VAT - 26.03.2018

Does HMRC’s “best judgement” reflect the facts?

BACKGROUND

The phrase “best judgement” is used in s.73 Value Added Tax Act 1994 . This gives an officer the power to raise an assessment where they think that tax has been underpaid. In reality, most assessments will relate to underpaid output tax rather than overclaimed input tax. The power can be used “where a person has failed to make a return” or where it “appears to the Commissioners that such returns are incomplete or incorrect.”

Pro advice. If an officer estimates the VAT liability for a period in the absence of a return, then the easy way to overturn the assessment is to submit the return for the period to declare the exact figures for both output and input tax. The assessment will be withdrawn on receipt of the VAT return.

PRACTICAL EXAMPLES

Let’s consider two underpayments of VAT:

• Steve the builder did a job for a private individual for £12,000 - he incorrectly zero-rated the job when it should have been standard-rated.
• Sally the publican has only declared a 25% gross profit on her annual accounts and VAT returns, even though her pricing structure suggests she should be making at least 60%. An officer from HMRC has decided that output tax has been underpaid.

In the first situation, Steve owes exactly £2,000 in underpaid VAT. However, the underpayment of output tax for Sally will never be established as an exact figure. The only strategy available to the officer is for them to estimate how much tax Sally owes by carrying out a series of calculations that take into account all known factors about the business and its trading structure.

Pro advice. The important phrase in the previous sentence is “known factors” - HMRC must take into account all information available about a business but it does not need to carry out extensive investigations to establish all relevant facts.

In the well-publicised case of Pegasus Birds Ltd v HMRC [2004] EWCA Civ 1015 (see Follow up ), HMRC raised an assessment for more than £650,000 against a company which imported and sold tropical birds. The assessment equated to about £4m of undisclosed sales, which seemed a very high figure (and a lot of birds!). The officer had carried out a mark-up exercise to project the total sales made by the company.

The first court that heard the taxpayer’s appeal concluded that the assessment was excessive, and not made to the Commissioners’ best judgement, and that “the tax evaded was only a small fraction of that assessed” .

Reversal

However, the Court of Appeal reversed the decision on the basis that the role of the Tribunal was not to determine whether the assessment was excessive but merely to establish whether HMRC had used “best judgement” in its calculations. The Court concluded that the officer raising the assessment “did his honest and genuine best, however mistaken he may have been” . The case was sent back to the Tribunal to establish the true amount of the assessment.

Two stages

Overall, the long-term outcome of the Pegasus case seems to be that a Tribunal will consider two stages in the process of reviewing a best judgement assessment.

Is there any evidence to suggest that:

• the officer has not used his best judgement in the calculation process, so has he acted dishonestly or unfairly, or ignored important information provided by the taxpayer?
• the actual amount of tax assessed is incorrect? Is there evidence to indicate that the assessed amount should be reduced?

Example. Sally the publican has received an assessment for £20,000 following a mark-up exercise carried out by the visiting HMRC officer on a compliance visit. Sally’s accountant has reviewed the figures, and identified that the officer has not taken into account reduced selling prices for some stock because of dating issues; the pub also has a happy hour every Thursday with half-price drinks, which he has also ignored. Plus he has failed to reduce the purchases for resale figure to reflect a loss of beer when the pipes are cleaned each week. The officer should be alerted to these facts and reduce his assessment accordingly.

HMRC’s approach

So how does HMRC instruct its officers to approach this subject? The VAT manual VAEC1460 (see Follow up ) is a good reference point and highlights the importance (or preference) of HMRC officers having more than one piece of evidence to suggest that output tax has been understated.

To quote directly from HMRC’s policy note “Once you have calculated the arrears to best judgement, you should ask yourself: is this figure credible? Could the business have actually under-declared this amount of tax.”

Pro advice. Don’t forget that an output tax assessment might not just relate to under-declared sales. It might, for example, relate to the declared split of zero-rated and standard-rated sales made by a business such as a café (with cold takeaway food mainly being zero-rated and other sales being standard-rated). It is important that clients have a strong audit trail and retain records to support their calculations about the split of sales between the different rates of VAT.

In some situations an HMRC officer might have evidence that off-record sales have been made by a business, and their challenge is to quantify the amount understated, i.e. with a calculation method that produces a fair result.

In the case of Hodges v HMRC [2015] TC04419 (see Follow up ), an assessment for £529,536 was reduced by the Tribunal to £11,153. HMRC had evidence that Mr Hodges (H) had suppressed some sales made by his scaffolding business because the officer identified ten addresses that displayed his sign boards but only one of the addresses was declared as a sale in his books and records. The officer concluded that 90% of all sales made by the business had been suppressed. The Tribunal described the assessment as ludicrous and accepted alternative calculations made by H as being “more nearly right”.

Pro advice. The key fact in the Hodges case was that 85% of his work was for other VAT-registered businesses, where it would be very difficult to suppress sales because of the high degree of paperwork involved in these deals. It would have been more sensible for the officer to conclude that 90% of the remaining 15% of sales had been suppressed, i.e. the private jobs for non-business customers. This is an example of an officer not using their “best judgement” and the Tribunal rightly reduced the assessment by over £500,000.

PENALTIES

Another important reason for challenging HMRC best judgement assessments is because a penalty will often be charged as well. If the behaviour alleged by HMRC is that the underpaid tax was deliberate and concealed, there is a minimum penalty of 30% of the tax involved. In some cases this penalty could be 100% of the tax if the business owner does not fully co-operate with HMRC to help establish the tax underpaid.

Challenging

When reviewing best judgement assessments, look at the documentation relating to the compliance check to see if any key factors have been ignored by the officer, for example sale events or spoiled stock.

If it appears that there are important facts that haven’t been accounted for, prepare your own computation for your client and send it to the officer, making it clear which factors they have omitted and why your version is more accurate.

Pegasus Birds Ltd v HMRC [2004] EWCA Civ 1015

VAEC1460

Hodges v HMRC [2015] TC04419