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Tolley's Practical Tax by Philip McNeill and Sarah McNeill

Philip and Sarah McNeill look at an emotive topic.In the coming year there are likely to be developments in the penalty arena. The consultation document ‘HM Revenue and Customs and the taxpayer: Modernising Powers, Deterrents and Safeguards’ has among its many objectives ‘as far as possible aligning powers and practices across different taxes’ and ‘dealing swiftly and effectively with those who deliberately flout their obligations’.

We have already seen a new code of practice – ‘Civil Investigation into Cases of Suspected Serious Fraud’ – being an alignment of former Customs and Revenue procedures. More guidance and legislation are likely to follow. In this context, it would seem opportune to review a few practical cases where penalties have been imposed, and to consider how these match up to HM Revenue and Customs (HMRC) current guidelines and future intentions.

Please to remember - 5 October

Autumn is a good time to look at the penalty question. After 5 October, we move into the late notification penalty period for 2004/05 income (TMA 1970 s 7(8)). We approach the end of the normal enquiry window for 2003/04 returns and look to submit 2004/05 returns before the filing deadline of 31 January 2006. What is likely to happen if there is a mistake in a return? And what defences and solutions may help?

Late filing

The basic position under TMA 1970 s 93(2) is that the taxpayer is liable to a fine of £100 when a self-assessment return is submitted late. The normal due date is 31 January following the year of assessment, but this may be extended if the return is issued late.

In practice, delivery by first post on 1 February is considered to be ‘on time’. Delivery by any means during 1 February, or by first post on 2 February avoids the penalty, but is considered late as regards the enquiry window, which is then extended. Barring the imposition of a daily penalty, another £100 is then charged six months after the filing date.

Returns outstanding for more than 12 months attract a tax-geared penalty of up to 100% of the tax due. However, if there is no liability on the return, there should be no penalty. The main defence against a late filing penalty is ‘reasonable excuse’.

Consider the following example. Mr H, having worked for the police service for many years becomes ill with severe anxiety depression a few years before he is due to retire. He receives an employer’s pension and has some rental income from a jointly owned house. Due to his illness, his tax affairs are left in abeyance for a number of years. As he starts to recover, he finds that he has penalty notices of over £600 mainly for late filing of returns.

Reasonable excuse

To maintain a successful appeal against the penalty, Mr H would need to demonstrate that this illness is a reasonable excuse throughout the period of default. HMRC would also expect him to show that he has dealt with his affairs as soon as possible after recovery. According to the Revenue leaflet ‘Penalties for late tax returns’ SA/BK6, this is expected to be within 14 days. It would also be relevant for a taxpayer to show that all his or her affairs were left unattended, not just the tax affairs. This is all quite onerous for someone not in the best of health.

Penalties - theory and practice Inaccurate returns

Going one stage further, what happens if a return is submitted, but then found to be inaccurate? The background is TMA 1970 s 95 (s 95A for partnerships). Penalties are due where a return is incorrect because of fraud or negligence. Innocent errors should not attract penalties. This is confirmed in Revenue guidance. The Enquiry Manual states ‘It is important to bear in mind that an incorrect return, statement or account does not of itself attract a penalty. You (ie the Inspector) must establish that the incorrect return was submitted fraudulently or negligently by the taxpayer.’(EM5101).

Defining innocence

How easy is it to establish that an error is innocent? Consider an example. Mrs A receives a letter from the tax office querying a return. A simple error has led to over-claimed expenses for a single year. £2,630 additional tax is due, to which a 10% penalty is added. There is no question of fraud. The error is ‘innocent’ in that the taxpayer made a genuine mistake and, on the error being pointed out, immediately accepted the correction.

The problem is, what is considered ‘innocent’ for these purposes? Revenue guidance is somewhat inconclusive. EM 5180 – Innocent Error – cites typical explanations offered by taxpayers. They include isolated arithmetical or transcription errors and being misinformed about assessibility by someone considered reliable. No comment is made, however, as to exactly which of these possible explanations could be considered innocent. The general comment is ‘Although the onus is always on you (the Inspector) to demonstrate that there has been fraud or negligence, you will normally show that there has been an error or omission and that there is no known acceptable explanation. The onus will then be on the taxpayer to establish that the error was entirely innocent of fraud and negligence: this is not an easy task’. (Emphasis added).

Furthermore, when we take a look at the interpretation of negligence given at EM5125, we see how little room there is, from a Revenue angle, to argue innocence. Based on Blyth v Birmingham Waterworks Co (1856), negligence is defined as ‘the omission to do something which a prudent and reasonable man would do’. The Revenue considers that the reasonable man will, inter alia, ‘make promptly, a complete and correct return of his income and gains when required to do so under statutory authority’. On reading this, the taxpayer might consider a response like Puddleglum’s. ‘Got to start by finding it have we? … Not allowed to
start by looking for it, I suppose?’ (CS Lewis, The Silver Chair). Is the expectation that the reasonable taxpayer will make a complete and correct return, or that he or she will take all reasonable care to submit a complete and correct return?

Whatever the final analysis, it is worth bearing in mind that innocence will not be assumed. This is an issue worth taking up. It should also be remembered that TMA 1970 s 97 turns an innocent error into a negligent error if the taxpayer delays notification when it comes to light.

Scenarios like these can cause considerable distress to the taxpayer. They are minor when viewed against the whole gamut of possible penalties, but it should be noted that even in cases like these, HMRC often assume that the very fact that there is an error proves negligence, thus opening the gateway to penalties.

At a slightly more serious level, consider this example. Mr Y, a joiner, has a friend who submits tax returns for him. In the first year, the private drawings figure is put down on the return as wages under the private use column. This is queried by the Tax Office. Mr Y then believes that the Revenue expects the figure to be put under wages as a deduction – not as private use. Some years later, the issue is re-examined on a later return and the error correctly recognised. Mr Y is asked to pay the additional tax, plus a 20% penalty. This is despite the fact that the error could be considered ‘innocent’ from the taxpayer’s point of view.

Disputed differences

Mr X and Mr T are two brothers in partnership as window cleaners. Theirs is a typical cash-based business. Following an enquiry, certain sums received by the partners are treated by the Revenue as business income. The finding is disputed by Mr X and Mr T who maintain that the amounts are gifts from family members.

However, the brothers cannot find unequivocal proof of their contention and the General Commissioners confirm the assessment, including the possible gifts, as trading income. The result is a tax demand for £11,000 plus penalties of about £9,000 – a loading of around 80%. From the brother’s point of view, this is little short of iniquitous. From the Revenue angle, it seems not unreasonable.

Theory

It will help to bridge this gap if we consider the background and examples published by the Revenue.

The power to mitigate penalties is given by TMA 1970 s 102. This is given in very broad terms. More detailed guidance has been developed giving reductions for disclosure, co-operation and seriousness. Practical examples can be found at EM6085 to 6089. Example 3 on EM6087 is the nearest to the window cleaning case. In the Revenue’s example, the taxpayer denies irregularities, and is obstructive throughout the enquiry. The Commissioners determine the liability in line with the Revenue’s expectations. The penalty loading is set at 70%, which is arrived at as follows. The maximum possible penalty is 100% of tax due. This can be mitigated for disclosure, cooperation and seriousness.

• Disclosure – possible maximum of 20%, rising to 30% when disclosure is voluntary in circumstances where the taxpayer has no fear of discovery. In this case, nil – the taxpayer did not make any disclosure.

• Co-operation – possible maximum of 40%. In this case nil – the taxpayer was obstructive and it was necessary to have the Commissioners confirm the assessment to make any progress.

• Seriousness (size and gravity) – possible maximum of 40%. In this case the omitted profits were not large in relation to the profits returned so 30% mitigation allowed.

The overall result in the Revenue’s example is therefore a 70% penalty.

Ability to pay: the point of congruence

All too often a taxpayer can face severe financial difficulties or even bankruptcy after the imposition of penalties. But that theory and practice need a point of congruence is recognised in the Enquiry Manual (EM5213). ‘It is not the Board’s policy nor is it common sense to go to the trouble of determining penalties where there is no possibility of the money being paid.’

If one is aware that a taxpayer does not have the means to pay it would be wise to raise this with the Inspector at the outset of negotiations, rather than leave it until the grand finale when penalties are imposed.

- And practice

To review again Mr X and Mr T. They continued to maintain their innocence, but they have not been well advised about the need to keep records – either to prove business income or verify non-business receipts. From the Revenue angle, they have maintained an inflexible, and unsubstantiated position.

The Commissioners’ powers were needed to make progress in the case. The tax at stake was not insubstantial. These factors led to a high penalty loading. Indeed, if records are poor, the threat of penalties under TMA 1970 s 12B(5) for failure to keep records (which can be up to £3,000) is likely to ensure that the final settlement is quite large.

October 2005

Philip and Sarah McNeill
Respectively TaxAid website editor and freelance writer

This article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.lexisnexis.co.uk/taxationweb