Ice Creaming it Off?

Russell Cockburn sings the praises of capital statements computations in cases of calculating unpaid taxes

THIS MONTH’S ARTICLE concentrates on another HMRC compliance check I have been dealing with recently. In particular, this case involved a commonly occurring issue on the subject of negotiating with HMRC about the quality of a client’s business records and their accuracy or otherwise!

The client, Sue, ran a small ice cream kiosk in a provincial town park selling the normal range of soft and hard ices, soft drinks, crisps and snacks, etc. For years the business had operated at a fairly low turnover level, closing for business at the end of each summer season or early autumn so as to ensure that the proprietor did not have to bother herself with the worry of registering for this annoying new-fangled thing called VAT. Or at least that was the story told to her accountant over the years. Everything seemed relatively straightforward and normal (perhaps too normal?).

One bright and breezy late October Sunday afternoon the accountant, out for a walk through the park with his dog, was a little surprised to see the kiosk open for trade and a good queue outside waiting to buy their treats. “Perhaps she’s just opened for the weekend,” he thought, “after all weather the forecast was pretty good for this time of year so it could be a one off, couldn’t it?”

A feeling of unease stayed with him all the way home. He had dealt with the odd dishonest client before and as this was a cash business there was inevitably a risk that the lady in question might be one of those who succumbed to the temptation to make a bit extra “on the side” without recording it in her takings; but surely not Sue? He had known her for years and had never had any such suspicions. Yes, she always had nice holidays and drove a smart car, but her husband had a really good job as the manager of a building society branch locally, and her father was a wealthy man who was known for his generosity, so their lifestyle did not seem out of kilter with their obvious means, did it?

Back in the office on Monday the accountant looked up the client’s file and reviewed her last couple of years’ accounts and tax returns just to set his mind at rest, but he could see no obvious problems. The gross profit looked about right for this type of business and the level of personal drawings was also reasonable. He put the case aside and forgot about it. A month later the same thing happened, on an unseasonably warm November Sunday afternoon. This time he felt he had to do something, and he emailed the client to ask her to pop in for a chat when she had a moment.

This turned out to have been a sensible move. Sue came in clearly with something on her mind and after only a few minutes gossip blurted out that she needed to “come clean” with her accountant. She had some money “stashed away” in a bank account that she had never mentioned to him and this came from business takings that she had not been declaring in her accounts. She’d actually seen him in the park a couple of weeks before and realised that this situation could not go on any longer. Also, she’d read something in a trade magazine about the taxman having a purge on cash businesses and knew it was probably only a matter of time before they looked at her affairs, so now was probably the time to sort things out once and for all.

To say the accountant was disappointed is probably an understatement. This was a client he’d always regarded as pretty straight compared with a few others he had dealt with over the years and he reminded himself that ‘expect the unexpected’ had always been his motto when dealing with the small business client. He explained to his client that it would be necessary to make a full and complete disclosure of all irregularities to HMRC, quantify the amounts by which profits had been understated and then pay the additional taxes and interest plus almost certainly a penalty for all the relevant years as well. The client understood this and asked the accountant to get things moving as quickly as possible.

A disclosure letter was immediately sent to HMRC and the accountant followed up with a telephone call to the officer dealing with the case to discuss the best way to proceed. He was asked to present revised tax returns and computations for the past four years quantifying the extent of the problem as far as possible. The client told the accountant that all the ‘diverted’ takings over a period of about eight years that the bank account had been in existence had gone into the previously unknown account, so initially he simply scheduled these and presented this to HMRC as a means of quantifying the undeclared takings.
HMRC’s response was inevitably a request to review the business records. Having done so they argued that the use of annual cash balancing figures to quantify the client’s drawings was evidence that the records were inaccurate and inadequate and, as such, they would produce a business economics gross profit model to recompute the takings for the business.

HMRC argued that using just the undeclared bankings could not be relied upon as it was unlikely that a client involved in such systematic extraction of profits for tax evasion purposes would have banked all the diverted profits, and was equally likely to have spent some money on themselves as well as saving it. This is a common argument HMRC will use in such cases and does hold a certain logic.

However, the client was adamant that they had only ever banked the diverted profits and never spent anything on themselves and that this was her own little ‘nest egg’ for retirement. The inspector’s argument at this stage was based on the fact that the records had had to be balanced by the accountant each year, i.e. there was normally an excess of income, business takings, over vouched expenditures and personal drawings recorded by the proprietor annually which the accountant had properly taken to personal drawings in order to balance the accounts.

This scenario will be very familiar to most accountants in practice and, even in these days of computerised record-keeping, is of course a very common occurrence. Most readers will be familiar with such ‘incomplete records’. The inspector argued that this meant the records were inaccurate and inadequate and that this was therefore a justification for recomputing the sale figure using a business economics model.

This is a crucial stage in such compliance checks cases. Case law has, of course, indicated in the past that if HMRC can indeed point to transactions having been omitted from business accounts then there is good cause to believe that other transactions may also have been omitted as well (see in this respect Hudson V Humbles, Ch D 1965, 42 TC 380).

However, what is key to this sort of case is the reliance of the client on the accountant having done a proper professional job in preparing their accounts, and also the necessity for HMRC to show that not only are the records inadequate, but that there is other evidence of tax evasion (for example, unidentified savings or investments or unjustifiable levels of personal expenditures).

Clearly in a case such as this, where a hidden bank account has come to light and the taxpayer is admitting that this represents effectively the proceeds of crime, then HMRC can insist on the profits being recomputed. This was what the accountant proposed to do. HMRC prepared a business economics model gross profit exercise based on the financial and business records with which they had been provided and the client’s known price list for the previous three years. This inevitably suggested significant understatements of sales and, indeed, would take the client over the VAT threshold. However, the accountant referred to the MacDonald’s steakhouse case (see Scott & Anor t/a Farthings Steak House v McDonald (HMIT) (1996) Sp C 91) and pointed out that although the client had accepted that profits were indeed understated, that particular case provided significant authority for the view that recomputing profits based on a business economics exercise was arguably of debateable usefulness when the accounts had been properly prepared based on records of a reasonable standard.

Clearly here the records (in this case a simple manual cash book written up weekly) were open to challenge as the client had already accepted that she had been involved in tax evasion. But the accountant argued that this was not a case suitable for recomputing profits based on a mathematical exercise using all sorts of assumptions about wastage rates, etc.

He then carried out an old fashioned ‘capital statements’ computation, identifying the client’s assets and liabilities at annual dates for the past six years and identifying known incomings and expenditures. He used this (including the balance on the unidentified bank account) to compute the increase in the client’s overall wealth, etc, for the past six years. When compared with the known level of income from the business this actually provided a result that showed a close correlation with the amounts that had been paid into the hidden bank account. After some further negotiation HRMC agreed to accept this as a more accurate means of recalculating the client’s declared taxable income for both income tax and VAT purposes.

It is often a difficult experience for a taxpayer and their adviser to deal with when presented with a recalculation of profits by an inspector of taxes based on a business economics or gross profit model. It can seem a very powerful and impressive computation when first put forward by HMRC and can seem really difficult to displace. However, it is always important to remember that it is simply an exercise and will always almost inevitably be based on a whole raft of assumptions that the inspector has had to make about business pricing, wastage rates, the efficiency of the businesses, etc, and must always be regarded with a healthy degree of scepticism.

The McDonald case mentioned above discussed this issue at some length and pointed out that where accounts have been properly prepared by a suitably competent and qualified professional accountant using normal sound accounting practices (which, by the way, in a lot of non-corporate business accounts will almost inevitably involve the use of a balancing figure at some stage), then it will take a lot of evidence before a Tax Tribunal will accept that the accounts prepared in this manner should be displaced by a business economics exercise.

It is just that, an exercise. Yes, in cases such as this one where there has already been an admission of profits being diverted then there is a prima facie case for using some other method of recalculating profits, but the business economics model may not always be the best way forward.

In a number of cases I have dealt with over the years the old-fashioned capital statements computations can provide a more persuasive means of testing the client’s overall wealth and cross-checking any unexplained increases. Yes, of course it too involves making assumptions and estimates about personal expenditures of the taxpayer, but these can often be more easily verified and so this method should not be overlooked.

The case has now been settled by agreement and undeclared profits subjected to income tax and interest and penalties as is normal in such cases. The important issue that it reconfirms is that there are always a number of alternative means of establishing undisclosed profits. The method put forward by HMRC may not always be the most appropriate and the adviser should always be willing to test their assumptions to destruction and consider alternative means of establishing and quantifying what has gone wrong. The first method put forward may not always produce the best or most reasonable result.

Russell Cockburn is a tax consultant, lecturer and author, and a former HMRC inspector. He can be contacted on 01909 824542 or by email at


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