Tax evasion and ‘shadow companies’

Richard Murphy’s latest report on the UK’s tax gap has been criticised by HMRC for its “highly inappropriate” methodology, the Financial Times has reported today under the headline “Evasion and hidden economy leave £40bn a year tax gap, says campaigner”. The report, running to 80 pages, has also been criticised by some tax professionals and commentators. I’ve read most of it today and here are my initial thoughts. Much of the report focuses on an important compliance issue that has received very little attention.

As the FT reported: “Murphy put the spotlight on an estimated 400,000 registered companies that tell the Revenue they are not trading. He said there was almost no checking of these accounts, raising a ‘strong possibility that significant fraud and tax loss could result from this almost total absence of regulation’.”

HMRC estimated (in October 2013) that the total tax gap of £35bn for 2011/12 included:

Evasion (illegal activity, eg. deliberate understatement)  £5.1bn
Hidden economy (undeclared economic activity)  £5.4bn
Total evasion and hidden economy £10.5bn

Murphy’s estimate is four times the official estimate, so I decided to look for an explanation. This is where I’m up to …

HMRC estimated the VAT element of the tax gap on a “top-down” basis, comparing consumption expenditure data with tax receipts. The direct tax (income tax, corporation tax etc.) element was estimated “bottom-up”, using HMRC data and management information.

So VAT losses were measured by comparing the net “VAT total theoretical liability” (VTTL) with actual VAT receipts, and the main methods used to estimate tax gaps for direct taxes were random enquiries, data matching and risk registers.

Murphy has suggested that £100bn of UK trading income may not have been recorded in accounts sent to HMRC in 2011/12, and his estimate is based on HMRC data and EU studies on VAT not paid.

It is clear from HMRC and EU data, he suggests, that around £1 trillion of trading income “should have arisen” in the UK in 2011/12. He adds: “If [as UK government estimates suggest] VAT is lost on about 10% of all VAT-chargeable sales then it is highly likely that about 10% of all sales, or £100bn in 2011/12, were unrecorded.”

Murphy’s report suggests that the total tax lost because of unrecorded sales alone in that year “might have been £40bn”.

He uses a “top-down” approach for all taxes and argues that HMRC’s “bottom-up” approach for direct taxes cannot take account of tax returns that are not received.

One likely explanation for the “astonishing” £40bn figure, he suggests, can be found in an estimated 400,000 “shadow companies” that are not declaring trading income:

“These 400,000 missing or ‘shadow’ companies provide one of the best possible explanations for where much of the UK’s missing £100bn worth of trade is taking place although some of that missing trade will, of course, also be the undeclared and under­declared income of the self-employed and some will also be the undeclared income of companies that do actually submit corporation tax returns.”

An average of 400,000 sets of accounts per year “are not [filed at Companies House] by companies who may well have traded”.

HMRC has said, the FT noted, that Murphy’s approach might give the correct order of magnitude for the tax gap for business profits of companies and sole traders but it gave ‘completely the wrong answer’ for the income tax due from employees, where international research suggests the tax gap is very small, at about 1%”.

HIs study was “seriously flawed”, HMRC said, because it was based on “among other things, a significant overestimate of the UK’s VAT gap”.

Clearly, the methodology behind the £40bn estimate is open to challenge. But the “shadow companies” issue is a compliance issue that deserves closer scrutiny, despite HMRC’s assurance that “we are extremely good at identifying companies that need to send in a tax return”.

One thought on “Tax evasion and ‘shadow companies’”

  1. Lots of things to look at.
    Just looking at one or two.
    I wonder if the estimated rate of tax used to calculate the “gap” is valid? RM starts with a rate of 36% to apply (p57). But if this 36% includes VAT, how can you can you apply it to “value added/sales/income” that is not subject to VAT?
    Secondly, I do not think that HMRC treats hidden sales in a company as PAYE income. I think they treat it as Director’s drawings and use the Loan Account approach. This means profits are not reduced and there can be interest and a penalty. RM discounts this (p55 and in footnote lii) on the grounds that PAYE applies to Loan Accounts. I don’t think it does.

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