Supreme Court provides guidance on Follower Notices

In R (on the application of Haworth) v HMRC [2021] UKSC 25, the Supreme Court has upheld the Court of Appeal's decision quashing a follower notice issued by HMRC under Part 4 of the Finance Act 2014.  The follower notice had been issued to the taxpayer in relation to a "round the world scheme", following the Court of Appeal's earlier decision in Smallwood v Revenue and Customs Commissioners [2010] EWCA Civ 778 ("Smallwood").

In coming to its decision, the Supreme Court held that a follower notice may only be issued where HMRC believes that there is "no scope for a reasonable person to disagree that the earlier ruling denies the taxpayer the advantage".  The decision is to be welcomed since it offers guidance in precise terms, and ensures that HMRC has now to pass over a high hurdle before it can take the draconian step of issuing a follower notice (which step has the effect of limiting a taxpayer's access to justice).

The Follower Notice Regime

Follower notices are issued by HMRC under Part 4 of the Finance Act 2014.  The regime essentially works as follows.

1. Where (a) a taxpayer claims a tax advantage based on a particular interpretation of the relevant taxing provisions in an appeal to HMRC, and (b) HMRC forms the opinion that the taxpayer is not entitled to that tax advantage because the "principles laid down" or "reasoning given" in a previous court or tribunal ruling "would, if applied to the chosen arrangements, deny the asserted advantage or a part of that advantage", then (c) HMRC may (if certain other conditions are satisfied) serve a "follower notice" on the taxpayer.
2. Upon service of a follower notice, the taxpayer must either (a) take 'corrective action' by conceding that it is not entitled to the tax advantage and is liable to pay the tax it initially sought to avoid, or (b) continue to maintain that HMRC are wrong and pursue its appeal before a tribunal or court.
3. If the taxpayer chooses not to concede, and ultimately loses its appeal before a tribunal or court, then the taxpayer will be liable not only for the tax owed, but a substantial additional penalty.

As such, the regime can be understood as a way for HMRC to raise the stakes in a dispute, encouraging a taxpayer litigant to capitulate where a previous case (engaging essentially similar issues) has already been determined.

The Facts

In his tax return for FY 2000/01, Mr Haworth disclosed that he had entered into arrangements that, according to Mr Haworth, had the legal effect of enabling him to avoid UK capital gains tax on the disposal of shares which he had settled on a foreign trust.

Essentially, Mr Haworth had hoped that the double taxation treaty between the UK and Mauritius (the "DTT") would apply to confer exclusive taxing rights over the transaction on Mauritius instead of the UK.  In an effort to secure this result, he arranged for (1) the resignation of his Jersey trustees in favour of trustees resident in Mauritius prior to the disposal, and (2) the replacement of those Mauritian trustees by UK-resident trustees after the disposal and in the same fiscal year, which, according to Mr Haworth, would have the ultimate effect of enabling him to avoid UK capital gains tax.

There were two key legal premises underlying the arrangement, both of which had to hold for it to work:

1. that, by appointing the UK-resident trustees, the trustees of the settlement in question would not be UK non-resident for the entire fiscal year for the purposes of s.86 of the Taxation of Capital Gains Act 1992 ("TCGA 1992"), which would otherwise attribute gains to the settlor; and
2. that, there were no attributable chargeable gains made on the disposal for the purposes of the then-existing s.77 TCGA 1992 because of the DTT operating to confer exclusive taxing rights on Mauritius, coupled with the fact that no capital gains tax was payable under Mauritian tax law.

A very similar avoidance arrangement, based on the same mechanics, had been the subject of the Court of Appeal's decision in Smallwood.  In that case, the Court ruled that the efficacy of the scheme turned on the application of the tie-breaker provision in Art. 4(3) of the DTT and, with it, the question of whether the "place of effective management" ("POEM") of the trust was Mauritius or the UK instead.  It was only if the POEM of the trust was in Mauritius that Mauritius would have exclusive taxing rights under the DTT, with the consequence that premise 2 above would hold.  By a 2:1 majority, the Court of Appeal held that (i) the question of where the POEM was located was a question of fact, and (ii) the Special Commissioners below were entitled to find, on the basis of 7 factual pointers which they had identified (including the place at which the scheme had been devised and the steps for it orchestrated), that the POEM was in the UK for the fiscal year in question, which finding could not be impugned on appeal on Edwards v Bairstow grounds. Accordingly, premise 2 did not hold, and the scheme did not work.

Relying on the reasoning in Smallwood, HMRC served Mr Haworth with a follower notice accompanied by an accelerated payment notice after forming the opinion that it was "likely" that Smallwood covered his avoidance scheme.  HMRC also took the view that Smallwood stood for the proposition that the presence of the 7 factual pointers found by the Special Commissioners would inevitably lead to the conclusion that the POEM of a trust was the UK.

Mr Haworth brought an application for judicial review of HMRC's issuance of the follower notice, contending (amongst other things) that the statutory requirements for its issuance had not been satisfied and that the follower notice was therefore issued unlawfully.  HMRC succeeded at first instance (see [2018] EWHC 1271 (Admin)), and Mr Haworth appealed.  The Court of Appeal found for Mr Haworth (see [2019] EWCA Civ 747), concluding (amongst other things) that: (1) the phrase "would … deny the asserted advantage or a part of that advantage" required HMRC to have a "a substantial degree of confidence in the outcome" and not merely that it was "likely"; and (2) HMRC had misunderstood the Court of Appeal's conclusions in Smallwood and had misdirected themselves.  HMRC appealed to the Supreme Court.

The Supreme Court's reasoning

The Supreme Court had four issues to address:

• Issue 1: whether HMRC formed the opinion required by s. 205(3)(b) FA 2014, being that "the principles laid down or reasoning given in [Smallwood] would, if applied to [Mr Haworth’s] arrangements, deny the asserted advantage".
• Issue 2: whether HMRC had misdirected themselves in their analysis of Smallwood and whether this invalidated their decision to issue the follower notice.
• Issue 3: whether factual findings form part of the "principles laid down" or "reasoning given" in a previous court or tribunal ruling for the purposes of s.205(3)(b) FA 2014.
• Issue 4: whether the follower notice could be invalidated on the alternative ground that HMRC had failed adequately to explain in the notice its reasons for concluding that Smallwood determined Mr Haworth’s case.

Lady Rose JSC, delivering the Court's judgment, found for Mr Haworth and dismissed HMRC's appeal.

Issue 1

On the first issue, Lady Rose clarified that the phrase "would … deny the asserted advantage or a part of that advantage" in s.205(3)(b) meant that "HMRC must form the opinion that there is no scope for a reasonable person to disagree that the earlier ruling denies the taxpayer the advantage", and not merely that it was "likely" to do so.  This was because the provision had used the word "would" as opposed to "might", and because s. 205(3)(b) had to be construed in accordance with the taxpayer's constitutional right of access to justice.  Referring to the Court's earlier decision in R (UNISON) v Lord Chancellor [2017] UKSC 51, the Court reiterated that, "where a statutory power authorises an intrusion upon the right of access to the courts, it must be interpreted as authorising only such a degree of intrusion as is reasonably necessary to fulfil the objective of the provision in question".  Such a principle required the word "would" in s.205(3)(b) to be given its "full weight".

Lady Rose added that whether HMRC can "reasonably" form the opinion that an earlier ruling "would" deny the asserted advantage (or part thereof) may depend on four factors:

1. "[H]ow fact sensitive the application of the relevant ruling is" or, in other words, "whether a small difference in the fact pattern of the taxpayer’s arrangements or circumstances as compared with the fact pattern described in the earlier ruling would prevent the principles or reasoning applying".  If the earlier ruling was "very fact dependent", it may be "more difficult" for HMRC validly to opine that the ruling "would" deny the advantage unless its investigations have progressed to a stage where it has sufficient knowledge of the facts.  By contrast, where the earlier ruling is less fact sensitive, such as where "the taxpayer has entered into the same mass marketed tax avoidance scheme as the taxpayer in the earlier ruling so that the provisions applicable in his case are identical to those held to be ineffective by the earlier ruling", it may be easier for HMRC validly to hold such an opinion where there exists no material difference between the facts of both cases.
2. The truthfulness of the taxpayer's evidence.
3. Whether the taxpayer has raised an argument that was not raised in the earlier ruling, such as in R (Locke) v Revenue and Customs Comrs [2019] EWCA Civ 1909.
4. The "nature of the relevant ruling", such as whether it was arrived at a hearing where the taxpayer did not appear, or was unrepresented, or where its reasoning was brief or unclear.

Applying these principles, the Court held that, because HMRC had only opined that it was "likely" that Smallwood would deny Mr Haworth the advantage he asserted, HMRC had not formed the requisite opinion, and the follower notice was unlawfully issued.

Issue 2

Lady Rose answered this issue in the affirmative, reasoning that HMRC had "overstate[d]" the conclusions of the majority in Smallwood when forming its opinion.  Accordingly, Hughes LJ had not held (for the majority) in Smallwood that satisfaction of the 7 pointers identified by the Special Commissioners automatically meant that a trust's POEM would be in the UK.  Rather, all three judges of that court (including Hughes LJ) had accepted that the test was that set out in the Commentary on Art. 4(3) of the Model Double Taxation Convention, which counselled that “no definitive rule can be given and all relevant facts and circumstances must be examined to determine the place of effective management”.  The correct ratio of Smallwood on that point was instead that the Special Commissioners were entitled to make the factual finding that the POEM of the trust in question was the UK in light of those pointers.

The Court also rejected HMRC's submission that it was highly likely that HMRC would have reached the same outcome if it properly understood the ratio of Smallwood and that therefore s.31(2A) of the Senior Courts Act 1981 precluded a court from quashing the follower notice it made.  Lady Rose explained that it was "by no means self-evident" that this would have been the case, had HMRC not erred in its analysis of Smallwood.

Issue 3

Lady Rose also answered this question affirmatively, rejecting counsel for the taxpayer's submission that factual findings in a judgment do not form part of the "principles laid down" or "reasoning given" in a ruling for the purposes of s.205(3)(b).  The Court explained that a tribunal or court's answer to the question of whether a tax provision encompassed or applied to a particular thing, such as whether a mobile oil rig was a "ship" under a statute, could be a finding of fact (as per Clark (HM Inspector of Taxes) v Perks [2001] EWCA Civ 1228) and still would form part of the reasoning of that court's decision, which had precedential value for subsequent cases.

Lady Rose also explained that, where an appellate decision upholds a first instance tribunal's findings of fact, then the FTT's findings of fact "to that extent becomes the reasoning given in the appellate judgment".  This would be the case whether or not there had been an Edwards v Bairstow challenge against it, and irrespective of whether the appellate court agreed with the subordinate fact-finder's findings or merely said that it was entitled to make those findings.

Issue 4

The Court answered this issue in the negative, reasoning that s.206 FA 2014 on its proper construction did not make it that any defect in a follower notice would render it invalid.  Therefore, although HMRC's follower notice to Mr Haworth was deficient for not explaining why HMRC thought that Smallwood applied to his avoidance scheme, as was required by s.206(b), that did not invalidate it.

Comment

The Court's reasoning on the meaning of "would … deny the asserted advantage" in s.205(3)(b) is not surprising.  From both a textual and purposive standpoint, there was ample reason to think that the expression "would" was intended by Parliament in context to denote a degree of certainty greater than the civil standard of proof.  What was less clear to commentators, following the Court of Appeal's judgment below, was how much more certain that belief had to be.

The Supreme Court's identification of the relevant standard to be that HMRC must opine that there is "no scope for a reasonable person to disagree that the earlier ruling denies the taxpayer the advantage" has the advantage of being more precise than the Court of Appeal's formulation of "a substantial degree of confidence in the outcome".  That it also involves a higher standard is soundly justified by how follower notices (and the potential penalties they attract) are likely to dissuade taxpayers from exercising their constitutional right of accessing the courts, making it sensible that the conditions for their issuance should be interpreted narrowly.

That being said, it might still be queried what the notion of there being "no scope for a reasonable person to disagree" exactly means.  Ostensibly the phrase was meant to denote the impossibility of reasonable disagreement about whether the earlier ruling precludes the taxpayer from seeking the advantage, but that is still quite imprecise.  A subsequent court might be tempted to invoke the summary judgment test (i.e. effectively whether HMRC thinks that it is 'hopeless' for anyone to contend that the earlier ruling would not deny the advantage), but it is noteworthy that Lady Rose seemingly chose not to adopt the taxpayer's “no reasonable prospect of success” formulation, which may suggest that a slightly different test was being contemplated.

A related wrinkle has to do with the question of whether it will always suffice for s.205(3)(b) purposes that HMRC subjectively believes that there is "no scope for a reasonable person to disagree that the earlier ruling denies the taxpayer the advantage".  The Supreme Court's identification of the four factors bearing on whether "HMRC can reasonably form the opinion that an earlier ruling is relevant to the taxpayer’s asserted advantage" suggests that there is an added requirement of "reasonableness".  In other words, not only must HMRC form the opinion that no reasonable person would disagree that the earlier ruling denies the taxpayer the advantage, but it must also form that opinion "reasonably".  It is not entirely clear where this additional criterion comes from, given that s.204(4) and s.205(3)(b) do not state that any opinion must "reasonably" be held by HMRC.  One possibility is this is merely an "irrationality" standard precluding HMRC from forming an opinion that no reasonable body could have formed, although one might still question why the Court did not speak of "rationality" when it did so earlier in its judgment but chose the term "reasonabl[eness]" instead.