Practical guide: is VAT penalty for "deliberate" behaviour justified?

Deliberate or careless?

If you have underpaid tax on a past return - by underpaying output tax or overstating input tax - it must have happened in one of three ways:

Human error- such as arithmetical errors or not understanding which sales are standard-rated and zero-rated.

Careless error- e.g. your staff have been “run off their feet” and not properly checked the figures declared on the returns.

Deliberate error- e.g. business sales have been paid into a private bank account and excluded from the accounts.

The key phrase for the amount of tax that is subject to a penalty is “potential lost revenue” However, if the error is deemed to be as a result of “careless behaviour”, the penalty can be reduced to nil if the error was unprompted, i.e. if you revealed it to HMRC, perhaps by submitting an error correction form VAT1614A rather than it being discovered by an officer on a compliance visit.

There are no penalties for human errors.

What does “deliberate” entail?

The challenge for HMRC is to consider all facts about the tax underpaid and establish why it happened. The officer should make a penalty decision based on the balance of probabilities. In reality, the onus of proof is on HMRC to prove “deliberate” behaviour led to the underpayment.

You should firstly consider the definition of a deliberate error in policy note CH81150 of HMRC’s Compliance Handbook. An example given is where a person gives a VAT return to HMRC that includes a figure of net VAT due that is too low because the person does not have the cash at that time to pay the full amount, and later telling HMRC the true figure when they have the funds to pay.

If HMRC alleges that an underpayment has been caused by deliberate behaviour, then dishonesty must be inferred. You should clearly establish how the underpayment occurred. Is dishonesty evident?

Case law

In Auxilium Project Management Ltd v HMRC (TC5024), the judge accepted that an error had been caused by the director’s confusion about the operation of the cash accounting scheme, not deliberate behaviour, and allowed the appeal, saying: “In our view, the inaccuracy in the return was not a deliberate inaccuracy. She did not knowingly and intentionally provide an inaccurate document to HMRC. She made a mistake but we all make mistakes despite our best efforts.” The penalty was cancelled.

The twist to the tale was that the returns in question were completed by the company’s external accountants, who took responsibility for the mistake. If you complete returns it is important to fully review unusual transactions/outcomes, e.g. your business that regularly pays VAT suddenly submits a repayment return.

Reducing a penalty

If an officer decides that you have made deliberate errors on past returns, resulting in an underpayment of VAT, the error could be subject to a penalty of at least 35% of the tax if discovered by an officer, known as a promoted disclosure. The penalty range is as follows:

• deliberate not concealed - unprompted - 25% to 70%
• deliberate not concealed - prompted - 35% to 70%
• deliberate and concealed - unprompted - 30% to 100%
• deliberate and concealed - prompted - 50% to 100%.

Your first challenge is to ensure that you fully co-operate with HMRC by ”telling” it how the underpayment arose; “giving” full information about how much tax has been underpaid; “allowing” the officer to review the accounting records if they want. These are known as the “telling, giving and allowing” conditions and will hopefully result in a final penalty which is closer to 35% rather than 100%.

HMRC’s guidance at in the Compliance Handbook lists three conditions that a business must meet to get the maximum penalty discount for “telling” HMRC about an underpayment. Firstly, there must be an admission that the return was inaccurate; secondly, the inaccuracy must be disclosed in full, along - thirdly - with an explanation about how and why it arose. You should be aware of these conditions to ensure that HMRC reduce the penalty as much as possible.

Knowledge

HMRC must take into account the knowledge and experience of your business in dealing with tax before issuing a penalty. For example, a management consultant advising clients how to improve their business operations would be expected to have a better knowledge of tax than, say, a builder. This requirement was noted by the judge in the APM case:

“The question is not whether a reasonable taxpayer might have made the same error or even whether this taxpayer failed to take all reasonable steps to ensure that the return was accurate. It is a question of the knowledge and intention of the particular taxpayer at the time.”

For deliberate behaviour penalties, HMRC officers are encouraged to hold at least two pieces of different evidence to indicate that tax has been deliberately underpaid.

Example. Marie trades as a restaurant and HMRC has concluded that the declared gross profit on her returns is too low based on the purchase and selling prices of the drinks and meals that she sells. The officer also noted that 90% of the declared sales relate to credit and debit card transactions, whereas the trading pattern noted by HMRC with observational checks indicates that card sales are only 70% of total sales. The officer has two pieces of evidence to conclude that Marie has deliberately suppressed some cash sales; a best judgement assessment and potential deliberate behaviour penalty could be issued.

Appealing

The legislation gives you the right to appeal against a penalty; both the reasons for it being issued and the total amount. For example, you might conclude that the underpayment was caused by carelessness or human error rather than deliberate behaviour and can ask for the behavioural outcome to be downgraded in your appeal. You might also think that HMRC has not given enough discount for the “telling, giving and allowing” opportunities and that the penalty should be reduced.

Ask for the decision to be reviewed by a separate HMRC officer. The review process will be an opportunity for you to provide detailed information and a full reply about why the penalty is excessive. When the officer has made their decision, they must issue an explanation letter, which must include the following information:

• the facts of the case
• the decision reached and the reasons for it being made
• the tax and penalty now owed following the appeal; and
• the legislation which supports the tax and penalty assessments.

At the time of issuing an assessment or penalty, HMRC must offer the right to an appeal if they disagree with the decision. This can be a direct appeal to the First-tier Tribunal or a local review by a separate HMRC officer as explained above. It makes sense to opt for the local review.