BIM65701 - Share transactions: by individuals and companies

Share Transactions by Individuals

Transactions by individuals in shares and securities are not generally trading transactions. Such transactions normally fall within the charge to Capital Gains Tax. This is also true of transactions in futures, options or other derivative contracts.

Pennycuick J considered whether an individual was trading in Lewis Emanuel & Son Ltd v White [1965] 42TC369 where he said at page 377:

“ The word ‘speculation’ is not, I think, as a matter of language, an accurate antithesis either to the word ‘trade’ or to the word ‘investment’: either a trade or investment may be speculative. On the other hand, it is certainly true, at any rate in the case of an individual, that he may carry out a whole range of financial activities which do not amount to a trade but which could equally not be described as an investment, even upon a short-term basis. These activities include betting and gambling in the narrow sense. They also include, it seems to me, all sorts of Stock Exchange transactions. For want of a better phrase, I will describe this class of activities as gambling transactions...”

Pennycuick did not accept that an individual speculating on the price movement in shares without intending to hold the shares even as short term investments was trading. He considered that such transactions are analogous to gambling, and so fall short of trading.

The question of whether an individual is trading is a question of fact. And if agreement cannot be reached, an issue for the Commissioners to decide. It is therefore important that all the salient facts are obtained, when an individual claims to be carrying on a financial trade. Once the facts are established the position usually speaks for itself.

The tax cases provide some useful pointers. But each case is dependent on its own facts. It is therefore vital to establish the facts first of all.

The decided cases make it very clear that there is no definitive checklist for determining whether an individual is trading or not. The “badges of trade” are only a guide. The presence of one, two or more of them is not conclusive. The position is summed up by Oliver J in Salt v Chamberlain[1979] 53TC143 at page 154:

“…I doubt whether the question whether in any given case a person is or is not carrying on a trade is capable of solution by the application of a logical progression of propositions culled from decided cases. The question is, I think, one of overall impression”.

In that case Mr Salt decided to put his expertise in computer technology for forecasting share movements to personal use speculating on the stock market. He effected some 200 purchases and sales of stocks and shares, financing himself by means of bank loans and insurance policies as well as personal means. The Commissioners determined that the Appellant was not trading and Oliver J upheld their decision.

It follows that reliance on the number and frequency of transactions, and the short term nature of the holdings of shares may be misleading. It is necessary to view these badges taking account of the fact that the assets are financial assets.

To determine if a speculative activity is trading (or an adventure in the nature of trade), it is important to consider whether the operations are carried out in the same way as any ordinary trader in those assets operates. Established traders in shares operate to minimise, or limit, the exposure to chance. They do this in a variety of ways.

• They have customers who sell to them and buy from them regularly, to whom they market their services, and will quote prices for buying and selling. The prices quoted will be spread, so they can achieve profits. They make profits from moving huge volumes of shares very quickly.
• They hedge large holdings of a security with derivative instruments to ensure that if they hold on to positions for any length of time, they have only a limited exposure to general market movements.
• They have very strict rules about the degree of risk to which any trader is allowed to expose the firm.

So, while share traders do buy and sell shares to profit from anticipated market movements it is not the sole way in which they make a profit. Speculation is only part, and a strictly controlled part, of a more complex trading operation. Their operations are designed to make profits whichever way market prices move, by turning over stock as a wholesaler or as a retailer. Whether an individual operates in the same way as a share trader is a question of fact. So, it is necessary first of all to establish how the individual operates and what action he or she takes to minimise risk and secure profits.

Derivatives Transactions by Individuals

Individuals sometimes contend that options and futures are different to shares, because they are not income producing assets unlike shares which produce dividends, and they are usually dealt in by way of trade. However, financial futures and options are contracts closely tied to movement in prices of shares, interest rates or share indices. They are often used in exactly the same way as shares. It is therefore important to establish the facts when an individual contends that he or she is trading in derivatives. So, as for transactions in shares and securities, the question is whether the individual has organised his or her activities in a way that amounts to trading or is simply speculating on price movements.

Derivative traders do not simply enter into contracts and await price movements, such traders operate in exactly the same way as stock market traders. They trade by turning over the assets in large volumes at a dealing margin. They buy and sell to those customers of the market who want to use the derivatives. Like share dealers, they will hedge against market movement so that their exposure to it is kept within strict limits. So, in determining whether an individual is trading in futures, options or contracts for differences, the factors which need to be considered are essentially the same as those for an individual trading in shares.

Some of the derivative exchanges, including LIFFE, have now largely abandoned floor trading in favour of a screen based trading system, where prices are displayed and contracts can be made electronically. Some former LIFFE ‘locals’ now deal in derivatives in this way. They should still be considered to be trading given their background and involvement in the derivatives market, if there has not been a significant change in the nature of the activities. In cases where there has been a significant change in the nature of their activities, then a decision should be reached on the basis of the facts of the case.

When all the facts have been gathered in a particular case it should be possible to conclude whether or not there is a trade. However, if once you have established the facts, there are doubts or difficulty, which cannot be resolved locally, you should refer the case to Business Tax (Technical) following ADM 6.109.

Shares and Derivatives transactions by Companies other than Financial Concerns or Banks

Whether or not a company, which is not a Financial Concern or a Bank is trading in shares is again ultimately a question of fact.

However, Pennycuick J recognised in Lewis Emanuel & Son Ltd v White 42TC309 that “it is much more difficult to bring the activities of a company within the class of gambling transactions.” because of the limitations placed on a company’s activities by its Memorandum of Association.

Since then Company Law has been amended, S35 (1) Companies Act 1985 as amended by S108 Companies Act 1989) says:

“The validity of an act by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s memorandum.”

In Cooper v C & J Clark [1982] 54TC670, Nourse J examined the judgement in the Lewis Emanuel case and extracted the following principles for a company:

• marketable securities, being income producing assets usually capable of increasing in value, are prima facie purchased and sold by way of investment and not by way of trade; a series of purchases and sales may sometimes, if carried out pursuant to a deliberate and organised scheme of profit-making, amount to a trade;
• it is easier to characterise a series of purchases and sales as a trade in a case where they are made by a trading entity as opposed to an individual;
• in a case of a trading entity that characterisation is more easily made where the purchases are substantial in relation to its other activities, all the more so where they are of frequent occurrence and extend over a long period of time.

It is sometimes helpful, although not decisive, to ask whether a series of sales and purchases is speculative or not. The questions of why it is sometimes helpful is that the answer may throw light in one direction or the other, but it is not decisive because according to the circumstances either a trade or a course of investment may be speculative.

Where companies undertake transactions in derivatives it is necessary to look at the context in which those transactions take place. In the case of Morgan Grenfell Ltd v Welwyn Hatfield District Council (1995 1 All ER 1) the local authority entered into interest rate swaps with another local authority facilitated by Morgan Grenfell. One of the preliminary points in the case considered by the courts was whether or not the interest rate swaps were a gaming or wagering contract. The court held that in the context of interest rate swaps, for contracts entered into by parties or institutions involved in the capital market and the making or receiving of loans, the normal inference would be that such contracts were not gaming or wagering but were commercial or financial transactions.

It is therefore possible for a derivative contract entered into by a company to be part of the company’s trading activities, if it is entered into to hedge exposure to risk in a commercial or financial transaction. See also CFM13580.

When all the facts have been gathered in a particular case it should be possible to conclude whether or not there is a trade. However any cases of doubt or difficulty ,which cannot be resolved locally should be referred to Business Tax (Technical).