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HMRC internal manual

Business Income Manual

Change of basis of computing taxable profits: historic overview

Tax case law

The two early tax cases on changes in basis of computing profits both concerned companies which changed their method of valuing stock. In one case the change was made on a challenge from the tax authority, and in the other the change was made voluntarily by the company.

The earlier case was Bombay Commissioner of Income Tax v Ahmedabad New Cotton Mills Co Ltd [1929] 8ATC575 (or 46TLR68). The accounts of Ahmedabad New Cotton Mills Co Ltd for the year ended 31 December 1925 described stock in trade as being ‘below cost’. It was subsequently agreed that the figure of closing stock in those accounts was about 37% of the proper valuation of ‘lower of cost and market value’. The company argued that if the value of closing stock was increased then it must also increase the value of its opening stock for that year in order to properly compute the profits for that year. The Privy Council decision was given by Lord Buckmaster. They agreed that in order to determine the annual profit it was not correct to raise the valuation of the closing stock without taking into consideration the similar undervaluation of the opening stock. This was a case in which the basis of valuation of stock was not an accepted method and was invalid so the company was made to change for tax purposes to a valid method.

In Pearce v Woodall-Duckham Ltd [1978] 51TC271, the company changed its method of valuing work in progress from an ’on-cost’ basis to an ’accrued profit’ basis in the 1969 accounts. It valued both the opening and the closing work-in-progress on the new basis and brought in the difference between the 1968 closing value and the 1969 opening value as ‘surplus arising on change in valuation of contract work in progress at 31 December 1968’. The figure was not taken to the trading profit and loss account but shown in the company’s profit and loss appropriation account under profit after taxation. It was common ground that both the old basis and the new basis were valid valuation methods for work in progress and that the change had been made for sound commercial reasons. It was held that the amount of the adjustment was taxable in 1969 as profits of that year.

Principles established by the cases

Where the change is from an invalid basis to a valid basis the profits for the period of account have to be computed on the new valid basis. Any adjustments which need to be made to previous periods’ computations in order to compute those profits on a valid basis must be done by changing the computations for those periods.

Where the change is from one valid basis to another valid basis for tax purposes the taxable profits for the accounting period include any tax adjustment needed for the prior period adjustment. The adjustment could either be in respect of profits recognised in the accounting period or of a loss recognised in the accounting period. This principle has now been made statutory (see below) and for Income Tax purposes an adjustment resulting in a profit is subjected to a stand-alone tax charge as ‘adjustment income’.



As mentioned above, there are now statutory rules covering the change of one valid basis to another valid basis. These are in S226-S240 Income Tax (Trading and Other Income) Act 2005 and S180-S187 Corporation Tax Act 2009 (previously S64, Sch 22 Finance Act 2002). See BIM34040 onwards.