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Albert Arkwright wants to woo his neighbour, Nurse Gladys, with a bottle of sparkling wine (champagne being too expensive for the frugal shopkeeper).
So he calls to his trusted assistant, young Granville, who fetches the stool and reaches up to the top shelf of Arkwright’s shop where the dusty bottles have lain for months.
Granville, whose father was, apparently, a Hungarian accountant, then reaches for the equally-dusty accounts ledger and records the normal retail price of the wine.
Arkwright, being in an unusually generous mood, has no problem with the books showing the removal of a bottle of wine from the stock. But he fails to understand why he must pay tax on a profit he did not even make.
Granville, no doubt, explains to his uncle the case of Sharkey v Wernher 36 TC 275 (as extended by Petrotim Securities Ltd v Ayres). 41 TC 389
To quote the Inland Revenue, that case ‘establishes the principle that where a trader takes stock from his business for private use or enjoyment the transfer should be dealt with for [direct] taxation purposes as if it were a sale at market value’ (Statement of Practice A32).
The correctness of Sharkey has been generally accepted, after all it was a decision by the House of Lords. However, it has not been without its opponents.
In his article Sharkey v Wernher: Has Time Moved On?, Simon Sweetman argues that time has moved on and the case should now be reviewed. He also challenges some of the reasoning of their Lordships.
This article picks up from this latter point and highlights some further flaws in some of the judgment.
The Sharkey facts
Being a case that pre-dated the independent taxation of married women, the facts of the case concern, not the taxpayer, Sir Harold Wernher, but his wife, Lady Zia Wernher.
As far as is relevant to the facts of the case, Lady Zia carried on two distinct activities: one being a stud farm, the other the training and racing of horses.
It was accepted by the parties that the stud farm constituted a trade, whereas the horse training and racing represented a recreational activity which was not subject to tax.
During 1948, Lady Zia transferred five horses from the stud farm to the racing stables. It was accepted by the taxpayer that an adjustment would have to be made in the stud farm’s accounts to reflect the transfer; the question that was eventually answered by the House of Lords was what figure should be included.
It was argued on behalf of the taxpayer that the adjustment should equal the cost of the stock withdrawn from the business. The Revenue argued that the normal selling price should be used.
The taxpayer won at the Commissioners, but this decision was overturned in the High Court. The Court of Appeal found for the Wernhers and thus it was the Revenue which appealed to the House of Lords.
The House of Lords’ decision
It should be noted that the decision was not reached unanimously. Of the five judges who sat in the House of Lords, three gave detailed reasons for their decision: Viscount Simonds and Lord Radcliffe in favour of the Revenue and Lord Oaksey in favour of the taxpayer.
Lord Radcliffe set out three possible methods to account for the horses that were withdrawn from the stud farm. One was to do nothing; one was to reflect the cost of the horses withdrawn (as favoured by the taxpayer); and the last (as argued for by the Revenue) was to treat the transaction as a sale at market value.
With regards to the first, Lord Radcliffe recognised the ‘absurd anomalies’ that this could lead to.
For example, it would enable traders to generate losses simply by acquiring stock which would then be appropriated for personal use. As a result, he rightly (in my view) went on to consider the merits of the other two methods.
Viscount Simonds, on the other hand, appeared initially more attracted to the idea of there being no entry in the stud farm’s accounts despite the appropriation of the five horses, on the basis that if no cash was received, it was at least arguable that the accounts should not show a notional credit.
He therefore expressed his surprise that the adjustment being argued for by both parties ‘could take the form of the fictitious entry of a receipt which had not been received’.
However, by the end of his judgment, he too had come to the view that Lady Zia ‘must be regarded as having traded with [herself]’.
Having reached this conclusion, Viscount Simonds held that this fictitious trade could only have been at the normal trading price. Viscount Simonds did consider briefly the alternative, i.e. to use the cost.
However, it appears that his dismissal of it was based on a misunderstanding of basic accounting. He felt that a taxpayer who would be subject to an adjustment at cost would object if ‘a very large service fee had been paid so that the cost of production was high and the market value did not equal it’.
It would appear that Viscount Simonds overlooked the fact that the cost of sales in such a scenario, would equally reflect the high service charge so that there would be no objectionable profit.
Lord Radcliffe also considered the middle option, that is to reflect merely the cost of the withdrawn stock.
He referred to the argument by counsel for the taxpayer which explained that such an entry would have the effect of reversing the costs previously attributed to the business in respect of the goods subsequently taken for the taxpayer’s (or in this case, the taxpayer’s wife’s) personal use.
While describing the argument as ‘attractive’, Lord Radcliffe dismissed it on the grounds that it does not explain why the reversal should take place. He then proceeded to adopt the third option on the basis that it was allegedly fairer (between taxpayers).
Comments on the decision
The judges seemed most concerned about the fact that the adjustment to be made to the accounts required some element of fiction, that being the notional proceeds associated with the disposal.
However, such a fiction is inevitable when a single person has, for tax purposes, two mutually-exclusive personalities: a trader who is subject to income tax on the profits of a trade and an individual who pursues a non-taxable hobby.
It appears that Lords Radcliffe and Simonds sought to reduce the ‘fiction quotient’ by deeming the fictional sale to be at the real, although unrealised, market value.
See, for example, the comment by Viscount Simonds: ‘I see no justification for an ex post facto adjustment of account which in effect adds to a fictional receipt a false attribution of expenditure’.
There is some merit in this approach. But I would nevertheless disagree with it for two reasons. First, in a world of fiction, there is no reason why a real sale price should be preferable to a fictional one, especially when the fiction has been introduced to avoid an absurd anomaly.
However, my second objection concerns the basis of the judges’ logic. They felt that the withdrawal of five horses from the stud farm constituted a notional sale, and therefore the adjustment should be consistent with the horses’ ‘normal’ selling price.
However, it is equally possible for the withdrawal of trading stock to be akin to the return of goods to a supplier. While it is accepted that such an analogy is difficult to imagine with respect to a stud farm, it is nevertheless made to highlight the fact that, in the general situation, there can be more than one destination for trading stock.
Thus, the fictional transaction introduced to the accounts to reflect the withdrawal of the trading stock need not be a sale.
Therefore, -Or, to use double entry bookkeeping terminology, there is no reason why one should credit the sales account when it is equally possible to credit the purchases.
Why the costs should be reversed
Up to and until a trader chooses to withdraw some of the trading stock for personal use, the trader would have enjoyed a deduction for the costs incurred on bringing the trading stock to its current state.
It would be inappropriate for these deductions to remain once the trading stock is withdrawn from the business.
It could be argued that some costs could not be accurately ascertained, for example the marginal costs of insuring the stock that is subsequently withdrawn.
This concern might lead one to the view that the only really ascertainable value is the market value.
However, the accountancy profession is well used to the idea of making estimates, and there seems to be no reason why an accurate adjustment for costs cannot be made reliably.
Further, this would reflect the position that exists for VAT. In addition, as has often be asserted, it can be equally difficult to ascertain the market value of some trading stock.
Scope of the decision
An alternative approach to the decision in Sharkey is that it has a much narrower scope than that generally attributed to it.
This was another point raised in Simon Sweetman’s article and would necessitate a further disagreement with the House of Lords, which unambiguously suggested that the case had a wider significance, although such comments are necessarily obiter.
Undoubtedly, one of the attractions to the Revenue of opting for the market price, was the fact that in a stud farm there is no prior purchase of the trading stock. As a result, the costs of the trading stock would be relatively low.
Secondly, there would be costs, such as vet fees, which would be relatively hard to attribute to individual animals. Consequently, the House of Lords might, wrongly, in my view, have been concerned about opting for an unreal cost figure, when a more easily ascertainable market value was available.
However, such logic would not be so valid in a shop where there would be few direct costs relating to goods besides the purchase price itself.
Alternatively, suppose a shopkeeper when visiting a wholesaler decides to purchase 100 widgets for the shop and a 101st for his personal use. Taking Sharkey to its logical conclusions, the shopkeeper would be better advised to take two chequebooks and obtain two invoices one to purchase the 100 widgets for the shop and one to purchase the 101st.
However, the Revenue is unlikely to require taxpayers to go to such extreme lengths and it would probably be content with an adjustment reflecting the cost of the widget intended for personal use. It must be wondered why there should be any difference between this situation and one where a shopkeeper, who had previously bought 101 widgets, subsequently takes one for personal use.
Another problem with the Sharkey decision is how it would apply if the withdrawal for personal consumption represented the sum total of a business’s activities for a particular year.
The situation is admittedly extreme, but suppose one had a farm which made no external sales in a year, but whose produce was used entirely for the farmer’s personal use.
Assume in this hypothetical case that there had been no collapse in the market price of the goods.
If the decision in Sharkey is correct, then the farm should be taxed on the profit it would have made, if any, had the produce all been sold in the market.
However, a non-farming family which grows some of its own food would not be subject to tax. If the judges were aiming to ensure equality for taxpayers, then perhaps they have failed.
Professions and vocations
As is well known, the decision in Sharkey does not apply to professions and vocations (see Mason v Innes 44 TC 326). While the judgments of the Court of Appeal focus on the use of the cash basis by the late Mr Innes (as opposed to the earnings basis used by Lady Zia in her farm accounts), it is suggested that the Court of Appeal was simply seeking to curb the effect of what seemed to them to be a particularly harsh proposition in Sharkey.
As Lord Denning Master of the Rolls stated: ‘Suppose an artist paints a picture of his mother and gives it to her. He does not receive a penny for it. Is he to pay tax on the value of it? It is unthinkable’.
In my opinion, it is equally unthinkable that a florist should be taxed on a notional profit on a gift of a bunch of flowers to the florist’s spouse.
Revenue practice
The Revenue presumably is concerned about the harshness of the Sharkey doctrine, and it therefore authorises its Inspectors ‘to take a reasonably broad view in applying [the] principle’ (Statement of Practice A32).
In that statement, the Revenue provides three examples of where ‘the decision is not considered to apply’. There appears to be no rationale for the exceptions, although, no doubt, they have been sufficient to deter challenges to the House of Lords’ decision.
Dealing with losses
Part of the basis of the Revenue’s arguments in Sharkey was that an adjustment in respect of the market price was consistent with the decision in Watson Bros v Hornby 24 TC 506.
There, the taxpayers ran two separate businesses (one assessable under Schedule D and the other under what was then Schedule B) and took stock from one to the other. In that case, the market price was below the cost price, and the taxpayers argued successfully that they should be entitled to a loss in the first business.
Although the facts of Watson Bros can be distinguished from those in Sharkey, in that there were two distinct taxable activities going on, it would appear that a review of Sharkey would lead to a restriction on the availability of losses where the market value is below cost.
Other jurisdictions
In other common law jurisdictions, it appears that the Sharkey doctrine was thought to apply.
However, it has been successfully challenged in Hong Kong. In Commissioner of Inland Revenue v Quitsubdue Ltd (HCIA No 5/98) (30 April 1999), which was argued by Michael Flesch QC, the judge held that in her opinion ‘the principle in Sharkey v Wernher does not apply, whether generally or in the circumstances of [the Quitsubdue] case’.
While, with respect, the Hong Kong High Court is of little persuasive authority in the British courts (especially where there is a binding precedent of the House of Lords), the Quitsubdue decision shows that there is scope to challenge the doctrine. It will be possible for the lower courts here to distinguish any case in front of them from the circumstances in Sharkey.
Should the case then proceed to the House of Lords, a more definitive re-evaluation of the doctrine might be appropriate.
Statutory intervention
While the courts may be reluctant to overturn a decision of the House of Lords that has remained unchallenged for nearly half a century, traders may now look to the statute for some assistance. Section 42, Finance Act 1998 (as amended) provides that ‘the profits of a trade [etc.] must be computed in accordance with generally accepted accounting practice subject to any adjustment required or authorised by law’.
Section 42 was intended to draw a line in the ground as regards what accounting practice would be acceptable to the Revenue when calculating profits.
Although it was the professions who were the hardest hit (with the loss of the cash basis), section 42 is explicitly drafted to apply to trades and vocations as well. It would therefore appear that post-Finance Act 1998, traders’ profits must be calculated in accordance with generally accepted accounting practice, notwithstanding any previous practice.
When Finance Act 1998 was introduced, the relevant accounting standard was Statement of Standard Accounting Practice 2 which defined the key accounting principles. One of these principles was prudence.
The prudence concept was intended to limit, for example, the overstatement of profits and the understatement of liabilities. Under the régime imposed by the statement, the inclusion in the accounts of a notional profit on the appropriation of a stock would not be allowed, as this would amount to the recognition of a profit that had not been realised.
However, for accounting periods ending on or after 22 June 2001, Statement of Standard Accounting Practice 2 has been superseded by the Financial Reporting Standard 18. Financial Reporting Standard 18 makes no explicit mention of prudence.
However, in response to comments at the consultation stage, paragraph 28 of the standard makes it clear that profits may only be shown in the accounts if they have been realised as at the balance sheet date.
Paragraph 29 provides some scope for exceptions. However, for an exception to arise, ‘as a minimum it [must be] possible to be reasonably certain that, although a gain is unrealised, it nevertheless exists’. It would appear therefore, that generally accepted accounting practice still precludes the inclusion of a notional profit when stock is appropriated from a trade.
There still remains one hurdle to overcome. The closing words of section 42(1) require and allow profits (as calculated in accordance with generally accepted accounting practice) to be adjusted ‘as required or authorised by law’.
This reference includes those statutory provisions that exclude certain expenses from qualifying for relief and the rules for capital allowances.
However, arguably, it may also cover adjustments to be made to the accounts as required by the courts in accordance with Sharkey.
While there is much to merit such an argument, it should be noted that the judges in that case (Viscount Simonds in particular) were not attempting to override accounting principles, their judgment was made in the absence of any evidence about the prevailing practice on the appropriation of stock from the business.
As a result, the final words of section 42(1) do not, in my opinion, require traders to bring in a notional profit on stock they have withdrawn from their business.
Conclusion
To conclude, I feel that I can do no better than to repeat part of Lord Oaksey’s dissenting speech in the House of Lords:
‘Traders must show in their trading accounts the value of their assets. If they sell those assets, they must credit the price obtained. If they do not sell them but get rid of them, either by using them themselves or in any other way, they must credit the figure at which the assets stand in their accounts or the profits of the account will be improperly diminished by the amount entered in the account as the value of the asset. Taxation under Schedule D is imposed on the balance of profits and gains. Profits are actual commercial profits and similarly the deductions allowed by the Act which produce the balance are deductions which are considered to be properly attributable to the profits as being commercial expenses incurred in order to earn the profits. It follows, in my opinion, that such expenses as have been incurred to produce an asset which is withdrawn from the trade cannot properly be deducted and must therefore be withdrawn from the account, which can only be done in accordance with accounting practice by crediting the amount of the expenses.’
Keith Gordon is currently a director of ukTAXhelp RPM Ltd, a company specialising in providing tax advice to other professional businesses. He is to be called to the Bar on 24 July 2003 and will be commencing pupillage at 24 Old Buildings Tax Chambers in September. Keith can be contacted by email. The views expressed in this article are those of the author.
