The Government is unlawfully using late-payment penalty fines against tens of thousands of small firms who do not file their tax returns on time as a "cash-generating scheme" for the Exchequer.
In a damning judgment, the Tax Tribunal has ruled that Her Majesty's Revenue and Customs is operating a policy of "deliberately" waiting months before alerting businesses that have not filed their tax returns so that late- payment fines stack up.
If upheld on appeal, the judgment could result in between 50,000 and 100,000 firms being able to claim refunds on tens of millions paid in fines.
"It is no function of the state to use the penalty system as a cash-generating scheme," said the judge, Geraint Jones, QC. "We have no doubt that any right-thinking member of society would consider that to be unfair and falling very far below the standard of fair dealing expected of an organ of the state."
The judgment will put more pressure on ministers to reform HMRC in the wake of a string of revelations about its poor management. The organisation has been accused of double standards after letting large companies like Goldman Sachs and Vodafone off billions of pounds in tax while clamping down on businesses without the financial resources to challenge its decisions.
Under the scheme, firms are given no notification of a failure to complete their end-of-year return by the May deadline. Instead, HMRC waits until September before sending out a computer-generated letter telling them they have failed to complete the return and are liable for four months of late payment fees of £100 each plus another £100 fine for late completion.
In court, HMRC tried to argue that it was not obliged to provide reminders to firms who failed to submit the correct tax returns and that the penalties for doing so were clearly publicised.
But in three separate rulings, Mr Jones dismissed this defence, saying that when Parliament legislated to allow a penalty fine it did so "to encourage compliance and, in cases where compliance did not take place, to levy a proportionate penalty".
He added: "It is unthinkable that Parliament would intend a manifestly unjust situation to arise as a result of HMRC being dilatory in sending out a first (or subsequent) penalty notice."
In another ruling, he said: "There can be no logical reason whatsoever for HMRC to delay sending out a penalty notice for four months so that, in effect, a minimum penalty of £500 will be levied unless the taxpayer has unilaterally realised that it has failed to undertake the necessary filing."
John Walker, national chairman of the Federation of Small Businesses, welcomed the judgment. "It is wrong if the system is deliberately set up so that a penalty notice is not given until the fine reaches £500," he said.
"We know that the department has been tasked with additional revenue- raising targets but to intentionally allow, and target small firms to accrue fines when it is making deals with larger firms that owe millions of pounds is immoral."
A spokeswoman for HMRC denied it was using penalties to raise revenue.
She said she could not comment on the tribunal case because the litigation was ongoing but added: "The vast majority of employers file their returns on time and with the current PAYE system, the timetable for issuing penalties for outstanding returns is designed to allow a reasonable period for HMRC to process all the returns received as well as the notifications received advising HMRC where there is no return due.
"Individual circumstances are fully taken into account in deciding on 'reasonable excuse' for missing a deadline and we apply the rules fairly."
Case study: The accountant who refused to be trampled by the taxman
John Williams gave no great thought to changing Britain's tax law when he decided to fight Her Majesty's Revenue and Customs over a £500 fine imposed on his client. He simply thought the demand was unjust.
Working on behalf of a small charity called Response International, which helps provide medical support in war zones, he thought the money could be better spent there than handing it over to the taxman.
So for free he went to the Tax Tribunal in London and challenged the decision in person, won the money back and in the process may well have changed the law in favour of thousands of other small businesses and charities.
"I just thought HMRC had behaved unfairly," he said yesterday. "But they tend to get away with it because it's more expensive to fight than to pay up. I rather stubbornly wanted to prove a point."
Mr Williams said dealing with the Revenue had become "very much worse". "In the past you had tax inspectors who had the power to look at a case and make a reasonable and fair decision. But now you're left dealing with call centres where nobody takes ownership of an issue."