Issued
01 Dec 1987

Income Tax Amendment Act 1987

Archived legislative commentary on the Income Tax Amendment Act 1987 from PIB vol 167 Dec 1987.

This commentary item was published in Public Information Bulletin Volume 167, December 1987

More information about Public Information Bulletins.

Trading Stock and Accrual Expenditure

Scope

1. This item deals with the amendments made to the Income Tax Act by sections 8, 9, 10, 11 and 18 of the Income Tax Amendment Act 1987 and section 25 of the Income Tax Amendment Act (No.2) 1987. Those provisions enact the accrual tax accounting regime so far as it relates to trading stock and "accrual expenditure". They do not deal with the new tax accounting regime for financial arrangements.

Trading Stock

2. Amendments relating to the trading stock provisions of the Income Tax Act 1976 (the principal Act) are made by sections 8, 9, 10 and 18 of the Income Tax Amendment Act 1987. The most important of these is section 8, which amends the definition of "trading stock" in section 85(1) of the principal Act. The amendments made by sections 9, 10 and 18 provide consistency in the definitions of "trading stock" in other provisions of the principal Act.

Section 8

3. Section 8 amends the definition of "trading stock" in section 85(1) of the principal Act to -

  1. Include trading stock purchased but not on hand;
  2. Exclude financial arrangements dealt with under sections 64B to 64M of the principal Act; and
  3. Alter the layout of the section, although this last change is purely consequential and is intended simply to make section 85(1) easier to read following the other changes.

Trading Stock Not On Hand

4. The new section 85(1)(d) includes within the meaning of "trading stock" "anything in respect of which expenditure is incurred after the 23rd day of October 1986 and which, if possession of that thing were taken, would be trading stock ...".

5. The reference to expenditure incurred after 23 October establishes the application date of the change: it relates only to expenditure incurred after 23 October 1986.

6. The words "Anything .... which, if possession of that thing were taken, would be trading stock ..." is intended to deal with a gap that previously existed in the treatment of expenditure incurred on trading stock.

7. Expenditure on trading stock is deductible under section 104 as it is incurred. To obtain the correct accrual tax accounting treatment of trading stock, section 85 provides that in calculating assessable income allowance must be made for the value of the taxpayer's trading stock at the beginning and end of the income year. Goods purchased for sale, manufacture, etc., of which possession has not yet been taken, may not, however, be trading stock, even though the taxpayer has obtained a deduction for the cost of those goods under section 104.

8. Thus, until section 85(1)(d) was enacted a taxpayer might -

  1. Incur expenditure on goods acquired for resale, manufacture, etc., and be entitled to a deduction for the expenditure under section 104; and
  2. Not be required to bring the goods to account as trading stock if the goods were not delivered into the taxpayer's possession at balance date.

Section 85(1)(d) ensures that whether or not possession is taken of the goods they must be included in trading stock for the purposes of section 85. This will be the case if the goods have not yet been manufactured or ascertained (i.e., separately identified for delivery).

Financial Arrangements

9. The new section 85(1)(f) excludes financial arrangements dealt with under sections 64B to 64M from the definition of "trading stock".

10. It is intended that sections 64B and 64M should provide a complete code for the income tax treatment of financial arrangements, including financial arrangements held as trading stock. It was therefore necessary to provide that section 85 shall not apply in relation to financial arrangements.

11. The exclusion applies only to financial arrangements the tax treatment of which is governed by sections 64B to 64M. The exclusion does not apply to -

  1. An excepted financial arrangement, except to the extent that -
    1. It is part of a financial arrangement; and
    2. The gain or loss on the excepted financial arrangement is treated as income deemed to be derived or expenditure deemed to be incurred in respect of the financial arrangement:
  2. A financial arrangement issued or acquired by the taxpayer before the "implementation date" (as defined in section 64B(1)) for the financial arrangement:
  3. A financial arrangement held by a non-resident if the financial arrangement is not held for the purposes of a business carried on by the non-resident through a fixed establishment in New Zealand.

Sections 9, 10 and 18

12. Sections 9, 10 and 18 of the Amendment Act amend sections 90(1), 91(1), and 197(1), respectively, of the principal Act. Each of the amended provisions is a definition of "trading stock", and each is amended consistent with the amendment to section 85(1).

Accrual Expenditure

13. The new section 104A, as inserted by section 11 of the Income Tax Amendment Act 1987 and amended by section 25 of the Income Tax Amendment Act (No.2) 1987, provides an accrual regime for expenditure complementary to the accrual rules for financial arrangements. The new section is not included in sections 64B to section 64M as it is concerned with expenditure other than expenditure relating to financial arrangements and represents a significant qualification of section 104 (the principal deductions provision).

Mischief

14. As noted in the 1986 Budget many tax avoidance schemes depend upon deficiencies in the rules governing the timing of tax deductions and the derivation of income. Under section 104 of the Act a deduction is allowed for expenditure as it is incurred, i.e., when the taxpayer is under a legal obligation to make payment, not when payment is actually made. Given that a deduction could be taken in advance of actual payment there were obvious cashflow advantages in advancing the point in time at which an obligation to make payment was assumed. The new section 104A removes such timing anomalies by introducing a regime similar to the treatment of trading stock for expenditure that is wholly or partly attributable to income years other than the year in which the expenditure is incurred.

General Structure

15. The definitions for this provision are provided in section 104A(1) and (2). The operative provisions, setting out the required tax accounting treatment of accrual expenditure, are in section 104A(3) and (4). Section 104A(5) and (6) provides a mechanism under which the Commissioner may exempt taxpayers from the tax accrual requirements of section 104A.

Definitions

"Accrual Expenditure"

16. The definition of "accrual expenditure" defines the types of expenditure to which the provision applies and fixes the effective application date of the provision.

17. The effective application date of section 104A is fixed in the definition of "accrual expenditure" by -

  1. The reference to "expenditure incurred on or after the 1st day of August 1986"; and
  2. The exclusion, in paragraph (d) of the definition, or expenditure incurred pursuant to a binding contract entered into before 8.30 pm New Zealand Standard Time on 31 July 1986.

Thus section 104A applies to all accrual expenditure incurred on or after 1 August 1986, except expenditure incurred under a binding contract entered into before 8.30 pm on 31 July 1986. Persons having a 1986 balance date between 31 July 1986 to 30 September 1986 may be affected in relation to their 1986 income tax returns.

18. "Accrual expenditure" is expenditure that is deductible under the Income Tax Act other than expenditure incurred -

  1. In the purchase of trading stock;
  2. In respect of any financial arrangement;
  3. In respect of a lease to which sections 222A and 222E of the Act apply; or
  4. Pursuant to a binding contract entered into before 8.30 pm New Zealand Standard Time on 31 July 1986.

19. Accrual expenditure does not include expenditure which, though it has been incurred, is not deductible -

  1. Under any other provision in the Income Tax Act;
  2. By virtue of an express prohibition on the deductibility of that expenditure (e.g., capital expenditure, section 106(1)(a) refers; expenditure for private or domestic purposes, section 106(1)(j) refers).

20. Expenditure incurred in the purchase of trading stock is excluded because there is a general accrual tax accounting provision for trading stock in section 85 of the Act. "Trading stock" is defined in section 104A(1) as having the same meaning as in section 85 of the Act, so the exclusion does not cover land that is trading stock. This means that a person who buys or develops land (including buildings and other fixtures to land) must account for that land for income tax purposes according to section 104A.

21. Expenditure in respect of a financial arrangement is excluded because an accrual tax accounting regime is provided for financial arrangements in sections 64B to 64M of the Act. "Financial arrangement" is defined in section 104A(1) as having the same meaning as in section 64B(1) of the Act.

22. Leases to which sections 222A to 222E of the Act apply are excluded because those sections provide an accrual tax accounting regime for such leases. The exclusion does not cover leases of real property, livestock or bloodstock.

23. Paragraph (d) of the definition, which refers to binding contracts entered into on or before 8.30 pm New Zealand Standard Time on 31 July 1986, is discussed at paragraph 17 above. It is intended to ensure that no one is disadvantaged by the enactment of section 104A because they are bound to incur expenditure after 31 July 1986 due to the terms of a contract that was binding upon them before the 1986 Budget announcement of the new policy.

24. The intention in enacting paragraph (d) of the definition requires that it be interpreted reasonably liberally. Where a contract is binding on one party before 8.30 pm on 31 July 1986 but not on others, the person on whom it was binding before 8.30 pm on 31 July 1986 should be given the advantage of the exclusion, but not the other parties.

"Goods"

25. For the purposes of section 104A "goods" means all real or personal property but does not include money or a chose in action. The classes of goods that are of most significance will be consumable aids generally and real property.

26. Consumable aids are goods, other than capital goods, that are consumed in the manufacturing or sales process but are not part of what is delivered to the customer. In an engineering process, for example, welding rods (which become part of the finished product) are to be treated as trading stock, while welding flux (which does not become part of the finished product) is a consumable aid.

27. Real property is immovable property: land and things (such as buildings, dams, roads, etc) that are so fixed to the land that they are a part of it. In general this will affect only persons whose business is dealing in land or developing land for sale. Expenditure incurred otherwise in relation to the purchase of land is generally not deductible, being either capital expenditure or expenditure of a private or domestic nature.

"Services"

28. For the purposes of section 104A, "services" means anything that is not goods or money or a chose in action. It includes repairs and maintenance work (but not the goods supplied in carrying out repairs or maintenance), telecommunications services, transport services, and advice and the application of labour, skills, knowledge, or equipment generally.

"Chose in Action"

29. The expression "chose in action" is not defined for section 104A and therefore is to be given its generally accepted meaning. A "chose in action" is a right enforceable by legal action. Examples are leases of land and royalty agreements. (See also paragraphs 41 to 44 below).

The Unexpired Portion

30. Section 104A(2) defines the unexpired portion of any accrual expenditure. Separate definitions are provided for the unexpired portion of accrual expenditure-

  1. Relating to the purchase of goods,
  2. Incurred on services, and
  3. Relating to payment for, or in relation to, a chose in action.

In Relation to Goods

31. The unexpired portion of accrual expenditure that relates to the purchase of goods is the amount of expenditure incurred on goods not used in the production of assessable income. At each balance date therefore it is necessary to determine how much of the original expenditure incurred on goods relates to goods not yet used in producing assessable income. The residue of the original expenditure attributable of such goods is the unexpired portion of that expenditure.

32. Accrual expenditure that relates to the purchase of goods includes -

  1. The price paid for the goods, and
  2. The costs associated with the purchase, such as any brokerage, government imposts, solicitors' and agents' fees and delivery costs. It therefore includes the cost of certain services.

33. Where a taxpayer holds goods purchased before 1 August 1986 or purchased pursuant to a binding contract entered into before 8.30 pm New Zealand Standard Time on 31 July 1986, as well as goods that do not fall within those classes, it will be necessary to distinguish them. The cost of goods purchased prior to the effective application date is not accrual expenditure, and therefore is not to be treated as or including an unexpired portion if the goods are still held at balance date.

34. In distinguishing expenditure that is excluded by the effective application date or by paragraph (d) of the definition of "accrual expenditure", taxpayers should give consideration to actual usage wherever reasonably possible. If the actual usage cannot be determined with reasonable accuracy a first-in-first-out accounting method is to be used.

Meaning of "Used"

35. A good is used in the production of assessable income when it is applied, consumed, put into operation, or otherwise employed, in the process that produces assessable income. It is not sufficient that it be available for use, and in particular it is not sufficient that the goods be available for examination or sale.

In Relation to Services

36. The unexpired portion of accrual expenditure that relates to payment of services is the amount incurred on services not performed.

Meaning of "Performed"

37. Services are performed where and to the extent that they are executed, carried out, or otherwise rendered. Where they are to be performed over a period of time there must be an apportionment if the time period includes a balance date. The reference to "services not yet performed" indicates clearly that the apportionment must be on the basis of the services yet to be performed in relation to the total services to be performed in consideration for the expenditure, rather than on a simple time basis.

38. Accrual expenditure that relates to services includes -

  1. The price paid for the services; and
  2. Costs related to the services, such as any solicitors' fees or government or local body levies.

In Relation to a Chose in Action

39. The unexpired portion of accrual expenditure that relates to a payment for, or in relation to, a chose in action is the amount that relates to the unexpired part of the period in relation to which the chose is enforceable.

40. A "chose in action" is literally a thing recoverable by (legal) action. Its modern use is to describe all personal rights of property that may be claimed or enforced by legal action including rights in relation to real property.

41. In determining the amount of expenditure that relates to the unexpired part of the period in relation to which rights under the chose in action are enforceable, one must consider the rights that may be exercised in relation to the part period. For example where an agreement provides for use of patent rights and it is expected with reasonable certainty (or is provided in the agreement) that the use of the patent rights will be -

  1. 15,000 units produced in the 6 months prior to balance date, and
  2. 85,000 units produced in the 6 months after balance date, -

The apportionment to calculate the unexpired portion will be on an output basis (85 percent of the accrual expenditure) rather than a simple time basis.

Operative Provisions

42. The operative provisions of section 104A are subsections (3) and (4). They require that the unexpired portion of accrual expenditure be -

  1. Deducted in the income year in which it is incurred (section 104A(3));
  2. Added back to assessable income for that year (section 104A)); and
  3. Deducted in the following income year (section 104A(4)).

The deduction in the following income year is subject to the same accrual provisions (section 104A(3)). The treatment is based on the income tax treatment of trading stock (section 85 refers ).

Example: Goods

43. Company X purchases lubricating oil which is stored in a tank. It is not possible to tell which lot of oil is being consumed at any time.

Purchases

Date Price Quantity
31 March 1986 $2/litre 100 litres
30 June 1986 $2.10/litre 20 litres
30 August 1986 $2.05/litre 30 litres
31 October 1986 $2.08/litre 20 litres
13 January 1987 $2.15/litre 20 litres
15 March 1987 $2.15/litre 20 litres

Stock on hand at balance date (31 March 1987): 45 litres.

Amount deductible for year ended 31 March 1987

20 litres @ $2.10 $42.00
30 litres @ $2.05 61.50
20 litres @ $2.08 41.60
20 litres @ $2.15 43.00
20 litres @ $2.15 43.00
  $231.10

Amount to be added back to income for the year ended 31 March 1987

20 litres @ $2.15 $43.00
20 litres @ $2.15 43.00
5 litres @ $2.08 10.04
  $96.04

Example: Services

44. Company Y engages the services of an advertising agency. Payment of $44,000 is made on 30 September 1987 for services to be performed over the following twelve months. Half of the total service is performed in the first month (October 1987) with even performance thereafter.

(a) Income Year ended 31 March 1988    
  Deduction under section 104   $44,000
  Unexpired portion $12,000  
  Included in assessable income   $12,000
  Net deduction   $32,000
(b) Income Year ended 31 March 1989    
  Deduction under section 104A(4)   $12,000

Example: Chose in Action

45. Company Z enters into a three year lease commencing on 1 April 1987 for a building at an annual rent of $20,000. On 31 March 1987 the company pays all of the rental payable under the lease. The company claims a deduction for $60,000 in its 1987 tax return. The building is to be wholly used in the production of assessable income so the $60,000 payment is deductible under section 104. Section 104A would apply to the payment as follows:

(a) Income Year ended 31 March 1987    
  Deduction under section 104   $60,000
  Unexpired portion (Section 104A(2)) $60,000  
  Included in assessable income    
  (Section 104A(4))   $60,000
  Net deduction   Nil
(b) Income Year ended 31 March 1988    
  Deduction under section 104A(4)   $60,000
  Unexpired portion $40,000  
  Included in assessable income   $40,000
  Net deduction   $20,000
(c) Income Year ended 31 March 1989    
  Deduction under section 104A(4)   $40,000
  Unexpired portion $20,000  
  Included in assessable income   $20,000
  Net deduction   $20,000
(d) Income Year ended 31 March 1990    
  Deduction under section 104A(4)   $20,000
  Unexpired portion Nil  
  Included in assessable income   Nil
  Net deduction   $20,000

By this mechanism the $60,000 payment made on 31 March 1987 is spread evenly over the period to which it relates. In each year the unexpired portion included in assessable income is that part of the original amount of accrual expenditure that relates to future income years.

Commissioner's Power to Exempt

46. In view of the cost of complying with section 104A provision has been made for the Commissioner to determine whether and to what extent a person or class of persons may be exempted from the requirements of section 104A. The legislation granting this power is section 104A(5) and (6).

47. Sections 104(5) and (6) are not in themselves an exemption. A taxpayer may not rely on them in claiming an exemption from the requirements of section 104A. It is necessary to rely on a determination made by the Commissioner.

48. At the time of writing this item the Commissioner had made one determination, which taxpayers generally may apply where the requirements of the determination are satisfied, and two applications had been received for determinations relating to the affairs of particular taxpayers. It is not intended to issue any further general determinations under section 104A(5) in the immediate future unless applications reveal a need to do so.

49. Section 104A(5) provides as follows:

  • "(5) For the purposes of this section the Commissioner may determine whether and to what extent any person or class of persons shall not be required to comply with this section in relation to any accrual expenditure incurred by the person, having regard to -
    • "(a) The nature and amount of the kinds of accrual expenditure regularly incurred by the person or class of persons:
    • "(b) The nature and size of the activity giving rise to the item or items of accrual expenditure incurred by the person or class of persons:
    • "(c) The costs of the person or class of persons in complying with this section in relation to the accrual expenditure incurred by the person or persons:
    • "(d) Whether, in respect of that person or class of persons and the item or items of accrual expenditure, the difference between expenditure that is determined under this section (other than this subsection) and expenditure that would be deductible if the discretion given to the Commissioner under this subsection were exercised, is not a material amount."

50. Any request for a determination to be made under section 104A(5) should be referred to the Accruals Unit, Inland Revenue Head Office. It should identify the person making the determination and should be justified by reference to one or more of the provisions of section 104A(5). Where it relates to the affairs of a particular taxpayer the application should be supported by copies of the last three years' income tax and financial accounts, budgets for the current year, and an explanation of usage and purchasing policy in relation to the accrual expenditure for which exemption is sought.

51. Section 104A(6) allows the Commissioner to cancel any determination made under section 104A(5).