Edited version of private advice

Authorisation Number: 1012619837835

Ruling

Subject: Trading stock

Question 1

Is the entity treated as having bought items of trading stock for the market value of the items, pursuant to sections 70-90 and 70-95 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Does section 118-25 ITAA 1997 apply to disregard the capital gain or capital loss made from the occurrence of a CGT event in relation to the disposal of the trading stock by the entity?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

1. Company A entered into Asset Sale Agreement with an unrelated party, Company B to acquire the business of Company B, as a going concern.

2. Company B was the wholly owned subsidiary of a foreign resident entity. Company B acted as the Australian wholesaler of products manufactured by the foreign parent.

3. Due to competition and other market activity, the foreign parent of Company B entered administration. The foreign parent was ultimately bought out by a competitor, which no longer had a need for the Australian subsidiary.

4. Company A paid an amount for the business in an arm's length transaction, as a single amount of consideration. The Sale Agreement did not apportion or assign the purchase price to any of the assets.

5. Company A is a subsidiary of a foreign parent which has acquired similar businesses globally from Company B parent entity. Company A is not related to any of the abovementioned vendor entities.

6. The assets of the Australian business acquired are summarised below:

a. Working capital (cash balance);

b. Trading stock;

c. Fixed assets;

d. Trade debtors and other receivables;

e. Trademarks.

7. Due to circumstances discussed above (ie. the sale out of Administration), the amount attributed as being paid for the trading stock was less than the market value of the trading stock.

8. Similarly, the amount attributed as being paid for the debtors was significantly less than their recoverable amount.

9. No amount was attributed as being paid for 'e', 'f' and 'g' above.

10. Management of Company A have assessed the market value of the trading stock. In assessing this market value of trading stock, management have used their skill and experience in the industry, and due to obsolescence, this valuation is significantly less than the original cost of the trading stock to Company B.

11. No ruling is sought of the valuation of the stock.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 section 70-90

Income Tax Assessment Act 1997 section 70-95

Income Tax Assessment Act 1997 section 118-25

Income Tax Assessment Act 1936 subsection 36(1)

Reasons for decision

Question 1

Summary

The Asset Sale Agreement required disposal of the trading stock as part of an overall agreement for the sale of the business operated by Company B.

The items of trading stock disposed of by Company B and acquired by Company A involved a disposal which was outside the ordinary course of business.

Section 70-90 of the ITAA 1997 applies to the disposal so that the market value of the items would be included in the assessable income of Company B.

Section 70-95 of the ITAA 1997 applies to the acquisition of the items by Company A. Company A is treated as having bought the items for the amount included in the assessable income of Company B.

Detailed reasoning

Section 70-90 of the Income Tax Assessment Act 1997 (ITAA 1997) relevantly provides:

(1) If you dispose of an item off your trading stock outside the ordinary course of a business:

a. that you are carrying on; and

b. of which the item is an asset;

your assessable income includes the market value of the item on the day of the disposal.

Section 70-95 of the ITAA 1997 relevantly provides:

If an entity disposes of an item of the entity's trading stock outside the ordinary course of business, the entity acquiring the item is treated as having bought it for the amount included in the disposing entity's assessable income under section 70-90.

Sections 70-90 and 70-95 of the ITAA 1997 were introduced in the Tax Law Improvement Act 1997. Similar provisions previously existed in the now repealed section 36 of the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 36(1) of the ITAA 1936 relevantly provided:

Subject to this section, where:

(a) a taxpayer disposes by sale, gift, or otherwise of property being trading stock, standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale;

(b) that property constitutes or constituted the whole or part of the assets of a business which is or was carried on by the taxpayer; and

(c) the disposal was not in the ordinary course of carrying on that business;

the value of that property shall be included in the assessable income of the taxpayer, and the person acquiring that property shall be deemed to have purchased it at a price equal to that value.

Disposal of trading stock

Section 70-90 of the ITAA 1997 requires that an entity dispose of an item of trading stock. The word 'dispose' is not defined in the ITAA 1997. The word 'dispose' as used in the now repealed subsection 36(1) of the ITAA 1936 was considered by the High Court of Australia in Rose v Federal Commissioner of Taxation (1951) 84 CLR 118 (Rose). Dixon, Fullager and Kitto JJ observed at page 126 that:

In employing the words "dispose of" s.36 doubtless meant to include every alienation of trading stock. "Disposition" and "dispose of" are expressions of the widest import. But the subject of the disposition must be considered as well as the ambit of the expression "dispose of".

The Asset Sale Agreement required Company B to dispose of items to Company A.

Section 70-10 of the ITAA 1997 relevantly provides that:

"Trading stock" includes:

(a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of business; and

(b) live stock;

but does not include a Division 230 financial arrangement.

Company B acted as an Australian wholesaler of products manufactured by a foreign parent. The items disposed of by Company B and acquired by Company A included working capital (cash balance), trading stock on hand, fixed assets, trade debtors and other receivables, trademarks, customer lists and the benefit of all contracts entered into by Company B.

The various items disposed of by Company B to Company A satisfy the definition of trading stock in section 70-10 of the ITAA 1997. Company B disposed of items of trading stock to Company A.

Disposal of trading stock outside ordinary course of business

Section 70-90 of the ITAA 1997 requires that the disposal of items of trading stock be outside the ordinary course of business.

Disposal of trading stock outside the ordinary course of business was considered in relation to the now repealed section 36(1) of the ITAA 1936 by the High Court of Australia in Farnsworth v Federal Commissioner of Taxation (1949) 78 CLR 504 (Farnsworth).

In Farnsworth a question to be determined was whether or not a fruit grower that delivered fruit to a packing company where it became inextricably mixed with the fruit of other growers disposed of trading stock for the purposes of section 36(1) of the ITAA 1936.

Latham CJ observed at page 514 that:

Section 36 relates to the disposal of the assets of a business, including, inter alia, trading stock. The terms of the section show that it was intended to be applied to a case where there was a disposal of assets of a business as such whether in whole or in part, and whether or not the assets were disposed of because the seller was going out of business or because the business was sold to another person. The section is intended to deal with a walk-in walk-out, with a clearing sale, and with a transaction which represents, not an ordinary sale of goods in the course of carrying on a business, but a disposal of the assets of the business so that the business is no longer being carried on by the person who has disposed of it.

Dixon J observed at page 519 that section 36(1) of the ITAA 1936:

…deals with the case of a taxpayer's disposing of the whole or any part of the assets of a business. If the whole or any part of such assets are disposed of by sale or otherwise howsoever, whether for the purpose of putting an end to the business or any part thereof or not, and the assets include any property being, amongst other things, trading stock, then the value of the property must be included in the taxpayer's assessable income.

This provision is generally considered to have no application to the regular disposal of trading stock in the ordinary course of carrying on a business.

In Farnsworth, it was determined that the trading stock had not been disposed of outside the ordinary course of business.

The term 'in the ordinary course of business' was previously used in the now repealed paragraph 95(2)(b) of the Commonwealth Bankruptcy Act 1924. The term was considered in Downs Distributing Co Pty Ltd v Associated Blue Star Stores Pty Ltd (Downs Distribution) (1948) 76 CLR 463.

In Downs Distributing a question to be determined was whether a transfer of property in a bankruptcy had taken place in the ordinary course of business. Rich J at page 477 observed that the term 'in the ordinary course of business' as used in paragraph 95(2)(b) of the Commonwealth Bankruptcy Act 1924

…does not require that the transaction shall be in the course of any particular trade, vocation or business. It speaks of the course of business in general. But it does suppose that according to the ordinary and common flow of transactions in affairs of business there is a course, an ordinary course. It means that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation.

The Asset Sale Agreement required disposal of the trading stock as part of an overall agreement for the sale of the business operated by Company B.

The items of trading stock disposed of by Company B and acquired by Company A involved a disposal which was outside the ordinary course of business.

Section 70-90 of the ITAA 1997 applies to the disposal so that the market value of the items would be included in the assessable income of Company B.

Section 70-95 of the ITAA 1997 applies to the acquisition of the items by Company A. Company A is treated as having bought the items for the amount included in the assessable income of Company B.

Question 2

Summary

It is considered that s118-25 ITAA 1997 should apply to disregard any capital gain or loss made from the occurrence of a CGT event in relation to the disposal of the trading stock by Company A.

Detailed reasoning

Section 118-25 of the ITAA 1997 relevantly provides:

1. A capital gain or capital loss you make from a CGT asset is disregarded if, at the time of the CGT event, the asset is:

(a) your trading stock; or

(b) if you are a partner, trading stock of the partnership; or

(c) if you are absolutely entitled to the asset as against the trustee of a trust (disregarding any legal disability), trading stock of the trustee.

2. A capital gain or capital loss you make in these circumstances is disregarded:

(a) you start holding as trading stock a CGT asset you already own but do not hold as trading stock; and

(b) you elect under paragraph 70-30(1)(a) to be treated as having sold the asset for its cost (worked out under that section).

As the particular items acquired by Company A fall within the definition of trading stock, as defined in the Act, then s118-25 ITAA 1997 should apply to disregard in full any capital gain or capital loss made from the occurrence of a CGT event in relation to the disposal of the trading stock by Company A.

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