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  • Badges of trade: is there are trading activity?

    Introduction – badges of trade

    Do not confuse the ‘badges of trade’ with the ‘badgers of trade’. Whilst the latter is an organisation of mercantile woodland creatures, the former is a set of key indicators that are used to determine whether a particular transaction or transactions are a trading activity.

    The finding of a trade can be significant.Firstly, the profits attributable will be treated as income rather than falling within the capital gains regime. For individuals might result in an exposure to a higher tax rate. However, there may also be important differences for a Company.

    On the plus side, the finding of the presence of a trade may also mean that the business will qualify for Entrepreneurs’ Relief (“ER”) and / or Business Property Relief (“BPR”), These are attractive tax reliefs for both Capital Gains Tax (“CGT”) and Inheritance Tax (“IHT”) respectively.

    What is trading?

    As this is a rather important distinction in the tax code, it is not surprising that there is a definition of trade in the tax code. However, what is surprising is how poor this definition is.

    The definition of trade can be found at ITA 2007, s989 (for income tax purposes) and CTA 2010, s1119(for corporation tax purposes) and it states that a trade is “any venture in the nature of trade”.

    This is a circular definition and is most unhelpful. As such, case law plugs the gaps. It is this body of case law that is termed the ‘badges of trade’. They were referred to as early as the 1950s as part of the Royal Commission.

    However, the best practical summary of this case law can be found Marson v Morton a case that took place in 1986. The key is that one must apply the badges of trade ‘in the round’.

    The badges of trade

    It is considered that there are nine badges of trade. These can be summarised as follows:

    • Is there a profit motive?
    • The frequency and number of transactions
    • Has the underlying asset been modified?
    • The Nature of the asset
    • Is the taxpayer involved in a similar trade?
    • What type of finance has been used?
    • Length of ownership of the asset?
    • The way the transaction is carried out
    • The reason for the acquisition/sale

    Is there a profit motive?

    The first of the badges expresses that, for an activity to constitute a trade, then it must be carried out with a view to making a profit.

    This is one of the chinks in the armour exploited by HMRC in its war against film schemes and other ‘leveraged’ loss schemes.

    It is also the platform from which HMRC might challenge a loss-making venture where, perhaps, it appears to HMRC as if it is merely a hobby (particularly hobby farming).

    Frequency and number of transactions

    Although it is quite possible that a single transaction can constitute a trade (due to the weight of other badges pointing towards this finding) it is generally the case that where there are few transactions that it will be more indicative of a non-trading activity.

    This was the case in Pickford v Quirke [1927] 13 TC 250. Here, the taxpayer bought a mill with the original intention that it would be used in the trade.  However, the mill was falling apart at the seams and, as such, he decided to strip out anything that was useful and sold it off bit by bit.

    The profit made from these transactions were taxed as trading profits because of the number of transactions of a similar nature.

    Underlying asset has been modified?

    Also indicative of trade, is where someone buys an asset and then modifies it in some way such that it becomes more valuable. The more someone does to modify the asset then the more chance that the process will be seen as a trade.

    Of course, an asset may be modified in a number of ways.

    It should be noted that just because an asset does not undergo any modification does not prevent it from being part of a trading transaction.

    For example, in the archetypal case of Cape Brandy Syndicate v CIR [1921] 12 TC 358 the taxpayers acquired a large quantity of brandy. They then blended it with a different French brandy before re-packaging it and selling it on. This was deemed to be a trade on the basis that the original brandy had been modified through the blending process.

    Nature of the asset

    The third badge relates to the nature of the asset under consideration.

    When we talk about nature we are taking in factors such as the type and quantity of an asset.

    For example, if, say, an asset such as painting is acquired and hung on the living room wall then this is likely to be considered as an investment rather than a trading asset. This is because the asset has been acquired for personal enjoyment.

    Every tax student knows the case of Rutledge v CIR [1929] 14 TC 490.Not necessarily because it contained a particularly elegant judgement from the Court but because the taxpayer bought and sold a million toilet rolls! Of course, opined the judge, the purchaser could not possibly require them all for personal use. As such it was deemed a trade (and cue lots of sniggering about curries from the back of the class).

    Similar trade

    Where a transaction is entered into that is similar to an existing trade carried on by that person then it points towards trading.

    For example, if a tax adviser sells a car then, in the absence of other badges, it is unlikely to be treated as trading transaction.

    However, if a taxpayer who runs a business as a mechanic sells a car then, because there is a link with an existing similar trade, then it is more likely to be considered a trading transaction.

    The same can be said for property professionals. If someone runs a property development company and then, personally, buys and sells a property then there is more of a chance of that property to be deemed a trading transaction. See Cooke v Haddock [1965] 39 TC 64.

    The type of finance

    Where an asset is purchased on a short-term finance package and, it is assumed, will be repaid out of the proceeds then this points towards a trading venture.

    For example, contrast a situation where a property is purchased on a 20 year interest only mortgage versus one bought on a 6 month bridging finance loan to be paid off from the sale proceeds.

    We all like Norman Wisdom don’t we? Well, I confess, I can’t stand his films. I am not certain that this was the reason why he was unsuccessful in front of tribunal. In Wisdom v Chamberlain [1969] 1 All ER 332 it was found that Sir Norman purchased silver bullion using loans subject to high rates of interest.  As such, the bullion needed to be sold quickly to satisfy the finance. It was held that this was a trading transaction.

    Length of ownership

    The shorter the period of ownership then the more likely there is to be a trade and vice versa.

    The way the transaction is carried out

    If the sale of the asset is carried out in a manner that would befit a trading organisation then this could indicate that the transaction is one that is trading in nature.

    Reason for acquisition / sale

    An asset that is acquired by means of an Inheritance or some other gift is unlikely to constitute a trading transaction.

    Similarly, an asset bought with the intention of holding it for the long-term is unlikely to be considered as a trading asset even if a subsequent change in intention. See Taylor v Good [1974].

    Conclusion – badges of trade

    The badges of trade should be considered in the round. No one badge is likely to determinative but all badges must be considered and given an appropriate weight in deciding whether an activity is of a trading nature

    If you have any queries over the badges of trade, whether a business is trading or any tax issues in general then please get in touch.

    Badges of trade was last updated on 8 October 2018