Companies might generally expect that the profits shown in their accounts, prepared in accordance with UK GAAP, should reflect their profits for tax purposes. While this rule usually applies to the taxation of loan relationships, a recent case in the First-Tier Tribunal (FTT) demonstrates that this is not always the case.
Facts
The case arose from the fallout from the collapse of Enron Corporation in 2001. GDF Suez Teeside Limited (formerly Teeside Power Limited) (TPL) was the operator Teeside Power Station. When Enron declared bankruptcy, TPL was owed very significant debts by Enron Corporation and the UK companies in the Enron group. TPL pursued claims against the relevant companies and their administrators to recover these debts and reached settlements of some of the debts.
TPL then established a Jersey based subsidiary and transferred the rights to recover the debts owed by the Enron companies to it in exchange for shares in the subsidiary. The shares which the subsidiary issued were valued at £200m, which was equal to the value of the rights to the claims which it had received from TPL. The main reason for this transfer was to reduce TPL's tax liability.
TPL’s accounts did not show a profit either in respect of the amounts due from the Enron companies or on receiving the shares from its subsidiary. The First Tier Tribunal accepted that this accounting treatment was compliant with UK GAAP.
However, HMRC argued that, even if the accounting treatment was correct, it did not 'fairly represent' TPL's profit and that, since this was the case, under s84 Finance Act 1996, the relevant profit for corporation tax purposes was the amount which did fairly represent the profit made.
The FTT’s ruling
The FTT agreed with HMRC and ruled that UK GAAP compliant accounts can be overridden for tax purposes, even if this requires construing a profit for tax purposes where the accounts showed no such profit. Although the FTT said that it would be slow to overturn UK GAAP compliant accounts, it noted that the intention of tax and accounting legislation is different in that accounting legislation is focused on ensuring that a company's accounts give an accurate view of its profit to its shareholders and other stakeholders, whereas tax legislation aims to ensure that companies pay a fair amount of tax on their profits. In addition, accounting standards tend to allow for some consolidation of parent and subsidiary companies, whereas tax legislation tends to treat each company as a separate entity. There are therefore situations in which taxation and accounting profits should differ.
Comment
The case was decided under s84 Finance Act 1996, which is soon to be superseded. However, a new anti-avoidance regime for loan relationships, which is likely to have similar effect to the “fairly represents' rule, will be brought in with the Finance (No 2) Bill 2015. The FTT acknowledged that it was effectively using the “fairly represents” rule as an anti-avoidance tool in any case. In fact, one of the reasons that the FTT was willing to deviate from the profits in the accounts when considering the position for tax purposes was that the transaction had been structured so as to remove profits from UK tax.
In most cases profits for accounting purposes will continue to be used to calculate tax due in the context of loan relationships. However, the taxpayer should be mindful of the potential for accounting profits to be displaced in some cases (especially where there is “avoidance”), potentially leading to high and unexpected tax liabilities.
Due to the large sum involved, this case may go to appeal, in which case it will be interesting to see whether the decision is upheld.