The Supreme Court’s new approach to mistake of law claims
Taxpayers often make mistakes. These mistakes can be a result of their own errors, like inserting the wrong number in a self-assessment, or failing to apply new rules brought in by the latest Finance Act. But mistakes can also arise when taxpayers – seemingly correctly – pay tax in accordance with the legal rules then in force but those rules later turn out to be unlawful. Perhaps the government implements law that is later found to be invalid, or a legal principle is overturned after years of litigation, and it becomes clear that tax never needed to be paid.
In these cases, taxpayers will want to recover as much overpaid tax as possible. The latest decision in the franked investment income GLO proceedings (FII), Test Claimants in the Franked Investment Income Group Litigation v HMRC [2020] UKSC 47, marks a fundamental shift in how such recovery works. This article considers the background to the case and the recovery of overpaid tax, how the Supreme Court’s decision changes the approach to limitation periods for overpayment claims, and the practical issues that claimants are now likely to encounter.
Background to FII: payments of tax as a result of unlawful legislation
This is the latest of more than a dozen decisions in the FII proceedings over the last 15 years, so the background is well-worn. To recap, the proceedings concern the UK’s approach to the taxation of dividends paid from profits generated outside the UK. The tax rules in question have now been abolished but, for decades, UK resident companies were ostensibly required to pay to HMRC:
- corporation tax on dividends they received from non-resident subsidiaries, which would not arise on dividends from UK resident subsidiaries; and
- advance corporation tax on dividends they paid to their UK shareholders, but without any associated tax credit if the dividends were received from non-resident subsidiaries.
These rules ultimately resulted in more favourable tax treatment for UK companies receiving dividends from the UK (rather than overseas) in a way that was contrary to EU law. As a result, the UK rules were unlawful and unenforceable.
The claimants in FII had made a "mistake of law" when paying tax in accordance with these unlawful rules over a long period, with some payments dating back to 1973. The claimants sought to recover substantial sums from HMRC, with initial estimates suggesting that the claims could be worth in the region of £5bn.
Recovering mistakenly paid tax
Statutory and Woolwich claims
Prior to the decision of the House of Lords in Deutsche Morgan Grenfell Group plc v IRC [2006] UKHL 49 (DMG) there were primarily two ways of recovering mistakenly paid tax from HMRC. First, the taxpayer could bring a repayment claim in accordance with the statutory regime governing the relevant tax (and this is still the case). Secondly, if the taxpayer could show that tax had been paid pursuant to an unlawful demand – which would be the case where the taxpayer mistakenly believed that the relevant tax rules were enforceable – they could bring a "Woolwich" claim for restitution at common law (named after the House of Lords decision in Woolwich Equitable Building Society v IRC [1993] AC 70 where it was first recognised).
Both types of claim have strict time limits. These are contained, respectively, in the specific tax legislation and the Limitation Act 1980 (LA 1980) and typically allow taxpayers to bring a claim within four to six years of when the mistaken payment was made.
However, mistakes of law can take much longer than this to come to light. In FII, the claimants argued that the earliest they realised their mistake was nearly 30 years after the first overpayment was made – when the first of a series of court decisions indicated the unenforceability of the relevant tax rules and they only commenced their claims around that time. Under the time limits for statutory and Woolwich claims, the claimants could have recovered only a fraction of their overpayments.
DMG claims
In DMG, the House of Lords recognised a further cause of action in cases of mistakenly paid tax: the common law claim for restitution of unjust enrichment. The essential ingredients of the claim are that:
- the defendant has been enriched at the expense of the claimant, which is clearly satisfied where a taxpayer makes a payment in respect of tax to HMRC; and
- the enrichment is "unjust", in the sense that it falls into a recognised category of unjust enrichment, rather than being unjust in a general sense.
In Kleinwort Benson Ltd v Lincoln City Council [1999] 2 AC 349 (Kleinwort Benson), the House of Lords recognised that payment under a mistake of law is a category of unjust enrichment.
"DMG claims" in unjust enrichment are generally available in similar circumstances to Woolwich claims. The courts have confirmed that, where both causes of action are available, taxpayers can choose which type of claim to pursue against HMRC.
This mattered to the claimants in PII because, unlike Woolwich claims, DMG claims are "action[s] for relief from the consequences of a mistake" within LA 1980 s 32(1)(c) (and its predecessor, Limitation Act 1939 s 26(c)). This means that the six-year limitation period for such claims commences when the claimant "has discovered the ... mistake ... or could with reasonable diligence have discovered it", not when (as for Woolwich claims) the payment is made.
A majority of the House of Lords in DMG held that a mistake of law becomes discoverable when the mistake is revealed by a judicial decision from which there is no right of appeal. Under this approach, a claim to recover tax paid in 1973 could be brought as late as 2007 if the relevant judicial decision was made in 2001.
As it can take years for mistakes of law to be detected and then resolved through the courts, the practical effect of s 32(1)(c), as interpreted in DMG, was to extend the limitation period for decades beyond a Woolwich claim.
The government twice introduced legislation which purported to curtail the limitation periods for DMG claims, including those that had already been commenced. However, so far as extant claims were concerned, these attempts fell foul of EU law and did little to mitigate the impact on the exchequer (even if they did manage to change the position prospectively – see below). In the latest PII case, HMRC changed tack and challenged the correctness of Kleinwort Benson and DMG regarding the application of s 32(1)(c) to unjust enrichment claims based on mistakes of law.
The latest FII Supreme Court decision: qualifying the extended time limit for DMG claims
HMRC contended before the Supreme Court that Kleinwort Benson and DMG had been wrongly decided and that:
- LA 1980 s 32(1)(c), which extends the limitation period to six years from the date of discovery of a mistake, does not apply to mistakes of law (issue one); and
- alternatively, if s 32(1)(c) applies to mistakes of law, a mistake of law is not necessarily discoverable when the courts reveal the true state of law; it can be discovered at an earlier point in time, depending on the facts of the case (issue two).
In resolving these issues, the Supreme Court had to decide whether to depart from previous decisions of the House of Lords and, if it agreed with HMRC on issue two, explain the correct test for the "discoverability" of a mistake of law. While the PII litigation has a reputation for complexity, these issues essentially boiled down to a balance between fairness and finality: should claimants be time-barred even if their mistake was not discoverable at all (or, at least, not judicially recognised), or should they be able to rely on an extended limitation period even if it risks keeping claims alive for many years, even decades?
Ultimately, the Supreme Court narrowly opted for fairness, albeit with additional qualifications around discoverability that should curtail (to some extent) the claims that can be brought:
- on issue one, by a majority of four to three, the Supreme Court held that s 32(1)(c) applies to mistakes of law; but
- on issue two, the Supreme Court held that the limitation period for DMG claims commences when the claimant discovers, or could with reasonable diligence have discovered, that a "worthwhile claim" has arisen, rather than when there is a relevant and final judicial decision, and to that extent departed from DMG.
The minority on issue one considered that DMG claims should be confined to the same six-year time limit as Woolwich claims. All seven judges agreed on issue two (on the basis of the majority’s approach to issue one). The Supreme Court also heard, and dismissed, certain procedural arguments from the claimants (that are beyond the scope of this article).
Issue one: extended limitation periods should apply to DMG claims
The majority of the Supreme Court acknowledged that unjust enrichment claims based on mistakes of law had not been judicially recognised when LA 1980 was enacted. However, Parliament’s clear intention behind s 32(1)(c) was to ensure that claimants are not disadvantaged by having to comply with strict limitation periods where they cannot reasonably be expected to do so.
Given that this consideration applies equally to unjust enrichment claims based on mistakes of law as it does to other mistake-based claims, it would be inconsistent for the courts not to apply s 32(1)(c) to such claims. Moreover, mistakes of law fall within the ordinary meaning of "mistake", so even if mistake of law claims were not consciously considered when LA 1980 was enacted, construing s 32(1)(c) to include them would be consistent with Parliament’s choice of language.
The majority also noted the issue was largely historic in the tax context given the prospective measures that had been taken in response to PII and other tax restitution claims, including the 45% corporation tax on compound interest paid on the proceeds of such claims and the prospective disapplication of s 32(1)(c) in 2003. They might also have mentioned the 2009 amendments to TMA 1970 Sch 1AB para 1 and FA 1998 Sch 18 para 51, which purport to exclude all common law claims for repayment of corporation tax and income tax respectively, but the effect of these amendments is currently being disputed before the courts (see The Claimants Listed in Class 8 of the CPC and Dividend GLO v HMRC [2019] EWHC 338, which is currently on appeal to the Court of Appeal).
Issue two: mistakes of law can be discovered before final judicial decisions
On the issue of discoverability, the Supreme Court held that the reasoning in DMG led to illogical consequences. Not only was the requirement for a final judicial decision inconsistent with other types of claim governed by LA 1980s 32(1), such as claims based on fraud, but it also meant that a mistake was potentially not "discoverable" until after a claim had been issued. This put mistake of law claims in a uniquely favourable position, as the commencement of the limitation period could be postponed until a claimant was certain of success.
The Supreme Court also noted that the concept of "discovery" in other contexts (for instance, in relation to discovery assessments) did not require the establishment of ‘truth’ by a final judicial decision.
Since it is not only judges who are influenced by developments in legal thinking, but also claimants and their advisors, the Supreme Court reasoned that the focus should not be on judicial decisions, but on the claimant’s ability to evaluate whether they have a worthwhile claim. The purpose of "discoverability" in the context of limitation is intended to protect claimants who cannot reasonably be expected to know they have a claim, and this purpose is still achieved if the limitation period begins to run from the point at which a claimant discovers, or could reasonably have discovered, that a "worthwhile claim" exists.
This test essentially depends on when the claimant has, or ought to have had, sufficient doubt about the legal correctness of the payment to justify embarking on the preliminaries to issuing a claim, such as putting the defendant on notice of a potential claim, taking advice and collecting evidence. The Supreme Court remitted the FII case back to the High Court to hear evidence and decide when the FII claimants could reasonably have discovered they had a worthwhile claim.
A bittersweet victory for the claimants
The Supreme Court almost concluded that a limitation period of six years from the date of payment would be appropriate, which would have significantly reduced the amounts the FII claimants could have expected to recover. This view has considerable academic support and would have followed the recent judicial trend of restricting the availability of remedies for mistake in the tax context (see, in the unjust enrichment context, Investment Trust Companies v HMRC [2017] UKSC 29, Littlewoods Ltd v HMRC [2017] UKSC 70 and Prudential Assurance Company Ltd v HMRC [2018] UKSC 39; and, in other contexts, Mackay v Wesley [2020] EWHC 1215 (Ch), MV Promotions Ltd v Telegraph Media Group Ltd and HMRC [2020] EWHC 1357 (Ch) and Re Webster [2020] EWHC 2275 (Ch)).
Consequently, the actual outcome – i.e. that the extended limitation period applies, albeit with a different test of "discoverability" – is likely to have come as some relief to the FII claimants, as they are at least in a better position than they would have been if LA 1980 s 32(1)(c) had not applied to their claims at all. However, it is a bittersweet victory, as the claimants are now faced with the prospect of yet more complex litigation to establish exactly when they discovered they had a "worthwhile claim". HMRC is likely to assert that the FII claimants were – or ought to have been – aware of their mistake much earlier than they claim. For one thing, other taxpayers commenced challenges to the relevant tax rules in 1995. It is perhaps difficult to see the High Court concluding that the FII claimants should still be entitled to all they claimed under the old approach to discoverability.
So, while the FII claimants have another favourable decision, the amounts recoverable from HMRC are likely to decrease and there will be further delay and cost before these amounts are eventually determined. As for the wider FII litigation, the Supreme Court has just concluded the hearing of another part of the appeals, this time concerning the availability of compound interest on the tax repayable by HMRC (and the significance of the decision in Prudential [2018] UKSC 39), so we should expect another decision on this issue later this year.
The wider impact and practical considerations
As noted above, legislative changes subsequent to the commencement of FII and similar proceedings have curbed, if not eliminated, the benefits of seeking repayment of tax by means of an unjust enrichment claim based on mistake of law. Furthermore, new EU law challenges to the enforceability of UK tax rules will be inhibited by Brexit.
Because of this, the decision in FII will be primarily relevant to:
- historic DMG claims, i.e. claims commenced before 8 September 2003, when the statutory changes to the limitation periods for DMG claims took prospective effect; and
- tax-related unjust enrichment claims against persons other than HMRC, for example in relation to payments of VAT from a customer to their supplier.
In theory, the new "worthwhile claim" test for discoverability looks to be a sensible and fair attempt to balance the competing concerns of fairness and finality. The new approach is much more consistent with other extended limitation periods that require detailed examination of the facts to determine when a claimant could have discovered their claim: see LA 1980 ss 11, 14A and 32(1)(a) which apply to personal injury, latent damage and fraud respectively.
However, in the context of mistakes of law, the new test is likely to create numerous practical issues.
First, the question of when it is reasonable for claimants to be aware that their understanding of the law is flawed is potentially uncertain and raises complex questions regarding the extent to which claimants (and their advisors) should question the state of the law. This could place a significant burden on lawyers, both external and in-house, to monitor whether the law is susceptible to challenge. Additionally, different claimants could be held to different standards depending on the legal resources at their disposal.
Second, it is difficult to see how claimants will be able to adduce evidence regarding the timing of discovery without, in some cases, disclosing privileged advice. Claimants are unlikely to want to cede this advantage to the defendant. Regardless of these privilege concerns, the question of what evidence is required to show a claimant discovered their mistake could, as the minority of the Supreme Court noted, entail a "deeply speculative process of hypothetical fact-finding". Will the courts determine for themselves what a reasonable view of the law was at a particular time, or will they require assistance from other lawyers as "experts" (which would not normally be permitted)? These evidential issues are likely to add significantly to hearings with accompanying cost consequences for the parties.
Third, unlike other provisions in LA 1980 that rely on a claimant discovering their cause of action, litigants and the courts in mistake of law claims will need to grapple with what the minority described as the "vague and intangible" notions of professional opinion and legal trends regarding the correct state of UK law without an established body of case law to assist them (which exists for other limitation provisions). This inevitably creates a greater likelihood of inconsistent judgments regarding the threshold for discoverability, particularly at the outset.
Fourth, potential claimants that have been waiting for a judicial decision before making a claim – and possibly others – might be deemed to have already discovered they have a "worthwhile claim" such that the limitation period for the claim has already commenced without their knowledge. Accordingly, potential claimants should review their records now to ensure they are not caught out by the Supreme Court’s new approach. This will be particularly important for any payments made more than six years ago, as it will not usually be possible to recover them other than through an unjust enrichment claim.
This article was first published by Tax Journal.
