Mark McLaughlin warns that poor or inadequate record keeping could cost business taxpayers in terms of additional – and unnecessary – tax liabilities.
When it comes to enquiries by HM Revenue and Customs (HMRC) into tax returns, it has to be said that some self-employed taxpayers are their own worst enemies, particularly if the business is a cash-based one.
Why? Because very often those individuals do not maintain adequate records of their business income and/or expenditure to withstand scrutiny from HMRC during the tax return enquiry.
This often puts the business owner on the back foot from the start of the enquiry, as it potentially gives HMRC the opportunity to challenge the figures in the accounts, and possibly to contend that cash receipts have been understated.
This can have unfortunate consequences, not least because it encourages HMRC to undertake ‘business economics’ exercises, based on assumptions which are not necessarily correct. The result is often inaccurate increases in business turnover and profits, leading to excessive tax liabilities and unnecessary penalties.
Don't encourage them!
HMRC guidance in its Enquiry manual (at EM2795) gives the following advice to its enquiry officers: “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 guidance adds is that it is not enough simply to show that the accounts are unreliable. However, if the records are incomplete, the HMRC officer is likely to investigate further. 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 HMRC is not satisfied with the accuracy or completeness of the business records, this may lead to HMRC undertaking a ‘business economics exercise’, which could result in turnover and profits for the period of enquiry (and possibly other periods as well) being increased. It is interesting to note that an entire page of HMRC’s Enquiry manual dealing with ‘cash flow tests’ (EM2960) has been withheld from the public domain, which suggests that HMRC does not want to give away too much information about its approach in such cases.
A ‘model’ of accuracy?
HMRC officers sometimes use ‘business models’ for the purpose of the above exercise. These can involve the use of formulae in arriving at an estimated figure for turnover. The HMRC officer in an enquiry may seek to justify the use of business models by attempting to discredit the accounting records of the business.
If a business model indicates significant differences compared with reported profits, HMRC will probably consider that this reinforces its view that the business records are incorrect and/or incomplete. However, HMRC’s alleged turnover figure must obviously be realistic. The business owner (or his adviser) should critically review HMRC’s business model; for example, was the business actually capable of making that much money for the period in question?
The accuracy of the business model will depend on various factors, including the nature and extent of any assumptions made by HMRC in arriving at its figures. HMRC officers are instructed to listen to any explanations by the taxpayer or adviser of alleged discrepancies (EM3502). If no agreement can be reached between the business owner and HMRC, it may be necessary for the tax tribunal to consider which turnover and profit figures are more accurate. These circumstances should clearly be avoided if possible, as the outcome of tax tribunal hearings can be very difficult to predict.
A walk on the ‘private side’
A review of the business may also involve HMRC seeking to examine the business owner’s financial affairs and lifestyle, so as to form a view of whether (s)he has spent unrecorded cash sales. HMRC may attempt to establish that the business records are inadequate (i.e. a practice sometimes referred to by HMRC as ‘breaking the records’), as justification to conduct a review of the taxpayer’s private financial affairs (or what HMRC commonly calls the ‘private side’ of the business owner’s affairs).
HMRC instructs its enquiry officers (at EM3350) to look at the private side of the taxpayer’s affairs if an examination of the records not only casts doubt on the accuracy of the figures entered on the tax return, but also suggests that the taxpayer’s level of drawings from the business lacks credibility. Furthermore, HMRC instructs its enquiry officers as follows (EM3308):
“If you can show that means available appear to be insufficient to account for the savings and still leave enough for adequate recurring personal and private expenditure and other non-business expenditure, and the taxpayer is unable to provide acceptable explanations of the deficiencies, you can contend that you have reason to believe that profits or income have been omitted or understated.”
Requests by HMRC for ‘private side’ details often lead to disputes with business owners and their advisers as to what personal information (if any) HMRC is entitled to see. That issue is beyond the scope of this article; suffice to say it may be possible to avoid such difficult issues arising in the first place, by maintaining complete and accurate business records. As HMRC’s guidance to its enquiry officers puts it (at EM3655):
“You have reason to test the adequacy of the recorded figure of drawings if the drawings are wholly or partly a balancing figure in the supporting accounts, or if the business records are shown to be unreliable, or if in the course of your enquiry you have, for example, established other undisclosed savings, or a generally unsatisfactory capital position.”
As indicated above, if HMRC disputes the figures for turnover and profit as reported in the accounts and tax returns, the business owner may need to demonstrate or explain why HMRC's alternative figures are flawed. If agreement cannot be reached, it could result in an appeal hearing before the First-tier Tribunal. This should be avoided if possible, as the outcome of tribunal hearings can be unpredictable. However, the taxpayer should be prepared to stand his ground, if HMRC’s conclusions are incorrect.
For example, in Jackson v Revenue & Customs  UKFTT 221 (TC) the taxpayer operated a limousine hire business. HMRC opened an enquiry into his tax return for 2011/12. Following a review of the appellant's business records, HMRC identified a low ratio of cash to credit/debit card payments. HMRC also formed the view based on business mileage that “all things being equal” cash takings had been suppressed. HMRC’s overall conclusion was that the sales figures for 2011/12 and 2010/11 were significantly understated, and raised assessments (and sought penalties) for those tax years. The taxpayer appealed.
The taxpayer recorded cash in the form of scraps of paper, which were handed to the bookkeeper (the taxpayer’s father). HMRC indicated to the First-tier Tribunal that there was no full reconciliation of cash banked and on-hand with the records of cash received and paid out. The scraps of paper were thrown away, so had not been seen by HMRC. However, the taxpayer maintained that HMRC's assumption about a shortage of cash in the business was wrong, as it was mainly a credit/debit card payment business.
Fortunately, the tribunal considered that the taxpayer was honest, and accepted the evidence of the taxpayer's father that he booked all the cash receipts of the business. The tribunal did not believe it to be a case involving the suppression of cash takings, as alleged by HMRC. There was no banking or other evidence to support this. The taxpayer's appeal was allowed.
In the Jackson case, the tribunal commented: “We are also bound to say that Mr Jackson’s bookkeeping system falls very far short of what is acceptable. To throw away primary records such as the “scraps” of paper recording cash receipts and some evidence of the payments by card is quite simply inviting problems in the event of an enquiry.” The tribunal also said “For these shortcomings Mr Jackson has only himself to blame for the difficulties which ensued.”
Nevertheless, it is worth bearing in mind that HMRC cannot simply rely on ‘hunches’ to assess extra tax; this point is acknowledged by HMRC (at EM3520): “the onus of proof in overturning HMRC amendments or assessments rests with the taxpayer, but that does not mean that you may make any amendments or assessments in whatever figures you like. They must be best judgements in all the circumstances.”
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This article was first printed in Tax Insider in September 2015.