In the second post in our new series on avoiding a tax investigation, we’re discussing the legal definitions of tax avoidance, tax evasion and tax planning, according to HMRC. And we’ll also take a look at the top potential triggers for a tax investigation, and how to avoid them.
If you haven’t read Part One: The Tax System, Simplified, head over and give it a read now.
Part Two: Are You at Risk of an Investigation?
Tax investigations last sixteen months on average and cost around £5,000 in accountancy fees. That’s a serious amount of time and money spent defending yourself and your business against an enquiry that could have arisen due to a careless mistake.
There’s no fool-proof way to avoid the threat of an investigation, as HMRC will sometimes conduct an audit at random with no apparent trigger. But, for most investigations, something will cause HMRC to put you on their radar.
The Difference Between Avoidance, Evasion and Planning
The terms ‘avoidance’ and ‘evasion’ are often used interchangeably, but they do have different legal meanings with reference to tax.
Broadly, tax evasion refers to concealing income or information from HMRC in order to deliberately underpay tax. This is always illegal.
Tax avoidance is a little more complicated. It generally refers to legal manoeuvring within the tax system to reduce your tax bill. HMRC frequently uncovers tax avoidance strategies by unscrupulous advisors who seduce high-net worth individuals into moving their wealth offshore or investing in fictional scheme and paying minimal tax as a result. Exposure can damage the individual’s reputation and result in an enormous tax bill when HMRC demand the underpayment be rectified.
Tax planning, on the other hand, is a completely legal and worthwhile method of structuring your finances to pay as little tax as you are legally required to. The UK tax system is complicated, and a trustworthy professional is worth their weight in gold when it comes to tax planning.
What Triggers an HMRC Investigation?
What can cause HMRC to want to take a closer look at your financial affairs?
One of the main triggers for an investigation is when HMRC receives information suggesting a business or individual may be partaking in tax-dodging activities. But why would someone you know report you to HMRC? Well, it’s usually somebody with a grievance against the accused. E.g.
- A disgruntled employee, or ex-employee
- A past romantic partner
- An angry customer
- Someone who finds your cash only policy suspicious
- Someone who may be jealous of your lifestyle and believe it to be beyond your means
- Someone who has responsibilities to report suspicions under the Money Laundering and Proceeds of Crime regulations
Mistakes on Your Returns
A single mistake won’t trigger HMRC to investigate you, they’re aware most people are not tax experts and make allowances for minor errors, as long as you can prove you weren’t trying to deliberately cook the books. But, if you make a mistake more than two years in a row, you should consider getting a reputable advisor to take a look at your financial affairs, and even be prepared to represent you to HMRC.
No business brings in the exact same amount of profit every year, but huge fluctuations are also quite rare, without a specific reason. Maybe you had a child or a period of ill health, or simply decided to increase or reduce your working hours that year. If you want to lower your risk of coming under investigation, you can use the notes section of your tax return to include a brief explanation of the fluctuation.
If your business has been running for a few years and has yet to turn a profit, HMRC is going to wonder why, and question how your business is still operating. It isn’t impossible, especially if you have a lot of initial investment to keep you going until things turn around, but usually a business will either become profitable or be forced to close. Again, you can use the notes section of your tax return to give the taxman an understanding of how your business is surviving the dry spell.
Inconsistency with your Industry
HMRC sees a lot of tax returns, so it has a good idea of what a business in any given industry should be earning. One simple way to reduce your risk of being investigated for being inconsistent with HMRC’s expectations is to establish yourself as the right business type.
A good accountant will be able to advise you which type is best for your individual circumstances, but in simple terms, if you’re a sole trader starting to turn over a large sum of money, it might be time to form a limited company.
Employees Earning More Than Directors
Directors being paid less than employees, whether by salary or dividends, smacks of tax avoidance, so prepare to have HMRC go through your financial dealings with a fine-tooth comb. Or, better yet, get the balance right for your earnings. If you really want to reward your staff, consider gifts or additional benefits instead.
Occasionally, business owners are tempted to leave certain receipts or payments off their tax return to reduce the tax they owe. But, as a business interacting with other businesses and financial institutions, your tax return isn’t the only place HMRC might come across your transaction history. Your name will be all over the tax returns of your clients, suppliers and lenders.
If you omit an interest payment you’ve received it could be missed by HMRC, but if they open an investigation into your client who made the payment, the discrepancy could be picked up and they would then be forced to investigate your submission as well.
When HMRC sees that a business has no accountant, they start to question whether the business owner is reluctant to let a professional see their finances, or if their return may be littered with mistakes due to a lack of knowledge and experience.
If you own a growing, profitable business and you don’t currently employ an accountant, you should consider engaging one to submit your tax returns at the very least. It could save you from a costly investigation.
Late Filings or Payments of Tax
The dates for filing tax returns and the payment of tax are non-negotiable. If you file your tax returns late it’s understandable HMRC will see this as disrespectful and question your attitude towards rules and regulations in general. If you can’t fuel your returns on time, what else are you doing wrong?
Submit your returns and pay your bills on time if you want to stay off HMRC’s radar and avoid a lengthy and expensive investigation.
In our next article on avoiding a tax investigation, Nature of an Enquiry, we’ll take a look at the four types of tax that attract the majority of enquiries: income tax, VAT, inheritance tax and capital gains tax. Don’t want to wait? Click here to get our guide, Happiness is Paying the Correct Tax now.
Get in touch to discuss your individual circumstances and get some independent, impartial advice on your business’s tax affairs.