Implications of HMRC’s desire to ‘shrink the tax gap’

October 2025  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

October 2025 Issue

The UK’s economic challenges are well-known, but broadly consist of a sluggish economy, a taxation burden at post-Second World War highs and resulting capital outflows which tax increases only seem likely to make worse.

The UK government is in need of a magic money tree. When UK governments feel that sort of pressure, they tend to promise to reduce the ‘tax gap’ – the difference between the amount of tax that the UK’s tax authority HMRC believes it should be able to collect, and the amount it actually collects.

This article asks how HMRC might go about that, and suggests some areas of particular concern.

The tax gap

HMRC’s latest figures (2023-24) show a tax gap of £46.8bn. That looks substantial – and represents funds that would be very welcome to a government that may need to increase taxes by up to £25bn in the Budget in the autumn of 2025.

Far better, in principle, is to collect what is already owed than to have to raise taxes again, especially where doing so would breach commitments in the government’s manifesto.

However, the reality of any taxation system is that some level of tax gap is inevitable. That is because it comprises tax unpaid by businesses that become insolvent and tax unpaid by criminals.

The UK’s tax gap of 5.3 percent is relatively low by international standards. In the US, for example, the most recent figures (for 2022) show a tax gap of 13.1 percent. Across the European Union, the tax gap for VAT, having been in the region of 15 percent for a number of years, has now fallen to 7 percent.

The UK’s tax gap has also fallen over time, from 8 percent in 2006 to a relatively stable 5 percent in recent years. There is probably limited scope for it to fall further.

Reduce the tax gap

A clear majority of the tax gap (almost £30bn) is attributable to ‘small businesses’. Some of the data are particularly concerning; for example 40 percent of corporation tax to which small businesses are liable goes uncollected.

However, targeted HMRC action in respect of ‘small business’ taxpayers, while important, is unlikely to deliver significant returns. ‘Small businesses’ comprise a relatively large group of taxpayers, so the ‘compliance yield’ from actions taken in respect of single ‘small business’ taxpayers is likely to be modest.

At the other end of the spectrum, ‘large business’ taxpayers, fewer in number (around 2000), represent potentially rich pickings for a tax investigation. As well as very large potential ‘compliance yields’, large businesses have a number of features that make them attractive to investigate.

Sophisticated tax, legal and compliance teams respond well to HMRC and ‘play by the rules’. Sufficient financial resources to pay tax assessments. External advisers who can guide them through the process. Each of these help HMRC as much as the taxpayer. Of course, some mid-sized businesses, particularly those in heavily regulated industries such as financial services (FS), will tend to share these characteristics, and will be of similar interest to HMRC.

Large businesses are subject to regular scrutiny in the form of a business risk review (BRR) carried out by an HMRC officer who (theoretically) is familiar with the business. The scrutiny goes further than check-ins every one to three years. At any one time, HMRC is investigating approximately half of all ‘large business’ taxpayers.

The continuing desire to shrink the tax gap means that large businesses are increasingly feeling the pressure of HMRC investigations. This is already happening, and can be expected to be exacerbated by the UK’s budgetary pressures. Increasingly, businesses are being faced with more demanding questions in the course of the BRR. They see ‘low’ risk ratings as difficult to obtain and are starting to meet some of the 5000 new compliance officers recently hired by HMRC.

All of this means that tax investigations are likely, increasingly, to matter to many different businesses.

Hot topics

Outlined below are three areas concerning the ‘tax gap’ that are likely to be of interest going forward.

Loan interest disallowance: unallowable purpose rules. Businesses have debt in their structures for a wide range of reasons: to fund acquisitions, to return cash without the need to declare a dividend, to maintain accounting ratios and to avoid dilution of ownership. Another possible reason is to benefit from the ability to deduct interest when calculating a taxable profit. This purpose is an ‘unallowable’ purpose of securing a tax advantage under part 5 of the Corporation Tax Act 2009, and that means that, insofar as the loan interest relates to that purpose, it cannot be deducted in calculating a taxable profit.

HMRC has had notable recent successes in ‘unallowable purpose’ disputes, with three cases, culminating in KwikFit v HMRC, going to the Court of Appeal. HMRC was successful in each of them.

These cases significantly increase the risk attaching to intergroup lending. The key lesson is that borrowing that has a commercial purpose can nevertheless have an unallowable (tax-related) purpose. In each of the cases, there were commercial good reasons to take the steps that the borrowing entities took. This did not protect them from the challenge that the particular intergroup arrangements had an unallowable purpose.

We are already seeing HMRC making good use of these cases. Before the summer, a ‘nudge letter’ was sent to taxpayers already subject to audit procedures where HMRC suspected that there might be a reason to raise an ‘unallowable purpose’ argument. This letter invites the recipient to engage in without-prejudice discussions to settle their audit issues. It is only a matter of time before HMRC starts to ask these questions more widely.

VAT. A number of FS are exempt from VAT. Many large FS businesses rely on these exemptions at two points: (i) when supplying services to their customers; and (ii) when buying in those services. The scope of these exemptions is generally perceived to have broadened over the past couple of decades.

Many businesses now perceive that the tide may be turning. While there appears to have been a pause in a Treasury project to rewrite many of the FS exemptions, HMRC has in recent years carried out strategic litigation targeting many of the exemptions, essentially by narrowing their scope.

Generally, HMRC takes two approaches in challenging a business’s entitlement to rely on an exemption. One is to question whether the services provided by the business fall properly within the scope of the exemption. Often there are arguments both ways. The second is to look at the services provided in the round and see whether there is some non-exempt service that ‘taints’ an otherwise exempt supply. If so, then the whole supply may be taxable.

Businesses can, and should consider whether to, address this latter risk. It is important to ensure that the contractual arrangements – which are often large multiparty global agreements – accurately reflect the economics of the transactions.

Partnerships. Limited liability partnerships (LLPs) are used widely across the FS sector, providing flexibility over management and remuneration, tax transparency and limited liability. An LLP member is treated as self-employed and benefits from lower social security taxes. Two sets of regulations relevant to LLPs are becoming hot topics.

First, under the salaried member rules, an LLP member can be deemed to be an employee if they satisfy three conditions: (i) Condition A, that 80 percent or more of their remuneration is disguised salary (i.e., is fixed, or is variable on something other than the LLP’s overall profits and losses); (ii) Condition B, that the member does not have ‘significant influence’ over the affairs of the LLP; and (iii) Condition C, that the member’s capital contribution is less than 25 percent of their expected disguised salary for the year.

The recent BlueCrest decision of the Court of Appeal was helpful to HMRC. On Condition A above, the court held that, if the LLP’s profit simply caps the remuneration that is variable without reference to overall profits, then it does not cause the condition to have been failed and therefore the rules not to apply.

On Condition B above, the court held that the relevant ‘significant influence’ necessarily proceeds from the statutory and contractual relationship between the LLP members, and between the LLP members and the LLP. The Supreme Court has agreed to hear BlueCrest’s appeal.

The other ‘hot topic’ for LLPs is the mixed member rules. These rules seek to prevent LLPs with a corporate partner from accumulating profits in the corporate partner, which benefits from lower rates of tax. Again, this has been the subject of recent litigation in the Boston Consulting Group case, and a decision from the Upper Tribunal is expected shortly. Meanwhile, businesses are seeing audit questions on this topic.

These cases highlight the importance of LLPs reviewing carefully their remuneration structures. We expect to see more cases in the future.

 

Craig Kirkham-Wilson is a managing associate at Simmons & Simmons. He can be contacted on +44 (0)20 7825 3638 or by email: craig.kirkham-wilson@simmons-simmons.com.

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Craig Kirkham-Wilson

Simmons & Simmons

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