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Taxation by Mark McLaughlin CTA (Fellow) ATT TEP & Beryl Mansworth

Mark McLaughlin CTA (Fellow) ATT TEP, and Beryl Mansworth of HM Revenue & Customs, debate the issue of penalties on technical adjustments in company enquiry cases.‘Keep your friends close, but your enemies closer!’ Perhaps this proverb draws an unkind, unfair analogy with the relationship between HM Revenue & Customs (HMRC) and professional advisers, particularly in this era of ‘Working Together’ and especially in a joint article between an HMRC Area Director and a tax adviser! However, in the context of enquiry work involving disputes over issues of culpability and penalties, tensions between tax professionals and HMRC can mount and communications can become adversarial. A clearer understanding of the ‘other side’s’ position can help to alleviate such problems, albeit that both parties may not necessarily agree at the end of the day.

Culpability in respect of technical adjustments in aspect company enquiry cases was the subject of a Working Together meeting held last year in Manchester. HMRC produced a number of case studies for discussion between professional advisers and HMRC officials. These were issued before the meeting, giving attendees the opportunity to consider the issues raised. Advisers and HMRC representatives, including a Technical Adviser from the Tax Administration Advice section of Central Policy and an Aspect Team Leader, expressed their views in a lively fashion.

The idea of a joint article by both sides dealing with penalties for technical adjustments was spawned from that meeting, and this article features three examples based on the case studies produced by HMRC.

For some professional advisers, the approach of HMRC in seeking penalties for technical adjustments is a relatively new and worrying development. Others believe that HMRC are arguing culpability on a far more regular basis. However, HMRC maintain that their approach on this penalty issue has not changed; it is simply that their policy of seeking penalties is being applied more consistently than before. This article examines the issue of culpability in company enquiry cases involving technical adjustments. All statutory references are to Finance Act 1998, Schedule 18 and to the HMRC Enquiry Manual, unless otherwise stated. The ‘HMRC’s views’ of the examples are expounded by Beryl Mansworth and the ‘tax adviser’s views’ are from Mark McLaughlin.

‘Technically’ negligent?

It needs to be recognised that an aspect enquiry is not limited to purely technical and therefore non-culpable adjustments, just as a full enquiry is not limited to culpable issues.

Technical adjustments can occur in full or aspect enquiries. A common situation where technical adjustments occur is in aspect enquiries, perhaps as the result of an unusual expense in the accounts or deduction in the corporation tax computation attracting the Officer’s attention.

The legislation concerning penalties for incorrect company tax returns (para 20) states: ‘A company which fraudulently or negligently delivers a company tax return which is incorrect…is liable to a tax related penalty.’ The key question is therefore: was the company negligent at the very least in delivering that incorrect return?

HMRC’s position

HMRC’s view is that there is no statutory definition of ‘negligence’. HMRC therefore test negligence against what a ‘prudent and reasonable man’ would do when submitting a return (Blyth v Birmingham Waterworks Co (Ex D 1856, 11 781)). This may include carefully reading any relevant notes supplied with the return, and seeking professional help with the return, if necessary (Enquiry Manual, para 5125). If the taxpayer is represented by an agent, the onus nevertheless remains with the taxpayer to submit a complete and correct return. This responsibility cannot be delegated. It is the taxpayer's duty to ensure that their return is correct and complete.

HMRC always seek to attach responsibility for an incorrect return to the taxpayer in the first instance (EM5182), and attempt to establish whether there has been a lack of reasonable care by the taxpayer. If so a penalty will be chargeable. The civil standard of proof (the balance of probabilities) applies for these purposes. Further information may be required from the taxpayer and agent for the purpose of establishing whether there has been negligence and thus culpability by the taxpayer. The test of culpability is whether the taxpayer failed to exercise reasonable care to ensure that the return is correct. Examples of acceptable standards of ‘reasonable care’ may include, for example, the following (see EM5140):

• understanding tax return entries through discussion with the agent;

• establishing the origin and principles underlying figures in agent computations;

• comparing agent computations with the figures provided; and

• reviewing comparative figures (e.g. for the previous year).

The test of a ‘prudent and reasonable man’ in the case of a company applies to its officers (or employees). The extent to which company officers are expected to be aware of the potential necessity for technical adjustments may depend on their business and accountancy knowledge and experience.

A company officer with no financial background may need to rely on professional assistance for technical matters beyond that which he could reasonably be expected to understand. However, company law obliges officers to establish the accuracy of the company’s financial statements. Any such director might reasonably be expected, for example, to check certain figures from the company’s accounts against the tax computations, and seek clarification of certain differences with the adviser. Two examples are included in the Enquiry Manual. The first is where a business sold plant and machinery for a significant amount, with the disposal not being reflected in the capital allowances computation. The second is where the certified accounts show a tax provision. HMRC would expect the company officer to check the provision against the corporation tax computation and satisfy himself about any difference. HMRC would also expect company officers to ensure accounting systems are sufficiently effective to enable the correct figures to be disclosed for the purposes of the company tax return.

Conversely, company officers with a financial background would be expected to be better able to understand many accountancy and tax issues in returns and computations. Similarly, large companies or groups with in-house tax departments will normally be well equipped to understand technical issues. HMRC may be unaware of the business background of company officers or key employees at the outset of an enquiry, and in the event of a technical adjustment resulting in additional tax will need to find out why incorrect figures or treatment were returned. The precise nature of the adjustment will also be relevant. HMRC acknowledge that many taxpayers will have insufficient understanding of complex technical adjustments to identify errors of that nature in returns, including where there is real uncertainty in law as to the proper tax treatment of a particular item. However, each case will be considered on its own facts.

Tax adviser’s view

My recent experience, and the consensus upon speaking to a number of accountants on this subject, is that many inspectors seem to automatically pursue penalties for technical adjustments. Indeed, the Enquiry Manual does instruct inspectors to consider culpability whenever a tax return adjustment results in additional tax. However, despite the fact that a technical adjustment may result in a return being incorrect, it does not automatically follow that the adjustment attracts a penalty. The loss of tax must result from the return having been submitted negligently (or fraudulently) by the taxpayer. As mentioned, the onus of proof initially rests with HMRC.

It is axiomatic that in signing the declaration on a tax return, the taxpayer assumes full responsibility for its contents and accuracy. However, the Enquiry Manual acknowledges that an incorrect return could be entirely the fault of an agent and the taxpayer completely innocent, on the basis that ‘…they could not reasonably be expected to know of, or to have informed themselves of the error, when they signed the return’. In those circumstances, there can be no penalty (EM5140).

The Enquiry Manual (at EM5130) also cites case law in support of the proposition that the taxpayer is held responsible if the agent submits an incorrect return. It can sometimes be intimidating for advisers with an opposing viewpoint to find case law being cited in the HMRC manuals. However, those cases need to reviewed and considered in their proper context. Clixby v Poutney [1967] 44 TC 515 is a back duty case. Before raising assessments out of time, the Revenue had to demonstrate ‘wilful default’ by or on behalf of the taxpayer. The Commissioners were not satisfied that the taxpayer was guilty of wilful default, but found that his agent was guilty on the taxpayer’s behalf. The High Court dismissed the taxpayer’s appeal. Similarly, in Pleasants v Atkinson [1987] STC 728, the taxpayer was found innocent of wilful default, but his accountants were found guilty on his behalf of a ‘…most extraordinary dereliction of duty in the preparation of the accounts.’

These days, the time limit for discovery tax assessments on companies is extended from six to twenty-one years if the loss of tax is attributable to the fraudulent or negligent conduct of the company or a person acting on its behalf (para 46). However, a penalty can be charged only if there is proven fraud or neglect by the company. Hence HMRC cannot penalise technical adjustments without first demonstrating at the very least a lack of care and attention on the part of the company’s officers or employees.

HMRC’s required standards of reasonable care appear to vary according to the taxpayer’s financial or accountancy background. However, it would seem that every company officer is expected to have a basic knowledge of tax and accounts (see EM5140). This is a sensible approach in principle, but how can it be measured consistently in practice? By their very nature, technical adjustments are surely beyond the expected remit of most small and medium sized company officers and employees? Unfortunately, it appears not. I have seen letters from HMRC asking about the qualifications and experience of directors for this purpose.

Professionals who prepare accounts and returns on behalf of client companies invariably require that a company officer confirms that the return and computations are complete and correct to best of their knowledge and belief. It is therefore not unreasonable to expect that individual to have checked the returns and accounts for obvious errors or omissions. However, it would seem that HMRC require a higher standard of care and attention if penalties for neglect are to be avoided. Unfortunately, this is not an ideal world, and most clients have neither the time nor the inclination to analytically review returns, particularly if they do not fully understand what they are reading. Nevertheless, it seems that in order to reduce the risk of HMRC arguing that any technical adjustments arising are culpable, many company officers will need to take a more active interest in returns and accounts. Moreover, they will need to demonstrate the steps taken to establish reasonable care.

Practical situations

So much for guidance and principles - how does HMRC’s approach apply in practical situations? Three illustrations are outlined below.

Example 1: Overdrawn account

Small Limited is a small family trading company with a turnover of £300,000 and an operating profit of £20,000 for the accounting period ended 31 January 2004. An enquiry is opened by HMRC, as directors’ remuneration has significantly fallen and the balance sheet shows an increase in ‘other debtors’.The enquiry establishes that the directors’ remuneration was supported by an overdrawn loan account of £20,000 that is not separately disclosed in the accounts and no liability under TA 1988, s 419 has been self-assessed on form CT600. The tax under TA 1988, s 419 of £5,000 was therefore omitted from the return. The company’s accountants claim ‘innocent error’ on the grounds that it is the first time that the company have had to account for any liabilities under TA 1988, s 419, and that they overlooked the matter due to the pressure of attending to the filing requirements of other non-corporate clients in the same month.

Example 1

In Example 1, the overdrawn directors’ loan account was inadvertently ‘hidden’ in other debtors. Should the company’s officers have been aware of its existence? And if so, could they reasonably be expected to be aware that an overdrawn loan account has implications under TA 1988, s 419?

HMRC’s view

The return and notes to the return clearly show that S419 liability arising on an overdrawn loan account should be declared. Regardless of the agent the company should be aware of this requirement. That the agent let them down is no excuse. The company had a duty to check the return before it was signed off. There is no question of an 'innocent error' defence because innocent error means innocent even of neglect.

Tax adviser’s view

The clients would probably have been unaware of the tax issue involved. However, it is necessary to consider whether they should have been aware, and whether they exercised reasonable care in submitting the return. In a small company, it is quite possible that the officers checking the return would be the same directors in receipt of the loan.
The consensus of professionals in the Working Together meeting mentioned earlier (me among them) concluded that the adjustment was culpable, and that a small penalty was justified in the circumstances.

Example 2: R & D overclaim

SME Limited is developing a new Widget. The company has a £7 million turnover but makes a loss and claims a Research and Development (R & D) tax credit repayment in its accounting period ended 30 November 2003. An enquiry is opened by HMRC, and it is found that R&D costs have been incorrectly overstated by £15,000.

The resulting overstated R & D tax credit repayment is £3,600 (i.e. £15,000 x 150% x 16%). Both the company’s agents and the company explain that the overstated claim arose because of administrative mispostings that were not identified during the annual audit.

The penalty provisions dealing with fraudulent or negligent R&D tax credit claims are contained in Finance Act 1998, Sch 18 para 83F, and specify a maximum penalty equal to the R&D tax credit overclaimed.

Example 2

In Example 2, the error is made by the company, which is not identified by the adviser during the audit.

HMRC’s view

There was clearly a lack of reasonable care by the company in not ensuring that the appropriate systems were in place to ensure the claim was correct. The adjustment therefore arises due to the company’s negligence and a penalty would be sought.

Tax adviser’s view

The error is an innocent one by the company. There is anecdotal evidence that some professionals have been resisting the imposition of penalties resulting from incorrect R&D claims. However, in Example 2 the overpayment does not arise due to a ‘technical’ adjustment over the deductibility of particular items of expenditure, but because of an error on the company’s part that was not detected by the company’s advisers. In my view, the adjustment is probably culpable. This was also the consensus of professionals in the Working Together meeting.

Example 3: Incorrect allowances

In Example 3, an adjustment arises because the company claimed first year allowances to which it is not technically entitled, being a large company for capital allowances purposes. Would it make any difference to the culpability issue if the company did not employ its own in-house accountants?

Example 3

Giant Ltd is a large company for capital allowances purposes in its accounting period ended 30 April 2003. The company employs fully qualified in-house accountants and a large, reputable firm of Chartered Accountants prepares statutory accounts.

An enquiry is opened into the company’s capital allowances claim, as the company had claimed first year allowances of 100% and 40% despite being a large company during the accounting period. The company immediately accepts that capital allowances should have been claimed at 25%, and apologises for the oversight. Revised computations are submitted, together with a cheque in respect of the additional corporation tax liability.

HMRC’s view

We consider that the adjustment is culpable, on the basis that the claim was negligent. The company had sufficient technical knowledge through its in-house accountants to determine that a capital allowances claim could not validly be made. Even if it did not employ in-house expertise, a large company would normally be expected to have an officer with an adequate financial background to be reasonably aware of the capital allowances position. There was also a competent firm of accountants to confirm the position.

Tax adviser’s view

This is perhaps the most debatable of the three scenarios. Here the adjustment is clearly a technical one. In my view, it would be difficult to resist a penalty where the company employs in-house accountants, because arguably they should have been aware of the restriction in first year allowances for large companies. However, in the absence of in-house accountants, the position is surely much more debatable. Some professionals in the Working Together meeting considered that there was no inherent negligence in this technical adjustment.

Conclusion

In many cases, questions of client negligence and culpability in technical adjustments will not be clear cut. Advisers should be aware that penalties cannot be automatically imposed. Equally, they should also be aware of the necessity to stress to company officers the importance of exercising reasonable care and diligence when approving tax returns and accounts. If an adjustment is established for which there appears to be no known acceptable explanation, the onus effectively shifts from HMRC to the taxpayer, who must then demonstrate that there was no neglect in submitting the return (EM5180).

Every case is different, and the outcome of disputes between tax professionals and HMRC will depend on the precise circumstances. Hopefully, this article will stimulate interest and a better appreciation of ‘where the other side is coming from’, even though in individual cases we may not necessarily agree.

Mark McLaughlin is Editor of TaxationWeb.co.uk and a tax consultant to professional firms.

Beryl Mansworth is the HM Revenue & Customs Area Director, Compliance, for the Manchester Area Office.

The above article was first published in ‘Taxation’ on 23 March 2006.