Tim Ambrose,Vice-President of the Institute, challenges the Revenue’s new interpretation on Depreciation in Stock. This article appeared in the September 2002 issue of Tax Adviser.
‘The amount or value of an asset is, of course, a credit
on the asset side of the balance sheet.’
‘Accountants do not possess a philosopher’s stone which can turn a debit into an asset.’
I expect that most readers will find these two statements puzzling. Most will think they are clearly incorrect. So will the accountancy profession and all bookkeepers, whose first rule is‘A Debit is an asset or expense, a Credit is a receipt or liability.’
But to Her Majesty’s Inland Revenue they are perfect sense !
The statements were made by Lord Millett, one of the United Kingdom (UK) Law Lords, in the course of a judgment in the Court of Final Appeal of the Hong Kong Special Administration Region (IR v Secan Limited, judgement 8 December 2000). The case concerned a Hong Kong property development company which had ‘capitalised’ its interest costs into Work in Progress as part of the cost of its property development in its financial statements, but which subsequently sought to obtain a tax deduction for the interest during the year it was incurred. It is not clear from the case whether the company was seeking only to deduct the interest earlier for tax purposes, or whether it was actually hoping to gain a double deduction for the interest (firstly as interest, when incurred, and later, as part of cost of sales, when the property was sold). The Hong Kong court held, quite properly in my opinion, that the tax treatment should follow the proper accounting treatment which had been adopted by the company, so that the interest should be deducted once only and as part of the cost of sales when the property was sold.
If matters had stopped there the case would have merited no more than a footnote as another small victory for common sense.
But the Judge thought it necessary to give an extraordinarily convoluted, and certainly contentious, explanation of the bookkeeping process - including the two statements at the head of this article and more in a similar vein. His words have since been picked up by the Revenue as justification for reversing their acceptance of a long standing, and in my view entirely correct, adjustment in a similar situation where a company includes depreciation in stock – see IR Bulletin issue 59, 24 June 2002: Interpretation – Depreciation in Trading Stocks.HM Revenue and Customs
By way of background, it may be helpful to remember that ever since the general adoption of Statement of Standard Accounting Practice (SSAP) 9 which became mandatory in the 1980s, companies have been obliged to state their stocks in their financial statements at ‘the lower of cost and net realisable value’, and cost is defined to include the cost of purchase, direct production costs, production overheads (specifically including depreciation) and the cost of other overheads attributable to bringing the product to its present location and condition. Statement of Standard Accounting Practice 9 is consistent with International Accounting Standard (IAS) 2 on the Valuation of Inventories, and with the UK Companies Act 1985, both of which require or allow the inclusion of a reasonable proportion of production overheads in the cost of stocks.
So where the production overheads include depreciation of the fixed assets used in the manufacturing process, companies must include an element of that depreciation in the cost of their stocks.
In many businesses, particularly those with a high turnover of stocks, or a quick manufacturing process, the depreciation element may be insignificant, and in practice it is frequently ignored. But in certain industries there are businesses which can directly attribute a substantial level of depreciation to their carrying value of stock. (such businesses generally maintain extremely precise costing records which show the cost of depreciation in each item of stock).
Unseen by the human eye
How then should one compute the taxable Sch. D Case I profit of such a company? Everyone knows that book depreciation must be added back as a disallowable (capital) expense and common sense therefore requires that the company should work out the amount of depreciation which has actually been deducted in determining the accounting profit – and add back this amount. This will be the amount of depreciation on non-production assets (which is not included in the cost of stocks) plus the depreciation included in the cost of goods sold in the period. If the company’s stock increases over the year, and the depreciation in that stock is greater at the end than at the beginning, the add-back will be less than the depreciation credited against fixed assets for that year, and if the depreciation in stock is declining, the add-back will be greater.
This has been agreed for some companies by the Business Profits Division of the Inland Revenue for many years, and has worked fairly. But the Revenue’s new interpretation, based on Lord Millett’s ‘extremely persuasive’ judgment in respect of interest, is that in some way unseen by the human eye and in a manner not perceived by accountants, the full amount of depreciation deducted from fixed assets is actually charged against the profits of the year, and that a separate, notional, and presumably fully-taxable amount representing an element of the value of the stock (note its ‘value’, not its ‘cost’) is then added to profit as part of the ‘sale’ of the closing stock from one year to the next. Lord Millett actually goes further than this notional sale – he states that ‘each year is treated as if it were a different trader’ - which to me is a novel concept.
Under the new Revenue interpretation, the add-back of disallowable depreciation must be the amount credited against fixed assets in the period, regardless of the amount of depreciation in the cost of stock at the beginning or end of the year.
The implications of this change are considerable, and in many cases defy logic or common sense. For example, one would have thought it axiomatic that the purpose of adding back a disallowable expense in the computation of trading profits for tax purposes is to determine what those profits would have been if the disallowable expense had not been charged in the first place. So the purpose of adding back depreciation is to determine the profits before depreciation – which will form the basis of the taxable profits after capital allowances etc.
Adopting the Revenue’s interpretation means that a company’s taxable profits will actually depend upon its accounting rate of depreciation – e.g. if a company changes its accounting policy for book depreciation (without, obviously, any change in its profits before depreciation) this by itself would alter its taxable profits if it changed the amount of depreciation in stock at the year end. This cannot be right in principle - can it ?
Similarly, one can imagine a start up company which makes no sales and has no income in its first period of account because all it does is to create some work in progress on hand at the end of the its first period. Although it has nil book profit or loss and no income or receipts, the Revenue would require that all the depreciation in stock must be added back, to create a taxable s. D Case I profit. This cannot be correct – can it ?
Common sense and equity
I believe it is likely that the Revenue’s new interpretation will be challenged and overturned in the courts – already robust counsel’s opinion has been obtained that Lord Millett’s words are far from an authoritative explanation of correct accounting practice. In the mean time I would urge any company facing a challenge from the Revenue to a Depreciation in Stock adjustment to resist strongly on the grounds of common sense and equity.
After all, it cannot be correct to add-back a disallowable that hasn’t actually been deducted in the first place – can it ?
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September 2002 by