UKHL 15

The House of Lords determined that the amount of depreciation to be added back under ICTA 1988, s. 74(1)(f) was the net amount. This was because only the net amount would have been deducted in computing the amount of the profits for the relevant period.

Facts

The dispute in these appeals concerned the computation of the trading profits of the taxpayers, Mars UK Ltd (‘Mars’), which made confectionery and pet food, and William Grant & Sons Distillers Ltd (‘Grant’), which made Scotch whisky, in the years ending 28 December 1996 and 28 December 2002 respectively. There was no dispute that the profits stated in their accounts had been computed on a basis which gave a true and fair view.

In each case, in accordance with current accounting standards, certain deductions were made for the depreciation of fixed assets. But ICTA 1988, s. 74(1)(f) provided that in computing profits for tax purposes, no sum should be deducted in respect of ‘any sum employed or intended to be employed as capital in the trade’. Although the language was by no means clear, that had always been taken to prohibit deductions for the depreciation of capital assets. Any sum which had been deducted for depreciation in the computation of profits had to be added back. The question was to identify which sums had been so deducted.

The methodology employed by the taxpayers in making their computations followed the relevant accounting standards (the Statement of Standard Accounting Practice (‘SSAP’)). In order for the financial statements to reflect properly all the costs of the enterprise it was necessary for there to be a charge against income in respect of the use of such assets (‘depreciation’). The accounting treatment in the profit and loss account had to be consistent with that used in the balance sheet. Hence, the depreciation charge in the profit and loss account for the period was to be based on the carrying amount of the asset in the balance sheet, whether historical cost or revalued amount. The whole of the depreciation charge should be reflected in the profit and loss account. The depreciation charge for each period had to be recognised as an expense in the profit and loss account unless it was permitted to be included in the carrying amount of another asset. The depreciation deducted in the profit and loss account for a given period had to correspond with the depreciation shown in the balance sheet as having occurred over that period, unless it was permitted to be included in the carrying amount of another asset.

In accordance with those standards, both taxpayers divided the depreciation which occurred during the year or was carried in the opening stock figure into two parts (‘A’ and ‘B’). A was the depreciation in fixed assets which related to the production of goods sold during the year or in assets which were not used for production at all. B was the depreciation in fixed assets which related to production of unsold stocks. They deducted A from the year's revenue and carried B forward as part of the cost of unsold stocks. Thus the Grant profit and loss account showed ‘Turnover’ of £137,512,000 and ‘Cost of Sales’ of £99,340,000. The latter figure did not include B.

Note 4 to the accounts said that operating profit was stated ‘after charging depreciation’. It gave the figure for total depreciation (A and B) and deducted the figure for depreciation ‘included within stock’ (B).

The Mars accounts were less explicit. Note 5 said that profit on ordinary activities before taxation was stated after charging ‘depreciation on tangible fixed assets’ and then gave a figure for A and B together. But Note 10 said that depreciation of £3,039,000 (B) had been ‘included in the stock valuation’ and there was no dispute that the figure for ‘Cost of Sales’ in the profit and loss account included A but not B.

The special commissioners heard and allowed the appeals of both taxpayers against assessments which added back the B part of the year's depreciation. The Revenue then appealed successfully against the Mars decision to Lightman J ([2005] BTC 236) and against the Grant decision to the Court of Session ([2005] BTC 483). Both taxpayers appealed to the House of Lords.

Issue

Whether the amount to be ‘added back’ to the reported profit for the relevant year, in order to arrive at the taxable profit for that year, was the whole of the amount by which the value of fixed assets had been written down during that year in the balance sheet, or the amount by which the reported profit had been reduced because of depreciation.

Decision

Lord Hoffmann (Lords Hope, Walker, Mance and Neuberger agreeing) (allowing the appeals) said that the expert accountants on both sides were agreed on the way the computations had been made and that the resulting statement of profits was in accordance with the standards and gave a true and fair view. And on these admitted facts, it was plain and obvious that, as only A had been deducted, s. 74(1)(f) did not require B to be added back.

Submissions that accounts had to comply with fundamental principles of accounting additional to the best practice of accountants as embodied in the accounting standards have been made in other cases but had always been rejected. In this case, it took the form of saying that profits had to be ascertained by taking all the revenue received during the year, deducting all the costs (including depreciation) incurred during the year and making an adjustment for the difference between opening and closing stocks, treating an increase in stock value as if it was revenue.

That was one way of computing profits and might have been the only practical method when record-keeping was not sufficiently sophisticated to enable one to make a meaningful attribution of costs in one year to sales in some future year. It was not, however, the philosophy of SSAP 9, which permitted the cost of unsold stock to be carried over into future years and set against future sales. In that exercise, relevant depreciation was simply another cost.

The Revenue had argued that treating depreciation carried in stock as a cost excluded from the current year's computation and held back for a future year's computation was a category mistake. Stock was an asset which had a value and could not be a cost. But that confused the role of stock in a balance sheet with its role in a profit and loss account. The balance sheet was a statement of assets and liabilities on a given date and in that statement, stock was one of the assets.

The profit and loss account, on the other hand, was concerned with revenue and costs, and in that context, the figure for stock represented a cost which SSAP 9 required to be kept out of the computation of profit for the year but recorded to be carried over into the computation for a future year.

A fall in the value of stock to below cost, although it involved no immediate outgoing or loss of income, was something which the principle of prudence required should be treated as an expense and reflected in a deduction from that year's profit. There was no conceptual problem about recognising such a write down as an immediate expense but carrying the cost of stock forward to be a future expense. Further, there was nothing in any of the provisions of the Companies Act 1985 which prevented depreciation (or any other cost) being deducted in a subsequent year if that was calculated to give a true and fair view of the profits.

House of Lords.
Opinions delivered 28 March 2007.