By Peter Garry, Cripps Harries Hall, Tunbridge Wells

Liability of salaried partners for Crown debts

HM Revenue & Customs (HMRC) will often be the largest creditor in a partnership insolvency. For as long as the firm is trading, the indebtedness to HMRC for VAT and - if there are employees - under the PAYE scheme may accrue on an almost daily basis.

In some firms, new salaried partners are asked to sign VAT2, which is a harmless-looking form that amounts to little more than a list of partners. Salaried partners may assume that under the VAT regulations they are required to sign the form because they are held out as partners. However, they are not.

They might well sign the form without a second thought, whether or not they have an express indemnity from the firm, and without any idea as to the financial health of the firm or of the true partners. In many cases, the form is presented for signature by a junior member of the accounting staff as an administrative matter. Salaried partners often do not later recall having signed the form and are surprised to see their signature when HMRC eventually produce a copy of it.

When the firm fails and HMRC comes calling, salaried partners may be able to argue that HMRC was on notice of their non-partner status by reason of their being remunerated as employees under the PAYE scheme and because they are not shown as partners with profit shares in the accounts of the firm. Of course, cases can arise where the firm fails before it has filed any accounts, or has not - despite its obligation to do so - set up PAYE accounting for its employees, which is often the cause, or one of the causes, of PAYE arrears arising in the first place.

Either way, when a firm does not pay its Crown debts over a long period, or fails with substantial Crown indebtedness, HMRC will normally aggressively pursue all persons held out as partners. It has been HMRC's practice to rely on VAT2 in support of the assertion that persons purporting to be salaried partners are liable as true partners, not only for VAT, but also for arrears of PAYE on the whole of the firm's payroll. Indeed, HMRC's own internal guidance notes have encouraged that course of action, at least in relation to paragraph 3.4.6 of VAT: Internal Guidance Notes V1-28.

The issue of liability of non-partners for VAT arose in a different guise in Revenue & Customs Commissioners v Pal & ors [2006] EWHC 2016 (Ch). Two individuals, who were not even salaried partners, let alone true partners, signed a VAT2 form relating to a restaurant business to persuade a landlord to allow the business to occupy certain premises. HMRC later required the non-partners to pay arrears of VAT, to which they responded that they had not made taxable supplies (because they were not partners), and thus were not liable to pay the VAT.

HMRC argued that the Value Added Tax Act 1994 creates an exclusive code that operates outside of normal legal considerations and that, having signed the form, the non-partners were liable, as persons registered as partners, to pay the VAT on the supplies by the registered partnership. Section 3 of the Act provides that 'a person is a taxable person for the purposes of this Act while he is, or is required to be, registered under this Act'.

HMRC also argued that the non-partners were liable on the basis of statutory holding-out, pursuant to section 14(1) of the Partnership Act 1890, and common law estoppel by representation, and relied on the VAT2 form as the required holding out/representation.

This raises interesting issues. An essential element under the statutory and common law routes is, respectively, reliance by the creditor on the apparent partners, or detriment suffered by the creditor. How could HMRC establish reliance on each individual 'partner' when the debt had accrued automatically by virtue of ongoing trading and HMRC had no option but to give the required 'credit'? It is not as though HMRC regularly takes any kind of credit decision based on the number of partners in a firm, or as though they could have declined to give credit by preventing continued trading by the partnership. Surely, whether two or four partners had appeared on the form, HMRC would have done the same thing, which is registered the partnership for VAT?

HMRC argued that the partners had acted to its detriment by allowing the partnership to register on the 'normal' basis of quarterly accounting, rather than monthly accounting, and without giving security.

The VAT tribunal had found on the facts that the non-partners were indeed non-partners. Accordingly, they could only be liable if the Value Added Tax Act imposed a stand-alone liability on persons signing VAT2, or if signing VAT2 could give rise to liability under section 14(1) or on the basis of estoppel.

The High Court held that:

l Section 14(1) requires the giving of credit in a private law transaction;

l Estoppel by representation could not be asserted because the detriment relied upon was not a sufficient detriment;

l To make persons liable for tax, a taxing statute requires an actual state of affairs to exist - in this case 'persons... carrying on a business in partnership' (section 45(1) of the Value Added Tax Act). HMRC could not establish liability based on a fictional state of affairs arising out of persons representing themselves to be partners, when in reality they were not partners; and

l The registration pursuant to the form VAT2 could only be effective to register the two true partners for the purposes of VAT.

The court's finding that a taxing statute requires an actual state of affairs to exist appears to be of wider application. Thus, in relation to PAYE, it would appear to follow from Pal that a person cannot be held to be responsible for deducting income tax and employee national insurance contributions, and paying them (together with employer contributions) to HMRC, if he is not actually the employer of the employees concerned, as opposed to merely being held out as such, a fortiori as he will not have signed any PAYE equivalent of a VAT2 form.

It remains to be seen whether salaried partners who may in the past have been found to be liable for VAT or PAYE debts of the true partners of a firm, or who have contributed to such debts under what may have amounted to a mistake as to the law, will, based on Pal, seek to set aside those findings or seek restitution.

It is beyond the scope of this article to consider in detail their ability to do so, but there are numerous cases that suggest some might succeed - see especially Arnold v National Westminster Bank [1991] 2 WLR 1177 HL (change in the law constituting exception to issue estoppel, re-litigation permitted), Property and Reversionary Investment Corporation Limited v Templar [1977] 1 WLR 1223 CA (appeal out of time allowed two and a half years after change in the law), Kleinwort Benson Limited v Lincoln City Council [1999] 2 AC 349 HL (changes in or clarification of common law operating retrospectively, restitution of monies paid under a mistake of law), Deutsche Morgan Grenfell Group plc v Inland Revenue Commissioners [2006] 3 WLR 781 HL (restitution of tax paid under a mistake of law), and, per contra, Brennan v Bolt Burdon [2005] QB 303 (state of doubt as to the law not a mistake of law, compromise not vitiated by mistake unless compromise impossible to perform).