1. Summary of Key Points
• Is your business in a risk sector?
• Does it have any risk factors which make it more likely to be investigated?
• Recently only 3% of self-assessment taxpayers have been investigated but this could well rise in 2010-11.
• You may need a specialist accountant who deals full-time in this sort of work.
• The bill can be £5k or more, but 50% of investigations end up in a bill of zero.
• Insurance is expensive unless your business is in a high risk category.
2. Background
Tax investigations have the potential to cause a great deal of business disruption. Not only that, following a National Audit Office report the penalty regime was toughened up so the fines and penalties – should the investigation turn up a tax shortfall – are stiffer. This note sets out the main risk factors to consider, and whether a business should insure against an investigation.
3. Risk Sectors
It costs the HMRC money to launch an investigation. So they concentrate their efforts where they are most likely to see a return, in terms of fines and penalties. They are more likely to find errors in the following sectors – and hence more likely to investigate businesses in these sectors:
• Construction
• Mobile Phones
• Computers
• Retailers and other cash businesses
• Exporters
• Landlords
The two sectors most likely to be investigated for compliance with Minimum Wage (MW) legislation are:
• Restaurants and pubs
• Hairdressers
Note that an investigation may start out as a VAT or MW investigation, but later mushroom into something much bigger. For example, a review of MW compliance may uncover an underpayment of PAYE and NI on tips in the business.
4. Reasons for the Investigation
Per specialist tax accountants’ statistics, just 3% of HMRC investigations are random. The most common reasons for an investigation are:
• High risk sectors as per the section above.
• A tip-off – from a disgruntled employee or tenant, for example.
• Information on the database – for example, a taxpayer declares a rental expense but the landlord is not declaring any property income.
• Poor record keeping.
• Unusual, unexplained fluctuations in a taxpayer’s accounts from year to year.
• Complex issues such as claiming non-domicile status or employment status under IR35.
• Using round numbers in every box on a tax return.
5. Types of HMRC Investigation
A standard investigation is bad enough. But it can be worse:
• A Code of Practice 9 (COP 9) investigation is launched when HMRC suspects tax fraud of over £75,000.
• A Code of Practice 8 (COP8 ) investigation arises when there is suspicion of serious tax avoidance.
If you are keeping good records, you can consider dealing with a standard investigation with the support of your normal accountant – but even then, if things get sticky, a specialist is a better bet. Specialist accountants who deal only in tax investigation work don’t come cheap, but anyone facing a COP8 or COP9 investigation should hire one.
6. How to Handle an Investigation
The HMRC Inspector will attempt to draw the taxpayer into making unsound statements which may appear innocent enough to anyone who does not understand tax law. So it is a good idea to:
• Seek advice and support from an accountant at the earliest stage.
• Only meet with HMRC if your accountant is present.
• Always be honest – the HMRC database has a lot more information on it than most taxpayers suspect. If they decide the taxpayer has been dishonest with them, they are legally obliged to charge heavier penalties.
Even though sending letters back and forth takes time, this can be a better idea than agreeing to a meeting. Under pressure, everyone is capable of saying things which aren’t necessarily in their own best interests.
7. How Much?
First of all the Inspector needs to establish how much – if any – tax has been underpaid. He or she can go back 6 years in a standard investigation, or 20 years in COP8 and COP9 ones. The assessment is made up of three elements:
• The amount of the underpayment PLUS
• A Penalty of up to 100% of the underpayment PLUS
• Interest on the underpayment.
If the taxpayer has made a simple mistake, co-operated fully with the Inspector and been open and honest then the penalty should be zero per cent. At the other end of the scale, a taxpayer who has made negligent and deliberate errors and then been uncooperative and dishonest in the course of the inspection can expect the full 100% penalty.
8. Should I Insure? (The Maths)
This is an immature field for insurance, a business with £100k sales can be quoted anything from £80 to over £200 for the same level of cover.
Specialist investigation accountants generally state that about 3% of those people submitting a tax return get investigated every year. However, HMRC have been given a strong political steer to hold back from investigations during the recession. The general view of experts in this area is that a lot more businesses will be investigated after the 2010 General Election, whoever wins it.
Of those investigated, about 50% get a final bill of zero. Just 1.5% of returns each year end up in a successful investigation. Let’s say the premium for the £100k business is £100.
From a mathematical viewpoint, the premium is worth it if the total bill – underpayment plus fine plus interest plus the cost of accountancy support plus any overtime worked by people in the business – exceeds:
100 / 1.5% = £66,667
It is a very unusual tax investigation in a £100k sales business which ends up costing more than £5,000. So we can conclude that there is no value in this insurance cover from a purely mathematical viewpoint.
9. Should I Insure? (Plain English)
I believe when this insurance market matures it will be like the US health insurance market. Many people get health insurance paid for by their employers. Of the rest, those who pay for health insurance have much worse health than the population at large. Only people who think they are ill ask for quotes! This in turn makes the insurance costs even higher, and results in even fewer healthy Americans considering insurance.
So if we take two extreme examples:
A non-domiciled taxpayer running a construction company paying staff gross, keeping poor accounting records, filing late returns and knowingly not complying with the construction industry tax regulations should seek to insure against an investigation. Such a person probably stands a 20% chance of being investigated, and a 90% chance of a big bill at the end of the process.
A UK domiciled and resident taxpayer running a one-person consultancy company invoicing all customers with VAT added, keeping excellent accounting records on spreadsheets and good Lever Arch files, filing tax and VAT returns well before the deadlines should not seek insurance. Such a person probably stands a 2% or less chance of being investigated, and an 80% chance of a zero bill at the end of the process.