George, the CEO of a company, was driving with his Finance Director, James, to a meeting. George had learned of a recent Tax Court case around stock values and was curious to know more.
“James what does this stock case mean?” George asked.
“Firstly, stock valuation has long been a bone of contention with SARS which has led to endless work, debate and argument with SARS. This tax case reconciles the company’s and SARS’ stock valuations and thus brings clarity and certainty” James replied.
“That’s a positive but how does it work, I’m curious” said George.
“It certainly is a positive” James answered.
“Well, as you know the value of stock at year end comes off cost of sales and the lower your stock value the less tax you pay.
If your sales are, say, R200 and
Cost of sales before closing stock is R100 and your closing stock is R20 then
Cost of sales is (R100-R20) R80 and
You therefore add (R200–R80) R120 to your taxable income.
But if closing stock was R10, then you would add R110 to your taxable income.
In reality this can have a large impact on the tax you pay. In the case we are talking about, the amount involved was more than R100 million.”
“Ok so far. Now carry on” said George
“How you value stock is clearly very important. The Accounting profession values it as the lower of cost and net realisable value (NRV). So whichever is the lower of the two methods is accepted as the stock value.”
“Cost is easy to determine – whatever you pay for the stock. NRV is more complex and is made up of any extra costs to getting your stock in a saleable condition less the selling price.”
“I should point out” continued James “that SARS agrees on cost but the Income Tax Act does not mention NRV but speaks of a diminution in value. Tellingly SARS is given discretion as to what it considers ‘just and reasonable’ in deciding what a diminution in value means. ”
“Let’s look at an example in measuring NRV. Say you sell raincoats for R75 and they cost R50 each. However, your supplier delivered them late and you have to keep them in stock for six months until the next rainy season.”
“They will then need to be dry-cleaned at a cost of R10, the cost to get them to shops is R7 and you will now need to incentivise shop assistants to sell the raincoats at a cost of R12.”
“These costs (R10+R7+R12) are deducted from the selling price of R75 making NRV R46. As this is less than the cost of R50, this becomes your stock cost.”
What’s IFRS and why is it important?
“Great” said George “the cost has dropped by R4 a raincoat but why is everyone talking about ‘IFRS’?”
“International Financial Reporting Standards (IFRS) is a globally accepted methodology of compiling financial statements” continued James. “What is important here is IFRS adopts a systematic approach to determining NRV.”
“The Court was impressed with this approach which gave a credible methodology in reaching NRV. As mentioned SARS has discretion in accepting or rejecting NRV. The Court ruled that the IFRS approach is to be accepted by SARS.”
“So” said George “the days of endless debate and argument between business and SARS on stock valuation are over. Business will pay less tax and there will be much less administration time.”
“Exactly” said James. “But we do need to bear in mind that this judgment, as persuasive as it is, isn’t actually binding in other cases unless a higher court ratifies it. Also of course SARS could appeal.”