Taxation logo taxation mission text

Since 1927 the leading authority on tax law, practice and administration

Farthings revisited

16 June 2005 / John Cassidy
Issue: 4012 / Categories: Comment & Analysis , HMRC powers
JOHN CASSIDY examines the parallels between a landmark pre-self-assessment tax investigation and the present day.

TWO THINGS HAVE recently reminded me of one of the best known cases in the field of tax investigations. In 1996, in Mr and Mrs Scott (trading as Farthings Steakhouse) (SpC 91), the taxpayers caused quite a stir as they were the first taxpayers to whom costs were awarded by the Special Commissioners because the Inland Revenue had acted 'wholly unreasonably'.
The first reminder came on 16 March 2005, when the Government published a consultation document on the administrative burden faced by small companies, 'Working towards a new relationship: a consultation on priorities for reducing the administrative burden of the tax system on small businesses', alongside the 2005 Budget. One of the issues featured in that document is the tax enquiry régime under self assessment. It is envisaged that the risk-based approach to opening enquiries will become more sophisticated than it is now, with the intention that this will lead to better targeted enquiries.
A logical conclusion of a focus on statistical risk is that more investigation resources will be focused on businesses whose declared results diverge from the norm that HMRC expects, or the average obtained by similar businesses. That is, in part, what led to Farthings Steakhouse being investigated. In that case, the Inland Revenue relied heavily on 'business economics exercises', i.e. assumptive calculations of undisclosed income, predicated on the basis that the gross profit margin on sales should have been higher, that is nearer to the margin allegedly being achieved by similar businesses in the area.
The second reminder was the Readers' Forum query T16,588 submitted by 'Squeezed Dry', Taxation, 14 April 2005. From the query, we learned that Squeezed Dry is a market trader selling fruit and vegetables who has been the subject of an Inland Revenue enquiry in which, like Farthings Steakhouse, it is alleged that his gross profit margin should be somewhat higher than it actually is. Other similarities include:

  • the trader does not have a till;
  • the trader has already put forward specific reasons for the apparently low gross profit margins;
  • there are high wastage levels;
  • simple, but adequate (according to the taxpayer) books and records have been kept.

This article is not designed to be specific advice to Squeezed Dry and I have no further knowledge of the details of that case. However, it reminded me of some of the key issues in Farthings Steakhouse and I think that this pre-self-assessment case is worth revisiting, as there are various aspects of it that will strike a chord with practitioners today, some nine years later.

Background to Farthings Steakhouse

Farthings Steakhouse commenced in business in 1982. At the time of the Special Commissioner's hearing, Mr Scott was the restaurant's only cook and Mrs Scott alone handled all the takings. A basic record keeping system was followed which involved entering details of the day's bills, at the end of each day, into an exercise book with those details being written up in an accounts book at weekly intervals. The restaurant had no till and Mrs Scott rarely banked coins but saved them and, at intervals, converted them into notes via the petty cash. In addition, until shortly before the 1996 hearing, copies of customers' bills were not retained after full details had been entered into Mrs Scott's exercise book.
An investigation began into the 1993 accounts with the Revenue asserting that the gross profit margin should have been around 70%, in line with the tax district's alleged experience of margins for other restaurants in the area. The actual profit margin was consistent at about 50% year on year. Due to this apparent discrepancy, estimated assessments were duly raised and appealed against to the Special Commissioners. It should also be noted that, at the suggestion of the Inspector, Mrs Scott began to retain customer bills and no significant alteration in the gross profit margin subsequently occurred.
Even from this brief summary, it is not difficult to see the similarities to Squeezed Dry and easy to conclude that today such a business would face an increased chance of selection for enquiry based on an HMRC risk assessment.

Business records

Contrary to the impression enquiring Inspectors sometimes give, it is not a legal requirement that all businesses must maintain reams of paperwork and complex business records. Nor is it valid to argue that if, say, a business does not have a copy of the daily till roll (or a till at all), the records are inadequate and large adjustments must therefore be made.
TMA 1970, s 12B requires a business person to 'keep all such records as may be requisite for the purposes of enabling him to make … a correct and complete return …'. These must include records of all amounts received and expended on goods or otherwise together with details of what matters those receipts and payments related to. Crucially, the legislation does not stipulate what form the records must take or that it is impossible to maintain proper records without a till.
Broadly, a business person must retain records that are adequate to show the income received and expenditure incurred during a given period, thereby enabling that person to complete a tax return correctly. If the nature of a small business dictates that this can be achieved by maintaining a basic cash book, nothing further is required. As long as the records are properly maintained, then no amount of peer comparison or business economics exercises can alter the figures.
As for using alleged 'normal' gross profit margins in an attempt to discredit basic records, one of the respondents to Squeezed Dry quite rightly stated that '… these are averages and cannot be blindly applied to all cases. It is the nature of an average that some traders will report results above this figure and some below'. All business people are individuals and operate in their own ways. For example, some may be first class negotiators and obtain excellent discounts from suppliers whereas others, like Squeezed Dry, may have to change their purchasing habits due to external forces, such as a local supermarket opening in direct competition.
I am not suggesting that only the bare minimum records ought to be maintained. Businesses may decide to keep more paperwork for many reasons, including staving off over-zealous tax Inspectors, but as long as those records are accurate and properly maintained, the Inspector should not be able to make a valid challenge to them.
It is not always that simple. In reality, Inspectors often make life unnecessarily difficult for the taxpayer by pursuing arguments in the full knowledge that the taxpayer does not have endless resources, or assuming that basic records are inadequate and that this justifies inflating the gross profit. In Farthings Steakhouse, the Inspector argued that the reported gross profit margin was too low and a lack of prime accounting records meant that significant adjustments were justified. In fact, although the prime records were basic, they had not been 'broken', were adequate for the small business concerned and proper accounts had been prepared from them.
In a modern self-assessment enquiry into a small business, is the Inspector likely to be prejudiced from the outset if there is no till or copies of customers' bills are not retained? Indeed, are HMRC likely to consider such small businesses as risky for the same reasons? The answer to both questions is probably yes. Squeezed Dry states that the Inspector has already concluded that proper records of sales have not been kept because there are no till rolls. Although we do not know if there are other facts to reinforce the Inspector's view, as Farthings Steakhouse demonstrates, the two do not necessarily go together.

Business economics exercises

In some cases, it may be that the Inspector has gathered independent evidence indicating that records are inadequate or that the declared profit margin is too low. In Farthings Steakhouse, various calculations were undertaken by the Inland Revenue in an attempt to justify higher assessments. However, these contained fundamental errors, such as the failure to read relevant correspondence on the taxpayers' files and even failing to add correctly columns of figures. In addition, the Inspector's calculations and investigations had failed to unearth any additional banked receipts, expenditure or increase in capital that had not been accounted for.
An extract from the old Investigation Handbook, para IH1975, was used in evidence on behalf of the taxpayers to highlight the Inland Revenue's own warnings to its staff when using business economics exercises. The current Enquiry Manual still recognises that the results of such models in isolation will not be conclusive without the underlying records having been discredited; see para EM3502.
The moral is that the Revenue's figures and calculations should never be taken at face value and should always be checked carefully. Valid explanations for differences to the perceived norm should also be noted and put to the Inspector with a written log being kept of such instances. Such additional data may prove invaluable in demonstrating that the Inspector's calculations are based on flawed assumptions or that an unreasonable stance has been taken.
In extreme cases (like Farthings Steakhouse), where an Inspector persists with an untenable argument, this could constitute 'wholly unreasonable' conduct and merit redress in the form of an award of costs to the taxpayer. The awarding of costs in such cases remains disappointingly rare.

Wastage levels

Different businesses in the same sector have different levels of wastage. There are many reasons for this, such as misjudging the market and ordering too many perishable goods or, perhaps, a desire to maintain high standards. Squeezed Dry apparently has potentially quite high wastage levels but there is a good reason for this: ripe fruit with a shorter shelf life is bought at a discount in order to be in a position to undercut the relatively new supermarket.
In Farthings, the Inland Revenue also argued that wastage was unduly high. However, Mr Scott had experienced problems with suppliers over the years and had to dispose of a significant proportion of the steaks supplied. In addition, he was extremely pernickety about the steaks and operated to high quality standards. Hence, there were commercial reasons why wastage was high and, as the Special Commissioner put it, 'that is no crime'.

Joined-up enquiries

The small company consultation document also confirms that joint inspection visits to businesses are being trialled. An earlier document termed an 'advice note' confirmed that until new powers for HMRC are finalised (see Ian Mills' and Martin Bradney's article 'New powers for a new era, Taxation, 26 May 2005, page 201), a single officer of HMRC may want to inspect records relating to a number of different taxes at one time or alternatively, different specialists will review different taxes at the same time.
The investigation into the Farthings Steakhouse was pre-self-assessment and was, therefore, not restricted to the tax returns of Mr and Mrs Scott. It turned out that PAYE had not been properly operated on waitresses' tips. However, this was accepted as being due to a lack of knowledge, rather than anything more nefarious, and was remedied once the error was discovered. Under the proposed joined-up enquiry régime, one suspects HMRC will regard errors found in one area, for example, VAT, as a risk indicator requiring investigation of other records. If we eventually reach the stage of one combined return for all business taxes, an innovation that I am sure would keep all advisers on their toes, will HRMC officers be able to confine themselves to aspect enquiries alone? I doubt it, but as Farthings Steakhouse demonstrates, an error in one area does not necessarily mean the taxpayer has underpaid tax in others.

Justified enquiries

In a recent speech to the CBI, Gordon Brown promised that the regulatory reforms flowing from the Hampton Review would mean 'no inspection without justification, no form filling without justification and no information requirements without justification'. Yet in Farthings Steakhouse, the Special Commissioner noted that business economics exercises alone can rarely, if ever, justify the sort of attack mounted by the Inland Revenue in that case.
We can only hope that, in the future, enquiries made under HMRC's risk-based approach are justified on a rather more specific basis than simply a business's failure to meet economic norms. If not, the true administrative burden on many small businesses is more likely to rise than fall.   
John Cassidy is a tax partner at PKF (UK) LLP, specialising in tax investigations, and can be contacted on 020 7065 0455, e-mail:

Issue: 4012 / Categories: Comment & Analysis , HMRC powers
back to top icon