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Cite as: [2005] CSIH 63, [2005] ScotCS CSIH_63

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Revenue And Customs v. William Grant & Sons Distillers Ltd [2005] ScotCS CSIH_63 (23 August 2005)

EXTRA DIVISION, INNER HOUSE, COURT OF SESSION

Lord Penrose

Lord Osborne

Lord Reed

 

 

 

 

 

[2005CSIH63]

XA47/04

OPINION OF LORD PENROSE

in

APPEAL TO THE COURT OF SESSION AS THE COURT OF EXCHEQUER IN SCOTLAND

under

Section 56A of the Taxes Management Act 1970 from a decision of the Special Commissioners of Income Tax communicated to the Appellants on 8 March 2004

by

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS

Appellants;

against

WILLIAM GRANT & SONS DISTILLERS LIMITED

Respondents:

_______

 

 

Act: C. M. Campbell Q.C., Paterson; Solicitor for Revenue & Customs

Alt: Tyre, Q.C., Mure; McGrigor Donald

23 August 2005

[1]      The appellants, the Commissioners of Her Majesty's Revenue and Customs (the Revenue), appeal against a decision of the Special Commissioners of Income Tax in which the tribunal answered in favour of William Grant, the respondents, a question referred to them for determination in connection with an enquiry relating to William Grant' s tax return for the year ended 28 December 2002. The case was heard together with an appeal by Mars UK Limited against an assessment for the year ended 28 December 1996. Both cases raised an issue of principle, and they were treated as test cases for a number of outstanding cases relating to other taxpayers. The Revenue appealed against the decision in each case. The appeal in the Mars case was heard by Mr Justice Lightman in February 2005, and was allowed on 12 April 2005.

[2]     
The factual contexts in which the issue for determination arose differed as between the two cases. For present purposes it is necessary to deal with parties' submissions only in relation to the facts of William Grant' s case. The question referred to the Special Commissioners was:

" 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."

Section 74 (1) (f) of the Income and Corporation Taxes Act 1988 provides that, subject to the provisions of the Tax Acts:

" ..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 ..."

Ever since Addie & Sons v Inland Revenue , it has been the unchallenged view that in computing profits for the purposes of Case I of Schedule D the deduction of provisions for depreciation of fixed assets is prohibited by paragraph (f) and its predecessors. Neither party to this appeal suggested otherwise. The dispute between the parties is as to the approach to be adopted in determining the amount properly to be treated as depreciation, and excluded from the cost of sales, in computing the profits of William Grant for tax purposes in successive accounting periods.

[3]     
In their decision, the Special Commissioners say that the issue arose as follows:

" 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."

[4]     
The accounting treatment adopted by William Grant in relation to depreciation and stock is described by the Special Commissioners in paragraphs 27 to 30 of the decision. As the appeal before this court proceeded, it became apparent that the summary provided by the Special Commissioners required expansion for a full appreciation of the issue between the parties. In particular, the derivation of the cumulative amount of £9,567,271, and the contribution towards that amount referable to 2002, were not explained. There was no dispute as to the facts: as indicated by the Special Commissioners William Grant' s records were extensive, and provided an accurate and comprehensive account of the company' s perception of what was required for the presentation of a true and fair view of the company' s profit and state of affairs.

[5]     
It was agreed at all stages in the proceedings that William Grant' s financial accounts for the accounting period in question gave a true and fair view of the state of affairs of the company as at 28 December 2002 and of its profits for the year then ended, and that the accounts had been properly prepared in accordance with the Companies Act 1985. William Grant used Format 1 for each of the profit and loss account and balance sheet statements produced to comply with the requirements of section 226 of and schedule 4 to the Companies Act 1985. One result of adopting that Format for the profit and loss statement was that the company' s published accounts did not provide an analysis of cost of sales by type or class of expenditure, and it was not possible to see in the profit and loss account what the charge for depreciation was. Relevant information was provided in the balance sheet and in the notes to the accounts.

[6]     
William Grant' s balance sheet at 28 December 2002 disclosed tangible fixed assets of £90,485,000. Note 7 to the balance sheet divided that sum between freehold land and buildings, on the one hand, and plant, vehicles and casks on the other, and disclosed the amounts of depreciation written off those items as brought forward at 29 December 2001, and for the current year. In summary, the depreciation reflected in the balance sheet was as follows:

Depreciation at 29 December 2001:

   

Freehold land and buildings

16,613,000

 

Plant vehicles and casks

69,233,000

85,846,000

Provided during the period:

   

Freehold land and buildings

1,585,000

 

Plant vehicles and casks

5,120,000

6,705,000

Disposals:

   

Plant vehicles and casks

156,000

(156,000)

     

Depreciation at 28 December 2002

 

92,395,000

[7]     
It was not disputed between the parties that the amounts provided for depreciation for the current year and the cumulative amounts brought forward and carried forward in the company' s balance sheet were computed on an appropriate basis. Since it was not disputed that the balance sheet presented a true and fair view of the company' s state of affairs at 28 December 2002, there could be no issue whether the depreciation reflected in the balance sheet reflected a sound application of generally accepted accounting practice (' GAAP' ). The issue between parties turned on the treatment of depreciation on plant vehicles and casks during the current period in computing taxable profits.

[8]     
The balance sheet at 28 December 2002 disclosed stocks of £178,315,000 with a comparative figure for the preceding year of £180,945,000. Note 9 to the balance sheet provided details of the components of raw materials, work in progress and finished goods comprised in the two balance sheet figures, but did not disclose in detail the computational methods used to arrive at the figures. In particular, the note did not disclose any amount of depreciation included in or taken into account in arriving at the stock figures. The relevant accounting policy set out in note 1 to the accounts stated:

" 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:

Raw materials - purchase cost on a first-in, first-out basis.

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."

So far as is material for present purposes, William Grant' s profit and loss account, properly prepared in terms of the Companies Act Format 1, disclosed turnover and cost of sales, and deduced an operating profit of £31,705,000. For the relevant year the cost of sales was stated at £99,340,000. Note 4 to the accounts stated:

Operating profit

   

This is stated after charging (crediting):

   
 

2002

£000

2001

£000

Depreciation:

   

- owned assets

5,852

6,204

- leased assets

853

943

- included within stock

(1,695)

(1,571)

[9]     
The Special Commissioners observe that 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" . They conclude:

" 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."

[10]     
As already noted, the Special Commissioners found that the amount of depreciation in stock, the amount that was the subject of the appeal, was £9,567,271. That sum was analysed in an appendix to William Grant' s tax computation for 2002. From the analysis it is clear that it represented the aggregate of a series of differences arising from the year ended 28 December 1992 to the current year between amounts of depreciation allocated to stock at the end of each accounting period, and amounts of depreciation previously accumulated in stocks that were sold within the relevant year. In that way the sum of £9,567,271 represented the total amount that, on the Revenue approach, William Grant had understated its taxable profits over the eleven year period. The amount in issue for 2002, as reflected in the company' s tax computation was:

Depreciation

' C'

6,704,623

Net depreciation included in stock

' C7'

(114,595)

[11]     
It was a matter of agreement that the ' Depreciation' amount added back in computing taxable profits, of £6,704,623, (rounded to £6,705,000 in the accounts) was the ' gross amount of depreciation' mentioned in the question referred to the Special Commissioners. The ' net amount (after adjusting for depreciation included in opening and closing stock)' , in terms of the question referred to the Special Commissioners, however, appears more accurately to be the sum of £5,590,028 (£6,704,623 less £114,595). As the table ' C7' discloses, - £114,595 was the net current year movement in the amount of depreciation reflected in the opening and closing balance sheet amounts for stock. It is that sum that is a component of the sum of £9,567,271. The Special Commissioners' analysis does not disclose the whole adjustments made by William Grant in respect of depreciation. In my view, it is necessary to describe the situation in some detail, to understand the background to the issue of principle.

[12]     
For 2002, the agreed position was as follows. The total, or gross, depreciation on all relevant assets for the year was £6,704,623. Some stock held at 29 December 2001 was sold during 2002. The accumulated depreciation reflected in the book amount for that stock at 29 December 2001 was £1,580,273. The accumulated depreciation for the year to 28 December 2002 allocated to the book amount for stock at 28 December 2002 was £1,694,868. William Grant' s contention was that depreciation apportioned to stock should be treated as an expense in the year in which the stock was realised and not before. In particular, the depreciation should not be treated as an expense to be added back in the year for which it was calculated. Accordingly, only the net difference between depreciation reflected in the book amount for stock at the end of the accounting period and the depreciation reflected in the opening stock amount for goods sold (the negative sum of £114,595 in the year in question) was to be recognised as an expense. Put another way, the depreciation element in stock should only be recognised as part of the cost of sales in the accounting period in which the sale occurred, and not as it was accumulated over the period when the goods were held as stock.

[13]     
The figures contributing to the treatment of depreciation in this way were not fully disclosed in the company' s financial statements. William Grant do not prepare trading and profit and loss accounts, or any form of revenue account which includes, or would include if prepared in the traditional form familiar from the authorities, opening and closing stock. It is necessary, in my view, to understand the accounting adjustments made to reach a resolution of the material issue between the parties.

[14]     
William Grant' s approach to accounting for profit and loss is facilitated by the use of modern information technology, and it appears likely that the approach could not have been realised in practice without the computing capacity and software now employed. But the accounting principles on which they rely are not dependent on the means by which they maintain their records. It will be necessary to return to the arguments advanced in detail later. But essentially, William Grant contend that in order to determine profit or loss it is essential to match reckonable expenditure to the appropriate revenue of the accounting period, and that that is the only relevant requirement of compliance with UK GAAP. In the context of ascertaining profit or loss, accounting for opening and closing stock is simply one means of making necessary adjustments to recorded expenditure to ensure that the appropriate match is achieved. Stock, as an asset, must be recorded in the balance sheet. But that does not lead to a conclusion that one must include amounts referable to stock as such in computing profit and loss. In that context, ' stock' reflects a bundle of costs for which adjustments must be made to achieve matching of income and expenditure. It is not necessary to regard it as tangible property requiring ' valuation' .

[15]     
As the first note to the financial accounts states, as an asset for balance sheet purposes, the company' s stocks are stated at the lower of cost or net realisable value. We were told that net realisable value, as an alternative to cost, was not applied to any stock at 28 December 2002, in the circumstances then obtaining. However, the policy statement reflects the conventional position that where net realisable value has fallen below cost, it is the appropriate measure of the amount to be included for the stock involved. Cost consists of expenditure in purchasing or producing stock and bringing it to its present location and condition, and includes raw material cost, and the cost of other direct materials, labour and attributable overheads based on a normal level of activity. In the case of the manufacturing activity, the apportionment of cost elements to stock and work in progress, therefore, proceeds on an assumption about total production. The derivation of unit costs is not directly related to actual output. A normal level of production is assumed for the accounting period in question, and total relevant costs are assumed to be incurred in producing that volume of production. In that way unit costs are derived and applied to actual production, and in particular to stock at accounting dates.

[16]     
However one describes the mechanism and the resulting stock figure, as a bundle of cost elements or otherwise, the components of the amount attributed to stock in the balance sheet are ' costs' , unless the alternative of net realisable value is the appropriate measure. It is not disputed that ' costs' are relevant to ascertaining profit or loss, but William Grant contend that it is only in so far as the costs incurred within an accounting period are properly viewed as expended in the earning of the revenue for that period that they require to be recognised in the trading and profit and loss account that is, effectively, provided in the tax computation. On their approach, any particular element of ' cost' may therefore attract a treatment appropriate to ascertaining the balance sheet amount to be applied, and a treatment appropriate to ascertaining the operating profit for the period, and those treatments may differ.

[17]     
Thus, William Grant prepare the balance sheet entries for tangible fixed assets on a basis that recognises and applies paragraph 18 of schedule 4 to the Companies Act 1985. In the case of assets having a limited useful economic life, provision is made for depreciation calculated to write off the historic cost of the asset less any estimated residual value within the span of the useful economic life of each asset. However, so the argument runs, nothing in the Act dictates that the gross amount written off to profit and loss account in any accounting period should be the same as applied in the balance sheet, and there are sound reasons why that should not be so. The whole amount of depreciation so computed for any accounting period may or may not be related to the revenue earned in that period. Some of it may properly be held over for deduction in computing the profits of later periods, and in particular the periods in which goods that have been manufactured are sold and generate revenue with which the expenditure can be matched.

[18]     
For the purpose of computing operating profit, William Grant achieve the result for which they contend by maintaining account headings in their ' books' for individual items of expenditure, such as direct materials, labour, and overheads, including depreciation. For any particular accounting period, there may be a residue of cost under any heading brought forward from earlier production periods, in which it was not thought appropriate to deduct as expenditure the whole cost incurred, and a balance of cost to be carried forward to later production periods because the goods and work in progress produced have not at the terminal date produced revenue. Some of the residue brought forward at the beginning of the accounting period will be recognised as expenditure, in the current accounting period, on the sale of goods previously included in stock.

[19]     
Thus, for 2002, the position, as recorded and as reflected in the tax computation, and in particular in appendix C7 to the tax computation, was as follows:

Depreciation:

B.S

 

P & L

Depreciation debited to stock at 29 December 2001

9,452,676

   

Current year depreciation as reflected in the balance sheet

1,694,868

 

[1,694,868]

   

11,147,544

 

Prior years' depreciation to 29 December 2001 on stock sold in current year

 

 

1,580,273

 

1,580,273

       

Depreciation debited to stock at 28 December 2001 and carried forward in balance sheet

 

 

9,567,271

 
       

Net movement in depreciation in opening and closing stock, as included in corporation tax computation

   

 

 

[114,595]

[20]     
The net charge for depreciation added back in the tax computation was £1,580,273. The component referable to depreciation in stock was - £114,595. That reflected William Grant' s contention that none of the depreciation attributed to stock held at the end of the period (£1,694,868 referable to 2002) was referable to sales during the period, (which is plainly correct if one confines one' s attention to the book entries for depreciation), but that the prior years' depreciation attributed to stock brought forward and sold in the period, £1,580,273, was properly an expense brought into account in computing the profits for the period.

[21]     
These accounting procedures are not confined to depreciation. Each cost category is treated in the same way. The cost of materials account, for example, is credited at the close of the accounting period with an amount equal to the materials component reflected in stock in the balance sheet at that date. There is a corresponding debit when the stock is sold. That amount is derived from the balance brought forward at the beginning of the accounting period. The net amount only of total materials expenditure is treated as an expense of the period. The same approach is adopted with other cost categories.

[22]     
On William Grant' s approach, the trader accounts, fully and properly, for profit by making such adjustments to the recorded costs incurred, to ensure that only the expenditure related to current period sales is taken into account in computing profit. Stock, as such, does not have to be brought into account for revenue purposes. There is no ' metamorphosis' or reification of the expenditure into new and distinct revenue items necessarily reflected in the company' s accounts for corporation tax purposes in name of opening and closing stock.

[23]     
In relation to the accounting aspects of the issue, the Revenue approach is that opening and closing adjustments for stock are required as a matter of principle in the computation of profit. Stock exists in reality, and is not a creature of accounting procedures. A figure must be determined in accordance with proper accounting practice for stock. That figure is the same for profit and loss account and balance sheet purposes. In accordance with current generally accepted accountancy practice the carrying amount for stock will include an amount for depreciation. The amount calculated and reflected in the balance sheet amount for stock is, and remains, the depreciation for the year, whatever accounting adjustments the taxpayer may make for internal accounting purposes. The net credit for depreciation cannot be included separately as a deduction from current year' s depreciation so as to limit the debit to profit and loss account. Accordingly the full amount computed for the period, as reflected in the balance sheet, must be added back. Quite apart from accountancy principle and practice the Revenue contend that the same result must be arrived at on a proper interpretation and application of statute.

THE SPECIAL COMMISSIONERS' DECISION

[24]     
The Special Commissioners gave their decision and the reasons for it as follows:

"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."

THE REVENUE ARGUMENT

[25]     
Both parties submitted written summaries of argument which were in some respects modified and extended in discussion. Counsel for the Revenue reformulated the issue of principle which the court required to resolve in these terms:

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?

The summary argument was:

  1. The Revenue accepted that William Grant' s financial accounts were prepared in accordance with GAAP, but contended that the necessary adjustment for tax purposes required by section 74 (1) (f) of the 1988 Act had not been made in the company' s tax computation, with the result that the company' s taxable profits for the accounting period had been understated. The Revenue' s approach was that, notwithstanding the use made of part of the depreciation in computing the amount for stock, the amount that was truly deducted when computing profits was the gross or full amount of depreciation, and if that was right it followed that the amount to be added back should be the same.
  2. The taxable profits and gains of the company for that period should be calculated by deducting from the profits and gains all the expenditure incurred to obtain them. The profit and loss account must include an amount for opening and closing unsold stock. GAAP required those items to be included at cost or net realisable value, which ever was the lower, otherwise a profit might be anticipated. The taxpayer' s right to include stocks at net realisable value if lower than cost was an exception to the general rule that a loss could not be anticipated. It was important to appreciate that, however, the sum for stock was calculated, it was a value. It was an asset of the business, not an item of expenditure or cost.
  3. When a company included in the carrying figure for stock an element to reflect the depreciation in the fixed assets used to make that stock, there was in reality an expenditure item reflected by a debit and a credit item in the profit and loss account, to reflect that element of depreciation in stock. This meant that the overall effect for the accounting profits was zero, hence both accounting experts could say that the overall net effect could be described as the deduction of only the net depreciation. However, the expenditure deducted (or debited), that is the gross depreciation, required to be added back for taxable profits in order to comply with section 74 (1) (f).
  4. The essential flaw in the company' s approach was that having decided to include in its accounts a depreciation figure on its fixed assets, it had failed to add back all of that figure for the purpose of ascertaining its taxable profits. The requirements of section 74 (1) (f) could not be elided by using part of the depreciation as an element in the calculation of the value of opening and closing stock. If it were thought that this might operate unfairly, it was relevant to remember that capital allowances were available. As a generality the company would not lose out financially.
  5. Thus, the submission was that the method adopted by the company had not correctly ascertained the full taxable profits as required by tax law, even though there was no criticism of the accounting practices themselves. The error of the company' s approach was in the tax consequences for which they contended in the preparation of the tax computation. There were two systems, one regulating the statement of financial results and the other requiring adjustment of those results for tax purposes. The adjustments were required to exclude any incompatibility there might be between the financial profits, properly stated, and the profits required for tax purposes.
  6. Commissioner of Inland Revenue v Secan Limited illustrated the Revenue propositions in action. Having ' capitalized' its expenses, including interest, in work-in-progress, the company had already deducted those expenses to achieve a zero effect on profits, whatever did or did not go through the profit and loss account. It followed that no further deduction could be required by section 16 of the Honk Kong Ordinance. That case was but one example of the operation of basic principles laid down in cases such as Edward Collins & Sons Ltd v Inland Revenue Commissioners; Whimster & Co v Inland Revenue Commissioners; Patrick v Broadstone Mills Ltd; Minister of National Revenue and Anaconda American Brass Ltd. and Duple Motor Bodies Ltd v Ostime. The law as laid down in those cases could not be affected by statements of standard accounting practice, such as SSAP 9, which set out the methodology for ascertaining the amount to be included in financial statements for stock. Nor could the substance of transactions be altered by the adoption of bookkeeping analyses. Secan also showed the importance of distinguishing between (a) an element of cost which was used to measure the value of an asset, and (b) the value of the asset. These were different things. The company' s approach failed to recognise that. If the assertion were that the effect of carrying depreciation in the figure attributed to unsold stock was to exclude that part of the depreciation from the amount of depreciation charged against profits for the year, that assertion was misconceived. The result would be that the amount of depreciation in stock would not be reflected in stock, but would be a credit against the expense item in profit and loss account. That ignored the reality of stock as an element in computing trading profit.
  7. The case of Gallagher v Jones, on which the company relied, was of no relevance or assistance. The court was not concerned with the operation of a statutory rule. The issue in the present appeal was not how accountants had come to develop their view of the world. Their view could not affect what was to be added back in terms of the Act. This appeal was concerned with a tax adjustment which was contrary to a statutory rule. The authorities made it clear that no change in the way accountants did things could suspend a legal requirement such as that contained in section 74 (1) (f).
  8. The basic submission for the Revenue was that when a manufacturing taxpayer had depreciated fixed assets in the accounts for an accounting period, and had also (in accordance with GAAP) included a figure for depreciation of those fixed assets in the value of stock (or work in progress) at the end of that period, the whole of the depreciation had to be added back when computing taxable profits otherwise there would be a breach of section 74 (1) (f). The fact that part of the depreciation had been used to calculate the value to the taxpayer of the stock carried forward did not mean that the full amount of depreciation has not in fact been charged to the profit and loss account, as Secan demonstrated. The accounting treatment was not determinative of the question whether the gross depreciation had been deducted.
  9. In a nutshell, the taxpayer had deducted gross depreciation, but sought to add back only net depreciation. Section 74 (1) (f) required the full gross depreciation to be added back.
  10. Further, the correct answer did not depend on how the accounts were presented. It was more fundamental than that. The cases directed one to look at substance, not form. Mr Justice Lightman' s decision in Small v Mars (UK) Ltd was correct in the outcome, but he had wrongly rejected some of the supporting reasoning of the Revenue case. Thus, he had left out of account important fundamentals which underpinned the Revenue approach to the whole matter.

WILLIAM GRANT' S ARGUMENT

[26]

  1. Counsel for William Grant argued that the purpose of section 74 (1) (f) was to cancel, in the taxpayer' s tax computation, any deduction in respect of capital employed in the business, which had reduced the company' s profits for the year in its commercial accounts.
  2. Determining what had been deducted, and what had not been deducted, by way of depreciation in computing the company' s profits for the year was a matter for expert accountancy evidence.
  3. William Grant' s treatment of depreciation was wholly in keeping with UK GAAP, as the experts agreed. Those principles allowed for not treating the whole depreciation as an expense in the profit and loss account in the year in which the depreciation was shown; but for ' depreciation in stock' to be debited instead to the cost of stock/work in progress.
  4. The mechanics of how this was done in the company' s books was of no relevance. The question was: was the depreciation treated as an expense of that year in computing the profit? And if it was, then to that extent and to that extent only, it fell to be added back for the purpose of the tax computation.
  5. It was not the case that the result of this logical approach was to deny to the Revenue disallowance as a deduction of the difference between net and gross depreciation. The case was about timing: adding depreciation to the cost of stock inevitably resulted in a deduction from profits in the year in which the stock was sold. That deduction would then be disallowed, and the amount ' added back' under section 74 (1) (f) in that latter year. Thus as SSAP 9 required, the determination of profit for an accounting year required the matching of costs with related revenues (paragraph 1 thereof)
  6. There was no legal rule or principle that required all depreciation to be treated as a having been deducted from profits, so as to ' trump' the GAAP found to have been followed in this case. Properly understood neither Gallagher v Jones nor Commissioner of Inland Revenue v Secan Limited required any different conclusion to be reached.
[27]     
In his submissions, William Grant' s senior counsel, Mr Tyre, expanded on and explained the taxpayer' s approach, and it is necessary to examine his submissions. Mr Tyre argued that there were only two rules of law that applied in the case. The first was uncontroversial: section 74 (1) (f), following Addie, precluded the deduction of depreciation in computing taxable profits. But that did not provide an answer to the question how it was to be done. The second rule was derived from section 42 of Finance Act 1998. It recognised what had long been the law: profits for corporation tax purposes had to be computed in accordance with UK GAAP, subject to the proviso, which, in turn, simply reflected Lord Clyde' s views in Whimster. But, insofar as there were observations in the older authorities that were in conflict with UK GAAP, they could no longer withstand scrutiny. The current position was reflected in the observations in the Court of Appeal in Duple Motor Bodies Ltd v Ostime and in Gallagher v Jones. There was now a clear two-stage approach. One had to ascertain whether the accounts had been prepared in accordance with UK GAAP, and then consider what adjustments had to be made for tax purposes. That was the Master of the Rolls' approach in Gallagher v Jones. UK GAAP had to apply unless there was an express or implied statutory requirement to depart from that standard. The case had a wider import than the Revenue contended for. There was now no justification for the application of judicial formulations from older cases in preference to later accountancy thought. Past pronouncements could be important, but not when accountancy practice had changed.

[28]      Mr Tyre said that accountants did not change the law. But they might change the way profits are brought into charge to tax. Thus, it was accepted that in Minister of National Revenue and Anaconda American Brass Ltd it was held that new theories of accountancy, though accepted for business purposes, might not necessarily determine income for tax purposes. But that allowed for accountancy practice to move on, and for the development of more sophisticated solutions to known problems. The taxpayer in Gallagher v Jones lost because he did not follow accepted accountancy practice.

[29]     
In the present case there was considerable agreement. William Grant' s profits were computed in accordance with UK GAAP. Whatever amount was included in the computation for depreciation had to be disallowed. As a matter of arithmetic the net impact of depreciation on the company' s profits was the net depreciation, as a matter of arithmetic derived from the current year' s total, the depreciation in stock brought forward on goods sold in the year, and the depreciation in stock carried forward. The whole issue between the parties related to whether the add-back was of gross depreciation or of depreciation adjusted for the movement of depreciation in stock between the beginning and end of the year.

[30]     
That was not a question of law. If it were, how would one answer it? It could not be answered without reference to the evidence of accountants. When one stripped out the legal issues, as he had sought to do, all that was left was a question of fact and that depended on accountancy evidence. No-one challenged the correctness of what William Grant did in terms of UK GAAP. It accorded with GAAP that the profit and loss account did not as a matter of arithmetic include stock, and therefore did not include depreciation in stock as part of the credit for closing stock. If William Grant had prepared a trading and profit and loss account that made provision for opening and closing stock, the company would have shown the stock figures as including depreciation in stock. There would then have been no deduction from the depreciation expense charged in the account. But they did not do so. They netted off the movement of depreciation in stock against the current year' s charge, and the question for the court was whether the accounting treatment should be reversed for tax purposes. That was where the interaction between tax law and accountancy practice operated.

[31]     
It was necessary to understand the essence of the respondents' position: it was all a question of timing. On the basis of the evidence at to accounting practice, depreciation was deducted in computing profits, and fell to be added back for tax purposes, when and to the extent that it was deducted in computing the financial profits for the year. Eventually the whole depreciation would be deducted when stock was sold, and would be added back. Section 74 told one nothing about such timing differences. Older practice was to take into account an amount for stock: that was the only way it could be done. Now there was a different system. All that was now relevant was the cost of sales. It was unnecessary to take stock into account. That was a development of accountancy practice that the law was bound to recognise. On the evidence there was a sharp distinction between an expense and a cost that was related to or part of an asset. The key question for the accountant was how much of the recorded costs were to be treated as expenses of the accounting period, and how much should be treated as part of the carrying cost of the asset. It was only insofar as there was an expense that a cost fell to be deducted in computing profits: that was the effect of paragraph 77 of FRS 15. That was wholly an issue for accountants.

[32]     
The issue of fact was resolved in favour of William Grant. The background was just a matter of bookkeeping. It made no odds whether total depreciation went through the profit and loss account or not: what mattered was the year-end adjustment, and that was for accountants to assess. The revenue analysis failed to follow through the accountancy evidence, and effectively stopped at the determination of the gross depreciation for the year, ignoring the year end adjustments to it. The evidence was that the depreciation in stock was not deducted in computing profits, and therefore did not have to be added back. The Special Commissioners had ample evidence to entitle them to reach the decision that only net depreciation had been deducted, and that therefore that was the measure of what should be added back. One had the happy result that the requirements of the law and accountancy practice coincided.

[33]     
So far as the Companies Act requirements were concerned, gross depreciation was disclosed. That was all that was required. Note 4 provided additional information unnecessarily. Paragraph 18 of schedule 4 had been complied with. The provision was not concerned with more than quantification. It did not disclose anything about the nature of depreciation. The Act required stock to be brought into account in the balance sheet. It did not require any amount to be brought into account in the profit and loss account.

[34]     
In relation to the issue whether stock was a bundle of costs or and asset that required to be valued, Mr Tyre submitted that it was an issue of relatively low importance generally, and mattered only when the stock was used, and the cost had to be ' expensed' . It was immaterial to ascertaining the cost of stock. At the point of sale, the composition of the cost of stock mattered only because depreciation was part of that cost and would be disallowed for tax purposes. Therefore it had to be identified. The accountants were not materially in dispute that stock was, or could be regarded as, a bundle of costs. The inconsistency in treatment of stock as an asset in the balance sheet and as a bundle of costs for revenue purposes was of no importance. There was no anomaly in the result when one appreciated that depreciation was disclosed only so that it could be written back. Depreciation differed from other cost elements in two respects. It was dealt with specifically for tax purposes. And it had to be disclosed for Companies Act purposes. The taxpayer' s analysis did not contravene any requirement that arose from those requirements. It simply asserted the central proposition that depreciation in stock was not expensed at the outset. If it mattered whether the process of finding a figure for stock was a costing exercise or a valuation, SSAP 9 was the most helpful indicator: it emphasised the matching of cost and revenue, and that was what was achieved on William Grant' s approach.

[35]     
Accountancy principles and practices developed over time: the authorities acknowledged that. The evidence showed that there had been a change in perception, a movement away from ideas such as notional purchases and sales between accounting periods. There was no recognition in SSAP 9 of any need for the ' metamorphosis' or reification of costs relating to stock. If it came to a choice, one should prefer current accountancy thinking to outdated judicial obiter comments.

[36]      Mr Justice Lightman' s approach should not commend itself to the court. He had not addressed the real issue, or alternatively he was in error in paragraphs 37 and 39 of his opinion in the views he formed of the effect of the accountancy evidence in the case.

OPINION

[37]     
In paragraphs 72, 73, 90 and 91 of their reasons, the Special commissioners develop the proposition that William Grant' s accounting treatment of depreciation involves a ' contra' credit to adjust for transferring an amount of depreciation to increase the carrying value of unsold stock, and thereby reducing the amount charged to profit and loss. The conclusions arrived at include the conclusion that any element of depreciation included in the carrying value of stock must be removed from the carrying amount in the balance sheet of unsold trading stock. Counsel for William Grant supported the conclusion formally, without developing any argument, but informed the court that this approach had not been proposed by either party before the Special Commissioners. He suggested that one could understand the Special Commissioners' reasoning as the same as the reasoning for supporting the taxpayers' submissions. They relied on the accountants' evidence and used their language. Their use of expressions such as ' capitalise' simply referred to an asset. The reference to a ' contra' was possibly an attempt to accommodate observations of Lord Millett.

[38]     
In my view the Special Commissioners' approach to this issue is unsustainable, and cannot be rescued by the sympathetic interpretation of the decision suggested by Mr Tyre. The agreed position before the Special Commissioners and the court was that William Grant' s financial accounts showed a true and fair view of the state of affairs of the company and of its profit for the year in question. There is nothing in any of the provisions of the Income and Corporation Taxes Acts to which the parties drew attention that would require or permit the adjustment of the taxpayer' s balance sheet in the way proposed, nor that would require a view to be taken of the proper treatment of depreciation in stock that necessarily undermined the basic premise on which parties proceeded, namely that the financial statements met current Companies Act and GAAP requirements. More significantly, however, the outcome of applying the Special Commissioners' reasoning as they do suggests that their analysis of the accounting position was flawed, and that a failure fully to reflect the accounting position as presented to them resulted in a material misdirection on the factual issues.

[39]     
In examining the question more particularly, it is appropriate to note in the first place that the Special Commissioners' approach is incompatible with William Grant' s basic position that the incidence of the charge for depreciation in the profit and loss account is a function of timing of the charge, not of the amount of the charge ascertained by reference to the depreciable assets of the company. The calculation of depreciation, reflected in the balance sheet, and in the charge of gross depreciation in the profit and loss account, reflect a correct application of the Companies Acts, and of accounting practice, and these steps are not amenable to alteration in the way suggested by the Special Commissioners. William Grant acknowledge that the amount or amounts so calculated from year to year will be debited to profit and loss account. Their contention is that the depreciation in stock should be recognised as an expense in the accounting period in which the sale occurs, not in the accounting period in which the depreciation arises and is computed. Approached in that way, the company' s argument seeks to avoid a problem that would occur if one were compelled to describe as ' depreciation' in profit and loss account for a later period an amount computed for an earlier period by reference to assets then held, and then having a reference value for purposes of computing depreciation, that no longer reflected the position in the balance sheet. The asset to which the depreciation referred might no longer exist in fact as an asset of the taxpayer, but if it did, it would, in the nature of things, have a lower book value brought forward as a basis for computing current depreciation. The company' s counsel resisted the suggestion that the prior years' depreciation brought into account on sale of the relevant stocks should be shown as ' depreciation' in the notes to the profit and loss account when it was, in the company' s terminology, ' released' to profit and loss account. There are issues with that. In particular, the result would be that the notes to the profit and loss account would not disclose the full amount of depreciation as a cost of sales.

[40]     
However, as approached by the Special Commissioners, the treatment of depreciation in stock would have the result that what was omitted by netting off the current year' s depreciation, so far as included in stock, would return as depreciation in the year of sale of the product. The ' contra' on the Commissioners approach must extinguish pro tanto the depreciation for the current year, and therefore must be reflected in a deduction in the balance sheet carrying amount for stock. When that stock was sold, the depreciation brought forward would be reflected in a credit in some form of depreciation account. It would have to be identified in order to ensure the matching of expenditure and revenue. But it could not be presented as current depreciation. It is not clear that there is any answer to the dilemma that emerges from the Special Commissioners' analysis. They do not offer any.

[41]     
There are further problems. The Special Commissioners do not provide an explanation of where the other half of the double entry implied by the cancellation of the depreciation in stock would appear. Superficially, if one reduces the balance sheet carrying amount for stock by excluding the depreciation element from it, one must also reduce an equivalent credit. The only obvious candidate is the depreciation deduction in calculating the net book value of tangible assets. If that is the only entry that is available for adjustment, as it appears to me it must be, the Special Commissioners' approach is exposed as fundamentally misdirected. It would require a balance sheet presentation that undermined the primary directive of the Companies Acts to write off depreciation over the useful economic life of the asset.

[42]     
The Special Commissioners preferred the ' contra' analysis arrived at without submission, but also supported their conclusion that in any event it was the net depreciation that was treated as an expense in profit and loss account and should be added back. That appears to be to be a significantly more complex problem.

[43]     
In my opinion, in approaching this issue, the availability of capital allowances on expenditure on the acquisition of qualifying assets was not relevant to the issue before the Special Commissioners and is not relevant to the issue before the court. To that extent I disagree with the comments of Lightman J. Some of the authorities from which it was sought to deduce principles or rules of law applicable to the computation of taxable profits were decided before capital allowances were available. Capital allowances are not now available on all assets that fall to be depreciated according to contemporary accounting standards and practices. And, among the expenditure that does qualify, are items that attract enhanced capital allowances (as in the case of some of William Grant' s expenditure on tangible fixed assets in the year to 28 December 2002). At some periods there has been provision for accelerated capital allowances. While capital allowances enable the taxpayer to obtain relief for qualifying capital expenditure, there is not such a correlation between those allowances and depreciation as required for financial accounting purposes as to support the Revenue argument that capital allowances avoid unfairness in the operation of section 74 (1) (f), or protect the taxpayer from losing out financially and are therefore relevant to the resolution of the current issue. If the Revenue are correct in arguing that section 74 (1) (f), Finance Act 1988 has the effect for which they contend, the immediate impact on the taxpayer is a matter that flows from the interpretation of the provision, and the fairness or otherwise of the result is of no moment.

[44]     
Turning to the issue, as I see it, the basic requirement of the Taxes Acts is that the full amount of profits and gains for the relevant accounting period must be brought into charge to tax. Section 70 (1) of the Income and Corporation Taxes Act 1988 provides:

" .... 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."

In considering how those profits and gains are to be computed, the starting point is section 42 of Finance Act 1998. That provides:

"(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."

[45]     
The conventional approach to the computation of taxable profits is to adjust the financial operating profit by increasing or reducing it to reflect differences between the requirements of financial accounting and accounting for tax purposes. That offers the convenience of a starting point that has a measure of independent validation. But that does not qualify section 79: the full amount of the profits or gains has to be returned. The deductions available are those authorised by the Corporation Tax Acts. The restriction of an add-back to financial profit, on conventional accounting for tax purposes, has precisely the same effect as a claim for a deduction in a free-standing account prepared for tax purposes. William Grant' s approach depends on section 42.

[46]     
The 1988 and 1998 provisions enact, with but minor variations in language, what had long been the effect of judicial interpretation of the requirements imposed on the taxpayer in computing taxable profits. Many of the cases referred specifically to stock and work in progress, and judicial observations have both general and particular relevance to the issues in this case. In Whimster & Co v Inland Revenue Commissioners, decided in 1925, Lord President Clyde said:

"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."

These two general and fundamental commonplaces are now enshrined in statute. What has changed over the eighty years since Whimster are not the general rules, but how they are understood and applied. The accountancy profession, domestically and internationally, has sought progressively to define and to refine statements of generally accepted practice which can be used as a measure of compliance by those responsible for the preparation and presentation of financial statements. In the case of publicly listed companies the duty to ' comply or explain' is established formally as a condition of listing. Accounts prepared in accordance with current GAAP reflect the understanding of contemporary accountants of the accounting requirements imposed by the Companies Acts in the particular circumstances reported on. In the present case it is a matter of some importance that William Grant present financial statements for the year to 28 December 2002 which, by agreement of the expert accountants on both sides of the case, comply with current UK GAAP.

[47]      However, in my opinion, the preparation of financial statements for Companies Act purposes must reflect the provisions of those Acts, and it is incorrect, as Mr Tyre suggested, that the accounting treatment of depreciation was only required because the amount had to be added back for tax purposes. The tax treatment of the many and varied items requiring adjustment from the figures taken into account in financial statements flows from the Taxes Acts, not the Companies Acts. Among other purposes of the Companies Acts, writing off depreciation to profit and loss account helps maintain the capital base of the company, by restricting amounts that might otherwise be available for distribution. The statutory requirements relating to financial statements are not ancillary to some wider purpose of providing the amounts requiring adjustment for tax purposes.

[48]     
William Grant' s financial statements bring out an operating profit in accordance with GAAP. As the analysis set out above demonstrates, as a matter of bookkeeping and presentation, that operating profit was struck without bringing into account amounts representing opening and closing stock. Arithmetically the operating profit is precisely the same as it would have been if a trading and profit and loss account had been prepared in traditional form. But the omission of opening and closing stock is not simply a short-cut. It reflects a difference in understanding of what is required by GAAP to arrive at a proper statement of operating profit from that which would have been reflected in accounting evidence in 1925, when Lord President Clyde went on to say:

"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."

At that stage in the development of accountancy practice it is difficult to envisage any other approach. The computing power required to maintain records of sufficient sophistication to achieve the objective of Lord President Clyde' s first commonplace without year-end calculations did not exist. As the authorities progressed, there was acknowledgement of developments in available information and in the way the adjustments for stock might be made. As mentioned above, Patrick v Broadstone Mills Ltd illustrated considerable development in accountants' thinking between 1925 and 1953 in the methodology for computing the book value of stock, and Duple Motor Bodies v Ostime illustrated further developments by 1960 in the understanding of how stock amounts could be calculated that persuaded the Inland Revenue, and the Special Commissioners on appeal, that certain overheads should be taken into account as costs of stock. The court' s decision showed that accounting opinion was still divided and that the direct cost method applied by the taxpayer could not be said to be wrong. It appears that current UK GAAP would now make it difficult to argue in most cases that overheads could be omitted from the calculation of stock where that was required in the computation of profits and gains, whether that was required for financial reporting purposes or for purposes of income tax or corporation tax.

[49]     
However, it is important to note that, whatever developments had taken place by 1960, or were to take place thereafter, the focus remained the same: adjusting for stock at the beginning and end of the accounting period at cost or market value. The alternative was, and in my view remains, important. The required adjustment has at no time been confined to an adjustment related to cost. One can readily understand that the recording and computation of costs are primarily matters of bookkeeping, internal to the trader' s organisation. Market value, or its modern equivalent, net realisable value, is a function of relationship between the trader and its external market in relation to the goods held for sale. Net realisable value may fall below the amount computed by reference to cost for many reasons. There may be changes in the general level of demand for the product. In the case of some goods, obsolescence may be a problem, brought about by technological changes for example. Stock may deteriorate in storage. Contamination or other form of physical change may render some kinds of stock wholly unmarketable. Accounting practice requires one to recognise the lower of cost and net realisable value, and that can occur only in a context that takes account of the actual market for the goods held as stock.

[50]     
It has long been recognised that this test deviates from strict adherence to the tax rule that profit or loss must be taken to consist of the difference between receipts from the business in the accounting period and the expenses incurred in earning those receipts. Where net realisable value is used in accounting for stock, it is sometimes said that loss is anticipated. Whether or not that is strictly correct, it is clear that the net realisable value alternative involves the recognition as an expense, in a period during which the goods in question have not been sold, of costs that have not been incurred in generating the receipts of that period. That, in my view, suggests that one must be slow to reduce the issue of principle in this case to one of accounting for cost or for expense. To do so would be to ignore the alternative. It is immaterial that a trader with the sophisticated information technology used by William Grant could apportion the reduction over cost headings as a matter of book-keeping. The recognition that the corporeal stock had a value derived externally from market conditions would be an inescapable part of the process of computing the amount of the reduction.

[51]     
William Grant' s accounts for the year ended 28 December 2002 meet the requirements of the first part of section 42 (1) of the Finance Act 1998. The operating profit has been computed in accordance with GAAP notwithstanding that it was arrived at without bringing into account opening and closing stock, and notwithstanding the depreciation adjustments made in arriving at the net debit reflected in the operating profit.

[52]     
The answer to the question before the Special Commissioners, and before the court, comes to be whether William Grant' s computation for corporation tax purposes makes the adjustment required by law for depreciation in computing profits for that purpose. That appears to me to resolve into a question, in terms of section 74 (1) (f), of what was the sum employed or intended to be employed as capital in the trade, given the decision in Addie that depreciation is or represents a sum employed or intended to be employed as capital of William Grant' s trade.

[53]     
In my opinion, one must begin by examining the wider context set by the Companies Acts. Depreciation is provided for in accounts not simply as a reflection of accounting theory or practice, but as a matter of obligation, in section 226 of and schedule 4 to the Companies Act 1985, to prepare a balance sheet and profit and loss account that give, respectively, a true and fair view of the state of affairs of the company at the end of its financial year and of the profit or loss of the company for that financial year. The rules of historical cost accounting set out in section B of the fourth schedule to the Act provide:

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

    1. its purchase price or production cost; or
    2. where it is estimated that any such assets will have a residual value at the end of the period of its useful economic life, its purchase price or production cost less that estimated residual value;

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

Depreciation therefore is mandatory and it has ascertainable characteristics implied in the requirement. Leaving to one side the scope for revaluation, depreciation is related to the historical cost of a fixed asset less any residual value at the end of its useful economic life. And it is a mechanism for writing off that net cost over the predicted useful economic life of the asset. Depreciation is not provided for in relation to current assets. Current assets are required to be included in the company' s accounts at their purchase price or production cost or, if lower, at net realisable value: paragraphs 22 and 23. Paragraph 26 applies to all assets and, so far as material for present purposes provides:

"(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.

    1. In addition, there may be included in the production cost of an asset -
    1. a reasonable proportion of the costs incurred by the company which are only indirectly attributable to the production of that asset, but only to the extent that they relate to the period of production..."
[54]     
William Grant follow paragraph 26 in the company' s bookkeeping practice. The addition of warehousing overheads is limited to the maturation periods required to convert raw spirit into whisky. But at that stage a marketable product exists that can be bottled, removed from bond, and sold. As is clear from the evidence, part of the production of raw spirit is sold in cask and held for customers. Adjustments are made to exclude from charge to revenue the elements of cost attributed to customers' stocks in bond. There is no issue about these stocks. The issue of substance between the parties relates to William Grants' own stocks. Depreciation on fixed assets is included in the indirect costs taken into account in striking the amount of those stocks (and work in progress) for balance sheet purposes, and that accords with GAAP. But it is important to note that the underlying basis of the statutory requirement is that there is an asset whose production cost requires to be ascertained.

[55]     
Nothing in schedule 4 authorises, or permits, the modification of the requirements of paragraph 18 where the computation of the amount attributed to any asset, fixed or current, includes an amount determined by reference to depreciation. Whatever the application of indirect costs resolved upon by the directors of the company and their accounting advisers, the amount of depreciation on fixed assets remains the same and must be written off in accordance with paragraph 26.

[56]     
Complex questions arise, for example in relation to the operation of the provisions that apply where a new fixed asset is manufactured for the trader' s own use. Depreciation of the machine tools employed to make the new fixed asset would be included in its cost in normal course. The new fixed asset would come into existence, and have a predicted useful economic life of its own. The schedule would require the production cost of the new asset to be written off over that useful life. The machine tools used in manufacturing the new asset might have been disposed of, having exhausted their own useful life long before the expiry of the relevant period for the new asset. This would be intelligible if, and only if, the source costs taken into account for the new asset expressed the cost of that asset, and lost the character they might have had originally in the books of the company. In particular, any notion that what was derived from depreciation of the machine tools would retain the character of depreciation of those machine tools would appear to be inconsistent with the requirement that the aggregate amount should be taken to be the cost of the new asset. The machine tools might have been disposed of. If still used in the business, they would still be subject to depreciation on their written down value.

[57]     
If the character of the cost did not change, a more or less precise parallel of the result that William Grant contend for, there would be a depreciation charge on the depreciation element carried forward, not as a charge of depreciation on the new asset, but as a charge of depreciation on the balance of depreciation on the source asset. One can readily understand how that could be achieved in bookkeeping terms, particularly with modern technology. It would be straightforward as a matter of arithmetic. But it would not accord with reality, nor with the apparent objectives of the legislation. There is no practical or realistic sense in which depreciation reflected in the cost of the new asset could continue to be depreciation on the source assets. On a sound view of the legislation, the expenditure is capitalised into the new asset, and loses its source character. As a practical matter, one would expect that the depreciation allocated to cost of the new asset would be apportioned out of the total depreciation as a balance sheet transfer, and the balance only of the year' s depreciation would be debited to profit and loss account. The transfer between capital accounts would recognise that to the extent that the depreciation so applied, it was not a trading expense of the accounting period.

[58]     
However, the incorporation of depreciation in the carrying amount attributed to stock in the balance sheet is not capitalisation, in Companies Act terms. ' Capitalisation' is defined by paragraph 79 of schedule 4 as follows:

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

Stock and work in progress are current assets, in terms of paragraph 77, in terms of part C of Format 1 in paragraph 8 of schedule 4, and in general principle. Whatever categorisation one applies to the adjustment required to reflect a depreciation element in the carrying amount of stock, it is not capitalisation for Companies Act purposes. The amount for stock must be adjusted through the trading and profit and loss account, real or hypothetical, notwithstanding that there is no specific provision for profit and loss account presentation of the adjustment, for statutory purposes, and nothing that would necessarily imply any particular presentation. For profit and loss purposes the presentation is neutral in effect, so far as the Companies Act requirements are concerned.

[59]     
This can be illustrated in the present case by altering the presentation of the figures already mentioned. From William Grant' s tax computation depreciation was added back of £6,704,623, with an adjustment for depreciation in stock of -£114,595, giving a net adjustment of £6,590,028. The sums comprised are:

Gross depreciation written off assets

6,704,623

Depreciation brought forward from prior years on stock sold during the year

1,580,273

Depreciation carried forward in stock

(1,694,868)

 

£6,590,028

[60]     
The note on depreciation in the accounts omits the charge for depreciation on stock sold. But that is immaterial for present purposes. If William Grant had prepared a trading and profit and loss account in traditional format, and included opening and closing stock, as it would do in that situation, the amounts would include an element representing aggregate depreciation for all source periods so far as reflected in the carrying amount entered for stock. The contribution that depreciation would have made to the movement in stock amounts between the beginning and end of the year would have been precisely the same. That was not controversial. The presentation of net depreciation in stock, as a credit to the depreciation expense item, or as an element in stating the opening and closing amount of stock is neutral in ascertaining the amount of the company' s profit.

[61]     
A trading and profit and loss account in that format would reflect precisely the requirements of Part 1 paragraphs 1 to 3 of SSAP 9, which is part of UK GAAP. It is, in my opinion, important to note that that paragraph is concerned explicitly with the determination of profit for an accounting period. It is not explicitly directed towards the presentation of a trading entity' s balance sheet, though obviously it would have implications for the balance sheet presentation of stock as an asset. Until SSAP 12 was superseded in part by FRS 15, GAAP would have required consistent treatment, as the Special Commissioners observe.

[62]     
The paragraphs in SSAP 9 provide:

"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."

[63]      Paragraph 5 defines ' net realisable value' as the estimated proceeds from the sale of items of stock less all further costs to completion and less all costs to be incurred in marketing, selling and distribution directly related to the items in question.

[64]     
Allowing for increasing sophistication in accounting language, these paragraphs effectively spell out the position set down by Lord President Clyde in Whimster. The expression ' value' is used only in relation to the alternative to cost appropriate where deterioration in quality or marketability has arisen in the case of individual items of stock or groups of items. The Lord President used the expression more generally with reference both to cost and market price. In my opinion, there was nothing more significant in his use of the term ' value' than to indicate the alternative processes by which an accountant would arrive at the appropriate figure to apply to the opening and closing stocks of the trader to ensure so far as practicable that only expenditure proper to the accounting period was set against the revenue of that period in ascertaining profits.

[65]     
Perhaps of greater significance is that both in Whimster and in SSAP 9 the focus is on stock as it exists in fact at the respective dates. Stock is a product of the manufacturing or trading activity that exists in the real world, incomplete or unsold, that had a cost, and may have a lower market or net realisable value, which have to be ascertained and taken into account in ascertaining profit.

[66]     
It is clear that ' valuation' of stock has come to be understood by accountants as a process that cannot accommodate the aggregation of elements of cost. One can understand that view. Valuation cases beginning before the twentieth century, in a range of tax and non-tax contexts, indicate that ' value' is an expression that has no precise meaning without further definition of the purpose for which a valuation is required, the context in which the exercise has to be carried out, the parties one may legitimately have in mind as populating the market and so on. But there is no reason to believe that Lord President Clyde used the term ' value' in the sense of the product of a valuation exercise generally. The word is used loosely by accountants as by others. Note 7 to William Grant' s financial accounts uses the expression ' net book value' in relation to assets, and that is as inappropriate a use of ' value' in the sense of the product of a process of valuation as one could imagine. In certain circumstances ' value' is useful shorthand, and, in my opinion, Lord President Clyde was clearly using the word in that way.

[67]     
In Patrick v Broadstone Mills Ltd at page 58, Singleton LJ narrated the Revenue argument in terms of ' valuation of stock made (either on market price or cost price)' . At page 68, expressing his own conclusions, he said:

"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."

The taxpayer' s base stock method was rejected for tax purposes. Birkett, L.J. at page 71 cited Lord Porter' s dictum in Ryan v Asia Mill Ltd in emphasising that, although the company' method was in accordance with sound accountancy practice:

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

The same emphasis on the distinction between computation of profits for commercial accounting purposes and for purposes of taxation is found in Anaconda American Brass Ltd, at page 98. At page 100, Lord President Clyde' s description of the requirements of computation of profits for tax purposes in Whimster is adopted as the foundation on which the income tax of the United Kingdom is founded.

[68]     
These cases provide support for the view, on which the Revenue relied, that there is a rule of law requiring the computation of profits for corporation tax purposes on a basis that explicitly brings into account opening and closing stock figures ascertained at the lower of cost and net realisable value. In terms of current GAAP that accounting procedure would require now to reflect depreciation applied in ascertaining stock figures to be included. To that extent there has been development of the accounting practices employed to measure stock, but no change in the asset whose cost if to be measured.

[69]     
The discussion took a further step forward in Duple Motor Bodies Ltd v Ostime. The courts were concerned with a competition between two currently accepted accounting views of the correct approach to ascertaining the cost of stock. The Special Commissioners had found in favour of the on-cost method in preference to the direct cost method. In the Court of Appeal, there was a clear emphasis on the over-riding purpose of computing profits. Pearce, L.J., having made some critical comments about ideological dispute having submerged the real issue, put the point most clearly at page 562:

"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."

[70]     
There was concern that the on-cost method would in certain circumstances operate unfairly. Current practice has avoided the problem by relating on-cost recovery to normal levels of production. However, leaving that aspect of the case aside, there was movement, in the Court of Appeal, towards an approach close to that for which the respondents contended before the Special Commissioners and before the court.

[71]     
In the House of Lords, Viscount Simonds was pre-disposed to dismiss the appeal on the basis that the case did not state a question of law which the court could properly answer. At page 566, however, he said:

" ... (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."

[72]     
It appears from these observations that Viscount Simonds had a clear view of the adjustment for stock as an exercise in ascertaining an amount to be brought into account in computing profits to represent the corporeal asset held as stock. Lord Reid was more explicit:

"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."

He commented further on the proper approach to take to the adjustment for stock in computing profits:

"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."

The credit for closing stock, on this approach, is a figure that excludes expenditure from the reference period by attributing it to the articles comprised in stock.

[73]     
Lord Guest, as I understand his speech, discussed more narrowly the competing methods of ascertaining the cost of stock and work in progress, but, with the majority, applied Whimster. From the passages cited, it appears clearly that the court focused on the tangible assets held by the trader, whether completed or in the course of manufacture, and re-affirmed the rule that a figure, ascertained by reference to cost or market price, in the language of the time, had to be ascertained and brought into account in computing taxable profits. The same appears from observations in Minister of National Revenue and Anaconda American Brass Ltd at page 102:

"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."

Failure to observe that was to disregard the facts.

[74]     
The Revenue submitted that their argument was supported by the approach adopted by the Court of Final Appeal of the Hong Kong Special Administrative Region in Commissioners of Inland Revenue v Secan Ltd. Counsel for William Grant were, in my view, with respect to Lord Millett N.P.J who delivered the court' s decision, correct in criticising some of the comments made on the accounting treatment of assets and liabilities. But that is not material to the submissions made. The taxpayer had adopted a particular approach to the preparation of its accounts during the initial phases of a major development project. Interest was rolled up. It was not debited in the company' s financial statements nor in the profit and loss account prepared and tendered to the Revenue. Instead it was debited directly to a development account shown on the balance sheet where it was included along with acquisition and other development costs as an asset carried forward. Since the development assets were shown at the lower of cost and net realisable value, and there was no reason to write the carrying amount down to net realisable value, nothing appeared in the profit and loss account apart from some administration costs. When the company began to realise parts of the investment, it sought to re-write its profit and loss accounts retrospectively, and to treat the interest payments as current year expenses, thereby generating significant allowable losses to carry forward against its emerging realised gains.

[75]     
Lord Millet described the position in the earlier years thus:

"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."

Lord Millet cited a number of cases on the treatment of stock at page 10, and proceeded:

"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."

[76]     
On the evidence, it was held that the interest had in substance been deducted in computing the taxpayer' s profit. It was not debited to profit and loss account. But it was debited to a revenue account, the development cost account. In the process, the accountant had to be taken mentally to have set the interest charge off against the increase in the development account, ' and because they cancelled each other out there was no net balance to bring into the profit and loss account' .

[77]     
The decision reflects a continuation of the established views that stock and work in progress are real, tangible, assets, that require accounting treatment, but goes further in suggesting that the accounting treatment may not be taken to disturb the underlying reality of the adjustments required in computing profits. In my view it is unnecessary for present purposes to rely on Lord Millett' s analysis beyond this, that he re-affirmed the rule that opening and closing stock must be taken into account at amounts representing the application of sound accounting principles and practices. It is against the background of these authorities that one must approach the submissions for William Grant in the present case to the effect that the judicial observations included in them were somewhat elderly obiter dicta that had been superseded by developing accounting theory and practice.

[78]      In my opinion, these cases, from Whimster onwards, established that, in computing the taxable profits of a trader, the trader must make appropriate adjustments to reflect the opening and closing stock and work in progress held for the purposes of the trade. The court will yield to accountants full authority to determine on generally accepted accounting principles and practices the amounts to be taken to represent the tangible assets so held, but, subject to the views expressed in the Court of Appeal in Duple Motor Bodies Ltd v Ostime, have adhered consistently to the view that it is for the court to say that in computing the full amount of the profits and gains arising in an accounting period such an amount shall be taken into account as a reflection of the cost incurred in acquiring or producing stock and work in progress, or, if lower, the net realisable value of those assets. The focus has been on the asset, and on the recognition of the need to credit against current expenses an amount to represent that asset if matching of revenue and expenditure is to be achieved.

[79]     
If that is right, Secan supports the Revenue contention that the taxpayer cannot avoid the consequences of the rule by crediting the individual cost components to the expense accounts from which they are derived and so directly reducing the amount treated as expenses in the period, notwithstanding that those sums have been ascertained in accordance with generally accepted accounting practice. The courts have taken a consistent approach to this issue over a long period of time in decisions of the highest authority, and the requirement is so well established that one would be slow to overthrow it without clear justification in law. In my opinion there is none. The essential error in the taxpayer' s approach, in my view, is in treating bookkeeping for expense as the reality, and ignoring the injunction in the authorities to focus on the reason for making any adjustment: that is that the trader holds unsold stock and unfinished work in progress. It is because of the objective fact of the existence of the assets that one requires bookkeeping adjustments to be made at the beginning and at the close of accounting periods. If that is wrong, and William Grant are correct in contending that for purposes of computing profits stock is simply a "bundle of costs", it would be difficult, if not impossible, to justify the alternative of net realisable value. Costs do not have a value. If the existing rule were undermined, it would be to the disadvantage of many taxpayers who are currently able, by adopting net realisable value, to carry stock at less than cost and, in that way, to treat the difference between cost and net realisable value as a current expense.

[80]     
However, as between the parties, there is no dispute that, if opening and closing figures do have to be taken into account in computing taxable profits, the carrying amount for stock and work in progress must be determined by identifying the lower of cost and net realisable value for each item or class of items of tangible assets held as stock or in the course of manufacture at the reference dates for each accounting period, and reflecting the appropriate amounts in computing taxable profits. In my opinion, the amount of depreciation that falls to be taken into account for closing stock in expressing the carrying amount is the amount apportioned out of gross depreciation provision for the period. If that is done, there remains nothing in name of depreciation in stock available to credit directly to the gross depreciation charge against revenue. The result is that there must be added back the whole depreciation computed for the accounting period. That is, the amount that falls within section 74 (1) (f) in respect of depreciation in accounts prepared under the Companies Act is the amount of depreciation that requires to be written off in terms of paragraph 18 of schedule 4, whatever the application of that sum in or towards the indirect production costs of other assets, and in particular stock.

[81]     
In my opinion, that is the result to which one is directed by the authorities. But it is necessary to have regard to the strength of the opposing view. As Pearce L.J. said in Duple Motor Bodies Ltd v Ostime, the costing of work in progress, and the same applies to the costing of stock, though it has traditionally been seen as a necessary part of accounting, can nevertheless be seen as only a means to ascertaining profit and not an end in itself. The opening and closing adjustments required are now so familiar that it is easy to understate the importance of examining at root the purpose for which they are required. If there is a substantial answer to William Grant' s approach other than that supplied by the authorities it must lie in that purpose.

[82]     
I have already referred to the basic rule: income is to be computed for the purposes of Case I of Schedule D on the ' full amount of the profits and gains' arising in the period. Adjustment for opening and closing stock has been a necessary step towards realising the objective implicit in that requirement. However, in case of the profit and loss account it is no longer necessary for accountants to adopt that approach. As the expert evidence in this case shows, accountancy techniques, and accounting theory, now recognise more directly that the object of the exercise is to ensure the matching of expenditure to revenue. The most direct way of achieving that, in a case such as the present, and on the approach favoured by the accountancy evidence preferred by the Special Commissioners, is to make opening and closing adjustments to expenses without aggregating the resulting amounts and presenting them as a measurement of ' value' of stock and work in progress.

[83]     
As already noted, the application of current techniques is not restricted to depreciation. In this case, the evidence of Mr Henderson demonstrated that the cost of bottled stock, calculated in packs, comprised cost of production, including production overheads, three or five years' warehousing costs, the current cost of packaging materials, the current cost of direct labour required to bottle a pack, an allocation of direct overheads of the bottling facility, a notional finance charge depending on the length of the maturation period, the cost of chilling and blending, and the cost of distribution and customer relations where appropriate. These several heads of expenditure are incurred over time. Crediting the amounts attributable to the cost of stock at the end of any accounting period removes from the debit taken into account in computing profit those elements that are properly regarded as relating to the later periods in which the stock is sold. The costs held over are charged in computing the profits of the period in which the sale takes place. For this purpose there is no need, on the taxpayers' approach, to reify the costs: they are financial items, adjusted by financial transfers within appropriate cost headings, and the purpose of making the adjustments is served when the expense for the period is ascertained.

[84]     
As already suggested, the computing capacity and the software required to give effect to the adjustments are the product of modern developments, and accounting theory and practice have developed in parallel. It has always been necessary to make estimates in arriving at carrying amounts for stock. The cases show that the introduction of on-costs was a relatively recent innovation. The objections raised by the court in Duple Motor Bodies Ltd v Ostime on the basis that fluctuations in production would result in unrealistic cost figures have been met, and may have been understood before the case to have been met, by the adoption of accounting controls limiting the overheads charge to a level of ' normal' production. Standard costing, in which deviations from standard are recognised and dealt with as circumstances demand, enable the spreading of overheads to be made fairly. Unanticipated downtime, for example, or idle capacity, beyond the 5% allowed by William Grant (document 13 exhibit 4) would be recognised and reflected in the charge against profit in the period in which the abnormality occurred. This level of sophistication could not have been anticipated in 1925. The use of the term ' value' generally in relation to stock reflected a reality of the time: there was no method of computing cost accurately to the degree now possible. There had to be an estimate of the character of a valuation to enable an appropriate adjustment to be made.

[85]     
William Grant relied heavily on the recognition of the importance of developing accountancy principles in Gallagher v Jones. The case related to the treatment of front-loaded rentals on the hire of tangible moveable assets. The judge had held that the expenditure fell to be deducted in the year in which it fell due. The issue before the Court of Appeal was put thus by the Master of the Rolls:

"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."

[86]      In a full analysis and discussion of the relevant authorities, the Master of the Rolls concluded that there was no rule of law of the kind for which the taxpayer contended. He said:

"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."

[87]     
Nolan, L.J. made observations to similar effect. Counsel for the Revenue argued that these observations should be viewed narrowly, confined to cases in which there was no relevant rule of tax law. However, in my opinion they are wide and of general import. Indeed, the greater the advances in accountancy theory and practice, the less must be the role of the court in developing constraints on the application of contemporary accounting standards. Section 42, Finance Act 1998, expresses an obligation to compute taxable profits in accordance with current generally accepted accounting practice. Sir Thomas Bingham' s observations reflect precisely the priority to be accorded to such practice. The answer to the application of GAAP in the present case is that, properly understood in the light of the authorities, there is a rule of tax law that precludes the application of current UK GAAP in one respect.

[88]     
However, it seems to me that there are other problems for the taxpayer on the Master of the Rolls' formulation. The practice creates the difficulties already alluded to when the alternative to cost has to be applied. While normally, in accounting for profitable trading, cost will be the measure of the carrying amount taken for stock and work in progress on financial statements, that will not invariably be the case. In appropriate circumstances net realisable value will be applied in the case of assets that have deteriorated, or lost marketability, or otherwise fallen in value below cost. Then the amount will have to be ascertained by reference to some external market, and the source expense items will play no part in determining the gross price the market will be expected to pay, or will be willing to pay, for the goods. The market might be wholly distinct from the market in which the trader customarily carries on business. There was no evidence as to where a whisky producer might sell contaminated stock. But one can predict with reasonable confidence that it would not be the market for bulk whisky for blending or bottling or the wholesale or retail market for bottled whisky. Market price would be likely to be determined by what a purchaser in that rather alien market would pay. It is unlikely that he would be interested in what it had cost William Grant to produce the contaminated spirit.

[89]     
For William Grant, it was said that this would present no problem in accounting terms: one would simply apportion the reduction among the several expense account headings on a rational basis. That would clearly be a practical solution. The apportionment provisions in section 72 of the Taxes Act 1988 are time-related and would not provide statutory authority for the exercise. But pro-rata apportionment would be an obvious arithmetical means of spreading the loss. However, such arithmetical adjustments would not reflect the whole picture. In the first place, if there is a fall in net realisable value that is not related to a general movement in market price, but to some damage to the stock, that damage can only be understood in relation to the physical asset. Any consequential financial adjustment, by apportionment of the fall in value or otherwise, acknowledges that changes in the physical asset have had an impact on the appropriateness of the prior allocations of cost to it. However, acknowledging the reality of that position is not consistent with an approach to initial accounting that seeks to divorce the profit and loss adjustments from the physical stock. On the contrary it tends to support the traditional view that what one is doing in adjusting expenses for the carrying costs reflected in stock is a recognition of the fact that it is the tangible asset that is the focus for expenses adjustments.

[90]     
In my view the alternative of net realisable value, which must be adopted where changes in circumstances, whether affecting the product as such or reflecting general market conditions, make that appropriate, demonstrates the validity of the traditional view that the year end adjustments for stock reflect the fact that the organisation holds tangible assets, and cannot be wholly divorced from those assets. There has been no change in the requirement to substitute net realisable value (or market price) for cost over many years. It remains the clearest indicator that the financial adjustments required are related to the tangible assets in stock or work in progress. If that were not so, there would be two exercises, one limited to the purely bookkeeping exercise of adjusting costs to restrict expenditure charged to profit and loss account to that appropriately related to the revenue of the period, and a distinct exercise of valuation, by reference to external markets, when on comparison with the outcome of the accounting exercise one identified items held by the trader that could not be expected to achieve on sale the sum of the costs allocated to them. That is not an impossible result if the legislature were to provide for it, or if the courts were abandon their established views. But it is an odd reflection of the application of a single test of the lower of cost and net realisable value to determine the appropriate amount to be entered for stock.

[91]     
It appears to be unnecessary to analyse the reasoning of the Special Commissioners in detail. On their approach it was necessary to make compensating adjustments to the balance sheet to reflect the view that only net depreciation was in fact charged to profit and loss account. That immediately divorced the analysis from one of the few reliable anchors of fact in the case: that the financial statements as a whole showed a true and fair view of the state of affairs of William Grant at the year end, and of its profit for the year then ended. The Revenue view involved no such qualification of the accounts. The operating profit of the company remained as shown in the financial statements. Section 74 (1) (f) of the Taxes Act 1988 required an adjustment to be made to those profits. The parties are agreed on that fact. This is therefore a case in which some departure from the financial statements is required notwithstanding that they met the requirements of UK GAAP. The issue is as to the amount of that adjustment, and that is a question of law. In my opinion the question posed should be answered in these terms: the amount required to be added back in computing the taxable profits of William Grant for the period in question is the gross amount of depreciation.

[92]     
The parties informed the court that they are in agreement as to the resolution of the practical implementation of such a decision in adjusting the company' s corporation tax computations. No further procedure is required. I would allow this appeal.

EXTRA DIVISION, INNER HOUSE, COURT OF SESSION

Lord Penrose

Lord Osborne

Lord Reed

 

 

 

 

 

[2005CSIH63]

XA47/04

OPINION OF LORD OSBORNE

in

APPEAL TO THE COURT OF SESSION AS THE COURT OF EXCHEQUER IN SCOTLAND

under

Section 56A of the Taxes Management Act 1970 from a decision of the Special Commissioners of Income Tax communicated to the Appellants on 8 March 2004

by

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS

Appellants;

against

WILLIAM GRANT & SONS DISTILLERS LIMITED

Respondents:

_______

 

 

Act: C. M. Campbell Q.C., Paterson; Solicitor for Revenue & Customs

Alt: Tyre, Q.C., Mure; McGrigor Donald

23 August 2005

[93]     
I have had the opportunity of reading the Opinion of your Lordship in the Chair. I am in agreement with the manner in which your Lordship proposes that the question posed for the court should be answered. In particular, I consider that the gross amount of depreciation is required to be added back in computing the taxable profits of the respondents for the period in question. However, I would wish to explain briefly the reasons which have caused me to reach that conclusion.

[94]     
It is quite plain, that for the purposes of the compilation a set of financial accounts for a company such as the respondents, it is necessary for values of stock held at the opening and closing of the accounting period to be developed. As I understand the law and practice relating to that matter, the value of stock is to be stated at the lower figure of cost or net realisable value. That is the effect of what is said in Whimster & Company v. Commissioners of Inland Revenue 1926 S.C. 20, at page 25; Patrick v. Broadstone Mills Limited 35 T.C. 44, at page 68; and Duple Motor Bodies Limited v. Ostime 39 TC 537 at pages 567 and 569 per Viscount Simonds and Lord Reid.

[95]      It is a feature of this case that there was agreement between the appellants and the respondents, recorded in paragraph 58 of the Special Commissioners' Decision, that the latter had computed their account profits in accordance with generally accepted accounting practice and principles, in conformity with section 42(1) of the Finance Act 1998, which is in the following terms:

"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."

In particular, the use of a portion of the depreciation of fixed assets employed in the process of the manufacture of whisky, as a component in the value of closing stock, was accepted to be in conformity with generally accepted accounting practice. It is, of course, in relation to that portion of the depreciation that the question in the present case has arisen. As to that question, it is not disputed that generally accepted accounting practice cannot be determinative of the issue. As Lord Reid put it in Duple Motor Bodies Limited v. Ostime, at pages 570 and 571:

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

Similarly, at pages 573 to 574 Lord Guest put the point thus:

"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."

[96]     
It is, of course, necessary to recognise that, in arriving at the taxable profits of a company for a particular period, certain deductions are impermissible, as provided by section 74(1) of the Income and Corporation Taxes Act 1988. It provides for certain general rules as to deductions which are not allowable. It is in the following terms:

"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

employed as capital in, the trade, profession or vocation, but so that this paragraph shall not be treated as disallowing the deduction of any interest; ... ".

It is a consequence of the provisions of section 74(1) that adjustments, by way of additions, may require to be made to profits stated in financial accounts, in computing profits for tax purposes. In connection with the application of the provisions of section 74(1)(f) of the 1988 Act, it has to be recognised that the deduction from profits of depreciation of fixed assets is affected by the statutory provisions just mentioned, as appears from Addie v. The Solicitor of Inland Revenue (1875) 2 R. 431.

[97]     
In applying the provisions of section 74(1)(f) of the 1988 Act, as understood in the light of Addie v. The Solicitor of Inland Revenue, one must next examine the concept of depreciation. To that end, it is necessary to turn to the provisions of section 226 of the Companies Act 1985. That section specifies the accounts which must be prepared for each financial year of a company. These are, of course, a balance sheet, as at the last day of the year, and a profit and loss account. These accounts are referred to in that legislation as "the company's individual accounts". Section 226(3) goes on to provide:

"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 present context, the focus of attention then becomes paragraph 18 of Schedule 4 to the 1985 Act. It provides that:

"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

the end of the period of its useful economic life, its purchase price or production cost less that estimated residual value;

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

[98]     
In my opinion, paragraph 18 contains, in substance, a statutory definition of the concept of depreciation. As is provided, that concept involves the writing off of the purchase price or production cost, or that amount less any residual value, systematically "over the period of the asset's useful economic life". Thus, depreciation is temporally associated with the useful economic life of the fixed asset to which it relates. In my opinion, it follows from that definition that when an element in a company's accounts, calculated by reference to depreciation as defined in paragraph 18 of Schedule 4, becomes temporally dissociated from the useful economic life of the fixed asset, that element cannot thereafter continue to be properly regarded as depreciation in any real sense. In my opinion, therein lies the key to the issue in the present case. It appears to me that whenever a portion of the depreciation of a fixed asset in a particular year is used as an element in the calculation of the value of the closing stock, that element ceases to be properly capable of being regarded as depreciation, since, ipso facto, that element has become dissociated in a temporal sense from the useful economic life of the fixed asset, which is the subject of the depreciation. By the use of that element in that way, in my view, it becomes, along with the other elements used to make up the closing value of the stock, absorbed in the homogeneity of the value of the stock. In my opinion, it follows from that state of affairs, that that portion of depreciation, along with the remainder, requires to be added back in the year in question, as part of the gross depreciation, in consequence of the provisions of section 74(1)(f) of the 1988 Act.

[99]     
It may be objected to this view that the inclusion of an element of depreciation in the development of the value of the closing stock is sanctified by generally accepted accounting practice. However, I consider that that objection is without merit, since section 42 of the 1988 Act contains qualifying words "subject to any adjustment required or authorised by law in computing profits for those purposes." In my view, generally accepted accounting practice is thereby made subordinate to what is required, directly or inferentially, by law, in this case in the form of paragraph 18 of Schedule 4 to the 1985 Act.

[100]     
I am confirmed in the views which I have just expressed by the implications of the legal principle that the valuation of stock may, in certain circumstances, be effected upon the basis of the lesser of cost and net realisable value, a principle established in, among others, the cases to which I have already referred. In my view, the recognition in law that such a value may be employed undermines the contention advanced by the respondents in this case that an element of depreciation may in some way survive the selection of such a basis of valuation. In my opinion, in a context such as that, there is no rational way in which an element of depreciation used to develop a figure for the value of stock could survive in any real sense in the event of the stock requiring to be valued on the basis of net realisable value. I found the attempts made to explain how the portion of depreciation could be handled in such a situation wholly unconvincing.

[101]     
Finally, I should make clear that I consider that none of the authorities referred to in the course of the debate before us, in my opinion, undermined any of the principles derived from the earlier authorities to which I have referred.

EXTRA DIVISION, INNER HOUSE, COURT OF SESSION

Lord Penrose

Lord Osborne

Lord Reed

 

 

 

 

 

[2005CSIH63]

XA47/04

OPINION OF LORD REED

in

APPEAL TO THE COURT OF SESSION AS THE COURT OF EXCHEQUER IN SCOTLAND

under

Section 56A of the Taxes Management Act 1970 from a decision of the Special Commissioners of Income Tax communicated to the Appellants on 8 March 2004

by

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS

Appellants;

against

WILLIAM GRANT & SONS DISTILLERS LIMITED

Respondents:

_______

 

 

Act: C. M. Campbell Q.C., Paterson; Solicitor for Revenue & Customs

Alt: Tyre, Q.C., Mure; McGrigor Donald

23 August 2005

Introduction

[102]     
Corporation tax is charged on profits of companies: Income and Corporation Taxes Act 1988 ("the 1988 Act"), as amended, section 6(1). For this purpose, "profits" means income and chargeable gains: section 6(4)(a) of the 1988 Act. Chargeable gains are not in issue in the present case, which is concerned solely with income. In relation to the computation of income, section 9(1) of the 1988 Act provides:

"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."

In particular, tax is charged under Case I of Schedule D in respect of the profits arising from any trade carried on in the United Kingdom: section 18 of the 1988 Act.

[103]     
Expenditure on capital assets does not enter into the computation of income for purposes of corporation tax. Such expenditure does not diminish the company's income: the expenditure is represented by the capital asset which has been acquired, so that (subject to any question of capital gains or losses) the company has made neither a profit nor a loss as a result of the expenditure. That principle is reflected in section 74(1) of the 1988 Act, which provides:

"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

employed as capital in, the trade, profession or vocation ... ".

A provision to this effect has been in force since at least 1842.

[104]     
In accordance with that provision, no deduction can be made, in computing a company's income for taxation purposes, in respect of depreciation in the value of capital assets: Addie v. Solicitor of Inland Revenue (1875) 2 R. 431.

[105]     
In a company's accounts, on the other hand, it has long been considered appropriate not only to make provision for depreciation in the value of fixed assets in the balance sheet, by writing off the value of such assets over a period of time, but also to make a corresponding deduction in calculating the company's profits. In that way the cost of fixed assets is, over time, charged as an expense. When the company's taxable profits are computed, however, the amount deducted in respect of depreciation has to be added back, in conformity with section 74(1)(f) of the 1988 Act.

[106]     
One other aspect of traditional accountancy practice has to be noted. In order to calculate a company's profits for an accounting period, it was at one time customary (in general) to bring into the account all the expenditure incurred during that period. Insofar as the company's expenditure during the accounting period had been used to produce (or purchase) goods which had not been sold during that period, that expenditure was reflected not in the company's income from sales, but in the extent by which the company's stock and work in progress at the end of the accounting period (the closing stock) was larger than the stock and work in progress at the beginning of the accounting period (the opening stock). The expenditure in question had not, of course, been wasted, and did not represent a loss. If that expenditure was to be brought into account, it was therefore necessary also to bring into account a countervailing figure representing the difference between the opening stock and the closing stock, sometimes referred to as the stock adjustment. For this purpose, a figure had to be attributed to the closing stock at the end of each accounting period, and that figure, carried forward into the account for the succeeding period, then became the figure attributed to the opening stock for the latter period. For taxation purposes, the figure could not be the market value of the closing stock, if that value was higher than the cost of the stock. That was because of the principle that a profit cannot be anticipated: the company was not to be taxed on the income which it would have derived if it had sold the stock in question, when that stock had not yet been sold. As was said by Lord President Clyde in Collins & Sons v. Inland Revenue 1925 S.C. 151 at page 156:

"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."

The closing stock was therefore normally entered in the accounts at its cost. The expenditure incurred in producing the additional stock which had not been sold was therefore (in principle) balanced by the stock adjustment, and the overall effect on the company's profits was neutral. If, however, the value of the closing stock was less than its cost, then it was accepted that that value, rather than the cost, should be used in computing the company's profits, for tax purposes as for other purposes. In summary, therefore, the closing stock was traditionally taken into account at cost or net realisable value, whichever was the lower.

[107]     
The use of accounts prepared in the manner just described in computing the taxable profits of companies has been endorsed on a number of occasions by the courts. In Whimster & Co. v. Inland Revenue 1926 S.C. 20, for example, Lord President Clyde observed, at pages 25 to 26:

"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"

(emphasis in the original). It is to be noted that the Lord President referred to the bringing into account of closing stock as an example of the ordinary principles of commercial accounting. The "fundamental commonplaces" were that the profits of a year consisted of the difference between the receipts during the year and the expenditure laid out to earn those receipts, and that that difference was to be ascertained consistently with the ordinary principles of commercial accounting (so far as consistent with the Taxes Acts).

[108]     
What Lord President Clyde described as the ordinary principles of commercial accounting are not written in tablets of stone. As the Lord President observed in Collins & Sons at page 157:

"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."

Accounting practice changes from time to time. Such changes are in principle reflected in the methods used to compute companies' profits for taxation purposes, except insofar as any accounting practice may be inconsistent with the requirements of the Taxes Acts. That long established principle is now expressed in section 42(1) of the Finance Act 1998 (as amended):

"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."

[109]     
The present case arises as a consequence of developments in generally accepted accounting practice. As explained more fully below, it is now generally accepted in accountancy that the cost of producing goods should normally be charged as an expense only when the goods are sold: the central principle 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. This principle has a number of consequences which are important in the present case. The first is that it is unnecessary for the opening and closing stock to appear in the profit and loss account (although a figure for stock continues to appear in the balance sheet, since stock forms part of the company's current assets). Since it is the cost (whenever incurred) of producing the stock sold during the accounting period which is charged as an expense in the profit and loss account, rather than the expenditure incurred during that period, it is inappropriate to make a stock adjustment representing the stock produced during the period but unsold at its end. Other consequences concern depreciation. The principle of matching cost and revenue in the year in which the revenue arises applies to the depreciation of fixed assets used in the production of goods, on the basis that such depreciation forms part of the cost of producing the goods. Accordingly, although provision continues to be made in the balance sheet for depreciation in the value of fixed assets in the traditional manner, by writing off the value of such assets over a period of time, the treatment of depreciation in the profit and loss account is different. Insofar as provision for depreciation in the balance sheet relates to fixed assets which are not used in the production of goods, a corresponding deduction continues to be made immediately in the profit and loss account, so that the cost of such assets is charged as an expense over the same period of time as that over which their value is written off in the balance sheet. Insofar as the provision for depreciation in the balance sheet relates to fixed assets used in the production of goods ("production assets"), on the other hand, the depreciation is treated as forming part of the cost of the goods produced. As such, it is not charged as an expense in the profit and loss account until the goods in question are sold: at that point, the depreciation forms an element of the cost of sales which is charged in the profit and loss account. The cost of production assets is thus charged as an expense over the period during which they are generating revenue (i.e. over the period during which the stock produced by the assets is sold), rather than over the period during which their value is written off in the balance sheet. One consequence is a deferral of the point at which such depreciation is charged as an expense in the profit and loss account (assuming that not all the stock produced in a given year is sold in the same year). The deferral is for a particularly long period in the Scotch whisky industry, because stocks are held for many years as they mature. Stock which remains unsold at the end of the accounting period forms part of the company's current assets; and the figure at which the stock is stated in the balance sheet is normally its cost, including the depreciation forming part of that cost. Depreciation on production assets is therefore said, in accountancy parlance, to be "carried to stock"; and it normally remains in the balance sheet, under the heading of current assets, unless and until the stock in question is sold, at which point the depreciation is charged as an expense in the profit and loss account under the heading of "cost of sales".

[110]     
Before considering the relatively complex facts of the present case, it may be helpful to illustrate the different accounting approaches by a simple example (although, inevitably, the discussion of the example at this stage anticipates some of the arguments to be considered later). Let us assume that a company has two fixed assets. The first is a factory which cost £250,000 and has an economic life of 25 years. The second is a machine for producing widgets, which was bought at the beginning of year one for £100,000 and has a useful life of 10 years, at the end of which its scrap value is nil. Assuming that the company adopts the straight line method of depreciation, it will write down the value of the factory in its balance sheet by £10,000 each year. It will also write down the value of the machine in its balance sheet by £10,000 each year. If it prepares its accounts in the traditional manner, then its annual profit and loss account will include, on the debit side, the expenditure incurred during the year and the opening stock, and, on the credit side, the revenue received during the year and the closing stock. The company will also charge £20,000 in its annual profit and loss account in respect of depreciation. The profit which would otherwise arise is thus reduced by £20,000 each year, in order to pay for the fixed assets. In order to calculate the company's taxable profit, it is therefore necessary to add back that £20,000 to the reported profit.

[111]     
If the company adopts the modern approach to accounting, on the other hand, then it will treat differently the depreciation on the machine. That depreciation will be treated as part of the cost of each widget produced. If 1 million widgets are produced each year, then a cost of 10 pence in respect of the depreciation of the machine will be attributed to each widget. The annual provision for depreciation in the balance sheet will be the same as under the traditional approach: the value of the factory and the value of the machine will each be written down by £10,000 each year. In the profit and loss account, on the other hand, only the £10,000 in respect of the factory will be charged immediately as depreciation. The depreciation in respect of the machine is however brought into the account in the cost of sales. That figure will be greater, by 10 pence per widget sold, than it would have been under the traditional approach. If 80,000 widgets are sold during a given year, then the cost of sales figure will be £8,000 greater than it would have been if the depreciation of the machine had not been taken into account. Following this approach, the closing stock and the opening stock do not enter into the computation of profit. From the turnover - the price of the widgets sold - will be deducted the cost of sales (including the £8,000 in respect of the depreciation of the machine), and in addition the £10,000 in respect of the depreciation of the factory. The profit which would otherwise have arisen is thus reduced by £18,000 to pay for the fixed assets. In order to calculate the company's taxable profit, it is therefore necessary to add back that £18,000 to the reported profit.

[112]     
The profit and loss account described in the previous paragraph could be presented in a different way, in order to make clearer the relationship between the £20,000 written off the value of the fixed assets in the balance sheet and the £10,000 charge for depreciation shown in the profit and loss account. The company could show, in the profit and loss account, a total charge for depreciation of £20,000, with a credit for £10,000 in respect of depreciation carried to stock ( a credit, that is to say, in respect of the £10,000 annual depreciation of the machine, which has not been directly charged as an expense but has instead been treated as a cost of producing the stock manufactured during that year). The effect on the company's reported profit would be the same: the profit which would otherwise have arisen, as the difference between the turnover and the cost of sales (costs, that is to say, other than the cost of fixed assets), is diminished by £18,000.

[113]     
A number of other points can be illustrated by this example. First, if the modern approach to accounting is adopted, the amount by which the company's reported profit is reduced by depreciation in any given year will not correspond to the amount by which the value of the company's fixed assets is written down in the balance sheet on account of depreciation during that year, unless either the company has no fixed assets used in the production of stock ( in which case the depreciation charged as an expense in the profit and loss account will be identical to the amount by which the fixed assets are written down that year in the balance sheet), or the depreciation included in the cost of the stock sold during the year is equal to the depreciation included in the cost of the stock produced during that year.

[114]     
Secondly, since it is possible that an item of stock may not be sold until after the assets used to produce it have been fully depreciated in the balance sheet (if, for example, a widget produced in year 1 is not sold until year 11), it is inherent in the modern approach to accounting that depreciation which has been treated as forming part of the cost of stock may not be fully charged in the profit and loss account until after the fixed asset used to produce the stock has been fully written down in the balance sheet.

[115]     
Thirdly, whether a company's accounts are prepared according to the traditional approach or the modern approach may well have an effect upon its taxable profit in any given year, insofar as the traditional approach is based upon matching cost and revenue (or what might be described as deemed revenue, in the form of the stock adjustment) in the year in which the cost is incurred, whereas the modern approach is based upon matching cost and revenue in the year in which the revenue arises. The difference in the treatment of depreciation, on the other hand, should not in itself affect the taxable profit, since the charging of depreciation in the profit and loss account, whenever and however it occurs, has to be disallowed for tax purposes. In particular, if the consequence of a company's accounts being prepared according to the modern approach is that it defers the charging of depreciation in its profit and loss account (because, for example, it holds stocks for prolonged periods prior to their sale), the company should not thereby either derive a tax advantage or suffer a tax disadvantage. If the amount of depreciation charged in the profit and loss account is reduced, the effect is to increase pro tanto the reported profit: in the above example, the reported profit is £2,000 greater than it would have been if the whole of the year's depreciation provision (as shown in the balance sheet) had been charged as an expense (since a total of £18,000 is charged, rather than £20,000). The taxable profit, on the other hand, will be the same if £18,000 is added back to the reported profit as it would have been if the whole £20,000 had been charged in calculating the reported profit and £20,000 had then been added back.

[116]     
Fourthly, if one were to calculate taxable profit by adding to the reported profit the amount by which the value of the fixed assets had been written down that year in the balance sheet, regardless of how depreciation had been treated in calculating the reported profit, one would arrive at a different amount of taxable profit, depending on the company's approach to the charging of depreciation in the profit and loss account. If, in particular, the company had charged the whole amount of the depreciation provision for the year in calculating its reported profit (as a company would do if it were following the traditional approach), then the amount added back would be equal to the amount of depreciation by which the reported profit had been reduced: in the example, the £20,000 added back would be identical to the £20,000 which had been charged as an expense in the profit and loss account. If, on the other hand, the modern approach had been followed, the amount added back would in all likelihood be different from the amount of depreciation by which the reported profit had been reduced: in the example, the £20,000 added back would be £2,000 greater than the £18,000 which had been charged (either expressly as an expense, to the extent of £10,000, or as an element in the cost of sales, to the extent of £8,000). Thus, if the depreciation provision disclosed in the balance sheet were automatically added back to the reported profit, regardless of whether the reported profit had actually been diminished by the whole of that amount, the taxable profit would be different (in the example, £2,000 greater) if the company had treated the depreciation of production assets as a cost and had charged it as an expense only when stock was sold, rather than charging depreciation immediately as an expense in the traditional manner. It might be thought that an approach to the calculation of taxable profit which makes the result dependent on the company's depreciation policy cannot be correct, since depreciation is concerned with capital, and the taxation of profits is concerned with income.

[117]     
The present taxpayers have prepared their accounts following what I have described as the modern approach to accounting since 1992. In computing their taxable profit for any given year, they have added back the net depreciation by which their reported profits were reduced in that year. That approach was accepted by the Revenue for several years. The Revenue now, however, maintain that the whole amount of the depreciation provision shown in the balance sheet for the year in question should be "added back" in computing the taxable profit for that year, even though the profit disclosed by the taxpayers' profit and loss and account has not been reduced by the whole of that amount.

[118]     
At first sight, it might be thought that the deferral of the point at which depreciation was charged as an expense should be reflected in the application of section 74(1)(f), as suggested above in the discussion of the example. Under section 74(1)(f), whatever has been deducted by way of depreciation in computing the company's profit has to be added back. Whether a given amount is deducted in year X or in year Y should have no effect on the taxable profit in either year, since the same amount has to be added back in year X or in year Y, as the case may be. It might also be thought, at first sight, that if the reported profit for a given year has not been reduced by the whole amount of the depreciation provision shown in the balance sheet for that year, then section 74(1)(f) does not authorise the "adding back" of that amount. The Revenue however argued the contrary, as explained below.

[119]     
The question referred to the Special Commissioners in the present case was:

"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."

More clearly expressed, the issue, as I understand it, is whether the amount to be "added back" to the reported profit for a given year, in order to arrive at the taxable profit for that year, is the whole of the amount by which the value of fixed assets has been written down during that year in the balance sheet, or is the amount by which the reported profit has been reduced because of depreciation. The "net amount" is the part of the year's depreciation which does not relate to production assets and is therefore charged that year as an expense in the profit and loss account, plus the depreciation which is included in the cost of sales during the year in question. Another way of describing the same figure is that the net amount is the depreciation provision for that year, as shown in the balance sheet, less the amount by which the depreciation included in the cost of the stock at the end of that year exceeds the depreciation included in the cost of the stock at the end of the previous year.

[120]     
Finally, by way of introduction, it is to be noted that the explanation of the factual circumstances contained in the Commissioners' decision is not altogether easy to understand. Some further explanation was provided, by agreement of the parties, during the hearing of the present appeal, and extensive reference was also made to the evidence before the Commissioners, in order to clarify their findings.

Accountancy practice

[121]     
It was common ground in the discussion before us that a distinction is drawn in modern accountancy practice between the depreciation of fixed assets which are used directly in the production of stock (e.g. casks) and the depreciation of fixed assets which are not so used (e.g. office furniture). In the case of the latter, the asset is depreciated over its useful economic life, and the depreciation provision made in any given year is charged as an expense in the profit and loss account for that year. In the case of the former type of asset, on the other hand, depreciation is treated differently.

[122]     
The relevant principle is stated in general terms in Statement of Standard Accounting Practice 9 ("SSAP 9"), Stocks and Long-Term Contracts, originally issued by the Accounting Standards Board in 1975 and revised in 1988. Paragraph 1 states:

"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."

Paragraph 3 states that the relevant costs, which require to be matched to revenue, "will include all related production overheads, even though these may accrue on a time basis". Paragraph 17 states:

"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."

Paragraph 19 defines the expression "cost of conversion" as including "production overheads (as defined in paragraph 20)". Paragraph 20 states:

"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"

Following this approach, when stocks are produced during a given year and remain unsold, the cost of producing those stocks - including the depreciation of fixed assets, so far as relating to production - is not charged to revenue in the year in question (so long as the cost exceeds the net realisable value), and therefore does not appear in the profit and loss account. Instead, the cost is carried forward to the following year: formally, this means that the cost is taken into account in the balance sheet as a current asset, under the heading of stocks. It is only when the stock in question is sold (or when its net realisable value is less than its cost) that the cost of producing the stock - including the depreciation which was carried forward - is charged to revenue, and therefore appears in the profit and loss account.

[123]      This approach is consistent with Financial Reporting Standard 15 ("FRS 15"), Tangible Fixed Assets, issued by the Accounting Standards Board in 1999. Paragraph 77 states:

"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"

(emphasis added). Accordingly, the value of a tangible fixed asset must be written down in the balance sheet, to reflect its depreciation, over its useful economic life. Whether the depreciation in respect of a given period should be charged as an expense in the profit and loss account, however, depends on whether that depreciation is permitted to be included in the carrying amount of another asset. So long, therefore, as the depreciation provision in respect of a fixed asset is properly included in the carrying amount of a current asset - stock - it is not to be charged as an expense in the profit and loss account.

[124]     
In relation to the interpretation of paragraph 77 of FRS 15, there was a dispute before the Commissioners, which was renewed during the hearing of the present appeal, as to whether the words "another asset", in the final sentence, referred only to fixed assets, or referred to any asset, including in particular stock. The Commissioners found (at paragraph 44 of their decision) that the latter interpretation was correct:

"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."

The Commissioners' interpretation of paragraph 77 appears to me to be correct, for the reasons they gave.

[125]     
In particular, it is apparent from Appendix III to FRS 15 that it is intended (subject to certain express qualifications) to comply with international accounting standards. In that regard, the Commissioners drew attention in particular to International Accounting Standard 2 ("IAS 2"), Inventories (effective from 1995). IAS 2 is concerned with the accounting treatment of "inventories", defined (by paragraph 4) as including assets held for sale in the ordinary course of business, i.e. unsold stock. Paragraph 5 states expressly that inventories "encompass finished goods produced". Paragraph 1 explains the objective of the Standard:

"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 ... ".

The conceptual framework appears to be the same as in SSAP 9 (perhaps unsurprisingly, since paragraph 46 of SSAP 9 states that "compliance with SSAP 9 will ensure compliance with ... IAS 2"). A cost may properly be treated as an asset (in which event it appears in the balance sheet), or as an expense (in which event it appears in the profit and loss account). If it is properly treated as an asset, then it will be carried forward until the related revenues are recognised (in the profit and loss account), at which point the cost will be recognised as an expense. In terms of paragraph 7 of IAS 2, the cost of inventories should include all "costs of conversion". The latter expression is defined by paragraph 10 as including production overheads, "such as depreciation ... of factory buildings and equipment". Under the heading, "Recognition as an Expense", paragraphs 31 and 32 state:

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

should be recognised as an expense in the period in which the related revenue is recognised. The amount of any write-down of inventories to net realisable value and all losses of inventories should be recognised as an expense in the period the write-down or loss occurs ...

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

inventories sold results in the matching of costs and revenues."

Like SSAP 9, therefore, IAS 2 envisages that the cost of producing stock - including the depreciation of the fixed assets involved - should be carried forward as an asset, as "inventories" (or stock), until the stock is sold, at which point the cost is charged as an expense.

[126]     
Even clearer guidance to the interpretation of paragraph 77 of FRS 15 is perhaps provided by International Accounting Standard 16 ("IAS 16"), Property, Plant and Equipment, effective from 1999. Paragraph 41 is in similar terms to paragraph 77 of FRS 15, stating in particular:

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

Paragraph 48 states:

"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"

(emphasis added). It is apparent from Appendix III to FRS 15 that it is intended to be consistent with IAS 16, subject to certain qualifications, none of which touches on paragraph 48 of the IAS.

[127]     
All the standards discussed - SSAP 9, FRS 15, IAS 2 and IAS 16 - are thus consistent in approving the treatment of depreciation of fixed assets used in the production of stock as part of the cost of that stock, to be carried forward as an asset until the stock is sold, and then charged as an expense. It is to be noted that, while only SSAP 9 and FRS 15 were directly relevant to UK companies at the material time, the Commissioners recorded (at paragraph 53 of their decision) that the International Accounting Standards had to be used by UK listed groups of companies for their consolidated accounts from 2005 onwards, and that individual companies could choose to move to those standards if they wished.

[128]     
If a manufacturing company were to prepare its financial statements in accordance with these standards, then part of the depreciation in its fixed assets in a given year would not be included as an expense in the profit and loss account (if stock remained unsold at the end of the year), but would instead be carried forward to the following year in the balance sheet as part of the carrying value of stock. In these circumstances, the company would not have made any deduction, in computing its profits, by reason of carrying forward that part of the depreciation: on the contrary, the whole point of carrying it forward is not to make a deduction at that stage, so that the deduction can be made at a later stage, when the stock in question is sold, enabling profit to be computed on what (from an accounting perspective) is regarded as a more realistic basis. Insofar as depreciation is carried forward, it is not deducted in the computation of profit, and, it might be thought, cannot therefore be "added back" under section 74(1)(f).

The Taxpayers' Accounts

[129]     
It was explained at the hearing of the present appeal, and was not in dispute, that the taxpayers, like most other manufacturing companies, have computerised stock systems which record automatically all the costs directly connected with the manufacture of the product at all stages in the production process. In broad terms, those systems include in the cost of the stock all production overheads, including depreciation in respect of the fixed assets used in the production process. For the purposes of the taxpayers' accounts, those systems produce a figure for the cost of the sales during the year (including the depreciation included in the cost of the stock sold), which can then be set against the figure for turnover.

[130]     
The Commissioners' findings in relation to this matter are expressed in terms which reflect the evidence but which might benefit from further explanation. They state (at paragraph 27 of their decision):

"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.)"

[131]     
As the Commissioners noted (at paragraph 26), the spirit has to be matured in an excise warehouse in Scotland for a period of three years before it can be described as Scotch whisky. It appears from the evidence (e.g. the witness statement of Mr. Ewan Henderson at paragraphs 4.4 to 5.3) that the expression "cost of make" refers to the cost of producing the raw spirit, expressed as a cost per litre. It includes depreciation of the relevant fixed assets, such as stills. The cost of holding the maturing spirit, until it becomes whisky, is added to the cost of make in order to determine the cost of stock for each year's production. The cost of holding the maturing spirit includes depreciation of warehouse buildings and casks. Once the spirit produced in a given year has become whisky, the cost of subsequent warehousing of the whisky is treated as an expense, rather than being added to the cost of the stock. For each year's stock, a total "spirit cost" is determined. This is the total of the cost of make plus the cost of the first three years' warehousing, adjusted to reflect losses (e.g. due to evaporation) which occur as the whisky matures and when the casks are emptied. This spirit cost forms part of the final "pack cost" of each case or litre of whisky sold (the other components of the final pack cost being such matters as packaging materials, distribution and customer relations). A pack cost is thus produced for each unit sold, and is charged to the profit and loss account as the "cost of sales" when the pack is sold to a customer. In this way, the cost of production is matched with the sales, as envisaged by SSAP 9. For example, when a pack of "Glenfiddich 12 year old" is sold, the "pack cost" will include the cost of producing the whisky twelve years ago (including the depreciation of the relevant fixed assets during that year, divided between each litre produced), and the first three years' warehousing costs (including the depreciation of the buildings and casks during those years, divided between each litre produced).

[132]     
This approach is reflected in the taxpayers' statutory accounts. It is a matter of agreement that the accounts give a true and fair view of the taxpayers' affairs and have been properly prepared in accordance with the Companies Act 1985. The profit and loss account for the year ended 28 December 2002 showed an operating profit of £31,705,000, brought out as follows:

 

Note

2002

£000

2001

£000

Turnover

2

137,512

123,790

Cost of sales

 

99,340

93,185

Gross profit

 

38,172

30,605

Administration expenses

 

6,467

6,277

Operating profit

4

31,705

24,328

As explained above, the figure for "cost of sales" is the "pack cost" of the whisky which was sold to produce the turnover, and includes the depreciation which formed part of the "spirit cost" of that whisky. That depreciation is of course distinct from the provision for depreciation of fixed assets made in the balance sheet in respect of 2002.

[133]     
In relation to fixed assets, the balance sheet as at 28 December 2002 states:

 

 

Note

2002

£000

2001

£000

Fixed assets

Tangible assets:

7

   

Land and buildings

Plant, vehicles and casks

 

43,709

46,776

45,176

48,541

[134]     
Note 7 to the accounts states:

7. Tangible fixed assets

   

Freehold land

and buildings

£000

Plant, vehicles

and casks

£000

Cost:

At 29 December 2001

 

61,789

117,774

Additions

Disposals

 

119

(1)

3,362

(163)

At 28 December 2002

 

61,907

120,973

Depreciation:

At 29 December 2001

 

 

16,613

 

69,233

Provided during the period

 

1,585

5,120

Disposals

 

-

(156)

At 28 December 2002

 

18,198

74,197

Net book value:

At 28 December 2002

 

 

43,709

 

46,776

At 29 December 2001

 

 

45,176

48,541

The amount by which the value of the taxpayers' fixed assets has been written down in 2002 by reason of depreciation is therefore £1,585,000 (on land and buildings) plus £5,120,000 (on plant, vehicles and casks), i.e. £6,705,000 altogether.

[135]     
In relation to current assets, the balance sheet states:

 

Note

2002

£000

2001

£000

Current assets

Stocks

9

178,315

180,945

In order to understand the figure for stocks, and more generally in order to interpret the accounts as a whole, it is necessary to have regard to note 1 to the accounts, which explains the basis upon which they have been prepared:

"1. Accounting policies

Basis of preparation

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

Depreciation

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

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-

out basis.

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

goods 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."

An informed reader, familiar with the accounting approach described in SSAP 9, would expect, from this explanation, that a proportion of the year's provision for depreciation would be carried to stock, and that only the balance of the year's depreciation would be charged immediately as an expense in the profit and loss account.

[136]     
That expectation is indeed confirmed by note 4 to the accounts, which explains the basis of the figure for operating profit in the profit and loss account:

"4. Operating profit

This is stated after charging/(crediting):

 

Note

2002

£000

2001

£000

Depreciation:

- owned assets

- leased assets

 

5,852

853

6,204

943

- included within stock

 

(1,695)

(1,571)"

As explained above, the total amount by which the fixed assets were written down for depreciation in 2002, in the balance sheet, was £6,705,000. That sum is the total of £5,852,000 and £853,000: the only difference between note 7 and note 4, so far as the sum of £6,705,000 is concerned, is that note 7 divides that amount between different categories of asset (land and buildings on the one hand; plant, vehicles and casks on the other hand), whereas note 4 divides the same amount according to whether the assets are owned or leased. What note 4 then makes clear is that only part of that amount has been charged as an expense in calculating the profit for the year: £1,695,000 has been included in the cost of stock produced during 2002 (and will therefore be debited in the profit and loss account, as part of the cost of sales, only when the stock in question comes to be sold). In other words, the amount of depreciation in fixed assets during 2002 which has been deducted as an expense in calculating the profit for 2002 is £5,010,000 (i.e. £6,705,000 minus £1,695,000). This is reflected in the Commissioners' findings (at paragraph 30 of their decision):

"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."

[137]     
In order to calculate the taxable profit for 2002, it is therefore necessary to add back the £5,010,000 to the operating profit stated in the profit and loss account. That is not however the whole story, since the cost of sales also included depreciation: in particular, depreciation from earlier years which had not at that time been deducted from profit but had instead been carried forward in the balance sheet in the figure for stock. It is therefore necessary to ascertain the amount of depreciation included in the cost of sales, so that that amount can also be added back.

[138]     
In relation to this matter, the Commissioners state (at paragraphs 31 to 33 of their decision):

"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."

[139]     
These matters were explained in greater detail in the evidence. In order to understand the issues, it may be helpful to summarise some of that evidence (e.g. section 7 of Mr. Henderson's statement), which was referred to during the hearing of the present appeal and was not contentious. As explained earlier, the taxpayers record the cost of producing raw spirit each year and warehousing it for the three years until it becomes Scotch whisky. Their records of the cost of each year's whisky include the amount of depreciation included in that cost. Their stock records therefore show, for each year's production, the amount of depreciation that has been carried forward rather than being charged as an expense in the profit and loss account. The taxpayers also record the location and contents of each cask of whisky, so that the amount and year of production of the whisky in every cask is known. When a cask is emptied, the amount of whisky obtained is also recorded. It is therefore possible to ascertain how much of each year's production has been sold in a given year, and thus to determine how much depreciation is included in the cost of sales. If, for example, in 1992 a total of £1m of depreciation was carried forward in the figure for the stock produced that year, and in 1995 20 per cent of the 1992 stock was sold, then £200,000 of depreciation (i.e. 20 per cent of £1m) would be included that year in the cost of sales in respect of that stock. In order to compute the taxable profit, it would be necessary to add back that £200,000. The same approach would apply, mutatis mutandis, in respect of all other stock sold during the year in question.

[140]     
The taxpayers' computation of their taxable profit for 2002 is based on this approach. Schedule C7 to the computation shows the treatment of depreciation which has been included in the figure for stock. It states, first, the part of the annual provision for depreciation, for each year from 1992 to 2002, which was carried forward in the balance sheet in the figure for stock instead of being treated as an expense in that year's profit and loss account. For example, for 2001 the figure was £1,571,166; for 2002 the figure was £1,694,868. Those are the figures which appear (rounded) in note 4 to the 2002 profit and loss account. The computation next states the amount of depreciation carried forward from previous years which was "released" to the profit and loss account during the year in question (released, that is to say, by being debited as part of the cost of sales). For example, for 2001 the figure was £1,195,819; for 2002 the figure was £1,580,273. The difference between the current year's depreciation provision carried forward, and the prior years' depreciation released to the profit and loss account, is then calculated. For 2001 and 2002, for example, the calculations are stated as follows:

 

28 Dec 2001

28 Dec 2002

Current year depreciation debited to stock

Prior year depreciation released to profit and loss account

£1,571,166

 

(1,195,819)

£1,694,868

 

(1,580,273)

Net current year movement

£ 375,347

£ 114,595

[141]     
In their computation of their taxable profit for 2002, the taxpayers take as their starting point the figure of £31,647,476. That is the figure which is stated (rounded to the nearest thousand) as their operating profit in the profit and loss account. They then add back £6,590,028 in respect of depreciation. That sum is the total of two amounts. The first amount is the part of the depreciation provision for 2002 which was deducted in arriving at the figure of £31,647,476, as explained in note 4 to the accounts, i.e. the total provision for depreciation in 2002 of £6,704,623 (rounded in the accounts to the nearest thousand) less the part of that depreciation which was carried forward in the cost of the stock produced that year, namely £1,694,868. The second amount is the depreciation carried forward from previous years which was included in the cost of sales during 2002, i.e. £1,580,273. In other words, since the operating profit of £31,647,476 was calculated by deducting from turnover a figure for cost of sales which included £1,580,273 of depreciation which had been carried forward from earlier years, and by charging £5,009,755 (i.e. £6,704,623 minus £1,694,868) in respect of depreciation in fixed assets during 2002, the taxpayers therefore add back those two amounts, totalling £6,590,028, in order to arrive at the taxable profit in accordance with section 74(1)(f).

[142]     
The contention of the Revenue, on the other hand, is that it is necessary to "add back" to the figure of £31,647,476 the whole of the amount of depreciation in fixed assets during 2002, i.e. £6,704,623. The difference between the parties, so far as the taxable profit for 2002 is concerned, is £114,595 (i.e. £6,704,623 minus £6,590,028). On the Revenue's approach, however, the depreciation which has been carried forward from earlier years, and has not yet been brought into the profit and loss account as a "cost of sales" (because the stock in question has not yet been sold) must similarly be "added back" in order that the taxable profits for earlier years can be re-calculated. The cumulative amount of depreciation carried forward in stock, as at 28 December 2002, was £9,567,271 (as appears from schedule C7 to the taxpayers' computation). That is why the Commissioners referred to that figure (in paragraph 33 of their decision, quoted earlier), not altogether accurately, as the "amount which is the subject of the appeal".

[143]     
Returning for a moment to the question referred to the Commissioners, the "gross amount of depreciation", in respect of the year to 28 December 2002, is £6,704,623. That is the amount by which the value of fixed assets has been written down in the balance sheet by reason of depreciation during that year. The "net amount (after adjusting for depreciation included in opening and closing stock)" is £6,590,028. The latter sum is the part of the year's depreciation which does not relate to production assets and is therefore charged immediately as an expense in the profit and loss account (£6,704,623 less £1,694,868, i.e. £5,009,755), plus the depreciation which is included in the cost of sales during the year (£1,580,273). The net amount can also be described as the depreciation provision for the year as shown in the balance sheet (£6,704,623) less the amount by which the depreciation included in the cost of the stock at the end of that year exceeds the depreciation included in the cost of the stock at the end of the previous year (the increase in depreciation included in stock being £1,694,868 less £1,580,273 i.e. £114,595). It is a matter of agreement that the net effect of depreciation on the company's reported profit is £6,590,028, i.e. if depreciation had been left out of account altogether, the profit disclosed by the profit and loss account would have been increased by £6,590,028. The Revenue's argument, however, is that the profit and loss account must be understood as debiting the gross amount of £6,704,623 and then crediting the figure of £114,595 (or £1,694,868 less £1,580,273). They argue that section 74(1)(f) requires the gross amount to be added back, and that that add-back cannot be reduced by the adjustment of £114,595, since (put shortly) the latter figure relates not to depreciation but to stock. The rejoinder of the taxpayers (put shortly) is that £6,704,623 cannot properly be added back to the reported profit, since that amount was not deducted in the first place in arriving at the reported profit.

The Commissioners' Decision

[144]     
Before considering the parties' submissions, it may be helpful first to discuss certain aspects of the Commissioners' decision. At paragraph 65, the Commissioners noted the decision in Addie:

"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."

That was, indeed, the conclusion at which the Commissioners arrived, at paragraph 95:

"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."

The reasoning by which the Commissioners arrived at this conclusion is, however, in some respects difficult to understand, and was not supported in its entirety by either party to the present appeal.

[145]     
The Commissioners appear to have considered that the amount by which fixed assets were written down for depreciation in the balance sheet in a given year ought logically to be reflected in an equivalent charge for depreciation in the profit and loss account for that year, even though they noted, at paragraph 70, that paragraph 77 of FRS 15

"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)."

The Commissioners continued (at paragraph 71):

"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."

It is unclear why the Commissioners considered that there was an inconsistency between writing off the value of a fixed asset in the balance sheet over the period of its economic life, and charging the depreciation as an expense in the profit and loss accounts for a different period. It was common ground between the parties that the accounts had been produced in accordance with generally accepted accountancy practice and with the relevant statutory requirements: the Commissioners noted, in particular (at paragraph 54), the evidence of the Revenue's expert witness that the accounts showed a true and fair view and complied with the requirements of the Companies Act 1985. As already explained, where an asset is used to produce another asset, modern accounting practice requires the depreciation provision in respect of the first asset to be included in the carrying amount of the second asset, rather than being treated immediately as an expense. In those circumstances, it is only when the second asset - stock- is sold, that the depreciation is debited to the profit and loss account as part of the cost of the sale. There is, of course, no logical connection between the date of the sale of the stock and the date of the scrapping of the depreciated asset which was used to produce the stock. There does not appear to me to be any logical contradiction involved in treating the depreciation of assets used in production as a cost of producing stock, which, for the purpose of computing profits, should be matched with the revenue derived from the sale of the stock at the point in time when the stock is sold, even though the asset itself may by then have been scrapped.

[146]     
It was apparently because of their view that there was such an inconsistency that the Commissioners employed the concept of a "contra" item, notionally present in the profit and loss account. In relation to that matter, they said (at paragraphs 72 to 73):

"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."

[147]     
I find this passage difficult to understand. Note 4 to the accounts explains that part of the depreciation in fixed assets in 2002 is included in the figure for stock in the balance sheet, and that only the balance has been charged as an expense in the profit and loss account. I cannot see any inconsistency between note 4 and the provision for depreciation shown in the balance sheet. As I have mentioned, it was common ground that the accounts were properly prepared. The Commissioners appear however to have considered that, in order to avoid an inconsistency between the profit and loss account and the balance sheet, there was in theory a deduction in the profit and loss account of the total depreciation provision for the year (what the Commissioners described as "gross depreciation"), with a "contra" adjustment in respect of the part of the depreciation for the year which was carried forward. They then appear to have regarded the correct characterisation of the "contra" as important to the determination of the appeal. It was common ground, at the hearing of the present appeal, that this reasoning had not been suggested by any party to the proceedings before the Commissioners.

[148]     
I also note that in this passage (and in paragraph 30) the Commissioners appear to have thought that the net depreciation which had been deducted in computing profits was the depreciation provision for the year (£6,704,623) less the part of that provision which was included in the carrying figure for stock (£1,694,868). Numerically, that figure is £5,009,755. That figure, however, leaves out of account the depreciation from previous years which was charged as part of the cost of sales (£1,580,273). The latter figure has to be added to £5,009,755 in order to arrive at the net amount of depreciation to which the question before the Commissioners referred, i.e. £6,590,028. The Commissioners noted (at paragraph 66) that the latter figure was the net depreciation which had been deducted in computing reported profits; but the discussion of net depreciation in the passage last quoted suggests that they may not have understood what that figure represented.

[149]     
At paragraph 77 of their decision the Commissioners identified a central flaw in the Revenue's reasoning, as it appears to me:

"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 other words (and avoiding the Commissioners' use of the term "capitalised", by which they appear to mean the inclusion of depreciation in the figure at which an asset is stated), when a company writes down the value of a fixed asset in its balance sheet by reason of depreciation, it does not thereby earn any income or incur any expenditure. Equally, if it carries forward that depreciation in its balance sheet in the figure at which stocks are stated, it does not thereby earn any income or incur any expenditure. It is only when it takes the depreciation into account so as to reduce its profits - whenever that may be - that the depreciation is treated as an expense, diminishing the company's income; and it is at that point that the amount which has been deducted for depreciation in calculating the company's income must be added back for tax purposes.

[150]     
At paragraph 90 of their decision the Commissioners returned to their theory of a "contra":

"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."

They then reached their decision, seemingly on two alternative bases. One possibility was that the "contra" could be accepted as having the effect that only the "net depreciation" was deducted in the profit and loss account, in which case only the net depreciation had to be added back. Alternatively, if the "contra" could not be accepted as having that effect, with the consequence that the "gross depreciation" must be taken to have been charged in the profit and loss account, then, the Commissioners stated (at paragraph 94):

"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."

Neither party sought to support this reasoning, and I am not certain that I understand quite what was meant.

The submissions for the Revenue

[151]     
The parties' submissions have been narrated by your Lordship in the chair. I need only discuss the submissions for the Revenue, as my own reasoning largely reflects the submissions made on behalf of the taxpayers. The submissions for the Revenue could be summarised as advancing two propositions. The first was that, as a matter of fact, the taxpayers had charged the whole amount of that year's provision for depreciation as an expense in the profit and loss account, and had then purported to set off the amount of depreciation included in the figure for closing stock. Since depreciation and stock were ontologically distinct categories, such a set off was impermissible: stock was a physical asset, not a bundle of costs, and the figure for stock in the accounts was therefore an indivisible sum which could not be treated as including depreciation. The second proposition was that where an allowance for depreciation of fixed assets was made in the balance sheet, it was legally impossible to do other than charge the whole of that depreciation as an expense in the profit and loss account for the period at the end of which the balance sheet had been drawn up, and therefore the whole of that depreciation must be added back for tax purposes.

[152]     
The first proposition took as its starting point a passage in the evidence of Mr. Henderson, the taxpayers' group tax manager, in which he replied in the affirmative to a question whether, in the profit and loss account, he took the whole of the year's depreciation as an expense, and subsequently moved part of it into stock. Mr. Henderson explained that the taxpayers maintain separate management accounts for each of their production centres, in which all the costs of production at each centre (including depreciation) are totalled. The cumulative production costs of all the production centres are then totalled, so as to arrive at the total production costs for the year. In preparing the profit and loss account, that figure is treated as a debit, but is adjusted by crediting the figures for depreciation included in "cost of make" and "warehousing costs", which are debited to stock. During the hearing of the present appeal, it was further explained that the taxpayers' record-keeping system, which is computerised, is programmed to produce figures for expense headings, including depreciation, out of which there are credited at the end of the year sums which contribute to the cost of the stock.

[153]     
This explanation of the taxpayers' internal book-keeping (as to which the Commissioners made no findings) is not in my opinion of critical importance: it would be unfortunate if it were, in a case where the Revenue seek a decision on an issue of general importance, since a different book-keeping system could doubtless be adopted. Whether the depreciation included in "cost of make" and "warehousing costs" is entered directly in the balance sheet, or is first put through the profit and loss account, can in my opinion be described, in the words of Lord Millett N.P.J. in Commissioners of Inland Revenue v. Secan Ltd. (2000) 74 T.C. 1 at page 6, as

"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".

For the purposes of section 74(1)(f), what is important, as it seems to me, is to ascertain the amount by which the reported profits have been diminished by a deduction of a capital nature. That is a question of substance rather than of form. Whether the reported profits are computed by first deducting the total depreciation provision for the year and then crediting the part of that depreciation which is treated as a cost of stock, or by deducting a figure representing the difference between those two amounts, appears to me to be of no consequence, since both methods have the same effect upon the amount of the reported profit. However depreciation affects the reported profit, that effect must be undone in order to arrive at the taxable profit. Furthermore, even if the first method were adopted, the adjusting credit entry would not represent a taxable receipt. What has to be considered, in other words, is the final position as to profit, and the extent to which that profit has been reduced by depreciation, rather than the internal accounting process by which that position has been arrived at.

[154]     
What I have described as the ontological argument appears to me to be in any event unsound. There is no doubt that depreciation is of a different nature from stock. One is a reduction in the value of fixed assets; the other is (in the present case) whisky. Accounts, on the other hand, do not contain whisky, but figures representing the cost of the whisky (or its net realisable value, if lower). Although, as the Revenue submitted, stock is not a bundle of costs but consists of physical assets, the figure at which stock is stated in accounts is cost or net realisable value, whichever is the lower. If stock is stated at cost, the appropriate figure is the cumulative total of all the production costs, including (in accordance with modern accounting practice) the depreciation of production assets. In those circumstances, the depreciation included in the cost of stock is not charged as an expense until the stock is sold (or until the cost of the stock exceeds its value, if that situation should arise). If the depreciation relates to other fixed assets, however, then it is immediately charged as an expense. Accountants therefore distinguish between depreciation which should be charged at once as an expense and depreciation which should not. Note 4 to the taxpayers' accounts discloses how that distinction has been drawn in respect of the depreciation provision for 2002, by deducting the depreciation included in the cost of stock from the total provision for depreciation reflected in the figure for fixed assets. That deduction does not involve any form of confusion between depreciation and stock. Nor would there be any such mistake if, instead of note 4, the profit and loss account were itself to show a debit for the whole of the year's depreciation provision and a credit for the depreciation included in the figure for stock.

[155]     
The Revenue's second proposition - that it is legally impossible to do other than charge the whole of the year's depreciation as an expense in that year's profit and loss account, and that the whole of the year's depreciation must therefore be added back - was advanced on two bases. The first was that, as a matter of income tax law, the closing stock must be taken into account in the profit and loss account as a notional receipt. If depreciation was included in the figure for closing stock, it must therefore be treated as a notional receipt: it lost the character of depreciation, since "stock" comprised physical assets. The second basis was that the Companies Act 1985 requires that whatever provision is made for depreciation in a company's balance sheet must be matched by an equivalent deduction in the corresponding profit and loss account.

[156]     
In relation to the first of these matters, counsel for the Revenue relied primarily upon the passage from the opinion of Lord President Clyde in Whimster which I have quoted, and in particular the statement that:

"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)".

In its context, the purpose of that statement was to give an example of the ordinary principles of commercial accounting, as recognised in 1925. The Lord President was not in my opinion laying down, for all time, a rule of law that closing stock must enter into the computation of profit, regardless of changes in accountancy practice. The relevant rule of law, as it seems to me, is what Lord Loreburn L.C. described in Sun Insurance Office v. Clark [1912] AC 443, at page 454, as

"the only Rule of Law that I know of, viz: that the true gains are to be ascertained as nearly as it can be done."

I do not overlook the fact that Viscount Simonds said, in Minister of National Revenue v. Anaconda American Brass Ltd. [1956] AC 85, at page 100, that

"The income tax law of Canada, as of the United Kingdom, is built upon the foundations described by Lord Clyde in Whimster",

and cited the passage from which I have quoted (including the observation about closing stock). The principle of bringing closing stock into account was not however in question in that case. I also note that Viscount Simonds subsequently referred to the same passage in Whimster, in Duple Motor Bodies v. Ostime [1961] 1 WLR 739 at pages 747-748, as being based on the practice of accountants.

[157]      As explained earlier, the purpose of taking closing stock into account, in computing profits, was to arrive at a realistic figure for the profit for the period, in a situation in which the expenditure used to produce that stock was itself being taken into account. The closing stock was treated as a notional receipt (as Nolan L J. explained in Gallagher v. Jones [1994] Ch. 107, at page 136) in order to match the expenditure incurred during the period of the accounts with the receipts (including that notional receipt) generated by the expenditure. Modern accountancy practice, on the other hand, as exemplified by SSAP 9, seeks to match cost and revenue in the year in which the revenue arises: an objective which is entirely consistent with what Lord President Clyde described as the fundamental commonplace that the profits of a year or accounting period

"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".

Since costs used to generate unsold stock are not brought into account, equally the unsold stock itself does not require to be brought into account. Plainly, the modern approach may not produce the same figure for profit in any given year as the older approach (although, over time, both approaches should produce more or less the same aggregate profit), and, as Lord Reid observed in Duple Motor Bodies (at pages 752-753), both cannot be true figures of profit for the same year. The reason why the accountancy profession prefers to match cost with revenue in the year when the revenue arises, rather than in the year when the cost is incurred, is that it is considered to produce a more realistic measure of profit. I see no reason, consistent with the dictum of Lord Loreburn L.C. which I quoted earlier, why (in general, and subject to any particular circumstances which might indicate otherwise) the court should insist on any other approach being adopted. On the contrary: as was observed by Sir Thomas Bingham M.R. in Gallagher v. Jones at page 123, it is "a very fundamental principle, that tax is to be charged on a taxpayer's real, or actual, profit". His Lordship quoted the dictum of Lord Herschell in Russell v. Town and Country Banks Ltd. (1888) 13 App. Cas. 418 at page 424:

"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."

At a time when it was not, in general, technically possible to match actual receipts with the expenditure necessary for the purpose of earning those receipts, it was considered appropriate to treat closing stock as a notional receipt, so that it and the actual receipts could be matched with the expenditure incurred during the year in question. The modern approach, however, by making use of sophisticated record-keeping systems which did not exist in 1925, aims to calculate, as accurately as possible, the actual profit as defined by Lord Herschell. Once it becomes technically possible to match actual receipts with the expenditure incurred in order to earn them, and once it is recognised that there is no rule of law requiring expenditure to be deducted in the year in which it is incurred (Gallagher v. Jones), the line of reasoning which required closing stock to be treated as a notional receipt becomes unnecessary.

[158]     
Counsel for the Revenue also founded on the judgment of Lord Millett N.P.J. in Commissioner of Inland Revenue v. Secan Ltd., a decision of the Court of Final Appeal of the Hong Kong Special Administrative Region. Lord Millett described the traditional manner of preparing a profit and loss account, and observed (at page 10), under reference to a number of cases, including those I have mentioned:

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

His Lordship was not however addressing an argument that a different system of preparing accounts was possible and was generally accepted to produce a more accurate result. I do not understand his Lordship to have intended to lay down a rule of law that the opening and closing stock must always be entered in a profit and loss account, regardless of developments in generally accepted accounting practice.

[159]     
Generally, in relation to this matter, I would respectfully adopt the following observations from the judgment of Sir Thomas Bingham M.R. in Gallagher v. Jones, at page 134:

"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."

Observations to similar effect were also made by Nolan L.J. (at page 140) and by Sir Christopher Slade (at pages 141-142).

[160]     
In relation to the Companies Act 1985, it was submitted on behalf of the Revenue (notwithstanding the agreement that the accounts had been prepared in accordance with that Act) that the taxpayers' contention that only the net amount of depreciation had been deducted in computing the reported profit, and that therefore only that net amount required to be added back for taxation purposes, was inconsistent with paragraph 18 of Schedule 4, with which the taxpayers were required to comply by virtue of section 226. Paragraph 18 provides:

"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

the end of the period of its useful economic life, its purchase price or production cost less that estimated residual value, shall be reduced by provisions for depreciation calculated to write off that amount systematically over the period of the asset's useful economic life."

It was submitted that the implication of the taxpayers' contention was that the value of certain fixed assets was not being written off over the assets' economic life but over some longer period. I am unable to accept that submission. Paragraph 18 is one of a number of provisions concerned with the amount to be included in accounts in respect of any fixed asset (as appears also from paragraph 17). It is in a company's balance sheet, not in its profit and loss account, that amounts appear in respect of fixed assets. It is in the balance sheet that provision must be made for depreciation in the value of assets of the kind described in paragraph 18. In the taxpayers' balance sheet, the amount included in respect of fixed assets is subject to provision for depreciation in accordance with paragraph 18. There is no suggestion that the balance sheet fails to state accurately the value of the taxpayers' assets: on the contrary, it is a matter of agreement that the accounts give a true and fair view.

[161]     
Generally, the implications of the Revenue's approach can be illustrated by the example of a company in its first year of activity which has incurred expenditure of 100 in producing goods, none of which it has yet sold, and has depreciated its fixed assets, used in the production of the goods, by 25. Following the traditional accounting approach described in Whimster, the company's profit and loss account would show a loss of 25: the closing stock of 100 would be balanced by the expenditure of 100, but the depreciation of 25 would also be charged as an expense. For tax purposes, however, the deduction of 25 in respect of depreciation would be added back, and the company would have made neither a profit nor a loss. Applying SSAP 9, the profit and loss account will show nil profit or loss: the turnover, and the cost of sales, are both nil. On the Revenue's approach, however, the company would seemingly be taxed on the basis that it has made a profit of 25, either on the basis that the stock at the end of the year, which appears in the balance sheet at 125, is a notional credit in the profit and loss account, from which expenditure of 100 is deducted, or on the basis that it is necessary to "add back" the depreciation of 25 which has been carried forward in the balance sheet. This appears to me to be conjuring a profit out of thin air: the company has not in fact made a profit; a computation based on the Whimster approach would not show a profit; and the 25 "added back" was not deducted by the company in computing its profit in the first place. The lack of realism is reflected in the consideration that, on the Revenue's approach, the company's taxable profits will depend on the rate of depreciation which it applies.

[162]     
Lest it be thought that this example turns on the fact that it concerns the first year of trading, one can also consider the position in the subsequent year, on the assumption that the company has sales of 200 (comprising 80 per cent of the stock produced during the previous year, and 20 per cent of the stock produced during the current year), closing stock of 100 (before depreciation is taken into account), expenditure of 100 and depreciation for the year of 30. Following the Whimster approach, the company's profit and loss account would show a profit of 70: on the credit side there would be the sales and the closing stock, totalling 300, and on the debit side there would be the expenditure of 100, the depreciation for the year of 30, and opening stock of 100, totalling 230. For tax purposes, the depreciation for the year of 30 would be added back, producing a taxable profit of 100. Applying SSAP 9, the profit and loss account would show a profit of 74: turnover of 200, less cost of sales of 126 (expenditure of 100, plus depreciation in respect of year one's stock of 80 per cent of 25, i.e. 20, plus depreciation in respect of year two's stock of 20 per cent of 30, i.e. 6). On the taxpayers' approach, the depreciation of 26 which was included in the cost of sales would have to be added back, producing a taxable profit of 100. On the Revenue's approach, however, it would seemingly be necessary to "add back" the year's depreciation provision of 30, producing a taxable profit of 104 (i.e. 74 plus 30). On the Revenue's approach, the company's taxable profits will again depend on the rate of depreciation which it applies (if, for example, the company's depreciation provision in year two had been 20, the Whimster approach and the taxpayers' approach would still produce a taxable profit of 100, but the Revenue's approach, as I understand it, would produce a taxable profit of 96). Taking the two years together, the Whimster approach and the taxpayers' approach would both produce taxable profits of 100; the Revenue's approach would produce taxable profits of 129.

[163]     
In effect, the Revenue's approach treats the carrying forward of depreciation as creating a taxable profit: if a company prepares its accounts in accordance with SSAP 9 and FRS 15, then its taxable profits for any year will be increased (on this approach) to the extent that it carries forward part of its depreciation provision for the year, and will to that extent depend on its accounting policy for depreciation. A tax on revenue will thus depend on the company's treatment of capital.

Summary

[164]     
In summary, it appears to me that the purpose of section 74(1)(f) of the 1988 Act is to ensure that, for the purposes of taxation, a company's profits are not reduced by any deduction in respect of capital employed in the business. Accordingly, to the extent that the company's reported profits have been reduced by any such deduction (including any deduction by reason of depreciation in the value of fixed assets), section 74(1)(f) requires that reduction to be cancelled by adding back an equivalent amount.

[165]     
The whole of the provision for depreciation in the value of fixed assets made in a company's balance sheet in respect of a given year has to be added to its reported profits, in order to avoid a breach of section 74(1)(f), only if those profits have been reduced by deducting the whole of that provision. Whether that has occurred is a question of fact. If part of the depreciation provision has not been so deducted in the year in question, but has been carried forward to a subsequent year, then section 74(1)(f) does not require it to be "added back".

[166]     
The carrying forward of depreciation, by treating it as a cost of stock and deducting it from profits only when the stock is sold, is in accordance with generally accepted principles of accountancy. I am unable to accept the submission that that practice violates the principles of income tax law. Nor do I accept the submission made on behalf of the Revenue that that practice enables taxpayers to secure a tax advantage by evading section 74(1)(f): whenever taxpayers reduce their reported profit by deducting depreciation - whether in the year in which the depreciation provision was made in their balance sheet, or in a subsequent year - the amount of the deduction will be added back in computing their taxable profit.

[167]     
It is possible that, applying this approach, depreciation may be carried forward, and eventually charged as an expense, after the fixed asset has itself been scrapped. This consequence does not however appear to me to be anomalous. The value of the asset is written off in the balance sheet over its economic life. Whether the annual provision for depreciation is charged as an expense in computing profits in that year or in a subsequent year appears to me to be a separate issue. The consequence of matching cost with revenue in the year in which the revenue arises, in accordance with SSAP 9, is that depreciation, so far as it is treated as a cost of production, may correctly be charged as an expense in a future year.

Conclusion

[168]     
In the whole circumstances, I regret that I find myself unable to agree with your Lordships. I would have affirmed the decision of the Commissioners and refused the appeal.

 

 


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