United Kingdom VAT & Duties Tribunals Decisions

Cardio-Analytics Ltd v Revenue & Customs [2006] UKVAT V19703 (15 August 2006)

19703

DEFAULT SURCHARGE – Reasonable excuse – Appellant trading through two separate unforseeable commercial setbacks – insufficiency of funds – whether reason for insufficiency afforded a reasonable excuse – held it did – appeal allowed

LONDON TRIBUNAL CENTRE

CARDIO-ANALYTICS LIMITED Appellant

- and -

THE COMMISSIONERS FOR HER MAJESTY'S

REVENUE AND CUSTOMS Respondents

Tribunal: JOHN WALTERS QC (Chairman)

Sitting in public in Plymouth on 23 May 2006

Mr. Ian Jarvis, ACA, FTII, Finance Director, for the Appellant

Mrs. Pauline Crinnion, Advocate, for the Respondents

© CROWN COPYRIGHT 2006

DECISION

1. Cardio-Analytics Limited ("the Appellant") appeals against a default surcharge of £905.61 imposed in respect of the VAT period 05/05 (1 March to 31 May 2005). It is calculated as 2 per cent. of the VAT declared on the return for that period (£45,280.64). The return was due on 30 June 2005, it was received the following day, 1 July 2005, but the VAT was not received until 12 October 2005.
2. The Appellant had been in default for the VAT period 11/04 (1 September to 30 November 2004) and a surcharge liability notice dated 14 January 2005 had been issued stating that it may be liable to a default surcharge if it was in default in respect of a prescribed accounting period (a VAT period) within the surcharge period running from the date of the notice (14 January 2005) until 30 November 2005.
3. The default surcharge is thus prima facie in order so far as the provisions of section 59(1) to (6) VAT Act 1994 ("VATA") are concerned. Those provisions set out the circumstances in which a taxable person may become liable to a default surcharge and the amount of the default surcharge. Section 59(4) VATA imposes the default surcharge.
4. However, by section 59(7)(b) VATA, where a person who would otherwise be liable to a default surcharge under section 59(4) satisfies the Commissioners or, on appeal, a tribunal, that in the case of a default which is material to the surcharge there is a reasonable excuse for the return or the VAT not having been dispatched in time, that person shall not be liable to the surcharge and for relevant purposes shall be treated as not having been in default for the VAT period in question.
5. In determining whether or not a reasonable excuse has been established, it is expressly provided by section 71(a) VATA that an insufficiency of funds to pay any VAT is not a reasonable excuse.
6. However, there are circumstances where the cause of an insufficiency of funds, the underlying cause of a taxable person's default, may give rise to a reasonable excuse within section 59(7)(b) VATA – see: Customs and Excise Commissioners v Steptoe [1992] STC 757, a decision of the Court of Appeal.
7. Mr. Jarvis, for the Appellant, explained in some detail the reasons for the Appellant's financial difficulties, which gave rise to the default.

The Facts

8. From the evidence of Mr. Jarvis, a Chartered Accountant, and the Finance Director of the Appellant, the Tribunal finds the following facts.
9. The Appellant carries on a specialised and international trade analysing cardiac data generated in clinical research into new pharmaceutical products (drugs). In particular, it carries out a cardiac safety assessment, which is a test or series of tests to ensure that the drug in question would not inflict damage on the heart of a person using it.
10. A 10-second ECG recording is taken at various points after the drug is administered and the ECG recording is examined for very small movements which could be caused by the drug.
11. The Appellant's main client has been a large US-based pharmaceutical company ("P"). The Appellant started working for the UK establishment of P and then obtained work from its European establishment, and ultimately from its US establishment. Work for P generated about one-half of the Appellant's turnover.
12. The Appellant's other work is mainly work referred from Phase 1 Clinical Trials Units in the UK. These are units where healthy volunteers offer to test new drugs, as the first occasion on which the drugs are tested on humans. There are about 25 of these units in the UK. Cardiac safety assessments are now required for every drug test. This is as a result of the tightening of the regulations by the Food and Drugs Administration ("FDA") in the USA over the past five years. The regulations in the UK have a "knock-on" effect on the requirements for testing in other countries. The busier the units are in the UK, the busier the Appellant will be in relation to this sector of its work.
13. An organisation known as Mortara certifies laboratories to the FDA and the Appellant has recently been certified by Mortara. It is the first European-based laboratory to obtain this certification. In order to obtain it, the Appellant had to incur expenditure of £100,000 on equipment.
14. 2003 was a good year for the Appellant. The FDA were bringing in regulations to increase the requirements for cardiac safety assessments. Based on this development, the Appellant expanded and built new premises. It also increased its specialised staffing from 30 to a maximum of 70 persons.
15. Subsequently, the Appellant's business suffered in two main areas. Mr. Jarvis said that it could have weathered one of these setbacks, but both coming together caused the insufficiency of funds which caused the VAT defaults.
16. First, there was a downturn in work from P. Whereas it is a normal risk that studies occasionally are cancelled before they start, this would be expected to happen in, say, 5 per cent. to 10 per cent. of cases. There might, for example, be a problem with ethical approval, in that local Ethics Committees might decide that the benefits of study did not justify the risks to healthy volunteers. But, in 2004, three consecutive large studies were cancelled by P. The first of these cancellations took place in May 2004. It meant that work which would have been billed for £600,000 over two months was lost. After the third cancellation, the Appellant found out that the reason for the cancellations was that P was substantially reducing its research and development budget.
17. The practical business problem for the Appellant was that in order to be able to carry out studies for P, the Appellant needed to maintain a large staff. Each cancellation by P was accompanied by an assurance that there would be another test in two or three months' time. The Appellant therefore took the view that it was impractical and bad business sense to get rid of highly specialised staff who could not be replaced or reassembled quickly. The work for P is very high value work. Thus, the business reality for the Appellant is that there are periods when very little is earned (and high establishment costs are accruing) and then some very valuable work will come in which will lead to a short period of high profitability. It is necessary for the Appellant to retain its establishment so that it can accept the work when it comes.
18. The second setback was that the work obtained from Phase 1 Units in the UK suffered as a direct result of the implementation by the UK on 1 May 2004 of the EU Clinical Trials Directive. The UK was chronologically the first Member State to implement the Directive.
19. The change implemented by the Directive was to centralise the approval of new clinical trials. Pharmaceutical companies were concerned that this would lead to difficulties in obtaining approval for studies and delays in the start-times of approved studies.
20. Two of the United Kingdom's main competitors in Europe in this field, the Netherlands and France, did not implement the Directive in 2005 and this was presented to the pharmaceutical companies as an advantage to them in carrying out studies and trials in those countries, rather than in the UK. The Netherlands, Mr. Jarvis told the Tribunal, has only just implemented the Directive, and France still has not done so.
21. Mr. Jarvis handed up a copy of a report entitled "The UK Clinical Contract Research Market: Size, Issues, Challenges", commissioned by the UK Trade and Investment Biotechnology and Pharmaceutical Sector Team. This document contains a section entitled "The Impact of the EU Directive on Phase I Clinical Trials in the UK", confirming what is said in the last three paragraphs. The Appellant is listed as one of 31 named companies interviewed by the compilers of the report. Included in the section referred to is a passage as follows:

"To quantify what the interviews revealed, the confidential responses of 10 Phase I companies were analysed. Their combined pre-Directive turnover was stated as £64M and their combined loss of revenue [resulting from the way the Directive was being perceived outside the UK and "leveraged by competitors"] was estimated to be £19.6M or 30.0 per cent."

22. By reason of this development, a number of the Appellant's customers were put into severe financial difficulty. There is no compensation from the UK Government in prospect for any of this damage.
23. Again, the practical business problem for the Appellant, arising out of this development, was that in order to be able to carry out work referred from Phase I Clinical Trials Units in the UK when such work materialised – and it did materialise from time to time, though not as frequently as before – the Appellant needed to maintain a large staff and considered it was it was impractical and bad business sense to get rid of highly specialised staff who could not be replaced or reassembled quickly.
24. The Appellant continued (and continues) to do work for P, and, as a percentage of the Appellant's turnover, the work for P has increased, because the work on referrals from Phase I Clinical Trials Units has never really recovered. In fact, in 2004, P named the Appellant its "Global Supplier of the Year".
25. P pays a cancellation fee for studies which it cancels, but it is in the region of only 10 to 20 per cent. of the cost of a study. The Appellant is not in a position to negotiate more favourable terms with P in this respect because it is in competition in a global business with large publicly quoted and well-funded companies.
26. The Appellant has been trading for 11 years. It was registered for VAT in August 1994. The decision to embark on a major expansion (a specialised building of 22,000 square feet costing £1.6 million, a major upgrade in equipment costing £250,000 and the training of additional staff) was taken in the spring of 2002. This was funded by bank mortgage (in the case of the building) and by finance leases on the equipment, and otherwise by retained profits and directors' loans. The Appellant moved into the new building in July 2003 and at that time started to increase the number of its specialised staff.
27. The Tribunal is satisfied that the motivation for the expansion was optimism about the future of the business which was justified at the time (2002 to 2003). Although that optimism was not undergirded by guarantees of future work, especially from P, the Appellant was justified in expecting a good flow of high value work from P, having been nominated by P as one of its "Preferred Vendors" amongst whom P's work would be shared out at its discretion.
28. The Appellant had no difficulty in servicing and sustaining its indebtedness in 2003. The turnover started to fall in March 2004. The Appellant's profit and loss account for the year ended 31 August 2004 reflected a sharply increased cost of sales against a declining turnover. This was explained by the fact that those accounts recorded the effects of four months of the implementation by the UK of the Clinical Trials Directive on 1 May 2004 leading to a reduced turnover, and that the increase in the specialised staff, which started around July 2003, had led to increased cost of sales in the year ended 31 August 2004.
29. The Appellant's accounts show that, at 31 August 2004, there were substantially increased net obligations under finance leases and HP contracts both in current and deferred liabilities (amounts falling due after more than one year) – £406,635 as opposed to £232,214 one year earlier – and that bank indebtedness (both current and deferred) had increased from £1,089,468 to £1,236,797 overall. Mr. Jarvis told us that bank finance was at that time running at 70% of the value of the property which was the main collateral.
30. On 22 October 2004, the Appellant carried out a refinancing operation: it moved from Lloyds Bank to HSBC because, according to Mr. Jarvis "Lloyds wouldn't lend us any more money".
31. With respect to the first VAT period in which the Appellant was in default, 11/04, the liability to the Commissioners was £16,714.42 according to the return submitted (late) on 8 February 2005. That VAT was due for payment on 31 December 2004. At that time the negotiated overdraft limit with HSBC was £140,000. The VAT was not completely paid until 2 June 2005: it had been paid by instalments over three months. The overdrawn balance was £139,381.71 on 27 December 2004, but was improved to £111,726.35 on 31 December 2004. Mr. Jarvis wrote to the Commissioners to propose the instalment payments, which were in fact made, on 21 February 2005, explaining that the Appellant's overdraft limit of £100,000 had been increased by HSBC to £200,000 to enable the Appellant to pay the wages due on 25 February 2005, but with the expectation that the temporary extra overdraft would be repaid by 31 May 2005. When asked in cross-examination why, given the overdraft facility in place, the VAT had not been paid earlier, Mr. Jarvis replied that he did not at the time know how he would have met the Appellant's other obligations if he had paid the VAT on time.
32. The VAT liability (if there was one) for the VAT period 02/05 appears to have been settled on time, but the return for the period 05/05 shows a liability of £45,280.64 (due for payment on 30 June 2005), which was not paid until 12 October 2005. It was this late payment, of course, which gave rise to the surcharge in issue in the appeal. At 30 June 2005, the overdraft stood at £237,120.43, as against the agreed limit of £200,000, which had been negotiated early in 2005.
33. On 30 June 2005, Mr. Jarvis contacted the Commissioners to inform them that the Appellant would not be able to pay the amount shown on the VAT return for the period 05/05 and was referred to the Debt Management Unit. The Tribunal was not told what had been the result of the reference.
34. Other default surcharges (not the subject of this appeal) were raised in respect of the VAT periods 11/05 and 02/06.
35. The Appellant has now made arrangements to regularise its financial position by selling its building and leasing back the part that it needs for its business operations (on a reduced scale). Some staff have also been made redundant, reducing the number of specialised personnel to around 35. Mr. Jarvis expected that the VAT liability for the period 05/06 and subsequent periods would be paid on time. The delay in making these arrangements was in large part due to a difficulty in finding the right person to deal with. In the event it has been possible to carry out the sale and leaseback with a private hospital. Mr. Jarvis also explained that the Appellant was reluctant to take the course of a sale and leaseback of the building earlier than it did, because it hoped that if it had been able to bring the business round, it would have profited from the expected appreciation in the value of the building.

The Steptoe decision

36. In Steptoe, the Court of Appeal decided that (in the words of Lord Donaldson of Lymington MR) "if 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" (ibid. at p.770d/e).
37. On the facts of Steptoe, a trader whose only real customer was persistently late in paying his bills, was able to show a reasonable excuse, in particular because the chairman of the tribunal had found as a fact that if he (the trader) had brought pressure to bear on his customer, he would probably have received no further orders and the bulk of his livelihood would have disappeared (see: ibid. at p.769d/e). This was the decision of the majority of the Court of Appeal (Lord Donaldson and Nolan LJ).
38. Scott LJ (the dissenting Lord Justice) preferred a more restrictive approach to the application of the reasonable excuse provision. He would have dismissed the appeal because: "if the normal hazards of a taxpayer's particular business include the late payment of bills, then the taxpayer should make arrangements to finance his cash flow on that footing." (ibid. at p.765f/g).
39. In a case, such as this, where the alleged underlying reasonable excuse for the late payment of VAT is not some external unfortunate event (such as, for example, a burglary – see: Fat Sam's American Food and Beverage Co. Ltd. v Customs and Excise Commissioners : LON/90/1408, unreported) but is instead one (or, in this case, two) unexpected business setbacks, the question for the Tribunal is whether in all the circumstances the inability to pay the VAT on time was "reasonably avoidable" – per Lord Donaldson in Steptoe at ibid. p.770f.
40. That question is to be answered by looking at the reality of the business situation in which the trader in question found itself. The Commissioners and, on appeal, the Tribunal, is to "distinguish between the trader who lacks the money to pay his tax by reason of culpable default and the trader who lacks the money by reason of unforeseeable and inescapable misfortune" (see: per Nolan LJ in Customs and Excise Commissioners v Salevon Ltd. [1989] STC 907, cited by him in Steptoe, ibid. at p.767h/i). Whether there is in any case "unforeseeable and inescapable misfortune" is to be approached on the basis that what is meant is not reasonably foreseeable and not reasonably avoidable (see; per Lord Donaldson MR ibid. at p.770e/f.
41. Tribunals have interpreted and applied the Steptoe tests in a number of decisions. Among them are Wood Floor Studio Limited (LON/2000/0965, Trib. Decision 17066), and Longstone Limited (LON/1999/0503, Trib. Decision 17132), both decisions of the President of these Tribunals, Stephen Oliver QC.
42. In Wood Floor Studio, the President commented on the situation of the appellant company trading "on a financial shoestring with the added disadvantage that the bank had a floating charge over all its assets" as follows: "Trading had to continue if there was to be any chance of fully paying off creditors. The reasonable businessman in those circumstances would have done everything in his power to keep creditors from instituting winding up proceedings".
43. In Longstone, some of the defaults were caused by an unsuccessful venture into a "finishing" trade as part of a publishing business. "Finishing" involves taking delivery of printed magazines in bulk, then inserting advertising material inside each one, putting "free gifts" on the front and bagging each magazine in a polythene wrapper. The evidence showed that the problems of the finishing trade revealed themselves quite soon after Longstone had started on that business. The President commented (ibid. at paragraph 15): "Nonetheless the decision to embark on that activity was a serious and bona fide entrepreneurial move on Longstone's part. There was, I think, nothing unreasonable about the decision to go into the finishing business. Nor could Longstone's management be criticised for persevering in hopes of pulling it round."

The Commissioners' Submission

44. Mrs. Crinnion, for the Commissioners, submitted that this case did not come within the criteria for an acceptable reasonable excuse as laid down in Steptoe. The chief reason she advanced in support of this submission was that the Appellant had not expanded its business with the security of specific written contracts with P, but had instead proceeded on the basis of unenforceable promises of work that had not materialised. In these circumstances, she submitted, the problems actually encountered were reasonably foreseeable.
45. The Tribunal rejects this submission. The decisions to acquire the specialised building and to upgrade the equipment, and train additional staff, taken in 2002, appear to be entirely justifiable on reasonable business grounds. Likewise the decision to embark on the increase in the number of specialised staff, which started around July 2003, seems to have been prudent and reasonable in the circumstances in which it was taken. The setbacks to the Appellant's business occurred in May 2004 and thereafter. There is no reason for the Tribunal to speculate that it might have been possible for the Appellant to secure enforceable contracts in advance from P. On the contrary, the Appellant probably would have obtained contracts if they had been available. Business decisions like those referred to are regularly taken by prudent business people on the basis of reasonably held (but unsecured) commercial expectations, and that is what the Tribunal finds to have happened in this case.

Conclusion

46. The Tribunal considers, first, the default in relation to the VAT period 11/04. The liability was £16,714.42. It was due to be paid on 31 December 2004. It was paid in four monthly instalments from March to June 2005 inclusive. The return, which should have been received by the Commissioners by 31 December 2004, was in fact received by them on 9 February 2005, having been signed and dated by Mr. Jarvis on 8 February 2005.
47. The Tribunal will assume that the return was submitted late because the Appellant knew that it was not going to be able to pay the VAT by the due date. Mr. Jarvis wrote to the Commissioners to propose the payment of the VAT due by instalments (which instalment payments were in fact made), on 21 February 2005.
48. The Tribunal regards the Appellant's conduct of its business to have been reasonably prudent in the circumstances which prevailed. In particular, the decisions to trade within the tight constraints in point of overdraft facility imposed by its bankers from time to time, and to persevere in the hope of bringing the business round were reasonable business decisions. Also reasonable were the Appellant's efforts to hold on to as many of its specialist staff as possible in the hope of an improvement in the business climate. Similarly, in the Tribunal's view, the Appellant is not be considered to have acted unreasonably in attempting to hold on to its ownership of the building until the time when it decided to engage in the sale and leaseback restructuring as the only realistic way of putting itself back on a sound financial footing.
49. The Tribunal understands the Commissioners to be resisting the Appellant's claim that it had a reasonable excuse for not paying the VAT for the periods 11/04 and 05/05 on time rather than making a special point with regard to the late submission of the return for the period 11/04. Certainly the Tribunal did not understand Mrs. Crinnion to make any such special point in her submissions and, unfortunately, in this type of appeal the Tribunal does not have the assistance which a Statement of Case might have rendered.
50. In all the circumstances, the Tribunal is satisfied that the Appellant had a reasonable excuse for the late payment of the VAT due for the period 11/04 – in that it was not "reasonably avoidable" – and considers that the same reasonable excuse covers the late submission of the return which, as a practical matter, the Tribunal finds to have been dealt with by Mr. Jarvis in connection with making the arrangements for the payment of the VAT due by instalments. On that basis, the Tribunal will not hold the Appellant in default for that period merely by reason of the late submission of the return.
51. In consequence of this decision, the surcharge liability notice sent with reference to the period 11/04 and dated 14 January 2005, is deemed not to have been served (see: section 59(7) VATA). This technically renders the surcharge for the period 05/05 incompetent, because, in order for it to be valid (even in the absence of a reasonable excuse) the default for the period 05/05 must have occurred "in respect of a prescribed accounting period ending within the surcharge period specified in" a surcharge notice which has been served on the trader (section 59(4) VATA). Once the surcharge notice dated 14 January 2005 is deemed not to have been served, this condition cannot have been satisfied in relation to the surcharge assessment for the period 05/05.
52. Nevertheless, the Tribunal also records its conclusion that there is a reasonable excuse for the late payment of the liability for the period 05/05 and for the late receipt (by one day) of the return for that period. The relevant VAT was £45,280.64 (due for payment on 30 June 2005), and, at 30 June 2005, the Appellant's overdraft stood at £237,120.43, as against the agreed limit of £200,000, which had been negotiated early in 2005. This demonstrates that the reason for the late payment was an insufficiency of funds. The cause of the insufficiency, the Tribunal concludes, was the fact that the Appellant's business had been carried on unprofitably and that the conditions of its trade produced cash flow problems. This would not have been sufficient to convince Scott LJ that the Appellant had a reasonable excuse (see: Steptoe at p.765c/d). However, in the Tribunal's judgment, the insufficiency of funds at 30 June 2005 was not "reasonably avoidable" for substantially the same reasons as those given above in relation to the period 11/04.
53. In the result, the appeal is allowed. The Appellant asked for costs estimated at £3.50. Pursuant to rule 29(1)(a) of the VAT Tribunals Rules 1986, the Tribunal directs the Commissioners to pay that amount to the Appellant within 28 days after the release of this Decision.

JOHN WALTERS QC

CHAIRMAN

RELEASE DATE: 15 August 2006

LON/2005/1009