There’s a saying that many sharemarket investors may have already heard: Don’t let the tax tail wag the investment dog. In other words, the best advice for your share portfolio is to base your decisions on investment merit, not on trying to save tax.

Even so, there are taxation consequences for everyone with an investment portfolio, so when a “grass is greener” tax option seems possible, it can be very tempting to chase after it.

Where a share trader has an advantage is that they are afforded the ability to deduct any share losses from assessable income — an immediate benefit not available to the passive share investor.

In times of better financial fortune, both trader and investor may enjoy occasional income-boosting dividends. But in a cooling economy the passive equities investor may find that selling shares results in a capital loss. This can only be offset against a capital gain, not against income, although if there is no capital gain in the current income year, the loss can be carried forward and used later.

The ability to deduct losses against other income sources would appear inviting to the passive investor. The trouble is, the tax treatment in these circumstances is one of those “either-or” situations. An investor who attempts to access better tax treatment when the economy cools down by claiming status as a share trader (without any discernible change in their pattern of buying and selling shares) will raise a big red flag for the taxman.

What the Tax Office looks for

The Tax Office’s definition of a share trader is someone who undertakes “business activities for the purpose of earning income from buying and selling shares”.

Relevant issues in determining the tax status of a taxpayer include the use or not of trading systems, the volume of transactions, the existence of a business plan, a profit motive, and records being kept in a “business-like manner”.

The Tax Office says that it will keep an active eye on people who “re-characterise” their activities from being a share investor to a share trader. Typically, it says, the people with that red flag hanging over their names will have claimed a CGT discount in previous returns but, now realising losses, want to be able to claim an immediate deduction on revenue account.

This is not to say that such a thing is impossible; provided that a bona fide business of share trading is being conducted. Many passive share investors may have indeed found some financial success from their forays into the sharemarket and begin to conduct a share trading business alongside other activities. But the Tax Office warns that it is carefully scrutinising these sort of claims to make sure they are a genuine business activity.

Whether or not a taxpayer is carrying on a business of share trading will always be determined on the basis of individual facts and circumstances, however important factors will typically include:

• the volume and repetition of transactions
• the professionalism the taxpayer displays in carrying out the activities (planning, strategies, record keeping, etc)
• the application of significant capital to the activity, and
• a discernible profit intent.

An important consideration for the Tax Office is the “intention” of the:

• investor (that is, to hold the shares for long-term capital growth and then sell to realise that growth), and
• the intention of the trader (that is, to buy and sell the shares purely for short-term profits),

and how these intentions can be evidenced down the track when it comes time to sell. This evidence of intention may include the factors mentioned above.

Implications of your tax status

The tax treatment of transactions entered into by share investors and share traders is quite different.

In the case of a share investor:

• the cost of buying shares is not an allowable deduction – it is a capital cost
• receipts from the sale of shares are not assessable income – however, any capital gain on disposal will be included in assessable income – the 50% general discount for individual investors may also be available for shares held for at least 12 months
• a net loss from the sale of shares may not be offset against income from other sources, but may be carried forward to offset against future capital gains
• costs incurred in buying or selling shares are not an allowable deduction in the year in which they are incurred, but are taken into account for capital gains calculations
• dividends are included in assessable income (including any franking credits)
• franking credits are offset against tax payable and may be refundable in certain circumstances
• costs incurred in earning dividend income – such as interest on borrowed money – are an allowable deduction.

For a share trader:

• receipts from the sale of shares are dealt with as income
• costs incurred in buying or selling shares are an allowable deduction in the year in which they are incurred
• dividends and other similar receipts are included in assessable income (including any franking credits).
• shares on hand at year-end are regarded as trading stock and therefore must be brought to account at either cost, market selling value, or replacement value (which enables unrealised losses to be deducted where, for example, market value at year-end is less than original cost)

A taxpayer may be characterised as an investor for particular parcels of shares and as a trader for other parcels of shares. So even if they are carrying out a bona fide business of trading in relation to most of the share portfolio, if they have been treating one parcel of shares as a long-term investment (no trading, no routine research and monitoring, no frequent records of market movements) then the expectation from the Tax Office will be that this parcel of shares should be taxed as an investment asset when sold.

Conversely, a capital investor who spies a great opportunity and buys and sells one specific parcel of shares with a definite profit motive should be taxed as a trader in relation to that parcel of shares but as an investor in relation to all other shares.

In all situations, taxpayers should seek to maximise the material available which evidences their intentions when shares are acquired. See this office if you require further information on whether you are a share investor or share trader.