BIM35105 - Capital/revenue divide: basis of computation: the measure of profits

The legislation and how the courts have applied it

As a general rule:

• Revenue expenditure is allowable unless there is a specific statutory prohibition.
• Capital expenditure is not allowable unless there is a specific statutory allowance.

ICTA88/S60 (1) describes the charge under Case I and II of Schedule D:

’income tax shall be charged under Cases I and II of Schedule D on the full amount of the profits of the year of assessment’.

ICTA88/S70 is the parallel provision for CT.

ICTA88/S817 sets out the general scheme for deductions:

1. In arriving at the amount of profits or gains for tax purposes:

2. 1. no other deductions shall be made than such as are expressly enumerated in the Tax Acts, and
   2. no deduction shall be made on account of any annuity.
3. In arriving at the amount of profits or gains from any property described in the Taxes Acts, or from any office or employment, no deduction shall be made on account of diminution of capital employed, or of loss sustained, in any trade or in any profession, employment or vocation.

Very few deductions are 'expressly enumerated'. The courts, faced with the prohibitions in what is now ICTA88/S817 and with the small number of sections expressly permitting deductions (for example ICTA88/S77 allows certain costs of raising loan finance - see BIM45800 onwards) had to decide as a general proposition what could be allowed. The basic principles were laid down in the earliest judgements. Lord Parker in Usher’s Wiltshire Brewery Ltd v Bruce [1914] 6TC399 (case concerning a brewer’s repairs to tied premises) described the general deduction scheme at page 429:

The difficulty is that nowhere in the Act is there any express allowance or enumeration of deductions, the scheme of the Act being to prohibit certain deductions with certain exceptions…where a deduction is proper and necessary to be made in order to ascertain the balance of profits and gains, it ought to be allowed notwithstanding anything in (what is now ICTA88/S817) provided there is no prohibition against such an allowance in any of the subsequent rules.

Lord Cave in Atherton v British Insulated and Helsby Cables Ltd [1925] 10TC155 developed this approach - see BIM35010. At page 191 he gives an early description of the interaction of accountancy principles and statute:

…in determining whether a particular item may or may not be deducted from profits, it is necessary first to enquire whether the deduction is expressly prohibited by the Act, and then, if it is not so prohibited, to consider whether it is of such a nature that it is proper to be charged against incomings in a computation of the balance of profits and gains for the year.

Thus Lord Cave reversed the order of approach to that used by Lord Parker. Lord Parker advises us to consider on general lines if the sum should be deducted and then look to the specific statutory prohibition; Lord Cave advises us to look to the specific statutory prohibition and then consider on general lines. Commenting on these two dicta the Master of the Rolls, Lord Hanworth, in Morley v Lawford and Company [1928] 14TC229 (a case concerning the deductibility of a payment under a guarantee to the British Empire Exhibition) tells us at page 239 that the order of approach makes no difference:

I do not know that it (the reversed order) makes any substantial difference…the court must deal with the question from two points of view, not merely from the point of view of a prohibition under (what is now ICTA88/S74) but a consideration of whether…the deduction that is asked for can be legitimately, according to ordinary rules of accountancy, brought into a profit and loss account…

This is the derivation of the 'commercial criterion' and from it, in turn, is derived the principle that revenue expenditure is allowable, because under the ordinary rules of accountancy a distinction is drawn between expenditure to be charged in the profit and loss account and other expenditure which is to be capitalised. However not everything that is charged in the profit and loss account is automatically allowable for income tax. For example, under the ordinary rules of commercial accounting it is customary to provide for depreciation of capital assets and to write off any losses on the disposal thereof. These are precluded by ICTA88/S74 although allowances may be obtainable under the capital allowances code.