HMRC investigations: How to prepare

If it feels as if small businesses are increasingly a focus of HMRC tax investigations, that’s because they are. And according to tax gap statistics, there’s good reason.

The tax gap in 2021/22, an HMRC report says, was estimated to be 4.8%, or £35.8 billion. That’s a good sign in terms of taxes collected, with HMRC having brought in 95.2% of taxes due. In 2005/06 the tax gap was 7.5%, meaning the recent figures are a dramatic improvement.
So, what does this have to do with SMEs?

The problem for small operators is that they are said to be responsible for the lion’s share of the current tax gap – more than half, in fact. HMRC puts the SME proportion of the estimated 2021/22 tax gap at 56%. Large businesses shoulder only 11% of the debt.

Small businesses have always been responsible for the largest portion of the tax gap, but that portion has been increasing steadily, from 40% in 2017/18, to 46% in 2019/20, to 56%, today.

HMRC, it seems, is determined to reverse that trend.

And money spent on tax investigation is a good investment for HMRC.

Depending on who you believe, for every pound spent by HMRC on tax investigations into individuals and small businesses, the tax office receives between £6.60 and £16 back.

It’s nowhere near the amount returned when large businesses are investigated – £56 for every pound spent – but it’s still significant.

Robin Jarvis, a Professor of Accounting and Finance at Brunel University, says it’s important to remember that the tax gap is an estimate.

“One of the issues for me with these figures is the lack of recognition of the structure of the group known as SMEs,” says Jarvis.

“The field is dominated by micro entities, which are businesses with fewer than 10 employees, and employs 32% of the total working population in the UK. The self-employed represent above half of these micro entities,” he says.

“This is relevant because if you look at the tax gap, maybe one of the issues is that over the past two or three years, there’s been a significant decrease in self-employed people. About 83,000 self-employed people stopped trading between 2021 and 2022. During the COVID period, profitability of those businesses would have declined. Another proportion of the self-employed would have fallen under the threshold of VAT.”

Whoever is responsible for the majority of the tax gap, investigations by HMRC do bring in revenue. When investigations fell as a result of the pandemic during 2020/21, 30% fewer compliance cases were investigated and criminal prosecutions dropped from 700 to 163. That cut tax revenue by up to £9 billion.

At the time, around 12% of HMRC staff had been moved to COVID-related roles. Now HMRC is making up for lost time – and revenue.

How to stay off HMRC’s radar

In last year’s Autumn Statement, “Chancellor Jeremy Hunt announced that the government would spend £79 million over five years to enable HMRC to allocate additional staff to tackle more cases of serious tax fraud, forecast to raise an extra £725 million over that time period,” the Financial Times reported.

Clearly, there’s strong motivation for HMRC to ramp up its investigations.

At the same time, there’s also excellent incentive for small businesses to get their tax matters in order, to avoid unwelcome and potentially expensive attention from HMRC.

There are certain actions small business owners should be aware of because they are likely to attract such attention.

“If you decrease your revenues, HMRC is going to be pretty hot on that,” Jarvis says. “They have general formulas for what people are likely to earn. If you’re a taxi driver, they have an idea of typical income levels. If you’re in that normal bracket, you’re not likely to attract attention.”

He adds that much higher deductions all of a sudden may also look odd, while businesses that venture into complex spaces, such as research and development, may find more questions tend to be asked.

The “exception”, Jarvis says, is far more likely to attract attention than the business that fits all of the usual rules.

How to prepare for a tax investigation

It’s best practice for business owners and sole traders to keep flawless accounting records, particularly via software that retains and files records in easily reportable formats, Jarvis says.

If records of expenses and invoices are well organised and easily accessed, fewer resources will be required during a tax investigation.

Jarvis tells the story of one micro-business owner whose HMRC investigation was greatly simplified by immaculate record keeping. The owner was worried, particularly as his businesses, which sold Chinese porcelain, traded in numerous territories. His very good records, however, enabled him to cruise through the investigation with a minimum of fuss.

“The standard of accounting at the small business level in the UK is pretty good,” Jarvis says, adding that using accountants effectively helps to reduce the need for investigation.

While the business owner risks investigation and penalties in cases of inaccurate or incomplete record-keeping, the accountant risks their reputation with HMRC if they don’t ensure the job is done well – and Jarvis believes the key to avoiding both risks is a good relationship between the business owners and accounting practitioner.

And that’s worth investing in upfront.

“There can be an enormous amount of stress, and there’s also the time factor involved in an investigation,” Jarvis says.