Tax Flash 2019 – Valuation of trading stock

In calculating the cost of sales of taxpayers for income tax purposes, section 22 of the Income Tax Act[1] operates in much the same manner as is the case for accounting purposes. In other words, the calculated cost of sales for the year is deducted from income for purposes of calculating a taxpayer’s taxable income for the relevant year of assessment.

Cost of sales is, broadly speaking, calculated as the cost of opening stock plus the cost of stock purchased during the year less the cost of stock held at the end of the relevant financial period. A decreased amount of closing stock will therefore lead to a higher amount of cost of sales and therefore to a decreased amount of net taxable income. 

Whether closing stock may be decreased for tax purposes in a similar manner to “net realisable value” as is the case for accounting purposes[2] was the topic of discussion in the recent Supreme Court of Appeal judgment in CSARS v Atlas Copco South Africa (Pty) Ltd.[3] The judgment in Atlas Copco follows hot on the heels of the Supreme Court of Appeal decision in the Volkswagen case,[4] which considered broadly the same principles.

Atlas Copco confirms the principles in Volkswagen, being that the tax cost of closing stock for purposes of section 22(1) of the Income Tax Act differs from what would be the reduced cost price for purposes of IAS2 where the cost of stock is decreased to net realisable value subsequently. In essence, the Court held that only decreases in stock of a permanent nature, and not that linked to price fluctuations as much and linked potentially to accounting purposes, would suffice in justifying a reduced cost for trading stock to be returned for tax purposes. In other words, where, for accounting purposes, a conservative valuation of stock is encouraged (because of the effect on accounting net profit and the company’s balance sheet caused by an overvaluation hereof) the contrary is true for tax purposes.

As a result of the judgments in Atlas Copco and Volkswagen, we believe that in many cases where stock is reduced to net realisable value for accounting purposes, it would not be justified to reduce the closing stock value for tax purposes too. A divergent treatment for accounting versus tax purposes will therefore likely ensue. 

All taxpayers who write down trading stock to net realisable value for accounting purposes should take note of the above two important judgments and which will likely require an adjustment be made to the taxpayer’s tax computation. If a net realisable value adjustment to closing stock is considered for accounting purposes, we recommend that advice be sought whether a corresponding adjustment would be justified for tax purposes too.

[1] 58 of 1962.

[2] As determined by IAS2 of the Accounting Standards forming part of GAAP, and specifically the definition of “net realisable value” as contemplated in that standard.

[3] CSARS v Atlas Copco South Africa (Pty) Ltd (834/2018) [2019] ZASCA 124 (27 September 2019).

[4] CSARS v Volkswagen South Africa (Pty) Ltd (1028/2017) [2018] ZASCA 116 (19 September 2018).