T O P I C 5

Trading stock P R E PA R E D B Y W E S O B S T A N D R A M I H A N E G B I F O R T H E U N I T T E A M

Contents

Introduction 1

Learning resources 1 Textbooks 1

Trading stock to be taken into account 1 Background 1 Major issues to be considered 2

Trading stock defined 2 General principles 2 Particular items 3

When is trading stock on hand? 4 Dispositive power test 4

The valuation of trading stock 5 Valuation generally 5 Choice relates to each item of trading stock 6

Transactions involving trading stock, not in the ordinarycourse of business 7 Change in use of an item from trading stock to some other use 7 Purchases of trading stock above *market value (non-arms length transactions) 7 Abnormal disposal of trading stock 8

Prepayments for trading stock 8

Simplified trading stock rules for small business entities: Subdiv. 328-E of ITAA 1997 8

Summary 8

Deak in Univers i ty

P r inc ip les o f Income Tax Law

Introduction Income tax aspects of trading stock will draw on your knowledge of income, deductions and to some extent CGT. For this reason it is difficult to deal with trading stock until all these other areas have been considered. The study of trading stock requires you to reconsider some of the issues covered earlier in your studies.

The rules and procedure for bringing trading stock into account for taxation purposes are deceptively simple. This area is, however, extremely complex and the treatment in this unit will of necessity be extremely superficial.

Learning resources

Textbooks For the study of this topic the content of the study guide is sufficient for this unit. However, if you wish you may supplement this material with Coleman et al. 2014, Chapter 17.

Coleman et al. Principles of taxation law 2014, Thomson Reuters, Pyrmont NSW.

Deutsch, RL Fundamental tax legislation 2014, Thomson Reuters, Pyrmont, NSW,

Trading stock to be taken into account

Background There are three main steps in taking into account the tax implications of trading stock:

(a) Receipts from the sale of trading are ordinary income and so assessable under s. 6-5 see s. 70-5(2)(b).

(b) Purchases of trading stock are deductible under s. 8-1 see s. 70-5(2)(a). It should be noted that purchases of trading stock are deemed not to be capital s. 70-25.

(c) The value of the trading stock that was on hand at the beginning of the year needs to be ascertained, as does the value of the trading stock that was on hand at the end of the year. The difference between these two values needs to be accounted for s. 70-35. Any increase in the value of trading stock will form part of assessable income (s. 70-35(2)), and any decrease will be deductible (s. 70-35(3)). This effectively means that although a deduction is claimed (s. 8-1) in the year the trading stock is purchased, the real effect of the deduction is not seen until that stock is sold (see example 5.1).

E X AM P L E 5 . 1 The following simple example illustrates how Div 70 defers the deduction for the purchase of trading stock to the year in which the stock is sold. This example starts with the commencement of a business and the purchase of one item of trading stock in the first year, with no sales. The sale of this one item occurs in the second year of business. As can be seen from this example, although a deduction is claimed in year one for the purchase of the stock, this is reversed by the increase in closing stock value, resulting in no actual deduction for the

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year. In the year when the stock is sold closing stock declines resulting in a deduction against the assessable income from the sale

Year 1 (business commences) Purchases (deduction s. 8-1) $10,000 Sales (assessable s. 6-5) $0 Net effect -$10,000

Div 70 Difference in opening and closing stock Opening stock $0 Closing stock (stock not sold) $10,000 Increase in trading is assessable (s. 70-35(2)) +$10,000

Net effect on taxable income $0 Year 2 (all trading stock sold)

Purchases (deduction s. 8-1) $0 Sales (assessable s. 6-5) $15,000 Net effect +$15,000

Div 70 Difference in opening and closing stock Opening stock (from yr 1 closing) $10,000 Closing stock $0 Decrease in trading stock is deductible (s. 70-35(3)) -$10,000

Net effect of taxable income +$5,000

Major issues to be considered The major issues that arise in relation to the determination of income from trading and manufacturing activities are:

defining what is trading stock under s. 70-10

determining when trading stock is on hand

valuation of closing stock on hand

valuation of abnormal transactions.

Trading stock defined

General principles Section 70-10 provides the following inclusive definition of trading stock:

Trading stock includes:

(a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a *business; and

(b) *livestock.

From the section 70-10 definition provided it can be seen that an item does not have to be intended for sale to be trading stock. It includes anything produced,

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manufactured or acquired for purposes of manufacture. Thus raw materials will be trading stock.

In FCT v. Sutton Motors (Chullora) Wholesale Pty Ltd ((1985) 16 ATR 567; 85 ATC 4398), it was held by the High Court that the s. 6(1) of ITAA 36 [s. 70-10 ITAA 97] definition was an inclusive definition and it was still necessary to examine the meaning of trading stock in ordinary usage.

Livestock is defined in s. 995-1(1) as not including animals used as beasts of burden or working beasts in a business other than a business of primary production. The special trading stock provisions for livestock and primary producers are not considered in this topic.

Particular items

Shares After some disagreement it is now beyond doubt that shares can be trading stock for the purposes of s. 70-35(1) ((IMFC v. FCT (1971) 2 ATR 361; 71 ATC 4140).

With the introduction of capital gains tax, it is important to consider whether particular shares held by a taxpayer are more appropriately classified as trading stock or as capital asset (i.e. investment). If they are trading stock, then all gains and losses will influence tax in the year they are incurred. However, if they are capital, losses can only be claimed against other capital gain, but the gains are usually indexed or subject to the 50% discount, thereby reducing the assessable income. Section 118-25(1) of the ITAA 97.

Land Land may be trading stock following the decision in St Huberts Island Pty Ltd v. FCT ((1978) 13 CLR 210, 8 ATR 452; 78 ATC 4104) if it is the subject of the business of buying and selling land or where the taxpayer is a land developer.

Under s. 70-30 it does not matter if the land was acquired for some other purpose so long as it is held for the purpose of sale which overcomes problems difficulties encountered in such cases as Whitfords Beach Pty v. FCT ((1982) 150 CLR 335, 12 ATR 692, 82 ATC 4031), Scottish Australian Mining Co. Ltd v. FCT ((1950) 81 CLR 188, 4 AITR 443, 9 ATD 134).

Items that yield trading stock It is important to make the distinction between something that yields trading stock and something that is trading stock. The purchase of an item that yields trading stock is of a capital nature and is not trading stock. For example, the purchase of the right to mine land is the acquisition of a capital asset and the trading stock does not come into existence until it is removed from the ground. In another example, the purchase of the right to remove standing timber has been held to be capital and not trading stock (Hood Barrs v. CIR (No. 2) ((1957) 37 TC 188; [1957] 1 ER 832).

Work in progress (WIP) There seems to be little difficulty in concluding that the unfinished product (WIP) of a manufacturer is trading stock according to the definition in s. 70-10.

From the definition in s. 70-10, which is inclusive, work in progress of a manufacturer will be trading stock, as it is considered to be trading stock under normal commercial and accounting principles. Cases dealing with work in progress include Philip Morris v. FCT ((1979) 10 ATR 44; 79 ATC 4352), Duple Motor Bodies

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Ltd v. Commissioners of Inland Revenue ((1961) 39 TC 537), St Huberts Island Pty Ltd v. FCT ((1978) 13 CLR 210, 8 ATR 452; 78 ATC 4104).

Unfinished work of a professional is not trading stock for the purposes of s. 75-35(1).

Q U E S TI O N 5 .1 A manufacturer who produces electric toasters has the following stock on hand at the end of the year:

(a) half-finished toasters

(b) stationery for use in the office

(c) metal plate which is used in making the toasters and forms part of the finished article

(d) finished toasters waiting to be delivered no money has been received but this is part of a standard order that is supplied each month under contract

(e) labels and cartons used to package the finished toasters ready for sale

(f) spare parts held for the repair of the machinery used to make the toasters

(g) moulds used in the metal presses that form the metal plate into toasters a mould can be used to form 500 toasters before it is replaced

(h) building materials to be used for extensions to the factory these extensions will enable increased production.

Which of these must be taken into account as trading stock for tax purposes?

Q U E S TI O N 5 .2 A nursery has a wide range of plants in stock at the end of the year. These fall into the categories listed below:

(a) the more delicate plants which are growing in pots and kept on tables in the fernery

(b) cuttings that are growing in long trays in the greenhouse these are not ready for sale

(c) larger trees which are growing in the ground out in the open if a customer wishes to purchase one of these, it is dug out and placed in a large pot.

Discuss whether the plants constitute trading stock.

When is trading stock on hand? Section 70-35(1) requires us to value the trading stock that is on hand at the beginning and at the end of the year. In accounting and business practice the term trading stock on hand or stock-in-trade in hand have never required the item of stock to be in the physical possession of the trader.

Dispositive power test The courts usually use the Dispositive Power Test to determine whether the trading stock is on hand or not. Under this test, if the taxpayer has a power to dispose of the trading stock then it will be on hand. The case of Farnsworth v. FCT ((1949) 78 CLR 504, 4 AITR 258; 9 ATD 33) presents an interesting problem. The taxpayer had delivered fruit to a marketing pool packaging house, where it had been mixed with the fruit of other growers. Upon delivery property passed to the

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pool operators. It was held by that as the taxpayer had lost its dispositive power over the goods they were no longer on hand. To use the words of Dixon J at CLR 518, AITR 266; ATD 40 the taxpayers:

fruit had been delivered irrevocably to the packing houseand left her with no dispositive power over the fruit

Consequently Dixon J found that the fruit was not trading stock on hand of the taxpayer, despite the fact that she had not derived income from its sale at the end of the year of income. As a result, the taxpayer had neither closing stock on hand under the equivalent of s. 70-35 nor income under the equivalent of s. 6-5 (as a cash basis for accounting was used).

Q U E S TI O N 5 .3 Can you envisage any circumstances where the same item may be trading stock of two different taxpayers at the same time when applying the tests set out above?

The valuation of trading stock

Valuation generally It is clear that the provisions of s. 70-35(1) require that all trading stock on hand be valued. The legislations determines that the value of stocks held at the beginning of the year is the same as the value used as closing value for the previous year (see s. 70-40). However, the valuation of closing stock is not as straightforward.

The closing value for each item of trading stock can be, at the option of the taxpayer (s. 70-45(1)), either its:

market selling value

cost

or

replacement value.

Section 70-50 allows the taxpayer to adopt a different value for each item of trading stock which does not comply with the requirements of s. 70-45(1) where the value selected is warranted because of obsolescence or any other special circumstances (see s. 70-50), provided the value elected is reasonable (see s. 70-50(b)).

It is important to note that each item of trading stock can be valued using a different method, i.e. the taxpayer need not use only one method for all of his or her trading stock. Furthermore, they can choose a new method for valuing each years closing trading stock.

A taxpayer will usually achieve the lowest taxable income in a particular tax year income by valuing the trading stock by the method that represents the lowest figure. This will usually (though not always) be cost, as an items cost is usually lower than its market selling value or replacement value.

Section 70-45(1A) provides that in working out these values any applicable GST input tax credit (if any) is to be disregarded.

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Each of the three methods used for the valuation of trading stock under s. 70-45 has received some attention from the courts either in Australia or other Commonwealth countries and these are considered below.

Choice relates to each item of trading stock

Market selling value This method provides few problems. The value of stock would be determined by estimating its value in the ordinary course of business, i.e. normal quantities in the normal market (Australasian Jam Co. Pty Ltd v. FCT ((1953) 88 CLR 23; 5 AITR 566; 10 ATD 217)). Exceptional assumptions such as a forced sale, are not relevant. It was also commented that where goods are sold in more than one market it is not possible to value them by reference to one market only, they were to be valued in the proper proportion in each market.

Cost Arriving at a cost price is not quite so simple. Accountants have developed a number of cost flow assumptions to calculate the cost of items of trading stock. Despite the fact that such a method may, or was permitted for accounting purposes, a cost flow assumption may be only used where they are appropriate to the particular item of trading stock so as to determine the actual cost of the item (see Australasian Jam Co. Pty Ltd v. FCT ((1953) 88 CLR 23; 5 AITR 566; 10 ATD 217).

Cost alternatives Specific identification (or unit cost method) is where the cost of individual

items of trading stock is individually recorded. This method is appropriate where the items are of great value or can be easily identified from normal accounting records. Examples would be motor vehicles which are recorded under vehicle number and gold bars each of which are impressed with serial number and weight. Also high value breeding livestock should be valued using this method (see Rowntree v. FCT (1934) 3 ATD 32).

First-in first-out cost flows are acceptable (Australasian Jam Co. Pty Ltd v. FCT ((1953) 88 CLR 23; 5 AITR 566; 10 ATD 217); MNR v. Anaconda American Brass Inc. [1956] AC 85).

Last-in first-out cost flows are not acceptable (MNR v. Anaconda American Brass Inc. [1956] AC 85).

Average cost is acceptable ((Australasian Jam Co. Pty Ltd v. FCT ((1953) 88 CLR 23; 5 AITR 566; 10 ATD 217)). Average cost should not include items which by their nature should be valued using specific identification (Rowntree v. FCT (1934) 3 ATD 32).

Standard costs are acceptable if kept up-to-date ((Australasian Jam Co. Pty Ltd v. FCT ((1953) 88 CLR 23; 5 AITR 566; 10 ATD 217).

For manufactured goods, there is the additional question of whether direct or absorption costing should be used:

Direct costing (under which only the variable costs of manufacturing are included in the value of WIP and finished goods) is not acceptable (Philip Morris v. FCT ((1979) 10 ATR 44; 79 ATC 4352)).

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Full absorption cost (fixed manufacturing costs are included in the value of work in progress and finished goods) should be used for manufactured and purchased items Philip Morris v. FCT ((1979) 10 ATR 44; 79 ATC 4352).

Replacement value For the income year commencing 1 July 2000 replacement value is used instead of replacement price. (The change from price to value is to avoid confusion of the definition of price in section 9-75 of the GST legislation. It is therefore not intended to change the meaning of the concept. Thus cases dealing with replacement cost are relevant in determining replacement value.) In Brigg Neumann & Co. v. Commissioners of Inland Revenue (1928) 12 TC 1191 at 1203, Rowlatt J held that replacement cost meant the price the taxpayer would have to pay in order to have the item on hand on the last day of the tax year. This agrees with the now withdrawn Recommendations on Accounting Principles II treatment of stock-in-trade and work in progress in financial accounts issued by the Institute of Chartered Accountants in Australia in December 1963. Paragraph 18 states that Replacement price:

means an estimate of the amount for which the stock could have been acquired or produced either at the balance sheet date or during the latest period up to and including that date.

Transactions involving trading stock, not in the ordinary course of business

Change in use of an item from trading stock to some other use

Value of trading stock taken for personal use or for use in taxpayers business Section 70-110 of the ITAA 97 specifically deals with this matter and provides that the item is deemed to have been disposed of at its cost and it then ceases to be trading stock. Section 70-110 will also apply where an item of trading stock is converted to a depreciating asset.

Change in use of an item from some other use to trading stock When a personal item, or an item that is a depreciating asset, is changed so that it is being held as trading stock section 70-30 deems the item to be acquired as trading stock either at its original cost or at its *market value. (The definition of market values was inserted into s. 995-1 as a consequence of the introduction of the GST legislation.) Where market value is elected there will be a CGT event K4 under s. 104-220 of the ITAA 97 as from 1 July 1998. There are no CGT consequences when cost is elected.

Purchases of trading stock above *market value (non-arms length transactions) Section 70-20 somewhat misleadingly headed non-arms length transactions provides that where a taxpayer incurs an outgoing relevant to your buying or obtaining delivery of trading stock (s. 70-20(a)) and the transaction was not at arms length (s. 70-20(b)) and the outgoing was greater than *market value of what the outgoing is for (s. 70-20(c)) the amount of the outgoing is deemed to be the market value.

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Abnormal disposal of trading stock Subdivision 70D deals with disposal of trading stock and certain other assets outside the normal course of business.

Section 70-90 deals with disposals of such assets outside the ordinary course of business. In such situations the taxpayer is deemed to have disposed of the item at its market value on the day of disposal. A disposal (alienation) or destruction of a taxpayers trading stock by a third party such as the intervention of a government authority does not constitute a disposal for the purposes of s. 70-90 because there is no disposal (alienation) etc. by the taxpayer

Under s. 70-90 the person acquiring the item is deemed to have acquired it at an amount equal to its *market value.

Prepayments for trading stock As mentioned above, under s. 8-1 there is an immediate deduction for the purchase of trading stock. In Raymor v. FCT an immediate deduction was allowed even though the trading stock was not delivered until the following year. Section the former s. 51(2a) and the current section 70-15 were introduced to overcome this decision.

Simplified trading stock rules for small business entities: Subdiv. 328-E of ITAA 1997

Businesses that have a turnover of less than can elect to use simplified trading stock rules. Under these rules trading stock does not have to be taken into account if the difference between opening and closing is not more than $5000. However, this is purely optional, and those businesses that dont have to take into account the changes in trading stock can still account for changes in trading stock if they choose to do so

Summary The calculation of trading stock values provides many practical problems for the practitioner which cannot be discussed in detail in this subject.

As a general principle, taxable income will be minimised if the closing value of trading stock is the minimum possible under the provisions of the ITAA 97. Of course, the opposite will apply if a taxpayer wishes to increase taxable income to avoid losses or utilise carry forward losses. The approach of minimising trading stock values will only affect the timing of tax as the full value will be taxed when these goods are sold.

It is important to remember that special provisions apply for live stock and also abnormal forced disposals for primary producers. These provisions are not dealt with in this topic.

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Q U E S TI O N 5 .4 X Ltd, a seller of party supplies, commenced business in July of the current tax year. For the current tax year, X Ltd had sales of $1.5m.

It made the following purchases of trading stock:

August $300 000

December $200 000

March $400 000

At the end of the year, its trading stock was as follows:

Item Quantity Cost Market selling value

Replacement value

Party hats 50 000 3 5 4

Confetti 40 000 8 7 9

Balloons 6 000 2 3 3

Whistles 9 000 15 18 13

Calculate the tax position for the sale of trading stock to obtain the lowest taxable income.

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Trading stockIntroductionLearning resourcesTextbooks

Trading stock to be taken into accountBackgroundExample 5.1

Major issues to be considered

Trading stock definedGeneral principlesQuestion 5.1Question 5.2

When is trading stock on hand?Dispositive power testQuestion 5.3

The valuation of trading stockValuation generallyChoice relates to each item of trading stockMarket selling valueCostCost alternatives

Replacement value

Transactions involving trading stock, not in the ordinary course of businessChange in use of an item from trading stock to some other useValue of trading stock taken for personal use or for use in taxpayers businessChange in use of an item from some other use to trading stock

Purchases of trading stock above *market value (non-arms length transactions)Abnormal disposal of trading stock

Prepayments for trading stockSimplified trading stock rules for small business entities: Subdiv. 328-E of ITAA 1997SummaryQuestion 5.4