Schedule 15
Finance Bill
12:15 pm
Mark Hoban (Shadow Minister, Treasury; Fareham, Conservative)
I speak to amendment No. 75, which stands in my name and those of my hon. Friends. The change in this schedule is one of the more technical in this year’s Finance Bill. The change is slightly odd. It seeks to put on a statutory footing a tax treatment that dates back to 1955, raising the question of why that is needed for what seems to be an established part of tax law. I am sure that the Minister will address that in her remarks, but it might be helpful for the Committee if I give some background to the schedule.
The tax treatment stems from a case, Sharkey v. Wernher, that was heard in the House of Lords in 1995. The case held that a trader who had appropriated the stock from her business for private purposes should account for tax purposes for the profit that would have arisen had the stock been sold in the normal course of business, where the value of the asset sold was in excess of its cost. Lady Zia Wernher ran a stud farm, which was classified as a trading activity. She also ran a racehorse stable, which was not classified as a trading activity—in line with many people who have had experience of owning horses. It was deemed that when Lady Wernher transferred her horse from the stud farm to the stable, the stud farm accounts should show, as profit, the difference between the cost of the horse and its market value at the time of the transfer. Thus the notional profit on the horse should be taxed. That is different to the accounting treatment of taxable profit. Case law has extended that, to ensure that it applies to transfers within groups, or to when an asset has moved from being part of the trading stock of a business to being a fixed asset. Schedule 15 seeks to codify that longstanding treatment.
There are two schools of thought about the schedule. The first is that it is an unnecessary move—the practice has been long established so why do it now? That is reinforced by the fact that when the Income Tax (Trading and Other Income) Act 2005 was passed as a result of the tax rewrite process, it was decided not to enact the treatment in statute. The Rewrite Committee reported:
“We see no reason to doubt that the principles explained in Sharkey v Wernher continue to apply to the calculation of business profits. But it would be wrong to enact those principles while others doubt the position. The only way to preserve the law is to continue to rely on case law in this area.”
That hints at another school of thought, which is that the original 1955 ruling was flawed. Keith Gordon, a tax barrister, argued in an article entitled “Sharkey Revisited” in Taxation, on 24 July 2003, that
“the rule was susceptible to challenge on two broad bases. First because their Lordships had not had the advantage of evidence concerning the accounting treatment of such appropriations, and secondly, because (arguably) the importance of accounting principles became even more pronounced following the enactment of”
the Finance Act 1998, section 42. That principle is now reflected in the 2005 Act to which I referred. The Institute of Chartered Accountants stated:
“The proposal is that trading stock appropriated or otherwise ‘used’ by the trader for his own benefit should be treated as sold at market value. This treatment is contrary to the treatment under UK GAAP”
—generally accepted accounting practice—
“under which the transaction should be accounted for at either the cost price of the stock or at the price paid on disposal. FA 1998 section 42 states that taxable profits must be computed in accordance with GAAP unless an adjustment is required or authorised by law.”
The different treatment in the Sharkey v. Wernher case and UK GAAP shows a difference between accounting and tax profits. Schedule 15 emphasises that difference and, by having that difference between taxable profits and accounting profits, works against the Government’s stated desire to simplify the tax system. It would be useful if the Economic Secretary could clarify why the Government decided to add schedule 15 to the Bill. Is it, as Keith Gordon suggests in his article, that taxpayers have been much more assertive in questioning the continued applicability of the rule? There is also the wider point that the schedule enshrines in statute a further gap between the tax and accounting definitions of profits. One of the ways to make tax simpler is to align more closely the two definitions of profit. Why have the Government not chosen to go down that route?
Another issue that arises from the codification of Sharkey v. Wernher is that the rule—the 1955 judgment—has been relaxed in statement of practice A32. Let me quote again from Mr. Gordon’s article:
“Statement of Practice A32 gives rise to another interesting issue. The current draft of the new clauses makes no reference to the undoubted relaxation of the Sharkey v Wernher rule, assuming that the rule is valid. Consequently it would appear that property developers and other traders who appropriate stock which they have constructed, as a fixed asset of the business, together with other traders who receive (or whose family or household members receive) meals or other services from the business, will now find that they have to start paying tax on profits they have not made and that this will apply in respect of appropriations after 11 March.”
The statement of practice has allowed certain relaxations of the Sharkey v. Wernher rules. The concern that Keith Gordon outlined in his article is whether the statement of practice still holds and whether it is overruled by the schedule. It is customary in the restaurant trade for the manager or owner to take some bottles of wine from the cellar for personal consumption and not pay the full price for them. As I understand it, such appropriations have not been deemed to be subject to tax in the past.
Will the Economic Secretary clarify whether Mr. Gordon’s interpretation is correct that the schedule will overrule the statement of practice? Has she considered the administrative impact that that will have on small businesses, which will be required to compute the market value of the assets appropriately? Sometimes that is not entirely straightforward. For example, it could depend on the point that the asset has reached in its construction.
I understand that the VAT treatment of these appropriations is to tax them at cost rather than market value. It would appear that there is a very logical approach in the VAT system, which is entirely consistent with UK general accounting principles. A different approach is used for income tax and corporation tax.
Where an asset is transferred at market value from a company’s trading stock to its fixed assets under the Sharkey v. Wernher rule, it creates a notional profit on the trading account of a business, which would be subject to corporation tax. For CGT purposes, the base cost becomes the market value of the asset transferred. The principle also works in reverse. For example, a fixed asset is transferred into trading stock. To use Lady Wernher’s example, a racehorse becomes part of a stud.
Under current rules, an election can be made under section 161(3) of the Taxation of Chargeable Gains Act 1992 to transfer the asset into trading stock at its original cost rather than its market value. That means that any gain or loss on the transfer is taxed within the business’ trading profits rather than as capital gains. There is therefore no chargeable gain or loss on transfer, but they are dealt with as part of the trading activities of the business. It is not clear in the schedule whether election under section 161(3) of the 1992 Act can be made in respect of these transfers. Amendments Nos. 75 and 76 would make it clear that the election continues to be available for those businesses subject to income tax, by amending the 2005 Act, and corporation tax.
Amendment No. 77 deals with the transfer of assets between group companies. As drafted, paragraph 9 ignores the possibility that group companies might wish to make the election under section 161(3) of the 1992 Act to transfer the gain or loss to the trading account and be subject to tax through that route, rather than as a chargeable gain.
I would like some clarification from the Economic Secretary on why the Government have chosen to legislate for the Sharkey v. Wernher ruling. With the amendments, I am keen to ensure that there is clarity that the existing elections available to businesses and individuals will still be available under schedule 15.