Article by Louise Pinfold, a senior technical editor with CCH Ltd and a consultant with IRPC Group Ltd.
Published in December 2001 issue of Tax Adviser.
Billions of pounds are considered ‘at risk’ and estimated to be lost to the Exchequer through non-compliance. Not all of this is attributable to people not known to the Revenue; a significant proportion is identified from enquiries into the returns of apparently compliant taxpayers (£5.4 billion in 1999–2000). As the Revenue said in their annual report:
’A key part of our strategy is to identify and put right non-compliance.’
As the additional liability from self-assessment enquiries continues to increase, it is clear that the strategy is working. But how do the Revenue go about identifying cases likely to produce additional liability?
Case identification
Cases are selected for enquiry in one of three ways:
- random enquiries – a central selection of a small percentage of cases to be worked as full enquiries, the concept of totally random selection being felt to provide a deterrent to non-compliance;
- mandatory reviews – cases with specific features which local offices must review (although not necessarily by conducting a full enquiry); and
- risk assessment – cases assessed against pre-set criteria.
As the Revenue's aim is to concentrate their resources on areas where there is high risk of evasion, the vast majority of returns come from the last category. To carry out risk assessment, the Revenue use information provided on the taxpayer's return and information from third parties.
Risk assessment
Risk assessment is not a new feature introduced by self-assessment; it has been used since the introduction of the ERA system in 1976. However, the process has been refined and computer support has been introduced with mixed results (see below). All cases are now assessed by computer using pre-defined risk rules to produce a risk score which assists in the identification of the cases most suitable for enquiry.
Before self-assessment , districts carried out risk assessment manually on the basis of local knowledge, maintaining district ’league tables’ which compared the gross profit rate (GPR) of local businesses within a particular category, together with information accumulated from personal observation or local newspaper articles or adverts. Then, as now, risk assessment was concerned largely with the business ratios shown by the accounts.
As accounts are no longer required under self-assessment, computerised risk assessment is carried out by reference to the Standard Accounts Information (SAI) submitted as part of the return. The ratios in any particular year are looked at both in isolation and in comparison with previous years. Levels of expenditure under particular headings are compared to identify fluctuations or any unusual features.
Anecdotal evidence has pointed to weaknesses in the computerised system, which has reportedly highlighted cases considered by local inspectors to be inappropriate for selection. It is known that some of these probably relate to inaccuracies in the Revenue's internal trade classification system which defines the sector into which a business falls.Others are believed to stem from the fact that there are far fewer categories of expenditure on the SAI compared to a set of accounts, resulting in items which would previously be identified separately being added together, thus giving misleading results.
However, the core risk rules are intended to ensure that cases are selected by reference to criteria which have yielded successful enquiry results in the past. Inevitably businesses with poor results and certain types of business, e.g. cash trades, tend to feature heavily. Furthermore the Revenue's focus on numerical targets tends to mean that local offices may concentrate on opening the more straightforward cases at the expense of the larger or more difficult ones (which are arguably more likely to produce the highest yield).
Risk features
Understandably the Revenue do not publish details of their risk rules, but advisers experienced in enquiry work will be familiar with the areas within an individual case which will typically be of concern and these are discussed below.
Unsatisfactory GPR
Where the business is one which consists of the purchase of goods for resale, the Revenue will focus on the GPR and will consider the possibility that unsatisfactory results may be due to an understatement of takings. ’Unsatisfactory’ in this context is traditionally taken to mean low, static, declining or fluctuating, particularly when the turnover exhibits similar features.
Where the business is not one where goods are purchased for resale, the inspector will look for other ratios which might give an indication of the reliability (or otherwise) of the accounts. There is often a correlation between income earned and a particular type of expenditure, e.g.:
- fuel – in the case of such businesses as that of a taxi driver, haulage contractor or driving instructor; or
- food – in the case of nursing homes, hotels, etc.
Where the business falls within the service industry, there will still be ratios to be considered, e.g. employee costs or time spent in the business by the proprietor.
The Revenue maintain that this is only a selection tool and that the individual results will always be considered in detail before selection. However the fact remains that for every success, in the investigation of a business with poor ratios, the more the Revenue are convinced their approachis correct. And with every success comes an increase in ratios, thus bringing into suspicion more cases which have lower than average results.
The now infamous Farthings Steak Housev McDonalds (1996 Sp C 91) did much to discredit the Revenue's business economics approach, but while self-assessment has placed more emphasis on examination of business records, inspectors will continue to use business models as a way of testing the accuracy of accounts.
Net profitability
As turnover increases movements in GPR become relatively insensitive as an indication of suppressed takings, e.g. the omission of sales of £2,000 from a turnover of £200,000 depresses the rate by only one per cent. In larger cases, the inspector may consider net profitability, i.e. the proportion of turnover accruing to the proprietor or directors and how this has changed over the years. The net profit is a smaller figure and will reflect evasion more markedly.
In the case of sole traders and partnerships, the ratio is:
net profit x 100
turnover
In a company case, the ratio is:
net profit + directors' remuneration and pension x 100
turnover
Low drawings
The question of whether declared means are adequate to fund the taxpayer's lifestyle is always considered in addition to looking at the business ratios. The taxpayer's risk score will increase.if drawings per the SAI:
- appear to be low in absolute terms, taking into account what is known (or assumed) about the person's lifestyle, investments and commitments;
- fluctuate from year to year without apparent reason; or
- stay at about the same level despite inflation.
Inadequate private use, etc. adjustments The need to revise adjustments for private use, goods for own consumption, etc., is not normally, in itself, ground for starting an enquiry. However if the revision required is so substantial that the person could not possibly have believed that the profits shown in his tax computation were correct, he will be culpable. The Revenue take the view that the level of neglect demonstrated is sufficient to bring into doubt the accuracy of the person's tax affairs in general and so justifies an enquiry.
Other factors
It is not possible in an article of this length to list all factors which may be considered, but some of the other common risk areas are:
- round sums, which may indicate a lack of accurate records;
- cash businesses – because of the greater opportunity to divert cash takings and the likelihood that records of cash will be inadequate;
- the ratio of debtors and credits to sales and purchases; and
- return on capital.
Information held The Revenue's formal sources of information are many, varied and increasing. Depending on the source and the nature of the information held, an enquiry may be a certainty rather than a risk. A review of Taxes Management Act 1970 (TMA 1970), s. 13–19 gives some indication of the areas in which the Revenue can require information from third parties in the form of annual returns. A wise maxim indeed is that one man's income is another man's deduction.
Add to this sources of information about capital transactions, which may indicate an accumulation of wealth, and the extensive informal sources of information, ranging from local publicity to informers, and one begins to appreciate the extent to which a case can be built before an enquiry is opened.
Whatever the source of the information, formal or informal, there is always the possibility that it can be wrong. Problems arise here because the inspector is instructed not to reveal his source and good deal of unnecessary time and expense may be incurred before the matter is resolved.
Avoiding unnecessary selection
No adviser can give a guarantee that his client will not be selected for enquiry but there are steps he can take to minimise the risk. By understanding the Revenue's selection process and undertaking a risk review of his client's return, he can ensure that information explaining apparent anomalies or unusual features can be presented at the same time as the return is submitted.
Fears have been expressed by advisers that giving the inspector reasons for apparently poor results can in itself result in the case being selected. However if the reasons are valid and can be justified, and provided there are no other areas of concern, no enquiry will result.
However, even if an enquiry is not prevented, the review will help the adviser and his client deal with the resulting queries more easily, as much of the information will have been already gathered – and at a time when details were fresh in the taxpayer's mind.
The future
Although the fundamental principles of risk assessment are unlikely to change, the Revenue are constantly refining the process to make better use of statistics and to incorporate modern techniques such as profiling.
The most recent significant change has been the move away from selection of cases at local district level to selection by specialist teams at area level known as Risk Intelligence and Analysis Teams (RIATs), to improve the focus of compliance work and introduce a more systematic and consistent approach to risk analysis. The establishment of the RIATs is an extension of the reorganisation of local districts and area management.
The Revenue see risk analysis as a separate specialisation to be carried out by those trained in this type of work, At the same time they wish to build on the existing expertise and experience of local districts. The work of the RIATs is evolving – it encompasses all risks to the assessment and collection of tax, as well as the risk that, e.g., tax credits are not being paid to those who are entitled to them. The Revenue is, these days, as much an enabling organisation as a regulator. As a senior Revenue official commented, when stressing that the RIATs' role also involved identifying the risks with a view to improving customer service and educating the public:
’It's not just about finding the bad guys’
Nevertheless, it would be naïve to think that identification of suitable enquiry cases is not a significant part of their work. Under the new structure, there are 64 area RIAT teams, although not all staff is in one office, depending on the size of the area. Each team is split into two: the Intelligence and Analysis Team and the Right Track Team, the latter operational, fulfilling the Grabiner proposals for dealing with the informal economy.
Role of the IAT
The IATs will be responsible for gathering and analysing information and spotting trends, with a view to identifying risks and thus suitable cases for enquiry. Modern techniques will be available to them, such as profiling and sophisticated data interrogation techniques using both internal and third party information systems. From their research, they will put together in a Standard Intelligence Package all the risk factors they have identified in a particular case (including third party information), which they will then pass to the local district to work as an enquiry. These have been referred to as ’oven-ready enquiries’ Any mention of turkeys would surely be unkind!
Anecdotal evidence suggests that local offices are less than happy that identification of enquiry cases has been taken away from them, seeing this as an erosion of their role. But Head Office is enthusiastic about the system and feels that local concerns are the result of a lack of understanding and will therefore evaporate once districts see the advantages in practice.
Conclusion
In a recent speech, Sir Nick Montagu put emphasis on ’communication, communication, communication’. But perhaps an increasingly important factor in the way the Revenue carry out their work is ’sophistication, sophistication, sophistication’. Increasing resources are being allocated to enquiry work and this, coupled with the Revenue's new target that 76 per cent of risk-based full enquiries should result in ’the detection of non-compliance’, means that enquiries are likely to get tougher.
Technical Department
020 7235 9381
December 2001 by Louise Pinfold
