How CFDs are taxed

If you’ve been unnerved at the market fall, and you dread conversations with your CFD provider, here’s a surefire way to turn the tables: ask your provider about the tax treatment of CFDs

Your provider will instantly utter the weasel word “compliance”, firmly state that it couldn’t possibly be seen to be giving individual tax advice, and refer you to its product disclosure statement (PDS), which in turn will refer to TR2005/15, the ruling on the taxation of CFDs issued by the Australian Taxation Office (ATO) in 2005.

No CFD provider that CompareShares spoke to would speak on the record about how CFDs are taxed. To say that it is a grey area is an understatement. The subject became even more confusing with the ATO’s announcement in March 2007 that CFDs may be used by self-managed superannuation funds (SMSFs) under certain circumstances.

It seems that the ultimate tax implications to you (or your SMSF) of using CFDs will depend on your personal circumstances (or those of your SMSF) and, as such, your provider’s rote recitation of “we do not give advice and recommend that clients consult an independent taxation advisor” is actually correct.

In general, the gains from a profitable CFD trade are treated as assessable income, and do not qualify for the 50 per cent capital gains tax (CGT) discount for assets owned for 12 months or longer. But there is the benefit of an immediate deduction for any commissions, interest and other fees paid to the CFD provider, and you can also get a full deduction for any losses.

ATO TR2005/15 also concludes that a loss from a CFD transaction where the gain would have been assessable is an allowable deduction.

However, TR2005/15 also contemplates that a gain from a CFD entered into for the purpose of recreation by gambling (and not for a profit-making purpose) will not be assessable as income (or capital gain).

“There are three ways that CFDs can be taxed,” says the inhouse tax expert at one CFD provider. “The first is if you’re carrying on a business of trading CFDs. If you’re doing this any gains or losses are either revenue or expenses from that business, and you’re not eligible for CGT. You can show a business plan, frequency of activity, a systematic approach to trading – the elements of a business are there, in that you’re organised. If you satisfy those aspects you fall into that first bucket.

“The second is if you enter the CFD position to make a profit. You’re not carrying on a business of trading, but you have bought the CFD to make money – which is different to buying shares for a profit. When you buy a share, you can say that it’s an investment because you’re deriving part of your profit from the dividend stream. The CFD doesn’t have that income stream, so there’s no chance of you making money from a CFD other than a gain on sale. In this case, you’re taxed on capital gain, and losses are deductible.

“The third is if you are using the CFD for recreational gambling – in which case any profit on the CFD is tax-free. But that has to be very sporadic, wholly recreational activity – it has to be subject to chance. You’re effectively saying that you’ve entered the CFD transaction blindly, on pure chance: you’ve got to come up with some really good arguments to support that. It’s a tough position to run: frequency of trading would work against it, knowledge would work against it, anything that you had to say it wasn’t just a toss of the coin would work against you,” says the CFD provider’s tax expert.

The expert says the ATO’s present view is that CFDs should not fall under the CGT rules. “That’s what the ATO appears to be saying. The ATO views you, when you buy a CFD, as either running a business, trying to make a profit, or gambling. It doesn’t want to tax you under CGT, because you’re not investing – that is, investment as contemplated by the CGT rules – because this investment has no chance of giving you an income stream,” says the CFD provider’s tax expert.

Out at the coalface of tax assessment, however, CFDs are being taxed under CGT – without the CGT discount.

“The taxation of CFDs is no different to that of shares,” says tax agent Michael Chang, of Taxation Strategies & Accounting Services in Perth. “But they don’t necessarily come under the CGT regime – it depends on the nature of the trading itself.

“If you’re buying and holding, like an investor, it comes under the CGT regime, but if you trade regularly on a day-to-day basis, and satisfy certain tests, then the buying and selling is considered to be part of the line of business that you are in. In that case, the sales and purchases are part of assessable income, but you don’t enjoy the 50 per cent capital gains tax discount if you held the CFDs for more than 12 months.”

Chang says the situation is exactly the same as the vexed question of whether a person’s share trading activity makes them a share trader – in which case any change booked in the value of a trader’s shares is either assessable as income or deductible as a loss. While many people consider themselves to be traders, the fact is that you cannot declare yourself to be a trader: your level of activity dictates whether the ATO treats you as such.

“The ATO has published a set of guidelines on what makes a person classed as a trader. From a simplistic point of view, if you buy a share today and sell it in a month’s time, that is not classed as a trade. To prove that you are a trader you have to be trading very frequently – buying and selling at least on a weekly basis. If you buy and sell on a monthly basis I think it’s debatable that you’re a trader,” says Chang.

“As tax accountants, we prepare the client’s activity statement and it then becomes a question of the ATO’s interpretation. If we can’t determine the client’s tax status there and then we might ask for a private ruling – to let the ATO decide if the taxpayer is a share trader, a share investor or both.

“But for the normal client, CFD gains and losses are just like those for shares. It’s just the name of the product: at the end of the day, it’s simply whether you make a profit or a loss,” says Chang.

Where the use of CFDs by SMSFs is concerned, the ATO has published three interpretative decisions: ID2007/56, 2007/57 and 2007/58. While borrowing by super funds is prohibited under the Superannuation Industry (Supervision) Act 1993 – SMSFs can’t use margin lending, or buy properties on credit – the ATO has concluded that provided a SMSF does not deposit fund assets with the CFD provider as security against their obligations to pay deposits or margins, then there is no loan between the CFD provider and the SMSF trustee.

Effectively, provided that a SMSF trustee deposits cash into a CFD bank account rather than fund assets, it does not contravene the prohibition on borrowing by a super fund.

CFD providers argue that CFDs are the perfect instrument to allow funds to hedge against market falls.

“We believe that SMSF trustees are quite entitled, without breaching the Act, to trade CFDs as long as two things are present: one, that this activity is part of their investment strategy; and two, that they have proper risk management procedures in place,” says the legal counsel to a CFD provider.

“By that, I mean that they should trade with guaranteed stop-losses. If they do that, and they are not trading in a speculative fashion, I don’t believe they’re breaching the Act, in fact I think they’re fully entitled to do it,” he says.