Change of Guidance in Calculation of Losses Deductions Cap​

In 2016 a news story came about concerning a specific situation in tax that affected both HMRC systems and third party software such as TaxCalc that resulted in an incorrect calculation of tax.

The situation required the following specific circumstances:

1. Losses needed to be brought forward from a previous tax year and relieved against income under the year of assessment; and
2. Losses in excess of £50,000 were arising in the tax year under assessment and were offset against other income; and
3. Total income in the tax year under assessment was in excess of £200,000.

The matter concerned the interaction of the income and losses brought forward in the calculation of the restriction of losses available for relief against other income (losses deduction cap). The restriction should have been calculated at either 25% of income or £50,000, whichever was the greater.

Unfortunately, HMRC issued incorrect guidance (both internally and externally) on how the legislation behind this is to be interpreted. The guidance initially calculated the restriction on the loss relief using the income after losses brought forward have been relieved. The legislation says to calculate it on income before any brought forward losses have been relieved. The incorrect guidance results in the losses deductions cap being calculated as a value lower than it should be.

As a result, both HMRC’s own systems and those developed by third parties calculated the loss restriction incorrectly. If the three conditions are met, the overall liability would be incorrect.

Although the circumstances by which the issue arises is rather remote, how the situation is to be handled is in HMRC’s court.

It goes without saying that HMRC is a very large organisation. When a party communicates with one department (in this case the journalist discovering the error), it takes time for other affected departments to come up with solutions. It’s relatively easy to reissue guidance, which is what HMRC have done, but another to change the underlying systems to match this, especially so far into the filing year.

It didn't just affect third party developers but we expected HMRC’s own online tax return system, the back-end systems that receive data and compute calculations from whichever source and the information and guidance that inspectors themselves have.

We software developers were caught in a catch-22 situation. HMRC issued  a specification to us from which the software is built. It told us what data to send and how the tax is calculated. We had to supply a computed tax liability as part of the submission, which was then instantly recomputed at HMRC’s end. If the two calculations agree, the return was accepted. If not, it was rejected.

Unless HMRC were to change their back-end system, if we went against the specification and changed the calculation, the returns simply would not file. The situation is quite different to a software error caused by substandard coding and a failure of testing procedures.

HMRC will issue to the developer community something called an exclusion. This is where the HMRC back-end detects the circumstances of the issue at point of submission and refuses to accept the return. The software would need to handle this and inform the end user as to why. 

Assuming an exclusion is put in place, the return will be rejected and the agent or taxpayer will need to complete a paper return and, if submitted after 31 October, will also have to complete a reasonable excuse form to avoid the paper filing penalty. Of course, the calculation guide that HMRC issue will also be incorrect but HMRC should recompute it at their end using the revised guidance.

We would also point out that we don’t simply assume HMRC’s specifications are infallible and, indeed, during the development of any tax year, we raise a number of queries on their implementation. It helps everybody, HMRC included, to get what is quite often a very complicated implementation as correct as it possibly can be. Unfortunately, in this case, the official guidance on how enacted statute is to be employed was in error. It would only be if we undertook the rather onerous task of comparing absolutely everything received from HMRC (numerous guidance articles, official specifications, forms, Helpsheets, tax manuals, calculation guides, official test cases and so on.) to the legislation that we could possibly find such an error.

Consequently, it would be unfair to argue that checking such documentation to legislation is the job of third party developers. Indeed, you could argue that same case against those that do not use third party software!