The current penalty regime for errors was introduced in Finance Act 2007, Sch 24, and has therefore been around for some time. Many tax advisers (and unfortunately some taxpayers on the receiving end!) will be familiar with the penalty regime as it applies to errors in tax returns by the taxpayer.
Potential lost revenue
In broad terms, a penalty is due where a person gives HM Revenue and Customs (HMRC) a document such as a tax return, where the document contains an inaccuracy which is either careless (i.e. where ‘reasonable care’ hasn’t been taken) or deliberate (FA 2007, Sch 24, para 1).
The type of inaccuracy that most commonly results in a penalty is the understatement of a tax liability. However, there are two other types of inaccuracy. The first is a false or inflated tax repayment claim, and the second is the false or inflated statement of a loss.
The amount of the penalty is based on ‘potential lost revenue’. An appropriate penalty percentage is generally applied to the potential lost revenue, depending on whether the inaccuracy was careless, or deliberate but not concealed, or deliberate and concealed. The maximum penalty may be reduced depending on the quality of the disclosure, subject to a minimum level.
Errors involving losses
There are various rules in the legislation to determine potential lost revenue. The general rule for a tax return error is that potential lost revenue is the additional amount due or payable in respect of tax as a result of correcting the error (FA 2007, Sch 24, para 5(1)).
However, there are separate rules to determine potential lost revenue where losses are involved. For example, if an error in an individual’s tax return results in a loss reducing a tax liability, the potential lost revenue is calculated based on the general rule, so it is the additional tax due as a result of correcting the error (FA 2007, Sch 24, para 7(1)).
Where any part of a loss has not been used to reduce a tax liability, the potential lost revenue is 10% of the part not used (Sch 24, para 7(2)(b)). This 10% rate is effectively a discounted rate of potential lost revenue, which is intended to recognise the uncertainty about what the tax value of the loss will be when it is eventually used to reduce a tax liability.
The following is an example of how this special rule works in practice.
Example – Single company with trading losses
Unlucky Ltd made a trading loss of £40,000 in its accounting period ended 31 March 2013. The trading loss was carried forward, as it had no other profits to set against the loss, and the company was not part of a group and therefore could not surrender the loss.
HMRC opened an enquiry into the return, and there was found to be a careless error in the return, resulting in the trading loss being overstated by £15,000.
The company continued to be loss making, and the overstated loss was still unused by the time the enquiry closed.
The potential lost revenue is: £15,000 x 10% = £1,500. The maximum penalty for a careless error is 30% of the potential lost revenue, although as mentioned this maximum percentage may be reduced depending on the quality of the company’s disclosure.
If Unlucky Ltd had been a member of a group of companies, it is possible that the loss may have been surrendered to another group member. The rules on potential lost revenue also apply to companies in a group. The calculations are beyond the scope of this article, but there is fairly detailed guidance and various worked examples in HMRC’s Compliance Handbook manual (at CH82280 and following, and also at CH82340 and following).
As mentioned, where any part of a loss has not been used, the potential lost revenue is calculated using a discounted rate of 10% of the unused loss, to reflect current uncertainty as to the value of the loss when it is eventually used. But what happens if it is not possible to use the loss for any reason?
If there is no reasonable prospect of the loss being used to reduce a tax liability, the potential lost revenue in respect of that loss is reduced to nil (FA 2007, Sch 24, para 7(5)). For example, a sole trader may cease trading and make a loss in the final period. There is a careless error resulting in the loss being overstated. Suppose that the overstated loss cannot be set off against the individual’s other income, or against profits of the previous three tax years. Nor can it be carried forward, because the trade has ceased and there is no further trading income to set the loss against. Thus the potential lost revenue in respect of the unused loss is likely to be nil in those circumstances (CH82331).
On the face of it, the ‘no reasonable prospect’ rule is a very useful potential ‘let out’ from penalties for tax return errors involving losses. Unfortunately, there is no definition of ‘reasonable’ for the purposes of determining whether there is a reasonable prospect of losses being used, so this can be an area of dispute between taxpayers and HMRC, which could ultimately lead to an appeal hearing before the tribunal.
No reasonable care
For example, in Elsina Ltd v Revenue & Customs  UKFTT 14 (TC), HMRC opened an enquiry into the company’s corporation tax return for the accounting period ended 31 May 2010. The company was a financial trader, and HMRC had concerns about its losses on trading investments. It transpired that dividend income of over £3 million, which was excluded from the company’s taxable income, was actually taxable (under CTA 2009, s 931W). Following an enquiry into the company’s accounting period ended 31 May 2011, it was also accepted that dividend income of almost £900,000 was similarly taxable.
The effect of the company omitting the dividend income from its computation of trading income was to inflate the amount of loss for the 2010 accounting period, and to understate the taxable trading profit for the 2011 accounting period, against which trading losses brought forward were set. The company had substantial carried forward losses at the end of both periods.
HMRC imposed penalties on the company (under FA 2007, Sch 24) in respect of the 2010 and 2011 accounting periods. In calculating potential lost revenue, HMRC applied the 10% rate, resulting in potential lost revenue of around £300,000 for 2010 and £90,000 for 2011. The company appealed.
The First-tier Tribunal had to consider whether the inaccuracies were careless, due to a failure to take reasonable care (FA 2007, Sch 24, para 3). The company’s returns were prepared by its adviser. The tribunal found that the adviser had not taken reasonable care, as he simply assumed that the dividends did not form part of the company’s taxable profits. The tribunal held that the company could not seek to rely on its absence of knowledge of the relevant law (in CTA 2009, s 931W). The company had delegated the preparation of its returns to the adviser, and the tribunal said it was satisfied that a taxpayer cannot “hide behind” an adviser who hasn’t exercised the appropriate level of care.
No ‘reasonable prospect’?
The company then argued that the potential lost revenue was nil (as opposed to 10% of the relevant losses), in particular on the basis that there was no reasonable prospect of the losses being used in a claim to reduce a tax liability. Unfortunately for the company, from the evidence provided, the tribunal was unable to arrive at a finding that there was no reasonable prospect of the losses being used to support a claim to reduce a tax liability. For example, approximately £14 million of losses had been used in the company’s 2011 accounting period.
With regard to the calculation of the penalty, the maximum penalty percentage for the errors was 30% and the minimum was 15%. The actual penalty percentage applied in this case after taking account of a reduction for disclosure was 15.75%. That percentage was applied to the potential lost revenue of approximately £300,000 for 2010, resulting in a penalty of approximately £47,500. For 2011, the potential lost revenue was approximately £90,000, so applying the percentage of 15.75% resulted in a penalty of approximately £14,100. The company’s appeal against HMRC’s decision to impose penalties (and also their decision not to suspend the penalties) was dismissed.
The tribunal in Elsina said that the onus was on the company to show that there was no reasonable prospect of the losses being used (i.e. in order for the potential lost revenue to be nil). However, the company was unable to prove that this was the case.
In practice, HMRC officers are required to use a two-step process in deciding whether or not there is a reasonable prospect of any part of a loss being used. Step one is to ask whether there is a legal or factual reason why the loss cannot ever be used. If the answer to that question is ‘yes’, the potential lost revenue for the unusable part of a wrongly recorded loss is nil.
If the answer to the question is ‘no’, step two is to ask if there is a reasonable prospect of the loss being used, taking into account the person’s future circumstances. HMRC guidance (at CH82370) states that the person should be invited to make representations to HMRC as to why there is no reasonable prospect of the loss being used. HMRC will then take those representations into account in reaching its decision.
HMRC considers that the circumstances where there is no reasonable prospect of a loss being used “will be limited”, but examples where this test may be satisfied are given in the Compliance Handbook manual (at CH82371).
Finally, the legislation states that in order for the potential lost revenue to be nil, there must be no reasonable prospect of the loss being used to reduce the tax liability of any person. This “any person” requirement will probably be difficult to satisfy in practice, for example, where the loss-making company is a member of a group of companies. HMRC’s view is that in those circumstances, it is necessary to take account of the group’s potential to reorganise its operations and structure to make effective use of surplus reliefs arising within the group.