If you own or manage a retail business in Australia, there are times where you purchase more inventory than you can sell in a year—especially for products that do not have an expiration date. This inventory overstock can affect your taxes and your total profits.
Businesses are taxed based on profits, meaning that unsold trading stock does have an effect on your annual tax return. That’s why deliberate business tax planning is so important – you’ll want to ensure you’re aware of all the factors that will affect your business tax well ahead of time.
The ATO provides two different methods of handling trading stock for tax purposes: General Trading Stock Rules and Simplified Trading Stock Rules. You’ll want to ensure your business is eligible to use Simplified Trading Stock Rules – otherwise, you may be required to do a stocktake.
Keen to learn more about inventory and taxes in Australia? Read on!
Table of Contents
What Counts as Inventory for Tax Purposes?
Inventory generally refers to items that businesses currently have that can be sold, including any other goods that will be used to manufacture goods that can be likewise sold. What is considered inventory may be broad and could be composed of a number of components.
In the broader sense of the word, inventory also refers to items that will be available for sale as part of a company’s primary business, and is not restricted to things that are on hand. If the business also partakes in the manufacturing industry, then the raw materials that will be used to create other products for sale, as well as incomplete/partially completed items (e.g. products that take days or weeks to be completed) will also be included in the inventory.
In addition, materials that were not inherently the business’ (e.g. parts fabricated/ created by other companies) that will be used to create products for sale will also be included in the inventory. Containers such as boxes which will be holding the goods, even if they are not yet being utilised, also form part of the inventory.
For business financial preparation and tax purposes, the value of each item in the inventory of any manufacturer is generally the sum of the costs incurred for the physical materials as well as the labour expended in its creation.
How is Trading Stock Dealt With for Tax Purposes in Australia?
According to the Australian Taxation Office (ATO), trading stock is anything that a business acquires, manufactures, or produces, for the purposes of manufacturing, exchanging or selling. Under this definition, even livestock is considered trading stock.
Based on the ATO’s definition of trading stock, it does not include:
- Standing/growing crops, fruit, or timber — the aforementioned are only counted as trading stock once they are harvested, picked, or felled.
- Stocks of spare parts that are being held for the purpose of equipment repair or maintenance.
- Any goods owned by lending businesses in which goods are used to earn income through hiring or rental, instead of sale, exchange, or manufacturing. Among these are DVDs, tools, vehicles, catering equipment, etc.
- Consumable goods that are used in the manufacturing of trading stock, such as sandpaper and cleaning agents.
Depending on the business, inventory or trading stock falls under one or two sets of ATO rules: general trading stock rules or simplified trading stock rules.
General Trading Stock Rules
According to the ATO, General Trading Stock Rules will apply if the value of the trading stock changes by more than $5,000, or by $5,000 or less and you choose to do a stocktake and account for the change in value.
You may opt to do a stocktake and use general stock trading rules even if you are eligible or qualified to use the Simplified Trading Stock Rules.
Under the General Trading Stock Rules, you will have to undertake an end-of-year stocktake as well as record the value of your entire trading stock on hand at the beginning and end of the income year.
The value of stock at the end of the income year is generally the same as its value at the beginning of the next income year. But if the value of the closing stock is:
- More than the opening stock, then one must include the difference as part of the assessable income
- Less than the opening stock, then one can reduce the assessable income by the difference.
Any increase in the value of the trading stock over the year is considered assessable income, while any decrease is considered an allowable deduction. For businesses that began trading in an income year, the total value of stock on hand at the end of that year should be included in the assessable income on your business tax return.
In the event that you begin holding on to a Capital Gains Tax (CGT) asset that you already possess (e.g. land) as your business’ trading stock, there could be implications for your CGT.
Under these rules, you may choose to hold the trading stock either at market value or original cost. If you choose the former, then CGT event K4 will take place — which means you may make a capital gain or loss.
Simplified Trading Stock Rules
According to the ATO, Simplified Trading Stock Rules can be utilised if:
- you are a small business with an aggregated turnover of less than $10 million per year;
- or you would be a small business except your aggregated turnover is $10 million or more but not over $50 million (for income years beginning on or after 01 July 2021);
- and if the estimated value of your trading stock changed by $5,000 or less this year.
If you use the Simplified Trading Stock Rules, you will no longer have to conduct a formal stocktake nor account for the changes in your trading stock’s value.
The ATO states that your estimate of trading stock value should be considered reasonable if:
- you maintain a constant level of stock each year and have a reasonable idea of the value of your trading stock on hand,
- or your stock levels fluctuate, but you can still make an estimate of the stock you have previously purchased, based on your records.
Should the difference in the trading stock’s value have varied by more than $5,000, then the General Trading Stock Rule should be used instead.
Do I Need to do a Stocktake for Tax Purposes in Australia?
Since 01 July 2021, businesses will only have to do end-of-year stocktakes for tax purposes if:
- the business turnover is at $10 million or more
- the business turnover does not reach $10 million, and there is a difference of at least $5,000 or more in stock levels during the start and end of the financial year
A ‘reasonable’ estimate may be used to determine the difference in stock value.
Although the aforementioned criteria could indicate that a business does not have to do a stocktake for the purposes of taxation, it may actually be beneficial to do a stocktake anyway.
This is because a stocktake can help with other business processes, including but not limited to ordering, pricing, and identifying missing stock. Should a stocktake be required, then it is best to do it as close to the end of the financial year as possible.
As previously mentioned, a business may still elect to do a stocktake and include the accessible income’s change in value even if such change is only $5,000 or less.
There are two reasons a business may choose to do this:
- If the value of stock is presumably increasing, this can increase the assessable income in small increments over a number of years, instead of making a large adjustment when the increase in stock value has hit the $5,000 threshold.
- If the value of stock is presumably decreasing, this can immediately reduce assessable income.
How Does Inventory Affect Your Taxes At The End Of The Year?
Your annual profit is the total amount of revenue minus the cost of goods sold (COGS). Because you are taxed on profit and not the total revenue, the amount of leftover inventory affects your taxes at the end of the year, which directly influences your overall profits.
The COGS (cost of goods sold) is your inventory at the start of the year plus anything you purchased, less the leftover inventory at the end of the year. Unless you hold onto valuable items that appreciate over time, leftover inventory can affect your taxes at the end of the tax year.
Is Inventory A Tax Deduction?
Inventory itself is not a tax deduction, it is a gross receipt reduction. There is a common misconception that inventory is a type of asset that can be deducted from your taxes, however, this is not the case. Tax deductions can only be applied for sold inventory, not purchased inventory.
Inventory is tax deductible when bought in surplus only when the items in your inventory have a lower market value than when you originally bought them. This means that trading stock must have a lower valuation or be obsolete to claim a tax deduction. You can also use stock that was subject to theft or donations as tax write-offs.
However, surplus inventory that has a higher or equivalent value to when it was purchased is not tax deductible. Failing to sell stock does affect the amount of profit, which can reduce your taxable income – but of course, this means you aren’t receiving any revenue in return for the money you’ve invested in that inventory.
What Can My Business Do With Leftover Inventory?
If you expect to have leftover inventory at the end of the year, one of the best strategies to minimise losses is by holding a sale or discount. However, if you really need to dispose of leftover trading stock, options include donating it, selling it to a liquidator or salvage company, or destroying obsolete stock.
Any business with physical inventory is likely to have leftovers at the end of the financial year. Failing to sell inventory as planned is never a good thing, but if you’re out of options, there are a few options to get rid of unsold trading stock.
Donations are typically considered tax deductible – so yes, you may be able to give away excess stock before the end of the financial year as a tax reduction strategy. Consider reaching out to local charities who can put donated goods to use. This may include Ozharvest or a local food bank for food items, a local shelter for toiletries and household items, or your local op shop.
From a business perspective, getting rid of leftover stock should only be considered for items that are difficult or impossible to sell. You should only consider donating inventory for tax reasons if you think it would be impossible to sell them even when the new year begins – or when perishable items will no longer be any good.
Implementing inventory management practices during the financial year is one of the best ways to avoid this problem. Ensure you’re practising stock rotation (first-in first-out), frequently checking best-before dates for perishables, and consider your pricing strategy if you’re frequently not selling your inventory.
If the nature of your business means you frequently have surplus or expiring stock – for instance, a bakery or a grocery store – a regular arrangement with a local food bank can be a win-win scenario.
How Is Trading Stock Valued For Tax Purposes?
There are three ways to value your trading stock for tax purposes: based on retail price, cost of acquisition or depreciated price. Depreciated price means marking down inventory when the market price of the items have fallen below their original cost.
This article is provided as general information only and does not consider your specific situation, objectives or needs. WealthVisory makes no warranties about the ongoing completeness or accuracy of this information. It does not represent financial advice upon which any person may act. Implementation and suitability requires a detailed analysis of your specific circumstances.
Aaron is a Chartered Accountant with over 15 years experience in the accounting industry. Aaron has been able to provide advice around structuring, cashflow, tax compliance and working with clients to develop strategies.