Before self assessment around 1 in 100 tax returns were examined; now the number will be around 1 in 10, possibly even higher if HMRC are given high resources. That means that every taxpayer – and that generally means every self employed person – will get inspected within a ten year period.
Interestingly though the yield per investigation is negative; HMRC only gets £0.30p for every £1 it spends enquiring into the self employed.
Both the increase in investigations and the low yield from them were outlined, and to some extend, predicted, in my book ‘How To Get The Most Out Of Your Accountant’ some years ago (now out of print). At that time I suspected that HMRC would increase their efforts in order to get more Revenue for increasing investigations, and this is what is now being announced. The subject of Investigations in covered in this website, and in my book ‘Self Employment – Making It Work For You’.
HMRC have acquired sweeping powers to investigate all aspects of your business and personal life. And, frankly, under the new regime within HMRC these powers are being used by Revenue Officers in ways that seem to us to border on the improper. You will be inconvenienced and distracted for months, and sometimes years, by such scrutiny.
We are forced to wonder at the message intended by the Government in naming their original cartoon taxman, used to herald the arrival of self assessment, in 1995 ‘Hector’. The Concise Oxford Dictionary defines ‘hector’ as ‘a bully, to bully, to intimidate’.
Under the self assessment regime you are responsible for submitting your tax return to HMRC once a year, containing details of all your income including the profits of your self-employed business. HMRC then have a finite period of time in which to make enquiries into - investigate - your affairs.
If you are to be investigated HMRC will write to you and / or your accountant to inform you of this. He or she will demand the presentation of certain documents, set out below, to be delivered by a specific date. Failure to meet that date can result in fines being imposed. Although the Code of Practice asks for taxpayers to be efficient in responding, the question of fines is not mentioned, an unfortunate omission we believe.
The Inspector will demand to see the business records including the books of account, receipts for expenditure and income invoices, the bank statements, paying-in books and cheque books of all business bank accounts. He may ask for non-financial records such as diaries, copies of advertisements placed by the business, and so on. Since there is a requirement in law to maintain these records for at least six years this request is reasonable.
Generally these records are sent to the Inspector’s office, but you can ask to have them examined at your business premises.
However, the Inspector may also ask to see personal records of private bank accounts, private building society accounts, dividend receipts, transactions involving the sale or purchase of shares or indeed any items. There is no requirement to keep such records, but as a taxpayer, and particularly a self-employed one, you will be regarded as ‘guilty unless you can prove yourself otherwise’. It is therefore important that when you become self-employed you realise this and maintain your personal records with equal diligence. Vital though this usually is in settling HMRC investigations, you will not find this requirement stated or even recommended in HMRC leaflets and guidelines. The fact of demanding them is mentioned in the Code of Practice 2 ‘HMRC investigations’ governing Investigations, but by then it may be too late if you have not retained them.
Of more concern under modern legislation is that HMRC may demand such equally detailed information of your husband, wife, or other relationship-partner. The justification for this is that a ‘couple’ may hide illegal transactions in the partner’s accounts. What is alarming is that HMRC are well aware that they have no powers in law to make these demands; individuals must be treated on their own merits. Several years ago we discussed this with an Inspector, who refused to be identified, and who blandly, and brusquely, stated that if ever he was refused - in his words, if the person being investigated did not volunteer their partner’s information - then he would simply commence an investigation into that other person. Put directly to HMRC they would accept that such an action is improper and not part of their practice. We believe that there are gulfs between the ideals set out in HMRC’s documentation and their actions in practice.
Why the investigation has been conducted.
HMRC’s guidelines (Code of Practice 2 - HMRC Investigations) indicate that you will be informed of why the investigation has been conducted. (“We will always tell you or your accountant the reasons for starting an investigation into your business accounts.” COP2) This is not true, except in the blandest terms. In fact, HMRC make a point of not telling you why they believe your accounts or tax return to be in error. Nor will they answer your questions as to why. We recall a case where the Inspector examined the accounts of a language school which had, correctly, shown only modest growth over the years. It got its ‘students’ from abroad in small numbers and was filled to its own capacity. One of the reasons given for the investigation was that the Inspector had ‘noticed an increasing number of students in the [university] town in which this small, private school was based. It was hardly a sensible basis for the investigation, and in our view probably not the truthful reason.
Furthermore HMRC state “We will start an investigation only if we think that your accounts or Tax Return may not be correct.” (COP2) Ironically this may well be true though it should not be. HMRC have been given powers to make random checks on tax returns but have informally admitted they have no intention of doing so. They will target their enquiries to areas where they feel there are errors. Reading between the lines what has actually happened is that they have sought and obtained powers to legally do what they have in any case been doing for years. They used to have to have a reason for starting an investigation - again, only blandly stated - but now they do not have to have such a reason. They can officially claim it was ‘random’. In fact they have stated that they are going to pursue cash businesses and certain other targets.
The implication is chilling. Everyone involved in a cash business is therefore to be assumed guilty of error or fraud. Indeed, every taxpayer under the new regime is to be assumed guilty. When police were challenged on what were known as the ‘suss’ laws - it was said they used stop and search in suspicious circumstances as a racist weapon against black people - they were prevented from doing so. Yet those same ‘suss’ laws are apparently thought appropriate against a different sector of society: the self-employed.
Having received your documentation the Inspector will examine them compiling a case against you in four ways:
- do the records accurately record your income and expenses so that no income has been omitted and no expenses claimed that should not have been? In other words, are your stated profits correct.
- can you live from the profits you state you have earned? The Inspector will compile a picture of your personal expenditures and ask you to explain how you paid for your food, home costs, holidays, and so on.
- a capital statement showing the acquisition of your personal wealth and assets over a period. In other words, if you have invested in shares, opened savings accounts, etc where did you get the money from to do this.
- sundry information. For example, if you have just taken out a larger mortgage than previously, how did you persuade the lender to give you that mortgage - did you show them higher profits than you are declaring to HMRC?
The object of this exercise is therefore to determine the true level of profits. The investigation usually examines only one year’s accounts but can be extended to other years if serious errors or omissions are uncovered.
Once the Inspector has examined the records, and perhaps corresponded for certain information then in almost all cases he or she will ask for a meeting where you and the Inspector can discuss your business, and the findings to date, face to face. You are not obliged in law to attend such meetings and you can provide the information in documentary form, but a meeting is often the best and quickest way to deal with many of the Inspector’s questions.
Such meetings are generally conducted politely and with civility. The Inspector will probe deeply into your private life to determine the facts, and sometimes this can become uncomfortable. But unfortunately there are times when Inspectors use tricks rather than truths. For these and other reasons you are strongly advised to be represented by an accountant. Apart from being experienced in such matters and having been through Investigations before he or she will also be able to remain clinical when you are feeling angry; which means that your case is put forward more carefully and appropriately. If you have used an accountant to prepare your accounts then it makes sense in any case for that person to present the figures they are already familiar with. But if you have been going it alone this is the time to engage an accountant. Bear in mind that if you had been accused of murder you would not be likely to try to present your own defence in court without legal representation - and, sadly, murderers have a fairer court system on their side. They are deemed to be innocent unless proven guilty; you are presumed guilty from the outset.
Do not think of the Inspector of Taxes as the judge; he or she is the prosecution.
You also appear to be up against a political situation. HMRC believe that if they had the resources to do more enquiries into tax returns and accounts they would be able to generate more tax revenue. It therefore seems to be important to them that as many investigations as possible should result in further tax payments. The small level of ‘add-backs’, additional tax payable, often vastly outweighs the costs of the investigation borne by the taxpayer. But there is often a high cost in accountancy fees payable by the person being investigated, to say nothing of the time and work lost in meetings etc. Sometimes a client will seek to settle an investigation rather than fight it, as the cheaper of two options. It has even been suggested that sometimes HMRC might pursue investigations, offering settlement in small sums, just to boost their numbers of ‘successes’, knowing that people will pay up rather than fight. HMRC have vigorously denied that, but the belief remains widespread in the business community.
An example of the type of situation that gives rise to this belief arose in an investigation handled by us for one of our clients. The client had a turnover of several hundred thousand pounds. After several months of to-ing and fro-ing the Inspector was unable to find fault with any of the figures presented. At a final meeting he resorted to challenging the client for claiming £2 per week towards the cost of heating and lighting in his home for running his office there - a very normal sum, and in fact very modest claim in his case. In this case, on principle, the client refused to back down stating - and meaning it, we know! - that he would rather go to the Commissioners for an independent ruling regardless of the cost. HMRC backed away on that occasion.
At the interview HMRC will make copious notes, a written record of what is discussed. These will then be sent to you and your accountant for your approval. If you believe them to be in error you must challenge them in writing before signing them to confirm your agreement. If you do not they will become the ‘true’ history of the meeting, whatever the reality. There is no general requirement to sign these records, which was once demanded by the Inspector, but it may still be useful to do so if the matter is likely to go to appeal.
Not all taxpayers are honest. The true number of taxpayers who seek to evade their proper tax liabilities is probably somewhere between the high number suspected by HMRC and the low numbers suggested by accountants’ files. But if you, who have just been notified you are under investigation, have anything to hide then this is the time to admit it. Your accountant is also skilled at presenting the facts in the best light.
Before presenting your case it is wise to confirm your own position from the same four viewpoints that HMRC will use, as noted above. Do not simply focus on sending HMRC the required records, but think again if the stated profits and other sources of income allow you to have had the lifestyle you have maintained. If not then there could be something amiss in your records and it would be wise to admit that up front. Unintended errors can get into accounts; better you discover them and volunteer them than they are discovered by the Inspector. Any voluntary disclosures on your part are taken into account in determining the extent of penalties that might later be levied.
It is also best to have a written summary of these four areas with you in the meeting to refer to; in the heat of investigation it is easy to overlook important matters and the Inspector will often not allow correction afterwards unless you have strong evidence to support a revised position. Take any documentary evidence you have to the meeting with the Inspector, and brief your accountant on it in a pre-meeting beforehand. Certainly take any documents that have been requested by the Inspector or you will prolong the investigation, possibly even needing another meeting.
Discuss the position with your spouse or relationship-partner. They may spot something you would overlook. The most common error is to forget the receipt of child benefit (which is non-taxable at the timer of writing) which is usually paid directly to the mother’s account. This contributes towards household living expenses but if you forget to mention it to the Inspector you could find yourself paying tax on ‘deemed undeclared income’ when the gap between your stated profits and your personal expenditures cannot be reconciled. Check also for ‘one-off’ items that may have contributed: cashing in insurance policies, sale of private assets from the house, gifts from relatives, and so on. All could explain apparently missing money that will otherwise be deemed undeclared income on which you may pay tax, fines and penalties.
Respectful of Confidentiality
HMRC are, in our experience, respectful of confidentiality. They acknowledge the delicacy of investigations and do not generally release information to friends, relatives, customers, employers unless you have authorised them to do so. COP2 confirms this, listing as an example of where information can be given without authorisation as the Appeal Commissioners. This is reasonable, they are more or less the equivalent of a judge in these matters. In one investigation a receipt of £500 was needed to explain income paid into a bank, but the sum had been given by the taxpayer’s daughter and son-in-law. Because the son-in-law was a high profile ‘celebrity’ the family had not wanted to even give him the worry of telling him that his father-in-law was being investigated. It would have caused great family difficulties between the daughter and son-in-law if the matter had been revealed. But in this case HMRC were intransigent in demanding confirmation from these third party family members. It took very strong protests from us as the accountants and HMRC’s decision to replace the investigating officer before a sensible compromise was reached. HMRC satisfied themselves by internally examining the tax records of the son-in-law to show that the gift was within his means. The son-in-law never knew of the matter.
In that investigation it had become apparent that the investigating officer had become somewhat committed to a ‘victorious’ outcome, and had lost reasonable balance in his enquiries. We were forthright in protesting to the District Inspector who was extremely helpful. HMRC did not admit to - or apparently accept - our allegations of lack of proper balance, but, unusually, the officer was removed from the investigation and the matter then quickly resolved by his successor, without any adjustment to our client’s stated profits.
HMRC are obliged to work with accountants or other advisors as stated in their Code of Practice on Investigations, and most officers seem to find that easy, and perhaps more professional to handle. There are a few who do not, and taxpayers and accountants sometimes find that Inspectors try to drive a wedge between the client and his or her advisor. In one investigation we dealt with a client was approached directly by HMRC and told that his accountants (us) were not co-operating. He knew better and we jointly complained to the District Inspector. She upheld HMRC’s own line and it was four years before, when the matter was resolved entirely to our client’s satisfaction, that HMRC admitted in writing that they had made serious errors of judgement in their handling of the case. They did not specify what errors, and during four years we catalogued a good many. Sexual discrimination certainly seemed to have come into the problem, and we suspected - quite without being able to obtain proof we must add - that racial prejudice had also entered the equation. It is only fair and proper to confirm that once these matters were brought to light and examined by the senior officials we involved that HMRC were extremely efficient and courteous in bringing matters to a finalisation and apologising. In fact they finalised the matter very professionally. We will probably never know what the internal consequences were for those involved, and we cannot name the parties involved.
HMRC are diligent in providing what information they can in our experience. When the investigation is started they immediately provide you with leaflets IR72 'Investigations: The Examination Of Business Accounts' and IR73 'HMRC Investigations: How Settlements Are Negotiated' setting out an outline of the investigation and its likely course.
Once you accept that there has been some underdeclaration or that you will not be able to disprove the Inspector’s allegations, and that therefore additional taxes will have to be paid it may be sensible to make payments on account as soon as possible to avoid interest charges running on the deemed underpayments.
At the point at which you accept that you will have to pay more tax, for whatever reason, HMRC have, and will almost certainly exercise, the right to add interest charges and penalties. Interest is, in part, deemed to be a measure of restitution to HMRC; you have had their money when they should have had it and they could have been earning interest on it so you will have to pay them what they should have earned. You could also have been earning interest on money they would have had, which would not be fair. Interest is calculated at set rates, which can vary according to the economic climate.
Penalties are punishments for your failure to pay the right tax, levied unfortunately whether or not there has been a genuine failure or whether it is just that the Inspector has you trapped between a rock and a hard place (accept the add back or pay more to prove it untrue). There are varying degrees of penalty depending on circumstances.
Finalising the investigation also involves signing a declaration, a Certificate of Disclosure, that you have now given details of everything that should be disclosed.
HMRC state that they do not “start another investigation in the future simply because something was wrong on a previous occasion” [COP2] and mostly we have found this to be true but we have known of rare situations where people have been investigated immediately after a previous investigation for no obvious proper reason we could identify.
There are levels of complaint you can make if you believe your investigation is not being conducted reasonably. There is an Officer in Charge at HMRC district dealing with you who can look into the matter. We believe that where prejudicial attitudes arise in individual inspectors this level of complaint usually resolves the matter fairly. You may, if that does not bring a resolution, also apply to an HMRC Controller who deals with the section of HMRC that covers your area.
The question of appeals procedure we shall shortly also examine.
There is also an Adjudicator who examines complaints against HMRC. The Adjudicator is limited to dealing with the way in which HMRC have dealt with taxpayers, not with the facts of investigations. The adjudicator can examine complaints of excessive delay in dealing with your affairs, of errors in the way they have been approached, of discourtesy and of any perceived lack of fairness in discretionary matters. The adjudicator does not hear appeals. The adjudicator should normally be approached as quickly as possible after a need is perceived. Generally, you would be expected to have complained within six months of the matter about which you were displeased.
There is also complaint available to the Ombudsman, an independent Parliamentary Commissioner. The Ombudsman can look at complaints the adjudicator has examined, but not vice versa. He can only investigate complaints made through a Member of Parliament.
Once the Inspector has all three components in place, tax deemed lost, interest and penalties, then he or she will ask you to agree with him or her and ‘make an offer’ in settlement. If the offer covers the amounts he or she believes reasonable then it will be accepted and when paid that is the end of the matter.
If agreement cannot be made between the taxpayer and HMRC then the matter can go to an independent appeal procedure. It is generally a fair procedure, and indeed one that HMRC often seek to avoid because it often goes ‘against them’. But in order to ‘dissuade’ you from using the procedure there is a stated threat to be wary of.
Simply, the Inspector sets out a level of penalty which may be mitigated for various reasons stated above, and expects your obedience to that figure. If you do not ‘make an offer’ in that same vein and the matter has to go to appeal then the mitigation is removed and the Inspector will demand full penalties. HMRC put it thus: “The figures we put forward may have to be higher than those we suggested to you during our negotiations, as they might have been 'without prejudice', and the Commissioners will need to consider all the facts and issues which you and we believe to be relevant.” [COP2] In other words, there is a price to pay if you wish to defend yourself. Unfortunately tax-related matters are (wrongly) regarded as ‘crimes’ of the middle classes and have not come to the attention of civil liberties groups, who would take a very different view of this sort of process if it were levied against, say, ethnic minorities.
Assuming that you do choose to go to the Commissioners then another leaflet which is not usually provided unless asked for is IR37 ‘Appeals against tax' which sets out the appeals procedure and describes the role of the independent commissioners. But this leaflet hardly prepares you for what is to follow. Up until this point there has been the semblance of co-operation between you and the Inspector. Frankly, at this point from the Inspector’s point of view, the gloves come off and you recognise an aggressive prosecution for what it actually has been all along. HMRC state that “Asking for this [appeal] to happen will not be regarded as a lack of co-operation on your part...” [COP2]. However, some inspectors respond as if they do feel it is a lack of co-operation.
In fact from any point during the investigation you have had the right to go to appeal, but this rarely happens unless there is a deadlock in trying to find an agreement with neither party willing to back down from their position.
Once that deadlock is recognised then the Inspector will simply raise an assessment - a demand for money - based on his or her view of the position. You then have 30 days to appeal against it, and the appeal is set before the Commissioners.
It is a very formal procedure. Both sides present their case, and exchange details of their case to each other beforehand, and the Commissioners determine the case on the basis of the facts presented. Witnesses may be called and formal statements presented. You should be represented by at least someone who can present your case well though it does not have to be a professionally qualified person, probably your accountant and almost certainly a solicitor. HMRC field very aggressive solicitors for their side.
We mentioned above the Adjudicator who examines the conduct of HMRC. It is worth looking at the procedures that will likely be followed if you decide to make a complaint to that office.
Apart from giving ‘routine’ matters such as details of yourself and your complaint it is suggested that you also set out what rectification you require. Is it compensation? Is it an apology? Or both? Or something else?
You should set out any costs that you feel you have wrongly incurred as the adjudicator can recommend compensation payments.
If the adjudicator can resolve matters between you and HMRC s/he will endeavour to do so. If not then s/he will make a recommendation for resolution. HMRC have agreed to be bound by those recommendations except in special circumstances which would then be brought to attention in a published annual report. In such circumstances you would not be identified.
The future of investigations
Considering that the process of investigation, while absolutely necessary, can be unfair and unfairly administered, the future for the self-employed looks bleak indeed.
For many reasons HMRC intends to step up their investigation processes, raining down on many more taxpayers than ever before. Considering that they seem to exhibit a bias towards employment and the PAYE system and a corresponding bias against self-employment then it could be argued that this concentration might frighten people away from self-employment where there is choice and that HMRC might see this as an advantage. True or not, HMRC’s stated belief is that they can capture more tax if they do more investigations.
Self Assessment was a necessary step towards that end. By placing the onus and the practical work of tax compliance on the taxpayers they freed up money and personnel to enable them to conduct more in-depth examinations.
Connor Spencer & Co are experienced in taking clients through the investigation process. We work with HMRC, within the legal framework, to represent clients in the most authoritative way, putting their side of the case most forcefully.