Contractor guide to Making Tax Digital VAT penalties

A top accounting software provider specifying HMRC’s Making Tax Digital penalties.

HMRC subsequently finding fault with that specification, effectively saying the provider wasn’t being specific enough!

Readers of ContractorUK then taking the issue with the Revenue, tweeting that the taxman isn’t being honest enough, because he could potentially hike MTD VAT penalty amounts – and then backdate them!

Well, one thing I think we can all agree on -- from just the above ding-dong -- is that some guidance on HMRC’s Making Tax Digital penalties for VAT is definitely needed, writes chartered Graham Jenner, founder of tax advisory Jenner & Co.

Who does MTD apply to?

Before I address the retrospective concern of ContractorUK readers, first some key background.

Making Tax Digital has applied for some time to the submission of VAT returns for most VAT-registered businesses where their turnover exceeds the VAT registration threshold of £85,000.

But since April this year, MTD applies to those traders with a turnover of less than £85,000. In other words, the digital tax account requirement now covers those businesses that are not required to VAT-register but have voluntarily registered. The requirement first kicks in where the return period starts on or after April 1st 2022.

Making Tax Digital: the thinking

The idea behind MTD is to reduce the number of errors being made on tax returns. HMRC estimates that in 2018-19, errors in returns (not just VAT returns) cost the Exchequer a hard-to-fathom £8.5 billion.

The way that MTD tackles error is by requiring digital records to be used for recording transactions, making calculations, and submitting information to HMRC. So, it eliminates (to a large degree) the chance of human intervention and therefore the chance of human error.

HMRC also argues that MTD encourages taxpayers to update their software, and says the digital system makes it easier to record transactions and submit returns.

So VAT-registered contractor limited companies should theoretically be more comfortable in the knowledge that their VAT returns are less prone to error.

MTD for VAT requirements

HMRC says its MTD for VAT requirements are for businesses to:

1. Keep records digitally
2. File returns using software

Accompanying regulations require VAT returns to be submitted to HMRC using “Functional Compatible Software.”

What is Functional Compatible Software?

FCS is a program or a set of programs, which:

1. Record and store digital records
2. Provide HMRC with information and VAT returns from the data held in those records
3. Receive information from HMRC

There are a number of products on the market which will fulfil all of the above. 

Bridging software: in a nutshell

However, contractors should note that Functional Compatible Software could be a set of programs -- the most common of which might be a spreadsheet for part (1) above and what is known as ‘bridging software’ for (b) and (c). Then, data from the spreadsheet is imported into the bridging software.

Alongside many other accountancy firms, we offer this ‘bridging software’ to our contractor clients. It works well, provided the spreadsheet includes all of the necessary information and the data can be formatted for import into the bridging software.

Be aware, links between the different programs within the set that makes up the Functional Compatible Software have to be digital links. Hence the reference above to importing data into the bridging software.

Manual, ‘cut and paste’ & APIs

The idea is that once the data is in the digital records, nothing is ‘manual’. For example, ‘cut and paste’ cannot be used to move data between spreadsheets or even into another file. Instead, linked cells should be used, or a small software program (effectively an Application Programming Interface) can be written, to extract and format the data. Actually, we have written APIs for some of our clients, not only for VAT records, but generally to assist with communication between different programs.

Likewise if needed, data can be exported for one piece of software, perhaps into a csv file, and then that file imported into another piece of software.

HMRC MTD VAT penalty overview

There are three types of penalty that can be charged in relation to Making Tax Digital for VAT:

Return submitted but NOT using functional compatible software:

(Referred to as “Filing Through the Incorrect Channel”)

• up to £400 per return (but please see “What does ‘Up To’ mean?”, below)

Not keeping the required records digitally, including not using digital links to transfer or exchange the data between separate software:

• £5 - £15 per day that the error continues

Making a mistake by failing to use the checking functions in the software:

• Up to 100% of the VAT error

What does ‘Up To’ mean?

As with many of the penalties that HMRC can levy, their guidance refers to “up to” without giving detail of how the amount levied will be determined. There is an element of scaremongering with this, encouraging the taxpayer to comply.

It is here that some of the clarifications (referred to at the outset) were made.

Furthermore, while £400 is the maximum penalty for filing through the incorrect channel, that only applies to businesses whose turnover is £22.8 million or more. That was something HMRC has pointed out of late to limited companies.

So for those businesses with an annual turnover of less than £100,000 the penalty is £100, and £200 for turnover between £100,000 and £5.6 million.

Implications for limited company contractors (cont.)

HMRC says that the most common penalty will be £100. For contractors, it is likely to be £100 or £200.

These figures are specified in the legislation [Para 25A(17) of The VAT Regulations 1995]. An amendment to those regulations would be needed in order to change the rates or the bands. As long as the penalties are seen as enough of a ‘stick’ (or ‘carrot’ depending on your viewpoint), they are unlikely to change.

Finally, to address the concerns expressed on Twitter that the 100-£200 likely Making Tax Digital VAT penalty for contractors is ‘just this year only, and then HMRC could [increase it and] backdate it,’ my view is not as gloomy! Remember, the penalties are designed to encourage compliance -- rather than to punish bad behaviour, so any changes would be highly unlikely to be applied retrospectively.

What does ‘£5 to £15 per day’ really mean?

If in the last 24 months, there have been no previous breaches of the requirement, the penalty is £5 per day. For one breach it is £10; otherwise it is £15.

Questions for HMRC

One thing though -- HMRC may find it difficult to establish how many days the breach has lasted. Bear in mind, you are allowed to keep paper records, as long as you also keep digital records. Most people will update their digital records from time to time. If they are updated once a VAT quarter, is there a breach of the requirement to keep the required records digitally? If so, how many days did the breach last for?

Similarly, if a digital link is only needed once a quarter, e.g. to link data from the source records (like a spreadsheet) to the bridging software, and isn’t used, how many days has there been a breach for?

Part of the problem for HMRC is that this is an old penalty regime that has been adapted for MTD for VAT. I suspect that there won’t be many penalties issued for this type of breach, unless significant errors have arisen as a result.

Other penalties

Remember that there are separate MTD penalties for late filing of a VAT return or late payment of VAT due. A new ‘penalty points’ system for these starts from January 1st 2023.

What to do now

HMRC estimates that there are 1.1 million VAT-registered businesses that did not, previously, have to register for MTD for VAT (although about ¼ of those registered voluntarily). If you are VAT-registered but haven’t yet registered with HMRC for MTD for Vat -- which apparently is a bit of an issue with limited companies, sign up here. Please note, you will need Functional Compatible Software in place before you sign up.

Penultimately, if you need advice on the appropriate software, or want help using a spreadsheet or similar, along with bridging software, speak to your accountant.

And finally…

Don’t panic! The penalties are meant to encourage VAT-registered businesses to comply, rather than penalising silly mistakes.

Very finally, an exception on my part. I would not normally encourage anyone to breach the rules but sometimes, accepting a penalty for doing so, is the lesser of two evils (or at least, the lesser of two penalties). For example, a £100 penalty for breaching the MTD rules, may be worth incurring, if it is necessary to enable a VAT return to be filed on time!