VAT and direct taxes (income tax or corporation tax) are often thought of as separate and unrelated. In principle, this is quite correct. In practice, though, both taxes are complex and errors in one can impact on the other.
A typical example is a business which accidentally overlooks the VAT it should have charged on a transaction. This oversight impacts not only VAT, but also the direct tax. The full amount received from the customer, including the portion which should have been accounted for as output VAT, will be recorded as net sales income, which in turn will result in the business’ taxable profits being overstated too.
Reversing such errors is not straightforward. The taxpayer must consider which VAT records need to be amended and what company accounts adjustments should be made. It might also be necessary to issue corrected VAT invoices to the customers. If the returns for VAT and direct tax have already been submitted, it will be necessary to submit adjustments to HMRC, paying the VAT liability and claiming back the direct tax overpaid on the overstated profits.
Penalties might later be imposed by HMRC for the errors, so the taxpayer should notify HMRC early and co-operate fully to obtain the best mitigation.
However, these steps might not be sufficient to reverse all the errors, as the time limits for amending errors are not the same for VAT and for direct taxes. Even then, there might be further steps to improve the taxpayer’s position, as illustrated by the case of Robert Wells v Revenue & Customs Commissioners ( UKFTT 495 (TC), published on 28 August 2012).
The taxpayer was a self-employed artist, who should have registered for VAT on 1 January 2007. On 27 September 2011, HMRC issued a VAT assessment to Mr Wells for £24,218 and imposed a penalty of £1,905.60 for the late notification of his liability to register for VAT.
As in our typical example above, Mr Wells had recorded the full amount received from customers as net sales and his profits were therefore overstated by the amount of the VAT error (£24,218). The VAT error had therefore caused an income tax overpayment of £2,593.
Unfortunately, Mr Wells’ VAT error only came to light after the time limit for claiming back the overpaid income tax had expired, so he suffered both a penalty for late VAT registration and the overpaid income tax. HMRC had the legal power to acknowledge that this was unfair by reducing the VAT penalty for belated notification (Section 70(1), VAT Act 1994), but it chose not to do so.
The Tribunal decided against HMRC. In reducing the VAT penalty to nil, the Tribunal said, “A situation where a fault on a taxpayer’s part, such as his failure to notify liability to be registered for VAT, has both given rise to a penalty and caused an irrecoverable overpayment of tax on his profits, may in our view be an occasion where it could be ‘proper’ to abate the penalty.”
This gives the taxpayer another option when reversing the original VAT error and its consequences: if they are out of time to claim back direct tax when the VAT error is discovered, the taxpayer should appeal to HMRC requesting a reduction in the VAT penalty, to the extent direct tax was overpaid due to the original VAT error.
In summary, our typical example might see the taxpayer:
- Amend the next VAT return or make a Voluntary Disclosure to HMRC;
- Notify HMRC of the errors, but show that due care was taken;
- Pay the additional VAT liability;
- Issue corrected VAT invoices to business customers;
- Amend the company accounts for net sales and VAT liability;
- Claim overpaid direct tax (income tax or corporation tax) ; and
- If the direct tax claim is out of time, request that HMRC reduce the VAT penalty.