Victory for the taxpayers in the Charlton case as the UT confirms that HMRC's discovery assessments were unlawful
The eagerly awaited decision of the Upper Tribunal ('UT') in HMRC v Charlton, Corfield & another  UK FTT 770, has now been delivered.
The UT had little hesitation in dismissing HMRC's appeal and confirmed the decision of the First-tier Tribunal ('FTT'), although for different reasons, that HMRC had not been entitled to make a 'discovery' assessment pursuant to section 29 Taxes Management Act 1970 ('TMA').
The issue related to whether HMRC had made valid discovery assessments on the three appellants, thereby denying capital losses that the taxpayers had expected to secure by participating in a tax planning arrangement for the tax year 2006/2007. Mr Corfield's return (the returns of the other appellants were in similar form so far as relevant for the purposes of the appeal) disclosed the amount of £58 as the gain with no declared liability to capital gains tax ('CGT') as the gain was less than the annual exemption for CGT. In the 'white space' of his return for Other Shares and Securities – further information, the allowable losses claimed of £195,323 were explained as follows:
"0.0000 shares were sold in Life Assurance policy [sic]. I acquired an Axa Isle of Man Limited Life Assurance Policy on 27 October 2006 for £205,303.92. Subsequently I made a partial surrender of the Policy on 15 November 2006 for proceeds of £192,577.45. I later sold my residual interest in the Policy on 28 November 2006 for proceeds of £9,981.41. The loss on sale is calculated as the difference between the sale proceeds and the cost of acquisition. The proceeds for the partial surrender are excluded from the capital gains calculation as they have already been taken into account as a receipt in computing income for the purposes of income tax."
By the time the appellants submitted their self-assessment tax returns HMRC had challenged a broadly similar arrangement provided by a different company and the Special Commissioner had decided in that case that the intended fiscal consequences did not arise and that the losses were not allowable (see Drummond v HMRC  STC (SCD) 682).
The FT's decision1
The FTT was in no doubt that the appellants' returns made clear to HMRC that the taxpayers concerned had implemented a tax avoidance scheme. Firstly, the tax returns contained an SRN number signifying that a disclosure was being made to HMRC under the disclosure of tax avoidance schemes ('DOTAS') regulations.2
"10. The Appellents' tax returns all revealed the large capital gains that had been made, and then set against those gains the losses of broadly similar amounts that they hoped would be available. In the "white spaces" in the tax returns, sufficient details of the insurance policy transactions … were given for us instantly to reach the understanding of the scheme …
12. The tax returns did not however make any mention of the Drummond decision, or the fact that those advising the Appellants must have known, by the time the returns were submitted, that HMRC was challenging schemes of this nature. Although general reference was made to the feature that the claim for the losses, assumed in producing the very modest figure of net capital gain in the returns, was based on a view of the law (almost certainly a genuine view at the time) that was at variance with the view that HMRC obviously held … "
The FTT was clear that a discovery assessment can be made where the original HMRC officer changes his mind or a new officer takes a different view. It was not necessary that "something new had to emerge". The issue, therefore, under section 29(5) TMA, was whether a notional officer, of average competence, could have been reasonably expected, on the basis of the information provided in the returns, and any other permissible information under section 29(6), to have been aware at the time the enquiry window closed on 31 January 2009, that there was an insufficiency of tax under section 29(1) TMA. The FTT said:
"83 It was contended on behalf of the Appellants that the information given in the return, particularly that in the "white space" was sufficient to make the facts of the transactions that the Appellants had effected perfectly clear. From those facts, even ignoring the reference to the avoidance scheme's disclosed SRN, it was obvious that the Appellants had participated in a tax avoidance scheme. "
In agreeing with the appellants, the FTT concluded:
"129 In applying the test in sub-section 29(5), the notional officer is deemed to be aware that:
- the taxpayers' realised capital losses in amounts roughly equivalent to the gains …
- those losses derived from transactions in insurance policies that were held for very short periods, not seemingly consistently with the two most obvious situations in which insurance policies might be taken out and held;
- the transactions in relation to the insurance policies oddly occasioned small actual losses, but were also treated, very much more surprisingly, as occasioning very large capital losses for tax purposes, in a figure greatly in excess of the actual small losses;
- the losses were said to derive from the fact that the amount received on the partial surrenders of the policies had been taken into account for the purposes of income tax, notwithstanding that no income had been declared as deriving from the policies; and
- as we noted … above, the text in the tax return had not been confined to summarising facts, but had given a sufficient indication of a tax thinking underlying the transactions for us at least to realise instantly precisely how it was thought that the scheme worked for tax purposes.
130. No HMRC officer could learn of those facts without it being instantly obvious that a tax avoidance scheme had been implemented …
134 Our conclusion is accordingly that … the taxpayers in this case are protected from the making of discovery assessments by sub-section 29(5).
135. Accordingly the three appeals are allowed."
The UT's decision
The UT concluded that HMRC had not been entitled to issue discovery assessments. The UT held that the key issue was whether the taxpayers had provided information which would have enabled a hypothetical officer of HMRC to have been aware of the under assessment. Under section 29(6) TMA, information would be provided by the taxpayer if it was:
- contained in the taxpayer's return for the relevant tax year or in any accounts, statements or documents accompanying the return;
- contained in any documents, accounts or particulars that, for the purposes of any enquiries into the return, were produced by the taxpayer or provided to an HMRC officer; or
- information the existence of which, and the relevance of which, as regards the under assessment, an HMRC officer could either reasonably be expected to infer from the above information or it is notified by the taxpayer in writing to the HMRC officer.
HMRC had argued that form AAG1, which was submitted not by the taxpayers but by the promoter of the scheme under the DOTAS regime, should not be regarded as having been made available to HMRC for the purposes of section 29 TMA. The UT rejected this argument and said:
"82…The SRN was included in each Respondent's tax return, but on a different page to the white space disclosures of the scheme and the pages setting out the capital gains computations and the figures for income on the surrender of the policy. We are, however, in no doubt that, first, the existence of the form AAG1 could reasonably have been expected to have been inferred by the hypothetical officer, and secondly that the physical separation of the SRN number from other relevant entries on the tax return would not have prevented an officer from making the necessary link between them so as reasonably to infer the relevance of the form AAG1 to the insufficiencies …
84. The circumstances of the form AAG1 in our view make it reasonable for its existence and relevance to be inferred. An officer would be aware of the significance of an SRN, and of the fact that a promoter would have been required under section 308(1) of the Finance Act 2004, to have provided information, in the form AAG1, to HMRC … In our view, the form AAG1 is just the sort of information the availability and relevance of which might reasonably be inferred from the inclusion of the SRN in a return which also discloses tax effects consistent with tax planning."
The UT also determined that, in addition to the information in the form AAG1, the hypothetical HMRC officer would have sufficient knowledge of second hand insurance policies to be able to appreciate the unusual nature of the entries in the taxpayers' returns. The officer would also have been aware of the Drummond decision.
Finally. the UT rejected the argument relied upon by HMRC that there was an overriding obligation on the taxpayer to explain how the arrangements work. The UT said:
"93. We do not accept that there is any overriding requirement that the information has to explain how the scheme works (although in this case we consider that would in any event be met by the availability of the form AAG1), nor that the information must specify, if it be the case, that the view adopted by the taxpayer is different from that taken by HMRC. It is a question of degree in all cases … it is not necessary that the hypothetical officer should have been able to comprehend all the workings of the scheme, or the legal and factual arguments that might arise, or be able to form a reasonable view of those matters. Having regard to the knowledge and understanding that we consider the hypothetical officer might reasonably be expected to have, the difference between the allowable loss claimed and the income declared was enough, in our judgement, to justify an officer making the assessment".
The UT did agree, however, with the reasoning of the FTT that a discovery assessment can be made where the original HMRC officer changes his mind or a new officer takes a different view. It was not necessary that something new had to emerge.
This is a welcome decision, in that it provides some measure of certainty for taxpayers who have entered into tax mitigation arrangements in circumstances where a DOTAS SRN reference number has been allocated. Charlton makes it clear that it is not necessary for the hypothetical officer to understand precisely how the scheme works. It is sufficient for him reasonably to be expected to be aware of the insufficiency such as to justify an assessment and the information contained in the form AAG1 can, as in this case, be sufficient to satisfy this test.
There has been a concern in recent years that HMRC have sought to use their discovery assessment powers in circumstances which were not intended by Parliament. HMRC are not entitled to issue discovery assessments whenever they are outside the usual time period for opening an enquiry. The Charlton is welcome confirmation that taxpayers are entitled to finality in their tax affairs. There are limits on HMRC's discovery powers and Parliament has provided that such assessments cannot be issued at the absolute discretion of HMRC. The conditions provided for in section 29 TMA must be satisfied if HMRC are to lawfully issue a discovery assessment.
Given the importance to HMRC of their discovery assessment powers, it is likely that HMRC will seek to appeal the UT's decision to the Court of Appeal, which will lead to further uncertainty in this important area of the law.
1  UK FTT 467 (TC).
2 As contained in sections 309-319 FA 2004 and secondary legislation.