This case examined the issue of proportionality in the context of a VAT default surcharge of almost £71,000 issued by HMRC for payments made one day late. The First-tier Tribunal (“FTT”) originally found the surcharge to be disproportionate.

The principle of proportionality is an unwritten concept developed by European case law. In simple terms, the principle is intended to ensure that, when dealing with taxpayers, the actions of Member States do not go further than necessary to achieve the particular objective being pursued. In the context of VAT surcharges, that objective is to ensure taxpayers submit their VAT returns on time and also make timely payments.

The Upper Tribunal (“UT”) overturned the FTT decision finding that the surcharge imposed was not disproportionate. It concluded that surcharges will only be disproportionate in very exceptional cases. Unfortunately it did not elicit further on this point. It is not clear yet whether the appellant will seek leave to appeal the UT decision further.

The UT noted the absence of a maximum penalty was a flaw but said “…we cannot ourselves readily identify common characteristics of a case where such a challenge to a default surcharge would be likely to succeed …”. Further litigation in relation to the default surcharge regime therefore seems inevitable.

This case is interesting in the context of HMRC’s June 2015 announcements that the department is to take a “planned, proportionate approach to penalty appeals”. These announcements cover self-assessment and real time information penalties only. One might therefore naturally expect a more common sense approach to the issue of penalties and surcharges generally, particularily in the context of the February 2015 consultation “HMRC penalties: a discussion document”.

That discussion document clearly identified that the current system of VAT default surcharges does not differentiate between “payments that are a day or two late from payments which are many months late”, precisely the point in issue in this case. The outcome of this discussion document is not yet clear. However, HMRC aim to publish a summary of responses document as soon as possible after the summer recess.

Background and key arguments

Trinity Mirror is a well-known publisher of newspapers and magazines. It originally had three-month long prescribed VAT accounting periods. The company had been directed by HMRC, pursuant to section 28(2A) of the Value Added Tax Act 1994 (“VATA”), to make payments on account of VAT. It was required to make two monthly payments on account and a third balancing payment on a specified date (notified in advance) approximately one month after the end of VAT period.

The company failed to make the balancing payment for its 06/07 VAT period by the due date, paying in full one day late. As a result HMRC served, pursuant to section 59A(2) VATA, a surcharge liability notice on the company. This specified a surcharge period from 31 August 2007 to 1 July 2008, and expressly notified Trinity Mirror that it would be liable to a surcharge if it defaulted in respect of a VAT period ending within that period.

Trinity Mirror failed to make the balancing payment for its 12/07 VAT period by the due date of 30 January 2008 and paid this one day late. The surcharge for that default was assessed at the rate of 2%, initially on the amount of balancing payment of £4,795,005 giving a surcharge liability of £95,900. This amount was paid to HMRC on 4 June 2008.

Subsequently, on 21 August 2008, the company made a voluntary disclosure of an overpayment of VAT for the 12/07 VAT period of £1,249,681. The surcharge amount was consequently reduced to £70,906, being 2% of the amount actually due and not paid by the due date.

In February 2010, Trinity Mirror wrote to HMRC following the FTT’s decision in favour of the taxpayer in Enersys Holdings UK Ltd v. Revenue and Customs Commissioners [2010] UKFTT 20 (TC) (“Enersys”). In that letter, Trinity Mirror repeated its position that the surcharge was disproportionate, invited HMRC to discharge the assessment and claimed repayment of the surcharge. Thereafter, at the invitation of HMRC, Trinity Mirror agreed to stay resolution of the dispute until after the Upper Tribunal has decided HMRC’s appeal in Enersys.

In January 2011, following HMRC’s withdrawal of their appeal in Enersys and repayment of the default surcharge in full to the taxpayer in that case, Trinity Mirror wrote to HMRC, again.

Following further correspondence between the parties, HMRC wrote to Trinity Mirror on April 2011, stating that the original case had been reviewed and a decision was made to uphold the assessment.

The UK default surcharge regime

For traders such as Trinity Mirror that are subject to the “payments on account” regime, the relevant default surcharge provisions are set out in section 59A VATA. A first default (a default in the making of a VAT return/a payment of VAT by the due date) does not give rise to any liability to a surcharge but triggers the issue of a surcharge liability notice.

That notice creates a “surcharge period”, which begins on the date the notice is issued and ends on the first anniversary of the VAT period for which the default arose. The significance of the surcharge period is that if there is a second default in a VAT period ending within that surcharge period, and the aggregate value of the defaults in that VAT period (including both defaults of payments on account/ balancing payments) is more than nil, the defaulting trader is liable to a surcharge calculated at a specified percentage.

For a first default within a surcharge period, the specified percentage is 2%. There is no surcharge if the taxable person demonstrates a reasonable excuse for non-payment. However, neither HMRC nor the FTT has power to mitigate a surcharge.

Where a default occurs within a surcharge period, that surcharge period is extended. On subsequent defaults within that extended period, the specified percentage applied to the aggregate value of the defaults for the relevant VAT period increases with successive VAT accounting periods of default to 5%, then 10%, and finally to a maximum of 15%.

The arguments

Trinity Mirror appealed to the FTT in May 2011. The basis for its appeal was as follows:

• That the surcharge is disproportionate and ought to be discharged by the Tribunal. The default surcharge regime must comply with the Community Law principle of proportionality. This requires that both the regime as a whole, and the surcharge imposed in this particular case, comply with the principle of proportionality
• The regime as a whole is flawed because there is no maximum penalty. Moreover, taking into account the circumstances of the default and the relevant characteristics of Trinity Mirror in this particular case, the surcharge is not a proportionate response to the gravity of the default which it seeks to penalise; and
• In the absence of any power to mitigate or otherwise reduce a disproportionate surcharge, the only possible course of action open to the Tribunal is to set aside the surcharge.

HMRC made the following points before the FTT:

• When taken as a whole the default surcharge regime is proportionate, consistent with European Law and compatible with the European Convention on Human Rights.
• The regime is within the “margin of appreciation” allowed to the United Kingdom to maintain a default surcharge system without an upper limit, or fixed cap on the amount of default surcharge that can be imposed in a particular case. The absence of an upper limit or fixed cap does not make the default system disproportionate.
• Even if the penalty is more than would be imposed by a Tribunal, the amount in this case does not approach the level to be considered disproportionate.
• If an upper limit on the penalty was imposed by the regime this can create unfairness on smaller businesses and create a disproportionate penalty.
• HMRC agreed that the default surcharge regime should comply with community law and the principle of proportionality and agreed with the Upper Tribunal. In the case of Revenue of Customs Commissioners v Total Technology Engineering) Limited [2012] UKUT 418 (TCC) (“Total Technology”) the UT “found the regime as a whole does not suffer from any flaw which renders it non-compliant with the principle in the sense that it, or some aspect of it, falls to be struck down”. HMRC disagreed with this decision that a system that is found to be proportionate could produce a penalty that is said to be disproportionate.
• It would be wrong to compare the circumstances leading to the imposition of a surcharge in Enersys with the surcharge in this case. In the Enersys decision there was an unexpected spike in trading which resulted in an unusually large VAT liability. In this case, there was no spike in trading and the company was warned of the consequences of the late payment thus cannot claim to be surprised at the amount of surcharge imposed on them. To set aside the surcharge in this case would make the surcharge system itself disproportionate. In effect, the Tribunal would be saying the surcharge imposed on a smaller company is proportionate but a larger surcharge on a larger company is not.

HMRC submitted that if the Tribunal set aside the surcharge in this case they would in effect be making the surcharge system disproportionate by saying that there are some businesses that are just too big to be surcharged.

The FTT decision

The FTT began by considering Total Technology. It referred to the conclusion reached by the Upper Tribunal that even if the structure of the default surcharge regime is a rational response to the late filing of returns and late payment of VAT, it is necessary to consider the effect of the regime on the individual case in hand.

The FTT considered whether the surcharge in this case was disproportionate. The FTT discussed what the tribunal in Total Technology had said, concerning the purpose and effect of the default surcharge regime, referring in particular to the feature noted by the UT that the penalty is for a failure to do something by a due date and not for a continuing failure to put right the original default.

The default surcharge regime looks at successive defaults during the surcharge period and that “its aim is to impose higher penalties on a taxable person who defaults repeatedly than those who default less frequently”. It found that this suggested that “the regime identifies the gravity of the particular infringement by reference to the number of times in the relevant surcharge period that the taxable person has previously been in default and penalises that person according to the gravity so identified. There is, as it were, a hierarchy of seriousness of breaches.”

In relation to the surcharge in this case, the FTT referred in particular to the decision of the FTT in Enersys and said this:

“Let us look at the surcharge in question. A Surcharge of £95,900 later reduced to £70,906.44 [that] was imposed on an otherwise compliant trader to penalise a one day default is plainly unfair. The regime recognises the level of penalty in this case (one default) as being at the low end of the hierarchy of penalties.

If compared to Enersys, where a 5% surcharge based on a fifth default over a two year period resulted in a £131,881 penalty, the surcharge here at 2% (or two and a half times less than the one levied in Enersys) would suggest a penalty level of £52,752.40 (being 40% of the £131,881 in Enersys) as being proportionate. The penalty imposed is disproportionate by comparison. This view finds support in the view of the Upper Tribunal in Total Technology, who gave a benchmark figure which they thought would be disproportionate. They suggested that a £50,000 penalty would be disproportionate in respect of a third default.

By this standard, the penalty imposed is harsh. There is a strong underlying intention in the legislation that different breaches warrant 30 different penalties and the gravity of the infringement is relevant. The gravity here is low but the penalty is high. The Tribunal does not agree with the counter argument that to set aside the surcharge in this case “would make the surcharge system itself disproportionate.” There is no evidence that this would be the case.”

The FTT also rejected arguments of HMRC based on waivers of certain small penalties, holding that this did not amount to evidence that HMRC considered the real question of proportionality.

The FTT concluded that the surcharge in the case of Trinity Mirror’s default went beyond what was strictly necessary for the objectives pursued and was excessive in view of the gravity of the infringement such that it imposed a disproportionate burden.

The surcharge was, accordingly, disproportionate, and as a consequence was to be discharged.

HMRC, appealed against the FTT decision arguing that the FTT made a number of errors of law and its decision was therefore flawed. They submitted that the UT should set aside the FTT’s decision and re-make it, by determining for itself whether the surcharge imposed in this case was disproportionate.

Decision

Errors of law

The UT took as its benchmark the amount of the 5% penalty in Enersys which had been determined by the FTT, in the circumstances of that case, to be disproportionate. It reasoned that the gravity of the default was to be assessed solely by reference to the number of defaults in the surcharge period, and appears to have concluded that relative gravity could thus be determined by the different rates of surcharge applied to each such default.

On that basis it considered that the application of the same ratio of 2 to 5, reflecting a comparison of a 2% surcharge (that in Trinity Mirror’s case) with a 5% surcharge (that in Enersys), should be applied to the respective surcharges to generate an appropriate benchmark figure for assessing the proportionality of a surcharge at 2%.

The UT found there to be no basis for an arithmetical approach of this nature. The conclusion as to whether the surcharge was disproportionate or not was not one that could be arrived at as a matter of law by the reasoning adopted by the FTT. The FTT’s reliance on Enersys was misguided. Irrespective of whether the conclusion in Enersys was correct on its own facts, it could never be right in principle for a tribunal in a different case to extrapolate from it a conclusion based on an arithmetical calculation.

The FTT approach had no regard to the individual circumstances of Trinity Mirror’s case, and provided no foundation for determining the proportionality of the surcharge on an individual basis. It was a flawed approach and an error of law on the part of the FTT.

Issue of proportionality

The principle of proportionality, according to EU law, is concerned with two objectives when concerned with penalties. One is the objective of the penalty itself; the other the underlying aims of the directive. But more broadly, the objective of the penalty in enforcing collection of tax is itself a natural consequence of the essential aim of the directive which is to ensure the neutrality of taxation of economic activities.

In Total Technology the UT rightly focused not only on the general aim of the default surcharge regime to ensure compliance with a taxpayer’s obligations to file returns and to pay tax, but on the specifics of that regime. It did so because questions of proportionality can only be judged against the aim of the legislation. But the tribunal did not examine in detail the other relevant objective, namely the underlying aim of the directive.

The UT considered this to be the more fundamental question because the way the principle of proportionality has been expressed in the case law is not confined to an examination of the penalty simply by reference to the gravity of the infringement. It is not enough for a penalty simply to be found to be disproportionate to the gravity of the default. It must be “so disproportionate to the gravity of the infringement that it becomes an obstacle to the underlying aims of the directive.”

The underlying aim of the directive is the principle of fiscal neutrality in its sense of ensuring a neutral tax burden which protects the taxable person, since the common system of VAT is intended to tax only the final consumer.

In the UT’s view, it is not appropriate for the courts or tribunals to seek to set any maximum penalty, or range of maximum penalties. That would in effect be to legislate. The task of the tribunal is to consider the relevant tests in the context of the individual case before it. It must not seek to establish a maximum and then compare the actual penalty to that benchmark. That was what the FTT attempted to do in this case, and it was wrong in law to have done so.

The correct approach is to determine whether the penalty goes beyond what is strictly necessary for the objectives pursued by the default surcharge regime.

The UT agreed with the tribunal in Total Technology that the default surcharge regime, viewed as a whole, is a rational scheme. The penalties are financial penalties, calculated by reference to the amount of tax unpaid at the due date. Although penalties may vary with the liability of the taxable person for the relevant VAT period, and increase commensurately with an increase in such liability (and, consequently, such default), the penalties are not entirely open-ended. The maximum liability for a fifth or subsequent period of default is 15% of the amount unpaid.

The UT accepted that, in the absence of any financial limit on the level of surcharge, this may result in an individual case in a penalty that might be considered disproportionate. This is only likely to occur only in a wholly exceptional case, dependent upon its own particular circumstances.

Although the absence of a maximum penalty means the possibility of a proper challenge on the basis of proportionality cannot be ruled out, the UT could not readily identify common characteristics of a case where such a challenge would be likely to succeed.

The UT found there to be no exceptional circumstances in Trinity Mirror’s case that could render the surcharge disproportionate. A financial penalty of this nature, based on a modest percentage of the amount of VAT unpaid by the due date, cannot be regarded as going beyond the objectives of the default surcharge regime.

The gravity of the default must be assessed by reference to the relevant factor. This was a second default. Trinity Mirror had been notified by the surcharge liability notice issued following the first default that further default within the surcharge period could result in a surcharge.

In the context of the need to preserve the fiscal neutrality of the VAT system, to enforce prompt payment of VAT collected by a taxable person, a penalty of 2% cannot be regarded as so disproportionate to the gravity of the infringement as to constitute an obstacle to the underlying aim of the directive.

The surcharge cannot be regarded as disproportionate by reference to the Convention. It has been arrived at by the application of a rational scheme that cannot be characterised as devoid of all reasonable foundation. Whilst admitting the penalty may be considered harsh, it cannot be regarded as plainly unfair.

For the reasons given the UT allowed HMRC’s appeal; and upheld the surcharge liability.

The full judgement in this case is available from:- http://www.tribunals.gov.uk/financeandtax/