Depreciation: Is It Correct to Add Back?
Author:
Mary O'Brien
Dating back to our earliest days of training in Chartered Accountancy, it is a well known practice that when preparing tax computations we add back the depreciation charged in the profit and loss account. The reason being, that depreciation is a capital item which is specifically disallowed. But when all the deprecation is not charged to the profit and loss account in one year, how much of the depreciation amount should be added back? Allow me to explain the predicament …
Predicament
I recall coming across a case of a distillery business which consisted of the distillation and maturation of whiskey. As part of the maturation process, the whiskey was stored in casks for a number of years.
The depreciation of the casks was included in the figure for stock. The effect was that the depreciation of those casks was not charged to the profit and loss account in the years that the whiskey was stored in the casks.
When the whiskey was sold, the depreciation of the casks that had stored the whiskey was charged to the profit and loss account in that year.
Tax treatment
In determining the treatment of the depreciation for tax purposes, the following seemed obvious at the time:
- the depreciation which was included in stock should not be added back in the tax computation because, in effect, it had not been charged to the profit and loss account and hence was not included in the profit before tax figure;
- when the whiskey was sold, the depreciation was added back in the tax computation as it had been charged to the profit and loss account at that time.
UK Case Law
Two recent UK tax cases have considered this issue. The cases were held separately in the UK High Court/Scottish Court of Session but held together in the UK House of Lords.
The judgements were delivered in the House of Lords on 28 March 2007 [Her Majesty’s Revenue and Customs v William Grant & Sons Distillers Limited (Scotland); and Small (Her Majesty’s Inspector of Taxes) v Mars UK Limited (Conjoined Appeals) [2007] UKHL 15].
I will now analyse the decision before applying the decision to the distillery case.
The taxpayer in one of the cases was Mars UK Ltd (‘Mars’), which makes confectionery and pet food and in the other case was William Grant & Sons Distillers Ltd (‘Grant’) which makes Scotch whiskey.
Before considering the House of Lords decision, it is necessary to deal with the High Court decision for Mars and the Scottish Court of Session decision for Grant which, while heard separately, deal with the same issue.
Accounting treatment
In computing tax, the starting point is the profit before tax which is computed in accordance with generally accepted accounting practice.
The accounting treatment for depreciation is in accordance with paragraph 77 of FRS 15.
This lays down a general requirement that the year's depreciation shown in the balance sheet should be deducted in that year's profit and loss account, but makes an exception for a case in which depreciation is "permitted to be included in the carrying amount of another asset", that is intended to include carrying forward an appropriate part of the depreciation as part of the cost of stocks, to be deducted as and when the stocks are sold in a future year.
Both Mars and Grant prepared their accounts in accordance with this accounting practice. In each case, the taxpayer deducted the full amount of depreciation in the profit and loss account, with a credit adjustment being made to the depreciation figure for an amount included in unsold stock.
The full amount of depreciation less the credit adjustment is referred to in this article as the net depreciation.
Tax treatment
Legislation provides that in computing profits for tax purposes, no sum shall be deducted in respect of "any sum employed or intended to be employed as capital in…the trade".
It was acknowledged in the Court that although the language is by no means clear, this has always been taken to prohibit deductions for the depreciation of capital assets.
Any sum which has been deducted for depreciation in the computation of profits must therefore be added back in the tax computation. The question is to identify which sums have been so deducted.
Arguments in favour and against
Revenue’s argument was that whatever the methodology described by the accounting standards may be, the taxpayers must be deemed to have deducted the full amount of depreciation and then added a sum equal to the amount of depreciation being included in closing stock back into profits in some other character which does not affect the deduction in respect of depreciation, i.e. the depreciation amount included in stock no longer retains the character of depreciation. Hence, the full amount of depreciation should be added back in the tax computation.
The taxpayer’s argument was that it was only the net depreciation figure that was deducted in the computation of profits in accordance with generally accepted accounting practice. Hence, the net amount should be added back in the tax computation.
Ruling
In the UK High Court and the Scottish Court of Session, the judgement was made in favour of Revenue, i.e. the full amount of depreciation should be added back in the tax computation, irrespective of the amount of depreciation included in the closing stock figure.
Reason for ruling
The basis for this decision is that the full depreciation figure had been deducted in the profit and loss account and hence had to be added back as the relevant legislative provision specifically disallows depreciation as a capital expense in the profit and loss account.
It was clear from the accounting treatment that the full amount had indeed been charged to the profit and loss account.
The problem arose in relation to the credit adjustment in the profit and loss account in respect of the depreciation included in the closing figure – there was no provision, statutory or otherwise, which required this figure to be adjusted in the tax computation.
The critical issue in dealing with the credit adjustment is the conclusion that depreciation no longer retained the character of depreciation when it was included in stock.
The above decision in the UK High Court and the Scottish Court of Session was as unexpected as it was extraordinary.
House of Lords
The House of Lords decision, which ruled unanimously in favour of the taxpayers, i.e. add back of the net depreciation only, restored sanity.
The key issue in the House of Lords decision is that depreciation does not lose the character of depreciation when it is carried forward in closing stock, and that there is nothing to prevent depreciation being deducted in a subsequent year if that is calculated to give a true and fair view of the profits.
Hence, it is clear that it is the net depreciation amount only that should be added back in the tax computation.
The following quote from the UK House of Lords sums up the decision:-
“In so far as depreciation was carried forward, it was not deducted in the computation of profit and could not therefore be added back under section 74(1)(f) of the 1988 Act”.
Application of case to Ireland
As with all UK case law, the above UK House of Lords decision should have persuasive authority in Ireland.
As the accounting standards are the same in Ireland and the United Kingdom, and the wording of the corresponding Irish tax legislation is very similar – “any sum employed or intended to be employed as capital in the trade” [s.81(2)(f) TCA 1997], this decision should have greater persuasive value.
In addition, the Irish Revenue have not issued any guidance on the treatment of depreciation where part of the depreciation is included in closing stock.
Conclusion
You can imagine the concern when the UK High Court and the Scottish Court of Session ruled that all depreciation should be added back in the tax computation, irrespective of whether part of the depreciation had been included in stock rather than being expended through the profit and loss account. This judgement seemed to be completely at odds with practical situations.
There was a collective sigh of relief when the UK House of Lords ruled in favour of the taxpayer in the appeal and ruled that only the net depreciation, which was in effect charged to the profit and loss account, should be added back in the tax computation.
So the casks can go back to doing what they were built to do – protecting that precious liquid until it matures!