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How to get to grips with tax treatment of derivatives

John Wasiliev

A budget announcement about the treatment of gains and losses from investment trading by superannuation investors has prompted a number of requests for clarification about the rules that apply to derivatives trading by do-it-yourself funds.

Derivatives are a family of investments that derive their performance from that of other investments. These other investments can be shares; precious metals such as gold and silver; currency; or structured investments known as index contracts.

An index contract allows you to trade a broad investment financial market or financial market sector, such as the top 200 shares in the Australian Stock Exchange. Derivatives such as exchange-traded options, instalment and trading warrants or contracts for difference allow trading on a short or medium-term time basis.

Short term can mean less than a week, while medium term can imply several weeks or months.

Special treatment inside super

Successful derivatives trading is a specialist skill and it’s important to be aware that their tax treatment will be different if inside super.

Superannuation lawyer Daniel Butler says that, for someone who actively trades derivatives outside super, it is possible to treat losses and gains as ordinary income.

This means trading losses can be offset against other income the trader may earn, such as dividends from shares or even personal income.

With a DIY super fund, on the other hand, losses and gains on derivative trades can’t be treated as ordinary income. They must be regarded in the same way as investments bought for capital gain.

Trading gains must be taxed under the capital gains rules and while trading losses can be used to reduce taxable gains, where they exceed gains in a financial year they can only be accumulated for offset against gains in a future year.

The trading stock issue

Butler says this treatment was the case prior to the recent budget change that took away any right that super funds had to offset losses on share investments specifically bought with a trading view.

Such investments were described as trading stock. Buying investments as trading stock is not a usual strategy for DIY funds and requires a different approach to investing. It suggests a DIY fund involved in the activity of trading investments, which contrasts with the more usual approach of being a long-term investor.

If a fund identified certain investments as trading stock, under the pre-budget rules they were allowed to offset losses against ordinary fund income such as dividends and interest and fund contributions.

This no-longer available concession could not be claimed on derivatives trading losses so the budget change will have made no difference, says Butler. This didn’t matter whether the losses were from exchange traded options, warrants or contracts for difference activity.

Butler says all derivatives traded through super funds are generally treated as capital investments for tax purposes.

Taxation is not the only issue

While tax is one side of the story, DIY funds that involve themselves in derivatives activity must be aware of arguably more important issues, namely any extra risk.

A feature of derivatives is they can allow a position to be taken that is greater than buying the investment outright, a characteristic described as leverage.

Whereas BHP Billiton shares, for instance, cost say about $43 each, a BHP Billiton derivative position with the same price movement potential as the actual share can cost 10 per cent of the price of the share.

Given a derivative has the scope to deliver the same price gain or loss as the shares, say $2 or about 5 per cent up to $45 or $2 or 5 per cent down to less than $41, where this movement is associated with a smaller cost, say 10 per cent, it will translate into a proportionally greater profit or loss on money invested.

While a direct share investor might gain or lose 5 per cent of the share capital they have invested if the price rises or falls, a derivative purchaser on a 10 per cent deposit will gain or lose 50 per cent of the derivative capital they have committed.

It’s like calculating the value of a house price rise or fall on the deposit you put up rather than the property purchase price. Butler says with certain derivatives you need to be aware they can cost you more than the deposit you put up, raising the scope for a potential debt over other fund investments, described as a charge.

Look at the small print

Because derivatives can involve complicated and lengthy legal documents, a detailed examination is required to analyse whether there is a charge.

Where the charge applies to a derivative product on a recognised financial market, such as a stock exchange, the super rules allow such investments provided the fund trustees acknowledge they are aware of the risks involved. This acknowledgement must be written down in a derivative risk management statement that is prepared in addition to the fund’s investment strategy.

That said, there are extensive super guidelines from regulators that include a statement that regardless of any risk management statement they consider it inappropriate for super trustees to use derivatives for speculation.

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