Strategies for Tax Free Trading

Fed up with the government including themselves as a sleeping partner in your business? Tired of working for the government for nearly half the year? Then you should try tax free trading!

There are a number of situations where tax free trading is possible, and we have only got room to mention some of them here. 


On The Level

We ought to make it quite clear from the outset that what we are not advocating here is the sort of trading that is only enabled to be tax free because you put your cash in your back pocket.  Obviously this is the simplest form of tax mitigation, but unfortunately it also happens to be a criminal offence.  This article, in contrast, is all about how you can save tax legitimately, by playing the game by the rules and winning.

At the end of the day opinions may differ on the morals of tax reduction, but we hope all readers have been taught at their mother's knee not to tell lies, and this is what most tax "evasion" entails.  So, without breaking any of the ten commandments, how can we trade tax free?


Money Grows on Trees

One little exploited device for making tax free profits is the commercial exploitation of woodlands.  This one has a long history behind it, and some of our older readers may remember the time when it was very tax efficient to own woodlands.  Not only could you get tax free profits, but you could also claim "losses" during the years in which the trees were growing and all you had to show on your profit and loss account was expenditure of developing and maintaining the growing crop. 

The way it worked was this.  Woodlands (and indeed, originally, all farming) was within the so called "Schedule B" system which charged the occupier not on any actual income received but on the basis of the "annual value" of the land the trees were growing on.  Because this gave rather strange results in an industry which tended to show no actual income for many years and then a large receipt at the end of the period, when the trees were felled for timber, an alternative treatment, which taxpayers could elect for, was introduced.  This was the so called "Schedule D Election" under which you could claim to have the woodland activity taxed in the normal way as a trade. 

This was a very good idea in the early years, because all you had was expenses which you could claim to offset against your other income and get tax refunds.

This made woodlands a very popular form of investment for high taxpaying individuals such as city traders, merchant bankers, stockbrokers etc, who, after their long and lucrative day in the office would return to their agreeable country houses and prepare their income tax repayment claims on the basis of the woodlands they owned. 

But what of the bitter reckoning when a huge taxable receipt came in through the door?  Simple!  By arranging for the property to be transferred from one name to another, the "Schedule D Election" ceased to have any relevance and the woodlands were back into the benign Schedule B regime.  This is an early example of having your cake and eating it.

Eventually, after this practice had been going on for a great many years, the government got tired of it. Schedule B was abolished and all woodland activity became exempt from tax.  The reason they did this, of course, was to stop people claiming "losses" against their personal tax when there was never going to be any profit to make up to the taxman for the refunds he had been making.

Because woodland profits are exempt from tax, woodland losses are also no longer relievable.

So there you have it, commercial occupation of woodlands is a tax free trade.  For those who are willing to work on a reasonably long time scale, woodlands can be very profitable, and of course if you are allowed to keep 100% of the profit, this effectively nearly doubles the attractiveness of this type of trade as compared with taxable ones. 

One brief word of warning; short rotation coppice, and growing Christmas trees, are not treated as the commercial occupation of woodlands for this purpose.


A Hot Tip

Another type of "business" where the treasury is so concerned about people claiming losses that it exempts both losses and profits is gambling.

This is based on a series of very old cases where the Inland Revenue tried to tax the gambling winnings of certain individuals who went about betting on the horses in a systematic and highly successful way. 

The point was not lost on the judges, though, that the vast majority of us end up on the wrong side of the ledger: otherwise bookmakers would go out of business.  Therefore they nipped in the bud any question of gambling being treated as a taxable activity. 

Gambling, of course, has a bad name, but all kinds of activities which are effectively gambling have more respectable titles.

One of the most popular, currently, is "spread betting" on the internet.  Most service providers will make a clear statement to the effect that profits made from spread betting are free of tax and, unfortunately, the converse is true that losses are non-relievable. 

As far as we are aware, this widespread orthodoxy has not been challenged by the Inland Revenue, and the result is that successful spread betters (and success depends on skill as well as luck) have a nice tax free source of income going.


Share and Derivative Trading

Some of the more jaundiced amongst us may say that there is not much difference, in reality, between dealing in shares and other financial instruments (such as foreign currency contracts) and gambling.
 
However, this is definitely not the sort of area where the Inland Revenue accept that trading can be carried out entirely tax free.

The Inland Revenue's attitude is quite different, and really rather surprising.  Their line is that most individuals who invest in shares are doing so as an investment activity and not a trading activity.

What does this mean?  Well, the distinction between investment and trading is essentially that, where you buy an investment, the main purpose you have in mind is holding it for income, and perhaps long term capital growth.  A person who trades, on the other hand, is buying to make a short term profit. 

Even though an individual may buy and sell shares etc several times a day though, the Inland Revenue still have a presumption that that individual is not trading, instead is liable to capital gains tax on any profits made. 

Well, I suppose that can be quite useful if you are only making profits up to the capital gains tax annual exemption of about £9,600, but for anybody who wants to approach making a living out of share dealing, CGT treatment is not much better than income treatment (i.e. trading). 

And there is one area where trading really scores as against investment treatment for tax.  This is where you have a possibly sizeable portfolio of shares some of which are standing at a loss as against their original cost, and also where you are funding your portfolio (or could be treated as funding it) by way of borrowing.

Let's explain what we mean about the advantages of trading treatment in this situation.  To simplify things down to the bone, let's say you own shares in A plc and B plc.  You bought each holding for £50,000 and you have just sold your shares in A plc for £60,000, realising a £10,000 profit.  B plc have done nothing like so well, and their shares are now standing at £40,000, giving you an unrealised loss of £10,000. 

You have no wish to sell the B plc shares, because you hope that management changes within the company will enable you to recoup your losses when the share price recovers.  If the taxman is treating your investment in A plc and B plc as a capital gains tax matter, you simply have a £10,000 capital gain to pay tax on, with no relief for your unrealised loss on the B plc shares. 

If, on the other hand, your share dealing activity is a trade, accounting rules enable you, effectively, to take relief for the unrealised loss.  The technical reason for this is that, in a share dealing trade, the share portfolio is treated as "trading stock", and accounting rules require trading stock to be shown at the lower of cost and net realisable value.  In other words whilst profits cannot be anticipated before they are realised (i.e. the shares sold) losses can and must be accounted for as they arise, even if they are unrealised.

In today's uncertain stock market climate, therefore, this one sided accounting treatment is quite likely to enable tax to be deferred, perhaps over a long period, particularly if you pick and choose the shares yourself.  You could easily end up with a total share portfolio worth significantly more than you paid for it, but have no tax to pay because of these very handy accounting rules.

The other advantage of share trading as against share investing is that you can claim interest relief against tax for borrowing.

It is probably because of these rules that the Inland Revenue take the approach they do, of needing a lot of convincing that an individual is trading in shares rather than investing in them.  So if you are after this favourable tax treatment, what can you do to make trading status more likely?  Here are a few hints:-

• Buy and sell shares as frequently as you can Hold on to shares for the minimum period you can Specialise (if appropriate) in a particular type of company share or other financial instrument
• Gather evidence that you spend a substantial amount of your time on the activity
• If you are financing your share portfolio by bank borrowing, borrow on a short term basis (such as overdraft) rather than a long term basis like a mortgage loan
• Account for your share dealings as a trade in your annual tax return
  
  
  Tax Free Vehicles
  
  No, this isn't a car , it is a reference to the "wrapper" through which you acquire the shares you are dealing in. In one case an individual who had ISA's (individual savings accounts) worth in excess of £1 million.  This is pretty neat going if you are only allowed to put £7,200 a year into ISA's, and the way this individual achieved it, amongst other things, was by being an expert share trader who used the initially fairly small funds in his ISA to build up a huge portfolio by way of wise investing. 

But the investing doesn't have to be as wise as all that, if you can rely on an entirely tax free environment like an ISA, where capital gains made on selling shares bear no tax, with the result that you have 100% of the proceeds left over to reinvest.

As well as ISA's self invested personal pensions (SIPP's) are a very good way of setting up a tax free environment. 

For one thing, SIPP's can have an awful lot more put into them in one go than ISA's, and the tax rules are being further relaxed, indeed, from 6 April 2008 to enable people to put in over £235,000 a year.  It is also true to say that SIPP's have the immediate advantage of tax relief for the money put in, so that, if, for example, you currently have an endowment policy worth £10,000, by cashing that in and putting it in to the SIPP you get nearly £13,000 relief against your higher rate tax, and the SIPP starts with nearly £13,000 to invest.  This is magicking tax relief out of nowhere by simply shifting where your money is invested.

Of course, you should always remember the quid pro quo for this tax relief on the way in is that most or all of what is in your SIPP is ultimately going to be taxed coming out, when you take the ultimate pension benefits.

In the meantime, though, if your share investment activities are efficient and profitable, escaping tax completely on all of the gains and income on the shares means, because of the effect of compounding, that you are likely to have a huge amount more in the "pot" at the end of the day.  And remember that money in approved pension schemes is outside of your estate for inheritance tax purposes as well. 
 
Again, just one word of warning.  Although we do not think the Inland Revenue take this point, because of their presumption about share investment being just that and not trading in most cases, the exemption from tax which an approved pension scheme gives you is only an exemption from investment income and capital gains, it is not an exemption from trading profits.  So, if you are using a SIPP, you want to avoid falling into the "trading category".  Although this is very easy to do because of the Inland Revenue presumption of investment, somebody who turned over millions of pounds in share sales and purchases each year and spent 24/7 doing it might be treading on rather thin ice!


Trading Offshore

The ultimate form of tax avoidance, of course, is taking your taxable activities outside the territorial scope of the UK Inland Revenue altogether.  But it is not as easy as the bloke in the saloon bar makes out.

Let's say you have a profitable business buying and selling widgets.  You buy them from China and sell them all round the UK and mainland Europe.

The chap in the saloon bar assures you that by doing what he has done, you can avoid all tax on the profits, that is by setting up a company in Guernsey through which all the transactions pass.

Well, we are not saying it doesn't work in that individual's case, but bear in mind that you have three hurdles to get over before this income can be treated as tax free in the UK:-

The profits must not be attributable to a "permanent establishment" in this country.  This phrase can mean anything from an office or a factory to a UK based agent.  If you are one of those businesses whose affairs can be dealt with entirely on the internet, make sure the file server is situated outside the UK (to be on the safe side) and make sure that there is no office with a telephone situated in the UK.  If a business appears to have no physical presence anywhere, the Inland Revenue will smell a rat, so you probably need to have a clearly functional office somewhere outside this country.

If you are trading through a company incorporated offshore, for example in a tax haven like Guernsey, make sure that the company is "centrally managed and controlled" outside the UK.  This really means that high level board decisions must be made outside the UK, and the Inland Revenue (who weren't born yesterday) will not be slow to take the argument, if they can, that the real decisions are made in the UK and merely "rubber stamped" at such offshore board meetings.  This rule makes it very difficult for a business which is effectively controlled by one dominant personality, who is resident in the UK, from claiming non UK residence for the company which carries it on.  Remember that the country of incorporation of the company is not what is relevant.  It is where it is controlled in practice. 

If you have successfully got over the first two hurdles, there is a lion waiting in your path in the form of Section 739 of the Taxes Act.  This provides that, if you have "transferred assets abroad" and as a result of that transfer income has become payable to a non-resident (for example company) that non resident's income can be treated as yours unless you can prove that the arrangements where not set up for tax avoidance reasons.

There are two main counters to the Section 739 gambit by the Revenue.

Firstly, if you are domiciled outside the UK, you can avoid tax under this rule unless you remit the income to the UK.  There are various clever ways of effectively enjoying the income in the UK without such a "taxable remittance". 
 
Secondly, you may be able to prove that the offshore company was set up for non-tax avoidance reasons.  True, this is not very easy to do where your company is based in a tax haven like the Channel Islands or the Isle of Man, but what about the Republic of Ireland?  Corporation tax rates there are very low, but the Republic has somehow managed to avoid being tarred with the "tax haven" brush.  Alternatively, many countries have a zero per cent corporation tax rate which are not actually treated as tax havens in common parlance.  We understand, for example, that most Estonian companies pay no corporation tax.  Also, countries in Africa are very often very free and easy about corporation tax liabilities.  One way to prove to the Inland Revenue that your choice of an offshore based company is commercially driven is to set up a company in the country in which the trade is actually carried on.  For example, if you are involved in property transactions in Estonia, there may be government rules which require you to do this through an Estonian company.  If you are undertaking some kind of trading (like mining) activities in the Gambia, the use of a Gambian company would seem natural and not likely to be undertaken for tax avoidance reasons.  It may even be possible to provide, in evidence, a letter from the government of the country concerned confirming that they required the business to be carried on through a locally incorporated and resident company.


Trading in the UK from Outside the UK

It is even possible, although no-one is pretending it is easy, to trade entirely in UK based goods, for example property deals, without having a UK base and, thereby, avoiding UK tax providing you personally are resident elsewhere.  This is where the tax planning gets fairly serious and we would not suggest you try this at home without professional advice!


Tax Free Investing

There are some situations where you really don't want your activities to be classified as a trade.  We can think of two major areas where, to make your profits tax free, you want the Inland Revenue to treat you as investing on a long term basis.

One of these is residential properties that become your own home (or second/third etc home).  If this can be treated as investing rather than trading in property, some or all of the gain on sale can be treated as exempt from tax under the "main residence provisions", which apply for capital gains tax but not for income tax.  Therefore you can easily catch a cold if the Inland Revenue decide that you are buying and selling homes so frequently as to be trading, effectively, in houses.

The other area is specialist vintage or classic cars.  We had an instance recently where an individual who paid a few thousand pounds for an Aston Martin in the 1950's was offered well over £1 million for it.  This particular individual, although he was very interested in cars, was not buying and selling them regularly, so the Inland Revenue were (we presume) quite happy to treat him as outside the trading net.  Cars, like certain other types of assets (for example antique clocks) are entirely exempt from capital gains tax, so if you are not "trading" you can make a substantial profit without paying any tax on it at all.  History doesn't relate whether the individual we are talking about accepted the offer for his Aston Martin, but if he had, £1 million plus tax free money is nice sugar!

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