SNP ministers were told flagship tax plan was beyond Holyrood's powers

The Government was also warned that even if it did work, their scheme would see a “significant” loss of revenue of around £1billion a year, could take eight years to introduce, and could lead to bigger bills for hard-up students and “adults with certain types of mental disabilities”.

But in spite of profound problems, ministers maintained their plan to switch to a local income tax remained a viable option, before backing away from it.

The failure of the policy led to the council tax freeze, which had been intended as a short-term stop gap, lasting nine years.

The broken state of the local income tax plan is laid bare in cabinet papers from the early months of the fledgling SNP administration, including a devastating legal opinion by the Lord Advocate, Elish Angiolini.

She said the plan, if passed by Holyrood, would be certain to attract a legal challenge.

“A decision that the tax was unlawful could, at its worst, prevent any further collection of the tax and require the repayment of all funds which had been collected. The consequences for local government finance and expenditure could be dramatic,” she said.

The SNP manifesto that year had stated: “We will scrap the unfair Council Tax and introduce a Local Income Tax set at 3p. This will apply at both the basic and higher income tax rate and will not be levied on savings income.” 

The pitch was that around two-thirds of homes would pay less than under council tax.

However a memorandum presented to the cabinet by Mr Swinney on 4 September 2007 listed a series of problems with the scheme.

These included the “critical” need for UK Government cooperation, including relying on HMRC to collect the tax - and HMRC saying the lead in time would be “around eight years”.

A local income tax (LIT) of 3 per cent would also represent “a significant tax cut for the Scottish Government”,creating a “revenue shortfall” of around £1billion a year.

In addition, “although there is a parliamentary majority for the abolition of council tax, we do not have a majority for the implementation of our proposed alternative”.

There were also “legal issues”, a section redacted in Mr Swinney’s paper, but illuminated by a rarely-released legal opinion by the Government’s top law officer, Ms Angiolini.

This was included in a paper due to be tabled to cabinet in late September, but ultimately not seen by ministers until late October.

In the paper, Mr Swinney admitted the Lord Advocate had “concluded that our proposals are outwith legislative competence”, meaning beyond Holyrood’s current powers.

This was down to two key aspects - firstly, the tax, due to be set by central government, was “not local’ enough” to qualify as a new local tax allowable under the Scotland Act.

Second, employers outside Scotland with workers in Scotland would need to make wage deductions for those Scottish employees based on the LIT - but Holyrood was specifically prohibited from taking powers “that would form part of the law of a country outside Scotland”. 

Mr Swinney wrote: “In summary, this means that the lion’s share of our LIT proposals will require UK legislation. Only the abolition of the council tax, and possibly the future tax on second homes, can form legislation for the Scottish Parliament."

There were also “a number of risks related specifically to the communication of this policy”. Mr Swinney explained: “The loss of the wide range of council tax exemptions and discounts will lead to a situation where many who could be seen as not particularly wealthy are worse off, for example some students and adults with certain types of mental disabilities.

“The business lobby could prove formidable opponents to this policy, both for reasons of increased bureaucracy and notions of ‘fiscal flight’.”

In a desperate sounding conclusion, Mr Swinney said: “We need to agree clear lines on how this policy change will be funded, a challenge that is aggravated by a lack of clarity as to which year it will be implemented.”

In her legal opinion, the Lord Advocate said: “The provisions necessary to give effect to the LIT proposal cannot wholly be delivered within the legislative competence of the Scottish Parliament because it seems to be the case that provision needs to be made which forms part of the law of a country or territory other than Scotland.”

She also said there was a “high” chance of the plan being challenged on the grounds of locality, and the consequences of a successful challenge “may be profound”.

Although the Scotland Act allowed the creation of novel local taxes, “the LIT proposal that I am asked to consider has no ‘local’ aspect to it at all other than that the revenue will be used to fund local authority expenditure”.

She concluded: “It is in my view certain that a challenge would be brought to the provisions of a Bill to give effect to the LIT proposal. A challenge to the Bill need not come from the UK Government, nor indeed by way of judicial review by a member of the public. 

“The tax will need to be collected, and a defence that the tax is ultra vires may be raised as a devolution issue by any defender in any proceedings to collect the tax.

“Were a court to agree that the tax was unlawful that could have profound consequences for both the Scottish Government and councils.

"While the courts are given wide discretion, under section 102 of the Scotland Act, to mitigate the impact of their decisions that the provisions of an Act of the Scottish Parliament is outside competence, a decision that the tax was unlawful could, at its worst, prevent any further collection of the tax and require the repayment of all funds which had been collected. 

“The consequences for local government finance and expenditure could be dramatic.”

However she said there was nothing to stop the Government consulting on an LIT.

When Mr Swinney discussed the issues with the cabinet in October 2007, he said HMRC had now indicated that “cooperation would be unlikely, and that, at best, the Government could expect a very long lead time for implementation of collection arrangements”.

The cabinet agreed to press on with a consultation but insisted the document “should not specify when in 2008 the Government would bring forward” its legislative proposals.

The consultation document said the Scottish Government would require “UK Government cooperation” to deliver on the “challenging” task of introducing an LIT, but there was no hint of the deep legal problems behind the scenes.

It was almost 18 months later, in February 2009, that Mr Swinney finally dropped the LIT, by which time it had been trashed by business groups, unions, the Treasury and tax experts.

In parliament, he blamed “swingeing Westminster-imposed cuts” for making it impossible to introduce the tax and insisted it remained SNP policy.

He told MSPs: “The Cabinet has…  decided not to introduce legislation to abolish the unfair council tax and replace it with a local income tax until after the election in 2011. 

“However, members should make no mistake - the Government will fight that election to win a parliamentary majority that backs the abolition of the unfair council tax.”

The SNP manifesto for the 2011 Holyrood election did not promise to bring back LIT.

Instead it said the council tax freeze would continue and the Government would “consult with others to produce a fairer system based on ability to pay to replace the council tax” which would be put to the people at the 2016 Holyrood election. It didn’t happen.