wealthy relative (be ready for a very sceptical reaction from the inspector), you might have received an inheritance or run up an overdraft on your private bank account.

If there is no explanation for low drawings, other than a frugal lifestyle, be prepared to be challenged. Speak to your accountant and agree an exercise to keep a detailed record of expenditure for a sample month and then notify the Revenue of the result when sending in your return. You could consider keeping the record going, paying particular attention to how the additional expenditure at Christmas, birthdays, holidays etc is met.

Another way the inspector will look at your drawings is to see if they increase in line with inflation each year. If they don’t, expect an investigation if you don’t explain the apparent anomaly. It may be that family circumstances have changed, with children leaving home, or additional expenditure has had to be met on such things as university fees. There might be expenditure on one-off items in some years such as a wedding, an expensive holiday etc.It may strike you as naïve that the Revenue assumes that the highest paid employee will never receive more than the proprietor draws from the business but that is the assumption that is made. Rather than fight it, be prepared to explain it. There are, of course, many reasons why this will be the case and taking the trouble to give these reasons when submitting the return will remove one more chance of being selected unnecessarily for investigation.

Unsatisfactory trading results

An important part of the Revenue’s risk-assessment involves looking at the trading results shown over a six year period. They will set out the accounts figures side-by-side to look for patterns and fluctuations and they will compare the business ratios both between years and against the industry norm. The ratios the Revenue will look at are the same as those you will use yourself to assess the performance of your business. The difference is the conclusions the Revenue will draw:

• a low gross profit rate will be taken as an indication of omitted takings rather than that you have got your pricing wrong or have failed to eliminate inefficiencies;

• an unexpected stock ratio will lead the inspector to question if stock has been properly valued or if an uplift to closing stock (and therefore to profit) is required;

• a low ratio of sales to wages might reveal that additional drawings or non-commercial ‘wages’ to family members are included in wages;· 

• if the creditor days calculation indicates an unexpectedly high figure of creditors, the inspector will look to see if previously omitted cash sales are being re-introduced as ‘creditors’ when the business is short of cash;

• high borrowings when there is little liquidity in the business may indicate substantial private assets which the inspector does not know about being given as security.

These are a few of the more important ratios which will be reviewed and some of the interpretations put on them which might lead to selection for investigation. Being aware of this when you make your own review of your trading results, think about how the inspector might interpret them and avoid an unnecessary enquiry by providing an explanation of the real reason for the results with your tax return.

Type of business

The Revenue’s risk-assessment includes risk factors which arise simply because of the type of business it is. Any cash business is immediately put into a high risk category. It is absolutely essential, therefore, that a cash business has an impeccable record of cash handling from the moment of receipt till it is banked or spent. The record must be:· 

• regularly and frequently written up;

• regularly and frequently reconciled;

• fully supported and verified by documentation.

An estimate for cash in hand at the accounting date is an open invitation to the inspector to start an investigation.

There are also certain businesses where experience has shown that employees are engaged on minimum wages which are then topped up with cash, particularly care home staff, drivers, labourers etc. The Revenue will often undertake as a project investigations into all the businesses of one of these types in the area because they generally yield very good results. The cash wages come from omitted takings, and this is rarely restricted to the amount paid out in wages. Although there is a deduction due for the extra wages paid, the Revenue gets another bite of the cherry with the tax and NIC which should have been paid under PAYE. Finally, the employees who have falsely claimed benefits because of their ‘low’ wages will have to repay them. It is extremely important that you don’t get involved in this sort of thing. As well as being very expensive, it is likely to lead to the matter being referred to the Revenue’s Special Compliance Office to consider a prosecution. This is because of the collusion between the employer and the employee to defraud the Revenue. The importance of the Revenue being able to show that the records are inadequate has already been touched on. Any omission from the business records will be sufficient to justify replacing the profit shown by the accounts with an estimate, usually based on a business economics exercise, and extending the enquiry to cover the person’s private affairs as part of the investigation. Inspectors are provided with guidance notes on particular types of business to help them to break the records. The guidance notes tell inspectors about the likelihood of small amounts of income, usually in cash, which are frequently omitted from the business records. For example, swearing fees paid to a solicitor, tips paid to a taxi proprietor, sales of small amounts of scrap metal by a manufacturing concern etc.

It will help to avoid unnecessary selection for investigation if the accounts for your business are sent with your tax return. The takings figure could be shown on the accounts could be split between the different sources of income, showing separately any small amount of subsidiary income. In this way the inspector will know that this income has been included and one more reason for selecting the return for investigation will have been removed.

Poor compliance record

As you will be aware the Taxes Acts impose numerous obligations on taxpayers generally, with an additional helping for those who employ people in their business. There are deadlines for making all the various returns and paying the tax and NIC which becomes due. Any failures to comply with these obligations will earn you points as part of the risk scoring used for risk-assessment.

Avoiding selection by having a good compliance record is entirely under your control. If things go wrong, it’s no good blaming your accountant; the Revenue is not interested in whose fault it was. The important thing to remember is that you must be fair to your accountant. If every client turns up on 25 January with a carrier bag full of unsorted invoices and scraps of paper and thinks it reasonable to expect the accountant to prepare accounts and submit their tax return by 31 January, it’s going to end in tears.

Summary

The initial selection for investigation by way of risk-assessment is an automated process using various risk rules. The next step is the critical review made by the inspector to decide whether or not to issue the enquiry notice.

Knowing the areas of risk will enable you to make sure that the Revenue has the information available which is needed to explain apparent anomalies and inconsistencies. This should be sufficient to satisfy the inspector at the critical review stage and so avoid unnecessary selection for investigation.

Be sure, however, to make your explanations detailed and credible. Vague generalisations, such as “competition meant I had to hold my prices down” won’t do. The explanation needs to cover who the competitors were, how they aimed to get a competitive edge, how you reacted to this and how this affected your margins. Unless the effect is reduced to figures and quantified, the explanation will be considered to be too vague, justifying further investigation to establish the full reasons for a low gross profit rate.

Obtaining information

Once an enquiry notice has been issued the inspector can ask for any documents you have which were used for completing the return and any information needed to check that the return is correct. As you would expect, it is an offence not to keep the documents used to complete the return or to destroy them when they are asked for.

These powers will be used to obtain the business records at the very start of the enquiry. The inspector’s aim will be to break the records so that the accounts profit can be increased to an estimated figure based on a business economics exercise (see below) or on some other basis. To break the records, the inspector will use various techniques, including:· 

• looking for specific omissions;

• carrying out a cashflow test;

• comparison with non-financial records.

Specific omissions

We saw earlier that the inspector is given guidance on what small amounts of cash from subsidiary sources to look out for in particular types of business. The amount is not important; even a single omission of a very small amount will be used by the inspector as evidence that the accounts are not reliable.

Another way in which omissions might be established would be to identify a large purchase – a bathroom suite purchased by a plumber, for example – and then check the sales invoices to see if there was a record of the work done. You will see how carefully you must identify purchases for yourself, family or friends etc and not charge these against your profits.

Cashflow test

Starting with the figure of opening cash shown in the previous year’s balance sheet, the inspector will prepare a cashflow test to reflect cash incomings, cash expenditure, cash banked or taken out of the bank to see if there is ever a position where there is ‘minus’ cash. Whereas you can be overdrawn at the bank, you cannot have ‘minus’ cash of course. If the test threw up such a result, the records would be broken. The simple solution to this is the impeccable cash record referred to earlier and the frequent reconciliation of the cash record against the actual cash held.

Non-financial records

We saw earlier that the Revenue can be very naïve about business matters and you will certainly experience this naivety if ever you suffer an examination of your non-financial records.

Many businesses have to have non-financial records for the efficient running of their business or because they are required by law. For example, a hairdresser will have an appointments diary, a hotel will have a booking chart, a farmer may have an animal movements book, a scrap dealer will have a police record book and so on. The Revenue assumes that because these records are required for reasons of efficiency or to comply with the law they will be accurate – indeed more accurate, in many cases, than the financial record. Always assume that the Revenue will see any record that you have for your business, financial or non-financial. If appointments are not kept keep a record of this beside the original entry in the diary. If hotel guests leave early or extend their stay, make sure the original record is adjusted accordingly, and so on. If these adjustments are not made to the record the inspector will simply assume that the original record is correct and that the income from it has been omitted.

Business economics exercise

In its simplest form, a business economics exercise uses the purchase invoices and the price list to establish the mark-up rate used in the business and then applies this mark-up rate to the cost of the goods sold in the year, adjusted for wastage etc, to recompute the takings. As anybody who has ever produced a business plan, including cashflow and profit and loss projections, knows, life is never that simple. However, once you have been selected for investigation and the inspector has broken the records, the simplistic approach will be used – and it has the approval of the courts! 

A simple example would be as follows:

(a)       Mark-up rate

(b)       Recomputed takings

You will see from this that if you hope to get anywhere near the true figure of takings using an exercise like this you will have to keep:

• details of prices for the year;

• a record of wastage;

• a record of discounts;

• a record of goods taken for own use; and

• your best estimate of losses due to theft.

You will need to keep these for at least a year after the filing date for the return.

Don’t think you’re safe if you don’t buy and sell things.  The Revenue will use other ways of constructing a business economics exercise, including a fuel takings ratio for taxis, hauliers, coach businesses etc, or hours worked and charge-out rates for service trades.

Further Action

• read the Revenue’s Code of Practice for investigations (COP2);

get advice from your accountant on the records to keep and write them up carefully and regularly.