BIM20252 – Trade: badges of trade: tax treatment of financial transactions

Financial transactions include the acquisition, holding, dealing with and disposal of financial assets such as shares and bonds, but also include taking synthetic positions in relation to such assets or corresponding indices, or discrete components of them.

In our view, there is no conceptual difference between a ‘real’ and a synthetic financial transaction (for example, buying a share or entering into a derivative contract that replicates the risks and rewards of ownership). We also accept the following propositions:

a) Short positions are conceptually the same as long positions.

Buying a share because you take the view that its price will rise and shorting a share because you think its price will fall are conceptually the same. In simple terms, a view is merely being taken on the direction of movement. It follows that synthetic long and short positions are conceptually the same as one another and the equivalent real transactions.

b) Derivatives that give exposure to part of an asset are conceptually the same as derivatives that give exposure to the whole asset.

A view may be expressed on a bundle of components embedded in an instrument, for example the coupon, liquidity, credit risk and currency of a bond, or alternatively a view may be expressed on one or a combination of these components. There is no conceptual difference between taking a view on all components by buying the instrument or entering a derivative contract that replicates ownership, or taking a view on one or a combination of the components via derivatives. There is no conceptual difference between taking a view on the direction of movement (as with simply long and short positions) or taking a view on the magnitude or timing of movements, or other components.

c) Multi-derivative or hybrid strategies should not be unbundled. Given the wide range of situations this principle can apply to, three examples are set out below. These are intended to be illustrative and not a definitive list.

In all cases involving any such “bundling” we would expect there to be evidence that the transactions were executed in pursuit of a clear prior strategy.

(i) Two or more derivatives

Where, for example, the view is that the price will increase but only within a certain band, and the most efficient way to express that single view is via a series of derivative transactions, those transactions should be considered as a whole and not each in isolation.

(ii) A derivative and another financial asset (e.g. shares)

Where the view is that an asset would not be acquired at current value but would be at a set lower value, a put option is written at that lower value, i.e. as a cost efficient method of acquisition. The writing of the option and the potential acquisition of the asset should be considered as a whole and not each in isolation

(iii) A sequential series of similar derivative strategies

A derivative that is close to maturity generally has greater liquidity than a derivative identical in every way, other than having a longer period to maturity. ‘Rolling’ short dated derivative strategies such that there is a sequential series of similar derivatives should be viewed as a whole and not each in isolation.

In our view, taking short positions and using synthetics to express views on all or any of the components of risk associated with an asset or index are not in themselves indicative of trading. All of these approaches may form part of an investment strategy and some of them may constitute investment in themselves.

In our view, financial transactions such as those described in this guidance may constitute either investment, trading, or speculation which, whilst not amounting to investment even on a short-term basis, nevertheless falls short of trading. Where such transactions are undertaken pursuant to an organised strategy, the question may arise in particular cases whether that strategy is consistent with an investment or trading objective. This is always a question of fact to be decided by reference to all of the facts and circumstances of particular cases.

For further guidance on specific circumstances in which financial transactions are taxed as part of a trade, see the Corporate Finance Manual at CFM5301a, the General Insurance Manual at GIM5000+ and Chapter 2 of the Life Assurance Manual.

Outside of such arrangements, short-term transactions in financial instruments that are not integral to a financial trade, such as banking, or not undertaken pursuant to an organised trading strategy, are likely in our view to constitute speculation that amounts to neither investment nor trading.

See also BIM65701.