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Mark McLaughlin CTA (Fellow) ATT TEP points out that HMRC business economics exercises on cash based businesses need to be looked at carefully.

Introduction

Owners of cash-based businesses are, on the face of it, a ‘soft target’ for enquiry by HM Revenue and Customs (HMRC). This is particularly the case if the trader has not kept full business records.

A lack of business records can, for example, open the way for HMRC to conduct business economics exercises. The results of those exercises are compared to disclosed turnover and profits. A perceived shortfall in the taxpayer’s figures can result in HMRC assessing additional profits, which the taxpayer may feel compelled to accept because of the difficulty in rebutting HMRC’s figures in the absence of proper records. HMRC may also assess earlier (and sometimes later) tax years if it is considered that an alleged under-declaration of profits has continued in other tax years, by applying the practice of ‘spreading’ established in Jonas v Bamford ([1973] STC 519).

Reasonable Conclusion?

However, HMRC’s business economics exercises need to be critically reviewed. For example, there may be errors or weaknesses in logic, or the figures may not take into account receipts from non-business sources, such as family members. By standing back and looking at HMRC’s figures objectively, errors or weaknesses can be revealed and ultimately challenged on appeal. Business owners and their advisers should obviously not accept HMRC figures if they are plainly wrong.

In Mehdvi v Revenue & Customs [2013] UKFTT 179 (TC), HMRC opened an enquiry into the taxpayer’s 2007-08 tax return. Upon closing the enquiry, HMRC increased the taxpayer’s profits as a self-employed taxi-driver from £13,425 to £40,425, i.e. an increase of £27,000. HMRC also raised assessments for 2005-06 and 2006-07, increasing profits as follows:

• 2005-06 – profits increased from £13,474 to £38,266
• 2006-07 – profits increased from £13,840 to £38,754

The taxpayer appealed against all of the increases. His taxi driving services operated exclusively to and from London’s airports. However, he had no records of fares, or receipts for expenses, with which to contest HMRC’s increase in profits.

One could perhaps be forgiven for thinking that the taxpayer’s appeals before the First-tier tribunal were doomed. However, the tribunal reviewed HMRC's calculations of the taxpayer's bankings, and concluded that they did not fairly represent taxi fares less business expenses. There were other sources of funds, such as loans from relatives, and the taxpayer's wife had provided money for household expenses such as groceries out of child benefit and tax credits.

In addition, the tribunal considered that HMRC's methodology was unreliable, as it produced a turnover figure for 2008 (i.e. £75,789) that was "...so far in excess of what is likely to have been achieved that we have to reject it", whereas the turnover recorded by the taxpayer for that (i.e. £41,313) was "sustainable". The tribunal commented:

"We acknowledge that we have no hard evidence. It seems to us, however, that the Respondents’ method of calculating turnover for the year is so far wrong that it cannot be accepted. It assumes a level of work that defies credibility. Moreover, we find that there were sources of funds, other than fares, that accounted for deposits in the Appellant’s bank."

The tribunal concluded that that the basis upon which HMRC calculated the taxpayer’s profits for 2008 could not be relied upon, and that the figures for 2006 and 2007 (which were calculated on the same basis as 2008, subject to adjustments for inflation) were "correspondingly flawed". The tribunal accepted the taxpayer's turnover for 2008 as included on his tax return, and did not consider that the disallowance of any expenses claimed by the taxpayer was justified. The taxpayer's appeals were allowed for all three years.

Conclusion

The Mehdvi case raises no new points of law. However, it acts as a useful reminder to taxpayers and agents that the tax appeal process is available to challenge HMRC's conclusions in an enquiry, particularly where HMRC's assessments of additional profits are based on practices or assumptions which appear to be flawed or illogical.

Challenging HMRC's assessments is particularly important where HMRC have re-opened other tax years and used the principle of spreading profit adjustments to those years, by applying the same inaccurate or unreasonable basis of calculation used for the year of enquiry.  

The above article is reproduced from Practice Update, a tax Newsletter produced by Mark McLaughlin Associates Limited. To download current and past copies, visit: Practice Update