The two early tax cases on changes in basis of computing profits
both concerned companies which changed their method of valuing
stock. In one case the change was made on a challenge from the tax
authority, and in the other the change was made voluntarily by the
company.
The earlier case was Bombay Commissioner of Income Tax v
Ahmedabad New Cotton Mills Co Ltd [1929] 8ATC575 (or 46TLR68). The
accounts of Ahmedabad New Cotton Mills Co Ltd for the year ended 31
December 1925 described stock in trade as being ‘below
cost’. It was subsequently agreed that the figure of closing
stock in those accounts was about 37% of the proper valuation of
’lower of cost and market value’. The company argued
that if the value of closing stock was increased then it must also
increase the value of its opening stock for that year in order to
properly compute the profits for that year. The Privy Council
decision was given by Lord Buckmaster. They agreed that in order to
determine the annual profit it was not correct to raise the
valuation of the closing stock without taking into consideration
the similar undervaluation of the opening stock. This was a case in
which the basis of valuation of stock was not an accepted method
and was invalid so the company was made to change for tax purposes
to a valid method.
In Pearce v Woodall-Duckham Ltd[1978] 51TC271, the company
changed its method of valuing work in progress from an
’on-cost’ basis to an ’accrued profit’
basis in the 1969 accounts. It valued both the opening and the
closing work-in-progress on the new basis and brought in the
difference between the 1968 closing value and the 1969 opening
value as ‘surplus arising on change in valuation of contract
work in progress at 31 December 1968’. The figure was not
taken to the trading profit and loss account but shown in the
company’s profit and loss appropriation account under profit
after taxation. It was common ground that both the old basis and
the new basis were valid valuation methods for work in progress and
that the change had been made for sound commercial reasons. It was
held that the amount of the adjustment was taxable in 1969 as
profits of that year. In the High Court Templeman J said:-
“When the change was made the valuation of work-in-progress at the end of 1968 could not, consistently with sound accountancy principles, be adopted as the valuation for the beginning of 1969. There was a new valuation which included in the opening valuation of work-in-progress a proportion of the profit anticipated in respect of that work-in-progress. This valuation was then set against a similar valuation of the work-in-progress at the end of the year, which became the opening valuation for the next year. The result of not bringing forward the same valuation of work-in-progress from 1968 to 1969 was, however, in the words of the chairman of the group, “to exclude from the year’s trading profits those which accrue from work done prior to 1st January 1969”. In accordance with sound principles of accountancy those profits appear in the 1969 accounts as a separate item of £579,874. It is admitted that this sum is a true profit of a revenue as opposed to a capital nature, and that it became immediately available as a sum on which to base dividends. This profit of £579,874 could not have been included in the accounts prior to 1969 because those earlier accounts were based on received and not anticipated profits. The profit of £579,874 could not be included in the 1969 accounts otherwise than as a separate item and would not be reflected in profits after 1969, as and when payments were received from the relevant contracts, because the accounts for 1969 and subsequent years are based on anticipated profits and not on received profits”. In the accounts for 1969 the item of £579,874 is described as “Surplus arising on change in valuation of contract work in progress at 31 December 1968”. This surplus is a profit. It is not a mere bookkeeping entry”.
Templeman J went on to consider whether it was appropriate to tax that profit in 1969 or whether it fell out of charge to tax and decided
“The anticipated profit for work carried out prior to 1969 falls to be taxed in the year 1969, when it is first revealed and first brought into account”.
The Court of Appeal upheld the decision.
Where the change is from an invalid basis to a valid basis the
profits for the accounting period have to be computed on the new
valid basis. Any adjustments which need to be made to previous
accounting periods’ computations in order to compute those
profits on a valid basis must be done by changing the computations
for those accounting periods.
Where the change is from one valid basis to another valid
basis for tax purposes the taxable profits for the accounting
period include any tax adjustment needed for the prior period
adjustment. The adjustment could either be in respect of profits
recognised in the accounting period or of a loss recognised in the
accounting period.
The cases both concerned trading companies and trading
profits where the adjustments were made in Schedule D Case I
computations.
ICTA88/S104 (as it became) was amended in 1968 to bring in amounts which would otherwise have fallen out of account on a change of basis when the profits of a trade, profession or vocation were computed on the ’conventional basis’. It caught any sums that would have fallen out of account on a change from a conventional basis to an earnings basis, and any sums that would have fallen out of account on a change of conventional basis. The sums were charged to Case VI. The relevant subsections were repealed by the 1998 legislation.
FA98/S44 enacted the principle established by Woodall - Duckham.
It also included, in FA98/SCH6, spreading provisions and determined
the date of a tax charge and the Case chargeable.
This legislation has now been replaced by FA02/S64 and
FA02/SCH22, incorporating further spreading provisions and changing
the date of the tax charge and the Case chargeable.
