Trading Stock, Capital Allowances and Personal Services Income

This chapter teaches three different timing and integrity systems. Trading stock prevents the deduction of unsold inventory from distorting annual profit. Capital allowances spread the tax recognition of capital assets across their useful lives. PSI rules prevent personal labour income being diverted through an entity to obtain deductions or income splitting that would not be available to the individual.

Part A — Trading stock

1. Why Division 70 exists

Suppose a retailer buys $100,000 of inventory on 25 June and sells none of it until July. The purchase may satisfy the ordinary business nexus in s 8-1, but if the entire cost were deducted in the first year while the sales revenue appeared only in the next year, taxable income would be distorted. Division 70 addresses that timing problem.

The course material therefore starts with three connected rules: sales proceeds from trading stock ordinarily form assessable income under s 6-5; purchases are ordinarily deductible under s 8-1; and s 70-35 adjusts taxable income for the movement between opening and closing stock. If closing stock exceeds opening stock, the excess is assessable. If opening stock exceeds closing stock, the excess is deductible.

2. What is trading stock? — s 70-10

The classification question is fundamental because stock is excluded from the ordinary Division 40 definition of a depreciating asset. An item held for sale or exchange in the ordinary course of business is an obvious example. The harder problems involve tradespeople and service businesses.

TR 98/8 is particularly useful. Materials and spare parts supplied to customers in the course of providing services can be trading stock where they remain separately identifiable, retain their character and ownership passes to the customer. The ruling's plumbing example is pedagogically valuable: pipes, elbow joints and tap washers can be trading stock; glue that is consumed in performing the work is a consumable rather than trading stock.

3. Closing stock — ss 70-35, 70-40 and 70-45

Each item of trading stock on hand at year end is valued under the statutory options. The course materials emphasise cost, market selling value and replacement price/value. The taxpayer can lawfully choose among permitted bases item by item. That means valuation is not simply bookkeeping: it can affect the timing of taxable income.

This explains why the Jacob seminar problem asks two apparently opposite questions. If the company wants to minimise current taxable income, it chooses the lowest lawful value for each item. If it has a carried-forward loss it wants to use, it may rationally choose higher lawful stock values so that more taxable income is generated and absorbed by the loss.

4. Special stock situations

Part B — Capital allowances

5. Why Division 40 is needed

Section 8-1 generally denies deductions for capital expenditure. Yet businesses necessarily acquire long-lived assets to produce income. A tax system that never recognised that economic consumption would overstate business profit. Division 40 therefore allows deductions for the decline in value of qualifying depreciating assets over time.

The correct starting sequence is: is there a depreciating asset under s 40-30; does the taxpayer hold it; has it started to be used or been installed ready for use; what is the taxable-use percentage; what is its cost; what is the effective life; and what method applies?

6. Depreciating asset — s 40-30

A depreciating asset has a limited effective life and can reasonably be expected to decline in value over the time it is used. Land and trading stock are excluded. Certain intangible assets are specifically brought into Division 40. Improvements and fixtures can be treated separately from land. Composite assets require a fact-and-degree analysis.

The course uses Carpentaria Transport to illustrate functional analysis of plant and machinery. Motorised roller doors were treated as machinery and depreciable, while a different result had been reached for manual doors that did not perform the same operational function. The lesson is not to categorise an item by appearance alone; ask what it does in the business.

7. Effective life and decline in value

Under the course framework, effective life may be taken from the Commissioner's determination or self-assessed under the statutory rules. The two familiar methods are prime cost and diminishing value. Prime cost spreads the asset's cost broadly evenly across effective life. Diminishing value produces larger deductions earlier because the rate applies to a reducing base value.

8. Balancing adjustments on disposal

Disposal is not the end of the Division 40 analysis. A balancing adjustment compares termination value with adjustable value. If termination value exceeds adjustable value, an amount can be included in assessable income. If termination value is lower, a deduction can arise. Non-taxable/private use reduces the income-tax component and can also trigger CGT event K7.

9. Low-value pools

The materials direct attention to ss 40-420 to 40-440. A pool treats qualifying assets collectively. Low-cost assets and qualifying low-value assets can enter the pool, with taxable-use percentages estimated under the statutory rules. The course uses the familiar 18.75% first-year and 37.5% later-year pool rates for the relevant framework.

10. Motor vehicles and the car limit

Passenger cars can be subject to the statutory car-cost limit under s 40-230. The critical year is the financial year in which the car is first used or held for use. The excess purchase price does not simply become deductible elsewhere. On disposal, s 40-325 adjusts termination value so that the balancing adjustment is consistent with the capped cost that was allowed into Division 40.

11. Website expenditure and TR 2016/3

Website expenditure is a good example of why labels are dangerous. “Website cost” can describe revenue maintenance, hosting, domain registration, content, in-house software or a capital enhancement. TR 2016/3 distinguishes routine operation and maintenance from expenditure that creates or significantly enhances functionality.

Periodic hosting and ordinary maintenance are generally revenue in character where the business nexus is present. New software functionality — for example shopping-cart, payment-processing and customer-database systems — can be capital and may form in-house software dealt with under Division 40. The tax treatment follows the nature of the expenditure, not the invoice heading.

12. Capital works — Division 43

Buildings and structural improvements are generally not depreciated as ordinary Division 40 plant where Division 43 applies. Construction expenditure can produce a capital-works deduction at the statutory rate, commonly 2.5% or 4% depending on commencement date and use. Deductions begin only when construction is completed and the capital works are used in the relevant income-producing way. A mid-year completion therefore requires day apportionment.

Part C — Personal Services Income

13. Why the PSI regime exists

PSI rules are integrity provisions aimed at the alienation of income generated mainly from an individual's personal effort or skill. If an accountant, consultant, engineer or other professional merely interposes a company, trust or partnership between the worker and the client, the underlying economic source of the income may still be the individual's labour.

Division 85 restricts certain deductions and Division 86 can attribute the entity's PSI back to the individual. Division 87 provides the personal-services-business pathway.

14. The PSB decision tree

The results test is not satisfied merely because an invoice is issued. The materials focus on whether remuneration is for producing a result, whether the worker supplies necessary tools/equipment, and whether the worker is liable to rectify defects. If the results test fails, the 80% rule controls access to the other self-assessment tests.

15. Integrated problem-solving checklist

• Trading stock: identify the item and why ownership/property will pass.
• Stock: calculate opening/closing adjustment separately from sales and purchases.
• Capital allowance: identify the asset before choosing a method.
• Check taxable-use percentage and GST treatment.
• On disposal, calculate decline to disposal date before balancing adjustment.
• Check private use and CGT K7.
• For buildings, test Division 43 rather than forcing them into Division 40.
• For websites, separate maintenance from new functionality.
• For PSI, identify the human effort producing the income.
• Apply the 80% rule before relying on the three additional PSB tests.