CORPORATION TAX - treatment of depreciation in stock - in preparing the financial statements gross depreciation was shown and then reduced by the amount of depreciation in stock leaving net depreciation - net depreciation was deducted in arriving at the accounting profits and depreciation in stock was capitalised - when adjusting the accounting profits for tax purposes only net depreciation was added back; the depreciation in stock was carried forward and deducted from profits in the year in which the stock was sold - the Inland Revenue argued that in each year the gross depreciation should be added back for tax purposes - whether, in making the tax adjustments to the accounting profits, gross depreciation should be added back - no - or whether net depreciation should be added back with the depreciation in stock being added back in the year in which the stock was sold - yes - appeal allowed - TA 1988 s 74(1)(f)
THE SPECIAL COMMISSIONERS
MARS UK LIMITEDAppellant
- and -
TREVOR WILLIAM SMALL
(H M INSPECTOR OF TAXES)
Respondent
WILLIAM GRANT & SONS DISTILLERS LIMITED
Appellant
- and -
THE COMMISSIONERS OF INLAND REVENUE
Respondents
SPECIAL COMMISSIONERS: DR NUALA BRICE
JOHN WALTERS QC
Sitting in public in London on 15, 16 and 17 December 2003
Graham Aaronson QC, instructed by Messrs Dorsey & Whitney Solicitors, for both Appellants
David Milne QC and Rupert Baldry, instructed by the Solicitor of Inland Revenue, for both Respondents
© CROWN COPYRIGHT 2004
1
DECISION
The appeal
1.Mars UK Limited (Mars) appeals against part of an assessment for the year ended 28 December 1996. The disputed amount is £1,969,335.76 and was assessed because the Inland Revenue were of the view that cumulative depreciation in stock up to 31 December 1996 should be brought within the charge to tax for that year.
2.William Grant & Sons Distillers Limited (William Grant) refers a question to the Special Commissioners for determination in connection with the subject matter of an enquiry into their return for the year ended 28 December 2002. The question is 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.
3.We were informed that these appeals were in the nature of test cases and that there were thirteen other companies with similar issues.
The legislation
4.Section 74 of the Income and Corporation Taxes Act 1988 (the 1988 Act) provides:
"74 General rules as to deductions not allowable
(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 sum employed or intended to be employed as capital in, the trade …. ."
5.As from 6 April 1999 section 42 of the Finance Act 1998 (the 1998 Act) provided:
"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 April 1999."
6.For completeness we set out the charging provision relative to Case I of Schedule D (part of section 18 of the 1988 Act):
“18 Schedule D
(1)The Schedule referred to as Schedule D is as follows–
SCHEDULE D
Tax under this Schedule shall be charged in respect of –
(a)the annual profits or gains arising or accruing–
(i)to any person residing in the United Kingdom from any kind of property whatever …
(2)Tax under Schedule D shall be charged under the Cases set out in subsection (3) below, and subject to and in accordance with the provisions of the Tax Acts applicable to those Cases respectively.
(3)The Cases are–
Case I: tax in respect of any trade carried on in the United Kingdom or elsewhere …”
The issue
7.We have adopted three definitions agreed by the expert witnesses. "Gross depreciation" is the gross amount of the charge fordepreciation 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 depreciationand 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 representingdepreciation in stock should be added back in the accounting period.
The evidence
12.Oral evidence was given on behalf of Mars by Mr Richard Collier-Keywood, the Head of Tax at PricewaterhouseCoopers LLP (PricewaterhouseCoopers) who advised Mars. A witness statement by Ms Linda Bacon, a Financial Controller and later Finance Director of Mars, containing evidence on behalf of Mars, was not objected to by the Respondents and so was admitted in evidence at the hearing. Oral evidence was given on behalf of William Grant by Mr Ewan Henderson, the Group Tax and Finance Manager of William Grant.
13Expert evidence on behalf of both Appellants was given by Mr Peter Holgate. Mr Holgate is a Fellow of the Institute of Chartered Accountants; a member of the Accounting Standards Board's Urgent Issues Task Force; a member of the Financial Reporting Committee and Research Board of the Institute of Chartered Accountants of England and Wales; and a member of the International Accounting Committee of the Consultative Committee of Accountancy Bodies. Between 1984 and 1986 he was the Secretary of the United Kingdom Accounting Standards Committee which set accounting standards including SSAP 9 and SSAP 12. Mr Holgate heads the United Kingdom Technical Department at PricewaterhouseCoopers which department is principally concerned with advising the firm and its clients on technical accounting matters.
14.Expert evidence on behalf of the Inland Revenue was given by Mr Thomas Charles Carne, the Advisory Accountant to the Board of Inland Revenue. Mr Carne is a Chartered Accountant and spent nine years in private practice and industry before joining the Inland Revenue in 1978. He then spent seven years as an Accountancy Advisor/Investigator in Enquiry Branch after which he took up the position of Accountancy Advisor to International Division. He spent six years there before taking up his present position.
15.After both experts had prepared their reports they met on 20 November 2003 to discuss their areas of agreement and disagreement. They then produced a joint report dated 4 December 2003 which was also before us.
The facts
16.From the evidence before us we find the following facts.
Mars
17.Mars is a subsidiary of Mars Incorporated (Mars Inc), a United States company. Mars Inc determines the worldwide policy for group activities and local management implements those policies. Mars manufactures and sells food for human consumption (especially confectionery) and pet food. The internal structure of Mars consists of a number of units which operate independently of each other although all activities are reported as a single business for statutory reporting purposes.
Mars - financial reporting
18.The financial reporting procedures followed by each unit are described in the Mars Finance Manual (the Manual) which all units in all territories must follow. The Manual recognises that Mars Inc is privately owned but nonetheless requires that United States Generally Accepted Accounting Procedures (US GAAP) are followed. All levels of the organisation must conduct their financial activities according to properly approved and written policies and procedures. At least since 1994 the Manual has provided:
"Manufacturing units will be expected … to value inventories at the lower of actual cost or market value." (Chapter 11, section C, subject 03, paragraph 1); and
"Finished goods represents the total costs of producing the finished product. The general principle is to record inventory each period at actual, fully absorbed cost in accordance with the requirement of generally accepted accounting principles. Therefore, conversion costs must be applied to inventory at every period through either the inventory valuation adjustment or the overhead in inventory adjustment. …
DOverhead in Inventory
Other manufacturing costs are to be included in the calculation of overhead in inventory every period. Example of such costs include: …
4.Manufacturing historic book depreciation … ." (Chapter 11, section C, subject 03, paragraph IV).
19.Thus the cost of closing stock included the cost of the overheads used in its production, including the depreciation on fixedassets used in the manufacturing process. The actual calculation of depreciation in stock was made in accordance with written instructions. These stated that, in order to reflect the relationship of costs incurred to production of inventory, certain manufacturing costs were included in the valuation of finished goods held as stock at the end of the year in accordance with SSAP 9. Examples of such manufacturing costs included manufacturing depreciation. In order to make the calculation one had to take the total overheads figure (including depreciation) for the year and divide it by the total production of goods during the year and then multiply it by the stock level at the end of the year.
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.
22.Prior to the signature of the 1996 accounts PricewaterhouseCoopers became aware that depreciation in stock may have been treated incorrectly for tax purposes. They noted that other manufacturers also debited gross depreciation to the profit and loss account and then credited to the profit and loss account the amount of depreciation in stock; however, for tax purposes they added back the amount of the gross depreciation. Messrs PricewaterhouseCoopers formed the view that this meant that taxable profits were being over-stated by the amount of depreciation in stock. They realised that, as far as Mars was concerned, the cumulative total of the overstatement of profits for tax purposes would be equal to the total depreciation held in closing stock on 28 December 1996. They realised that, technically, computations for each relevant year should be amended but proposed to the Inland Revenue that a single adjustment should be made to taxable profits for depreciation in stock as at 28 December 1996.
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. Meetings between PricewaterhouseCoopers and the Inland Revenue were held on 12 June 1997 and on 11 August 1997 when the Inland Revenue appeared to be willing to accept Mars' proposal. Later the Inland Revenue refused to accept the computations and it is the reduction of taxable profits by £3,039,000 in 1996 which is the subject of Mars' appeal.
25.From 1996 the tax computations were made on the basis that the amount of depreciation to be added back to the accounting profits did not include depreciation in stock and a note similar to note 10 to the 1996 accounts was included in subsequent years. Mars also made an adjustment for the movement in the amount of depreciation in stock. The impact of the adjustment on the accounting profits for 1997 and subsequent years could be either an increase or a decrease depending upon the movement in the value of the depreciation in stock. The movement in depreciation in stock has resulted in both positive and negative adjustments to profits since 1996.
William Grant
26.William Grant is one of the largest independent Scotch whisky companies in the United Kingdom. It is both a distiller and blender and produces "Glenfiddich" a Scotch malt whisky, "Grant's Family Reserve" a blended Scotch whisky, and "The Balvenie" a leading Scotch whisky. It is a family controlled company and has a number of wholly owned subsidiary companies of which William Grant is one. William Grant distils and matures bulk whisky and also bottles whisky at its bottling plants. Although the term "Scotch Whisky" means whisky that has been matured in an excise warehouse in Scotland for a period of not less than three years, many companies (including William Grant) will mature whisky for periods significantly longer than this. William Grant's main brands are matured for periods ranging from four years to eighteen years (for Glenfiddich Ancient Reserve).
William Grant - financial reporting
27.Depreciation of manufacturing fixedassets 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.)
28. At least since 1994 William Grant have prepared their financial accounts on the basis that part of the annual depreciation charge was included in the cost of unsold stock. William Grant's accounting policy for stock was recorded in its statutory accounts for the year ended December 2002 as:
"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 … Work in progress and finished goods - cost of direct materials, labour, and attributable overheads based on a normal level of activity."