The House of Lords today ruled unanimously in favour of William Grant, the whisky distiller and Mars, the global confectionary, beverages and pet food company in their dispute with HM Revenue & Customs (HMRC). The decision is a triumph for the application of modern accounting practice for tax purposes and will have a considerable impact on the tax liabilities not just of the two companies, but of a number of large manufacturing businesses waiting upon the outcome of the case.

Mark Stephenson, tax partner at Deloitte with responsibility for manufacturing in the North West, comments:
“The subject of the dispute - depreciation charged to stock – relates to the question of whether companies should pay tax on profits before they’ve earned them. Specifically, it’s concerned with depreciation of assets used in the production process. In a tax computation, the depreciation charged against profit in the year has to be added back to arrive at the taxable profit (and is replaced by deductions for capital allowances). The issue is whether the add-back should be the (gross) amount written off the asset in the year or the (net) amount actually charged against profit after carrying part of it forward in closing stock.

“HMRC believed it should be the gross amount. This would result in the full amount of the depreciation being taxed in the year even though part of it doesn’t get charged to profit in the year. The companies believed it should be the net amount, so the tax charge would reflect the company’s true profit for the year – and the House of Lords upheld the companies’ view.”

Maurice Parry-Wingfield, tax director at Deloitte, added “The judgment in the Lords dealt with an issue of fundamental importance: the extent to which tax should be based upon accounting profits, in tune with modern practice, or upon the traditional and legalistic approach favoured by HMRC. This issue has been around for over 20 years and it’s good to see it resolved by the House of Lords.  As Lord Hoffmann said in dismissing HMRC’s argument ‘It may have been the only practical method when record-keeping was not sufficiently sophisticated to enable one to make a meaningful attribution of costs in one year to sales in some future year’. And as Lord Hope put it, ‘the golden rule is that the profits of a trading company must be computed in accordance with currently accepted accounting principles’.”

Other points to note:

• Whilst the amount of money at stake in the cases (estimated to be around £3m for William Grant and £1m for Mars) is relatively small, the case will affect many other manufacturers;
• in William Grant’s case, the long time it takes to mature its whisky means that it would take many years to recoup the extra tax out of future sales; and
• the two cases (see Notes to Editors) will create a precedent for a number of large-scale manufacturers that also have outstanding tax appeals hanging on the issue, including the chemical and pharmaceutical industries.

Notes for Editors
Depreciation in stock
The subject matter of the dispute is quite technical so it’s best described by an example. Consider a distilling company which has bought a new still costing £200, 00. The company writes off the depreciation as a revenue expense over a period of 20 years, ie £10,000 a year. Because this is a capital cost the depreciation isn’t allowed for tax (capital allowances are given instead). In other words, when the company produces its corporation tax computation for the Revenue, it starts with the profit shown in the accounts and adds back the depreciation charged against those profits. So far, this is relatively straightforward, and it applies to depreciation on all the equipment and structures used in producing the whisky.

The complication comes because the company doesn’t sell all the whisky you’ve made in the year. Much of it will be kept to mature over a long period, say 12 years for malt whisky. As a result, the company will have a substantial amount of unsold stock at the year end. This means that, whereas some of the depreciation will be charged against the year’s profit, much of it will be carried forward in stock and not written off as an expense until the stock is sold.

So the question before the Lords was how much depreciation should be added back for tax. Should it be the (gross) amount charged in the year, representing the amount written off the assets? Or should it be the (net) amount matched with sales in the year, resulting in a lower taxable profit?

Modern accounting versus old law
The Lords found on a basis which was rooted in cases going back 80 years or more when accountancy was comparatively undeveloped. They believed that the depreciation charged against profit was simply the amount written off the asset in the balance sheet, and that the closing stock was disconnected from any depreciation as an ingredient of it. Lord Hoffman, who delivered the leading judgement, found in favour of the company on the basis that modern accountancy matches costs against revenue, so the depreciation carried forward as a cost to be matched with future sales shouldn’t be added back in the current year. This view appears to be common sense and reflects the views of many commentators on accountancy and tax matters.

Ends

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