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KEY POINTS
- The scope of service company has been narrowed for the 2007-08 tax return.
- Questions on the tax return should relate to an aspect of the tax legislation.
- What is a tax return for?
- Is it all right to leave the service companies question blank?
The distinction between 'the world that HMRC would like to inhabit' and the world in which we currently live, was noted by Andy Wells of Mercury Tax Group in a recent article in Tax Adviser.
While the rules of engagement in the latter world are steeped in legislation and the rule of law, we can often get a glimpse of the former world by reading HMRC guidance.
A good example of the differences between the two worlds is the new 'question' on this year's tax return under the heading of 'Service companies' requesting:
'[the] total amount of any income included anywhere on this tax return, derived from the provision of your services through a service company'.
That it should come to this
One of the Government's main targets in the past decade in its crackdown on what it considers to be unacceptable tax avoidance is the service company. First, we had IR35, then we had the revised interpretation of how the settlements provisions applied: a matter that was eventually resolved by the House of Lords last July.
Then, partly because of the wholly unhelpful way in which the IR35 provisions were introduced, we have had to consider the legislation dealing with managed service companies.
And, fourthly, over the past year, we have had the spectre of legislation designed to reverse the benefits of 'income shifting', provided that any such income shift occurs in a business context.
In case that is not enough to tell the entrepreneurs of this country to give up the ghost, this year's tax return has added to their woes.
Wild and whirling words
In view of this recent persecution of personal service companies (under IR35) and managed service companies, it would be reasonable to assume that the question concerns such entities and not those registered with Companies House that happen to operate in a service industry.
However, if one reads the guidance notes that accompany a tax return, it soon becomes apparent that, in fact, income from any type of company providing personal services is required. The guidance notes do continue, however, by stating that such income 'including employment income and dividends' is required only if the taxpayer concerned owns shares in the company. (Given the drive to increase employee share ownership, I would have expected many individuals to come within this category.)
Following discussions with the Institute of Chartered Accountants in England and Wales and the Chartered Institute of Taxation, HMRC now admit that the original guidance was unclear and they have now produced revised instructions.
First, they have now narrowed the scope of what is meant by a service company for the purposes of this entry on the tax return and, secondly, they have now decided that no entry is needed if all the income 'derived' from the company is employment income.
Foul deeds will rise
While it is always possible for individuals to try their best to comply with HMRC guidance, the unusual aspect of this question is that it does not sit comfortably with any statutory test. We are all happy adding up individuals' dividend income and inserting the total on the tax return, because we know that dividend income is one of the elements that go towards an individual's taxable income, from which the individual's tax liability is calculated; it is the same with the profits of an individual's profession, trade or vocation.
Furthermore, because we know the importance of the distinction between employment income and income from a self employment, we have no qualms about ensuring that the two are separately returned (except where the status of the worker is difficult to discern or where special rules override the normal differences between the two).
However, when it comes to the service companies question on the tax return, we have no underlying statutory guidance to help us. In particular, the question is clearly addressed at entities that fall outside the scope of the IR35 rules (which do not actually refer to the term 'service company') or the meaning of managed service company as found in the MSC legislation.
I am also confident that the question is not concerned merely with companies that come within the only other statutory example of the term being used (ITEPA 2003, Sch 2
para 29(2)).
In my view, the fact that the question does not seem to relate to any particular aspect of the tax legislation is an enormous clue as to how the question should be tackled.
Gave us not that capability
Older tax advisers (for this, I mean anyone who has nostalgia for the 1970 (or even the 1952) consolidation of the tax code) will remember when tax returns required individuals to list the assets that they had acquired in the tax year to which the return related.
I remember in my early days of chartered accountancy finding this record of acquisitions of considerable assistance when dealing with any subsequent disposals (as well as checking that investment income had been fully returned). However, much to my surprise, the question was soon omitted from the return.
I was advised that the reason for the omission was that the former Inland Revenue did not have the right to ask for such information. With that in mind, I have therefore considered whether or not the question on this year's tax return can be dealt with in a similar fashion.
The purpose of a tax return is found in TMA 1970, s 8(1). It is explicitly stated that a return is to be made by an individual 'for the purpose of establishing the amounts in which [the individual] is chargeable to income tax and capital gains tax for a year of assessment and the amount payable by him by way of income tax for that year'.
Section 113(1) provides that the Commissioners for HMRC shall prescribe the form of a tax return. Section 113(3) goes further and provides that any document required to be used in assessing tax shall be in the form prescribed by the Commissioners and such documents shall be 'valid and effectual'.
In my view, s 113(3) does not relate to the actual form of a self assessment return as this is covered by subsection (1). However, the key to understanding s 113 is that it does not permit HMRC to ask taxpayers whatever they like. It merely provides that the mechanics of designing and approving a form to be used as a tax return is a responsibility that falls upon the Commissioners. Such a form must satisfy the purpose set out in s 8(1), i.e. to establish an individual's taxable income and capital gains and to assist the calculation of the individual's tax liability as a result.
With this in mind, it puts the service companies question in a wholly different light. Not only is the question totally unclear, and its lack of clarity is a result of the fact that the question does not tally with any specific aspect of the tax code, but answering the question will not assist in the task of establishing a person's taxable income (or gains); nor will it help to establish a person's liability to tax.
For this reason, it is my view that the question is ultra vires.
Words without thoughts
Clearly, however, HMRC have a reason for asking the question. It might be for the purposes of providing statistical information. Alternatively, (and the cynics would suggest that this is the more likely option) it might be to allow HMRC to identify which taxpayers' returns are more likely to be incorrect, so that they can then confirm the 'correct' levels of taxable income and the 'correct' tax liabilities arising.
The true answer can be found in the joint guidance prepared by the ICAEW and the CIOT in the form of frequently asked questions which accompany HMRC's revised guidance. From the answers to those FAQs, it becomes clear that the purpose for the question was to assist HMRC in monitoring the compliance of the IR35 and MSC rules.
However, HMRC have deliberately cast the net more widely than companies that are within those sets of rules. Furthermore, those answers make it clear that the term 'service companies' in the question, and the guidance, is a red herring.
However, as the professional bodies implicitly acknowledge, that is mistaking the taxpayer's role of assessment (when completing the tax return) and HMRC's duty to police the system through the enquiries mechanism.
In the course of an enquiry, HMRC have considerable powers that they can exercise to compel the provision of such information, i.e. under TMA 1970, s 19A, although it should be noted they do sometimes seek information not covered by that section. However, those powers are matched with rights that the taxpayer can exercise to ensure that the powers are not improperly exercised.
Therefore, if HMRC wish to ascertain how much of an individual's income derives from a particular type of company, HMRC have every right to ask for it. However, such a request must come within the scope of an enquiry. They may not circumvent the enquiry rules by including extraneous questions in a tax return.
Honoured in the breach
In view of the 'previous' lack of clarity concerning the question on this year's return, HMRC have recently announced that taxpayers who have already submitted their 2007-08 tax returns need not worry about revisiting their returns.
In particular, they confirm:
'There will be no adverse consequences simply because you… left blank… the question in a return filed prior to today's date [presumably, the date that the revised guidance was published, being 5 September 2008]'.
However, given the lack of statutory basis for the question, it is my view that the question can be safely left blank in any event, irrespective of the date of submission. While penalties can be imposed for the failure to submit a return by the due date, it is my view that a penalty cannot be imposed where the only failure is to comply with a request that is ultra vires. Therefore, a return that is complete but for the question on service companies is a complete return.
It is not, nor it cannot come to good
It has been suggested that HMRC are aware that their request for information concerning income from service companies is on rather shaky ground.
Whether or not this is the case, HMRC no doubt regard this as a mere temporary glitch on the basis that any missing link is now provided for by the FA 2008, Sch 36 para 1(1) (or will be, once the relevant commencement order under FA 2008, s 113(2) is in place). Paragraph 1(1) reads as follows:
'1(1) An officer of Revenue and Customs may by notice in writing require a person ('the taxpayer'):
'(a) to provide information; or
'(b) to produce a document;'if the information or document is reasonably required by the officer for the purpose of checking the taxpayer's tax position.'
Therefore, at some point in the not-too-distant future, HMRC will be able to ask a taxpayer to provide information that may be reasonably required by the officer to check the taxpayer's tax position.
Thus, para 1(1) will permit HMRC to ask taxpayers how much of their income in a particular year does actually derive from companies that satisfy certain criteria (whether or not those criteria strictly correspond with any statutory test).
Whereas we currently inhabit a world in which such questions may not generally be asked outside the scope of an enquiry (or, at least, taxpayers are not currently compelled to answer such questions outside an enquiry), Sch 36 takes us into new territory. In particular, para 21 provides that taxpayer notices (being requests for information under para 1(1)) may now be given before a return is submitted.
Thus, it will not be ultra vires for HMRC to make requests for such information after 5 April 2009 (assuming that Sch 36 is by then in force). However, two points are worth making.
First, the request (while physically found on a tax return) will not be part of the statutory return, for the reasons set out above.
More importantly, Sch 36, para 29(1) provides taxpayers with a right to appeal against taxpayer notices.
Therefore, if my 2009 return contains a request for the income I derive from a service company (however that may be defined on the return or in the accompanying guidance), I will not hesitate to appeal against the notice. After all, making an indiscriminate request of all taxpayers cannot be a reasonable use of the powers in para 1.
Keith Gordon MA(Oxon), FCA, CTA (Fellow), barrister practises from Atlas Chambers (020 7269 7980). Keith can be contacted by email at keith@keithmgordon.co.uk.
