For financial statements properly to reflect business costs they
have to take account of the wearing out or other reduction in the
useful economic life of fixed assets. Depreciation is a measure of
this and is charged against income in arriving at the commercial
profit. For tax purposes depreciation of fixed assets is a capital
matter and therefore must be added back in the tax computation.
Until 2007 HMRC’S view, following principles derived
from case law, accountancy and the Companies Act, was that the year
in which the depreciation was to be added back was the year in
which the stock was manufactured. Additional support for this view
was given by the Hong Kong case of Secan Limited v CIR [2000]
74TC1. Where depreciation was included in trading stock we believed
taxpayers were deducting the full amount of depreciation in their
profit and loss account and were bringing in a credit representing
the value of the stock on the other side of the profit and loss
account. The fact that the ‘cost’ or fall in value of
the fixed assets had been included as part of the value to the
taxpayer of the stock carried forward did not mean that the full
amount of depreciation had not been charged to the profit and loss
account. Further, even if the accounts showed only the
‘net’ figure charged to profit and loss account, this
was irrelevant. It was not a matter of accounting principle. Rather
it is, in Lord Millet’s words,
“merely a matter of
presentation”.
Guidance following the decision in Secan was published in
TB59 in June 2002. From that date where an adjustment to the
depreciation add-back in respect of depreciation in trading stock
had, unusually, been an accepted part of tax computations,
taxpayers had to move to the revised basis for computing taxable
profits.
HMRC’s approach has been successfully challenged, the House of Lords finding against us in a decision dated 28 March 2007. The case involved joint appeals by Mars UK Ltd and William Grant & Sons Distillers Ltd.
Lord Hoffman said that the applicable accounting standard for
depreciation is FRS15, which replaced SSAP12 in 1999. Paragraph 16
of SSAP12 had required that the whole of the depreciation charge
should be reflected in the profit and loss account. Paragraph 77 of
FRS15 clarified and refined paragraph 16 of SSAP12.
Paragraph 77 requires that the depreciation charge for each
period is recognised as an expense in the profit and loss account
for the period
unless it is permitted to be included in the
carrying amount of another asset. Hoffman explains what this means
by reference to the principle that the determination of profit for
an accounting period requires the matching of costs with related
revenues. Hoffman goes on to say:
“This fundamental principle is given
effect by taking the revenue which has arisen in therelevant year and deducting from it only those
costs which are attributable to those sales.These costs may have been incurred in the year
in question, or they may have been incurredin earlier years and carried forward in
accordance with the general principle, to be matchedwith the related sales when they occur. The
costs of stocks which remain unsold at the yearend are not deducted for the purpose of
computing profit in that year but are carried forwardto be matched against revenue from their sale
in future years.”
Paragraph 17 of SSAP9 says that the cost of stocks includes
not only the cost of purchasing the materials but also the
‘costs of conversion’. These are defined to include
costs ‘specifically attributable to units of
production’, including ‘production overheads’.
Paragraph 20 of SSAP9 specifically provides that such overheads
should include the depreciation of assets ‘which relate to
production’.
Both Mars and Grant prepared their accounts in accordance
with these standards. They divided the depreciation which occurred
during the year or was carried in the opening stock into two
parts:
Both Mars and Grant deducted the first part depreciation from the year’s revenue and carried forward the second part as part of the cost of unsold stock. Expert accountancy evidence on both sides agreed that:
On this basis Hoffman considered it
“plain and obvious” that
only the first part depreciation had been deducted in arriving at
the profit for the year.
The tax effect resulting from this accounting analysis is
that ICTA88/S74(1)(f) does not require the second part of
depreciation to be added back. It will be added back when the stock
is disposed of and the depreciation is deducted in arriving at the
profit for the year of the disposal.
Businesses should use the method approved by the House of Lords
in the first computations accompanying accounts prepared and
submitted after the date of the decision.
Unusually, there may be some instances when the accounts
themselves treat the depreciation of assets used in the manufacture
of stock in the way outlined under “The applicable
accountancy” for the first time after the House of Lords
decision. If so please contact CT & VAT or speak to your HMRC
compliance accountant to ensure that the accounts before and after
the change comply with generally accepted accounting practice.
Where the business was trading in years prior to the date of the
decision you will need to consider the ’change of
basis‘ legislation where there is a move from computations
prepared following HMRC’s earlier view to those following the
House of Lords’ view. This will apply where returns are filed
using the new approach for the first time after the House of
Lords’ decision or where there are earlier open years
If items of stock are held over more than one accounting
period end the computations should show an adjustment to take into
account a change of basis within FA2002/S64 and Schedule 22 (or on
decided principles in earlier years) and ITTOIA 2005 Chapter 17
(Section 226 and following). This is sometimes referred to as a
’catch up‘ adjustment – it will be a negative or
positive (in some more unusual circumstances) adjustment arising
from a computational change from adding back depreciation on
manufacture of stock to adding it back on disposal. In very simple
terms you will need to consider the figure for depreciation that
was added back in earlier years but relates to stock that has not
yet been sold. See BIM 34000 and following for further information.
The accounts will not show a prior period adjustment because it is
only in relation to the computations that changes are required, not
the accounts themselves.
You should reject ‘Error or Mistake’ claims seeking to rely on this decision. This is on the basis that computations submitted and agreed in accordance with the position set out in earlier guidance were prepared in accordance with the then ‘prevailing practice’ – TMA70/S33(2A) refers. See SACM12000 and following for further information.
You will need to consider whether the business has in place
appropriate mechanisms to ensure that depreciation is added back in
the computation for each year/period of disposal of the stock in
question.
Where there are only a small number of relatively large
items in stock businesses will find it easier to track the
depreciation within stock and so ensure that on the disposal of the
stock in question the relevant depreciation is correctly included
in the tax computation.
Where the stock comprises a very large number of individual
items each of relatively modest value, businesses may find the
record keeping requirements to be burdensome when the new
depreciation in stock approach is adopted. They must however follow
the method approved by the House of Lords and cannot use the former
method.
