Contractors, be wary of HMRC benchmark letters
It’s long been kept under wraps, but the taxman’s risk assessment process is moving out of the shadows and into taxpayers’ letterboxes in the shape of benchmarking letters, writes Guy Smith, tax investigations manager at Abbey Tax Protection.
Benchmarking – HMRC’s latest tactic
In fact, HM Revenue & Customs has started testing the use of ‘benchmarks’ on selected business sectors, in order to improve voluntary compliance and behaviour by businesses within the targeted sectors.
The department has been analysing the trading accounts submitted by businesses to calculate a series of net profit ratios. The net profit ratios determine the ‘benchmarking range’ as HMRC compares the business results achieved by SMEs in the same sector.
By publishing the net profit ratio benchmarking ranges and common risk areas where the most mistakes are made, HMRC hopes to reduce the scope for errors before tax returns are filed. However, the underlying message from HMRC in the letters to the chosen businesses is clear: If you have received a benchmarking letter and still make mistakes, a tax enquiry is a real possibility.
The net profit ratio
In order to calculate the net profit ratio, HMRC deducts the total expenses claimed from the turnover declared to arrive at the net profit. The net profit is then divided by the turnover declared and multiplied by 100 to arrive at the net profit ratio.
For example, HMRC has used information from the tax returns of all painters and decorators for the last three years to arrive at a benchmark range of between 59-79%. A similar exercise was undertaken on the tax returns submitted by driving instructors to arrive at a range of 31-67%.
The ranges are comparatively wide because HMRC accepts there will be variables between businesses, such as geographical location and niche specialisms.
What do the letters say?
Entitled ‘Helping you complete your 2013-14 tax return’, the Transparent Benchmarking Team within HMRC state: ‘We are testing the use of benchmarks because we think it could help business owners to make sure their Self Assessment returns are correct’ and go on to say, ‘If the net profit for your business doesn’t look right, it could be a sign that some of the figures on your Self Assessment return aren’t correct.’
The common risk areas
Apart from advising the businesses involved to check that all cash payments and other ancillary income has been declared in the turnover figure, the letters refer to items of expenditure which are most often calculated incorrectly:
Are only businesses being targeted?
No. HMRC has also been benchmarking tax returns filed by individuals, which has proven to be very controversial. One thousand letters entitled ‘Your effective rate of tax’ have been issued with the recipients told ‘We can see that your effective rate of tax is lower than the average for people with a similar amount of income to you. This could mean that there is something wrong with your Self Assessment tax return.’
Further into the letter, the individual is asked to ‘Please check that the entries on your Self Assessment tax return are correct and that you have:
- declared all of your income and gains
- claimed the right amount of expenses, deductions and tax reliefs’
Many people who received these letters immediately pointed out that they had made a large one-off gift aid donation during the year, or a pension payment or even carried forward a loss. Several tax advisers have been quoted calling the letters ‘bullying’ in tone and issued in a ‘scattergun’ fashion, without a thorough check of the individuals personal circumstances.
Guidance if you receive a HMRC benchmarking letter
If you have received a benchmarking-style letter from the tax authority, ensure you speak to your accountant or seek help from a professional adviser like Abbey Tax. This is important to do because HMRC has been writing to business owners direct, and not automatically sending copies to the authorised tax agent. Indeed, the letters to businesses state ‘If you have a tax agent (e.g. accountant) please let them have a copy of this letter as soon as possible.’
HMRC has not publicised which business sectors will be targeted next and whether contractors will be subjected to benchmarking. Nevertheless, it is important to be vigilant if such a letter is received because of the possibility of a tax enquiry if mistakes are subsequently made.