Capital or Revenue?

Capital or Revenue?

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Solicitor purchased another solicitors for £1.  About 6 months following the date of purchase a number of discrepancies on client account were uncovered and these are unlikely to be repaid by the previous solicitors.  The purchaser, therefore, repaid the client account.  

Can this repayment be included in the accounts as a revenue item and be used to reduce taxable profits?

No significant due diligence work was carried out because of the low price and steady income the other firm was offering. These discrepancies (which totalled about 5% of turnover) could have been identified prior to takeover and I wondered if it could be argued that this payment is capital eg goodwill.

 Thanks for any assistance.

Replies (9)

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David Winch
By David Winch
23rd Jan 2011 20:14

Worrying

This worries me.  If the deficiencies on client account had existed for any length of time they should have been known to the outgoing solicitor, not least because they should have been picked up by his accountants during their routine examination of client account balances and reconciliations.

Did the outgoing solicitor misrepresent the business to the new solicitor (for example, by implying that there were no problems with the client account)?  If so has the outgoing solicitor defrauded the purchaser by a dishonest misrepresentation which has caused him loss?  Has the outgoing solicitor evaded his own liability to his former clients by passing it on to the new solicitor?

Have you considered whether a report to your MLRO or to SOCA is required under s330 PoCA 2002 / MLR 2007 in relation to the outgoing solicitor?

Client account balances should be examined and reconciled with the client bank account balances by the solicitor at least once in every 5 weeks (i.e. typically at a month end).  How was it that the problems did not come to light for 6 months after the new solicitor took over?

Presumably when you report to the Law Society under the Solicitors' Accounts Rules you will refer to the temporary deficiency in client funds and the delay in bringing this to light.

Are you satisfied that a similar problem cannot re-occur (especially if the new solicitor has taken over some staff from the outgoing solicitor)?

David

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By SDGREEN
24th Jan 2011 06:42

But what about the tax position?!
The previous solicitors systems were a shambles and the takeover was continuously delayed. They had inherited the business and were totally out of their depth. My client was advised not to proceed but went ahead. The full picture did not emerge until further down the line when 'reconciliations' and balances were provided.

The SRA have been advised of the errors found and the potential problems going forward have been eliminated.

Thanks for your help but, would they get immediate relief for tax against the payments made to rectify the balances?

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By thisistibi
24th Jan 2011 09:11

Interesting

As far as the tax position goes, it's a pretty unusual case.  It reminds me of the case Cooke v Quick Shoe Repair Service, which you might find useful if you decide to claim a tax deduction for this.

There are two questions here:  is the cost capital, and is it wholly & exclusively incurred for the purposes of the trade.  Taking each of those points in order:

HMRC manuals BIM35540 discuss the Quick Shoe case  and summarises "a payment that has the effect of preserving the existing business, its goodwill or assets will likely be on revenue account."  It seems to me that is exactly the position your client is in... the payment is being made to preserve the future of the business.  Otherwise clearly they wouldn't have paid it.  It's not true to say that the payment is directly connected with the acquisition of the business - as I assume no reduction in the purchase price occured to account for the client account issue (it seems at least the purchaser was unaware of it at the time of acquisition). 

HMRC manuals BIM38330 discusses the Quick Shoe case in the context of "wholly & exclusively".  In concludes "where a payment is wholly and exclusively for the purposes of the trade it matters not that the payment discharges someone else’s legal obligation."  That seems slightly counter-intuitive to me because I would normally say that a "black hole" in the accounts should be disallowed as it isn't incurred wholly & exclusively.  But I think this can be differentiated because it's an obligation of the former owner - through no fault of the new owner.

So, provided it's supported by the accounting treatment, I think there is actually a strong case to allow these costs perhaps with adequate disclosure to protect against a discovery assessment.

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By paulwakefield1
24th Jan 2011 14:06

Goodwill?

From a purely accounting viewpoint, I would view this as a cost of acquisition (assumption of liabilities) even if it was accidental and consequently would form purchased goodwill if it exceeds the fair value of assets acquired (which sounds likely!).

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John Toon
By John Toon
28th Jan 2011 13:34

£1 allowable

I don't think the refunds to clients can be treated as taxable because the new practice is effectively refunding monies "misappropriated" by the previous practice. This can't possibly be wholly and exclusively for trade (I'm no tax expert) can it?

The only thing you could argue since the practice was acquired for a knock down price, is that the £1 paid represented goodwill and I'd write it off!

The only way the new practice can seek recompense for the monies paid back to the clients is to pursue the previous practice through the courts.....

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By Jon Stow
28th Jan 2011 15:47

Revenue expense I think.

I agree with thisistibi . I would add that expenditure to protect and preserve the business is allowable as a revenue item and if this is the purpose in the business owner's mind at the time of the outlay then the expense is tax deductible. See Morgan v Tate and Lyle, 35TC367.

Jon Stow

 

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By julieraikes
28th Jan 2011 17:26

Goodwill I think

The SRA have been informed but they will expect the incoming practice to make good anyway.  I would say they would be very interested in knowing who the previous accountants were as there are actually more accountants struck off for problems with SAR reports than solicitors - they will follow up.

The incoming solicitors could try to recover the shortfall from the outgoing firm but presumably buying the business for £1 means here are going to be problems!.  The funds injected represent investment by the new firm and will increase the value of of the business in that it is compliant!.

Its not a trading expense, how can it be P&L 

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By Jon Stow
30th Jan 2011 11:55

Respectfully disagree

I would have thought that Cooke v Quick Shoe Repair Service [1949] 30TC460 and Morgan v Tate & Lyle Ltd [1954] 35TC367 would be quite sufficient to justify a revenue deduction for tax purposes and I would be happy to argue the case. Remember that the motive of the business owners at the time of payment is crucial in determining the tax treatment.

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By Cirius di Lemma
31st Jan 2011 09:54

I'm with the allowits...

... avoiding creating bad will, is an entirely different thing from creating goodwill, and the precedents that have been cited are quite persuasive.

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