Since the 1990s the prevailing mantra has been ‘tax follows the accounts’. There is an inherent contradiction in this formula.
Accounting is judgmental. Law is prescriptive. Tax is a matter of law, not of accounting. There cannot be a straight read-through from the accounting result to the tax result, because there can be more than one possible accounting treatment, but only one tax outcome.
Since the 1970s accountancy has been dominated by the search for the holy grail of an income recognition standard, to determine when (ie, in which accounting period) revenue should be recognised. That depends upon the answer to the question: what is a realised profit?
Since 2003 UK GAAP has contained an income recognition standard in the form of Application Note G to FRS 5. Just as the Holy Roman Empire was neither holy, Roman nor an empire, FRS 5 Application Note G is not an Application Note, nor has it anything to do with FRS 5.
It was intended to serve as an interim accounting standard in its own right, pending completion of the joint project between IAS and FASB on revenue recognition. The perceived inadequacies of FRS 5 Application Note G were such that it rapidly had to be supplemented by UITF 40, which overturned conventional wisdom on how the profits of service providers should be reported.
While IAS does have two income recognition standards, IAS 11 (Construction Contracts) and IAS 18 (Revenue), the International Accounting Board itself has called these two standards ‘inconsistent, vague and … difficult to apply’.
FRS 5 (to which there is no equivalent in IAS) was the final step in the long process of development by the ASB, and its predecessor the ASC, of a standard on ‘Reporting the substance of transactions’, more commonly known as ‘off balance sheet finance’.
Traditionally, the profit and loss account recorded a profit or loss, which was then automatically transferred to the balance sheet by inclusion in reserves.
FRS 5, by contrast, focused on recognising in the balance sheet assets and liabilities which did not arise from a transaction with a third party which would have been recorded in the profit and loss account.
The balance sheet approach was reflected in the 2009 IAS Discussion Paper Preliminary Views on Revenue Recognition in Contracts with Customers, which has been a major landmark in the yet uncompleted quest for a definitive, contract-based revenue recognition standard.
According to the Discussion Paper, a performance obligation is a promise in a contract to transfer an ‘asset’ (goods or services) to a customer. A customer who receives a haircut thus obtains an asset, be it that the asset in question is immediately consumed. ‘Transfer of an asset’ means transfer of control of the asset.
In the case of a sale of goods, this is when the customer obtains control of the goods. In the case of services, it is when the customer obtains control of the service being provided (the construction site, the tax return, the trust deed).
This is all fine and dandy, but it threatens to reverse the changes introduced by SSAP 9, FRS 5 and UITF 40. Thus today’s orthodoxy is tomorrow’s heresy and vice versa.
The changes which have transformed accountancy in the last 20 years have been uniformly driven by the desire to make accounting less of an art and more of a science, and to eliminate hidden profits and losses.
‘Certainty’ in this context is necessary or desirable for commercial and investment purposes. It remains a relative concept. There is no sovereign legislator or final court of appeal in the world of accountancy. Confusion arises from demanding the appearance of certainty where certainty cannot exist.
In the field of tax, by contrast, certainty is a component of the rule of law. It embodies the fundamental principle of legality, to which the tax system should conform. ‘Certainty’ in accounting does not have the same meaning as ‘certainty’ in law, because they are operating in quite different spheres.
To all tax questions there are only two possible answers: a correct answer and an incorrect answer. Take the great goodwill debate. Some accountants tell us goodwill is created when it is recognised. Others say it is recognised when it has been created. Both views are tenable.
For tax purposes one is wrong and the other is right. Mr Justice Arnold has now told us what the answer is in Greenbank Holidays Ltd v HMRC [FTC/46/2010]. Discussion is only effective if you can stop people talking. It is at that point that the courts have to speak a last word.
The Revenue has the right and obligation to choose between competing accounting views. The inspector is perfectly entitled to tell the accountant that he does not agree with his accounting.
What the inspector cannot do is to tell the accountant how to do his job. That is a confusion of roles. Clients should not be required to subsidise a theological debate about what is ‘correct’ accounting.
In the story of Tristan and Isolde, Tristan is given the task of delivering Isolde virgo intacta to her future husband, King Mark. He fails spectacularly.
However, when King Mark finds Isolde sleeping in a cave with Tristan, his misgivings are allayed because he observes that between them has been placed the mystic sword of chastity. This is an apt metaphor for the relationship of tax and accounting.
Accountants play a vital role in the tax system. Revenue officers (as we must now call them) have equally vital and challenging responsibilities. However, their functions are different, because they are operating in different, though related, spheres.
If the formula ‘tax follows the accounts’ is allowed to serve as a disguise for a witch-hunt against accountants, the result will be incoherent in principle, because it confuses pluralist with monolithic certainty.
That is much too chillingly reminiscent of early 17th-century Salem to be tolerated in a free society.
David Southern, Barrister, Temple Tax Chambers
