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Tax Investigations – how penalties are calculated

Tax Investigations – how penalties are calculated

HMRC have the power to “enquire” into any tax return from a company, a partnership, or an individual. They do not have to give a reason for the enquiry.


Anyone who submits a self assessment tax return may face an Enquiry – each Tax Office opens a certain number of random Enquiries every year.


This is not the place for a detailed examination of how to deal with a tax investigation, but there is one vital piece of advice – do not attempt to deal with it yourself! In particular, if you receive a notice from the tax inspector to say he has decided to “Enquire” into your return, seek professional help immediately – in the first instance, from your accountant, though in serious cases he may well want to call in a tax specialist like me.


If it is found that tax has been underpaid, then penalties may be due:


Undeclared Income


Mr Burke is a sole trader, and when his return and accounts are investigated, it is found that he has failed to include £10,000 income for the year – the rent from a property he owns.


The inspector explains that Mr Burke should have paid £4,000 income tax on this income, and so Mr Burke will have to pay:




Interest for late payment (say)


Penalties at 25% of tax (see later in this Part)




Rounded up to



(in reality, it is also likely that the settlement would include tax, interest, and penalties for previous years in which the rent had been received and not declared, but I have ignored this for the sake of simplicity)


Mr Burke agrees to this, pays up, and that is the end of the matter.



You will note that Mr Burke pays penalties of £1,000. There is a standard way to calculate these penalties. The calculation starts from the amount of the tax that has been wrongly underpaid – this is the maximum possible penalty.


This maximum is then “mitigated” according to a formula:



Maximum mitigation


20% (25% in special cases)



Size and gravity






Disclosure refers to whether the taxpayer “owned up” to the tax irregularities, or whether he denied everything until he could no longer think of any more excuses. Broadly, a taxpayer who “puts his hands up” and admits everything immediately the enquiry begins will get 20%.


At the other extreme, the taxpayer who denies and denies, perhaps forcing HMRC to go to the Tax Commissioners – an independent tribunal that decides disputes between HMRC and taxpayers – would get 0%.


The “extra” 5% to make up 25% is only for a taxpayer who voluntarily approaches HMRC and confesses, and then only if he “has no reason to fear discovery”.


Unfortunately, this does not mean you can get a repayment of 5% - the extra 5% is used to mitigate the penalties under the other two headings!


Co-operation – this is fairly self-explanatory, and is why you should never drag your feet during an investigation, but you will need a good tax adviser to help you understand the difference between lack of co-operation and insisting on fair treatment and arguing technical issues.


Size and Gravity – this seems to cause the most arguments in settlement negotiations. The mitigation ranges from 40% for cases of muddle and mistake involving small sums, to (theoretically) 0% for serious fraud involving forgery, conspiracy and large sums of tax – though at this end of the scale, it is more likely that there would be a criminal prosecution. A Tax Adviser will be particularly on his guard with an inexperienced inspector here – they always seem to think that their investigation targets are more “heinous” than anyone else’s!


If we go back to Mr Burke in our Case Study:


Penalty Calculation


Mr Burke had concealed £10,000 income (by not declaring rent he received from a property). His penalties were agreed as:


Disclosure 15% - Mr Burke initially denied it all, but quickly realised this was stupid and admitted he had been receiving the rent


Co-operation 30% - Having admitted to the rents, Mr Burke quickly produced a schedule showing the amounts and dates, which proved to be an accurate one when the inspector checked it. However, he also tried to make a claim for some repairs, but had to withdraw this when he could not produce any invoices


Size and Gravity 30% - Mr Burke simply did not include the rent in his return – he did not produce any false documents, no-one else was involved, and the money was not hidden in offshore accounts or anything of that sort. On the other hand, £10,000 is a lot of money and it is clear he deliberately did not declare it even though he knew he should have done.


The total of Mr Burke’s mitigation was 75%, and that is why the penalty was 25% as shown in the Case Study.





Finally, here are the golden rules for dealing with tax enquiries:


  • DON’T try to handle it yourself – get advice before you reply to the initial letter from the inspector, and at all costs DON’T ring the inspector up to “have a chat and sort this out”
  • DON’T ignore it and hope it will go away – remember the mitigation of penalties for co-operation and disclosure
  • DO be honest and upfront with your Tax Adviser – only then will he be able to help you
DO talk to your accountant about taking out insurance to cover the fees for a tax investigation – the professional fees can be very expensive