This article first appeared in The Actuary, 1 September 2008:
Partnerships have previously enjoyed a light touch under the self-assessment tax regime, but the taxman is now placing them under closer scrutiny.
The self-assessment tax regime started life some 10 years ago. The monitoring of it was always intended to take the form of periodic ‘enquiries’ into the self assessed tax returns by staff of Her Majesty’s Revenue and Customs (HMRC).
Until recently 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 amongst a portfolio of mainly corporate ‘customers’. Inspectors tended therefore to spend their time in reviewing company tax returns rather than their few partnership cases – as this was the work they were most comfortable with, and indeed that their training was focussed on.
Now, the newly-established specialist units will focus specifically on partnerships and their tax affairs. The Inspectors in these units deal only with partnerships and Limited Liability Partnerships (LLPs), and are now gaining a bank of experience in this area.
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 enquiry, and over the past 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 enquiry is needed. In the absence of any specific issues that bring a case forward to review, it seems that large partnerships will in the future systematically undergo an enquiry at least every three to four years largely, with smaller partnerships being selected for enquiry more at random.
At the start of an enquiry every ‘large’ 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 in complying with tax legislation or incorrect application of accounting principles.
When an enquiry is launched, HMRC will write to the partnership’s nominated partner and external accountant to ask for additional information which relates to their areas of concern, usually requesting further analysis of the figures within the annual accounts and tax computation.
A full written response is usually required within 30-40 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 by the firm (usually via their accountant) may be enough to satisfy the Inspector (or agreement is reached as to appropriate adjustments) and end the enquiry.
However, although many issues can be resolved by such correspondence, HMRC 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.
Firms will need to consider whether they should make their accounting records available to HMRC at their accountants offices rather than their own. They will also need to consider whether it is tactically better for their accountants to hold any meeting with HMRC alone, rather than with representatives of their management or accounts department staff also being present.
If a resolution still cannot be agreed with the Inspector any dispute is put before the Tax Commissioners with subsequent appeal being via the Court System.
An enquiry will focus on two broad areas: specific tax matters and accounting policy. The detailed points of enquiry might include:
- Asking for detailed analysis of potentially tax-sensitive expense categories - eg to identify if any entertaining costs have been misdescribed as marketing, advertising or conference costs. (Entertaining costs are not allowable for tax relief whereas advertising costs are)
- 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; (repairs are tax deductible whereas capital costs are not unless they qualify for phased tax relief under the capital allowance regime)
- 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; (the personal use element of such costs is not tax deductible).
- Considering the basis of capital allowance claims on office fit-out costs
Questioning the basis of computing accrued income under accounting standards 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 accounting standard FRS12 and the evidence thereof eg on dilapidations and onerous lease obligations
- Even having been satisfied that a dilapidations provision has been correctly computed under FRS12 HMRC will look to check that the capital element of such provided costs have been separately identified from the repairs element.
Seeking an understanding of the bad debt/credit note provision policy and the detailed methodology used to arrive at the provision
- Reviewing whether rent free periods have been correctly spread under accounting standard UITF28.
A particularly contentious area at present is whether ‘partner recruitment fees’ are tax-deductible. HMRC are of the firm view that such costs are not deductible and this is being driven from their Head Office. It is a matter they are taking internal legal advice on as there is no specific case law on the tax position of such costs. In almost all partnership enquiries they are asking if such fees have been incurred and are seeking acceptance of a disallowance where they have been. Where firms are not accepting a disallowance HMRC are leaving the enquiry open in the likelihood that a case will be taken to the Courts in the next year or two.
It should be noted that HMRC will look at compliance with Generally Accepted Accounting Principles (GAAP) just as much as carrying out detailed expense analysis (where they are searching for incorrect application of tax legislation).
Limited liability partnerships (LLPs), of course have to prepare their accounts in accordance with UK GAAP – unlike partnerships who can prepare their accounts on whatever basis they wish. However, for tax purposes under 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 profit 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 therefore expect partnerships, even though those who seek to produce GAAP accounts for their own purposes, to find greater accounting scrutiny from HMRC. Such partnerships’ accounts are normally only reviewed by their 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.
HMRC have highlighted that the accountancy standards they pay particular attention to are those on income recognition (FRS5/UITF40), accruals and deferred income, and provisions FRS12. Their aim is to check that firms are recognising income in the right period (and not delaying tax by delaying income recognition) and not accelerating recognition of expenses (and thus trying to accelerate tax relief).
In conclusion, those firms operating as partnerships or LLPs will find their tax affairs under closer scrutiny from HMRC in the future. If your firm has not yet had an “enquiry” from HMRC in all likelihood it will within the next couple of years, and in more focussed detail than previously.
Louis Baker is a tax partner at Horwath Clark Whitehill
Email Louis: louis.baker@horwath.co.uk
