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Is HMRC entitled to tax earlier years as well, if it finds income not declared in a tax return? Mark McLaughlin considers some recent cases.

Introduction

Most tax agents involved with enquiry work will be familiar with the HMRC practice of 'spreading'. This generally occurs when there is an agreed addition to the taxpayer's income for the year of enquiry. HMRC will often seek to assess similar additions in earlier years, and sometimes to agree additions for later years as well. This is on the basis of a 'presumption of continuity', i.e., that the taxpayer's default for the year of enquiry was continued in other tax years as well, unless there is evidence to the contrary.

HMRC points to case law in support of ‘spreading’ in its Enquiry Manual (see EM3310). Probably the most well-known of these cases is Jonas v Bamford [1973] STC 519. In that case, Judge Walton J expressed the presumption of continuity as follows: 
 

 "...once the inspector comes to the conclusion that, on the facts which he has discovered, Mr Jonas has additional income beyond that which he has so far declared to the Inspector, then the usual presumption of continuity will apply. The situation will be presumed to go on until there is some change in the situation, the onus of proof of which is clearly on the taxpayer".

HMRC encourages its enquiry staff to use spreading where it is considered to be appropriate (EM3309). For example:

“…if you have proven omissions for which there is no ready explanation and the business and way of life of the taxpayer have not changed you will be in a much stronger position to argue for addition to other years.”

Disallowing Expenses?

In addition to applying the concept of spreading to assess additional income for other years, it seems that HMRC will also seek to disallow expenses on a similar basis.

In Syed v Revenue & Customs [2011] UKFTT 315 (TC), HMRC amended the taxpayer’s return for 2005/06 following an enquiry, and raised discovery assessments for the tax years 2001/02 to 2004/05 inclusive, and for 2006/07. HMRC sought to increase the taxpayer’s profits for 2005/06 as a dentist, not only in respect of unrecorded income, but also by disallowing certain expenses (e.g., repairs, legal and professional costs and interest paid). HMRC's adjustments going back to 2001/02 and forward to 2006/07 were made on the assumption that the errors identified for 2005/06 had been repeated in the other years. The taxpayer's appeals against the assessments were dismissed. The tribunal held that there was no evidence to suggest that the adjustments for disallowed costs were wrong (and there was also insufficient evidence that the additional income was not business income).

The decision in Syed is worrying, because it indicates that accepting (say) the disallowance of an item of business expenditure during the course of an enquiry will require careful thought, due to the potential for HMRC to apply spreading and seek adjustments in respect of other tax years. 

Limitations to HMRC Spreading

However, there have been indications that the presumption of continuity may be more limited in its scope than HMRC perhaps consider it to be. For example, in the Syed case the tribunal made the following comments about the application of the principle established in Jonas v Bamford: “In our view [the above quotation by Walton J] expresses no legal principle. It seems to us that it would be quite wrong as a matter of law to say that because X happened in Year A it must be assumed that it happened in the prior year.” The tribunal added:

"In practice it will generally be reasonable and sensible to conclude that if there was a pattern of behaviour this year then the same behaviour will have been followed last year. Sometimes however that will not be a proper inference: there will be occasions when the behaviour related to a one off situation, perhaps a particular disposal, or particular expenses; in those circumstances continuity is unlikely to be present.”

In addition, it should be noted that the Judgment of Walton J in Jonas v Bamford indicates that the presumption of continuity, on the basis of that case, applies to the future and not the past.

Back and Forth

Backwards and forwards spreading was at point in Chapman v Revenue & Customs [2011] UKFTT 756 (TC). In that case, the taxpayer appealed against assessments for 2004/05 to 2007/08. The enquiry year was 2006/07. In the absence of adequate business records, HMRC conducted a ‘Takings Build-Up’ exercise. HMRC considered that the retail price index should be applied to calculate the shortfall in declared income for 2004/05 and 2005/06, and the later year of 2007/08.

However, the tribunal noted that virtually all the evidence presented related to the period covered by the year of enquiry. With regard to HMRC’s Takings Build-Up exercise, the tribunal noted that it was only an estimate, and held that the resulting turnover figure was “wholly unrealistic.” The omitted sales figure for 2006/07 was reduced accordingly. The tribunal also noted that a Takings Build-Up was not produced for 2004/05 or 2005/06 due to “time constraints”, and commented: “…we cannot endorse such an approach in this case where the takings build-up relies on a number of specific transactions peculiar to the enquiry year”.

The tribunal added in the context of business economics exercises generally: “Where a capital statement is prepared for one year and sought to be applied to other years, they have to be adjusted to take account of exceptional items peculiar to the particular year. That was not done here”. The tribunal concluded that the assessments therefore could not stand, and that because there was no basis on which to substitute other figures, the assessments must be reduced to nil. Similarly, the tribunal held that HMRC’s takings build-up calculation for 2007-08 seemed arbitrary, and therefore could not stand. The assessment for that year was also reduced to nil.

Red Star

The presumption of continuity was also considered recently in The Red Star v Revenue & Customs [2011] UKFTT 812 (TC). In that case, following an enquiry into a partnership return for 2005/06, HMRC considered that there had been a suppression of sales and profit at the partnership's Chinese takeaway restaurant business. HMRC adjusted the sales and profit figures for 2005/06 based on the quantities of rice used in the business. Applying the presumption of continuity, HMRC then adjusted the profits for all the other tax years from 2002/03 to 2007/08 to the same figure, subject to rounding, an inflationary adjustment and time apportionment for the final period of trading in 2007-08 of less than a year.

However, the tribunal was not satisfied that the presumption of continuity applied in the way that HMRC had sought to apply it. The tribunal considered that HMRC should have amended partnership profits for earlier years not by simply substituting an inflation adjusted figure carried back from 2005-06, but by applying the same methodology used in arriving at the 2005-06 figure, and assuming the same degree of under-declaration of both sales and purchases. With regard to later years, the tribunal commented that if proper partnership returns had been made for those years, the retirement of the senior partner during 2006 would have been sufficient to displace the presumption of continuity. However, as the partnership returns for 2006-07 and 2007-08 were estimated, the profit figures for those tax years were amended based on the revised 2005-06 figure, subject to an adjustment for inflation and time-apportionment for the cessation period.       

Conclusion

Taxpayers who are subject to 'spreading' in HMRC assessments of additional income following an enquiry should be prepared to challenge HMRC's calculations in appropriate circumstances, particularly where there is evidence to indicate that a presumption of continuity is not the correct approach based on the facts and particular circumstances of the case. Whilst the tribunal decision in Chapman offers taxpayers some encouragement it does not create a binding precedent, and further guidance regarding the limitations of the presumption of continuity would therefore be welcomed.

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.