Introduction

[14.1] Tax accounting for trading stock has been explained, in [5.23]–[5.26] and [12.1]–[12.3] above, as a hybrid of accounting for receipts and outgoings, and accounting for profit or loss. The effect of s. 51 (2) is that an outlay that is the cost of trading stock is an allowable deduction. The corollary that the gross proceeds of realisation of trading stock is assessable income is, however, merely implied. Allowing a deduction of an outlay that is the cost of trading stock would bring about an unacceptable distortion in the operation of the Assessment Act, were it not for the provisions of s. 28. That section in its most common operation will negative the allowance of the deduction by bringing in a like amount as income, if the item of stock has not been disposed of by the end of the year of income. In effect, the deduction of cost is deferred till the year of income in which the stock is realised and there is a matching receipt of assessable income. In the result the taxable income comes to include a profit or loss arising from the dealing in the item of trading stock.

[14.2] While this is the common operation of s. 28 where stock remains undisposed of at year end, the provisions of ss 31 and 32 allow the taxpayer, in the exercise of options open to him, in effect to anticipate a specific profit or loss. Those sections bring in as assessable income at year end, not the cost of the item but its market selling value or, in the case of trading stock other than livestock, its replacement value. In most circumstances a taxpayer will only exercise an option so as to anticipate a profit that will be his income where there is a loss carry forward that he will wish to use before the period of carry forward expires. The exercise of an option to value stock undisposed of at year end at market selling value or replacement value will anticipate a specific profit if market selling value or a replacement value is greater than cost. A taxpayer will generally wish to exercise an option to anticipate a specific loss. The anticipation of the loss will minimise his tax liability in the year of income. The exercise of an option to value stock at market selling value or replacement value will anticipate a loss whenever market selling value or replacement cost is less than cost.

[14.3] The scope given by ss 28, 31 and 32 to anticipate a loss is an advantage that trading stock accounting gives to a taxpayer. No such advantage would appear to be available to a taxpayer in relation to a revenue asset that is not trading stock. Prior to amendments that followed the decision in Westraders (1980) 144 C.L.R. 55, there were other advantages of trading stock accounting. As interpreted in that case, the election s. 36A gave to the old and the new interests on a change in interests in trading stock to treat the item as disposed of at cost and acquired by the new interests at cost, made possible the transfer of a potential specific loss from one taxpayer to other taxpayers. And it was assumed that a potential loss could be transferred by allowing s. 36A to operate without any election. The manner of this transferring of a potential loss is the subject of further comment in [14.69] below. Advantages arising from an election under s. 36A(2), or the operation of s. 36A without an election, have now been denied by amendments to s. 36A and s. 36.

[14.4] As against the continuing advantage of trading stock accounting over specific profit or loss accounting in the opportunity afforded to anticipate a profit or loss, a number of disadvantages for the taxpayer should be noted. A disposal of trading stock of a business that is not made in the ordinary course of business is, by force of s. 36, a deemed disposal at market value. In the language adopted in [12.99]–[12.108] above, s. 36 precludes an abortion of a dealing in trading stock by a non-business disposal which might otherwise have involved an escape from tax on a potential profit. A non-business disposal may be a way of aborting a transaction involving a revenue asset that is not trading stock.

[14.5] If an item that is trading stock of a business is realised, there will be a derivation of the proceeds of realisation, if the taxpayer is on an accruals basis in relation to the receipt of the proceeds, immediately there is a receivable of an ascertained amount that is not contingent, and this notwithstanding that there has been no actual receipt and the receivable is not presently receivable. This is the outcome of the decision in J. Rowe & Son Pty Ltd (1971) 124 C.L.R. 421 referred to in [11.47] above. Where the item is a revenue asset of a business but is not trading stock, the profit that is the item of income may be calculated on a profit emerging basis, which can significantly defer the derivation of income.

[14.6] Thus a conclusion that its holding of land is trading stock of its business involves the consequences for a taxpayer in the circumstances of the taxpayer in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 that a disposal not in the ordinary course of carrying on business will be a disposal at market value. It also involves the consequence that a disposal in the ordinary course of business will give rise to a derivation of income immediately on disposition, even though receipt of the proceeds of disposition is deferred. Where the land is a revenue asset but is not trading stock the first consequence is at least doubtful, and the second consequence does not follow: profit emerging accounting will apply.

The Nature of Trading Stock

[14.7] Clearly, it is important to know when assets are trading stock of a business. The question is a composite one. It is of no necessary consequence that an item is trading stock in the sense that it is within the definition of trading stock or within the meaning of the word without the aid of the definition. The trading stock provisions (Subdiv. B of Div. 2 of Pt III) operate only when items that are trading stock, within the definition or that meaning, are assets of a business or were assets of a business, presumably of a continuing business. And they operate only when they are or were revenue assets of such a business. It would be to allow the definition of “trading stock” in s. 6 to deprive the word “trading” of any sigficance if it were held that Subdiv. B applied in relation to “anything … acquired … for purposes of manufacture”, even though the item will serve its purpose in manufacture by being plant of a manufacturing business. It is true that the concluding words of the definition— “and also includes livestock”—taken with the definition of “livestock” may be thought to support the denial of significance to the word “trading”. In a piece of convoluted drafting it is provided that the definition of livestock “does not include animals used as beasts of burden or working beast in a business other than in a business of primary production”. But the drafting is equally consistent with an assertion of the significance of the notion of trading, and the identifying of exceptions to that notion.

[14.8] A reference to trading stock in the following discussions is intended as a reference to trading stock of a business. And the characterising of an item as trading stock is taken to require that the taxpayer trades or has traded in the item, save in the exceptional case of a taxpayer who is engaged in a business of primary production that includes in its assets animals used as beasts of burden or working beasts.

[14.9] There remains the question as to the actual significance to be given to the word “trading”. Trading may take some of its meaning from the words “sale or exchange” in the definition of trading stock in s. 6. At least it seems to be intended that the item will at some stage be held for sale or exchange, though it may have to undergo change or manufacture to become an item presently held for sale or exchange. The definition of trading stock in s. 6, though obscurely framed, supports the Commissioner’s practice of treating raw materials and part-manufactured goods that will be converted into goods held for sale or exchange as trading stock. A view was adopted by two of the judges involved in the proceedings in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 that land is not yet trading stock until, by development, it has come to be in the form in which it will be held for sale. In the High Court, Stephen J. (dissenting) took this view, supporting a conclusion of Mahoney J. at first instance. But the view did not prevail. It would involve unwelcome problems of timing of the deduction of cost, and the fixing of costs. Thus it might be asked whether the costs of acquisition and development would all become deductible under s. 51(1), as outgoings incurred, at the moment the item comes to be in the form in which it is intended to be sold. Section 82 would prevent a second allowance of deductions already allowed under s. 51(1). But “cost” for purposes of determining the value of closing stock would, presumably, include those costs. There would thus be a risk of some bunching of taxable income in the year in which the land comes to be in the form in which it is intended to be sold, albeit a bunching that is the consequence of taxable income having been understated in earlier years. The costs allowed in earlier years should have been treated as costs of revenue assets and not deductible.

[14.10] An item that is not intended at any stage to be held for sale or exchange in the carrying on of business may be a revenue asset, but it will not be trading stock. An export licence may be an illustration. Even if sale or exchange is anticipated, it may yet be that the item is not trading stock because it is not dealt in. An item, it would be said, is not dealt in unless it is held for profit-making in the sale or exchange. It is arguable then that the assets of a life insurance or banking company that may have to be sold in the carrying on of business in order to satisfy the claims of policy holders or depositors, are not trading stock. And it is arguable that the assets of a company engaged in a business of investing of the kind found by Gibbs J. to be the business of the taxpayer in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106, are not trading stock.

[14.11] At one time it was debated whether choses in action could be trading stock. Indeed, there was a like debate in regard to land, a debate that focused on the word “anything” in the definition of trading stock. In regard to some choses in action, a more persuasive reason for exclusion may be advanced. Expenses may be incurred in activity which ultimately leads to the acquisition of a copyright: an author may be engaged in research for a book. If it be assumed that he is in business as an author, there is room to argue that the costs are costs of the copyright. But there is no asset that might be identified as trading stock in relation to which the trading stock provisions might apply until the copyright comes into existence. There is another difficulty. The author may intend either sale of the copyright or licensing another to use the copyright on payment of royalties. Do the mixed intentions deprive the copyright of any character it might have had as trading stock? If the trading stock provisions are treated as applicable and the taxpayer does give a licence, there will be difficulty in the allowing of costs of the copyright, deferred by the operation of s. 28, against the royalty receipts. The copyright would still be “on hand”— the test of when continuing deferring of costs is appropriate. The taxpayer might achieve a result that approximates the allowance of his costs by writing down the value of the copyright by the choice under s. 31 of market selling value at year end. The written down value would serve as the value for purposes of s. 28. But this is to warp the function of s. 28.

[14.12] The taxpayer who disposes of his copyright in exchange for royalties will be in a better position. The copyright, it could be said, is no longer “on hand” and deferral of the costs is no longer appropriate. Yet immediate deduction may be thought inappropriate where matching receipts will be delayed.

[14.13] The conclusion is that the operation of the trading stock provisions must produce some inappropriate consequences in an area of operation outside the more elementary affairs of merchants and manufacturers. At the same time, it must be conceded, specific profit accounting does not operate in the situations envisaged in an obviously superior way. Some of the problems are considered above in [11.268]–[11.283] in relation to accounting for royalties.

[14.14] Investment & Merchant Finance Corp. Ltd (1971) 125 C.L.R. 249 confirmed the application of the trading stock provisions to a taxpayer dealing in shares. The High Court thus overcame what members of the court saw as the inappropriateness of the only alternative accounting it assumed would be applicable—a basic receipts and outgoings accounting. At that time the recognition of specific profit or loss accounting had yet to become established. The application of trading stock accounting to a dealer in shares in fact facilitated dividend stripping operations and made it necessary that there be qualifications on the dividend rebate provisions by further provisions that now appear in s. 46A and s. 46B. It cannot be said that the application of specific profit or loss accounting would have defeated dividend stripping operations.The High Court might yet have insisted that dividend receipts cannot in any circumstances be regarded as proceeds of realisation of shares. But the possibility that they could be so regarded would at least have been open.

[14.15] The application of trading stock accounting to the business operations of a share dealer raises other difficulties. Bonus shares, rights and options acquired by a trader in shares are additions to his trading stock. If he purchases them, they will have costs for purposes of the trading stock provisions. And if he exercises rights or options that he has purchased, the costs of the rights or options are costs of the shares acquired in their exercise, in the same manner as the costs of raw materials become costs of finished goods. One would not treat the exercise of the options or rights as disposals of them. If one did, there would be a problem of identifying the proceeds of a disposal that should be treated as income.

[14.16] More difficult questions arise when bonus shares, rights or options are acquired by the taxpayer as the holder of shares in relation to which the bonus shares, rights or options are issued. Curran (1974) 131 C.L.R. 409 is authority that the bonus shares, rights or options are trading stock of a share trader. Curran was concerned with bonus shares that, because of s. 44(2), were not in any respect income of the shareholder. The High Court held that a cost should be given to the bonus shares of the amount paid up on the shares in the course of the making of the bonus issue. It was not suggested that some part of the cost of the shares in relation to which the bonus shares were issued should be treated as a cost of the bonus shares. The decision in Curran allowing as a cost the amount paid up on the shares was the subject of comment in [6.194]ff., [7.24], [12.75], [12.78]ff. and [12.85] above. The effect of the decision has been overcome by the provisions of s. 6BA. The allowing of a cost is denied (s. 6BA(2)). At the same time the section, in subs. (3), gives the Commisisoner a discretion to treat some part of the cost of the shares in respect of which the bonus shares were issued as a cost of the bonus shares. The provision denying the allowing of a cost does not apply where the amount that is applied in paying up the bonus shares is assessable income of the taxpayer, and he is an individual. The amount will be assessable income when it involves a crediting to the taxpayer of an amount from a revenue profit of the company. The allowing of a cost in such circumstances would follow a principle discussed in [12.84] above. A revenue asset that is received in the carrying on of a business must be given a cost of the amount that is treated as income because of the receipt. It must be so treated to prevent double taxation, or to protect an exemption from tax if the amount treated as income is exempt income. The allowance of the cost does not affect the Commissioner’s discretion to attribute to the bonus shares some part of the cost of the shares in respect of which they were issued, though one might expect that the allowance of the cost will be relevant to the exercise of the Commissioner’s discretion.

[14.17] There is no provision equivalent to s. 6BA applicable to rights or options that are derived in the carrying on of a continuing business. Yet on the reasoning of Gibbs J. in Curran, costs should be attributed to rights or options received in the course of carrying on a business, even though they are not income. The view taken in this Volume is that Curran should be reversed by the High Court. While it remains authority there may be room for tax planning that will exploit the implication of the decision in relation to rights or options issues. Section 6BA will not have any operation. The Commissioner could possibly call on s. 52A to neutralise the consequences of Curran by denying as a cost some part of the cost of the shares in respect of which the rights or options were issued. But the availability of s. 52A is less than obvious.

[14.18] Where there is a rights or options issue, there is no express power in the Commissioner, of the kind included in s. 6BA(3), which would enable him to attribute to the rights or options some part of the cost of the shares in respect of which the rights or options were issued. The inclusion of an express power in s. 6BA(3) in relation to bonus shares might be used to base an argument that there is no power in relation to rights or options. The general trading stock provisions may in any event be too rigid to admit a principle of specific profit accounting that would allow what is in effect a spreading of the cost of the shares over those shares and the issues made in relation to them.

[14.19] There is no judicial decision holding that building materials that have not yet been incorporated in a structure on real estate are trading stock of a builder. In [12.64]ff. above, building was treated as a business to which specific profit accounting was applicable, and questions were raised as to the determination of a profit emerging from a building operation. To hold that building materials are trading stock would be to attract problems of reconciling trading stock accounting and specific profit accounting that should, if possible, be avoided. The application of trading stock accounting to all aspects of the transaction involved in a building contract would be simply unacceptable. It is conceivable that building materials might be treated as trading stock up to the time when they are incorporated in a building, but the accounting on incorporation would be awkward. Section 36 might be applied on the incorporation if the incorporation could be seen as a disposal not in the ordinary course of business, so that the value at that time is brought in as income. And they could be treated as ceasing to be on hand at that time. It is a mark of the rigidity of the trading stock provisions that their operation might be triggered by the consequence of a principle of property law that a builder ceases to have property in an item when it has become part of land owned by another. And the bringing in of market value requires a fixing of that value, which in the circumstances would be onerous. A specific provision added to the trading stock provisions might require that the item should be brought in at cost. But on balance a finding that trading stock does not include materials of a builder is the most appropriate outcome.

[14.20] Tax accounting in relation to spare parts that are revenue assets of a business but are not trading stock was considered in [12.17] above. Guinea Airways Ltd (1950) 83 C.L.R. 584 is authority that spare parts that are held exclusively for repairs to capital assets of the taxpayer’s business are not trading stock. Spare parts held by a trader who deals in spare parts are obviously trading stock. If the spare parts are held by a taxpayer whose business is to repair property belonging to others they are presumably trading stock. The definition in s. 6 is not definitive: the spare parts may not be “sold” where property in them passes under that part of the law that is concerned with contracts for labour and supply of materials. But the definition in s. 6 is not exclusive, and it may be enough to make an item trading stock that it is held for disposal in the carrying on of the taxpayer’s business. The operation of s. 36 depends on disposal, which may be the moment of incorporation of the spare part in the property of another. If the repair work is carried out in a transaction that is not in the ordinary course of the taxpayer’s business, there will be a deemed realisation at market value at the time of incorporation. The amount the taxpayer receives for effecting the repair will be income derived, and there is a problem of correlating this derivation with the operation of s. 36. A principle against double taxation requires some abatement of the amount received for repairs that is income, to take into account the deemed derivation under s. 36. The method of adjustment is not obvious.

[14.21] Spare parts may be held for a number of purposes, undifferentiated in relation to particular items. They may be held for repair to the taxpayer’s capital assets, for sale in the ordinary course of his business as a dealer in spare parts and for disposal in a business of effecting repairs. Guinea Airways may suggest that one characterisation has to be made of all the spare parts held. Presumably, it is the dominant purpose in holding that will govern. If the conclusion is that the items are trading stock, there will be questions of the operation of the trading stock provisions when an item is used in effecting a repair to a capital asset belonging to the taxpayer. Guinea Airways, as the case is interpreted in [12.17] above, will allow a deduction of the cost of the spare part at the time that cost is consumed in effecting the repair, if the spare part is not trading stock. In the circumstances now considered the trading stock provisions must be applied. Murphy (1961) 106 C.L.R. 146 may be authority that there is no disposal of the trading stock until the capital asset itself is the subject of a disposal, at which stage s. 36 will apply. This is a singularly inconvenient outcome. It gives a bizarre operation to the trading stock provisions. Finding the value of a spare part in the capital asset at the time the asset is disposed of will be an impossible exercise. Whatever the authority of Murphy in relation to an item of trading stock that ceases to be held for sale in the ordinary course of business but retains its separate identity, there is good reason to conclude that the item of trading stock is disposed of when it is incorporated into the capital asset. There will be an operation of s. 36 at that time, and a deemed cost of the same amount. That cost may be a repair outgoing, or if an improvement or reconstruction of an entirety is involved, an amount of cost for purposes of the depreciation provisions.

[14.22] St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 includes opinions on the questions whether acquisition for sale in the course of business is necessary if revenue assets of a business are to be held to be trading stock. The balance of opinions in the case is that there must be acquisition for sale but it is not necessary that there have been repetitive acquisitions. The land in that case had been bought for development and sale, and the case is not authority in relation to land that may have been acquired as a capital or a private asset and is subsequently committed as a revenue asset of a business. In earlier discussions it has been assumed that such land may become trading stock by being committed to the business as stock for sale. The land will have a cost of the amount of its value at the time it is so committed. The assumption in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 that the trading stock provisions were not applicable gives some support to the view that an item that is not acquired as a revenue asset cannot be trading stock. A dealer in land who holds land acquired for sale may receive land as a gift or by inheritance and proceed to develop the latter with the land acquired for sale. If the land acquired by gift or inheritance is subject to specific profit accounting, and the land acquired for sale is subject to trading stock accounting, complexity and arbitrary difference in outcome will result.

[14.23] The English Court of Appeal decision in Mason v. Innes [1967] 2 W.L.R. 479 may stand for a proposition that a taxpayer who is on a cash basis in relation to receipts and outgoings does not have trading stock. It is however a decision in relation to trading stock as understood in United Kingdom law, and its significance for Australian law is limited. There is no express provision in the Australian law that will exclude trading stock accounting where the taxpayer is on a cash basis. But the operation of the trading stock provisions in these circumstances will produce some odd consequences. Thus the taxpayer may sell stock in one year on terms that require payment in a later year. Any deferral of cost will cease on sale because the item is no longer on hand, but the proceeds of sale will be income as actually received in later years. Where the revenue assets are goods, opinions expressed in Executor Trustee & Agency Co. of S.A. Ltd v. C. of T. (S.A.) (Carden’s case) (1938) 63 C.L.R. 108 and J. Rowe & Sons Pty Ltd (1971) 124 C.L.R. 421 leave virtually no room for cash accounting, and the question whether cash accounting excludes characterisation of revenue assets as trading stock may not be significant. But there is room for cash accounting in relation, for example, to the copyrights which result from the work of a person in business as an author. Mason v. Innes involved such copyrights. If the trading stock provisions are excluded, s. 36 will be denied to the Commissioner. Questions as to the possible operation of a general principle requiring a deemed disposal at market value when a revenue asset is disposed of otherwise than in the course of carrying on business are then raised. These questions are considered in [12.21]ff. and [12.89] above.

The Bringing in of Value at Year End

[14.24] The role of the trading stock provisions has been explained in discussion so far as providing a regime of what is, in effect, specific profit accounting, through an adapted regime of receipts and outgoings accounting. Section 28 has been explained as providing for the deferral of the cost of trading stock, deductible under subss (1) and (2) of s. 51, to the year in which the stock is realised and proceeds are an item of income. If one isolates a transaction in one item of stock from all others, subss (1) and (2) of s. 51 will allow a deduction of cost in the year of income in which the item is acquired, and s. 28 in that same year will bring in an item of income of the amount of the cost if the item remains on hand at the end of the year. The excess of closing stock over opening stock, reflecting the acquisition of the item, will be assessable income under s. 28(1). If the item is sold in the following year of income the proceeds of sale will be income and there will, in effect, be a deduction of the cost. There will in that year be opening stock of the amount of the cost and closing stock of a nil amount, since the item is no longer on hand. The excess of opening stock over closing stock is an allowable deduction under s. 28(2).

[14.25] The above analysis assumes that the taxpayer has elected cost as the value of his trading on hand at year end, an election given him by ss 31 and 32. The election is in general unrestricted in regard to a choice by the taxpayer, that may be made in regard to each individual item of stock, between cost, market selling value and replacement cost, where the item is not livestock (s. 31). Where the item is livestock, the election is restricted to a choice between cost and market selling value, and a restriction precludes a change in a later year in the choice he has made save by leave of the Commissioner (ss 32 and 33). The same choice must be made in regard to all livestock.

[14.26] Where an election is open to the taxpayer and is exercised so as to substitute market selling value for cost, the effect will be to anticipate a profit or anticipate a loss which appears likely to arise when the item is realised. There is thus a departure from a general principle that the Assessment Act is concerned only with realised profits or losses. The anticipation where the item is not livestock is always in the choice of the taxpayer. Having elected market selling value at the end of one year in respect of an item whose market selling value is greater than cost, and thus anticipated a profit, he may in the following year by electing cost in respect of that item at the end of that year reverse the anticipation of profit. An election of market selling value in respect of an item whose market selling value is less than cost, will anticipate a loss, and an election of cost at the end of the following year will reverse that anticipation.

[14.27] In the case of livestock, an election of market selling value will anticipate a profit or a loss. But the election once made cannot be reversed in a subsequent year save with the leave of the Commissioner. Since the election once made applies to all livestock, the taxpayer who elects market selling value is in effect required to anticipate profit or loss each year in respect of all items of livestock, unless he obtains the leave of the Commissioner to change the election he has made.

[14.28] An election of replacement cost is available only in relation to trading stock other than livestock. It may have the same consequences as an election of market selling value. There will be an anticipation of profit where replacement cost is higher than cost, or an anticipation of loss where it is lower.

[14.29] Regarding the term “market selling value”, Fullagar J. said in Australasian Jam Co. Pty Ltd (1953) 88 C.L.R. 23 at 31:

Market selling value refers to value in the market in which the taxpayer normally sells. There may be difficulty in identifying that value where, for example, the taxpayer sells both by wholesale and retail.

The Determination of Cost

Direct costing and absorption costing

[14.30] Attention was given in [12.9] above to the line of demarcation between expenses which, though associated with the acquisition of an asset, are not regarded as costs of the asset and are deductible immediately as outgoings, and expenses which are costs of the asset. The latter are not deductible as outgoings unless made so by specific provision. Under specific profit accounting they will enter the determination of a profit that is income or a loss that is deductible on realisation. Trading stock accounting in s. 51(2) has a specific provision by which outlays on stock are made outgoings. But the problem of demarcation of the line between deductible outgoings and costs of an asset in specific profit accounting, has its parallel in trading stock accounting in the demarcation of the line between expenses associated with the acquisition of an asset that need not be deferred and those that must be deferred by the operation of s. 28 as costs of the asset.

[14.31] A good deal of attention has been given, most recently in Phillip Morris Ltd (1979) 79 A.T.C. 4352, to the determination of cost for purposes of the trading stock provisions. In Phillip Morris a number of United Kingdom and Australian decisions are referred to including Duple Motor Bodies Ltd v. I.R.C. (1961) 1 W.L.R. 739; B.S.C. Footwear Ltd v. Ridgway [1972] A.C. 544; Australasian Jam Co. Pty Ltd (1953) 88 C.L.R. 23; and B.P. Refinery (Kwinana) Ltd (1961) 12 A.T.D. 204. The debate reflected in these decisions concerns the extent to which expenses which are the more remote from what may be described as the “direct” costs of the item, must enter the determination of cost when cost has been elected as the value for purposes of s. 28. Treating more remote expenses as entering the determination of cost where cost has been elected will increase the deferral of outgoings under the trading stock provisions, and thus bring out a higher taxable income than would result if direct costs only entered the determination of cost.

[14.32] Phillip Morris is authority that more remote costs may enter the determination of cost. In this it follows “absorption” costing, which financial accounting principles would allow to be appropriate in the determination of profit as an alternative to “direct” costing. Absorption costing, in the case of manufactured goods, will treat as costs not only the expenses directly related to the manufacture—the cost of raw materials, and the cost of labour that carries out operations on those materials—but also a number of costs that do not vary with the quantity of goods produced, for example the wages of inspectors, and depreciation of factory plant used in the manufacture.

[14.33] No principle can set definitively what remote costs will enter the determination of cost. The cost of servicing the taxpayer’s overdraft, and the managing director’s salary, have some relationship with the acquisition of goods, or the manufacture of goods. But to treat them as costs of the goods acquired or produced would be to apply a method of tax accounting to a continuing business which would be unmanageable. It is possible that all costs are to be treated as costs that must enter the determination of profit on the realisation of assets where a business is an isolated venture. Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 may suggest this, and such accounting, it seems, applies to a scheme within the second limb of s. 25A(1). These matters are raised in [12.40] and [12.48] above. But where there is a continuing business, neither specific profit accounting nor its equivalent in trading stock accounting, should wholly displace the operation of general receipts and outgoings accounting.

[14.34] Debate about the applicability of absorption costing in regard to livestock acquired by natural increase is settled in an arbitrary fashion by s. 34(1). The taxpayer may select a cost price not being less than the appropriate minimum prescribed cost price. A price so selected cannot be the subject of a new selection except by leave of the Commissioner. The minimum prescribed prices are nominal only. The effect is that the taxpayer is under very little constraint to defer costs until realisation. Section 34(1) is, in effect, a provision giving privileged tax treatment to primary producers.

[14.35] The description of the elections open to a taxpayer in preceding paragraphs omits reference to two provisions. By s. 31(2), which presumably has no application to livestock, the Commissioner may in some circumstances at the request of the taxpayer determine an amount that will be the value of trading stock at year end. The amount so determined must be less than the lowest value that could have been applicable—lower then than cost, market selling price, or replacement cost. The matters to which the Commissioner is to have regard indicate that the function of the provision is to authorise a lower value where the taxpayer would not be expected to sell all the trading stock on hand in normal course of business for an amount equal to cost, market selling value or replacement cost.

[14.36] There is a proviso in s. 32 whose function is not so obvious. Where a taxpayer satisfies the Commissioner that there are circumstances which justify adoption by him of some value other than cost or market selling value for the whole or part of his livestock, he may, with the leave of the Commissioner, adopt that other value.

The identification of the cost of an item

[14.37] Where cost is applicable to determine the value of trading stock at year end, costs of acquisition that have been incurred must in some way be identified as the costs of items of trading stock on hand at year end. Sometimes it may be possible to make an actual identification. Generally, however, there must be resort to some convention. Where a convention is likely to reflect the actual experience it will be applicable. Thus, an item of closing stock may be treated as having been acquired for a cost that is the average cost of the trading stock on hand at the beginning of the year and stock acquired during the year. A first in first out convention (F.I.F.O.) is likely to reflect actual experience, and will be attractive to the Commissioner in conditions of inflation —the items on hand at year end will be treated as the items most recently acquired and, in conditions of inflation, are likely to have the higher costs. Deferral of cost is thus at a maximum. A last in first out (L.I.F.O.) convention is unlikely to reflect actual experience, though allowing it might operate to offer some relief from the unreality of gains arising in conditions of inflation. The items on hand at year end are treated as the earliest acquired. The deferral of cost is thus at a minimum.

Cost where an item was already owned before it became trading stock

[14.38] Attention was given in [12.78]ff. above to the question whether an item held by the taxpayer as a capital asset, or held privately, may become trading stock. Some observations in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 may suggest that it cannot. It would follow that it may only become the subject of specific profit accounting. In which event, it was suggested in [12.78] above, the market value of the item at the time it becomes a revenue asset is its cost for purposes of the determination of a profit or loss on realisation. If it is admitted that the item may become trading stock, the value at the time it became trading stock will be the cost of the item for purposes of the operation of the trading stock provisions.

Cost where an item comes into existence on severance

[14.39] The item may be severed from an item that is a capital or private asset, or it may be severed from an item that is a revenue asset which may be an item of trading stock.

[14.40] The latter situation admits of a straightforward analysis. Difficulty however is created by the decision of the High Court in Webster (1926) 39 C.L.R. 130. The straightforward analysis would say that shorn wool should have as a cost some part of the cost of the sheep in wool that have been purchased and later shorn. To the extent that a cost is then attributed to the wool, it will diminish the cost of the sheep. Where the sheep are natural increase, some part of the cost price of natural increase adopted by the taxpayer should in theory be attributed to the wool, though the amount so attributed would be minimal. The trading stock provisions may not be flexible enough to accept this analysis: the notion that the cost of the sheep changes at the time of shearing is not easily comprehended by those provisions. If the analysis is not accepted, the wool will have no cost.

[14.41] In Webster the majority (Knox C.J., Rich and Higgins JJ.) rejected the straightforward analysis, at least in the application to the facts of the case. The dissenting judges (Gavan Duffy and Starke JJ.) adopted it. It seems that the partnership of which the taxpayer was a member had in its own accounts distributed the cost of the sheep between the sheep and the wool. They had accounted for the sheep for tax purposes on the basis that their cost was the amount distributed to them, and for the wool on the basis that the cost of the wool was the amount distributed to the wool. The Commissioner accepted the accounting in regard to the sheep and no issue was raised in that respect. He refused to accept the accounting in regard to the wool, asserting that the wool had no cost. The issue in the case was the correctness of the assertion that the wool had no cost. The decision in the case is adequately explained as a conclusion that the trading stock provisions at the time of the decision did not have sufficient flexibility to accept the straightforward analysis. It was just unfortunate for the partnership that it had claimed in its tax account, as the cost of the sheep, the amount distributed to the sheep, and not the full amount paid for the sheep—an amount which in turn had been determined by an allocation within a total price paid for the farm with the sheep in wool.

[14.42] The reason for the decision given by the majority is, however, that the price paid for sheep in a purchase of a farm and sheep in a walk-in walk-out purchase is a capital outgoing. It is the price of capital assets. Perhaps this view is the explanation of the drafting of s. 51(2) of the Assessment Act in providing that expenditure in acquiring trading stock shall be deemed not to be an outgoing of capital or of a capital nature. The function of s. 51(2) is otherwise explained in [5.23]–[5.26] above. The reason given by the majority emphasises that the price was paid as part of the price of buying the farm. With that emphasis, it reflects a principle which is a corollary of a principle that a receipt on the sale of sheep in a walk-in walk-out sale of a farm is not an income receipt. The latter principle is displaced by the provisions of s. 36 of the present Assessment Act. The majority view has unacceptable implications. If the buyer of a farm acquires the sheep in a distinct purchase, albeit from the seller of the farm, the sheep will be revenue assets and trading stock. It is the purchase of the sheep with the farm that requires them to be treated as capital assets and not trading stock. The view of this Volume would be that assets purchased in the purchase of a business may be revenue assets to be accounted for under general specific profit accounting, or revenue assets that are trading stock to be accounted for under the trading stock provisions if they qualify in other respects as trading stock. Section 36 deems the purchaser of a business who acquires in a purchase assets that were trading stock of the seller to have purchased the assets at their market value. In this deeming the section assumes that the stock so acquired may be trading stock of the purchaser.

[14.43] The matter of cost when an asset comes into existence on severance from a capital or private asset of the taxpayer, and is thereafter held and disposed of in the carrying on of a business, has been the subject of consideration in a number of earlier paragraphs. A taxpayer may own land and hold it as a capital asset of a farming business, or he may hold it privately. In the land there is a valuable deposit of gravel. The view has been taken in this Volume that, as a matter of general principle, if the taxpayer takes the gravel from the land and sells it in the course of a business he is entitled to a cost of the gravel taken that will include its value as part of the land—in effect what another would have paid the taxpayer for the right to take the gravel from the land. This element of cost is the value at the time of taking. Where the asset taken becomes trading stock on the taking, there will be an allowable deduction of the value of the asset taken. This value will be part of the cost of closing stock if the asset remains on hand at year end.

[14.44] There may be reason to distinguish, as a matter of general principle, the case of gravel from the case of timber or other resource that is produced by land. If a taxpayer takes timber from land held as a capital asset of a business of producing and selling timber, and sells the timber, it is arguable that the cost of the timber should include, not its value at the time of taking, but its value at the time the land became committed to the business of producing and selling timber. If the land was acquired to be used in this way, the cost would be that part of the price paid for the land that was attributable to the timber standing on the land at the time of purchase. There is an express provision in s. 124J in regard to timber. The significance of that provision is considered in [12.82] above. Where the produce of the land is one of those referred to in s. 36—standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale—that section will have some significance. In this context, as in regard to trading stock, the section deems the purchaser to have acquired the crop or trees at their value at the time of acquisition. The deeming indicates an assumption that a purchaser who is in business producing and selling crops or trees will have, on severance, trading stock with a cost that will include the value at the time of acquisition of the land.

[14.45] Clearly, a taxpayer who acquires land in which seed has been sown does not acquire a distinct asset consisting of some part of the crop that will ultimately be harvested and sold. On the other hand, a taxpayer who acquires land with plants in ripe fruit acquires a distinct asset consisting of the crop that will be harvested and sold. There are many intermediate situations. A line must be drawn, and it should be drawn in terms of the state of maturity of the crop: is it commercially identifiable in its condition at the time of acquisition? The view taken in the United Kingdom decision in Saunders v. Pilcher [1949] 2 All E.R. 1097 is that there can be an acquisition of a crop that will be a revenue asset of the taxpayer who acquires only if the crop is acquired in a transaction which is separable from the transaction by which the land is acquired—though presumably both transactions may be in the same contract. The separateness of a transaction presumably involves something more than an allocation of price to the crop. A line drawn in terms of legal forms seems hardly appropriate. Jenkins L.J. (at 1106) supports such a line by pointing to the situation of the seller, and making the assumption that the seller will derive income on the sale of the land only if the crop is sold in a separate transaction. Symmetry in the treatment of seller and buyer is not a principle of income tax law, though it may be a desirable policy objective. But there is no authority that would support the assumption made by Jenkins L.J., and a view that the seller may derive income if he sells land with a crop that is identifiable is equally open.

[14.46] Section 36(1), in its reference to crops, crop-stools and trees planted and tended for the purposes of sale, has an operation to bring about a derivation of income by a taxpayer who disposes of crops, crop-stools or trees, whether or not there is a transaction in this regard separable from another by which there is a disposition of the land. It will thus be important to know the meaning of the word “crop-stool”, a matter considered by Kitto J. in Amy Strongman Butcher (1950) 9 A.T.D. 177. And it is possible that, moved by a sense of symmetry, a conclusion will be reached that an assumption of s. 36(1)—that the person acquiring is entitled to a cost—has been made law in regard to items with which s. 36(1) is concerned. It would follow that where there is an acquisition by a taxpayer of land carrying a crop that is identifiable the taxpayer will be entitled to a cost if he is in a business of selling the crop. The conclusion of Kitto J. was that the item in question in Amy Strongman Butcher was not a crop-stool so that the section could have no application. He did however contemplate that the assumption of s. 36(1) is made law in regard to the items with which the section is concerned. He said (at 178): “The section does not go on to provide that the person acquiring the property shall be entitled to treat the value of it as an allowable deduction, and it was contended by counsel for the respondent that that result does not follow from the section or any other provision of the Act. If this contention is correct, it is difficult to see any purpose in enacting that the purchaser shall be deemed to have purchased the property at its value, and I should have thought that there would be much to be said against the contention. Indeed, I understand the Deputy Commissioner to have acted under s. 36 in allowing the £550 allocated to the purchase of hanging fruit. It is not necessary, however, to express a final opinion on the point, because of the conclusion to which I have come upon the preliminary question whether banana plants fall within the descriptions of property contained in s. 36.”

[14.47] On the question whether there is a cost of a revenue asset in other circumstances, he said:

Webster (1926) 39 C.L.R. 130 is the subject of comment in [14.41]–[14.42] above. It does not dictate any general conclusion. In any case, in the particular facts of Butcher, there could not be said to be the acquisition of a revenue asset. The bananas that would eventually emerge from the plants had not yet emerged. They were not yet commercially identifiable. Kitto J. may be taken to have rejected a general principle that would, in the context of the trading stock provisions, allow a deduction of the cost of the growing crop. He would, presumably, explain s. 36(1) as expressing a policy that where a gain that results from the growth of a crop has been brought in as assessable income of a seller on realisation of the land, the value of that growth should be excluded in determining any gain by the buyer that is income on a realisation by him. The implication of that policy would be that where any gain by the seller has not been brought to account as assessable income, the value of the growth should be taxed to the buyer, at least when he sells the resulting crop. The assumption is that where s. 36(1) does not operate, the seller, on realisation of the land, will not derive a profit that is income. That assumption will not always be correct—the land may be a revenue asset of the seller. In any case, it is not easy to see why the tax consequences for the seller should determine the tax consequences for the buyer. If they do, some rethinking of principle will be necessary if capital gains come to be generally subject to tax. Kitto J. might perhaps have sought a justification by reference to the law that will treat, as an income gain, a gain derived from property, more especially interest or a dividend that would be said to have “accrued” in part prior to the acquisition of the debt or share by the taxpayer who derives the interest or dividend. The interest or dividend is treated as a gain, as to the whole of its amount, realised by the taxpayer who has acquired the debt or share. It would be said that allowing the taxpayer to exclude the cost of the crop in determining income arising from the taking and sale of the crop, would demand that a taxpayer who acquires a debt or a share should be entitled to a deduction, when he derives interest or a dividend, of so much of the cost of the debt or share as is attributable to the impending payment of the interest or divended. The logic of the argument is sound, but there are problems of attribution, at least in the case of the impending dividend, that would always restrain the recognition of the logic in the development of the law. In any event, there is no justification for treating the failure to allow a deduction in the debt or share situation as reason for denying a deduction in the case of land with a growing crop, or, for that matter, in the case of sheep in wool. The fact that there are some departures from the principle that an item is not income unless it is a gain, does not require an abandonment of that principle.

Cost where more than a normal supply of stock is acquired

[14.48] One basis of the decision in Guinea Airways (1950) 83 C.L.R. 584 was that the stock of spare parts held by the taxpayer exceeded a normal supply, and the spare parts were therefore capital assets. A deprivation of them did not in the result give rise to a deductible loss. One implication of that basis of decision would be that there would be a deduction of the value—not the cost—of a spare part taken from the supply and used in a repair of one of the taxpayer’s aircraft.

[14.49] The question now raised is whether items in a more than normal supply of assets—a stock pile—that would otherwise be trading stock are not trading stock but capital assets. The notion of “normal supply” is, of course, indeterminate. It might have been said in Guinea Airways that, having regard to the remoteness of the taxpayer’s operations from a source of supply of spare parts, a substantial supply might none the less have been normal. A normal supply of spare parts is one that gives reasonable assurance that there will be spare parts available when they are needed. And a normal supply of trading stock would be one that gives reasonable assurance that the taxpayer will have stock to sell to meet a demand that should be anticipated. A supply would be abnormal where it has been built up in the course of a plan to dominate the market.

[14.50] There is no case in which status as trading stock has been denied on the ground that the supply held is abnormal. If status as trading stock were denied on this ground, the taxpayer who holds an abnormal supply would run the risk that a loss on deprivation would not be an allowable deduction. An item sold from the stock pile in the ordinary course of business would however become trading stock in the act of disposition. Its cost for purposes of the trading stock provisions would, presumably, be its value at the time of that sale. The result is that there will, very likely, be no profit brought to tax. Which may be thought so incongruous as to demand a reconsideration of any principle that stockpiling will attract the character of capital assets to what would otherwise be revenue assets and trading stock. An alternative analysis would be that the items of stock as they enter the process of sale have no cost, though the proceeds are income. That alternative may be thought to follow from some of the reasoning in Webster (1926) 39 C.L.R. 130, considered in [14.41] above. The result will be that tax is imposed on what is obviously not a gain. Which is also incongruous, and will equally demand reconsideration of any principle that stock-piled assets must be capital assets.

Cost in a two stage acquisition

[14.51] It is accepted that raw materials and partly fashioned goods of a manufacturer are trading stock. There is in this a rejection of the view taken by Stephen J. (dissenting) in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 a 221, adopting the view of Mahoney J. at first instance, that an item is not trading stock until it is in the form in which it is intended that it be sold.

[14.52] The transition from partly fashioned to fully fashioned goods does not amount to a realisation of the former. The partly fashioned goods in effect remain on hand at year end as part of the fully fashioned goods, and the cost of the latter will include the costs of the former. The same analysis was adopted in [14.50] above in relation to the exercise of rights or options that are trading stock. The rights or options in effect remain on hand as incorporated in the shares that are acquired by their exercise, and any costs of the rights or options are costs of the shares.

Cost where there is an element of gift by the person from whom trading stock is required

[14.53] The view was taken in [12.84]–[12.85] above that the amount paid for goods is not their cost where there is an evident pure gift by the seller in the transaction in which the goods were acquired. The cost is the value of the item at the time it is acquired. A receipt that is a pure gift is not within the base of the income tax. It would be caught up in the base if no cost is allowed reflecting the value of the gift.

[14.54] In some circumstances a gift received will be income of the taxpayer. The matter is examined in [2.132]ff. above. Thus a trader may receive a non-commercial discount from a supplier in recognition of a gratuitous service that the trader has performed for the supplier. In such circumstances there is a distinct reason why the element of gift in the allowing of the discount should be treated as a cost of the goods. If the element of gift is not treated as a cost, what is in substance the same gain will be taxed twice—once as a reward for service and the second time as a profit on the realisation of trading stock.

[14.55] In the last paragraph a distinction is drawn between a commercial and a non-commercial discount. That distinction will not always be easily drawn. Jacgilden v. Castle [1969] 3 W.L.R. 839, referred to in [12.86] above, asserts an important principle: even though there is a discount in the sense of a lower price charged for goods than what might be thought to be the prevailing market price, the price charged will none the less be the cost if the discount was allowed in an “honest bargain” between the parties. If it were not so, the law would fail to tax a profit that might be thought to arise from good buying by a taxpayer.

[14.56] It was suggested in [12.87] above that a price that reflects an element of gift by the buyer to the seller should not be treated as proceeds of sale by the seller. The realisation should be taken to have been made at market value. The surplus over market value in the amount received may be income otherwise than as a profit on the sale of trading stock, for example as a reward for services. The amount paid by the buyer will be a cost of the trading stock only to the extent of the market value. He may have a deduction for the surplus in appropriate circumstances, for example as a payment for services used in business operations. Again the principle in Jacgilden that a price paid in an “honest bargain” should stand, is applicable. The finding of an element of gift should not easily be reached.

Cost where the amount paid for trading stock is excessive

[14.57] The immediately preceding paragraphs adopt a principle that a price paid for trading stock in an “honest bargain” should stand as the cost of the stock. That principle bears no affinity with an approach to the interpretation and operation of s. 51(1) which is described in [9.17]ff. above as “form and blinkers”. Indeed, it reflects a rejection of that approach. There is no honest bargain, though there is a contract under which the trading stock is acquired, if the price paid significanty exceeds the market price and the parties are not at arm’s length. Cecil Bros Pty Ltd (1964) 111 C.L.R. 430 may be an illustration, though the excessiveness of the price in that case was modest. Excessiveness and the relationship between the parties justify the finding of an element of gift—in the circumstances of Cecil a gift made in the course of profit-shifting between taxpayers.

[14.58] The “honest bargain” principle applied in the interpretation and operation of s. 51(1) will allow the denial as a cost of some part of the price of trading stock. To an extent it makes the express provisions in ss 31C, 65 and 82KJ and 82KL and Div. 13 of Pt III unnecessary. Those provisions are explained in [10.289]–[10.362] above. Section 31C, however, may direct the denial of a cost where it would otherwise be allowed. It may deny part of a cost, notwithstanding that there might be said to be an honest bargain, where the Commissioner is satisfied that the purchaser of an item of trading stock could have purchased an identical article from another person for a price less than that cost. It will have this effect if the Commissioner is satisfied that the parties were not dealing with each other at arm’s length in relation to the transaction. And it will have this effect even though the Commissioner is unable to reach a state of satisfaction that the price charged was not an “arm’s length price”. Section 31C may operate to deny a cost when s. 51(1), even on the interpretation and operation of that provision asserted in this Volume, would not. Thus s. 51(1) may not deny a cost in the circumstances of Cecil, but s. 31C will admit of such a denial. An arm’s length price that a taxpayer might pay for trading stock will presumably increase, the lower the level of distribution at which the stock is acquired. The family company supplying the taxpayer company in Cecil was supplying at a lower level of distribution than the wholesalers with whom the taxpayer had formerly dealt. It is thus arguable that the price charged by the family company was a price that the family company might have charged had it been dealing at arm’s length with the taxpayer.

Accounting on the Realisation of Trading Stock

[14.59] Section 51(2) overcomes what was thought to be a difficulty about the deductibility under s. 51(1) of the cost of trading stock. The effect of s. 51(2) is examined in [14.1] above. But s. 51(2) leaves the matter of what is to be treated as an outgoing to the operation of general principles of tax accounting. To the extent that an outgoing for trading stock might be accounted for on a cash basis, it is arguable that there is no “cost” to be deferred by the operation of s. 28 until the stock have been paid for. It would be a rogue operation of the trading stock provisions that a taxpayer electing cost might be required to bring in an amount as income in respect of stock on hand at year end, when he is not yet entitled to deduct the outgoing in respect of the stock because he has not yet paid for the stock. Similarly it would be argued that there is no “cost” to the extent that an accruals basis taxpayer is not yet entitled to deduct an outgoing. A provision for long service leave in respect of employees employed in the taxpayer’s manufacturing operation should not be treated as a cost of manufactured goods.

[14.60] The deferral of the deduction of cost that results from s. 28 ceases when an item of trading stock ceases to be “on hand”. There is, however, no statutory provision identifying the moment when there will be a derivation of income that is the proceeds, or the deemed proceeds of realisation of trading stock. The conclusion of the High Court in J. Rowe & Sons Pty Ltd (1971) 124 C.L.R. 421 that the actual proceeds of sale of trading stock, where accruals applies, should be accounted for when they become receivable even though they are not presently receivable, was in part moved by the view that there should be an item of income to match the outgoing for cost that, in effect, becomes deductible when the trading stock ceases to be “on hand”. But the operation of accruals accounting in this way will not necessarily produce that result. A taxpayer on accruals who produces trading stock that are acquired by a marketing authority, may not yet have proceeds of realisation because the amount that he is entitled to receive has yet to be ascertained. Farnsworth (1949) 78 C.L.R. 504 affords an illustration. The trading stock provisions in these circumstances have a rogue operation.

[14.61] Where a taxpayer disposes of trading stock otherwise than in the ordinary course of carrying on his business, there will be a derivation of income in the amount of the value of the stock (s. 36). Value, as defined in s. 36(8), is “the market value of the [trading stock] on the day of the disposal; or if, in the opinion of the Commissioner, there is insufficient evidence of the market value on that day—the value which in his opinion is fair and reasonable”. A valid opinion must, presumably, be directed to an estimate of market value. In this situation, it is irrelevant how much the taxpayer may have received or be entitled to receive. And it is irrelevant that an amount he is entitled to receive has not yet been ascertained. If the words “on hand” in s. 28 and the word “disposes” in s. 36(1) are construed so that an item necessarily ceases to be on hand when it is disposed of, the possibility that there may, in effect, be a deduction of cost before there are matching proceeds is overcome.

[14.62] Generally, an accruals basis taxpayer will derive income, in the form of a receivable, when he has realised an item of trading stock. An item is not realised until property has passed and the passing of property will generally be a condition precedent to a claim to receive proceeds. A reference to passing of property attracts the law’s distinction between a passing of property in equity and a passing of property in law. Where an equitable title passes in land—the contract of sale being specifically enforceable—there will presumably be a realisation. If the contract does not in fact proceed to completion, so that legal title does not pass, the analysis of the transaction becomes complex. If the buyer makes some payment to the seller to obtain a release from his obligation to complete, the receipt by that seller will be his income as compensation for a profit he would have made had the contract been completed. The seller has also derived income of any amount received under the contract that he is entitled to retain. And he is now entitled to a deduction of the cost of the property he has again acquired. A satisfactory analysis would assert that the seller has incurred an outgoing in the reacquisition of the equitable title, and that outgoing is thereafter his cost in respect of the property. The outgoing is the value of his right to the proceeds of sale: s. 21 is attracted. The final outcome, apart from the possible derivation of a compensation receipt and a deposit retained that are income, is that the seller’s cost of the land has been written up by the amount of the difference between the original cost and the proceeds to which he was entitled under the sale that did not proceed to completion, and there is, to this extent, a derivation of income by him. Or, if the proceeds are less than cost, there will have been a write-down of the original cost, and to this extent the seller has an allowable deduction. An alternative analysis would treat the agreement to rescind the contract as a giving up of the claim to the proceeds of sale, which will give rise to an allowable deduction of the amount of the claim. The land will be treated as still on hand at its original cost. The taxpayer will have income in the amount of the proceeds of sale, any compensation for profit lost and the amount of any deposit received he is entitled to retain. The alternative analysis will, of course, be generally the more attractive to the taxpayer.

[14.63] Section 36 may be said to treat a disposal, in the circumstances to which it applies, as a deemed realisation for an amount equal to the value of the property. That amount is forthwith income derived, whatever may be the taxpayer’s basis of accounting in relation to the item. The question was raised in [12.89] and [12.99]ff. whether a general principle of tax accounting might not apply to bring about a deemed realisation, with the like consequences, in other circumstances.

[14.64] A taxpayer may take an item out of trading stock and use it as a capital asset of his business when it will become subject to the depreciation provisions—a taxpayer dealing in motor cars may take an item of stock and use it as a “demonstrator” vehicle, or use it for the conveyance of staff and clients. The most rational analysis would treat the change of use as a realisation at market value. The cost of the item for depreciation purposes would be that market value. The consequences on ultimate actual disposal would be those applicable under the depreciation provisions. Trading stock accounting would at that time have no application. Attention was given in [12.104] above to the difficulty, in adopting this analysis, which is posed by s. 36 as it has been interpreted in Murphy (1961) 106 C.L.R. 146. That section, as so interpreted, may displace any general principle. The taking of an item out of trading stock of a business, and the use of it for private purposes, were the essential facts in the United Kingdom decision in Sharkey v. Wernher [1956] A.C. 58 where a general principle of deemed realisation on change of use was recognised. If any general principle is displaced, the item of trading stock will remain on hand as an item of trading stock despite the change of use. The cost of the item will, in effect, be deductible at the time of actual disposal. That disposal will presumably be a disposal otherwise than in the ordinary course of business so that s. 36 will then apply. Such an operation of the trading stock provisions may be acceptable, though analytically unsatisfactory, provided the depreciation provisions are simply ignored. But a like operation of the trading stock provisions will be unacceptable if an item of trading stock is taken from stock and used by the taxpayer for private purposes. There will of course be no room for the depreciation provisions, but treating the item of stock as still on hand until disposal, and the operation of the trading stock provisions on disposal, will in effect allow the taxpayer a deduction for the depreciation of an item of property used for private purposes.

[14.65] A principle that there is a deemed realisation on change of use would extend to the taking of an item out of the trading stock of one business and its inclusion in the trading stock of another business of the same taxpayer. There will be questions as to whether the second business is a distinct business, or a division of the old. If it is a distinct business the operation of the principle will give a more rational system of tax accounting. It would, however, bring about a derivation of profit on the deemed disposal, and might be seen as an unacceptable anticipation of income. Section 36 would presumably not be applicable on the eventual realisation of the item in the ordinary course of carrying on the second business, though it is arguable that the disposal is not in the ordinary course of carrying on “that business”—the phrase used in s. 36(1)(c). The reference in that phrase is to the first business. Disposal in the second business could not be in the ordinary course of carrying on the first.

[14.66] Taking for private purposes would extend to the killing of an item of livestock for rations, at least where those consuming the rations are the taxpayer and his family. The instructions for filing returns issued by the Commissioner direct that in these circumstances income equal to the cost of the item of livestock should be taken to be derived. The assumption is that s. 36 is not applicable—the item of livestock has not been disposed of. The direction does not appear to be justified by any other specific provision, or any general principle. The direction, if followed, will achieve some correction of what would otherwise, in effect, be the allowance of a deduction in respect of expenses of producing or acquiring food consumed by the taxpayer. It is of course only a partial correction. The correction is minimal where the item is natural increase and the scheduled cost price of natural increase is applicable.

[14.67] Where s. 36 operates the taxpayer acquiring the property is deemed to have purchased it at a price equal to its value. This deeming will, presumably, displace any actual consideration given by the taxpayer acquiring the property. Where there is an element of gift in the disposal of the trading stock to the person who acquires it, the deeming will protect that gift from being taxed in the hands of the person acquiring it. That gift might otherwise be taxed as a part of any profit that is income when the taxpayer who has acquired realises the item. If the acquisition of the property is a derivation of income by the taxpayer who acquires it, the deeming will protect the taxpayer against being taxed twice on the amount. There may be a derivation of income to the extent that the value of property exceeds the consideration given where the opportunity to acquire the property at less than the value of the item is, for example, received by way of a reward for services performed by the taxpayer who acquires it.

[14.68] In St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 a distribution of land in specie made to a holding company in the liquidation of the taxpayer company, was held to be a disposal of the land to which s. 36 applied. The case was not concerned with the tax consequences for the holding company. Those consequences raise a question of the operation of s. 36 in deeming the person who has acquired the property the subject of the disposal to have “purchased it at a price equal to its value”. The deeming may preclude the operation of s. 47 in relation to the distribution in specie. Section 47 would deem the distribution, to the extent to which it presents income derived by the company making the distribution, to be dividends paid to its shareholders by that company out of profits derived by it. On the facts of St Hubert’s Island there may be some analytical difficulty in saying that the land distributed to the holding company in part represented the income that was derived, by force of s. 36, in the very act of making the distribution. In other circumstances, however, property distributed in specie may clearly represent income derived on an earlier occasion by the company making the distribution, in whatever way one answers the question whether it represents income arising from the operation of s. 36 in the act of distribution. There is then a competition of deemings. Presumably the land could not be said to be both a dividend and an item purchased at its value by the shareholder receiving the distribution. The resolution of the competition might adopt the deeming in s. 47 as the more specific.

[14.69] Subsection (9) of s. 36 was added to s. 36 in 1978 to deal with planning to transfer an unrealised loss to another taxpayer or to a partnership of taxpayers. The unrealised loss would be inherent in a situation involving dividend stripping. A taxpayer company might have acquired all the shares in another company and have intended to strip the company of its assets by taking them in a dividend distribution. If it did take the assets in this way, it would receive rebatable dividends: Investment & Merchant Finance Corp. Ltd (1971) 125 C.L.R. 249 had established as much. And if it were a share trader and sold the shares after the stripping, it would, in effect, incur a substantial loss by the operation of the trading stock provisions. Investment & Merchant Finance had also established that shares acquired in these circumstances were none the less trading stock—a decision criticised in [2.451] above. The taxpayer company, A, might not be able to make effective use of the loss realised in this way, having inadequate income against which it might be set. The planning would then have been to defer both the taking of the dividends and the realisation of the loss. The shares, X, would be sold to another taxpayer (or partnership of taxpayers), B, in business in share trading for an actual price that reflected other aspects of the plan by which the purchaser would be under an obligation to ensure that new shares, Y, in the company whose shares had been purchased would be allotted either to the taxpayer company A or to its associated company, and dividends were then paid on those shares so that the company was stripped of its profits. Subsequent to the stripping, the shares acquired by the taxpayer (or partnership of taxpayers), B, would be sold and this sale, it was argued, generated a substantial loss. It was said that the sale by taxpayer company A to taxpayer B or partnership of taxpayers B was not in the ordinary course of business by A, so that there was a deemed sale under s. 36 at market value, and not at the much lower price in the actual sale. Taxpayer (or partnership of taxpayers) B was in the result deemed by s. 36 to have acquired at that value, so that there was a tax loss experienced on the on-sale after stripping.

[14.70] Planning of this kind has been affected by new ss 46A and 46B which may result in a denial of the dividend rebate otherwise afforded by s. 46. Section 46A dates from 1972 and has been the subject of a number of amendments. Section 46B dates from 1978. Planning of this kind has also been affected by s. 36(9) which gives the Commissioner a discretion, in circumstances which include those described, to treat the sale otherwise than in the ordinary course of business as a sale not at market value but at such value as the Commissioner considers reasonable. The Commissioner may set a value on the sale by taxpayer company A that will ensure that the loss is suffered by that taxpayer at the time of that sale, and not by taxpayer B, or partnership of taxpayers B, on the on-sale.

[14.71] It may be doubted whether s. 36(9) was necessary. There is an assumption that what is sold by taxpayer company A in the plan described above is all the rights that make up the shares. It is at least arguable that the agreement between buyer and seller limits the rights that are the subject of the sale. It is the market value of these limited rights that must be determined under subss (1) and (8) of s. 36.

[14.72] Section 36A overcomes the decision in Rose (1951) 84 C.L.R. 118, and extends the operation of s. 36 to circumstances where a change has occurred in the ownership of, or in the interests of persons in trading stock, but the change does not involve a disposal by the person or persons who owned or possessed interests before the change. The typical, perhaps the only circumstances to which the section can apply, will be those specifically identified in the section—the formation or dissolution of a partnership, or a variation in the constitution of a partnership, or in the interests of the partners. Section 36A provides that s. 36 will apply “as if the person or persons who owned the property before the change, had, on the day on which the change occurred, disposed of the whole of the property to the person, or all the persons, by whom the property is owned after the change”.

[14.73] Section 36A(2) gives an election that will allow the parties to a change in interests within s. 36A(1) to escape, to a degree, the operation of s. 36. The election requires a 25 per cent continuity of interest, and the participation of all the persons who owned before and of all the persons who own after the change in interests.

[14.74] The effect of the election by the parties to a change is to substitute for the market value that would otherwise be the value on the deemed disposition, “the value (if any) that would have been take into account at the end of the year of income if no disposal had taken place and the year of income had ended on the date of the change”. Thus the election might ensure that the trading stock was the subject of a deemed disposal at cost. There is, however, a problem of identification raised by s. 36A(2) in the reference to “the value …that would have been taken into account at the end of the year of income if no disposal had taken place”. That value could have been determined by the exercise of an option under s. 31 or s. 33. It may be that a specification of a value in the election will serve as an exercise of an option for purposes of determining the value that would have been taken into account.

[14.75] Section 36A(2) gives rise to other problems of interpretation. Thus it might be thought to be inapplicable to the withdrawal of a partner, since not all those who owned before the change will be represented among those who own after the change. In fact the section has not been interpreted in this way.

[14.76] Since 1977 the election is only available where the market value is greater than the value that would be applicable if the election were effective. The significance of this restriction appears in [14.80] below. The election given by s. 36A(2) is only available where, upon the change in interests, the property becomes an asset of a business carried on by the person or persons by whom the property is owned after the change. A change in interests that will bring s. 36A(2) into operation includes the death of a partner, and s. 36A(4) specifies the parties that must participate in the election. The place of the deceased partner is taken by the “trustee of his estate and the beneficiaries (if any) who are liable to be assessed in respect of the whole or a share in the income of the business of which the property becomes an asset”. Where death brings about a dissolution of partnership, the condition that those who own the property after the change in interests must carry on business will not be satisfied, though the surviving partner may carry on business using the deceased partners share in the assets. No election will therefore be possible (Elder’s Trustee & Executor Co. Ltd (Satchell’s case) (1961) 104 C.L.R. 12).

[14.77] Where the death of a partner does not bring about a dissolution of partnership, an election is available. The death of a partner will not bring about a dissolution of the partnership if the partnership agreement provides that the partnership business will be continued by the surviving partners for their benefit and the benefit of the estate of the deceased. An election is necessary to prevent the operation of s. 36A—which will, in effect, bring about a write-up of the trading stock to market value—notwithstanding that the death of the partner is not an occasion for the taking of a partnership account, and there will be no operation of ss 90 and 92 to bring about derivation of income by the surviving partners and by the deceased partner.

[14.78] Prior to 1977, planning of the kind described in [14.69] above had involved the use of the election given by s. 36A(2). Such planning was held effective in Westraders Pty Ltd (1980) 144 C.L.R. 55. Taxpayer company A would have taken dividends on the shares, X, before the sale to a partnership of taxpayers B. Taxpayer company A would have a 25 percent interest in the partnership of taxpayers B. An election would require the operation of s. 36, in such a way that the shares X would be taken to have been disposed of at cost. The partnership of taxpayers B would pay only marginally more than the market value for the shares, but would be deemed to have acquired them at their cost to taxpayer company A. That cost, paid by taxpayer company A before the dividend stripping, would be a much higher figure than the value of the shares at the time of the disposition to partnership of taxpayers B. On the on-sale by partnership of taxpayers B, the trading stock provisions would, in effect, give rise to a substantial loss, which would, under the partnership provisions, more particularly s. 92(2), be distributed among the partners including taxpayer company A. In the outcome, taxpayer company A as a partner in the partnership would have realised a part of the potential loss on the shares that had been the subject of the dividend strip, and gained by the price in fact charged the partnership of taxpayers B, which would reflect to a degree the value of the remainder of the potential loss.

[14.79] Planning of this kind associated with dividend stripping has now been made impossible by s. 36A(5), inserted in 1977, and s. 36A(6) inserted in 1979. By those provisions the privilege of election is denied when the change in ownership or interests relates to a chose in action. The planning described in the last paragraph would, after 1977, have been defeated in any event by the addition in that year of one of the general conditions of the availability of an election now specified in s. 36A(2)(c). The market value of the property must be greater than the value that would be applicable if the election were effective.

[14.80] Where planning relates to property other than choses in action, an attempt to transfer a loss, if not defeated by the conditions of availability of an election under s. 36A(2), is now defeated by s. 36A(7), inserted in 1979. An election is not available when the value of the property as determined by the Commissioner under s. 36(9) is less than or equal to the value of the property that would be applicable if the election were effective. In determining the value under s. 36(9) the Commissioner is entitled to have regard to an amount specified as the value of the property, or as the consideration receivable in respect of the disposal in any agreement entered into in connection with the disposal of the property.

[14.81] The s. 36A(2) election is not available where there is an outright disposition of trading stock from one taxpayer to another. At least one, perhaps all, of the persons who own before the change must have a continuing interest after the change. It was however suggested prior to the addition of subss (8) to (10) of s. 36A in 1981 that appropriate planning might achieve an outright disposition by way of two transfers, each of which involves a continuing interest. Thus A might take another taxpayer, to whom he proposed to transfer his business, into partnership with him, and the partners might make an election under s. 36A(2) so that the stock was disposed of and acquired at cost. He might then dispose of his continuing interest to the other taxpayer, and the parties might make another election to the same effect. The second election raised a problem of interpretation of s. 36A(2) to which reference was made in [14.74] above, and it might always have been ineffective to preclude the operation of ss 36A and 36. In any event, subss (8), (9) and (10) of s. 36A have qualified the effectiveness of the planning. Subsection (8) precludes an effective election where a change in interests has occurred, otherwise than in the course of ordinary family or commercial dealing, and the amount of the consideration received or receivable in respect of the change in interests by the person or persons who owned before the change, or any one of them, substantially exceeds the consideration that might reasonably be expected to have been received or receivable if the value of the property before the change had been the value that would have been applicable if the election had been effective.

[14.82] Two transfers that are parts of a single plan are unlikely to be held in the course of ordinary family or commercial dealing, and the effectiveness of the elections will depend on the amount of the consideration received or receivable. Where the plan involves an outright transfer at arm’s length, the amount of the consideration receivable is likely to defeat the elections, where the market value of the trading stock is substantially higher than the value that would be applicable if each election were effective. Where the planning involves a transfer of ownership, for example, to a family company in which the transferor has no interest, the consideration received or receivable could be such as would allow the effectiveness of the elections. Where the transfer is to a company in which the transferor has a substantial interest, the consideration receivable will include the increase in the value of his interest in the company, and is likely to involve a defeat of the elections. Curiously the latter situation might be thought to be one where a tax deferral brought about by elections is more acceptable.

Accounting for Trading Stock on Death

[14.83] Section 37 applies a regime in respect of trading stock held at the date of a taxpayer’s death, which is similar to the regime applied by s. 36 to trading stock that is the subject of a disposal otherwise than in the course of carrying on the taxpayer’s business. But there is a number of differences which may be more than verbal.

[14.84] Section 37(1) provides that “where the assets of a business carried on by a taxpayer devolve by reason of his death, and those assets include any property being trading stock, standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale, the value of that property shall … be included in the assessable income derived by the deceased up to the date of his death, and the person upon whom the property devolves shall be deemed to have purchased it at that value”. It will be noted that the subsection operates when property “devolves”. Presumably the consequence is that trading stock ceases to be “on hand” at the moment of derivation of assessable income of the amount of the value of that stock. Otherwise there would be an item of assessable income and no matching deduction of the cost, or other value chosen by the taxpayer under s. 31 or s. 33.

[14.85] The subsection refers to the “assets of a business carried on by a taxpayer” and may require that the business is carried on by the taxpayer at the time of his death. Indeed the differences in the comparable provisions of s. 36 may dictate such a conclusion. Section 36 refers to “property” that “constitutes or constituted the whole or part of the assets of a business which is or was carried on by the taxpayer”. It would follow that if a taxpayer has ceased to carry on business at some time before his death, but retains until his death items that had been trading stock of that business, s. 37 will have no operation. There is some prospect that s. 36 will have operated at the time when the business ceased. If it did not, questions as to the tax consequences on death need to be resolved. One might accept that there is no derivation of assessable income on death if there is no deduction of cost or other value effective at that time. There will be a deduction if devolution on death precludes the trading stock being on hand at death. It has already been noted that s. 37 assumes that trading stock ceases to be on hand at death. It would be argued that the assumption is equally valid if s. 37 does not operate to bring on a derivation of income. But the allowing of a deduction of cost or other value when there is no matching item of assessable income gives a rogue operation to the trading stock provisions which is unacceptable. The appropriate outcome might be the recognition of a simple abortion of the transaction in the trading stock, so that there is no profit brought to tax and no loss deductible. That outcome would be rational in most circumstances, though there would be unmatched deductions where natural increase of livestock that are trading stock have been brought to account under s. 28 at the nominal amounts prescribed by regulations. The rational outcome requires a conclusion that s. 37 does not operate, and that an item that was trading stock remains on hand at the moment of death.

[14.86] When s. 37 operates, “the value” of the property is included in the assessable income derived by the deceased up to the date of his death, and the person upon whom the property devolves is deemed to have purchased it at that value (s. 37(1)). “Value” for this purpose is identified as the amount which, under s. 36, would have been included in respect of that property in the assessable income of the deceased if he had not died but had disposed of the property otherwise than in the ordinary course of his business on the day of his death (s. 37(2)). This value, by the operation of s. 36(8), is the market value of the property on the day of the disposal, or if, in the opinion of the Commissioner, there is insufficient evidence of the market value on that day, the value which in the Commissioner’s opinion is fair and reasonable.

[14.87] Section 37(2) includes a proviso that “if the trustee of the estate of the deceased and the beneficiaries (if any) who are liable to be assessed in respect of the income of the business, or of a share in that income, unanimously so agree and give notice of their agreement to the Commissioner at the time and in the manner prescribed, that value” (the value for purposes of s. 37(1)) “shall be the value, if any, at which that property would have been taken into account at the date of the death of the deceased person if he had not died, but an assessment had been made in respect of the income derived by him up to that date”. The reference to “value at which the property would have been taken into account” is a reference to value for purpose of s. 28(1). That value, in the case of trading stock other than livestock, depends on the exercise by the taxpayer of the election given to him by s. 32. It is not evident what assumption as to the exercise of that election is required by s. 37(2). In the case of livestock, the value also depends on the exercise by the taxpayer of an election, though in this case a change to a different election is not available except with the leave of the Commissioner (ss 32, 33). To give efficacy to s. 37(2), it seems necessary to imply a power, in the parties to the election, to specify a value that could have been specified by the deceased in making the election, if he had not died.

[14.88] The operation of the election given by the proviso to s. 37(2), where the item of property is standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale, is obscure. It may be that an item of property of the kinds mentioned is already trading stock, though it is not yet severed from the land. However, the drafting of ss 36 and 37 tends to assume that it is not: the listing of items refers to trading stock and then to the other items. If the other items are not trading stock, there will be no value that would have been taken into account at the end of the year of income. Section 37(2) contemplates this situation in the words “if any” appearing in the proviso. The amount to be included in the assessable income derived by the deceased is zero, and the estate will be deemed to have purchased the items at zero cost.

[14.89] There is a question whether the election given by s. 37(2) proviso is available if the trustee of the deceased estate does not carry on a business in which the trading stock or other items of property are revenue assets. Where a partner dies and s. 36A is operative, there is an election given by s. 36A(2) and s. 36A(4) which is not available unless the item of property becomes “an asset of a business carried on by the person or persons by whom the property is owned after the change” (s. 36A(2)(a)). In Elder’s Trustee & Executor Co. Ltd (Satchell’s case) (1961) 104 C.L.R. 12 Windeyer J. took the view that no election was available when death brought a partnership to an end. Though there are no words in the s. 37(2) proviso corresponding with the words of s. 36A(2)(a), an inference might be drawn from the reference to “beneficiaries (if any) who are liable to be assessed in respect of the income of the business” that an election is available only when the estate carries on a business of which the items of property are revenue assets. The words used are “the income of the business”, which may suggest some principle of continuity of business which transcends the proprietorship of the assets of the business. Official Receiver in Bankruptcy (Fox’s case) (1956) 96 C.L.R. 370 may be taken to reject any such principle, though it was concerned with the possibility that a profit-making scheme, within the second limb of s. 26(a), now s. 25A(1), might have continuity from the deceased to the deceased estate. A distinct business carried on by the estate, of which the assets are revenue assets should be sufficient to make an election possible. The distinct business must presumably be a continuing business: it is not enough that the trustee embarks on an isolated business venture in relation to the items of property that devolve on him. The distinction between a continuing business and an isolated business venture, considered in [2.431]–[2.434] above is raised. If the judgment of Jacobs J. in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 at 237 is accepted, there cannot be a continuing business unless there has been at least one acquisition of property for the purpose of resale. If a trustee merely carries out development and sale of property that has devolved from a deceased who had purchased the property and carried out some development and sale, the trustee will not carry on a continuing business. It is true that the operation of s. 37 is that a purchase by the trustee of the estate is deemed to have occurred. But it may be doubted that this deemed purchase would supply an element that will make the activity of the trustee a continuing business so that an election is available.

[14.90] Section 37 makes an assumption that assets that devolve on the trustee of a deceased estate and are held by him for sale in the carrying on of a business can be revenue assets of a continuing business carried on by the trustee. That assumption is in some conflict with the judgment of Jacobs J. in St Hubert’s Island. And it is in conflict with Webster (1926) 39 C.L.R. 130 ([14.41] above) and observations in the judgment of Kitto J. in Amy Strongman Butcher (1950) 9 A.T.D. 177, quoted in [14.47] above. The view of this Volume is that the assumption of s. 37 is to be preferred.