“I can’t possibly have earned the profits which HMRC is suggesting – if I did, where has all of the money gone?”
I suspect that most of us at some point have had that reaction from a client faced with an assessment at the end of a tax enquiry. Mr Allan, a painter and decorator, whose appeal has just been reported  UKFTT 504 (TC) had that view. The first ground in his notice of appeal was “it is ridiculous to suggest a sole trader, working as a painter and decorator, would earn the level of profits as assessed by HMRC”. It got him nowhere. His attempts to say that it was up to HMRC to prove that the unexplained lodgements into his bank account were business income got him nowhere. The tribunal had to remind him that once an irregularity has been proved (which it had in this case) it was up to the taxpayer to demonstrate why HMRC’s assessment were wrong. In a 1978 case (Johnson v Scott 52 TC 383) the court summarised the position thus: it is impossible to see how the Crown, in cases of this kind, could do anything else but attempt to draw inferences. The true facts are known, presumably, if known at all, to one person only, the taxpayer himself.
That does not mean that HMRC has complete carte blanche to make up the numbers. They must have some semblance of reality. HMRC have been criticised in the past by tribunals for producing figures which are completely over the top. But this is rare: once an irregularity has been demonstrated the solution really lies in the taxpayer’s own hands. HMRC does not have to prove anything, and provided that their proposed assessments are not ridiculously high they will stand. However unfair this might seem to clients – and it does often seem very unfair – the law is very clear.
As to where the money goes – the problem is that small irregularities soon mount up. Let’s assume a trader takes £5 out of the takings every day to buy his lunch and “forgets” about it when computing his takings for the day. Assume that he works five days a week and for 45 weeks a year. That is £1,125 per year. Assume the investigation goes back six years. That is omitted income of £6,750 which at 40% gives a tax bill of £2,700. I think everybody underestimates the amount he or she spends. If you look back 6 years at your own spending on everyday items you may well ask yourself: “where did the money go”.
The burden of proof is however quite different for penalties. The burden in penalty cases rests squarely with HMRC. HMRC cannot simply say: “we think you omitted income deliberately. We will charge you a penalty unless you prove otherwise”. It is for HMRC to prove their case. That is not of course to say that HMRC will not try to reverse the burden. Advisers need to be vigilant in ensuring that they protect their client’s interests. In extreme cases this may involve taking an appeal to a tribunal. Writing in Tax Journal last year Ian MacCleod provided a thoughtful review of the case law and showed that in the right circumstances it is well worth appealing. Few taxpayers will want to do this, and I suspect that many clients would in the end accept a penalty simply to bring matters to a close. But the law is there to be used by both sides. I strongly support HMRC charging penalties in cases where there has unquestionably been deliberate understatement by the taxpayer. But I also strongly support the right of taxpayers to assert their legal rights and insist that HMRC properly adhere to the rules about burden of proof.
There are additional wrinkles to the rules on burden of proof – particularly where HMRC is looking to go back to out of date years. I don’t want to go through these here, but you need to be aware of them in appropriate cases.
I talk to a lot of tax advisers in my role as Editor in Chief of Taxation. Quite often I find that people are rather vague about the mechanics of the way that assessments, enquiries, appeals and penalties work. I have a lot of sympathy with them, as the rules can be incredibly complicated and there are plenty of areas where there is still some doubt about how they work. But a grasp of the basics is essential and if you aren’t on top of them you could end up landing your clients with tax bills they don’t actually need to pay.
Why not have a look at the tax investigations topic that appears on TolleyGuidance Owner-Managed Businesses module.
Life doesn’t get any easier.
Andrew Hubbard is Former CIOT president, current editor in chief of Taxation and partner of RSM.