Why the Revenue had to stop a managed service company Invistigation

What do you do when your client rings you up and says that she has just received … no ordinary letter from the Revenue & Customs, but one suggesting that she might be running a managed service company? This happened to me last year, and she knew and I knew the implications at once – certain bankruptcy for her if they prevailed, and considerable damage to my reputation as I had advised her (with the help of learned counsel, be it said) how to make sure that she was on the right side of the law here. Fortunately I had also warned her at the time that, with the sector that she was in, her card was marked, and a Revenue investigation on these lines was more likely than not. Forthrightness with one’s clients generally pays off.

The managed service company (‘MSC’) rules are possibly the most deadly in the whole of the tax code. They were introduced in April 2007 as sections 61A to 61J of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA’) and the Social Security Contributions (Managed Service Companies) Regulations 2007, to combat mass market avoidance of PAYE and NI amongst service companies. They followed on from the IR35 legislation, which had come to be widely seen as ineffective. The MSC legislation is particularly punitive as it can be used to transfer PAYE and National Insurance debts to directors and owners of companies. For the kind of company that it is aimed at, the tax liability will frequently be in the order of fifteen times its profit margin. No-one is going to be able to afford to pay that.

I was confident that we would be able to ward off this threat by conventional means – I had after all advised the client how to arrange her affairs. However nothing is certain in law, and it turned out that we had another interesting weapon in our armoury, so we decided to leave nothing to chance. A VAT inspector had come along some years back and determined that our client was supplying medical services (exempt), not medical staff (standard-rated). The difference between the two is too arcane to go into here; suffice it to say that it looked to me like an exact mirror of the test in S. 61B(1)(a) of ITEPA, which says that a company is an MSC if ‘its business consists wholly or mainly of providing … the services of an individual to other persons’. Counsel then confirmed his view that this was just so.

So – what is sauce for the goose is sauce for the gander. We wrote to HMRC and pointed out that they had in effect already made a decision on this one, and it was negative. We did, of course, supply them with enough information for them to be able to see that the clients’ contracts had not changed since the VAT inspection, but told them that they were not getting anything more. Needless to say they issued an information and documents notice compelling us to disgorge rather more than this, so we lodged an appeal with the Tax Tribunal against the notice. Some months later HMRC told us that they were not going to contest our appeal. No reasons were given for backing down, so one can only guess at what might have caused this change of approach. However it seems likely that there were some or all of three factors at play, as follows:

 1 – The Tax Tribunal can now hear points of public law (at least sometimes).Public law concerns the behaviour of public bodies, and until recently it was thought that the Tribunal could not concern itself with these. One had to bring a judicial review (often in proceedings parallel with those that the Tribunal could hear) – a very expensive, cumbersome and uncertain process.

This all changed with Oxfam v. H.M. Revenue & Customs [2009] EWHC 3078 (Ch.) in 2009, in which Sales J. explained that there were quite a number of circumstances in which the Tribunal could hear points of public law, although in tax matters this did have to be explicitly laid down in statute. What we were complaining about was not that HMRC were necessarily wrong in their approach to MSC’s, but that they were bound by what they had decided previously in our client’s case: we had what lawyers know as a ‘legitimate expectation’. The Revenue notice had been given under paragraph 1 of Schedule 36 to the Finance Act 2008, which enables a Revenue officer to require someone to provide information or documents ‘if the information or document is reasonably required by the officer for the purpose of checking the taxpayer’s tax position’ [my italics]. Whenever one sees the word ‘reasonably’ in a statute one knows that one is in public law territory. However paragraph 29 is quite explicit: an appeal against this kind of notice is to the Tribunal.

2 – A decision made with respect to one tax can be binding on HMRC’s approach to other taxes. Legitimate expectation is a fast-changing area of public law that has developed hugely over the last twenty years, and we could find no exact precedent for this. A publicauthority is bound by a promise made or a procedure laid down (either formally or well established in practice). What we had here was neither of these: it was an unsolicited decision made as to the character of our clients’ contracts. Had the clients asked HMRC for clearance as to the VAT treatment of their supplies, the legitimate expectation would unquestionably have been confined to VAT. It was the fact that the decision was made on HMRC’s initiative that would have been crucial here in extending it to another tax.

3 – There may be public policy reasons for HMRC to refrain from challenging cases in the Tribunal. With their vast resources, £14 million at stake (or so they said), and a well-known desire to make their MSC legislation stick, why would HMRC so suddenly back off? Our case on the first point above – that the tribunal could hear this point – might look pretty robust, but on the second? This, surely, was novel territory: there were no precedents, and add to this the fact that public law remedies are always discretionary – would that not have been worth their while fighting? Well, evidently not. We do not know why, but there is a possible – indeed, quite likely – reason which has all to do with the fact that tribunal judgments are public. If they had taken this battle on and lost, they would effectively have broadcast to the whole of the UK tax profession a novel method of challenging them. Even if they had won, they might have been handed down a judgment that gave some other taxpayer with slightly different facts grounds to defeat them next time. Better from their point of view to keep people guessing. The First-tier Tax Tribunal does not set precedents, but is quite capable of delivering a robust rebuff to the authorities when its judges feel that this is warranted.

In this instance, how many other potential managed service companies had had VAT inspections that might cast doubt on what HMRC was trying to assert? Judged by the facts of the little-known case of Moher v. H.M. Revenue & Customs ([2011] UKFTT 286 (TC)) there could be quite a number. Here they stated that they had reviewed the law in the area of supplies of staff in 2007 and that their understanding of it had changed. However there was never any publication of this different view, and, extraordinarily, they went on to admit that they had continued to allow exemption to businesses whose supplies continued to meet the criteria applied before their change of interpretation. One can well understand that they would not want another case publicised that might draw attention to this.

The lessons to be learned from this are, firstly, that the Government can be held to what it has said; secondly, that points of public law are well worth trying if you have any novel or unusual points; thirdly, that challenging HMRC on public law is easier and less expensive than it was.

That is not to say that it is cheap. We used two barristers on this – one a tax specialist and the other a public law specialist. So my final tip is: get the right specialists on board. As an employment status specialist myself I would always use an employment barrister in a status case, even in the Tax Tribunal. So it is with public law questions: use a public law specialist for public law matters.

The author runs a tax consultancy specialising in PAYE, National Insurance and employment status, and he can be contacted on 0845 519 5041 or at