Having it both ways

That wise man Alfred Adler once noted: ‘It is always easier to fight for one’s principles than live up to them.’ In the accountancy and tax field there have been many bouts in the long-running fight over which principles are applicable for tax purposes, and the latest round has just been decided in the High Court.

In an admirable piece of leadership, Edward Walker-Arnott, senior partner at law firm Herbert Smith, has personally succeeded in taking his firm’s case on this issue through the appeal process. As a result, we have another landmark decision in the development of the law governing accounting principles and taxation. The full judgment in Herbert Smith v Honour can be found at STC (1999) 173.

This was a highly technical and complicated case, and even the judge, Mr Justice Lloyd, remarked: ‘I admit to having found the resolution of the issues far from easy.’ But the crux of the problem will be very familiar to accountants: to what accounting period do you attribute those particular items of expenditure which do not readily fit into one slot?

The dilemma for Herbert Smith related to a provision for excess rentals.

The firm used to maintain four London offices, all held on leases. It managed to secure a single building in which to accommodate all of its staff and set about trying to end its obligations on the old buildings. The firm, however, was tied into two of the leases for several years, and it was apparent that any sub-letting income would not cover the costs Herbert Smith would have to meet for the main lease. It therefore wanted to provide for the resulting loss and made a provision of more than #5.5m in the accounts for the 12 months to 30 April 1990. This was accepted by the auditors as a true and fair view of the partnership profit for the year.

The problems came when Herbert Smith wished to use the accounting-based principles for tax purposes. It was accepted by all parties that the accounts had been properly prepared and used correct commercial accounting principles. The Inland Revenue further agreed that excess rentals were a proper deduction for calculating the firm’s taxable profits, but disagreed that the provision should have been made in the one accounting period. The Revenue said it would prefer the provision to have been made over subsequent years. That would have meant it being made year by year as the shortfall occurred. This relies on the principles set out in ICTA 1988 (section 60) which states that tax should be charged, ‘on the full amount of the profits or gains of the year’, no more and no less.

The case was heard by the Special Commissioners in September 1997, who agreed with the Revenue’s approach. Herbert Smith appealed to the High Court on the basis that this decision was wrong in law. In the High Court, the earlier decision was overturned.

The application of accountancy principles relating to the anticipation of losses has been hotly disputed by the Revenue for many years. It has long been its view that losses cannot be anticipated, although the authority for this view was far from clear, bearing in mind the conflicting case law on this point. In his evidence, Walker-Arnott described the Revenue’s viewpoint as a theoretical basis divorced from the principles of commercial accountancy.

The judge agreed. He did not think that the correct application of accountancy principles to this case was overruled by any rule of tax law. Thus it followed that the deduction of a provision in accordance with the prudence concept set out in SSAP 2 was allowable for tax purposes. The judgement also agreed with Walker-Arnott that, if he adopted the Revenue’s approach, he would be supporting a rival method of accounting for the rental shortfall that had no foundation in accepted commercial accounting principles. It could not therefore represent a true and fair view of the financial position of the firm in the relevant year, and could not be the basis of the profits for tax purposes.

The judge said that this case was almost a mirror image of another recent landmark decision in this field, namely Gallagher v Jones (see STC (1993) 537). There, the Revenue had successfully argued in favour of the use of generally accepted accounting principles. The judge, in effect, told the Revenue that it could not have its cake and eat it too.

This decision is clearly a major setback for the Revenue, particularly when set against the increasing importance of accounting principles in the computation of taxable profits. It remains to be seen whether the Revenue will appeal. It seems unlikely that the decision will be reversed.

The judge’s comments on the similarities between this case and the Gallagher decision appear entirely reasonable, and it will take a brave Court of Appeal to draw a distinction between this case and the Gallagher decision.

Furthermore, the Revenue may not be overly concerned at losing this case, because in future provisions must now be computed in accordance with Financial Reporting Standard 12: Provisions, contingent liabilities and contingent assets. This standard replaces SSAP 18 and applies for all financial statements intended to show a true and fair view for accounting periods ending on or after 23 March 1999.

A key condition necessary before a provision or a contingent liability can be recognised under FRS 12 is that a sufficiently reliable estimate of the obligation must be made. This is a new requirement and will limit the number of cases where a provision will be allowed.

The Herbert Smith provision would probably be allowed under FRS 12 because a reliable estimate clearly could be made. In many instances, however, this condition cannot be met and no provision will now be allowed. It appears, for example, that the provision made for future aircraft engine repairs in the Britannia Airways case (see STC (1994) 763), which was allowed for tax purposes, would not satisfy the FRS 12 requirements. Given the advent of FRS 12, the Revenue may not be that unhappy that it lost this case.

It remains to be seen whether this is a landmark decision or just another stage on the winding road leading to the convergence of tax and accounting profits. In the meantime, the accountancy profession should applaud Mr Walker-Arnott for fighting for the correct application of accountancy principles to tax computations. It is ironic that it took a senior solicitor to stand up and establish a principle of crucial importance to the accounting profession. The judge was clearly impressed with Walker-Arnott’s commercial acumen. Perhaps he has missed his vocation.

Francesca Lagerberg and Frank Haskew are technical managers at the English ICA Tax Faculty

Related reading