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Quick Reference Guide

Chapter 8 - Trading Stock (or Inventory)

8.1 OVERVIEW (ITA s EA 1, Subpart EB)

The tax treatment of your business’ trading stock has a big impact on your taxable income.

Quite simply:

Total sales

Less: Opening stock for the year

Purchases for the year

Add: Closing stock for the year

Equals gross profit

That is to say:

  • Amount of stock on hand at beginning of the year

  • Purchases made during the year

  • Stock on hand at the end of the year

  • Valuation of that stock

all have a big impact on your business’ gross profit.

Trading stock purchases are a regular and significant revenue expense for many businesses. However unlike many other revenue expenses, a tax deduction for trading stock is only allowed at the time the stock is sold.

For these reasons, the Income Tax Act contains rules which deal with the valuation and treatment of trading stock. These requirements and a number of opportunities relating to trading stock are discussed below.

8.2 - Application (ITA s EB 2, YA 1)

8.2.1 - Effect on Income

The Income Tax Act defines trading stock. In brief, trading stock is anything acquired or manufactured by a business for sale in the ordinary course of business. More specifically, trading stock is defined as including:

  • anything that is manufactured produced or acquired; and

  • held for sale or exchange in the ordinary course of business

  • work in progress

  • materials held for use in the manufacture or production of trading stock

  • livestock, timber for land for resale

Before the annual profitability of any business can be determined, it is necessary to calculate the cost of trading stock sold during the year. The year’s expenditure on trading stock is determined when the trading stock on hand is valued at year end.

The reason for taking year-end trading stock into account becomes clear if we look at the table opposite.

Example

A business has $2,000 in opening stock, purchases of $11,000 during the year, and sales for the year totaling $8,000. In cash flow terms the business is $3,000 behind at year end. What is the profit or loss on these trading stock transactions? It is impossible to tell until we know the cost of the stock on hand at the end of the year. Let’s assume the value of closing stock (stock on hand at year end) is $7,000 at cost price.

 
C8 Table 1.PNG
 

As can be seen from the above example, “profit” and “cash flow” can be quite different when measured over a particular period of time. Only by adding back closing trading stock can we properly match the year’s sales with the cost of those sales.

8.2.2 - Closing Stock  (ITA s CH 1, EB 2, EB 3, YA 1)

The definition of trading stock is important. This is because the value of trading stock on hand at year end (i.e. unsold trading stock) must be added back to assessable income. This has the effect of increasing assessable income. For this reason it is necessary to determine:

  • Whether expenditure incurred during the year relates to trading stock or alternatively to some other immediately deductible revenue expenditure

  • What year-end valuation method should be adopted for trading stock

Retailers have few problems in identifying the cost of trading stock purchases. The cost of trading stock for retailers include the cost of purchases and costs associated with customs and transportation of that stock to their shops.

However, for manufacturers the identification of trading stock costs is more involved. It is tempting for a manufacturer to obtain immediate tax deductions for as many manufacturing costs as possible.

The Income Tax Act now requires “cost” to be determined with regard to generally accepted accounting principles.

8.2.3 - Valuation of Trading Stock (ITA s DB 49, Subpart EB)

For tax calculation purposes the trading stock on hand at year end can be valued at the option of the taxpayer by using any of the following methods:

  • cost or

  • market selling value (but only if this is less than cost)

Cost will be determined by reference to generally accepted accounting principles and in particular the accounting standard NZ IAS 2 on inventories & NZ IAS 8 on disclosure. A consistent approach must be used.

Replacement price or discounted selling price may be used to approximate cost under certain circumstances.

The valuation method adopted to value stock at the year-end closing date can have a significant effect on your business year-end profit and therefore tax payable! Therefore, it is important to do a year-end stock take and consider the year- end valuation method that should apply to particular lines of trading stock. For small taxpayers however, see 8.2.4 below.

There are a number of alternative methods of arriving at cost as noted below.

8.2.4 - No Valuation of Trading Stock Required in Certain Cases (ITA s EB 23)

Taxpayers who have sales of less than $1.3 million in an income year and can reasonably estimate that they have less than $10,000 worth of trading stock at year end will be allowed:

  • Not to value it; or

  • Not to include any change in the value of this trading stock in their calculation of annual income

8.2.5 - Cost Valuation Method (ITA s EB 6)

As a general guide the cost of stock is determined using generally accepted accounting practice and includes:

  • Actual cost of the goods/materials

  • Import duties or other purchase taxes

  • The costs of transport and handling the stock

  • The costs of bringing stock to its present location including the production overhead costs

  • Deductions for immediate or deferred discounts, tax credits, and subsidies

  • Any other directly attributable costs

  • Cost of conversion - cost of labour, subcontract work and other production costs

Where taxpayers are able to use a discounted selling price or a replacement price to approximate cost in their financial accounts then this method of stock valuation will be acceptable for tax purposes.

8.2.6 - Market Selling Value Method (ITA s EB 11)

The Income Tax Act permits taxpayers to use market selling value (MSV) if it is lower than cost.

Those categorised as “small taxpayers” may use MSV as an alternative to cost valuation method.

To arrive at MSV the normal selling price is reduced by estimated cost of completion and expected selling costs such as:

  • Transportation

  • Insurance

  • Sales commissions

  • Discounts

Taxpayers are required to maintain “reasonable evidence” in order to prove the MSV of a stock item. It is recommended that evidence be obtained around balance date rather than later in the year when the tax return is prepared. Evidence is likely to include price lists and sales invoices of any sales made at a reduced price.

8.2.7 - Stock Obsolescence  (ITA ss EB 4, EB 6, EB 11)

Stock affected by obsolescence may be valued using market selling value if the offering price is less than cost. Obsolete and slow moving stock must be valued at cost if it could be sold for more than cost.

8.2.8 - Excepted Financial Arrangements (ITA ss EB 3, ED1, ED 2)

An excepted financial arrangement such as shares, which are held as trading stock, must be valued at cost. Any transfers of excepted financial arrangements within a wholly owned group of companies are deemed to occur at cost.

8.3 - Practical Hints

8.3.1 - Trading Stock Transferred to Shareholders or Related Parties (ITA s EB 5, GC 1)

In a tax audit situation, tax inspectors frequently identify transfers of trading stock from a business to the owners of the business, (i.e. used for private consumption). Beware, if you take trading stock from your business, you must pay market value for the stock taken. If you do not, the IRD are likely to assess you with FBT, or deemed dividends.

Further, it is common for related businesses to transfer trading stock between themselves at “book value”, usually cost price. However, unless the businesses are companies who are members of the same wholly owned group, the stock is deemed to be transferred at market value. This can give rise to tax consequences.

8.3.2 - Year-end Stock Take (ITA s EB 3)

As we have seen, the value of trading stock on hand at year end has a direct impact on the year’s taxable profit. For this reason, the Department expects taxpayers to be able to substantiate trading stock value at year end. In particular, the IRD will expect all but small taxpayers (See 8.2.4) to have performed an annual stock take of trading stock on hand at balance date. When performing the stock take, ensure that adequate records are kept and ensure that you identify slow moving stock lines which may be valued on a market selling value basis (assuming market selling value is lower than original cost).

The Act also requires records to be maintained to support the value given to stock at year end.

Jump to chapter...
Chapter 1 - New Zealand Tax Framework

New Zealand taxation is imposed by the Income Tax Act 2007 (ITA). The basis for calculating tax is summarised in the following flowchart from the Core Provisions set out in Part B of the Act. This overview provides the context for details discussed in this quick reference guide.

Chapter 2 – Tax Planning

Tax rates have come down in the past several years, but rates still vary for different taxpayers such as individuals, companies and trusts. There are also special rules that apply to certain taxpayers and not to others. While this is so, opportunities will exist to structure your affairs to benefit from the different rules and tax rates.

Chapter 3 – Tax Residence and Source of Income

“Tax residence” and “source of income” are central to determining liability for taxation in New Zealand. Residence determines the jurisdiction and source relates to where income is earned or deemed to be earned.

Chapter 4 – Assessable Income

Not every gain received by you or your business is taxable. The Income Tax Act only imposes tax on taxable income.

Chapter 5 – Deductible Expenditure

The questions of what expenditure is deductible and when, are of prime importance in determining your tax liability. For most expenditure, the question of deductibility is straight forward. However, there are exceptions. This chapter looks at what you may deduct and when.

Chapter 6 - Depreciation

Expenditure on capital assets cannot be deducted immediately. The value of the asset depreciates over time and the cost is spread over its useful life. Costs are there- by matched against any income that the asset generates and the tax deduction occurs each year on a more gradual basis until the asset is fully depreciated.

Chapter 7 - Entertainment Tax

Entertainment expenditure must be for business purposes to be deductible and special rules exist to clarify what may be claimed for tax. The rules are slightly different for GST. There is a working party looking at simplifying the regime but in the meantime, the current rules apply.

Chapter 8 - Trading Stock (or Inventory)

Trading stock purchases are a regular and significant revenue expense for many businesses. However unlike many other revenue expenses, a tax deduction for trading stock is only allowed at the time the stock is sold.

Chapter 9 – Real Estate Transactions

This chapter distinguishes between taxable and non-taxable property transactions.

Chapter 10 - Financial Arrangements

The Financial Arrangements or Accrual Rules are a detailed set of rules relating to the tax treatment of debts and debt instruments and transactions including debt related aspects.

Chapter   11 - Business Structures

Your business structure can have a huge impact on taxation and the legal framework under which your business operates. Here, we compare the different business structures available to you. These are discussed in greater depth in following chapters.

Chapter 12 - Companies

Companies are a popular structure for doing business because they allow a degree of protection and flexibility. Companies offer business people the advantages of limited liability and may provide a beneficial structure for tax purposes.

Chapter 13 – Partnerships and Trusts

A partnership is formed by a contract between parties, to carry on business or commercial activities in common, with a view to making a profit.

A trust is a legal promise by a trustee or trustees to hold and administer property, sold or gifted by a settlor, for the benefit of identified beneficiaries.

Chapter 14 – Farming

Primary production in New Zealand forms a major part of our GDP. Not surprisingly there are specific tax provisions relating to this form of enterprise. Agricultural production is unique since it is the only form of production involving “natural increase”. As a result, special accounting and tax rules are required.

Chapter 15 – Forestry

A number of events in the forest life cycle give rise to taxable forestry income. Clearly, this includes the net proceeds of sales, including felled timber and thinnings etc. In addition, sales or transfers of forestry or cutting rights are also taxable. The forestry regime also contains special rules for deduction of forestry expenditure.

Chapter 16 – PIE and Offshore Investments

Being a small country, much of our investment is off shore. Although this accounts for a relatively small portion of New Zealand’s tax revenue, overseas investment is governed by quite a complex regime and affects a large percentage of the population either directly or indirectly.

Chapter 17 – Provisional Tax

Provisional tax is a means of paying tax on income, that is not fully taxed at source via PAYE or other withholding payments.

Chapter 18 – Withholding Taxes

In this chapter, we consider withholding tax obligations in respect of interest, dividends and royalties paid. We also look at Non- Resident Contractors Tax. Chapter 26 “Employment Responsibilities” discusses withholding tax obligations when you pay New Zealand resident contractors, including commission agents, builders etc.

Chapter 19 – Fringe Benefit Tax

Fringe benefit tax (FBT) was introduced to tax non-cash benefits provided to employees or associates of employees. These rules also apply to non-cash benefits provided to shareholder employees and their associates.

Chapter 20 – Goods and Services Tax

The application of GST to the majority of New Zealand business transactions is straightforward. GST can however give rise to difficult issues, especially in the area of “non standard” transactions. This would include the sale and purchase of real estate, financial services based transactions, GST on fringe benefits provided and GST adjustments for entertainment tax.

Chapter 21 – Accident Compensation

Accidents and injuries in New Zealand are covered by a publicly funded insurance scheme administered by the Accident Compensation Corporation (ACC).

Chapter 22 – Year-End Tax Planning

Year-end tax planning is an important part of managing your tax expense. Year-end tax planning should be undertaken prior to year end. For 31 March balance date businesses, this review should be conducted in February.

Chapter 23 – Tax Administration

Unless these matters are handled by a bookkeeper or dealt with efficiently, a considerable amount of your otherwise productive business time will be expended in complying with your basic tax obligations.

Chapter 24 – Penalties, Binding Rulings & Disputes Resolutions

Failure to meet tax obligations may result in civil penalties, criminal penalties (discussed below) or both. Further, the penalties are not deductible for taxation purposes!

Chapter   25  –  Business Legislation

The business laws addressed in this chapter have a huge bearing on how you can and can’t do business in New Zealand. In the documentation that you keep for running your business, it is well worth noting relevant legal matters and how you plan to ensure compliance.

Chapter 26 – Employment Responsibilities

This section summarises key points to help you fulfil your obligations as a good employer, reduce day-to-day problems and comply with the law.

Appendix – Tax Facts – A Brief Summary

Editor | FBA
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