Judgments - Smith (FC) (Appellant) v. Secretary of State for Work and Pensions and another (Respondents)

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    45.  It is curious that these changes (which rely heavily on documents and information actually available to the AP) were introduced at about the same time as the CSA was (by the Welfare Reform and Pensions Act 1999) granted much wider statutory powers to seek information direct from the Inland Revenue. But none of the parties made anything of that in their submissions to your Lordships.

Self-assessment in practice

    46.  I have already referred briefly to the introduction of self-assessment for income tax with effect from 1996-97. In order to understand the new para 2A and 2B it is necessary to go into more detail as to the administrative arrangements for self-assessment. The starting point is section 8 of the Taxes Management Act 1970 ("TMA 1970") (as substituted by section 90 of the Finance Act 1990 and largely re-substituted by section 178 of the Finance Act 1994) which imposes on a taxpayer a statutory obligation to make a return if required to do so. Section 113 of TMA 1970 empowers the Board of Inland Revenue to prescribe the form of the return. Sections 9A, 9C and 28A of TMA 1970 as amended (and apart from later amendments not material to this appeal) enabled the Inland Revenue to institute an inquiry into a completed return and the amount of its self-assessment if necessary to make good a loss of tax. Section 28C of TMA 1990 enables the Inland Revenue to determine the tax payable in a case where no return was delivered at all, despite a notice under section 8.

    47.  The form of return prescribed by the Inland Revenue is described as follows in Tolley's Income Tax 2005-6 para 72.1 (and the summary appears to be apt for the position during 2000-01 as well):

    "Returns. The return for individuals consists of a basic eight pages to which will be attached any supplementary pages relevant to the individual concerned, forming a 'customised' tax return. The supplementary pages are colour-coded and cover employment, share schemes, self-employment, partnership income, land and property, foreign income, trust income, capital gains and non-residence etc. Each individual will also receive a tax return guide containing explanatory notes relevant to his circumstances. It is the individual's responsibility to obtain any supplementary pages he needs but has not received, which he may do by telephoning an HMRC Orderline, by which means he may also obtain the relevant explanatory notes and/or 'helpsheets' on specific topics. Each return sent out will be accompanied by a tax calculation guide designed to assist the individual in calculating his tax liability if he chooses to do so."

    The same publication states at para 67.2 (and again, this seems to hold good for 2000-01):

    "Accounts. Business accounts are not required with the return except in the case of partnerships with an annual turnover exceeding £15m. Instead, the return includes a section in which standard accounts information (SAI) must be completed as well as space for additional information … Accounts should otherwise be retained in case of enquiry.

    (Revenue Press Release 31 May 1996, Tax Bulletins June 1996 pp 313-315, June 1997 p 436 and HMRC Income Tax Self-Assessment: The Legal Framework Manual SALF 203, paras 2.18, 2.19)."

    48.  Your Lordships have seen copies of Mr Smith's self-assessment return for the tax year 2000-01, including the pages relating to his income from self-employment (which was in fact his only source of income). Because of the way in which the argument has proceeded, it is necessary to describe the self-employment pages in considerable detail. There are four pages divided into various sections. For present purposes the relevant sections are those headed "Capital allowances - summary"; "Income and expenses - annual turnover £15,000 or more"; "Tax adjustments to net profit or loss"; and "Adjustments to arrive at taxable profit or loss." Each section contains several numbered boxes.

    49.  In the section headed "Capital allowances - summary" Mr Smith filled in three boxes:

    Cars [box 3.14]  £146,946

    Other business plant and machinery [3.16]  £1,682

    Total capital allowances [3.22]  £148, 628

    50.  The section headed "Income and expenses - annual turnover £15,000 or more" contains the SAI (summary of account information). The boxes include two parallel columns of boxes, the left-hand column headed "Disallowable expenses included in [the right-hand column]" and the right-hand column headed "Total expenses." In each of the adjoining boxes 3.44 and 3.62 (depreciation and loss/(profit) on sale) Mr Smith inserted £107,301. The total of the expenses in the right-hand column [3.64] was £221,012, deductible from his turnover (less direct costs) [3.49] of £282,317 so as to arrive at "net profit/(loss) [3.65] of £61,305.

    51.  The procedure described in the last paragraph calls for some explanation. The SAI assumes, as its name suggests, that self-employed traders (or professionals taxable under Schedule D Case II) will have accounts, usually prepared by professional accountants, which will include all the items normally shown in a profit and loss account, including depreciation. But depreciation (together with some other expenses such as the cost of business entertainment, where incurred), although always included in properly prepared accounts, is expressly prohibited as a deduction for tax purposes (ICTA 1988 sections 74(1)(f) and 577; the rule about depreciation is very long-established, going back at least to the decision of this House in Coltness Iron Co v Black (1881) 6 App Cas 315). So a self-employed taxpayer transcribing figures from his accounts (which he will not send to the Inland Revenue) to the SAI will find a figure for depreciation which he will enter in both columns, disallowable expenses and total expenses. The figure in box 3.65 (in Mr Smith's case, £61,305), although the "bottom line" figure in that section of the form, will be an intermediate figure which must be increased by adding back the disallowable expenses in box 3.66 of the next section (in Mr Smith's case, £108,215) to arrive at the true profit figure chargeable to tax. But that figure may then be reduced (and in Mr Smith's case, was very substantially reduced) by a claim for capital allowances. It might also have been reduced (but in Mr Smith's case was not reduced) by a claim for loss relief. Those matters are dealt with in the next two sections of the self-employed pages, to which I now return.

    52.  In the section headed "Tax adjustments to net profit or loss" Mr Smith filled in five boxes as follows:

    Disallowable expenses [3.66]   £108,215

    Total additions to net profit [3.69]  £108,215

    Capital allowances from box 3.22 [3.70]  £148,628

    Deductions from net profit [3.72]  £148,628

    Net business profit for tax purposes

    [boxes 3.65 plus 3.69 minus 3.72]  £20,892

    It is noteworthy that the deduction for capital allowances was nearly 40% larger than the depreciation figure which (together with some other trivial disallowable expenses) had to be added back. This is a reminder that capital allowances often do not reflect an accountant's view of economic reality.

    53.  The next section, headed "Adjustments to arrive at taxable profit or loss" permitted adjustments to be made for various types of loss relief under Part X, Chapter I of ICTA 1988. Mr Smith did not have any claim for loss relief, so that the only figure entered in three boxes (3.76, 3.90 and 3.92) was the sum of £20,892 already mentioned. The respondents understandably place a great deal of weight on the caption to box 3.92, another "bottom line" box, "Total taxable profits from this business"—the words "total taxable profits" being identical with the words used in para 2A(2) of the amended Schedule 1 to MASC. So at last we come to the central point in the appeal. The question which the Child Support Commissioner posed to himself was, as already noted:

    "In calculating a self-employed trader's earnings for child support purposes, is he or is he not entitled to any deduction for capital depreciation or capital allowances?"

    If he was entitled to a deduction for capital allowances, his earnings for the 2000-01 tax year, for child support purposes, were £20,892. If he was not entitled to the deduction, his earnings were £169,520 (the total of the intermediate "bottom line" figure of £61,305 [3.65] and the disallowable expenses of £108,215 [3.66]).

The proceedings below

    54.  In his decision the Child Support Commissioner noted (para 3) that he had to choose between two rival interpretations of the amended version of MASC, each of which could be seen as unfair. After summarising the relevant primary and secondary legislation he set out the problem (para 12):

    "In cases where paragraph 2A does now apply however, what is in my view a quite unnecessary ambiguity has been introduced, by the Secretary of State's use of the undefined expression 'total taxable profits' (which is not a defined term of art in the income tax legislation either) without making it clear whether he means by this:

    (A) the annual trading profit net of allowable revenue expenses, which is the profit chargeable to income tax under Schedule D; or

    (B) that amount less the capital allowances the trader can claim against it for the tax year in question, which is the net figure carried to his taxable income in working out how much tax he actually has to pay.

    Either figure can be easily got from any tax return or Inland Revenue calculation, so the choice between them is neutral so far as the stated aim of paragraph 2A to save administrative work is concerned."

    He also noted (para 14):

    "Both sides agreed that the choice has to be a straight 'either/or' one between (A) and (B). Either the whole of the Inland Revenue capital allowances are deductible, or nothing at all. There is no 'third way' of being able to use some intermediate figure, such as the actual profit of the business shown in the profit and loss account after the deduction of capital depreciation in accordance with normal accountancy principles, even though that may be closer than anything else to showing a true and fair picture of the real profitability of the business over the relevant period—that being of course the whole point of the accountancy standards and principles reflected in the way properly drawn accounts are presented."

    55.  The Child Support Commissioner preferred the submissions made by Mr Mostyn QC (appearing pro bono on behalf of Mrs Smith) as to the inconsistency between the treatment of capital allowances under para 2A (if interpreted in accordance with the Secretary of State's views) and under para 3, which remains in force as a default provision. He also relied on the parliamentary statement made by Baroness Hollis, which gave no support to the notion that the amendment was intended to make substantive changes. He also noted (para 29) that capital allowances are regularly used by the Chancellor of the Exchequer as a tool of economic management:

    "These fluctuations in the amounts that may be claimed by a self-employed business for capital allowances are no doubt for good policy reasons in the general management of the economy, but there can I think be no rational basis for their being taken as intended to affect the amount of child support maintenance required to be provided for children, or what a parent responsible for such maintenance should fairly be made liable to pay."

    It is apparent from his decision (paras 16 and 17) that the Commissioner had before him Mr Smith's tax returns for 1999-2000 and 2000-2001, but he did not identify the various box numbers; it is not clear whether he was urged to attach particular importance to the caption to the "bottom line" box 3.92.

    56.  This summary fails to do justice to the Commissioner's conspicuously clear decision, which combines thoroughness with conciseness. However it will serve to give a general idea of his reasoning.

    57.  In the Court of Appeal, by contrast, great importance was attached to the detail of the return form, and in particular to the figure entered in box 3.92. Ward LJ treated it as more or less decisive (para 40):

    "Rather than construing the phrase in isolation, it is preferable to look at the words in the whole of their legislative context. Thus reading paragraphs 2A(2) and 2B(2) together, meaning must be given to the words: 'total taxable profits from self-employment of that earner as submitted to the Inland Revenue in accordance with their requirements.' The only identified requirement of the Inland Revenue is that contained in section 8 of the Taxes Management Act 1970 to make and deliver a return containing such information as may reasonably be required by the notice given to the taxpayer. One must, therefore, look to the tax return to see if that assists in ascertaining 'total taxable profits.' It does assist. We find the answer in box 3.92: 'Total taxable profits from this business.' There it is. QED."

    58.  Ward LJ rejected the contrary arguments for five reasons (paras 48-52). They can be briefly summarised as follows.

    (1)  Parliament could easily have excluded capital allowances expressly had it wished to do so.

    (2)  Para 3 of Schedule 1 to MASC was not dominant; para 2A was the rule and para 3 the exception.

    (3)  When para 3 did apply its application was likely to be temporary.

    (4)  "Capital expenditure is, and always has been, properly excluded from an assessment of taxable income, but the system of capital allowances, rough and ready, artificial and variable, as it is, is at least some recognition of an economic reality. The burden of that economic reality should be for the family to share."

    (5)  Mrs Smith could seek a departure direction to alleviate any hardship; Mr Smith had no possible ground for seeking a departure direction.

    59.  Wall LJ felt driven, with obvious reluctance, to the same result. He was finally persuaded (para 67) that the possibility of Mrs Smith obtaining a departure direction was the decisive factor. Sir Martin Nourse agreed without giving a separate judgment. Again, this brief summary is inadequate but it indicates the main lines of reasoning in the Court of Appeal.


    60.  In my opinion the Child Support Commissioner was correct in his starting point, that either interpretation is possible as a matter of language. The phrase "total taxable profits" is an ambiguous expression, and (as the Commissioner observed) either figure can easily be extracted from a self-employed person's tax return. (I shall come back to whether the caption to box 3.92 gives the figure in that box any special potency). If a trader who is not an accountant or a lawyer, but who takes an intelligent interest in his own affairs, were asked the amount of his total taxable profits for Schedule D purposes, he would be likely to respond by asking whether the questioner meant before or after capital allowances. If his only capital allowances were for (say) a single modest personal computer, he might not bother to ask; but if his trade had any resemblance to Mr Smith's, he would be very likely to do so.

    61.  An accountant or lawyer would also have been likely to respond to the question with a question of his own. The professional would be aware that capital allowances have to be claimed, and that sometimes there are good tax reasons for not claiming them. Section 140(2) of CAA 1990 provides that for income tax purposes capital allowances "shall be given effect by treating the amount of any allowance as a trading expense of the trade in that period" (emphasis supplied) but that is a deeming process, and the fact that it is a deeming process may be significant: see Elliss v BP Oil Northern Ireland Refinery Ltd [1987] STC 52, 55-56.

    62.  It is common ground that before the introduction of para 2A there would have been no question of deducting capital allowances. The changes to Schedule 1 to MASC made in 1999 were described as making administrative improvements, not changes of substance. The interpretation contended for by the respondents would be a significant change of substance, and the effect of the change from para 3 to para 2A would be startling, in a case like this, even if para 3 had been repealed and entirely replaced. As it is para 3 remains in force as a default provision. The inconsistency is to my mind very striking, and potentially very unfair to a PWC in the position of Mrs Smith. I do not think that the unfairness is removed by observing that para 3 is not a dominant provision, or that it is unlikely to apply for long.

    63.  I do not attach to box 3.92 anything like as much weight as Ward LJ did. I am prepared to assume in favour of the respondents that a form very like that used for Mr Smith's 1999-2000 and 2000-2001 tax returns would have been in use when the amending regulations were drafted in 1999. But I am not prepared to assume that the draftsman (presumably working in-house in the Department for Work and Pensions) had such a form before him, and deliberately copied the words "Total taxable profits" from box 3.92. If that was his deliberate intention, he was not only making a change of substance in relation to capital allowances but also introducing further possible inconsistency with para 3 in the treatment of losses from other accounting periods, or from other trades. I regard it as over-literal, and not in line with the modern approach to statutory construction, to attach so much weight to the coincidence of the use of three words—"total taxable profits"—which amount to a composite expression of uncertain meaning, without regard to the context and consequences of that reading. Ward LJ considered himself to be looking at the words in the whole of their legislative context, but in my respectful view he was not doing so.

    64.  Nor can I attach any weight to Ward LJ's fourth and fifth reasons for rejecting the submissions made on behalf of Mrs Smith. The economic reality is that capital allowances have enabled Mr Smith to build up a profitable and expanding business while paying very little income tax. He has had the benefit of this, and his children (and Mrs Smith in her struggles to maintain the children) have had the burden of it. I can see no fairness in that. The possibility of the position being alleviated by a departure direction (a consideration which was decisive with Wall LJ) is too speculative to be given any weight as an argument on construction. There is no necessary relation between "life-style" (the expression used in regulation 25 of DDCA 1996 (SI 1996/2907)) and entitlement to capital allowances. Even if Mr Smith were to choose a monastic, miserly life-style he would still, on the view taken by the Court of Appeal, be entitled to the full benefit of the capital allowances.

    65.  Mr Mostyn QC, in his carefully crafted and forthrightly delivered submissions on behalf of Mrs Smith, placed some reliance on article 8 of the European Convention on Human Rights (respect for family life) and on section 3 of the Human Rights Act 1998. He argued that the state has a positive obligation to provide an effective system of child support, under which substantial and reasonable maintenance, proportionate to an AP's means, is paid regularly to the PWC. He was inclined to be critical, so far as courtesy and precedent permitted, of the recent decision of your Lordships' House in M v Secretary of State for Work and Pensions [2006] 2 WLR 637. To my mind that decision has very little to do with Mr Mostyn's submissions in this case. It was concerned with alleged discrimination under article 14, primarily in conjunction with the private life element of article 8, although also in conjunction with the family life element of article 8 and with article 1 of the First Protocol. I do see considerable force in Mr Mostyn's submission that a state which prevents a PWC claiming child support from an AP through the ordinary court system, as CSA 1991 does, must be under a positive obligation to provide an effective alternative system of child support. But I do not think that your Lordships need decide that point in order to dispose of this appeal, and for my part I think it is better not to do so. This appeal can be disposed of, in my opinion, on conventional principles of statutory construction.

    66.  For these reasons I would allow this appeal and restore the decision of the Child Support Commissioner.


My Lords,

    67.  Our task is to interpret the phrase "total taxable profits from self-employment . . . as submitted to the Inland Revenue". That (after deduction of income tax, national insurance contributions and half of any retirement annuity premium) is what is meant by the "earnings" of a self-employed earner in the cases covered by paragraph 2A of Schedule 1 to the Child Support (Maintenance Assessments and Special Cases) Regulations 1992 (SI 1992/1815), as amended by the Child Support (Miscellaneous Amendments) Regulations 1999 (SI 1999/977) with effect from 4 October 1999.

    68.  "Total taxable profits from self-employment" is not defined in the regulations, nor is it a term of art in tax law. As the Child Support Commissioner explained in paragraph 12 of his decision, it could mean either:

    (A)  the annual trading profit net of allowable revenue expenses, which is the profit chargeable to income tax under Schedule D; or

    (B)     that amount less the capital allowances the trader can claim against it for the tax year in question, which is the net figure carried to his taxable income in working out how much tax he actually has to pay.

    69.  There are several very good reasons to think that when Parliament amended the regulations it must have intended meaning (A). First, paragraph 3 of the same Schedule makes it entirely clear that capital allowances are not to be deducted in arriving at the figure of earnings for the purposes of calculating child support in the cases to which paragraph 3 applies. Paragraph 3 represented the law before the regulations were amended. It still represents the law in the cases to which it applies. These are, in essence, where it is not reasonably practicable for the self-employed earner to provide information in the form submitted to the Inland Revenue (paragraph 2C), where that information is too old (paragraph 5A(1)), or where it does not accurately reflect the normal weekly earnings of the self-employed earner (paragraph 5A(3)). There is no rational reason why capital allowances should not be deductible in those cases but should be deductible in the cases covered by paragraph 2A. It is an anomaly and completely inexplicable. Parliament should be presumed not to intend to produce inexplicable anomalies.

    70.  Secondly, as already explained, interpretation (A) leaves the basic principles of the calculation unchanged, whereas interpretation (B) would make a substantial change. There is no indication at all that Parliament intended to change the principles by which self-employed earnings were calculated. Neither Baroness Hollis in the House of Lords nor Angela Eagle MP in the House of Commons gave any indication that this was the Government's intention. The intention was to make it much easier for the child support officer to discover what those earnings were, and indeed for the parent whose earnings were being assessed to provide the information required: the tax return would be sufficient for both purposes. If the taxpayer did not supply it, the officer could now obtain it from the Inland Revenue direct.

    71.  Thirdly, some light may be thrown on the meaning of a legislative definition by the term which is being defined. Here the term being defined is the person's "earnings" from self-employment. The ordinary and natural meaning of earnings is the money one has made from the work one has done. This too would lead to the trading profit, the money made, less the allowable costs of making it. Capital allowances play no part in the meaning of earnings in this sense. The tax system provides for them to be deducted from earnings in certain circumstances before the actual tax payable is calculated. But it is common ground that they bear no necessary relationship to economic reality. Furthermore, the taxpayer can choose whether or not to claim them and may have good reasons to claim in one year rather than another.

    72.  Fourthly, child support liability is calculated by reference to income not capital. A parent may have substantial capital assets which it would be entirely reasonable to expect him to realise in order to keep his children, but he is under no obligation to do so. The scheme is only concerned with his income. (Indeed the new scheme which superseded the original one also largely ignores income derived from capital). As capital resources cannot be included in the calculation, it would be very strange if capital expenditure could have the effect of drastically reducing the proportion of his income on which the calculation of his child support liability was based. This would be even stranger when the allowances can be claimed against income which has undoubtedly been earned at a different time from when the capital expenditure has been made. That is, indeed, the nature of a capital allowance. Although it reflects expenditure which has actually been made, it does not usually reflect it at the time when it has been made. It is spread over a different period.

    73.  Fifthly, the child support scheme is supposed to produce a sum which reflects what the child needs and the parent can afford to pay. Capital allowances are obviously not connected with the child's needs but nor are they connected with the parent's ability to pay. Quite apart from the fact that they reflect past rather than present expenditure, they are used as an instrument of fiscal policy to provide various kinds of economic incentive. They may be more or less generous accordingly. They have nothing to do with the amount of money in the parent's pocket before he has to pay his taxes. Indeed, their effect is to increase the amount of money in his pocket at the end of the day by reducing the amount of tax which he has to pay. The facts of this case are a dramatic illustration of this.

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