HMRC v AS

His Majesty’s Revenue and Customs (‘HMRC’) is the Appellant in this Upper Tribunal appeal but was the respondent before the First-tier Tribunal. To avoid confusion, I refer to the lady who was the appellant in the First-tier Tribunal proceedings but is now the Respondent as ‘the claimant’.

I held a telephone hearing of HMRC’s appeal on 19 December 2022. Mr David Eland represented HMRC and the claimant represented herself. I am grateful to them both for their contributions. I then directed a further round of written submissions after the hearing, which mostly explains the delay in finalising this decision.

On one level this appeal might appear to be about a relatively straightforward dispute to do with the calculation of the claimant’s earnings for the purposes of her entitlement to tax credits.

Shorn of all the legal complexities, the question is how the claimant’s earnings should be calculated for a short part-year period of just over a fortnight from 6 April 2019 to 22 April 2019. This question was prompted by the claimant applying for universal credit, as a result of which her award of tax credits terminated.

The claimant and the First-tier Tribunal say that her earnings for that period were £693.43. The First-tier Tribunal arrived at this figure by the following process. First, it identified the claimant’s monthly earnings received in the 17-day period from 6 April 2019 to 22 April 2019 (£1,244). Secondly, it multiplied that figure by 12 to arrive at an annual amount (£14,928). Thirdly, this total was divided by the number of days in the (leap) year (366), producing a daily figure of £40.79. Fourthly, and finally, it multiplied the daily rate by 17, generating an apportioned earnings figure for the 17-day period of £693.43.

In contrast, HMRC say that her earnings for that period were £1,127.85. HMRC rely on some complicated methodology in the secondary legislation governing tax credits. At this stage I will not even try to summarise the steps in the process of calculation advocated by HMRC. Suffice to say that the HMRC method focusses on the total earnings actually received in the course of the 17-day period and not (as the First-tier Tribunal concluded) the income attributable to that period by a process of apportionment.

My decision is that HMRC’s approach to the calculation is correct, and so the First-tier Tribunal erred in law, for the reasons that follow. I re-make the First-tier Tribunal’s decision accordingly.

The claimant is a teaching assistant on a modest salary. Her P60s showed her annual pay was £10,413.30 for the 2017/18 tax year, £11,428.73 for 2018/19 and £15,352.52 for 2019/20. For the first two of those three tax years, her annual pay was below the threshold for paying income tax. She was paid monthly on the 15^th of each month. So, for example, on 15 April 2019 she received net pay of £1,131.70 (her total gross pay for that pay period was £1,320.70 and her taxable pay £1,244.10). The figures for her taxable pay and net pay on 15 April 2019 were confirmed by an HMRC RTI Payment Record Information print-out. The claimant had been in receipt of tax credits for a number of years.

However, this all changed when the claimant applied for universal credit on 23 April 2019. The effect of this, in plain English, was that her tax credits award ended, as provided for by regulation 8 of the Universal Credit (Transitional Provisions) Regulations 2014 (SI 2014/1230; referred to in this decision as ‘the 2014 Transitional Regulations’). This development then prompted HMRC to make a final assessment of the claimant’s tax credits entitlement for the period from 6 April 2019 (the start of the 2019/20 tax year) to 22 April 2019 (the day before the claimant’s universal credit award commenced).

On 4 June 2019 HMRC sent the claimant a final award notice for the 2019/20 tax year. This gave her a tax credits entitlement of £36.74 for child tax credit and £0 in working tax credit for the 17-day period from 6 April 2019 to 22 April 2019. According to the HMRC screen-print associated with the decision, “DUE TO THE LEVEL OF YOUR INCOME, YOUR WORKING TAX CREDIT IS REDUCED TO NIL”. This final decision was taken under section 18 of the Tax Credits Act 2002. A side-effect of that decision was that the claimant had been overpaid tax credit for the period in question.

On 11 July 2019 the claimant applied for a mandatory reconsideration. Her contention, in short, was that HMRC had been wrong to take into account the whole of the payment made on 15 April 2019. Her argument was that the earnings paid on that date related to an entire month and not just to the 17 day period.

On 26 July 2019 HMRC responded but did not change its decision. Its reasoning, as set out in the mandatory reconsideration notice, was as follows:

The Appellant lodged an appeal, stating again that “The information you used to calculate my award for 6^th April 2019 to 22^nd April 2019 is not the figure that I supplied you with. I clearly remember having a telephone conversation and I advised that the figure you used of £1,244.10 was for my taxable pay – the whole month of April my salary was £1,131.70 … I cannot understand why a salary of £26,782 [p.a.] has been used, I have never suggested in any way that was my salary.”

On 16 April 2021 the First-tier Tribunal held a remote hearing by telephone and allowed the claimant’s appeal. It directed HMRC to recalculate the claimant’s tax credits entitlement for the 2019/20 tax year based on her part tax year income being £693.43 (and not £1,127.85). In its detailed Decision Notice, the First-tier Tribunal explained how it arrived at that figure:

This explanation was repeated in the First-tier Tribunal’s Statement of Reasons.

On 14 June 2021 a District Tribunal Judge gave HMRC permission to appeal. She neatly summarised HMRC’s grounds of appeal as follows: “[HMRC’s] argument is that the level of income to be taken into account when calculating notional current income is income actually received whereas the tribunal has used income attributable to the period in question”.

There is nothing wrong, at least in the abstract, with the First-tier Tribunal’s arithmetic. The problem lies in its application of the relevant law. The Tribunal’s failure to apply the correct legal principles led it astray into asking itself the wrong arithmetical questions. The discussion that follows falls into two parts – the first considers in outline ‘end of year’ final decisions and the second deals in more detail with ‘in-year’ final decisions.

The standard model for tax credits decision-making is that entitlement is assessed at the end of the tax year, As tax credits are means-tested, entitlement depends in part on a person’s “relevant income” (see section 7(1) of the Tax Credits Act 2002). An individual’s “relevant income” is defined in several different ways by section 7(3), but in each case depends on three variables: (i) the individual’s current year income; (ii) that person’s previous year income; and (iii) two thresholds, each of £2,500, which are set by regulation 5 of the Tax Credits (Thresholds and Determination of Rates) Regulations 2002 (SI 2002/2008). The figure for a recipient’s “relevant income” then feeds into the calculations for the determination of the actual rates of entitlement to working tax credit and child tax credit, as governed by regulations 7 and 8 respectively of the Tax Credits (Thresholds and Determination of Rates) Regulations 2002. The former requires a 12-step calculation process while the latter mandates a marginally simpler 8-step process. However, both regulations share Step 3 (‘Finding the income for the relevant period’) in identical terms:

The “relevant period” is defined by regulations 7(2) and 8(2) respectively for each type of tax credit. In summary, it means any part of the period of award throughout which the recipient’s entitlement to tax credits remains the same. The effect of Step 3 is that the relevant income (see section 7(3) and letter ‘I’ in the equation) is reduced to a daily rate by dividing the amount by the number of days in the tax year (‘N1’), and that daily rate is then multiplied by the number of days in the relevant period (regulation 7(2) and ‘N2’). This produces an income figure for the relevant period. If there are changes in entitlement, such that there are different relevant periods, the Step 3 calculation will need to be repeated for each such period.

The position as summarised above for end of year final decisions is modified where a tax credit recipient makes a claim for universal credit, so bringing their tax credit award to an end. The process of assessment for an in-year final decision necessarily involves following a somewhat tortuous path through the dense thicket of tax credits primary and secondary legislation.

The best place to start is regulation 12 of the 2014 Transitional Regulations, entitled ‘Modification of tax credits legislation: overpayments and penalties’. Regulation 12(1) defines the scope of the regulation:

Pausing there, the claimant in the present case had made a claim for universal credit and so regulation 12(1)(a) was undoubtedly satisfied. She had also been entitled to tax credits in the same tax year (albeit for a brief 17-day period) and so met regulation 12(1)(b). Additionally regulation 12(1)(c) was fulfilled, as the Secretary of State was satisfied that she met most of the basic conditions of entitlement to universal credit as set out in section 4(1)(a)-(d) of the Welfare Reform Act 2012 (this third requirement has since been revoked by regulation 5 of the Universal Credit (Transitional Provisions) Amendment Regulations 2022 (SI 2022/752)). It follows that the claimant was covered by regulation 12.

That being so, regulation 12(5) modified section 48 of the Tax Credits Act 2002 to include the following new definition:

“part tax year” means a period of less than a year beginning with 6^th April and ending with the date on which the award of a tax credit terminated.

It will be evident from the discussion above that the “part tax year” in the claimant’s case was the 17-day period from 6 April 2019 to 22 April 2019.

The next provision of note is regulation 12A of the 2014 Transitional Regulations, as inserted by the Universal Credit (Transitional Provisions) (Amendment) Regulations 2014 (SI 2014/1626). Regulation 12A is promisingly headed ‘Modification of tax credits legislation: finalisation of tax credits’ and at the material time provided as follows:

The claimant here met all the criteria specified in regulation 12A(1), just as she had met the identical provisions in regulation 12(1). That being so, then “the amount of the tax credit to which the person is entitled is to be calculated in accordance with the 2002 Act and regulations made under that Act, as modified by the Schedule to these Regulations (“the modified legislation”)” (see regulation 12A(2)).

The purpose of regulation 12A was explained in the following terms by the Explanatory Memorandum to the Universal Credit (Transitional Provisions) (Amendment) Regulations 2014:

It was said this would reduce administrative complexity and confusion for claimants (Explanatory Memorandum, paragraph 7.5). The claimant in HMRC’s current appeal may well question whether that worthy intention has been realised.

In any event, what is now Schedule 1 to the 2014 Transitional Regulations makes a series of modifications to the Tax Credits Act 2002 and assorted tax credits secondary legislation which are to be applied in cases of in-year finalisation of tax credit entitlements. In particular, section 7(1)-(5) of the Tax Credits Act 2002 are modified by paragraph 2 of Schedule 1 to the 2014 Transitional Regulations so that they read as follows. In this version the relevant modifications are underlined (and note that subsections (6)-(10) have been omitted altogether as not material to this appeal):

The language used in these modifications is telling. Thus for end of year final decisions section 7(3) (as originally enacted) is predicated in part on the claimant’s “current year income”, whereas for in-year final assessments the calculation under the modified section 7(3) is based on a “notional current year income”. This terminology perhaps suggests some degree of detachment from reality.

As already noted in the context of end of year final decisions, tax credits entitlement depends in part on a person’s “relevant income” as defined in various different ways by section 7(3). Once the modifications have been applied, the first of the three variables is the recipient’s notional current year income. So, whichever way one turns, an essential component figure for defining “relevant income” in an in-year finalisation case is that person’s “notional current year income”. This expression is defined in turn by section 7(4A), also added by the modifications. In the case of a single person, as with the claimant in the present appeal by HMRC, her “notional current year income” is defined by section 7(4A)(b) as being “the income of the person for that part tax year, divided by the number of days in that part tax year, multiplied by the number of days in the tax year in which the part tax year is included and rounded down to the next whole number of pence”.

The starting point for the modified calculation is therefore “the income of the person for that part tax year”. We know what is the “part tax year”, namely the period from 6 April 2019 to 22 April 2019. But what then was the claimant’s “income … for that [period]”?

This income figure is identified by reference to the Tax Credits (Definition and Calculation of Income) Regulations 2002 (SI 2002/2006; ‘the Tax Credits (DCI) Regulations 2002’). This is just one of the several sets of secondary legislation which are modified by Schedule 1 to the 2014 Transitional Regulations (and in particular by paragraphs 11-23). In particular, paragraph 12 of Schedule 1 modifies regulation 2(2) of the Tax Credits (DCI) Regulations 2002 to insert the same definition of a “part tax year” as noted above. Regulation 3(1) then specifies the four steps to be used when calculating a person’s income for tax credits purposes (Step 4 is omitted from the extract below as it relates to trading income, which is immaterial in this case). As modified by paragraph 13 of Schedule 1 to the 2014 Regulations, and with the modifications underlined again, regulation 3(1) of the Tax Credits (DCI) Regulations 2002 reads as follows:

In the claimant’s case, the only type of income which comes into the equation is “employment income”, which is governed by regulation 4 of the Tax Credits (DCI) Regulations 2002. Regulation 4(1) itemises a total of 13 different types of income that are stated to fall within the meaning of the umbrella term “employment income” (sub-paragraphs (1)(a)-(m)). They include, for example, the cash equivalent of certain types of vouchers and credit-tokens (sub-paragraphs (1)(c)-(e)). However, the income in the present case is straightforward salary income. This falls squarely within regulation 4(1)(a). As modified by paragraph 14(a) of Schedule 1 to the 2014 Transitional Regulations, this sub-paragraph covers (text in bold for emphasis):

Therein lies the error of law made by the First-tier Tribunal. In a nutshell, the Tribunal looked at and took into account the claimant’s “earnings from an … employment attributable to the part tax year” rather than her “earnings from an … employment received in the part tax year”.

There is no dispute in this case but that the claimant received earnings in the sense of taxable pay in the sum of £1,244 on 15 April 2019. That date plainly fell within the part tax year of 6 April 2019 to 22 April 2019. It follows that £1,244 was the figure that ought to have been incorporated into the Tribunal’s calculation for the purposes of determining the “notional current year income” in accordance with section 7(4A)(b) of the Tax Credits Act 2002. This means – with the appropriate figures inserted – “the income of the person for that part tax year [£1,244], divided by the number of days in that part tax year [17], multiplied by the number of days in the tax year in which the part tax year is included [366] and rounded down to the next whole number of pence”. Doing that calculation produces a figure for the claimant’s notional current year income – with the emphasis very much on the word “notional” – of £26,782.

The figure for the notional current year income is then subjected to further number-crunching in accordance with the various provisions of the tax credits legislation. The next stage, having found the notional current year income, is to identify the claimant’s “relevant income” as defined by section 7(3). In this instance, the circumstances are such that section 7(3)(b) applies. With the modifications underlined and the appropriate figures again included in parentheses, this provides that the claimant’s “relevant income” is as follows:

The subtraction required by section 7(3)(b) necessarily produces a “relevant income” figure in this case of £24,282 (£26,782 - £2,500).

As previously explained, thedetermination of the actual rates of entitlement to tax credits is then governed by regulations 7 and 8 of the Tax Credits (Thresholds and Determination of Rates) Regulations 2002. As modified by paragraphs 26 and 27 of Schedule 1 to the 2014 Transitional Regulations, Step 3 specifies in each case as follows:

As such, Step 3 requires the following calculation. First, the amount indicated by the letter “I” is identified, namely “the relevant income for the part tax year to which the claim for the tax credit relates”. At first blush I took this to be simply the relevant income figure of £24,282, but applying the formula this would result in the very strange if not outlandish outcome of the claimant being treated as having a relevant income in that same amount for the 17-day part tax year. I therefore agree with Mr Eland’s submission that an amount “must first be produced by dividing the relevant income (such being the applicable annual or annualised amount as determined with reference to modified section 7(3)), by the number of days in the tax year and then multiplying the result by the number of days in the part tax year”. This is an appropriately purposive interpretation which gives practical effect to the full expression “the relevant income for the part tax year to which the claim for the tax credit relates”.

In the claimant’s case, that means the annual relevant income figure of £24,282 is divided by 366 and multiplied by 17, producing a relevant income figure for the one relevant period of £1,127.85. Applying the formula in Step 3 then results in a worked calculation where the outcome is £1,127.85 – namely £1,127.85 (I) divided by 17 (N1) and multiplied by 17 (N2). This may appear to be unnecessarily circuitous, but as Mr Eland rightly points out there may be more than one relevant period in issue and so the Step 3 calculation may need to be repeated.

Mr Eland also rightly accepts on behalf of HMRC that “as it stands the rule is perhaps not as clear as it ought to be” in the context of the modified Step 3. He reports that HMRC “are liaising with the Secretary of State’s officials to have this regulation amended at the earliest available opportunity”.

I have not overlooked the claimant’s argument that she should not be penalised for a lack of clarity in the regulations. However, as noted above, the alternative reading of the modified Step 3 would have resulted in an even more disadvantageous outcome for her. The construction advanced by Mr Eland (see paragraph 40 above) is the only reasonable interpretation of the modified Step 3 and is consistent with the overall purpose of the legislative scheme.

I have also not overlooked the claimant’s argument that she never had annual earnings of £24,282 (let alone £26,782). As Mr Eland explained, there is no suggestion that she had. The clue lies in the terms of the modified tax credits legislation which applies to in-year final decisions e.g. where a claim for universal credit is made, so terminating a tax credits award. In such cases the calculations are based on a notional current year income, not an actual current year income – not least because at the time the decision is taken the actual earnings for the tax year in question will not yet be known. The legislative scheme as modified for in-year final decisions focusses on earnings actually received in the part tax year concerned, and not simply the earnings directly attributable to that period. The policy justification for the approach adopted in the modified tax credits legislation may not be immediately obvious, but the statutory focus is clearly on “any earnings from an… employment received in the part tax year.”

In contrast, the approach to the calculation taken by the First-tier Tribunal in this case, while superficially understandable, had no basis whatsoever in the modified statutory provisions governing the assessment of entitlement to tax credits.

I just make one final observation. It is unclear from the paperwork on file whether HMRC has already sought recovery of the resulting overpayment of tax credits. That is a discretionary decision over which neither the Upper Tribunal nor the First-tier Tribunal has any jurisdiction. In deciding whether to recover the overpayment, and if so on what terms, I hope that HMRC will bear in mind that the claimant, through no fault of her own, has experienced considerable anxiety as this matter has taken several years to resolve.

I can sum up as follows. The First-tier Tribunal was wrong as a matter of law. It follows I must allow HMRC’s appeal (section 11 of the Tribunals, Courts and Enforcement Act 2007), set aside the First-tier Tribunal’s decision and re-make the First-tier Tribunal’s decision accordingly.