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Replies to Queries - 3 - Sharkey shock

20 November 2002
Issue: 3884 / Categories:

Our client company is a close company whose principal activity is that of house builders and developers.

Our client company is a close company whose principal activity is that of house builders and developers.

The company acquired a house, which was a listed building, together with some land on which its intention was to obtain planning permission and build new houses for resale. The managing director decided that he would like the house as his own residence and therefore the house, together with a small parcel of the land, was conveyed from the company to him personally and the balance of the land was retained by the company as stock and subsequently developed by the company.

As the house had obviously been bought originally as trading stock, the director acquired at a valuation and he paid into the company a sum representing the market value at the date of his purchase. The Inspector accepts that no tax implication arises out of this transaction, as full market value was paid.

The house, now in the ownership of the director, was then substantially renovated. The company paid for the materials and subcontractors used for this work, and the director paid into the company for these costs.

The Inspector contends that, in determining the taxable profits of the company for corporation tax purposes, the costs of the work carried out is either trading stock or work in progress and therefore the case of Sharkey v Wernher 36 TC 275 should be applied so that market value is credited for tax purposes. We are claiming that the costs incurred do not form part of the normal trading stock or work in progress as they were incurred for a specific purpose of renovating the director's residence and that therefore no profit element should be taken into account.

Readers' advice on this matter would be appreciated together with any implication relating to a tax charge on the director as a benefit in kind.

(Query T16,114) - Confused.

If the amount expended by the company on renovating the director's residence did represent trading stock or work in progress, the Inspector's position would be correct. The basis is set out in the Inland Revenue Inspector's Manual at paragraph IM300. The manual also makes reference to the cases of Petrotim Securities Ltd v Ayres 41 TC 389 and Skinner v Berry Head Lands Ltd 46 TC 377.

The query does not give any indication as to why the Inspector may believe that the expenditure represents trading stock or work in progress. Has it been treated as such in the accounts? If so, this could present difficulties.

It would seem more likely that the director needing to spend money on his own house decided to take advantage of the wholesale prices at which the company could buy materials. He also gained the comfort of using known subcontractors instead of having to get out the Yellow Pages to find a firm. When the costs had been incurred, 'Confused' indicates that the company was reimbursed for the cost of materials and subcontractors, so that the company did not lose out. As such, the market value of the work done would not have to be credited in the accounts for tax purposes.

This only leaves the question of whether the arrangements resulted in a benefit in kind for the director. This is an in-house benefit and so, following on from the case of Pepper v Hart 65 TC 421, the Revenue set out its practice in relation to such benefits in a press release dated 21 January 1993. The basic rule derived from Pepper v Hart is that where an employee meets the marginal cost to the employer of providing the benefit, the cash equivalent of the benefit is nil.

An area in which a benefit could arise is if employees of the company were used to do, or oversee, the work on the house, or other facilities were provided. In determining this issue, 'Confused' will have to find out if the people or the assets would have been used in other ways if he had not been having work done on his house. If the employees or assets would just have been standing idle, the cash equivalent of the benefit is nil, as the provision of the benefit has not cost the company a penny.

Alternatively if employees had to be pulled off other jobs, or if overtime had to be paid, the separate elements of the cost will have to be identified and the benefit quantified.

Where it is ultimately shown that there is a benefit in kind that is greater than the figure declared on form P11D for the director, a penalty may be levied on the company for the completion of an incorrect P11D. There will also have been an underpayment of Class 1A National Insurance contributions by the company. The tax return for the director will have been incorrect and will require repair, if in time, leading to additional tax, interest and possibly surcharges or penalties. - Hodgy.


Although 'Confused' does not mention VAT, this could be a serious problem. It is not clear from what is said whether any direct labour was employed but it presumably was, the company being a house builder as well as a developer. Moreover, its staff will have supervised the job.

If that is so, Customs are likely to argue that there was a supply of building services by the company and that, the supply being to a connected person, it should be valued at market value (paragraph 1 of Schedule 6 to the VAT Act 1994). Even if the situation was at least partly handled correctly - with the VAT being recovered on the materials bought in or taken from stock and on the subcontractors' invoices and then charged on in both cases - there are presumably records of staff time, which are the basis for the corporation tax problem. One could try the argument that there is no VAT on a free supply of services, but the problem will be that the elements already charged will be seen as part consideration for a single supply, and not separate from that of the staff time.

'Confused's' client may think that the work was all zero rated as the alteration of a listed building, but that is unlikely if it was already a house. Substantial renovation is likely to have included much work, which was repairs rather than alterations.

Finally, the house will need to have been unoccupied for at least three years for the 5 per cent reduced rate for renovations to be a possibility. - John Price.

Extracts from further replies received:

Reference should also be made to the Inland Revenue Inspector's Manual at paragraph IM1960. This refers to houses built or taken by builders for their own use and confirms that a house built and intended for personal use from the outset is not caught. Again, the costs should be disallowed in the accounts. It includes the comment: 'In practice, many cases fall between these two extremes and should be dealt with by determining the extent to which the house and land can be regarded as trading stock. For example, a private residence built on land held as trading stock would give rise to a Sharkey v Wernher adjustment in respect of the land alone'. While the costs of the work are required to be disallowed, the income will not be taxable either: the work is effectively a tax nothing. - Wentworth.

I have heard of cases where the Revenue has tried to apply the Sharkey v Wernher decision to situations where stock is removed from a company and, in my opinion, the decision only applies to unincorporated businesses. This is because in the case of a company, section 154(1), Taxes Act 1988 will apply. This states that a director will be taxed on the 'cash equivalent' of the benefit provided and section 156(1) defines the cash equivalent to be the cost to the employer (i.e. the company).

I had a similar case earlier this year: a window company where windows were taken out of stock for the director's own use. The Inspector suggested that the taxable amount should be based on market value and even suggested that there were several tax cases to support his view. I put the above argument to him and asked him to put forward the cases supporting his view. No cases were put forward and the enquiry was closed down. - Hutch.

Issue: 3884 / Categories:
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