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We have all probably tried at some time to explain to a shopkeeper client why he has to charge himself the full retail value if he takes a can of beans from the shelf for his tea, and then watched his face as we explained that this is because of a case about the breeding of racehorses
However, this is what the Inland Revenue has always maintained should happen, and few people have disagreed.
The question in Sharkey v Wernher 36 TC 275 concerned the value to be placed on trading stock, namely home bred foals, transferred between one enterprise of Lady Zia Wernher's, a stud farm, and another, the racing stable.
Although one was a trading enterprise and the other was not, this was said at the time to be not important.
It is not, in theory, important to look at the context of decisions by the House of Lords, but these days their Lordships can, if they so wish, reverse previous decisions.
An unusual situation?
More to the point, perhaps, is just how unusual the situation was for a case of such importance. The stud farm, although it did sell the occasional animal, existed largely to supply the racing stables, and in all probability was only treated as a trade at all because it was farming.
Remember that it was only in 1944, the first of the five years referred to in the case, that farming (and hence stud farming) had been brought under Schedule D and was taxed on its profits for the first time.
There was certainly no profit without the decision made eventually by the House of Lords. It was, in other words, the raison d'etre of the stud farm that it supplied the stables. In five years, 20 foals had been born at the stud and only three had been sold away (and those were probably sold because they were not up to standard).
The Inland Revenue Inspector's Manual at paragraph 572 states:
'The opinions delivered in the House of Lords in Sharkey v Wernher [1955] 36 TC 275 establish the principle that where a trader takes stock from his business for private use or for use in another business which he owns, or where he transfers to his business stock which he owns in some other capacity than that of proprietor of that business, the transfer should be dealt with for taxation purposes as if it were a sale or purchase at market value. Thus, goods which a trader takes from his trading stock (for example, for the personal use and enjoyment of himself and members of his household) should be credited at market value.'
In Sharkey v Wernher, the House of Lords reversed the decision of the Court of Appeal, although the decision in the House of Lords was not unanimous. Lord Radcliffe said:
'The problem, therefore, in all its simplicity is whether a person, carrying on the trade of farming or, I suppose, any other trade, who disposes of part of his stock-in-trade not by way of sale in the course of trade but for his own use, enjoyment, or recreation, must bring into his trading account for income tax purposes the market value of that stock-in-trade at the time of such disposition.'
It appears to be the case that the learned judges all expressed themselves amazed by the need for 'fictions' in this case, and said that in fact, as Lady Zia Wernher (qua stud farm) had in fact received nothing at all, then they were deciding between two fictions (cost and market value) of apparently equal standing.
Other options
But this is not the case: assuming the straightforward situation of a trader who withdraws goods from his trading stock for his own use, it is clear that the correct accounting treatment in these circumstances would be to credit the accounts with the cost and not with the market value.
Lord Radcliffe's judgment is crucial. He suggested there were three alternatives when an item is withdrawn from trading stock (and we should note that while he was not prepared to say that this was by way of trade, he would certainly not have said that it was not, and this may yet be the crucial point):
- Do nothing — of which he said 'a tax system which allows business losses to be set off against taxable income from other sources is in my opinion bound to reject such a method because of the absurd anomalies it would create between one taxpayer and another'.
- Bring in the cost of the item as a credit (though perhaps this omits the logical option, which is to take the lower of cost and net realisable value).
- Bring in the market value.
He chose the last, saying 'in a situation where everything is to some extent fictitious, I think that we should choose the third alternative of entering as a receipt a figure equivalent to the current realisable value of the stock item transferred'. He gives two reasons for his choice:
- 'It gives a fairer measure of assessable profit between one taxpayer and another, for it eliminates variations which are due to no other cause than any one taxpayer's decision as to what proportion of his total product he will supply to himself'.
- 'It seems to me better economics to credit the trading owner with the current realisable value of any stock which he has chosen to dispose of without commercial disposal than to credit him with an amount equivalent to the accumulated expenses in respect of that stock'.
Reasons are not arguments
These are reasons, but they are not arguments. Lord Radcliffe was doing what many judges do, which is to find the possible alternatives and see which one suits best.
However, that is by no means a rigorous procedure, and risks are now being viewed as mere prejudice of the time and being affected by the facts of a particular case.
Many would now argue, I think, that 'where everything is to some extent fictitious' one would look first of all for the principles of commercial accounting to decide which fiction to choose.
Lord Radcliffe was accepting the decision in Watson Bros v Hornby 24 TC 506, concerning a partnership which carried on a chick hatchery and a poultry farm.
Both these enterprises were trading enterprises, but what is very crucial is that the farming enterprise was assessed under Schedule B, so that only the hatchery was assessed to tax on its profits.
Too absolute?
What is true of both Watson Bros v Hornby and Sharkey v Wernher is that the trading enterprise in question existed primarily to service the other activity, as if a man should keep a corner shop so as to stock his own table.
It seems to me that this in itself calls the universality of the decision into question: is there not room here for distinguishing these cases from the more usual pattern?
Furthermore, in both cases one had to find a value. This is unlike the retailer, who knows exactly what he paid for the goods.
We might also reflect on the times.
While it would perhaps be an exaggeration to suggest that the Law Lords had been carried away by the same socialist tide which swept Attlee to victory in 1945, the fact remains that it was a time when tax evasion (with very high rates for the rich) was not popular because it had overtones of spivvery.
One can pretend that our highest court of appeal is above these things and does not create law, but I suspect the truth is otherwise.
Admittedly this particular point of law has been engrained into our tax system since 1955 and thus it will be all the harder to have it reversed.
Nevertheless is there a brave reader who is going to be the first to take this argument into an enquiry interview?
Simon Sweetman is an independent practitioner advising accountants, solicitors and other professions on tax issues. He can be contacted by telephone on 01394 274857 or by email.
