Recent years have seen an increasing number of HMRC enquiries into tax returns, which can be a stressful experience for the taxpayer. In this article, we consider some top tips for dealing with such enquiries, focusing on the capital versus revenue expenditure allocation, which is a common area investigated by HMRC.
What does an enquiry entail?
HM Revenue & Customs (HMRC) will deliver a notice to the taxpayer that they intend to raise an enquiry into a return. Importantly, the taxpayer must be in receipt of the notice within the relevant 12-month enquiry window.
There are a number of different types of enquiry: One is an aspect enquiry, whereby HMRC is interested in a particular aspect of the return. HMRC will only review all significant risk areas of the return during a full enquiry.
A discovery assessment is where new evidence has been identified to suggest that there has been a disclosure deficiency (and a loss of tax), and allows HMRC to open a previous year’s tax return. These are rare, and the exact time limit in terms of how far back HMRC can go depends on the behaviour of the taxpayer, although can extend up to 20 years.
There are a relatively small number of enquiries that arise through random selection. Enquiries generally emerge due to particular items, or combinations of items being highlighted by HMRC as a result of an automated risk analysis. Alternatively, the taxpayer could be on HMRC’s risk list.
Top tips
Double check the time frame
Check the date that the enquiry notice was received and the date that the tax return was filed, as occasionally HMRC will raise an enquiry outside of its permitted enquiry window.
Maximum disclosure
Tax returns include a white space which can be used to specify unusual items, or particular details regarding a transaction, so try to disclose as much as possible at the time the tax return is filed.
Insurance against costs
Dealing with an enquiry can be expensive, especially if a professional adviser is engaged to assist. Relatively low-cost professional fee insurance policies are available that will cover the cost of professional advisers’ fees in the event of an HMRC enquiry. Dependent on risk profile, this could be a consideration that will provide peace of mind, should an enquiry arise.
Work with the inspector
Reply promptly to requests from the inspector and don’t be afraid to prompt them if they have not replied. Comply with all requests raised by the inspector, to lead to a quicker resolution of the enquiry. It is sometimes possible for HMRC to suspend a penalty. Think carefully about what is reasonably required for the enquiry, as an inspector cannot conduct a fishing expedition.
Preparation is key
Where a meeting is scheduled, ask the inspector for an agenda and then evidence can be collated in advance and made available during the meeting.
Minutes of meetings
Inspectors will usually attend meetings with a colleague, often so that one can take minutes of the meeting. A review and authorisation of these minutes may be required. Therefore, take notes during meetings and ensure that anything you agree to is a true representation of the discussions that took place.
Speak to a professional adviser
Finally, if you feel uncomfortable dealing with the enquiry, ask someone experienced to deal with it on your behalf.
‘Repair’ or ‘improvement’?
On a tax return, distinguishing between expenditure that is a ‘repair’ and expenditure that is ‘improvement’ is important due to the different tax treatment of each. This is a common cause of a tax enquiry.
The distinction between repairs (treated as revenue and therefore income tax deductible) and improvements (capital expenditure and therefore not income tax deductible) is often quite difficult to identify. To summarise the difference:
- Expenditure is treated as a repair where it is the restoration, renewal or replacement of a lesser part of the whole.
- Expenditure is treated as capital (an improvement) when there is reconstruction of the entirety or there is a new addition to the asset. Rather than an income tax deduction, capital expenditure will qualify for capital allowances if the asset acquired is qualifying plant and machinery or structures and buildings (from 29 October 2018). Land does not qualify.
If the replacement is better than the original, both in terms of functionality and useful life, the tax treatment usually remains unaffected, provided the character of the larger object remains unchanged.
For example, the replacement of windows in a house from wooden single glazing to double glazed PVCu would be regarded as a repair, even though technology has vastly improved since the windows were first purchased and the new windows have improved functionality.
The like-for-like replacement of a fitted kitchen, for example, should be allowable as revenue expenditure, as the fitted kitchen is part of the entirety being replaced. That is provided the kitchen is replaced with something of equivalent size, function and durability.
If new materials have to be used rather than the originals, the following principles apply:
- The work is a repair and not an improvement if, after the work is completed, the asset does the same job as previously.
- The work is an improvement and therefore not allowable for income tax if, as a result of the work, more can be done with the asset, or the asset can be used to do something that it could not do before.
Where modern materials are used there may well be an element of improvement simply by technological advancement. As per the double glazing example above, this does not necessarily mean the expense is not an allowable revenue item. Although once expenditure is incurred and, in reality, a new and improved asset has been achieved, it is not possible to dissect the capital apportionment and deduct a notional sum against repairs. However, where the expenditure on a large project is clearly apparent between capital and revenue, it is permissible to identify the key parts of the work undertaken and allocate the costs accordingly.
If an asset has been recently acquired, the cost of repairs usually remains allowable revenue expenditure. However, if an asset is acquired in a run-down condition and the purchase price reflects the state of repair, the cost of putting the asset into a useable condition is capital expenditure and not an allowable revenue deduction.
There is a substantial amount of case law, although each case needs to be considered on its own facts, that supports the general theme that a repair involves the restoration of an asset to a condition it formerly had without changing its character.
In summary, providing the character of an asset remains unchanged, expenditure incurred will be treated as repairs and therefore allowable as an income tax deduction. When undertaking major projects it is important to consider the tax implications at an early stage, by classifying as a repair, tax savings of up to 45% (for additional rate taxpayers and trusts) could be achieved.
Hannah Mazrae
Director – Audit
