England and Wales High Court (Chancery Division) Decisions

IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION

		Royal Courts of Justice Strand, London, WC2A 2LL
		12/04/2005

Mr Justice Lightman:

INTRODUCTION

1. This is an appeal by the appellant Mr Trevor Small, HM Inspector of Taxes, ("the Revenue") from a decision ("the Decision") of the Special Commissioners ("the Commissioners") released on the 8^th March 2004. By the Decision the Commissioners allowed an appeal by the Respondent Mars UK Limited ("Mars") against the assessment of the sum of £1,969,335.76 in respect of cumulative depreciation in stock of £3,039,000 in the period up to the 31^st December 1996. The important question raised in this test case is on the construction of section 74(1) of the Income and Corporation Taxes Act 1988 ("the 1988 Act"). The effect of section 74(1)(f) provides that in computing the amount of the profits to be charged under Case I or Case II of Schedule D no sum shall be deducted in respect of depreciation of capital assets. The issue of general application raised is whether this extends to a part of that depreciation which is not charged as an expense but is included as a cost in the carrying figure for stock.
2. Together with the appeal by Mars the Commissioners also considered a question referred to them by William Grant & Sons Distillers Limited ("Grant") under paragraph 31A of Schedule 18 of the Finance Act 1998. That referral raised the same issue as the appeal in Mars. The Decision determined the issue in both cases in favour of the taxpayer. The Revenue are appealing both decisions. Whilst the appeal by Mars lies to the High Court in London, the appeal by Grant lies to the Court of Session in Scotland and that appeal is due to be heard in May 2005. Because of the great importance of the issue of construction the Commissioners granted a Court of Appeal certificate under section 56A(2) of the Taxes Management Act 1970. The parties who have afforded me every assistance reasonably intend and anticipate that appeal from my decision will leapfrog to the House of Lords and that there will be a direct appeal from the decision of the Court of Session to the House of Lords.

STATUTORY PROVISIONS

3. In this judgment references to sections and schedules (unless otherwise indicated) are to sections and schedules to the 1988 Act.
4. Section 70 provides that for the purposes of corporation tax income shall be computed under Schedule D:

"…on the full amount of the profits or gains or income arising in the period…without any other deduction than is authorised by the Corporation Tax Acts."

Section 18(1)(a) provides that tax under Schedule D shall be charged in respect of:

"the annual profits or gains arising or accruing to any person…from any trade…"

Section 18(2) provides that tax under Schedule D is charged under the Cases set out in section 18(3) "subject to and in accordance with the provisions of the Tax Acts applicable to those Cases"; and that Case I is tax in respect of any trade carried on. Section 60(1) provides:

"…tax shall be charged under Cases I and II of Schedule D on the full amount of the profits or gains of the year …."

5. The critical section in this case is section 74 which provides that certain amounts are not allowable in computing taxable profits. Section 74(1) (so far as material) reads as follows:

"General rules as to deductions not allowable.

Subject to the provisions of the Tax Acts, in computing the amount of the profits or gains to be charged under Case I or Case II of Schedule D, no sum shall be deducted in respect of-

(f) any capital withdrawn from, or any sum employed or intended to be employed as capital in, the trade, profession, or vocation…"

6. The effect of section 74(1)(f) is that no allowance for depreciation can be made in ascertaining the taxable profits of that year: Addie & Sons v. CIR (1875) 1 TC 1. Alternative provision for depreciation may however be available under the separate statutory provision under which fixed assets may qualify for capital allowances on plant and machinery.
7. I should also set out section 42 of the Finance Act 1998 ("the 1998 Act"):

"42 Computation of profits of trade, profession or vocation.

(1) For the purposes of Case I or Case II of Schedule D the profits of a trade … must be computed in accordance with generally accepted accountancy practice, subject to any adjustment required or authorised by law in computing profits for those purposes….

(3) This section applies to periods of account beginning after 6^th April 1999."

8. The 1998 Act only came into force as from the 6^th April 1999, but this provision is declaratory of the previous (and accordingly applicable) law: see Gallagher v. Jones [1993] STC 537 ("Gallagher").

HISTORY

9. Mars is a subsidiary of Mars Incorporated, a United States company. Mars manufactures food for human consumption and pet food.
10. In Mars's annual report for the financial year ended the 28^th December 1996, the profit and loss account stated the company's profit on ordinary activities before taxation of £50,097,000 after charging £41,823,939 in respect of depreciation on tangible fixed assets (see Note 5 to the accounts on page 13). Mars's balance sheet recorded that as at the 28^th December 1996 Mars held stock valued at £131,398,000. Note 10 to the accounts (on page 16) recorded that "At 28 December 1996, depreciation of £3,039,000 had been included in the stock valuation". The basis for this treatment was set out in the accounts' "Statement of accounting policies" at (c) on page 6:

"In the case of manufactured products, cost includes all direct expenditure and production overheads, including a share of manufacturing depreciation, based on the normal level of activity."

11. The auditors certified that the accounts showed a true and fair view. In its tax computation for the accounting period ended 31^st December 1996 Mars added back to the figure of profit before tax of £50,096,843 depreciation of £41,823,939 in respect of tangible fixed assets but subtracted the amount of £3,039,000 in respect of depreciation in unsold trading stock. The Revenue took the view that the subtraction of the sum of £3,039,000 ought not to be allowed and made the assessment. The Special Commissioners by the Decision allowed the appeal by Mars.

THE DECISION

12. The Decision began by setting out the issue to be determined and how it arose:

"7. We have adopted three definitions agreed by the expert witnesses. 'Gross depreciation' is the gross amount of the charge for depreciation calculated for the year on fixed assets. "Depreciation in stock" is that element of depreciation on fixed assets that is included in the carrying amount (or value) of unsold trading stock in a company's balance sheet at the end of the year. 'Net depreciation' is the gross depreciation charge after adjustment for depreciation in stock.

8. In preparing their financial statements both Appellants included in the cost of unsold trading stock the overhead costs incurred in producing the trading stock. At the end of the year depreciation on manufacturing fixed assets was treated as an overhead cost, capitalised and included in the carrying value (i.e. the balance sheet value) of closing stock and carried forward to the next year. The gross depreciation was debited in the profit and loss account followed by a simultaneous credit to the profit and loss account to adjust for the capitalisation of the depreciation in stock. The other side of the double entry dealing with this adjustment was a debit to the carrying value of closing stock (thereby increasing that carrying value by the amount of depreciation in stock). The amount of the final accounting profits was calculated by deducting net depreciation and not gross depreciation.

9. Because section 74(1)(f) of the 1988 Act prohibits, for tax purposes, the deduction of sums employed as capital in the trade, and because depreciation in respect of fixed assets is a deduction in respect of capital, the accounting profits shown in any trader's profit and loss account (although they are computed in accordance with generally accepted accounting practice) have to be adjusted for tax purposes by cancelling the deduction for depreciation. This cancelling is known as 'adding back'. In preparing their tax computations the Appellants added back the amount of net depreciation but did not add back the amount of depreciation in stock; depreciation in stock was carried forward and effectively added back in the year when the stock was sold.

10. The Inland Revenue accepted that both Mars and William Grant had computed their accounting profits in accordance with generally accepted accounting practice. However, they argued that gross depreciation, including depreciation in stock, had been deducted in the accounting period and so should be added back in the accounting period. The Appellants argued that the depreciation in stock had not been deducted from the accounting profits and so it was wrong to require it to be added back to the accounting profits for tax purposes.

11. Thus the issue for determination in the appeals was whether the amount representing depreciation in stock should be added back in the accounting period.

…

20. The statutory accounts for the year 1996 indicated that the gross amount of depreciation was shown as a charge in the profit and loss account and the amount for depreciation in stock was then credited to the profit and loss account. Thus the net effect was that it was only net depreciation which was charged as an expense (deducted from profits) in the year. The approach adopted by Mars is consistent with UK GAAP and with SSAP 9.

Mars - tax computations

21. Thus Mars prepared their statutory accounts on the basis that part of the annual depreciation charge was included in the cost of unsold stock on hand at the year end. However, until 1996, when adding back depreciation for corporation tax purposes, Mars used to add back, to the accounting profits, gross depreciation, namely the whole of the year's depreciation charge, including depreciation in stock.

…

23. The single adjustment proposed by PricewaterhouseCoopers for 1996 was to reduce the depreciation added back in that year by the cumulative amount of depreciation in stock. This reduced taxable profits by £3,039,000. Also, in 1996 the disclosure in Mars' statutory accounts was expanded to show depreciation in stock. A new sentence was added to note 10 to the accounts (Stocks) which read: 'At 28 December 1996 depreciation of £3,039,000 had been included in the stock valuation.' There was no change in accounting policy for statutory reporting purposes; there was merely a change in disclosure to make the treatment of depreciation in stock more visible.

24. Mars' corporation tax returns were therefore filed on that basis….

13. The Decision went on to consider the relevant provisions of the Companies Act 1985:

"35. Section 226 of the Companies Act 1985 provides that the directors of every company shall prepare for each financial year a balance sheet and a profit and loss account. As to their form and content these shall comply with the provisions of Schedule 4. Section A of Part I of Schedule 4 contains general rules and Section B contains required formats. For balance sheets there are two formats (formats 1 and 2) and for profit and loss accounts there are four formats (formats 1, 2, 3 and 4). Both Mars and William Grant used format 1 and the expert witnesses agreed that most companies in the United Kingdom use format 1.

36. Format 1 mentions twenty items including cost of sales and profit or loss for the financial year. Mr Carne [the expert called by the Revenue] agreed that the profit or loss would take into account the net depreciation. Format 1 does not deal with types of expenditure and so it is not possible to see in the profit and loss account what the charge for depreciation is. Note 14 on the profit and loss accounts formats states that cost of sales shall be stated after taking into account any necessary provisions for depreciation. Note 17 states that, where the profit and loss account is prepared by reference to format 1, the amount of any provision for depreciation shall be disclosed in a note to the accounts.

37. Part II of Schedule 4 contains accounting principles and rules. Part VII contains provisions about the interpretation of the Schedule and paragraph 88 provides:

'88(1) References to provisions for depreciation or diminution in value of assets are to any amount written off by way of providing for depreciation or diminution in value of assets.

(2) Any reference in the profit and loss account formats set out in Part I of this Schedule to the depreciation of, or amounts written off, assets of any description is to any provision for depreciation or diminution in value of assets of that description.'"

It was common ground that the provisions of the Companies Act 1985 required disclosure in one form or another of the gross depreciation and the amount of gross depreciation was relevant in the compilation of the provision for depreciation which appears in the balance sheet (see paragraph 67).

14. The Decision then turned to the relevant accounting principles:

"The accounting principles

38. Statement of Standard Accounting Practice 9 (Stocks and long-term contracts) (SSAP 9) was originally issued in 1975 and revised in 1988. It applied to both Appellants in all relevant years. Explanatory Note 1 read:

'The determination of profit for an accounting year requires the matching of costs with related revenues. The cost of unsold or unconsumed stocks will have been incurred in the expectation of future revenue, and when this will not arise until a later year it is appropriate to carry forward this cost to be matched with the revenue when it arises; the applicable concept 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. If there is no reasonable expectation of sufficient future revenue to cover cost incurred (e.g., as a result of deterioration, obsolescence or a change in demand) the irrecoverable cost should be charged to revenue in the year under review. Thus stocks normally need to be stated at cost , or, if lower, at net realisable value.'

39. Paragraphs 17, 19 and 20 provide:

'17 Cost is defined in relation to the different categories of stocks as being the expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. The expenditure should include, in addition to cost of purchase … such cost of conversion (as defined in paragraph 19) as are appropriate to that location and condition.'

'19. Cost of conversion comprises:

(a) costs which are specifically attributable to units of production, e.g. direct labour, direct expenses and sub-contracted work;

(b) production over heads (as defined in paragraph 20);

(c) other overheads, if any, attributable to the particular circumstances of the business to bringing the product or service to its present location and condition.

20 Production overheads: Overheads incurred in respect of materials, labour or services for production, based on the normal level of activity, taking one year with another. For this purpose each overhead should be classified according to function (e.g. production, selling or administration) so as to ensure the inclusion, in the cost of conversion, of those overheads (including deprecation) which relate to production notwithstanding that these may accrue wholly or partly on a time basis.'

40. Thus SSAP 9 requires that companies include within stock valuation not only the cost of purchasing raw materials but also "costs of conversion" which includes production overheads which in turn include depreciation.

41. Statement of Standard Accounting Practice 12 (Accounting for depreciation) (SSAP 12) was first issued in 1977. Paragraph 2 of the explanatory notes states:

'Virtually all fixed assets have finite useful economic lives. In order for the financial statements to reflect properly all the costs of the enterprise it is necessary for there to be a charge against income in respect of the use of such assets. This charge is referred to as depreciation (or amortisation in the case of leasehold property).'

42. Paragraph 16 states:

'The accounting treatment in the profit and loss account should be consistent with that used in the balance sheet, Hence, the depreciation charge in the profit and loss account for the period should be based on the carrying amount of the asset in the balance sheet, whether historical cost or revalued amount. The whole of the depreciation charge should be reflected in the profit and loss account. No part of the depreciation charge should be set directly against reserves.'

43. SSAP 12 was in force in 1996 (the relevant year so far as Mars is concerned). In February 1999 SSAP 12 was replaced by Financial Reporting Standard 15 (Tangible fixed assets) (FRS 15). This applied for accounting periods ending on or after 23 March 2000 and so applies to the relevant year for William Grant. Paragraph 77 read:

'The depreciable amount of a tangible fixed asset should be allocated on a systematic basis over its useful economic life. The depreciation method used should reflect as fairly as possible the pattern in which the asset's economic benefits are consumed by the entity. The depreciation charge for each period should be recognised as an expense in the profit and loss account unless it is permitted to be included in the carrying amount of another asset."

15. The comment is to be made in respect of paragraph 77 of FRS 15 that (as is common ground) paragraph 77 merely makes explicit what was implicit in SSAP12.
16. The Decision then turned to the expert evidence. Both the Revenue and Mars called distinguished experts in accountancy. The Revenue called Mr Carne and Mars called Mr Holgate. Both gave reports and thereafter they together produced the joint report referred to in paragraph 15 of the Decision. They both gave evidence in chief and were cross-examined before the Commissioners. Their summary of matters of agreement included the following:

"2.1 We agree that the overall net effect on reported profits is the net depreciation charge; that is, using a simplified example, where total depreciation on fixed assets for the year was 50 but, of that, 10 was included in closing stock, we are agreed that the net impact of depreciation charged in arriving at reported profits is 40. (Mr Holgate says that only the net amount of depreciation is charged in the profit and loss account. Mr Carne agreed that this is one possible interpretation, but the other is that the gross amount of depreciation is charged to the profit and loss account and that there is then a credit for closing stock.)

…

2.5 We agree that the Companies Act 1985 requires that the gross amount of depreciation provision calculated for the year on fixed assets should be disclosed in the notes to the financial statements, if it is not shown on the face of the profit and loss account.

…

2.7 We agree that … Mars … [has] disclosed, in the notes to the financial statements, the gross amount of depreciation charged in the profit and loss account.

…

2.9 We agree that the method of stock valuation applied under UK GAAP is the lower of cost and net realisable value and that this has been applied by … Mars.

2.10 We agree that under UK GAAP it is accepted practice to carry forward costs of production (including depreciation) in inventory to the extent that they are recoverable.

2.11 We agree that net realisable value can be viewed as either being (a) cost less a provision for impairment or (b) the adoption of a valuation basis that is other than cost.

2.12 We agree that in some circumstances stocks are held at a valuation (for example trading stock of a commodity trader) and in these circumstances where stocks are 'marked to market' that this does not represent cost. However, mark to market accounting is not relevant to Mars …, nor indeed to the generality of manufacturing companies."

17. In paragraphs 45 to 57 the Commissioners reviewed the evidence of Mr Holgate and Mr Carne.
18. The expert evidence was in particular directed to the resolution of three issues. I can take the first and second together. The first was whether the figure in the accounts for stock at the year end represented the value or the cost of the stock. The second was whether the opening stock should be treated as a notional purchase from the previous year of account and whether closing stock should be treated as a notional sale from one year to the next. The traditional view prior to the 1970s was that the figure of the stock represented the value and that the opening and closing stock should be treated as notional purchases and sales. The traditional view is reflected in a whole series of cases decided prior to 1975 (including Whimster & Co v. CIR (1925) 12 TC 813 at 823, Minister of National Revenue v. Anaconda American Brass Ltd [1956] AC 85 and Duple Motor Bodies v. Ostime (1961) 39 TC 537) and in an obiter observation of Nolan LJ in Gallagher (which I cite later) and permeated the judgment of Lord Millett in Secan v. CIR 74 TC 1, a decision of the Hong Kong Court of Final Appeal delivered on the 27^th November 1998 ("Secan"). For example at page 11 Lord Millett said:

"… there are always some sales, for the stock is carried forward in the balance sheet from year to year and is treated as a sale by one year to the next…. The value of the closing stock of one year is treated as sold to the next year and becomes the cost of purchasing the opening stock of that year."

19. These authorities were referred to and relied on by the Revenue in support of their submission that the Commissioners and this court should adhere to the traditional view. The Commissioners however held that with the development of accepted principles of commercial accountancy culminating in SSAP 9 in 1975 the position had changed and the figure for stock since that date (if not previously) represented cost.

"78. We go on to consider the development of the authorities cited to us, bearing in mind as we do so that the accepted principles of commercial accountancy are not static; as the evidence in this case shows, they may be modified, refined or elaborated over time as circumstances change and accounting insights sharpen."

[I pause to interject that this language is borrowed from the judgment of Sir Thomas Bingham MR in Gallagher at 555g].

"79. As long ago as 1925, it was decided in Whimster that: in computing profits or gains for the purposes of income tax, the profits of any particular year must be taken to consist of the difference between the receipts for that year and the expenditure laid out to earn those receipts; that the amount of profit or loss must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the rules of the Taxes Acts; that the ordinary principles of commercial accounting require that the values of stock in trade at the beginning and the end of the period should be entered at cost or market price whichever is the lower; and that even if profits are put to reserve they are nonetheless profits for the year to which the account relates and, as such, assessable to income tax. Mr Milne [counsel for the Revenue] relied upon Whimster for the principle that for tax purposes what was relevant was the value of stock at the end of the year, not the cost of it. However, Whimster was decided in 1925 before the issue of SSAP 9 in 1975. The Explanatory Note to SSAP 9 makes it clear that the applicable concept is the matching of cost and revenue, not value. Thus we would now read the references in Whimster to the values of stock as being references to the cost of stock (or to value if that is lower).

83. In 1975 Statement of Standard Accounting Practice 9 (SSAP 9) was originally issued. It provided that the determination of profit for an accounting year required the matching of costs with related revenues. The cost of unsold or unconsumed stocks will have been incurred in the expectation of future revenue, and when this will not arise until a later year it is appropriate to carry forward this cost to be matched with the revenue when it arises; the applicable concept 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. Duple Motor Bodies was decided before the issue of SSAP 9 and so would probably not be decided in the same way today. "

20. The Commissioners went on to note that the experts were united in the view that the traditional view of the appropriate treatment of opening and closing stock likewise no longer prevailed:

"86. (We record that the expert witnesses were of the opinion that opening stock would not now be regarded as a purchase from the previous year of account and that closing stock would not be described as being a notional sale from one year to the next; the most common approach would be to regard closing stock as one of the assets carried forward from one year to the next.)"

21. The third issue to be resolved was whether the gross or net depreciation had been deducted by Mars in computing the accounting profits. The Commissioners set out the arguments addressed to them:

"58. For the Inland Revenue Mr Milne accepted that both Mars and William Grant had computed their accounting profits in accordance with generally accepted accounting practice and principles in accordance with section 42 of the 1998 Act (although strictly that section applied only to the appeal of William Grant). He also accepted that there was no difference in net effect between debiting the net depreciation to the profit and loss account on the one hand and debiting gross depreciation and then crediting the amount which was capitalised in depreciation in stock on the other hand.

59. However, Mr Milne did dispute that the correct tax adjustment had been made to those properly computed profits. He argued that the relevant question was how much depreciation had been deducted in computing profits not what was the net effect of depreciation on the profit. It was his argument that gross depreciation had been deducted in computing profits. He argued that the amounts incurred on stock were expenses of the year in which they were incurred but at the end of the year there was a further process of arriving at a value to be placed on closing stock which was carried forward to the following year; this was not merely a carry forward of costs but a valuation of stock. That meant that there was a deduction of the whole of the expenses incurred during the year followed by a credit of a closing figure for unsold stock. Accordingly, the Appellants had deducted the full amount of depreciation in computing their accounting profits even though an amount had been included in the value of stock at the end of the year.

66. Both expert witnesses agreed that it was only net depreciation which had been deducted in computing the accounting profits. That would suggest that it is only net depreciation which has to be added back for tax purposes."

22. The statement by the Commissioners that the expert witness had agreed that only the net depreciation was deducted must be read in the light of paragraph 2.1 of the experts joint report set out in paragraph 16 of this judgment. The experts had merely agreed that this was the net effect.
23. The Commissioners then proceeded to set out the reasoning for their decision in paragraphs 84-95:

"84. The next development occurred in Gallagher v Jones (1993) which concerned the prepayment of expenses and so is not directly relevant to this appeal but is of interest. That appeal concerned traders who hired out boats in the short term. One trader acquired three boats under leases for a primary period of twenty-four months with an initial payment of £14,562 followed by seventeen monthly payments of £2,080 each and thereafter for a secondary period of twenty-one years at an annual rent of £5. The trading accounts for the first year treated as expenditure the initial payment and the five monthly payments made that year. The accounts showed a trading loss which the trader claimed to carry forward, arguing that expenditure should be deducted in the year in which it is incurred. The Court of Appeal held otherwise. In his judgment at 556g to 557e, which passage was relied upon by Mr Milne, Lord Justice Nolan considered whether there had previously been any exceptions to the rule that expenses are deductible in the period of account in which they are incurred. Mr Glick, for the Inland Revenue, suggested that the effect of the accountancy practice whereby unsold stock in trade was brought into account at the beginning and end of an accounting period was to disallow the deduction of expenditure on the unsold stock and carry it forward to be set against the price for which the stock was sold. Lord Justice Nolan accepted that that was one way of describing the effect of the practice but thought that, as a matter of legal analysis, the practice involved the deduction of the whole of the expenses incurred during the period but the crediting against them of a closing figure for unsold stock as a notional receipt.

85. SSAP 9 was not relevant in that appeal but it is clear from SSAP 9 that the applicable accounting concept for stocks 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. As far as depreciation is concerned SSAP 12 is consistent with Lord Justice Nolan's view because it sets out an accounting principle that all depreciation should be reflected in the profit and loss account even if closing stock also includes depreciation in stock.

…

87. It is against this background that it is possible to consider the decision in Secan. In Secan a construction company purchased in 1988 a site and incurred development costs. To meet the costs it borrowed and incurred interest and financing charges. It could have treated the interest as part of general expenses thus producing a substantial loss each year to be carried forward to future years. Instead it decided to capitalise the interest charges by treating them as additional costs of the development. At the end of the year the value of the property shown in the balance sheet included the costs of acquisition and development and also interest. The interest was not mentioned in the profit and loss account. This practice was also followed for 1989 and 1990. In 1989 there was a note to the accounts showing that interest had been capitalised and added to the value of the property under development. During these three years small losses were made. In 1990 a profit was made and, after deducting the losses of the previous years, tax was due and paid. In 1991 the company began to sell the flats. If it had continued to prepare its accounts in the same way as formerly it would have obtained relief for the interest payments by treating them as part of the cost of sales and deducting the appropriate portion from the proceeds of sales made in the current year. Instead it sought to re-write all its accounts retrospectively so as to set all the interest charges from 1998 onwards against the proceeds of sale for the current year. However, the company realised that this would give a double deduction for the cost of sales because interest had already been taken into account as part of the costs of the development. It therefore made an adjustment so as in effect to re-calculate the cost of sales in the current year by retrospectively excluding capitalised interest from the cost of sales.

88. The company argued that its original accounting method had not been in accordance with the relevant Hong Kong statute which required that all outgoings and expenses, including interest, should be deducted to the extent to which they were incurred during the basis period for the year of assessment. The Inland Revenue argued that the statute did not prohibit the capitalisation of interest and that the interest had already been deducted in the years in which it was incurred but, because it had been capitalised, the deduction did not give rise to any losses capable of being carried forward.

89. The Court held that the statute permitted outgoings to be deducted only to the extent to which they were incurred in the relevant year; that the accounts for the first three years were properly prepared in accordance with ordinary accounting principles, and that interest had been deducted not by a reduction of earnings in the profit and loss account but by an increase in the value of an asset in the balance sheet. There was no basis on which a taxpayer could challenge an assessment based on its own financial statements so long as those were prepared in accordance with ordinary accounting principles, showed a true and fair view of its affairs, and were not inconsistent with the statute."

24. I comment that the statement in paragraph 89 of the Decision that "interest had been deducted, not by a reduction of earnings in the profit and loss account but by an increase in the value of an asset in the balance sheet" cannot be correct. Interest cannot be deducted by an increase in the value of an asset in the balance sheet. An increase in the value of an asset in the balance sheet goes, when that asset is trading stock, to produce a profit. Secan's accounts did not show a profit and it followed that there must have been a deduction somewhere in the accounts for interest: otherwise the accounts would have had to show a profit.
25. The Decision continued:

"90. Applying the principles in Secan to the facts of the present appeal we start from the fact that the accounts of the Appellants have been prepared in accordance with the correct principles of commercial accountancy and show a true and fair view of their affairs. In their financial statements the Appellants have, in effect, taken account of the gross amount of depreciation in their profit and loss account (in order to make the provision for depreciation which appears in the balance sheet) but then capitalised some of it and transferred that part to the balance sheet as part of the asset of stock. So far as the profit and loss account is concerned, this transfer has (in accordance with correct principles of commercial accountancy) been treated as a true "contra" item, with the result that only net depreciation therefore is treated for those purposes as an expense in the profit and loss account.

91. Section 74(1)(f) of the 1988 Act requires the computation of profits for tax purposes to be made without any deduction in respect of capital. This excludes any deduction for depreciation. In our judgment this requires that any depreciation charged to the profit and loss account must be "added back" for tax purposes. We also consider that for tax purposes any element of depreciation must be removed from the carrying amount in the balance sheet of unsold trading stock.

92. We conclude that the amount to be "added back" must be the amount of net depreciation.

93. The reasoning supporting this conclusion is either that, as the Appellants argued, it is only net depreciation that has been deducted in the computations of profits in accordance with generally accepted accountancy practice which are before us. On that basis the "contra" item is accepted as a true "contra" item reducing the charge for depreciation in the profit and loss account from the amount of gross depreciation to the amount of net depreciation.

94. Alternatively, as we prefer, the "contra" item, although a true "contra" item for accountancy purposes, is not to be accepted as such as a matter of law – because the provisions for depreciation in the balance sheets prepared in accordance with the Companies Act 1985 do not recognise the "contra" item as actually reducing the charge for depreciation in the profit and loss account. Therefore the amount of gross depreciation must be taken to have been actually charged in the profit and loss account. This accords with the ratio in Secan and with Lord Justice Nolan's observations in Gallagher v Jones. But the matter does not stop there. The adjustment required by section 74(1)(f) of the 1988 Act in respect of the amount of gross depreciation must be offset by the amount of the "contra" item in order to avoid that capital amount becoming chargeable to corporation tax on income in the period – a result for which there is no statutory authority.

Decision

95. Our decision on the issue for determination in the appeals is that the adjustment required for the purposes of corporation tax by way of "adding back" depreciation to arrive at the amount of taxable profits is the amount of net depreciation, not the amount of gross depreciation."

DECISION

A. COST OR VALUE

26. The first issue before me is whether the conclusion of the Commissioners should stand that for the purpose of computing the profits of Mars what is relevant is the cost, and not the value, of stock at the end of the year. The issue turns on whether the choice between the two criteria is a matter of law which has been authoritatively laid down in the cases in which it has been applied or is to be determined in accordance with current accepted principles of commercial accountancy. I have no doubt that the latter criterion is to be adopted. It is correct (as pointed out by Nolan LJ in Gallagher) that in the pre- 1975 authorities the judges state as a matter of law that the relevant criterion is value, but these statements must be read in the context where this was at the time the relevant criterion in accordance with the then current accountancy practice and no alternative accountancy practice was suggested. In my judgment the Commissioners were correct in recognising the change in accepted principles of commercial accountancy and in holding that the issue had to be determined in accordance with current accepted principles of commercial accountancy and that the pre 1975 judicial decisions are to be explained as reached in the absence of, or on different, accepted principles.
27. I must likewise discount the observations of Lord Millett in his judgment in Secan. It is common ground that the same principles of commercial accountancy prevail in Hong Kong as here, but it is not apparent that in that case the issue was addressed in the evidence or in argument whether there had been a change in this regard in accepted principles of commercial accountancy since the pre 1975 authorities and I cannot therefore give to his words in this regard the weight which would ordinarily attach to them. In any event his views on what were the accepted principles of commercial accountancy (which is an issue of fact) cannot prevail against the findings of fact by the Commissioners.

B. SALE OR CARRY FORWARD

28. The second issue is whether for the purpose of computing the profits of Mars there should be a notional purchase of opening and a notional sale of closing stock. Very much following what I have said regarding cost and value, I hold that, notwithstanding the observations of Lord Millett in Secan, current commercial accountancy principles establish that there is no notional purchase of opening or sale of closing stock: the stock is merely carried forward.

C. SECAN

29. The third issue relates to the decision in Secan. Lord Millett set out the reasoning for his decision in Secan as follows:

"Capitalisation of interest

Capitalisation of interest is justified only in certain circumstances. This is explained in Statement of Accounting Practice No. 2.205 (Accounting Guidelines on Capitalisation of Borrowing Costs) published by the Council of the Hong Kong Society of Accountants. The Statement was produced in evidence given to the Board of Review on behalf of the taxpayer by Mt. Fong Hup.

The Statement distinguishes between two different situations. Normally borrowing costs are essentially period costs and are charged to income without any contra credit regardless of how the borrowing is applied.

The interest is treated, like rent or office overheads, as part of the general costs of carrying on the business. In certain specific instances, however,

'the borrowing costs can be regarded as forming part of the cost of the asset with which they can be identified and can be capitalised as part of the carrying amount of the asset.'

The justification for this treatment is stated as follows:

'(a) Borrowing costs incurred as a consequence of a decision to acquire an asset are not intrinsically different from other costs which are commonly capitalised. If an asset requires a substantial period of time to bring it to the condition and location necessary for its intended use, the borrowing costs incurred during that period as a result of expenditures on the asset are a part of the cost of acquiring the asset.

(b) Failure to capitalise the borrowing costs associated with the acquisition of assets reduces earnings merely as a consequence of the acquisition of assets.'

Thus capitalisation of interest has nothing to do with the debit side of the account. Whether interest is capitalised or not, it represents an outgoing and must be deducted in ascertaining the taxpayer's profits or losses. When it is capitalised, however, it is treated as part of the cost of acquiring an asset, in this case the property under development. Since assets are valued at the lesser of cost and net realisable value, the cost of an asset is normally the same as its carrying amount or value in the balance sheet. Any increase in its cost is reflected by a corresponding increase in its value. The amount or value of an asset is, of course, a credit on the asset side of the balance sheet. Provided that the directors are satisfied that the value of the asset is not less than its increased cost, they are entitled to increase the carrying value of the asset in the balance sheet by an amount equal to the interest, exactly as if the interest represented the cost of an additional asset. This eliminates any reduction of earnings consequent on the payment of interest, not by omitting to debit the outgoing (representing the cost of the asset), but by bringing in a corresponding credit (representing its value on the other side of the account).

There can be no inconsistency between s 16 of the Ordinance, which is concerned with debits, and the capitalisation of interest, which is concerned with credits. This is sufficient to dispose of the appeals, since there is no basis on which a taxpayer can challenge an assessment based on its own financial statements, so long as these are prepared in accordance with ordinary accounting principles, show a true and fair view of its affairs and are not inconsistent with a provision of the Ordinance. "

30. As it seems to me, what Lord Millett decided was that for the purposes of the Ordinance it was open to the taxpayer in accordance with the legislation and current commercial accountancy principles to reflect the deduction of interest in two alternative ways. The first way was simply to charge it as an expense in the profit and loss account and thereby reduce the profit or increase the loss by the amount of the expense. The second way was to charge it as an expense in the profit and loss and account and at the same time to "capitalise" the expense by adding it to the closing value of the stock and treating it as a cost of acquiring the stock. If the closing stock is then brought into the computation at cost (which includes the interest), the deduction of interest has no net impact on the profit or loss. Lord Millett went on to hold that, having exercised his election between the two alternatives in its accounts, the taxpayer was bound by that election. I do not think that the decision in that case is of substantial assistance in answering the question raised on this appeal.

SECTION 74

31. The fourth issue is the tax status of the £3,039,000.
32. A Schedule D Case 1 computation must be made in accordance with proper principles and those principles require that opening and closing stock figures are brought in the computation. The process of "adding back" is one way of calculating taxable profits: the process adjusts the profits shown in the taxpayer's commercial accounts by adding to it things which have been deducted in arriving at it, but which, according to the law about taxes on income, cannot be deducted for tax purposes.
33. Section 74(1)(f) provides that in computing the amount of profits to be charged under Case I of Schedule D no sum shall be deducted in respect of "… any sum … employed … as capital in the trade". The critical question is whether there was in this case a deduction of £3,039,000. The company's profit and loss account states its profits after charging £41,823,939 in respect of depreciation on tangible fixed assets; its balance sheet records that depreciation of £3,039,000 had been included in the stock valuation and its tax computation subtracts from the expense of £41,823,939 in respect of depreciation the sum of £3,039,000. The question raised is whether Mars deducted the £3,039,000 in computing the amount of its profits.
34. Before going further it is apposite to have in mind the words of Lord Nicholls in paragraphs 3 and 32 of his speech giving the opinion of the Appellate Committee in Barclays Mercantile Business Finance Ltd v. Mawson [2004] UKHL 51 ("Barclays") regarding deductions for depreciation and the modern approach to the construction of taxing statutes.

"[3] … a trader computing his profits or losses will ordinarily make some deduction for depreciation in the value of the machinery or plant which he uses. Otherwise the computation will take no account of the need for the eventual replacement of wasting assets and the true profits will be overstated. But the computation required by Sch D (whether for the purpose of income or corporation tax) has always excluded such a deduction. Parliament therefore makes separate provision for depreciation by means of capital allowances against what would otherwise be taxable income. In addition, generous initial or first-year allowances, exceeding actual depreciation, are sometimes provided as a positive incentive to investment in new plant.

…

32. The essence of the new approach was to give the statutory provision a purposive construction in order to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description. Of course this does not mean that the courts have to put their reasoning into the straitjacket of first construing the statute in the abstract and then looking at the facts. It might be more convenient to analyse the facts and then ask whether they satisfy the requirements of the statute. But however one approaches the matter, the question is always whether the relevant provision of statute, upon its true construction, applies to the facts as found. As Lord Nicholls of Birkenhead said in Macniven (Inspector of Taxes) v Westmoreland Investments Ltd [2001] UKHL 6 at [8], [2001] STC 237 at [8]. [2003] 1 AC 311:

'The paramount question always is one of interpretation of the particular statutory provision and its application to the facts of the case.'"

35. Subject to any express or implied statutory rule to the contrary, the way to ascertain the profits of a trade for tax purposes is to apply accepted principles of commercial accountancy: Gallagher at 555g-h per Sir Thomas Bingham MR. In particular, accountancy principles may require an allowance for the depreciation of an asset on which capital has been expended in order to give a true and fair view of the profits earned by a trade in a given year. Once the profits of a trade have been ascertained in accordance with accepted principles of commercial accountancy, those profits must be adjusted for tax purposes in accordance with the provisions of the Tax Acts applicable to Case I of Schedule D.
36. The statutory purpose underlying section 74(1)(f) is clear. Where any deduction for depreciation is made in computing a company's taxable profits in accordance with accepted principles of commercial accountancy, the amount deducted must be added back to arrive at the amount of profits properly chargeable to tax under Schedule D Case I. This ensures corporation tax is charged on the full amount of those profits without any deduction other than is expressly authorised: section 70(1) ICTA. As Lord Nicholls said in Barclays, Parliament has made separate provision for depreciation by means of capital allowance. In the circumstances, it is in my judgment not to be expected that Parliament intended that (save as expressly provided) any sum deducted in respect of depreciation should avoid being added back merely because it was reflected as an item of cost in the figure shown for stock.
37. In my judgment, the answer to the question raised is a short one. Section 74 prohibits any deduction or allowance for depreciation of capital assets in the computation of the taxable profits for the year to be charged under Case 1 of Schedule D. The prohibition is general and overrides any established accountancy principle governing the treatment of depreciation. Established accountancy principles have an important role in computing tax profits for tax purposes. They do not, however, qualify the application of section 74. The profit and loss accounts of Mars charge the full depreciation as an expense in computing profits for the year. The subtraction of £3,039,000 and capitalisation of that sum as an item of cost in the figure for stock is an exercise which accords with establishing accounting principles but does not alter the character of the figure of £3,039,000 as depreciation or disapply section 74(1)(f).
38. This conclusion accords with the view expressed by the Commissioners in paragraph 91 of the Decision and the first part of paragraph 94. Nonetheless, the Commissioners went on to hold in the alternative that: (1) in accordance with generally accepted accountancy practice only the net figure of £41,823,939 less £3,039,000 had been deducted in the computation of profits; and (2) that the figure of gross depreciation of £41,823,939 needed to be adjusted by an offset of £3,039,000 to avoid that capital amount becoming chargeable to corporation tax on income in the period which they described as "a result for which there is no statutory authority".
39. With all respect I find neither of these processes of reasoning satisfactory or convincing. As to the first process of reasoning, I have two concerns. The first is that the evidence did not establish that it was in accordance with generally accepted accountancy practice that only the net sum was deducted. What the evidence established was that the full sum of £41,823,939 was deducted, but that the effect of the credit of £3,039,000 was that only the net sum was deducted (see paragraph 22 above). The second is that the application of section 74(1)(f) does not turn on accountancy practice. The application turns on the construction of section 74 and its application to the established facts as revealed in the accounts. As to the second process I do not accept the existence of the suggested need to avoid the capital amount becoming chargeable to corporation tax on income or that it impels any such conclusion as they have reached. By adding the £3,039,000 capital depreciation to closing stock, Mars has by its own choice turned it into income: it becomes, in effect, an income receipt just by being part of the closing stock value.

CONCLUSION

40. Accordingly, for the reasons which I have given, I allow this appeal.