Two partners trade in American car parts through a general partnership. Following a computer crash, they lose their records. To ensure their tax return is accurate, they value their stock at current prices rather than at historical cost. They record the difference via the capital account. The tax inspector does not accept this. The revaluation should be included in the profit. The business owner defends himself by invoking the doctrine of error.
Power jump
The inspector notes that the partnership’s closing balance as at 31 December 2018 does not match the opening balance as at 1 January 2019. The difference amounts to €219,384. The business owner explains that this is due to a computer crash, which resulted in the loss of a significant amount of data. In order to reconstruct the accounts, he has valued the stock at the current purchase prices as at 1 January 2021 rather than at historical cost. He has recorded the difference in the other partner’s capital account.
Historical cost is the standard
The inspector maintains that stock must be valued for tax purposes at historical cost. A revaluation to current prices is contrary to generally accepted accounting practice. Furthermore, a revaluation must not be recorded in the equity account, but should be recognised in the profit and loss account. By revaluing the stock and excluding the difference from profit, the general partnership will report an artificially low gross margin – and consequently insufficient profit – in subsequent years.
Limited correction
The inspector initially adjusted the full difference, but revised his position following an appeal. The accounts show that the stock was valued at €340,000 as at 1 January 2019, whilst the balance sheet as at 31 December 2018 shows stock valued at €177,968. The difference of €162,032 was recorded in the capital account rather than in the profit and loss account. The inspector therefore corrects this amount. As the business owner is entitled to the profit under 50%, his correction amounts to €81,016.
The theory of errors offers no solace
The business owner argues that the cause of the discrepancy lies in previous years and that any correction must be made there. The court rejects this argument. Even if the error arose in earlier years, the tax inspector may, on the basis of the doctrine of errors, correct it in the oldest year for which the tax return is still outstanding. In this case, that is 2019. After all, the total profit must be taxed. A sudden increase in assets that remains untaxed is therefore ruled out.