HM Revenue and Customs v William Grant and Sons Distillers Ltd; Small (Inspector of Taxes) v Mars UK Ltd
| Jurisdiction | Scotland |
| Judgment Date | 23 August 2005 |
| Docket Number | No 2 |
| Date | 23 August 2005 |
| Court | Court of Session (Inner House - Extra Division) |
Court of Session, Inner House (Extra Division).
Lord Penrose, Lord Osborne, Lord Reed.
CM Campbell QC and Jane Paterson (instructed by the Solicitor for Revenue & Customs) for the Crown.
Colin Tyre QC and James Mure (instructed by McGrigor Donald) for the taxpayer.
The following cases were referred to in the judgment:
Addie v IR CommrsTAXUNK (1875) 1 TC 1; (1875) 2 R 431
Duple Motor Bodies Ltd v Ostime (HMIT)TAXWLR (1961) 39 TC 537; [1961] 1 WLR 739
Edward Collins & Sons Ltd v IR CommrsTAXENR (1924) 12 TC 773; 1925 SC 151
Gallagher v Jones (HMIT)TAXELR [1993] BTC 310; [1994] Ch 107
IR Commrs v Secan LtdTAX (1998) 74 TC 1
Minister of National Revenue v Anaconda American Brass LtdELR [1956] AC 85
Patrick (HMIT) v Broadstone Mills LtdTAX (1953) 35 TC 44
Russell v Town and Country Banks LtdELR (1888) 13 App Cas 418
Ryan v Asia Mills LtdTAX (1951) 32 TC 275
Small (HMIT) v Mars (UK) LtdTAX [2005] BTC 236
Sun Insurance Office v ClarkTAXELR (1912) 6 TC 59; [1912] AC 443
Whimster & Co v IR CommrsTAXENR (1925) 12 TC 813; 1926 SC 20
Corporation tax - Capital or revenue expenditure - Depreciation - Treatment of depreciation in stock - In preparing financial statements gross depreciation shown and then reduced by amount of depreciation in stock leaving net depreciation - Net depreciation deducted in arriving at accounting profits and depreciation in stock capitalised - When adjusting accounting profits for tax purposes only net depreciation added back; depreciation in stock carried forward and deducted from profits in year in which stock sold - Inland Revenue argued that in each year gross depreciation should be added back for tax purposes - Whether, in making tax adjustments to accounting profits, net depreciation should be added back with depreciation in stock being added back in year in which stock sold - Income and Corporation Taxes Act 1988 section 74 subsec-or-para 1Income and Corporation Taxes Act 1988, s. 74(1)(f).
This was an appeal by the Revenue against a decision of the special commissioners ((2004) Sp C 408) that, in making tax adjustments to accounting profits, net depreciation should be added back with depreciation in stock being added back in year in which stock sold.
In preparing its financial statements the taxpayer included in the cost of unsold trading stock the overhead costs incurred in producing the trading stock. At the end of the year depreciation on manufacturing fixed assets was treated as an overhead cost, capitalised and included in the carrying value (i.e. the balance sheet value) of closing stock and carried forward to the next year. The gross depreciation was debited in the profit and loss account followed by a simultaneous credit to the profit and loss account to adjust for the capitalisation of the depreciation in stock. The other side of the double entry dealing with that adjustment was a debit to the carrying value of closing stock (thereby increasing that carrying value by the amount of depreciation in stock). The amount of the final accounting profits was calculated by deducting net depreciation and not gross depreciation.
Because s. 74(1)(f) of the Income and Corporation Taxes Act 1988 prohibited, for tax purposes, the deduction of sums employed as capital in the trade, and because depreciation in respect of fixed assets was a deduction in respect of capital, the accounting profits shown in any trader's profit and loss account (although they were computed in accordance with generally accepted accounting practice) had to be adjusted for tax purposes by cancelling the deduction for depreciation. That cancelling was known as "adding back". In preparing its tax computations the taxpayer added back the amount of net depreciation but did not add back the amount of depreciation in stock; depreciation in stock was carried forward and effectively added back in the year when the stock was sold.
The Inland Revenue accepted that the taxpayer had computed its accounting profits in accordance with generally accepted accounting practice. However, they argued that gross depreciation, including depreciation in stock, had been deducted in the accounting period and so should be added back in the accounting period. The taxpayer argued that the depreciation in stock had not been deducted from the accounting profits and so it was wrong to require it to be added back to the accounting profits for tax purposes.
The special commissioners decided that the adjustment required for the purposes of corporation tax by way of "adding back" depreciation to arrive at the amount of taxable profits was the amount of net depreciation, not the amount of gross depreciation.
The Revenue appealed to the Court of Session. While they accepted that the taxpayer's financial accounts were prepared in accordance with GAAP, they contended that the necessary adjustment for tax purposes required by ICTA 1988, s. 74(1)(f) had not been made in the company's tax computation, with the result that the taxpayer's taxable profits for the accounting period had been understated. Notwithstanding the use made of part of the depreciation in computing the amount for stock, the amount that was truly deducted when computing profits was the gross or full amount of depreciation, and if that was right it followed that the amount to be added back should be the same.
The taxpayer contended that the purpose of s. 74(1)(f) was to cancel, in the taxpayer's tax computation, any deduction in respect of capital employed in the business, which had reduced the company's profits for the year in its commercial accounts. The taxpayer's treatment of depreciation was wholly in keeping with UK GAAP which allowed for not treating the whole depreciation as an expense in the profit and loss account in the year in which the depreciation was shown; but for "depreciation in stock" to be debited instead to the cost of stock/work in progress. The depreciation was to be treated as an expense of the year in computing the profit and, to that extent only, it fell to be added back for the purpose of the tax computation.
Held, allowing the appeal (by a majority):
1.The question, in terms of s. 74(1)(f), was what was the sum employed or intended to be employed as capital in the trade, given that depreciation was or represented a sum employed or intended to be employed as capital of the taxpayer's trade. (Addie v IR Commrs (1875) 2 R 431 applied.)
2.In computing the taxable profits of a trader, the trader had to make appropriate adjustments to reflect the opening and closing stock and work in progress held for the purposes of the trade. The court would yield to accountants full authority to determine on generally accepted accounting principles and practices the amounts to be taken to represent the tangible assets so held, but it was for the court to say that in computing the full amount of the profits and gains arising in an accounting period such an amount should be taken into account as a reflection of the cost incurred in acquiring or producing stock and work in progress, or, if lower, the net realisable value of those assets.
3.If that was right, the taxpayer could not avoid the consequences of the rule by crediting the individual cost components to the expense accounts from which they were derived and so directly reducing the amount treated as expenses in the period, notwithstanding that those sums had been ascertained in accordance with generally accepted accounting practice. The essential error in the taxpayer's approach was in treating bookkeeping for expense as the reality, and ignoring the injunction in the authorities to focus on the reason for making any adjustment, i.e. that the trader held unsold stock and unfinished work in progress.
4.As between the parties, there was no dispute that, if opening and closing figures had to be taken into account in computing taxable profits, the carrying amount for stock and work in progress had to be determined by identifying the lower of cost and net realisable value for each item or class of items of tangible assets held as stock or in the course of manufacture at the reference dates for each accounting period, and reflecting the appropriate amounts in computing taxable profits. The amount of depreciation that fell to be taken into account for closing stock in expressing the carrying amount was the amount apportioned out of gross depreciation provision for the period. If that was done, there remained nothing in name of depreciation in stock available to credit directly to the gross depreciation charge against revenue. The result was that there should be added back the whole depreciation computed for the accounting period. The amount that fell within s. 74(1)(f) in respect of depreciation in accounts prepared under the Companies Act was the amount of depreciation that required to be written off, whatever the application of that sum in or towards the indirect production costs of other assets, and in particular stock.
5.This was a case in which some departure from the financial statements was required notwithstanding that they met the requirements of UK GAAP. The issue was as to the amount of that adjustment, and that was a question of law. In all the circumstances, the amount required to be added back in computing the taxable profits of the taxpayer for the period in question was the gross amount of depreciation.
Lord Penrose:
[1] The appellants, the Commissioners of Revenue and Customs (the Revenue), appeal against a decision of the Special Commissioners of Income Tax ((2004) Sp C 408) in which the tribunal answered in favour of William Grant, the respondents, a question referred to them for determination in connection with an enquiry relating to William Grant's tax return for the year ended 28 December 2002. The case was heard together with an appeal by Mars UK Limited against an assessment for the...
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HM Revenue and Customs v William Grant & Sons Distillers Ltd Small (HM Inspector of Taxes v Mars UK Ltd
...These were appeals by the taxpayers against a decision of the High Court ([2005] BTC 236) and a decision of the Court of Session ([2005] BTC 483) that no allowance for the depreciation of assets was permissible in computing the taxable profits of the respective taxpayers. The dispute in the......