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Penalty points

Michelle Sloane, a solicitor at The Khan Partnership LLP, provides a summary of HMRC’s new penalties regime and advises on the steps that businesses can take to avoid a penalty.

Following the merger of Inland Revenue with Customs & Excise in 2005, HMRC inherited a wide-ranging and confusing collection of penalty powers covering both direct and indirect tax. HMRC state that in order to make the tax system simpler and more consistent, they have introduced a new set of penalties that will apply across all the tax regimes. However, it is clear from their comments and their marked aggressive approach to tax compliance that the new regime is designed to increase the scope and bite of penalties in an attempt to “close the tax gap”.

When does it start and what taxes are affected?

The new penalties regime applies to returns commencing on or after 1 April 2008 which are submitted from 1 April 2009. The taxes initially affected by the new penalty regime are Corporation Tax, Income Tax, PAYE, NICs, the Construction Industry Scheme and VAT.

The regime will be extended to other taxes for periods commencing from 1 April 2009 where the return is due to be filed on or after 1 April 2010. This includes Environmental Taxes, Excise Duty, Stamp Duty, Student Loans, Inheritance Tax, Insurance Premium Tax, Pension Schemes and Petroleum Revenue Tax.

What are the new penalties?

Under Schedule 24 of the Finance Act 2007, a penalty will be charged on inaccurate documents if two conditions are satisfied:

The document must contain an inaccuracy which results in an understatement of a liability to tax, a false or inflated loss, or a false or inflated claim to repayment; and
The inaccuracy must be careless or deliberate.
The penalty is a percentage of the potential lost revenue and is set on a sliding scale depending on the behaviour that gave rise to the error and whether there has been a disclosure to HMRC. The less serious the behaviour, the smaller the penalty:

Reasonable care – no penalty;
Carelessness – up to a maximum of 30%
Deliberate – a minimum of 20% up to a maximum of 70%
Deliberate and concealed – a minimum of 30% and a maximum of 100%

What is new about the penalties?

Financial penalties for incorrect returns have been part of the tax system for many years, however, the test for awarding a penalty focused on the concepts of the taxpayer being fraudulent or negligent. Under the new scheme, the test instead focuses on the behavior of the business which led to the inaccuracy, and the taxpayer’s history. The concept of inaccurate documents represents an extension of the existing penalty provisions, which are largely based on the submission of an incorrect return. It is anticipated that the penalty bandings, although providing clarity, will undoubtedly have the effect of increasing the number of penalties as HMRC will be bound to apply the statutory bandings. The size of the penalties has also increased. This is particularly significant for VAT which currently has a misdeclaration penalty of a maximum of 15%.

What is reasonable care?

Reasonable care is not defined in the Finance Act 2007. HMRC’s Guidance indicates that it depends on the particular circumstances of the taxpayer. HMRC have suggested that they would not expect the same level of knowledge or expertise from a self-employed and un-represented individual as from a large multi-national company. HMRC expect a higher degree of care to be taken over large and complex matters compared to simple straightforward transactions. There is also a focus on the systems underlying the document or return and HMRC would look favorably on a business which has systems in place that are followed.

This highlights that the taxpayer will need to demonstrate to HMRC that they have thought about and taken action to treat their tax affairs correctly in order to avoid a penalty.

What if you do not agree with the penalty?

There is a right of appeal to the VAT and Duties Tribunal against a penalty decision, the amount of the penalty, the decision not to suspend a penalty and the conditions of suspension.

Are there any reductions or suspensions?

The aim of the new penalty regime is to encourage positive behavior and in particular encourage disclosure. Accordingly, if disclosure is made penalties will be reduced. This is a significant change from the previous regime where errors that were voluntarily disclosed did not normally incur a penalty. The rate of the reduction of the penalty is dependent upon whether disclosure is prompted or unprompted by HMRC. A disclosure will be viewed as unprompted if it is made at the time when the taxpayer has no reason to believe that HMRC has discovered, or is about to discover, the inaccuracy. The reduction can also be enhanced by telling and helping HMRC and then responding positively to their requests for information and access to records. The effective management of possible errors and communication with HMRC is going to be a crucial element in reducing any penalty due. If a business has a voluntary disclosure to make it would be wise to make it before penalties under the new regime apply.

The new regime allows for penalties to be suspended for up to two years. The suspension cannot be applied where the error was deliberate. Penalties will be suspended by means of a notice specifying what part of the penalty is to be suspended, the period of suspension and the conditions of suspension. Factors that HMRC will consider when deciding to allow a suspension include general compliance behaviour, the level of disclosure and the nature of the inaccuracy. If, at the end of the period of suspension, HMRC is satisfied that the conditions of suspension have been complied with, the suspended penalty will not become payable.

What if you do not agree with the penalty?

There is a right of appeal to the VAT and Duties Tribunal against a penalty decision, the amount of the penalty, the decision not to suspend a penalty and the conditions of suspension.

So what do taxpayers need to do?

Taxpayers need to ensure that they are taking reasonable care of their tax affairs (and be able to evidence this) in order to prevent penalties being incurred. Prior to the new regime coming into force all taxpayers should conduct a review of the procedures in place for determining the correct tax treatment of transactions and how they prepare for the completion of tax returns. In particular, they should consider the following:

Is the person who is in charge of making decisions regarding the tax treatment of business transactions and preparation of returns appropriately qualified/sufficiently trained and how are they kept up to date?
Has systems documentation been prepared in relation to all the processes involved for the preparation of returns?
Are there controls in place to check on both the completeness and accuracy of returns?
If a transaction is significantly complex is formal advice sought or guidance requested from HMRC?
Is there a well documented audit trail for transactions?

If you would like to know more about the new penalty regime, make a voluntary disclosure or discuss any other tax issue please contact Hassan Khan or Michelle Sloane at The Khan Partnership LLP on 0207 612 2530 for further advice.

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