As a result more partnerships are being caught in the net when HMRC chooses cases for enquiry and a more systematic approach to partnerships enquiries has emerged.

The new approach

HMRC has a programme to enquire into all ‘large partnerships’ over a two to three year period. The term ‘large’ varies in meaning between HMRC units and is not clearly defined.  As a rule of thumb, HMRC considers firms to be large if they have a turnover of over £5 million, or more than ten partners.

With enhanced expertise and increased manpower, each large partnership’s accounts and tax return are now being reviewed annually for any unusual activity in order to gauge whether a specific enquiry is needed. If no activity arouses suspicion, it seems that large partnerships will in the future systematically undergo an enquiry at least every three to four years. Smaller partnerships will be selected for enquiry 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.

At the start of an enquiry, HMRC will write to the partnership’s nominated partner and external accountant requesting information relating to their areas of concern and for further analysis of the figures submitted. A full written response is usually required within 30-40 days. An average enquiry involves three to four exchanges of correspondence, depending on the complexity of the case. In many cases, the information provided may be enough to satisfy the Inspector, or an agreement may be reached as to appropriate adjustments to the firm’s tax figures, thus ending the enquiry. While many issues can be resolved simply through 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).

If asked for original documents, the firm can choose whether they send the relevant documents to the Inspector or make their accounting records available to HMRC at their accountant’s office or their own premises.  If facing a request for a meeting with the Inspector, representatives from the firm’s management or accounts department do not have to be present – it can usually be handled solely by the external accountant if preferred.

If issues are still not resolved after the meeting stage, any dispute is put before the Tax Commissioners with subsequent appeal being via the Court System.

Potential Focus of a Tax Enquiry

An enquiry will focus on two broad areas – specific tax matters and accounting policy.  The detailed points of enquiry might include:

• Reviewing whether provisions have been appropriately calculated under accounting standard FRS12 and the evidence thereof eg on dilapidations and onerous lease obligations.
• 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.
• Seeking an understanding of the bad debt/credit note provision policy and the detailed methodology used to arrive at the provision.
• Asking for detailed analysis of potentially tax-sensitive expense categories - eg to identify if any entertaining costs have been misdescribed as marketing - entertaining costs are not allowable for tax relief whereas advertising costs are.
• 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. 
• Assessing 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). 
• Considering the basis of capital allowance claims on office fit-out costs.

  A particularly contentious area at the moment is whether partner recruitment fees are tax deductible. HMRC is taking internal legal advice on this issue as there is no case law on the tax position of such costs, but it is taking the view that such costs are not deductible and are seeking an acceptance of a disallowance where such fees have been incurred.

  HMRC will also look at compliance with Generally Accepted Accounting Principles (GAAP) when searching for incorrect application of tax legislation. LLPs 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 profit under GAAP.

  One would therefore expect partnerships, even those who seek to produce GAAP accounts for their own purposes, to face greater accounting scrutiny from HMRC. Their accounts are normally only reviewed by external accountants rather than audited therefore compliance with the exact detail of specific GAAP policies might be more approximate than by LLPs.

  Firms should be aware that HMRC’s accountants are now involved in the enquiry process from the start, and responses should be framed with that in mind. Any flippant explanations of accounting matters will be picked up by HMRC and result in more questions and challenges as to proper compliance with GAAP.

  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 at louis.baker@horwath.co.uk