Scottish Court of Session Decisions

" Whether, for the purposes of corporation tax, the gross amount of depreciation is required to be added back in arriving at taxable profits or whether only the net amount (after adjusting for depreciation included in opening and closing stock) is to be disallowed."

" ..in computing the amount of the profits to be charged under Case I .. 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(f) any capital withdrawn from, or any sum employed or intended to be employed as capital in, the trade ..."

" 31. For many years and at least since 1992 William Grant has prepared its tax computations on the basis that the amount of depreciation to be added back to the accounting profits did not include that amount of the charge for depreciation represented by depreciation in stock. When the closing stock became the opening stock of the next year, and was sold in the next year, the cost of stock (including the depreciation in stock) was deducted from the profit and loss account and the amount of depreciation in stock was added back in that year. If the opening stock was not sold in that year it was again added back in that year. If that opening stock was not sold in that year it was again carried forward to the next year on the same basis.

32. William Grant' s tax treatment of depreciation in stock was discussed with the Inland Revenue in 1995 and in 1996. In 1995 the Inland Revenue were prepared to accept that only the net depreciation need be added back for tax purposes so long as accurate records were kept of the amount of depreciation in stock to ensure that future adjustments were made. William Grant suggested that the adjustments could be made by reference to movements in stock during the course of the year. For example, if in year one 20% of depreciation was taken to stock and not added back in that year, and if in year three 20% of the year one stock was sold, then 20% of the stock in year one would be added back in year three. As William Grant' s records were extensive the Inland Revenue accepted the proposal and it was agreed that the amount of depreciation that should be added back for tax purposes should be the net amount debited to profit and loss account, which did not include the amount for depreciation in stock. Later it was agreed that there would be a cut off point so that all stock not actually sold would be adjusted after twelve years for malt stocks and five years for grain stocks.

33. In 2002 the Inland Revenue informed William Grant that computation adjustments in respect of depreciation in stock were contrary to the rules of Case 1 of Schedule D and that companies who had followed the practice had to change their tax adjustment basis. The Inland Revenue now require that the amount of depreciation added back should include depreciation in stock. William Grant' s corporation tax computation for the year 2002 does not incorporate the change of practice proposed by the Inland Revenue. A cumulative amount of £9,567,271, which represents the amount of depreciation in stock, has not been added back in the year in which it was incurred. It is that amount which is the subject of the appeal of William Grant."

" Stocks are stated at the lower of cost or net realisable value. Cost consists of expenditure in purchasing or producing stock and bringing it to its present location and condition as follows:

Work in progress and finished goods - cost of direct materials, labour and attributable overheads based on a normal level of activity.

Net realisable value is based on estimated selling price in the normal course of business, less all additional costs to completion and disposal."

" The remaining £5,010,000 was charged (deducted) in the profit and loss account. Thus the operating profit for 2002 was stated after deducting the net amount of depreciation which did not include depreciation in stock."

"63. In considering the arguments of the parties we start with the words of the legislation.

64. Section 42 of the 1998 Act provides that the profits of a trade must be computed in accordance with generally accepted accountancy practice, subject to any adjustment required by law in computing profits for those purposes. Section 42 applies to periods of account beginning after 6 April 1999 and so applies to the appeal of William Grant. However, it was not disputed that section 42 reflects the law as it existed before 6 April 1999 and that the same principle applied to the appeal of Mars.

65. In these appeals it was agreed that both Appellants had computed their profits in accordance with generally accepted accountancy practice. Accordingly we can pass to the second stage of the test in section 42 and consider the application of the adjustment required by law. The adjustment required by law in these appeals is set out in section 74(1)(f) of the 1988 Act which provides that, in computing the amount of profits to be charged to tax, no sum shall be deducted in respect of any sum employed or intended to be employed as capital in the trade. Addie is authority for the principle that depreciation of fixed assets is expenditure of additional capital and so cannot be a deduction for tax purposes. Clearly therefore an accounting profit, which has been calculated by making a deduction for depreciation, must be adjusted for tax purposes by cancelling that deduction or " adding it back" . What we have to find is the amount of depreciation which has been deducted in computing the accounting profits.

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.

67. However a feature of this case is that, although it is accepted that accounts produced in accordance with generally accepted accountancy practice show a deduction (in the profit and loss account) of only the amount of the net depreciation, nevertheless the amount of the gross depreciation is relevant in the computation of the provision for depreciation, which appears in the balance sheet. It is that provision, of course, which shows, " the diminution in value" of the assets being depreciated, to adopt the language of paragraph 88 of Schedule 4 to the Companies Act 1985.

68. Thus it is perfectly possible, where the accounting policy adopted by the Appellants is followed, for the following situation to arise. A certain fixed asset - say, a machine - may be fully depreciated, so that it stands in the balance sheet at nil value (represented by mutually cancelling amounts of cost and provision for depreciation), but nevertheless the full amount of depreciation (equal to both the cost of the machine and the provision for depreciation) has not been effectively charged to the profit and loss account. This is the position because part of that depreciation, instead of being effectively charged to the profit and loss account is instead accounted for as an element of the cost of unsold trading stock.

69. In this way, the accounting policy adopted by the Appellants shows a transfer of value from a fixed asset (the cost or value of the machine) to unsold trading stock, which is generally regarded as a current asset, without that transfer being " reflected in the profit and loss account" , to adopt the language of paragraph 16 of SSAP 12.

70. The wording of SSAP 12 is relevant to the Mars appeal, but (as we have noted) it was superseded with effect from 2000 by FRS 15, which, at paragraph 77, permitted the depreciation charge for a period not to be recognised in the profit and loss account if it was " permitted to be included in the carrying amount of another asset" (in this case unsold trading stock).

71. Nevertheless, even on the wording of paragraph 77 a peculiarity arises, namely that although part of the depreciation charge can in certain circumstances not be recognised in the profit and loss account, the " depreciable amount" of a tangible fixed asset must be " allocated on a systematic basis over its [i.e. the asset' s] useful economic life" and " the depreciation method used should reflect as fairly as possible the pattern in which the asset' s economic benefits are consumed by the entity" . This seems to tie down the period over which an asset can be depreciated to the period of that asset' s useful economic life, and this is inconsistent with a policy which recognises the full charge for depreciating the asset over a longer period than this - effectively a period ending only when the trading stock whose value is debited with part of the depreciation charge is finally sold or written down.

72. Furthermore, a provision for depreciation in the balance sheet which takes account of the gross depreciation, but a computation of profits which recognises only a deduction of the amount of the net depreciation in the profit and loss account, seem to be inconsistent one with another. The " contra" item, whereby the gross depreciation charged to the profit and loss account is adjusted by transferring an amount out of the profit and loss account to increase the carrying value of unsold trading stock, must be examined. If that " contra" item is truly a " contra" item, so that one can say that the amount of depreciation charged to the profit and loss account is only the amount of the net depreciation, not the amount of the gross depreciation, it is difficult to see how the provision for depreciation in the balance sheet can stand. This is the situation which is recognised by note 4 in the 2002 statutory accounts of William Grant, which clearly shows what has happened, namely that there has been a gross depreciation charge of £6,705,000, of which £1,695,000 has been the subject of a " contra" item and debited to the carrying value of unsold trading stock - but begs the question as to how in these circumstances the amount of the provision for depreciation stated in the balance sheet is made up.

73. We intend absolutely no criticism of Mars, William Grant or their advisers in making this observation. The precise nature of the " contra" item, whether it is in every respect a pro tanto cancellation of the gross depreciation charge or alternatively an accounting adjustment to the gross depreciation charge, debiting the carrying amount of unsold trading stock with an amount representing depreciation on fixed assets, is a matter of no importance in any accounting context - or indeed in any context (as far as we can see) other than the determination of the issue arising in the present case.

74. Insofar as the features which we have mentioned relate to the accounting treatment, as to which there is general agreement as to its correctness, they do not call for any comment from us. We are only concerned with the question of the adjustments required or authorised by the 1988 Act in computing profits for the purposes of Case I of Schedule D.

75. Profits computed for those purposes allow no deduction in respect of capital. This mirrors the Schedule D charging provision which refers to annual profits or gains and excludes capital receipts (however they are accounted for). Since Addie, which was the first case reported in the first volume of Tax Cases, it has been recognised that depreciation cannot be deducted for the purposes of Case I, because depreciation is in the nature of capital.

76. However, generally accepted accountancy practice (of course) treats depreciation as a revenue (not a capital) expense, and, further, treats depreciation as capable of constituting an element of the cost of unsold stock. Our recognition of the validity of the accountancy practice does not affect the legal nature of depreciation for the purposes of Case I as capital, or the requirement that no sum shall be deducted in respect of it in the computation of profits for Case I purposes.

77. We accept the expert evidence of Mr Holgate that the capitalisation of depreciation is, as a matter of generally accepted accountancy practice, part of the accumulation of the total cost of an asset in relation to which the capitalisation has been made - in this case unsold trading stock. But it seems to us (although neither side argued this) that the part of the cost of unsold trading stock which is represented by capitalised depreciation ought not to be recognised (as, effectively, a taxable receipt) in the computation of trading profits for the purposes of Case I. This is because, as a matter of law, it is in the nature of capital, and its capital nature is not altered by its absorption into the cost of trading stock for accounting purposes - any more than the capital nature of depreciation is altered by its treatment as a periodic charge in the profit and loss account. Thus the increase in the value of trading stock in the balance sheet which is represented by depreciation in stock ought not to be taken into account for the purposes of the computation for tax purposes of trading profits. To do so would effectively charge a capital amount to corporation tax on income, without any statutory authority. As we have observed, the charge to tax on trading profits under Case I of Schedule D extends only to " annual profits or gains" - see section 18 of the 1988 Act.

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.

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 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).

80. In 1949 it was decided in Cock Russell at 392 that, although there is nothing in the legislation which indicates that, in computing the profits and gains of a commercial concern, regard should be paid to the value of the stock in trade at the start and end of the accounting period, that must be done as it is impossible to assess profits and gains merely on a statement of receipts and payments. Thus it was established at this early stage that, in computing profits, it is necessary to bring into account the amount of stock at both the start and the end of the accounting period; by " amount" we mean cost or market value whichever is the lower.

81. In Duple Motor Bodies (1961) the issue was whether an amount for work in progress should be calculated by taking the direct costs of materials and labour alone (as argued by the taxpayer company) or whether a proportion of overhead expenditure should also be added (as argued by the Inland Revenue). The then accountancy evidence was that either method would produce a true figure of profit for tax purposes and the House of Lords did not require the taxpayer company to change its practice.

82. We note that there was no question of including any capital element in trading stock values in Whimster, Cock Russell, or Duple Motor Bodies.

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.

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.

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.)

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.

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.

96 The appeals are therefore allowed."

What is the correct method of computing a company' s profits for corporation tax purposes when part of the gross amount of depreciation deducted in the balance sheet and debited to profit and loss account is used to calculate, along with other elements of cost, the closing figure for unsold stock?

" .... For the purposes of corporation tax for any accounting period income shall be computed under Cases I to VI of Schedule D on the full amount of the profits or gains arising in the period ..., without any other deduction than is authorised by the Corporation Tax Acts."

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

"In computing the balance of profits and gains for the purposes of Income Tax ..., two general and fundamental commonplaces have always to be kept in mind. In the first place, the profits of any particular year or accounting period must be taken to consist of the difference between the receipts from the trade or business during such year or accounting period and the expenditure laid out to earn those receipts. In the second place, the account of profit and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the with the rules of the Income Tax Act."

"For example, the ordinary principles of commercial accounting require that in the profit and loss account of a merchant' s or manufacturer' s business the values of the stock-in-trade at the beginning and at the end of the period covered by the account should be entered at cost or market price, whichever is the lower; although there is nothing about this in the taxing statutes."

"18 In the case of any fixed asset which has a limited useful economic life, the amount of -

shall be reduced by provisions for depreciation calculated to write off that amount systematically over the period of the asset' s useful economic life."

"(2) The production cost of an asset shall be determined by adding to the purchase price of the raw materials and consumables used the amount of the costs incurred by the company which are directly attributable to the production of that asset.

"References to capitalising any work or costs are to treating that work or those costs as a fixed asset."

"1. The determination of profit for an accounting year requires the matching of cost with related revenues. The cost of unsold or unconsumed stock 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 application 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.

2. The comparison of cost and net realisable value needs to be made in respect of each item of stock separately. Where this is impractical, groups or categories of stock items which are similar will need to be taken together. To compare the total realisable value of stocks with the total cost could result in an unacceptable setting off of foreseeable losses against unrealised profits.

3. In order to match costs and revenue, ' costs' of stocks should comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. Such costs will include all related production overheads, even though these may accrue on a time basis."

"I would state these general propositions: (1) You cannot arrive at the profits of the year without taking into account the value of the stock you have at the beginning of, and at the end of, the accounting year. (2) The figures for stock are just as important as any other figures. Values may have to be estimated when market price is taken, but any departure from accuracy is reflected in the trading account. (3) Stock should be taken either at cost price or at market price, whichever is the lower."

"What may be prudent accountancy for a company is not necessarily the correct method of ascertaining the proper assessment for Income Tax."

"It must be remembered that the costing of the work in progress, though it is a necessary part of accounting both from a commercial point of view and, since the Whimster case, from the Income Tax point of view, is nevertheless only a means to the ascertainment of the profit and not an end in itself. Moreover, one year will correct the errors of another. And it would be unfortunate if dogmas of method obscured the real purpose - the finding of fair, true and reasonable assessment of the real profit of the business for the year."

" ... (I)t is proper to say, ..., that it is common ground that some value must be attributed to work in progress and that, in ascertaining that value, two considerations must be borne in mind: first, that the ordinary principles of commercial accounting must, so far as practicable, be observed and, secondly, that the law relating to Income Tax must not be violated (see Whimster & Co v Commissioners of Inland Revenue...) - that is to say, by one means or another the full amount of the profits or gains of the trade must be determined....

The practice of accountants, though it were general or even universal, could not by itself determine the amount of profits and gains of a trade for tax purposes: see, for example, Minister of National Revenue and Anaconda American Brass Ltd ...On the other hand, it was the basis of Lord President Clyde' s decision in Whimster' s case that the ordinary principles of commercial accounting require that in the profit and loss account of a manufacturer' s business the values of stock-in-trade at the beginning and end of the period covered by the account should be entered at cost or market price whichever is the lower, although there is nothing about this in the taxing Statutes. It is for this reason that stock-in-trade (and work in progress also, though nothing is said of this in Whimster' s case) is brought into account. If this is so, regard must be paid to accountancy principles also in ascertaining what that cost is, subject always to the condition that the taxing Statutes must not be violated."

"It appears that at one time it was common to take no account of the stock-in-trade or work in progress for Income Tax purposes; but long ago it became customary to take account of stock-in-trade, and for a simple reason. If the amount of stock-in-trade has increased materially during the year, then in effect sums which have gone to swell the year' s profits are represented at the end of the year by tangible assets, the extra stock-in-trade which they were spent to buy; and similar reasoning will apply if the amount of stock-in-trade has decreased. So to omit the stock-in-trade would give a false result..... Then the question is, what figure should be taken to represent the stock-in-trade."

"So the question is not what expenditure it is proper to leave in the account as attributable to goods sold during the year, but what expenditure it is proper in effect to exclude from the account by setting it against a figure representing stock-in-trade and work in progress. You must justify what you seek to exclude in this way as being properly attributable to, and properly represented by, those articles."

"There is no room for theories as to flow of costs, nor is it legitimate to regard the closing inventory as an unabsorbed residue of cost rather than as a concrete stock of metals awaiting the day of process."

"It is common ground that the taxpayer' s financial statements, including its profit and loss accounts, gave a true and fair view of its profits or losses for each of these years. Any increase in the cost of work in progress, whether resulting from the incurring of further construction costs or the payment of interest, was matched by a corresponding increase in the value of property under development and gave rise to neither profit nor loss. Thus the exclusion of both figures from the profit and loss account did not affect the final balance on the account. The two figures would have cancelled each other out, reflecting the fact that the acquisition of an asset at a cost equal to its value produces neither a profit nor a loss."

"On the taxpayer' s behalf it was submitted that the purpose of entering the opening and closing stock is to ascertain the cost of sales and that there is no need to do so if there are no sales. I do not accept this proposition. The process is undertaken for the purpose of ascertaining the trading profits or losses for the year. The cost of sales is merely one element in the computation. But in any event 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. But I can accept the taxpayer' s argument to this extent, that is there are purchases during the year but no sales to third parties, the cost of the purchases (the debit) is normally matched by the increase in the value of the stock (the credit). Since the figures cancel each other out, they do not affect the profits or losses for the year. In these circumstances it does not matter whether they are entered and set off against each other in the profit and loss account or elsewhere. This is merely a matter of presentation."

"In his judgement, the judge appeared to be laying down a very wide overriding principle of tax law, that a taxpayer can or must charge revenue expenditure referable to his trade in the accounting period in which it is incurred, even where to do so is contrary to the ordinary principles of commercial accounting. So stated, the principle has potentially far-reaching implications, and caused the revenue some concern, which has led to the expedition of these appeals. But the judgment is capable of a narrower ratio, that expenditure incurred by a taxpayer for the purposes of his trade falls to be deducted, in computing the profits or losses of that trade, during the accounting period during which it is incurred under the relevant contract even though ordinary principles of commercial accounting would allocate the expenditure wholly or partly to other accounting periods. In arguing these appeals, leading counsel for the taxpayers did not regard it as necessary, and accordingly did not seek, to uphold the wider ratio. The issue, therefore, is whether the narrower ratio is right or wrong. In approaching this issue it was common ground between the parties, as it had been below, that the hire agreements in question were genuine commercial transactions and were not to be regarded as artificial or sham. It was also common ground that the payments under the agreements were revenue, not capital, payments. These are important points, which counsel for the taxpayers was right to emphasis. The common ground between the parties did not end there. They agreed that in the ordinary way the computation of a taxpayer' s trading profits and losses for tax purposes must be made according to the ordinary principles of commercial accountancy. But they also agreed that the application of such principles is subject to any rule of tax law, statutory or otherwise, which precludes or limits such application. The Crown contended that there was no rule of tax law which precluded or limited the application or ordinary principles of commercial accountancy, ... For the taxpayer it was argued that there were such rules of tax law: a rule that expenditure under these hiring agreements lies where it falls; a rule that neither profit nor loss may be anticipated and a rule that regard must be had to the true nature in law of the relevant arguments."

"Despite the length of this judgment, the central issue is at root a very short one. The object is to determine, as accurately as possible, the profits or losses of the taxpayers' businesses for the accounting periods in question. Subject to any express or implied statutory rule, of which there is none here, the ordinary was to ascertain the profits or losses of a business is to apply accepted principles of commercial accountancy. That is the very purpose for which such principles are formulated. As has often been pointed out, such principles are not static: they may be modified, refined and elaborated over time as circumstances change and accounting insights sharpen. But so long as such principles remain current and generally accepted they provide the surest answer to the question the legislation requires to be answered. ...

The authorities do not persuade me that there is any rule of law such as that for which the taxpayers contend and the judge found. Indeed, given the plain language of the legislation, I find it hard to understand how any judge-made rule could override the application of a generally accepted rule of commercial accountancy which (a) applied to the situation in question, (b) was not one of two or more rules applicable to the situation in question and (c) was not shown to be inconsistent with the true facts or otherwise inapt to determine the true profits or losses of the business. I need not pursuer this speculation, however, since I do not understand it to be challenged that the principles embodied in the Statements of Standard Accounting Practice Nos 2 and 21 meet these three conditions and I find no judge-made rule which could require these principles to be displaced."

"For the purposes of case I or II of Schedule D the profits of a trade, profession or vocation must be computed in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in computing profits for those purposes."

"Normally a court attaches great weight to the view of the accountancy profession, though the court must always have the last word."

"It can never rest with the taxpayer to decide upon what principle his income tax is assessed for tax purposes. The Directors' decision can never be decisive of the matter for income tax purposes (see Patrick v. Broadstone Mills Limited 35 T.C. 44). The assessment, in addition to being consistent with normal accounting practice, must be made according to the provisions of the Income Tax Acts."

"Subject to the provisions of the Tax Acts, 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 -

...

(f) any capital withdrawn from, or any sum employed or intended to be

"A company's individual accounts shall comply with the provisions of Schedule 4 as to the form and content of the balance sheet and profit and loss account and additional information to be provided by way of notes to the accounts."

"In the case of any fixed asset which has a limited useful economic life, the amount of -

(a) its purchase price or production cost; or

(b) where it is estimated that any such asset will have a residual value at

shall be reduced by provisions for depreciation calculated to write off that amount systematically over the period of the asset's useful economic life."

"9.-(1) Except as otherwise provided by the Tax Acts, the amount of any income shall for purposes of corporation tax be computed in accordance with income tax principles, all questions as to the amounts which are or are not to be taken into account as income, or in computing income, or charged to tax as a person's income, or as to the time when any such amount is to be treated as arising, being determined in accordance with income tax law and practice as if accounting periods were years of assessment."

"74.-(1) Subject to the provisions of the Tax Acts, 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 -

...

(f) any capital withdrawn from, or any sum employed or intended to be

"It is a general principle in the computation of the annual profits of a trade or business under the Income Tax Acts that those elements of profit or gain, and those only, enter into the computation which are earned or ascertained in the year to which the inquiry refers; and, in like manner, only those elements of loss or expense enter into the computation which are suffered or incurred during that year."

"In computing the balance of profits and gains for the purposes of income tax, or for the purposes of excess profits duty, two general and fundamental commonplaces have always to be kept in mind. In the first place, the profits of any particular year or accounting period must be taken to consist of the difference between the receipts from the trade or business during such year or accounting period and the expenditure laid out to earn those receipts. In the second place, the account of profit and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the rules of the Income Tax Act, or of that Act as modified by the provisions and schedules to the Acts regulating excess profits duty, as the case may be. For example, the ordinary principles of commercial accounting require that, in the profit and loss account of a merchant's or manufacturer's business, the values of the stock in trade at the beginning and at the end of the period covered by the account should be entered at cost or market price (whichever is the lower); although there is nothing about this in the taxing statutes"

"It is a commonplace that, subject always to the observance of the rules and general principles of the Income Tax Act, no particular method of computing profits is a part of the law universal."

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

"Whether the gross amount of depreciation in stock is required to be disallowed as a deduction in arriving at taxable profits or whether only the net amount (after adjusting for depreciation included in opening and closing stock) is to be disallowed."

"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."

"Cost is defined in relation to the different categories of stocks as being that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. This expenditure should include ... such costs of conversion (as defined in paragraph 19) as are appropriate to that location and condition."

"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 cost of conversion, of those overheads (including depreciation) which relate to production, notwithstanding that these may accrue wholly or partly on a time basis"

"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"

"We agree with Mr. Holgate's interpretation of paragraph 77 [vide. that the final words could include stock] because we think that if the last sentence was intended to apply only to intangible fixed assets it would have said so. It is also relevant that in International Accounting Standards 2 (Inventories) depreciation is not considered to be an expense if it is carried forward in stock."

"A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. The Standard provides practical guidance on the determination of cost and its subsequent recognition as an expense ... ".

"31. When inventories are sold, the carrying amount of those inventories

32. The process of recognising as an expense the carrying amount of

"The depreciation charge for each period should be recognised as an expense unless it is included in the carrying amount of another asset."

"The depreciation charge for a period is usually recognised as an expense. However, in some circumstances, the economic benefits embodied in an asset are absorbed by the enterprise in producing other assets rather than giving rise to an expense. In this case, the depreciation charge comprises part of the cost of the other asset and is included in its carrying amount. For example, the depreciation of manufacturing plant and equipment is included in the costs of conversion of inventories (see IAS 2, Inventories). Similarly, depreciation of property, plant and equipment used for development activities may be included in the cost of an intangible asset that is recognised under IAS 38, Intangible Assets"

"27. Depreciation of manufacturing fixed assets is included in the standard cost of stock as part of the general allocation of overheads (including depreciation) to stock. This occurs in two contexts - first in the cost of make and secondly in the cost of holding the spirit until it becomes whisky. As part of its internal costing system William Grant calculates the cost of making each litre of whisky. 'Cost of make' depreciation is included within fixed costs. Next the cost of holding the spirit until it becomes whisky is added to each year's 'cost of make'. This is usually the cost involved in running the warehouses and also cask and pallet depreciation and warehouse depreciation. (William Grant capitalises warehousing costs into stock for three years and such costs are thereafter written off directly to the profit and loss account.)"

"1. Accounting policies

The accounts are prepared under the historical cost convention and in accordance with applicable accounting standards.

Depreciation is provided on all tangible fixed assets, other than freehold land, at rates calculated to write off their cost in equal annual instalments over their expected useful lives, as follows:

Freehold buildings - 25 to 50 years

Plant, vehicles and casks - 5 to 20 years

...

Stocks are stated at the lower of cost or net realisable value. Cost consists of the expenditure in purchasing or producing stock and bringing it to its present location and condition as follows:

Raw materials - purchase cost on a first-in, first-

Work in progress and finished - cost of direct materials, labour

goods and attributable overheads based

Net realisable value is based on estimated selling price in the normal course of business, less all additional costs to completion and disposal."

"4. Operating profit

This is stated after charging/(crediting):

"Thus note 4 makes it clear that of total depreciation of £6,705,000 the amount of £1,695,000 was the amount of depreciation in stock. The remaining £5,010,000 was charged (deducted) in the profit and loss account. Thus the operating profit for 2002 was stated after deducting the net amount of depreciation which did not include depreciation in stock."

"31. For many years and at least since 1992 William Grant has prepared its tax computations on the basis that the amount of depreciation to be added back to the accounting profits did not include that amount of the charge for depreciation represented by depreciation in stock. When the closing stock became the opening stock of the next year, and was sold in the next year, the cost of the stock (including the depreciation in stock) was deducted from the profit and loss account and the amount for depreciation in stock was added back in that year. If the opening stock was not sold in that year it was again carried forward to the next year on the same basis.

32. William Grant's tax treatment of depreciation in stock was discussed with the Inland Revenue in 1995 and in 1996. In 1995 the Inland Revenue were prepared to accept that only the net depreciation need be added back for tax purposes so long as accurate records were kept of the amount of depreciation in stock to ensure that future adjustments were made. William Grant suggested that the adjustments could be made by reference to movements in stock during the course of the year. For example, if in year one 20% of depreciation was taken to stock and not added back in that year, and if in year three 20% of the year one stock was sold, then 20% of the depreciation in stock in year one would be added back in year three. As William Grant's records were extensive the Inland Revenue accepted the proposal and it was agreed that the amount of depreciation that should be added back for tax purposes should be the net amount debited to the profit and loss account, which did not include the amount for depreciation in stock. Later it was agreed that there would be a cut off point so that all stock not actually sold would be adjusted after twelve years for malt stocks and five years for grain stocks.

33. In 2002 the Inland Revenue informed William Grant that computation adjustments in respect of depreciation in stock were contrary to the rules of Case I of Schedule D and that companies who had followed the practice had to change their tax adjustment basis. The Inland Revenue now require that the amount of depreciation added back should include depreciation in stock. William Grant's corporation tax computation for the year 2002 does not incorporate the change of practice proposed by the Inland Revenue. A cumulative amount of £9,567,271, which represents the amount of depreciation in stock, has not been added back in the year in which it was incurred. It is that amount which is the subject of the appeal of William Grant."

"65. ... Addie is authority for the principle that depreciation of fixed assets is expenditure of additional capital and so cannot be a deduction for tax purposes. Clearly therefore an accounting profit, which has been calculated by making a deduction for depreciation, must be adjusted for tax purposes by cancelling that deduction or 'adding it back'. What we have to find is the amount of depreciation which has been deducted in computing the accounting profits.

66. Both expert witnesses agreed that it was only net depreciation (i.e. the figure of £6,590,028, as distinct from the 'gross depreciation' of £6,704,623) 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."

"95. Our decision on the issue for determination in the appeal 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."

"permitted the depreciation charge for a period not to be recognised in the profit and loss account if it was 'permitted to be included in the carrying amount of another asset' (in this case unsold trading stock)."

"71. Nevertheless, even on the wording of paragraph 77 a peculiarity arises, namely that although part of the depreciation charge can in certain circumstances not be recognised in the profit and loss account, the 'depreciable amount' of a tangible fixed asset must be 'allocated on a systematic basis over its[i.e. the asset's] useful economic life' and 'the depreciation method used should reflect as fairly as possible the pattern in which the asset's economic benefits are consumed by the entity.' This seems to tie down the period over which an asset can be depreciated to the period of that asset's useful economic life, and this is inconsistent with a policy which recognises the full charge for depreciating the asset over a longer period than this - effectively a period ending only when the trading stock whose value is debited with part of the depreciation charge is finally sold or written down."

"72. Furthermore, a provision for depreciation in the balance sheet which takes account of the gross depreciation, but a computation of profits which recognises only a deduction of the amount of the net depreciation in the profit and loss account, seem to be inconsistent one with another. The 'contra' item, whereby the gross depreciation charged to the profit and loss account is adjusted by transferring an amount out of the profit and loss account to increase the carrying value of unsold trading stock, must be examined. If that 'contra' item is truly a 'contra' item, so that one can say that the amount of depreciation charged to the profit and loss account is only the amount of the net depreciation, not the amount of the gross depreciation, it is difficult to see how the provision for depreciation in the balance sheet can stand. This is the situation which is recognised by note 4 in the 2002 statutory accounts of William Grant, which clearly shows what has happened, namely that there has been a gross depreciation charge of £6,705,000, of which £1,695,000 has been the subject of a 'contra' item and debited to the carrying value of unsold trading stock - but begs the question as to how in these circumstances the amount of the provision for depreciation stated in the balance sheet is made up.

73. We intend absolutely no criticism of Mars, William Grant or their advisers in making this observation. The precise nature of the 'contra' item, whether it is in every respect a pro tanto cancellation of the gross depreciation charge or alternatively an accounting adjustment to the gross depreciation charge, debiting the carrying amount of unsold trading stock with an amount representing depreciation on fixed assets, is a matter of no importance in any accounting context - or indeed in any context (as far as we can see) other than the determination of the issue arising in the present case."

"But it seems to us (although neither side argued this) that the part of the cost of unsold trading stock which is represented by capitalised depreciation ought not to be recognised (as, effectively, a taxable receipt) in the computation of trading profits for the purposes of Case I. This is because, as a matter of law, it is in the nature of capital, and its capital nature is not altered by its absorption into the cost of trading stock for accounting purposes - any more than the capital nature of depreciation is altered by its treatment as a periodic charge in the profit and loss account. Thus the increase in the value of trading stock in the balance sheet which is represented by depreciation in stock ought not to be taken into account for the purposes of the computation for tax purposes of trading profits. To do so would effectively charge a capital amount to corporation tax on income, without any statutory authority."

"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."

"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."

"mere bookkeeping [which] should not be confused with the application of accounting principles to arrive at the true amount of the profit or loss for the year".

"the ordinary principles of commercial accounting require that in the profit and loss account of a merchant's or manufacturer's business the values of the stock in trade at the beginning and at the end of the period covered by the account should be entered at cost or market price (whichever is the lower)".

"consist of the difference between the receipts from the trade or business during such year or accounting period and the expenditure laid out to earn those receipts".

"The profit of a trade or business is the surplus by which the receipts from the trade or business exceed the expenditure necessary for the purpose of earning those receipts."

"The need to enter the opening and closing stock is well established by the authorities".

"The object is to determine, as accurately as possible, the profits or losses of the taxpayers' businesses for the accounting periods in question. Subject to any express or implied statutory rule, of which there is none here, the ordinary way to ascertain the profits or losses of a business is to apply accepted principles of commercial accountancy. That is the very purpose for which such principles are formulated. As has often been pointed out, such principles are not static: they may be modified, refined and elaborated over time as circumstances change and accounting insights sharpen. But so long as such principles remain current and generally accepted they provide the surest answer to the question which the legislation requires to be answered."

"18. In the case of any fixed asset which has a limited useful economic life, the amount of -

(a) its purchase price or production cost; or

(b) where it is estimated that any such asset will have a residual value at