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MAY CONTAIN NUTS, it said on the snack I bought from the local supermarket recently. Not surprising, since it was a packet of mixed nuts … Perhaps William Grant & Sons should adopt a similar practice of stating the blindingly obvious, and include the title of this article on the front cover of their financial statements for 2005.
It is a quote from Lord Reed's decision in the Revenue's appeal to the Court of Session over the amount of depreciation that has to be added back in their tax computation. Lord Reed's decision is a model of cogent analysis, which shows a clear understanding of modern accounting principles. In particular, he understands that the figure for stock in the balance sheet will (in normal circumstances) simply be a cumulative figure representing all the production costs, including depreciation. It will, in other words, be a figure arrived at from bookkeeping entries; it won't actually be the physical stock.
Unfortunately his is the dissenting view. Lord Penrose, giving the majority view of the court in favour of HMRC, cannot quite get himself away from the idea that it is the asset — in William Grant's case, the whisky — that matters, and that the elements which make up the figure in the financial statements have somehow been transmuted in the blending process. That might well be an appropriate statement to make about whisky itself; it is not appropriate when discussing stock.
The depreciation problem
The facts were set out in a previous article of mine, 'Whisky Galore' (Taxation, 2 September 2004, page 567). This concerned the Special Commissioners' decision in the joined cases of William Grant Distillers and Mars (SpC 408) where the taxpayers won. These cases split on appeal (one being English and the other Scottish), Mars going to the High Court and reported at [2005] STC 958, where the taxpayer lost. We commented on this in 'Mars barred' (Taxation, 30 June 2005, page 346).
Put simply, the problem is this. Say that £100,000 of depreciation has been charged as an expense in the accounts, as a debit to cost of sales. However, production overheads have to be taken into account in valuing stock, including depreciation. Say £10,000 of the depreciation is included in the closing stock valuation. Since this will be credited to cost of sales, the net effect is that only £90,000 of depreciation has been charged (with an adjustment for opening stock, if appropriate, of the amount of depreciation included in that). However, HMRC's practice is to require the full £100,000 of depreciation to be added back in the tax computation. This practice has been inflexible since 2002; prior to that they did sometimes allow a 'net depreciation' calculation, and they had done so for William Grant up until 2002. The appeal concerned the subsequent years, so the company had never (or at least not for many years) submitted a computation on any other basis.
The company's accounting systems
One of the key points in the case is the way that the company put together its cost of sales figure. In the words of Lord Penrose:
'William Grant do not prepare trading and profit and loss accounts, or any form of revenue account which includes, or which would include if prepared in the traditional form familiar from the authorities, opening and closing stock' (para 13).
I don't think I am being too far-fetched in detecting a faint whiff of nostalgia here. Although neither Lord Penrose nor Lord Reed can be faulted for thoroughness in considering the way that the figures were arrived at, a reader does definitely get the feeling that Lord Penrose is continually trying to map the new accounting approach back onto the old authorities, with their 'proper' accounts, whereas Lord Reed is looking to take only the principles from the old authorities, and to then apply them to the new practices.
It is only in Lord Reed's judgment that a clear understanding of the company's system can be found; one which he refers to as the 'modern approach to accounting'. There are three basic stages in the production of a bottle of whisky as sold by William Grant & Sons. First there is the production of the raw spirit. Then there is the cost of holding the spirit for three years as it matures to the point where it is legally allowed to be called whisky. Finally there is the further maturing (e.g. into 12-year old whisky), packaging and distribution.
The company uses sophisticated IT accounting systems to allocate the overheads (including depreciation) of the cost of producing the raw spirit and the first three years maturation into production (the cost of warehousing after three years is written off in the year it is incurred). The total 'spirit cost' is calculated for each year's production, and reflected in the 'pack cost' when bought by the customer:
'For example, when a pack of “Glenfiddich 12 year old” is sold, the “pack cost” will include the cost of producing the whisky twelve years ago (including the depreciation of the relevant fixed assets during the year, divided by each litre produced), and the first three years' warehousing costs (including the depreciation of the buildings and casks during those years, divided between each litre produced)' (para 131).
It is this 'pack cost' which is included in cost of sales, matched with the revenue from the goods sold during the year. The key point to note from this is that William Grant will never include a gross total for depreciation on production assets in any revenue account. In simple terms, the accounting entries for the year's depreciation on production assets are 'Dr: Stock, Cr: Accumulated depreciation'. Only when the stock is sold is there a P&L entry — 'Dr: Cost of sales, Cr: Stock'. The depreciation is by then part of the total 'pack cost'. This is a point which Lord Reed grasps clearly, saying that:
'Although provision continues to be made in the balance sheet for depreciation in the value of fixed assets in the traditional manner, by writing off the value of such assets over a period of time, the treatment of depreciation in the profit and loss account is different … Insofar as the provision for depreciation in the balance sheet relates to fixed assets used in the production of goods … [it] is treated as forming part of the costs of the goods produced.'
This difference between the treatment in the P&L and the balance sheet is crucial; as will become apparent later, it is the failure to distinguish the two that appears to be one of the main factors that leads Lord Penrose to his conclusion that the appeal should be allowed.
Statutory provisions
The statutory authority for adding back depreciation is TA 1988, s 74 (1)(f), which prohibits a deduction for 'any sum employed or intended to be employed as capital in the trade'. Addie & Sons (1875) 1 TC 1 is the authority for saying that the cost of fixed assets (and hence the depreciation) cannot be claimed because of this provision.
There are two sections that deal with the overall calculation of profits. TA 1988, s 70(1) says that tax must be charged 'on the full amount of the profits or gains arising in the period'. FA 1998, s 42 says that for Sch D, Case I the profits 'must be computed in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in computing profits for those purposes'.
It was not disputed that the approach adopted by William Grant & Sons complied with GAAP. It might be thought, therefore, that the only adjustments to be made to their profit were those required or authorised by statute — in other words, that you start with the GAAP profit and adjust for the specific requirements of the Taxes Acts. Confusingly, although Lord Penrose accepts that this is the 'conventional approach', he continues by saying:
'That does not qualify section 79: the full amount of the profits or gains has to be returned. The deductions available are those authorised by the Corporation Taxes Acts. The restriction of an add-back to financial profit, on conventional accounting for tax purposes, has precisely the same effect as a claim for a deduction in a free-standing account prepared for tax purposes.'
I could not, at first, make head or tail of this statement, but when it is viewed in the context of the case it becomes clearer. The 'add-back to financial profit' in a conventional tax computation is the add-back of depreciation in this case. The 'restriction of an add-back' is therefore the claim to add back only net depreciation — an analysis which begs any number of questions, starting with the fact that s 74(1)(f) does not specify net or gross depreciation, since it does not mention depreciation at all …
Onwards. This is to be compared to a claim for a deduction in a frees-tanding account for tax purposes. WHAT free-standing account for tax purposes? The Taxes Acts do not provide sufficient information for such a free-standing account to be constructed. In particular, they do not provide a 'list of deductions'. Section 74 is really the key provision here, and that only provides a list of items that cannot be deducted — it says that you cannot deduct an expense which is not incurred wholly and exclusively for the purposes of the trade; it does not actually say that you can deduct one that is. That right of deduction flows from the GAAP now referred to in FA 1998, s 42, and which were in any case seen as the starting point by previous case law. Again, that is Lord Reed's analysis — he starts with the case law and says that this established the principles of commercial accounting as the starting point, and then says that this has now been enshrined in the statute by s 42.
Companies Acts
There is a jump in Lord Penrose's argument in para 47, after he has nodded in the direction of the case law, which I find very difficult to follow. After noting that the financial statements complied with UK GAAP, he says that 'the preparation of financial statements for Companies Act purposes must reflect the provisions of those Acts'. However, he also says that the tax adjustments flow from the Taxes Acts and not the Companies Acts. It would appear that this comes out of an argument put forward by Mr Tyre, counsel for the company, that the only requirement of the Companies Acts was that the depreciation should be disclosed; but it is not easy, from the summary of his argument given by Lord Penrose, to see precisely what point of Mr Tyre's is being answered.
However, this leads Lord Penrose to concentrate on the requirements of the Companies Acts, and to treat these as a counterbalance to GAAP:
'Depreciation is provided for in accounts not simply as a reflection of accounting theory or practice, but as a matter of obligation, in s 226 and Schedule 4 to the Companies Act 1985'. (para 53)
My problem with this is that, as has previously been noted, he fails to distinguish between the treatment of depreciation in the balance sheet and the treatment in the P&L. He correctly highlights the requirement to provide for depreciation that will reduce the carrying cost of an asset over its useful economic life, but assumes that the write-off must go direct to P&L. Nothing in the Companies Act requires that. Lord Osborne, in a short judgment that supports Lord Penrose, is even stronger on this point, saying that the Companies Acts provide 'in substance a statutory definition of the concept of depreciation', which appears to me to precisely reverse the relationship between the Companies Acts and GAAP. Again, Lord Reed grasps the point:
'It was submitted that the implication of the taxpayers' contention was that the value of certain fixed assets was not being written off over the assets' economic life but over some longer period. I am unable to accept that submission … It is in a company's balance sheet, not in its profit and loss account, that amounts appear in respect of fixed assets … In the taxpayers' balance sheet, the amount included in respect of fixed assets is subject to provision for depreciation in accordance with [the Companies Acts].'
The authorities
Another area of major disagreement between Lords Penrose and Reed is on the fundamental accounting principles established by the case law. Both start from comments of Lord Clyde in Whimster & Co v Inland Revenue [1926] SC 20. Summarised, he said that there were two 'fundamental commonplaces' in computing profits for tax. The first was that 'the profits of any particular year' were 'the difference between the receipts from the trade or business during that year … and the expenditure laid out to earn those receipts'. The second was that the P&L account which ascertained that difference had to be drawn up in accordance with 'the ordinary principles of commercial accounting, so far as applicable, and in conformity with the [Taxes Acts]'. He then goes on to say that 'for example' stock had to be included at cost or market value, whichever is the lower.
The two judges, however, draw different conclusions from this. Lord Reed says that the ordinary principles of commercial accounting 'are not written in tablets of stone'. The modern accounting approach means that 'it is unnecessary for the opening and closing stock to appear in the profit and loss account'. The 'central principle is the matching of cost and revenue in the year in which the revenue arises, rather than in the year in which the cost is incurred' (para 109).
At times Lord Penrose seems to agree. Later in his judgment, in a long section which looks as if it may have been written after seeing a draft of Lord Reed's judgment, he concedes that 'the greater the advances in accountancy theory and practice, the less must be the role of the court in developing constraints on the application of contemporary accounting standards'. However, he concludes that this is a case where 'properly understood in the light of the authorities, there is a rule of tax law that precludes the application of GAAP in one respect' (para 87). This, it appears, is his view expressed in para 78 that:
'Subject to the views expressed by the Court of Appeal in Duple Motor Bodies Ltd v Ostime, [the courts] have adhered consistently to the view that it is for the court to say that in computing the full amount of the profits and gains arising in an accounting period, such an amount shall 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.'
As has already been seen, the foundation stone of this doctrine (Whimster) uses that as an example, not as one of the two fundamental concepts. Old cases will treat stock in this way because accounting practice at the time did so — accounting practice has changed. And what the Court of Appeal actually said in Duple Motor Bodies was: 'it must be remembered that the costing of work in progress … is nevertheless only a means to the ascertainment of the profit and not an end in itself'.
Net realisable value
The final sticking point for Lord Penrose seems to be the alternative of net realisable value. If it is correct to see stock as a 'bundle of costs', then he says that it would be difficult, if not impossible, to justify the alternative of net realisable value (para 79). He does later admit that there would be one answer to this:
'There would be two exercises, one limited to the purely bookkeeping exercise of adjusting costs … and a distinct exercise of valuation, by reference to external markets, when … one identified items held by the trader that could not be expected to achieve on sale the sum of the costs allocated to them. That is not an impossible result … but it is an odd reflection of the application of a single test of the lower of cost or net realisable value …'
But it is, of course, precisely what happens in practice. On the assumption that businesses generally don't sell stock for less than the cost of production, the figure for stock generally reflects an allocation of costs, and has nothing to do with the value, however determined, of the physical assets, since to do so would be to anticipate a profit. However, when it is clear that a loss will in due course result from a sale below cost, then prudence dictates that it is provided for. The two ARE distinct exercises, because they reflect distinct principles; in the first the eventual outcome on sale is not anticipated, in the second it quite properly is.
Prediction failure
My prediction record in these two cases is 0-2. I said in my original article that there was a good chance of the Commissioners' decision being upheld, and I said that the Mars case in the High Court gave William Grant & Sons grounds for hope, because their position was better. So I won't make any predictions about the result of the inevitable appeal to the House of Lords. I just hope that the decision bears a greater resemblance to the commercial accounting principles than this one does.
