Andrew Needham looks at how a VAT assessment can affect other taxes as well.
If a business makes an error and overpays or underpays VAT, it can result in a repayment of VAT or an assessment for underpaid VAT plus interest and penalties. In certain circumstances, this can affect the bottom line profits of a business and impact its direct tax liabilities.
There are some obvious circumstances where a business has, for example, suppressed its takings, so a VAT assessment based on under-declared takings would result in an increase in the business’s takings and therefore increased profits and an additional direct tax liability as well; either income tax or corporation tax, depending on whether the business was incorporated or not.
The right to a refund of VAT typically arises following a change of view as to the legal obligation to pay a sum in the past. Whether the change of view arises from a Court decision (UK or European) or for some other reason does not alter the treatment of the refund for direct tax purposes.
Who bears the burden?
In other cases, it can depend on where the burden of the VAT lies. If a business receives a repayment for overpaid VAT but has to refund it to its customers under the ‘unjust enrichment’ rules, the repayment of the VAT does not affect the business's taxable profits, and there is no additional tax burden.
HMRC accepts the principle that unless a taxpayer deducted an expense in computing its profits, the reversal of the expense does not give rise to a taxable receipt. A refund to the business of an expense that was not allowed as a deduction is not taxable. In the normal course, VAT assessed may not be thought of as an expense. HMRC’s own guidance recognises that VAT can be an expense. It is necessary to establish whether the VAT is collected by the trader (when it is outside the scope of direct tax and not deductible) or its burden is borne by the trader, in which case it is an expense and taxable.
For example, if a business did not claim input tax on a purchase that it should have, the VAT would form part of the costs of the purchase and would reduce the taxable profits of the business. If the VAT is refunded at a later date, it would then represent a taxable receipt and be subject to tax.
Interest and penalties
If a business receives statutory interest on an overpayment, it has been argued that it is, in reality, compensation and not subject to tax. However, tribunals have rejected this argument, so any interest received from an overpayment is treated as taxable income.
Unfortunately, if a business makes a mistake and ends up paying HMRC interest and penalties on an error, these costs are not treated as a deductible expense for the business, and there is no tax relief on these costs, giving the business a ‘double whammy’.
When is the tax due?
The timing for direct tax follows the accountancy treatment. This means that the refund is taken into account in the period in which it is recognised (or should be recognised) in the profit and loss account.
Practical tip
If your business is assessed for VAT and suffers interest or penalties, these cannot be offset for direct tax, but if you receive a repayment or interest, it counts as taxable income and is subject to tax.
