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HMRC internal manual

Business Income Manual

Wholly and exclusively: fines, penalties and damages: application of hindsight

S34 Income Tax (Trading and Other Income) Act 2005, S54 Corporation Tax Act 2009

Adjustment for post balance sheet events

UK GAAP recognises the need from time to time to adjust accounts to cater for certain events after the balance sheet date (see BIM31040). When figures are amended taking advantage of hindsight then the use of hindsight should be unfettered.

The case of Simpson v Jones [1968] 44 TC 599 concerned a deduction claimed against trading profits of a solicitor. In July 1955, as a result of fraudulent transactions by X, a former partner and trusted client, a bank obtained judgment against Mr Simpson and Sconering Estates Ltd (a company controlled by X) for some £35,000.

Early in 1956, the bank received some £6,000 out of proceeds of the sale of assets of X’s associated companies, and in July 1956 X was adjudicated bankrupt. The bank and Mr Simpson each proved for £35,000 in the bankruptcy and in the winding-up of Sconering Estates Ltd, but Mr Simpson later withdrew his proofs.

By a deed dated 18 June 1958, Mr Simpson undertook to pay the bank £3,000 by fixed instalments, and the bank released him from any further payment on account of the judgment debt. The accounts of Mr Simpson’s practice for the year to 31 March 1956 incorrectly made no reference to the judgment debt, and it did not appear in the profit and loss account until the accounts to March 1958, prepared after the aforesaid deed was entered into, showed it as a bad debt from X.On appeal, Mr Simpson contended that his liability should be adjusted by reference to the loss resulting from reopening the profit and loss account for the year to March 1956 and debiting it with £29,000 (£35,000 less £6,000) on account of the judgment debt.

The Crown contended that the account should be reopened and debited with £3,000.

The Special Commissioners found that the accounts in question were incorrect and should, in accordance with normal accounting practice, have made provision for the loss estimated as likely to be incurred by Mr Simpson having regard to the sums which might be recovered by the bank from X and Sconering Estates Ltd. They held that any such estimated and provisional entry would, for tax purposes, have been subject to correction when his actual loss could be ascertained, and that accordingly the accounts should be adjusted by allowing a deduction for £3,000.

Megarry J in the High Court decided that the Commissioners’ decision was correct. He commented on the use of hindsight when reopening accounts. Once it is decided that the accounts should be reopened and hindsight invoked, such invocation should be comprehensive and not differential. The solicitor’s accountants wished to insert the figure of debt as it would have stood in 1956 when no entry had in fact been made in the accounts and the amount subsequently actually paid was very much less. Megarry J explained that, if hindsight is to be used, it should not be used to substitute a different incorrect figure for the existing incorrect figure when the correct figure was known.

The part of Megarry J’s judgment on which the above guidance is based is set out at pages 608-609:

`In thickets so dense and statute-laden as the law of income tax, common sense is, I suppose, a frail guide. Certainly it cannot become the master, for then it would usurp the function of the Statute book. But in territory which remains unoccupied by either statute law or case law, I do not see why common sense should be abjured. Here I have a situation in which it is accepted on all hands that the accounts in question must be reopened so as to include a debt. It is also beyond question that, although that debt was once £34,000, events have occurred which have reduced it, first to £28,000 and then to £3,000. When the hand of accountancy now comes to write that debt into the accounts, Mr Graham tells me that what must be written is not the £3,000 that the debt truly is but the £28,000 that it has not been since 18th June 1958. If authority tells me that for accountancy purposes I must here resurrect an extinct debt, I shall of course obey. But so far as I am aware, there is no such authority; and certainly the British Mexican case (16TC570) does not bind me to do so. In the absence of any such authority, I refuse to countenance the insertion into the accounts for the year ended 31 March 1956 of a debt of £28,000 when that is £25,000 more than I know the true debt to be. I can understand that sometimes accounts may have to be left as they stand, despite supervening events. I can also understand that sometimes accounts may have to be reopened so as to give effect to supervening events. But I find it difficult to appreciate a doctrine which binds an accountant who is reopening the accounts to be selective in making corrections to a particular item, giving effect to some and rejecting others, in order that he may substitute one incorrect figure for another. I am not saying that hindsight is always one and indivisible. What I am saying is that, once hindsight is let in, then unless there is some compelling reason to the contrary that hindsight ought to be comprehensive and not differential. In this case I have heard no such reason.

Perhaps I may add this. 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 well-known case of Bwllfa and Merthyr Dare Steam Collieries (1891) Ltd v Pontypridd Waterworks Co [1903] AC 426…

… I would apply the same principle to accounts, and tell the accountant who is reopening any accounts that unless authority compels him to the contrary he should take into consideration all the vicissitudes which have afflicted a debt, so that the accounts will show, not the imperfect estimates of the amount of that debt which would have been made at the time, but the true amount of that debt which has ultimately been established. Accountancy is difficult enough as it is, and I would deprecate a practice which might require accountants to clear their minds of today’s knowledge so that they may act today on the prophecies which they would have made yesterday if in a suitable state of ignorance of what the future then held.’