HMRC is seeking to recoup more than £4m from Audit Scotland over VAT rebates which it claims have been wrongly paid to Scotland's public spending watchdog since 2006.
Audit Scotland is understood to have recouped the VAT incurred by external companies that it contracted in to do audit work.
The issue came to light at a meeting of the Scottish Commission for Public Audit (SCPA) at the Scottish Parliament, when Auditor General Caroline Gardner told MSPs that the organisation had not budgeted for the tax demand and was challenging the bill.
It relates to the tax status of the former Accounts Commission for Scotland, which merged with the National Audit Office's activities in Scotland to form a new body, Audit Scotland, in 2000. Prior to the merger, the Accounts Commission had Section 33 status, which enabled it to reclaim input tax on the audit fees charged to local government.
HMRC is now challenging this arrangement and says the tax recovered during this period should be repaid. The past liability is assessed as £4.1m, with Audit Scotland reclaiming between £400,000 and £500,000 a year.
In a letter to the Scottish Commission for Public Audit (SCPA), the parliamentary body which polices the watchdog, Gardner warned the debt could have a knock-on effect for local authorities, which could see their fees for audit work increased by around 5%.
Gardiner said: 'We believe HMRC have some fundamental misunderstandings about the current arrangements and have responded robustly.'
Audit Scotland has recently gone through a four-year budget strategy in which it has reduced the cost of audit by more than 20%, Gardiner said.
'I struggle to see how we could reduce our costs by anything approaching that amount. We would continue to apply that pressure, but the options we would have would be to ask the SCPA for funding or look at recovering it through local government fees, neither of which is palatable,' Gardiner said.
The question of the potential VAT rebate is a new issue for Audit Scotland, Gardiner explained, but the watchdog has also been in discussion with HMRC for two years over a second tax dispute which has now been settled.
This relates to the registration of Audit Scotland for business activities, and will see Audit Scotland pay £160,000 plus penalties which are likely to be around 15% of the total.
