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There’s No Accounting for Choice: Smith and Nephew Overseas Limited and Others v HMRC

Tax laws in many jurisdictions, including the United Kingdom, are – to varying degrees – based on accounting standards. The interaction between tax accounting and financial accounting almost inevitably raises a number of questions, such as why is there a difference, what precisely are the differences and whether (let alone can!) these differences can be reconciled.

For taxpayers, given the “principles-based” approach taken by many accounting standards, the reliance of tax accounting on financial accounting has resulted in taxpayers being able to make choices when preparing tax accounts. In the UK, where a choice of accounting approaches that are consistent with generally accepted accounting principles (GAAP) exists, taxpayers have generally been free to choose which approach to adopt and the courts have generally respected this choice.

A number of recent UK cases[1] demonstrate the UK courts taking a more nuanced approach to the choices made by taxpayers in respect of the preparation of tax accounts based on financial accounting standards. 

The cases of GDF Suez and Ball UK Holdings concerned tax avoidance schemes which had been disclosed to the UK revenue authority under the UK’s disclosure of tax avoidance schemes (DOTAS) legislation.  Both cases were decided in favour of the UK revenue authority, HMRC, although for reasons other than just the presence of perceived tax avoidance. By contrast, Smith and Nephew did not concern a tax avoidance scheme that was disclosed under the DOTAS rules. Upholding the decision of the First-tier Tribunal (the FTT), the Upper Tribunal (the UT) found in favour of the taxpayer in the Smith and Nephew case.

In Smith and Nephew, the question arose as to how certain entities within the Smith and Nephew group should account for a change in functional currency following a reorganisation. HMRC had appealed against each of the three findings of the FTT, being that: 

(1) the taxpayer’s accounts were drawn up in accordance with GAAP;

(2) the foreign exchange differences gave rise to “exchange losses” within the meaning of the legislation; and

(3) those “exchange differences” did “fairly represent” losses within the meaning of the legislation. 

Out of these three findings, the decision on the first issue is likely to be the one with the most practical importance, as we shall see below.

In respect of the first issue, the decision of the UT draws out some of the problems faced by taxpayers when preparing tax accounts by reference to inherently subjective accounting standards. It had been agreed in the FTT that the relevant accounting standard dealing with foreign currency transaction was SSAP 20, “Foreign Currency Translation”. However, this standard did not set out how changes in local currency should be accounted for. Instead, it was agreed there were two commonly accepted methods which the taxpayers were able to choose from, those being the “foreign operation” method or the “single rate” method. In the absence of reliance on SSAP20, the directors of the taxpayers were required to develop accounting policies which they judged to be the “most appropriate” to the company’s circumstances for the purposes of giving a true and fair view by reference to the four criteria of “relevance, reliability, comparability and understandability”.

Importantly, the application of the “foreign operation” method (being the accounting method chosen by the taxpayers) had the effect of producing foreign exchange losses in the circumstances whereas no foreign exchange losses would have arisen under the “single rate” method. The taxpayers relied on expert accounting evidence, including guidance from the manuals of three of the “Big Four” accountancy firms in support of the “foreign operation” method being the most appropriate.

Whilst other cases have concerned choices between accounting methods expressly granted under an accounting statement, the UT noted that here the taxpayer was required to formulate its own accounting policies by reference to the four criteria mentioned above. The UT rejected HMRC’s narrow reading of “most appropriate” as requiring a binary analysis and instead considered that more than one view as to the “most appropriate” method may be reached given the “multi-factorial question of judgment” and balancing of several factors required of the taxpayer.

Ultimately the UT upheld the findings of the FTT that the taxpayers’ accounts were prepared in accordance with GAAP when based on the “foreign operation” method.

It remains to be seen whether the UT decision in Smith and Nephew will be appealed. In any event, the decision highlights the difficulties faced by taxpayers when required to prepare tax accounts based on accounting standards. In addition, the decision should provide some comfort that HMRC will face difficulties in overturning the choice of accounting method used by the taxpayer, especially in the absence of any tax avoidance.


[1] Among others, see the Court of Appeal in GDF Suez Teesside Limited [2018] ECWA Civ 2075 and the Upper Tribunal in Smith & Nephew Overseas Limited and others [2018] UKUT 393 (TCC) and Ball UK Holdings Ltd [2018] UKUT 407 (TCC).

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