Trading stock: short selling of shares

Where a taxpayer is under an obligation at year end to provide shares to a securities lender to close out a short sale, can the shares be considered trading stock for the purposes of section 70-10 of the Income Tax Assessment Act 1997 (ITAA 1997) even though the shares had not been acquired before the end of its income year?

No. The shares that are yet to be acquired in order to close out the arrangement are not trading stock held by the short seller at the end of its income year for the purposes of section 70-10 of the ITAA 1997.

The taxpayer's business activities include entering into short sale share transactions.

The taxpayer's income year ends on 30 June.

In June 2006, under a short sale share transaction, the taxpayer 'borrowed' shares from a securities lender and sold them to a buyer. Under the terms of the transaction, the taxpayer had a contractual obligation to deliver an equivalent number and type of shares to the securities lender. The taxpayer had not entered into any contractual arrangement which obligated it to buy shares from a seller.

In the following income year, the taxpayer covered the short sale by buying from a third party seller an equivalent number and type of shares. Under the short sale share transaction, these were then returned to the securities lender.

Section 70-10 of the ITAA 1997 defines trading stock to include: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and (b) livestock.

In All States Frozen Foods Pty. Limited v. Federal Commissioner of Taxation (1990) 21 FCR 457; (1990) 90 ATC 4175; (1990) 20 ATR 1874, the taxpayer was a wholesale dealer in frozen foods. At 30 June 1985 the taxpayer was awaiting delivery by sea of certain imported goods. These had been bought under a number of contracts with prices having been paid and bills of lading delivered to the taxpayer prior to 30 June. Property in the goods had vested in the taxpayer. It was held that the goods were trading stock on hand, notwithstanding that physical delivery had not occurred.

The majority judgment of the Full High Court in John v. Federal Commissioner of Taxation (1989) 166 CLR 417; (1989) 89 ATC 4101; (1989) 20 ATR 1 indicated that the definition of trading stock, when speaking of the purposes of manufacture, sale or exchange, implies the acquisition of the item in question.

As at 30 June 2006 the taxpayer had not entered into any contractual arrangement, or made any payment which resulted in title to the shares yet to be acquired being passed. As the taxpayer had not acquired the replacement shares for return to the securities lender, they could not be said to be 'held' in the sense required by section 70-10 of the ITAA 1997. Accordingly, the shares to be acquired were not trading stock as at 30 June 2006.