Supreme Court confirms primacy of GAAP for corporation tax deductions

The Supreme Court has confirmed the earlier judgments of the lower courts in holding that accounting debits arising in the context of the grant of share options were deductible for corporation tax purposes, despite the lack of any actual expenditure by the companies concerned: HMRC v NCL Investments Ltd [2022] UKSC 9.

Whilst the specific decision is largely of historical interest due to changes in the law introduced in 2013, the judgment is still of wider interest in confirming the primacy of accounting entries for CT purposes and limiting the scope of the restrictions on CT deductions for accounting debits.

Background

The case concerned the proper treatment for CT purposes of accounting debits arising the in the accounts of NCL Investments and related companies, which were subsidiaries of a holding company, Smith & Williamson Holdings Limited (SWHL). The debits arose as a result of the grant to the companies' employees of options to acquire shares in SWHL. These option grants were made via an employee benefit trust (EBT) set up by SWHL.

International Financial Reporting Standard 2 (IFRS2) required the companies to recognise an expense on their income statements in respect of the grant of the options by the EBT. Although the grant of the options did not require the companies to part with any cash or other assets, IFRS2 nonetheless required the recognition of an expense. The debits on the companies' income statement had to be matched by a corresponding credit on their balance sheets. As the share options came originally from SWHL, IFRS2 required the companies to treat the corresponding credit as a capital contribution from a parent company.

In computing their liability to CT, the companies therefore claimed to be entitled to deduct an amount equal to the accounting debits from their profits. HMRC contended that the debits should not be taken into account in this way, relying on a number of grounds. The First-tier Tribunal, the Upper Tribunal and the Court of Appeal all rejected HMRC's arguments.

Decision of the Supreme Court

The Supreme Court has unanimously dismissed each of HMRC's arguments for overturning the earlier decisions.  

Whether disregarding the debits is an "adjustment required or authorised by law"

Section 46(1) Corporation Tax Act 2009 (CTA 2009) requires that profits are to be computed on an accounting basis "subject to any adjustment required or authorised by law". Whilst accepting that IFRS2 required the companies to recognise an expense in their income statements equal to the fair value of the options, HMRC argued that this was a situation where an adjustment was required. In particular, HMRC argued that these debits did not affect the trading profits of the companies for CT purposes. The debits arose because the companies' parent company, SWHL, established an EBT and the EBT Trustee granted the options to the companies' employees. These transactions were treated by IFRS2 as a capital contribution (benefit) granted by SWHL to the companies. The debits did not represent any cost to the companies, nor did they anticipate or reflect an actual cost which would arise in the future.

The Supreme Court rejected this argument. Odeon Associated Theatres Ltd v Jones [1971] 1 WLR 442 and cases following it established that the profit of a taxpayer's trade is to be determined in accordance with "ordinary principles of commercial accountancy" and this is now reflected in section 46(1) CTA 2009. HMRC relied on the decision in Lowry v Consolidated African Selection Trust [1940] AC 648 that an adjustment was required. That case concerned an issue of shares at below market value where the company claimed the difference as a tax deduction and the House of Lords held that a deduction could not be claimed as there was no cost to the company. However, the Supreme Court has held that Lowry is not general authority for the fact that a company must suffer some cost or economic burden for a deduction to be available.

The Court noted that there was no equivalent of section 46(1) at the time Lowry was decided giving statutory primacy to generally accepted accounting practice. "Tax is the creature of statute and... adjustments required or authorised to be made to profits calculated in accordance with generally accepted accounting principles are likely to be adjustments specified by statute. While it is possible for a judge-made rule to require or authorise such an adjustment to be made, it would have to be a rule which it is clear applies notwithstanding that the company's profits have been calculated in accordance with generally accepted accounting principles. Lowry provides no support for there being such a rule."  

HMRC also argued that generally accepted accounting practices which are directed at preserving the integrity of the taxpayer's balance sheet (such as IFRS2) were less relevant to CT than other accounting practices, because CT was concerned primarily with a company's profit and loss account. The Supreme Court rejected such a distinction. A company's balance sheet and profit and loss account are not separate and severable because entries on one may affect entries on the other in order that overall they give a true and fair view of the financial state of the company.

Whether the deduction is disallowed by section 54(1)(a) CTA 2009

Section 54(1)(a) CTA 2009 states that no deduction should be made for "expenses not incurred wholly and exclusively for the purposes of the trade". HMRC argued that the debits were not "incurred" because the companies suffered no loss in relation to them, and / or the debits were not for the purposes of trade.

The Supreme Court rejected HMRC's case that section 54 imports a further requirement for an "expense" to be deductible, namely that it must be "incurred". The requirements for what constitutes a deductible expense are set out in sections 46 and 48 CTA 2009. Section 54 does not address how profits are to be calculated but rather what deductions are to be disallowed, with a particular focus on expenses incurred for a dual purpose.

The Supreme Court also rejected HMRC's argument that, as the debits arose from a transaction to which the companies were not parties, it was impossible to ascribe any "purposes" to the debits on the part of the companies. The FTT had made a finding of fact that the debits were incurred for the purposes of the companies' trades and there were no grounds for challenging that finding.

Whether the deduction is disallowed by section 53 CTA 2009

Section 53 CTA 2009 provides that "no deduction is allowed for items of a capital nature". HMRC argued that the debits were of a capital nature because they are simply the corresponding entry required to match the capital contribution from SWHL. The Supreme Court rejected this argument, agreeing with the FTT that the debits had a revenue, rather than capital, nature. The IFRS2 debits arose because the companies' employees were remunerated with share options and the remuneration of employees has a revenue character. The fact that the matching credit entry was a capital contribution did not change this; what matters was the character of the debits themselves.

Whether the deduction is disallowed (or deferred) by section 1290 CTA 2009

Section 1290 CTA 2009 places restrictions on deductions that would otherwise be allowable when calculating a company's profits, if that deduction is a deduction in respect of "employee benefit contributions". This is defined in section 1291 CTA 2009, the critical part of which requires property to be "held... under an employee benefit scheme".

The Supreme Court analysed the definition of an employee benefit contribution and, in agreement with the lower courts, has held that what happened in this case did not involve any property being so held. If the property were regarded as the options, then once the options had been granted to the employees they were theirs absolutely and were not "held" or "used" under an employee benefit scheme. If the property referred to in section 1291 was the shares, then the fact that the EBT Trustee needed to obtain shares to meet its contractual obligations when the options were exercised did not mean that those shares were to be held by the EBT Trustee "under" the employee benefit scheme in the necessary sense. The shares were not acquired to confer a benefit on the employees because any benefit had already been provided in the form of the option which was granted by the companies. The EBT Trustee acquired the shares in order to fulfil its contract - it was not conferring some benefit on the employees in addition to the benefit already conferred on them by their employer.

Comment

The relevant legislation dealing with share based payments was amended by Finance Act 2013 in relation to accounting periods ending on or after 20 March 2013, specifically to prevent relief in the circumstances of this case. As such, the specific decision is largely of historical interest.

However, the decision of the Supreme Court confirms the importance of generally accepted accounting principles for calculating profits for tax purposes and demonstrates that the circumstances in which adjustments are required will be largely limited to those provided for by statute. In particular, it confirms that it is not necessary for there to be any true cost or cash expenditure in order for accounting debits to be deductible. Of course, the decision by implication also indicates that if the accounts recognise a credit or income, it will be hard to treat this as non-taxable in the absence of a specific legislative override.