The legal and tax treatment of investment instruments is always worth considering before getting involved. Chances are, whatever the type of investment or speculation you’re engaging in, taxes will be applicable on any profits and gains you generate, and so it’s important to take these into account. These will generally be either capital gains tax or stamp duty liability, or income tax liability in some narrower circumstances. For those trading CFDs, they represent a tax efficient way to access equity markets, allowing savings on applicable tax as compared to other instruments.

As a would-be CFD trader, understanding the tax treatment of your investments and the gains that you derive from them is an important part of being able to competently calculate and assess the relative viability of different positions. In the UK, for example, applicable taxes to trading including capital gains tax, stamp duty and even income tax liability in some circumstances, and traders are responsible for ensuring they adhere to their obligations, with criminal penalties for those that fail to obey.

In addition to being of significant legal importance in terms of preventing liability to the revenue and wider trouble with the authorities, it actually has an important role to play in the calculation of how profitable different positions and trades might prove to be. Fortunately, for CFD traders there are tax advantages to trading in CFDs as opposed to other instruments, which means it often makes sense to prefer CFDs.

Why CFDs Are Different From Shares

Contracts for difference are treated in a complete separate way to shares for tax purposes, primarily because they are completely instruments with completely separate entitlements and obligations. A share is a direct proportion of ownership and influence in a company. A contract for difference, while perhaps linked to the value of a share market, is in fact an agreement completely removed from the transaction of actual shares. A CFD is just a contract relating to the value of shares, rather than being any tangible asset in its own right. This single distinction between contracts for difference and shares means the two are regarded in completely distinct legal terms, and therefore treated differently for tax purposes.

While these technical distinctions do exist, in practice CFDs operate in much the same way as trading shares, only with much more significant degrees of leverage to play with. This means that CFDs can be more profitable in the first instances, in addition to creating a saving on tax compared with trading a position in shares or other assets directly.

Tax Position on Shares

Shares are liable for tax in two main ways: stamp duty and capital gains. Stamp duty is a particular tax attributed to certain asset transfers in the UK, namely the transfer of property and the transfer of business ownership, through the mechanism of shares. It is charged at a flat percentage and is historically low, at around 0.5% of the transaction; nevertheless, this is an additional layer of cost within the edges of the trade that traders must be conscious of when instigating different positions, and it remains important in assessing the viability of some share trades.

Unfortunately, the tax man isn’t done there. For share positions that return capital growth, capital gains tax is applicable and charged on the value of the gains in capital so made. Capital gains tax is much more complex in terms of how it works and the various reliefs and allowances that are built in to it, and at some stage this will inevitably become a more challenging assessment for traders to have to make. While this is a trading inefficiency and distorts the process of actually trading, it is nonetheless a legal compulsion, and share traders can expect to pay in the region of 20% on gains when the dust settles.

Stamp Duty on CFDs

In the instance of stamp duty, CFDs are exempt from this liability because they are not shares. While they might be based on shares, CFDs are a distinct type of instrument and therefore don’t fall under the parameters of stamp duty. However, they can essentially be used to achieve the same trading ends, thus the tax distinction between the two can be an important measure of whether one or other transaction type is best. With the saving on stamp duty a tangible amount, traders can look to maximise their capital efficiency and the level of their returns through trading CFDs as opposed to other instruments (in this case, namely shares).

Capital Gains on CFDs

Unfortunately, contracts for difference are not tax free and so they do still create some liability, and therefore some of a tax burden. Capital gains tends to be the vehicle through which these taxes are applied, so traders should look to become more familiar with the laws relating to accounting for these gains in order to best calculate their liability.

Tax And CFDs – Conclusion

CFDs don’t offer the same kind of tax benefits as spread betting, but they do nevertheless have a slight tax advantage over trading in underlying markets directly. Tax will rarely be the sole motivation for trading in CFDs over any other form of investment, but nevertheless as an advantageous aside it’s worth noting that CFDs do offer a discount against share dealing. CFDs are subject to the usual tax on capital gains, but are exempt from stamp duty – even when the underlying asset is a UK security. Stamp duty is normally payable at around 0.5% on the total transaction value of share sales, but is not applicable for CFD transactions which attract no liability beyond that to CGT. This translates into more money in your pocket with a CFD position than with a share position, and that’s without factoring in the enormous advantage of trading on margin.

When Is It Most Tax Efficient To Trade CFDs?

This then leads to the conclusion that CFDs can be traded most tax efficiently when you’re faced with potential stamp duty liability. If you’re considering a share purchase, CFDs can provide a substantial saving to tax in addition to a whole host of other benefits that we’ve covered in some depth. But for traders trading CFDs as a rule, the knowledge that there are no obvious tax disadvantages makes reconciling CFD trading as a viable strategy more easy for the serious trader.

Getting to grips with the numbers of CFDs is a key stepping stone towards being more comfortable with how they work. Having a clear understanding of how much you can expect to pay over the lifetime of your CFD transaction is essential to allow adequate planning and financial forecasting, and without a command of the charges, taxes and commissions applicable, doing the necessary on-the-spot arithmetic to make trading decisions will become a lot more complicated that needs be.