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Sir John Bourn, head of the NAO, today published a report on HM Revenue and Customs’ (HMRC’s) accounts for the year 2005-2006. HMRC collected total revenue of some £404 billion. For the fourth year running, Sir John has qualified his opinion on the Trust Statement in respect of tax credits because of the likely level of claimant error and fraud.

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Attack on the tax credits system

The Tax Credits system has been targeted by organised fraudsters and in 2005-06 HMRC prevented payments of £409 million in respect of suspected organised fraud. It has also identified incorrect payments made of £131 million, including fraudulent claims made using stolen identities through the tax credits e-portal of £55 million at the end of 2005. HMRC closed the tax credits e-portal on 2 December 2005 as a consequence of this attack and it accepts that additional controls need to be built into the e-portal before it can be re-opened. HMRC needs to ensure that the new system fully complies with established government standards on security. HMRC has reviewed the other channels through which tax credits can be claimed and has introduced new measures to safeguard against fraud. It needs to continue to assess the wider implications of the fraud and how organised criminals might respond to the closure of the tax credits e-portal.

Tax credit overpayments

HMRC estimates that it overpaid £1.8 billion and underpaid £556 million in tax credits in 2004-05 and that the position for 2005-06 will be similar. It cannot recover all overpayments and in 2005-06 wrote-off £397 million and made a provision of £409 million for doubtful debts. The December 2005 Pre-Budget Report announced changes to the tax credits system which were designed to provide greater certainty to claimants, particularly when families see a rise in income. HMRC’s success in managing these measures to reduce overpayments and recoveries will become apparent only in 2008 following finalisation of 2006-07 awards.

Tax credit fraud and error

HMRC has now completed its exercise to provide more information on the level of claimant fraud and error under the new tax credits. According to the results, in 2003-04 payments of between £1.06 billion and £1.28 billion (between 8.8 and 10.6 per cent of the total by value) were made to claimants who were not entitled to them as a result of error and fraud. HMRC also estimates that claimant error resulted in between £190 million and £280 million of tax credits (between 1.6 to 2.3 per cent of the total by value) not being paid to claimants when they were entitled to them. These are the first full results for the new scheme since it was introduced in April 2003. These levels are unacceptably high and there is currently no evidence to justify a lower estimate for 2005-06. As a result, Sir John qualified his opinion on the Trust Statement.

The collection of income tax through Pay As You Earn (PAYE)

To operate PAYE effectively, HMRC depends on employers and employees providing it with accurate and timely information. This does not always happen and can lead to the risk that taxpayers do not pay the right amount of tax. These difficulties have been compounded by inconsistent working practices within HMRC. Deficiencies in management information have made it difficult for HMRC to prevent or detect errors made by staff. And in recent years HMRC has diverted PAYE resources to other areas of work which it considered had higher priority, such as tax credits. Changes in the labour market have also increased the volume and complexity of the PAYE population.

HMRC has recently produced new information to provide a better picture of the scale of the problems with PAYE. Its Internal Audit Office estimates that each year HMRC may not be pursuing some £1 billion of tax due, taxpayers may have overpaid around £500 million and consequently that 5.7 million taxpayers may not be paying the right amount of tax. These figures suggest a net under-collection of tax revenue of some 0.5 per cent of the £114 billion collected through PAYE in 2005-06.

HMRC recognises that improvement requires fundamental changes and has a modernisation programme in place. HMRC has developed a series of responses to manage the risks in the interim period, but it needs to articulate these more clearly into an overall strategy. Effective operation of PAYE also depends on employers and employees meeting their obligations and HMRC needs to target and take further action to improve compliance by employers and employees who do not meet their obligations.

VAT: missing trader fraud

VAT missing trader fraud represents one of the most serious attacks on the tax system ever seen. It is an EU-wide problem, perpetrated by organised criminals seeking to steal large sums, in which bogus traders register for VAT, complete intra-community transactions and evade paying over the VAT due on domestic sales to the tax authorities. HMRC’s strategy in tackling the fraud resulted in a reduction in losses in 2002-03 and 2003-04. However, this success was reversed in 2004-05, where the estimate of the VAT loss increased from between £1.06 billion and £1.73 billion in 2003-04 to between £1.12 billon and £1.90 billion. Operational indicators for 2005-06 show the level of activity relating to the fraud has increased. Estimates of the fraud are published annually alongside the Pre-Budget Report. HMRC is currently using all its available tools to tackle missing trader fraud. The Government sought derogation from the 6th VAT Directive to permit the introduction of a reverse charge for goods associated with the fraud such as mobile phones and computer chips. If approved, HMRC has estimated that this measure will yield an additional £1 billion of VAT receipts over the next three years. There is a risk that the fraudsters may divert their attention to goods not covered by the derogation. The reverse charge will be an important tool in tackling current levels of the fraud, but it is only one part of the broader strategy.

Given that missing trader fraud is a problem across the EU, HMRC will need to continue to work closely with the European Commission and other Member States to identify a long-term solution to eradicate missing trader fraud.

On tax credits

“The first full results of the new tax credit scheme since its introduction in April 2003 show that the level of claimant error and fraud was unacceptably high. I have therefore once again qualified my audit opinion on the Trust Statement. HMRC must now use this baseline figure to continue to target future reductions in error and fraud. HMRC closed the tax credits e-portal because of a serious attack by organised criminals submitting false claims using stolen identities. It must ensure that the new system fully complies with established government standards on security.”

On income tax (Pay As You Earn)

“HMRC has identified a number of problems with the way PAYE is working, especially for more complex cases, which have led to employees paying too much or too little tax. HMRC should closely monitor the effect of its planned improvements in ensuring that taxpayers pay the right amount of tax.”

On VAT missing trader fraud

“Missing trader fraud is a fraud perpetrated against the VAT system that has affected EU Member States. HMRC has sought to use all of the tools at its disposal to combat the fraud, but the confidence of the fraudsters over the last eighteen months has increased. The Department should continue to work with the European Commission and other Member States. Such concerted action is essential in successfully tackling this problem.

Sir John Bourn


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