Mark McLaughlin CTA (Fellow) ATT TEP highlights the forthcoming changes to penalties for incorrect tax returns.

Mark McLaughlin

Foul play 

The Government is keen to deter ‘foul play’ by taxpayers. Changes to the law will affect taxpayers who submit incorrect tax returns to HM Revenue & Customs (HMRC), through the introduction of a new penalty regime. The new rules are wide ranging, and will not only affect individuals, trustees or partnerships who file self assessment returns, but will also impact on company tax returns, PAYE returns and the VAT returns of businesses. 

To continue with a footballing analogy, in many cases, the new basis for HMRC to ‘award a penalty’ against taxpayers will result in mistakes proving more expensive than under existing practice. Fortunately, the start of the new penalty regime has been delayed. This gives taxpayers time to review current practices for complying with their tax obligations, and to seek professional help, if appropriate.  

Current score

Under the existing rules, if a taxpayer (or agent) files an incorrect tax return fraudulently or negligently, HMRC can impose penalties. If an incorrect return is not corrected without unreasonable delay, the return is treated as if it had been made fraudulently or negligently. The maximum penalty is broadly the tax lost, i.e. the additional tax resulting from the correction. However, those penalties may be reduced depending on the circumstances. Guidance for individuals is given in the HMRC leaflet IR160 ‘Enquiries under Self Assessment’ (http://www.hmrc.gov.uk/pdfs/ir160.pdf), but in broad terms penalties may be subject to discounts, as follows:

• Disclosure of the error – up to 20% (exceptionally 30%);
• Co-operation with HMRC – up to 40%;
• Size and gravity of the offence – up to 40%

In exceptional circumstances, the above abatements can result in no penalties to pay. However, in practice the level of penalties is generally subject to some negotiation between HMRC and the taxpayer or his agent, resulting in some penalties becoming chargeable. 

It appears that the new penalty rules may limit the scope for negotiation over the level of penalties to be charged, or rather the degree of discretion that HMRC Officers are able to exercise in the course of negotiating the level of penalties.

Moving the goalposts

The rules on penalties for incorrect returns were announced in Budget 2007. They apply to taxpayers who make errors in returns and certain other documents. Penalties may be charged for an incorrect return, which results in either an understatement of tax, the overstatement of losses, or a false or inflated tax repayment claim. However, penalties may only be imposed if the inaccuracy was ‘careless or deliberate’.

The level of penalties will be charged on an increasing scale, depending upon whether the taxpayer’s actions are considered to be careless, or deliberate but not concealed from HMRC, or deliberate and concealed. Words like ‘careless’ and ‘deliberate’ are subjective in nature, and normally call for a degree of judgement. The legislation attempts to define them, but unfortunately the definitions themselves call for some degree of judgement. A taxpayer is ‘careless’ if there is a failure to take reasonable care, but what is ‘reasonable’ in this context? A mistake is ‘deliberate and concealed’ if arrangements are made to hide it, such as by submitting false evidence to support it.

In addition to mistakes by taxpayers, penalties may be charged broadly if errors by HMRC, which lead to a tax shortfall, are not reported within 30 days. HMRC Officers will be able to judge whether the taxpayer knew, or should have known, about the error.

On the penalty spot

As mentioned, the level of penalty is dependent on the degree of culpability of the taxpayer (or his agent), and is charged on the potential lost revenue. The term ‘potential lost revenue’ has its own definition. However, in broad terms it includes the extra tax (and National Insurance contributions, if appropriate) as a result of correcting an incorrect return or HMRC assessment, or an incorrect tax repayment. There are some fairly complicated rules to allow for the offset of tax overstated against additional tax in calculating potential lost revenue, and hence the level of penalties. However, when calculating the potential lost revenue for groups of companies, no account will be taken of any group relief claims that may be made. A similar position applies in respect of loans to participators of close companies (i.e. the potential lost revenue is calculated before relief is calculated upon a complete or partial repayment of the loan).

The level of penalties depends upon the taxpayer’s behaviour, which are divided into three possible categories:

• Careless (or failing to report HMRC errors) – Maximum penalty 30%;
• Deliberate but not concealed – Maximum penalty 70%; and
• Deliberate and concealed – Maximum penalty 100% 

The above penalty rates can also be applied in respect of overstated claims for tax losses, where the losses have been used to reduce tax liabilities. In addition, if any losses have not been used (e.g. if they have been carried forward to another tax year), the penalty is based on 10% of the unused losses. However, no penalty is charged if there is no reasonable prospect of the losses being used. If an error results in tax being declared later than it should have been, the penalty is based on 5% of the delayed tax for each year of the delay.

There are no penalties for errors not falling within the above categories. In HMRC’s consultation document ‘Modernising Powers, Deterrents and Safeguards – A New Approach To Penalties’ which can be downloaded from HMRC’s website (www.hmrc.gov.uk), HMRC state: “Mistakes or misinterpretations of fact or law, where reasonable care has been taken, would not be subject to a penalty.” Examples given by HMRC include:

• an innocent error after taking reasonable care;
• a reasonable view of the law that proves to be wrong or is not pursued;
• an action or omission that does not form part of a pattern of behaviour and is untypical of the taxpayer concerned; or
• the adoption of a treatment for tax purposes that is clearly disclosed to HMRC in a return or accounts, even if subsequently changed by agreement or determination of a tribunal.

However, the taxpayer will probably need to demonstrate that the circumstances of their case fall outside those in which a penalty may be imposed, and into the ‘harmless’ category for penalty purposes.
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As with the previous system, penalties may be reduced. The level of reduction depends upon ‘disclosure’ by the taxpayer (i.e. telling HMRC, giving them ‘reasonable help’ to correct the error and allowing HMRC access to records for this purpose), and whether the disclosure is prompted by HMRC, or is unprompted. A disclosure is ‘unprompted’ if the taxpayer has no reason to believe that HMRC would otherwise discover it.

The potential penalty reductions result in the following maximum and minimum penalty boundaries:

The actual levels of penalty within the above boundaries will depend upon the ‘quality’ (i.e. timing, nature and extent) of the disclosure. HMRC may also reduce penalties in special circumstances. The term ‘special circumstances’ is not defined, and the taxpayer would therefore need to satisfy HMRC that their circumstances satisfy this criteria. However, the ability to pay, or the fact that a potential loss of revenue from one taxpayer is balanced by another taxpayer’s overpayment, is not considered to be ‘special’ for these purposes.

A penalty charge is treated like a tax charge, and is subject to similar procedures (e.g. in respect of collection, the right of appeal, etc). HMRC must assess penalties within certain time limits. For taxpayer errors, the assessment time limit is within 12 months from the end of the appeal period or the date when the error is corrected. For failures to notify HMRC of an under-assessment, the time limit is 12 months from the end of the period for appealing against the assessment to correct the error.

HMRC also have the power to suspend penalties for up to two years, if certain conditions are satisfied. After the suspension period, the penalty may either be cancelled, or become payable.

Taxpayers are still generally subject to penalties if, for example, their accountant submits an incorrect tax return, or fails to take reasonable steps to notify HMRC about tax under-assessed. However, an act or omission by an agent does not result in a penalty if taxpayers can satisfy HMRC that they took reasonable care to avoid the problem occurring.   

Taxpayers have the right of appeal against penalties imposed by HMRC, i.e. against the decision to impose a penalty, the amount of appeal payable, a decision by HMRC not to suspend a penalty or the conditions set by HMRC for a penalty suspension.

Company officers and business partners may become personally responsible for a proportion of the penalties imposed, if a deliberate inaccuracy was attributable to them.

They think it’s all over…

The new penalty regime was made law earlier this year, but will not be introduced until 1 April 2009 at the earliest. This gives taxpayers time to get used to the new rules. It also allows time to ensure that there are safeguards in place to prevent mistakes in their tax returns (e.g. by appointing a tax adviser to act for them).

The tax rules can be complex, depending on the taxpayer’s circumstances. In some cases, it can be very difficult to prepare tax returns in an acceptable manner. For example, the tax treatment of a particular item of income or expenditure may be uncertain, and open to more than one interpretation of the tax legislation. It is hoped that HMRC will apply the new rules in a fair, commonsense and consistent manner. After all, it is the deliberately non-compliant taxpayer that deserves a ‘straight red card’, not those who make occasional mistakes despite their best endeavours.

Mark McLaughlin CTA (Fellow) ATT TEP is a Consultant to TaxDebts (www.taxdebts.co.uk), who assist taxpayers with outstanding tax problems.