If you run a business, the law requires you to keep full records of your income and expenditure. In the case of limited companies, there is specific legislation concerning the nature of the records to be kept, but all businesses must keep sufficient records to enable them to prepare accurate accounts and tax computations.
There are penalties for failure to comply with these rules, but a recent case (Mirsamadi v HMRC [2015] UKFTT 58 (TC)) highlights the other consequences of poor record keeping, which are often more serious than mere fines imposed by the legislation.
The case centred on Mr Mirsamadi’s 2007/08 self-assessment return. This showed a small amount of property income, but apparently HMRC had information about other business activities, including other property lettings and the operation of food takeaways.
Mr Mirsamadi had not kept proper records of his business activities – he admitted this – and so HMRC embarked on an exercise to calculate the likely level of undeclared income.
HMRC’s methods
There are two main ways in which HMRC will do this. They can take the ‘business economics’ approach, whereby industry norms of profit ratios are applied to the known facts. A typical example in a retail business is to look at stock purchased and to apply a mark-up derived from the taxpayer’s own price lists, or from typical profit margins for the sector concerned. This is particularly effective when takings have been suppressed but the purchases have been correctly recorded. Some of the ratios used can be rather exotic – a colleague of mine when I was a tax inspector claimed to have increased the taxable profits of a greengrocer based upon the number of brown paper bags he had purchased, which were far more than was needed to fill with the quantity of fruit and vegetables he claimed to have sold!
In Mr Mirsamadi’s case (possibly because the records were so poor that a business economic approach could not be used), HMRC adopted the other approach, based on looking at the taxpayer’s personal expenditure. The details of this are usually complex, but the proposition is simple: work out the increase in the taxpayer’s assets over a period, and his expenditure on everyday living during the same period. If there is a lack of sufficient declared drawings from the business to cover these costs, the assumption is made that the shortfall represents undeclared income.
Unrecorded takings?
Tax inspectors look at business records with a view to ‘breaking’ them – that is, demonstrating that the records cannot be correct either because they are internally contradictory or because large estimates have been needed in order to balance the books. For example, if there is more money in the business bank account than can be accounted for using the known sales, the taxpayer may have assumed he must have introduced cash into the business. Unless he can prove this, HMRC will take the view that the extra money in the bank is unrecorded takings.
‘Breaking the records’ is fundamental to the more serious type of tax enquiry. Once HMRC have demonstrated that the records cannot be relied on to provide an accurate figure for business profits, HMRC can substitute their own figures, based either on ‘business economics’ or the ‘means test’ approach used in the case of Mr Mirsamadi. Provided their methods and results are ‘reasonable’ the tribunal is likely to uphold their findings, as it did in the case of Mr Mirsamadi.
Practical Tip:
It makes sense to keep proper records in any event, in order to know how your business is doing; but if you fail to do so, and are subjected to a tax enquiry, you may be handing a blank cheque to the taxman.
