Why HMRC start tax investigations

Reasons for tax investigations

HMRC conducts inquiries into tax returns for many reasons. Some key triggers involve:

Random selection: As part of its efforts to ensure taxpayers comply with their obligations, HMRC randomly selects a subset of self-assessment tax returns for investigation. This approach is designed to promote fairness and consistency across the board by identifying potential areas of non-compliance and addressing them promptly and effectively. The selection process uses a range of data-driven techniques and criteria and is subject to regular review to ensure that it is robust and proportionate. 

Industry sweeps: In the past few years, HMRC has targeted an entire sector, such as IT contractors, electricians, or e-commerce sellers. The approach enables HMRC to focus on a specific industry, ensuring all participants comply with tax regulations and pay the correct taxes. HMRC can identify any widespread non-compliance issues and take appropriate enforcement action to rectify the situation. 

Industry and work type: Jobs where cash payments are common, such as those in the taxi, restaurant, and construction industries, tend to attract much attention to tax compliance and checks. Cash transactions can be more discreet and less traceable than electronic payments, making them more appealing to people who want to avoid taxes or other legal obligations. 

Tip offs: HMRC sometimes depends to a certain extent on information provided by the public about potential instances of non-compliance. These tip-offs can trigger targeted investigations into individuals or businesses suspected of violating tax laws. The information provided by informants can be used to uncover fraudulent activity, tax evasion, or other forms of non-compliance.

Inconsistent reporting: Significant fluctuations in reported income or expenses from one year to the next can raise red flags for investigators. In such cases, any investigation aims to understand the reasons behind the volatility, ranging from legitimate business changes to fraudulent activities. By closely examining the data and conducting interviews with relevant parties, HMRC can determine whether the inconsistencies are due to external factors like market conditions or internal factors such as accounting errors or intentional misreporting. 

Large, unexplained changes in income: With sudden increases or decreases in the income earned by self-employed individuals, HMRC may conduct a compliance check to ensure that the source of the additional income is legitimate and correlates with the business expenses. This may involve a closer examination of the business's records, such as invoices, receipts, and bank statements, to determine the nature and origin of the funds. 

Reporting discrepancies: Tax return figures, bank statement deposits, and amounts reported for benefits do not match, which may lead to confusion and raise questions. These discrepancies could occur for various reasons, such as incorrect data entry, missing information, or fraudulent activities. 

Past issues: When a taxpayer is investigated or penalised by HMRC, the taxman may conduct follow-up inquiries. HMRC guidance rules to ensure that all necessary corrective measures have been taken and adopted. During the follow-up inquiries, taxpayers may be asked to provide additional documentation or information to demonstrate that they have taken the necessary steps to comply with guidance. 

Preparing for a tax investigation  

While anxiety-provoking, tax inquiries don't need to be scary with the right preparation. Steps to take include:

Maintain organised records: Keep detailed books recording payments, expenses, receipts, and other financial data for at least five years. Thorough records make verification easy.

Report accurately: Filling out returns fully and accurately per tax rules leaves less room for suspicion. Using a tax consultant when unsure demonstrates due diligence. 

Request receipt notices: Those selected for investigation receive formal notice by mail or phone. Requesting written notice begins important timelines for response.

Learn investigation rights: Citizens Advice and other organisations offer useful information on taxpayers' rights during an investigation, outlining the inquiry process and available appeal options.

Seek qualified advice: Consulting a qualified accountant or tax advisor helps self-employed individuals understand investigation procedures and submission requirements. Their expertise proves invaluable.

Common issues examined

During a tax investigation, HMRC typically examines certain aspects like:

Income confirmation: Tax Inspectors verify that customer payments match the amounts reported. Undeclared or underreported funds often lead to additional taxes plus penalties.

Expense verification: Business expenses should be done in the due course of business operations. Any expenditure unrelated to business or without evidence will be disallowed, resulting in additional tax to pay. 

Usage of personal vs business accounts: Keeping personal and business finances separate minimises confusion. Co-mingling can prompt non-business-related withdrawals to face higher taxes.

Cash transactions: Due to the difficulty of tracking cash, investigators pay close attention to large or frequent cash deposits. Strict records are essential for justification.     

Penalties and consequences

Depending on investigation findings, self-employed individuals may face:

Back taxes owed: If taxpayers fail to report or under-report all their income, they are committing tax evasion. This is a serious offence; if caught, they will be required to pay the proper taxes, interest, and late fees. HMRC has the power to raid premises and seize goods and assets. If tax evasion is not attributed to a criminal offence, HMRC will open an inquiry under Code of Practice 9 (COP9), which is still a civil inquiry and gives immunity to prosecution if accepted. 

Financial penalties: HMRC issues fines for inaccurate, erroneous, or deceptive tax submissions ranging from 30% to over 100% of tax due. Large cash transaction violations draw smaller penalties, around 15% per infraction. It's dependent on taxpayer cooperation with HMRC, details of income and records produced and demonstrating that every effort has been made to update the records for the taxman. 

Criminal prosecution: If an individual or a business is found to have committed severe tax evasion or money laundering with evidence of intentional fraudulent activity, HMRC may invoke the "tax cheating charge".

This will result in a criminal investigation by a combination of the police, CPS and HMRC forces. The penalties may include significant fines imposed by the court, seizure of assets, and even imprisonment.

While tax inquiries create understandable unease, self-employed individuals and businesses can take proactive preparation steps for streamlined processes and positive resolutions. Maintaining thorough financial records, reporting accurately per guidelines, and utilising appeal options when warranted lead to favourable outcomes. Leveraging professional support from qualified accountants or tax consultants adds reassurance for those preferring expert guidance.