How they arise, how they are recovered, and how to challenge them

• Introduction




• The annual nature of the tax credit system

  • The income disregard and its implications
  • Accrual of tax credits income during the tax year




• How do overpayments arise?




• Recovery of overpayments – Revenue discretion

  • HMRC practice
  • Stopping awards where no entitlement
  • Fairly and sensibly?




• When will HMRC not seek recovery?

  • Hardship
  • Revenue or other official error
  • The reasonableness test
  • Remedies




• Couples




• Additional information

  • Changes in tax credit overpayment recovery announced since November 2005
  • Recovery of overpayments – comparison of 2004/05 with 2007 versions of COP26

Introduction

• Of the many differences between traditional social security benefits and tax credits, one of the most fundamental is that, in tax credits, overpayments are an integral and unavoidable part of the system.



• While a benefit claimant's entitlement is generally ascertainable at the time of payment, entitlement to tax credits for a tax year cannot be established until after the year–end.



• Payment during the year is based on income of a previous year, or an estimate of income for the current year; but it is not until after the year–end that the current year income can be ascertained and actual entitlement assessed. If it then transpires that the claimant's entitlement exceeds what they have been paid, there is an underpayment; if it is less, an overpayment arises.




• This provisional structure gives rise to three fundamental differences in the nature of overpayments as between the tax credits and social security regimes:

  1. Under the social security system, overpayments are recoverable by the Secretary of State only if the statute so prescribes. In tax credits, overpayments are part of the system and all are recoverable by statute if HM Revenue and Customs (HMRC) decide to recover them (which they nearly always will).
  
  
  
  2. In social security there is a right of appeal by which the recoverability of an overpayment can be judicially tested. There is, however, no right of appeal against an HMRC decision to recover a tax credit overpayment.
  
  
  

  3. In most social security benefits, overpayments are only recoverable if they arise through misrepresentation or failure to disclose on the part of the claimant, whether fraudulently or otherwise (Social Security Administration Act 1992, s 71).

     Housing benefit and council tax benefit overpayments are also recoverable if they arise from official error, and the claimant can reasonably be expected to have known that they were being overpaid; if they cannot reasonably have known that, the overpayment is not recoverable (Housing Benefit Regulations 2006/213, reg 100(2); Council Tax Benefit Regulations 2006/215, reg 83(2)). In tax credits, by contrast, there is no distinction between recoverable and non–recoverable overpayments – they are all recoverable at the discretion of HMRC, which can (and generally do) recover even a tax credit overpaid by reason of their own error.

  4. We shall examine those propositions further below. But first let us look in greater detail at how the tax credit system is structured, as it is necessary to understand that in order to grasp how tax credit overpayments arise.

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The annual nature of the tax credit system

• The cycle of award and entitlement

  The reason why overpayments are endemic in the tax credit system is that the system works on the basis of pay now, establish entitlement later.

  Unlike any other welfare benefits, entitlement to tax credits is based on the tax year, 6 April to the following 5 April, but it is not until after the end of the tax year in which payment is made that entitlement is finally ascertained. This cycle of award followed by entitlement works like this.

  An initial award is made at the start of the year, or when a claim is received, based on the claimants' current circumstances, and their income for the previous tax year (for 2003/04 the previous tax year was deemed to be 2001/02 to enable claims to be made in advance).

  As the year progresses the claimant has the opportunity to notify changes in circumstances and income so as to keep their award updated, and is obliged to report certain changes such as alterations in the composition of the adult members of the household, in the children or young persons for whom a claimant is responsible, and in normal weekly working hours.

  The first of those groups includes single claimants entering a relationship, couples splitting up, or one member of a couple dying or going abroad for a prolonged period.

  The second might include children leaving the household and going into care, young people over 16 dropping out of further education or training, or a child dying.

  The third group involves reporting to HMRC if normal weekly working hours drop from 16 or more hours a week to below 16, or from 30 or more hours a week to less than 30.




• Assessing entitlement for current year

  After the year end, HMRC send a stack of renewal papers, the purpose of which is to ascertain the claimants' actual entitlement for the year just gone. Changes in entitlement will arise from changes in personal circumstances and changes in income. For income the final entitlement is based on the following formula:

  • If current year income (CYI) is less than previous year income (PYI), the final award is based on the lower CYI and there may be an underpayment;
  
  
  
  • If CYI is equal to PYI, or greater than PYI by no more than a certain amount (known as the income disregard (see 2.1)), the final award is based on PYI;
  
  
  
  • If CYI is greater than PYI by more than the income disregard, the final award is based on CYI less the income disregard, and an overpayment may arise.




• Establishing initial award for following year

  The same information is also used to establish the claimants' initial award for the following tax year although in that case the full CY income is used. The income disregard for the current year, CY, can only be used to compare CY income with preceding year income; it cannot be carried forward to the following tax year.

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The income disregard and its implications

The income disregard in each year from 2003/04 to 2005/06 inclusive was £2,500.

Its purpose was to provide a buffer zone in which a family's income could increase during the course of a year without affecting their tax credit entitlement. Though considered generous at the time it was introduced, the £2,500 buffer zone proved in the event insufficient to prevent hardship to families whose income increased above that amount.

Therefore in 2006/07, in a bid to reduce the volume of overpayments arising from increases in income, the income disregard was increased quite dramatically to £25,000. See Tax Credits (Income Thresholds and Determination of Rates) Regulations 2002/2008, reg 5.

That was probably the most significant of the changes announced in the pre–Budget Report on 5 December 2005 (PBR 2005).

The effect of the increase has been to bring tax credits closer to mainstream social security benefits, in that the great majority of tax credits awards are now based on preceding year income.

This will in time bring greater certainty for claimants in a system where a major problem has hitherto been the sheer unpredictability of what families can expect to receive. Yet, the tax credit system retains some flexibility for those whose income goes down in a year to claim a higher entitlement, subject to one important new restriction discussed at point 3.

However, there are some traps.

1. Cross–year overpayments originating before 2006/07

   The £25,000 disregard applies only to income rises in 2006/07 and subsequent years – overpayments being recovered now from final awards for 2005/06 and earlier years will still be calculated by reference to the £2,500 disregard applying in those years. See Doing the sums for more details and an example.




2. Reporting income increases to HMRC

   Secondly, it might at first seem that any income rises of £25,000 or less, because they have no effect on the current year's award, need not be reported to HMRC until the renewal process gets underway at the start of the following tax year.

   But in fact it is sound advice to report such changes during the current tax year, even if they have no effect on the current year's entitlement, in order to avoid overpayment of provisional payments in the early part of the following tax year.

   Again, see Doing the sums for examples of how this works.

   To guard against overpayments generated by provisional payments that reflect outdated income figures, the Government announced two specific measures in PBR 2005.

   • At the end of the tax year 2006/07, in early calendar year 2007, HMRC would contact key groups of claimants to obtain more up–to–date income information on which to base the next year's payments while the finalisation process is completed.
   
   
   
   • From 2008/09, where claimants have not provided up–to–date information about their income and circumstances, the income figure used to calculate provisional payments will be uprated by average earnings.




3. Income decreasing then increasing in–year

   The £25,000 disregard covers any increase in income over and above the level of the previous year's income. Where income falls below the level of the previous year, then rises again, the subsequent increase is not covered by the disregard until it reaches the same level as the previous year's income.

   Therefore, there is a risk of a recoverable overpayment accruing if income falls, and the claimant, in order to secure extra tax credits, submits a revised income estimate, which is based on the lower figure. If income rises again in the same year, that initial estimate may turn out to be too low, and tax credits paid on the basis of the low estimate may turn out to have been overpaid.

   This is a point that needs to be borne in mind particularly in periods of maternity leave, sick leave and similar periods of temporary absence from work when income levels fall but might rise again later in the year if the claimant returns to work.

   There are more details with worked examples at Doing the sums.

   The problem is partly alleviated from 2007/08 by a PBR 2005 measure under which claimants reporting a fall in income will have the rest of their payments for the year adjusted accordingly, but will not be paid the accrued entitlement from the earlier part of the year.

   At the end of the year, when final income is known, any remaining underpayment will be paid over. According to the PBR announcement:

   ...this approach will provide a buffer against any overpayment accumulated by the family during the year, especially where their estimate of income proves to have been too low.

   This measure will help those whose incomes fall during the year then rise again in that any ensuing overpayment will be kept within limits. However, it will be of less assistance to those whose income falls and stays low in that they will not get the underpayment that will have accrued up to that point until the end of the year.

   The measure has been criticised by bodies such as the Child Poverty Action Group on those grounds. Nevertheless, tax credit entitlement for the remainder of the award period will be adjusted from the point at which the claimant reports the fall in income.

   Again, there are numerical examples at Doing the sums.

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Accrual of tax credits income during the tax year

• As shown at the beginning of this article, a tax credit overpayment generally arises by operation of the system, irrespective of any claimant misrepresentation or non–disclosure.



• One of the features of the annual basis of assessment for tax credits is that income, as assessed for tax credits purposes, is deemed to accrue evenly day by day throughout the year.




• Therefore, in tax years when the income disregard was only £2,500, claimants reporting an increase in income would notice that an overpayment had accrued for the period before they reported the increase, as well as after, even if they reported the increase promptly. A simplified example will illustrate how this worked:

  Example

  Fergus and Deirdre made a joint claim for tax credits in 2005/06. In the first six months of 2005/06, only Fergus was working. Their joint income for 2004/05 was £12,000 a year, Fergus's annual salary. Therefore, for the first six months of 2005/06 their tax credit award was based on joint income of £6,000 (half of Fergus's earnings).

  Fergus continued on the same salary level in 2005/06. Half way through the tax year Deirdre started working, also earning £12,000 a year, so their annual income in a full tax year doubled to £24,000 and their joint income for the second half of the year to £12,000.

  Fergus and Deirdre reported this change to The Tax Credit Office straight away, who processed it promptly. The Tax Credit Office recomputed their income ignoring the first £2,500 of the increase, and recalculated their tax credits accordingly.

  Now because of the way the regulations spread income over the whole tax year, when Fergus's and Deirdre's income for the whole of 2005/06 is recalculated, it is spread evenly over both six–month periods.

  Thus, because their annual income is now £18,000 (£12,000 for Fergus and £6,000 for Deirdre), for the first six months their joint income is recomputed as £9,000, not £6,000. Even with the £2,500 disregard, this is bound to make a difference to their entitlement for those six months and could mean that an overpayment will have arisen in that period.



• This washback effect of income–based overpayments is barely noticeable now that the disregard has been raised to £25,000. But in earlier years, the fact that overpayments could arise even if claimants reported everything promptly, and did all that they were supposed to do, was barely acknowledged in HMRC literature and guidance.



• Hence, a lack of claimant understanding – not helped by incomplete or misleading guidance from HMRC – merely compounded the problem of overpayments in the early years.

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How do overpayments arise?

• Apart from income rises, other ways in which overpayments can arise include:

  
  
  • through claimant error;
  
  
  
  • through official error (see below);
  
  
  
  • through claimant delay in notifying changes of circumstances or income;
  
  
  
  • through official delay in processing changes of circumstances or income (see below);
  
  
  
  • through adjustment of an award following an in–year examination or an end–of–year enquiry;
  
  
  
  • because provisional payments in the first few weeks of a new tax year pending completion of the renewal formalities are too generous. This is often because they are based on income or circumstances which are out of date, whether because the claimant has failed to keep HMRC updated on changes, or because HMRC has failed to register them.



• Also, while WTC was being paid to employees through the payroll, an employer was allowed up to 42 days to process a change in an employee'sWTC paid in that way. An overpayment would tend to accrue during that waiting period. No new overpayments can arise in this way as the system of Payment Via Employer (PVE) came to an end in February 2006.

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Recovery of overpayments – Revenue discretion

• Note the text of TCA 2002, s 28(1):

  Where the amount of a tax credit paid for a tax year to a person or persons exceeds the amount of the tax credit to which he is entitled, or they are jointly entitled, for the tax year . . . .the Board may decide that the excess, or any part of it , is to be repaid to the Board.




• Section 28(1) should be read in conjunction with s 28(5), which gives HMRC power to adjust an award in–year if they detect that an overpayment is likely to arise at the end of it:

  Where it appears to the Board that there is likely to be an overpayment of a tax credit for a tax year under an award made to a person or persons, the Board may, with a view to reducing or eliminating the overpayment, amend the award or any other award of any tax credit made to the person or persons . . .




• When questioned about this during the passage of the Tax Credits Bill through Parliament, the responsible minister Paul Boateng MP said that he expected the then Inland Revenue to use their discretion sensibly and fairly (Hansard, Standing Committee A, 22 January 2002, col 185).

  So how in fact does HMRC exercise this discretion given them by statute, and is their exercise of it fair and sensible? This is the question on which much of the controversy regarding tax credits has focused in the first four years of the system's operation.

HMRC practice

• Under TCA 2002, s 29(3) to (5), HMRC may recover overpayments in one of three ways:

  • by deduction from any tax credit award made to the claimants; or
  
  
  
  • by direct recovery; or
  
  
  
  • through PAYE coding.




• HMRC have set out their practice on recovery in COP 26. This has been modified a number of times, and the current version dates from April 2007:




1. Recovery by deduction from continuing award

   This is HMRC's preferred method of recovery. Under the current version of COP26, there are certain limits on the amount by which payments of tax credits can be reduced in order to recover an overpayment which arose in the previous year (cross–year overpayment). Those limits, which depend upon a claimant's income, are as follows:

   • 10% of the award payment for claimants on maximum tax credits;
   • 100% for claimants receiving only the family element of child tax credit; and
   • 25% for all other claimants.
   
   

   Sometimes HMRC will adjust an award during the award period in order to try to prevent an overpayment from accruing. In such cases the limits set out above apply to restrict recovery.

   HMRC will reduce, or even stop, payment of tax credits where the claimant reports a change in circumstances or income that results in a lower entitlement, or entitlement ceasing altogether.

   Potential overpayments that are identified during the award period in this way are loosely termed in–year overpayments.

   In certain circumstances, HMRC will agree to reduce the recovery percentages further, or collect an overpayment over a longer period, or write off an overpayment altogether if the claimant is experiencing particular hardship (see 5.1).




2. Former recovery practices

   Recovery practices were not always so simple. Historically, the above limits applied only to cross–year overpayments. In–year overpayments were recovered differently. HMRC's computer would automatically adjust the award to ensure that tax credit was paid at the right amount for the whole year.

   If this caused hardship, claimants could ask for additional payments, which might prevent them from falling into poverty but prolonged the recovery of the overpayment debt into later years.

   Also, the initial hardship caused by the automatic 100% in–year recovery was only alleviated if the claimant asked, and knew that it is possible to ask, for additional payments.

   The additional payments, where made, brought payments back up to a certain percentage of what they were before the recovery began, that percentage depending on the circumstances of the claimant. Up to and including March 2006 those percentages were:

   • 10% for those on income support or jobseeker's allowance whose child tax credit payments had fallen below 90% of what they would have received if they had not been overpaid;
   • 25% for those on maximum working tax credit or child tax credit, or in receipt of a disability element in either tax credit;
   • 50% for other claimants whose payments had dropped below that percentage of what they would have received if they had not been overpaid.
   
   

   Additional payments were not made to those receiving only the family element of child tax credit, or to those whose award was reduced because the Revenue found that something was wrong with their claim.

   In addition, where an overpayment had arisen from an increase in income of more than £2,500, no additional payments were made. That latter restriction was removed with effect from 13 February 2006.

   After March 2006 the percentage rates of in–year recovery were brought into line with the more generous rates applied to cross –year overpayment recovery – ie the 10%, 100% and 25% rates set out above.

   This was announced in a statement made by the Paymaster General to the House of Commons Treasury Sub–Committee dated 1 February 2006.

   In an earlier statement made at the same time as the pre–Budget Report on 5 December 2005, the Paymaster General announced that from November 2006 in–year overpayment recovery would be subject to automatic limits set at those 10%, 25% and 100% rates.

   In other words, in–year overpayments would no longer be subject to 100% automatic recovery, and there would no longer be any difference between the rates of recovery of in–year and cross–year overpayments.

   Both these announcements were in response to specific lobbying by LITRG and other tax and welfare rights bodies.

   Then, in a further statement on 6 December 2006, the Paymaster General announced that it had not been possible for the technology to achieve the automatic limits on recovery promised for in–year overpayments from November 2006.

   Instead, the automatic limits would apply from April 2007; the limits would be applied manually in appropriate cases, without the claimants having to ask, from January 2007; and meanwhile HMRC remained open to requests for top–up payments from those eligible.

   The fully automated limits were finally implemented during a system upgrade over the weekend of 30 June/1 July 2007.




3. Recovery of cross–year overpayments from additional payments

   For 2004/05 and 2005/06, where a cross–year overpayment was being collected at the 10%, 25% or 100% rate (see above), it was recovered at the same percentage from any additional payments made.

   Thus, if additional payments were being made at the 90% rate, and a cross–year overpayment was still being collected at 10%, the effective rate of additional payment was 81%, ie 90% less 10% of 90%. It is understood that this double recovery has not applied since April 2006.

   Use the link here to access a table that traces the developments in the history of HMRC's tax credit overpayment recovery since just before and after the 2005 pre–Budget report. The second table shows the differences between policy under the 2004/05 version of COP26, and the 2006/07 version.




4. Direct recovery

   HMRC generally recover tax credit overpayments directly like any other tax debt in two situations:

   • where there is no continuing award; or

   • where there has been a change of household and the overpayment being collected arose under the claim made by the previous household.

   Where such payments are demanded by HMRC sending a notice to pay, they are strictly due within 30 days, but claimants can immediately ask to repay the overpayment over 12 months.

   In some cases, a time to pay arrangement can be made to pay back the money over a longer period based on the claimants' circumstances.

   Direct recovery is administered by the debt collection arm of HMRC, known as Debt Management and Banking (DMB). It was renamed in 2005 having previously been known as Receivables Management Service (RMS). Most probably still prefer to think of it as HM Collector of Taxes.




5. Recovery through PAYE coding

   While provision is made in the Tax Credit Act 2002, s 29(5) for tax credit overpayments to be collected through the PAYE system, it is understood that the Revenue cannot offer this at present.

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Stopping awards where no entitlement

• COP 26 states:

  If you tell us about a change of circumstances and we find you are not entitled to tax credits at all, we will stop paying you tax credits for the rest of the year.

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Fairly and sensibly?

• In operating these systems, are HMRC recovering tax credit overpayments fairly and sensibly, as Paul Boateng MP hoped when introducing the Tax Credits Bill in January 2002 (see above)?



• Having devised a welfare system that aimed to be responsive to changes in income and circumstances, for the Government then to create a regime where overpayments could be corrected with the minimum hardship to claimants was always going to be a tough challenge.



• But the solutions initially decided upon (practically without consultation) resulted in HMRC facing accusations of maladministration, as the implementation of policy all too often plunged claimants back into the very poverty from which it was the purpose of the system to relieve them.



• During the summer of 2005, a succession of reports such as those by One Parent Families, the Adjudicator, the Parliamentary Ombudsman and Citizens Advice drew attention to the hard cases and injustices created by the prevailing regime.




• Meanwhile, the tax professional and welfare rights bodies involved in tax credits work were agitating for specific changes, urging HMRC and Government:

  • to cease automatic 100% in–year recoveries, and consider freezing all in–year recoveries;
  
  
  
  • to take greater care in setting provisional payments so as not to set them too high;
  
  
  
  • to consider applying the percentage recovery rates to the cumulative total of overpayments, without distinguishing between in–year and previous year overpayments, while enabling those who wish to pay early to do so;
  
  
  
  • to introduce a pause before recovery began, so that those facing overpayments had a chance to budget.



• The first and third points were dealt with by the Paymaster General's announcement that automatic in–year recovery would reflect the percentage rates applicable to cross–year recoveries, and that from April 2006 those same rates would be applied to additional payments made to claimants put in hardship because of in–year recovery.



• Regarding the second point, after 2004/05 HMRC ceased the practice of automatically deducting the £2,500 disregard when setting the levels of provisional payments at the start of a new tax year, so that fewer claimants were paid too much in the early part of the year.



• Arguably, once the Paymaster General's announcements are fully implemented after June 2007, we should have the makings of a fairer system. But perhaps the most important objection to the present regime is to the way in which HMRC deal with claimants who are overpaid owing to official error, but who are still expected to repay. It is to that difficulty that we now turn.

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When will HMRC not seek recovery?

There are two sets of circumstances in which, according to COP26, HMRC will not seek recovery of an overpayment. These are:

• where recovery would cause the claimants hardship, and



• in cases where the overpayment has resulted from a mistake made by HMRC or another department, and the claimant could reasonably have thought that their award was right.

Hardship

• In its April 2007 version, COP26 states:

  In exceptional circumstances, we may write off all or part of an overpayment if it would cause you or your family hardship to pay it back.




• COP26 then goes on to list the factors, which HMRC will take into account if they are considering allowing payment at a lower rate, or writing off the overpayment, on hardship grounds. These are, briefly:

  • family circumstances, in particular young children, and anyone chronically ill or disabled;
  
  
  
  • present and future income;
  
  
  
  • living expenses (such as rent, gas or electricity bills);
  
  
  
  • savings, investments and other assets;
  
  
  
  • other debts (such as mortgage repayments);
  
  
  
  • how long it will take to pay back the overpayment;
  
  
  
  • any earlier payments to HMRC



• In practice, HMRC are reluctant to write off overpayments altogether on grounds of hardship, preferring to give the claimant time to pay.



• The question of hardship does arise, however, when there is no ongoing award and overpayments are recovered directly. In such cases, Debt Management and Banking applies the same criteria as for other forms of tax debt, and in appropriate cases this can involve writing off the overpayment.



• Internal HMRC procedures in hardship cases are described in the Tax Credit Office Manual here.