Supreme Court clarifies when tax follower notice can be issued

The Supreme Court decided that HM Revenue and Customs (HMRC) can only issue a follower notice to a taxpayer where it is of the opinion that there is "no scope for a reasonable person to disagree that the earlier ruling denies the taxpayer the advantage". It is not sufficient for HMRC to form the view that it was "likely" that the application of the earlier case would deny the tax advantage, the court said.

HMRC can issue a follower notice where an enquiry or tax appeal is in progress in relation to arrangements where it is reasonable to conclude that obtaining a tax advantage was the main purpose or one of the main purposes of the arrangements. The rules allow the issue of a follower notice where HMRC is “of the opinion that there is a judicial ruling which is relevant to [the taxpayer's] arrangements". A ruling is relevant if principles laid down or reasoning given in the ruling would, if applied to the arrangements, deny the asserted advantage, or part of it.

Once a follower notice is issued, HMRC can also issue an accelerated payment notice (APN) requiring payment of the disputed tax before the dispute between HMRC and the taxpayer is resolved.

Tax disputes expert Steven Porter of Pinsent Masons said: “Follower notices have very serious consequences for the taxpayer. A taxpayer who does not agree to settle their dispute not only has to pay the disputed tax upfront, but has the risk of a significant extra penalty hanging over them should they ultimately lose their case. It is therefore right that there should be a high bar for HMRC issuing a follower notice.”

“Follower notices are really aimed at marketed avoidance schemes, where HMRC has succeeded in the courts against one scheme user. In this case, HMRC tried to use the rules in relation to tax planning which was similar to that in a decided case, but which was not a mass marketed avoidance scheme. The decision shows that the follower notice provisions are not as wide as HMRC considers,” Porter said.

In this case the taxpayer, Mr Haworth, had entered into arrangements which he claimed meant that he was not subject to capital gains tax in relation to the disposal of shares by a trust of which he was the settlor. The arrangements involved the resignation of Jersey trustees in favour of trustees resident in Mauritius. The trust then disposed of shares realising a substantial gain and the Mauritian trustees were then replaced by UK resident trustees within the same fiscal year.

The avoidance of the CGT charge depended on the residence of the trust being Mauritius at the time the disposal was made for the purposes of the UK/Mauritius double tax treaty. This would make the gain subject to tax only in Mauritius, where there was no tax liability in these circumstances.

HMRC issued a follower notice to Mr Haworth on the basis that a 2010 Court of Appeal decision involving Mr and Mrs Smallwood, who had entered into similar arrangements, meant that the double tax treaty did not relieve him of a liability to capital gains tax. The Court of Appeal decided in the Smallwood case that the trustees were resident in both Mauritius and the UK and under the double tax treaty ‘tie breaker’ provision the ‘place of effective management’ of the trust was the UK and not Mauritius and so the gain was subject to capital gains tax.

The Supreme Court said that deciding whether a previous ruling “would” deny the taxpayer the advantage claimed may, depending on the circumstances, depend on how fact sensitive the application of the relevant ruling is, whether HMRC is satisfied that the taxpayer’s evidence is untruthful or whether the taxpayer is relying on an argument that was not raised in the earlier ruling.

In deciding whether to issue follower notices after the Smallwood case, HMRC had identified seven factors mentioned in the judgment.  HMRC considered that if these factors were present in the case of a later taxpayer, the Smallwood case would mean that the taxpayer’s appeal would be likely to fail.

The Supreme Court said that this overstated the conclusion of the Court of Appeal in Smallwood and the factors were not intended to be necessary and sufficient to establish in any other case that the place of effective management of the trust is the UK. Instead the full facts of the case would need to be considered.

Steven Porter said: “This case sets out a more stringent test for when follower notices can be issued, which will make them less likely to be used in very fact specific scenarios, such as the Haworth case. However, we can still expect them to be used in mass market avoidance schemes”.

Although Mr Haworth’s follower notice was quashed, the Supreme Court dismissed another argument on behalf of Mr Haworth that the follower notice was invalid because it did not adequately set out why the reasoning in the Smallwood decision applied to Mr Haworth’s circumstances.

“The notice need not be lengthy, but it should have contained a description of the features of Mr Haworth’s arrangements that in HMRC’s opinion meant that Smallwood would deny him the tax advantage asserted,” the Supreme Court judgment given by Lady Rose said.

“Surprisingly the Supreme Court said that although the follower notice was defective, it was not invalid because there was nothing in the legislation which said that any defect in the notice would render it invalid,” Steven Porter said.

In her judgment Lady Rose agreed with the reasoning of Lord Justice Newey in the Court of Appeal. Lord Justice Newey pointed out that failures to comply with the notice requirement could “vary enormously in their importance, from the egregious and damaging to the minor and inconsequential” and said that parliament could not be taken to have intended that total invalidity should result from any irregularity, regardless of the extent of the default and the seriousness of its consequences. He said that the fact that the word "must" has been used does not in the context of this provision imply total invalidity.

Lord Justice Newey said that the deficiency in the follower notice issued to Mr Haworth should not render the notice invalid because it was not a case of “wholesale or egregious non-compliance” by HMRC. It had provided some information, just not enough, and there was no reason to suppose Mr Haworth had suffered any prejudice because his advisers were aware of why HMRC considered the Smallwood case applied to his circumstances.

“There is a risk that these comments by the Court of Appeal and Supreme Court will embolden HMRC to stick by partial failed notices of other types. That would be a worrying trend, particularly if it applies to closure notices,” Porter said.

“Does this leniency in complying with conditions for notices set out in the legislation go both ways? For example, does it mean that notices provided by taxpayers, such as notices of appeal, will not be invalid if they don’t quite satisfy all the notice conditions?” he said.

The government has changed the penalties which apply when a follower notice is issued and the taxpayer fails to settle their dispute, in response to recommendations from the House of Lords Economic Affairs Committee in December 2018 that the "draconian" penalties be abolished on the basis that they restrict access to justice.

This year’s Finance Act replaces the 50% penalty for failing to settle the dispute after receipt of the notice with  a 30% penalty. An additional 20% penalty can be imposed if a tax tribunal or court strikes out the taxpayer’s appeal on the grounds that it has no reasonable prospect of success or that there is an abuse of process or alternatively if the tax tribunal or court makes a statement that the taxpayer has acted unreasonably in bringing or conducting the proceedings.