Law Report: No tax rule against anticipated losses

Friday Law Report: 19 February 1999; Herbert Smith (a firm) v Honour (HMIT) Chancery Division (Mr Justice Lloyd) 12 February 1999

THERE WAS no rule of tax law against anticipation of liabilities, and accordingly a provision in a firm's accounts, made according to generally accepted principles of commercial accounting, for expected losses on leases which could not be terminated and which could only be sublet at a rent lower than that payable under the firm's own leases, was legitimate in the assessment of the firm's income for tax purposes.

The taxpayer's appeal against the decision of the Special Commissioners that it was not entitled to make provision for anticipated losses was allowed.

The taxpayer was a firm of solicitors, which decided to move from four leasehold offices to a single office. In relation to two of the four offices, it was able to put an end to its continuing obligations for rent. The other two leases, however, were at rents which were then well above the market level, and were not capable of being terminated. The firm was thus left with two leases which it would only be able to sublet, if at all, for a lower rent than it had to pay under its own leases.

The firm's accounts were audited in accordance with the principles that would apply if it were a company, so as to show a true and fair view both of the partnership at the balance sheet date, and of the partnership's profits and source and application of funds for the year. In its accounts for the 12-month period to 30 April 1990 a provision was made for the expected loss on the two leases, in one case for the remainder of the lease and in the other until 1998, which was the date of a rent review.

The Inland Revenue contended that although that was the proper approach as a matter of generally accepted principles of commercial accounting, and a fair approach as between the firm's partners, to make provision for future rent liability nevertheless anticipated losses in a way which was not legitimate in the assessment of the firm's income for tax purposes.

Edward Walker-Arnott, solicitor advocate (of Herbert Smith), for the taxpayer; Nicholas Warren QC and Rabinder Singh (Solicitor of Inland Revenue) for the Revenue.

Mr Justice Lloyd said that the dispute was not whether the firm was entitled to deduct the shortfall in the rent, but whether the shortfall was to be deducted in advance, or year by year as it occurred.

The legal issue was what was to be brought into account in respect of the net rent payable for the premises when calculating "the full amount of the profits or gains of the year", those profits being the annual profits "arising or accruing . . . from any trade, profession or vocation": see sections 60(1) and 18(1) of the Income and Corporation Taxes Act 1988.

It was contended on behalf of the firm that the amount in any given year of the profits of a partnership which had its accounts prepared and audited on generally accepted principles of commercial accountancy was the amount shown by the accounts for that year, and that there was only very limited scope for going behind those accounts. The present case was not one in which that could be done.

It was submitted for the Revenue that there was a rule of tax law that neither profits nor losses might be anticipated and that if, on their true analysis, accounts prepared in accordance with generally accepted principles of commercial accounting involved such anticipation, they could not be used for tax purposes but had to give way to a calculation which eliminated any such anticipation.

That argument would be rejected. Such a rule would be inconsistent with resort to generally accepted principles of commercial accounting in very many cases, since it would disallow any provision made in accordance with the concept of prudence. In Threlfall v Jones, Gallagher v Jones [1994] Ch 107, the Court of Appeal had considered that the generally accepted principles of commercial accounting operated so as to preclude illegitimate anticipation, and the present case was a mirror of that case.

Kate O'Hanlon,

Barrister