A Contract for Difference (CFD) is a high-risk speculative investment from which investors make a profit or loss on the price movement of underlying financial assets without actually owning those assets. CFD’s typically relate to shares, but are also used for share price indices, commodity prices, interest rates, currencies and futures contracts. Under such a contract, the investor take a position that the underlying share price, for example, will or will not exceed a given price at some time in the future.
The CFD holder may take a short position, a long position or both. A short position is taken where the CFD holder believes the value of the underlying assets will fall. A long position is taken where the CFD holder believes the value will increase. The investor receives or pays the difference in price of the underlying security, multiplied by the number of units, between the time the CFD contract opens and closes.
If the investor makes a gain, the provider pays the investor an amount equal to the gain. Conversely, if the investor makes a loss, the investor pays the amount of the loss to the provider.
How is Contracts for Differences taxed?
In simple terms, there are three ways in which gains or losses from CFDs can be treated.
The most common scenario is that you trade CFDs as a business venture. Any trading profits will be assessed as ordinary income, expenses incurred in trading are deductible and so are any losses incurred as part of the trading. Amongst the expenses which can be claimed are subscriptions, courses, professional fees and – if you have a home office set aside for trading activities – the costs associated with running that office.
To demonstrate that you’re in business, keep comprehensive records, maintain a business plan and ensure that you trade frequently and regularly.
Losses arising from trading will normally be deductible against other income arising in the same year. Take care though; if you’re running losses year in, year out, the ATO may argue that you’re not in business to make a profit and can apply the non-commercial loss rules. If that happens, losses will be quarantined and only capable of being offset against profits from CFD trading in future years. If you cease to trade CFDs, you may therefore lose the benefit of accumulated losses altogether.
As a general rule, the non-commercial loss rules will only allow losses to be offset against other income where your adjusted taxable income is less than $250,000 and either the assessable income from the CFD trading is greater than $20,000, the activity has made a profit in 3 of the last 5 income years or the cost base of the assets used in the business is at least $500,000. From those rules, it can be seen that the ATO is looking to limit loss relief claimed by those traders (so-called 'hobby' businesses) who are not trading with a view to profit or the scale of whose activities is too small to justify treatment as a business.
The second scenario arises where the investor is not in business but undertakes isolated profit making transactions involving CFD’s. If a CFD transaction is entered into with a profit-making purpose, the gain or loss will be assessable or deductible even though not undertaken as part of carrying on a business. So, speculative transactions will be taxable if the circumstances surrounding the transactions suggest a profit-making intention, particularly where the transaction relies for its success on the application of skill and judgement. In such a situation, the gains arising will – as in scenario one – be taxable as ordinary income (but any loss will be deductible).
The third, and least likely, situation is that the Commissioner treats the CFD transactions as a form of gambling or recreational pursuit. Gains arrived at in these circumstances are not taxable but don’t bank on this treatment applying; it’s only in very rare circumstances where a taxpayer enters into a one-off CFD transaction as part of a 'hobby' of recreational gambling that any gains stand a chance of falling outside the scope of tax. If this path is followed, any losses arising can’t be claimed back. If you claim this treatment and you make gains, expect the ATO to look very carefully at the transactions because they will be eager to establish a profit-making motive.
Whilst a CFD is theoretically an asset to which the Capital Gains Tax (CGT) rules could apply, in practice this is unlikely to be the case. The ATO have made it clear that in their view, such a product is almost always entered into with a profit-making purpose or as part of a recreational pursuit. This means that the gain or loss will almost always either be on revenue account or non-taxable as the product of gambling. Whilst a case can be put that a gain or loss might be subject to the CGT rules where the tax treatment of the underlying asset also arises on capital account, such cases are likely to be few and far between.
Interests and dividends received on Contracts for Difference
Interest is calculated on contracts that remain open at the end of each day. Holders of CFDs pay interest on open buy contracts and receive interest on open sell contracts. Typically, these amounts will be taxable as ordinary assessable income, with an allowable deduction available for any interest paid.
Other amounts may arise by certain events occurring in respect of the underlying shares, such as the share going ex-dividend, the issue of bonus shares or rights issues. CFD holders pay an amount equivalent to the cash dividend declared on sell contracts that were open prior to the day the underlying shares go ex-dividend. Conversely, investors receive an amount equivalent to the cash dividend declared on buy contracts that were open prior to the day the underlying shares go ex-dividend. These amounts are treated as ordinary income.
Generally, as the investor has no interest in the underlying reference asset, a CFD provider will have no obligation to pay franking credits attached to any distribution in respect of the underlying asset. Nor will the investor receive franking credits or have an entitlement to apply the gross up and offset mechanism which applies to shareholder recipients of franked dividends.
The tax treatment of CFD’s can be complex and will vary according to your specific circumstances so always take professional tax advice as part of any investment strategy involving CFDs.
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