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Ruling

Subject: Income and deductions; Carrying on a business; Isolated transactions

Question 1

Will the gain made from the sale of Securities be included in the taxpayer's taxable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) for the income year ended 30 June 2010?

Answer

Yes, as the taxpayer was carrying on a business during that income year.

Question 2

Will the losses made from the sale of Securities be deductible from the taxpayer's taxable income under section 8-1 of the ITAA 1997 for the income year ended 30 June 2010?

Answer

Yes, as the taxpayer was carrying on a business during that income year.

This ruling applies for the following period

Income year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts and circumstances

The taxpayer has been involved in the finance industry for a significant number of years and is well versed in the financial markets.

The taxpayer's background is predominantly in the area of finance and investments.

In the taxpayer's extensive experience, the taxpayer :

· was employed by a major bank for a number of years where they started the equity derivatives function and listing the first warrants on the ASX;

· moved to another major bank and established the equity derivatives and trading business. Within a few years, making them a market leader in equity derivatives;

· established a retail margin lending business, distributing through advisers and directly to clients;

· started Company 1 in 199X, a private investment manager specialising in Australian and offshore equities and derivatives, which is now recognised as providing highly innovative and unique investment solutions to high net worth individuals and retail investors; and

· started Company 2 in 20XX, which is formed to bring high value, unique or difficult to access investment opportunities to individual wholesale investors and self-managed super funds using an individually managed account structure.

The taxpayer's current employment is full-time as managing director and as the founder of the business, requires a substantial devotion of time and effort far beyond that of a standard working week. The taxpayer does not have substantial time to devote to activities outside of employment.

During the year in question, the taxpayer entered into transactions, which for the purpose of this ruling application will be called Securities, involving the following:

· Direct equities (shares);

· Options to acquire shares (call options);

· Options to dispose of shares (put options); and

· Commodities including: Foreign Currency, Indexed Futures and Contracts for Difference (CFDs)

Over the course of the year, the taxpayer entered into Securities transactions for the purpose of taking both long positions (where a gain would be realised if the Securities increase in value) and short positions (where a gain would be realised if the Securities decrease in value),

All transactions were entered into with the purpose of closing out the Securities Transaction within a short period of time, thus deriving a profit.

The Securities (that are subject to this ruling) were not acquired for the purpose of deriving an ongoing income stream or for long term capital gains.

The taxpayer did not apply any set methodology or pattern in undertaking the Securities transactions. Instead, the taxpayer's Securities transactions were determined on the basis of whether the taxpayer:

· had a personal interest in particular classes of Securities at the time;

· had time available (having regard to his full time role at Company 2); and

· saw an opportunity in the market that he wished to take.

Because of the inherently subjective way that the taxpayer was operating, there was no consistent pattern to the taxpayer's Securities transactions during the year in question.

During periods of inactivity, the taxpayer would not continue to hold any Securities and the taxpayer was not 'in the market'.

The taxpayer had several accounts that they operated for their Securities transactions. The taxpayer made significant numbers of transaction, which valued in millions.

On review of the transactions for each account, only one month of the year was inactive.

The Securities transactions were funded from the taxpayer's accumulated wealth and borrowed funds.

At any point in time, the taxpayer had substantial amount of funds exposed to the market in a manner whereby it could be lost if the various Securities transactions trended in the wrong direction.

The taxpayer acquired and disposed of Securities through the platform of his Company 1, which provided the facility to undertake the Securities transactions. The Securities transactions records and register is administered within the Company 1's system.

The taxpayer did not have a budget, business plan or any similar document that determined the way in which they would enter into the Securities transactions. Rather, the taxpayer's methodology was to wait until they identified opportunities within a select number of securities, at which time they would enter into the relevant transaction.

The amount to be committed at the time of entering into a transaction was determined based on the taxpayer's feel for the transaction, taking into account his experience and knowledge of markets.

The taxpayer's Securities transactions were originally recorded in the business item of his individual tax return in the 2010 income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Receipts from share trading activities would be assessable as ordinary income under section 6-5 of the ITAA 1997 and expenses would be deductible under section 8-1 of the ITAA 1997 if the activities were from carrying on a business as a share trader.

Profits from an isolated commercial transaction would be assessable under section 6-5 of the ITAA 1997 and losses from an isolated commercial transaction would be deductible under section 8-1 of the ITAA 1997.

Carrying on a business

Whether the trading activities of a taxpayer amount to the carrying on a business depends on the facts. 'Business' is defined in section 995-1 of the ITAA 1997 as 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

Whilst the existence of a business or otherwise is a question of fact, a number of factors/indicators have emerged from case law, which are considered relevant to this question.

In Federal Commissioner of Taxation v. Radnor Pty Ltd (1991) 102 ALR 187; (1991) 22 ATR 344; (1991) 91 ATC 4689 (Radnor's Case), Hill J stated:

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

There has been much judicial comment as to what is meant by the phrase 'carrying on a business'. However, the difficulties associated with the question are probably best summed up by the following comments in Martin v. Federal Commissioner of Taxation (1953) 90 CLR 470; (1953) 10 ATD 226; (1953) 5 AITR 548:

The test is both subjective and objective; it is made by regarding the nature and extent of the activities under review, as well as the purpose of the individual engaging in them and a determination is eventually based on the large and general impression gained.

Taxation Ruling TR 97/11 provides an outline of the factors, which are often referred to as business indicators.

In Case X86 90 ATC 621; AAT Case 6297 (1990) ATR 3747 (Case X86), the 'business indicators' were consolidated and applied to reach a decision on the facts. The business indicators were subsequently applied in Shields v. Deputy Commissioner of Taxation (Cth); Case [1999] AATA 4 (1999) 41 ATR 1042; (1999) 99 ATC 2037 (Shield's case)  Block J said:

The question is essentially one of fact. In deciding this issue the case law has established the following factors as generally relevant considerations:

(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; and

(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 share transactions on a gross receipts basis; and

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

To appreciate the implications of these criteria, it is necessary to briefly look at some of the more relevant cases.

In Case W8 89 ATC 171; AAT Case 4847 (1988) 20 ATR 3182 (Case W8), a trainee accountant purchased 21 parcels of shares between April 1986 and February 1987. All the shares were sold between September 1986 and April 1987, no share having been held for more than five months. A small loss made on four parcels was claimed as a deduction under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936). The Administrative Appeals Tribunal (AAT) held that the shares were purchased as trading stock during the 1987 year within the meaning of section 28 and 160L(3) of the ITAA 1936. As the shares were bought and sold repeatedly with a view to making a profit and all shares were sold within a year of acquisition, the person was in the business of share dealing.

In contrast to this decision, Case X86 disallowed losses under subsection 51(1) on two parcels of shares sold after the 1987 stock market crash. Instead, the losses were quarantined under the capital gains provisions of the ITAA 1936. It was found that the taxpayer lacked a sophisticated share trading technique, a business plan, market research in the shares invested, and a contingency plan in a falling market or a large number of transactions. The taxpayer's activities did not exhibit a system of operation of a business in share trading. The taxpayer had limited contact with the share market, which he entered for the purpose of making quick profits by generally buying and selling speculative mining shares. The taxpayer was not engaged in a business of share trading but rather he was a speculator in the share market. The taxpayer was unable to satisfy the AAT that he had established a proper pattern of trading in shares. The share trading was not done in a regular, routine and systematic manner. This was despite arguments that he traded in speculative shares, received regular advice from his accountant, had discussions with his stockbroker, and there was a continuity of business, the aim of which was to make a profit.

In conclusion, both these cases demonstrate that a share trader may be seen as one whose dealings are part of a more extensive business of buying and selling shares where transactions have the character of a continuing business enterprise. In contrast, a speculator makes individual forays in particular stock with a view to resale. The difference may be determined by the following two-stage test:

(a) Is there a discernible pattern of trading in shares?

(b) If not, is there an evident intention to trade regularly, routinely and systematically?

The intention of the taxpayer is determined by an objective consideration of the facts and the circumstances of the case.

(a) The Nature of the Activities and Profit Making Intention

This question refers to 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 dividends.

The intention to make a profit is not, of itself, sufficient to establish that a business is being carried on. Shares may be held for either investment or trading purposes, and profits on sale are earned in either case.

It is necessary to consider evidence of how the activity has actually been carried out, or evidence on how the activities will be conducted.

In this case, the taxpayer states that their aim is to make a profit from their Securities transactions. According to the information provided, the taxpayer has undertaken a significant number of transactions (both buying and selling) in the income year ended 30 June 2010.

In addition, the applicant's claim that the taxpayer's primary objective during the 2010 income year was to operate Company 2 appears to be at odds with the facts provided, which were that Company 2 was not started until 20XX.

(b) The Complexity and Magnitude of the Undertaking

Whilst the existence (or otherwise) of a structured business plan or program is not determinative such existence is a clear indicator that the taxpayer intends to proceed on a long term project and has established very clear goals and aim of the activity.

The taxpayer does not have a budget, business plan or any similar document that determined the way in which he would enter into the Securities transactions. The Securities transactions are funded from the taxpayer's accumulated wealth and borrowed funds. The borrowed funds allow him to maximise the potential profits realised from the Securities transactions.

The taxpayer acquired and disposed of Securities through Company 1's platform, which provided the facility to undertake the Securities transactions. The taxpayer makes no accounting for the Securities transaction. Instead, they use the record of the Securities transactions and register of current Securities holdings administered within Company 1's system.

In the 2009-10 income year, the taxpayer's Securities accounts amounted to several millions and they made a significant number of buy and sell transactions. We consider this to be large given the number of trades and the amount of capital involved.

It is also noted that in Mehta v Federal Commissioner of Taxation [2012] AATA 208; 2012 ATC 10-246, a case involving a considerably lower number of trades during the relevant period, the taxpayer's activities in share trading were held to amount to carrying on a business.

(c) The Repetition and Regularity of the Activities

Repetition is a significant characteristic of business activities. Repetition refers to the frequency of transactions, or the number of similar transactions.

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 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.

In Shields case, 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 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 contrast is Radnor's case. 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.

In this case, it is considered that the taxpayer was carrying on a business. The taxpayer made a significant number of buy and sell Securities transactions in the income year 2009-10. The taxpayer stated that he intended to buy and sell the Securities on a short term basis. The taxpayer fulfilled the most salient indicator, namely, repetition and regularity in the buying and selling of Securities. Further, the taxpayer has a significant background in the financial markets and their employment is in the field of advising and guiding investors in the financial market. The taxpayer's experience of the financial market guides them in his activity with the specific intention of buying and selling Securities over the short term.

(d) Organisation in a business-like manner, the keeping of books, records and the use of a system

Generally, it can be said that most businesses have some form of forward planning to take account of contingencies and market fluctuations. They would also set profit targets, budgets, have periodic financial reviews, record keeping systems, an appropriate office and so forth. It would be reasonable to expect such a business to involve the study of daily and longer term trends, analysis of company's prospectus and annual reports, and seeking the advice of experts. According to Case X86, this means having or operating on a particular plan with the main goal of maximising profits.

In this case, the taxpayer acquired and disposed of Securities through Company 1's platform. As the founder and director of this company, they was able to use their system to administer their transactions and register the Securities. As their employment is in the field of advising investors in the financial market, the taxpayer would be aware of how the market is travelling to be able to make the appropriate decisions as to buying and selling Securities. Accordingly, it is considered that the taxpayer operated in a business-like manner with a considerable degree of sophistication.

(e) Profit/Loss Arising from Discernible Pattern of Trading

The taxpayer advises that they do not apply a set methodology or pattern in undertaking the Securities transactions. Instead, the transactions were determined on the basis of whether they had a personal interest in particular classes of Securities at the time, had time available from their employment and if they saw an opportunity in the market that they wished to take.

According to the information provided regarding the taxpayer's Securities transactions, the large number of transactions made in the year in question show a discernible pattern of trading.

(f) The Volume of Operations and the Amount of Capital Employed

The higher the volume of purchases and sales, the more likely it is that the taxpayer would be regarded as being in business.

In Case W8, the taxpayer made a small profit on buying and selling shares. He sold 21 parcels of shares, 17 of which generated a net profit of almost $4,500; the other four sales resulted in losses of $325. All shares were sold within 5 months of purchase. The Tribunal found that the activities constituted a business of share trading.

The amount of capital employed in the activity is not a determinative factor and must be considered in line with the other factors. An example is provided in Case X86 where the taxpayer invested $100,000 and was not found to be carrying on a business, whilst in Case W8, the taxpayer invested $1,300 and was found to be carrying on a business. However, the larger the amount of capital that is invested, the more likely it is that the person is carrying on a business.

In this case, the taxpayer states that at any point in time, a substantial amount is exposed to the market in a manner whereby it could be lost if the various Securities transactions trended in the wrong direction. The amount of capital exposed to the market represented 1 to 2% of the taxpayer's wealth.

It is accepted that the amounts of funds invested and subsequently traded were sufficient to demonstrate this indicator

Conclusion on whether a business

Based on all the relevant factors it is considered that the taxpayer was carrying on a business of Securities trading during the 2010 income year. The taxpayer's trading activities had the following characteristics of a business:

· there was evidence of a profit-making purpose and appropriate records were kept;

· the activities were conducted in a business-like manner using the taxpayer's extensive experience of the financial market;

· the volume of buy and sell transactions was large in view of the number of transactions and the amount of capital involved; and

· the Securities were held for short term gain and not for the purposes of receiving dividend income.

The Commissioner considers that the taxpayer has established a pattern of making Securities transactions. The facts show that the transactions were done in a regular, routine and systematic manner. The taxpayer's extensive knowledge and experience in the financial market and their employment in the same field gave them an advantage in determining which Securities would provide the best chance for profits.

Isolated Transactions: Profit or Loss

Taxation Ruling TR 92/3 states the Commissioner of Taxation's view on whether profits on isolated transactions are assessable income. Taxation Ruling TR 92/4 details whether losses on isolated transactions are deductible.

TR 92/3 and TR 92/4 are intended to be read together and the principles outlined in TR 92/3 apply to the taxpayer that has made a loss, instead of a profit, from the transaction or operation.

An 'isolated transaction' is defined as those transactions outside the ordinary course of business of a taxpayer carrying on a business and those transactions entered into by non-business taxpayers.

TR 92/3 represents the Commissioner's application of the High Court's decision in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693 (Myer Case).

As is stated at paragraph 4 of TR 92/4, a loss from an isolated transaction will be deductible when both of the following are present:

· the intention or purpose of entering into the transaction was to make a profit or gain; and

· the transaction was entered into and the loss was made, in the course of carrying out a business operation or commercial transaction.

The intention of the taxpayer is determined by an objective consideration of the facts and circumstances of the case. Profit-making does not need to be the sole or dominant purpose for entering the transaction, but must be a significant purpose. The purpose must exist at the time the transaction or operation was entered into.

A transaction may be characterised as a business operation or commercial transaction if the transaction is business or commercial in character.

Paragraph 13 of TR 92/3 lists some of the factors that have evolved from case law that may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction:

· the nature of the entity undertaking the operation or transaction. For example, if the entity is a corporation with substantial assets rather than an individual, this may be an indication that the operation or transaction was commercial in nature;

· the nature and scale of the activities undertaken;

· the amount of money involved in the transaction and the size of the profit that was sought or obtained;

· the nature, scale and complexity of the operation or transaction;

· the manner in which the operation or transaction was carried out. For example, whether professional agents and advisers were used and whether the operation or transaction was in a public market;

· the nature of any connection between the taxpayer and any other party to the operation or transaction. For example, the relationship may suggest that the operation was essentially a family dealing;

· the nature of any property disposed of. For example, if the property has no use other than as a subject of trade, it is easier to infer the transaction was commercial in nature; and

· the timing of the transaction or the various steps involved. For example, if the transaction involves the acquisition and disposal of property, then holding the property for many years may indicate the transaction was not business or commercial in nature.

Application to this situation

As it has been determined that the taxpayer is carrying on a business, the isolated transactions rules will not be applicable to the Securities transactions made in the 2009-10 income year.

Conclusion

Therefore, as the taxpayer was carrying on a business during that income year, receipts from the Securities transactions activities would be assessable as ordinary income under section 6-5 of the ITAA 1997 and expenses would be deductible under section 8-1 of the ITAA 1997. It also stands to reason that the trading stock rules will apply.