Edited version of your written advice

Authorisation Number: 1012753054394

Ruling

Subject: Trading Stock

Question 1

Is the election to value spare parts, being trading stock of Company A, by writing them down by the percentages specified in the table below warranted by reason of obsolescence or other special circumstances and reasonable within the meaning of section 70-50 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Year	Percentage Write-down
Year of purchase	0%
1 year after purchase	15%
2 years after purchase	30%
3 years after purchase	60%
4 years after purchase	95%

Answer

Yes.

Question 2

If the election referred to in Question 1 is not considered warranted and reasonable within the meaning of section 70-50 of the ITAA 1997, how will spare parts on hand on 31 December 2013 be valued on 31 December 2014 under section 70-45 of the ITAA 1997?

Answer

Not necessary to answer.

This ruling applies for the following periods:

Income tax years spanning 1 January 2014 to 31 December 2016.

Relevant facts and circumstances

Company A supplies machinery to specialised customers in industries within Australia and the Oceanic region. Company A is part of the multi-national Group and the majority of its products are imported into Australia from the Group's overseas production facilities. Company A does limited manufacturing of certain components in Australia.

As part of its business, Company A provides ongoing maintenance and repairs for all its customers. Each machine sold generally has a X year warranty period but customers may enter into special arrangements for a certain extended period of repair and maintenance. Customers tend to maintain machines with original parts throughout the life of the machine.

Company A must therefore maintain a sufficient stock of spares in order to provide the expected level of service to its customers for the repair and maintenance requirements of machinery that is sold in Australia. All spares are sourced from overseas and it can take over a month to import a part from overseas into Australia. In order to meet the requirements of customers and provide the expected level of service a high level of spares are carried. A consequence of the necessity to carry a high level stock of spares is that there are a large number of spare parts and trading stock on hand at any given time that will not be used for many years or that may ultimately never be used.

The Group has a policy to regularly update models of its products. On a model being updated the demand for many of the spares related to the old model significantly decreases. However, as customers may still be using older models with the expectation that they will be serviced and repaired according to the established standard, a stock of spares for superseded models must also be maintained for some years to come by Company A. The model lifecycle for the various classes of machinery manufactured and sold is generally as follows:

Company A does not know how many of its machines will remain in use after being sold or for how long, particularly when ownership may change after the initial sale by Company A.

Company A must maintain a sufficient level of spares to meet all servicing and maintenance requirements of its customers and this inevitably leads to overstocking and obsolescence with some of the stock of spare parts never being sold. This applies to all the classes of machinery sold by Company A. As a result, Company A is unable to calculate the obsolescence rate for any one line of spares and has therefore adopted an average write-off rate for all spares.

Company A has, for a number of years, written down its stock of spares on hand at the end of each income year in accordance with the rates contained in the table in Question 1 of this Ruling. The rates yield write-downs that are broadly comparable with the International Financial Reporting Standards (IFRS) policy on write-downs for obsolescence.

The Group has a policy for scrapping obsolescent stock that is based on the IFRS. Stock is defined as surplus where there has been no sale of that part for three years and the value of that stock of spares has been written down to 1%. Proceeds from the sale of scrapped stock over the past few years have amounted to between 0.1% and 0.7% of the IFRS written down value.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 70-45

Income Tax Assessment Act 1997 Section 70-50 and

Income Tax Assessment Act 1936 Subsection 31(2).

Reasons for decision

Question 1

Section 70-50 of the ITAA 1997 states:

You may elect to value an item of your trading stock below all the values in section 70-45 if:

(a) that is warranted because of obsolescence or any other special circumstances relating to that item; and

(b) the value you elect is reasonable.

The purpose of section 70-50 of the ITAA 1997 is to allow a taxpayer to adopt an alternative basis of valuing trading stock on hand at the end of an income year if the taxpayer would be disadvantaged in valuing particular trading stock under one of the methods set out in section 70-45 of the ITAA 1997. The section requires the presence of obsolescence or any other special circumstances and a test of reasonableness. The value that is determined under section 70-50 of the ITAA 1997 is the value that, judged objectively, is reasonable and not the value considered to be reasonable by the Commissioner.

Section 70-50 of the ITAA 1997 replaced subsection 31(2) of the Income Tax Assessment Act 1936 (ITAA 1936). Taxation Ruling TR 93/23 was issued to provide guidance on the application of former subsection 31(2) of the ITAA 1936 but can also be applied to the application of section 70-50 of the ITAA 1997.

Obsolescence

Taxation Ruling TR 93/23 discusses the valuation of trading stock subject to obsolescence or other special circumstances. Obsolescence in this context refers to stock which is either:

a) going out of use, going out of date, becoming unfashionable or becoming outmoded (i.e. becoming obsolete); or

b) out of use, out of date, unfashionable or outmoded (i.e. obsolete stock).

Provided adequate documentation supporting the calculation is maintained, any fair and reasonable value may be accepted for trading stock affected by obsolescence if it is calculated taking into account the factors listed in the former subsection 31(2) of the ITAA 1936. The factors are not listed in section 70-50 of the ITAA 1997, but are still relevant in determining if a value is 'fair and reasonable' for the purposes of section 70-50 of the ITAA 1997.

Paragraph 5 of TR 93/23 sets out the following additional factors that may also be relevant depending on a taxpayer's circumstances in determining the value of trading stock affected by obsolescence:

a) the age of the stock on hand;

b) the quantities of the stock on hand which, according to the operating and sales budgets, are expected to be used or sold during the year and in the future;

c) the length of time since the last sale, exchange or use of an item of the stock;

d) industry experience/taxpayer expertise in relation to the same kind or class of trading stock;

e) the price at which the last sale of the stock was made, the price of the stock on the taxpayer's price list, and the price at which the taxpayer is prepared to sell the stock; and

f) if the stock is spare parts:

(i) the past movements of the stock and the expected future movements of the stock compared with the total number of units in existence which might require that stock; and

(ii) the approximate date by which the last of those units can be expected to have gone out of use.

Paragraph 10 of TR 93/23 provides that a standard write down for a particular class of stock will only be accepted if a taxpayer can show that the particular class of stock is always subject to the same degree of obsolescence.

TR 93/23 recommends a progressive write-down of stock if a taxpayer knows that an amount of stock will remain unsaleable but is unable to quantify that amount with any accuracy. A taxpayer should only write down that proportion of the stock which it is reasonably certain will not be sold. The valuation should recognise that a loss has already been sustained by the taxpayer.

Special Circumstances

Paragraphs 15 and 16 of TR 93/23 set out the Commissioner's opinion of what constitutes 'special circumstances'. Subparagraph 16(d) of TR 93/23 provides that one such special circumstance may be an unavoidable overstocking of spare parts to satisfy warranties and future service needs.

As with obsolescence, provided adequate documentation supporting the calculation is maintained, any fair and reasonable value may be accepted for trading stock affected by special circumstances which is calculated taking into account the factors listed in subsection 31(2) of the ITAA 1936. Paragraph 17 of TR 93/23 lists additional factors, similar to those listed at paragraph 5 in relation to obsolescence, which may be relevant depending on a taxpayer's circumstances in determining the value of trading stock affected by special circumstances.

Application of TR 93/23

As the Group replaces older models with newer models to maintain its technological leadership and the older models are no longer used by customers there is a readily apparent ongoing process of spare parts becoming obsolete. The situation of Company A in relation to obsolescence accords with that described in TR 93/23 and a value determined for obsolescence is therefore warranted in accordance with subsection 70-50(a) of the ITAA 1997

Company A has stated that it needs to maintain a readily available stock of spare parts to ensure that the service needs of its customers can be met promptly. This leads to the overstocking of spares and over time with model changes the demand for those spares declines. Company A's situation in relation to special circumstances accords with that described in subparagraph 16(d) of TR 93/23 and therefore a value determined for special circumstances is also considered warranted in accordance with subsection 70-50(a) of the ITAA 1997.

The general model lifecycle for the various classes of machinery manufactured and sold is a fair and reasonable basis for calculating the value of trading stock affected by obsolescence or special circumstances across all classes. The value of trading stock calculated using this methodology is broadly comparable to that calculated for accounting purposes under the IFRS accounting policy on write-downs. The rates of write-down set out in the table in Question 1 of this Ruling are considered to be reasonable within the meaning of subsection 70-50(b) of the ITAA 1997.

The percentage write-downs proposed by the taxpayer in the table in Question 1 of this Ruling are therefore warranted due to obsolescence or special circumstances and are reasonable for the purposes of section 70-50 of the ITAA 1997.

Question 2

While it is unnecessary to provide an answer to Question 2 in view of the favourable response provided to Question 1, for completeness we note as general guidance that it is a question of fact whether conditions exist that would allow for the application of section 70-50 of the ITAA 1997. If conditions do exist, a reasonable value can be adopted without having to notify the Commissioner.

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