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The UK Tax System: An Introduction by Malcolm James

Malcolm James, author of ‘The UK Tax System: An Introduction’ provides an overview of the HMRC enquiry process.

Reasons for Initiating Tax Investigations

If HM Revenue & Customs wish to instigate an investigation (as distinct from initiating an enquiry under the self-assessment regime) a taxpayer will normally be sent a letter indicating that HMRC believe that his tax affairs are not in order and inviting him to make full disclosure immediately. In line with the current philosophy that all organisations must be cost-effective, HMRC will only do this if they believe that the additional tax that they can recover will exceed the cost of the investigation and not just because they consider it unjust that taxpayers should be able to get away with tax evasion. Most investigations are handled by the local Officer, but major investigations will be passed on to the specialist Special Compliance Office. It would be unwise for a taxpayer to ignore such a letter since HMRC should not take such action unless they have clear prima facie evidence of irregularities. The taxpayer will doubtless incur substantial professional fees and it is unfortunate that investigations are very costly even if the taxpayer proves to be completely innocent or, at any rate, only minor irregularities are discovered.

HM Revenue & Customs’ information may come from several sources. First, they may have received information from a third party. Whilst they must guard against malicious false allegations, many a tax evader has been undone by the vengeance of an ex-spouse, disgruntled former employee or business partner with whom he has fallen out. Secondly, HMRC may allege that the declared income or business drawings are insufficient to maintain the taxpayer’s lifestyle and invite him to account for how he funds his outgoings. In one well-known instance, there was a television series where wealthy people showed off their opulent lifestyle. One individual featured had become wealthy partly through not declaring a large proportion of his income and was blissfully unaware that the programme was required viewing for HMRC. The most important factor is that any explanation must be well documented. A large legacy or pools or lottery win may therefore provide adequate explanation, provided that there is sufficient documentation.

Thirdly, HMRC may scrutinise the gross profit margin of businesses and compare it with average margins for the type of business and request the taxpayer to account for any discrepancy where it considers the margin to be significantly below the average. In one case, HMRC were investigating a business where the accounts for one year showed a gross loss, i.e. cost of sales exceeded sales. In this case this was due to bad management and misappropriation of cash by employees going undetected rather than false accounting by the proprietor and needless to say the business did not last long. Finally, HMRC employees may report situations which they themselves encounter and which give rise to suspicion, such as plumbers and car mechanics who are prepared to accept a substantial discount if payment is made in cash.

HM Revenue & Customs may revise business accounts using the ‘business economics’ method, i.e. using statistical data gathered on particular trades. Investigations are also undertaken in areas where there is a large amount of tax at risk, but no serious fraud is suspected (code 8 investigations). Most of these cases originate from research rather than a referral from a local office. Other teams investigate, for example, abuses of the special tax exemption documents in the construction industry or non-compliance problems in the clothing industry.

The audit of PAYE and national insurance contributions is now combined to eliminate the duplication of work and the inconvenience to employers.

Conduct of Investigation

Introduction

Once the taxpayer has consulted a professional advisor and replied to the letter, the Officer will often wish to interview the taxpayer, who will usually be accompanied by his advisor. During the investigation the taxpayer will normally be asked to produce a statement of his private and business assets and liabilities and/or a certificate of full disclosure. The Officer cannot compel the taxpayer to complete these but it would be imprudent for him not to do so. Failure to complete a statement of assets and liabilities would result in the Officer raising an estimated assessment and invoking formal powers. Failure to complete a certificate of full disclosure will be taken as evidence that the taxpayer has not made full disclosure. A statement of assets may also be requested when a monetary settlement is being negotiated if the taxpayer claims that he cannot pay the amount demanded.

Powers to Obtain Documents

HM Revenue & Customs have formal powers to obtain documents containing information which is reasonably required to check a return, such as invoices, air tickets and work diaries. These requests are generally used sparingly to support informal requests where it believes the taxpayer would otherwise be unwilling to co-operate. The term ‘documents’ is defined to include computer records as well as hard copies (TMA 1970 s.20D(3); FA 1988 s.127), although certain documents may be retained as personal documents and professional privilege may be claimed in certain circumstances. A notice may be served on a taxpayer under TMA 1970 s.20(1)&(2) to produce documents if they can reasonably be expected to contain information relating to the taxpayer’s liability. Documents which have been brought into existence for the purpose of the enquiry or which relate to an earlier return which is not under investigation may not be requested. The documents required must be specified in the notice (i.e. the phrase ‘anything relevant to your return’ or similar should not be used) and the notice must also state the taxpayer’s name. The taxpayer may make the documents available for inspection rather than delivering them to HM Revenue & Customs.

TMA 1970 s.19A does not specifically permit access to private documents, but HM Revenue & Customs take the view that it is permissible to request such documents, but only if it is reasonable to expect them to contain relevant information. These will not be requested in the opening letter as a matter of course, but may be if the accounts are not based on a robust record keeping system or there are substantial unverified sums.

A notice may also be served on a third party, e.g. a bank (TMA 1970 s.20(3)). The notice must be issued with the consent of an appeal Commissioner who must be satisfied that the issue of the notice is justified (TMA 1970 s.20(7)). The taxpayer does not have the right to appear or be represented at the application to the Commissioner. The Commissioner giving the consent may not take part in any later appeal by the taxpayer if there is reason to believe that the information being sought by the notice might feature in the later appeal (TMA 1970 s.20(7AB) & (7AC)). A taxpayer must be provided with a written summary of the reasons for the consent being given (TMA 1970 s.20(8E)), except where fraud is suspected by the Commissioner (TMA 1970 s.20(8F) & 20B(1B)). The summary need not contain any information which might identify a person on whose information the Officer has acted (TMA 1970 s.20(8G)(a)) or where the disclosure might prejudice the assessment or collection of tax (TMA 1970 s.20(8G)(b) & (8H)).

Power to Obtain Documents – Suspected Serious Fraud

In cases of potential serious fraud, HM Revenue & Customs may apply to a circuit judge (or a sheriff in Scotland) to order the delivery of documents as an alternative to issuing a search warrant. An order may not require the production of documents which are the subject of legal privilege (TMA 1970 Sch.1AA, para. 5).
HM Revenue & Customs may make regulations governing the resolution of disputes regarding legal privilege (TMA 1970 Sch.1AA, para. 6). The documents must be delivered to HM Revenue & Customs within 10 working days of the notice (or a longer period specified in the notice). Records stored on a computer must be produced in a visible and legible form and HM Revenue & Customs may give precise instructions on how the order is to be complied with (TMA 1970 Sch.1AA, para. 7). The Officer must state under oath that he has reason to believe that the person to whom the order is directed possesses documents which may be needed as evidence in a prosecution for serious fraud and the judge must be convinced of the possibility of serious fraud. An order must specify the documents to be delivered and can only cover documents which will be used in evidence (TMA 1970 s.20BA(1)). A copy of the order must be sent to the person who is the subject of the order and this person has a right to attend the application hearing unless the judge believes his attendance would prejudice the investigation (TMA 1970 Sch.1AA, para.3). Once a notice has been issued, it is a criminal offence to destroy documents covered in the order and the person to whom the order is directed is forbidden from informing anyone else, except his clients in connection with legal advice, of the circumstances of the order (TMA 1970 Sch. 1AA, para.4).

Once HM Revenue & Customs have finished with the documents, they must be returned to the person who supplied them in the same manner as documents removed during a search (TMA 1970 s.20CC(3) – (9)). A person who fails to comply with the order may be charged with contempt of court (TMA 1970 Sch.1AA, para. 9).

Powers to Demand Papers of Tax Accountant and Solicitor

Subject to certain restrictions, papers may be required from a tax accountant, i.e. any person who has assisted the client in the preparation of the tax return and accounts, if he has been convicted of any tax offence in the UK or of assisting the preparation of an incorrect return (TMA 1970 s.20A(1)). A tax accountant may be required to hand over all his papers if the Officer has reason to believe that they contain information relevant to the tax liability of any of his clients, whether or not the conviction was concerned with the affairs of the particular client or not. A notice must be in writing made within 12 months of the date of the conviction (TMA 1970 s.20A(4)). An Officer must be authorised by the Board to make the submission and a circuit judge must be satisfied that the Officer is justified in proceeding (TMA 1970 s.20A(3)). There must be no appeal pending against the conviction, although there may be an appeal pending against the sentence or penalty.

Notices to barristers, solicitors or advocates can only be issued by the Board. If an Officer feels that this is necessary he will submit the file with a report to the Board. Notices from the Board do not require the consent of the Commissioners. A barrister, advocate or solicitor is not obliged to produce documents for which legal privilege can be claimed without the consent of his client.

Restrictions on Powers of Officer

Any person required to produce documents must be given a reasonable opportunity to do so if a formal notice is issued (TMA 1970 s.20B(1)). Where a notice is issued to a person other than the taxpayer, a copy must be sent to the taxpayer, unless the Officer can convince the Commissioners that there is the likelihood of fraud (TMA 1970 s.20B(1A) & (1B)). A person cannot be required to hand over documents relating to an appeal which is still pending (TMA 1970 s.20B(2)). A notice may only be issued to a barrister, solicitor or advocate by the Board and no documents which are subject to legal privilege may be produced without the consent of the client (TMA 1970 s.20B(3)). Producing copies of documents is acceptable, but the originals must be available for inspection if required (TMA 1970 s.20B(4)). A person cannot be required to produce a document which is more than six years old when the notice was issued, unless the Commissioners agree to exclude this rule. This will only be permitted where there are reasonable grounds for believing that there has been fraud resulting in a loss of tax (TMA 1970 s.20B(5) & (6)).

Power to Enter Premises

Whilst HM Revenue & Customs will in general try to obtain documents by issuing orders for delivery, they have the power to obtain a search warrant. In certain cases, such as where the element of surprise is necessary, HMRC may apply to a circuit judge (or a sheriff in Scotland) for a search warrant (TMA 1970 s.20C). HMRC may enter by force if necessary. A judge must be satisfied that there are reasonable grounds for believing that the documents are on the premises and an official must give evidence on oath. HMRC have 14 days to search premises from the date a warrant is issued and seize all documents which might be required, unless they are privileged documents in the hands of a lawyer (TMA 1970 s.20C(4)). An occupier is entitled to receive a list of items which have been removed and must be given reasonable access to any documents which they can show are necessary for the running of the business (TMA 1970 s.20CC). An official may require information stored on a computer which can be accessed from the premises to be produced in a visible and legible form if they have reason to believe that the information stored may be required as evidence (TMA 1970 s.20C(1A); FA 2000 s.150(3)).

Confidentiality

It is the view of HM Revenue & Customs that TMA 1970 s.19A overrides the duty of confidentiality of the legal and medical profession towards their clients (a view in support of which they quote Guyer v Walton (Sp C 274/01)). However, they are aware that a breach of confidentiality towards the taxpayer by HMRC is a serious offence and seek to ensure that any information will not be passed on unless there is specific permission to do so. The exchange of information for the purpose of double taxation or with other EU states is permitted by ICTA 1988 s.816.

Information may also be provided for non-tax reasons such as statistical purposes or to assist the police in countering drug trafficking or money laundering.

Under ICTA 1988 s.815C information may be exchanged with overseas tax authorities for the purpose of ensuring tax compliance in the UK or overseas where tax information agreements are in place. Tax returns may also be produced in personal injury or matrimonial cases.

Legal Privilege

The Police and Criminal Evidence Act 1984 s.10 (reproduced in TMA 1970 s.20C(4A) 7 (4B)) summarises the situations where legal privilege applies. These are:

• communications between a professional legal adviser and his client or any person representing his client made in connection with the giving of legal advice to the client;

• communications between a professional legal adviser and his client or any person representing his client or between such an adviser or his client or any such representative and any other person made in connection with or in contemplation of legal proceedings and for the purpose of such proceedings.

Any items held with the intention of furthering a criminal purpose are not the subject of legal privilege. The criminal purpose is not confined to that of the lawyer holding the documents, but covers the client or a third party (R v CentralCriminal Court ex parte Francis & Francis (1989)). Communication between solicitors, barristers, their legal staff, the client’s accountant and the client in connection with the giving of legal advice is also subject to legal privilege.

Although it is not a tax case, the scope of legal professional privilege was affected by the Court of Appeal ruling in Three Rivers District Council and others v Governor and Company of the Bank of England (2004) (EWCA Civ. 218). Legal privilege applies to advice given by a lawyer concerning legal rights and liabilities and such protection would be given where a relationship between a solicitor and client was formed in order to obtain such advice. Legal privilege is not necessarily available in relation to advice or assistance merely because it was given by a solicitor in the normal course of business. The House of Lords’ has subsequently passed judgment on this case.

An auditor cannot be required to produce documents prepared for the purpose of a statutory audit, but this protection does not extend to any supporting documents e.g. ledgers, cash books and personal and business bank statements (TMA 1970 s.20B(9)(a)).

A tax adviser cannot be required to produce documents brought into existence for the purpose of giving tax advice (not including supporting schedules of a tax return) (TMA 1970 s.20B(10)). Copies of a communication with a client may be required directly from the client.

HM Revenue & Customs are not required to give reasons for demanding information (R v IRC ex parte TC Coombs & Co. (1991)), although it will only do so where it has been unable to satisfy itself by other means (SP 5/90). The restrictions on HM Revenue & Customs’ powers do not apply where an accountant has been convicted of a tax offence carrying a penalty under TMA 1970 s.99.

Meetings

There will usually be one or more meetings between the Officer and the taxpayer
and his agent. The agent will normally be invited to attend and a meeting will proceed without the agent only if the agent refuses to attend or the taxpayer makes it clear that he does not wish the agent to attend. An agenda setting out the main areas to be covered will be sent before the meeting. The agent should not answer questions on the client’s behalf. The Officer should send notes of the meeting to the taxpayer or agent after the meeting. The taxpayer may request that a meeting be taped, but a request to video the meeting will normally be refused.

At any meeting the Officer should draw attention to any clear errors established and outline any more general areas of concern. He should tell the taxpayer about the possibility of penalties and explain that he does not have to co-operate and should cover the same points as in the letter, but may use his own words. If the taxpayer refuses to answer questions, the Officer may also explain his formal powers. The appropriate penalty leaflet and the Public Funding Notice should be given to the taxpayer. The Officer should check that the taxpayer understands and explain again if he does not. The taxpayer should then be invited to explain errors and make any further clarification.

It may be necessary for a taxpayer’s spouse or partner to be interviewed. They will be interviewed together if they consent, otherwise they will be interviewed separately. The Officer may disclose confidential information to a spouse or partner, but he should only do so if this is necessary and relevant to the enquiry.

The Officer will draw attention to any clear errors and outline more general areas of concern. An opportunity will be given to the taxpayer to make disclosure.

Adjustments to Accounts

At some stage during an investigation it is likely that an Officer will propose adjustments to accounts to reflect an alleged understatement. The adjustment may
be calculated in a number of ways.

Business Models

HM Revenue & Customs may use statistical data in the form of average gross profit or mark‐up ratios or wastage rates and compare these with the ratios achieved by a business. It will also take into account any goods taken by the taxpayer for his own or his family’s use and personal goods purchased through the business since these will affect the gross profit achieved. It must be emphasised that the statistical data are average ratios and it is entirely reasonable to expect that a particular business may achieve a ratio which is below the average, so an Officer’s figures should not be accepted without question.

Cash Flow Tests

If a balance sheet has not been recorded on a return an Officer will have no information on the capital account and drawings of a business. A taxpayer should keep a record of withdrawals of cash from the business or the business bank account, or the personal bank account, if no separate bank account is maintained.

If a balance sheet has been produced, a cash reconciliation should be prepared, which should balance the proprietor’s personal finances. Where there is a shortfall it will be assumed that the balance relates either to additional drawings or an undisclosed source of income.

An Officer may ask how cash is withdrawn from the business, i.e. whether cash is withdrawn directly or whether it is transferred by cheque or standing order to a private bank account and the amount of private cash which is generally available.

In addition to the situation where withdrawals consistently appear to be inadequate to fund expenditure, attention will be paid to irregular withdrawals where there are periods during which no cash appears to have been available and where there are no fluctuations to cover periods such as Christmas or holidays.

An Officer may wish to review a taxpayer’s private bank account, but HMRC recognise that this is an invasion of privacy and that this could involve the taxpayer in considerable expense, so they will consider carefully whether the information can be obtained by other means and may, for example, restrict the request to a sample period. An Officer will look for patterns of expenditure, evidence of the existence of other accounts and of transfers to and from a spouse or partner, which might indicate that the spouse or partner should be brought into the enquiry.

Means Test

A means test may be required whereby the known outgoings are subtracted from known income in order to assess whether the balance available is reasonable. However, it is recognised that this method has limitations (for example there may be difficulty in assessing occasional expenditure) and this technique is not used on its own, but may be used to reinforce a conclusion reached by other means.

Officers are advised always to be mindful of the difficulty that they might face if they were required to produce such evidence relating to their own finances and not automatically to take any sign of difficulty or vagueness on the part of the taxpayer as evidence of wrongdoing.

Statement of Assets and Liabilities

Once it has been established that profits have been understated, a taxpayer will generally be required to produce a statement of assets and liabilities. This should contain all assets and liabilities of significant value and should include UK assets:

• of the taxpayer;

• of the taxpayer’s spouse or partner;

• of the taxpayer’s minor or dependent children;

• held by nominees or otherwise held on the taxpayer’s behalf.

It is important that this statement be complete and it should be signed and dated and refer clearly to the date on which the assets were listed. This will normally be the end of the accounting period or return which is the subject of the enquiry, although the statement may relate to the present time. The statement is used to confirm the level of omissions and the ability to fund a settlement. If a statement is found to be false, this could undermine other statements of the taxpayer and may be viewed as a serious offence. In the Lester Piggott enquiry, a negotiated settlement was reached, but HMRC discovered on receiving the cheque that it had been drawn on a bank account which had not been disclosed. It was this omission which prompted them to instigate criminal proceedings.

Settlements

Although HM Revenue & Customs have wide powers in an investigation, they generally prefer a negotiated settlement in respect of tax underpaid, and interest and penalties in return for an agreement not to invoke formal proceedings (TMA 1970 s.105). Information received in connection with such an offer is admissible as evidence in court if legal proceedings are eventually brought. HM Revenue & Customs publish a leaflet, IR160, explaining how settlements are negotiated. This will be sent to the taxpayer at any stage of an enquiry upon request, but Officers are advised to use discretion in issuing the leaflet unprompted, lest the impression be given that HM Revenue & Customs are attempting to ‘ram penalties down the taxpayer’s throat’, which may be counter‐productive if the taxpayer is cooperating. The leaflet will therefore generally be sent only once the Officer has formed a clear view on the existence of culpable understatements. The Officer will answer questions about the leaflet, but will not usually give any indication of the amount of penalty being sought until all the facts are known.

An invitation will be made to the taxpayer to offer a sum in settlement, which must cover unpaid tax, interest and any flat‐rate and tax‐geared penalties. If an offer is accepted by HM Revenue & Customs, it is binding on both parties. In most investigations a settlement will be negotiated in a meeting between the taxpayer and his advisors and HM Revenue & Customs. It is normal to review the facts of the case at this meeting and to agree the computation, if this has not already been done. The Officer should bring out all factors relating to the taxpayer’s culpability and explain that in his opinion the taxpayer is liable to interest and penalties and to refer to the appropriate statutory provisions. The taxpayer’s right of appeal and to dispute the imposition of a penalty, the maximum penalties and the policy on the mitigation of penalties are explained. The Officer may make it clear that he would be prepared to accept a lower amount of tax and penalties than he would seek in appeal proceedings, particularly if the taxpayer is reluctant to negotiate a settlement. References to the Commissioners should not be used as a threat to the taxpayer, particularly as there is no guarantee that the Commissioners would in fact determine assessments at a higher level.

The taxpayer is then invited to make any points he wishes to be taken into account and to make an offer in settlement. In PAYE cases and cases dealt with by the local office the Officer is permitted to state an amount which he would consider acceptable. In the case of PAYE or national insurance audits, it will be pointed out that the tax or contributions are deductible against business profits, whilst the interest and penalties are not.

Although an offer may be agreed orally at a meeting, the taxpayer must follow this by making the offer in writing. Sample offer letters for various situations may be produced to help taxpayers use the recommended wording in making an offer. In particular the letter must not, for example, reserve the right to re‐open an offer if further evidence of unexplained sources of income or capital should subsequently come to light, nor should it make any vague or conditional terms, such as, ‘I will pay £x if I can sell my house.’ The letter should quote separately the gross amount of the offer and any amounts to be offset against that sum, e.g. certificates of tax deposit.

The Crown Prosecution Service may take criminal proceedings, if it is within their powers, even if a settlement has been reached between a taxpayer and HMRC.

The application of Article 6 of the Human Rights Act is uncertain in the context of penalties imposed on the personal representatives of deceased taxpayers. HM Revenue & Customs will seek to negotiate a settlement with the personal representatives, but will state in a side letter that penalties will be refunded if the courts subsequently decide that the penalty cannot be charged.

Penalties

Penalties are calculated as a percentage of the tax underpaid and HM Revenue & Customs may normally impose penalties of up to 100%. They have the power to mitigate these penalties and they take the following factors into consideration in deciding the level of penalties to be imposed in each case.

Gravity

An abatement of up to 40% is available if the irregularities discovered are very minor. If the case has involved fraudulent conduct only a very small abatement, if any, will be offered. Regard will be had to the size of any understatement, both in absolute terms and in relation to the taxpayer’s income.

Full disclosure

If the taxpayer has made full disclosure at an early stage, HM Revenue & Customs may abate the penalties by up to 20%. A larger abatement may be awarded if the taxpayer has made full voluntary disclosure before he had reason to believe that the Officer was contemplating an investigation. If a taxpayer only makes disclosures after the Officer has invoked formal powers, has made incomplete voluntary disclosures, an incomplete disclosure under challenge or made disclosures at a late stage when it has been clearly established that tax has been underpaid, he will be awarded, at the most, a very small abatement.

Co-operation

If the taxpayer has co-operated fully in the investigation, provided all information promptly and attended all interviews promptly HMRC may award an abatement of up to 40%. If the taxpayer has delayed replies as long as possible and/or has given inaccurate and misleading information, no abatement will be given.

Payment of Tax and Penalties

Payment should normally be made in a single lump sum on an agreed date, but in cases of hardship HM Revenue & Customs may consider the payment of a substantial initial payment followed by payment of the balance by instalments over a short period. Such an agreement will be made formally in writing.

Malcolm James
October 2005

The above article is adapted from ‘The UK Tax System: An Introduction’ published by Spiramus Press Ltd. To order The UK Tax System: An Introduction
click here

About the author

Malcolm James is a Senior Lecturer in Accounting and Taxation at the University of Wales Institute, Cardiff and has lectured widely on the subject of taxation on both professional and undergraduate courses. He has also lectured for the Chartered Institute of Taxation and written a number of articles for their journal Tax Adviser. He also contributes regularly to CCH and Lexis Nexis tax publications. Before becoming a lecturer he worked for several large firms of accountants and also in industry.