Tax Issue: Investor vs. Trader

Dear all,

I am an accountant and familiar with the ATO's instructions on how to classify your activity on the stock market (find link below) but have recently become concerned because classifying entities has become extremely difficult.

A professional opinion seems to count for very little these days. There are several instances to date where I or a colleague classify an entity one way and the ATO classify them as the other; more often than not, the ATO's classification results in a higher Tax Payable for the entity. Worryingly, the ATO seems to disregard issues such as trading frequency, the length of time a parcel was held, etc... The primary determinant of their assessments seems to hinge upon the profit made, which is silly (very few people I know enter the stock market with the intention of eroding their financial position...).

The ATO also seems to lack an awareness of how complex the share market can be totally ignoring explanations provided by clients or brokers. For example I had a client (classed as an Investor) who had held a large parcel of a small cap resource stock for about 5 years with no activity. The stock experienced some substantial gains and the client was advised by his broker to offload the majority of his stock and realise some profit. The client placed a single order with the broker who took more than a week to sell the parcel in small lots due to poor depth for the stock. The ATO classified each broker transaction as a discrete and unrelated trading event and proceeded to reclassify the taxpayer as a trader...!!? Of course reaping a hefty tax bill.

I hate giving advice that I cannot back up and worry about my own activity as the tax consequences can be significant. Does anybody know of recent studies academic or otherwise that would suggest how long the average "Investor" holds a parcel of shares or how many trades the average "Trader" engages in. I am unable to get any clear rules of thumb from the ATO which makes it hard to be sure of any classification personally or professionally.

Thanks

Link to ATO Guidelines : http://www.ato.gov.au/businesses/content.aspx?doc=/content/21749.htm&pc=001/003/007/001/006&mnu=0&mfp=&st=&cy=

I had my f.y. earnings assessed by an accountant today and to my surprise the stock I was holding on the 30th June 2011 was considered as ummm inventory/stock as in any item a business owner would have. So although I had not made profit nor loss via sale of them, they were considered as "stock held" and hence reduced my loss claim by the whole amount. Had not experienced this with my original accountant who did not treat the end of financial year holdings as such.

Assiduous said:

The ATO classified each broker transaction as a discrete and unrelated trading event and proceeded to reclassify the taxpayer as a trader...!!? Of course reaping a hefty tax bill.

Click to expand...

This seems quite strange. Although there is fuzziness in regards to what is required to qualify as a trader, all the research I have done up to now suggests that the ATO is only concerned with those who are not traders that are trying to be taxed as traders so they can write off current year losses against other income.

I have always understood that if you want to be treated as an investor for tax purpose it didn't matter what your trading behaviour was. The ATO would deem you to be an investor if that is how you want to be treated.

In other words, a person who deems himself to be a trader could be treated as an investor by the ATO if that person didn't qualify under the fuzzy guidelines set by the ATO, but a person who deems himself to be an investor would never be treated by the ATO as a trader, even if their trading behaviour would be more fitting of a trader.

Wysiwyg said:

I had my f.y. earnings assessed by an accountant today and to my surprise the stock I was holding on the 30th June 2011 was considered as ummm inventory/stock as in any item a business owner would have. So although I had not made profit nor loss via sale of them, they were considered as "stock held" and hence reduced my loss claim by the whole amount. Had not experienced this with my original accountant who did not treat the end of financial year holdings as such.

Click to expand...

If you are deeming yourself to be a stock trader and not an investor, that is correct. You can make a profit or loss based on the year end valuation of your shares (for instance, if they are valued at market price) even if you have not bought or sold any of those shares during the year.

A traders income is Sales - Cost of Good Sold. The latter is Opening Stock + Purchases - Closing Stock.

If you value closing stock at market price, then even if Sales and Purchases are zero, you may actually make a profit or loss due to the difference in the value of your opening and closing stock.

A trader does NOT come under the CGT system in regards to trading stock.

Assiduous said:

For example I had a client (classed as an Investor) who had held a large parcel of a small cap resource stock for about 5 years with no activity. The stock experienced some substantial gains and the client was advised by his broker to offload the majority of his stock and realise some profit. The client placed a single order with the broker who took more than a week to sell the parcel in small lots due to poor depth for the stock. The ATO classified each broker transaction as a discrete and unrelated trading event and proceeded to reclassify the taxpayer as a trader...!!? Of course reaping a hefty tax bill.

Click to expand...

I'm no expert but this is my take.

Were the small cap resource stocks dividend payers? An Investor needs to have the intention of earning income through 'holding' the shares. Otherwise the intention to profit through buying and selling becomes the primary determinant, holding period and number of transactions would be secondary considerations. If they were dividend paying or the person could successfully argue they believed the stocks would become dividend paying in their period of holding then they should have a reasonable case for being classified as an investor, if they wanted to fight it.

craft said:

I'm no expert but this is my take.

Were the small cap resource stocks dividend payers? An Investor needs to have the intention of earning income through 'holding' the shares. Otherwise the intention to profit through buying and selling becomes the primary determinant, holding period and number of transactions would be secondary considerations. If they were dividend paying or the person could successfully argue they believed the stocks would become dividend paying in their period of holding then they should have a reasonable case for being classified as an investor, if they wanted to fight it.

Click to expand...

You could be right, Craft, but that raises some interesting issues. When I first looked at this issue, over 10 years ago now, I contacted the tax office on two occasions and was told that if one wanted to be classified as a trader (at the time I wanted to be), then it would be an all or nothing choice. You would not be able to quarantine part of your stock holdings as trading stock and another part as investments. In fact they advised me to set up a company to do the trading, as I had large stock holdings in my own name that held discountable capital gains and I risked losing the discountable gain if it were deemed trading stock. In the last few years the story seems to have changed. A single individual can be both a trader and investor so long as they adequately separate both activities to the satisfaction of the ATO (e.g. different broker accounts for investing and trading).

If you are right then that makes things even cloudier. Particularly for anyone who has investments in US stocks as many pay no dividends because 'investors' prefer to take their earnings as capital gains (15% tax from memory) than as dividends (taxed at the marginal rate and, unlike here, there is no dividend imputation).

This has been a frequent topic on this forum, but up to now it has mainly been addressed from the perspective of someone wanting to be taxed as a trader rather than someone not wanting to be taxed as a trader.

Assiduous said:

For example I had a client (classed as an Investor) who had held a large parcel of a small cap resource stock for about 5 years with no activity. The stock experienced some substantial gains and the client was advised by his broker to offload the majority of his stock and realise some profit. The client placed a single order with the broker who took more than a week to sell the parcel in small lots due to poor depth for the stock. The ATO classified each broker transaction as a discrete and unrelated trading event and proceeded to reclassify the taxpayer as a trader...!!? Of course reaping a hefty tax bill.

Click to expand...

If your client made a loss on this transaction the ATO would see it as a CGT event - the double standard stinks. It makes me wonder if a trader can hold investments.

Unless there is a special rule for shares I am unaware of, you can choose what method you use to value the stock (assuming you are deemed a trader). If no transactions are made during the year, and you choose to value at cost price all the time, there will be no profit or loss arising .


Valuing trading stock

Generally, you must undertake a stocktake to work out the value of trading stock at the end of the income year. This means you must work out the physical quantities of stock on hand and assign a value to each item of stock.

You can choose from three methods of valuing trading stock:

Cost price - this includes all costs connected with bringing the stock into existence. The cost of finished goods, for example, must include freight, customs duties and delivery charges, as well as the purchase price. For manufactured goods and work in progress, the full cost includes the cost of labour and materials, plus an appropriate proportion of fixed and variable factory overheads, such as power, rent, rates and factory administration costs.

Market selling value - the current value of the stock you sell in the normal course of business. Under this method, you cannot allow a reduced valuation where you are forced to sell the stock for some reason.

Replacement value - the price of a substantially similar replacement item you purchase in your normal buying market on the last day of the income year.
You can change the method you use to work out the value of trading stock each year and can also use different methods for different items of stock. However, the value of stock at the beginning of each income year must be the same as the value of the stock at the end of the previous income year.

You can change the method you use to work out the value of trading stock each year and can also use different methods for different items of stock. However, the value of stock at the beginning of each income year must be the same as the value of the stock at the end of the previous income year.

village idiot said:

Unless there is a special rule for shares I am unaware of, you can choose what method you use to value the stock (assuming you are deemed a trader). If no transactions are made during the year, and you choose to value at cost price all the time, there will be no profit or loss arising .

Click to expand...

That is correct. You can value at cost, at market or at the lower of cost and market. I assume replacement value is the same as market value when it comes to shares.

It can be different for each parcel of shares bought, provided you maintain adequate records to identify the parcel and any transactions that might have been placed against the parcel since purchase (e.g. if you bought 1000 and subsequently sold 100).

So you could have, for example, 10 parcels of BHP in your inventory, that were bought at different times, some parcels could be valued at cost and some at market. This is how I work out my closing inventory. I value each parcel individually using both market and cost and then choose whichever is the lowest for each parcel. This minimises the amount of tax that has to be paid in the current year. However, it just defers the tax saved to a subsequent year.

As mentioned in the extract, your opening inventory in the following tax year MUST be the same as your closing inventory in the previous year.

bellenuit said:

If you are deeming yourself to be a stock trader and not an investor, that is correct. You can make a profit or loss based on the year end valuation of your shares (for instance, if they are valued at market price) even if you have not bought or sold any of those shares during the year.

A traders income is Sales - Cost of Good Sold. The latter is Opening Stock + Purchases - Closing Stock.

If you value closing stock at market price, then even if Sales and Purchases are zero, you may actually make a profit or loss due to the difference in the value of your opening and closing stock.

A trader does NOT come under the CGT system in regards to trading stock.

Click to expand...

Deeply sorry for not acknowledging your reply earlier Bellenuit and thanks so much for the explanation.

I don't agree with the method of 'closing stock' value on 30/06/2011 as being deductible from f.y. gains/losses since no gain/loss has occurred on the stock held. They were bought a few days before 30/06/2011. I believe the gain/loss should be registered upon sale only and the stock held considered as 'opening stock' for the present financial year.

Next year I will sell everything prior to the end of financial year so this does not occur again.

Thank you.

Hi All,

Does one need to make a formal application to the ATO to be classified as a trader? Or you just file your tax return as a trader and if the ATO has doubts then they will contact you for proof?

This is the first financial year that I worked full time on my trading. I ended the year with a slight loss of 1.23%. I won't be paying any tax this year of course but can I carry over the loss till next year?

Cheers

Paradiso,

I just keep an excell spreadsheet of my trades & expenses & hand it to my accountant. I make approx. 20 trades per year over the last 7 years & never had an issue with the ATO. I have not registered as a trader, I think they just want to see that you are actively trading and keeping good, professional records.

You can carry over losses for 5 years and use them to offset any capital gain you make on other capital investments, but DYOR as I am not an accountant !

Paradiso said:

Hi All,

Does one need to make a formal application to the ATO to be classified as a trader? Or you just file your tax return as a trader and if the ATO has doubts then they will contact you for proof?

Click to expand...

No, but if they do decide to review you and deem you not to be a trader in their eyes, then you may end up paying back taxes and penalties, if the deemed change means you owe tax.

Sorry, I can't answer the second question.