House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer,the Hon Ralph Willis, M.P.)

Chapter 5 Deferral of Deductions for Trading Stock Purchases Involving Prepayments

Clauses: 14 and 63

Overview

Ensures that deductions for expenditure on goods to be used as trading stock are not allowable until the goods actually become part of the buyer's trading stock.

Deferral of Deductions for Trading Stock Purchases Involving Prepayments

Deferral of Deductions for Trading Stock Purchases Involving Prepayments

Summary of the proposed amendments

5.1 This amendment deals with deductions under section 51 of the Act for purchases of goods to be used as trading stock in a business. It will only have an effect in cases where the goods have not become part of the buyer's trading stock by the end of a year of income. In these cases the amendment will defer the deduction, under section 51, for the cost of the goods until they become trading stock of the purchaser.

Background to the legislation

Deductions for purchasing trading stock - section 51

5.2 Section 51 of the Act contains what are often called the general deduction provisions of the income tax law. The section allows deductions for expenditure incurred in a year of income to the extent the expenditure is incurred in earning assessable income. Expenditure incurred in a year in buying trading stock for a business is deductible under section 51.

Current law defers deductions for trading stock on hand at year end - section 28

5.3 The law already defers deductions for trading stock that remains "on hand" at the end of a year of income. It does this (section 28 of the Act) by effectively requiring the value of a taxpayer's closing stock to be written back as assessable income. In doing this the tax law simply follows the ordinary accounting practice of matching costs against revenues in appropriate reporting periods.

5.4 Ordinarily, expenditure on trading stock is deductible, under subsection 51(1) of the Act, in the year in which the expenditure is incurred. Writing back the value of closing stock effectively cancels the benefit of any deduction allowable in respect of that stock. The law ensures that the benefit is not lost, though, by effectively allowing a deduction for the value of trading stock on hand at the beginning of the next year of income (section 28). If the stock remains unsold at the end of that year, section 28 would operate to defer the deduction again until the following year. Through this process the law allows deductions for expenditure on trading stock in the same year that the income from selling the stock is included in assessable income.

5.5 These provisions only apply where trading stock is "on hand" at the end of a year of income and do not apply where trading stock has not become "on hand".

When is trading stock on hand?

5.6 This is a difficult question that has come before the Courts on a number of occasions and there is no clear-cut answer. It has been held, for instance, that trading stock need not be in a taxpayer's physical possession to be on hand (see All States Frozen Foods Pty Ltd v. F.C. of T.
90 ATC 4175 ). Many acquisitions of trading stock (for example, of imports like those in the All States case) are very complex transactions where the correct application of the law is difficult to ascertain, both for the Tax Office and tax practitioners.

5.7 Not surprisingly then, there are instances, like that in F.C. of T. v. Raymor (NSW) Pty Ltd
90 ATC 4347 , where section 28 of the Act does not achieve its aim of matching deductions for trading stock purchases against assessable income from selling that stock.

Raymor's case

5.8 In that case the taxpayer entered into forward purchase contracts, and paid, for trading stock that would not be delivered, and in some cases not even be made, until after the end of the year of income. The Federal Court held that the cost of the trading stock was fully deductible in the year in which the taxpayer bound itself as a party to the contracts and so became committed to pay for the stock. This was so even though the undelivered stock was not on hand with the taxpayer and so could not be brought to account under section 28 as trading stock on hand at the end of the year of income. The consequence of the Court's decision was that the taxpayer was able to gain a tax advantage by bringing forward a tax deduction for trading stock that would not be sold until a later year.

Explanation of the proposed amendments

Deduction for expenditure on trading stock deferred until stock is on hand

5.9 The Bill will ensure that a deduction is not allowable under section 51 for expenditure on trading stock until that stock is on hand with the taxpayer. [Clause 14]

Why amend the law?

5.10 In some instances the present law does not achieve its aim of matching trading stock expenses against trading stock income. An example of an instance where this may happen was highlighted in the Federal Court's decision in F.C. of T. v. Raymor (NSW) Pty Ltd
90 ATC 4347 already discussed in the background notes. The amendment proposed by clause 14 will ensure appropriate matching of deductions for expenditure on trading stock against income derived from selling the stock. This will change the operation of the law, in cases like Raymor, but also clarify it in other instances where it might be argued that there would be a mismatch between the timing of deductions for, and recognition of income from, trading stock, e.g., where goods are in transit at year end.

How will the amendment work?

5.11 We have already noted that section 28 overrides section 51 in the sense that it defers deductions for trading stock on hand at the end of a year of income. New subsection 51(2A) will bolster the operation of the law by deferring deductions under section 51 for expenditure on trading stock where section 28 cannot apply, because the stock is not on hand, but a deduction should not be allowed, because the stock has not been sold. New subsection 51(2A) [clause 14] will override the ordinary operation of section 51 of the Act where the three conditions set down in new paragraphs 51(2A) (a), (b) and (c) are met. In short, subsection 51(2A) will apply if a deduction would otherwise be available under subsection 51(1) for the cost of acquiring anything that is to be used as trading stock, where any part of that stock has not yet become trading stock on hand of the taxpayer.

5.12 In these circumstances, subsection 51(2A) will deny the deduction otherwise allowable under subsection 51(1) in the year the expenditure was incurred. Instead, subsection 51(2A) will allow a deduction for that expenditure under subsection 51(1) only when the stock first becomes trading stock on hand of the taxpayer. In practical terms, a deduction for trading stock will be available under section 51 in the year it is first on hand, for the purposes of section 28 of the Act, at year end or, if it is sold before the end of the year it first becomes stock on hand, in that year. This means a deduction for expenditure on trading stock under section 51 may be spread over more than one year of income.

5.13 For instance, a taxpayer might enter into a contract on 30 April 1992 to buy 1,000 widgets at a cost of $1 per widget. Under the present law, the taxpayer would be entitled to a deduction of $1,000 under section 51 in the 1991-92 income year. At 30 June 1992, 500 widgets have been delivered to the taxpayer but the remaining 500 are still in production. The taxpayer has sold 100 of the widgets delivered. There are 400 widgets on hand at the end of the 1991-92 year. They are sold in 1992-93. The other 500 widgets are delivered in the 1992-93 income year and are held unsold at 30 June 1993. They are then sold in 1993-94.

5.14 To match the cost of trading stock in this example against income from selling that stock, the law should only allow a deduction in 1991-92 for the cost ($100) of the 100 widgets sold in that year. This means that a deduction for the cost of the remaining 900 widgets needs to be deferred until a later year. The present law would fail because only $400 (400 widgets on hand at $1 each) could be written back as assessable income under section 28 (assuming closing stock is valued at cost). This means there would be a mismatch in 1991-92, and in the year or years the stock is sold, in respect of the 500 undelivered widgets.

5.15 In these circumstances, new subsection 51(2A) will deny the deduction otherwise allowable under section 51. In the 1991-92 year, subsection 51(2A) will instead allow a deduction for the expenditure attributable to the stock that first became trading stock on hand in that year, i.e., the 100 widgets sold and the 400 widgets on hand at 30 June 1992.

5.16 In our example, the deduction for 1991-92 under section 51 would be $500 and $400 would still be written back under section 28. The effective deduction for expenditure on trading stock in 1991-92 would be $100 (i.e., $500, less $400 written back). The $400 written back would be deductible, through the operation of section 28, when it becomes opening stock in 1992-93 and is sold in that year.

5.17 In the following year subsection 51(2A) would allow a deduction for the cost of the other 500 widgets on hand at the end of that year, i.e., another $500 deduction would be available under section 51 in 1992-93 and that $500 would be written back under section 28 as the stock is on hand at the end of that year. A deduction for this $500 would effectively be allowed when the relevant stock is sold. The table below illustrates how the provisions work.

Commencement Date

5.18 The amendment affecting deductions for trading stock purchases will apply to expenditure incurred after the date of introduction of this Bill.

Clauses involved in the proposed amendments

Clause 14: inserts new subsection 51(2A) in the Act. Subsection 51(2A) will defer deductions under section 51 for expenditure on stock until the stock first becomes trading stock on hand of the taxpayer.

Subclause 63(4): sets out the application date for the amendment made by clause 14.