Edited version of private advice

Authorisation Number: 1012621680897

Ruling

Subject: Income Tax: Trading Stock

Question 1

Is the commencement of the 'fry' stage in the life cycle of salmon and trout trading stock the point when expenses cease to be absorbed into the 'cost' of the trading stock?

Answer

Yes

Question 2

Is the 'cost' of salmon and trout trading stock for the purposes of subsection 70-45(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) calculated using the full absorption cost method for all expenses of acquisition and production up until the commencement of the 'fry' stage in the life cycle?

Answer

Yes

Question 3

Will the expenses of production of the taxpayer incurred after the commencement of the 'fry' stage in the life cycle be deductible under section 8-1 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commences on:

1 July 2012.

Relevant facts and circumstances

The taxpayer is the head entity of a tax consolidated group.

The taxpayer carries on an aquaculture business farming specific salmon and ocean trout.

The taxpayer operates land-based hatcheries and sea farms at separate locations.

Process used by the taxpayer to nurture salmon into harvesting age

Each brood female produces between 3,000 and 6,000 eggs which are hand stripped, fertilised and incubated in the nursery. The hatched offspring go through a number of distinct growth stages, detailed below:

• The eggs are laid down in the hatchery's incubators for between 60 and 90 days. The fertilised eggs develop to eyed eggs. The eyed eggs are laid out in troughs and trays in preparation for hatching.

• Immediately after hatching the juveniles carry their yolk sac and have the appearance of tadpoles. At this stage the juveniles are known as alevin.

• Alevin then develop into free-feeding individuals (after about 40 days) with the appearance of small fish and are known as fry. At this stage they are about 2 centimetres long and weighing about 0.2 to 0.4 grams. The fry are transferred from the hatchery into small tanks where they are cared for and protected from predators as they grow.

• Fry develop distinctive markings at about 5 centimetres and it is at this stage they are defined as parr. Throughout the lifecycle the fish are progressively moved to larger tanks and ponds. Controlled water temperature and lights help to regulate growth.

• At about 8 to 12 months old, parr undergo an internal transformation which enables them to live in both saltwater and fresh water (smoltification) and are at this stage known as smolt. The smolt is then transferred from the hatchery system to sea farms. In open water pens the fish adapt to living in both salt and fresh water as they grow.

• The fish are continuously monitored and moved into larger pens and more exposed sites, where the fish fully benefit from life at sea as they grow out to adult fish. Adults are harvested for sale at 2 to 3 years of age and can weigh anywhere between 2 to 10 kilograms.

Salmon survival rates

The ordinary survival rates in the taxpayer's aquaculture operations during the hatching and development stages up to transfer are:

• Survival egg to alevin: 70% (successfully hatched into alevin)

• Survival alevin to fry: 90 to 95% (successfully to first feeding)

• Survival fry to par: 95 to 97%

• Survival par to smolt: > 99%

• Graded and cull: 30% at 5gm and 5% at 50gm

It is stated that at the fry stage the salmon are fully independent and have a high chance of survival.

Culled fish are scrapped and not sold.

Life cycle of ocean trout

The lifecycle of ocean trout closely follows that of specific salmon described above with the key difference being that ocean trout do not go through the smoltification transformation. Trout at the same lifecycle as salmon smolt are referred to as fingerlings. Ocean trout are just transferred to sea farms at the appropriate size and weight.

The lifecycle principles and survival rates of salmon equally apply to ocean trout.

Purchase of production stock

The company also buys production stock as part of its normal operations. Production stock is usually purchased at the smolt stage of the life cycle.

Sea farm operations

The sea farm operations consist of the following:

• The smolt/fingerlings are placed into sea pens

• The smolt/fingerlings are nurtured, fed and held to grow out, up until they reach up to 18 months old ('at sea')

• Adult salmon and trout are then removed from the sea pens and are harvested.

Ongoing production costs in sea farm operations

The ongoing production costs incurred in the sea farm operations are generally as follows:

• Labour costs

• Facility maintenance (the cost of maintaining the pens and nets to house the smolt and fingerlings)

• Feed

• Depreciation; and

• Utilities.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 subsection 31(1)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 70

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 subsection 70-45(1)

Income Tax Assessment Act 1997 subsection 70-55(1)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The Commissioner accepts that it is at the commencement of the fry stage of the salmon and trout life cycle that expenses cease to be absorbed in to the 'cost' of the trading stock.

Detailed reasoning

Are farmed salmon and ocean trout trading stock?

Division 70 of the ITAA 1997 provides special rules to account for trading stock for income tax purposes.

Section 70-10 of the ITAA 1997 defines trading stock as including;

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

(b) livestock.

The use of the word 'includes' in the definition of trading stock in section 70-10 of the ITAA 1997 signifies that a thing may be trading stock for the purposes of the provision if it meets the requirements in paragraphs 70-10(a) or 70-10(b) of the ITAA 1997 or is otherwise trading stock within the ordinary meaning of that term.

The term 'livestock' is defined in subsection 995-1(1) of the ITAA 1997 to 'not include animals used as beasts of burden or working beasts in a *business other than a *primary production business'.

The High Court in Federal Commissioner of Taxation v. Wade (1951) 84 CLR 105; (1951) 9 ATD 337 considered this definition of livestock when it was then found in subsection 6(1) of the Income Tax Assessment Act 1936. Dixon and Fullagar JJ stated at CLR 110; ATD 342 that the definition, by inference, makes it clear that all animals used in a primary production business are included as livestock.

Paragraph (b) of the definition of 'primary production business' in subsection 995-1(1) of the ITAA 1997 includes as a primary production business, a business of 'maintaining animals for the purpose of selling them or their bodily produce (including natural increase)'.

Salmon and trout are animals. Therefore, salmon and trout produced for sale are considered to be trading stock both within the ordinary meaning of the term and as livestock for the purpose of section 70-10 of the ITAA 1997.

At what stage of lifecycle are salmon and trout deemed to be acquired through natural increase?

It is necessary to determine at what stage of the life cycle of specific salmon and ocean trout that trading stock is deemed to be acquired by natural increase.

The taxpayer produces salmon and trout for sale, the process beginning at its hatchery and finishing at its sea farm.

The taxpayer has provided the lifecycle and survival rates for farmed salmon in the company's aquaculture operations during the hatching and development stages up to transfer. The survival rates are as follows:

• Survival egg to alevin: 70% (successfully hatched into alevin)

• Survival alevin to fry: 90 to 95% (successfully to first feeding)

• Survival fry to par: 95 to 97%

• Survival par to smolt: > 99%

• Graded and cull: 30% at 5 gram and 5% at 50 gram

The taxpayer states that the lifecycle of ocean trout closely follows that of specific salmon described above with the key difference being that ocean trout do not go through the smoltification transformation. Trout at the same lifecycle as Salmon smolt are referred to as fingerlings. Ocean trout are just transferred to sea farms at the appropriate size and weight.

The lifecycle principles and survival rates of salmon equally apply to ocean trout.

The taxpayer has asserted that a live, identifiable fish is first created at the fry stage of the life cycle and it is at this point that they have livestock and an item of trading stock. This is because from the fry stage the mortality rates of the juvenile fish are low (average survival rate of 90% to 95% occurs at fry stage) and the population stabilises and reflects the substantial majority of fish that would be expected to be transferred to sea farms and held for sale.

It is from the fry stage that the taxpayer must also begin to feed the fish until it has grown into adulthood and is sold.

It is considered by the taxpayer that the natural increase of salmon and trout is produced at the fry stage, at which a substantial majority of the fish would be expected to be transferred to sea farms.

ATO Interpretive Decision 2011/23 Trading stock: natural increase - relevance of survival rates (ATO ID 2011/23) has considered this issue and provides the following:

…Atlantic salmon bred in a land-based nursery as part of an aquaculture business become an 'animal that you hold as livestock' for the purposes of section 70-55 of the ITAA 1997 when they reach the 'fry' stage of development.

Section 70-55 of the ITAA 1997 provides for working out the cost of natural increase of livestock. Section 70 55(1) states:

The cost of an animal you hold as livestock that you acquired by natural increase is whichever of these that you elect:

(a) The actual cost of the animal;

(b) The cost prescribed by the regulations for each animal in the applicable class of livestock.

As the regulations do not prescribe for farmed fish, the cost of the animal is the actual cost of the animal up until the point in time the fish are deemed to be trading stock, which is at the commencement of the fry stage.

Therefore, the Commissioner accepts that it is at the commencement of the fry stage of the salmon and trout life cycle that expenses cease to be absorbed in to the 'cost' of the trading stock.

Question 2

Summary

The 'cost' of aquaculture trading stock (salmon and trout) for the purposes of paragraph 70-45(1)(a) of the ITAA 1997 is calculated using the full absorption cost method for all expenses of acquisition and production up until the commencement of the fry stage of development.

Detailed reasoning

Under subsection 70-45(1) of the ITAA 1997 the taxpayer must elect to value each item of trading stock on hand at the end of the income year at either:

• its cost; or

• its market selling value; or

• its replacement value.

There are also special valuation rules for working out the cost of natural increase of livestock. Subsection 70-55(1) of the ITAA 1997 states:

The cost of an animal you hold as livestock that you acquired by natural increase is whichever of these you elect:

(a) the actual cost of the animal;

(b) the cost prescribed by the regulations for each animal in the applicable class of livestock.

The regulations do not prescribe a cost for the natural increase of spawning species such as fish. Therefore, for the purposes of the trading stock provisions, the cost of the natural increase of these species is the actual cost of producing the animals.

The taxpayer has referred to ATO Interpretive Decision 2003/44 Trading Stock: Valuation of Abalone (ATO ID 2003/44) and have compared their operation to that of the abalone operation. The interpretive decision concludes:

The Commissioner accepts that the production of abalone does not constitute manufacture. However, the same principles of valuing manufactured trading stock apply such that the absorption cost method is the appropriate method to use to include those costs sufficiently associated with the production of trading stock.

On this basis, all costs of production in bringing abalone to a saleable condition would need to be added to the acquisition cost of the abalone. However in order to be consistent with accepted practice in relation to the rearing and maintenance of livestock generally, the ongoing production costs will be allowed as a deduction as and when they are incurred in the normal carrying on of the abalone business.

As such, 'cost' would include only those expenses incurred up until the abalone reach the spat stage of development and expenses of production thereafter would be deductible as incurred. Accordingly, the 'cost' of abalone for the purposes of paragraph 70-45(1)(a) of the ITAA 1997 does not need to be calculated using the full absorption cost method for all expenses of acquisition and production.

Taxation Ruling IT 2350 Income Tax: Value of trading stock on hand at end of year: Cost price: Absorption cost recognises that the courts have established the following general propositions about how a taxpayer values manufactured trading stock at 'cost price' under subsection 31(1) of the Income Tax Assessment Act 1936 (ITAA 1936):

• 'cost price' is read simply to mean 'actual cost' (Fullagar J in Australasian Jam Co Pty Ltd v. Federal Commissioner of Taxation (1953) 88 CLR 23; (1953) 10 ATD 217; (1953) 5 AITR 566).

• 'cost' is directed to the expenditure needed to bring the article to the state in which it was when it became trading stock (Jenkinson J in Philip Morris Ltd v. Commissioner of Taxation (Cth) (1979) 79 ATC 4352; (1979) 10 ATR 44 (Philip Morris Case)); and

• the absorption cost method is the correct method to value the 'cost' of manufactured trading stock (Jenkinson J in Philip Morris).

Section 70-45 of the ITAA 1997, which replaces subsection 31(1) of the ITAA 1936, is compatible with the case law and rulings relating to subsection 31(1) of the ITAA 1936. Under paragraph 70-45(1)(a) of the ITAA 1997, trading stock is valued at 'cost' rather than 'cost price'.

As with abalone (ATO ID 2003/44), the Commissioner accepts that the production of salmon and trout does not constitute manufacturing. However, the same principles of valuing manufactured trading stock apply such that the absorption cost method is the appropriate method to use to include those costs sufficiently associated with the production of trading stock. This is consistent with the definition of trading stock which includes 'anything produced', as well as 'anything manufactured'.

On this basis, all costs of production in bringing the salmon and trout to the point at which natural increase is recognised as having been produced would need to be capitalised into the value of the trading stock on hand.

The term 'cost' for the purposes of section 70-45 of the ITAA 1997 is considered to mean the cost of the stock to the taxpayer including charges in getting it into its existing condition and bringing it to a place where it is 'on hand'.

The salmon and trout would not be considered to be an 'animal you hold as trading stock' until they reach the commencement of the fry stage of development as was recently determined in ATO ID 2011/23.

Accordingly, the 'cost' of salmon and trout for the purposes of paragraph 70-45(1)(a) of the ITAA 1997 would be calculated using the full absorption cost method for all expenses of acquisition and production up until the commencement of the fry stage of development.

Question 3

Summary

The ongoing expenses of production incurred after the commencement of the fry stage of development will be deductible when incurred provided they satisfy the requirements of section 8-1 of the ITAA 1997.

Detailed reasoning

In order to be consistent with accepted practice in relation to the rearing and maintenance of livestock generally, the ongoing production costs will be allowed as a deduction as and when they are incurred in the normal carrying on of the aquaculture business.

There are three keys features of tax accounting for trading stock in section 70-5 of the ITAA 1997. Paragraph 70-5(2)(a) of the ITAA 1997 provides for the first part of the second key feature as follows:

(2) Those outgoings and earnings are on revenue account, not capital account. As a result:

(a) the gross outgoings are usually deductible as general deductions under section 8-1 (when the trading stock becomes trading stock on hand);…

Expenses of production after the salmon and trout reach the commencement of the fry stage of the life cycle would be deductible as incurred, as this marks the beginning of a period of rearing and maintenance and the trading stock is on hand.

Therefore, once the fish reach the commencement of the fry stage of development, the ongoing production costs will be allowed as a deduction under section 8-1 of the ITAA 1997 as and when they are incurred in the normal carrying on of the aquaculture business.