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2. Trading Receipts And Corporate Profit Notes

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

2. TRADING RECEIPTS AND CORPORATE PROFIT

1. Relationship with Accounting Principles A. Calculation of Profits in Accordance with Generally Accepted Accounting Practice (GAAP) B. Post-2013: Small Business Election for Cash-Basis Receipts (Individuals and Partnerships Only)

2. Taxable Receipts of the Trade A. Introduction to Taxable Receipts B. Valuation of "Trading Stock" - GAAP in Practice C. Definitional Problems - When is a Receipt (not) Taxable?
D. Receipts which are Not Trading Receipts E. Capital Receipts Not Taxable Trading Receipts - Capital or Income?
F. Capital or Income: Restriction of Activities

3. Timing of Receipts - The Judicial Approach A. The Old Judicial Approach (now subject to GAAP) B. Judicial Treatment of Deposits (now subject to GAAP)

4. Anti-Avoidance: "Self-Supply" and the Rule in Sharkey v Wernher A. The Common Law Rule in Sharkey v Wernher B. The Common Law Limits to the Rule in Sharkey v Wernher C. Codified and Statutory Limits: A32 and Supply of Trading Stock to Charities etc. __________________________________________________________________________________

Obviously there has to be a different approach to taxing trading, selfemployed or corporate income from employment income, but how different should it be?
While employees are taxable on wages and other earnings from employment, traders are taxed on net profits (and not receipts: it would be unfair, for example, to tax a shop keeper on sales receipts without taking into account the costs incurred)

1. Relationship with Accounting Principles A. Calculation of Profits in Accordance with Generally Accepted Accounting Practice (GAAP)
* Income Tax (Trading and Other Income) Act (ITTOIA) 2005 applies primarily to sole-traders viz. unincorporated businesspersons. Corporation Tax Act(s) (CTA) 2009 and 2010 apply primarily to corporations, but will contain almost identical provisions to ITTOIA 2005 for these purposes*
Section 24 Income Tax (Trading and Other Income) Act 2005 - Professions and Vocations

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

"…the provisions of this Chapter apply to professions and vocations as they apply to trades" Section 46 Corporation Tax Act 2009 - Generally Accepted Accounting Practice "(1) The profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for corporation tax purposes..." Section 25 ITTOIA - Generally Accepted Accounting Practice "(1) The profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for income tax purposes (2) This does not - (a) require a person to comply with the requirements of the Companies Act 2006 (b) impose any requirements as to audit or disclosure…" Section 46 Corporation Tax Act 2009 - Generally Accepted Accounting Practice "(1) The profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for corporation tax purposes..."

Section 25 ITTOIA/Section 46 CTA 2009 requires consideration of "generally accepted accounting [principles]/practice" (GAAP); in the UK this will be set either by the UK's own Accounting Standards Board (ASB) or the International Accounting Standards Board (IASB) These provisions also contain the important limitation that this is subject to any adjustment required or authorised by law; this question is addressed by the courts (see notes below) Before Finance Act 1998 there were two distinct approaches to the relationship between questions of law and principles of accountancy: one asserted that the court should first look to see what accountancy prescribed and then see whether any rule of law contradicted it - this is the approach adopted in Odeon v Jones and reaffirmed in Gallagher v Jones:

Odeon Associated Theatres v Jones Pennycuick VC

The concern of the court in this connection is to ascertain the true profit of the taxpayer… in so ascertaining the true profit of a trade the court applies the correct principles of the prevailing system of commercial accountancy

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)


Bachelor of Civil Law

I use the word "correct" deliberately: in order to ascertain what are the correct principles it has recourse to the evidence of accountants That evidence is conclusive on the practice of the accountants in the sense of principles on which accountants act in practice That is a question of pure fact, but the court itself has to make a final decision as to whether that practice corresponds to the correct principles of commercial accountancy… at the end of the day the court must determine what is the correct principle to be applied

Comment

The other approach was that the court should first determine the question as a matter of law and then see whether accountancy gave a different answer, and then determine which one was to prevail The first approach enshrined in Odeon Associated Theatres gives much greater weight to accountancy practice than the second, and the former approach has now been enshrined in legislation (but had already been reached by case law, per Gallagher v Jones)

Gallagher v Jones Sir Thomas Bingham MR

I find it hard to understand how any judge-made rule could override the application of a generally accepted rule of commercial accountancy which (a) applied to the situation in question, (b) was not one of two or more rules applicable to the situation in question and (c) was not shown to be consistent with the true facts or otherwise inapt to determine the true profits or losses of the business

Comment

In Gallagher v Jones, the Court of Appeal considered that no judge-made rule could override generally accepted principles of commercial accountancy where, inter alia, there was not one of two or more rules applicable to the situation In Willingdale v International Commercial Bank, the House of Lords held that the bank, although having made up its accounts on one basis, was entitled to insist for tax purposes that another basis should be taken

Accounting Standards Board 2000, Financial Reporting Standards (FRS) 18 Appendix 4

As SSAP (Statements of Standard Account Practice) envisaged, the meaning attaching to the fundamental accounting concepts, and their individual importance relative to one another, have developed and evolved over time.

1 - Going Concerns and Accruals

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

Going concern and accrual concepts form the bedrock of accounting With accruals, SSAP explained that revenues and costs should be matched with one another so far as their relationship can be established or "justifiably assumed", and dealt with in the profit and loss account of the period to which they relate FRS takes a different approach: emphasising instead that the non-cash effects of transactions should be reflected in financial statements for the accounting period in which they occur and not in the period in which cash is received SSAP did not require financial statements to be prepared in accordance with the going concern and accrual concepts; rather, where this was not the case, it required the facts to be disclosed and explained But several respondents suggested that the role of the concepts be strengthened and that disclosure should be required of any material uncertainty as to ability to be a going concern As a result FRS now requires financial statements to be prepared on a going concern and accruals basis and also requires directors to assess whether there are any significant doubts about an entity's ability to continue as a going concern / disclose any material uncertainty

2 - Consistency

Consistency and Prudence are desirable qualities of financial information rather than the bedrock of accounting principles, like going concern and accrual concepts are FRS regards comparability as more fundamental than consistency; information should thus be prepared in a way that enables users to discern differences and similarities in and between the nature and effects of transactions and other events Although comparability is usually achieved through consistency, the latter is not an end in itself; whilst it is important it should not be allowed to prevent improvements in accounting and should not be used as an argument justifying retention of a disadvantageous policy

3 - Prudence and Realisation

SSAP described prudence as revenue and profits being included in the profit and loss account only when realised in the form of cash; but FRS does not refer to realisation in discussing prudence The notion of realisation was originally concerned with conversion of noncash into cash and was intended to ensure that sufficient cash was available to distribute profits But by the time SSAP was issued, the notion had involved and was used to ensure that only gains that were reasonably certain were included in the profits and loss account The linking of prudence and realisation is now out of date; market developments mean that it is now possible to measure the certainty a gain 4

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

exists or will exist with sufficient reliability even if no realisation has occurred

However, though the Board thinks it no longer useful to link prudence and realisation, the respondents were concerned that realisation is nevertheless part of company legislation and were concerned therefore that the Board appeared to encourage entities to ignore or flout those requirements. As a result, Para 14 FRS makes clear that entities should adopt accounting policies that are consistent with the requirements of other accounting standards and legislation, which will include any requirements in the companies legislation as to realisation.

B. Post-2013: Small Business Election for Cash-Basis Receipts (Individuals & Partnerships Only)


By virtue of Section 17 Finance Act 2013, now Section 25A ITTOIA 2005, individuals carrying on a trade or profession, either as sole traders or in partnership, can choose to use a cash basis to calculate taxable income, instead of doing so in accordance with prevailing GAAP. This is done by election and will not apply automatically Importantly, it is available only to unincorporated businesspersons and not to companies (note that there is no equivalent to Section 25A ITTOIA in the CTA legislation!) The meaning of cash/receipts-basis and earnings/accruals-basis is dealt with above.

Section 25A ITTOIA 2005 - Cash Basis for Small Business "(1) A person who is or has been carrying on a trade may elect for the profits of the trade to be calculated on the cash basis (instead of in accordance with GAAP)

(3) Chapter 3A contains provision about(a) when a person may make an election under this section, and (b) the effect of such an election (4) Where an election under this section has effect in relation to a trade, sections 27, 28 and 30 do not apply in relation to the calculation of the profits of the trade"

Therefore, if the prevailing GAAP at the time is e.g. to work out receipts on an accruals basis, a small business who satisfies the following criteria can elect to use a cash-basis instead (Sections 31A, 31B(5) and 31E ITTOIA 2005): 5

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

o

Cash basis receipts do not exceed the "relevant maximum"

o

The taxpayer is an individual or partnership comprised solely of individuals

o

Is not an excluded person (Section 31C: partnership with a corporate partner or LLP)

o

The "relevant maximum" is the VAT threshold for the year (£79,000 in 2013/14)

o

The cash basis is calculated as the total number of receipts of the trades for the year minus the amount of expense of the trade paid

2. Taxable Receipts of the Trade A. Introduction to Taxable Receipts

Section 5 ITTOIA 2005/Sections 2 and 35 CTA 2009 charge tax on the profits of the trade, profession or vocation, while Section 7 ITTOIA/Section 8 CTA 2009 charge the full amount of the profits of the basis period for that year, by reference to accounting periods It should be noted that under ITTOIA, chargeable gains will not be taxed, but will instead be taxed under Section 2 Taxation of Chargeable Gains Act (TCGA) 1992; whereas chargeable gains will be taxed as trading receipts, as corporate income, by virtue of Section 2 CTA 2009

B. Valuation of "Trading Stock" - GAAP in Practice

A payment arising from the disposal of trading stock in the normal course of business is normally treated as a trading receipt The question of what "trading stock" is has led to tax avoidance opportunities, and anti-avoidance provisions - see the notes later on the rule in Sharkey v Wernher This has also proved problematic in the group relief context (X-reference notes on Groups), as well as the intention to trade (X-reference notes on the Badges of Trade); in particular consider the case New Angel Court v Adam. Traditionally "trading stock" meant (a) raw materials (b) finished products and (c) work in progress, but it does not extend to plant or mere utensils (as distinct from raw materials)

Section 174 ITTOIA 2005/Section 156 CTA 2009 - Meaning of "Trading Stock" (1) In this Chapter "trading stock" means - (a) any property (whether land or other property) which is sold in the ordinary course of the trade or would be so sold if it were mature or its manufacture, preparation or construction were complete or 6

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

(b) materials used in the manufacture, preparation or construction of any property mentioned in (a) (2) "Trading stock" also includes any services performed in the ordinary course of the trade… [subject to (2)(a) and (2)(b)] and any article produced or material used in the performance of such services"

This will be revisited when we consider the rule in Sharkey v Wernher How have the cases applied GAAP to the valuation of trading stock?

IRC v Cock, Russell


A company, who were wine merchants, purchased certain pipes of port as part of their trading stock; at the end of the accounting year the pipes had fallen in market value to a figure below their cost The company brought these pipes in at market value Croom-Johnson J held that this was the correct valuation; that the profits were to be computed as a business man employing sound principles of commercial accountancy would compute them subject to statutory modification of such principles

Croom-Johnson J

Has the Crown succeeded in showing that the principle contended for by the company is wrong, it being established that the principle is not merely sound and right from the point of view of commercial accountancy but that it is the one used in commercial circles?
In my view the General Commissioners did not err in law: they accepted the evidence which was before them which was all one way - profits for income tax purposes are to be computed as a business man employing sound principles of commercial accountancy would compute them subject to statutory modification of such principles I cannot imagine anything which is more clearly a question of fact than what is the value of stock in trade at a particular time and I see nothing to indicate that the General Commissioners have gone wrong in deciding this matter

Minister of National Revenue v Anaconda (Privy Council)

Anaconda carried on the business of purchasing metals, manufacturing them into sheets, rods and tubes and selling the manufactured products; it was constantly purchasing metals to replace those which were being used but did not keep sufficient records Due to the lack of knowledge, it adopted a LIFO system (Last-In-Last-Out) whereby the cost per pound of the metal most recently purchased was the cost per pound of metal to be charged against the next sale of processed metals

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