Whisky Galore

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Whisky Galore

MIKE TRUMAN analyses the implications of the Mars and Distillers cases for add back of depreciation.

'WHEN IN DOUBT draw a T account.' Halfway through reading the Special Commissioners' decision in the combined Mars and William Grant Distillers cases (SpC 408), I found myself doodling T accounts in the margins to try and understand what was going on. The cases concerned the amount that should be added back for depreciation in the tax computation — should it be the gross charge that increases the balance sheet provision, or should it be a net figure after adjusting for the depreciation in stock? Before I try to explain what happened in the cases, let's look at a far simpler example.

Mr Toad's widgets

Mr Toad starts a business making widgets for the motor industry, which he sells for £1 each. It's a simple business — he buys in strip metal, and feeds it into a press which stamps out the widgets. He has no employees and no other costs. The press cost £10,000 and has a useful economic life of nine years, after which he can sell it for £1,000. During his first year Mr Toad presses 100,000 widgets. At the end of the year he has 10,000 widgets in stock. The total cost of the strip metal bought in the year was £20,000 and there is none in stock at the end of the year.

In preparing a statement of income and expenditure (see Example 1), Mr Toad puts through a provision for depreciation on the press of £1,000. The debit is to depreciation in the profit and loss account, the credit to accumulated depreciation in the balance sheet.

Stock has to be valued at the lower of cost or net realisable value. Generally accepted accounting practice requires overheads to be included, which in Mr Toad's case means an appropriate proportion of the depreciation. Since 10 per cent of production is left in stock, 10 per cent of the cost of strip metal, £2,000, needs to be debited to stock; and 10 per cent of the depreciation, £100, giving a total value for stock of £2,100.

Debit stock, credit? Cost of sales, of course. So in our simple example, the cost of sales for Mr Toad is £20,000 less £2,100, making £17,900. His net profit (see Example 2) is £71,100. This can be analysed as sales of 90 per cent of the production for £90,000, less 90 per cent of the raw material cost, £18,000 and 90 per cent of the depreciation, £900.

Tax return

So Mr Toad then prepares his tax return. All is fine until he comes to box 3.44 on the self-employment pages. He has entered £1,000 into box 3.62 as depreciation. The notes to the self-employment pages tell him that, unless finance leases are involved, 'any figure in box 3.62 should be cancelled by putting the same figure in box 3.44'. The result is that his taxable profit before capital allowances is now £72,100. The £72,000 is fair enough, it being the proceeds of selling 90,000 widgets at £1 each less the raw material costs of that production, £18,000. But where has the £100 come from?

The answer is that it is the amount of depreciation carried in stock. Although in Mr Toad's accounts the net amount of depreciation charged was £900, that is made up of the gross charge for the year of £1,000 deducted in calculating net profit, less the £100 that was included in the stock valuation.

Mr Toad thinks this seems very unfair. He has only really charged £900 of depreciation, net, in his income and expenditure account and yet £1,000 has been added back.

That, in essence, is the argument of both Mars and Distillers. The main difference is that, following Format 1 for company profit and loss accounts, the gross depreciation charge was also debited to cost of sales, since the three expense headings in the profit and loss account are to be stated including any depreciation. If Mr Toad had prepared his accounts in the same way, the T account would have been as set out in Example 3, and the argument that the depreciation charge for the year charged to profit and loss was only £900 would have been even stronger.

Mars and William Grant Distillers

The facts in Mars were that the company had for many years charged gross depreciation to cost of sales and then, according to the case report, credited the amount for depreciation in stock. Presumably this simply meant that they credited the total figure for closing stock which included an amount for depreciation. In the corporation tax computation, they added back the full charge that had been taken to accumulated depreciation; in other words the gross charge.

In 1996 PricewaterhouseCoopers, the accountants for Mars, formed the view that the taxable profits were therefore overstated. Only the net depreciation charge, after crediting the amount carried in stock, should have been added back in the tax computation. They therefore expanded the note on stock in the 1996 accounts to show that depreciation of just over £3 million had been included in the valuation, and submitted a computation for the year which reduced the taxable profit by this amount. They realised that, strictly, the computations for the earlier years should have been reopened, but proposed the single adjustment as an easier way of making the correction. The Inland Revenue refused to accept the reduction at all, and that refusal was the subject of the appeal.

William Grant Distillers, on the other hand, had prepared their tax computations on the basis that only net depreciation was added back since at least 1992. This was discussed with the Inland Revenue in 1995 and 1996, and accepted on the basis that William Grant had records which allowed them to identify the movements in stock for each year and to make adjustments accordingly.

However, in 2002, the Inland Revenue told William Grant that this approach to depreciation was no longer acceptable, and that depreciation in stock should be included in the amount added back. This followed a Tax Bulletin item that is now in the Business Income Manual at paragraph BIM33190 and was triggered by the decision in the Hong Kong case of Secan Ltd v Commissioners of Inland Revenue FACV 9 of 2000.

Secan

The case concerned interest that had been capitalised by being debited to a development account. The taxpayers were trying to retrospectively reverse the decision to capitalise interest by claiming that it breached a requirement in Hong Kong tax law to deduct interest in the year that it arose.

Lord Millett's analysis of the case was that the interest had been deducted in the year, by debiting it to the development account as a cost. In his analysis, the development account is a revenue account, and the value of the development is then taken to the balance sheet. Just because this value is the same as the cost does not mean that the cost has not been deducted in the year — it has been deducted and then the value capitalised.

The distinction between the cost and the value seems rather odd, given that the development is simply carried at the lesser of cost or net realisable value. There are also some rather disconcerting comments about debits and credits:

To a layman, used to seeing his affairs as stated in the bank's books, a debit may indeed be a liability, but not to an accountant. One can, perhaps, see what his Lordship is trying to say, but the use of layman's terminology in the quotations above when the rest of the judgment tries to give an interpretation in accounting principles was rather unhelpful.

The Inland Revenue, however, relied on it as authority that the inclusion of depreciation in stock did not mean that only the net depreciation had actually been charged to profit and loss. Simply because some of the depreciation had later been capitalised did not mean that the gross depreciation had not originally been charged, and the gross was therefore the figure that had to be added back.

Special Commissioners

The more I read the Special Commissioners' decision, the more I feel that it is an implicit rebuttal of Lord Millett's argument in Secan. It is perhaps not coincidental, given the points above, that they set out in some detail the basic 'accounting equation' issues for debits, including:

They then go on to point out that section 42, Finance Act 1998 starts by requiring the profits of a trade to be computed in accordance with generally accepted accounting practice. Both companies had complied with this. The section goes on to make this subject to any adjustments required by law. The law concerned is section 74(1)(f), Taxes Act 1988 which prohibits deductions in connection with capital. The case of Addie & Sons v Commissioners of Inland Revenue (1875) 1 TC 1 is authority for the principle that depreciation falls within this definition, so must be added back.

Both expert accountancy witnesses, called by the taxpayers, had agreed that only net depreciation had been deducted in computing the accounting profits, because the gross depreciation had been reduced by a true 'contra' item for the depreciation carried in stock. However, the Special Commissioners took a different line, which had not been suggested by either party. The diminution in the value of the asset was the addition to the provision for depreciation in the balance sheet, and this was the gross amount. The Special Commissioners were therefore minded to see the increase to the provision for depreciation as the amount which must be added back. However, they did not stop there.

As well as providing for depreciation in the accumulated depreciation provision, some depreciation had also been included in the valuation of stock. This also related to capital, and therefore should be deducted from the taxable profit. The result was that the net depreciation was added back, either because the gross figure was offset by a true contra as the taxpayers had argued, or on the Special Commissioners' view that both the increased provision and the depreciation in the stock valuation carried in the balance sheet had to be removed as relating to capital.

Making a claim

So is it worth making a claim and, if it is, who can make one? It is important to realise that this is essentially a timing difference. In his first year, Mr Toad in our example would reduce his taxable profit by £100 if only the net depreciation was added back. But if year two was an exact repeat of year one, the £100 left in stock at the end of the year would be matched by the £100 brought forward in opening stock and they would cancel each other out. It is therefore only worth considering when stock carries a high and rising amount of depreciation.

Finally, who can make a claim? The Inland Revenue will probably want to argue that past cases cannot be reopened under error or mistake relief because they were prepared according to prevailing practice. However, the need for the Tax Bulletin article in the first place, and the acceptance of the William Grant Distillers computations until 2002, would suggest that there was no clear prevailing practice.

Alternatively, the Inland Revenue might argue that there is no error or mistake, because the right to offset depended on the presentation of the financial statements. Here the answer may depend on whether the Special Commissioners' preferred interpretation or that of the taxpayers is correct.

On the basis of the taxpayers' argument, it might indeed be possible for the Inland Revenue to argue that the right to deduct the amount of depreciation in stock only arose for those who had shown the depreciation as a separate item in the notes to the accounts. However, on the interpretation of the Special Commissioners this would be irrelevant, as the adjustment for depreciation in stock arises from section 74 and not from the accounting treatment.

The amount of profit to be added back if Mars lose on the Revenue's appeal is over £3 million, and for William Grant Distillers it is over £9 million. These two are test cases for a further thirteen companies with similar issues, according to the Special Commissioners. Not surprisingly, permission has been given to 'leapfrog' the case to the Court of Appeal. However, the Special Commissioners' judgment seems to be based on good accountancy principles, and must stand a good chance of being upheld.

Example 1

Depreciation a/c

Accumulated Depreciation 1,000 Profit & Loss 1,000

Accumulated dep'n a/c

Balance Sheet 1,000 Depreciation 1,000

Stock a/c

Cost of sales 2,100 Balance Sheet 2,100

Cost of sales a/c

Purchases 20,000 Stock 2,100

Profit & Loss 17,900

20,000

Example 2

Statement of income and expenditure: £

Sales 90,000

Less:

Cost of sales 17,900

Gross profit 72,100

Less:

Depreciation 1,000

Net profit 71,100

Example 3

Cost of sales a/c

Purchases 20,000 Stock:

Depreciation 1,000 Materials 2,000

Depreciation 100 2,100

To P&L 18,900

21,000 21,000

Issue: 3973 / Categories: