News & Articles

Rediscovering America - PSL win landmark case on discovery

In his article below, originally published in Taxation magazine, Aman Bharti of Premier Strategies gives an inside view of a recent case relating to discovery, “The Charlton case” which was recently won by the taxpayer at the First Tier Tribunal. The author was part of the Premier Strategies team which instructed counsel for the taxpayer, and was present through all stages of the hearing. HMRC are expected to appeal this decision, as the courts have tended to find in favour of HMRC in previous cases relating to discovery despite significant levels of disclosure from taxpayers. For now, this case represents an important success for all taxpayers and their advisors, as it shows that there are limits to HMRC’s discovery powers, and provides reassurance that the statutory protection against discovery assessments is not illusory.

KEY POINTS

• Discovery cases under TMA 1970, s 29 have tended to go against the taxpayer.
• HMRC’s view after Langham v Veltema is now challenged by Lansdowne and Charlton.
• Discovery does not require any new facts to be revealed.
• The ‘notional HMRC officer’ can be expected to act as they would in the real world.

When self assessment was introduced in 1996, it was described as the most fundamental reform of the direct tax system since the introduction of PAYE in 1944.

Taxpayers were asked to take responsibility for completing their own tax returns and assessing their liability to tax, which had previously been the then Inland Revenue’s responsibility. In return, taxpayers were promised a new system that would be ‘simpler, fairer and more straightforward’.

To police the system, the Revenue had the power to check whether a tax return was correct by opening an enquiry in the 12 months after the return was submitted. After the end of this twelve-month period, the taxpayer would have absolute finality and certainty about his tax affairs. The only exception to this time limit was to be under the discovery rules.

These discovery rules were deliberately restricted and, we were told at the time, designed to ensure that a taxpayer who had made a full disclosure on his or her return would still have absolute finality twelve months after the filing date (even if the return was subsequently found to be incorrect), unless the ‘incorrectness’ was because of fraudulent or negligent conduct.

This article is only concerned with the application of the discovery rules where the taxpayer has been honest and careful (that is, not fraudulent or negligent, or careless or deliberate).

Discovery problems

In the early years of self assessment, it seems that not much thought was given to the discovery rules, and what they meant in practice for the honest and careful taxpayer. There was little discussion about what level of disclosure in a tax return was sufficient to give taxpayers finality, and protect them against a future discovery assessment.

This situation changed in February 2004 when the Court of Appeal judgment in Langham v Veltema [2004] EWCA Civ 193 was published. The taxpayer had won at both the General Commissioners and the High Court, but the Court of Appeal decided against the taxpayer, saying his disclosure had not been sufficient. This case put discovery in the spotlight, and it has remained there ever since.
 

The judgment caused considerable alarm within the tax profession. Taxation ran an article titled Certainty? What certainty? on the implications of the case. Elsewhere, I found an article on the judgment, which was called Scary story. In his book Revenue Law (2005), Professor John Tiley observed that:

‘The new system [of self-assessment] was a compromise between the Revenue, whose costs were greatly reduced, and taxpayers whose costs were increased in return for greater and earlier finality. This decision [Langham v Veltema] unbalances that compromise.’

Even HMRC acknowledged that the judgment had raised concerns about the lack of finality for the taxpayer, as well as the inherent difficulty in complying with the law as expounded in the Court of Appeal.

Run of cases

If the tax profession had been concerned by Langham v Veltema (and it was), there was worse to come.

In a brief analysis of the discovery cases since the Veltema judgment in February 2004, I counted 16 cases where taxpayers sought protection from a discovery assessment on the basis of sufficient disclosure in their return.

In 14 of those 16 cases, the courts ultimately found the taxpayer was not entitled to any such protection.

A further cause for concern for taxpayers was that HMRC kept winning cases where the taxpayer had made greater and greater levels of disclosure. No level of disclosure seemed sufficient to protect a taxpayer in court against a discovery assessment. Especially prominent defeats for the taxpayer were Corbally-Stourton v HMRC [2008] UKSPC SPC00692, and Pattullo, Re Judicial Review [2009] ScotCS CSOH 137.

In the entire period from 2004, there were only two reported cases where the taxpayer had some success against a discovery assessment on the grounds of full disclosure. In the first case (Agnew v HMRC [2010] UKFTT 272 (TC)), the taxpayer was successful in respect of one tax year, but HMRC won for three tax years.

The second case (HMRC v Lansdowne Partners LP [2010] EWHC 2582 (Ch)) has been the only substantial success to date for the taxpayer. The taxpayer has so far won at the General Commissioners and the High Court.

The matter is, however, not yet final. HMRC have appealed again, and the case is expected to be heard by the Court of Appeal this November.

This is why the latest discovery case is likely to be of interest to most taxpayers and their advisers. Charlton & Ors v Revenue & Customs [2011] UKFTT 467 (TC) was heard by the First-tier Tax Tribunal in June 2011 and the decision has just been published.

The author was part of the team which instructed counsel for the taxpayer, and was present through all stages of the hearing.

The tribunal found that, although their returns were incorrect, the taxpayers were protected from discovery assessments on the basis of the disclosure they had made in them.

Background to Charlton

The three appellants undertook a tax avoidance scheme in the 2006/07 tax year. The scheme sought to create a capital loss for tax purposes, without a corresponding economic loss. The capital loss could then be offset against capital gains made in the same year.
 

The scheme involved the acquisition of specific second-hand insurance policies. Soon after acquisition, a partial surrender was made of the policies, which were finally sold.

It was thought that, due to the specific attributes of the policies and the prescriptive wording of the relevant legislation (TCGA 1992, s 37), these transactions would result in a capital loss for tax purposes.

While the scheme was undoubtedly aggressive, the appellants had taken specialist tax advice, and two respected Counsel had favourably opined on the planning.

The appellants completed the planning in November 2006. Subsequently, in early 2007, HMRC took a case involving a similar scheme to the Special Commissioners and won. This was the Drummond case (Drummond v HMRC [2007] UKSPC SPC00617).

The facts of that case were somewhat different, but the basis on which it was decided in HMRC’s favour (specifically the purposive interpretation of TCGA 1992, s 37) undermined the planning undertaken by the appellants.

The Drummond judgment was made in July 2007, shortly before the appellants submitted their tax returns. The appellants knew that the Drummond decision was unfavourable to them, but also knew that the matter was not final and were hopeful that it would be overturned on appeal.

The appellants submitted their tax returns in the second half of 2007. Subsequently, there were two further appeals by the taxpayer in Drummond.

However, both the High Court (in July 2008), and the Court of Appeal (in June 2009) also concluded that the scheme did not work. Mr Drummond was not given permission to appeal to the Supreme Court, making the Court of Appeal judgment final.

HMRC’s twelve-month time limit for opening an enquiry into our clients’ returns ended on 31 January 2009. At that date, because of (and only because of) multiple administrative failures, no valid enquiries had been opened into the returns.

In one case, HMRC thought they had opened an enquiry, but hadn’t. In the other two, the tax returns had been flagged up for enquiry, but were then ignored for six months during which the enquiry window closed.

To the best of our knowledge, all other taxpayers who had carried out the planning were the subject of enquiries opened within the time limit.

HMRC subsequently realised that valid enquiries had not been opened into the three appellants’ returns, and raised discovery assessments.

The appeals

The appellants accepted that the Drummond decision applied to them, and that their tax returns were incorrect. However, they argued that they had properly disclosed everything in their tax returns, and were therefore entitled to protection from the discovery assessments by TMA 1970, s 29.

There were two points of contention. The first was about the meaning of ‘discovery’ itself. In making a discovery, does something new have to be found?

As Keith Gordon, counsel for the appellants, succinctly put it, ‘could America be discovered more than once?’

At the end of the enquiry period, HMRC knew what transactions the appellants had undertaken, what scheme had been entered into, and of the Special Commissioners’ and High Court’s judgments in Drummond. What, then, had been newly discovered by the officer raising the assessment?

Unfortunately, this argument was not successful. The tribunal concluded that earlier case law showed that nothing new had to be found for there to be a discovery.

This is an interesting point that deserves further consideration and analysis, but in the interest of brevity, this article focuses on the second argument: was there sufficient disclosure in the appellants’ tax returns to negate the requirement for a discovery assessment in TMA 1970, s 29(5), that an HMRC officer ‘could not have been reasonably expected, on the basis of information made available before that time, to be aware of’ the insufficiency in the assessment.

The relevant information is defined in s 29(6), and includes the return itself and supporting documentation.

Full disclosure?

Before turning to the arguments, it is useful to summarise what was disclosed. Each tax return contained:

• Numerical details of a substantial capital gains tax loss and a small income tax gain.
• A two-paragraph white space disclosure in the capital gains tax pages that summarised the transactions that took place and the tax consequences of the transactions.
• A two-paragraph white space disclosure in the foreign pages that summarised the transactions that took place and the tax consequences of the transactions.
• The DOTAS number, and confirmation the tax advantage arose in respect of 2006/07.

HMRC accepted that they had been alerted that a tax avoidance scheme had been undertaken. However, they went on to argue that some tax avoidance schemes worked and some did not, and they were not alerted to the fact that this one did not.

The tax return did not include a detailed interpretation of the legislation, or the relevant legislative references. The tax return did not mention the Drummond case or that a different interpretation of the legislation had been taken.

The appellants argued that the DOTAS number on the tax return should have alerted HMRC to the DOTAS disclosure made to HMRC by the scheme promoters, which explained how the scheme worked.

HMRC disagreed, saying that the information in the initial disclosure was not on the appellants’ tax returns, and the contents (as opposed to the existence) of the initial disclosure could not be expected to be inferred by an officer of the board. Interestingly, the tribunal agreed with HMRC on this point.

The notional officer

So what test do the discovery rules actually require? The authorities say that they require a hypothetical test of whether a notional HMRC officer could, based on the taxpayer’s disclosures, have been aware of an under-assessment at the end of the enquiry window. There was much argument about what this actually meant in practice.

HMRC’s interpretation of this test (supported in their view by case law) was that the notional officer is not expected to refer to any legislation, books, manuals, or consult with any colleagues, etc. before arriving at a conclusion.

In our case, for example, the notional officer would notice the DOTAS number on the appellants’ returns, but would not be expected to look at what information had been previously provided to HMRC, or to find out what HMRC’s view of the scheme was.
 

Taking this approach to its logical conclusion, it would seem that even giving references to the tax legislation or the Revenue’s manuals would offer the taxpayer no protection from discovery unless the taxpayer also provided the actual legislation and manuals!

The decision

The tribunal found that the disclosures in the returns were certainly not meant to conceal anything. Indeed, the tribunal said that, even without referring to the DOTAS number, no HMRC officer could learn of the facts disclosed without it being instantly obvious that a tax avoidance scheme had been implemented.

The tribunal additionally found that the inclusion of the DOTAS number should have revealed that someone within HMRC had already considered the details of the scheme which had been implemented (otherwise no DOTAS number would have been issued). HMRC accepted this, but argued the notional officer would not go any further.

The tribunal disagreed, saying that HMRC’s interpretation of the notional officer test was not appropriate here.

While that interpretation may be appropriate for a simple situation, in cases where it was ‘glaringly obvious either that the relevant officer should consider the law... or ask for guidance’, the notional officer should be treated as proceeding on that basis – i.e. in a complex case he or she should do more than simply observe that there was a DOTAS number.

The officer should be expected to ‘approach matters realistically, as HMRC would inevitably expect him to operate’.

This is a particularly welcome part of the judgment, and brings some much-needed common sense to the interpretation of the discovery rules.

The tribunal additionally found that even if it was wrong on this point, and that the notional officer could not behave in the sensible way described above, the officer could still, from the information made available, have been able to conclude there was an insufficiency and to raise an assessment at the end of the enquiry period.

When the discovery assessments actually were issued in this case, no further information was required from the taxpayers beyond what they had already disclosed in their tax returns.

At the hearing, HMRC had argued that some tax schemes work, and some do not, and since one could not tell from the disclosures which category this scheme fell within, they were entitled to raise a discovery assessment later.

The tribunal said that, rather than dithering and doing nothing while the enquiry window closed, a more sensible view would have been to raise the assessment, while being aware that ‘some assessments are sustained on appeal, and others are not’.

It strikes me that this was an odd argument for HMRC to raise, given they usually have no compunction in raising protective discovery assessments even when it is far from clear that any tax is due (for example when the matter is subject to litigation).

They might therefore actually have reason to be grateful that the tribunal did not accept their argument on this point.

Based on its findings, the tribunal allowed the three appeals.

Implications for taxpayers

The judgment has interesting implications for other taxpayers. Logically, HMRC’s approach in this case (and those before it) suggests that taxpayers should exercise prudence by duplicating in their tax returns any information that they know has been provided to HMRC in any other form.

This includes information that was properly, and in accordance with HMRC’s own guidance, disclosed elsewhere. Certainly where the taxpayer has carried out a DOTAS scheme, they should replicate the entire initial disclosure on the tax return.

Arguably, the taxpayer should not just provide legislative references, but the relevant legislation as well. I say this a little in jest, but at the same time this does seem to be the logical consequence of HMRC’s position in Charlton.

Perhaps a period of over-disclosure by taxpayers might be a stimulus to encourage HMRC to accept a more reasonable interpretation of what information has been made available to them by taxpayers.

Taxpayers will benefit greatly from the tribunal’s decision that, when dealing with information made available, an HMRC officer should be expected to ‘approach matters realistically, as HMRC would inevitably expect him to operate.’

This means taxpayers are not expected to alert an HMRC officer sitting in a dark room who does not consult legislation or colleagues.
 

Instead, what they have to do is alert an HMRC officer who behaves the way a reasonable HMRC officer functioning in the real world should. Such an officer does occasionally refer to the legislation and HMRC manuals, and consult his colleagues when appropriate.
 

This must be a sensible approach and if it is accepted by HMRC and/or the higher courts, would go some way to restoring balance between HMRC powers and taxpayer rights in the context of discovery.

Conversely, if HMRC resist this interpretation and find supports in the higher courts, it should highlight the inadequacy – indeed, I might go as far as to say the absurdity – of the existing rules, and thus hasten legislative change.

What’s next?

The recent success (so far) of the taxpayer in this case and also in Lansdowne makes the discovery rules a little more palatable, but for now there remains much in existing case law to suggest that the discovery rules as a whole need to be revisited and remoulded to give greater statutory protection to the taxpayer.

It is not yet known whether HMRC will appeal the decision in our case. Given their apparent reluctance to cede any ground to the taxpayer on discovery, this is unlikely to be the end of the matter.