In November 2017, HM Treasury published “Tackling Tax Avoidance, Evasion and Non-Compliance” which set out 100 + measures implemented to reduce lost revenue. Most of the measures are aimed at targeting avoidance schemes and have little relevance to the trader receiving cash. HMRC must rely on tried and tested methods to qualify traders with undeclared income. Comparable business information from data sources (e.g. other taxpayers/social media/other government departments/financial institutions) may indicate a failure to declare income although the methods to quantify undeclared income remain virtually identical to those deployed over the past few decades.
The presumption is that many of those receiving cash for goods or services do not declare that cash for tax purposes: a waiter or taxi driver doesn’t declare tips; an electrician or plumber provides services “free of VAT” for cash or a burger van banks only some of its takings.
This article refers to a real situation involving a roadside fast food outlet serving breakfast rolls and beverages. The letter opening enquiry stated, “I will be checking the whole of your return” and “During the period of the check we may search the internet including social media sites for information that has been published about you or your business”. It is interesting that HMRC draw attention to information on social media sites. Fortunately, the “Heart Burn Café” (not the real name) didn’t post too heavily on ‘LinkedIn’ or ‘Facebook’ about increased turnover and soaring profits.
One difficulty for an adviser will be the potential quantum of work required to manage an enquiry into undeclared cash sales and the ability to recover professional costs. The concern may not be so prevalent where insurance is in place to cover the cost of an enquiry.
An acting adviser may also have to manage a case where:
- A trader does not declare all cash
- The books and records lack substance
- Even if cash is banked, it may not be all the cash received
- The officer is likely to have the starting point that not all cash has been declared (is it human nature?)
- A trader will generally claim all expenses
- Wastage will appear high
- Lifestyle or family expenditure indicates income levels
The accountants acting on behalf of Heart Burn Café chose to keep professional costs to a minimum and handed business records direct to the HMRC officer. This was possibly on the basis that the client confirmed they had nothing to hide and warranted that cash takings had been declared in their entirety. The response was:
- “you have not maintained accurate business records”
- “the figures on your self-assessment tax return are unsubstantiated” and
- “the figure of turnover is unsupported, and I will need to review your private finances and will require information about your personal and household income and expenditure.”
A more proactive approach is for an adviser to review records and present their findings to the officer, although with this comes professional cost. The opportunity cost of simply sending information to an officer without review is potentially higher penalties.
The officer also suggested a telephone call meeting and set out an agenda:
- Nature of trade
- Business expenses
- Record keeping
- Income from property
A meeting may be risky if the client is not fully prepared and, again, the professional cost of preparing for and being in attendance need to be considered. A more reasonable approach may be to deny the meeting until a later time requesting a more comprehensive list of specific questions for the client to consider.
The officer wanted a household outgoings schedule, personal credit cards (including those for the spouse) and all other bank and credit card statements for the tax year under HMRC enquiry. The legal minimum of 30 days to provide additional information was given. HMRC manuals encourage officers to provide more time if it is reasonable. Issues that may make a longer period reasonable include length of time to obtain or review information with the adviser’s other commitments also being taken into consideration.
Identifying business profits
Where income received is cash and it is inferred that business records are poor, the officer will assert that further information is required to identify the correct level of business profits. The methods adopted are set out in HMRC’s enquiry manuali. The methods are:
- Cash flow tests: Identifying cash drawings and balancing to personal finances.
- Pattern of cash withdrawals: Identifying personal cash expenditure and whether met from personal bank withdrawals.
- Personal bank statements: Identify expenditure payments to other accounts and receipts.
- Means test: A calculation of the amount available for living expenses. ii
- Capital statements: Personal expenditure, increase in total wealth equals total income.
The methods require the analysis of drawings, personal expenditure met from bank or credit card (or loans), business expenditure met from cash or bank (personal or business) as well as increases or decreases in wealth. This information is then used to identify whether the income supports lifestyle and an increase in wealth.
The officer stated: “I will require information about your client’s private finances as part of my check” and “I will require information about your clients personal and household income and expenditure”. The client’s private finances were intertwined with that of his wife. To complicate matters the husband and wife held separate and joint bank accounts as well as several credit cards. The credit cards had been utilised for both personal and business expenses.
The HMRC enquiry manual states that an officer “may find that drawings have not been fully recorded and you will need to see the private bank account statements to satisfy yourself that these are consistent with declared drawings, and other information provided”.iii The manual also suggests that the officer may be able to request a sample period and if, after their review, they are satisfied “there will be no need for the taxpayer to incur additional costs on providing information for the rest of the period.iv An adviser should remember this approach and suggest to an officer they limit their initial review to a sample period, say three months. Given that HMRC’s enquiry manual indicates that this is acceptable, it is likely an officer will agree.
Where lifestyle expenditure is met through another (a spouse or partner) taxpayer’s bank, an immediate issue arises: the information is not that of the taxpayer under enquiry. Normally an officer will make an informal request for information. Powers exist under Schedule 36 Finance Act 2008 that may be used to issue a formal notice to a taxpayer (a taxpayer notice) requiring them to provide information and documents reasonably required to check their tax position. The notice must be given in writing and may:
- require information or documents which are:
- reasonably required for the purposes of checking the tax position of the relevant person
- within the person’s power or possession
- require the recipient to create new documents, e.g. explanations or data lists
- provide the recipient with a reasonable time to respond and comply
If household expenditure is met through a partner’s bank account, the information would not be in the person’s power or possession. In the absence of the information, HMRC would calculate profits of the business based on the information available to them and the onus to disprove would be with the taxpayer. It may be appropriate for the partner to agree to share those records.
HMRC will often undertake a “mark up exercise” where records are unreliable. The method adopted either relies on comparable industry information or links between expenses and profitability.
A business economics exercise establishes key relationships between expenses and takings so that turnover can be recomputed from the expenses. For example, Heart Burn Café incurred expenses on rolls, bacon, sausages, cans of drinks, tea and coffee. Having obtained the price list (possibly by visiting ahead of opening the enquiry), turnover can be calculated although subject to adjustment for wastage etc.:
Purchases for week 1:
Predicted sales for week 1:
|Bacon & Sausage Rolls||150||£2.50||£375|
Assuming utility costs are £60 per week, a simple business economic exercise would put profits at £594 before wastage. Fast food and restaurant wastage is estimated to be between 11% and 15% and this would further reduce profits. Annual expenditure would include premises (£210), street license (£1,380), insurance (£130), phone (£216), motor costs (£3,815) and accountancy (£500). Assuming a forty-eight week working year, the model returns profits of £17,984.
HMRC consider this a reliable basis because it is likely that all the expenses will have been claimed and there will be industry norms to compare results. However, the exercise cannot on its own be reliable.
Some readers may recall the Steak House Farthing Casev. The Revenue failed to discover any unaccounted for bankings, expenditure or any increase in capital. In December 1994 the Inspector raised discovery assessments for 1988/89 to 1994/95, relying on business economic exercises. The taxpayers had alleged a low gross profit rate, low personal consumption and expenditure, and high wastage. There was a lack of prime records. The taxpayers appealed contending that the Revenue had failed to act with due diligence relying, inter alia, on the inaccuracy of several of the business economic exercises. Representations had been made by the accountant to the first inspector, which were not considered when preparing the business economic exercises. Furthermore, an adviser to the taxpayer’s accountants about the investigation provided evidence that in a telephone conversation with the district inspector, he was not willing to settle the appeals wishing to ‘get his own back’ on the taxpayer’s accountant ‘who had not only complained to Head Office but had also compelled the district inspector to go before a General Commissioner with an application to obtain the taxpayer’s records. An application for an order of costs was made against the Revenue.
Due care and diligence had not been exercised by the Revenue. Incorrect business economic exercise had been undertaken because the contents of a letter from the taxpayer’s accountants had not been considered. The second inspector had compounded matters by failing to read the correspondence file which led to a series of errors. Neither had the inspector held an honest and bona fide belief. There was no evidence to support the allegation concerning the district inspector’s comments. Correspondence showed that the Revenue’s approach had been heavy-handed throughout. It was found that there had been no honest bona fide discovery by the inspector of taxes when the further assessments were made.
The Special Commissioner (T H K EVERETT) stated:
- “In any event business economic exercises alone could rarely if ever justify the raising of further assessments”
- “The gross profit rate throughout had been almost level…when copies of customer’s bills were retained for part of the accounting period”
- “The rates achieved by the taxpayers were higher than the rates for comparable businesses nationally”
- “The low own consumption was explained by the taxpayer’s frugal lifestyle and the allegedly high wastage was the result of their inefficiency in business”
It is also noted that the taxpayers had been able to support their lifestyle expenditure.
A more recent case, Ernest O Bustard TC04703  UKFTT 546 (TC) will be of great assistance to any adviser facing a business economics exercise in the fast food takeaway sector. HMRC had effectively alleged through the economics exercise that undeclared cash funds of £538,117 had been diverted. This amounted to £10,000 a month. The Appellant’s adviser stated that HMRC “had to ask the question ‘what had he done with the money?’” The Appellant failed to retain till records and could not provide evidence of wastage or food given to employees – HMRC were justified in undertaking a mark-up exercise and it was considered a necessity. However, HMRC did not produce any evidence to substantiate its findings. It was noted that the Appellant’s annual profit was only 2% less than the national hot food takeaway industry average and for the three previous years the profits did not deviate more than 3%. HMRC’s initial justification was based on other hot food takeaways in the locality, which had significantly higher margins. HMRC’s guidance states, each shop’s output is the product of the individual tradesman concerned and may be very different from that of neighbouring rivals. It was held that:
“On the basis of all the evidence, we find that the Appellant’s gross profit margin during the appeal period has been accurately reflected in his accounts and VAT returns. Although the assessments by HMRC have not been reached capriciously, arbitrarily or as a ‘spurious estimate or guess in which all elements of judgement are missing’, in our view, on the information and material available and for the reasons set out above, the assessments to VAT and Income Tax, are not to best judgement.”
In many cases, a mark-up approach will be justified:
- In Coy v Kime (HMIT), the court accepted that the profits should be re-computed, supported by a means test, once it had been shown that the records were inadequate. The court approved the use of an exercise based on a fuel: takings ratio for a taxi driver.
- In Brittain v Gibbs (HMIT) the use of an hourly charge rate was accepted as the basis for computing profits. The business was the provision of services (a painter and decorator).
Heart Burn Café
Given the approach taken by HMRC and the courts, the necessary approach is to undertake both a business economics exercise as well as testing the affordability of lifestyle through analysing expenditure through banks/credit cards, cash drawn, cash drawings etc.:
“Please find attached with this letter, the results of the cashflow test I prepared. As I explained on 21 February the results are preliminary at this stage, as I still need to establish how much of the business expenses were not cash and actually paid by credit cards instead.”
The review needed to cover the business records and personal bank accounts, bank accounts of partners and spouses and credit cards. It is a time-consuming necessity although advisable to agree with the HMRC officer to select a review period. The objective is to demonstrate that:
- “Any balancing figure taken as cash drawings in the business accounts, will if it is correct, ‘balance’ the proprietor’s personal finances”vi
- Identify the pattern of withdrawals and whether there are periods when no cash appears to be availablevii or whether withdrawals are consistent with lifestyle expenditure
Given that lifestyle expenses were met by the spouse, income and expenditure had to be verified against the spouse’s account. There was a need to identify deposits into bank account that were not takings. In the absence of undertaking this exercise the officer wanted to attribute 85% of all cash lifestyle expenses to the taxpayer as undeclared income. This was clearly wrong in principle given the spouse’s income was more than three times that of her husband. It would be reasonable to conclude that she would have met more of the expense, although in the absence of adequate records, the officer wanted evidence.
The approach of the officer in the case was consistently ‘assertive’ requiring information by the statutory minimum or before. Obviously, less than the statutory minimum is not acceptable and any time to respond should consider whether it is reasonable given the request; on one occasion further information was requested including twenty-two additional queries. Requests made previously (and answered) were made again. On one occasion the officer was willing to extend deadline to respond beyond the minimum by one day!
The position could have been much easier had the client (with the help of the adviser):
- Implemented a better sales record (till with itemised sale items)
- Reconciled sales to bank deposits
- Deposited all cash takings
- Met expenses through a business account or credit card
- Used only a business account for income and expenditure
- Kept a wastage record
- Recorded days and hours of business
- Reviewed profitability on a regular basis
In the case we have referred to, the outcome demonstrates the potentially nasty result if the HMRC business economics exercise had been accepted:
- HMRC contended tax of £5,357.09 for 1 year and wished to extrapolate back six years
- Tax was agreed at £2,321.36 and extrapolation because it was demonstrated that turnover and expenses were consistent with previous years
The professional costs outweighed the actual tax liability but not the proposed liability. Professional fee insurance is definitely a wise consideration!
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v Scott and another (trading as Farthings Steak House) v McDonald (Inspector of Taxes)  STC (SCD) 381