Back in 1955, Lady Zia Wernher had a business of breeding racehorses. Some of the horses she bred were sold on to new owners, but some of them she kept, trained herself, and entered in races. Owning and racing horses was not considered a trade.
Lady Zia, therefore, was taking some of her trading stock (the young racehorses) for her personal use. She and the taxman could not agree on what figure should be included in the accounts of her breeding business for these young racehorses she was keeping for herself. There were three possible answers:
§ Nothing, because the business had received nothing for the horses
§ An estimate of the cost of breeding and keeping the horses up to the date they were taken out of the business for Lady Zia’s own use – reasonable, you might think, because after all, it was only fair that she should not get a tax deduction for the costs of producing a horse she wasn’t going to sell
§ The open market value of the horse, because the taxman said so!
The case went all the way to the House of Lords, who must have been having an off day (or perhaps some of them had recently lost money on one of Lady Zia’s horses?), because they agreed with the taxman that the correct thing to do was to put a figure in the breeding business’ sales equivalent to the market value of the racehorses when they were taken for Lady Zia’s own use.
Most tax advisers (and in private, off the record, some tax inspectors) think that their Lordships got it wrong. When you read their judgement, it is certainly apparent that they did not understand some of the basic principles of accountancy – for example, they made much of the difficulty of arriving at a figure for the “cost” of breeding any particular racehorse. The reality of course, as anyone who runs a business knows, is that it is not very difficult at all to come up with a perfectly reasonable estimate of the cost of any particular item of stock.
Unfortunately, as the highest court in the land has decided that market value is the correct figure to use, any trader who takes goods from his trading stock for his own use must prepare his accounts as if he had sold those goods at their market value.
I suspect that HM Revenue and Customs know in their hearts that Sharkey v Wernher was wrongly decided – certainly, inspectors are instructed to “take a reasonably broad view” when they use the case to impose market value.
For example, if the trader gives special discounts (on similar deals) to other customers, he can take advantage of them himself. There are also some specific statutory exceptions to the “market value” rule:
§ Services (rather than goods) provided to the trader or his household should be dealt with by disallowing the cost rather than charging the market value
§ Meals provided free to proprietors of hotels, pubs, and restaurants and their families should be treated in the same way – disallow the cost
Note that the above applies to sole traders and partnerships – the situation is more complicated where the trade is run through a limited company.
§ Goods and services provided to employees as a reward should be accounted for at market value, but a deduction can also be claimed (as a cost of employing the member of staff) for that value. There can be problems if the employee is also a relative or a shareholder in the company, and also in how to measure the “benefit” for the employee’s tax purposes.
§ Builders can have problems if they use their tools and employees to build a house for their own use. If they own the land outside the business, then they should simply disallow the cost of the work and materials – but if the land was part of the builder’s trading stock, then it is a case of market value for the land at the time it is decided the proprietor is going to have it for himself, and thereafter, disallow the cost of any further work done.
The Final Hurdle
Optimists among tax advisers hope that one day the law will be changed, or someone will take a case all the way to the Lords again so that they can correct the mistake their fathers made back in 1955, but until then (and don’t hold your breath), Sharkey v Wernher remains to show that racehorses can be expensive in unexpected ways!