PENALTIES are emotive – and frequently painful. In soccer, a penalty is rarely uncontroversial but usually makes one side happy. In the tax field, penalties will never please the taxpayer’s side and, with a new regime just starting, may start to become more frequent.
So what is happening and, more importantly, how do businesses in particular avoid falling foul of the taxman’s new powers? All taxpayers are potentially affected but, inevitably, businesses have more tax issues to manage.
Why penalties?
Most taxpayers do their best to meet their tax responsibilities. Some, it has to be said, don’t and so any tax authority needs a system to encourage the recalcitrant and careless to do better and not end up with an unfair advantage over those who do try their best.
That “encouragement” starts with an interest charge on late tax payments (currently 7.5% for income tax, for example) but can rapidly escalate to a formal financial penalty.
Why the changes?
The coming together of the Inland Revenue and HM Customs & Excise into HM Revenue & Customs (HMRC) in 2005 meant that there would have to be a harmonisation of much of the administration of the 20- plus taxes under the control of the separate bodies. One of the areas where action has proceeded with relative dispatch is the general powers regime, including the penalties available to the taxman.
There has been a good evolution of proposals, with some fresh thinking and productive consultation. But the result presages a shift in how HMRC will police the tax system and the penalties to be applied to tax offences.
Where are we now?
The current penalty regime contains differences in approach between direct and indirect tax. VAT offences have a more mechanical scale of penalties than direct tax offences, with the latter usually being subject to negotiation and typically ending up with a 20-30% penalty.
This rarely pleases everyone, with taxpayers often feeling unfairly penalised for what may have been an innocent mistake and with HMRC and the adviser wondering if the pressure to settle produced a fair result.
Which taxes – and when?
This new regime will apply to all of the taxes under HMRC’s care. It applies to what might be termed the main ones – income tax, VAT, PAYE, NIC, construction industry tax and corporation tax – from April 2008, but only for returns or documents due to be sent to HMRC from April 2009. All other taxes are likely to come into the system from 2010.
Penalties: where are we going?
The new penalty regime borrows the mechanical approach of VAT and melds it with a philosophy of gradation to match the offence and encouragement to taxpayers to come clean and get their house in order. There are effectively four categories of “offence”:
- mistake;
- careless conduct;
- deliberate action, but not concealed;
- deliberate action with concealment.
One important move is that a “mistake” – an innocent error – will no longer attract a penalty. This will eliminate a lot of seemingly unfair results, particularly, perhaps, in the PAYE/NIC arena.
The penalties for the other conducts are laid down, with the discounts for disclosure (differentiating between prompted and unprompted) set out. The result is in many ways best expressed as a diagram (see below).
How much?
The penalties are calculated by reference to the “potential lost revenue”, i.e. the VAT, income tax or whatever that has been underpaid to HMRC as a result of the error.
Boundary issues arising
There are inevitably going to be boundary issues. It is not wholly clear where the line is between “mistake” (nil penalty) and “careless” (defined as “failure to take reasonable care” – 30% penalty). HMRC has said that it will expect different standards of care – and, in effect, technical ability – from different types of taxpayer.
A large PLC should have effective systems for VAT and employment taxes, for example. But for a sole trader, getting PAYE or VAT wrong a number of times, despite their best efforts, sounds more like a mistake rather than carelessness … though if the small business is making repeated errors, HMRC might well expect it to get outside assistance, or otherwise face being classed as failing to take reasonable care.
All taxpayers are expected to make and keep reasonable records sufficient to enable them to meet their responsibilities, which include making complete and accurate returns. Whilst a small businessman wouldn’t be expected to know all the ins and outs of the rules, HMRC expects them to be responsible – which must include getting assistance when issues arise that they are not familiar with.
Disclosing errors
It will be noted that even if the taxpayer agrees that the error is as a result of carelessness, it is possible to get a discount to 0% for “unprompted disclosure”.
This is another facet of the new system with its encouragement to “come clean”. However, this raises the question of how and when the small trader is supposed to recognise the error. HMRC might be more likely to spot it during a check, leading to the correction being “prompted”.
One fallback is the availability of “suspension”, i.e. the option HMRC has to suspend a carelessness penalty for up to two years and, in essence, to give the trader a chance to get its house in order.
This is aimed at systemic failings and is, in principle, a good move. It should be one to argue for if HMRC does not immediately offer it. It will probably mean the trader has to get an adviser to help with system improvements and potentially certify that all has been well but, if that causes the threatened penalty to evaporate, it will be worth it.
Deliberate errors
There may also be boundary issues over the concealment/nonconcealment differentiator. The immediate reaction of many may be that anyone deliberately trying to evade taxes is bound to do some concealing but HMRC has in mind trails of false invoices as indicating “concealment”.
How to avoid penalties
The starting point for a penalty-free life must be to get to know the requirements of the tax system and make sure systems are properly geared towards meeting them.
Putting it another way, the guideline for businesses is at once simple – to take tax responsibilities seriously and get it right first time (so what’s new, many may ask?) – and demanding, in that most taxpayers, especially those in business, have other priorities than tax in mind.
There will be leeway for genuine mistakes, and small businesses in particular are not expected to be omniscient. But the practical step that many will need to take over the next year is to sit down with their advisers and do something of a stocktake of how well records and systems are geared to cope with their tax responsibilities.
Being realistic, some errors will arise in even the best-run businesses but do aim to minimise them, spot them when they do arise and disclose – and be ready to argue for a suspension of any penalty that does crop up. Don’t, though, rely on suspension as the first line of defence. Like the offside trap, it can’t be relied on.
There is also a preliminary step – to sign up for the tax system on time. A similar stepped approach is likely to come in from April 2010 for penalising failure to notify HMRC about a tax issue: for example, reaching the turnover threshold and so having to register for VAT or starting self employment and so being liable to Class 2 NICs and income tax.
Going forward
The regime will require a certain change of approach by both advisers and by HMRC. There seems to be quite a need for briefing/training on both sides – and perhaps, an attitude shift by many HMRC people away from the “error = penalty” stance that many practitioners have often encountered.
HMRC insists that the new regime is not intended to raise more money – it doesn’t want to levy penalties but “to encourage people to comply with their legal obligations and improve their compliance behaviour”.
Most taxpayers will readily support that aim of not levying penalties but, as in soccer, the method is to know the rules and avoid the foul, not to protest after the event.
