Edited version of private ruling

Authorisation Number: 1011619780143

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Ruling

Subject: Capital v Income - International Shares

Questions

1. Are profits that the trust receives on selling its stock taxed as a capital gain and not as assessable income?

Yes. The profits will be treated as a capital gain.

2. Are profits that the trust receives from selling covered calls on its stock taxed as a capital gain and not as assessable income?

Yes.

Relevant facts and circumstances

The trustee does not hold formal qualifications in finance or accounting but has completed courses in several subjects including economics and valuations.

The trustee operates the trading investment from his home and the amount of time spent on actual trading is minimal, being no more than 2 hours per week, this alone would clearly lead one to think that the trustee is not a share trader. The investment varies from month to month and in most cases would be less than $5,000.

The trustee does not maintain any accounting records of trades completed as the trust is reliant on a broker to maintain records. Also at the end of each financial year a tax accountant prepares the tax returns for the trust.

You do not buy and sell shares for profit but buy them to hold as long-term investments. You do not buy options with the intention of selling them at a profit and therefore do not regard yourself as an options trader in that sense.

However, to gain extra return from some of your shares in your investment portfolio, you write call options, using your shares as collateral.

The shares that you use as collateral are investment shares enabling the purchaser of the call option to be able to trade the option in the market place.

Relevant legislative provisions

Income Tax Assessment Act 1997 (ITAA 1997) Section 108-5

Income Tax Assessment Act 1997 (ITAA 1997) Section 115-25

Income Tax Assessment Act 1997 (ITAA 1997) Section 118-25

Income Tax Assessment Act 1997 (ITAA 1997) Section 70-10

Question 1

Detailed reasoning

The difference between CGT assets and trading stock

Section 108-5 of the Income Tax Assessment Act 1997 (ITAA 1997) is about capital gains tax (CGT) assets. It defines a CGT asset as any kind of property or a legal or equitable right that is not property.

Examples of CGT assets listed in section 108-5 of the ITAA 1997 are land and buildings; shares in a company and units in a unit trust; options; debts owed to you; a right to enforce a contractual obligation; and foreign currency.

Section 115-25 of the ITAA 1997 is about discount capital gains. It states to be a discount capital gain, the capital gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least twelve months before the CGT event.

Section 118-25 of the ITAA 1997 is about trading stock. It states a capital gain or capital loss you make from a CGT asset is disregarded if, at the time of the CGT event, the asset is your trading stock.

Section 70-10 of the ITAA 1997 is also about trading stock. It defines trading stock as including anything produced, manufactured or acquired that is held for the purpose of manufacture, sale or exchange in the ordinary course of business.

As such, when a taxpayer is a share market investor, their shares are CGT assets and they may avail themselves of the discount capital gains if they have held their shares for at least twelve months.

To the contrary, when a taxpayer is carrying on a business of share market trading, their shares are trading stock and they cannot avail themselves of the discount capital gains. This is because section 118-25 of the ITAA 1997 states a capital gain or capital loss made from a CGT asset is disregarded if, at the time of the CGT event, the asset is trading stock.

The difference between a share market investor and a share market business

The distinction between a share market investor and carrying on a business of share market trading has been established in the body of law through many court cases.

In AAT Case 6297 (1990) 21 ATR 3747; (1990) 90 ATC 621, the following criteria were established particularly in respect of share traders:

(a) repetition and regularity in the buying and selling of shares;

(b) turnover;

(c) whether the taxpayer is operating to a plan, setting budgets and targets, keeping records;

(d) maintenance of an office;

(e) accounting for the share transactions on a gross receipts basis;

(f) whether the taxpayer is engaged in another full-time profession.

An example of a court case is AAT Case 4847 (1988) 20 ATR 3182; (1988) 89 ATC 171. Here, a taxpayer purchased twenty parcels of shares between April 1986 and February 1987. All the shares were sold between September 1986 and April 1987.

No share was held for more than five months.

The AAT ruled the shares were purchased as trading stock in the carrying on of a business because the shares were bought and sold repeatedly with a view to making a profit and because all shares were sold within a year of acquisition.

Another example is the case of Shields v. Deputy Commissioner of Taxation (Cth); Case [1999] AATA 4 (1999) 41 ATR 1042; (1999) 99 ATC 2037. Here, during the period from 6 February 1996 to 4 March 1996, the taxpayer bought shares in Australian banks which were about to pay franked dividends for cum dividend prices and sold shares in the same banks at their ex dividend prices.

Applying the factors listed in AAT Case 6297, even though the activity was for a short time only, the AAT decided the taxpayer was carrying on a business because of the volume of transactions and because the transactions were so carefully and systematically organised and handled.

In contrast to the cases above is the Federal Court case of Federal Commissioner of Taxation v. Radnor Pty Ltd (1991) 102 ALR 187; (1991) 22 ATR 344; (1991) 91 ATC 4689. Here, the taxpayer was held not to be carrying on a business of share trading because there was no pattern of buying and selling and a low volume and frequency of transactions. At 91 ATC 4702, the emphasis upon a pattern of buying and selling and the distinction between trading and investment activity was summed up as follows:

The sale in question, referred to as having been one made by the manager, hardly seems to be an act of trading. The stock itself was not speculative, nor can one see a pattern of buying and selling as suggested.

Ultimately, the question whether the respondent was carrying on a business of dealing in shares is a question of fact and degree, a question of impression.

In this case the trustee does not hold formal qualifications in finance or accounting but has completed courses in several subjects including economics and valuations.

The trustee operates the trading investment from his home and the amount of time spent on actual trading is minimal, being no more than 2 hours per week, this alone would clearly lead one to think that the trustee is not a share trader. The investment varies from month to month and in most cases would be less than $5,000.

The trustee does not maintain any accounting records of trades completed as the trust is reliant on a broker to maintain records. Also at the end of each financial year a tax accountant prepares the tax returns for the trust.

In my view this case falls on that side of the line where the activity of the taxpayer can be seen, not as involving the carrying on of a business of dealing in shares, but rather of investing in shares.

ATO carrying on a business of share trading fact sheet

Based on the above principles established in the body of law, the Tax Office has prepared the facts sheet called Carrying on a business of share trading. This facts sheet, available on the ATO website at www.ato.gov.au provides the following example:

Molly is an electrical engineer. After seeing a television program, Molly decides to become involved in share trading activities.

Molly sets up an office in one of the rooms in her house. She has a computer and access to the internet.

Molly has $100,000 of her own funds available to purchase shares and, in addition, she has access to a $50,000 borrowing facility through her bank.

Molly conducts daily analysis and assessment of developments in equity markets. The resources she uses include financial newspapers, investment magazines and stock market reports.

Molly's objective is to identify stocks that will increase in value in the short term to enable her to sell at a profit after holding them for a brief period.

In the year ended 30 June 2001, Molly conducted 60 share transactions: 35 buying and 25 selling. The average buying transaction involved 500 shares and the average cost was $1,000. The average selling transaction involved 750 shares and the average selling price was $1,800. All the transactions were conducted through stock broking facilities on the internet. The average time that Molly held shares before selling them was twelve weeks. Molly's activities resulted in a loss of $5,000 after expenses.

Molly's activities show all the factors that would be expected from a person carrying on a business. Her share trading operation demonstrates a profit making intention even though a loss has resulted. Molly's activities are regular and repetitive, and they are organised in a business-like manner. The volume of shares turned over is high and Molly has injected a large amount of capital into the operation.

Conclusion

In this case, the trust is not carrying on a business of share market trading because the trust's activity did not involve regular and repetitive buying or selling. The method was and remains to hold an investment for over long periods.

Therefore the shares are not considered trading stock; subsequently any profit from the sale of shares gained by the trust is assessed as a capital gain under Division 102 of Part 3-1 of the Income Tax Assessment Act 1997

Question 2:

Detailed reasoning

The act of investing in shares and that of investing in options is fairly similar in nature. Therefore, it is considered appropriate to apply the principles of determining whether someone is a share trader or investor to a person to determine if they are an options trader or investor.

What is "carrying on a business" of share trading?

A "business" includes "any profession, trade, employment, vocation or calling, but does not include occupation as an employee" (subsection 995-1(1) of the ITAA 1997). This would include a business of share-trading.

In FCT v Radnor Pty Ltd (1991) 22 ATR 344; 91 ATC 4689 Hill J stated at 359:

Ultimately, the question of whether the respondent was carrying on a business of dealing in shares is a question of fact and degree, a question of impression. (Emphasis added)

The question of whether a person is a share-trader or a share-holder is to be determined in each individual case, taking into account the factors considered in Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261:

· the nature of the activities, particularly whether they have the purpose of profit making;

· the repetition and regularity of the activities;

· organisation in a business like manner, the keeping of books records and the use of a system;

· the volume of the operations; and

· the amount of capital employed.

The importance of these factors will vary depending on the nature of the activities carried out by the taxpayer, and the nature of the industry in which the taxpayer operates.

Nature of activity

In many cases it may be clear that a business is being carried on because of the type of activity, or because of the type of property being traded.

This question may be less clear in the case of share-trading than in many industries. The question is whether a taxpayer's activities may be characterised as those of a share-trader with an active turnover of shares and the intention to make profit from sales, or a passive investor with an intention to earn income from the shares.

In your case, you do not buy and sell shares for profit but buy them to hold as long-term investments. You do not buy options with the intention of selling them at a profit and therefore do not regard yourself as an options trader in that sense.

However, to gain extra return from some of your shares in your investment portfolio, you write call options, using your shares as collateral.

The shares that you use as collateral are investment shares enabling the purchaser of the call option to be able to trade the option in the market place.

Profit motive

The intention to make a profit is not, on its own, sufficient to establish that a business is being carried on. Shares may be held for either investment and trading purposes and profits on sale are earned in either case. A person who invests in shares as a share-holder (rather than a share-trader) does so with the intention of earning income, but is not carrying on business activities.

It is necessary to consider not only a taxpayer's subjective intention to make a profit, but also the objective facts of the case. This includes evidence of how the activity has actually been carried out, or evidence (e.g. a specific plan) of how the activities will be conducted.

Such a plan might, for example, show:

· an analysis of each potential investment;

· analysis of the current market and various segments of the market;

· research to show when or where a profit may arise;

· the basis of decisions by the taxpayer as to when to hold or to sell shares

Profit making intention cannot be considered in isolation. In the majority of situations, the intention to make a profit is paramount. In your application for a private ruling, you state that the trust has written call options to gain extra return from some of the shares in the investment portfolio and that it is your intention to gain a regular inflow of cash from writing the call options.

Although it is your intention is to make profit, this factor alone does not determine that you are a share trader.

Repetition and regularity of activity

An intention to engage in trade regularly, routinely and systematically is a significant characteristic when considering if someone is a share trader. In FCT v Radnor Pty Ltd (1991) 22 ATR 344, a trader was not held to be carrying on a business of share trading, primarily because there was no pattern of buying and selling and the low volume and frequency of transactions that were made.

The trust writes call options on shares that you will hold. You will look at writing the options a few times a year if you consider that conditions are suitable.

For a commercial options trader, this number is quite low. Although it is your intention to write options a few times a year, at present it cannot be said that you are trading on a routine, systematic or regular basis.

This factor indicates that you are a share/options investor rather than a share/options trader.

Business-like manner & Keeping Records

Generally, most businesses have some form of forward planning to take account of contingencies and market fluctuations, as well as setting profit targets, budgets, periodic financial reviews, record keeping systems, an appropriate office and so forth.

It would be reasonable to expect a share trading business to involve study of daily and longer-term trends, analysis of a company's prospectus and annual reports, and the seeking of advice from experts.

In Case X86 90 ATC 621, in which the taxpayer was found not to be carrying on a business of share-trading, the taxpayer sought advice and consulted relevant newspapers, but did not operate to any particular plan apart from his goal of maximising profits.

Any qualifications, expertise, training, or skills which a taxpayer may have in this area would be relevant to determining whether business activities were being carried on.

If records of purchases and sales of shares were not kept, it would be more difficult for a taxpayer to establish that a business of share-trading was being carried on.

However, the fact that records of purchases and sales are kept would, in itself, lend little support to the question of whether a taxpayer was carrying on of a business of share-trading, given that the taxpayer would be required to keep the same records for capital gains tax (CGT) purposes if the shares were held as an investment.

You do not have any formal qualifications in this field but you have educated yourself and you are gaining experience by actually writing options.

You use the services of a broker and operate from your home and only spend a few hours per month on the activity.

Your self-education and putting your knowledge into practice suggest that you are a passive investor and not actively carrying on a business.

As such, we do not consider that you carry out significant market research which would be expected of an options trader and it cannot be said that you use a complex approach for your trading activity. The lack of formal accounting records suggests that you are more likely a share investor.

Volume of operation & amount of capital injected

The amount of capital injected is not, on its own, considered to be a crucial factor in determining whether a person is carrying on a business of share-trading. This is an area in which it is possible to carry out business activities with a relatively small amount of capital.

It is also an area in which a taxpayer might invest a substantial amount of capital, without being in a business of share-trading. The larger the amount of capital that is invested, the more likely it is that the person is carrying on a business.

For example, in Case X86 90 ATC 621 the taxpayer invested $100,000 and was not considered to be carrying on a business, whilst in Case W8 89 ATC 171 the taxpayer invested approximately $1,300 and was held to be carrying on a business.

In this case the volumes of to trade are minimal compared to that of a commercial options trader. In our view the share trading falls on that side of the line where the activity of the taxpayer can be seen, not as involving the carrying on of a business of dealing in shares, but rather of investing in shares

Note: The trustee has confirmed that the trust accountant is aware of the CGT concessions available to small business and trusts.

Conclusion

After considering the above factors and your particular circumstances, we conclude that you are not carrying on a business of share/option trading by writing call options and we regard you as a share/options investor.

Therefore the net profits from options trading are to be accounted for as capital gains under Division 102 of Part 3-1 of the ITAA 1997.

Please note that being a share/options trader or investor is a status that can change over time as your level of activity changes. Therefore you should evaluate your level of activity on a regular basis to see whether or not you continue to be an options investor.

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