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Spread bets and tax tactics

Created:

25 November 2005

Written by:

Dan Oakey

The tax position for spread betting seems cut and dried. You can disregard stamp duty, ignore income tax on dividends and laugh in the face of capital gains tax (CGT). No other financial derivative can claim as much.

Yet many investors fail to appreciate three important provisos. Firstly, you can earn up to £8,500 a year in capital gains before the taxman demands a penny. Secondly, any spread betting losses are not tax-deductible. Thirdly, you can hold shares, contracts for difference (CFDs) and covered warrants within a self-invested personal pension, where they will be protected from the taxman - but you can't do that with spread bets.

Scenario one

Suppose you start off with £10,000 of capital and use it to trade CFDs or spread bets. That much initial capital might let you open up a position worth £100,000 (if you trade on a 10 per cent margin). Now imagine that you make a 10 per cent gross return on that total exposure, or £10,000 in a year. You have doubled your capital to £20,000. That gross return ignores financing fees, though.

If your £10,000 of capital were committed all year, it would attract fees of 7 per cent on £100,000, or £7,000. Take that off and your profit is now £3,000 - or a 30 per cent return.

Still, you would now have £13,000. Reinvest that and keep up the 10 per cent returns and you will have £137,858 in your spread-betting account after 10 years.

Scenario two

Now consider the same trading performance but using CFDs. If you had to pay 40 per cent on all capital gains, your final tally would be £52,338 - a drop of 62 per cent. In reality, your tax bill would be far less because of your £8,500 annual allowance. Factor that in, and you could avoid CGT until the end of year five, by which time your capital would have grown to £37,102. Even then, you are only liable to pay CGT on the part of your gains that exceeds £8,500 (assuming the allowance is frozen).

In year five, that amounts to £68, of which £27.20 is lost to the taxman, assuming you are a higher-rate taxpayer.

In the next five years, CGT bites more deeply into your CFD profits. Even so, after a decade of paying all your CGT bills, you would still have £109,205.

Of course, it is unreasonable to assume steady 30 per cent profits year after year. Investing is risky, and trading on margin is riskier still.

So let's suppose that, in two out of three years, you manage a 30 per cent return but that, every third year, you finish the year 10 per cent down. With a spread bet, those losses are your problem, a matter of supreme uninterest to the taxman. However, the one consolation of losing money with CFDs is that you can set them against tax claims on future gains.

Raising the stakes

To see what difference that makes, let's up the stakes and imagine that you start with £28,500 of capital. At this level, an annual return of 30 per cent will make you £8,550, just enough to bump the CFD trader above the CGT threshold.

Now consider what happens in years three, four and five. After a 10 per cent loss in the third year, the CFD trader has a £4,709 loss. He can add this to his £8,500 allowance the next time he makes a profit. In year four, both the spread better and the CFD trader make 30 per cent returns. The CFD trader pays no CGT because his £8,500 allowance, combined with the losses from year three, more than soak up the profits.

The same thing happens each time a CFD trader incurs a loss. The net result is that, after 10 years of alternating profits and losses, the spread-betting client would have £130,369 and the CFD client £109,987.

If there were nothing more to choose between the products, the advantage would still lie with the spread bet - albeit by a narrower margin. However, if you were trading on this scale - risking tens of thousands at a time - you would find that dealing fees for spread bets were higher than for CFDs.

Here, we have only dealt with two scenarios and the outcomes are highly sensitive to the rates of return that you assume. The reality is that the less you factor in the chance of a sizeable and regular fall, the fewer capital losses you will generate, and the greater the tax difference between spread bets and CFDs.

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