Revenue 3: Treatment of Income Tax

Revenue Law
Tutorial 3

1. What is the relevance of accountancy practice in calculating the income tax profits of a trade, profession or vocation? 

Relevant sections for income tax 

• S5 ITTOIA 2005 "trade, profession or vocation" 
• S7(1) ITTOIA: full amounts of profit for that tax year 
• s8 ITTOIA: T needs to be 'receiving' or 'entitled' to the profits 

Definition of 'profits' 

• Re Spanish Prospecting Co: Amount of gain made by a business ascertained by comparison of the assets of the business between two dates (beginning and end of tax year), taking into account transfers in capital. 
• Mersey Docks and Harbour Board v Lucas: profit means gains of a trade for whatever reason 

Significance of accountancy practice: 

• S25: must be calculated in accordance to generally accepted accounting practice, taking into account any adjustments allowed by law 
• S24: applies to trade, professions, vocations 

Criticism: accounting practice can be very subjective or misleading … (John Tiley) 

• BSC Footwear v Ridgway (before 25 enacted):  

True and fair view 

• S997 ITA 2007: refers to UK accounting practice, of which are intended to give a true and fair view. 
• R&C Comrs v William Grant & Sons Distillers: courts are to be guided on contents of what a 'true and fair' view is, by expert opnions of accountants – authoratative statements by the Accounting Standards Board.  

Note: These are issued by the Financial Reporting Council (UK), and International Financial Reporting Standards (International). 

2. Explain the law on the cash basis and the earnings basis of accouting for profits 

S31 E ITTOIA 2005: To determine profits on cash basis 

• Calculate total amount of receipts during tax year 
• Deduct from that amount total expenses 
• Subject to any adjustments required or authorised by law 

Records revenue and expenses when they are paid in cash. It does not taking into account money you're owed but not yet received. Same as expenditures: does not take into account money owed, only applicable once you've paid. 

Peter Gravestock: a simple tax arrangement intended for small businesses has result in complex problems: this proposal requires some 28 pages of Finance Act. 

Earnings basis of accounting: 

• Rankine v IRC: earnings basis is the most ideal, but where this is not commonsense practical or expedient, cash basis can be used. Method of computation: the best practicable approximation to the desired result. 

S27 ITTOIA 2005: In the content of calculation of profits of a trade, references to receipts and expenses are to any items brought into account as credits or debits in calculating the profits. 

• No implication any amount actually paid or received 
• Subject to express provision to the contrary 

This means that any debts owed to and by the taxpayer are immediately recorded, regardless of whether they have been paid or not. 

3. On the earnings basis of accounting, when is a receipt credited; and when is an item of expenditure deductible? 

Receipts – debts owed to the taxpayer: 

• Hall (JP) v IRC: Selling arrangement that items delivered each month, for 18 months. Payment only made after each monthly delivery. Held that profits made after each delivery, not in one bulk sum immediately after conclusion of the contract.  
• Lord Sterndale: Should use ordinary commercial way of making up accounts. Would be wrong to record as profits of one year the estimated profits that would accrue in subsequent years, bearing in mind the risk that they may never be made at all. 

The rule here is: debt only added to account of taxpayer the year they are legally due to be paid 

• Gardner, Mountain and D'Ambrumenil Ltd v IRC: taxpayers were arrangement of bond underwriters. Payments of commission were only to be maid two years after the underwriting was done, as it would be when profits are realized. HL found that the commission should be treated as concluded in the year the underwriting was conducted. 

• Viscount Simon: Deferred payment cannot be treated as pure loss in the year which it incurred. The principle is to refer back to the year in which it was earned, so far as possible, remuneration subsequently received, even though it can only precisely calculated afterwards.  
• The rejected argument: "where some remuneration is certain, but its quantum is not, it must still be regarded as profits of the year it was earned. Not to do so would be to hazard a guess on future earnings that may not happen". HL held this not to be the case. 

Rule: Where taxpayer has completely performed his part of the contract, but payment deferred. An estimate must be made if practicable. The payment can be adjusted later once payment made. 

• Symons v Llewelyn-Davies: Taxpayer was architect firm. They entered into stage payments agreement, but the agreement was front-loaded (earlier payments were significantly larger than work done). Accounting instead spread profits out to properly reflect the cost, but Revenue argued that exact amounts paid must be recorded as a rule of law. HL found in favour of TP. 

Rule: Receipts need not be entered immediately if accountancy practice would delay entry to give a truer reflection of profits. Under industry standards, architect fees payable before costs are incurred for long term contracts, so delayed entry was permitted. 

Expenditures – debts owed by the taxpayer: 

• Spencer v IRC: general rule is that debt owed by the taxpayer should be deducted in the year it was liable to be paid. 
• Southern Railway of Peru v Owen: But, debt may be deducted earlier if 

• It gave a truer reflection of profits in the earler year 
• There is a sufficiently accurate measure of the taxpayer's liability 

Facts: taxpayer had to pay sums upon termination of employment depending on years worked. Nothing was due until termination but liability grew every year. Held annual deduction for growing liability better reflected TP's financial position, but TP's argument failed because their numbers were not accurate. 

TIley and Loutenhiser: common examples of deductions before liability arises are: "warranties, refunds, environmental costs, health and safety, oenerous leases and court cases." 

4. How should stock in trade be treated in calculating profits? How is work in progress treated? 

Stock in trade: unsold item of stock. Accoungting practice is conservative in valuing stock, not anticipating profit. Equally, income tax is one income received, not expected. Therefore, general stock valued at cost to buy not market price.  

• Unless market value fallen below cost, then whatever lower is used 
• IRC v Cock, Ruseel & Co: taxpayer may divide stock up, value some items at cost or market value, whichever is lower. 

Takes into account value of partly manufactured goods, growing rights to payment under partly performed contracts for services. 

• Ostime v Duple Motor Bodies: confirms general rule, but notes that because work in progress has no market value (no-one will buy it), cost will invariably be used. 
• Pearce v Woodal Duckham: an exception is long-term service contracts.  

• Contract runs for several years and payment only due upon completion 
• Profit can be apportioned evenly 
• Calculation: average cost, plus a proportion of anticipated final profit 

One advantage of this being avoiding the risk of falling in a higher rate tax band. 

Meaning of 'cost' or 'market value' 

• (Cost) Ostime v Duple Motor Bodies Ltd: the taxpayer may use one of two methods 1) cost of an item, 2) cost of an item + a proportion of overheads spent for the year. Provided the accounting profession regards it as acceptable. 
• (Market value) BSC Footwear v Ridgeway: available price in the market sells in which the taxpayer sells during his buisness – disposal costs (e.g. commission paid to staff). Sometimes several markets: wholesale, retail, second-hand … focus is on where the TP sells.  

Receipts which should(not) be included when calculating profits: 

• S96 only receipts of income nature 
• S95 applies to all p/v/t 

Whether the receipt has become the TP's property 

Deposits and part payments: Elson v Prices Tailors  

• Facts: the T were tailors, who took deposits for orders but has the practice of returning them if the goods did not satisfy it's clients. Held that deposits were 'property', owned by the TP regardless of the risk of future repayment. 
• "T's practice of refunding deposits on cancellation was said to be irrelevant to their legal nature" 

• Repayment would be a separate, independent decision of the company 

• But mere part-payment is not property until contract provides 

Security deposits: Total Mauritius v Mauritius Revenue Authority 

• Referring to International Accounting Standards: Security deposits taken from customers, refundable upon the return of some property, remain the customers' property and thus not receipts.  

Money held on behalf of clients: Morley v Tattersall 

• Sums received on behalf of clients were not receipts, not the taxpayer's property 
• Did not matter if merged with T's general funds 
• Even when the chances of refund are very small 

Client recovery becomes barred: Jay's The Jeweller v IRC 

• TP were pawn brokers 
• Held: distinguished Morley v Tattersall, held deposit becomes receipt once repayment had been barred 

Customer overpayments: Pertempts Recruitment Partnership v R&C Comrs 

• Accounting practice: over-payments were kept for 6 months, after which they are entered into profit and loss accounts 
• Held: 

• Overpayments were trading receipts, having regarded the nature of the payment and its purpose 
• Should be credited as receipt as soon as accounting practice dictates 
• Overpayments was the property of the T, until a restitutionary claim under mistake was made, after which a tax adjustment (deduction) would be made. 

Whether item is receipt or windfall (income or capital)  

London and Thames Haven Oil Wharves v Attwooll per L.Diplock: "where a business receives compensation for loss of income under any legal right (e.g. damages for breach of contract, tort, or insurance payout), it would be regarded as income.  

Denny v Gooda Walker: Lord BW suggested obiter that L.Diplock's rule may be too wide. Sometimes, such compensation should be classed as a windfall, gave example below 

Higgs v Olivier as contrasted to Thompson v Magnesium Elektron. Both cases involved the taxpayer receiving compensation for not making profits – not conducting business.  

• Higgs: held both a windfall and capital receipt 
• Thompson: held to be a trading income receipt 

Seems like an either way decision, whichever decision the tribunal makes will be final. 

White v G and M Davies: held that compensation for a promise not to conduct business in one way, combined with a positive promise to conduct business in another way, is of income nature. 

• It is only a capital receipt if T could point to some specific fixed capital asset, and prove that compensation was for its devaluation 
• Here agreement not to farm was income, and not capital because the farmland had devalued during this time 

Compensation for loss of fixed capital:  

Glenboig Union Fireclay Co v IRC 

• Compensation for loss or damage of fixed asset is capital receipt, even if the fixed asset was generating income.  
• Income capital only if the sum "can be regarded as profits, in the nature of profits, or earned in the course of the trade or business" 

Gliksten and son v Green 

• Damage or loss of circulating capital is income receipt 

Van den Berghs v Clark 

• Compensation for voluntary destruction or devaluation of a fixed asset is capital receipt, even if the asset was income producing. 

Fleming v Bellow Machine 

• Compensation for voluntary destruction or devaluation of a circulating capital asset 
• In applying this to a long-term contractual right of a business, such a right would only be regarded as fixed capital if it represented the entire, or substantial entire framework of the business.  

Donald Fisher v Spencer 

• Compensation for increased costs, which means lower profits, are of an income character 

5. T trades as a dealer in machinery. Timeline as follows 1) 2010: purchased item into stock for £5k cash; 2) 2011: entered into contract to sell item, £10k contract price; 3) 2013: payment due under delivery, scheduled for 2013 

Tax consequences: 

Transaction of income nature – item added into stock, therefore part of circulating capital as held in Smith & Son v Moore "circulating capital generates profit when the owner parts with it". 

This transaction generates an income charge under s5. ITTOIA 2005 "income tax is charged on the profits of a trade, profession or vocation". Here T sells a machine in the course of his business, therefore generates an income charge under a trade. 

By Mersey Docks v Lucas, profits means gains of a trade for whatever reason. Profit of the transaction would be £5000k. This must be calculated in accordance to generally accepted accounting practice … (s25). Must be a 'true and fair' view as guided by Financial Reporting Council if in the UK, or International Financial Reporting Standards if international. 

Cash basis is only allowed for small businesses under s31 E ITTOIA 2005. Otherwise, the earnings basis will be used. Rankine v IRC recognised that earnings basis is the most ideal. The tax will be computed to the best practical approximation.  

Tax year starts from 6th April and ends on 5th April.  

When does a receipt arise? 

• Hall (JP) v IRC: the general rule is that the receipt is added to the account of the taxpayer the year they are legally due to be paid.  
• Gardner, Mountain and D'Ambrumenil Ltd v IRC: even if the quantum of the payment is not certain. A tax adjustment can be made once the sum has actually been paid.  

Here payment will be legally required  after delivery, scheduled for the 2013 tax year, receipt will be recorded for that year even if the buyer has not paid yet.  

Currently the item remains with T, how is this dealt with? 

• This should not be regarded as an item of stock, as I would regard this as an item not yet delivered, not an item unsold.  
• Otherwise, stock would be valued at cost to buy, not market price, unless market value has fallen below cost. Whichever is lower, will be used (IRC v Cock, Ruseel and co),  

The resultant tax position would be this: 

• 2011 tax year ==> possible deduction for income expenditure of £5000 
• 2013 tax year ==> income charge for £10000 

Would answer be different if machinery delivered in 2012, but price to be paid in 2013? 

Yes, the receipt would be included in the 2012 tax year assessment. T has completely performed his part of the contract, but payment is deferred. An estimate must be made if practicable (£10k). A tax adjustment can be made later where actual payment performed (Gardner, Mountain and D'abrumenil v IRC) 

6. T trades as a distribution agent. Holds (5) 10 year agency contracts, roughly equal value. He surrenders one, receives £150k compensation for termination of the contract. 

Main point of contest: is this receipt of income or capital nature. 

• London and Thames Haven Oil Wharves v Attwooll: general rule is that when a business receives compensation for loss of income under any legal right, it would be regarded as income. Apply: here there would be loss of income upon termination of a contract. 
• Fleming v Bellow Machine fits facts of the case. Compensation for voluntary destruction of a circulating capital asset – here a long term 10 year contract. This will be an income receipt. A long-term contract right would only be regarded as fixed capital if it represented the entire, or substantial (85% in this case) entire framework of the business.  

Here T has 5 contracts, each of roughly equal value, so the contract in question only makes of 20% of his business, not a fixed asset. £150k generates an income charge. 

Could also be an ex-gratia payment for termination of business relations. Taxable receipts must be 1) an income receipt, not a windfall, and not of 2) capital nature

• Simpson v John Reynolds: If the taxpayer is paid a gratuity (upon no legal obligations), it can only an income charge if:
• It is effectively delayed payment for past services not adequately awarded, even though agreed price may have been paid at the time
• Effectively a payment to facilitate a future business relationship
• McGowan v Brown: judgement of implies that delayed payment for services is always of an income nature.
• The gift was seen to have been ‘earned’ by the taxpayer. “If they earned a gift, then the gift is taxable, no matter who paid it.
• Note that the payment in this case was made in respect of cutting short a trading relationship.
• IRC v Falkirk Ice Rink: a customer donation to preserve the taxpayer’s loss making business. Suggested that payment facilitating future relations will be income, unless there is good reason to view it as capital, such as large size.
• “a payment … intended to artificially supplement its trading revenue …”  
• Murray v Goodhews: if ex-gratia payment was made without any connection to profits earned or with future trading relations between the parties, then not an income receipt.

7. T an industrial manufacturer, receives a special grant from DIT of £80k, which he applies in the purchase of new machinery to keep up with his Japanese competitors.  

Situation: 80 in, 80 out. How is this taxed? 

Grants and subsidies 

If the TP receives a grant, and for it to be an income receipt, the grant has to be 

• A business receipt (not a windfall) 
• Must be of an income nature (not capital) 

Courts have not been consistent in apply these criteria 

• Seaham Harbour Dock v Crook: HL held that grants or subsidies are not business receipts, so whether they have been utilized in an income or capital nature is irrelevant.  
• ‘I find myself quite unable to see that this was a trade receipt, or anything similar to a trade receipt …, and cannot be included in revenue for the purposes of tax’.
• Lincolnshire Sugar Co v Smart : but a few years later HL held that they are business receipts, and should be recorded in profits if of an income nature
• Facts: this was a subsidy case, applied per unit of production
• “It has  was with the very object of enabling them to meet their trading obligations …, intended to artificially supplement their trading receipts … so they can maintain solvency …”
• Burman v Torn Domestic Appliances: Grant for interest relief, to
• Held to be income receipt
• “intended for the extinction, pro tanto, of the interest burden which the company would otherwise have to pay”
• Distinguished Seaham, the grant there was not in the nature of income.
• Poulter v Gayjon:
• “It is sufficient and decisive that for present purposes the payment was made to be used or employed in the business …” to be taxed
• Also distinguished Seaham on unconvincing grounds
• Ryan v Crabtree Denims: added that in effect, a presumption that a grant or subsidy is of an income nature. Presumption can be rebutted by:
• There was a stipulation the money be used for capital purpose; or
• Amount was so large relative to the size of the taxpayer’s business, that th payment must be seen as an addition to its capital

Bottom line: grants an subsidies are business receipts, and are presumed to be income recipts, unless there is a reason (Crabtree Denims) to see them as capital.

S105 ITTOIA 2005: Industrial Development Grants

A trader that receives an ‘industrial development grant’ under s7,8 of the Industrial Development Act 1982, is considered a income receipt unless

• Designated as made towards capital expenditure
• Or as compensation for loss of capital assets

Application:

T is a manufacturer, receives £80k grant from DIT. Using Ryan v Crabtree Denims, grants are prima facie income  receipt, unless there was a stipulation that it is made for a capital purpose.

T has applied towards buying new machinery, no doubt an endeavor of capital purpose.

However, the case would pivot on what the DIT designated this grant towards, as it would only be sufficient that the payment was made to be employed in the business for it to be an income receipt (verify) (Poulter v Gayjon)

8. T, a professional doctor with her own, sole private practice, has received a legacy from a wealthy patient “in recognition of her splendid service over the years”. Tax liability?

Could be an ex-gratia payment, upon termination of business relations. Simpson v John Reynolds holds that this generates an income charge if it is effectively compensation for past services not adequately compensated, or to facilitate future relations.

No concrete evidence of delayed service to apply McGowan v Brown (delayed payment always income nature), but could rely on patient’s quote. Could also to facilitate future relations under IRC v Falkirk, unless payment there is good reason to view it as capital. £10k relatively small for a personal medical clinic, so not capital.

Bottom line, use Murray v Goodhews: if ex-gratia payment was made without any connection to profits earned or with future trading relations between the parties, then not an income receipt. Court reserved opinion on whether payment in this case was capital or income. (so not taxed?)

9. T traded using an unpatentable industrial technique in the manufacture of shoes for many years. She sold this technique for £50k, is this taxable?

Business left-overs or situations where receipts are treated by statute as being income, when otherwise they would or might be regarded as capital.

Wain’s Executors v Cameron: a business can derive taxable income from leftovers - items generated in the business, not originally intended to be profit-making, but later exploited. Here an author made professional income from copyrights, but later sold:

• Original manuscripts and notes: professional income, “course of the taxpayer’s activities as an author”.
• Love letters: sale of private capital, not produced in the business .

Application: This would likely apply to industrial technique, created in the course of T’s business as a shoe manufacturer. The fact that it is unpatented will probably not bar it from being an asset of income nature. ‘know how’ might be more applicable …

Situations treated by statute as income receipt:

“Know-how” business expertise which is not property – e.g. not a patented industrial process.

S193 ITTOA: “a payment, whether in money or any other valuable consideration, to a trader for imparting business know-how is receipt liable to income tax, even if it is of a capital nature.”

OR

S192: “payment for restrictive covenant made by TP as part of the deal also taxable in same way”. An exchange of know-how also treated like a sale.

Therefore this section automatically applies, no need to look at Wain. 7

(background: there used to be a test in Moriarty v Evans, Rolls Royce v Jeffrey, and Musker v English Electric to differentiate whether payment was of income or capital nature. Now longer required because of statute).

--

Other situations: “Reverse premiums” , a payment by a landlord to induce the TP to take on a business lease. CIR v Wattie in 1992 held it was a capital receipt, but by statute s101 and s95 ITTOIA it is a trading income receipt.

10. T is a professional stockbroker. In return for her professional service, she accepts a shareholding in a private company, subject to a covenant not to dispose of the shares for 5 years. Tax consequences?

Notional receipts, taxpayers treated as if they had received money. “Money’s worth or payment in kind”. Taxpayer receives assets, here they are shares in a company.

• Gold Coast Selection Trust v Humphrey: The taxpayer must add the money value of the payment – if capable – as notional cash received in tax year received. (case concerned consideration being £800k worth of shares)
• Where the payment is in asset form, the notional cash receipt should be the value of the assets at the end of the accounting year, if property still held then, rather than date of the receipt.
• It is irrelevant that the asset cannot turn into cash immediately (here 5 year covenant), must be given cash value. But court accepted that value may be reduced by because value of asset cannot be instantly realized.

Therefore, shares taxed the year they were received, at their value at the end of the tax year, minus possible deductions for inability to be sold.

11. 1) T trades as a second-hand car dealer. He removes a car from stock, paid £7k for, which he displayed at £10k, and gifted it to his girlfriend. Tax consequences?

The rule in Sharkey v Wernher: a caselaw rule, now codified in statute

• S172B ITTOIA: trader withdraws item of stock (stock in trade or work in progress) for personal use, treated as if he sold the item at market price. That price entered as a notional receipt.
• S172 D ITTOIA: same if he has given it away, or sells it at an undervalue

Above two applied to gifts out of the course of business, not in it.

• S172E ITTOIA: where there is a gift or sale at an undervalue to a trader, who take it into stock, the recipient trader must enter market value of property as its cost of acquisition, rather than actual consideration given. This prevents recipient from paying same tax donor paid, over again, when he sells the asset.

Application: S 172D would apply here. D has given business asset away, so transaction would be considered to have generated a £10k income receipt.

However, Jacgilden v Castle: held that if sale was at a gross undervalue but commercially negotiated, no deliberate element of gift ➔  S172D and E will not apply.

S172A: above rules apply to both stock in trade and work in progress, but not raw material or provisions of services.

S108-110: but no receipt for deemed charitable purposes, e.g. education

Mason v Innes: seemed to say the above rules only concerned traders, not professions or vocations. Statute confirms this by only mentioning trades.

“This is not a major issue:  since most professions supply services rather than goods.  For Sharkey v Wernher rules to apply, property within the business must be taken out; they do not apply if services are provided free, which could have been charged for within the business - e.g. pro bono work.

The reason for codification: to make clear the courts should not follow accountancy practice under s. 25 ITTOIA 2005 (mentioned previously), because here the legal rule is different.  Accountants would only cancel out (in the accounts) deductions for money previously spent on the item, by entering that cost as the notional receipt; they would not treat the taxpayer as making a profit on the item by entering market value.  The codification makes the law clear:  market value continues to be used.”

2) T2 is a professional author, makes a gift of one of his copyrights.

Codified rules in Sharkey v Wernher not applicable, as an author is a profession, not a trade. Still taxable? Made a capital disposition?