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HMRC internal manual

Enquiry Manual

Recalculating Profits: Business Models: General

Business models are used by businesses, traders, accountants, bank managers and financial analysts to

  • check pricing policy
  • forecast future turnover
  • verify the results shown by accounts.

A detailed model involves applying certain formulae to items in the Standard Accounts Information (SAI), the underlying records or the accounts, to arrive at an estimated figure of turnover. The more accurate the assumptions which are built into the formulae, the more accurate the model.

The Courts have held that business models are an acceptable way to calculate profits EM3710 and EM3711.

Analysis of the Standard Accounts Information (SAI) in a return, or of a set of accounts, can often identify significant relationships between certain figures from which we can test the credibility of figures returned.

For example, you can use business models to test the likely accuracy of declared turnover, when you are reviewing the SAI, supporting accounts and/or any underlying records. The model used most often in HMRC Direct Taxes is based on gross profit rate, but this is only one possibility.

In isolation, the results of a business model may not mean very much and will not provide you with a conclusive figure of profits to overturn the returned figure. However, if you have shown that the figures in the return cannot be relied upon by discrediting the underlying records then a model provides a plausible computation of the real profits.

If it suggests that the real profits were significantly different to the declared profits, this reinforces the view that the records are not correct and complete. If there is no other reason to believe the records are unreliable, the profits shown by the business model are merely an alternative to those shown in the return and the tribunal might consider the latter to be more reliable.

Where any disputes arise, or you reach an impasse, you should consider whether Alternative Dispute Resolution (ADR) may help you and the taxpayer resolve these. See the ADR web pages for guidance about ADR.

Whatever model you use, make every attempt to understand the business and how it works. (This content has been withheld because of exemptions in the Freedom of Information Act 2000) (This content has been withheld because of exemptions in the Freedom of Information Act 2000)

  • (This content has been withheld because of exemptions in the Freedom of Information Act 2000)
  • Use facts from the actual business and wherever possible these should come from contemporary documentation, such as price lists, purchase invoices, etc. Alternatively, you can ask the taxpayer to provide the necessary information from his or her knowledge of the business and verify this if you can - perhaps by looking at documentation for the current period. You should not use an average mark-up, either national or local, unless there is no evidence available at all of the particular mark-up. Make it clear in your computation if you are using any averages.
  • When presenting your business model, state clearly whatever assumptions you have made in preparing it, such as the assumed rate of wastage, shrinkage or the number of sales per container.
  • Draw attention to anything which is estimated, or about which you are uncertain. For instance, a quantity which is unclear from an invoice.
  • Make sure that any test period is likely to be representative. If there is any doubt, and especially if there is dispute over the model, consult the taxpayer and extend the period or choose another one, as a crosscheck.
  • Consider whether the results shown by the business model are possible given your knowledge of the trade in general, and this business in particular. Does the figure of turnover seem realistic - neither too high nor too low? Is the business capable of taking that much money a week?
  • Is it possible the input figure has been understated? Some purchases could have been excluded, a farmer’s field might have been omitted, or extra hours worked at peak periods without being recorded.
  • Consider the results of the model in the wider context of all you know about the taxpayer. Could the individual you have met actually have earned and spent the money which the model suggests has not been declared? If the result does not seem realistic, what might have gone wrong with your computation?

Some common errors include failing to adjust correctly for

* Stock
* Own goods
* Failing to take account of the impact of in-year price changes
* Failing to take proper account of issues that might affect the product mix for example discounts and loss leaders.
  • You may wish to compare the results of your model with other methods of quantifying omitted profits to strengthen your case.

When all the relevant comparisons have been made and you are reasonably satisfied with the results show them to the taxpayer and his or her agent. The taxpayer may have a reasonable explanation for any apparent discrepancies. Listen to any explanations and using the detailed knowledge you have of the business and the workings of your model, test the taxpayer’s argument and explanations. Be prepared to defend your figures and counter arguments where you cannot accept the reliability of the explanations offered.