How do HMRC investigate a business?

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Taxwise deal with over 6,000 insurance claims each year which arise as a consequence of HM Revenue & Customs (HMRC) enquiries, these enquiries involve different trades and originate from all over the country.  This gives us a unique perspective on the enquiry landscape, and clients often ask us what triggers an HMRC enquiry, what can they do to avoid an enquiry and what does an enquiry involve? Whilst HMRC can launch an investigation into a business at any time within the statutory time limits enquiry notices are usually timed to be issued at specific times of the year in order to control work flow within the department.  There tends to be a surge in January as the twelve month window of enquiry closes.   Fridays are another favoured time for issuing enquiry notices – what better way to start a weekend than to open the post on Saturday morning and discover that HMRC is about to investigate your business? HMRC has a variety of techniques which are employed in deciding whether or not a business should be investigated. This ‘risk assessment’ process can be very informative as it will compare the results of the business to other similar businesses; it will produce statistics such as gross profit margin, mark-up rate and comparisons to earlier years. The problem is that if a case is ‘risk assessed’ the officer cannot decline the invitation to investigate. Officers have quite openly admitted that they had no choice but to open an enquiry, even though they knew that there was nothing in it for them, because the risk assessment process had identified the case as warranting an enquiry. So what is likely to trigger an enquiry under the risk-assessment process?  The simple answer is patterns! HMRC loves to see consistency across a business, both within the business itself and also across similar businesses. It will expect turnover to be fairly level whilst accepting modest fluctuations in either direction. If turnover goes down it will expect expenses to decrease. If profit goes down HMRC will raise an eyebrow if proprietors’ drawings/directors remuneration goes up! If turnover increases substantially it begs the thought that maybe not all of the turnover in the previous year was declared. If it drops significantly then maybe some has been taken by the owner and not declared? Suspicion is aroused if the claim in respect of power and light increases well beyond what would be expected comparing it with the previous year (and bearing in mind known increases in tariff). The HMRC officer will wonder whether working hours have increased (hence the increase in power/light) and therefore the officer will wonder why turnover has gone down! Proprietors’ drawings will be similarly scrutinised – a substantial increase could mean that drawings may have been understated in the past, leading HMRC to wonder whether any cash takings have found their way into the proprietors pocket rather than the company’s books.  If the drawings are less than the salary paid to the highest paid employee HMRC will be very uneasy – business owners are expected to be the highest earners in the business! Gross profit margins are a favourite barometer for judging whether or not a businessman is declaring all of his income to HMRC. The gross profit of the business will be examined over a period of up to 6 years to see whether or not it is consistent. It will also be compared to similar businesses and fluctuations of more than 3% will arouse suspicion. HMRC has access to a wealth of information to indicate what the gross profit of a particular type of business should be and will be well aware of most of the tricks which the less scrupulous businessman may try in order to disguise the true gross profit of his business. HMRC will scrutinise invoices carefully. An example of this involved a Chinese Restaurant.  HMRC found that when purchasing potatoes the proprietor bought 5 sacks for which he paid by cheque with a further two sacks for which he paid in cash. The two sacks for cash were converted to chips and the sales were not recorded, thus the gross profit was unaffected by the unrecorded sale. How did HMRC discover this? – it was written on every invoice “five sacks by cheque plus two by cash”!! This practice had been going on for years and a significant settlement was agreed with HMRC! HMRC will be concerned as to whether or not an individual has the means to finance his standard of living. Information will be gained in this regard from a variety of sources, giving HMRC details of property owned, cars, boats, bank accounts, horses etc. Even though there will often be perfectly sound explanations as to how such assets may have been acquired. Another client was the subject of a tip-off to HMRC by a neighbour who became somewhat jealous at seeing a new Porsche parked in the drive every other year. The explanation was again quite simple – once the first Porsche was acquired, it only cost around £20k to exchange it after 2 years for a new model, but again it took a full scale enquiry into the client’s company before HMRC would close the case down. Some HMRC officers will scour the weekly adverts in the free local paper to see who is advertising their services and will then check to ensure that they are all registered with HMRC. They may check adverts in newsagents’ windows, in supermarkets and DIY stores with the same purpose in mind. Jealous neighbours, relatives and ex-wives will volunteer information to HMRC some of which may be malicious but some may be true and HMRC will usually investigate to see whether or not there is a case to answer. Enquiries will vary in their nature and complexity.  HMRC have become very adept at using data from third parties in order to identify potential underpayment of tax.  For example HMRC will use information from banks or building Societies to identify potential undeclared bank interest, or information from the land registry to identify undeclared capital gains on the sale of rental properties.  Enquiries in this respect will often focus on the one transaction and go no further and can usually be dealt with quickly and a relatively low cost. Other enquiries will go into far more depth.  PAYE and VAT compliance Visits will normally involve a visit to the taxpayers premises and a full audit of the books and records (normally for a day, but on occasion longer).  Following the visit HMRC will either request more information (perhaps not available on the day), confirm that they are happy with the taxpayers affairs or raise an assessment confirming that tax has been underpaid and the additional amount due.  The taxpayer can either then pay the additional tax, or where there are grounds dispute HMRC’s findings. Corporation and Income Tax enquiries have historically been conducted by post and will often begin with a request to view the taxpayer’s full books and records.  From here HMRC may identify various issues with regards to which they require further clarification.  The issues will normally narrow as the enquiry progresses with HMRC eventually either concluding that they are happy with the taxpayer’s affairs or raising an assessment for additional tax.  Enquiries will often involve several rounds of correspondence and meetings, therefore professional representation by the taxpayer’s accountant is essential, in order to help head off any issues.  From a corporation and income tax point of view HMRC are slowly changing their approach, trying to move away from postal enquiries and instead commence enquiries with an initial on site audit (in the same way as they do for PAYE and VAT) with a view to minimising costs and establishing an early and open dialogue with the taxpayer in respect of the risks identified. So you can see from the above how HMRC can acquire information and use it to investigate a business.  Effort should be made by the taxpayer and their professional advisor to identify and possible inconsistencies in advance of submitting self-assessment returns to HMRC. In this way explanations can be provided which may help to avoid an enquiry or the client can be made aware in advance that his figures pose a risk. Taxwise provides insurance to protect against the cost of professional accountancy fees incurred dealing with an HM Revenue & Customs (HMRC) enquiry.  In addition to our insurance services, our in house consultants and external consultancy partners have many years’ experience are always on hand to assist, should one of our clients become the subject of an HMRC enquiry. For more information on Taxwise then please contact us on: 0844 89 22 473


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