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.