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Steve Allen, Director of VAT Advisers Ltd, describes a specialised check performed by HM Revenue & Customs (HMRC) during VAT inspections of businesses.

Introduction

Clients sometimes ask what sort of checks HMRC make when they come to visit, as they sometimes ask for documents that you wouldn’t normally expect.

Apart from the usual checks on annual accounts, purchase and sales records, etc., HMRC also have a number of specialised checks they carry out on certain business sectors. These checks are useful to HMRC but they rely on ratios and extrapolation of the results. This is not always good for the taxpayer, as the results can be inaccurate, particularly if HMRC do not have all the information available, and can cost time and money for you to sort out. So it may be useful to know how these checks work, so that you can spot them if HMRC use them on you, and can make sure that they get the right information.

Parts and Labour VAT Checks

One of the most popular of these checks is referred to as ‘parts and labour’ by HMRC. This is how it works; Businesses that predominantly undertake repair work supply their customers with a mixture of spare parts and the labour costs of fitting them (e.g., garages and electrical repair specialists). In most cases, the invoices they issue split the total charge between the costs of the parts, including mark-up, and the labour costs. 

HMRC will look at a sample of sales invoices, add up the total of the parts and the total of the labour, and work out the ratio of the two. They will then look at a sample of the purchase invoices for the parts, and establish the sale price so that they can arrive at a mark-up. They should do this for each line, and work out what is known as a ‘weighted mark-up’ that takes account of the proportion of sales for each line. Having achieved a mark-up figure, they will then mark-up the parts purchases for a period (e.g., VAT quarter or year) to give an expected sales figure for the parts. They will then apply the ratio of the parts and labour to give an expected sales figure for the period. If this is markedly different from the figures on your VAT return, HMRC will likely give you a bill for the difference, which is something you don’t want, of course.

Example:

Sales invoices
Total sale of parts = £5,000
Total labour charges = £25,000

Ratio of labour to parts = 5:1 (25,000/5,000 = 5)

Purchase invoices
Total parts purchases = £4,000
Weighted mark-up = 45%

Expected sale of parts = £5,800 (4,000 + 45%)

Total expected sales = £34,800 (5,800 x 5 + 5,800)

In the example, if the invoices show sales of £30,000, but the part and labour exercise show expected sales of £34,800, HMRC will bill you for the VAT on £4,800!

Problems with Parts and Labour Checks

So then, if HMRC carry out a parts and labour check, what can you do to make sure you don’t get a bill? The first thing you could do is not separate the part and labour elements on the invoice, but this is not usually commercially possible.  However, you can check up on HMRC to make sure they are taking everything into account. In one Tribunal case, it was found that HMRC had added delivery notes into the purchases, making the total purchase figure over-inflated. Sometimes, HMRC forget to take account of stock figures - an increase in stock can have a big effect in this type of exercise. In some cases, HMRC take a short-cut, and don’t do a weighted mark-up, merely a simple average mark-up that can reduce the accuracy of their calculations.

Tip

Make sure your records are in good order before HMRC visit, and separate out delivery notes, pro-formas etc., so there can be no mix-ups. If you think HMRC is doing a parts and labour exercise, make sure they know if stock levels have increased (you may have bought an item, but if you haven’t sold it yet, they can’t include it in their calculations). If, after completing their checks, they challenge what you have declared, tell them you know what they have been doing, and ask if they have done a weighted mark-up, or taken into account wastage and stock level changes, etc.