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The Actuary The magazine of the Institute & Faculty of Actuaries

Tax: An uneasy partnership

The self-assessment tax regime started life some 10 years ago and monitoring of the system 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 among a portfolio of mainly corporate ‘customers’. Inspectors tended therefore to spend their time reviewing company tax returns rather than their few partnership cases – as this was the work with which they were most comfortable, and indeed on which their training was focused.

Now, the newly-established specialist units will turn their attention specifically to partnerships and their tax affairs. The inspectors in these units deal only with partnerships and limited liability partnerships (LLPs), and are gaining a bank of experience in this area.

At the same time, HMRC has 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 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. The current rule of thumb seems to be that 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 systematically undergo an enquiry at least every three to four years, 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. 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 to 40 days and, typically, one would expect to see perhaps three or four exchanges of correspondence, depending on the complexity of the case.

At this stage, the information provided by the firm, usually via its accountant, may be enough to satisfy the inspector and end the enquiry, or agreement is reached as to appropriate adjustments. 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 advantageous for their accountants to hold any meeting with HMRC alone, rather than with representatives of their management or accounts department staff. If a resolution still cannot be agreed with the inspector, any dispute is put before the tax commissioners with subsequent appeal via the court system.

Enquiry details
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 – for example, to identify if any entertaining costs have been miscategorised as marketing, advertising or conference costs. Unlike advertising costs, entertaining costs are not eligible for tax relief
>> Reviewing whether items that should be treated as capital items for tax purposes are included in revenue costs – for example, 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, such as 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 outfitting 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 – for example, 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 is of the firm view that such costs are not deductible and this is being driven from their head office. It is a matter on which they are taking internal legal advice 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 is leaving the enquiry open in the likelihood that a case will be taken to the courts in the next year or two.

Mind the GAAP
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.

LLPs, of course, have to prepare their accounts in accordance with UK GAAP – unlike partnerships that 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. As sizeable LLPs will have been obliged to have 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, therefore 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 has 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, not delaying tax by delaying income recognition and not accelerating recognition of expenses and therefore trying to accelerate tax relief.

In conclusion, those firms operating as partnerships or LLPs will find their tax affairs subject to closer study 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 detail than previously.

Louis Baker is the lead partnership tax partner at Horwath Clark Whitehill. He is a member of the Tax Committee of the Association of Partnership Practitioners and the personal tax committee of the Institute of Chartered Accountants in England and Wales.