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TaxZone Newthwire 61: Tax geared and capped penalties

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1st Jan 2005
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TaxZone Newthwire
Issue 61 - 27 September 2004 - Tax geared and capped penalties
Available on subscription at:
https://www.accountingweb.co.uk/premium_content/newthwire


Editorial Note
 Will Heard
This edition of the Newthwire is the first of two contributions from Shaw & Co tax investigations specialist Will Heard examining the Inland Revenue's penalty mitigation procedures.

Since all tax geared penalties are quasi criminal, the question arises whether the system of investigation, invitation to offer and settlement is relevant. This first installment identifies the statutory basis for many of the decisions - and areas where there is scope for the adviser to negotiate.

The subject of penalties and penalty negotiations must start
with the relevant statute, which provides for tax geared and
capped penalties (all statutory references are to Taxes
Management Act 1970). It should be noted that where appropriate
compliance failures involving National Insurance Contributions
will also attract penalties geared in the same way as for Inland
Revenue taxes generally.

Regards,
Will Heard
mailto:[email protected]

Disclaimer
==========
No responsibility for loss occasioned to any person acting or
refraining from action as a result of any information in this
wire is accepted by the author or AccountingWEB. In all cases,
appropriate professional advice should be sought before making
a decision.

Tax geared penalties
====================
A tax geared penalty is one which is variable depending on the
amount of tax affected by the compliance failure. The Taxes
Management Act provides for such penalties by defining the
maximum amount as a figure equal to the difference between the
tax now found to be payable and the tax payable on the basis of
the original return (or the tax now payable in circumstances
where no return was originally made).

Since the act defines a maximum figure the Inland Revenue has
the right to mitigate a penalty and does so in given
circumstances. Therefore the actual penalty can range
(theoretically) from 0% to 100%. Prior to Finance Act 1989 the
maximum penalty in cases of fraud was 200% of the tax
difference.

Offences attracting a tax geared penalty
========================================
1. Section 7 (8) Failure to notify chargeability within six
months of the end of the relevant year.

If the tax arising on any subsequent self assessment or
assessment under S29 is not paid on or before 31 January next
following the relevant year then the penalty is an amount "not
exceeding" the amount of the tax so assessed or self assessed.

Note: This provision is operative as from 1995/96 for general
tax purposes (consult the statute for some minor differences to
this general rule). Prior to this year there were no tax geared
penalties for failure to notify chargeability. The penalty was
an amount not exceeding 100 pounds.

2. Section 93. Failure to make a return for income tax or
capital gains tax.

Where a return has been issued but has not been submitted to the
Revenue within 12 months of the filing date for that return
there is a tax geared penalty not exceeding the amount of tax
that would have been shown on that return.

Note: The filing date is either 31 January following the
relevant year of assessment or if the return was issued after 31
October following the year then it is three months beginning
with the day on which the return was issued (s8(1A)). There is
also provision in s93 for penalties in cases where there is a
failure to submit a return but it is ultimately found that no
tax would have been payable. These are naturally not tax
geared.

The current s93 is operative from 1996/97 but there was a tax
geared penalty under the pre-SA rules if the failure continued
after the end of the year of assessment following that during
which the return was issued.

3. Section 95. Incorrect return or accounts for income tax or
capital gains tax.

The penalty is tax geared if a return is made that is fraudulent
or negligent. It is an amount not exceeding the difference
between the income tax and/or capital gains tax payable for the
year and the amount that would have been payable if the return
had been correct.

4. The equivalent statute applying to companies

See Sections 10, 94 and 96 respectively for failure to notify
chargeability, failure to submit a return and the submission of
an incorrect return. FA 1998, Schedule 18 para 20 is also
relevant to post SA company returns. There are also equivalent
penalty arrangements concerned with the understatement of
PAYE/NIC liabilities in s98A(3).

Because tax geared penalties might apply in respect of a failure
to notify chargeability under s7 and subsequently an incorrect
return under s95 once the failure to notify is discovered and a
return is issued, Section 97A operates to ensure that when two
or more tax geared penalties are chargeable on the same tax the
aggregate penalty does not exceed the greater or greatest of the
penalties.

Capped penalties
================
Practitioners sometimes do not appreciate that capped penalties,
ie where the penalty must not exceed a certain absolute figure
(unlike a tax geared penalty which depends for its limits on the
amount of tax that can attract the penalty), is also variable
below the cap and can be the subject of negotiation in exactly
the same way as a tax geared penalty.

Negotiation is particularly apposite in the case of penalties
covering failures in respect of forms P11D since the theoretical
maximum penalty can often far exceed the tax that has been lost
to the Revenue through the compliance failure. A fraudulent or
negligent form P11D attracts a maximum penalty of 3,000 pounds
per occasion so some minor infringement covering a given P11D
for six years would determine a maximum of 18,000 pounds whereas
the director's or employee's taxable benefit might amount only
to a few pounds of tax.

Other examples of capped penalties are for failures to keep
proper business records (s12B), failures to supply information
under a s19A notice and where returns have been issued under s13
(persons in receipt of taxable income belonging to others) and
s15 (forms P14, P35 and P11D). The penalty is initially a
figure not exceeding 300 pounds and then not exceeding 60 pounds
per day for a continuing failure - s98(1) apart from a s12B
offence where the penalty is one not exceeding 3,000 pounds
(s12B(5)).

Finally s99 should not be neglected. This section is sometimes
used to devastating effect by Special Compliance Office. It
provides for a penalty, usually applied to a practising
accountant, in cases where a person has assisted in the
preparation or delivery of any information, return or accounts
or other documents that he knows are likely to be used for the
purposes of tax which he knows to be incorrect.

The penalty is an amount not exceeding 3,000 pounds. As with
incorrect forms P11D this penalty is applied per occasion
therefore a massive maximum potential fine can accrue but it is
still negotiable though advise ought to be sought in such a case
owing to this and other ramifications of a s99 penalty (see
s20A).

The determination of penalties
==============================
Inspectors have had the power to determine most types of penalty
since Finance Act 1989. Section 100 excludes certain penalty
situations from the inspector's powers of determination (mainly
S93(1), S94(1) and S98(1)) but those penalties mentioned above
all come under the Revenue's powers.

In the writer's experience the power of determination has never
been used therefore it is probably rarely used overall. The
Revenue clearly wishes to agree penalties by negotiation in
normal circumstances although the threat of a determination has
probably eased through some tricky cases over the years.

There is an appeals process in those cases where penalties are
determined under the formal procedure (s100B).

Tax geared penalties are quasi criminal in nature
=================================================
In recent years there have been some significant court decisions
concerning the precise nature of tax geared penalties.

The following extract (under this heading) is taken from an
article in Taxation Magazine written by the current writer,
which dealt with this subject in detail.

The judgment in King v Walden [2001] STC 822 considered (amongst
other matters) the nature of tax geared penalties. It was taken
shortly after several VAT cases (including C&E Commissioners v
Han and Yau and others [2001]STC1188) had found that penalties
under VATA 1994 s60 were essentially criminal in nature. The
following is quoted from Tolleys VAT Case Digest section 32.4.

"In three appeals involving penalties under VATA 1994, s60, the
tribunal held, as a preliminary issue, that the imposition of a
penalty under VATA 1994, s 60 gave rise to a 'criminal charge'
within Article 6 of the European Convention on Human Rights. The
chairman observed that 'cases where section 60 penalties are in
issue usually involve allegations of dishonest and systemic
suppressions of sales or use of fictitious invoices over a
number of accounting periods... the level of criminality
alleged against the appellant does not appear significantly
different from that involved in Crown Court fraud trials'. The
CA upheld this decision (by a 2-1 majority, Sir Martin Nourse
dissenting). Potter LJ held that the effect of the ECHR
decisions in Bendenoun v France, ECHR Case 12547/86, 18 EHRR 54
(TTC 30.3) and AP, MP and TP v Switzerland, ECHR Case 19958/92,
26 EHRR 541 (TTC 30.6) was that the penalties had to be regarded
as involving a 'criminal charge' for the purposes of Article 6."

The judge in King v Walden necessarily had to consider the
impact of these decisions and the European cases that were at
their root when dealing with the question of penalties
applicable in the Inland Revenue investigation. He said that in
his judgment "the system of imposition of penalties for
fraudulent or negligent delivery of incorrect returns or
statements is 'criminal' for the purposes of art 6(2) [of the
European Convention on Human Rights].".

The penalties under consideration were those that apply in all
Inland Revenue investigations where it is found that business
profits have been understated either fraudulently or negligently
ie the tax geared penalties under TMA 1970 s95 (and its
company equivalent). The following reasons were given for that
conclusion:

1. Plainly the system is intended to punish the defaulting
taxpayer and to operate as a deterrent.
2. The amount of fine is potentially very substantial.
3. The amount of fine is not related to any administrative
matter. In particular the fine is not limited to the
administrative and other extra cost of dealing with the taxpayer
concerned.
4. The amount of fine imposed depends upon the degree of
culpability of the taxpayer, the less culpable the more
mitigation there is. Mitigation is an essentially criminal
rather than civil consideration.
5. It is accepted that generally (leaving out of account s46(2)
and s101) it is not for the taxpayer to show that the
determination of penalties was wrong. On appeal the burden of
proof lies on the Crown. In this regard there is a clear
distinction between a penalty determination and an appeal
against ordinary assessment where the burden of showing it was
wrong lies on the taxpayer.

On the assumption that this analysis is correct does it have any
ramifications for the way that the penalty element is applied in
tax investigation cases? The answer is in the negative so long
as the case is handled informally culminating in an offer being
made to the Revenue (either as a lump sum or by installments).

Why is this so? The answer lies in the nature of the offer that
is to be made to the Revenue. This is in the form of a contract
made between the Revenue and the taxpayer. The taxpayer makes
an offer "in consideration of no proceedings" being taken
against him. Those proceedings involve the raising of
assessments and the determination of interest and penalties.

The offer is thus a monetary amount calculated by reference to
the tax, interest and penalties that the inspector might be able
to put into legal charge. The offer does not constitute
elements of tax, interest or penalty but simply a lump sum. If
discovery assessments are in place and under appeal then these
stay in place but in suspension pending completion of the terms
of the offer. Indeed open assessments for years that are covered
by a settlement offer are neither determined under s54 nor are
they taken off the Revenue's books, since they may need to be
resurrected if the terms of the offer are not finally complied
with. Consequently neither the Revenue nor the client needs to
worry about the true nature of a penalty in informal
proceedings.

However, if penalty negotiations break down so leading to a
determination under s100 and an appeal under s100B then both
sides should be acutely aware of their respective positions.
The onus will be on the Revenue to establish that fraud or
neglect has occurred. In doing so the Revenue will necessarily
have to concede (if cross examined by the defending advocate)
that a tax geared penalty is quasi criminal in nature.

Consequently the defence open to the client would be that he was
not properly informed of the position when the Revenue commenced
the investigation. In particular he was not interviewed under
caution at any point (see the case of R v Gill and another
[2003] STC 1229) therefore the Revenue's attempt to impose a
penalty would be ultra vires.

Negotiating the penalty element under an informal offer
=======================================================
It is tempting to think of the penalty element of a settlement
offer as if it were a completely separate subject unconnected to
the process and conduct of the preceding investigation. After
all it is a procedure that comes at the end of the investigation
after the tax figure has been agreed and tends to be the subject
of a sketchy discussion between inspector and adviser almost as
an afterthought to the preceding battle of wills.

This should not be the case. If a penalty is to be tax geared
then the starting point for the penalty negotiation is the
quantum of tax, not the percentage that will be applied to the
tax.

Negotiators should not be inhibited from putting the penalty
issue on the table for discussion at some point during the
preceding investigation or at least to bear the penalty issue in
mind when negotiating the additional profits that will give rise
to the tax which will have the penalty applied to it.

Given that the formal determination of penalties is a rarity and
the possibility may never enter the inspector's mind there is no
reason why the spectre should overshadow the adviser's thought
processes either. On this basis negotiation can be freer
flowing than some people might think. The inspector is only
human and may have his own agenda with regard to penalties and
their interface with the quantification of tax.

[The next two paragraphs have been quoted from the writer's book
for Tolleys entitled "Practical Representation in Tax
Investigations".]

For example on some occasions, the technical basis behind some
part of the additional tax element might be more important to
the inspector than the absolute level of the additional profits
that have to be taxed. For example, the inspector might consider
a victory in a disagreement about a capital allowance claim or a
capital/revenue argument to be more important than trying to
increase the adjustment in the case of 'grey area' cash
additions to the profits, whereas other inspectors may have the
opposite view. Similarly the client may be adamant that he never
pocketed anything like the amount of cash that the inspector has
estimated but he may have no view about a more tax technical
matter that might still culminate in the same bottom line
number.

On other occasions the level of penalty might be more important
to the inspector or the adviser than the amount of additional
profits to be taxed. Theoretically the inspector might want to
get a higher percentage penalty established but will concede a
lower level of grey area adjustment to the profits or the
adviser might want to achieve the opposite. The inspector may be
prepared to concede a lower tax element so long as the adviser
does not argue too much about the level of penalty, so that in
money terms the amount might be the same but may have been
arrived at via different routes by each party.

This far sighted approach to penalty negotiations may even
extend to the "size and gravity" element of the mitigation
factors (of which more later). This element is the most
difficult to influence during an investigation because the level
of mitigation depends on what has already happened given that
the fraud or neglect has already occurred whereas the other two
elements of "cooperation" and "quality of disclosure" are fully
under the control of the client and his adviser from the day
that the enquiry or investigation commences.

However, it is still worth trying to spot opportunities for
influencing the size and gravity mitigation element if the case
warrants it. For example, if the investigation gives rise to
various open ended areas for negotiation it may be possible to
substitute a less serious adjustment for a more serious one
through negotiation so as to mitigate penalties, even though the
tax figure might be the same. For example, if it is discovered
that the stock valuation is only an estimate and that there is
likely to have been significant cash defalcation as well then
the inspector is more likely to want to maximize the adjustment
to profits through additional cash sales than to adjust the
stock valuation. This is particularly so in the case of a
company because of the TA 1988 s419 implications.

One case dealt with by the writer springs to mind in which this
approach paid off successfully [Example taken from Tolleys
'Practical Representation in Tax Investigations'].

A local tax district once investigated a family that had a
thriving business in scrap metal, rubbish removal, the supply of
crushed bricks for hardcore, and earth moving (salvage of top
soil). Indeed they dealt in and processed virtually anything
that other people wanted to throw away.

The inspector had perfectly reasonable suspicions that cash
control was non-existent and that the family had made more
profits than declared. The question was, how much. On the basis
of cost of living indices she was adamant that the profits over
a period of time must have been understated by more than
50,000 pounds. The family was adamant that the amount was
nowhere near that sum, notwithstanding that neither side had any
real idea of the amounts involved and neither did the advisers.
The matter dragged on until the inspector decided that it was
time for a showdown and insisted on meeting the family on site.
Still there was stalemate.

Outside the office, which was housed in a battered portacabin,
there was a pile of scrap metal, crushed cars, washing machines,
dishwashers, torn and twisted metal and the like that must have
been 20 metres in diameter and 10 metres high.

During the heated discussions it dawned on one of the advisers
that the pile of metal outside had never featured as end of year
stock or work in progress, even though the accounts did
recognise both in view of the business's activities. As with the
cash problem no one knew how much was involved or had been spent
in accumulating it nor had they any idea how to find a market
value. In fact no one knew what was inside the mound which
tended to wax and wane in size on the outside depending what was
happening in the business at any one time. Arguably it had no
stock value since it had been accumulated on a free basis over
many years, in all sorts of ways.

The stock of scrap saved the day. All concerned could focus on
the scrap and forget about the cash. The family could talk about
the scrap without getting heated and the inspector could see it
as a pile of money to be taxed. It did not take long to agree an
adjustment of 50,000 pounds of which 25,000 pounds was cash and
25,000 pounds was accumulated understated stock.

The clients were happy to accept the deal because they had 'won'
the day on the cash argument. The inspector went in hard on the
penalties to compensate somewhat for not achieving her cash
target, so she was happy. Since this was a company, the adviser
was happy that he had done his best to minimise the overall cost
to the client and particularly the hit on the directors' loan
accounts. Even the other adviser, who was the clients'
accountant, was happy. After all one year's closing stock is
another year's opening stock, so he could incorporate the deal
into the next set of accounts, which had not yet been prepared
(this was in the days before pay and file or self assessment)
and then write it off at the end of that account (who was going
to argue?).

Mitigating penalties
====================
Section 102 states that the Board may in their discretion
mitigate any penalty, or stay or compound any proceedings for a
penalty, and may also, after judgment, further mitigate or
entirely remit the penalty. However, this applies only to
penalties that have been formally determined.

The mitigation that is applied to penalties in investigation
cases that lead to an informal offer is available through the
Revenue's general remit to have care and management of the tax
system since, as noted above, the percentage penalty that is
negotiated informally is not in fact a penalty. It is merely
part of an offer to stop proceedings being taken even though it
is convenient to regard this element of the offer as a penalty.

The Revenue applies mitigation to the theoretical maximum tax
geared or capped penalty in order to encourage frank disclosure
and cooperation from clients who may have an inherent bias
against both conditions. However, even the most frank and
co-operative must be punished for doing wrong therefore it also
operates mitigation for the size of the problem that has been
uncovered and its gravity geared to recognise the severity of
the offence in relation both to the case itself and the taxpayer
at large.

Most readers will be familiar with the concept of penalty
mitigation and the parameters that are applied by the inspector
in arriving at the expected percentage.

This is calculated by reducing the maximum penalty (whether
defined by the tax at stake or the capped maximum) through the
award of points judged against the following parameters (EM
6065):
a) disclosure - up to 20% (or up to 30% in exceptional
circumstances); and
b) co-operation in the investigation - up to 40%; and
c) size and gravity of the offence or offence - up to 40%.

Disclosure (EM 6070)
-------------------
This is concerned with the circumstances surrounding a
disclosure of some form of compliance failure and the nature of
the disclosure per se. The inspector is instructed that
disclosure 'implies a positive, voluntary and useful
contribution to your knowledge of the irregularities. Thus, a
statement which may constitute a disclosure at an early stage in
the investigation (for example, assisting the quantification of
the irregularities or the establishment of culpability) may, if
made at a late stage in the investigation be no more than a
worthless confirmation of what you irrefutably established.' [EM
6070].

A totally spontaneous disclosure ie one that is made in
circumstances where the client has no fear of discovery and one
which is sufficiently complete when made to be treated as a full
disclosure will attract not only the full 20% mitigation but a
further 10% as a reward for the frankness and spontaneity. This
can then be set against one of the other penalty elements such
as "size and gravity" where mitigation might be harder to
achieve.

This does not mean that one should wait until a full disclosure
report has been prepared before the matter is raised with the
Revenue but it does mean that nothing of a material nature
should be omitted when the disclosure is made. It would be
folly, for example, for a client to disclose that he has settled
an overseas trust with money derived from tax evasion without
also mentioning that the precursor to the trust was an offshore
bank account and that the interest has also been omitted from
his returns.

However, the more time that elapses before a disclosure is made
the more chance that circumstances might arise enabling the
inspector to argue that the disclosure was not entirely
spontaneous.

More than 20% but less than 30% may be given in cases where a
voluntary disclosure has been made but where the fear of
discovery might be present.

In one case within the writer's experience the SCO Group Leader
refused to sanction the full 10% premium because the UK resident
client had received a letter from an Irish bank explaining that
one of his accounts had been singled out as part of a sample of
accounts that were to be reviewed under the Irish Revenue's
Deposit Interest Retention Tax (DIRT) investigations. The Group
Leader's view was that the client would have realised that
details of his account would filter through to the UK Revenue
sooner or later therefore the disclosure was not totally
spontaneous.

The following levels of disclosure are listed in the inspectors'
instructions at EM 6070:
a) A voluntary and complete disclosure by a taxpayer who has
some reason to suspect early discovery.
b) Full disclosure on challenge.
c) A voluntary disclosure which turns out to be partial.
d) Partial disclosure on challenge.
e) Denial of irregularities on challenge, but disclosures
subsequently made.

It is suggested that 20% should be allowed for a case within the
first two categories, and 5% if the disclosure is very belated
under the final category.

Co-operation (EM 6075)
---------------------
The inspector takes the following factors into account when
the abatement for co-operation is considered:
a) the extent to which the taxpayer has been prepared to
co-operate throughout the investigation and thus help to bring
it to a speedy conclusion; and
b) the time taken to reach a settlement (but recognising that a
complex case will take longer to settle than a straightforward
case) taking into account the following matters:
I prevarication and procrastination;
ii concealment of assets;
iii piecemeal disclosures;
iv truthfulness;
v the number of Commissioners' meetings required to force
progress;
vi the necessity for making further normal and extended time
limit assessments to force progress;
vii the use of information powers;
viii persistence in unacceptable stories of gifts, cash hoards,
betting wins;
ix necessity to have the liabilities determined by the
Commissioners;
x irregularities continuing during the course of the
investigation;
xi payments on account.

This is an impressive list of sub elements but when considered
in relation to the size of the mitigation element and the type
of sub elements that are listed it is clear that a well managed
case should attract the maximum mitigation. Except in
exceptional circumstances such as the decision to force a
Commissioners' meeting on the grounds of principle there is
virtually no excuse for not achieving the maximum.

However, the abatement for co-operation is not affected by, say,
disagreement with the inspector over the interpretation of a set
of facts or the statute or reference of the matter to a Member
of Parliament where the grievance is genuine and is not a
cynical attempt to delay the inspector from proceeding.
Delay or lack of co-operation by the adviser is deemed by the
Inland Revenue to be the responsibility of the taxpayer.

Size and gravity (EM 6080)
-------------------------
This is a complex mitigation factor that depends partly on the
nature of the offences that have been committed, partly on the
size both in relation to the case itself as well as
investigation cases as a whole, and partly on the seriousness of
the offence in terms of its execution.

'Size' may be absolute or relative. Consequently under the
criterion of size someone who deliberately omits, say, 20,000
pounds of sales from a business making 200,000 pounds taxable
profit a year may be regarded in the same category of
seriousness as a small trader who omits, say, 30% of his takings
even though that may amount to only 10,000 pounds.

'Gravity' means the degree of culpability, ranging from a minor
degree of negligence to a case of serious fraud, with a variety
of intermediate steps as follows:
a) In cases in which fraud cannot be proved the abatement should
be not less than 15%.
b) There is a range of abatements between 15% and 40% covering
cases of neglect. For example 15% abatement would cover a most
serious case in which culpability falls short of fraud; but
c) an offence which involves only a minor degree of negligence
associated with muddle and confusion might, subject to size and
circumstances, attract an abatement of say 35%.
d) An abatement of 40% would thus be a rare occurrence.
It should be noted that in normal circumstances a case handled
by the Hansard section of Special Compl

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