Profits Tax - Valuation of stock
As there is no specific
provision in Inland Revenue Ordinance on the topic, we have to follow the
generally accepted accounting practices and the relevant case law.
Indeed, it is a well known practice that stock is valued at the
lower of cost and net realizable value.
What is Cost?
The IRD adopts the
definition of “cost” in the Statements of Standard of Accounting
Practice (SSAP) issued by Hong Kong Society of Accountants. In
brief, “cost” means the actual or historical cost. This includes all
costs incurred directly on the purchase, conversion and bringing the
stock to its existing location and condition. Also included is any
overhead expenditure which can appropriately be allocated to the
cost of stock and carried forward in the circumstances of the
business, instead of being recognized as a revenue expense in the
period in which it was incurred. In limited circumstances, borrowing
costs are included in the cost of stock.
For manufactured goods, cost includes raw materials, direct labor and other direct
extent indirect expenses or overheads should be included in the
stock valuation? This question can sometimes give problems.
Normally, the generally accepted practice of that particular
industry should be adopted; but it is not uncommon to find different
methods adopted by different accountants in the same industry. In
that case, the emphasis is on “consistency” --- providing the method
is consistently adopted from year to year, the Revenue will accept
it for tax purpose.
Which method of stock valuation is acceptable for tax purpose?
method is generally acceptable for tax purpose.
This method is acceptable if the standards are frequently
revised to reflect the actual or historic cost,
Adjusted selling price
(i.e. stock is valued at selling price less the normal profit
margin): This method is frequently used by retailing industry,
for example supermarkets. It is acceptable if it gives a
reasonable approximation of the historical cost.
method is not acceptable for tax purpose because it does not
reflect the historical cost of closing stock.
Base stock: This method
is not acceptable for tax purpose, also for the reason
applicable to Last In First Out.
What is Net
Net realizable value means
the anticipated selling price less the selling expenses. This value
should be determined under normal market conditions and not under
forced sale in bulk.
Court cases on
There are a number of court
cases on stock valuation. The following is a summary.
Ahmedabad New Cotton
Mills Ltd. v. Bombay Commissioners of Income Tax: if opening and
closing stocks were undervalued, the true profits could be
established by raising both valuations.
CIR v. Cock Russell &
Co. Ltd: it is right to use the lower of cost or market value
(i.e. net relisable v to individual items of stock.
Minister of National
Revenue v. Anaconda American Brass Ltd: the Last In First Out method of
determining cost was rejected by the Privy Council.
Patrick v. Broadstone:
the base stock method was rejected.
Duple Motor Bodies Ltd.
v. Ostime: the valuation method should be consistent from year
Freeman, Hardy & Willis
v. Ridgeway: the replacement value method was rejected.
CIR v. Quitsubdue Ltd: A
trader takes goods out of trading stock for own use was not
trading. The cost should be deducted from the purchase cost of
the stock. No profit computed on the market value of the stock
taken should be assessed.
CIR v. Secan Limited:
interest expense was absorbed into the valuation of
work-in-progress of a property developer. The property
developer's claim for full deduction of the interest expense on
the grounds that it has already been incurred during the basis
period was rejected. This was because by capitalization of the
interest, the interest would be deductible when the trading
stock was sold. Moreover, where a GAAP has been adopted by the
taxpayer for preparation of accounts, it should be followed for
determination of assessable profits unless there are specific
provisions in the law.