Trading Or Investment: Why Do We Care? 

This is an excerpt from our popular updated tax report: Property Investment V Property Trading

Individuals And Non-Corporate Entities: Income Tax V CGT 

There can be a substantive difference between the tax, etc., applied to a trading activity when compared to an investment activity – at least for unincorporated businesses. 

There can also be a difference in the treatment for losses. 

There is no ‘hard and fast rule’ as to which is the better approach; nor is there often a choice. But let’s say for simplicity that a residential property is being sold by an individual for £500,000 that cost only £300,000. The profit or gain is £200,000. In such a simple example, the profit would be the same as the gain: 

(NB Income Tax rates differ in Scotland, but not by so much as to substantively affect result) 

While the CGT Annual Exemption is slightly less generous than the Personal Allowance, capital gains are generally taxed less harshly than income. 

*In fact, these are the CGT rates for residential properties. For property disposals on or after 6 April 2016, where the capital gain is on a commercial property the rates fall to 0%/10%/20%. 

Furthermore, trading income attracts a Class 4 National Insurance Contributions charge: 

(There is also a fixed Class 2 NICs charge, currently £156.00, for most trading activity) 

On the basis that the band for the main rate of Class 4 NICs broadly overlaps the Basic Rate Band for Income Tax purposes, the main combined rates for trading will be 0%/29%/42%/47%. 

This opens up a huge margin between the tax that will be levied on a trading profit when compared to a capital gain on the same amount – the combined tax and NICs rate of 29% in the ‘Basic’ Rate Band is almost three times the rate of 10% that would apply to the capital disposal of a commercial property in that band. (Investment income, such as from rental profits, has no National Insurance charge). 

Since property tends to be ‘lumpy’, profits and/or gains commonly end up at many tens or even hundreds of thousands of pounds, so even relatively small rate differences can result in dramatically higher tax bills through being taxed as a trade, for non-corporates. 

This difference is exacerbated for non-corporates with long-term projects that might span more than one tax year because unused Personal Allowances/Basic Rate Bands, etc., in Year 1 cannot be rolled into the following year to soak up large profits from, say, a property development profit in Year 2. (While this approach applies also to capital gains, the rates are lower, so it is less problematic). 

The end result is that a great deal of self-employed property development profits may well end up being taxed at 47%, compared to 28% at most for capital gains on the sale of a residential property (or as little as 20% for a commercial property gain). 

Companies 

For companies, the rate of tax is the same regardless of whether it is trading profits or capital gains – currently 19%. For now, companies can also claim Indexation Allowance – a form of inflation-proofing – on their capital gains, to further reduce the tax charge on capital disposals. (TCGA 1992 ss 53/54). Note that the 2017 Autumn Budget announced that Indexation Allowance would be frozen at December 2017 for future corporate capital disposals and is likely to be withdrawn completely at some point in the future (this is what happened to Indexation Allowance for individuals: frozen in 1998 and withdrawn completely in 2008). Until this happens, however, Indexation Allowance is likely to remain extremely valuable to many long-term corporate investors. 

Companies are also potentially useful for holding residential property that would otherwise be subject to 18%/28% CGT if held personally: selling company shares is NOT selling the bricks and mortar that the company owns, so will be taxable at only 10%/20%, using the rates as above. (But see the next section).

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