Edition 54 The Tax Treatment of Trading Stock

Transcription

1 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 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 Trading Stock? Yes No Live stock Unless they are beasts of burden or working beasts in nonprimary production businesses Shares * Land and property * Crops and Trees Unless they are harvested, felled or picked Goods for Hire Futures Contracts Plant and Equipment Work in Progress Unless under a long-term contract Computer Software Produced Unless developed for licence for Sale Spare Parts Held Unless held for the purpose of maintenance 1

2 *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. 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: 2

3 $ $ Sales Less Cost of Sales: Opening Stock 100 Purchases 500 Closing Stock on Hand (200) Total Cost of Sales Gross Profit 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. Stock on Hand 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. 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: 3

4 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 Depreciation on factory, factory plant and equipment 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 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: Cost M: Market selling value R: 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. 4

5 Type of Business Amount (excluding GST) for a adult/child over 16 years of age Amount (excluding GST) for a child up to 16 years Bakery $1 070 $535 Butcher $720 $360 Restaurant/Café (Licensed) $3 680 $1 470 Restaurant/Café (Unlicensed) $2 940 $1 470 Caterer $3 190 $1 595 Delicatessen $2 940 $1 470 Fruiterer/Greengrocer $770 $385 Takeaway Food Shop $2 780 $1 390 Mixed Business (Includes Milk Bar, General Store and Convenience Store $3 520 $1 760 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 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). 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: Stock Taken for Private Use N-T 25 Inventory N-T 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. 5

6 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. 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: Donated Stock N-T 300 Inventory N-T 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. 6

7 - 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. Cash at Bank N-T 440 Lay-By Deposits N-T 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: Cash at Bank N-T 440 Lay-By Deposits N-T 440 Because final payment has been made, the full $200 of GST (1/11 th 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: Lay-By Deposits N-T Sales GST GST Payable N-T Cash Brad s bookkeeper will make the following journal entry in relation to that initial lay-by payment. Cash at Bank N-T 440 Lay-By Deposits GST 400 GST Payable N-T 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: Cash at Bank N-T 440 Lay-By Deposits GST 400 GST Payable N-T 40 The journal entry to record the sale of the bike is as follows: Lay-By Deposits N-T Sales N-T

8 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. Kenny is a floor sander who has an aggregated annual turnover of $ 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 $ At the end of the previous income year he valued his stock at $ 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 $ 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. 8

9 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. 9