Penalties For Tax Return Errors – All Is Not Lost!

Mark McLaughlin warns that penalties can be charged for tax return errors involving losses, but highlights a useful let-out in certain circumstances.

The penalty rules for errors in tax returns, etc., potentially apply if a tax return contains an inaccuracy that results in a tax liability being understated. In addition, a penalty can apply if an error gives rise to false or inflated loss (FA 2007, 24, para 1). 

The amount of penalty for errors is based on ‘potential lost revenue’ (PLR). For example, if an error in an individual’s tax return results in a loss that reduces a tax liability, the PLR is broadly the additional tax due as a result of correcting the error. 

If any part of a loss has not been used to reduce a tax liability, PLR is 10% of the part not used. This 10% rate 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. 

What happens if it is not possible to use a loss for any reason? If there is no reasonable prospect of the loss being used to reduce a tax liability, the PLR in respect of that loss is nil (Sch 24, para 7(5)). This rule can provide a useful escape from significant penalties in some cases. 

For example, in Fry v Revenue and Customs [2017] UKFTT 158 (TC), the taxpayer was the sole director shareholder of a company (K Ltd). In 2003, the taxpayer lent funds to K Ltd. In December 2004, the taxpayer was issued with shares in conversion of his loan to the company. In his tax return for 2009/10, the taxpayer claimed capital loss relief (under TCGA 1992, s 253) of £10,736,038, on the basis that his loan to K Ltd had become irrecoverable in December 2009. Part of the loss (£202,071) was set against chargeable gains accruing to the taxpayer in 2009/10; the balance of the loss (£10,533,967) was carried forward.

However, HM Revenue and Customs (HMRC) refused his loss relief claim, on the basis that the taxpayer’s loan to the company had been converted into shares. The taxpayer withdrew the loss relief claim. In correspondence with HMRC, his agent pointed out that the taxpayer was resident in the USA but working in Switzerland, and that he was unlikely to be returning to the UK. 

Subsequently, HMRC concluded that the taxpayer was careless in submitting an incorrect tax return for 2009/10. The penalty was 15% of PLR. HMRC calculated the PLR as all of the tax which came into charge as a result of the inaccuracy being corrected, plus 10% of the unused balance of the loss claimed in the taxpayer’s return.

The First-tier Tribunal held that the error in the taxpayer’s tax return for 2009/10 was careless, so the conditions were met for a penalty to be imposed. However, the tribunal concluded in the circumstances that when the penalty was imposed (May 2015), there was no reasonable prospect of the remainder of the loss being used. The taxpayer was not resident in the UK, he was unlikely to return to the UK in the foreseeable future and, even if a return to the UK was contemplated at some point in the more distant future, it was unlikely that the taxpayer would wait until that point to realise capital gains. As there was no reasonable prospect of the remainder of the loss being used to reduce the taxpayer’s tax liability, the penalty relating to the unused part of the loss claimed was reduced to nil. 

HMRC guidance (in its Compliance Handbook manual at CH82370) sets out a two-step process to determine whether there is a reasonable prospect of any part of a taxpayer’s loss being used. Step one requires HMRC to consider whether, in the current circumstances, there is a ‘legal or factual reason’ why the loss cannot ever be used. If the answer is ‘no’, step two requires HMRC to assess the taxpayer’s personal circumstances, and ask if there is a reasonable prospect of the loss being used. It is unclear whether HMRC applied this test in Fry, but if so it is difficult (for me at least!) to see how it arrived at a different conclusion to the tribunal.

The ‘no reasonable prospect’ let-out from penalties is well worth considering in potentially appropriate circumstances. For example, in the case of unused trading losses, HMRC accepts that there may be no reasonable prospect of using them if no further trading profits may arise, such as if the trade is ceasing (see CH82371). Making representations to this effect to HMRC or the tribunal can be worthwhile. In Fry, the reduction in PLR for unused losses reduced the penalties from £163,192 to £5,183.