The dangerous tax trap that every day trader should know about

If you do not know the difference between sock trading as an individual or a professional, let me tell you that the difference in terms of taxes that you pay in some countries can be huge. It is important that you know the differences between these types of stock trading, even if there are countries where they are not fully regulated.

In the strict sense of the word, stocks not only refer to shares, but also to futures and derivatives -such as options and swaps- as long as they are derived from a specific underlying asset. Moreover, participation certificates, warrants and other property rights are also included. This issue refers more specifically to how capital gains are taxed. In the majority of countries around the world, this type of income is taxed at a lower rate than salary income.

Often -but not always- capital gains are subject to a capital gains tax similar to that on dividends and yields. For example, this is the case with the German compensation tax or the Austrian income tax. With 26.375% or a uniform 25/27.5%, this tax is more favourable than personal income tax, regardless of income and starting with a relatively low tax progression. This is also the case in Spain where taxes range from 19% to 28%, and in Mexico, with a 10% tax on stock market profits.

In Spain or Germany, private traders “only” have to pay the state a quarter of their investment profits, contrary to employees and the freelancers who have to pay up to half of their earnings. Even so, the difference is much greater in other European countries: in Belgium -which has the highest tax progression in all of the EU with an income tax of 50% from just €38,080- capital gains from assessed private assets are completely exempt from tax. The other two Benelux countries, the Netherlands and Luxembourg, enjoy similar privileges, but with less pronounced differences regarding local tax rates. Of course, we cannot forget Switzerland, where you do not pay tax on capital gains.

This “tax privilege” on capital gains over other types of income is found in nearly every country in the world. However, this does not mean that this is also the case in the country that you live in or that it cannot change in the future.

The problem of your investments or trading being seen as a professional activity

Investment or trading activity of certain wealthy individuals is already considered to be a professional activity in some countries. In such cases, you may think that you are exempt from taxes, but suddenly you discover that you have to pay local income tax on your capital gains because the asset management you are carrying out is not seen as a purely private activity. This is a huge and dangerous tax trap.

In Spain, the difference between private asset management and professional trading (with personal funds) is not particularly relevant. Even day traders have problems because suddenly they are considered to be carrying out commercial activity for which they have to pay personal income tax, as well as registering with the social security system.

However, things are different in Switzerland, Belgium and many other countries in the world: the local tax authorities there tend to be slow in deciding if the type of trading you are doing is a commercial activity or not, which turns the expected exemption from capital gains tax into a huge tax on a professional activity.

In principle, we are faced with the problem of differentiating between professional and personal trading in all countries where capital gains are totally or partially tax-free (we have already spoken about the best countries for traders in a previous article).

As well as Switzerland, the Netherlands, Belgium and Luxembourg, we are also faced with this problem in the non-dom states, such as Malta, Ireland and England where non-imported foreign income is usually exempt from tax – only for non-doms, of course -. What happens is that these countries consider, with a certain logic, that the non-dom is trading within the country and, therefore, it spoiled be considered domestic income. So, in a way, we are faced with the “effective direction” rule, even though in this case there is no company. Some countries with stricter territorial taxation, such as Hong Kong or Singapore, can also cause problems in this regard.

When are you considered a professional trader?

The definition of “commercial trading” and its distinction from private management of assets is open to interpretation. There is no law in the world that defines this distinction comprehensively. The best summary of all the possible differences is given by the German Federal Tax Administration in Circular 36 of 2012, which states:

In order to guarantee adequate legal security for the majority of taxpayers, criteria have been established for the application of the law on the basis of which the commercial exchange of securities can be excluded in the course of a preliminary examination. In any case, the tax authorities assume the management of private wealth or private capital gains tax-free if the following criteria are all met.

1. The holding period of the securities sold is at least six months.
2. The total volume of transactions – the sum of all purchase prices and sales proceeds – per calendar year does not exceed five times the balance of stocks and receivables at the beginning of the tax period.
3. The obtaining of capital gains on securities does not require the replacement of missing or lost income for living expenses. This is usually the case when the realised capital gains are less than 50% of the net income in the tax period.
4. The investments are not financed by debt, and the taxable capital gains on the securities – interest, dividends…- are not more than the pro-rata interest on the debt.
5. Trading in derivatives (especially in the case of options) is limited to the coverage of one’s own stock positions.

If the above criteria are not met, this does not automatically mean that a commercial activity is not being carried out. The corresponding assessment is made on a case-by-case basis (see section 4).

If some of these 5 criteria are met, this does not directly lead to classification as a professional trader, but it can be interpreted as a sign that you are one. Therefore, the occasional sale of shares after a short period of time multiplying your income does not necessarily make you a professional trader, but it can be a sign that you are one.

What is important is the way of earning a living aside from capital gains. In this regard, we have to take into account what we do when we are working as an employee or freelancer. If the job is in the financial sector and is specifically related to investment, the authorities can easily conclude that we are professionals in this field. Therefore, our trading should be taxed as commercial activity despite the fact that we are managing our own private assets.

Of course, if we are trading with family or friends’ funds, we can also easily fall into the classification of professional activity, given that we are essentially financing our investments with money that is not ours, just as we would with a bank loan.

The German circular again states:

Main criteria:

• Amount of transaction volume (frequency of transactions and short period of ownership).

A short period of ownership indicates that the taxpayer is not pursuing for investment purposes, but rather is interested in making a quick profit (ASA 69, 652 and 788; 63, 43,59, 709). In some circumstances, even one transaction can give rise to the existence of self-employment (2A.23/2004; ASA 69, 652). The frequency of transactions and the short period of ownership of stocks are indications that the taxpayer is not aiming for a medium-term capital investment, but is depending on a quick capital gain and also accepts that significant losses could occur (ASA 71, 627).

• Use of external funds to finance investments

The use of substantial external funds in private asset management is somewhat atypical. Normally with ordinary investments of private wealth, the goal is to ensure that income exceeds expenditure (ASA 69, 788). However if external finance is used, the taxpayer will take more risk, which is an indication of being self-employed. If the interests and expenses of the debt cannot be covered with regular income and need to be payed off through capital gains, it is no longer possible to refer to it as private management of assets (ASA 69, 788). The fact that the taxpayer waives the deduction of both the debt and the interest on the debt, does not automatically imply that the financed stocks with external funds have the status of private assets. Depending on the relevant case-law, it will be decided whether the stocks are to be classified as private or business assets according to the specific circumstances of the case.

• Use of derivatives

The trading of derivatives can be a means of covering equity assets. However, if the use of derivatives goes beyond risk coverage and a large amount in relation to the total assets is traded, the trading of derivatives will be considered speculative. This implies a commercial activity.

Minor circumstantial evidence:

• Systematic or planned action

The taxpayer actively increase the value of bonds or intends to exploit the development of a market in order to make a profit (ASA 69, 652 and 788; 67, 483). According to the case-law of the Federal Supreme Court, for the assumption of an independent activity with stocks, it is not necessary that the taxpayer conducts this activity in a real and organised company (ASA 71, 627; 69, 788), nor that he visibly participates in economic traffic (ASA 69, 652; 67, 483; 66, 224). The reinvestment of the profits earned in similar assets can be regarded as part of a planned action. The fact that the profits made are invested in similar assets also indicates that there is lucrative activity with stocks for one’s own benefit (ASA 69, 652 y 788; 67, 483; 66, 224).

• The close relationship of the transactions to the taxpayer’s professional activity, as well as the use of specialised knowledge.

The close relationship of the transactions to the taxpayer’s professional activities may also be an indication that they are not working on a personal level, and instead is trying to make a profit as a part-time or full-time self-employed person (ASA 66, 224).

The decision of the Federal Supreme Court of 23 October 2009 (2C.868/2008) has given secondary importance to these two indications.

Solutions for traders who are considered professionals.

Reality tends to be more flexible than it seems here. However, once the relevant tax authority starts to suspect that our activity could be professional, you should check the 5 parameters we have just listed to avoid unpleasant surprises.

Normally, typical day traders do not have to worry too much about getting tax residency and, therefore, double taxation treaties. You only need to be able to comply with the legal compliance procedures and KYC required to open an account with a broker. Otherwise, you will have no problems as a Perpetual Tourist.

If the majority of your income comes from capital gains through the buying and selling of shares, futures, currency trades, options or other derivatives, you will generally not have any problems with taxes and withholding.

However, in this case too, it might be useful to use some type of structure (companies, trusts or foundations) to better protect your assets or to avoid certain financial market regulations (like those in the EU). In case you are a tax resident in a country, the structure can help you to take advantage of certain tax benefits (Being classified as a trader you would have to pay even higher income tax and in some cases even social security contributions). However, with a company it is possible to avoid this.

In this case, given that the price increase of each daily transaction you make – be it a couple or a few dozen transactions a day – is at stake, any small percentage reduction is important. Normally, it is preferable to opt for having to pay corporate tax (which is a fixed rate), instead of having to pay personal income tax, especially once you reach a certain volume, even if you then add tax payment on dividends or profits. Therefore, Swiss residents for example classified as traders can limit the amount of tax they pay per trade to 12.3% by forming a GmbH company in Lucerne.

Another reason for opting to use a structure may be, for example, that the countries in which you reside pay heavy capital gains taxes, but do not have CFC rules. In these cases, with the adequate business structure, you will be able to legally operate without paying taxes. Sometimes, like in the case of non-doms in Cyprus, only certain categories of capital gains – such as dividends – are tax-free, for which, logically, you will need a company. Often, with the right offshore jurisdiction, you can even avoid the tedious accounting that would be required for many of the trades in your country of tax residence.

Conclusion

In conclusion, you can opt to trade as an individual or you can do it through a company. The more assets you have, the more reasons there will be to manage them through business structures, and even more if you live in one of the countries where the tax trap could be activated. Undoubtedly, from approximately one million euros, it is highly recommended to make sure that you are not going to have problems because of your trading being considered a professional activity. Generally, for smaller amounts you should have no problems.

If you want us to help you discover which is the best option for you to achieve a tax-free trading life, you can book a consultation here.