Tax Investigations – The New Penalty Regime

Tax Investigations – The New Penalty Regime
When the 2007 Finance Bill is published shortly after the Budget Speech on 21 March, it is likely to contain new legislation dealing with penalties for tax offences. Draft legislation has already been published by HMRC in a Consultation Document.


In the most serious of cases, tax evaders are prosecuted under the criminal law but this is rare. The vast majority of tax investigations are settled by a payment consisting of the tax that has been evaded, interest on that tax, and a penalty calculated as a percentage of the tax involved.


The current rules


At present, the penalty regime for “direct taxes” (income tax, NIC, CGT, and corporation tax) works on the basis of a maximum penalty of the total amount of tax that has been lost as a result of the offence which is then reduced on the basis of three categories – “Disclosure”, “Co-operation”, and “Size and Gravity”.


The reduction of the penalty for “Disclosure” can be up to 20% (25% in the case of someone who “discloses” a tax offence when he has “no reason to fear discovery”), so in a case where HMRC open up an “Enquiry” into your Self-Assessment Return and you immediately admit to any errors in it, the penalty should be reduced by 20%.


“Co-operation” is probably the most important of the categories of mitigation and can reduce the penalty by a further 40%. This is why it is essential to deal with a tax investigation in a proactive way, answering HMRC’s letters promptly and supplying them with the information they require. It does not mean you have to agree with everything they say – you are perfectly entitled to argue your side of the matter – but if you do not do your best to get matters resolved as soon as possible it will count against you when it comes to the penalty.


The final category is “Size and Gravity”. “Size” refers to the amount of tax lost and is judged in both absolute and relative terms. £100,000 tax is a lot of anyone’s money but in the case of a taxpayer whose profits are £25,000 per year, if income of £5,000 has been concealed, that is a relatively large slice of his total profits. “Gravity” varies from sloppy record keeping and stupid mistakes to more “heinous” (a word tax inspectors are fond of) behaviour such as conspiracy, forgery, and deliberate lies. Like “Co-operation”, there is a discount of up to 40% for “Size and Gravity”.


In a typical local investigation case the penalties generally range from about 10% (for a careless mistake in a tax return) to about 35% (for significantly understated profits or deliberate omissions from a return). Notice that on the current system, assuming you put your hands up as soon as you are challenged (20% off for “Disclosure”) and you are fully “Co-operative” in dealing with HMRC’s enquiries (another 40% off), the penalty could not be more than 40% of the tax involved. The worst case of tax evasion I have ever dealt with, which involved tax lost of over £1million, deliberately falsified accounts and tax returns, a fraudulent offshore trust, conspiracy with other traders and forged invoices, attracted a penalty of 38% of the tax involved because the client admitted everything and co-operated by providing a detailed report on what he had been up to.


The New Rules


HMRC and Gordon Brown have apparently decided that these levels of penalties are not high enough. The new regime will be based on the same concept of a maximum penalty of the total tax lost which is then reduced to take account of the particular aspects of the case, but there will now be three levels of culpability and each will have its own maximum and minimum penalty levels. The percentages quoted below do not appear in the draft legislation, but informed sources say that these are the likely figures. This new regime will also apply to VAT penalties.


The three new levels of culpability are:


A – “Failure to take reasonable care”. This would probably include such things as being over-optimistic when estimating the amount of business mileage done in your car, forgetting to add back adjustments for private use of business assets, and so on. If yours is an “A” case, then if you disclose the mistakes to HMRC without being prompted to do so (by a tax investigation, for example) the penalty will be a percentage of the tax lost of between zero and 30%. If you wait until you get investigated before you make the disclosure, the penalty percentage will be between 15% and 30%.


B – “Deliberate understatement”. This is where you know full well that your return is not correct or your accounts do not disclose all your profits but you do not try to cover this up, for example by presenting false information to the tax inspector. The same categories of “prompted” and unprompted” disclosure apply here but the levels of penalty are higher – the maximum penalty will be 70% of the tax lost with a minimum penalty of 20% for an “unprompted” disclosure, and 35% for a “prompted” disclosure.


C – “Deliberate understatement with concealment”.  This is the most serious and involves deliberately manufacturing false evidence as part of your tax evasion, such as forging invoices from suppliers, denying the existence of a bank account where you keep your ill-gotten gains, and so on. The maximum penalty here is, unsurprisingly, 100% of the tax lost and the minimum level is 30% for an “unprompted” disclosure and 50% in a case where you had to be asked before you admitted it.


Tougher penalties


The majority of tax investigations of family businesses would probably fall into the “B” category (deliberate but not concealed) – for example, the farmer who does not declare his income from providing Bed and Breakfast, or the pub landlord who helps himself to drinks and cigarettes and “skims” some cash from the till. At present, I would expect to settle such a case with a penalty of about 25% to 30%, but under the new rules the minimum penalty will be 35%, assuming that the matter only comes to light when an investigation is launched.


And what if the landlord does not merely skim some cash but also deliberately fails to ring up all his sales in order to cover this up? Presumably, HMRC will say that makes it a C penalty case (because he has done something to conceal his skimming) so the minimum penalty is now 50%.


Suspended Penalties


Another new idea in the consultative document is “suspended” penalties. It seems this will only apply in “A” penalty cases (“failure to take reasonable care”). In such cases, instead of demanding payment of the penalty immediately (30 days is the usual time given to the taxpayer to settle up at the end of an Enquiry), HMRC will have the option of waiting for up to two years and then checking to see if whatever caused the original errors has now been corrected.


For example, if the records you keep for your business are inadequate and this leads to an understatement of your profits, HMRC might charge a penalty of 25% but “suspend” this for two years. After two years, if an inspection of your records showed they were now being kept correctly, the penalty would be cancelled.




Given the existence of minimum levels of penalty for each type of offence and the possibility of “suspended” penalties for “A” penalties, it is inevitable that there will be a lot of discussion between HMRC and tax advisers as to which category their client falls into.


At what point does “failure to take reasonable care” become “deliberate understatement”, and exactly what is meant by “concealment”?


The Consultation Document refers to “keeping books and records that are incomplete in some respects” as an example of “failing to take reasonable care”. When a set of accounts is prepared from business records there will almost always be at least one “balancing figure” – that is, the debits and credits do not correspond exactly, because nobody’s perfect – and when investigating accounts HMRC will always argue that this demonstrates that the records are “incomplete” and so cannot be relied upon. If they take this hard line under the new penalty regime, it is difficult to see how anyone will be able to get their suspended penalties cancelled because when the books are examined after two years, there will almost inevitably still be some “balancing figures”.


It is likely that the new rules will first apply for the 2008/09 tax year. One thing is certain – the new regime will mean higher penalties at the end of most tax investigations.