Supreme Court VAT ruling clarifies when time bar challenge can be used

The judgment also confirms that HMRC has an implicit power to refuse to pay a VAT credit while it verifies the validity of the claim and that any unfairness between the position for a repayment trader and an under-declaring payment trader does not amount to unjustified discrimination.

The Supreme Court’s clarifications on these two issues that arise in VAT disputes were provided in its decision in the case of DCM (Optical Holdings) Limited Ltd v HMRC.

What was the case about?

The decision concerned an appeal made by DCM (Optical Holdings) Limited, which was the holding company and VAT representative member of a group that ran optician and other health businesses, mainly trading as Optical Express.

While the group’s work supplying glasses is subject to VAT, the provision of eye tests and other optician services is not, making it a partially exempt VAT group.

Partially exempt businesses can, under section 19(4) of the Value Added Tax Act 1994 (VATA), recover some of their input VAT – that being the VAT paid on supplies to it – according to an appropriate method of apportionment between the taxable and exempt elements.

DCM has been in dispute with HMRC about its partial exemption method for nearly 25 years and there had been an earlier appeal to the tax tribunal and settlements of specific periods. This case concerned two specific issues.

Firstly, HMRC raised an assessment in October 2005, imposing its apportionment method – a percentage split – onto DCM for October 2002 to January 2004. DCM appealed against that assessment, arguing that HMRC was out of time to raise it – the “time-bar challenge”.

Secondly, DCM had submitted “repayment returns” to HMRC between 2008 and 2013. A repayment return is a return with a greater amount of input tax to claim than output tax to pay in the period. The effect, in usual circumstances, is that the business is entitled to a VAT credit, which is either set off against other amounts due from the business or repaid directly to the business. HMRC had decided that it would not make such credits or repayments to DCM until the returns had been verified. DCM challenged whether HMRC has the power to take that approach – the “vires challenge”.

The time-bar challenge

Subject to a four, previously three, year longstop, VAT assessments must generally be raised within two years of the relevant period or, if later, within “one year after evidence of facts, sufficient in the opinion of the Commissioners to justify the making of the assessment, comes to their knowledge”. DCM sought to rely on this one-year rule.

DCM argued that HMRC knew that “something was wrong” with its VAT apportionment method in January 2004 and, from then, had one year to make its assessment. HMRC’s assessment in October 2005 was therefore too late and invalid.

The Supreme Court found that the assessment was made within that time limit. There were several interesting elements to that conclusion, which will be relevant to anyone considering using this rule to challenge an assessment.

The Supreme Court approved the principles from the case of Pegasus Birds v HMRC in 1999, where five principles for applying this time-bar were established:

• the commissioners’ opinion is an opinion as to whether they have evidence of facts sufficient to justify making the assessment;
• the evidence in question must be sufficient to justify the making of the assessment in question;
• the knowledge referred to is actual knowledge, not constructive knowledge;
• the approach to adopt is to decide which facts justified the making of the assessment and then to determine when the last of those facts was communicated to the commissioners – the year starts to run at that point;
• an officer’s decision to make an assessment, or not, can only be challenged on the grounds that it is unreasonable under the so-called Wednesbury principle – that being no reasonable person acting reasonably could have held that opinion.

The Supreme Court confirmed that the reference in the legislation to “the making of the assessment” addresses the specific assessment that HMRC in fact made.

The taxpayer had sought to argue that, at a meeting in January 2004, HMRC had become aware that DCM was not using the percentage split method that had been agreed for earlier years and therefore could have raised an assessment based on that split at that time, meaning that the one-year limit expired in January 2005.

HMRC, by contrast, argued that the October 2005 assessment used figures obtained during a visit to DCM’s premises in September 2005 and that they were unable to raise the assessment before then.

Based on these principles, the Supreme Court upheld the first-tier tax tribunal’s (FTT) decision that HMRC obtained the last pieces of evidence relevant to its assessment in September 2005 when it visited DCM’s premises. As Lord Hodge put it – the Pegasus Birds principles, when applied to this taxpayer’s facts, “blow a hole in DCM’s case below the water line”. The clock for the one-year rule only began to run from this date because before it, HMRC did not have sufficient evidence of facts to raise the assessment that it did. DCM’s time-bar challenge was therefore dismissed.

What are the consequences for taxpayers?

Although the Supreme Court judgment limits the circumstances in which the one-year rule can successfully be relied upon, taxpayers should continue to consider whether this time limit has been met in deciding whether and how to challenge any VAT assessments. In so doing, taxpayers might also consider other FTT decisions on the one-year rule, although they are not binding. For example, in other cases, it has been found that:

• even where HMRC had information from one source they were entitled to seek verification of that information from another source without necessarily triggering the one-year time limit;
• where HMRC have sufficient information to make a best judgment assessment, the relevant officer may request further information in order to issue a more informed assessment. However, HMRC take the risk that the further information won’t be particularly useful in which case it might not reset the time limit;
• where there is evidence that the HMRC officer did consider that they had sufficient evidence to raise an assessment by a particular date, but does not do so within a year, any later assessment risks being time-barred even though further useful information may be obtained during the intervening period.

Taxpayers should bear in mind that:

• if the time-bar challenge proceeds to tribunal, it must then determine when the assessing officer received the last piece of evidence which, in the officer’s opinion, was of sufficient weight to justify the making of the assessment. The opinion of the assessing officer will be determined from contemporaneous emails or other correspondence and cross examination – it may be necessary to make a disclosure application to obtain information from HMRC’s records.
• the best possible case must be presented to the FTT, where the facts are found. Ultimately the facts found by the FTT undid DCM’s case because they showed that additional information, which contributed to the assessment made, was not obtained by HMRC until much later.
• if the HMRC officer was not themselves of the opinion that they had sufficient evidence, a taxpayer cannot run the argument that HMRC could have made an earlier, different, assessment based on the information that it had at an earlier point, before ‘topping it up’ later as required. That is unless the HMRC officer’s opinion was akin to Wednesbury unreasonable. The Upper Tribunal in the case of Rasul v HMRC in 2017 confirmed that the fact that the evidence might reasonably have been regarded as sufficient to form the basis of a valid best judgment assessment does not automatically mean that the officer’s opinion not to assess earlier is Wednesbury unreasonable, because the bar for a valid best judgment assessment is lower.

The vires challenge

DCM argued that HMRC did not have the power to reduce its VAT credits because section 25(3) of VATA mandates that, if the amount of input VAT exceeds the amount of output VAT, the excess must be paid to the taxable person by HMRC as a VAT credit. DCM relied on the wording “the amount of the credit or, as the case may be, the amount of the excess shall be paid”, arguing that the words “shall be paid” do not allow any discretion.

The Supreme Court acknowledged that there is no express power allowing HMRC to refuse to pay, however it dismissed the challenge, finding that it is implicit in section 25(3) that the obligation on HMRC to pay a VAT credit arises only once it is established by the verification process that the VAT credit is due.

The Supreme Court cited six reasons for its conclusion:

• HMRC has the power and duty to conduct a reasonable and proportionate investigation into the validity of claims and is entitled to take a reasonable time to investigate before authorising payment;
• having established the power, HMRC can simply tell the taxpayer their decision, and is not obliged to use specific legislative provisions to deal with the non-payment, e.g. asking the trader to amend its return or requiring security as a condition for payment;
• the obligation to pay under section 25 only arises once it is established that the VAT credit is due, i.e. the “shall” only applies to a valid VAT credit and the obligation to pay does not depend solely on the say-so of the taxpayer;
• HMRC’s power to verify and to refuse to pay sums which are not due is implicit in the statement of HMRC’s duty in Schedule 11 to VATA which states: “[HMRC] shall be responsible for the collection and management of VAT”;
• the principle of fiscal neutrality, which the Supreme Court stated “underpins EU law and domestic law jurisprudence in relation to VAT”, requires the verification exercise before payment in order to prevent an “unwarranted cash flow advantage” to a repayment trader when compared with a payment trader. Although a payment trader that understates its output tax and therefore pays less than is due would be in a better position, the Supreme Court concluded that this difference of treatment did not amount to unjustified discrimination;
• HMRC’s power to verify claims and to refuse to pay out is not inconsistent with VATA and a taxpayer can still, if HMRC’s verification exercise is not expeditious or proportionate, pursue a claim in judicial review.

The impact of the vires decision on taxpayers

The court’s ruling on DCM’s vires challenge is interesting because it means that HMRC can refuse to pay a repayment return while a claim is being verified, provided the verification process is not conducted unreasonably. As the Supreme Court noted, this could present a cash flow issue for certain businesses and gives payment traders an advantage over repayment traders. If a payment trader overstates their input tax, for example, they only initially need to pay the sum in their VAT return, whereas a repayment trader must wait for verification.

Although HMRC is under a duty to process claims and undertake verification expeditiously, the difficulties caused to some taxpayers are unlikely to be alleviated by the potential option to pursue judicial review.

On a practical level, it is helpful to have clarification that after carrying out the verification process, HMRC does not have to follow a specific procedure, but may simply give its decision to the taxpayer. That decision is then appealable under section 83(1)(c) of VATA.

Editor's note 30/11/22: The original version of this article, published on 20 October 2022, has been updated with this longer form version. An earlier version of this longer form report was published by the Tax Journal on 16 November 2022.