QUEEN'S BENCH DIVISION
Strand, London, WC2A 2LL
B e f o r e :
MR JUSTICE JULIAN KNOWLES
| The Queen on the Application of
|- and -
|1) The Crown Court at Blackfriars
2) The Commissioners for Her Majesty's Revenue and Customs
Andrew Bird (instructed by HMRC) for the Second Defendants
Hearing dates: 8th, 9th November 2017
Crown Copyright ©
Lord Justice Holroyde :
" a small consultancy which was established to support small and medium size businesses. In particular, OCS supports owner-managed businesses through the creation of modern business structures which promote shared ownership, profit sharing and tax efficiency."
"The model comprises a bifurcated structure whereby the LLP operates as a captive licensee business and the team members become LLP Members, sharing in operational profits on a part fixed / part variable basis. They retain their employment status with the existing LTD Company but on reduced salaries. As LLP Members they participate in profits and receive monthly drawings."
"It is thus becoming increasingly clear that LLP Members are, for all practical purposes, employees as well as being partners. This is particularly important for mortgage (and other loan) purposes. When applying for mortgages and loans LLP Members should always declare themselves as "employees". But for tax purposes partnerships have always been taxed on the basis of partnership profits rather than on payments taken out of the business as partners' drawings. This is similar to the way that people who are "self-employed" are taxed but, of course, LLP Members are not actually "self-employed", as noted above."
The legislative framework
"A constable may obtain access to excluded material or special procedure material for the purposes of a criminal investigation by making an application under Schedule 1 below and in accordance with that Schedule."
It is common ground between the parties that HMRC were entitled to make an application under section 9, and it is therefore not necessary, in the circumstances of this case, to consider the detailed definition of "special procedure material" contained in section 14 of the Act.
"The first set of access conditions is fulfilled if
a) there are reasonable grounds for believing
i) that an indictable offence has been committed;
ii) that there is material which consists of special procedure material or includes special procedure material and does not also include excluded material on premises specified in the application ;
iii) that the material is likely to be of substantial value (whether by itself or together with other material) to the investigation in connection with which the application is made; and
iv) the material is likely to be relevant evidence;
b) other methods of obtaining the material
i) have been tried without success; or
ii) have not been tried because it appeared that they were bound to fail; and
c) it is in the public interest, having regard
i) to the benefit likely to accrue to the investigation if the material is obtained; and
ii) to the circumstances under which the person in possession of the material holds it, -
that the material should be produced or that access to it should be given."
"a) that it is not practicable to communicate with any person entitled to grant entry to the premises;
b) that it is practicable to communicate with a person entitled to grant entry to the premises but it is not practicable to communicate with any person entitled to grant access to the material;
c) that the material contains information which
i) is subject to a restriction or obligation such as is mentioned in section 11(2)(b) above; and
ii) is likely to be disclosed in breach of it if a warrant is not issued;
d) that service of notice of an application for an order under paragraph 4 above may seriously prejudice the investigation."
In the present case, HMRC relied on the first set of access conditions and on the further condition identified in paragraph 14(d).
"In considering whether the requirements of paragraph 2 have been met, the investigator is obviously not in a position to know for certain what the outcome of any request for voluntary disclosure of documents might be. Nor, in the context of an application for a warrant under paragraph 12, can the investigator know for sure whether a production or access order under paragraph 4 might have been sufficient to secure the documents. Therefore, paragraph 2 can not, consistently with the purpose of the statute, be read literally: whether a less intrusive measure would, or would not, be "bound to fail" must in the end be a matter of judgment for the investigator based on his or her knowledge of the investigation so far and the evidence available. It must, in our judgement, be understood to mean that the investigator believes on the basis of the evidence that there is no lesser measure available which is likely to be effective in securing the relevant documents. Plainly, the investigator must have cogent grounds for his belief. In the context of an application for a warrant, where no notice will be given in advance of execution, the belief is likely to be based on the investigator's suspicion that the relevant material will be disposed of or hidden if advance warning is given, and for that reason, any lesser measure (which would mean that the target is put on notice of the investigation) would be an ineffective means of pursuing the investigation. But, as is clearly stated in S, F and L at [62 to 64] and [95 to 97], a bare assertion of such a belief is insufficient if the basis of that belief is not adequately explained in a focussed application dealing with the actual facts of the case. If the investigator has explained the reasons for so suspecting, in terms that are reasonable and compelling, he or she will have fulfilled the requirement in paragraph 2."
"put on his defence hat and ask himself what, if he was representing the defendant or a party with a relevant interest, he would be saying to the judge."
"The question for the court, in judicial review proceedings, is whether the information that is alleged should have been given to the magistrate might reasonably have led him to refuse to issue the warrant."
That test was adopted in R (Mills) v The Chief Constable of Sussex  1 WLR 2199, in which Elias LJ considered the point in detail at paragraphs 47 to 64 of his judgment. Elias LJ set out cogent reasons of principle why Stanley Burnton LJ's approach was correct. He therefore applied, to the circumstance of the case before him, the test of whether
" the warrant should be set aside because there was material non-disclosure which may well have led the judge to issue a warrant which, had there been full candour, he would have refused to issue".
Similarly, in Newcastle United FC Ltd, the court concluded (at paragraph 75) that although mistakes had been made in the application for a warrant, those mistakes were mere slips which were not material to the application or its treatment by the judge to whom it was made, and so
" the information which it is alleged should have been given to the judge could not be said to have reasonably led him to refuse to issue the warrant".
"(1) For income tax purposes, if a limited liability partnership carries on a trade, profession or business with a view to profit
a) all the activities of the limited liability partnership are treated as carried on in partnership by its members (and not by the limited liability partnership as such),
b) anything done by, to or in relation to the limited liability partnership for the purposes of, or in connection with, any of its activities is treated as done by, to or in relation to the members as partners, and
c) the property of the limited liability partnership is treated as held by the members as partnership property."
"An amount within the total amount is "disguised salary" if it
a) is fixed,
b) is variable, but is varied without reference to the overall amount of the profits or losses of the LLP or,
c) is not, in practice, affected by the overall amount of those profits or losses."
In summary, condition A cannot apply to an individual member if more than 20% of his remuneration is variable by reference to the performance of the LLP as a whole.
"LLP Members should receive their Hypo payslip each month. Clients should pay this net amount as one bank payment (not split). We do not distribute Actual payslips to LLP Members as a matter of course. The Hypo payslips are used for mortgage applications and the like so should not show the words "LLP" or "Hypo" see suggested naming advice. The Gross pay shown on the payslip must be described as "pay" not "drawings". Note also for mortgage applications it is important to tick the "employed" box and not the "self-employed" box. LLP members are employees for all purposes apart from for tax purposes and in the business sense, where they are "partners". Partner designation should be shown on business cards and email signatures. LLP members should receive the actual P60 by 31 May each year. If people specifically request a Hypo P60, e.g. for a mortgage application, then we will issue one, but not as a matter of course."
The papers placed before this court include copies of hypothetical payslips in relation to a number of workers with some of OSC's clients. A typical example shows the name of the business, but without either LTD or LLP status being shown. The payslip bears the name of the worker, his or her NI number, but also the worker's NI category and tax code, neither of which have any relevance to a self-employed person. It shows a figure for total pay which represents the monthly amount of the worker's gross pay under his or her former employment by the LTD (but is, of course, much larger than the gross pay in respect of the changed hours and rate of pay). It then shows an amount of deductions from that figure in relation to income tax and national insurance (even though the LTD has not paid such an amount to HMRC). It finally sets out a summary of various amounts, including the "NIable pay" and the "employer's NI", neither of which has any relevance to a self-employed person.
" to use a legal structure that fits that partnership model. This also means they benefit from the robustness of finances that a partnership model allows. Salaries are a cost to a company and are difficult to vary depending on the profitability of the business. PAYE must be paid to HMRC every month even if the business is not profitable and losses can not be offset against this liability. In contrast, in a partnership tax is only paid when a business makes a profit. [The first claimant] advises clients that they should be paying tax, but only when they can afford it. OCS wants to see its clients being successful and paying tax out of profitability, not out of funds they need."
The first claimant was asked whether the charge for OCS's services was a percentage of savings achieved. His reply was differently noted by the two sides present at the meeting, but the first claimant says he explained that OCS preferred to set a fixed monthly retainer, with a regular review, which was sometimes done "on the basis of a proportion of the forecast or actual cash flow benefits association with adopting a partnership model". The first claimant was also asked about the hypothetical payslips, and was asked whether an example payslip could be provided. He said he did not have one with him, but explained what it would show, adding that OCS would explain things to individual workers so that they would understand that what looked like a payslip showing employment income in fact showed their drawings.
"The easy option for them would be to "start again" and allow HMRC to pursue a winding up order from which, of course, HMRC typically receive nothing. However, through our efforts these companies can recover, move back to profitability and clear all their debts including the amounts owed to HMRC who then become a net (charge free) beneficiary of our work."
The first claimant went on to refer to the continuing requests which HMRC were delivering to OCS for information about various clients. He said that he could not continue to allow the business disruption and unnecessary costs incurred in dealing with those enquiries without the proper justification, and was therefore taking professional advice.
"Looking at the case, I am unable to agree that you have been transparent and answered our queries. It appears to me that you have not submitted information in an open or timely fashion".
The written application for the search warrants
"7) Central to the success of this scheme is the need to convince HMRC that the employees are genuine partners who actively participate in the strategic management of the LLP. Legitimate partners should benefit from the profit and share the burden of the losses of the business. It is also necessary to convince HMRC that the roles carried on by the individuals as employees and as "partners" are sufficiently distinguishable such that the compensation payments received are legitimately non-taxable.
8) It is believed OC, in their desire to do this, have misrepresented to HMRC the reality of the "partners" roles within the LLPs in order to convince HMRC that their tax treatment is correct."
Mr Russell then summarised responses received to some of HMRC's enquiries, in which a number of workers had indicated in effect that following the transfer their duties had not changed at all and they had played no part in the management of the LLP. He continued
"11) These responses demonstrate that OC have falsely represented the scheme to HMRC in order to legitimise the treatment of the employees as "partners" for tax purposes by demonstrating a non-existent difference between the work previously done as an employee of the company, and that which is now undertaken as a "partner" of the LLP.
14) It is believed that these LLP structures lack true substance and the businesses carry on trading exactly as they were prior to the scheme being implemented. The company's customers are not informed of the existence of the LLP.
15) In reality the role of the new "partners" does not change and they do not participate in the management of the company. The "partners" continue working as if nothing were to have changed. OC advise their clients to make the payment of the national minimum wage from the Limited Company and the drawings from the LLP in one single payment. The amount of the LLP drawings is then cross-charged between the limited company back to the LLP, although this is often only represented by a book entry and no physical transfer takes place. There are other charges between the Limited Company and the LLP, though the legitimacy of these fees is questionable.
16) The LLPs often operate with no bank account and all financial transactions are paid via the Limited Company's bank account. This includes the "partners" pay which is paid in one single sum together with the employee's salary from the Limited Company."
"In compensation for the agreement reached with the Company to reduce their working hours, the employee receives a lump sum payment known as a Variation and Settlement Agreement (VASA) receipt. OC claim that this receipt is exempt from tax under section 401 Income Tax (Earnings and Pensions) Act 2003 as it represents a genuine payment as compensation for an employee's change in duties or earnings. This compensation payment is capped at £30,000, which is also the limit to which the exemption applies. However HMRC do not agree with this lump sum being exempt from tax as section 401 Income Tax (Earnings and Pensions) Act 2003 is only applicable to instances in which there has been a genuine termination or change to a person's employment duties or pay. Since HMRC believe that this is not the case and the employee's role, hours and salary are in fact the same, section 401 Income Tax (Earnings and Pensions) Act 2003 should not apply."
Mr Russell then referred to the hypothetical payroll and payslip, and illustrated in a table the reduction in the monthly amount payable to HMRC by the LTD. He said that OCS had described the scheme as doing no more than deferring the payment of income tax and national insurance, because the PAYE bill would not be paid by the LTD at monthly intervals, but the individual workers would be paid on a self-assessment basis after the end of the tax year. At paragraph 27, in another passage which was the subject of lengthy submissions, he said of that description
"27) However, we suspect that this has been misrepresented to HMRC. There are a number of fees which flow between the Company and the LLP which HMRC suspects are deliberately designed to ensure that the LLP will never make a profit, and therefore the "partners" will not have to pay HMRC any tax or NICs. Grant Thornton LLP, acting for a user and in correspondence with HMRC, explained that "it is highly unlikely that the LLP will ever make a significant profit"."
"During the course of the civil investigation, Optimal Compliance Services LLP have failed to provide an honest and accurate account of their business operations and continue to thwart any attempt by HMRC to gain an accurate understanding of how the tax scheme operates. Therefore, due to Optimal Compliance Services LLP's refusal to cooperate and provide the accurate information previously I believe that a search of premises is now necessary in order for the material sort to be gathered as part of the criminal investigation."
Mr Russell then referred to the first claimant's letter of complaint and said
"An enquiry should cause no distress to any individual if there is a Limited Liability Partnership operating in a genuine commercial manner. It would appear that in most cases, a member of Optimal Compliance Services LLP contacts the individual LLPs to instruct them not to respond to HMRC directly and that they will on their behalf. HMRC believes that this is to ensure that OC can send a uniform response detailing a false business structure".
"It is not practicable to communicate with any person entitled to grant entry to the premises, as mentioned in the information of this warrant during the civil investigation into Optimal Compliance Services LLP, the business and those operating within it [the claimants] have demonstrated an unwillingness to cooperate with any request or enquiry thus far by Counter Avoidance. Furthermore, there has been direct attempts by OC and their employees to intentionally thwart the HMRC's enquiries, this is seen by the correspondence disclosed to HMRC telling "partners" to not contact HMRC or respond to the enquiries. HMRC instead have received fabricated letters in an attempt to misrepresent the true nature of the scheme to HMRC.
Additionally, service of notice of an application for a production order under Paragraph 4 of PACE Schedule 1 may seriously prejudice the investigation. This is due to the fact that should a production order be served on any business accounts of OC this may raise their awareness of HMRC's investigation".
"I believe the individuals subject to this application are not going to comply with any order to produce material, this has been demonstrated by the attempts of OC to frustrate the civil investigation and not to supply the requested documentation."
The hearing of the application
"Judge: The real question I have in this case is in relation to obtaining the material in any other way rather than by way of a search warrant. So the civil investigation says that they have been obstructed or misleading
Witness: Yes, we believe so.
Judge: and serving a production order on them would result you believe in destruction of documents or
Witness: We believe there's a potential for that, yes.
Judge: Yes. But, has consideration been given to other matters or other methods of obtaining the information other than by the draconian step of a search warrant?
Witness: Yes, we did consider a production order but I believe that was not the best route to go down, after our colleagues on the civil side experienced the difficulties that they have. You know, in the warrant it mentions the complaint letter that we received from him. They have proved very difficult to cooperate with. We believe they have submitted documents to us which have been intentionally given to, sort of, misrepresent their business and the whole idea behind the scheme. So, yeah, we believe that gaining material in any other way isn't really feasible at this time.
Judge: And, on the civil side in relation to the civil investigation, just run me through that, that they were asked for information. They gave either this misleading information or were obstructive. Was there any other court order sought in respect of the civil investigation?
Witness: Not [that] I know, sir."
After some further enquiries into the manner in which searches would be carried out, the judge gave his ruling issuing the warrants. He accepted the evidence of Mr Russell that it was considered that less draconian methods would lead to "further obstruction, further misrepresentation and destruction of that which is being sought" and concluded that he was satisfied that the use of a production order rather than a search warrant "would seriously prejudice the application". That last word must, I think, be an error, and the judge must have meant to say "investigation".
"It is with regret that full analysis of the LLPs and their partners' returns was not conducted in advance of the warrant application, and I sincerely apologise to all parties for having made this assertion of suspicion without having carried out a full analysis of all the LLP returns which would have been available to me from HMRC records".
Mr Faulkner has similarly made a statement apologising for making the suggestion, that the LLPs were designed not to make a profit, without having first checked all the LLP tax returns.
1) Was the judge misled as to the applicable law?
2) Were the facts upon which HMRC relied misrepresented to the judge?
3) Were there material facts which should have been, but were not, drawn to the judge's attention?
4) If question 2 and or question 3 are answered in the affirmative, were those deficiencies such that the judge might reasonably have refused to issue the warrants if the correct information had been placed before him?
5) If question 4 is answered in the affirmative, what relief should be granted to the claimants?
" to issue, on the application of the person who is in possession of the property at the time of the application under this section, a warrant in pursuance of which, or in the exercise of which, it would be lawful to seize the property."
Mr Justice Julian Knowles:
Addendum to judgment by Holroyde LJ and Julian Knowles J:
i) The claimants have been successful in obtaining the relief which they sought, in circumstances where it was not possible to reach agreement between the parties that the warrants were unlawfully issued and should be quashed.
ii) Although the claimants only succeeded on "a narrow basis which was far from the central thrust of" their case, it was nonetheless a basis which was sufficient to justify their obtaining all the relief which they sought; and it was a basis which involved on the part of HMRC a material misrepresentation of the facts, and a material failure to draw relevant matters to the judge's attention.
iii) However, the costs and length of the hearing were significantly increased by the claimants' inappropriate focus on the merits in principle of their model, which formed the central, but unsuccessful, argument in support of their claim.