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Mark McLaughlin CTA (Fellow) ATT TEP outlines forthcoming deadlines and topical practice points for accountants and tax practitioners.

A new approach

As forewarned in ‘Penalties: a new landscape’ (Busy Practitioner, July 2006), HM Revenue & Customs (HMRC) are proposing a new approach to penalties, involving a single structure for penalties relating to incorrect tax returns. It will apply to income tax, corporation tax, capital gains tax, VAT and employers PAYE and National Insurance contributions. However, it will not apply to inheritance tax.

HMRC’s proposals are still at the development stage. A consultation document ‘Modernising powers, deterrents and safeguards: penalties for incorrect returns’ was issued for comment on 19 December 2006. HMRC consider that it is important for a penalty regime to be structured not only as a deterrent, but also to offer “positive encouragement to people to volunteer if they think they might not have paid the right tax.” A conclusion from previous consultation is that a system of ‘sanctions’ should have the following qualities:

• visible, understandable and set in statute; 
  
• proportionate; 
  
• efficient to administer; 
  
• effective in deterring non-compliance; 
  
• mitigable; 
  
• consistently applied including enforcement once they have been awarded; 
  
• subject to appeal (where they cannot be overturned by taxpayer action); and 
  
• conformant with Human Rights legislation.

It seems that an important objective behind the new penalty regime is to differentiate between taxpayers who “do their best” to pay “the right amount of tax” but make a mistake, and those taxpayers “contemplating the deliberate understatement of their tax liabilities” or those who do not take “reasonable care” over their tax affairs.

A further important feature is that the regime is intended to encourage non-compliant taxpayers to return to being compliant on a voluntary basis (i.e. spontaneously, or in response to an HMRC approach), depending on whether the disclosure was prompted, and also the quality and timeliness of their disclosures. An interesting feature of the proposed disclosure abatement is that as part of this process, the taxpayer must allow HMRC access to records “for the purpose of ensuring that the inaccuracy or under-assessment is fully utilised”.

Penalties and abatements

The consultation document does not indicate the percentages for penalties or abatements. However, the starting point will be a standard penalty, expressed as a percentage of potential lost revenue. HMRC consider that the present, familiar system of penalty abatements under self-assessment for individuals and companies of a maximum 100 per cent is such that the level of penalties charged for neglect (at one extreme) and fraud (at the other) is comparatively narrow and small, as abatement levels have risen over time. The new approach involves consideration of the taxpayer’s behaviour in making the incorrect return. It identifies four different types of behaviour, with the level of penalty for the three culpable behaviours depending on how serious they are considered to be:

1. “Mistakes” or “misinterpretations” of fact or law, where reasonable care has been taken. This seems to include, for example, a one-off act or omission, or a ‘clearly disclosed’ tax treatment – no penalty would be charged in those cases.

2. failures to take reasonable care, resulting in a tax understatement or over-claim (referred to in draft legislation as “careless”).

3. deliberate understatements or over-claims (i.e. “deliberate but not concealed”).

4. deliberate understatements where the behaviour is aggravated by concealment, but the offence is not to be investigated with a view to criminal prosecution (i.e. “deliberate and concealed”).

Penalties in the latter three categories would increase in steps so that, for 4 above, HMRC consider that in the most serious cases the penalty rate would be 100 per cent. However, all cases of penalties would be subject to an appeal process, in terms of both liability and amount.

Mistakes or misinterpretations

HMRC cite instances of mistakes or misinterpretations despite taking reasonable care. Examples of circumstances in which no penalty would be include the following:

• an arithmetical error, but not so big as to produce an odd result that ought to have been questioned;
  
• misinterpreting legislation or regulations in respect of an unusual item, not big enough to prompt the need for professional advice;
  
• omitting a small (relative to overall liability) item from a return which is otherwise correct;
  
• a reasonable judgement is made (after advice where appropriate) where the legislation requires this (e.g. a valuation), and the basis on which the valuation is made is disclosed;
  
• a reasonable view of the law is adopted after giving it careful consideration or taking advice where appropriate, even if this differs from HMRC guidance; and
  
• trying to get HMRC advice but:
  - finding none was available in a form accessible to the taxpayer;
  - not being able to find it or understand it; or
  - it subsequently proved to be wrong or out of date.

It will be interesting to see how narrowly or widely HMRC seek to apply judgemental issues in some of the cases listed above.

What is reasonable?

The difficulty in using terms such as “reasonable care” (which replaces the current terms “negligence” and “negligent conduct”) lies in defining what “reasonable” means, and applying it consistently. HMRC acknowledge that the term would need to be interpreted based on individual facts and circumstances. HMRC’s draft guidance on the meaning of “reasonable” states that it “…must be interpreted according to the circumstances of the taxpayer. It must reflect relative complexity of the tax affairs in the return, the size of the figures, the capability and circumstances of the taxpayer involved.”

Of course, problems generally arise in situations calling for the exercise of human judgement on such matters as proportionality and materiality. It is not difficult to envisage cases reaching the Commissioners and Courts (and eventually the new appeals Tribunal) in the early stages of the new regime on the definition of reasonable. Its meaning in the context of penalties seems likely to evolve from judicial decisions.  

Deliberate or not?

Similar difficulties are likely to arise when determining if there has been a “deliberate understatement”. In the absence of an admission from the taxpayer that an act or omission was deliberate, how will it be possible to consistently judge whether there was a conscious intention to do or not do something? Some instances of deliberate intention will be obvious (e.g. systematically paying wages without operating PAYE or NIC), and others perhaps less so (e.g. if there has been no previous history or pattern of understatements). What should a taxpayer be reasonably be expected to know?

Suspended penalties

HMRC are also considering the introduction of a system of suspended penalties, for offences other than deliberate understatement. The penalty would be suspended for a specified period, possibly a maximum of two years, and may represent all or part of the penalties imposed.

The consultation period on the new penalty regime ends on 13 March 2007. This provides an opportunity for practitioners to have their say on the proposed new regime. Contact can be made in various ways, including by e-mail (powers.review-of-hmrc@hmrc.gsi.gov.uk) and by telephone (020 7147 2401). Those practitioners who deal with self-assessment enquiries, VAT or PAYE penalty issues on a regular basis should express their views on the single penalty structure. HMRC have raised a number of questions for consultation. The document ‘Modernising powers, deterrents and safeguards: penalties for incorrect returns’ also includes draft legislative clauses dealing with penalties. It can be downloaded (in pdf format) from the HMRC website.