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Ruling

Subject: Valuation of trading stock

Question 1

Is the election to value spare parts, being trading stock of A Pty Ltd (A Co), by writing them down by the percentages specified with the following table:

Year	Percent
Year of purchase	0%
1 year after purchase	15%
2 years after purchase	30%
3 years after purchase	60%
4 years after purchase	95%

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)?

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 as at 31 December XXXX be valued under section 70-45 of the ITAA 1997?

Answer

Not necessary to answer

This ruling applies for the following periods:

1 January XXXX to 31 December YYYY

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A Co sells heavy construction and earth moving machinery to customers in the mining and construction industries within Australia and the Oceanic region as well as manufacturing certain components for that machinery.
As part of its business, A Co provides on-going maintenance and repairs for all its customers. Its customers expect high standard of service and require an immediate turn-around of replacement parts to ensure that the downtime of any product is kept to a minimum. With some customers A Co enters in service agreements to provide support and maintenance to the customers over the life of the piece of equipment sold.

To provide the expected level of service to its customers, A Co must maintain a stock of spares that is sufficient to meet, as rapidly as possible, the repair and maintenance requirements of the machinery that is sold to its customers. As all the spares that A Co uses in its operations are sourced from overseas, it is essential that it carries sufficient spares in Australia to service its customers. Consequently, A Co must carry high levels of spares to meet these requirements.

Further, the Group has a policy of updating and improving the machinery that it sells as part of its business strategy of being a technological leader in its industry. This accounts for the relatively short model lifecycles, as set out in the following table, for the various classes of machinery it manufactures and sells.

For each new model that it produces and sells, A Co must maintain an appropriate level of spares. However, it must continue to maintain stocks of parts for the superseded models as these will continue to be used by customers who will expect A Co to service and repair them according to the established standard. A Co does not know how many of its machines remain in use after being sold or for how long, particularly when their ownership changes after the initial sale by A Co.

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

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 five years have amounted to between 0.1% and 0.7% of the IFRS written down value

Relevant legislative provisions

Income Tax Assessment Act 1997 70-45

Income Tax Assessment Act 1997 70-50.

Reasons for decision

Question 1

Section 70-50 of the ITAA 1997 states:

70-50 Valuation if trading stock obsolete etc.

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 the legislation 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 other special circumstances and a test of reasonableness. The value that is determined under section 70-50 of the ITAA 1997 is not the value considered by the Commissioner to be reasonable, but is the value that, judged objectively, is reasonable.

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 which was issued to provide guidance on the application of subsection 31(2) of the ITAA 1936, may 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 which is calculated taken into account the factors listed in subsection 31(2) of the ITAA 1936) may be accepted for trading stock affected by obsolescence. These 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 that purpose.

Paragraph 5 of TR 93/23 sets out the following additional factors that may also be relevant, depending on a taxpayer's circumstances.

o the age of the stock;

o the quantities of stock on hand which are expected to be used or sold during the year and into the future;

o the length of time since the last sale;

o industry experience/taxpayer expertise in that kind of stock;

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

o if the stock is spare parts:

i) the past and expected future movements compared with the potential sales; and

ii) the approximate date by which the last of those units can be expected to no longer be in 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 the taxpayer knows that an amount of stock will remain unsaleable but is unable to quantify that amount with any accuracy. The 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' for the purposes of this legislation. In particular, subparagraph 16(d) of TR 93/23 says one such special circumstance is '… 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 which is calculated taken into account the factors listed in subsection 31(2) of the ITAA 1936 may be accepted for trading stock affected by special circumstances. Paragraph 17 of TR 93/23 lists additional factors that may be relevant, similar to those listed at paragraph 5 in relation to obsolescence.

Application of TR 93/23

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

The taxpayer 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. In some instances, these service commitments are bound by contractual obligations. This leads to overstocking of spares and, over time and with model changes, the demand for them declines. The taxpayer's situation in relation to special circumstances accords with that described in subparagraph 16(d) of TR 93/23 and therefore a value determined in accordance with subsection 70-50(a) of the ITAA 1997 for special circumstance is also considered warranted.

The timeframe of models being upgraded and superseded (refer model lifecycle table above) is a fair and reasonable basis for calculating the value of trading stock affected by obsolescence/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. Accordingly, the rates of write-down set out in the table in Question 1 of this Ruling are considered reasonable within the meaning of subsection 70-50(b) of the ITAA 1997.

Accordingly, the percentage write-downs proposed by the taxpayer in the table in Question 1 of this Ruling are warranted due to obsolescence or special circumstances and are reasonable within the meaning 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 for general guidance that it is a question of fact whether the conditions for section 70-50 of the ITAA 1997 to apply do exist. If they do, a reasonable value can be adopted without having to notify the Commissioner.