When a taxpayer claims a loss in error, they may pay a penalty based on a sum far higher than the amount of the loss which has been used to trigger a tax repayment, as Andy Keates explains.
In 2003, Simon Fry lent money to his personal company KXDNA Ltd. The aim was that this money would be lent onwards to a separate trading company, of which Fry was also a director.
In 2009, the second company asked for the inter-company loan to be waived, and it was. As a result, Fry filed a 2009/2010 tax return claiming capital loss relief of £10,736,038 (TCGA 1992 s 253) on the basis that his loan to KXDNA had become irrecoverable.
When HMRC looked into the case in 2013, they discovered an awkward fact which, it appears, Fry had completely forgotten. In 2004, in an attempt to secure outside funding he had agreed to the appointment of an additional director of KXDNA, and his loan to the company was converted into 9,068,853 deferred shares of £0.000000001 each – a total nominal value of just under a penny.
That means Fry’s loan didn’t become irrecoverable since he hadn’t actually had a loan for over five years! HMRC felt justified in issuing a penalty for a careless inaccuracy under FA 2007, Sch 24.
The penalty was charged on the basis that a false or inflated loss was claimed due to an error, and that error had resulted from carelessness on the part of Fry. In cases of carelessness with no offshore elements, the starting point for the penalty is 30% of the potential lost revenue (PLR). HMRC applied an eventual figure of 15% x PLR based on Fry’s level of cooperation and because it was a prompted disclosure.
Only part of the capital loss had been used, giving under-assessed tax of £34,554.78, which Fry duly repaid without argument, together with interest. The bulk of the loss (£10,533,967) had been carried forward.
Unfortunately for Fry, in the case of errors involving losses, FA 2007, Sch 24 para 7 defines the PLR as the amount of tax under-assessed (where any of the false loss has been offset against other income or gains) plus 10% of any loss which has been carried forward. The result was an eye-watering penalty of £163,192.65.
Fry’s appeal (case TC05651) covered several aspects, including a suggestion that the penalty was excessive and disproportionate to the alleged carelessness. In the end, only two aspects were considered by FTT:
(1) whether the return had been made carelessly; and
(2) whether due to “the nature of… [Fry’s] circumstances, there is no reasonable prospect of the loss being used to support a claim to reduce a tax liability”. If this was so, the penalty relating to the carried forward loss would be reduced to nil.
The FTT made short work of this point. You would expect a director who was obliged to convert a loan worth around £10m into shares worth a penny to remember the fact, even a number of years later. “We consider that a prudent taxpayer would have undertaken ... checks to establish the loan history before submitting his tax return”. Fry was undoubtedly careless.
Fry had left the UK in 2013 and was working full-time in Switzerland. His wife was an American citizen, and their son was attending a school in California. Fry was seeking employment in the USA and was planning to join his family there, presumably at least until the son completed his education.
The likelihood of Fry returning to the UK and realising future capital gains was, at the time the penalty was charged, extremely small. This satisfied the test in FA 2007, Sch 24 para 7(5) of “no reasonable prospect”, and so the penalty in respect of the capital loss carried forward was reduced to nil. That just left the 15% penalty on the actual tax of £34,554.78; a grand total of £5,183.21.
Fry had accepted in his submissions to the Tribunal that a penalty of this level would be appropriate and acceptable, so the FTT did not need to go any further.
The Tribunal members didn’t have to examine whether the PLR, which was in part based on 10% of carried forward loss, created a penalty on tax that was never actually under-assessed, so it might have been excessive. In Fry’s case, the penalty would have been nearly five times the under-assessed tax. This does seem a bit steep for those of us who grew up with the pre-2009 penalty system, where even full-fledged tax fraud was capped at a 200% penalty.
At some stage, the courts will have to consider the proportionality issue where penalties have been calculated under FA 2007, Sch 24 para 7.
These penalty powers were controversial when they were enacted, and the sort of numbers coming through in cases such as this one will do little to ease that feeling.