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Taxation Practitioner by Mark McLaughlin ATII TEP

What are the badges of trade, and how did they evolve? The decision as to whether a transaction gives rise to a trading or capital receipt can be significant, particularly where the opportunity exists to take advantage of available CGT reliefs and exemptions.'How's the studying going?' I asked my faithful tax assistant, Alf Wright.

'Not bad, boss' he replied, in a seemingly automatic manner.

The badges of trade would probably be on page one of his Paper II correspondence course, I thought - has he taken the wrapping off the manual yet, I wonder?

'Yeah, course I have. Covered it ages ago. The toilet roll case, and all that...'

'You mean Rutledge v CIR (1929 14 TC 490)', I sighed.

'That's the one'.

Without further ado, I generously offered Alf some study guidance on the badges of trade.

'Actually' I began, 'the badges of trade are as relevant to tax practitioners as they are to students. The decision as to whether a transaction is trading or a capital receipt can be significant, for example where a potential opportunity exists to use one's annual capital gains tax exemption. There is a main body of established case law that you will need to be aware of for your exams, and new cases on the subject are regularly being decided, Lynch v Edmondson (Inspector of Taxes) (SpC 164) being a prime example'.

That concerned a self-employed bricklayer, who built two flats on a plot of land. He appealed after the Inland Revenue assessed him to income tax under Sch. D Case I in respect of the premium received for a ninety-nine year lease of one of the flats. In reaching his decision, the Special Commissioner applied badges of trade principles (see below) to the particular circumstances of the case. Most (but not all) of the badges pointed towards the lease constituting a trading transaction, resulting in the taxpayer's appeal being dismissed.

The badges of trade have evolved from the element of doubt which exists as to whether a transaction or series of transactions fall within the statutory definition of 'trade'. ICTA 1988 s 832 widely defines a trade as including "every trade, manufacture, adventure or concern in the nature of a trade". The question precisely what constitutes a trade has been considered by the courts in many decided cases. In June 1955, the Royal Commission on the Taxation of Profits and Income used these judicial decisions to establish what they regarded to be the following main criteria in identifying the 'badges of trade':

- The subject matter of the realisation;
- The length of the period of ownership;
- The frequency or number of similar transactions by the same person;
- Supplementary work on or in connection with the property realised;
- The circumstances that were responsible for the realisation; and
- Motive.

In Marson v Morton [1986] 59 TC 381, the profit on a single transaction in land was held to be a capital receipt, rather than arising from a trade. In his judgement, Sir Nicholas Browne-Wilkinson V-C confirmed the view expressed in the Inspector's Manual (para 120(c)), that whether there has been an adventure in the nature of trade is a question of fact that depends on all the facts and circumstances of each particular case. The judge expanded upon the badges, specifying nine factors to be considered in determining the existence of a trade. These factors are considered below:

'Frequency or number of similar transactions by the same person'.

Although a one-off transaction is capable of being a trading transaction, a lack of repetition generally points away from the existence of a trade, a view acknowledged by the Special Commissioner in the Lynch case. Aside from Marson v Morton, other decisions of relevance to students and practitioners on the issue of frequency include the following:

- Salt v Chamberlain [1979] 53 TC 143 - a number of Stock Exchange transactions (200 sales and purchases over a three-year period) was not sufficient to establish that the taxpayer was trading;

- Pickford v Quirke (1927) 13 TC 251 - the taxpayer's participation on four separate occasions in similar transactions for the purchase of a mill-owning company and sale of assets was collectively held to constitute a trade;

- Leach v Pogson (1962) 40 TC 585 - the taxpayer was held to have operated a trade on each sale of around 30 driving schools. This included the first driving school set up and sold, as Judge Ungoed-Thomas determined that the taxpayer's intention was to embark upon the business of establishing and selling driving schools immediately before he sold the original motoring school;

'The subject matter of the realisation'.

The subject matter of the Lynch case was the land on which the property was constructed. An asset such as land can be the subject matter of a trade. Possible alternatives to the treatment of an asset as stock-in-trade include an investment purchased to yield a return (potentially liable to Capital Gains Tax), or perhaps an appreciating asset acquired for personal use and enjoyment (such as a work of art).

In Rutledge v CIR 1929 14 TC 490, the court held that one million rolls of toilet paper, purchased for no other purpose than for resale at a profit, was an adventure in the nature of trade (but not necessarily a trade itself) because of the nature of asset involved.

Was the transaction carried through in a manner typical of the trade in a commodity of that nature?

The fact that property in the Lynch case was leased immediately following completion of the building work was considered to be a further indicator towards trading.

In Murray v IRC (1951) 32 TC 238, a timber merchant's sale of the rights to cut timber in two plantations purchased some years earlier was held to form part of his normal trading profits, chargeable to income tax.

What was the source of finance of the transaction?

Where money is borrowed, this often indicates an intention to re-sell in the short term, a fair pointer towards trading. In the Lynch case, bank borrowings financed the property construction on terms whereby the loan would be repaid out of the sale proceeds from the first flat, a factor indicating that a trade was being carried on.

Was the transaction in some way related to the trade which the taxpayer otherwise carries on?

The Special Commissioner in the Lynch case noted that the construction of the flats was related to the taxpayer's trade of bricklaying, and the fact that the taxpayer was directly involved in their construction was deemed to be an indicator towards trading.

'Supplementary work on or in connection with the property realised'.

Work carried out on an asset prior to sale is a factor in determining the existence of a trade. The asset in the Lynch case was the land on which the flats were built. Their construction was considered relevant to the badge of supplementary work, and provided a further pointer towards trading.

Additionally, a body or organisation assembled to attract purchasers, or arrangements that resemble a formal undertaking, generally indicate a potential source of trading income.

In Cape Brandy Syndicate v CIR [1921] 12 TC 358, three individuals who acquired a quantity of Cape brandy and blended it with French brandy before re-casking and selling it were deemed to have made a profit from a trade or business.

In Martin v Lowry [1927] 11 TC 320, it was held that profits from the purchase and re-sale of the Government's entire surplus stock of aeroplane linen (some 44 million yards!) through a separate operation set up for that purpose, had arisen from a trading activity.

Was the item purchased was resold in one lot, or was broken down into several lots?

The sale of the flats separately in the Lynch case was considered to be a further indicator towards trading.

'Motive'

An intention to re-sell in the short term might be a pointer towards a trading transaction, as opposed to an investment. The taxpayer in the Lynch case intended to sell one of the flats at the time of purchase, as agreed under the terms of the bank loan to finance the construction work.

The presence of a profit-seeking motive is not necessarily a decisive pointer to the existence of a trade. However, evidence indicating that the sole object of acquiring an asset was to re-sell at a profit, with no apparent investment motive, will normally favour trading treatment.

In Wisdom v Chamberlain [1969] 45 TC 103, the purchase of silver bullion on a short-term basis as a hedge against the devaluation of sterling was considered to possess the characteristics of an adventure in the nature of trade, rather than an investment.

In IRC v Fraser 1942 24 TC 498, an isolated transaction in the purchase and re-sale of whisky in bond was held to be an adventure in the nature of trade. The nature of the commodity and quantity purchased was such that it could not reasonably be considered to be for own consumption, and there was insufficient evidence to indicate an investment motive. See also Marson v Morton (cited above).

Did the item purchased either provide enjoyment for the purchaser, or produce income pending resale?

Where one or both of these factors are present, this generally indicates an investment rather than a trading transaction.

In addition, the Inspector's Manual (para 120g) identifies the following criteria in the process of establishing whether a trade exists:

- The interval between purchase and re-sale and the reason for that interval ('The length of the period of ownership').

Broadly, short time periods between transactions tend to favour trading rather than investment treatment (see Wisdom v Chamberlain above), although it should be emphasised that this is a general rule.

- The way in which the transactions of purchase and sale were carried out - this might incorporate 'The circumstances that were responsible for the realisation'. The Revenue consider that transactions carried out in the same manner as a trader in that commodity would complete them, are a pointer towards trading. A sudden emergency or necessity to quickly realise an asset is therefore likely to dispel any argument as to the existence of a trade. In IRC v Old Bushmills Distillery Co Ltd [1928] 12 TC 1148, it was held that sales by a liquidator of the whisky stock of a distilling company that went into liquidation constituted the realisation of company assets, and that the liquidator was therefore not engaged in a trade.



'An important point to remember, Alf' I continued, 'is that whether or not a transaction or series of transactions constitute trading will depend upon the circumstances of each individual case. No single badge of trade is conclusive evidence in itself. It is therefore necessary to critically examine the overall picture, distinguishing any unique features'.

I looked up from my book of case law to find an empty chair where Alf had been sitting. Pinned to his seat was a scribbled note saying: 'gone to lunch'.

Attention all employers out there: anybody need a new tax assistant? Feel free to take mine ... please!!!