V. Trading Stock

8.113. The matching of income and expense, which is necessary if net income is to reflect a ‘true’ profit from business operations, requires a method of deferring costs which relate to stock held at the close of a year of income. The present method is set down in the provisions of the Act in respect of trading stock. If net income is to reflect ‘true’ profits, there is also a need for provisions by which an anticipated loss of the sale of stock may be brought to account. This, too, is met by the trading stock provisions. Those provisions have a third function: they make possible the anticipation of a profit by writing up the value of stock to its market selling value. This anticipation, though not related to the determination of a ‘true’ profit of a year of income, makes

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possible a spreading of income of a number of years. In this function the trading stock provisions act to support the loss carry-forward provisions and, in the case of individual primary producer taxpayers, to support any provisions relating to the averaging of incomes.

8.114. Trading stock is defined in the Act as including anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange and also includes livestock (section 6 (1) ). Other provisions relating to trading stock include the following:

  • (a) A taxpayer carrying on any business is to bring to account the value of his trading stock on hand as at the beginning and the end of each year of income in order to ascertain his taxable income (section 28).
  • (b) The value of the stock at the beginning of a year is the value ascertained under the Act at the end of the previous year (section 29).
  • (c) The value of each item of stock, other than livestock, on hand at the end of the year may be, at the option of the taxpayer, its ‘cost price or market selling value or the price at which it can be replaced’ (section 31 (1) ). The latter terms are not defined in the Act. A fourth basis of valuation applies where the taxpayer, on application, satisfies the Commissioner that, by reason of obsolescence or any other special circumstances (e.g., slow turnover items), a value other than one provided by section 31 (1) is appropriate for that item.
  • (d) Disposals of trading stock otherwise than in the ordinary course of business are to be brought to account at the market value of the trading stock on the date of disposal (section 36).
  • (e) A notional disposal at market value is deemed to occur where, for any reason, there is a change in ownership of or the interests of persons in trading stock (but specifically including change by reason of formation, dissolution or variation of a partnership) and one or more persons who owned or had an interest in the stock before the change has a continuing ownership interest after the change. There is relief from this requirement, if the parties so request, where a person or persons having an interest in the partnership before the change have at least a 25 per cent interest after the change (section 36A).
  • (f) A market valuation of trading stock applies on devolution of trading stock on death of a taxpayer; but relief is again given where the trustee of the estate and the beneficiaries (if any) agree and give notice that the valuation should be on the basis of a continuing business (section 37).

8.115. A number of aspects of the trading stock provisions call for consideration. These relate to the assets to which the provisions might apply, the methods of valuing trading stock and of identifying stock which remain on hand at the end of a year of income, and the operation of those provisions which in some circumstances will deem a disposition of trading stock to have been made at market value.

Definition of Trading Stock

8.116. The present definition of trading stock is giving rise to difficulty in determining whether it embraces several classes of assets which are on occasions dealt with as stock in hand for financial accounting purposes. The assets in question generally fall into one of three groups:

  • (a) land held for resale;

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    (b) plant spares and consumable stores;
  • (c) shares, debentures and similar assets.

8.117. Land held for resale. In defining trading stock section 6 (1) uses the expression ‘anything …’ and sections 29 and 31 refer to ‘each article’ of trading stock. The question arises, whether land is to be regarded as trading stock. Opinion is divided, though it is understood that in practice the Commissioner treats land purchased by a dealer in land as trading stock. If land does not fall within the definition of trading stock, disposals by a land dealer other than in the ordinary course of business would not have to be valued at market value (section 36). Such a disposal would include, for example, a gift of land by a taxpayer, who might otherwise have been assessable on the sale of the land, to his wife. Where real property is held for resale by a taxpayer who is engaged in a business of trading in real property, the asset should, in the Committee's view, be treated for income tax purposes as trading stock and the definition should be amended to give this result.

8.118. Plant spares and consumable stores. The problem of plant spares held in stock for future use is of a different nature. The items do not fall within the present definition of trading stock as they are not acquired or manufactured for the purpose of sale. In addition, they are not articles depreciable as ‘plant’ because they are not ‘installed ready for use’. Thus while the cost of items actually used in repairs during the income year are deductible, any loss on sale or scrapping of spare parts for which the taxpayer has no use is a capital loss and not deductible. Consumable stores such as oils, lubricants, protective clothing, cleaning materials, etc., which are used in manufacture but do not form part of the finished product also do not constitute trading stock for the purposes of the Act: they may be deductible in full in the year of purchase. In this regard the taxation treatment differs from the accounting treatment where such stock have a significant value. The Committee recommends that provision be inserted in the Act which will permit supplies on hand, including plant spares, to be treated on the same basis as trading stock.

8.119. Shares, debentures and similar assets. Another area of doubt is whether the definition of trading stock extends to shares, debentures and similar assets. This question was considered by the Ligertwood Committee which proposed that the definition should not be extended to include such assets: to do so would permit the deduction of unrealised losses on some of them without regard to unrealised gains on others.

8.120. A decision of the High Court in 1971 has substantially resolved this question in relation to shares,note but the Committee believes the position of all these assets needs clarification.

8.121. There are circumstances where the profits on sale of property may be assessable income, even though the taxpayer is not classified as a dealer in such property and the property is not within the definition of trading stock. An example is where the varying of investments and turning them to account is an essential feature of the business: it has been held that the profit on realisation of portfolio investments by banks, life insurance companies and some investment trusts is assessable income under section 25 of the Act. In the Committee's view these assets should be treated as trading stock if they are to be subject to income tax. If they are not treated as trading stock, these profits should be subject to capital gains tax.

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8.122. The Committee sees merit in the point raised by the Ligertwood Committee, referred to in paragraph 8.119. When shares, debentures and similar assets are treated as trading stock for income tax purposes, the basis of valuation elected under the trading stock provisions should be applied not to individual assets but to all assets falling within a particular class: for example, to all debentures or to all shares.

Methods of Valuing Trading Stock

8.123. The valuation of trading stock is discussed here in the context of general business. The special provisions of the Act in respect of livestock are dealt with separately in Chapter 18.

8.124. Under the present provisions of the Act each article of trading stock may, at the option of the taxpayer, be valued at its cost price or market selling value or the price at which it can be replaced. There is also provision for valuing trading stock at a lower figure where the taxpayer requests this and the Commissioner can be satisfied that, due to obsolescence or other special circumstances, a lower value is more appropriate.

8.125. The terms ‘cost price’, ‘market selling value’ and ‘the price at which it can be replaced’ are not defined in the Act and have been the subject of litigation and discussion over the years. It is therefore proposed to consider each term separately and the problems associated with it.

8.126. Cost price. Cost is regarded as identifiable or historical cost and the elements which make up cost are:

  • (a) The purchase price of goods and, in the case of manufactured stock, materials used in manufacture.
  • (b) Direct expenditure incurred in bringing the stock into its existing condition and location.
  • (c) Depending upon the circumstances, indirect or overhead expenditure attributable to the stock.

In large businesses it is often either impossible or impracticable for the actual cost of each article of stock on hand to be ascertained. This is recognised by both the accounting profession and the Revenue, and certain methods or formulae have been devised which produce an estimate of the cost of trading stock. These include:

  • (i) First-in-first-out (FIFO).
  • (ii) Average cost.
  • (iii) Standard cost.
  • (iv) Adjusted selling value.
  • (v) Last-in-first-out (LIFO).
  • (vi) Base stock.

The accounting literature on stock valuation is extensive, and it is not therefore proposed to describe each of these methods in detail.

8.127. The Revenue does not accept the LIFO and base stock methods, and, understandably, accepts standard costs only where the standards are reviewed regularly to equate with current prices.

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8.128. The major area of disagreement between the taxpayer and the Revenue as regards valuation at cost is the extent and nature of overhead expenses which need to be included in the cost of manufactured products and items in process of manufacture. Other problems include the meaning of ‘cost’ in special situations: for example, in relation to imported goods when foreign exchange rates change in the interval between purchase and payment; in relation to second-hand cars when discount on a new car is given by higher trade-in on a second-hand car (recently solved but only by Commissioner's compromise); and in relation to by-products. These problems arise out of the many possible interpretations of ‘cost’ when applied to different businesses.

8.129. In practice there is quite often disagreement of a technical nature regarding costs to be included. Because of the variety of methods of valuation applicable to particular types of businesses, it would not be possible to lay down statutory definitions. This was the view reached by the Spooner and Ligertwood Committees, and also by the Carter Commission in Canada.

8.130. A number of submissions have drawn attention to the difficulties currently being experienced in valuing stocks at cost figures acceptable for income tax purposes. These are some of the points which have been raised:

  • (a) There is some inconsistency in the rulings given by departmental officers as to the extent that overheads are to be included in determining cost.
  • (b) The appropriate method of calculating manufacturing cost depends on the nature of the business.
  • (c) The valuation of trading stock which is in accordance with accepted accounting standards consistently applied should be acceptable for tax purposes.

8.131. Generally the Commissioner requires, when the basis of valuation of a taxpayer's stock comes under review, that cost be determined on a full absorption basis that takes to account all production overhead expenses whether they be fixed or variable. However, it seems that many taxpayers for both financial accounting and tax purposes use a direct cost basis which allows only for production overheads varying according to volume of production. Direct costing excludes a value for many overhead costs normally brought to account on a full absorption cost basis. When the basis adopted is consistently applied from year to year in the case of a continuing business, the effect of the method used on net income of a year is not usually significant.

8.132. Having regard to the many and varying factors which need to be given due weight in determining the appropriate method for arriving at cost, particularly of manufactured stock, the consistent application of a generally accepted method of valuation may well be an adequate test of the reasonableness of the value. It would be most undesirable, from an efficiency viewpoint, were a large body of taxpayers to find it necessary to value their stock on two different bases, one for financial accounting and the other for tax accounting.

8.133. The Committee makes no recommendations for amendment of the present provisions relating to the valuation of trading stock at cost. It believes, however, that many taxpayers in business would benefit were the Commissioner to publish information dealing with the interpretation and operation of the law on stock valuation. This should help to remove some of the uncertainty that now exists.

8.134. It would be helpful if there were a requirement that where the valuation of trading stock has an important bearing on the determination of net income, taxpayers should disclose their methods of valuation and whether or not the method has been

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consistently applied. This raises the question of special provisions to cope with situations where taxpayers decide it is necessary or appropriate to vary their method of valuation.

8.135. Where a taxpayer changes his method, it has been the practice to require that the new method be also applied to valuation of stock at the commencement of the year of income. Where this results in opening stocks being valued at below the closing value of the previous year, the taxpayer loses a deduction for the amount by which the opening stock value in the year of change is decreased. The Committee recommends that special provision be made so that differences such as these arising from a change in method of valuation will be spread and brought to account over a period of, say, five years. A somewhat similar recommendation has been made in respect of a change in the basis of taxation from cash to accruals (paragraph 8.25).

8.136. Market selling value. By market selling value is meant the price at which the item could be expected to be sold in the market in which the trade of selling by the taxpayer is conducted. It contemplates a sale in the ordinary course of business and not a forced sale. No allowance is made for a possible fall in market price in the future, even when such an eventuality is reasonably anticipated.

8.137. Market selling value ceased to be an acceptable method of stock valuation for financial accounting purposes many years ago when it was replaced by the concept of valuation at ‘net realisable value’, provided it is less than cost. Net realisable value has been defined as the price at which it is estimated that the stock can be realised in the normal course of business, either in its existing condition or as embodied in the product normally sold, after allowing for expenditure to be incurred before and in the process of disposal. In estimating this price, regard is to be had to excess and obsolete stocks, the trend of the market and the prospects of disposal.

8.138. The main ground for rejecting net realisable value as a basis for tax treatment is that it involves estimates which would be difficult for the Revenue to confirm. However, the problems in this area should be no greater than currently apply in computing net income under the accruals method (for example, in estimating the liability of a general insurance company for outstanding claims). The Committee therefore recommends that the Act be amended to substitute net realisable value for market value as one of the alternative bases of valuation of trading stock.

8.139. Replacement price. Replacement price means the price at which the taxpayer can buy the goods on the last day of the year of income. This basis appears to be a satisfactory alternative and the Committee believes it should be retained.

Disposal of Trading Stock

8.140. A number of problems are occurring in the operation of the special provisions of the Act dealing with the disposal of trading stock otherwise than in the ordinary course of business. Where a taxpayer disposes, whether by sale, gift or in some other way, of trading stock which is an asset of his business activity and the disposal is not made in the ordinary course of that business, the value of the asset so disposed of is included in his assessable income at its market value (section 36).

8.141. This provision extends to disposal of trading stock flowing from a change in ownership or of interests following the formation, dissolution or variation of interests of a partnership; but the parties concerned may elect that it shall not apply if the persons holding not less than a 25 per cent interest prior to the change continue to have an interest of not less than 25 per cent after the change has been implemented. Where

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the parties so elect, the value of the trading stock shall be the figure at which it would have been valued if no disposal had occurred and the year of income had ended on the date of the change (section 36A).

8.142. The major weaknesses in the existing provisions appear to flow from the limitation of their application to assets of a business carried on by the taxpayer.

8.143. For example, a taxpayer who may, on disposal of property, have been liable under section 26 (a) may gift the property to another person. Section 36 will not apply, as the taxpayer was not carrying on a business of which the property was an asset. The other party will not be taxable on the profits on disposal of the property as, having acquired the property as a recipient of an unsolicited and unencumbered gift, he could not be said to have acquired it for resale at a profit.

8.144. The Committee believes that an additional provision is necessary to extend the requirement for bringing to account as assessable income the market value of any asset disposed of, where the profit on disposition is subject to tax and the asset disposed of was not included in the assets of a business carried on by the taxpayer. A new provision modelled on the existing subsection (4) of section 26AAA would be worth considering.

8.145. It is desirable that there be two exceptions, available at the election of the taxpayer, to the general rule that, on disposal otherwise than in the ordinary course of business, trading stock and other assets should be valued at market price. Firstly, the rule should not apply to transfers of assets between companies forming part of a company group. Secondly, it should not apply when assets are transferred in the course of an amalgamation, reconstruction or merger of one or more companies.

8.146. Consideration also needs to be given to the devolution at death of assets other than trading stock and from which any profit realised prior to death of the taxpayer would have fallen to be taxed. Under the present law trading stock must, on the death of a taxpayer, be brought to account at its market value (section 37); there is a proviso, however, by which the trustees and beneficiaries may give notice of their agreement to the Commissioner that the value of trading stock forming part of the business assets of the deceased shall be their value determined on the basis that the deceased had not died, with the result that any difference between tax value and market value is not brought to account for tax as at the date of death (section 37). This proviso is of considerable assistance to the beneficiaries of a deceased taxpayer who had been carrying on primary production and valuing livestock at average cost values. In the Committee's view, the proviso should be retained.

8.147. The question arises whether there should be a provision, equivalent to section 37, which will bring about a deemed realisation at death for income tax purposes in the case of an asset of the kind referred to in paragraph 8.144, i.e., an asset whose disposition will generate a taxable profit but which is not an asset of a business carried on by the taxpayer. It would be somewhat illogical if there were no provision to this effect when, under the Committee's recommendations, there will be a deemed realisation of other assets at death for capital gains tax purposes.

8.148. The difficulties arising from the operation of the special provision (section 36A) relating to changes in interests of partnerships carrying on business and with assets which include trading stock, growing crops, etc. are somewhat different.

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8.149. Section 36A was introduced into the Act in 1952 following a recommendation of the Spooner Committee. The basic rationale was to avoid the inequitable taxation of unrealised profits which arose from the application of section 36 where there was a continuity of interest in the members of a partnership following a variation, dissolution, etc. of an old partnership. Unfortunately it seems that in addition to correcting the old inequity, section 36A, as at present worded, has also created a ready means of income-splitting.

8.150. For instance, a sole trader disposing of livestock, having a market value far higher than its average cost value as used for income tax purposes, to a family partnership would, but for section 36A, be required to bring the disposal to account at the then market value of the stock. Where the sole trader holds a substantial interest in the new partnership, it is reasonable that he should not be called upon to pay tax on a profit largely unrealised. However, by a two-stage arrangement it has been found possible to transfer the whole interest in the stock to a family partnership or family company without incurring tax on the excess of market value over income tax value. By this method the tax liability on the excess can be transferred from a person paying a high marginal rate of personal income tax to other members of the family paying at lower marginal rates when the profit is realised in the normal course of business.

8.151. The Committee recommends that the principles adopted in New Zealand income tax legislation in relation to the disposition of an interest in trading stock be embodied in the Australian law. In New Zealand the following wording is inserted after sections of the Act dealing with disposals of the entirety of trading stock:

‘The foregoing provisions of this subsection shall with necessary modifications apply in any case where a share or interest in any trading stock is sold or otherwise disposed of by any taxpayer.’

A taxpayer disposing of a share or interest in trading stock is required to bring to account his share of the market value of trading stock so sold or transferred. The purchaser or transferee of the interest is deemed to have purchased the share of the trading stock at the same market value. Problems which might otherwise arise of assessing continuing partners in a partnership on profits which have not been realised are overcome by permitting their interest in trading stock on hand at the balance date following the acquisition to be valued on the same basis as would have applied had there been no change in the constitution of the partnership.

8.152. The following is an example illustrating the operation of the New Zealand principles. A, a grazier, operating as a sole trader enters into partnership with B on 31 August 1973, each having a half-interest in partnership profits and capital. A transfers to the new partnership his livestock which had an average cost value of $10,000 and a market value of $16,000. The provisions operate as follows:

  • (a) A brings to account his disposal of livestock to the new partnership at market value: $16,000.
  • (b) The partnership brings to account its opening livestock at 31 August 1973 at the same figure: $16,000.
  • (c) At the end of the income year, 30 June 1974, the partnership is entitled to value its closing livestock at what would have been A's average cost had he carried on the business for the full year.
  • (d) The result may be summarised as follows. A's income for the year includes the full profit of $6,000 on the disposal of the partnership. However, his share of partnership income is reduced by the loss on writing down livestock from

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    its market value to his average cost, which virtually eliminates any unrealised profit on livestock flowing from his continuing half-interest in it. B's share of partnership profits is also reduced by the writing down of the value of livestock He obtains a deduction for the full cost of his interest in this asset of the new partnership.

8.153. The adoption of provisions based on those in force in New Zealand should eliminate a major weakness in the existing provisions. It is appreciated that this new approach will permit a deferral of income arising from the reduction from market value to average cost, for example in respect of B's income in the illustration above. However, any loss to Revenue on this count should be largely offset by tax payable on the profit realised on the interest in trading stock disposed of, which currently is being largely deferred by the operation of section 36A.

8.154. Where a share or interest devolves by the death of a taxpayer, the principles of the present section 37 of the Act considered in paragraph 8.146 should apply.