A Step Too Far

JOHN CASSIDY suggests that Inspectors are making requests for information which are really outside the scope of a corporation tax self-assessment enquiry.

THE INLAND REVENUE'S disappointing approach to full self-assessment enquiries into close companies was discussed by Mark Morton in his excellent article 'Overstepping The Line' in Taxation, 17 January 2002 at page 356. Mark's experiences mirror my own in dealing with some Inspectors undertaking enquiries into close companies; I agree with the points raised and conclusions drawn. Incidentally, the Inspector in Mark's case requested sight of all of the company's records, not just those relevant to the tax return such as accounting books. This seems excessive, particularly at the opening stage of an enquiry.

The purpose of this article is not to provide a reference work or definitive answers but to approach the issues from a slightly different angle and introduce some additional thoughts. It is hoped that this opening salvo will promote further debate on the Revenue's approach to these enquiries. It would be helpful ultimately, perhaps following such debate, to reach the stage where demands from different Inspectors are consistent, relevant and specific to the business in question and acceptable under the legislation as it stands.

Personal records

As already mentioned, Inspectors are insisting on a review of the personal records of the directors at the outset of enquiries into close companies. Where this is resisted, enquiries into the directors' personal tax affairs may be opened and documents requested under section 19A, Taxes Management Act 1970. There may, however, be grounds for not providing this material, even if it has been formally asked for under that section.

Under section 19A, the only documents which can be demanded are those needed to determine whether that person's income tax return is incorrect or incomplete. The records cannot be demanded for any different reason, for example to help facilitate the enquiry into the company's return. The Board of Inland Revenue's guidance given in the Investigation Handbook at paragraph 2937, which covers requests for directors' bank accounts during corporate enquiries, states that the appropriate statutory authority for such demands is section 20(3). However, that paragraph emphasises that that is only the case if an enquiry has not been opened into the particular director's own tax return; if such an enquiry has been opened, the guidance given is that section 19A should always be used in preference. That is not correct. As noted above, personal documents cannot be sought to help the working of the enquiry into the company. In fact, paragraph 2937 of the Investigation Handbook was amended only last July. Previously it clearly recognised the issue, the old wording being:

'Where, in order to check that a company's return is correct and complete, you need to examine the private financial accounts of the director(s), you should normally request the information as part of your enquiry into the company. You should normally only open a section 9A enquiry into the director's own return if you want to enquire into it on its own merit …'

That paragraph also stated:

'Where your motive for requesting private details of the director(s) is to check the company's return, the appropriate statutory power will be section 20.'

It is clearly arguable that requests for personal records can, therefore, be resisted, even if made as part of a separate income tax self-assessment enquiry. The key issue is the Inspector's motive, which is usually obvious in these circumstances. In order to obtain a notice under section 20(3), the power to call for documents from third parties, the Inspector will require the consent of a General or Special Commissioner. Consent will not be given without the Commissioner being satisfied that, in all the circumstances, the Inspector is justified in proceeding under that section.

Records examination - a re-audit?

Inspectors are keen to look at the underlying accounting records of close companies under enquiry in great detail to establish how those papers translate into the financial statements. The records examination envisaged by the Inspector described in Mark Morton's article corroborates this point. Such a detailed review, tracing data in source documents through the company's system to their eventual inclusion in the published accounts, appears to be a re-audit of the company's accounting books. In an address given in late 1998, John Gribbon, as director of Inland Revenue Compliance Division, stated that the Revenue would not be conducting an audit, and that the department's job was not to second guess the company's auditor. Regardless of this, it is clear that some Inspectors do see their role in these enquiries as being to check the accounting system and the accuracy of the figures included in the financial statements.

Under paragraph 27(1) of Schedule 18 to the Finance Act 1998, only documents reasonably required for the purposes of an enquiry can be obtained. The purpose or scope of the enquiry is restricted by paragraph 25 of that Schedule to checking the accuracy (or otherwise) of the company's form CT600 and supplementary pages. That return is normally generated using the company's financial statements together with detailed analyses of entries therein, such as legal and professional fees and fixed asset movements. It is not based on source documents such as invoices and delivery notes. Is it right, therefore, that such documents and accountants' link papers should be provided at all? By demanding this data, the enquiring officer is seeking to establish a route from the raw data to the entries in the return. The definition of link papers given by the Revenue as 'those papers which show how the figures in the return are derived from the figures in the prime records …' demonstrates this.

It is accepted that Inspectors have to be satisfied that the full amount of profit is taxed. In most circumstances, however, that means examining the profit before tax as reported in the published accounts, adjusted as necessary to comply with specific tax rules. It is also accepted that ten accountants, given the same raw data, would inevitably end up with ten different sets of accounts. That is because estimates and judgment calls are necessary when preparing financial statements, and these are matters in which an auditing accountant is trained. A single set of undeniably correct figures will never exist, but a fully audited and unqualified set of accounts should represent an acceptable package. Some enquiring officers seem to be totally ignoring the published accounts from which the returns were prepared. By way of analogy, in an income tax self-assessment enquiry, an Inspector would rely on a dividend voucher; he would not study the underlying data on which it was prepared in order to ensure that the correct amount of income had been calculated and allocated to the taxpayer and eventually recorded in his tax return. It is not his role to check the voucher itself.

It seems that little or no reliance is being placed on unqualified audit reports. Under section 237(1), Companies Act 1985 auditors' duties include the carrying out of such investigations as will enable them to form an opinion as to:

• whether proper accounting records have been kept; and
• whether the company's accounts agree with the accounting records.

An unqualified audit report therefore ought, in theory, to satisfy any enquirer on both these issues. If the Inspector is not effecting a re-audit, why does he seek to use base records and link papers to check the accuracy of the tax return, rather than place reliance on the unqualified audit report? Acting in this way, he is making sure that the translation of the basic source documents and accounting books into the financial statements has been done correctly, and this is essentially a re-audit.

The Revenue itself recognised, in Tax Bulletin 37 issued as long ago as October 1998, that any company satisfying the record keeping requirements of the Companies Act will have satisfied the requirement to keep and preserve records for corporation tax purposes. The inevitable implication overall must be that, as proper accounting records have been maintained, they are reliable and sufficient for the company in question. Why then cannot the accounts be accepted as they stand, with detailed breakdowns of income and expenditure provided as necessary enabling verification that entries within those accounts have been treated correctly from a tax perspective?

In a period when the audit profession is increasingly under the microscope, it is possible that Revenue officers will seek to test the credibility of base records in ever greater detail. It is vital that auditors should be able to back up their conclusions by demonstrating that appropriate testing was undertaken and proper audit evidence obtained. Anything less may leave the auditor's standards, as well as the published accounts, open to question.

Two specific areas on which enquiring officers seem to focus during close company enquiries are materiality and accruals.

Materiality

Materiality is, according to Statement of Auditing Standards 220, an expression of the relative significance or importance of a particular matter in the context of the financial statements as a whole. A matter is material if its omission would reasonably influence the decisions of an addressee of the audit report, i.e. the members, but in practice this ought to be taken as meaning the users of the published accounts. The Revenue does not have a formal policy on materiality, instead leaving it to individual Inspectors to decide what they consider to be material. This paves the way for inconsistencies depending on which particular Inspector is effecting an enquiry. It also seems to give Inspectors the prerogative to challenge the financial statements by substituting their own judgments in place of those of auditors. This is precisely what Mr Gribbon stated would not be happening, i.e. that the department's role was not to second guess the company's auditor.

It is known that situations have arisen where the Inspector has attacked small accounting errors that may or may not have been unearthed during the audit, but had not been adjusted in finalising the accounts. One of the reasons for not making an audit adjustment is that the amounts involved are immaterial; for all the small errors in one direction there will in all likelihood be compensating amounts going the other way. Regrettably, the approach of enquiring officers seems to be to search out minor amendments in the Revenue's favour, ignoring any balancing adjustments. Would it not be preferable all round for Inspectors to recognise materiality, thereby ignoring otherwise adjustable items below the auditor's threshold on the assumption that other, equally immaterial but opposite, amendments probably exist? This would save time, effort and argument, as well as costs to the client that can otherwise be considerable and perhaps disproportionate to the size of the company and/or to any proposed adjustments. As noted above, auditors must be able to support judgments made by them in respect of both the materiality level chosen and the significance of individual aspects of the financial statements, whether qualitative or quantitative.

Accruals

Inspectors seem especially keen to attack accruals and prepayments. They have sought to make tax adjustments because the entries (again in the Revenue's favour only) were not entirely accurate, albeit inexact only by small amounts. When preparing all but the simplest of financial statements, a degree of imprecision is inevitable because of inherent uncertainties and the need to use judgment in making accounting estimates and selecting appropriate accounting policies. Using hindsight to investigate and question the exactitude of an accrual or similar item amounts to checking the accuracy of entries in the accounts, or re-auditing them. It cannot be right to substitute a test of precision for honestly made judgments at the time the accounts were finalised and the audit report signed.

Such an attack by the Revenue on those accounting entries is again a demonstration of a lack of faith in the audit report. It is worth stressing that accountants and auditors must be able to demonstrate that their calculations and conclusions at the relevant times were reasonable, and that a balanced view was taken. If the enquiring officer uncovers a tendency always substantially to over-accrue, the auditor's assumptions, interpretations, judgments and general probity may be called into question along with the credibility of the financial statements.

Actual role

The amount of documentation and information that can be 'reasonably required' at least during the opening stages of a full enquiry is limited. Perhaps nothing more than a detailed profit and loss account and analyses of expense and balance sheet, etc. headings should initially be required in the absence of a qualified audit report. It is not an Inspector's role under the self-assessment régime to re-draft the accounts on the basis of a re-audit of the company's accounting books and records.

In addition, it is arguable that personal records of close company directors should not be demanded under the guise of an income tax self-assessment enquiry where it is clear that the motive for that request is to assist the Inspector's enquiry into the company.

It is not being suggested that a robust stance be taken automatically, as that could lead to disproportionate expense, stress, conflict and general unpleasantness. As Mark Morton noted, the holistic approach avoids the need for several piecemeal enquiries and is often sensible. However, there may be times when the Inspector abuses the goodwill demonstrated by the taxpayer and his agent in adopting this comprehensive approach. It may even be that some Inspectors have been allowed so much leeway in effecting old-fashioned full investigations into all financial aspects of companies and their directors (even after corporate self assessment commenced) that they believe that such an approach is their right and is appropriate in all cases. It is not. As Treasury Minister, Andrew Smith, said on 9 January 2002:

'The Inland Revenue carries out inquiries, as opposed to investigations, into tax returns …'

There is a difference; the scope of a self-assessment enquiry into a company, close or otherwise, is restricted by paragraph 25 of Schedule 18 to the Finance Act 1998, whereas an investigation under the previous régime is not. Encouraging Inspectors not to demand at the outset of an enquiry each and every piece of paper making up the company's accounting records may prove beneficial to all parties in the long run. One reason why such demands are made is, perhaps, because it is perceived by Inspectors to be easier and less time consuming to ask for everything simultaneously at the beginning. They should, however, be encouraged to think about the specific characteristics of the particular company in question and the business field within which it operates. All actions and requests by Inspectors as part of self-assessment enquiries should be effected within the framework of a limiting legislation and restrictions imposed by the Board of Inland Revenue's internal instructions to its staff.

John Cassidy is a senior manager in the tax investigations unit of PKF in London. John can be contacted on 020 7831 7393; e-mail: john.cassidy@uk.pkf.com.

Issue: 3849 / Categories: