Sarah Bradford outlines what constitutes trading and the ‘badges of trade’.
Income tax is charged on the profits of a trade, profession or vocation. To establish whether there are profits from a trade, it is first necessary to consider whether there is, in fact, a trade and whether a person is trading.
Not much help
Interestingly, there is no statutory definition of ‘trade’ beyond that which states that ‘‘’trade’’ includes any venture in the nature of the trade’. It has therefore been left to the courts to put the flesh on the bones.
In their Business Income manual, HMRC note that, broadly, ‘trade’ can be taken to refer to an operation of a commercial kind by which a trader provides to customers for reward some kind of goods or services. The legislative inclusion of ‘ventures in the nature of trade’ allows for the possibility of regarding isolated or speculative transactions as trading.
Badges of trade
Over the years, the courts have tended to look for the presence or absence of common characteristics of a trade in establishing whether there is, in fact, a trade. Back in 1955, the Royal Commission on the Taxation of Profits reviewed case law and identified six ‘badges’ – the badges of trade. Since that date, the concept has been refined and expanded.
It should be noted that each ‘badge’ will not be present in every case, and where badges are found, some may indicate that there is a trade, while others may indicate otherwise. The presence or absence of a particular badge is unlikely by itself to provide a conclusive answer to the question of whether there is a trade. Further, the weight that is attached to each badge will depend on the circumstances.
The approach, therefore, is to consider the presence or absence of the badges of trade and to form an overall impression of whether there is a trade.
The badges are discussed below.
Profit motive
The intention of a profit motive suggests that a trade may be being carried on; however, it is not conclusive. It must be considered along with other factors.
Systematic and repeated transactions
Systematic and repeated transactions suggest a trade. This is particularly so where the nature of the transactions is similar to those carried out by an established trade in the same line of business.
In CIR v Fraser [1942] 24 TC 498, a woodcutter bought a consignment of whiskey in bond and sold it through an agent at a profit. The quantity involved was considerably in excess of that which could be used by the woodcutter and his family and, importantly, the dealings were of the type that take place in ordinary trade. The judge found there to be a trade.
While a single isolated transaction can amount to the carrying on of a trade for tax purposes, it is difficult to show this to be the case, given that for there to be a trade there has to be a venture in the nature of the trade. By contrast, systematic repetition of a transaction is a pointer towards trading. Consideration should be given to the number and frequency of the transactions.
Thus, while one transaction may not suggest a trade, repeating the transaction again and again suggests a trade.
Nature of the asset
When considering the nature of the asset, the question to ask here is whether the asset is of such a type that it can only be turned to advantage by sale or is such that it yields an income or gives ‘pride of possession’, as would be the case for a picture purchased for personal enjoyment. The nature of the assets can be significant – even decisive – in deciding whether there is a trade.
If an asset produces income, the initial presumption that it is an investment is likely to be greater than where the asset produces no income. However, the lack of income does not mean the asset is a trading asset, as it might be held for capital growth.
Some assets, however, are of a nature that produces no income, has no aesthetic enjoyment and no ‘pride of possession’, and are of a type normally dealt with by way of trade.
The quantity purchased can also indicate whether there is a trade. The oft-cited case here is Rutledge v CIR [1929] 14 TC 490, where the transaction in question involved the purchase and sale of one million rolls of toilet paper.
However, this badge alone is not conclusive, and the other badges of trade must normally be present to establish the existence of a trade.
Connection with an existing trade
If there is an existing trade, the similarity of the transaction under consideration may suggest the presence of trading. In Marson v Morton & Ors [1986] 59 TC 381, the judge observed: “the purchase of silver cutlery by a general dealer is much more likely to be a trade transaction than such a purchase by a retired colonel”.
Modification of the asset
Whether anything happens to the asset pending resale may also be relevant in determining whether there is a trade. Modifications by way of processing or manufacture, or some form of adaptation to make it more marketable, are typical in trading transactions.
Likewise, breaking down the asset into smaller lots to facilitate sale may suggest trading. In Cape Brandy Syndicate v CIR [1921] 12 TC 358, work on a large quantity of Cape brandy to ship it to the UK, blend expertly with French brandy, re-cask and sell in numerous lots helped the Commissioners establish that a trade was carried on.
However, it should be noted that the absence of modification is a neutral factor rather than indicative of the lack of trading. Further, expenditure on an asset after purchase and before sale is not always evidence of trading – the nature and scale of the expenditure must be considered.
Organisation of the activity
If the activities are carried out in the same way as those undertaken by an undisputed trader, it suggests that there is a trade. Further, any form of organised activity designed to promote sales suggests trading. This may be the existence of a sales or advertising campaign, or the employment of sales staff or a sales agency.
By contrast, the absence of normal business systems and structures expected of a trader may be an indicator against the existence of a trade.
Method of finance
The way that the purchase of an asset is financed may provide a clue as to whether there is a trade. If the purchase of the asset is made from the resources of an existing trade, this may indicate that a trade is being carried on. This is further strengthened if the proceeds from the asset are introduced into the existing trade, and the needs of the business are such to suggest the funds would need to be returned in a limited period of time.
By contrast, where the funds are derived from the sale of an investment, the purchaser may simply switch investments rather than trading.
Interval between purchase and sale
The time lag between the purchase of an asset and its sale may be important in establishing whether there is a trade. A short period of ownership suggests trading, whereas a person who buys an asset and holds it for some time before selling it is in a stronger position to argue that the asset was purchased as an investment.
However, it should be noted that this factor is not conclusive of itself.
The way in which the asset was acquired
The way in which the asset was acquired can indicate whether there was a trading motive or not. The subsequent sale of an asset acquired by gift or inheritance is unlikely to suggest a trade.
Intention
Where a person disputes that a transaction amounts to trading, it is unlikely they will admit that their intention is to trade. However, where there are losses for which relief is sought, it is likely there will be a stated intention to trade.
In establishing whether there is a trade, HMRC will look beyond the stated intention at the facts surrounding the transaction and determine whether the picture that emerges is one of trading.
Practical tip:
To establish whether a transaction or series of transactions amounts to trading, look for the presence or absence of the badges of trade in order to form an impression as to whether a trade exists.
