Private ruling: Allocation of indirect development costs
Published: October 2013
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ending 30 June 2014 | Year ending 30 June 2015 | Year ending 30 June 2016
Date scheme commenced: 1 July 2011

Ruling: Q1: Does the Commissioner accept the methodology proposed by the Company whereby the cost of its trading stock is determined under section 70-45 of the Income Tax Assessment Act 1997 by allocating indirect development costs on an unescalated anticipated selling price basis? | A1: Yes.

Relevant facts and circumstances: The Company is a land developer. Its main asset is inventory; comprising undeveloped land, land under development and completed lots. Currently the Company determines its accounting and tax inventory costs in the same way. The Company currently allocates direct costs which benefit or give rise to specific lots such as earthworks, sewage, retaining walls and roads specifically to relevant land. Indirect costs which benefit more than one stage or the project as a whole such as project entry statements, major entry roads, sewage upgrades, water connections for the project are allocated over the lots they benefit and using estimated sales price at year end in accordance with valuer's advice, the Company's sales experience and actual sales. A sales price is estimated for all lots to be developed in accordance with the development plan. Sales are escalated by an inflation factor (escalated sales price). As a lot is sold a pro rata portion of direct and indirect costs in proportion to the sale price compared to estimated total sales is offset against the sales revenue. Due to the inflation factor earlier sales have less costs allocated against them and later sales more costs. An example of this methodology is set out below: (1) Base Assumptions Produce and sell 5 lots over 5 years @ 1 lot pa. Escalation (inflation) rates: income 6%pa; costs 3%pa 6% 3%. Lot prices and production costs at current market value are: Price Direct Cost Year 1 Lot 1 220,000 120,000 Year 2 Lot 2 250,000 120,000 Year 3 Lot 3 249,000 120,000 Year 4 Lot 4 220,000 120,000 Year 5 Lot 5 235,000 120,000 There are $400,000 of indirect infrastructure costs incurred 50% in year 1 and the balance in year 4. (2) Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Total Revenue escalation 6%pa 106.00% 112.36% 119.10% 126.25% 133.82% Today's selling prices 220,000 250,000 249,000 220,000 235,000 1,174,000 Escalated selling prices 233,200 280,900 296,563 277,745 314,483 1,402,891 3%pa Escalated costs Direct costs 123,600 127,308 131,127 135,061 139,113 656,209 Indirect costs 206,000 - - 225,102 - 431,102 Escalated costs 329,600 127,308 131,127 360,163 139,113 1,087,311 (3) Outcomes Cost alternatives Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Total 1 Escalated basis 195,261 213,627 222,260 220,411 235,752 1,087,311 2 Unescalated basis 204,386 219,110 222,562 215,847 225,407 1,087,311 The results at step 3 of the table above are a function of an apportionment calculation based on the prices at step 2, that are subsequently applied to indirect costs. For instance, the value at Yr 1 of 195,261 (using the escalated basis) is calculated thus: 233,200 / 1,402,891 x (206,000 + 225,102) + 123,600 = 195,261 Similarly the value at Yr 1 using the unescalated basis is calculated as follows: 220,000 / 1,174,000 x (206,000 + 225,102) + 123,600 = 204,386 The Company has indicated that at no stage in valuing trading stock, are costs accounted for - for tax purposes - unless they have been incurred. The Company is seeking advice as to whether it is appropriate to use the unescalated selling prices to allocate indirect costs for the purposes of calculating the closing value of its trading stock. It currently uses escalated selling prices.

Relevant legislative provisions: Section 70-45 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Subsection 70-45(1) of the Income Tax Assessment Act 1997 provides that you must elect to value each item of trading stock on hand at the end of an income year at: · its cost; or · its market selling value; or · its replacement value. Guidance on the appropriate method of valuing land is taken from Taxation Ruling TR 2006/8 Income tax: the cost basis of valuing trading stock for taxpayers in the retail and wholesale industries . Paragraphs 16 and 17 of TR 2006/8 indicate that cost is the appropriate method of valuing trading stock in relation to a land developer who purchased land in the form of broadacres and converted the broadacres into subdivided blocks. In the Company's case the cost method is used to value trading stock. In calculating the cost of trading stock on hand, the indirect costs associated with the provision of the infrastructure (e.g. major entry roads, sewage upgrades, water connections) must be absorbed in determining the cost of the trading stock (FC of T v Kurts Development Limited 98 ATC 4877; (1998) 39 ATR 493). Guidance on the absorption costs of trading stock can be taken from Taxation Ruling No. IT 2350 Income Tax: Value of trading stock on hand at end of year: cost price: absorption cost . Relevantly to the question of this ruling, paragraph 14 of IT 2350 states: ...Any method capable of consistently producing a total valuation of trading stock on hand reasonably approximating its full absorption cost will be acceptable. This paragraph has relevance to the means by which a land developer allocates its indirect costs, since it is often not practicable to specifically allocate these costs to given lots. In the Company's case the indirect costs associated with the development are allocated to individual lots based on their 'anticipated selling price' as a percentage of total expected sales. That is, the ratio of a lot's expected selling price to total expected sales is applied to the development's total indirect costs. The resulting figure is the amount of indirect costs associated with that particular lot. This calculation can be described thus: Anticipated selling price of lot X x Total indirect costs of development = Indirect costs allocated to lot X Total expected sales of development When performing the calculation the Company currently factors expected inflation into its anticipated selling prices and total expected sales. The effect is that indirect costs - and therefore closing value of trading stock - will tend to be higher towards the end of the development as inflation theoretically rises. The Commissioner considers that the anticipated selling price method generally affords an appropriate basis of allocating costs (however, any other reasonable method, consistently applied, that will match costs with related revenue may be used). The Company wishes to excise the use of inflation from its calculations. It is considered that there is no practical difference between the anticipated selling price method and the Company's proposed unescalated selling price (which disregards predicted inflation). It follows that the Commissioner considers this to be a reasonable method of apportioning indirect costs between the individual lots that make up the development.