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KEY POINTS
- HMRC continue to stand by the rule in Sharkey v Wernher
- Clauses dropped from ITTOIA three years ago, have resurfaced in this year's Finance Bill
- Where will the new legislation leave Statement of Practice A32?
- Taxpayers will have to pay more tax as a result of the new provisions.
These days, as is well known yet regrettable, the Chancellor's Budget speech no longer contains announcements of all the proposed changes to be contained in the forthcoming Finance Bill.
Budget Note 19 contains the details of one matter which the Chancellor failed to announce on Budget day. It announced that the Government was going to put on a firm statutory footing the rule in Sharkey v Wernher with effect from 12 March 2008.
In Sharkey v Wernher (1955) 36 TC 275, the House of Lords (by a four-one majority) held that a trader, who appropriated stock from her business for private purposes, should account, for tax purposes, for the profit that would have arisen had the stock been sold in the normal course of business.
In my article Sharkey Revisited I argued that the rule was susceptible to challenge on two broad bases.
First, because their Lordships had not had the advantage of evidence concerning the accounting treatment of such appropriations and, secondly, because (arguably) the importance of accounting principles became even more pronounced following the enactment of FA 1998, s 42 (now reflected for income tax purposes in ITTOIA 2005, s 25).
HMRC position
Despite challenges to the continued validity of the rule — not just from me, I hasten to add — HMRC have stood by it. The rule has proved a very useful source of additional revenue on enquiries into traders.
Furthermore, HMRC proposed to codify the rule when ITTOIA was introduced three years ago.
That proposal was shelved because three quarters of respondents to the proposal objected. As the Rewrite Project stated at the time:
'We see no reason to doubt that the principles explained in Sharkey v Wernher continue to apply to the calculation of business profits. But it would be wrong to enact those principles while others doubt the position. The only way to preserve the law is to continue to rely on case law in this area.'
Despite this, the clauses that were dropped from ITTOIA can now be found (almost word for word) in proposed Chapter 11A to be inserted into Part 2 of ITTOIA by Sch 15 to this year's Finance Bill. The corporation tax rules are being similarly adjusted but, pending the enactment of the Rewrite's Corporation Tax Bill next year, the provisions will remain in Sch 15.
What has changed?
Unsurprisingly, neither HMRC nor the Treasury admit that their assertions concerning the validity of the Sharkey v Wernher rule are on shaky ground.
However, given the competition for space in a Finance Bill (the usual excuse given by Treasury officials for not making statutory changes requested by taxpayers), one must assume that they were coming under increased pressure from taxpayers and/or were beginning to have doubts themselves about the rule's applicability.
Furthermore, I have picked up anecdotal evidence, both from tax advisers and HMRC officers, that taxpayers are challenging more vociferously adjustments proposed by HMRC under the rule.
Ultimately, cases have settled: taxpayers are afraid to risk the costs of a trip to the Commissioners and HMRC are concerned about the rule being overturned in a public forum.
There is, however, one clue in the public domain that the Government has some doubts about the validity of the Sharkey v Wernher rule. This can be found in a technical note which was prepared in the course of the corporation tax reform.
That document noted the decision to drop the codification of the Sharkey v Wernher rule from the income tax rewrite, but suggested that codification of the rule for corporation tax nevertheless remained appropriate.
The justification for this was that 'the arguments for and against codifying these principles in the context of corporate business are not necessarily on all fours with those in relation to unincorporated traders'.
If only
I sincerely hope that the proposed new provisions will not be enacted. In theory, at least, they are to be debated in Parliament with the pros and cons to be considered properly. In the meantime, the various professional bodies and other representative groups will make their views felt.
I hope, therefore, that common sense will prevail and that clause 34 and Sch 15 will quietly (or, if necessary, not so quietly) disappear. Reasons to object to the rule, and especially its codification, include the following.
- The correctness of the common law rule itself is not beyond doubt.
- Adjustments in accordance with Sharkey v Wernher are an unnecessary complication for traders. They have to decide how much profit they would have made on an item of stock had it been sold in the open market at the time of the appropriation. That might seem straightforward but even the simplest case gives rise to questions.
For example, consider a situation involving a grocer who, at 4 pm say, takes a loaf of bread (cost £0.50, marked up price £1) off the shelf to give to her family.
A customer might have been asked to pay £1 for that same loaf but that is no guarantee that that represents the open market value at that time.
A canny shopper, aware that there is a risk that the loaf might go unsold at the end of the day, could negotiate a better price (not necessarily above cost price).
That is potentially the better gauge of what represents the open market value rather than simply comparing the price on the label.
That also illustrates how difficult it will be to ascertain the market value — and that assumes that one can actually identify the market (i.e. wholesale or retail) one should be looking at.
Of course, if a taxpayer can demonstrate that the market value is less than cost (particularly if one is using the wholesale market and the bread is a little less fresh than when first bought), the Sharkey v Wernher rule will enable taxpayers to create losses.
However, one must expect HMRC to be reluctant to accept valuations that give rise to such a result.
- The difficulties in agreeing a valuation were perfectly illustrated in a Readers' Forum query T16,907, Variable value. That query concerned a restaurateur who (rather regularly) took wine from the restaurant's cellars for personal consumption. It was argued by HMRC that an adjustment was necessary to reflect the menu price of the wine even though such a price also reflects the other benefits to the diner (the ambience, the service, the risk of the wine having corked, the washing up etc).
- Furthermore, this is a complexity that does not arise for VAT purposes (although to illustrate that I had better change my example to ice cream, say, being a product that is definitely not zero rated). At a time when we are being told that the main benefit to be derived from the merger of the Inland Revenue and HM Customs and Excise is a greater harmonisation of the taxes, there is some irony in the Government pushing forward a rule in which direct and indirect taxes take such a fundamentally different approach.
- In addition, it is hard to imagine how the rule could be satisfactorily operated in practice. The current HMRC guidance requires officers 'to take a reasonably broad view in applying this principle' (BIM33630). The recent hardening of attitudes in local tax offices suggests that there might be a significant contraction of what would have been considered 'reasonably broad' a few years ago.
- The rule also distinguishes between traders and those carrying on a profession or vocation; see Mason v Innes (1967) 44 TC 326.
- Another complexity is that the rule distinguishes between those taxpayers who buy additional 'stock' which they later appropriate for private use and those who are able to segregate such purchases so that, technically, there is no actual subsequent appropriation.
In its drive against tax avoidance the revenue authorities have successfully persuaded the courts to remove artificial distinctions between arrangements that are technically different and to tax transactions in accordance with their underlying substance. Yet, by enforcing the Sharkey v Wernher rule, the Government encourages taxpayers to make such artificial distinctions in relation to their trading stock and similar purchases. - But the most fundamental objection is that the rule is simply unfair. It requires traders to pay tax on a profit that has not been made, will not be made and might never have been made.
Common sense, good accounting practice and (in my view) the law provide that traders should not obtain a tax deduction in respect of items removed from the trade.
But why should an imaginary profit be imputed and taxed? The proposal amounts to yet another attack on business and, in particular, the small business sector.
Why is the rule still there?
Given the numerous reasons that suggest that Sharkey v Wernher was wrongly decided (both on grounds of accounting treatment and policy), one can be forgiven for asking why it has not been overturned.
As mentioned above, many taxpayers are unwilling to take a case to the Commissioners. However, undoubtedly, for some taxpayers affected by the rule the tax at stake can be quite substantial.
For example, suppose a property developer builds an office block for sale but then decides to appropriate the block as a head office for its own business.
To the extent that the rule applies, that situation would seem to fit squarely within its terms. And, as one can imagine, particularly in buoyant times, the notional profit could be quite significant.
In such cases, one would expect the taxpayer to put up a fight before paying the tax, so why has there been no case challenging the rule? The answer is simple.
The former Inland Revenue issued a Statement of Practice (A32) in which it decided that the rule 'is not considered to apply' in such cases (and also in cases involving services rendered to individual taxpayers or to members of the taxpayer's household or involving meals provided to proprietors of hotels, boarding houses and dining establishments and to family members).
There is no explanation in the statement as to why the rule is not considered to apply in such cases; one must wonder whether the official HMRC view is that they also 'consider the rule not to apply' in such cases.
However, whatever the justification, the statement has ensured that many arguable cases have been kept away from the Commissioners, notably those where there might have been sufficient funds to finance an appeal.
The future of SP A32
Statement of Practice A32 gives rise to another interesting issue. The current draft of the new clauses makes no reference to the undoubted relaxation of the Sharkey v Wernher rule, assuming that the rule is valid.
Consequently, it would appear that property developers and other traders who appropriate stock, which they have constructed, as a fixed asset of the business, together with other traders who receive (or whose family or household members receive) meals or other services from the business, will now find that they will have to start paying tax on profits they have not made and that this will apply in respect of appropriations after 11 March.
If, as I have suspected, the statement of practice was introduced solely to prevent challenges being made to the continued validity of the Sharkey v Wernher rule, then HMRC will no longer have any requirement for it once the rule is codified: the rule will give unfair results but appeal to the Commissioners (or the tribunals that will replace them) will be pointless as it will now have statutory effect; in short, the statement of practice can be said to have served its purpose.
Alternatively, perhaps HMRC will continue to assert that the rule is still not considered to apply in such cases and they will continue to adopt a relaxed approach.
The lawfulness of ESCs
While relaxations to the rule should to be welcomed, it is doubtful whether continuing Statement of Practice A32 would be lawful given the clear words that will be (assuming the proposals are ultimately enacted) in the statute.
This follows the concerns raised by the House of Lords in R (on the application of Wilkinson) v CIR 77 TC 78.
Readers will be aware that the constitutional difficulties highlighted in Wilkinson are being tackled in clause 154 of this year's Finance Bill. That clause will permit the Treasury to validate (by order) existing HMRC concessions, including statements of practice.
The purpose of clause 154 is to ensure that such concessions, to the extent that HMRC continue to wish them to apply, can continue to be operated without HMRC being accused of failing in their duties under section 5 of the Commissioners for Revenue and Customs Act 2005.
Section 5 gives HMRC responsibility for 'the collection and management of revenue', a term that is defined in section 51(3) to have the same meaning as 'the care and management of revenue', the phrase that was previously found in the statute.
I see two potential difficulties with Statement of Practice A32 being applied to the proposed statutory provisions.
The first is that, clause 154 could be said to apply only to HMRC, Revenue or Customs statements, made before the passing of the FA 2008, which have the effect of reducing a taxpayer's liability to tax (or giving another concession relating to tax) to which they are not or may not be entitled in accordance with the law.
I believe (as previously argued) that Sharkey v Wernher was decided per incuriam (i.e. by judicial error or in the absence of the court being directed to the proper authority — in this case the accounting treatment) and that the true state of the law is that the rule does not apply (or that it ceased to apply following Finance Act 1998).
If that is the case, the statement of practice simply provides that HMRC will not try to operate the rule in certain circumstances. However, if the rule is a nullity, it cannot be said that it has the effect of reducing anyone's tax liability.
However, this would not, in my view, accord with the better reading of clause 154. In particular, I would read clause 154 as applying to any statement by HMRC, in existence at the date of Royal Assent, that HMRC will treat taxpayers as entitled to the reduction in their tax liability.
Furthermore, since clause 154 covers any other concession relating to taxes, it is my view that the statement is within the scope of the clause, even if it were found that Sharkey v Wernher had been wrongly decided. This is because a statement by HMRC that they would not take the point in particular cases is often worth as much to taxpayers as the tax at stake.
More importantly, however, there is a further (and in my view stronger) argument which should prevent any possible extension to the statement. This is because clause 154 is drafted in terms of legitimising existing concessions. It is not a licence to allow future concessions to be announced.
In other words, it effectively allows the Government to ratify previous extra-constitutional conduct but still requires the proper constitutional niceties, i.e. the need for concessions to be enshrined in statute, to be followed in future.
Even though clause 154 will permit existing statements of practice (and other concessions) to be given effect with modification and for supplementary, incidental, consequential or transitional provisions to be made, I believe that the clause will not permit such concessions to be extended to new legislation, even if the effect of the legislation is ostensibly to codify a part of the common law.
Opening old cases
If the provisions are enacted, unless a way can be found through the provisions, in future, taxpayers will have to pay the additional tax and hope (and lobby) for the provisions' repeal. However, the provisions will have no effect in respect of appropriations before Budget day.
In my view, clause 34 and Sch 15 amount to a final admission of defeat by HMRC. They are effectively saying that, despite asserting the contrary for over 50 years, the rule in Sharkey v Wernher was a fallacy (or, at best, was restricted to its own particular facts).
For this reason, the decision to enact the rule should give taxpayers with open enquiries involving such issues additional confidence in resisting HMRC's calls for an adjustment to the taxable profits.
However, for the more adventurous taxpayer, it is perhaps now an opportunity to make an error or mistake claim going back up to five or six years (TMA 1970, s 33 or, for corporation tax purposes, FA 1998, Sch 18 para 51).
The main obstacle with such claims is that they will be defeated if HMRC can show that the previous returns (applying the rule in Sharkey v Wernher) were made 'on the basis or in accordance with the practice generally prevailing at the time when [the return] was made'.
However, given the fact that a number of commentators have long questioned the validity of the rule and, judging by the number of times the matter has arisen in the course of enquiries, it appears that a significant number of taxpayers have not followed the rule.
It is my view, therefore, that HMRC would have major difficulties in showing that there has been any widespread basis or practice, let alone one which can be said to have been generally prevailing.
If the rule is to be codified, then it might be fair to say that taxpayers will have to learn to live with it. But that does not mean that taxpayers need to put up with it in respect of pre-12 March 2008 transactions.
Keith Gordon MA (Oxon), FCA, CTA (Fellow), barrister, practises from Atlas Chambers (020 7269 7980, ) where he provides tax advice and litigation support for accountants, tax advisers and lawyers. He can be contacted at keith@keithmgordon.co.uk.
This article is dedicated to the memory of Bernard Summers FCA (1 May 1908 — 1 October 2001).
