Broken stalemates

We all accept that divorcing couples will save themselves time and money by reaching a financial settlement through mediation, rather than fighting over the family assets in court. Put simply, the same is true with tax disputes. Alternative dispute resolution (ADR) is now available to facilitate such mediated settlements with the UK tax authority, HM Revenue & Customs (HMRC).

Why an alternative is needed

There were nearly 27,000 tax disputes waiting to be heard by the First-tier Tax Tribunal in 2012–2013 (up from just 13,456 in 2009–2010) and it takes an average of 70 weeks just to get to a hearing. This is locking up billions of pounds in uncollected tax: for 2011–2012, HMRC estimates that GBP7.2 billion of the tax gap arises from taxpayer error or failure to take reasonable care. ADR is seen as part of the answer to raise revenue and reduce the backlog of court cases for HMRC, but it can also benefit taxpayers.

Prudent taxpayers in dispute with HMRC will set aside the tax at stake. Also, if tax does become payable, there is likely to be interest due (currently 3 per cent per annum). In long-running cases, interest can soon mount up, on top of the opportunity cost of keeping a tax reserve. So anything that can speed up a tax resolution is usually good news for clients.

The psychological cost of having a tax dispute hanging over you should not be underestimated – most taxpayers find it very stressful and distracting. As in divorce cases, an aggressive or uncooperative attitude will often make the dispute harder to resolve, leading to entrenched positions and a gradual, expensive slide towards litigation.

The ADR route is voluntary and non-statutory so any party can withdraw at any point with no negative implications, making ADR a potentially risk-free strategy for clients. The nature of the mediation process is less confrontational than conventional tax dispute resolution. This also helps the taxpayer, as HMRC’s objective for ADR shifts from maximising the tax yield towards reaching a cost-effective settlement.

For many private clients, trustees and executors, the real beauty of ADR is that the process is completely confidential, and all discussions will be on a ‘without prejudice’ basis. This is as opposed to the situation in the Tax Tribunal, whereby all case decisions are published in the public domain, which can often lead to unwanted publicity or breaches of privacy.

Pilot highlights

Out of the cases accepted in the pilot, disputes lasted an average of 23 months prior to ADR. It is significant that the small and medium enterprises (SME) and individual pilot statistics show that, while new evidence or education of the taxpayer or HMRC decision-maker was the key to mediating a settlement in 80 per cent of cases, 20 per cent of cases were resolved simply because both sides started communicating again. Trust and estate disputes with HMRC would be mediated using the SME and individual route.

Many more SME and individual cases were accepted into the pilot than large or complex cases. HMRC addressed this partway through the pilot by putting in place a Tax Disputes Resolution Board and procedures that caused a significant increase in accepted applications for large or complex cases.

There are clear criteria for applications for ADR being accepted. The case may involve:

• facts that are capable of further clarification;
• a misunderstanding of the facts or information provided;
• a dispute that could benefit from obtaining more suitable evidence; or
• situations where there is legitimate scope for one party to get a better understanding of the other’s arguments.

However, in all cases the issues in dispute must be capable of mediation and settlement by agreement within the framework of HMRC’s Litigation and Settlements Strategy (LSS). Cases that are not will be refused, as will cases where:

• the dispute has issues linked to coordinated appeals (i.e. stood behind cases);
• there is still scope to resolve issues normally with the taxpayer’s client relationship manager at HMRC;
• the issues have a wider (industry-wide) application; or
• they could only be resolved by HMRC departing from its established technical or policy view.

HMRC may still accept an application to mediate if a case is listed for a tribunal hearing, but, where the hearing date is imminent and both sides are fully prepared, the ADR application is likely to be rejected by HMRC.

As ADR goes forward, these criteria will become more widely understood by advisors and resistance within HMRC ranks will reduce: refusal rates for applications should drop significantly.

Doubts expressed about the neutrality of facilitators recruited from within HMRC proved unfounded, and, in our experience, the facilitators are experienced and senior HMRC personnel who tend to have a refreshingly pragmatic approach. However, the pilot also shows that dual mediation (including an independent mediator) is more acceptable to taxpayers. The ADR process itself is a free service provided by HMRC, so engaging a second mediator need not add to costs significantly. In fact, cost saving is one of the key advantages to both parties, as a day at ADR is much cheaper than a year preparing for a court case.

As 34 per cent of the SME and individual cases and 35 per cent of the large or complex cases accepted in the pilot were resolved, HMRC saw the pilot as a success. We would agree. After a successful two-year trial of ADR, HMRC expects resolution rates to improve following ADR being rolled out nationally on 2 September 2013. ADR seems to be successful so far, as the most recent statistics on ADR applications between 1 April 2013 and 14 January 2014 show 79 per cent of SME cases were resolved within 120 days. They also show 83 per cent of the large and complex cases that went to ADR were resolved and there is evidence to suggest that simply applying for ADR motivates large companies and their HMRC relationship managers to sort disputes out before they need to get a mediator involved. 

Case study

A district enquiry was opened into the affairs of an unrepresented UK taxpayer (Client X) on the disposal of a large residential property that the taxpayer did not include on her return for 2007/08 (she considered it was her main residence and, therefore, that no capital gains tax was due).

Client X asked for advice and, after reviewing the complex facts available, her advisors prepared a computation of the tax due. Following initial submission in late 2009, HMRC challenged a number of the factual positions included in the computation. This led to eventual stalemate. The factors in dispute included:

• how much main residence and lettings relief was available;
• the total base cost of the property (and valuation of property transfers); and
• the amount of enhancement expenditure (Client X had no invoices or independent summary of works).

By June 2012, HMRC was seeking tax of GBP460,000 (and a 30 per cent penalty), as opposed to the GBP160,000 (with no penalty) that her advisors argued was due. In July 2012, her advisors applied to resolve matters through the ADR pilot programme. HMRC agreed and the mediation took place in September 2012.

On the day, the morning progressed relatively slowly, with both parties repeating well-worn arguments. But, as time went on, it became apparent that the previously entrenched positions of both parties were open to quite significant movement.

The first breakthrough was on the property valuation: a relatively quick solution was accepted, with both parties agreeing to meet at about halfway following discussion with the district valuer who attended the mediation. On the other disputed points, it was again obvious that, in the absence of any further information, reasonable assumptions would have to be accepted. Once HMRC overcame this psychological hurdle, work centred on giving credence to assumptions through the use of general data available on the internet (tracking house price movements, etc). 

On the penalty, her advisors countered HMRC’s insistence on a 30 per cent rate, arguing that Client X was not at fault and, under the pre-2008/09 penalty regime, she should get full mitigation and a zero penalty. HMRC quickly agreed.

With all the issues resolved, the draft settlement agreement that both parties signed showed a final figure of GBP210,000 tax due – an excellent result for Client X and a successful resolution to a costly and time-consuming enquiry for HMRC.

Successful ADR

It is important that the taxpayer appreciates the framework within which HMRC must operate during ADR (i.e. what is possible), so understanding HMRC’s LSS is crucial. The key elements of the LSS are, first of all, that it puts a responsibility on HMRC to resolve all issues in non-confrontational and collaborative ways where possible. Therefore, it is vital to make agreement ‘possible’ by cooperating.

Second, the LSS requires that ‘all disputes should be dealt with on their own merits and “package” deals can never be an appropriate basis of settlement’. It also states: ‘It is always appropriate to have regard for materiality.’ The point here is that every disputed issue will need to be resolved (unless it can be agreed as not material) so there are no areas that clients can gloss over. Although package deals cannot be done, conceding on certain points in the spirit of cooperation does help to ease the agreement process for other issues.

Still a role for the Tax Tribunal?

Despite ADR’s success, there will continue to be many cases where a point of law or public policy merits a full examination at the tribunal. Barristers should no longer be swamped by cases where one side or the other is clutching at technical straws to support a weak argument. Hopefully, ADR will also result in less dubious case law created simply because the tribunal is faced with an uncooperative taxpayer or HMRC officer with a poor case. Of course, cases where ADR fails or is abandoned will probably still end up in tribunal.

Advisors cannot use ADR to break any new boundaries of tax law. But, if you use ADR to get a fresh start with entrenched but relatively straightforward tax disputes, it can be a highly cost-effective tool.