Trading Vs. Investment – Why Getting It Right Is Important

 

With a record number of people buying properties as investment assets, it is becoming increasingly important for property owners to ensure the correct designation between holding a property as an investment, or as a trading asset.

 

Once upon a time, the majority of taxpayers who paid property taxes were either those who had a holiday home (e.g. capital gains tax (CGT) on profit made on sale) or professional landlords who owned a number of let properties (e.g. income tax for individuals, or corporation tax for companies). That has all changed, not least because of low interest rates and the unpopularity of pension schemes. People are looking for higher returns on their investments, and are turning to property for that return.

 

This has not gone unnoticed by HM Revenue & Customs (HMRC), who have already made two campaigns referring to property. 

 

The first termed the ‘property sales campaign’ only secured an additional £28,666 in CGT, and could hardly be said to have been worth the time and effort. The second campaign (the ‘let property campaign’) started in September 2013, targeting the residential property letting market. The ‘tax take’ on this campaign is unknown as it still has a year to go, but with two campaigns out of a total of twelve run relating to property, it could be suggested that HMRC believes there is more tax to be gained from this sector.

 

Apart from specific campaigns, it is known that HMRC have been concentrating their efforts on examining the designation of property transactions.

 

The tests for trading in property are much the same as for any other trade. There is no definition in the legislation as to what constitutes a ‘trade’; therefore HMRC use the ‘badges of trade’ as a basis in identifying whether or not a trading activity exists. 

 

‘Badges of trade’ are also not found in statute, having been developed by the courts. However, in 1955 a Royal Commission report on the taxation of profits and income used previous judicial decisions to identify six ‘badges of trade’; this number has increased to nine following rulings in subsequent tax cases. 

 

It is not necessary for a transaction to have all of the ‘badges’ in place to be regarded as trading; the existence of one single ‘badge’ can be enough. Clearly, some ‘badges’ carry greater weight than others, given differing circumstances. 

 

The nine ‘badges of trade’ are listed in HMRC’s Business Income manual (at BIM 20205) as follows: 

 

• profit seeking motive;
• number of transactions;
• nature of the asset;
• existence of similar trading transactions;
• changes to the asset;
• method of sale;
• source of finance;
• interval of time between purchase and sale; and
• method of acquisition.

Using these ‘badges’, the following are possible areas of HMRC interest with particular reference to property transactions:

 

• profit seeking motive – Did the owner originally intend to trade, or were the transactions for investment purposes only?
• number of transactions and existence of previous similar transactions;
• nature of the asset – What exactly was the character of the land, was it suitable for long-term investment or for immediate development?
• method of acquisition and source of finance – How was the purchase funded and under what terms if purchased via a loan?
• method of sale – How was the transaction organised? Was it typical of a land dealer? and
• interval of time between purchase and sale - The length of time that the land was held. Had the sale been prearranged?

Note that profits from furnished holiday lets are treated as a trade for all taxes except National Insurance contributions and inheritance tax.

 

The distinction between dealing in property (trade) and investing is usually relatively straightforward; a purchaser buying to let out on a long-term basis is an investor, whereas someone buying property to refurbish then sell, whether resulting in a capital gain or not, will most likely be a trader - the main difference being intention. Where the intention is to develop the property, hold it to generate income from rental activities and achieve capital growth over a period of time, the tax treatment is more likely to be that of an investment. ‘Intention’ will therefore directly affect the tax treatment.

 

Whether it is more beneficial for a property transaction to be taxed as trading or investment will depend upon number of factors, not least whether the taxpayer is an individual or a company, the taxpayer’s own position (e.g. losses, CGT annual exemption, tax rate, etc), and the overall values involved. 

 

Generally, wherever possible, if a property transaction is deemed to be an investment transaction then it may be worth considering holding the property personally rather than through a company, (e.g. comparing the CGT rate with the overall tax cost if the gain is taxed within the company, and the post-tax gain is subsequently extracted from the company, such by salary or dividend). Remember that an individual is allowed an annual allowance, whereas a company is not. 

 

Should the transaction be trading in nature, the reverse is often true, because the charge to income tax (and NIC) may be much higher than the corporation tax rate. 

 

However, an investment activity tends not to have the same tax planning advantages as a trading one, as an inheritance tax case shows. In DWC Piercy’s Executors v HMRC ([2008] SpC 687), HMRC tried to deny ‘business property relief’ to a property developer, contending that the property was held as an investment rather than as trading stock. HMRC lost the case, as the judge found that the land was stock, the company did not hold any other types of investment, and it was not an investment company. 

 

Property held as trading stock can change to being an investment, and vice versa; again, intention is key. A change might include a property developer purchasing a property with the full intention of developing for sale, who then finds it difficult to sell, deciding to keep the property as his own principal private residence (PPR). 

 

In this situation, a disposal at market value will be deemed to have taken place, resulting in a trading profit as the movement is from trading stock to investment. A similar situation was present in the case of Paul Gibson v HMRC [2013] UKFTT 636 (TC), where Mr Gibson totally rebuilt and then sold his house. HMRC denied PPR relief on the basis that the house had been acquired ‘wholly or partly’ for the purpose of realising a gain on disposal and the court agreed.

 

In September 2013, leading ‘think tank’, The Smith Institute, published a paper suggesting the use of a property speculation tax (PST). The main reason for the suggestion was to curb property speculation believing that the current increase in property values is at least partly due to property owners giving the impression of intention to hold as a long term investment whereas, in reality, the transaction should be taxed as a trade because of the relative short time of ownership. 

 

PST is used in other EU countries and imposes a higher rate of tax on properties sold quickly – usually within ten years of purchase. The tax is tapered, with lower rates being charged the longer the property is kept. A PST would exclude ordinary home-owners and longer term investors, but could include second homes and empty properties

(see www.smith-institute.org.uk/file/The%20Case%20for%20a%20Property%20Speculation%20Tax.pdf). 

 

HMRC places significant emphasis on the intention of the purchaser from the actual moment of acquisition, and it is therefore important to retain evidence as proof. As well as the usual legal documentation, if the purchase was through a company for example, copies of board minutes may be relevant in the decision as to whether a purchase is for investment or trading purposes.