Edition 54
The Tax Treatment of Trading
Stock
INTRODUCTION
In the first of a two-part series, we look at the tax treatment of trading stock. The next edition of
Bookkeepers Knowledge Base will focus on the accounting treatment of inventory, examining the two
main inventory systems – the periodic and perpetual systems. While bookkeepers do not directly deal
with the tax aspects of trading stock, it is important that they understand the effect that trading stock has
on a client’s taxable income particularly given the central role of trading stock in most businesses.
Specifically, issues such as:
Donated stock
•
Stock taken for personal use, and
•
The treatment of lay-bys
•
are matters that bookkeepers are likely to deal with from time to time. A working knowledge of this topic
is therefore essential.
WHAT IS TRADING STOCK?
Trading stock is defined in Section 70-10 of the Income Tax Assessment Act (1997): as:
anything produced, manufactured or acquired that is held for the purpose of
manufacture, sale or exchange in the ordinary course of a business.
Therefore, an item can only be trading stock if it is capable of sale or exchange as part of a business, or
if it goods, property or services in the process of production but not yet completed (i.e. work in
progress). For example, biscuits for sale in a convenience store would constitute trading stock, while the
shelves on which those biscuits are displayed would not, as the shelves are not available for sale or
exchange to customers.
The following table outlines some contentious items and whether they constitute trading stock. To
qualify as trading stock, they will of course need to be available for manufacture, sale or exchange in the
ordinary course of business:
Item
Live stock
Trading Stock?
Yes
Unless they are beasts of
burden or working beasts in nonprimary production businesses
*
*
Unless they are harvested, felled
or picked
Shares
Land and property
Crops and Trees
Goods for Hire
Futures Contracts
Plant and Equipment
Work in Progress
Computer Software Produced
for Sale
Spare Parts Held
No
Unless under a long-term
contract
Unless developed for licence
Unless held for the purpose of
maintenance
BOOKKEEPERS KNOWLEDGE BASE
1
*Shares and property generally do not constitute trading stock unless the transactions are frequent and
significant resources are devoted to the activity, such that the taxpayer is deemed to be in the business
of share or property trading. For instance, where a person merely owns one or two investment
properties or from time to time dabbles in the share market, the properties and the shares respectively
will not constitute trading stock. The relevant factors to consider are outlined in the Tax Office
publication Carrying on a business of share trading
For manufacturers, trading stock typically consists of raw materials, work in progress (unless that work
is part of a long-term contract) and finished goods. However, consumables and business inputs such as
sandpaper and cleaning agents are not trading stock.
For service-based industries, materials and spare parts are only trading stock if:
•
•
•
A business is providing services to customers for reward
The materials or spare parts are supplied by the business to the customer in the course of, and
as an essential part of, performing the services, and
The materials or spare parts are separately identifiable things before and after the services are
provided which retain their individual character or nature.
Example
Paul is an air-conditioning repair man who at all times holds a stock of filters, pipes and glue in order to
repair the air-conditioning systems of his customers.
The filters and pipes will be held to be trading stock as they are disposed of by Paul to his customers in
the ordinary course of carrying of his business – they are an essential part of supplying his services,
they are not consumables that are expended, and they retain their individual character when passed
onto his customers as part of the repair.
By contrast, the glue is not trading stock. It is a consumable which is expended by Paul in carrying on
his business. Unlike the pipes and filters, the glue does not pass as glue (i.e. a bottle of glue for sale) to
his customers. It does not retain its pre-sale character and is not separately identifiable, post-sale.
Bookkeepers need to familiarise themselves with what constitutes trading stock because, as per below,
you will at various points play a significant role for the accountant in them providing the correct tax
treatment for the client. To summarise, as per Accounting Standard AASB 102 Inventories, trading stock
is defined as assets:
(a) Held for sale or exchange in the ordinary course of business
(b) In the process of production for such sale, or
(c) In the form of materials or supplies to be consumed in the production process or in the
rendering of services.
GENERAL TAX TREATMENT
Three simple rules apply:
1.
A deduction is allowed for the cost of purchasing trading stock
2.
If closing stock exceeds opening stock, the difference is assessable, and
3.
If opening stock exceeds closing stock, the difference is deductible.
The value of closing stock on hand at the end of the income year is deducted from purchases and
opening stock to determine the cost of stock sold. The higher the value of closing stock on hand, the
higher the taxable income and vice versa.
TIPS
•
•
Using the lowest amount of trading stock permissible can save income tax, and
Select the valuation method (see later) which gives you the lowest stock value.
The value of trading stock on hand at year-end will add to taxable income for the financial year as the
following example demonstrates:
BOOKKEEPERS KNOWLEDGE BASE
2
Example
$
Sales
Less Cost of Sales:
Opening Stock
Purchases
Closing Stock on Hand
Total Cost of Sales
Gross Profit
100
500
(200)
400
$
1 000
400
600
Tax Treatment
Gross Sales of $1 000 are assessable
•
Purchases of $500 are deductible
•
As the value of closing stock of $200 is greater than the value of opening stock of $100, the
•
difference of $100 is assessable.
Therefore, the total assessable amount is $1 100 (sales + the difference in closing stock and
opening stock). On the other hand, the total deductible amount is $500.
The difference between those amounts is a net assessable amount of $600 which should also
equate to the gross profit.
Stock on Hand
For stock to be taken into account in determining a taxpayer’s assessable income, the stock must be ‘on
hand’ at year-end. According to Taxation Ruling IT 2670, stock will be ‘on hand’ when a taxpayer has
the power to deal with it as if it were their own. Put simply, stock will be ‘on hand’ when you have legal
ownership of it – regardless of whether you have actual physical possession. In most cases legal
ownership will be self-evident, however sometimes it can depend on the terms of shipment:
•
Where the terms of the shipment are Freight-On-Board (FOB) Shipping Point, the legal
title passes of the goods passes to the buyer at the point of shipping.
•
Where the terms of the shipment are FOB Destination, the legal title to the goods remains
with the seller until the goods are received by the buyer at the point of destination. Therefore,
under such terms, although the seller no longer has physical possession while the goods are
being shipped, they still have ownership of the goods until such time as they are received by
the buyer at the point of destination – and therefore the stock is still ‘on hand’ for the seller.
In the case of lay-bys, ownership of the goods remains with the seller until the buyer has paid the final
instalment. Therefore, until that final instalment is paid, the seller must include the full value of the goods
in their closing stock at year-end.
VALUATION
Whether it is individual items to include in assessable income (e.g. where stock is disposed of outside
the ordinary course of business) or the year-end stocktake, most taxpayers will at some point during the
year need to value their trading stock. For tax purposes, taxpayers have a choice of the following three
valuation methods:
1.
Cost Price – This method includes not just the invoice or purchase price, but all the costs
associated with bringing the stock to its present condition and location within your business (e.g.
freight and delivery charges). For manufacturers, costs will include labour and materials as well
as a percentage of factory overheads such as electricity and rent.
Taxation Ruling IT 2350 outlines some of the costs that are included and excluded from the
Cost Price method for manufacturers as outlined in the following table:
BOOKKEEPERS KNOWLEDGE BASE
3
Costs Included and Excluded From the Cost Price Valuation Method
Included
Factory light and power
Factory rent, maintenance and repair expenses
Factory rates and taxes
Insurance of factory plant and machinery
Wages including holiday pay, sick pay, long
service leave, workers compensation,
superannuation, payroll tax
Indirect materials and supplies
Royalties in respect of any production process
Tools and equipment not capitalised
Quality control and inspection
Factory administration expenses
Raw materials – handling and storage
Excluded
Marketing expenses
Storage expenses
Advertising expenses
Selling expenses
Employee benefits such as training, profit sharing,
employee shares, first aid stations, cafeteria and
recreational facilities
Other distribution expenses
Interest and other financial expenses
Research and experimental expenses including
engineering and product development
Income taxes
General administrative expenses
Costs associated with strikes, rework labour scrap
and spoilage
Depreciation on factory, factory plant and
equipment
2.
Replacement Value – This is the amount that you would have to pay at arm’s-length in the
marketplace to replace the item on the last day of the income year. Accordingly, to use this
method, there must be similar items available in the marketplace. Consequently, antique
dealers may be unable to use this method as identical items may be difficult to source and
therefore compare.
3.
Market Selling Value – This is the amount you would receive via an ordinary sale (as distinct
from a forced or distressed sale) in the course of your business.
A taxpayer can change the method used to calculate trading stock each year and can also use different
methods for different items of stock. However, the value of stock at the beginning of each income year
must be the same as the value of stock on hand at the end of the previous income year. If a taxpayer
did not have any trading stock in the previous income year (as will be the case for a business that has
just commenced) the value of stock at the start of the year is zero.
TIP
Taxpayers generally elect to use the Cost Price as their valuation method as it generally gives the
lowest stock valuation. However, a review of your annual stocktake will invariably isolate individual items
of stock that may be valued at a lesser price using the Replacement or Market Selling methods.
Although time consuming, applying different valuation methods to different items can save substantial
amounts of income tax.
By looking at a copy of the client’s most recent income tax return, you will be able to identify which
trading stock valuation method the client has mostly adopted, and it will be signified by the use of one of
the following codes:
•
•
•
C:
M:
R:
Cost
Market selling value
Replacement value.
Usually it will be the accountant rather than the bookkeeper who will choose which trading stock
valuation method that will be adopted for tax purposes.
STOCK DISPOSED OF OUTSIDE THE ORDINARY COURSE OF BUSINESS
A] Personal Use
It is quite common for the owner of a business to take trading stock from their business for their own
personal use/consumption. In such cases, the business owner is required to include in their assessable
income the Cost Price (see earlier) of the item of stock on the date of ‘disposal’. Because in some
industries it is particularly difficult for business owners to determine the Cost Price of goods taken from
trading stock for personal use, the Tax Office issues an annual Determination which provides standard
values for goods taken for private use in certain industries. The amounts for the 2008/2009 income year
are reproduced in the following table.
BOOKKEEPERS KNOWLEDGE BASE
4
Type of Business
Bakery
Butcher
Restaurant/Café (Licensed)
Restaurant/Café (Unlicensed)
Caterer
Delicatessen
Fruiterer/Greengrocer
Takeaway Food Shop
Mixed Business (Includes Milk
Bar, General Store and
Convenience Store
Amount (excluding GST) for a
adult/child over 16 years of
age
$1 070
$720
$3 680
$2 940
$3 190
$2 940
$770
$2 780
Amount (excluding GST) for a
child up to 16 years
$3 520
$1 760
$535
$360
$1 470
$1 470
$1 595
$1 470
$385
$1 390
The amounts for the 2009/2010 financial year were not published at the time of writing but are available
in January each year from the legal database section of the Tax Office website
http://law.ato.gov.au/atolaw/index.htm
Example
Adam is a Greengrocer who runs his own business. Each Saturday he takes home a crate of fruit for his
12-year old daughter. Regardless of the actual cost of the crate, Adam can make use of the above table
and include $385 in his assessable income for the 2008/2009 financial year. This will save him from
keeping the necessary records showing the actual value of stock taken for personal use. However, if
Adam considers that the $385 does not reflect the actual value of stock taken, he can elect to maintain
suitable records of the actual amount of fruit taken and record that amount (instead of the $385) in his
assessable income instead.
As shown, the effect of a business owner taking trading stock for personal use is significant – they must
include the Cost Price of that stock in their assessable income.
In this area, bookkeepers have a vital role to play. To alert the accountant that the owner has taken
stock for personal use, bookkeepers need to record each transaction in the management accounts –
failure to do so will make it impossible for the accountant to detect these ‘transactions’ at tax time.
To record the transaction, bookkeepers need to debit the “Stock taken for private use” account and
credit the “inventory” account. The amount you will record will be the Cost Price, not the Market Selling
Value. You will therefore need to familiarise yourself with the elements that go in to the Cost Price
(outlined earlier).
Example
Following on from the example above, assume that Adam purchased each crate for $25. He would need
to record this amount (assuming a perpetual inventory system is maintained), each time a crate was
taken for personal use, as follows:
Account
Tax Code
Debit
Stock Taken for Private Use
N-T
25
Inventory
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
25
Note that an adjustment for GST credits claimed in relation to stock taken for private use may also need
to be made. The adjustment will be an increasing adjustment – that is, the business owner will owe the
Tax Office additional GST (the difference between planned and actual use). For more information on
how to make and calculate an adjustment, see the Tax Office publication Making an Adjustment on Your
Activity Statement or Bookkeepers Knowledge Base # 37.
In the above example, Adam will not need to make an adjustment as the GST-exclusive value of the
purchase was less than $1 000 and fruit is GST-free anyway.
B] Third Parties
In most cases, a business disposes of its trading stock by selling it to its customers during the normal
course of its operations with the sale proceeds being brought to account as assessable income.
However, on occasions, a business may dispose of its trading stock outside the ordinary course of
business – for instance, it may be given away to friends or donated to charity.
BOOKKEEPERS KNOWLEDGE BASE
5
Where this is the case, a business must include in its assessable income the Market Selling Value (see
earlier) of that stock on the date of disposal.
In some cases, the donation may be made to a deductible gift recipient (DGR). In such a case, the
business owner will be entitled to a tax deduction.
Bookkeepers again have a vital role to play. Without the bookkeeper recording the transaction in the
management accounts, the accountant has no way of knowing a disposal has taken place outside the
ordinary course of business.
Bookkeepers should record the transaction by debiting ‘donated stock’ and crediting the ‘inventory’
account. This should be done at Cost Price, not at Market Value. When the accountant subsequently
sees that this account exists in the management accounts, they should make the necessary
adjustments to Market Value in the client’s income tax return.
Example
Brad is a toy shop owner and decides to donate a children’s bicycle to Lifeline. The costs Brad incurred
in relation to the bike are as follows:
Invoice price:
$200
•
Storage:
$ 80
•
Freight:
$100.
•
Because this is a disposal outside the ordinary course of business, it will need to be included in Brad’s
assessable income at the Market Value on the day of disposal. Because Lifeline is a DGR, Brad will also
be able to claim a deduction for the donation.
Brad’s bookkeeper will need to record the transaction, if a perpetual system is being used, showing only
the Cost Price (i.e. the invoice and freight costs), as follows:
Account
Tax Code
Debit
Donated Stock
N-T
300
Inventory
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
300
If a periodic system was used, the deduction for the donated stock will already be implicit in the fact that
the stock purchase will have been expensed- and the closing stock that much less as a result of the item
being donated.
LAY-BYS
As noted earlier, trading stock which is subject to a lay-by arrangement, remains stock of the seller until
the final payment is made by the buyer and therefore until that payment is made must be included as
part of the closing stock on hand at year-end.
Accounting for lay-by transactions is relatively straightforward:
•
•
When a customer makes an instalment payment (whether it be a deposit or progress payment),
the ‘cash at bank’ account should be debited and the current liability account ‘lay-by deposits’
should be credited, and
When the customer pays the final instalment and the goods are delivered to them, the ‘lay-by
deposits’ account should be debited and the ‘sales revenue’ account credited.
Regarding GST, taxpayers who account on a cash basis must remit GST to the Tax Office as each
payment is made. By contrast, taxpayers who account on an accruals basis will remit GST to the Tax
Office only once the final instalment has been paid.
BOOKKEEPERS KNOWLEDGE BASE
6
Example - Accruals
Following on from the example above, in April 2009, a customer buys by way of lay-by a $2 200 (GSTinclusive) bicycle from Brad (who accounts quarterly on an accruals basis). At this time, the customer
makes an initial payment of $440. Brad’s bookkeeper will make the following journal entry in relation to
that initial lay-by payment.
Account
Tax Code
Debit
Cash at Bank
N-T
440
Lay-By Deposits
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
440
At this point, no GST will be remitted to the Tax Office as no sale has taken place – i.e. the final
payment for the bike has not been made. Furthermore, if 30 June passes and the final payment has not
been made, the full value of the bike will classified as part Brad’s trading stock on hand at year-end.
In December 2009, the customer makes the final payment of $440 and takes possession of the bike.
Brad’s bookkeeper will at this point make the following journal entry:
Account
Tax Code
Debit
Cash at Bank
N-T
440
Lay-By Deposits
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
440
Because final payment has been made, the full $200 of GST (1/11th x $2 200) will be remitted to the Tax
Office in Brad’s October-December 2009 BAS.
The journal entry to record the sale of the bike is as follows:
Account
Tax Code
Debit
Lay-By Deposits
N-T
2 200
Sales
GST
GST Payable
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
2 000
200
Example - Cash
Brad’s bookkeeper will make the following journal entry in relation to that initial lay-by payment.
Account
Tax Code
Debit
Cash at Bank
N-T
440
Lay-By Deposits
GST
GST Payable
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
400
40
Under the cash system of accounting, GST will be remitted to the Tax Office as each lay-by instalment
is paid by the customer. Again, if 30 June passes and the final payment has not been made, the full
value of the bike will classified as part Brad’s trading stock on hand at year-end.
In December 2009, the customer makes the final payment of $440 and takes possession of the bike.
Brad’s bookkeeper will at this point make the following journal entry:
Account
Cash at Bank
Lay-By Deposits
GST Payable
Tax Code
N-T
GST
N-T
Debit
440
Credit
400
40
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
The journal entry to record the sale of the bike is as follows:
Account
Tax Code
Debit
Lay-By Deposits
N-T
2 000
Sales
N-T
(Where N-T=outside the scope of the GST system; GST=subject to GST.)
Credit
2 000
BOOKKEEPERS KNOWLEDGE BASE
7
THE NEED TO CONDUCT A STOCKTAKE
Whether your client needs to conduct a year-end stocktake depends principally on whether they are a
small business taxpayer or not.
1. Non-Small Business Taxpayers
If your aggregated annual turnover (i.e. the annual turnover of your business, plus entities which are
connected or affiliated with you) is $2 million or more, you will need to conduct a physical stocktake at
year-end. That is, you must record the value of stock on hand at:
•
•
The beginning of the financial year (which will be the same value as at the end of the previous
financial year), and
The end of the financial year.
As stated earlier, following the stocktake, if:
•
•
Opening stock exceeds closing stock, the difference is deductible, and
Closing stock exceeds opening stock, the difference is assessable.
2. Small Business Taxpayers
Whilst non-small business taxpayers will need to conduct a stocktake at year-end, small business
taxpayers (i.e. individuals, partnerships, trusts or companies with an aggregated annual turnover of less
than $2 million) can elect not to conduct a stocktake if there is a difference of $5 000 or less between:
•
•
The value of stock on hand at the start of the income year, and
A reasonable estimate of the value of stock on hand at the end of the income year.
The value of stock on hand at the start of the income year must be the same amount included in the
tax return at the end of the previous income year.
If the value of trading stock varies (increases or decreases) by $5 000 or less and you elect not to
account for the difference, the value of trading stock on hand at the end of the income year is deemed to
be the same as the start of the income year.
A reasonable estimate of the value of stock on hand at the end of the income year is reasonable
where it:
•
•
•
Takes account of all relevant factors (both internal and external to the business) likely to affect
the number and value of the company’s trading stock on hand
Has been undertaken in good faith, and
Is capable of explanation to a third party.
Example
Kenny is a floor sander who has an aggregated annual turnover of $200 000. Mostly he carries out small
repair and installation jobs, for which he needs fairly standard stock items. In past income years this
stock has been valued at year-end at between $4 000 and $6 000. At the end of the previous income
year he valued his stock at $5 400.
Despite the economic downturn, Kenny’s business has not changed during the current income year. He
therefore estimates that the quantity of stock held at the end of the current year is similar to previous
years however as with previous years, he expects the price of most of the stock he purchases to rise by
10%. He therefore increases the value of stock on hand at the end of the previous income year by 10%
to arrive at a reasonable estimate of $5 940.
Because he is a small business taxpayer (i.e. his aggregated annual turnover is less than $2 million)
and the difference between his opening stock ($5 400) and his reasonable estimate of his closing stock
($5 940) is less than $5 000, Kenny will not need to conduct a stocktake at year-end or account for the
change in value of trading stock when calculating his assessable income.
TIP
If you are a small business taxpayer, you can pick and choose which of the small business concessions
you adopt. Unlike the former STS system, you are not obliged to use all of the concessions available.
Therefore, instead of electing not to conduct a stocktake under the small business concessions, it might
be to your advantage to opt out of this concession and conduct a stocktake anyway - for example,
where your stock on hand at the end of the income year is less than at the start of the income year.
BOOKKEEPERS KNOWLEDGE BASE
8
In such a case, you could obtain a deduction rather than opting out of a stocktake.
Disclaimer—The information contained in this edition is current as at time of writing (December 2009). Information
contained herein is general in nature and is intended to provide guidance to bookkeepers in providing bookkeeping
services for their clients. It is not intended to be taken as a substitute for you or your clients seeking professional
advice in relation to their own specific circumstances.
Copyright—Except for use with other staff members or contractors of your bookkeeping firm, no part of this
publication may be reproduced without the express permission of Australian Bookkeepers Network Pty. Ltd.
BOOKKEEPERS KNOWLEDGE BASE
9