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Trading stock
P R E PAR E D BY WE S OBS T AND R AMI HANE GBI F OR T HE UNI T T E AM
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


Deakin University
P rinciples of I ncome Tax Law
Introducti on
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.
Learni ng 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,
Tradi ng stock to be taken i nto 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).
EXAMPLE 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


Maj or i ssues to be consi dered
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.
Tradi ng stock defi ned
General pri nci pl es
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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P rinciples of I ncome Tax Law
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.
Parti cul ar i tems
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 yi el d tradi ng 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 i n 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).
QUESTI ON 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 recei ved 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?
QUESTI ON 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 i s tradi ng 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.
Di sposi ti ve 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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P rinciples of I ncome Tax Law
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).
QUESTI ON 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 val uati on of tradi ng stock
Val uati on general l y
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.
Choi ce rel ates to each i tem of tradi ng stock
Market sel l i ng val ue
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 al t ernat i ves
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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P rinciples of I ncome Tax Law
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).
Repl acement val ue
For the income year commencing 1 J uly 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.
Transacti ons i nvol vi ng tradi ng stock, not i n the ordi nary course of
busi ness
Change i n use of an i tem from tradi ng stock to some other use
Val ue of tradi ng stock taken for personal use or for use i n taxpayer s
busi ness
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 i n use of an i tem from some other use to tradi ng 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 J uly 1998. There are no CGT
consequences when cost is elected.
Purchases of tradi ng stock above *market val ue ( non-arms
l ength transacti ons )
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 di sposal of tradi ng 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 tradi ng 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.
Si mpl i fi ed tradi ng stock rul es for smal l busi ness enti ti es:
Subdi v. 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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P rinciples of I ncome Tax Law
QUESTI ON 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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