Are you at risk from a tax investigation?

Many people have an underlying fear of dentists but that is nothing compared to the distress dentists experience when faced with an Inland Revenue investigation into their tax affairs. Could it happen to you?

Yes it could, and the odds are that it will happen this month. January is the peak time for the Inland Revenue to open enquiries into tax returns as the Inspector has a maximum of 12 months to initiate an investigation after the deadline passes for submitting the return. Enquiry is the new cuddly word for a tax investigation, but the painful process is much the same. The tax return you completed for the tax year that ran to 5 April 2001 had to be submitted by 31 January 2002, so the Inspector has until 31 January 2003 to issue a formal letter that starts the enquiry process.

Any business or individual can be picked for a tax enquiry. The Revenue selects tax returns on a random basis as well as following risk assessments. So your return may be chosen even though it contains nothing specific which has drawn the Inspector's attention.

A risk assessment helps the Inspector identify the tax returns that may contain errors or omissions. The first step is a manual sift that discards the majority of tax returns which are considered as low risk. A computer programme called PRISE is then used to screen the rest. PRISE compares the figures on the current tax return with those reported in earlier years, as well as to those from other dental practices in the local area and to national statistics. The main amounts under scrutiny by the computer program for general dental practices are gross profit margins, disallowable expenses, drawings and capital introduced.

This creates problems for dentists as the gross profits earned by one dental practice can vary enormously from another if it has an unusual proportion of non-exempt patients, or if the principal dentist carries out a degree of specialist work. Capital introduced and drawings may also fluctuate significantly from year to year depending on the other financial pressures on the practitioner.

At this stage it is only the figures included on the self-employed pages of the tax return that are examined. If these comparisons turn up an unusual pattern the Inspector will want to look at the full practice accounts for further explanations. If you do not submit a copy of the practice accounts with your tax return the Inspector will have to formally open an enquiry to ask for a set, which will permit him to proceed with all sorts of probing questions.

The Inspector does not have to say whether your tax return was chosen randomly or not, but he will tell you if the enquiry is going to be an aspect or a full enquiry. An aspect enquiry concentrates on only one part of your tax return, for example your pension contributions. The letter opening an aspect enquiry should pose a maximum of seven innocent looking questions. You should not be tempted to deal with this letter yourself, as an aspect enquiry can easily grow beyond the initial target area.

A full enquiry is a fundamental challenge to the accuracy of your tax return and accounts. The Inspector can ask questions about every entry on your tax return, and every detail of your financial life, which can be very time consuming, stressful and expensive. Most enquiries for GDPs will be full enquiries as the majority of the entries on your tax return are connected with the practice accounts, and Inspectors find it difficult to isolate one item to examine using an aspect enquiry.

The opening letter for a full enquiry will normally request access to the books and records for the practice accounts for the year under investigation. The Inspector may offer to examine the records at your office or surgery but this is generally not a good idea. Apart from the practical constraints on space, there is a danger of casual remarks by staff being misinterpreted by the Inspector. Patients' records should also be strictly off-limits to the Inspector. The confidentiality barrier can be broken in some circumstances, but not as part of a routine tax investigation.

The Inspector's approach to the practice records is to extract certain items from the accounts, and pick them over in detail. If he finds a flaw he will magnify it and extrapolate the consequences to the reported accounts to produce a figure of additional tax due. The resultant tax demand will also carry interest of at least 6.5% as well as a level of penalties imposed at between 20% and 100% of the tax owing.

Example:
The Inspector finds that a GDP has omitted private earnings of £200 in May 1999, so he assumes that the practice accounts for the year to 30 April 2000 have income of a similar level missing for every month totalling £2,400 (12 x £200). When the enquiry is complete the income tax, interest and penalties arising from that one omission could amount to nearly £1500:

If the Inspector finds one omission it will be up to you to prove that similar items have not also been overlooked in other periods. Proving a negative is very difficult so your recording keeping must be robust enough to stand up to scrutiny.