If HMRC discovers that tax has been underpaid, the lost tax may be recovered with interest and financial penalties.
The underpaid tax can be recovered through the enquiry process if the discovery is made before the deadline for opening an enquiry.
However, if the underpayment is discovered after the enquiry deadline then a discovery assessment may be made.
For most practical purposes, UK legislation provides a two-hurdle test as to whether a discovery assessment can be made after a return has been submitted and the deadline for opening an enquiry into that return has passed
First – The HMRC officer must discover an insufficiency of tax. This hurdle is not very high; it doesn’t require a new fact to come to light or new understanding of the law.
Second – The officer could not have been reasonably expected, on the basis of the information made available to him from the taxpayer before the enquiry deadline, to be aware of the insufficiency of tax. In other words, if the officer could have been reasonably expected to be aware of the insufficiency of tax before the enquiry deadline then a discovery assessment can’t be made.
Therefore, making information available that is sufficiently complete and simple so that if HMRC review the return it’s obvious to the officer that there is an underpayment, is an important hurdle for the taxpayer to overcome to avoid a discovery assessment.
This note looks at which years HMRC are entitled to challenge and the legal background to discovery assessments, in particular the importance of the quality of information made available by the taxpayer.
Discovery assessments in UK Transfer Pricing audits
In common with tax authorities around the world, the UK tax authorities (HMRC) view Transfer Pricing (TP) as a high risk area, resulting in an increase in TP enquiries across all sectors.
This note looks at which years HMRC are entitled to challenge, with reference to the long-standing concept of “discovery” in UK tax law and the importance of the quality of information provided by the taxpayer before the enquiry deadline. It doesn’t go into the detail of all aspects of the discovery statute and case law, but covers the salient points for TP.
The UK operates a “self-assessment” (SA) regime for corporation tax that requires companies to complete an SA return by a due date.
HMRC then has a statutory right to open an enquiry into that return. Such an enquiry will cover the period(s) of that return.
The time limit for giving a notice of enquiry in most TP cases is twelve months from the statutory filing date, longer for late-delivered returns.
If an enquiry is opened and the SA return is found to be incorrect, HMRC has powers to recover any underpaid tax.
In some circumstances HMRC may also recover underpaid tax in earlier years, even though there are no open enquiries for these years and the enquiry windows have closed. This can be done by means of discovery assessments.
Therefore, the question whether HMRC is entitled to raise a discovery assessment for an otherwise out-of-time accounting period is of real practical significance.
Paragraphs 41 – 49, Schedule 18 of Finance Act 1998, allow an HMRC officer to make a corporation tax discovery assessment for an accounting period of a company on discovering that:
– an amount which ought to have been assessed to tax has not been assessed, or
– an assessment to tax is or has become insufficient, or
– relief has been given which is or has become excessive.
A discovery determination may be made for an accounting period of a company where an incorrect return affects the tax payable for another accounting period or for another company.
The amount of the discovery assessment is the amount which, in the officer’s opinion, ought to be charged to make good the loss of tax.
The normal time limit for HMRC to make a discovery assessment, in the absence of careless or deliberate behaviour by the company or a person acting on its behalf, is four years from the end of the accounting period to which the assessment relates.
HMRC does not owe any general duty to the taxpayer to raise assessments promptly on making a discovery. An assessment raised within the statutory time limit is not invalidated by any delay by HMRC.
To protect the taxpayer, discovery is subject to a couple of statutory conditions, one of which must be met to allow HMRC to make a discovery assessment.
Firstly, the loss of tax has to be attributable to careless or deliberate behaviour by the company.
Secondly, in the absence of careless or deliberate behaviour, an HMRC officer can still make a discovery assessment for an accounting period where: a) the company has delivered a tax return, b) the deadline for opening an enquiry has passed (or enquiries have been opened and formally concluded) and c) where the officer could not have been reasonably expected, on the basis on the information available to him before that time, to be aware of the underpayment of tax.
The latter is the scenario most likely to be in point in a TP enquiry.
The word ‘discovers’ has a long history in UK tax law. The making of a discovery assessment and the legal meaning of the word ‘discover’ has been much litigated in the UK.
The courts/tribunals have sought to set out the scope of the test for when HMRC is insufficiently informed of the company’s circumstances and may therefore raise a discovery assessment.
In Hankinson(6), the Court of Appeal held that the meaning of the word ‘discovers’ has not changed following the introduction of self-assessment.
Accordingly, the leading authority remains Cenlon Finance(1), where the House of Lords held that it was not necessary for the officer to be required to ascertain a new fact to entitle him to have ‘discovered’ for the purposes of raising a discovery assessment. It is sufficient that it ‘newly appears that the taxpayer has been undercharged’.
In Langham(2), where agreement with HMRC over a valuation had not been reached at the end of the enquiry window, Auld LJ said there was “… no basis upon which … the Inspector ought reasonably to have been aware of the [tax] insufficiency …: until the higher value was later agreed”. Therefore, in these circumstances, the Inspector could not “reasonably be expected” to infer that the assessment was incorrect on the basis of the information given at the end of the enquiry window.
Auld LJ further stated that there was no obligation on tax inspectors to conduct a time-consuming scrutiny of self-assessment returns that do not disclose an insufficiency simply to establish, before the enquiry deadline, whether or not there was an insufficiency. He said that the statutory test was concerned with what an inspector could have been reasonably expected to be aware of from the information made available to him by the taxpayer relating to an actual insufficiency in the assessment, not with what the inspector could reasonably have been expected to do to check whether there is such an insufficiency.
However, there must be a basis for the different view being held by HMRC. HMRC accepts that ‘mere suspicion’ that an assessment may be insufficient is not enough. (HMRC Statement of Practice 1/06)(3)
In Kennerley (4), an HMRC officer requested a considerable amount of information in relation to a taxpayer’s self-assessment return. This request was made within the enquiry window but no enquiry notice was ever given. Eventually a discovery assessment was raised for that year. The Special Commissioner held that the discovery provisions had no time limit on its application (other than the statutory limits) and did not require an enquiry to have been opened. There had clearly been a discovery that the self-assessment was insufficient and therefore the discovery assessment was valid. (This is of course subject to other cases which require, at least in a case where a return has been submitted, the discovery to be made after the end of any enquiry window. In other words, if there were still time for the matter to have been dealt with in the course of any enquiry, there could be no discovery.)
In Corbally-Stourton(5) the Special Commissioner stated that ‘what is required is that he (i.e. the officer) comes to the conclusion on the information available to him and the law as he understands it, that it is more likely than not that there is an insufficiency. I shall call this a conclusion that it is probable that there is an insufficiency.’ He added that “it is clear however that mere suspicion, something short of a conclusion that it is probable that there is an insufficiency, is not enough.”
In addition, in Hankinson(6) the First Tier Tribunal held that the relevant test is that ‘the officer must have evidential basis beyond mere suspicion in order to arrive honestly at the conclusion that, on balance, there is an insufficiency.’
In Lansdowne(7) the Chancellor (Morritt) in the Court of Appeal made similar observations as were made in Langham.. He adopted the reasoning of Auld LJ which said that the question boiled down to ‘whether the hypothetical Inspector having before him [documents and a note of meeting] would have been aware of an actual insufficiency’ in the returned profit.
Moses L.J. in Lansdowne expressed the view that the question is “whether the taxpayer has provided sufficient information to an officer, with such understanding as he might reasonably be expected to have, to justify the exercise of the power to raise the assessment to make good the insufficiency.” In this case the Court decided that the taxpayer had provided sufficient information before the enquiry deadline for the officer to be aware of an insufficiency in the self-assessment.
This is a very clear statement of what the test involves on the part of the taxpayer (that it should provide sufficient information such that a subsequent assessment is not justified) and on the part of the Inspector (who must justify an assessment to make good an insufficiency on the basis of the understanding he could reasonably be expected to have).
The Blumenthal(8) case commented on when the “reasonable inspector” should have been aware of an insufficiency of tax, making these points:
– The disclosure (i.e. the information provided by the taxpayer) needs to be sufficient to enable an officer to determine whether or not an insufficiency exists.
– The adequacy of the disclosure depends on the nature of the arrangements and does not involve any consideration of the ‘assumed knowledge’ of the inspector; there is no need to debate whether or not head office should have been involved. The disclosure must make clear the facts and the position that the taxpayer takes on those facts (but not what HMRC might think about the position).
– Where the facts and law are complex – disclosure needs to be more than just the facts – it needs to include ‘some brief explanation of the main tax law issues and the position taken in respect of those issues’. The inspector is not required to play ‘spot the fiscal ball’.
– If the disclosure in the return includes all the material facts and, in complex cases, an adequate explanation (which can be brief) of the technical issues raised by those facts and the position taken in relation to those issues, it would be reasonable to expect an officer to be aware of an insufficiency.
The Blumenthal Tribunal found for HMRC on the discovery issue.
They accepted that if disclosure (both factual and technical) is adequate in the circumstances of the case then a hypothetical officer can reasonably be expected to be aware of an insufficiency in tax payable, even in a complex case or one involving specialist technical knowledge.
However, they concluded that this was not the case here. The disclosure must alert the officer to an objective awareness of an actual insufficiency and it was considered that the Blumenthal disclosure did not do so.
Charlton(9) First Tier Tribunal confirmed that there is a discovery where it has “newly appeared to an HMRC officer, acting honestly and reasonably, that there is an insufficiency in an assessment. That can be for any reason, including a change of view, change of opinion, or correction of an oversight”. The officer in mind is a “hypothetical officer”.
So, he must have pertinent material before him, provided by the taxpayer, upon which to found his decision, which must be a reasonable conclusion drawn from that material. (Charlton)
The Upper Tribunal in Charlton said that the ‘correct focus … is on the quality and extent of the information made available [by the taxpayer], and not on the qualities of the hypothetical officer’. ‘All that is needed is that from the information available to the hypothetical officer he can reasonably be expected to be aware of the insufficiency of tax such as to justify an assessment.’
The Upper Tier Tribunal added “We accept that the test is not whether the officer should have opened an enquiry. There is a clear distinction between cases where the information made available to the officer merely raises questions, which can only be resolved by the obtaining of further information, and those where the available information provides awareness of an insufficiency that is sufficient to justify the making of an assessment. Langham v Veltema is an example of the former case; Lansdowne an example of the latter.”
In Smith(10), which involved an avoidance scheme, the appellant disclosed details of the offending transaction but failed to state specifically that this was related to an avoidance scheme and did not provide the scheme’s HMRC reference number. Therefore, it was concluded that the Inspector could not have been reasonably expected, on the basis of the information made available to him by the taxpayer, to be aware of an insufficiency. So, even though HMRC had an awareness of the scheme, it was held that the only information which can be taken into account is that actually provided by the taxpayer himself.
Charlton is distinguishable from Smith because in Charlton the taxpayers had declared in their self-assessment returns that they had participated in an avoidance scheme and had included the avoidance scheme reference number allocated by HMRC.
So the inspector cannot be taken to know every fact known to HMRC nor is he expected to carry the entire corpus of knowledge relevant to his job in his head. However, he should know when he has to look things up and where to look, and when he needs to consult colleagues. In addition, he should be equipped to do the job and to perform the role within HMRC for which he has been appointed.
Therefore, whilst it is not necessary for an HMRC officer to have legal evidence of a tax underpayment, there must be sufficient evidence to support a genuine discovery by the officer.
In other words, making information available that is sufficiently complete and simple so that if HMRC review the return it’s obvious to the officer that there is an underpayment, is a critical hurdle for the taxpayer to overcome to avoid a discovery assessment.
Bye for now.
1 – Cenlon Finance Co Ltd v Ellwood  AC 782
2 – Langham v Veltema 76 TC 259 CA;  STC 544;  EWCA CIV 193
3 – HMRC Statement of Practice SP1/06
4 – Kennerley v R&C Commrs  SpC 578
5 – Corbally-Stourton v HMRC  STC (SCD) 907 Sp. Comm.
6 – Hankinson v HMRC  UKFTT 384 (TC)
7 – HMRC v Lansdowne Partners Ltd Partnership  EWCA Civ 1578
8 – William Blumenthal v HMRC  UKFTT 497 (TC)
9 – HMRC v Charlton and others  UKUT 770 (TCC)
10 – Robert Smith v HMRC  TC2768
Tax Journal article, 3 February 2012, Analysis – Discovery assessments post-Hankinson
Tax Journal article, 11 October 2012, ‘Charlton: discovery assessments’
Taxation Magazine article, 13 November 2013, “A discovery too far”
HMRC Company Taxation manual, CTM95030 et seq
Taxes management Act 1970, S29 et seq
Finance Act 1998, Schedule 18, Paragraph 41 et seq
Wolters Kluwer, CCH Online
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