Trading or Investing: The Badges of Trade
A client of mine asked me recently how can you tell whether a business is a trading business or an investment business? It’ll usually be pretty obvious, but in some cases, it won’t be clear at all. The most important source of tax rules will be the Irish Tax Acts, specifically the Taxes Consolidation Act (TCA) 1997 which covers income tax, corporation tax and capital gains tax (CGT). If a business is deemed to be trading, than the rules of income tax and corporation tax will need to be followed. However, if a business is one of investment, we’re into the area of CGT.
Whilst TCA 1997 is important, when it comes to the issue of whether a business is trading or one of investment the Badges of Trade established in the UK by the Royal Commission in 1955, has been considered persuasive by the Irish Courts ever since. So what are the Badges of Trade? There are six of them in all and each one should be considered by both professional advisers and Revenue in determining how the profits/losses of such a business are to be taxed.
Before we get into them, a quick word on why this is important. If you have a business, we’ll call it Business A, making lots of money and looking at a potentially high income tax or corporation tax liability, you’ll take any opportunity to reduce these taxable profits. One excellent way of doing so is if you have another business that’s losing money, we’ll call this Business B. You can then set the losses of Business B against the profits of Business A and now you’ve got much less tax to pay. If Revenue challenge the nature of the trade of Business B and state their view that Business B is an investment business, then you can’t set the losses in B against the profits in A. The losses in B are now in limbo until you make a capital profit elsewhere or Business B starts making profits.
The classification of whether Business B is a trading or investment business has been the subject of dozens of cases before the Courts over the years in both the UK and Ireland. The reason being that there are often hundreds of thousands of sterling/euro at stake depending on the ultimate outcome. With that in mind let’s look at the first issue which in the subject matter of the trade.
1. The subject matter of the realisation: This is a fancy way of asking what is being sold by the taxpayer? If an item is going to be viewed as trading, it should be capable of being stock in trade. Restaurants buy food and drink as their stock-in-trade and so there is no question they are trading. If a company is buying stocks or investments, we’re more likely talking an investment business.
In the UK case of Salt vs Chamberlain (1979), the taxpayer was selling securities, and made a strong case that he was trading, however the General Commissioners took the view that as the taxpayer was selling items that would be typically considered investments, their view was that this was an investment business. In contrast, also in the UK, Akhtar Ali vs HMRC (The name of the Revenue in the UK), a pharmacist who was also a day trader, was successful in having his day trade business classed as trading as he had met so many criteria of the Badges of Trade. He was therefore allowed to use his losses from day trading against his pharmacy profits. The courts had consistently taken the view that trading in financial investments was to be an investment, but in this case the taxpayer had a busines plan that showed he was trading rather than gambling.
2. The length of period of ownership: This one is a bit more straight forward. If you’re a magic shop and you’re selling balloons that you buy and then resell shortly afterwards, it indicates that you’ve a trading business. If on the other hand, it regularly takes you 6-9 months to sell items that you buy, you’re more likely an investment business. If you’re in the business of buying land and selling it after a few years, it’s pretty clear that you’ve got an investment business.
3. Frequency and number of transactions: if you’re a pub and you’re buying kegs of beer and then restocking a few weeks later, the frequency of similar transactions will indicate you’ve a trading business. The complexity will be where the frequency is much lower. Is an art gallery that restocks every three months, engaged in sufficiently frequent activity that their activity is trading or is it fact an investment business?
No one badge on its own merit is enough to determine the overall position. However, occasionally one factor is particularly strongly suggestive that its trading or investment. If you have a holiday home park that is fully catered with full time staff, you would think that activity is trading. However, if the owners of the park decide to build a one off property and then rent it out, the fact that it’s a one off exercise and unconnected to their other trading activity would, by the principle of frequency and number of transactions, be considered an investment activity. Here you have one trading business and one investment business.
4. Has there been any supplementary work carried on or in connection with the property: Property in this case means the item under consideration to be trading or investment activity. A sandwich shop may be buying bread but it’s also combining this with many other items and selling them separately to customers as sandwiches. This last example is clearly a trading business, partly down to the supplementary work being carried on. Where you would run into more trouble would be an antique shop where little or no work is performed by the business owner after he has acquired the antique. A developer who acquires land and then employs workers and buys materials to convert this land into a housing estate would be considered trading.
If an Irish distributor takes an order from an Irish consumer and purchases the products from China, without doing much more than that, they could be considered under this heading to be operating an investment business. However, he may carry out this activity frequently and never hold the stock for more than a few days. This is an example of the various badges being considered together and I would take the view that such a person is engaged in trading activity rather than investment business.
5. What were the circumstances arising from the activity: Why is the seller carrying out the transaction? Let’s say John inherited a house and is now selling the property because he is under financial pressure to pay for the education of his children who are attending graduate school in Harvard. Given the circumstances I believe its clear that this is not to be considered trading activity. A liquidator may take over a trading business. As the liquidator is appointed to sell the assets of the business and discharge the liabilities, he would probably not be considered to be trading and this was found to be the case in IRC vs Old Bushmills Distillery.
6. What is the profit motive: The final badge deals with the motivation of the seller. If a business is being run to make a profit, it is usually considered evidence of trading activity. The motive of the seller can be gleaned from the circumstances even if this contradicts the seller’s intention. The case of Akhtar Ali vs HMRC should not be expected to be the future position of the Courts in either Ireland or the UK. Trading in financial assets is still likely to be considered as an investment activity.
A business that is really a hobby may not be allowed to reduce other trading profits. S381B and S381C of the TCA 1997, work together to limit any relief from hobby type businesses against the profits of a traders profitable business.
When considering whether a business will be treated as a trading business, all six badges of trade must be considered. This can be a grey area and given the potential impact, where there are any doubts at all, you should consult with a tax adviser. I would welcome any such query on this area or other areas of tax where clarity is required. Please feel free to contact me at [email protected]