England and Wales Court of Appeal (Civil Division) Decisions

IN THE SUPREME COURT OF JUDICATURE
COURT OF APPEAL
ON APPEAL FROM THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
(REVENUE PAPER)

		Royal Courts of Justice, Strand, London, W.C.2.
		28th February 1978

LORD JUSTICE STAMP: I shall ask Lord Justice Orr to deliver the first judgment.

LORD JUSTICE ORR: This is an appeal by Woodall-Duckham Limited, whom I shall call "the company", and who were assessed to corporation tax of £600,000 in respect of an accounting period comprising the calendar year 1969, against a judgment of Mr. Justice Templeman on 26th November 1976, whereby, reversing a determination of the Special Commissioners who had reduced the assessment to £405,495 but decided a point of principle in favour of the company, he allowed an appeal by the Crown on the point of principle and remitted the case to the Special Commissioners for consideration in the light of his judgment.

The company, which was incorporated in 1920 under a different name, is a wholly-owned subsidiary of the Woodall-Duckham Group, (which I will call "the Group" and of which Babcock & Wilcox have been since 1973 the holding company), and was prior to 1960 engaged primarily in the design and construction of town gas plants and coke oven plants for the steel industry but in the early 1960s, owing to a change in demand, diversified into other markets including, from the late 1960s, exports. During this period the company's projects also became larger and the design and construction of each took correspondingly longer, extending in the late 1960s to as long as 35 months and in the early 1970s to 56 months. There was also a corresponding increase in the cost of the projects which in the middle and late 1960s ranged between £166,000 and £540,000 and in the early 1970s between £716,000 and £25,000,000. These changes in the nature and volume of the business led the Board of the company to examine and question its accounting procedures, and references to this matter were made by the Chairman in his statements appended to the company's accounts for 1965 and 1967.

Until the end of December 1968, work in progress of contracts (other than that carried out by the company's Australian branch) was at the end of each financial year (being the calendar year) valued in the accounts at prime cost plus a proportion of overheads but less a provision for any foreseeable losses; no profit on the contracts being brought into account until expiry of the maintenance period but losses being provided for in the year in which the likelihood of incurring such losses was foreseen.

For a number of reasons set out and accepted in the case stated by the Special Commissioners this basis of valuing work in progress was not altered until 1969, but a formal decision to change to a new basis was taken at a Board meeting held on 23rd December of that year and the new basis was subsequently defined as follows — and I read (1) to (5) on page 19 of the agreed documents: "NEW BASIS (1) The anticipated final gross margin (both overheads and profit) on each contract is calculated as the difference between the anticipated final selling price receivable from the customer and the anticipated final prime cost to be incurred on carrying out that contract. Prime cost includes the direct cost of engineering design time and technical time carried out in the Company's offices, the direct cost of materials, construction labour, site services, royalties and other expenses directly attributable to the contract. (2) A proportion of the anticipated final gross margin is included in the valuation of Work in Progress pro rata to the cumulative prime cost incurred to the date of the accounts as a proportion of the anticipated final prime cost. (3) The gross margin calculated under (2) above is subject to a deduction for a general reserve on all contracts not yet in their maintenance period representing 2% of the prime costs incurred to date on those contracts. In addition specific provisions are set aside on contracts to meet risks and contingencies which cannot be satisfactorily quantified but in respect of which, in the opinion of the Directors, some provision against over-expenditure is necessary. The value of the specific provision is deducted from the valuation of Work in Progress pro rata to the prime costs incurred except where 80% or more of the prime cost has been: incurred in which case 100% of the specific provision is deducted. (4) If at the date of the accounts less than 25% of the anticipated final prime cost has been incurred on a contract then the contract is valued in Work in Progress at cost and no margin is included. (5) Losses are provided for in the year in which the likelihood of incurring such losses is foreseen."

It was accepted by the Special Commissioners that, while the tax implications of this new basis (which it will be convenient to call "the accrued profit basis") had been considered by the Board and the company's auditors, the timing of the change was not governed by tax considerations, and it was also common ground that the new basis is one of the accepted accounting bases for valuing work in progress on, inter alia, long term contracts, and that in the circumstances there were reasonable and proper grounds for the decision to change the basis. The effect, however, of the change in basis was that, whereas on the old basis the opening figure of work in progress for a succeeding year had always been the same as the closing figure for the previous year, it was considered necessary for the application of the new basis to the year 1969 that the opening as well as the closing figure for that year should be calculated on the new basis, with the result that the opening figure for 1959 was different from the closing figure for 1968 and disclosed in both the Group Consolidated Profit and Loss Account and the company's Profit and Loss Account for 1969 a sum of £579,874 which was described in the Group accounts as "Surplus arising on change in accounting basis" and in the company's accounts, under the heading of "Profit after Taxation" as "Surplus arising on change in valuation of contract work in progress at 31st December, 1968" with a reference to Note (1) to the accounts which states "In order to effect the change in accounting basis the contract work in progress at the beginning of the year has been revalued on the new basis and the resultant excess of £579,874 over the old valuation has been brought into account as a separate item."

The issue before the Special Commissioners was whether this sum of £579,874 was, as the Revenue claimed, or was not, as the company claimed, chargeable to tax as part of the profits of the company arising in the year 1969. On this issue the Special Commissioners were referred to a number of statements of accountancy practice and they also heard evidence from four accountants: Mr. Nightingale, in effect the company's financial director; Mr. Dunkerley, a partner in the company's firm of auditors; Mr. Hobson, who was accepted as an independent expert; and Mr. Lawson for the Inland Revenue. All these witnesses were agreed, inter alia, that a major or fundamental change of accounting basis should not be made without good reason but that the company's new basis, which is gradually being adopted by a growing number of companies, is superior to the old basis, and that the company was fully justified in making the change; and they were further agreed that it is desirable as a matter of consistency that valuation of work in progress at the beginning and end of a period should be on the same basis, and that the surplus on valuation disclosed in the company's 1969 accounts was of a revenue as opposed to a capital nature.

Mr. Hobson, supported by Mr. Dunkerley and Mr. Nightingale, gave evidence, which the Special Commissioners accepted, that it would have been quite wrong as a matter of accounting if the company had adopted the old basis for the beginning of 1969 and changed to the new basis for the end of the same year, and that "surplus" was a proper description of the sum in question because it was not a trading profit arising or realised in 1969 but an adjustment relating to earlier years and deriving from a change in accounting policy. Mr. Lawson on the other hand took the view that the sum in question was a profit which had arisen from the company's business in the year in question.

On this material the Special Commissioners allowed the company's appeal and gave as their reason that they were not persuaded that the "surplus" represented or reflected profits arising in the period or that some other accounting treatment more favourable to the Revenue should have been used.

From that decision the revenue appealed to the High Court and on 26th November 1976 Mr. Justice Templeman gave judgment determining the point of principle in favour of the Crown and remitting the case to the Special Commissioners for consideration in the light of his judgment. In his judgment he distinguished the case of Commissioner of Income Tax, Bombay v. Ahmedabad New Cotton Mills Company Ltd. (1929 46) Times Law Reports 68 (a decision of the Privy Council)) on which much reliance has been placed for the appellant, and held that the sum in question was properly chargeable to tax for the year 1969.

Against that judgment the company now appeals and the two questions which arise in the appeal are whether the sum of £579,974, described in the company's accounts as "Profit after Taxation", and admitted to be of a revenue as opposed to a capital nature, is, for the purpose of corporation tax, a trading profit of the company, and if so for what year.

We were referred in argument to a number of cases and in the course of the hearing a print of the speeches delivered in the House of Lords in Willingale v. International Commercial Bank Ltd. became available but it is common ground that they do not affect this case, and in my judgment the only relevant passages in the speeches delivered in the House of Lords in Duple Motor Bodies Ltd. v. Ostime (39 TC 537) and B.S.C. Footwear v. Ridgeway (47 TC 495) are those in which Lord Reid (39 TC 572) and Viscount Dilhorne (47 TC 538) refer to the difficulties which necessarily arise when there is a change from one accounting method to another. The case, however, most strongly relied on for the appellants was the Bombay case, already referred to, in which the Privy Council affirmed a judgment of the High Court of Bombay upon a reference to that court of a question of law. The facts of the case were that the company's stocks had admittedly been undervalued at the end of the year in question and the company claimed, and it was assumed by the High Court for the purpose of the reference, that the stocks had also been under-valued at the beginning of the year. The income tax commissioner had rectified the value of the stock at the end of the year but had declined to make any corresponding alteration with reference to the stock at the opening of the year on the ground that accounting principles required that the opening value of stock must be taken to be the same as the closing value for the preceding year. The High Court held that it would be wrong to accept the company's return for the beginning of the year and only to rectify the figure at the end of the year, the correct principle being that it was necessary to ascertain the true profits of the year. On appeal the judgment of the High Court was affirmed by the Privy Council, on the ground (per Lord Buckmaster) that

"The one thing that is essential is that there should be a definite method of valuation adopted which should be carried through from year to year so that in case of any deviation from strict market value in the entry of the stock at the close of one year it will be rectified by the accounts in the next year."

But, with great respect to the argument for the present appellants, the Bombay case differs materially from the present case in that it did not involve, whereas the present case does involve, a change in the basis of valuation, and for this reason it cannot, in my judgment, provide an answer to the question raised by the appeal.

In the absence of direct authority on the point at issue I turn to principle and practice, and find it helpful to consider first the established practice in relation to the writing down of the value of trading stock and the writing off of bad debts, which are the converse of what was done in the present case. It is a long established practice, accepted for the purpose of income tax, that if in a given year a trader, applying a reasonable commercial judgment to the matter, decides that his trading stock, because of market conditions or for other reasons, is worth only half the value at which it stands in his books, or that a trading debt owed to him is valueless or reduced in value, writes down the stock or writes off the debt as bad, his decision takes effect for tax purposes in the year in which he makes it notwithstanding that the stock or the debt may have been going down in value in previous years. On principle I can see no reason why the tax consequences should be any different where, as here, a trader decides, in relation to a contract for which the price has been contractually agreed, and the performance of which, in the form of work in progress, has taken place over more than one year, to attribute year by year to work done in performance of the contract a percentage of the total gross margin which he will eventually be entitled to receive as part of the price, but subject to such prudent restrictions as were applied in the present case, namely that no element of gross margin should be attributed to work in progress until 25% of the anticipated final prime cost has been earned, and subject also to a deduction by way of general reserve representing 2% of the prime costs incurred to date on those contracts which have net reached their maintenance period. It cannot be said in such a case that the entire profit has been earned in the final year of performance of the contract for it has in fact been earned by the work in progress, year by year, and if the trader can in a given year write down the value of his stock in trade or work in progress I can see no reason why he should not attribute to work in progress a fair share of the final gross margin. To do so is, in my judgment, to effect a genuine economic writing up of the work in progress comparable with the genuine economic writing down to which I have earlier referred, and in my judgment the acceptance by the accountancy profession of the new basis, adopted in 1969, as a proper basis of valuation clearly recognises that fact.

There remains the question whether the element of gross margin brought into account in 1969 has been properly treated as attributable, for corporation tax purposes, to that year or is in part attributable to some other year or years. It is clear from the definition of the new accounting basis which I have earlier quoted, and is common ground, that the so-called surplus of £579,874 is not referable only to work which was in progress during the year 1969. By the definition no element of gross margin may be taken until 25% of the anticipated final prime cost has been incurred on the contract but when that point has been reached a proportion of the anticipated final gross margin is to be included in the valuation of work in progress pro rata to the cumulative prime cost incurred to the date of the accounts as a proportion of the final prime costs. It follows that if in respect of any contract the 25% level was reached in 1969 the valuation could largely represent work done in previous years and the same would apply to a contract as to which the 25% level had been reached before the change to the new basis. In my judgment, however, the element of gross margin which the new accounting basis requires to be brought into account cannot be attributed to any earlier year than 1969, when the new basis was introduced, any more than a bad debt can be attributed to a year earlier than that in which it was recognised to be bad.

For these reasons, agreeing with the conclusion reached by Mr. Justice Templeman and with great respect rejecting, on what I consider to be an issue of law, the conclusion reached by the Special Commissioners, I would dismiss this appeal, and I would only add that I am also in entire agreement with the judgment about to be delivered by my Lord , Lord Justice Stamp which, since writing this judgment, I have had the opportunity of reading.

LORD JUSTICE EVELEIGH: I agree, and I also agree with the judgment about to be delivered, which I have had the opportunity of reading, and I have nothing further to add.

LORD JUSTICE STAMP: I agree. For the purpose of computing the profits of the tax payer prior to 1969 the work in progress was brought in on the receipts side of the trading account at what I will call its "prime cost" though adjustments were made.

In the year 1969 it was determined for reasons which my Lord, Lord Justice Orr has given and which is common ground were good commercial reasons, to distinguish between work in progress on contracts where less than 25% of the anticipated prime cost had been incurred and those where 25% or more had

been incurred. In relation to the first class the work in progress was valued as before. I will refer to this as the "lower basis". In relation to the second class of contract there was brought into account what, forsaking accuracy for convenience, can be described for the purposes of this judgment as the proportion of the estimated profit on the contract attributable to the work done, I will refer to this as the "higher basis".

Where the work in progress on a contract falls to be valued on the same basis at the beginning and at the end of a year the excess of the valuation at the end over the valuation at the beginning of the year will be an item on the receipts side of the trading, or schedule D computation, falling to be taken into account in ascertaining the trading profit for the year.

It is however to be noted that in 1969 and in years thereafter there would, as the result of the change of practice, be work in progress which at the beginning of the year fell to be valued on the lower basis and at the end of the year would have crossed the 25% threshold and become subject to the valuation on the higher basis. The excess of the figure ascertained on a valuation on the higher basis at the end of the year over the figure ascertained on a valuation on the lower basis at the beginning of the year (which will be the same figure as appears at the foot of the previous year's account) must surely represent an item falling to be brought into account on the receipts side of the trading account in ascertaining the trading profits during the year and ought to be brought into the schedule D computation accordingly. If this is not done part of the difference, namely the estimated profit element, will have to be shown as a non-trading profit and the profits of the tax payer will never be subject to taxation. I do not think Mr. Rees on behalf of the tax payer has submitted otherwise.

The latter process however transgresses Mr. Rees proposition that in comparing the value of work in progress at the beginning of the year with its value at the end of the year for the purpose of computing trading profits under Schedule D like must be compared with like; for in relation to contracts which crossed the threshold during the year you are not comparing like with like but ascertaining the value at the beginning of the year on one basis, and at the end of the year on a different basis. So when examining Mr. Rees' submission that for the purposes of computing the trading profits of 1969 you must compare like with like I do not find it convincing.

Indeed if there were contracts which had not crossed the threshold at the beginning of 1969 itself but did so during that year what I have said about them would apply. You would take the valuation made on the old basis at the end of 1968 and compare it with the valuation at the end of 1969 made on the new basis, so throwing up as part of the trading profit for 1969 the effect of the change of policy. To exclude that part of the profit would be wrong and I can see no justification for not adopting the same process in relation to contracts which already at the end of 1968 had crossed the threshold. To depart from that process would, in my judgment, be to ignore the element of profit recognised by the revaluation of the work in progress.

The £579,874, being the difference between the value put upon the work in progress at the end of 1968 and the valuation at the opening of the 1969 account, appears to me to be an artificial and unreal figure not representing a profit. The true profit is arrived at by comparing the value put upon the work in progress at the end of 1968 and the value put upon it at the end of 1969, and it is a trading and not a casual or non-trading profit. True, you are not comparing like with like but that must always be so when for good commercial reasons and without infringing any principle of income tax law — I refer in particular to the rule that you must not anticipate a profit — trading stock or work in progress falls to be written up or written down.

Mr. Rees submitted that the figure of £579,874 represented the previously unrecognised trading profit of earlier years and not a profit which fell to be included in the 1969 trading account. He points to the fact that the tax "for any financial year shall be charged on profits arising in that year" (see Section 243 (3) and 250 (1) of the Income & Corporation Taxes Act 1970). If that submission were well founded it would, so it appears to me, follow that when under the pre-1969 policy a contract reached maturity, the profits which would otherwise be brought into account in that year would escape the taxation on the ground that they had been earned in earlier years. I think the short answer to Mr. Rees' submission in that regard is that the difference between the value of the work in progress on a particular contract or on the totality of the contracts at the end of the year and its or their value at the beginning of the year,

whether it be a plus or minus figure, is not the profit (or loss) "arising in that year" but one of the items brought in to the accounts for the purpose of determining that profit.

I too would dismiss the appeal.

MR POTTER: Would your Lordship direct that the matter be remitted to the Commissioners to adjust the assessments in accordance with your Lordships' judgments?

LORD JUSTICE STAMP: No; do we not just dismiss the appeal?

MR POTTER: With respect, it is desirable that it be remitted for this reason, that Mr. Justice Templeman had added a rider at the end of his judgment which none of your Lordships has added, and it would avoid confusion therefore if the Commissioners were directed to adjust the assessments.

LORD JUSTICE STAMP: Remind me what the order was.

MR POTTER: The order is in the classic form and appears on pages 5 and 6 in the bundle. The learned judge allowed the appeal and ordered that the case should stand for judgment of this court, transcript's being annexed. Your Lordship's will remember that there was a very substantial discussion at the end of the transcript of the judgment below because the last paragraph of the judgment, having decided the matter as a question of principle, indicated that having regard to that decision of principle it might be open to the respondent company to adduce further evidence or further submissions of fact before the Commissioners. That matter is no longer open, having regard to your Lordships judgments; therefore I would submit that the proper order would be not simply to dismiss the appeal but to order that the matter be remitted to the Commissioners to adjust the assessments having regard to your Lordships' judgments and not to the judgment of Mr. Justice Templeman.

LORD JUSTICE STAMP: That would be right, would it not?

MR REES: It would be clearer if your Lordships acceded to that suggestion. I may have confused the matter in the court below; it would put it beyond doubt if it were remitted for the assessments to be adjusted in accordance with your Lordships' judgments.

LORD JUSTICE STAMP: We vary the order of Mr. Justice Templeman only to that extent.

MR POTTER: I then ask for costs.

LORD JUSTICE STAMP: We just omit the words "a transcript whereof is being filed with this order", do we not?

MR POTTER: Quite so.

LORD JUSTICE STAMP: You cannot resist costs, Mr. Rees, can you?

MR REES: No. When it has been possible to give due consideration to the judgments, which are of great importance, I hope that if my clients should be so advised they might have leave to go to the House of Lords. Your Lordships' decision does overturn previous accountancy and revenue practice. It is a point of general importance.

LORD JUSTICE STAMP: I do not accept that; but what do the Crown say about this?

MR POTTER: We make no submission.

LORD JUSTICE STAMP: Then you can have leave, Mr. Rees.

(Appeal dismissed with costs. Case to be remitted to the Special Commissioners for assessments to be adjusted in accordance with the judgment of this court. Order varied by deletion of words "A transcript whereof is being filed with the Order". Leave to appeal to House of Lords granted.)