The sinner that repents

Key points

• An example of undeclared income from self-employment.
• Should one call for specialist help where there is undeclared income?
• Negotiating a settlement with a local Inspector.
• The relevant factors to facilitating a settlement.
• Settling the Class 2 National Insurance contributions liability.

Don't you fear the dreaded question? I suppose my two sisters have a worse problem; for them, a conversation that starts with 'I hear you're a doctor' is usually heading towards an impromptu and unwanted consultation about something medical. But 'I understand you do tax' can be nearly as bad, particularly when it's from someone you know. Would your friends tell you about their social diseases? Probably not. Would they want you to sort out their fiscal irregularities? Perhaps.

Issues, issues

The trouble is that the next line is rarely 'I would like to give you some lucrative and easy work that fits well within your range of competence'. It's no good discussing your bone problems with a dermatologist, but the public thinks that a doctor is a doctor — the same applies to a tax accountant.

Recently, someone I know socially — I'll call him Geoff — told me that he had not paid tax on all his income, and he would like to put himself straight with the authorities because he was about to get married and he didn't want to enter matrimony with a skeleton in his cupboard. I'm not sure whether he was more frightened of discovery by HMRC or his bride-to-be.

Having failed to stop him mid-sentence, I was faced with several different issues. Anyone who has had a similar conversation — and I suspect that will be many accountants — will be familiar with some or all of them.

• I am a VAT lecturer who prepares a few personal tax returns each year — I have never dealt with disclosure and settlement of undeclared liabilities. Should I simply pass him on to someone else?
• I know the man — can I be properly objective in finding out and reporting the true extent of his misdemeanours? What if HMRC impose a big penalty — will he blame me?
• Should I already be making a money laundering report?
• Is there the remotest possibility of charging a realistic fee for the time involved, whether the work is done by me or by someone else?

I am a sucker for an expression of childlike faith in my ability to help. Geoff knew no one else who dealt with tax, and did not want to throw himself into the arms of someone he didn't know anything about. I told him I would see what I could do.
The one thing that I was sure of was that I could not now tell him to go elsewhere and simply forget about it. I did not know yet whether this was criminal tax evasion or negligence, but if he failed to put things right after I had read the 'Riot Act' to him, it would surely be a crime — and that would require a money laundering report.

The story

I started by interviewing Geoff and taking down as much information as I could. As such things go, and much to my relief, this was very small beer — but it would still require dealing with, and neither the income nor the tax suggested a decent fee.

Geoff was a part-time teacher. He had started tutoring pupils out of school hours a few years ago, and had done nothing about declaring the income. It had been fairly small — maybe three or four thousand pounds a year — until 2006-07, when it had jumped to three times that.

Geoff had never filled in a tax return, and had paid tax under PAYE through the school's payroll. He knew that he was entirely in the wrong and was terrified — literally — of what might happen if the taxman came knocking at his door. His fear of the consequences contributed to his delay — by the time it had sunk in that he really needed to address the problem, he was unable to face doing so. As he dithered, the liability — which he could only guess at — increased, making it harder still to do anything about it. Anyone who has experienced toothache and a fear of the dentist should sympathise.

I gave him the bad news: a potential maximum penalty equal to the tax, plus bits and pieces for failure to notify chargeability to Class 2 National Insurance contributions and what not. He gave me the good news: the great majority of his pupils' parents pay by cheque, and all the cheques had been paid into a building society account. He had a bundle of passbooks going back to 2000. I explained that the Inspector would want to know about cash income, but at least we had a starting point to work from.

It was also clear that he had never done anything to conceal his income. He might have a safe deposit box full of cash or an offshore account in the Cayman Islands, but that seemed unlikely — if he had wanted to hide his tracks, he had gone about it very badly.

Where to start?

Meanwhile, I wondered how to go about making a disclosure. I wanted to do so as quickly as possible, to avoid the worst possible outcome — HMRC choosing this very moment to ask him a question. I sought the views of professional colleagues and a quick and plainly sensible response was given by John Newth: 'do not do this by yourself if you have no experience'. The advice seemed to be: 'find someone who knows what to do. The client may baulk at the level of fees, but it is likely to be worth it in reduced trouble and penalties'.

Fortunately, I knew just such a person, and contacted Mike Down of Baker Tilly, a tax investigations specialist who provides support to small practices.

The choice

What was unfamiliar to me was routine to someone who works in investigations. He reassured me that this could be sorted out before the wedding and without too much fuss, but we needed to go about it the right way. It was possible to write to the tax office that dealt with Geoff's PAYE — but a remote PAYE district might take a long time to think of what to do with the letter, and longer still to come to a settlement. It would be as unfamiliar to them as it was to me.

Mike's recommended alternative was to approach an Inspector at a local tax office with whom he was currently agreeing another settlement. He thought that this Inspector would agree to take the case on and would be likely to deal with it efficiently — it would be routine for him as well. Mike could not guarantee what the attitude to penalties would be, but he was sure that we could finish the job in a few months.

I agreed this approach with the client and Mike set up a meeting. Geoff was enormously relieved that he did not have to attend it. I told him that he might be called for later, but at this point all he had to do was dig out his old bank statements and other records.

The meeting

I got lost on the way to the tax office so I had to brief Mike while walking round the block, rather than in Starbucks as planned. He explained that there would be an Inspector and his assistant and the two of us. He would introduce me and outline the situation; I would give a more detailed account of Geoff's position; he would raise the question of penalties, if the Inspector did not, and point out that this was a wholly unprompted disclosure and a relatively small amount of money with no attempt at concealment, and it should therefore warrant the maximum possible mitigation.

The meeting was formal, but friendly. I suppose the Inspector sees worse cases all the time, and there is joy in HMRC over one sinner who repents. I explained Geoff's situation and why he had finally determined to make an honest man of himself. Mike's suggestion that 100% mitigation of penalties would be appropriate raised a chuckle and the remark: 'we'll have to think about that later'.

The points that seemed to be important to the Inspector were as follows.

• Geoff had never filled in a tax return — he had failed to notify his new source of income, but he had never made a positive declaration that was a lie.
• The amounts involved would not be large enough to make Geoff a higher rate taxpayer in any year.
• It would be necessary to provide evidence of as many of our assertions as possible.
• In particular, it would be useful to demonstrate how significant asset purchases were financed — loans from family, mortgages and other non-taxable sources should be evidenced.
• A substantial and early payment on account of arrears would be likely to influence any decision about penalties.
• It would be appropriate to deal with all the years up to and including 2006-07 by way of contract settlement — for 2007-08 Geoff would come within self assessment as usual.
• The tax office would deal with underpaid income tax and Class 4 NICs. Class 2 NICs were a different matter and would have to be settled separately with NICO, including any related penalties.

The next day I received a set of notes of the meeting as recorded by the second officer, which I agreed as accurately reflecting what we had discussed. Geoff's father provided a loan for the payment on account, which went in a couple of days after the meeting. The next step was for me to prepare a statement setting out the undeclared income and collect appropriate evidence. Mike would only need to get involved again if I needed advice, or maybe help with negotiating penalties.

The letter

I set out my statement in the form of a covering letter with a spreadsheet showing the numbers and narrative notes providing explanations, plus photocopies of various original documents such as Geoff's graduation certificate to confirm the earliest date on which he could possibly have started the business. I plead the Fifth Amendment about the amount of time that went into it: ascending the learning curve on a single assignment that you don't intend to repeat is not good business. I wanted to make sure that it was accurate and obviously so. I decided that I would prefer to do all the work up front rather than provide too little information and leave the Inspector wanting more.

The most difficult part for me, not surprisingly, was the question of cash receipts. It was clear from an examination of the building society books and the bank statements that the basic story was accurate: salary went into one and self-employed cheque income into the other. As long as there were no other accounts — and I had seen nothing to suggest that Geoff was concealing anything from me — the only thing missing was the cash.

Geoff explained that he preferred to charge up front for a series of tutorials, and people paid those fees by cheque. If he charged by the session — when people might give him cash — he suffered more last-minute cancellations and loss of income. So there were only a few customers who he trusted enough to deal with on this basis. He was able to say roughly when he started to tutor their children, so it was possible to make a reasonable estimate of the cash income from the number of sessions in a term, the list of pupils and the rate per session.

In the event, the Inspector raised very few points. The main one was the extent of private use of capital assets — a computer and a motorbike. Geoff had explained to me that he did not use either for anything other than business, and stuck to this when I suggested that the Inspector might want to account for some private benefit. The bike was for getting around to different pupils' homes in the evening, and couldn't be used for shopping; Geoff was a technophobe who bought a computer because parents wanted to communicate with him by e-mail. He was adamant that any private use was wholly incidental to the business purpose. I relayed this to the Inspector, who accepted the explanations as reasonable in the circumstances.

After making a few minor adjustments, we agreed profit figures going back to the start of the tutoring business — six years in all. It was then possible to compute the underpaid income tax and Class 4 NIC, and the interest on that. The interest calculation is a horrible mess — due dates for balancing payments and payments on account, and consideration of whether payments on account would be necessary given the level of PAYE already paid — but it has to be checked, precisely because it is so messy. The HMRC computer came up with a similar figure to mine, so I was satisfied.

Class 2 NICs

Meanwhile, I had sent a separate letter to NICO explaining that I was in the process of settling an underpayment of income tax and asking for the Class 2 NIC position to be rectified. For the first four years of Geoff's business he was below the small earnings exception, so I explained that Class 2 should only be payable for the most recent three years (including 2007-08, even though that was not within the income tax settlement).

NICO asked Geoff for seven years' worth of Class 2 NICs. When I rang to question this, I had a surreal conversation — the officer said, 'So you want us to waive the liability for those first four years, then?' I was tempted to say that this should be obvious, but I bit my tongue and wrote another letter. The liability was reduced to three years' worth.

Done and dusted

Once the figures were agreed, the Inspector rang to discuss the settlement. I had explained to Geoff that the maximum penalty for a failure to notify chargeability was 100% of the tax paid late as a result, but that he could expect substantial mitigation for unprompted disclosure and co-operation, which included a very detailed report and a payment on account that covered the whole of the tax plus interest. The question of 'seriousness' remained. On the one hand, there was no deliberate attempt to conceal the income, and the amounts were not very great; on the other, the failure to notify had continued over several years.

Here I will leave the reader in suspense. I do not want to suggest any particular figure for mitigation that might be regarded as a precedent or an expectation, so I will only say that I thought the Inspector was very reasonable about it and Geoff was happy. He signed his letter of offer, paid his debt to society and joined the ranks of the taxpaying public. All settled a month before the wedding, as Mike Down had predicted.

Afterthoughts

My limited adventure in investigations was an unusually positive experience. I found the local tax office helpful, efficient and reasonable, and willing to accept that Geoff was a truly repentant sinner rather than treating him as harshly as he expected. I have no experience of trying to do the same thing with a remote PAYE district, but my general dealings with those behemoths would not encourage me to expect such a quick and efficient settlement.

I don't think that Geoff will always pay his future taxes with a smile, but I think he holds HMRC in higher esteem than many people do. He feels he has been fairly treated and means to follow the straight and narrow path. I think that's a good result on both sides, and the epitome of tax authorities and profession 'working together'.

On the other hand, I think I will stick to lecturing. Theoretical examples are much less messy than real lives!

Mike Thexton MA, FCA, CTA (Thexton Training Ltd) writes and lectures on tax issues and runs a small practice.
Baker Tilly has a tax investigations helpline, telephone: 0800 032 8374.

Issue: 4180 / Categories: Comment & Analysis