Inland Revenue officers often try to base arguments that taxable profits are understated on business economics models. Although such models can be used to ascertain whether, for instance, stock and debtor levels are in line with industry norms, the main attacks will normally be aimed at turnover, using the gross profit percentage.
If faced with an argument that profits are understated, based upon a business economics model, it is often useful to bear the following in mind:
i) A business model does not give conclusive proof of what a business’ results were. Any model is a calculation based upon assumptions; if those assumptions can be shown to be inaccurate then the results will be invalidated;
ii) The Inland Revenue publishes Business Economics Notes for various types of business. The Inland Revenue officers will invariably have looked at them when putting together a model, so it is worthwhile having a look too when checking that model’s validity. To view the published Business Economics Notes, click here;
iii) consider whether the results thrown up by a model are possible given the size of a business and the actual pricing and cost structures adopted;
iv) a business model will generally cover a relatively short sample period. If results suggest a large uplift in profits, consider looking at an extended period.
If the records of a business are well maintained and there is no other evidence to suggest that they are inaccurate or incomplete, then the chances of successfully arguing against a case based purely upon a business economics model would generally be high. If agreement cannot be reached with the Inspector, then the matter would ultimately end up before the Commissioners. The aim then would be to present evidence to show that the records are adequate, and to highlight any errors or inaccuracies in the assumptions that the model is based upon.
If doubt has been cast upon the adequacy of the financial records, then more evidence would normally be required to counter arguments based upon business economics models. Again information to highlight inaccuracies in assumptions used is helpful. This may be combined with a comparison of the results from the model with the results of a review of the private financial affairs of the business owner(s). If the source and destination of all private funds and other asset and liability movements, and funding of all private expenditure, can be identified, then this will help to refute suggestions that turnover has been understated and funds taken personally by the owners. Should it be agreed that sales have in fact not been recorded and the funds taken privately, then a personal financial review may be an alternative method to business economics models of computing the level of understated income.
For more details concerning the review of private financial information please click here.