HMRC's watchful eye

‘Only the stupid, greedy and unlucky [are] ever caught not paying the
right amount of tax’. This adage was commonly heard at HMRC a decade ago when
I was a tax inspector, less so now. The cynical would say that targets are chosen to raise cash (and they would be partly right); however, HMRC chooses enquiries based on risk. Do law firms, then, exhibit ‘risky behaviour’, particular to their profession, which makes them a target for the tax man?

Perhaps; lawyers are highly qualified and
are more than capable of understanding and interpreting tax legislation. This means they
could be singled out, given that their particular skills set is what is employed to avoid tax.

Still, lawyers will be happy to hear that they
do not merit such special treatment, and that
they exhibit the same risk profile as any other professional firm, such as accountants. However, like accountants, HMRC are not likely to give lawyers the benefit of the doubt for not understanding the legislation and its interpretation, given their professional standing. This is important when considering the issue of penalties as these are linked to behaviour; it is more likely that a lawyer or law firm which did not take sufficient care in preparing their tax return will be hit with a larger penalty.

While it is not possible to list all of the risk factors HMRC would examine, typically it would look at:

1. The calculation of work in progress (WIP);

2. Entertainment expenditure;

3. Travel costs;

4. Cash receipts;

5. The validity of some of the payroll costs (i.e. family members on the payroll); and

6. Structure – especially since the introduction of the mixed partnership and corporate member legislation, along with the deemed salary members legislation.

The rules governing the first three are well known. The fifth, however, is a particular bugbear. It is something I uncovered more than once as an inspector and, unless they are taking an active role in the business, there is no justification for family members drawing a salary. When discovered, HMRC is likely to hit the firm very hard indeed.

The sixth point is relatively new and is
something directly targeted at professional firms. Understanding how the law operates is important and I am sure readers have spent time reviewing their own structures to ensure they comply with the new laws. However, given the newness of the legislation, many have different views on how HMRC will interpret it. Also, HMRC may have a harder time employing the mixed partnership rules than some anticipate. Most corporate members play a genuine commercial role in the business and so the perceived damage to this sort of structure may be less than is thought. Of course, each case
is heavily dependent on its own facts, but I would caution against making any rash changes to structure before looking carefully at how it could be attacked by HMRC.

The fourth is always problematic for lawyers as it is unlikely a client is going to pay the standard £10 fee necessary for statutory declarations with anything other than cash. Like any cash receipts these need to be recorded carefully, but their presence remains a risk as, although the sums
are normally very small, they can be numerous.
If strong controls are not in place, HMRC may look to manufacture a taxable profit out of what they consider to be normal for a business of law firm size.

At a personal level, lawyers, like all taxpayers, can bring issues with their own tax affairs to HMRC’s attention. Until 9 March 2015, HMRC offered an opportunity for lawyers to disclose their undeclared income. It is not yet known
how many lawyers came forward, but those who did have until 9 June 2015 to complete and file a disclosure form. If a lawyer has not notified HMRC under this procedure, but believes they have something they should disclose, they must do
so immediately, explaining why they didn’t take advantage of the HMRC offer.

Lawyers face the same penalties as anyone
else if found to have undeclared income. However, lawyers, like accountants, face a far greater sanction if they are found to have committed tax fraud – they are likely to be struck off. This is probably why lawyers are far less likely to involve themselves in tax evasion – and even avoidance – than taxpayers on the whole.
Why would a lawyer risk their career and their reputation? Greed or stupidity, perhaps?

Handling investigations

A Code of Practice 9 (COP9) investigation is an enquiry into the fraudulent activity of a taxpayer (or lawyer), which comes with one added benefit:
if the taxpayer tells HMRC everything they have done wrong over the past 20 years as regards
their tax affairs, HMRC promises not to criminally prosecute. The very mention of the words ‘fraud’ and ‘criminally prosecute’ tends to terrify, which is why many will approach a lawyer as opposed to
an accountant for help.

HMRC’s focus on who they investigate under COP9 is not industry specific. However, some industries are less likely to attract HMRC attention simply because of the regulations imposed on them. Lawyers are, like accountants and independent financial advisers (IFAs), governed by their own regulatory bodies and must report certain information to them. Equally, most frauds are carried out by as few people as possible. Lawyers tend to practise in partnership and therefore any fraudulent tax activity would normally need all of the partners to be involved; however, they could find themselves the subject of a COP9. If this were to happen, the initial decision as to whether to admit fraud is critical because admitting fraud is likely to cause serious repercussions for their practice.

Moreover, a COP9 is normally issued against everyone who HMRC suspects could be part of the fraud. Where a partnership is concerned, each partner will almost certainly be issued with a COP9,along with any vehicles in which they conduct their business. Although most partners would want to keep the situation to themselves, given the importance of the initial response to HMRC, I would strongly recommend they approach a specialist before taking any other steps.

To enjoy the benefits of a COP9 offer, the taxpayer must make a disclosure under the terms of the contractual disclosure facility (CDF). The CDF requires the taxpayer to do the following:

• Respond to HMRC’s initial COP9 letter confirming that they have committed tax fraud and are taking HMRC up on its offer;
• Prepare and submit a valid outline disclosure describing the fraudulent conduct that led to the under-declaration of tax; and
• Prepare and submit a formal disclosure including a certified statement that the taxpayer has made a full, complete, and accurate disclosure of all of their tax irregularities, along with a certified statement of their assets and liabilities, including a list of all bank accounts and credit cards they have operated throughout the affected period.

Before declaring fraud was committed to HMRC, it’s very important that all the facts are uncovered.

It is worth pointing out two things. First, HMRC will only ever launch a COP9 investigation and offer the CDF if they have a suspicion that tax fraud was committed. Accordingly, criminal prosecution will have been considered based on the evidence HMRC already has, but it will have decided not to pursue this route.

Second, fraud cannot be committed accidently or unknowingly – it must be deliberate. Simply being careless or negligent is not the same as being fraudulent. Equally, having a valid opinion
of the operation of the law that differs from
HMRC is not fraudulent behaviour. Unfortunately,
I have seen taxpayers being badly advised and responding to HMRC confirming that they have committed tax fraud without the facts being checked. Once a taxpayer has admitted to committing fraud, it cannot be rescinded.

If you don’t respond to HMRC confirming that the taxpayer has committed fraud, then HMRC will reconsider whether to pursue a criminal prosecution. There is therefore a significant risk
to not admitting fraud – even where you suspect that none has taken place. However, on the occasions where, after reviewing the taxpayer’s history, we have formed the opinion that they have not committed fraud and the client has followed that advice and informed HMRC of the same, to date (touch wood!), no further action
has been taken by HMRC.

It is also worth noting how much tax, interest, and penalties a taxpayer could pay to HMRC on a disclosed fraud. Of course, every case is different but, as a rule of thumb, the amount payable is usually not far off the amount of income or gains that was previously undisclosed.

The main reason for this is that the taxpayer is likely to be chargeable to at least the higher rate
of tax on the undisclosed amount, and it is more likely that the undisclosed amount is chargeable
to income tax (and potentially national insurance)
as opposed to capital gains or corporation tax.
The fraud is likely to have gone on for some time, therefore interest on the tax will have accumulated and the rate of penalty is unlikely to be far off 70 per cent of the previously undisclosed tax. As a result,
it is sensible to let the client know they will be liable for a significant tax bill on conclusion of the COP9 and so should start to consider how to pay it.

Outline disclosure

Too often these are hurried. The more care taken and detail provided in the outline disclosure, the more cooperation you show to HMRC. While this doesn’t sound like a lot, showing cooperation does a great deal to appease any misgivings HMRC will have, given the nature of the investigation.

This is often overlooked by those handling COP9 investigations. Many see HMRC as the enemy, and if you treat it as such with regards
to a COP9 investigation, it will almost certainly respond poorly and deem this proof of poor cooperation. If HMRC takes that view, then along with admitting fraud and paying a large amount of tax, interest, and a hefty penalty, the taxpayer’s details will be published in the public domain.
For some this is simply irritating, but for those whose reputation is currency (celebrities, politicians, and those in the professions), this
can be painful. Ultimately, if HMRC isn’t satisfied then it is the taxpayer who suffers.

When putting together an outline disclosure, where the facts are available, I almost always treat it as a formal disclosure. While a 60-day window for a response is short and certainly doesn’t
allow for a full investigation into complex cases,
it does provide enough time in most cases to put together a response that will provide HMRC with enough comfort not to request a formal report. SJ

Thomas Adcock is a tax partner at chartered accountancy firm Carter Backer Winter