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In this post, Tim Sales, a partner in the Dispute Resolution team at CMS, and Hannah Jones, who works in the Tax team at CMS, comment on the decision handed down by the UK Supreme Court in the matter of R (on the application of Haworth) v Commissioners for Her Majesty’s Revenue and Customs [2021] UKSC 25.

The Supreme Court has unanimously dismissed HMRC’s appeal against the Court of Appeal’s decision to quash a follower notice (and the associated accelerated payment notice) issued to Mr Haworth and, in doing so, has provided helpful clarification on some of the principles applying to follower notices generally.

Context

Where HMRC considers that a taxpayer has used a tax avoidance scheme which has previously been successfully litigated by HMRC, the follower notice regime (contained in Chapter 3 of Part 4 to the Finance Act 2014) allows them to issue a notice to that taxpayer, demanding that they counteract or surrender the tax advantage claimed. Since the regime:

  • allows a substantial penalty (up to 50% of the advantage claimed) to be levied on the recipient if they unsuccessfully dispute the follower notice; and
  • paves the way for HMRC to issue an accelerated payments notice (which broadly requires the payment of the disputed sum within 90 days of receiving the notice),

the legislation bestows HMRC with considerable power vis-à-vis the taxpayer.

Due to the regime’s punitive nature, the Supreme Court’s judgment in Haworth, which many see as imposing a curb on HMRC’s powers under the follower notice regime, is likely to be seen as a significant victory for the taxpayer.

Background

The alleged tax avoidance scheme used by Mr Haworth involved the appointment of Mauritian trustees to a trust of which Mr Haworth was the settlor. This was effected in order to take advantage of the UK/Mauritius double tax treaty (the “Treaty”) and so avoid a tax charge on a capital gain arising on a disposal of shares held by the trust. Mauritius was the chosen location of the trustees because (i) it has no capital gains tax equivalent and (ii) the Treaty (under Article 14(3)) provides for any capital gain to be taxable solely in the jurisdiction where the “alienor” (i.e. the legal person transferring the shares) is tax resident.

In order to be able to take the advantage of the Treaty – and specifically Article 14(3) – the Mauritian trustees had to resign and be replaced by UK resident trustees before the end of the tax year in which the disposal took place. Mr Haworth’s tax return was then filed on the basis that the trustees were, at the time of disposal, tax resident in Mauritius under the Treaty (as Mauritius was the “place of effective management” of the trust). This type of arrangement is commonly known as a “round-the-world” scheme.

HMRC’s contention was that Mr Haworth’s arrangements, as described above, were, in all material respects the same as those used by the taxpayer in HM Revenue and Customs v Smallwood & Anor [2010] EWCA Civ 778 (“Smallwood”), where it was decided that the “place of effective management” of the trust in question was the UK at the time of the disposal in question, and therefore the gain was subject to UK capital gains tax.

Mr Haworth challenged the follower notice (and accelerated payment notice) via judicial review proceedings.

The relevant statutory framework

Under section 204, four requirements must be met for HMRC to issue a follower notice. It was the meaning of the third condition (known as Condition C) which was at the centre of both parties’ arguments as the case progressed through the courts.

Condition C states that, as a requirement for issuing a follower notice, HMRC must be “of the opinion that there is a judicial ruling which is relevant to the chosen arrangements”.

In order for a judicial ruling to be deemed to be “relevant to the chosen arrangements”, it must be the case that “the principles laid down, or reasoning given, in the ruling would, if applied to the chosen arrangements, deny the asserted advantage or part of that advantage” (section 205(3)(b)).

The particular issue was the meaning of “would” in section 205(3)(b).

Further points raised in front of all three courts were:

  • whether the notices (due to their brevity and lack of explanation of HMRC’s reasoning) had failed to meet the requirement to explain why HMRC considered that section 205(3)(b) was met in respect of the ruling – and were therefore defective and invalid; and
  • whether HMRC had misdirected itself in its analysis of Smallwood, and its application of Smallwood to Mr Haworth’s trust’s arrangements.

Decisions of the lower courts

The High Court found in favour of HMRC. Mr Justice Cranston held that:

  • the principles and reasoning contained in Smallwood were capable of application to other similar schemes by other taxpayers, including Mr Haworth’s;
  • HMRC were correct to decide that Smallwood denied the asserted tax advantage to Mr Haworth’s trust (because its “place of effective management” was, per Smallwood, in the UK); and
  • the follower notice was neither defective nor invalid, despite Mr Haworth’s contention that the notices did not contain sufficient detail or explanation.

Mr Haworth appealed to the Court of Appeal.

The Court of Appeal then quashed the notices, holding that:

  • in order to give a follower notice, it was not enough for HMRC to consider that the principles or reasoning in a ruling would be “more likely than not” to deny the tax advantage – they must consider that it “would” deny that advantage; and
  • HMRC had misdirected themselves in their analysis of Smallwood and particularly its application to Mr Haworth’s trust arrangements.

However, the Court of Appeal disagreed with Mr Haworth on two points:

  • while the follower notice was defective (since it failed to explain HMRC’s reasoning for considering that Smallwood was “relevant” to the chosen arrangements), that did not render it invalid; and
  • that the phrase “the principles laid down or reasoning given” in section 205(3)(b) does not refer solely to the ratio of a judgment, but, more widely, to other reasoning laid down in it.

The four issues before the Supreme Court

HMRC’s appeal to the Supreme Court raised four issues:

  1. Does the phrase “principles laid down or reasoning given”, as set out in section 205(3)(b), refer exclusively to points of law determined in the judicial ruling in question, and not points of fact?
  2. Had HMRC failed to meet the level of certainty required by the word “would” in subsection 205(3)(b)?
  3. Had HMRC misdirected itself in its analysis of Smallwood? In particular, had they overstated the significance of the judgment, in particular the list of “pointers” which indicated that the trust’s place of effective management and control was in the UK?
  4. Was the follower notice defective (and, if so, was it invalid) because it failed to explain sufficiently why HMRC considered that the Smallwood ruling determined Haworth’s arrangements, thereby failing to meet the requirements of section 206?

The first and last issues were raised by Mr Haworth, with the second and third issues raised by HMRC.

The Supreme Court disagreed with Mr Haworth on the first issue. They reasoned that the phrase “principles laid down or reasoning given” does not narrow the scope to the ratio of a case, but also includes findings of fact.

However, Lady Rose (in delivering the decision on behalf of the Supreme Court) found in favour of Mr Hawarth on the second and third issues (leading to the quashing of HMRC’s appeal). The Court strongly disagreed with HMRC’s argument that “would” in section 205(3)(b) required no more than for HMRC to consider that the principles or reasoning given in Smallwood were “more likely than not” to result in the advantage asserted by Mr Haworth to be denied. In passages that will become key weapons in a taxpayer’s future defences against follower notices, the judgment:

  • concludes that it is clear that the word “would” requires “more certainty than just a perception that there is a 51% chance of the advantage being denied”; and
  • rejects HMRC’s contention that if Parliament had intended the wording of s205(3)(b) to mean that the taxpayer’s asserted advantage (in light of the successfully litigated case) was “hopeless”, the legislation would have clearly provided for it.

In the judgment, there was a clear focus on the particularly penal nature of the follower notice and accelerated payments notice regimes, in particular the significant penalties and the restriction on the constitutional right of access to the court.

The Court also found in favour of Mr Haworth on the third issue, concluding that the Court of Appeal, in its judgment in Smallwood, should only have been understood to be providing “pointers” where it is open to the Special Commissioner to say that the place of effective management of a trust is in the UK; rather than providing a determinative list of factors.

Mr Haworth was less successful in respect of the fourth issue, with the Supreme Court deciding that the follower notice was not invalid. This is perhaps a surprising result since Lady Rose did agree that the follower notice was “deficient” (in respect of the requirement in section 206(b) in particular), since it was drafted in generic terms and failed to explain why HMRC reasoned that the “place of effective management” of the trust was the UK. However, the Court considered that “total invalidity” should not result from “any” irregularity, and pointed to the fact that Mr Haworth was not prejudiced by the lack of explanation, since he and his advisors clearly understood HMRC’s arguments and responded in detail to their assertions.

Comment

On the meaning of the word “would” in section 205(b), the Supreme Court’s judgment will be seen as a significant “win” for the taxpayer. The court is clearly of the opinion that the bar for issuing a follower notice is far higher than that which has presumably been understood, and operated on, by HMRC to-date.

On the other hand, HMRC will undoubtedly be pleased with the court’s decision that, where a follower notice is deficient by virtue of its failure adequately to explain HMRC’s reasons for a previous judgment denying the asserted tax advantage, as required by section 206(b), it will not necessarily be rendered invalid. However, it remains to be seen whether, if the taxpayer in question is prejudiced by even a small irregularity, rather than more serious non-compliance, the courts could take a different view.