Many accountants have had the experience of someone coming to see them out of the blue, and saying something like, ‘I’ve never declared my rental income as I have a very small portfolio. What should I do to get my affairs right, and what is my worst case scenario?’
Without condoning the suppression of income in this way, many accountants can understand the temptation. Perhaps the individual concerned doesn’t even fill in tax returns, and the red tape involved in getting into the self-assessment situation is off-putting. After a year or so, when the taxpayer is now definitely in default, it becomes a case of ‘I must sort that tax business out – some time.’ Others assume, actually wrongly, that turning a blind eye to the receipt of a small amount of rental income is part of the culture – what everyone does. Another class assume that they would probably have enough expenses to offset, and so there’s no rental profit to pay tax on anyway. Sometimes this is true in the earlier years, when a lot needs to be done to the property or properties concerned, but it becomes untrue at some definite point, which might slip by without the landlord really noticing it.
The trouble is, it all looks very different when the taxman knocks on the door. HMRC tend to show a distinct lack of sympathy for the doubt and vacillations of taxpayers in this situation. On the principle of getting the worst over first, let’s look at the bad news, and then the good news (or perhaps the not so bad news).
The bad news
To anyone who thinks that they can get away with not declaring rental income for year after year, honesty compels us to admit that they may well be right. Whilst the inner workings of HMRC are not necessarily known outside the organisation to any but a small number of recently ex-HMRC officers, the strong impression that we get is that they simply haven’t got enough staff to sniff out every little bit of untaxed income that might be out there. Leaving questions of legal and moral duty to one side for the moment (which of course one can’t do permanently) there is definitely a chance, and it might be a fairly reasonable one, that a small peccadillo like the one we are imagining here might never come to light. But, on the other hand, anyone who is in this position is sitting under the Sword of Damocles.
Probably the most frequent reason why undeclared income comes to light is because a malicious informant tells HMRC about it. No doubt the most frequent sort of malicious informant, it has to be said, is a disgruntled spouse on a matrimonial break-up. Former employees who have been sacked are also frequent informers. We’re told, too, that all land registry transactions are notified to HMRC. Sometimes (very occasionally, if truth were told) they seem to use this information: usually for enquiring as to why capital gains have not been disclosed on disposal of a property. But it’s also not beyond the wit of the taxman to start trying to build up a picture of a person’s financial life. Why does someone apparently own two or three properties, but not receive any rents?
How far back can HMRC go? Like every question involving HMRC and the statutory rules, the answer is a little bit complicated.
The basic time limit is four years. If the taxman wants to go back more than this, and assess undeclared income that he’s discovered, he needs to show that: (a) the taxpayer has been ‘careless’ – in which case the four-year time limit becomes six years; or (b) he needs to show that the omission of the rents was deliberate. In this case we have a twenty-year time limit. In Dorothy Whipple’s excellent novel High Wages, a leading industrialist gets caught with his tax trousers down, and the result is no less than ruin. Whilst the rules applying at the time that book was written have been changed since, of course, the changes have actually been for the worse, as far as the taxpayer is concerned. The reason why past tax liabilities can be ruinous is because of the fact that, in addition to finding a lot of tax on income you have probably spent, you will also have penalties and interest.
The following table is a handy ‘ready reckoner’ as to the kind of level of penalties someone can normally expect for arrears of income tax, with the percentage figures relating to a percentage of the tax previously lost:
Careless Deliberate but Deliberate and
not concealed and concealed
% % $
Maximum 30 70 100
Minimum – prompted disclosure 15 35 50
Minimum – unprompted disclosure Nil 20 30
The level of the penalty depends, therefore, on two main factors, which are the extent to which the taxpayer’s omission of income was guilty; and the extent and readiness with which he has put the matter right. A swingeing 100% penalty applies where the omission is deliberate, concealed, and has not even been disclosed when prompted by HMRC. At the other end of the spectrum, someone who realises their mistake, which was perhaps merely a careless one, and makes an unprompted disclosure, could get away with no penalties at all – reasonably enough.
The not so bad news
Having looked at worst case scenario, in answer to our landlord’s second question, now let’s look at the first question: how do we put things right, and as cheaply as possible?
Firstly, it is obviously sensible if possible to get your disclosure in before HMRC have started making any enquiries. Unprompted disclosure obviously reduces any potential penalties.
Secondly, we find it helpful to present HMRC with a complete ‘pack’, comprising calculations of the arrears of tax, with readily available supporting documentation, where possible, and clear explanations of where estimates have had to be used. If you do all of the bureaucrat’s work for him, he is likely to view your previous default with a much less jaundiced eye. This is particularly the case, of course, if you are able to send him a cheque for a reasonable amount, or even the whole, of the tax arrears along with the disclosure.
But putting the matter right isn’t all just a case of lying down and being kicked. Here are a few principles which will help resolve the problem, it is to be hoped, as cheaply as possible.
- Argue if possible that the omission is careless rather than deliberate. It may genuinely be the case that a landlord was under the impression that his expenses exceeded his income: one common area of misunderstanding, for example, is that in making mortgage payments it is only the interest that is allowable, and not the capital, as some people seem to think.
- Don’t forget to claim losses from earlier years, which can normally be brought forward and offset against current year rental profits. Even if it means going back an awful lot of years and making your best fist at a rental income and expenditure account, these losses are well worth claiming – rather than simply starting from the first year in which profits are made.
- Don’t forget to claim such things as wear and tear allowance in those past years, and adopt a reasonable approach to claiming expenses, including the expenses of substantial refurbishments where these are arguably ‘revenue’ in nature.
Practical Tips:
Finally, remember that you are allowed a deduction for expenses incurred. This may seem too obvious to be worth mentioning, but sometimes investigating HMRC officers give the impression that you can’t claim an expense unless you can find a supporting voucher or invoice. Although they will say it with great confidence, the flaw in their argument is that the law doesn’t actually say this. There are cases where you can show by basic reasoning, or other evidence than pieces of paper, that you must have incurred an expense. Even if you don’t know exactly how much the expense was at this lapse of time, it’s better to make a fair estimate than simply leave out any claim for the amount concerned. The aim is to arrive at a fair and accurate picture of the actual rental profits received, not a figure that you can’t prove you haven’t received.
