Income v Capital

By | 8 February 2011

The distinction between income and capital assumed greater importance following the introduction of a 50% income tax rate. The subsequent introduction of a 28% capital gains tax rate has narrowed the differential between the tax rates, but the gap is still significant.

The treatment of an activity as a trade (as opposed to, say, an investment) can also be useful if losses arise, as trading losses can be relieved against general income.

In Manzur v Revenue & Customs [2010] UKFTT 580 (TC), the taxpayer, a retired surgeon, invested in stocks and shares. His share transactions resulted in losses, for which claims were made against general income. HM Revenue and Customs (HMRC) refused the claims, and the taxpayers appealed.

Badges of Trade

The taxpayer argued that the share transactions were trading as they fitted within the ‘badges of trade’, i.e. the shares were acquired for trading purposes held for a short period, the transactions were similar in character and carried on in significantly the same way, stockbrokers fees arose regardless of whether a profit was made and the risk was personal to the taxpayer. HMRC argued (among other things) that the transactions were not high volume, the taxpayer had no customers or clients, that he did not have the requisite qualifications for a share dealing business and was not regulated by the Financial Services Authority (FSA). HMRC said that the taxpayer did not have the characteristics of a normal trader in shares, and so it was not an adventure in the nature of a trade. HMRC’s view that share transactions by individuals are not generally trading transactions is expressed in its Business Income Manual (at BIM65701).

Overall impression

The tribunal held that the activities undertaken by the taxpayer amounted to investment rather than trading activities, and dismissed the taxpayer’s appeal. The tribunal noted that there is no definite checklist for determining whether or not an individual is trading, and that although the ‘badges of trade’ provide some guidance, it is not definite in each case. It was stated in Salt v Chamberlain [1979] S3 TC 143 that “the questions is, I think, one of overall impression”. The tribunal in Manzur also considered that the share transactions were “not numerous” (between 240 and 300 a year), and were undertaken on a “very part-time basis” (two hours in the afternoon). It was “important when looking at share trading to see whether the transactions and operations in question are conducted in the same way as other trades in shares who operate established businesses”. Share dealing by an individual was considered more likely to give rise to a capital gains tax charge.

Reference was made by the tribunal to comments made by Pennycuick J in Lewis Emmanuel & Sons Ltd v White [1965] 42 TC 369, which indicate that if an individual speculates on price movements in shares without intending to hold them even as a short-term investment, the transactions are analogous to gambling. It is perhaps not too difficult to understand why HMRC are seemingly keen to resist attempts by taxpayers to argue for trading status when engaging in activities such as horse betting, card games and even share transactions. The resulting loss relief claims would probably be catastrophic for the Government!

The tribunal considered that share trading as a business contains a number of characteristics, including:

(a) Customers;
(b) Trading in large volumes of shares frequently;
(c) A degree of hedging to decrease risk exposure (and clear rules on risks exposure over a period of time); and
(d) The business is usually regulated by the FSA.

The tribunal expressed the view that it would be easier to classify share dealing by a company as trading than for an individual. The appellant’s share dealings were considered to be more in the nature of portfolio management, and were really transactions in the nature of investments. On that basis, the tribunal concluded that the appellant had undertaken an investment activity, and dismissed the taxpayer’s appeal.

Trade ‘venture’

In practice, the trading and investment distinction can be a difficult one, as there is virtually no statutory guidance. This has resulted in a number of tax cases over the years on the issue. The legislation simply states that “trade includes any venture in the nature of a trade” (ITA 2007, s 989). Prior to ITA 2007, the ‘old’ legislation referred to an “adventure in the nature of trade”, and it is this definition that most tax cases have considered (although the change from ‘venture’ to ‘adventure’ was not apparently intended to effect a change of meaning).

What is the difference between a ‘trade’ and an ‘adventure in the nature of a trade’? A leading Tax Counsel has indicated to me that a trade normally has an infrastructure, and is established as a continuous operation. An ‘adventure in the nature of a trade’ may lack the attributes of infrastructure and continuity, and yet have the essence of trade about it.

Thus an ‘adventure in the nature of trade’ is potentially wider than ‘trade’ in its meaning and scope. The former expression dates back to at least the Income Tax Act 1853. A report by the Royal Commission on the Taxation of Profits and Income in 1955 identified the following six ‘badges of trade’ following a review of case law:

  • The subject matter of the realisation;
  • The length of the period of ownership;
  • The frequency or number of similar transactions by the same person;
  • Supplementary work on or in connection with the property realised;
  • The circumstances that were responsible for the realisation; and
  • Motive.

HMRC’s Business Income manual devotes a section to this subject (BIM20200 onwards), and lists a further three badges (at BIM20205):

  • The existence of similar trading transactions or interests;
  • The source of finance; and
  • Method of acquisition. 

HMRC state that the presence or absence of a particular badge is …”unlikely, by itself, to provide a conclusive answer to the question of whether or not there is a trade.” Whilst the badges are helpful, the question of whether there is a trade (or a venture in the nature of one) will depend upon the specific facts and circumstances of each case, and a matter of standing back and examining the overall picture.

The above article is reproduced from ‘Practice Update’ (January/February 2011), a tax Newsletter produced by Mark McLaughlin Associates Ltd. To download current and past editions of Practice Update, see the Newsletters section.