The self-assessment tax regime started life some 10 years ago. The monitoring was intended to take the form of periodic ‘enquiries’ into tax returns by Her Majesty’s Revenue and Customs (HMRC).
Until recently law firms and indeed partnerships generally have got off lightly, with very few such enquiries being undertaken. However, this landscape has changed with the recent creation by HMRC of five new specialist partnership tax units, which are placing partnerships’ tax affairs under increased scrutiny.
In the past, HMRC inspectors looking at business cases might have dealt with just one or two partnership cases among a portfolio of mainly corporate ‘customers’. Now the newly-established specialist units will focus specifically on partnerships and their tax affairs.
At the same time, HMRC has also recruited more trained accountants to work alongside its tax inspectors. This enhanced expertise and focused manpower means that HMRC is increasingly including partnerships when selecting cases for inquiry, and over the past 12 to 18 months a more systematic approach has emerged.
HMRC currently has a programme of enquiring into all ‘large partnerships’ over a two- to three-year period. The term ‘large’ is not defined and therefore varies in meaning between the HMRC units.
A rule of thumb currently seems to mean that those firms with a turnover of over £5m, or more than 10 partners, may be considered ‘large’ by HMRC.
Each large partnership’s accounts and tax return are now being reviewed annually for any unusual items, to see if a specific inquiry is needed. Otherwise it seems that large partnerships will in future systematically undergo an inquiry at least every three to four years, with smaller partnerships selected for inquiry more at random.
Every case is reviewed by both a tax inspector and an HMRC accountant, and enquiries will look at a combination of tax and accounting information to identify any potential errors or incorrect application of accounting principles.
When an inquiry is launched, HMRC will write to the partnership’s nominated partner and external accountant to ask for additional information that relates to its areas of concern – usually requesting further analysis of the figures submitted.
A full written response is usually required within 30 to 40 days, and typically one would expect to see perhaps three to four exchanges of correspondence, depending on the complexity of the case.
At this stage the information provided may be enough to satisfy the inspector – or agreement is reached as to appropriate adjustments – and end the inquiry.
However, although many issues can be resolved by such correspondence, HMRC inspectors may also wish to meet in person to discuss specific matters, particularly if their queries are disputed.
The inspector may seek to visit the partnership’s premises and has powers to see all relevant financial records, often required in electronic format. If a resolution still cannot be agreed with the inspector, any dispute is put before the tax commissioners, with any subsequent appeal being via the court system.
An inquiry will focus on two broad areas: specific tax matters and accounting policy. The detailed points of inquiry might include:
• Asking for detailed analysis of potentially tax-sensitive expense categories – eg to identify if any entertaining costs have been misdescribed as marketing.
• Reviewing whether items that should be treated as capital items for tax purposes are included in revenue costs – eg capital improvements or additions within repairs.
• Asking for the evidence of business use percentages of costs with a mixed private and business purpose – eg business use of partners’ home phone bills and motor costs.
• Considering the basis of capital allowance claims on office fit-out costs.
• Questioning the basis of computing accrued income under FRS5/UITF40, the records used and methodology adopted, in particular in identifying contingent work and the valuation treatment of such work.
• Reviewing whether provisions have been appropriately calculated under FRS12 and the evidence thereof – eg on dilapidations and onerous lease obligations.
• Seeking an understanding of the bad debt/credit note provision policy and the detailed methodology used to arrive at the provision.
Mind the GAAP
It should thus be noted that HMRC will look at compliance with Generally Accepted Accounting Principles (GAAP) just as much as carrying out detailed expense analysis.
Limited liability partnerships (LLPs), of course, have to prepare their accounts in accordance with UK GAAP – unlike partnerships, which can prepare their accounts on whatever basis they wish. However, for tax purposes under the Finance Act 1998, partnerships are taxed on profits calculated under GAAP. Therefore, partnerships that do not follow GAAP in their own accounts are expected to make an adjustment in their tax return to declare their profits under GAAP.
As sizeable LLPs will have had to have had their accounts audited, one would hope that HMRC would not find an error in the application of GAAP, though it might be irksome to have to prove this in detail.
One would expect partnerships, even those that seek to produce GAAP accounts for their own purposes, to find greater accounting scrutiny from HMRC. Such partnerships’ accounts are normally only reviewed by external accountants, rather than audited. Thus compliance with the exact detail of specific GAAP policies might be more approximate than by LLPs, and HMRC’s accountants will be alert to this possibility.
It is important to bear in mind that HMRC’s accountants are now involved in the inquiry process from the start and responses should be framed with that in mind. Any ‘loose’ or flippant explanations of accounting matters will be picked up by HMRC and result in more questions and challenges as to proper compliance with GAAP.
With another financial year end approaching, firms need to be looking again at their accounting policy compliance with GAAP and their procedures in meeting the requirement of specific accounting standards. For any UK law firm that has not had an inquiry yet, the chances are high that one will be just around the corner. Be prepared.
• Louis Baker is a tax partner at accountancy firm Horwath Clark Whitehill