18810
VAT – default surcharge – trading difficulties – insufficiency of funds – whether underlying reasons for insufficiency provided a reasonable excuse – yes initially – whether those reasons continued to provide a reasonable excuse in later periods – no – appeal allowed for one period and dismissed for the others

LONDON TRIBUNAL CENTRE

	SECOND NATURE LIMITED	Appellant

	- and -

	THE COMMISSIONERS OF CUSTOMS AND EXCISE	Respondents

				Tribunal:	Malcolm Gammie Q.C. (Chairman)
						Mrs S Sadeque MBCS

Sitting in public in London on 19th May 2004

Mr A Penson, accountant, for the Appellant

Mr A Dougal (Solicitor) for the Respondents

© CROWN COPYRIGHT 2004

DECISION

Introduction

1. This is an appeal by Second Nature Limited (“the Appellant”) against default surcharges for a number of periods.  We summarise the schedule of defaults below—

Period	Tax due	Tax paid on due date	Rate %	Surcharge	
02/00	£80,531.93	£0	0	0	
08/00	£32,842.34	£0	2%	£656.84	
11/00	£50,693.46	£0	5%	£2,034.67	
02/01	£75,207.01	£0	10%	£7,520.70	
05/01	£18,613.36	£10,000	15%	£1,292.00	
08/01	£39,069.33	£0	15%	£5,860.39	
11/01	£111,772.66	£0	15%	£11,177.26	
02/02	£57,912.55	£0	15%	£8,686.88	
05/02	£51,183.14	£0	15%	£7,677.47	
08/02	£26,554.52	£0	15%	£3,983.17	
11/02	£55,862.55	£0	15%	£8,379.38	

The return and payment for the period 05/00 (which involved the relatively small sum of £3,124.81)) were received on time.  The surcharge notice for the period 11/01 is expressed to be calculated at the 15% rate but the amount stated in the notice represents only 10% of the unpaid tax.  

2. The VAT returns for the periods 02/00 and 08/00 were signed by Clive Petty.  Those for periods 11/00, 02/01, 08/02 and 11/02 by H Deleia and those for periods 05/01 to 05/02 by David Salter.

3. Tax for the first default period 02/00 was paid in a single sum on 25th May 2000.  For the periods from 08/00 to 08/02 tax the Appellant has paid the tax in instalments, although it appears that the instalments for period 08/02 did not fully discharge the tax due.  Tax for the final default period 11/02 was paid in a single sum on 15th January 2003.

4. The notes to the surcharge notice state—

	“5. Can I ask to have a surcharge assessment withdrawn?
-	you can ask your local VAT office to reconsider your liability to sucharge
-	you can also, subject to certain conditions, appeal direct to an Independent VAT Tribunal.”

On 27th March 2002 David Salter, the Appellant’s financial controller, faxed the Respondents appealing against the surcharge for the period 11/01.  No appeals had been lodged in respect of the earlier periods nor were further appeals formally made in respect of later periods.

5. The appeal letter of March 2002 indicates that the Appellant had agreed in late October 2001 to pay the outstanding VAT in three equal instalments over the three months from January to March 2002, which it did.  The letter also noted that a similar arrangement had been agreed for the period 08/01.  Tax due for that period was paid in seven instalments between 3rd October 2001 and 4th January 2002.  

6. The Respondents replied to the appeal letter on 21st June 2002 pointing out that insufficiency of funds was explicitly excluded as a reasonable excuse for late payment of the tax and that Time to Pay agreements neither prevented nor cancelled defaults or liability to surcharge.  

The reasons for the defaults

7. On 7th October 2002, Alan Penson for the Appellant wrote to the Respondents regarding the tax due for the period 08/02 proposing that the Appellant pay it in three equal instalments.  The first of these appears to have been paid with the submission of the return on 9th October.  The second instalment suggested for 4th November appears not to have been paid and the third was paid on 3rd December 2002.  

8. Mr Penson’s letter outlined the difficulties that the Appellant was facing.  We set out below the relevant extracts—

	“The company designs and distributes greetings cards, most of which are made in the Far East.  The business lost a major customer during 2001 and, as a result, lost [a] significant amount of money in that year. In consequence 2002 has also been a struggle and we have lost more money. We have spent the last nine months cutting costs and refocusing the operations. In September 2002, we are now at last back on a break-even basis month by month. Nonetheless the company’s cashflow is extremely tight.

	Our bankers have been very supportive during this period and we have agreed and are on the point of signing a revised facility arrangement with the Bank, which will underpin the business’s future.

	The directors are concerned about the current financial situation and are fully aware of their obligations to meet all liabilities, perhaps especially VAT and other tax liabilities.  Over the past three or four months [they] have considered their responsibilities under the rules governing insolvency. The revised arrangements with the bank and also the shareholders should help the situation, although much depends on the success of the new range of Christmas cards this year and also Valentine’s cards in 2003.”

9. In March 2003, Morley & Scott on behalf of the Appellant wrote to the Respondents’ Reconsiderations Team seeking the Respondents’ agreement that all defaults from 05/00 to 11/02 were covered by the reasonable excuse provisions and that the default surcharge liability notices should be withdrawn.  It appears from this letter that most of the default surcharges had in fact been paid although a balance remained outstanding for which the Respondents had commenced winding up proceedings.  

10.  The grounds for the reasonable excuse that Morley and Scott put forward were these—

	“1. In March 2000 the company unexpectedly lost 3 large customers representing annual sales of around £2 million or some 40% of the company’s annual turnover.

	2. The company’s factoring company Versaille Finance went into liquidation owing the company around £100,000

	3. In consequence an aggressive marketing plan was initiated which resulted in additional turnover at a cost of increased overheads, lower margins and an additional strain on cashflow.  In particular the company incurred significant set-up costs for shelf space within new customers’ retail outlets.

	4. In tandem with the company’s loss of 3 large customers, the company undertook a costly warehouse move on the Isle of Wight which increased still further the strain on cash resources around April/May 2000.

	5. The company’s Financial Controller at that time  is now known to have been experiencing personal problems which manifestly affected his judgement concerning management of the company’s financial position. [His] problems culminated in his prosecution around a year ago for driving whilst under the influence of alcohol, followed by his enforced removal from the company’s employment. (Subsequent correspondence indicates that his employment was terminated at the end of July 2002.) 

	6. In June 2002, Mr Alan Penson was appointed as a financial accountant to assist in the control and management of the company’s finances. Mr Penson quickly identified that the level of the bank indebtedness was insupportable from company profitability and projected cashflow.  He therefore initiated a plan to capitalise part of the company’s indebtedness and inject further capital into the company by means of a Rights Issue to existing shareholders.

	The plan was successfully implemented around the Christmas/New Year period a few months ago.  In particular, the restructuring permitted the availability of cash resources to settle the whole of the company’s VAT liability for the quarter 11/02 by early January 2003.  Although a few days late, the settlement of the entire quarter’s liability by early January demonstrates the successful outcome of the debt restructuring initiated by Mr Penson.”

11. By reply of 16th April 2003 the Respondents pointed out that there was no default for the period 05/00 but that there was for the period 02/00, for which the Appellant’s cheque had been refused payment by its bank.  The Respondents agreed to consider the periods 02/00 and 08/00 to 11/02 to see whether there was a reasonable excuse underlying the lack of funds and asked for further information.  

12. The further information requested was supplied on 20th May and 11th June 2003.  We refer to this information below but it was followed on 18th June 2003 by the Respondents’ request for further information.  This further request included for details of the amount and date of sales invoices raised for the periods in question on a quarter-by-quarter basis, details of the dates and amounts of monies received in respect of the invoices, details of payments relating to earlier invoices received during the periods under appeal.  

13. On 11th July 2003 Morley and Scott replied that the volume of transactions made it impossible to comply with this request.  They noted that there were 25,000 sales invoices for the period in question, the majority of which were in amounts of less than £400.  They pointed out that an analysis of monthly turnover had already been supplied for the years 2000, 2001 and 2002.  Based on their initial letter of March 2003 and the further information, Morley and Scott concluded that—

	“It is clear from the points made  that the company suffered extraordinary misfortunes as a result of:

-	Losing more than 50% of budgeted turnover in March 2000;
-	Losing the sum of £80,000-£100,000 when the factoring company was struck off the Stock Exchange for fraud, also in March 2000;
-	Suffering from the upheaval caused by the company’s warehouse move and change of computer system in March 2000;
-	The inadequate performance of the company’s financial controller 

14. On 31st July 2003, the Respondents wrote to Morley and Scott informing them that the Respondents did not accept that the Appellant had any reasonable excuse.  The reasons given were these—

	“For the majority of quarters under appeal the received monies exceed the sales outputs for those quarters.  From previous correspondence it would seem that your client has received enough monies in to cover the VAT due for each quarter.  

	Relating to the 05/00 period due to your circumstances around that time we may have considered removing this surcharge, however, no surcharge was incurred for this period.

	For the 08/02 the return was received late, therefore, for that reason the default must still stand.”

15. On 22nd August 2003 Morley and Scott wrote again expressing disagreement with the Respondents’ view that the figures showed sufficient monies in to cover the tax due for each quarter and requested a further reconsideration.  Following reconsideration the Respondents replied on 17th September 2003 indicating that they still did not accept that the Appellant had a reasonable excuse for the defaults.

16. On 29th September 2003 Trevor Schragger, a director and major shareholder of the Appellant, wrote to the Respondents.  He rejected the suggestion that the Appellant had sufficient funds in the relevant period to meet the VAT liability and pointed out that at no time during the period was the Appellant not behind in payments to its creditors and was under constant threat of legal action and winding up notices.  Mr Penson produced to us a sheaf of legal papers supporting this statement.

17. Mr Schragger also pointed out in his letter that to keep the business alive the Appellant had to create sales at low margins and with high overheads.  He and the other shareholders also introduced additional finance together with the bank, which invested £1.2 million of its £1.7 million debt in the business.  It was only this that prevented the Appellant going into liquidation in December 2002.

18. The Respondents replied to Mr Schragger on 13th October 2003 reiterating their view that the Appellant did not have a reasonable excuse for the relevant periods.  They drew Mr Schragger’s attention to the Appellant’s right to appeal to this Tribunal but noted that the Appellant would have to request to appeal out of time.

19. In a letter of 10th November 2003 to the Tribunal, Mr Schragger drew our attention to the following points—

(1)	In March 2000 the Company lost customers who at that time accounted for 50 per cent of the company’s sales;
(2)	The ensuing period running over 2001 and 2002 was a period in which the company was battling to stay trading and for most of that time was technically insolvent;
(3)	The combination of financial pressures on the company over that period was exceptional;
(4)	Over that period all creditor payments were being delayed and payment arrangements were made daily with suppliers as well as with the Respondents and the Inland Revenue in respect of PAYE liabilities
(5)	Creditor days were averaging 120-150 days when they should have been 60-90 days and on average the company was short of £250,000 to pay its creditors as required
(6)	The company’s borrowing facilities throughout the period were used to the maximum.

The company’s financial position

20. We summarise below the relevant information from the VAT returns for 02/00 to 11/02.  

Period	Outputs	Output tax	Inputs	Input tax	
02/00	2,133,594	302,788	2,222,734	222,256	
05/00	1,218,683	150,387	1,442,109	147,263	
08/00	836,733	124,039	984,970	91,197	
11/00	1,108,861	158,618	1,113,216	107,925	
Total	5,297,871	735,834	5,763,029	568,642	
					
02/01	1,615,610	228,943	1,421,474	153,736	
05/01	949,989	125,416	950,311	106,803	
08/01	939,852	128,285	1,123,015	89,216	
11/01	1,622,104	216,479	1,015,922	104,706	
Total	5,127,555	699,125	4,510,722	454,462	
					
02/02	1,388,028	142,698	887,078	84,786	
05/02	901,138	109,980	1,025,130	58,797	
08/02	902,378	98,530	868,101	71,975	
11/02	1,311,367	169,057	1,056,975	113,195	
Total	4,502,911	520,267	3,837,284	328,754	

The total VAT due in each of the years was £167,192 up to 11/00, £244,662 to 11/01 and £191,512 to 11/02. 

21. At the hearing Mr Penson explained the company’s financial position over the relevant period in more detail.  The summary of the company’s major customers with which we were provided indicated that in March 2000 the company had lost customers representing sales to budget of some £2,420,000, representing around 50 per cent of turnover.  Mr Penson indicated that the turnover that had been lost represented an even larger proportion of the company’s profits and that although the company had been able to generate new turnover to replace what had been lost it was far less profitable business.  The new turnover comprised a combination of new customers and increased sales to existing customers and while the fall in sales is apparent from the figures we were given it is by no means as severe as one might have anticipated.  The new turnover was, however, achieved at higher cost and lower profitability both through the nature of the turnover but also by employing more people and increasing overhead and direct marketing expenditure.  There were no expenses that the company could reduce; rather it was forced to increase its expenses as it struggled to survive.  The company incurred large losses in 2001 and 2002 after breaking even in 2000.

22. Explaining the warehouse move in March 2000, Mr Penson said that the company had previously rented warehouse space and its existing lease was due to expire.  The move was therefore unavoidable.  The company had large but variable storage requirements due to the seasonal nature of its trade.  It had started looking for new premises in December 1999 and it had taken two months to find something suitable.  The move of premises had cost the company around £100,000.

23. The company’s standard payment terms were 30 days from the end of the month in which invoices are issued but a number of customers enjoyed extended payment terms and in practice the average debt settlement period was usually 90 days.  As the VAT returns reflect, Christmas sales represented a relatively high proportion of annual turnover.  Christmas cards were normally delivered and invoiced in September or October each year but settlement terms were extended until January or February in the following year.  Valentine’s Day cards are delivered and invoiced in December and January for settlement in March and Mother’s Day cards are invoiced in January for settlement in April.  At the same time the company was sourcing an increased number of supplies from China, where the Chinese supplier was unprepared to contemplate more flexible payment terms.  

24. As a result there was a discrepancy between the sales receipts representing the VAT and the VAT that was due on invoiced sales.  At the end of the period 02/00 the sum of £168,000 output VAT had been invoiced for which no cash had been received.  Mr Penson produced a schedule demonstrating how this net balance of output VAT moved over the subsequent periods.  It declined to £84,000 by the end of 11/00 before picking up to £119,000 by the end of 02/01.  It had been eliminated by the end of 08/01 before increasing over the Christmas quarters 11/01 and 02/02 to remain in deficit throughout 2002.

25. Throughout the two years from January 2000 to December 2001 the company’s overdraft facility was drawn close to or in excess of the agreed limits on a continual basis.  In January 2000 the facility stood at £900,000.  This was increased to £1,400,000 in June 2000 and to £1,700,000 in September 2001.  Mr Penson provided a detailed breakdown of bank receipts and payments from January 2000 until December 2002.  Over that period there is no doubt that the company’s receipts were sufficient to discharge its VAT obligations.  Its problem, however, was the number of other creditors who required to be paid and who were otherwise threatening to bring the company down.  The shareholders had to contribute £200,000 as further funding in July 2001.  The bank eventually agreed to capitalise £1,200,000 of its debt in December 2002.

Out of time appeals

26. As a preliminary point, Mr Dougal for the Commissioners began by objecting to our hearing the company’s appeal for any period other than for the period 11/01 on the basis that no appeal had been lodged in time in respect of any of the other periods.  Mr Penson did not dispute that the company had failed to give notice of appeal in time for any period other than 11/01 but asked that the Tribunal exercise its discretion to hear the appeals nonetheless.

29. In his submissions on this point Mr Dougal referred us to Designspeedy Limited v Commissioners of Customs and Excise LON/03/0361 and to the other decisions referred to in that case.  The Tribunal in Designspeedy had regard in particular to the guidance offered by Lord Donaldson in Norwich & Peterborough Building Society v Steed [1991] 1 WLR 449 at 454G and the approach adopted by the Tribunal in Mr W Y Wan and Mrs Y S Wan t/a Wans Chinese Takeaway v Commissioners of Customs and Excise.  We considered the company’s application on the basis of the principles contained in these decisions.

30. Designspeedy concerned a deliberate fraud by the person responsible for the company’s VAT returns.  As a result the company’s VAT was not paid and default surcharges were raised by the Commissioners.  The defaults arose between 1996 and 1998 and in June 2000 following the discovery of the fraud, the company sought a review of these surcharges and the correspondence with Customs then continued until February 2003.  The company then submitted notices of appeal in March 2003 with an application for an extension of time to make the appeal.

31. The grounds advanced by Designspeedy in support of its application, which was refused, included the complexity of its case, its continuing correspondence with Customs and the fraud that it had suffered.  For his part Mr Penson noted that the grounds for his application were closely woven with the arguments that he would advance as reasonable excuse for the failure to pay VAT on time.  He cited the personal problems of the company’s financial controller.  His personal problems meant that he had failed to deal with matters properly and had also misled the directors about the scale of the problem by keeping information from them and giving misleading reports.  

32. Mr Penson accepted that, in an ordinary situation, the shortcomings of the person responsible for dealing with the company’s VAT affairs and the failure of the directors to discover what was going on would provide no justification.  In the company’s case, however, once disaster struck at the beginning of 2000 the directors overriding concern and objective was to keep the company alive.  This was the sole focus of their attention for the following three years during which the company could have gone under at any time.  Furthermore, as soon as the financial controller’s problems had become apparent and the true nature of the company’s VAT position revealed, the directors had taken steps through Morley and Scott to rectify the position.

33. Mr Dougal for the Commissioners drew our attention to the signatories of the VAT returns and said that the directors must have appreciated that the company had failed to pay its VAT as required.  He also drew our attention to the fact that what Mr Penson had said regarding the company’s financial controller was unsupported by any evidence of the true situation.  

34. It seemed to us that the problem for the taxpayer in Designspeedy was that, “the appeals against all the surcharges were grotesquely out of time” not just by reference when it first suffered the fraud but even by reference to the time when the fraud was discovered.  In this case, the directors must have known (or ought to have known) that the company was failing to pay its VAT on time given its financial circumstances.  On the other hand, we can appreciate that just keeping the company afloat on a day-to-day basis must have been the directors’ overwhelming concern.  In those circumstances we are prepared to believe Mr Penson when he says that they did not immediately identify and deal with the financial controller’s personal problems or appreciate the company’s liability to the default surcharges or that the financial controller had failed to appeal those surcharges as he should.  Once the full extent of the problem became apparent in the second half of 2002 they had taken steps to put matters right.

35. Having taken time to consider the respective submissions, we therefore decided to allow the company’s application and to hear the appeals.  

The parties’ submissions on reasonable excuse

35. We have already set out the financial background to this appeal.  Mr Penson’s submissions were effectively to take us through the company’s financial position from the beginning of 2000 to the end of 2002.  He stressed the seasonal nature of the company’s trade and the change in the nature of its customer base following the events of early 2000.   He submitted that the company’s problems over the entire period stemmed from the events of early 2000.  It had effectively taken three years for the company to stage a recovery from these financial shocks, although it was by no means out of the woods.

36. For his part Mr Dougal accepted that the combination of events of early 2000 were capable of forming grounds for excusing some of the defaults. He submitted, however, that there comes a point at which a company can no longer rely on the circumstances that initially arose to create the problems and must accept that the continuing financial problems have become part of the ordinary trading situation in which the company finds itself.  

37. Mr Dougal noted that the scope for appeal on the basis of reasonable excuse is limited where the reason is insufficiency of funds. Although section 59(7)(b) of the Value Added Tax Act 1994 provides that there is no liability for default surcharge if there is a reasonable excuse, section 71(1)(a) provides that an insufficiency of funds to pay any tax due is not a reasonable excuse.  In certain cases it has been held that the reason for the insufficiency (as opposed to the insufficiency itself) can be a reasonable excuse.  The number of cases in which this has been established, however, is relatively few.  Mr Dougal drew our attention to the leading case on this issue, Customs and Excise Commissioners v Steptoe [1992] STC 757, and also to Fat Sam’s American Food and Beverage Co Ltd v Customs and Excise Commissioners (LON/90/1408). 

Our decision

38. In Steptoe, Lord Donaldson of Lymington MR said this at page 770d:

	“[I]f the exercise of reasonable foresight and of due diligence and a proper regard for the fact that the tax would become due on a particular date would not have avoided the insufficiency of funds which led to the default, then the taxpayer may well have a reasonable excuse for non-payment, but that excuse will be exhausted by the date on which such foresight, diligence and regard would have overcome the insufficiency of funds.”

39. The wrongful act of another person, or some unforeseeable or inescapable misfortune, leading to an insufficiency of funds, count among the reasons for accepting that there is a reasonable excuse.  In the present case, we accept (and we did not understand Mr Dougal to dissent from this) that in early 2000, the company was struck by a combination of events that allow it to establish a reasonable excuse for non-payment to the extent that that combination of events led to an insufficiency of funds.  The company could have anticipated that its current warehouse lease would expire around this time and that there would be the one-off expense of finding and moving to new storage space.  We do not think that it could have anticipated that this would coincide with the loss of such a large proportion of its turnover or the financial loss it suffered as a result of the liquidation of Versailles Finance.

40. In our view this would account for the periods 02/00 and 05/00 but the company’s problem is that although the tax was paid late in the first of these periods there was no default surcharge.  In the period 05/00 the company paid its VAT on time (presumably because only a relatively small sum was due).  The real question we therefore have to answer is whether the circumstances that became apparent in the first quarter of 2000 reasonably excuses the continuing defaults over the ensuing two or more years.  In our view they do not.

41. It is clear that the company’s circumstances are very different from those in Steptoe.  The loss over a short period of 50 per cent of the company’s existing turnover was obviously a significant blow but this did not involve those customers reneging on long-term contracts or otherwise defaulting on their payment or other obligations.  Nor did this affect the essential character of the company’s business as a seasonal business.  It was a seasonal business before and after these events.  Certainly, the company’s trading conditions became very difficult and one can understand that in the initial periods of 2000 the company was reeling under the shock of events.  The combination of events at that time was unforeseen but by the middle of 2000 its changed trading conditions were clear.  What followed was a struggle to survive by organising additional finance and managing the company’s finances so that it could continue to trade on a basis that avoided its creditors tipping the company into liquidation.

42. We have no doubt that the struggle continued for an extended period.  The problem for the company is that Customs and Excise is not an ordinary creditor but one that Parliament has provided can exact a penalty for the persistent failure to pay on time.  This reflects the fact that Customs and Excise is a creditor in respect of amounts that the business collects on Customs’ behalf.  The cases in which a trader with insufficient funds to pay his VAT can successfully invoke the defence of reasonable excuse are therefore likely to be rare because traders receive from their customers the amount of tax which must be paid to Customs and Excise. If a trader uses that money in his business so that it is no longer available when the date for payment arrives, he will normally have difficulty persuading the tribunal that he has a reasonable excuse for late payment.  Mr Penson has put the case for the company very well but ultimately he has not persuaded us that the company has a reasonable excuse of which we can take account.

43. Any business must manage its financial resources as best it can and may go through periods of highly unfavourable trading conditions, so that it becomes extremely difficult to meet the demands of all its creditors.  In such circumstances it would be easy for a trader to meet the demands of other creditors and to say to Customs and Excise that it does not have the funds to pay its VAT, even though VAT forms part of the financial resources that it has or will recover from its customers.  For that reason, no doubt, Parliament has provided that insufficiency of funds by itself is not a reasonable excuse.  A trader may fail to pay his tax on time but in that eventuality he must suffer the penalty attaching to this particular debt if he is persistent in his failure.

43. In the present case the company was able to secure additional funding and its receipts were sufficient to cover the VAT it owed.  It has not become insolvent even though we accept that the company has had to manage its financial resources in the way that it considered best to secure its continued existence.  The problem is that Parliament does not allow that reason – essentially an insufficiency of funds – to stand as a reasonable excuse.  

44. As Nolan J (as he then was) said in Customs and Excise Commissioners v Salevon Ltd [1989] STC 907:

	“Suppose a trader was able to demonstrate as a matter of fact that when the time for payment came he was, at least temporarily, bereft of funds and unable to borrow what was needed; that might be regarded in the absence of [section 71(1)(a)] as a reasonable excuse for non-payment. The law does not as a general rule require the impossible. But [section 71(1)(a)] makes it plain that an insufficiency of funds cannot be so regarded. Insolvency is not enough.”

45. We can express our admiration for the way in which the directors and proprietors of this company have fought for its survival. We can accept that the imposition of the default surcharges is harsh in the circumstances.  We do find that the company had a reasonable excuse for its initial default in the period 02/00 and would have had a reasonable excuse had it defaulted in the period 05/00.  What we cannot do, however, is accept that the company had a permissible reasonable excuse for the periods 08/00 to 11/02.  

46. We accordingly dismiss the company’s appeals in respect of those later periods.

MALCOLM GAMMIE QC
CHAIRMAN

RELEASED DATE: 21 October 2004

LON/03/1150