Uk Taxation Of Options Trading

Uk taxation of options trading

Tax Treatment of Options and Warrants

About the Author


The Author of this article is our site Editor, Lee Hadnum. Lee is a rarity among tax advisers having both legal and chartered accountant qualifications. After qualifying a prize winner in the Institute of Chartered Accountants exams, he also went on to become a chartered tax adviser (CTA).

He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice.

He is now a full time tax author.Google+

Lee is also the former tax columnist for "Your Trading Edge" magazine. Our site members can ask Lee tax planning questions at:

Options are used to speculate on share price movements or hedge portfolios against share price falls.

Either way, the profits are normally subject to capital gains tax.

Trading Taxes in the UK

The same goes for warrants.

I say 'normally' because it is possible to be classed as a trader in options, just as it is possible to be classed as a trader in shares. In these instances your profits will be subject to income tax.

In this section we'll examine the capital gains tax implications of buying and selling options and warrants as it's these tax rules that will apply most often.

If you're buying and selling options frequently, the normal share matching rules will apply, provided the options are of the same 'class' and 'series' (in other words, provided they have the same expiry date and exercise price).

The main difference between the ordinary CGT rules and the rules which apply to warrants and traded options is that the abandonment of the option is treated as a disposal.

This means that the grantee of the option (that is, the person who buys the option) will obtain an allowable loss for capital gains tax purposes if the option is simply allowed to expire.

If you decide to exercise an option or warrant, its cost is added to the exercise price of the shares to determine the base cost for the CGT calculation.

Example

David buys 5,000 warrants in ABC plc, which give him the right to purchase one share per warrant at a price of £3.00 within the next three years.

Uk taxation of options trading

He pays a premium of 10p per warrant. If he subsequently exercises the warrants, his total base cost will be £15,500 (the cost of the warrants and the cost of the shares).

David subsequently sells the 5,000 shares for £5.00 each.

The CGT calculation will be as follows:

Proceeds £25,000

Less: Cost £15,500

Gain £9,500

Of course, the actual option or warrant may never be exercised if you sell it for a profit before the expiry date. This would be a simple disposal for CGT purposes and the gain (before CGT reliefs) would be the uplift in value from the price paid to proceeds received.

Tax Planning

Options and warrants can be put to a number of uses:

Crystallisation of Losses

Let's assume Bob holds 1,000 shares in Slump plc.

He purchased them at a price of £4.40, but the share price has now decreased to £1.40. He is therefore sitting on a capital loss of £3,000 (£4.40 - £1.40 x 1,000).

He has made other share disposals during the tax year and has crystallised gains of £13,100.

To avoid paying any tax, it may be desirable for Bob to dispose of the Slump plc shares and offset his loss against his gains, with the remaining gain being reduced by the annual capital gains tax exemption.

However, maybe Bob is reluctant to dispose of his Slump plc shares as he is confident they are going to enjoy a rebound shortly.

What should he do?

He could sell the Slump plc shares, thereby crystallising his loss for tax purposes but take out an option to buy the shares. If the price subsequently rises he will still benefit by holding a position in Slump but will have reduced his CGT liability by utilizing his loss.

Using the Annual CGT Exemption

Options and warrants allow you to take profits to utilise your annual CGT exemption (worth up to £2,968 per year in saved tax) and avoid falling foul of the taxman's share matching rules.

Remember the share matching rules prevent you from selling shares and buying them back for 30 days.

However, there's nothing HMRC can do if, instead of buying back the shares, you buy options instead. Using options (and spread betting contracts for that matter) you can make sure that you retain your exposure to the underlying asset and make maximum use of the annual CGT exemption.

Delaying the Date of Disposal

Options can be used to delay the date of disposal of a shareholding.

Postponing the disposal date provides three key tax benefits:

• You could end up with an extra 12 months to pay capital gains tax, if you manage to push your disposal into the next tax year.

• It can help you make the most of capital losses.

• If you have used your annual exemption for the current tax year but don't expect to do so for the next tax year it can allow you to delay the disposal date to utilise the additional annual exemption.

Example

Denis owns 20,000 shares in Dosh plc. They were acquired in May 2003 for £20,000. Denis decides to sell them for £50,000 in February 2012.

The tax calculation will be as follows:

Proceeds = £50,000

Less:

Cost = £20,000

CGT exemption = £10,600

Taxable Gain = £19,400

Tax @ 28% = £5,432

After-tax proceeds= £44,568

Denis is expecting to incur a capital loss of £10,000 in the following tax year.

He may therefore want to hold onto the shares until after 5 April 2012. If he believes the price of Dosh shares will drop if he holds them until after April, one possibility would be to obtain put options for £2.80 over 20,000 Dosh plc shares at a premium of 0.15p each.

Let's say the value of the shares has decreased to £45,000 in June 2012 and Denis decides to exercise his option.

His gain will be calculated as follows:

Proceeds (£2.8 x 20,000) = £56,000

Less:

Original cost = £20,000

Cost of option = £3,000

Capital loss = £10,000

CGT exemption = £10,600

Taxable Gain = £12,400

Tax @ 28% = £3,472

After-tax profits = £52,528

Note that in this case the investor's after-tax profits have increased.

He has been able to take advantage of the falling price, the capital loss and the tax payment date has been put back from 31 January 2013 to 31 January 2014.

Uk taxation of options trading

This is an extra 12 months that the CGT will be in his bank or invested and making him more money.

Options and the CGT Matching Rules

We've looked at how the matching rules operate when you sell shares, allowing you to determine the correct base cost. The same rules that apply to shares also apply to options.

Generally traded options are on one of three possible expiry cycles:

• January, April, July, October

• February, May, August, November

• March, June, September, December.

Therefore, at any one time there are equity options available with three possible expiry dates. When a new equity option is introduced it is allocated to one of the three cycles.

All options of the same type (ie put or call) relating to the same share are called a class.

All options of the same class with the same expiry date and exercise price form a series.

Tax Basics for Stock Market Investors!

For capital gains tax purposes options of the same series will be subject to the share matching rules.

As we've seen, there is a definite order in which acquisitions should be treated. So when you sell options you should look at your holding of options of the same series and match the disposals with:

• Options acquired on the date of disposal

• Options acquired in the 30 days following the date of disposal

• Options acquired before the disposal (ie the new pool)

Contracts for Difference (CFDs)

A CFD is a method of investing in shares that looks to mirror the benefits of direct ownership while eliminating many of the disadvantages.

In particular, CFDs allow for margin payments which means you can invest without paying the full market price of the shares upfront.

They also allow you to benefit from any dividends the company pays during your period of 'ownership' and, unlike shares, CFDs are not subject to stamp duty.

In terms of tax, CFDs are subject to capital gains tax so any losses can be offset against other gains made during the tax year -- for example, gains on share disposals.

We're often asked whether the share-matching rules apply to CFDs as well.

The special share-matching rules apply only to 'fungible assets'. CFDs would usually be treated as a fungible asset and therefore the share-matching rules would apply.

A fungible asset is one which can be freely exchanged with another of like nature -- the individual parts cannot be identified separately.

Day Trader vs Investor Status

This applies to shares/securities as well as commodity and financial futures, quoted options, forex and various other assets (eg goodwill).

There are a number of uses for CFDs although the tax implications are closely linked to your particular trading strategy.

One use is to sidestep the provisions that prevent 'bed and breakfasting' of shares.

As we know, these apply where shares are sold one day and bought back the next in order to crystallize a loss or use the annual CGT exemption.

HMRC prevents this by stating that any repurchase of the shares in the next 30 days will be matched with the disposal, effectively meaning that the shares are deemed not to be sold at all. However, many investors use CFDs to circumvent this rule.

Repurchasing shares in the form of a CFD allows you to maintain a position in the company during the 30 day period, and you can then repurchase without having lost out on any growth and without the bed and breakfast anti-avoidance rules applying.

Example

Elliott owns shares that are standing at a small gain, for example £5,000, or even at a loss.

Prior to the end of the tax year he could dispose of the shares and crystallize the loss or gain. If the shares are showing a gain he could eliminate any tax bill by offsetting his annual exemption. If he can repurchase the shares he will have secured a tax-free uplift in the base cost of the shares.

Elliott then purchases a CFD for the same number of shares. After 31 days he sells the CFD and repurchases the ordinary shares.

Binary options and the UK tax position

By using CFDs he will have maintained a position in the shares and won't be any better or worse off if the shares rise or fall in value. For example, if the shares slump then the loss on the CFD trade is offset by the cheaper price he will pay for the shares when they're bought again.

Investors can also use a CFD to hedge against price falls and this short selling is a useful way of managing your liability for capital gains tax. In particular, you can sell CFDs against an existing holding allowing you to control the time at which you crystallize capital gains or losses. This can also be useful for ensuring correct offset of losses and utilization of the annual exemption.

The Tax Benefit of CFDs Over Shares

Most investors knows that CFDs are free of stamp duty.

This in itself can result in a sizeable saving where you are investing in contacts with a substantial value. This is not the only tax benefit of CFDs. To see exactly how good they are you need to look at the alternative, which is a direct investment in the underlying shares (or a currency or commodity).

If you purchase the underlying asset directly the chances are you'll be subject to capital gains tax when you sell it. As such you'll be taxed at 18% or 28% on any capital gain. Any dividends received would be subject to income tax at your marginal rate of income tax.

So if you're a higher-rate taxpayer the effective rate of income tax would currently be 25% rising to 36.1% if you're a high income earner subject to the new additional rate of tax.

The only expenses that you would be able to deduct would be the acquisition cost of the shares and any incidental costs of buying and selling -- essentially stamp duty and dealing costs.

If you borrowed to invest in the shares there would be no tax deduction for any interest that you incurred. Unless you were taxed as a financial trader this interest paid by you would therefore not qualify for tax relief.

What if You Were Treated as a Trader?

If you were a taxed as a trader you would qualify for tax relief on the interest paid but your profits would be taxed at your marginal income tax rate.

Again, if you're a higher-rate taxpayer this would be 40% (50% if you are in the additional tax band). Dividends would still be taxed at an effective rate of 25% or 36.1%. So you might get the benefit of the interest deduction but your tax rate would go up substantially.

CFD Investors

Now let's take a look at the position for CFD investors.

Tcns clothing company pvt ltd ipo

The whole of the net gain is subject to capital gains tax. This means that you would also benefit from:

• A capital gains tax deduction for interest charged by the CFD provider.

• Dividends subject to CGT and not income tax. You are still able to deduct commission, as would a share investor, but the additional interest deduction would not be available to a share investor. This potentially saves you tax at 28% on your interest costs.

Similarly the dividends are rolled up as part of the gain and taxed at 18% or 28% and not 25% or 36.1%.

Of course, this doesn't take account of the different rates etc that CFD providers charge but, other things being equal, you would expect a CFD investor to have higher after-tax returns than a direct investor.

CFD Calculations

Investors in CFDs can choose whether to go long or short, just as they would if they were investing in the shares or share index directly.

Obviously if you go long you will receive a payment based on the increase in the value of the shares or index between you entering into the contract and closing out the contract.

How Are Futures & Options Taxed?

Contracts are commonly closed out by entering into an equal and opposite contract.

If you go short you'll receive a payment based on the fall in value during the life of the contract.

Dividends and Interest

Factored into the CFD receipt/payments will be any dividends or interest.

Uk taxation of options trading

Dividends will be attributed as a receipt to your CFD account if you go long and dividends are payable on the shares.

Interest will be treated as a debit or an expense of your CFD account as its based on the amount of 'loan' that the derivatives provider gives to you for the purchase. For example if the shares were worth £50,000 and you put a deposit of £10,000 you'll be charged interest on the £40,000.

Uk taxation of options trading

CFDs therefore look to mimic as much as possible the position that an investor would be in if they purchased the shares directly. However, the benefit of CFDs is that they're not actually classed as purchases of the shares and therefore there is no stamp duty chargeable.

If you go short the dividends would be debited (ie as an expense) of the account and the interest would be a receipt.

Tax Position

Although they may be referred to as 'dividends' and 'interest' they are just artificial payments that are labelled as such.

If you're a CFD investor the tax legislation states that all amounts are subject to capital gains tax.

So you would not show amounts received as investment income (interest or dividends) on your self-assessment return.

You simply take all of the debit and credits including interest, dividends as well as broker commission and CFD payment and net them off to arrive at your capital gain.

So you would have proceeds equivalent to your credits and costs equivalent to your debits.

Any unused personal allowance could not be offset against the deemed interest or dividends.

If you are a CFD trader you would calculate your trading profit by bringing in all of your receipts and deducting the expenses that were 'wholly and exclusively' for the purposes of your trade. This would therefore include the dividends, interest, commission as well as the actual CFD profit or loss when calculating your taxable profits.

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