BIM37850 - Wholly and exclusively: expense of earning or application of profits?: accountancy fees in connection with an appeal

S34 Income Tax (Trading and Other Income) Act 2005, S54 Corporation Tax Act 2009

The Revenue’s long standing practice

You should allow the normal professional costs of preparing tax computations and supporting accounts.

In the cases of Smith’s Potato Estates Ltd v Bolland [1948] 30 TC 267 and Smith's Potato Crisps (1929) Ltd v CIR 30 TC 267, the company in the first case (the Estates Company - Estates) was a wholly owned subsidiary of the company in the second case (the parent company) and was formed to purchase and work an estate.

In computing Estates’ profits for Excess Profits Tax [EPT] (which was a tax which applied at the time to profits over and above a certain level) purposes the Inland Revenue decided that only just over half of the estate manager’s remuneration should be allowed. The company was of the opinion that if this decision were upheld, similar decisions, which it would then be almost impossible to resist, would be made for subsequent chargeable accounting periods. For these subsequent periods there would be a right to recover from the manager the additional EPT resulting from the decisions and it was thought that the parent company, being a public company, might be bound to exercise this right. Such action might seriously prejudice the company's future by causing the loss of the services of the manager. The Estates company therefore appealed against the decision to the Board of Referees, who held that 90% of the manager's remuneration was allowable. In conducting the appeal, the Estates company incurred expenditure of £622 on legal costs and accountancy fees.

On appeals to the Special Commissioners against an assessment to Income Tax (the regime which applied prior to the introduction of Corporation Tax) on Estates and an assessment to EPT on the parent company in respect of its subsidiary's profits, the appellants contended that the expenditure of £622 was allowable as a deduction in computing the profits of its trade for Income Tax and EPT purposes. The Crown contended that the case was indistinguishable in principle from Allen v Farquharson Brothers & Co [1932] 17 TC 59 (see BIM37840), and that the appellants' motive in conducting the appeal was irrelevant. The Special Commissioners dismissed the appeals.

The Crown lost in the High Court, won a unanimous verdict in the Court of Appeal and was successful by a three to two majority in the House of Lords.

The company argued that if the cost of preparing its accounts was allowable for tax purposes then the cost of the appeal to the Board of Referees should be similarly allowable - the purpose of the appeal, as with the drawing up of accounts, being to ascertain the correct profits. Lord Porter began by saying that the dicta in Strong & Co of Romsey Ltd v Woodifield [1906] 5 TC 215 (see BIM37300) should not be pressed too far. The dicta merely gave a gloss on the statutory wording. It is safer to stick to the actual statutory words and consider if the facts in an individual case satisfy the test imposed by what is now S54(1)(a) Corporation Tax Act 2009.

Lord Porter went on to explain that accounts may be drawn up for a variety of purposes and the costs of preparation and agreement must be considered in the light of the purpose or purposes served. Lord Porter gave express approval to the practice of allowing a deduction for the costs of preparing accounts for submission to the Revenue; costs that in strictness are not allowable - the expense being for the purpose of computing the profits rather than expended in earning the profits.

Lord Porter then explained why the specific costs claimed in this case were not allowable; the costs were incurred solely for the purpose of ascertaining a tax liability and nothing else.

Finally, Lord Porter dealt with the argument that because EPT was imposed on a person only because they carry on a trade, the costs of dealing with matters arising must be trade expenses. Lord Porter acknowledged that only a trader is liable to pay EPT, but it is not payable by the trader as a trader. The trader pays as an individual, like any other individual, tax on the sum that they have earned as a trader.

The part of Lord Porter’s judgment commenting on Strong & Co is set out below:

`The argument, so far, extends only to expenditure incurred for the purpose of finding out what the balance of profits or gains is, but, it is said, if the cost of ascertaining that balance by making up the Company's accounts is wholly and exclusively laid out for the purposes of its trade, so the expense of ensuring by an appeal to the Board of Referees the correctness of the figure reached is equally wholly and exclusively laid out for that purpose.

The opposite view, maintained by the Crown, is perhaps best expressed in the case of Strong and Company of Romsey, Ltd v Woodifield [1906] AC 448, at page 453 [5 TC 215, at page 220], where Lord Davey says:

“These words ... appear to me to mean for the purpose of enabling a person to carry on and earn profits in the trade”.

My Lords, that expression has often been referred to and approved, but it was used in reference to the circumstances of the case then under consideration, and I doubt if it carries the matter to a final conclusion. It still leaves open the question: What expense is incurred for the purpose of enabling a trader to earn profits? and the adoption of a phrase helpful in analysing the meaning of words in an Act of Parliament with reference to a particular set of circumstances is not necessarily either useful or conclusive in all cases. It is probably safer to retain the wording of the Act itself and, by applying it to the facts established, to discover whether the deduction falls within its terms or not.’

The part of Lord Porter’s judgment giving express approval to the practice on the deduction of accountancy fees is set out below:

`Regarding the circumstances which your Lordships have to consider from this point of view, I should myself draw a marked distinction between accounts made up on the purely trading basis and those which are prepared for and accepted by the Inland Revenue. If there were no obligation to ascertain and pay either of these taxes, there would be no necessity for making up accounts on Income Tax principles, it would suffice to make up the ordinary commercial accounts. The computation of accounts for tax purposes is therefore not directly associated with the carrying on of the business. It is an obligation imposed upon the Company for another and extraneous purpose, that is, for the purpose of ascertaining the tax to be paid out of profits. It is not, at any rate directly, undertaken for trade purposes but to satisfy the Revenue authorities.

It is true that as a matter of convenience the cost of making up accounts for the Inland Revenue is allowed by the authorities as a deduction from profits, as is the cost of making up the strictly business accounts of the trade, but this is not a matter of principle but of expediency. The two duties overlap and in practice are almost indivisible. Moreover it is of advantage to the Revenue to have the figures required for their purposes carefully and accurately made up. Strictly, however, I think the expenses should be divided, and any additional cost of making up Revenue accounts should be disallowed in determining the allowable deduction for Income Tax purposes, but the advantages of allowing both to be deducted as a practical measure outweigh the disadvantages, though the result may not be strictly logical.’

The part of Lord Porter’s judgment explaining why no deduction was due is set out below:

`But no such illogicality has to be faced when the sum which is alleged to be deductible is not the cost of accountant's work ascertaining trading profits, but the expense of an appeal to the Board of Referees for the purpose of discovering the true measure of profits for tax purposes only. Such expenditure is incurred directly for tax purposes and for nothing else, though it may indirectly affect both the amount available for distribution to the proprietors of the business and that proper to be put to reserve.

This is the conclusion which I should have reached if left to determine the question unassisted and unembarrassed by authority. It remains to be determined whether your Lordships' decisions in previous cases throw doubt upon this view.’

The part of Lord Porter’s judgment explaining why the restriction of EPT to traders did not make the cost of computing the tax an allowable deduction is set out below:

`So far as Income Tax is concerned there is direct authority in the High Court in Allen v Farquharson Bros and Co [see BIM37840], that the cost of opposing the Inland Revenue in a contest as to what the profits of a business are, is not deductible. But it is said that case merely followed Strong v Woodifeld [see BIM37300], and in any case Excess Profits Tax differs inasmuch as it is imposed on a trader only and therefore the cost of ascertaining it is part of the trade. I do not accept this contention. It is true that a trader only is liable to pay it, but it is not payable by him as a trader. He pays as an individual, like any other individual, tax on the sum which he has earned as a trader.

“To my mind”, said Lord Selborne, LC, in Mersey Docks and Harbour Board v Lucas (1883), 8 App Cas 891, at page 905 (2 TC 25, at page 29), “it is reasonably plain that the gains of a trade are that which is gained by the trading, for whatever purposes it is used”, and therefore what your Lordships have to determine is whether the expense is incurred in order to earn gain, or is the application or distribution of that gain when earned. With all respect to the opposing view, expenditure to ascertain the true amount of tax to be paid, whether it be Income Tax or Excess Profits Tax, and whether successful or unsuccessful, is, in my opinion, incurred, at any rate in part, in order to determine the correct amount of Income Tax or Excess Profits Tax, as the case may be, and not in order to earn gain, even though that phrase be given a broad significance. The same conclusion might be reached by saying, in the words of this statute, that such expense is not wholly or exclusively laid out for the purposes of trade. It is in truth partially, if not wholly, laid out in order to discover what sum is to be paid to the Crown out of the profits or gains, which have already been earned and computed.’