Trading stock: Federal court case highlights taxpayer responsibility and credibility

Charlesworth J recently handed down a decision in the Federal Court case of Makrylos v Commissioner of Taxation [2023] FCA971.

This case provides insight into the significance of credibility as a witness and a taxpayer’s onus of proof, particularly in the context of provisions such as the trading stock rules, where ‘purpose’ is a determinative factor. 

The Federal Court held that land bought and held by Mr Makrylos was trading stock from its date of acquisition and not the later date contended by Mr Makrylos. 

Key facts of the case

Mr Makrylos was an experienced land and property developer who bought a large block of land in Darwin in 2006 and went on to later subdivide and sell the lots.  The initial tax returns lodged by Mr Makrylos treated this land as his main residence for a period of time until he decided to subdivide and sell the land.  Mr Makrylos alleged he did not hold the land as trading stock until a Joint Venture Agreement to develop the land was entered into between him and one of his corporate entities in April 2010.

The Commissioner of Taxation (Commissioner) conducted an audit in relation to the property.  The audit concluded that Mr Makrylos held the property as trading stock from the date of its acquisition in 2006.  This finding significantly increased Mr Makrylos’ taxable income for the 2013 and 2014 income years, during which the subdivided blocks were sold.  The Commissioner issued amended returns for 2013 and 2014 and shortfall penalty notices. 

The decision

On appeal to the court, Mr Makrylos argued that the property was not held as trading stock until he was legally obligated to commit the property to the joint venture, which was in May 2011, when a development permit was issued.

The court was not satisfied that the earliest date Mr Makrylos held the property as trading stock was May 2011 or April 2010.  As such, he failed to show what his assessments for 2013 and 2014 should have been and the court dismissed his appeal against the ATO’s objections.

The court rejected a lot of Mr Makrylos’ evidence and statements as his oral evidence was inconsistent with his written evidence and he also “variously presented as argumentative, selectively evasive, vague and unresponsive”. The inconsistencies between what Mr Makrylos was saying in court, what was provided as evidence to the court, and the depositions of other witnesses regarded as more credible by the court led to the conclusion that the evidence provided supported that any original intent to build a home on the property had been replaced by an intent to subdivide it by June 2006.

Specifically, the court rejected that he did not believe the property could be subdivided when he purchased the property.  The court also found that written declarations in 2007 and 2008 to the ATO, ASIC, and AEC stating he resided at the property were false.  There were also multiple payments from companies within his group related to the subdivision and development of the property.  From this, the court inferred that the property was held as trading stock with a view to subdivide, which is exactly what happened some years later.

What is trading stock?

Trading stock is defined by ss70-10(1) of the Income Tax Assessment Act 1997 (ITAA 97) as “anything produced manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business”.  As the ordinary course of business has a different meaning to everyone, something that you might consider to be trading stock for yourself may not be considered trading stock for someone else.

Trading stock in income tax returns

Sales revenue is assessable as ordinary income, whereas expenditure incurred in acquiring trading stock can be deducted under s8-1 of the ITAA 97.  You must also account for the difference between the value of your trading stock at the start and the end of the income year (i.e., the difference between the value of the trading stock on hand at the end of an income year versus at the beginning of that income year will either be deemed an allowable deduction or assessable income)

If you start holding an item you already own as trading stock, then you are treated as if just before you elect the item as trading stock you had sold the item to someone else at either cost or market value and then you had immediately bought it back for the same amount.  There is a provision to elect to value the trading stock at either cost or market value from the date you determine it is now trading stock. 

Mr Makrylos had the land valued in April 2010 at $5,000,000, one of the dates he argued he started to hold the land as trading stock.  The ATO concluded that he held the land as trading stock from when he acquired it for $825,000.  As a result of the ATO considering the land was held as trading stock at acquisition led to Mr Makrylos receiving amended assessments totaling a tax liability of over $1.8 million.

Key takeaways

In addition to demonstrating that simply electing something as either being trading stock or not will not determine whether or not it truly is trading stock or otherwise. Both the Commissioner and courts will necessarily have regard to subjective intention. 

Additionally, the method you use to value your trading stock can have big implications when completing your income tax return.  It may be worth reviewing how your trading stock is valued. 

The case also highlights how important it is to keep well-documented records that may be related to your tax affairs even many years after your return is lodged, those records may be important to assist in any reviews from the ATO. It also highlighted the importance that any deposition by a taxpayer must be absolutely consistent with those records and the depositions of other witnesses, particularly when the high onus of proof faced by taxpayers is considered.  

For more information

If you would like to discuss trading stock, please contact your local RSM tax advisor.