VAT Penalties And Appeals: A Guide For Small Businesses

You've received a VAT penalty or an assessment for VAT you don't think you owe. The number on the letter may be large enough to threaten your business. And unlike income tax, you may need to pay the disputed amount before your appeal can even be heard.

Before you do anything else, note the date on the letter. You have 30 days to appeal, and that deadline runs whether or not you can afford to pay. File your appeal first. Then deal with payment and hardship separately.

This guide covers the penalties you might be facing, the defences available to you, and the appeal process—including the pay-first rule that catches many small businesses off guard.

Which VAT Penalty Are You Facing?

VAT penalties come from several different statutory regimes, depending on when the period falls and what went wrong. Your letter should tell you which regime applies—look for references to "Surcharge Liability Notice" or "section 59" (old regime), "penalty points" (new late filing), "late payment penalty" (new late payment), or "section 73" (best judgment assessment). Here's a map.

Default Surcharge (VAT Periods Before January 2023)

If your penalty relates to a VAT period that started before 1 January 2023, it falls under the old default surcharge regime in section 59 of the VAT Act 1994. This regime was replaced in January 2023, but appeals from earlier periods are still being heard—cases like Foster and Sons Ltd v HMRC [2024] UKFTT 1009 (TC) and Bicester Property Interiors Ltd v HMRC [2023] UKFTT 13 (TC) were decided under these rules.

The system works like this. Your first default—either a late return or late payment—triggers a Surcharge Liability Notice (SLN), which establishes a 12-month surcharge period. No money is due at this stage. But if you default again within that period, a surcharge is calculated as a percentage of the VAT outstanding:

Each further default extends the surcharge period by another 12 months. The minimum surcharge is £30, and no assessment is issued if the calculated amount is less than £400.

The surcharge is applied to the total VAT outstanding at the end of the period, not to individual payments. For example, if you owe £20,000 in VAT and this is your third default in the surcharge period, the surcharge is 5% × £20,000 = £1,000. Each default within the surcharge period ratchets the percentage up—a business that hits a bad patch can escalate from 2% to 15% within a couple of years.

Late Filing Points (From January 2023)

From 1 January 2023, all VAT-registered businesses moved to a points-based late filing regime under Schedule 24 of the Finance Act 2021. Each late return earns one penalty point. When you reach the threshold, a £200 financial penalty is triggered—and every subsequent late return at or above the threshold triggers another £200.

The thresholds depend on how often you file:

Points below the threshold expire after 24 months. But once you hit the threshold, you must file every return on time for a compliance period (6 months for monthly filers, 12 months for quarterly, 24 months for annual) and submit all outstanding returns from the past 24 months before your points reset to zero.

For full details—including worked examples and the tribunal's first wave of decisions—see our guide to the new penalty regime.

Late Payment Penalties (From January 2023)

Late payment penalties under the new regime are set out in Schedule 26 of the Finance Act 2021. They work on a percentage basis with a 15-day grace period:

These rates were increased in May 2025 by SI 2025/589—the initial penalties rose from 2% to 3%, and the daily accrual rate from 4% to 10% per annum. The increased rates do not apply to VAT for accounting periods beginning before 1 April 2025—if you're being penalised for an older period, the lower rates should apply.

On top of penalties, late payment interest runs at 7.75% from the day after the due date until payment. Interest cannot be appealed. For details on how interest works, see our interest guide.

The key lever in this regime: a Time to Pay (TTP) arrangement agreed with HMRC before day 15 prevents all late payment penalties. Paragraph 4 of Schedule 26 is explicit. Call HMRC's Business Payment Support Service on 0300 200 3831 as soon as you know you can't pay on time. They will ask about your income, expenses, assets, and what you can afford to pay monthly. If you miss a TTP payment, the penalty protection can fall away—so only agree to a schedule you can actually keep.

Best Judgment Assessments

If you haven't filed VAT returns, or HMRC believes your returns are incomplete or incorrect, they can assess the VAT they think you owe under section 73(1) of the VAT Act 1994. This is called a "best judgment" assessment.

The "best judgment" requirement is unique to VAT. For income tax, HMRC simply raises a discovery assessment under section 29 TMA 1970 with no equivalent constraint on methodology. For VAT, HMRC must make "an honest and genuine attempt to make a reasoned assessment" on the material available to them. This gives you a ground of challenge that doesn't exist in direct tax.

The time limits for best judgment assessments are set by section 77 VATA 1994: four years from the end of the accounting period as a general rule, extending to 20 years where HMRC alleges deliberate behaviour.

Best judgment assessments are most commonly raised against cash-heavy businesses—restaurants, takeaways, market traders, and similar. HMRC typically uses mark-up analysis, test purchases, or supplier records to estimate turnover.

In Homsub Ltd v HMRC [2019] UKFTT 536 (TC), for example, HMRC assessed a Subway franchise based on transaction counts rather than transaction values—which overstated the proportion of standard-rated sales because a single transaction might include both a hot coffee (standard-rated) and a cold sandwich (zero-rated).

Challenging best judgment: The courts have established a two-stage approach (from Rahman v Customs & Excise [2002] EWCA Civ 1881).

First, was the assessment made to best judgment? The bar is high—you must show it was "wholly unreasonable" in the Wednesbury sense, not merely that the tribunal would have reached a different figure. As the Court of Appeal confirmed in Pegasus Birds Ltd v Customs & Excise [2004] EWCA Civ 1015, an assessment stands if the officer honestly did their best on the material available.

Second, even if the assessment passes the best judgment test, the tribunal can still adjust the amount on appeal.

The practical point: don't assume a methodological flaw automatically overturns the assessment. The bar is "wholly unreasonable"—but if you can show HMRC's methodology was fundamentally flawed (as in Homsub), or that they ignored material you provided, you have a real argument.

Late VAT Registration Penalties

If your taxable turnover exceeds the VAT registration threshold—currently £90,000 (from 1 April 2024, per SI 2024/307)—you must notify HMRC within 30 days of the end of the month in which you crossed it. If you don't, HMRC can charge a failure-to-notify penalty under Schedule 41 of the Finance Act 2008.

The penalty is calculated as a percentage of the "potential lost revenue"—the VAT that should have been collected during the period between when you should have registered and when HMRC became aware of the failure. The percentage depends on behaviour:

Unprompted disclosure—telling HMRC before they discover the problem—leads to significantly lower penalties than prompted disclosure. Many small businesses don't realise they've crossed the threshold until months or years later, particularly if turnover fluctuates.

The penalty can be substantial because it covers all the VAT that should have been charged to customers during the unregistered period. In Dagdelen (t/a Deep Sea Fish Bar) v HMRC [2020] UKFTT 9 (TC), a fish and chip shop operator faced both a late registration penalty and inaccuracy penalties for suppressed sales—illustrating how these penalties can compound.

Reasonable excuse is available for non-deliberate failures only.

Inaccuracy Penalties

If your VAT return contains an inaccuracy that leads to too little tax being paid, HMRC can charge a penalty under Schedule 24 of the Finance Act 2007. This is the same regime that applies to income tax returns—careless inaccuracies attract penalties of up to 30%, deliberate up to 70%, and deliberate with concealment up to 100%.

In VAT, common inaccuracy scenarios include applying the wrong VAT rate (standard vs reduced vs zero), incorrect treatment of exempt supplies, and suppressed sales in cash businesses. For a full explanation of how inaccuracy penalties work, see our penalties guide. For what "deliberate" means after the Supreme Court's decision in Tooth, see our analysis of that case.

HMRC can suspend careless inaccuracy penalties for up to two years with compliance conditions—if you meet the conditions, the penalty is cancelled.

The Reasonable Excuse Defence For VAT

Most VAT penalties can be reduced or cancelled if you had a "reasonable excuse" for the failure. But the VAT reasonable excuse rules have their own statutory home and their own case law—and two defences that are particularly important for VAT.

The basic framework is in section 71 of the VAT Act 1994. It mirrors the income tax provisions but with two statutory restrictions: (1) insufficiency of funds is not a reasonable excuse, and (2) reliance on another person is not a reasonable excuse. Both have important exceptions—and those exceptions are where most VAT reasonable excuse arguments are won or lost.

For the general reasonable excuse framework—including the four-step Perrin test that applies to all tax penalties—see our reasonable excuse guide and Perrin case analysis.

The Clean Car Co Test

The standard against which all reasonable excuse claims are judged comes from The Clean Car Co Ltd v Customs & Excise Commissioners [1991] VATTR 234—a VAT case that became the foundational test for reasonable excuse across all UK tax law. It asks:

Was what the taxpayer did a reasonable thing for a responsible trader conscious of and intending to comply with his obligations regarding tax, but having the experience and other relevant attributes of the taxpayer and placed in the situation that the taxpayer found himself in at the relevant time, a reasonable thing to do?

This is an objective test. An honest belief that you've met your obligations is not enough on its own—the question is what a responsible trader in your position would have done. The Upper Tribunal adopted this test as part of the four-step framework in Perrin v HMRC [2018] UKUT 156 (TCC).

The Steptoe Defence: When Cashflow Problems Are A Reasonable Excuse

Section 71 says insufficiency of funds is not a reasonable excuse. But the Court of Appeal held in Customs & Excise Commissioners v Steptoe [1992] STC 757 that the cause of the insufficiency can be. This is the "Steptoe defence"—the most important VAT-specific reasonable excuse tool.

Lord Donaldson MR put it this way:

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.

In practice, the Steptoe defence succeeds when the cashflow problem was caused by something outside the trader's control:

• In Bicester Property Interiors Ltd v HMRC [2023] UKFTT 13 (TC), COVID-19 caused the insufficiency of funds. The tribunal found the business had been carried on with the expected level of foresight and diligence, and the shortfall was unavoidable. Appeal allowed.

• In Chameleon Technology (UK) Ltd v HMRC [2018] UKFTT 603 (TC), logistical problems delayed delivery of goods to customers, which delayed customer payments, which caused the cash shortfall. The cause was outside the company's control. Appeal allowed.

• Under the new regime, in ESC Studios Ltd v HMRC [2025] UKFTT 747 (TC), a film company couldn't pay £225,000 in VAT because HMRC was holding back a £479,000 repayment pending security checks on an earlier period. The tribunal applied the Steptoe principle and cancelled the late payment penalty.

The Steptoe defence requires evidence. You need to show your business was properly managed—bank statements, debtor and creditor records, proof of credit control measures—and that the specific event that caused the shortfall was genuinely outside your control.

When Reasonable Excuse Fails

The Steptoe defence does not mean that cashflow problems are automatically an excuse. The cause must be unforeseeable or unavoidable despite proper management:

• In W W M Rose and Sons Ltd v HMRC [2023] UKFTT 470 (TC), the business paid by direct debit and assumed the collection date was the due date. It wasn't—the statutory due date is earlier than the direct debit collection date. No reasonable excuse.

• Relying on an agent without verifying their work consistently fails. In Luzha v HMRC [2026] UKFTT 320 (TC), a sole trader assumed her accountant was filing quarterly VAT returns without ever checking. The tribunal held this did not satisfy the "reasonable care" requirement.

• In Five Star (Development) Homes Ltd v HMRC [2025] UKFTT 1255 (TC), a company delegated VAT filing to an employee using software that failed to submit returns correctly—and no one checked whether submissions had actually gone through. Seventeen consecutive late filings. The tribunal held that an employer is responsible for supervising staff who handle tax compliance.

The pattern is consistent: if the failure was within your control—or within the control of someone you should have been supervising—reasonable excuse will not succeed.

What Happens If You Do Not Act

If you do not appeal within 30 days, the penalty or assessment becomes final. You lose the right to challenge it and HMRC will treat the amount as an established debt.

Interest keeps running. Late payment interest accrues daily at 7.75% from the day after the VAT was due until the day you pay—including throughout any appeal. On a £50,000 assessment, that is roughly £10 per day. Over a 12-month appeal, interest alone could add nearly £4,000. Interest cannot be appealed. For the full picture, see our interest guide.

HMRC can enforce. For VAT assessments where you haven't paid and haven't obtained hardship relief, HMRC can pursue the debt even while an appeal is technically pending but not yet "entertained." Enforcement can include collecting through your bank, taking control of your goods (distraint), County Court judgments, and in serious cases, insolvency proceedings. Filing an appeal and applying for hardship is the way to hold enforcement at bay.

The worst outcome is doing nothing. Even if you think the penalty is unfair, the 30-day deadline does not wait.

How To Appeal A VAT Decision

The 30-Day Deadline

You have 30 days from the date of the decision to appeal. This applies to VAT penalties, best judgment assessments, registration decisions, and every other appealable decision listed in section 83 of the VAT Act 1994.

The deadline runs regardless of whether you can pay the disputed amount. Sorting out payment before filing the appeal risks missing the 30-day window—and if you do, you'll need to apply for permission to make a late appeal, which is not guaranteed.

Request A Review First

Before going to the tribunal, you can accept HMRC's offer to review the decision under sections 83A–83C VATA 1994. A different HMRC officer takes a fresh look at your case within 45 days.

The review statistics for VAT penalties are notable: around 81% of VAT penalty reasonable excuse cases are cancelled or varied on review, compared with around 56% across all reviewed decisions. A review is free and does not prevent you from appealing to the tribunal afterwards—if the review upholds the decision, you have a further 30 days to appeal.

For a full guide to how reviews work, see our HMRC internal review article.

The Pay-First Rule And Hardship Applications

This is the critical difference between VAT appeals and income tax appeals. For income tax, you can apply to postpone payment during an appeal by showing reasonable grounds for believing you've been overcharged. For VAT, the rules are fundamentally different.

Under section 84(3) VATA 1994, the tribunal cannot "entertain" your appeal against a VAT assessment unless you have first paid or deposited the disputed VAT. This is a jurisdictional requirement—the tribunal simply cannot hear your case without it.

There is one exception: hardship. Under section 84(3B), the appeal can proceed without payment if:

1. HMRC is satisfied, on your application, that paying would cause you hardship, or
2. The tribunal decides hardship exists (if HMRC is not satisfied)

What "hardship" means: The leading case is Elbrook (Cash & Carry) Ltd v HMRC [2017] UKUT 181 (TCC). The Upper Tribunal held that hardship is a forward-looking test—would the requirement to pay now cause hardship? Available borrowing facilities and non-business assets are relevant. Simply preferring not to pay, or having the money but wanting to keep it, is not hardship.

The critical distinction—"made" vs "entertained": Your appeal can be validly made (filed) without payment. The pay-first rule only prevents it being entertained (heard). This means the 30-day deadline for filing runs regardless. File first, then deal with payment or hardship.

Penalties are different: The pay-first rule applies to the VAT assessment itself, not to penalties or interest assessed alongside it. You can appeal a VAT penalty without paying it first.

Multiple assessments: If you face several assessments and can only afford to pay some, the tribunal has the power to require payment of what you can afford and allow the remaining appeals to proceed without payment (Totel Ltd v HMRC [2014] UKUT 0485 (TCC)).

How to apply for hardship: Write to HMRC's appeals unit (the address will be on your assessment notice), explaining why paying the disputed VAT would cause your business hardship. There is no standard form—use a letter. Include management accounts, bank statements, debtor and creditor lists, and projected cashflow showing inability to pay. If HMRC refuses, you can apply to the tribunal. The tribunal's decision on hardship is final and cannot be appealed further.

Filing Your Appeal

The appeal goes to the First-tier Tribunal (Tax Chamber). There is no fee (£0). You can appeal online through the GOV.UK portal or by post using Form T240.

The VAT appeal route is set out in section 83G VATA 1994—a different statute from the income tax appeal provisions in the Taxes Management Act 1970, but the destination is the same tribunal.

For a step-by-step guide to the filing process, see our how to appeal guide. For help structuring your arguments, see our guide to writing grounds of appeal.

If you're challenging a best judgment assessment, your grounds should address both stages: (1) why HMRC's methodology was flawed, and (2) what the correct figure should be. If you're appealing a penalty, focus on whether you had a reasonable excuse and, if relevant, whether HMRC correctly classified your behaviour.

Cases take typically 6-12 months to resolve. Most VAT penalty appeals are allocated to the Default Paper or Basic category—limited paperwork and each side bears its own costs. The tribunal can only order one party to pay the other's costs if it finds unreasonable conduct—a high bar that requires conduct outside the range of what a reasonable person would do. For more on what this means in practice, see our guide to tribunal tracks and costs.

If you're considering settlement rather than a full hearing, that remains an option at any stage of the appeal process.

Key Legislation And Resources

Legislation

• Section 59, VATA 1994—default surcharge (pre-January 2023)
• Section 71, VATA 1994—reasonable excuse construction rules for VAT
• Section 73, VATA 1994—best judgment assessments
• Section 77, VATA 1994—time limits for assessments
• Section 83, VATA 1994—appealable decisions
• Section 83G, VATA 1994—appeal procedure
• Section 84, VATA 1994—pay-first rule and hardship
• Schedule 24, FA 2021—late submission penalties (points-based)
• Schedule 26, FA 2021—late payment penalties (percentage-based)
• Schedule 24, FA 2007—inaccuracy penalties
• Schedule 41, FA 2008—failure to notify penalties

Key Cases

• Pegasus Birds Ltd v Customs & Excise [2004] EWCA Civ 1015—best judgment: "honest and genuine attempt to make a reasoned assessment" standard
• Rahman v Customs & Excise [2002] EWCA Civ 1881—best judgment: two-stage approach
• Homsub Ltd v HMRC [2019] UKFTT 536 (TC)—best judgment: flawed transaction-counting methodology
• Elbrook (Cash & Carry) Ltd v HMRC [2017] UKUT 181 (TCC)—hardship: the leading case on s.84 applications
• Totel Ltd v HMRC [2014] UKUT 0485 (TCC)—hardship: partial payment and multiple assessments
• Foster and Sons Ltd v HMRC [2024] UKFTT 1009 (TC)—default surcharge: service of notices
• Bicester Property Interiors Ltd v HMRC [2023] UKFTT 13 (TC)—Steptoe defence: COVID cashflow as reasonable excuse
• Chameleon Technology (UK) Ltd v HMRC [2018] UKFTT 603 (TC)—Steptoe defence: customer non-payment from logistical delays
• ESC Studios Ltd v HMRC [2025] UKFTT 747 (TC)—Steptoe principle under the new regime; HMRC withholding repayment
• Dagdelen (t/a Deep Sea Fish Bar) v HMRC [2020] UKFTT 9 (TC)—late registration: combined failure to notify and inaccuracy penalties
• W W M Rose and Sons Ltd v HMRC [2023] UKFTT 470 (TC)—direct debit timing does not extend statutory due date
• The Clean Car Co Ltd v Customs & Excise Commissioners [1991] VATTR 234—foundational "reasonable trader" test for reasonable excuse
• Customs & Excise Commissioners v Steptoe [1992] STC 757 (CA)—cause of insufficiency of funds can be a reasonable excuse (first instance: Steptoe v Revenue & Customs [1989] UKVAT V4283)

GOV.UK Guidance

• VAT penalties and interest—collection page for the new regime
• Late submission penalty points—how the points system works
• Late payment penalties for VAT—percentage-based penalties
• VAT registration—current thresholds and obligations
• Late registration penalty (Notice 700/41)—failure to notify penalties

On This Site

• The new penalty regime—full guide to points-based and percentage-based penalties
• HMRC penalties explained—penalty types and inaccuracy calculations
• What is a reasonable excuse?—the general reasonable excuse framework
• Perrin v HMRC: the four-step test—the landmark reasonable excuse case
• Understanding your appeal rights—overview of appealable HMRC decisions
• HMRC internal review—the free review step before the tribunal
• How to appeal to the tax tribunal—step-by-step filing guide
• Late appeals to the tax tribunal—if you've missed the 30-day deadline
• Writing grounds of appeal—structuring your case
• Discovery assessments—the income tax equivalent of s.73 assessments
• Postponing payment during appeal—s.55 TMA for direct taxes; hardship comparison for VAT
• Interest on unpaid tax—how late payment interest is calculated
• Settling your tax tribunal case—settlement as an alternative to a hearing
• Tax dispute timeline—the full roadmap from HMRC decision to tribunal
• Tribunal tracks and costs—case categories and costs regime
• Unreasonable conduct costs—when the tribunal awards costs
• Tooth v HMRC—what "deliberate" means for inaccuracy penalties

This article is for informational purposes only and does not constitute legal or tax advice. For advice specific to your situation, consult a qualified tax adviser, accountant, or solicitor.