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By Jimmy B. Prince, author of Tax for Australians for Dummies

A contract for difference (CFD) is a derivative that allows you to speculate in the price movement of underlying securities such as shares, indices and commodities without the need to actually own them.

Expressed simply a CFD transaction is normally a short term contract between a buyer and a professional CFD provider, with both parties taking an opposite view as to whether the value of the underlying security (for instance shares) will increase or decrease in value. Settlement is by way of a cash payment being the difference between the opening and closing value of the underlying security. If the outcome is positive the CFD provider pays the difference (e.g. the increase in value), and the buyer will derive a profit. On the other hand if the outcome is negative, the buyer pays the difference to the CFD provider (e.g. the decrease in value), and the buyer will incur a loss.

The Australian Taxation Office (ATO) views on the tax treatment of financial contracts for differences are set out in Tax Ruling TR 2005/15 ‘Income tax – tax consequences of financial contracts for differences’.

According to the Tax Ruling if you carry on a business (or enter into a commercial transaction) of buying and selling CFDs for a purpose of profit making, any gain you make will be assessable income and any loss you incur will be an allowable deduction. Whether you’re carrying on a business (or commercial transaction) is always a question of fact. The main tests to determine this are set below:

•    Whether you’re carrying on your activities in a systematic, organised and businesslike matter for the purpose of profit making,
•    The size and scale of your operations
•    The number of transactions you enter into each year (e.g. on a weekly basis); and
•    The degree of skill employed in performing these activities.

Having a little flutter

If the facts suggest you’re not carrying on a business (or commercial transaction), any gain or loss you make would normally fall for consideration under the Capital Gains Tax (CGT) provisions. As a CFD is a CGT-asset, a capital gain is ordinarily assessable while a capital loss can be deducted from a current or future capital gain.

However, the ATO has thrown a cat among the pigeons, as it would seem from the ruling that this will not be the case in respect to CFD transactions. This is because the ATO takes the view that contracts for differences are essentially contracts of speculation, in that you’re basically betting (gambling) that the underlying security will either increase or decrease in value. If this is the case, any capital gain or capital loss you make ‘from a financial contract for differences entered into for the purpose of recreation by gambling’ will be disregarded under the CGT gambling exemption provision.

So if you happen to have made a $1,000,000 capital gain from a CFD transaction, you will be laughing all the way to the bank, if you can convince the ATO the transaction was entered into for the purpose of recreation by gambling. It’s reasonable to say no one is going to rock the boat, questioning the wisdom of the Tax Office’s decision to exempt and disregard a capital gain from having a little flutter!

But what if the outcome was a $1,000,000 capital loss ouch! Under these circumstances you wouldn’t be impressed, as you will effectively lose the capacity to offset the capital loss from any current or future capital gain.

Since the Tax Office takes the view that financial contracts for differences are predominantly entered into for a profit making purpose or gambling purpose, it will be very difficult for you to claim a capital loss if you can’t prove you’re carrying on a business or commercial transaction. Although it’s not mission impossible if you decide to have a go; it will be ‘exceedingly unlikely’ that you will succeed. However, if you do happen to pull it off, I’m quite sure someone will erect a statue in your honor!

Other articles in this week’s newsletter

Investors are making quick profits on equity raisings

18 Share Tips

Why volume is an important clue for traders

The tax treatment of CFDs

Contributing $100,000 to super this financial year

Mainstream investors are adding gold to their portfolios

Stock of the week

Top 10 CFD stocks for the week

Market data – NEW

More breaking news

 

Important information

The information in this article does not take into account your objectives, financial situation or needs. Therefore, before acting on the information, you should consider its appropriateness to your personal circumstances. Although this information was obtained from sources considered to be reliable, it is not guaranteed to be accurate or complete. The information is current as at 13 May 2009 and may change over time.