Should you pay Income Tax or Capital Gains Tax? Look at the 9 Badges of Trade

The government is cracking down on tax evasion. HMRC is increasingly looking into people not paying their fair share of tax. Just look at the articles showing HMRC going after ebay, Etsy and Gumtree sellers for proof of this. In a world where government tax authorities are going after every Tom, Dick and Harry to raise much needed finances it is important that you pay your tax in order not to be subject on any enquiries from the tax authorities.

Whilst most people would like to pay their fair share of tax, the intricacies of the tax code make it difficult for you to assess how much tax you need to pay. One example of this is people often get confused about how much tax to pay when they sell items as a hobby or as a side business or just to raise some money via Ebay. Most people think that selling items this way will make make them liable to Capital Gains Tax instead of Income Tax. And as we all know, Capital Gains Tax rates are lower than Income Tax and thus it would make more sense to pay Capital Gains. Furthermore, we all get a Capital gains annual allowance and that fact that a good chunk of items you sell is CGT free, makes Capital Gains Tax more advantageous to Income Tax.

But as with most things, it is not up to you to decide if you have to pay income tax or capital gains tax. It is set in law.

To Pay Income Tax or Capital Gains Tax

Basically, you need to pay Income Tax on profits that come from a trade and you pay Capital Gains Tax from investments or on sale of personal possessions.

When deciding if the items you sold constitutes a trade and would bring about a liability to income tax, you need to look at 9 factors. None of these 9 factors on its own are conclusive but you need to look at them in conjunction with each other.

  1. Nature of the asset – Some types of assets by their nature can only be turned to advantage by resale and thus it would be considered tan act of trading. If you buy a large quantity of shoes which is too large for personal use, and subsequently sell them, it will be classed as a trade. On the other hand if you bought a few shoes you intended to wear but never did and decided to sell them , it would not be trading.
  2. Similar trading interest – If you trade is similar to the transaction under consideration, then this points to a trade. So if you are a mechanic and car dealer and you sell a car, it would be classed as trading income. On the other hand if you are a doctor and sell your car, it would not be trading income. (Note you don’t pay capital gains tax on cars so it would be tax free if the doctor in this case made a profit).
  3.  Modification of asset – If the asset in question has been modified or altered in any way (to make it more marketable) and subsequently sold, it is classed as an act of trading. So even if you buy cartons of cigarettes and sell them only buy the pack, it could be classed as trading. You have broken down the carton into smaller lots (individual packs) and thus you have altered the assets.
  4. Organisation – If the way you organised a sale in the same way a normal trader would, it would point to trading. So if you put up an organised process like advertised and getting sales staff, it would point to trading.
  5. Source if finance – If you get a loans to purchase an asset and the loan can only be repaid by the sale of the asset in question, it would point towards trading.
  6. Interval of time between trading and sale – An asset that is purchased and subsequently disposed off within a short period of time is likely to point to trading. The reason is that it will be akin to trading stock as trading stock purchased within a short amount of time before sale. Your intention at the time of purchase is also an important consideration. If you intend to hold the asset indefinitely, it points to non-trading activity.
  7. Method of acquisition – If you acquired the item in the same way trading stock is acquired, it points to trading. So a sale of an item you inherited or received as a gift is unlikely to be classed as trading.
  8. Number of transactions – If the transaction is repeated and systematic, it points towards trading. So if you purchase and sell a certain kind of asset a number of times within a specified amount of time, it points towards trading. But one of transactions can be a pointer towards trading. In the instances where the transaction is out of the same king of character as it would have been under a normal trader, it points to trading.
  9. Profit seeking motive – If the only possible reason for the purchase of the its was to sell it int he short term, it points towards trading.

As you can see from the above, if your buying and selling activities hit the majority of the 9 points mentioned above, then you will need to pay Income Tax instead of Capital Gains Tax.
So for example,

  • If you bought one house as an investment and then subsequently sold it, the sale would be liable to capital gains tax. This is because a single purchase and sale of a house does not hot any of the 9 badges of trade mentioned above and thus it cannot be classed as a trade.
  • If on the other hand you buy, fix up and sell multiple properties this likely to be a trade. This is because it encompasses a number of badges of trade mentioned above such multiple numbers of transactions, modification of the asset by fixing it, profit seeking motive and the likelihood that the time between your purchase, fix up and sale will be short.

So the next time you have a dilemma over whether you have to pay Income tax or Capital Gains tax, have a look at the 9 badges of trade mentioned above in order to determine this. As always, if you are in any doubt, you should seek the advice of a qualified tax professional. It is better to pay a tax accountant a small fee now than having to deal with HMRC for over a year!