Profits for tax purposes

A recent letter from the President sent to all firms, brought information from three sources that might unkindly be described as an unholy trinity - The Law Society of Scotland (with its equivalents in Northern Ireland and England and Wales), the Inland Revenue and the accountancy profession.

Circular letters from Drumsheugh Gardens can rarely be mistaken for a postal ray of sunshine; this was no exception.  But as with all such communications, it should not be ignored - there is much to be lost by doing so - and, perhaps, a great deal to be gained by informed reaction to the contents.

Much of the information and guidance contained in the President’s letter should be familiar to solicitors’ accountants, but perhaps the first thing that should be done is to ensure that this is the case.

Doubtless guidance will be given by accountants where required, but the onus is on solicitors to ensure that their systems are ready to meet the new (and now explicit) requirements.  The guidance circulated will assist in doing this; further guidance with useful examples is available from a note published in Tax Bulletin Issue 38 (December 1998 p 606).  This can be found on the Internet at http://www.inlandrevenue.gov.uk/legal_docs/bulletins/bullframe.htm

The basic point is that following changes made in Finance Act 1998 (sections 42-46 and Schedule 6), the profits of a trade, profession or vocation require to be computed on an accounting basis which gives a true and fair view.  This concept, well known to accountants and company lawyers, requires what is known as an “earnings” basis to be adopted in all cases.  Put rather simply, this will at least require debtors and creditors to be brought into account where they may not have been in the past.  Work in progress will also have to be brought in.  In relation to that aspect in particular, it may be that where work in progress has in the past been brought into accounts, this has not been done in the correct manner.  This, as a management guru might observe, may all provide opportunities as well as threats!

There are a number of points to emphasise and perhaps clarify about the new approach.  The first is in relation to dates.  The new system will indeed apply to accounting periods beginning after 6 April 1999.

This might lead to a temptation to believe that the changes are not imminent, or that the matter can be deferred until the accounts for that period are sorted out.  Nothing could be further from the truth.

In the first place, it will be necessary to begin the new accounting period on the correct basis, which means that figures from the end of the previous accounting period - that is the last one ending after 5 April 1999 - will require to be available on the new basis.

In the second place, any change to the new basis may involve a “catch-up charge” to tax (see below).  The guidance note states that “For most firms which previously operated on a cash basis, or upon a hybrid or other basis, which did not recognise work-in-progress in full, the application of the new provisions will result in a windfall charge to tax in the first period of account commencing after 6 April 1998.”

Strictly speaking, that is not quite correct - the legislation (Finance Act 1998, Schedule 6, paragraph 2(2)(a) - headline stuff!) provides that any necessary adjustment is treated as income arising on the first day of the first period of account for which the new basis is adopted.  That is the period of account commencing after 6 April 1999 - but because the charge is under Schedule D Case VI, it is taxed in the year in which that first day occurs.  That will be tax year 1999-2000, when tax will be charged in relation to the period of account commencing after 6 April 1998.  Thus the new system, or at the very least the need to put in hand preparations for it, is with us already.

In order to understand the nature of the change, it is necessary to go back to first principles.  A “true and fair” view demands that profits are calculated on an earnings basis, calculating the amount of profit actually earned in a period.  This requires adjustments to be made to the mere subtraction of actual expenditure from actual receipts in a given period.  In particular, it requires additions or subtractions to be made in respect of those who have not yet paid their bills (whether incoming or outgoing) and in respect of work in progress.  When these matters are dealt with both at the beginning and at the end of a period of account, they will at least to some extent balance each other out.  But when they have never been brought into account before, their first appearance will generally result in an increase in profits - and that change is what leads to the catch-up charge.

It is crucial to note that the change in the requirements may affect many solicitors’ firms - even those who are currently on an earnings basis.  The opportunity should be taken by these firms to review their systems, to ensure that they can comply with the requirements.  Such firms may even have a pleasant surprise, in that they may find that they have been including too much in their work in progress (see further below).

Much of the published guidance relates to the valuation of work in progress.  Again to revert to basic principles, bringing in an addition for work in progress at the end of an accounting period is really to carry forward expenditure on such work to the period in which the income to be produced is earned - it is an “add-back” of expenditure actually incurred before the related receipt has been received.

This may help to explain one of the apparent anomalies in the guidance - no work in progress requires to be included for equity partners’ own time.  There is of course no actual expenditure included in a profit and loss account for such time, which is an appropriation of profits rather than an actual cost.

This may enable some firms currently calculating profits on an earnings basis to reduce work in progress (and hence profits) if previously partners’ time has been included.

The other factor which may lead to the same result is the need to include work in progress only at its cost (or, if lower, its net realisable value), not its selling price.  Thus if the time of a fee-earner is recorded with a translation into the price which will be charged to a client, it may be possible to reduce this, depending on the “profit” anticipated on selling that fee- earner’s efforts.

Another useful thing about the guidance published is that it is made clear that the Revenue will not be pursuing too pedantic a line.  Thus effectively sampling and percentages can be used, removing the absolute need to consider each individual file at the end of an accounting period. (Only that would produce a really accurate “true and fair” view and in theory this is what could be demanded.)  Much here will depend on the use of acceptable accountancy principles, which are coming to be more and more dominant for tax purposes.  (This is also evident, in different contexts, from a range of recent tax decisions.)  It will not, I fear, be acceptable to weigh or measure files, attributing a “per kilo” or “per inch” figure for work in progress.  But the opportunity should be taken to decide whether current methods are accurate - and whether different types of work require different treatments.

The final point in the guidance note, which deals with the ability to spread the “catch-up charge” over ten years is particularly important for partnerships.  For those which change their make-up over that period, serious attention will have to be given to the effects on arriving, remaining or departing partners.  This adds one more layer to a situation which is already complex, following the move to the current year basis of assessment, the introduction of self assessment and separate assessment for individual partners rather than assessment on the partnership as a body.

All in all, the new rules may resemble a patch of rather unattractive nettles, but they must be grasped - and the sooner the better. 

Alan Barr is Director of the Legal Practice Unit at Edinburgh University and a Consultant with Brodies WS.