The High Court held that the Revenue were not precluded from making a discovery assessment in respect of a payment made by the taxpayer into an employee benefit trust merely because it would have been reasonable for the inspector to initiate an inquiry into the taxpayer's tax return to reveal the true facts of the matter. The burden of proof was on the taxpayer to show that there was a mistake in its return to which the exclusion in FA 1998, Sch. 18, para. 45 applied.

Facts

This was an appeal by way of case stated by the Revenue against a decision of the general commissioners whereby they allowed the appeal of the taxpayer company, against an assessment to corporation tax in respect of its accounting period ended 31 December 1999. The assessment was a 'discovery assessment' made pursuant to para. 41 of Sch. 18 to the FinanceAct 1998, made on the basis that an amount which ought to have been assessed to tax had not been assessed.

The purpose of the assessment was to charge to corporation tax a sum of £60,000 which the taxpayer had contributed in 1999 to an employee benefit trust (EBT) established by it in the previous year, and which the taxpayer had deducted in computing its trading profits chargeable to tax under Sch. D, Case I for its 1999 accounting period. There was no dispute that the deduction was properly made in accordance with normal accountancy principles, but following the decision of the House of Lords in July 2005 in Macdonald (HMIT) v Dextra Accessories Ltd [2005] BTC 355, the Revenue took the view that the deduction was disallowed by the provisions of FA 1989, s. 43 on the basis that the payment of the £60,000 was a payment of 'potential emoluments' within the meaning of s. 43(11), and no part of that sum had been paid as actual emoluments to beneficiaries of the EBT before the expiry of nine months from the end of the 1999 accounting period.

The taxpayer accepted, in the light of the decision in Macdonald v Dextra, that the assessment was correct both in principle and in amount. Nevertheless, the taxpayer contended successfully before the general commissioners that the assessment was invalid on two separate grounds: (1) the assessment was not made in the circumstances specified in Sch. 18, para. 44, which applied where, as in the present case, a taxpayer had delivered a company tax return, and empowered the Revenue to made a discovery assessment if at the time when they ceased to be entitled to give a notice of enquiry into the return, they could not have been reasonably expected, on the basis of the information made available to them before that time, to be aware of the relevant situation mentioned in para. 41(1) (i.e. in the present case that an amount which ought to have been assessed to tax had not been assessed); and (2) the assessment was also precluded by Sch. 18, para. 45, which provided that no discovery assessment could be made for an accounting period for which a company had delivered a company tax return if the relevant situation in para. 41(1) was attributable to a mistake in the return, and the return was in fact made 'on the basis or in accordance with the practice generally prevailing at the time when it was made'. The Revenue appealed.

Issue

Whether the Revenue were precluded from making a discovery assessment by the restrictions in FA 1998, Sch. 18, para. 44 and 45.

Decision

Henderson J (allowing the appeal) said that it seemed that the commissioners had concluded that the objective non-awareness test in Sch. 18, para. 44(1) was not satisfied, because at the end of the enquiry window period (which was agreed to have been 31 December 2001) the inspector knew of the existence of the EBT and the payment into it of £60,000 in July 1999, and on any reasonable view he ought to have opened an enquiry within the window period given the Revenue's view that payments into an EBT were not deductible 'except in circumstances which would negate the purpose of the EBT'.

However that conclusion could not be supported in the light of the decision of the Court of Appeal in Langham (HMIT) v Veltema [2004] BTC 156.

The crucial point was that FA 1989, s. 43 did not automatically disqualify from deduction all potential emoluments held by the trustees of an EBT, but only emoluments which were not actually paid to employees before the end of the specified period (see s. 43(1)(c), which stated that as one of the conditions which had to be satisfied if s. 43(2), which prohibited the deduction in year one, was to apply).

There was no suggestion that the terms of the EBT in the present case were such that it would have been impossible for the £60,000 to be applied in the payment of actual emoluments within the specified period, i.e. before the end of September 2000.

Accordingly, however unlikely it might have been as a matter of practical common sense, it was a course of action legitimately open to the trustees, and there were therefore circumstances in which the taxpayer could properly have deducted the £60,000 in computing its Sch. D profits. Since the taxpayer computed its profits on the basis that the £60,000 was deductible, and since no relevant adjustment was made to reverse that deduction in the tax computation submitted to the inspector, he was entitled to proceed on the basis that the taxpayer's self-assessment was correct. There was nothing in the taxpayer's tax returns for 1999 or the two immediately preceding accounting periods (the ‘relevant returns’ for the purposes of para. 44), or in the documents accompanying those returns, which should have clearly alerted the inspector to the insufficiency of the taxpayer's self-assessment.

Nor could it be said that the inspector could reasonably be expected to have inferred, from the mere existence of the EBT and the payment into it of £60,000, that the money had not in fact been paid as actual emoluments to employees before the end of September 2000. The only reasonable inference that the inspector could have drawn from the relevant information supplied to him by the taxpayer was that the money had been so paid, because that was the only basis upon which the self-assessment could be correct. Had he applied his mind to the question, his experience of other EBTs, and indeed common sense, might well have led him to doubt the correctness of the self-assessment and to open an enquiry; but that was very different from saying that he should be regarded as knowing, or as having inferred, what such an enquiry would probably have revealed.

Accordingly, the Revenue were not precluded from making a discovery assessment in the present case merely because it would have been reasonable for the inspector, had he thought about it, to initiate an enquiry into the taxpayer's 1999 return which could have been expected to reveal the true facts.

The commissioners decided that issue by reference to the burden of proof, holding in para. 3 of their conclusions that para. 45 did not apply because HMRC had not satisfied them that the return was not made in accordance with a generally prevailing practice. In other words, that the burden was on HMRC to satisfy them that the return was not, in the words of para. 45, 'in fact made on the basis of or in accordance with the practice generally prevailing at the time when it was made'; and that since HMRC had adduced no evidence to discharge that burden, it was not open to them to make a discovery assessment.

The commissioners plainly fell into error in adopting that approach to para. 45. It was necessary to begin by examining the relationship of para. 45 to para. 42, 43 and 44. By virtue of para. 42(1), the power to make a discovery assessment for an accounting period for which the company had delivered a company tax return was 'only exercisable in the circumstances specified in paragraph 43 or 44 and subject to paragraph 45 below'.

Thus it was only necessary to consider para. 45 in a case where the conditions of either para. 43 or 44 were satisfied, and it operated as a further restriction on the power of the Revenue to make a discovery assessment. However, as a matter of general principle, the burden of proof rested on the party who asserted that there had been an operative mistake in the return, and that the return was in fact made in accordance with the generally prevailing practice. The burden lay on the taxpayer to establish that para. 45 applied, not on the Revenue to establish that it did not apply.

Chancery Division.
Judgment delivered 12 July 2007.