The VAT default surcharge penalises both the late submission of VAT returns and the late payment of VAT. Finance Bill 2021, as part of a broader aim to harmonise penalties across taxes, abolishes the surcharge and introduces separate penalties for late submission and for late payment, combined with late payment interest and repayment interest (“RPI”).

This article summarises how the surcharge currently works, using the example of Enersys Holdings UK Ltd TC00335 (“EHUK”) to illustrate just how badly it can operate. It then outlines the main features of the new system and uses EHUK to demonstrate how different the outcomes might prove to be.

Default surcharge

A default arises whenever a person submits a late VAT return and/or is late in paying the VAT due under a return. HMRC issues a surcharge liability notice each time a default occurs. This notifies the person of a surcharge period, which will run for 12 months from the end of the latest period for which the person is in default. They need to be fully up to date throughout that period to get off the surcharge treadmill. Otherwise, each time during a surcharge period that they are in default, the period is extended and, if the default relates to a return giving rise to a payment, they incur a surcharge.

The rates of surcharge start at 2 percent of the net tax on the return and rise to 15 percent. EHUK was notorious because one day’s lateness gave rise to a 5 percent surcharge of £131,891. The Tribunal dismissed the company’s appeal on reasonable excuse grounds but allowed it on the grounds that the surcharge ran counter to the EU principle of proportionality.

New system: general observations

The new system will apply from the beginning of a person’s first return period beginning on or after 1 April 2022. All the new provisions refer to the due date, which is normally the end of the calendar month following the end of the return period. HMRC currently exercises its discretion to allow a further seven days to those who pay by direct debit, and there is no apparent reason to think this practice will not continue. Penalties must be paid within 30 days of the issue of a notice of penalty.

As with default surcharge, there is no penalty where the person satisfies HMRC or, on appeal, the Tribunal, that there was a reasonable excuse for the failure. The same exclusions apply (insufficiency of funds, reliance on another person) but these exclusions are modified in line with other more recent penalties.

For example, insufficiency of funds is permitted where, following the principle in Steptoe [1992] STC 757, the lack of cash is “attributable to events outside the person’s control”. HMRC also has discretion not to award points or levy penalties, or to reduce them, where they consider it appropriate in the circumstances, which cannot include a person’s inability to pay. The usual review and Tribunal appeals procedures apply except the penalties do not need to be paid before an appeal can be lodged.

The Tribunal can substitute its own discretion with regard to special circumstances. However, it can only do so where it considers HMRC’s decision to be “flawed”, as that term is understood in Judicial Review proceedings.

Late submission penalties

The rules all turn on the frequency with which returns are made (monthly, quarterly, or annually), as summarised in Table 1:

There are special rules to cover regular non-standard return periods and where a person changes the frequency with which they make returns. Generally, HMRC will award a penalty point whenever a person makes a return after the due date. A person will incur a £200 penalty whenever they make a return late and either:

1. That lateness means they have reached the maximum number of penalty points for their frequency. For example, Mr Tardy is on quarterly returns. He is liable to a penalty once he makes a late return for the fourth time; or
2. They have already reached the maximum. So, Mr Tardy will continue to incur a penalty every time that he makes another late return until he has achieved what the Budget Day guidance calls “a period of compliance”.

Points expire 24 months from the first day of the month following the one in which a failure giving rise to a point occurred. Therefore, if Mr Tardy makes his quarterly return to 30 June 2022 late, HMRC will award a point, but it will expire on 30 June 2024. However, this does not apply where a person has reached the maximum for their frequency. That means that Mr Tardy’s points would not expire on 30 June 2024 if by then he had made a further three late returns. However, all points expire if a person achieves a period of compliance.

There is a period of compliance where a person:

1. Has made all the returns that they are due to have made in the previous 24 months; and
2. They have submitted all their returns on time for the appropriate number of months for their frequency (for example, 12 months if they make quarterly returns – see Table 1).

Table 1 indicates the time limits within which HMRC may award points. Where the failure gives rise to a penalty HMRC must notify the person of that failure and has 24 months in which to assess.

Penalties for late payment

For the purposes of these penalties, applying to HMRC for a time to pay agreement (“TTP”) is treated as equivalent to paying the tax in question, provided that an agreement is subsequently entered into and complied with. Breaching an agreement results in the tax being treated as if there had never been such an agreement. A TTP has no impact on interest, which remains payable.

The rate of penalties applicable is set out in Table 2. HMRC has 24 months in which to assess penalties arising or, if later, 12 months from the end of the period for appealing an assessment on the underlying tax.

Interest

Late payment interest (“LPI”) runs independently of penalties on outstanding tax and runs from the due date until the tax is received by HMRC. It will be calculated on a simple basis at base rate + 2.5 percent.

Repayment interest (“RPI”) is calculated on a simple basis at base rate less 1 percent (subject to a minimum 0.3 percent) and runs from the later of due date or the date it is received by HMRC to the date it is repaid and excluding:

1. Any period referable to the raising and answering of reasonable enquiries by HMRC regarding a VAT return; or
2. The correction by HMRC of any errors or omission in a return; or
3. Any period that a return remains outstanding.

The period referable to reasonable enquiries runs from the date HMRC first think it necessary to make an enquiry to the date they receive a complete answer or decide not to pursue.

The period referable to the correction of errors runs from when the error or omission first comes to HMRC’s attention until the error is corrected.

Enersys?

So how would EHUK have fared under this new system?

Assuming that EHUK had a VAT liability, in round terms, of £2.6 million in its fifth default period, what would it have incurred by way of penalties and interest under the new rules? It would probably have looked something like this:

1. A second £200 late submission penalty as this would have been its second failure since reaching the maximum number of points for a person on quarterly returns;
2. No late payment penalty because it paid the VAT within 15 days of the due date; and
3. Late payment interest at 2.6 percent (0.1 percent being the bank rate as at time of writing) of £185.20.

The Judge would have been much less likely to have described this as “not merely harsh but plainly unfair”. The new system is fiddly and may take some getting used to but should only seriously impinge on the habitually late and those who prefer to use HMRC as their lender of first resort.

Terry Dockley is a Chartered Tax Adviser and has worked in tax for over 40 years, including the Inland Revenue and 14 years with PwC in Belfast. He has run his own VAT advisory practice for the last ten years, helping accountants and lawyers with non-routine VAT queries, especially in relation to charities and property. thd@terrydockley.co.uk