Lee Sharpe looks at a recent case regarding tax and accounting principles and warns that, while welcome overall, the decisions in it were not entirely helpful.
HMRC has received a sound, repeated and unanimous thrashing at the courts over fundamental principles underpinning the taxation of profits. While involving share options through an employee benefit trust (EBT), this article covers the wider aspects of a case involving accounting adjustments.
Setting the scene
The taxpayer company was part of a group, operating as the employer on behalf of other group members. The taxpayer company then re-charged its costs, with a mark-up, to the other group companies. This is quite a common scenario for larger corporate groups.
The taxpayer company operated a share reward scheme for group employees; again, not unusual. International Financial Reporting Standards (IFRS 2) required that the original company recognised expenditure in its own accounts in relation to those transactions, despite the onward re-charge to sibling companies. HMRC took a strong dislike to the IFRS 2-related debit adjustments in the employing company’s profit and loss statement.
First Tier Tribunal: First principles (NCL Investments v HMRC [2017] UKFTT 0495 (TC))
The tax legislation (at CTA 2009, s 46) states: ‘The profits of a trade must be calculated in accordance with generally accepted accounting practice, (GAAP), subject to any adjustment required or authorised by law in calculating profits for corporation tax purposes.’ Both HMRC and the taxpayer agreed that observing IFRS was in accordance with GAAP.
However, aside from matters more specific to EBTs, HMRC argued that:
-
the company did not really incur any expense in relation to these accounting debits but even if it did, they were not incurred wholly and exclusively for the purposes of its trade (the standard rule under CTA 2009, s 54); and
-
the debit to the profit and loss account of the company was really capital in nature because it simply mirrored a capital contribution in its balance sheet and should therefore be disallowed (CTA 2009, s 53).
Did the debit qualify as an expense incurred?
HMRC argued that the predecessor legislation (ICTA 1988, s 74) had required that money be wholly and exclusively ‘laid out or expended’ rather than simply ‘incurred’, implying that funds must actually have been applied, rather than an adjustment by mathematical exercise.
However, the judge in the First Tier Tribunal (FTT) pointed out that HMRC was about 20 years too late to be litigating under ICTA 1988. Moreover, CTA 2009, s 48 specifically links ‘expense’ to accounting debits, saying that it should not be taken to imply that an amount must actually have been paid in order to be allowable.
Wholly and exclusively?
The judge referred to Lord Brightman’s decision in Mallalieu v Drummond [1983] 57 TC 330; did the accounting adjustment “enable the taxpayer company to carry on and earn profits in its trade”? Perhaps not, but taken literally, no adjustment in a set of accounts does.
It was therefore necessary to look at the context of the adjustment. The company had become involved in the share options as part of the remuneration or reward for employees that it then re-charged to its fellow group members – its trade. The IFRS 2 debits arose directly from the share options; the adjustment was intended to represent a measure of the value of the employees’ services to the company that it ‘consumed’ in return for the share options, and had a direct link to how the company earned its profits (neither was there any non-trade purpose to the shares as reward).
Was it disallowable as capital expenditure?
HMRC argued that the debit in the profit and loss account was a direct contra to a capital contribution in the company’s balance sheet, so it must be inherently capital in nature, despite having found its way to the company’s profit and loss account. In this respect, the accounting treatment was persuasive, but not determinative.
The FTT nevertheless found that HMRC’s argument “started in the middle of the story”, that the capital contributions themselves arose only because of the ongoing share awards that were inherently revenue in nature, being part of how the company rewarded the employees that it then re-charged as its trade, and the adjustments were recurring amounts, not “one-off”. The debits were not capital but expenditure on account of revenue.
Upper Tribunal (HMRC v NCL Investments Ltd [2019] UKUT 0111 (TCC))
The Upper Tribunal emphatically agreed with the FTT.
As regards whether or not the debits could be considered wholly and exclusively to have a trading purpose, and borrowing again from Brightman in Mallalieu v Drummond [1983] 57 TC 330, the Upper Tribunal decided that this was “one of those obvious cases… which speaks for itself”, and should be considered in light of the circumstances that gave rise to the debit.
Court of Appeal (HMRC v NCL Investments Ltd [2020] EWCA Civ 663)
The Court of Appeal judge again gave short shrift to HMRC’s argument that mere accounting adjustments in accordance with GAAP could not amount to expenditure incurred, pointing out that, in this regard, CTA 2009, s 46 as above had effectively codified the GAAP-observant approach in HMRC v William Grant and Sons Distillers Ltd [2007] UKHL 15, which involved accounting adjustments in respect of depreciation (simply, HMRC was prevented from disallowing two competing adjustments in respect of the same underlying amount of depreciation).
HMRC sought assistance from the then-recent Upper Tribunal case of Ingenious Games LLP v HMRC [2019] UKUT 226 (TCC). The taxpayer had lost that case, with obiter remarks that the accounting adjustments claimed by those taxpayers had not been expenditure “incurred for the purposes of CTA 2009, s 54”. But this was to overlook that in Ingenious, more importantly, the taxpayers were found not to have been trading, nor were the accounts GAAP-compliant, in the first place: doubly obiter.
Supreme Court (HMRC v NCL Investments Ltd [2022] UKSC 9)
This time, HMRC argued that CTA 2009, s 46 set GAAP as the starting point only insofar as to ensure that the company’s profit and loss account gave rise to a ‘true and fair view’ of the company’s profitability, and IFRS 2 was not really relevant to the company’s profits but to the integrity of its Balance Sheet.
The Supreme Court disagreed:
“There is nothing in the cases cited to us, or in the taxing statute or in the accounting standards themselves that make a distinction between those accounting practices which are directed at showing a true and fair picture of profit and those which are directed at showing a true and fair picture of something else…a company’s balance sheet and P&L account are not separate and severable…overall, they give a true and fair view of the financial state of the company.”
HMRC again tried to use the old ICTA 1988, s 74 definition to cast doubt on whether expenditure had really been ‘laid out or expended’, saying that the tax law rewrite to ‘incurred’ in CTA 2009, s 54 did not change the law. HMRC said it should be able to rely on more demanding pre-rewrite case law, in line with Lady Arden’s comments in R (Derry) v Revenue and Customs Commrs [2019] UKSC 19.
However, the Supreme Court agreed with the FTT that “when Parliament uses the word ‘incurred’ it does so simply as a participle that takes its colour from the word ‘expenses’”. There should not be a need to keep referring to older legislative provisions to determine what the new statute really meant.
Conclusion
At first glance, there is little more remarkable about this series of cases than HMRC’s determination to prove that ‘there are none so blind as those who can afford not to see’.
However, there is also a tension here. The Supreme Court’s disinclination to check the meaning of certain provisions in CTA 2009 against their ICTA 1988 predecessors is understandable, but if the Tax Law Rewrite Project was supposed to clarify and consolidate, rather than confuse and change, then meanings should have remained consistent and old case law should still be able to cast constructive light on current tax conundrums. Otherwise, should we ignore all cases heard before a statute has been rewritten?
After all, the Supreme Court itself quoted the “golden rule” – that tax follows GAAP accounts – from the 2007 Grant’s Distillers case to back its position on CTA 2009, s 46. In fact, it also went back 50 years to Odeon Associated Theatres Ltd v Jones [1971] 1 WLR 442. Poor HMRC wanted to go back only another 30 years, to Lowry v Consolidated African Selection Trust Ltd [1940] AC 648. This tension could easily rear up in future cases; difficult to resolve to everyone’s satisfaction.
