A Question Of Trading: It Matters!

Ken Moody highlights the importance of trading status for the purposes of certain tax reliefs.

The question of whether a ‘trade’ is carried on is vital to a number of tax reliefs and the definition varies according to the legislation applicable. This article undertakes a review of what ‘trade’ or ‘trading’ means in two main contexts. 

A number of capital gains tax (CGT) reliefs depend upon whether a trade is carried on, perhaps most importantly for the purposes of:

It is not the purpose of this article to undertake a detailed analysis of the distinction between ‘trade’ and investment, which is largely drawn from case law. 

Property letting is rarely treated as trading, though furnished holiday letting is treated as a trade for CGT purposes (by TCGA 1992, s 241), and also for income tax purposes but not inheritance tax (IHT).

For ER purposes, the main relief is in respect of a ‘material disposal’ of ‘business assets’, and there is a subsidiary relief for ‘associated disposals’. Both are ‘qualifying business disposals’ (within TCGA 1992, s 169H(2)). 

A disposal of:

a) the whole or part of a business;

b) property used in a business at the time business ceases to be carried on; and

c) shares or securities in a company

is a disposal of business assets (TCGA 1992, s 169I(2)).

A sole trader may only make a material disposal within (a) or (b) above, while the relief for associated disposals relates to assets which are in use for the purposes of the business of a company or a partnership. However, the individual must also make a material disposal of a share in the partnership or of shares in the company as part of their withdrawal or partial withdrawal from the business (s 169K). ER in respect of an associated disposal is restricted where there has been any non-business use of the asset during the period of ownership, or where (since April 2008) rent has been paid (n.b. such restrictions do not apply to assets within (a) or (b) above, which may present a tax planning opportunity). 

While TCGA 1992, s 169I(2) refers to a business, this is defined by s 169S(1) as a trade, profession or vocation carried on on a commercial basis with a view to profits.

Section 169S(5) refers to ITA 2007, s 989, which defines trade as including ‘any venture in the nature of trade’; but this gets us no further. As to whether a company is a trading company or a holding company of a trading group, s 169S(4A) directs us to s 165A. Section 165A is also relevant in relation to claims for hold-over relief (under s 165 for gifts of business assets), and defines ‘trading company’ as: ‘… a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities (s 165A(3)’ (emphasis added)). 

Many readers will be aware of HMRC’s views on what is regarded as a ‘substantial extent’ based upon a number of factors but viewed ‘in the round’ (where no single factor is necessarily conclusive):

HMRC considers that a ‘substantial extent’ is more than 20% applied to the above (and/or perhaps other) indicators (see HMRC’s Capital Gains manual at CG64090). This is partly based on case law applicable to IHT business property relief (BPR), which is denied if a company’s business consists wholly or mainly of dealing in stocks, shares, land or holding or making investments. 

However, before we get to whether any non-trading activity is substantial, we need to consider what ‘trading activities’ means. This is defined (by s 165A(4)) as activities carried on by a company:

a) in the course of or for the purposes of a trade carried on by it; 

b) for the purposes of a trade it is preparing to carry on; and

c) with a view to its acquiring or starting to carry on a trade.

A similar theme applies to the definitions of ‘trading group’ and ‘trading activities’, in a group context (at s 165A(8), (9)).

The effect of the retention of substantial cash deposits is referred to in HMRC’s guidance, which accepts that retention of surplus funds in the form of bank deposits, bonds or equities could count as being for the purposes of the trade, but that the long-term retention of funds generated from trading activities might amount to an investment activity. This will depend on a number of factors, such as the form of the investment, the company’s cash flow requirements, whether the funds are earmarked for a particular purpose and how actively the funds are managed. 

In Jowett v O’Neill & Brennan Construction Ltd [1998] STC 482, it was decided that the company was not carrying on business (for the ‘associated company’ test) by holding substantial funds on bank deposit and receiving interest, which may therefore not constitute an ‘activity’ at all. Any other form of investment such as equities may be a different matter, and property investment and letting would clearly be a non-trading activity unless this forms part of the trading premises or was acquired for the purposes of the trade but is surplus to current requirements (see CG64085).

However, the question of what activities might be accepted as being carried on in the course of a trade or preparing to carry on a trade, as with the 20% test itself, could be finely balanced in some cases. HMRC recognise this and will accept applications to establish the status of the company for the purposes of the above reliefs via its non-statutory business clearance service (see CG64100).

The substantial shareholdings exemption (SSE) broadly provides exemption from corporation tax in respect of the disposal of a shareholding in a company in which the investing company holds at least 10% of the investee company’s ordinary share capital (TCGA 1992, Sch 7AC). 

Each company must, broadly, be a trading company or the holding company of a trading group both before and after the disposal (though see TCGA 1992, Sch 7AC, para 3 and CG53165 for exceptions).

The meaning of ‘trading company’ and ‘trading group’ (at Sch 7AC, paras 20, 21) are couched in similar terms to s 165A(3), (8).

The legislation concerning a company purchase of own shares (at CTA 2010, ss 1033–1043) and demergers (at ss 1073–1085) both contain requirements as to the status of the company or companies involved. Without relieving provisions these transactions would be regarded as distributions (within s 1000(1)B) and would be liable to income tax. 

A basic test in both cases is that the transaction must be for the benefit of the trade of the company or a subsidiary, or the group as a whole (ss 1033(2)(a), 1081(3)).

For a company purchase of own shares, the company must be an unquoted trading company or the unquoted holding company of a trading group (s 1033(1)(a)).

The demergers legislation is designed to facilitate either:

Basically, each company involved must either be a trading company or the holding company of a trading group before and after the demerger.

For a company purchase of own shares the definition of ‘trading company’ is a company or group whose business consists wholly or mainly of carrying on a trade or trades: ‘trading group’ is similarly defined taking the group’s activities together (s 1048(1)). The definitions of these terms in s 1099(1) for the purposes of the demergers legislation are identical (and in both cases the definition or ‘trade’ excludes dealing in stocks and shares, land or futures). 

The case law concerning BPR (see above) would clearly be of relevance with regard to the ‘wholly or mainly’ test for the purposes of the above legislation.

On a disposal of company shares the test of the company’s status as a trading company or holding company of a trading group needs to be met only for one year, usually ending with the date of disposal (TCGA 1992, s 169I(6), (7). It may be possible therefore to take action in advance to secure the company’s trading status for that period (e.g. by ceasing any non-trading activities).