EM3508 - Recalculating Profits: Business Models: Gross Profit Rate Model - Example
The model used most often to establish likely omissions and recalculate takings is based on gross profit rate. There is a basic pattern to such models, although the model for every different trade, indeed every individual business, will require tailoring to fit the particular circumstances. The basic pattern is illustrated by the following example.
Example
An SA return covering the first period of trading of a trader who runs a general store, selling groceries, cigarettes, toys and stationery etc, is received. The return is risk assessed by the Risk Team and selected for a full enquiry as the GPR, derived from the Standard Accounts Information, is 11%. This figure is lower than the gross profit rates generally achieved for similar local businesses. Even allowing for substantial cigarette sales this level of GPR seems unlikely.
The SAI shows gross sales of £112,410 and cost of sales of £100,036. A Section 9A enquiry is opened into the return.
An early meeting is arranged with the taxpayer and his agent. It has already been established that the taxpayer has kept no records of drawings and therefore the accountant has used a substantial balancing figure when preparing the accounts.
During the course of the meeting, held at the business premises information is obtained from the taxpayer about the business.
At the outset it is important to discuss in detail the aspects of the business which may ultimately impact on the business economics model. Through careful questioning the taxpayer’s policies on pricing, product mix etc is established and every possible likely explanation for the lower than anticipated gross profit rate is explored including:
- change in product mix - selling goods with lower MUR.
- Change in pricing policy - price cuts, discounts.
- Pilfering and burglary (shrinkage).
- Wastage.
- Competition.
- Inexperience.
- Poor stock at the commencement of a new business.
- Factors beyond the trader’s control - for example recession.
These explanations are tested and where found credible an adjustment made. Where appropriate the taxpayer is asked to provide evidence or further details to allow quantification of the adjustments required to be taken into account in the model.
Analysis of a sample of purchase invoices (agreed to be typical) shows the following product mix:
| Product | Percentage of mix |
|---|---|
| Groceries | 25% |
| Cigarettes | 45% |
| Sweets | 15% |
| Stationery and toys | 15% |
Rates of mark-up for each category are agreed, relying heavily on purchase invoices, current costs and selling prices (This content has been withheld because of exemptions in the Freedom of Information Act 2000) for verification.
Mark-up on cigarettes is easily agreed at 10 per cent. There is no cut-price policy.
Groceries present more of a problem because there are varying rates for different products and they need weighting in favour of the most common items. Eventually, after further reference to invoices, it is agreed that, on groceries generally the mark-up would be 18 per cent.
Similar discussions produce 25 per cent for confectionery and 35 per cent for stationery, toys etc.
(These percentages are only illustrative)
The expected gross profit (in cash terms) is worked out by applying the different rates of mark up to apportioned purchases, or by marking up total purchases by the overall mark-up rate, that is:
- (25 X 18) + (45 X 10) + (15 X 25) + (15 X 35) / 100 = 18%
After giving due consideration to the variety of explanations offered by the taxpayer and making adjustments to the provisional model to accommodate those which can be verified or are considered reasonable, the business economics model still points towards a higher GPR than that shown by the figures returned.
The trader has shown that, his gross profit, after adjustment for VAT, should be in the region of £16,000 whereas the return shows only £12,374. He objects, on the grounds that the method is too imprecise and cannot show the true profit.
The ultimate aim of the enquiry is either to verify the figure in the return or where it can be shown that the records are incomplete to substitute a more accurate figure. If this cannot be achieved by negotiation the enquiry officer can ultimately amend the return figure under TMA70/S28A. The taxpayer may then appeal.
In this example the enquiry officer acknowledges that the business economics exercise based on the sample period may not be precise but remains satisfied that the records are unreliable and that they are entitled to base their estimate on appropriate evidence.
The taxpayer is offered the opportunity to present a revised calculation based on a detailed analysis of the whole year’s invoices (or some other representative period) using the agreed mark-ups if he wishes to undertake the task. The taxpayer, after discussion with the agent, decides not to pursue this.
After further discussion, the understatement of profits (allowing for the approximate nature of the calculations and reconsidering the adjustments for wastage etc) is quantified at £3,000 for the year.
The above example is very simplistic and merely provides an outline of how a GPR model can be used in negotiations.