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 charges.

To what 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?

First-in-first-out: This method is generally acceptable for tax purpose.

Standard cost: 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.

Last-in-first-out: This 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 LIFO.

What is Net Realizable Value?

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 stock valuation

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 L.I.F.O. 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 to 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.