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HMRC internal manual

Business Income Manual

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HM Revenue & Customs
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Change of basis of computing taxable profits: what are invalid and valid basis?

Valid and invalid bases are not accountancy terms but ones used by HMRC. We are talking about the overall method of computing taxable profits.

A valid basis

A valid basis is one that follows the basic rule (S25 Income Tax (Trading and Other Income) Act 2005, S46 Corporation Tax Act 2009) that the profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for Income Tax or Corporation Tax purposes. See BIM30510.

A valid basis will include agreed adjustments in the tax computation in accordance with HMRC practice and current interpretation of the law. For example, adjustments will have been made to exclude capital items such as depreciation. Amendments may also have been made as a result of the operation of an HMRC extra-statutory concession or statement of practice. So a valid basis will accord with the law or practice applicable to the period of account being considered.

In addition a valid basis will correctly reflect the facts. There is a general principle in the law that where facts are available they are to be preferred to prophecies. This is sometimes called the Bwllfa principle, from the case of Bwllfa and Merthyr Dare Steam Collieries (1891) Ltd. v Pontypridd Waterworks Co. [1903] AC 426.

 

An invalid basis

An invalid basis is one that does not meet these standards of acceptability. An invalid basis of computing taxable profits is one that is not in accordance with either the law or practice.

For example, for those applying SSAP9, there are only two acceptable methods of valuing stock (excluding work in progress), (1) the lower of cost and net realisable value, and (2) for certain financial instruments mark to market value. All other methods are not acceptable and are invalid bases.

Any method that did not pay sufficient attention to the facts would also be an invalid basis.

The change of basis legislation only applies where there is a change of basis from valid to valid. It does not apply if the change is from invalid to valid, where the rule in BIM34030 applies.

 

Prior period adjustments

Prior period adjustments appear in accounts where there is a change in accounting policy or to correct a material error in the previous accounts. Where accounts have a prior period adjustment for a material error, the previous accounts may have been computed on an invalid basis.

 

Tax computation adjustments to a valid basis

The HMRC view is that where an accounting policy, which is a valid basis for tax purposes, has been adopted in a trader’s accounts a different basis cannot then be adopted in computing the profits figure to be entered on his tax return.

In Johnston v Britannia Airways [1994] 67TC99 Knox J said:

‘Which of the three ways in which the attribution of cost to a period or periods of accounting is adopted is, in my view, essentially a matter of accountancy judgment, and I am quite unable to detect any legal basis for excluding any of them.’

Admittedly in that case the Special Commissioners had expressed a preference for the method actually adopted by the trader but that was not the basis of their decision.

It follows that it is only where the accounting policy used in the accounts is an invalid basis for tax purposes that tax adjustments to the accounting policy should be made.