Edited version of private ruling

Authorisation Number: 1011632673843

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Ruling

Subject: Share trading and margin loan interest expenses

Questions and Answers:

1. Were you carrying on a business of trading in shares and managed investment products?

No.

2. In the situation (due to ordinary financial obligations) where you have an economic inability to repay your margin loan in full, can you claim ongoing interest deductions in relation to this margin loan that was used for investments which were subsequently sold at a loss?

Yes.

Relevant facts and circumstances

You have a university degree and you are employed as a financial advisor.

For the relevant income years, you held managed investments, which you occasionally bought and sold on a short term basis. However, for the most part, before the onset of the Global Financial Crisis, the majority of your income from these managed investments was earned from dividends and discounted capital gains.

In summary, for the relevant income years, your buying and selling of various managed investments and shares.

To help finance the above mentioned activities, you had a margin loan, a personal loan and, on one occasion, borrowed to meet a margin call.

For the relevant income years, you lodged your own income tax returns, where you returned the above mentioned activities as capital gains and losses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question 1: Were you carrying on a business?

Paragraph 8-1(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are necessarily incurred in carrying on a business for the purpose of producing assessable income, except where the outgoings are of a capital, private or domestic nature.

Where losses are from investment activity, they are generally accounted for under the capital gains tax provisions in Part 3-1 of the ITAA 1997.

Section 995-1 of the ITAA 1997 defines a 'business' to include any profession, trade, employment, vocation or calling but does not include occupation as an employee.

This definition, however, simply states what activities may be included in a business. It does not provide any guidance for determining whether the nature, extent and manner of undertaking those activities amount to the carrying on of a business.

For the purpose of determining whether an activity is the carrying on of a business, it is necessary to turn to the definitions and determinations established in court cases.

In the High Court of Australia case of Hope v. Bathurst City Council (1980) 144 CLR 1; (1980) 29 ALR 577; (1980) 80 ATC 4386; [1980] HCA 16 (Hope), carrying on a business was described in the following ways:

It is the words "carrying on'' which imply the repetition of acts and activities which possess something of a permanent character.

…activities engaged in for the purpose of profit on a continuous and repetitive basis.

Transactions were entered into on a continuous and repetitive basis for the purpose of making a profit…manifested the essential characteristics required of a business.

In respect of share market trading, AAT Case 6297 (1990) 21 ATR 3747; Case X86 90 ATC 621 (AAT Case 6297), listed the following indicators of carrying on a business:

(a) the nature of the activities and whether they have the purpose of profit-making;

(b) the complexity and magnitude of the undertaking;

(c) an intention to engage in trade regularly, routinely or systematically;

(d) operating in a business-like manner and the degree of sophistication involved;

(e) whether any profit or loss is regarded as arising from a discernible pattern of trading;

(f) the volume of the taxpayer's operation and the amount of capital employed by him;

and more 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 occupation.

Whether a taxpayer is carrying on a business of dealing in shares "is a question of fact and degree, a question of impression'' (Federal Commissioner of Taxation v. Radnor Pty Ltd 91 ATC 4689 at 4702; (1991) 102 ALR 187 at 205 per Hill J).

In most legal cases, the greatest weighting is given to the repetition and regularity of the activities, occasionally followed by organisation in a business-like manner as a supportive indicator.

In AAT Case 4847 (1988) 20 ATR 3182; (1988) 89 ATC 171, 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 Tribunal ruled there was 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.

In Shields v. Deputy Commissioner of Taxation (Cth); Case [1999] AATA 4 (1999) 41 ATR 1042; (1999) 99 ATC 2037, 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; Case X86, even though the activity was for a short time only, the Tribunal 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 Damien Patch and Li-anne Grew v. Commissioner of Taxation [2005] AATA 240, the taxpayers undertook twenty-seven buy and thirty-seven sell transactions over a period of three months. Although there was a remarkable lack of sophistication and planning about the trading, the Tribunal concluded, on balance, the taxpayers were carrying on a business. Here, the Tribunal had regard to the amount of capital involved, the repetition and regularity of the activity and the profit making purpose, coupled with the fact the taxpayers had no other real occupation.

In AAT Case 6297; Case X86, one factor contributing to the decision the taxpayer was not carrying on a business was the small number of share transactions. During the relevant income year, only two lots of shares in two different companies were sold (which were part of six lots of shares bought in six companies in the previous income year, of which four lots were disposed of in that previous income year).

In the Federal Court case of Radnor Pty Ltd, it was decided the taxpayer did not carry on a business because there was no pattern of buying and selling of shares. In general, many of the shares in question were held for many years.

In AAT Case 9183, 27 ATR 1168; Case 1/94, 94 ATC 101, whilst accepting the taxpayer's evidence that shares in one company were purchased for resale and the dominant motive was profit making by sale, the primary factor contributing to the decision the taxpayer was not carrying on a business was there was no evidence of any regular, routine or systematic trading in shares. The purchase of any of the shares appeared to have been made on a very spasmodic basis.

A recent Administrative Appeals Tribunal case is that of Smith v. Federal Commissioner of Taxation [2010] AATA 576; 2010 ATC 10-146. The primary reasons in determining the taxpayer was not carrying on a business of share trading were stated as follows:

As to the purpose of profit making...Mr Smith held his shares and securities for longer periods than a trader would generally be expected to, as profit taking would be a primary motive for a share trader's regular buying and selling of stocks. AGL Energy for example, was held for up to 75 months, AMP up to 71 months, Aristocrat Leisure up to 37 months, BHP up to 53 months, Cochlear up to 34 months, Macquarie Airports up to 35 months, Qantas up to 39 months, Telstra up to 39 months, and Westfield Group up to 47 months.

Mr Smith did not use share price charting strategies or techniques as a share trader would. He submitted that for example in relation to Telstra shares, Mr Smith would, had he used such techniques, recognised many months earlier that there was no support for Telstra shares above $4.90, and accordingly sold them far earlier.

I am satisfied from the evidence and submissions that Mr Smith's activities in buying and selling shares did not demonstrate that he did so regularly, routinely or systematically. He did not demonstrate to my satisfaction that there was any plan, and that there was repetition and regularity in the buying and selling of his shares. As noted above, he held shares for longer periods than a trader would, and did not take profits as they arose.

During 2008, his sales appeared to be due to the substantial downturn in values of his shares which occurred due to the economic downturn. Accordingly he gave the impression that he was more of an investor than a trader.

I have come to the conclusion that Mr Smith could not demonstrate to my satisfaction that the nature of his activities had the purpose of profit making. He held his shares for periods longer than a share trader generally would, and took DRPs and dividends. His activities did not demonstrate to my satisfaction repetition and regularity in the buying and selling of shares in order to demonstrate that he was in business (Hope v Bathurst City Council).

I am satisfied that given his background and education, as discussed above, and the fact that he worked as an investment banker, he knew what he was doing in regard to his investments and his shares. I am satisfied that Mr Smith found himself with amounts of disposable income to invest which he had not previously had, and found after he transferred to the BT Margin lending facility on 7 July 2006, and after lodging his 2007 and 2008 returns, and discussions with his accountant, that perhaps he might claim to be in the business of share trading.

I am also mindful that many of the analyses and decisions undertaken in relation to buying and selling shares apply both to investors and share traders. Mr Smith acknowledged this when giving his evidence, stating that many of the indicia upon which he relied to classify himself as a share trader may well also have applied to investors

In your case, for the relevant income years, you were not carrying on a business of trading in shares and managed investment products.

Your activity did not exhibit the primary indicia of carrying on a business of share trading, which is regularity and repetition in the buying and selling of shares on a short term basis.

For the first income year, you bought and sold on a short term basis on four occasions. These four transactions, where each sale occurred on the same day, are far too spasmodic to be considered as forming a business. Further, as the gain from three of these four transactions comprised of 6% of your total year capital gains (of which the vast majority was discounted), these four transactions are merely incidental to what was unambiguously investment activity, centred on receiving discounted capital gains and dividend income.

For the next income year, apart from shares in one company (company X), the vast majority of sales were for managed investments you held for over 12 months. The other three were held for lees than 12 months. As your company X shares were held for Y days and acquired and disposed of subject to a takeover offer, we do not regard this as a sophisticated act of trading. Your profit on company X was negligible, giving the impression you bought with the hope of an increased takeover offer rather than buying to trade company X in an active, ordinary market, subject to ordinary fluctuations.

Also, for this income year, the majority of your investments sold were acquired over a year before the first affects of the sub-prime lending crisis. Your activity did not exhibit short term profit taking when there was the opportunity. To the contrary, your selling primarily occurred in a period of falling markets, starting with the first widespread concerns and major market fall due to the sub-prime lending crisis and the emerging Global Financial Crisis.

For the third income year, your total activity comprised of Z sales. These transactions, occurring in one month, are far too spasmodic and over too small a time frame to be considered as forming a business. The sales were managed investments held from prior to the onset of the sub-prime crisis, which is indicative of investment activity. The other sales, of which three were significant capital outlays, represent your final purchases, which you subsequently sold with your longer term holdings.

There is no evidence to suggest these final purchases were any different to your other investment, that is, non-trading activities. The sale of these final purchases occurred with the sale of your longer term holdings. Altogether, these sales give the impression of unsophisticated sales in falling markets, which is an indicator of investment rather than trading activity. In short, the impression gained is you liquidated your entire portfolio due to falling markets.

Also, whilst not verified as a fact, you held margin loans and may have possibly been subject to forced sales due to margin calls. If this was the case, forced sales from margin calls are not considered to be sophisticated acts of trading.

In addition, whilst not determinative, it is arguable the buying and selling of managed investment products, which generally comprise of a basket of shares and have prices that follow various share market indices, does not have a businesslike character in respect of share trading. Generally, a basket of shares is designed to hedge risk and reduce volatility. It follows, due to reduced volatility, the potential for short term trading profits is more limited for managed investment products in comparison to trading in individual shares, where each individual share can be appraised according to its changing fundamentals or technical attributes. For example, if the price of iron ore rises or falls, this should more significantly affect the price of BHP shares than it would affect the price of a managed investment product that includes the top ten or twenty blue-chip shares (including BHP).

In summary, your case has many similarities to the case of Smith v Federal Commissioner of Taxation [2010] AATA 576; 2010 ATC 10-146 (Smith), in particular where the Tribunal stated:

the...buying and selling shares did not demonstrate that he did so regularly, routinely or systematically.

He did not demonstrate to my satisfaction that there was any plan, and that there was repetition and regularity in the buying and selling of his shares.

…he held shares for longer periods than a trader would, and did not take profits as they arose.

During 2008, his sales appeared to be due to the substantial downturn in values of his shares which occurred due to the economic downturn. Accordingly he gave the impression that he was more of an investor than a trader.

I am satisfied that given his background and education, as discussed above, and the fact that he worked as an investment banker, he knew what he was doing in regard to his investments and his shares.

I am also mindful that many of the analyses and decisions undertaken in relation to buying and selling shares apply both to investors and share traders.

…after lodging his 2007 and 2008 returns, and discussions with his accountant,…perhaps he might claim to be in the business of share trading.

Please note your education and employment do not provide any favourable determinative weight in your case. If fact, your education provide weight against your carrying on of a business.

It was not only observed in the case of Smith that both investors and traders may use analytical knowledge and techniques to appraise their undertakings. The Tribunal also observed it was expected Mr Smith "knew what he was doing in regard to his investments and his shares".

In other words, in apply these observations in Smith to your case, because you were a financial advisor, it is expected you knew what you were doing in respect to the differences between capital and revenue, investing and trading and the manner in which you prepared your income tax returns.

To conclude, both the character of your activity and the manner in which you lodged your tax returns give the impression you did not carry on a business nor intended to carry on a business.

Both the character of your activity and the manner in which you lodged your tax returns give the impression your intention was to avail yourself of dividend income and capital gains tax discounts in the manner of an investor.

Question 2: Interest deductions

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 allows deductions for interest expenses following the cessation of relevant income earning activities when a taxpayer can demonstrate a legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

Regarding the phrase 'economic inability to repay', this means where a taxpayer does not have an excess of funds beyond those required for their basic living expenses. The outstanding loan must have the character of a continuing obligation that is a burdensome legacy of the past.

As examples, TR 2004/4 states where there are sufficient funds held in a bank account that could easily be used to repay the loan principal or where the proceeds from the sale of assets purchased with the loan are used to purchase a leisure yacht, the refusal to repay the loan suggests the loan is being kept on foot for reasons other than the former income earning activities. In such cases, the nexus between the borrowings and the relevant income earning activities will be broken and the relevant interest expenses will not be deductible.

On the other hand, if a taxpayer sells their primary residence and uses the proceeds from the sale to purchase another residence closer to a new place of employment, this would not have the effect of breaking the nexus between the borrowings and the former income earning activities. In such a case, the relevant interest expenses will continue to be deductible.

These guidelines in TR 2004/4 follow the decision in the Full Federal Court case of Federal Commissioner of Taxation v. Jones 2002 ATC 4135; (2002) 49 ATR 188 (Jones). In this case, the taxpayer and her husband had conducted a trucking and equipment hire business in partnership since 1967. In 1992, the taxpayer's husband died. Despite efforts to sell the partnership assets to clear as much debt as possible, the taxpayer was faced with a net debt from an ANZ loan of around $80,000. In 1994, the taxpayer recommenced full time employment as a nurse and used more than half of her after tax salary to repay the loan. In May 1996, the taxpayer refinanced the loan through RAMS to obtain a lower interest rate. After paying out the ANZ loan, the taxpayer owed about $74,000 to RAMS. The Court held the relevant interest expenses were deductible because the taxpayer had no free choice between continuing the loan and repaying it. The failure to repay the loan over the lengthy period since her husband's death was attributable to her financial position and not to any decision to keep the loan on foot for other reasons.

In your case, you purchased managed investments, which provided significant amounts of dividend income. It follows there is a nexus between your current incurring of the interest expenses and the gaining or producing of assessable income.

If your current financial situation creates an economic inability to repay the loan in full, you are eligible to claim deductions for the relevant expenses, as long as this economic inability to repay the loan in full remains.

If you receive or have received discretionary funds, the decision in the case of Jones suggests you should apply such funds to your loan principal. If you do not apply such funds to the loan principal, the nexus between the relevant interest expenses and the former income earning activity may be broken and the relevant interest expense may cease to be deductible.