Using Contracts for Difference (CFDs) For 'Bed & Breakfast' Capital Gains Tax Management

The UK treasury closed the well known Capital Gains tax trick of 'Bed & Breakfasting' a few years back. Then, an investor could sell shares on the last day of the tax year to realise a profit or loss so reducing or using up a yearly capital gains tax allowance. Currently £8,500 of capital gains is allowed per year tax-free.

• For example, say you've made a realised profit of £10,000 on ABC shares but have a unrealised £7,000 loss (ie you still own the shares) in XYZ
• A bed & breakfast deal would have you selling the XYZ shares on the 5th April and repurchasing them on the 6th April
• This would mean that instead of paying tax on the £10,000 profit there would in fact be no tax to pay as a realised capital gain of only £3,000 has been made

The Treasury didn't like people playing these legal tax-avoidance games so bought in a new rule which put a 30 day limit on share buys/sells. This means that if you sell and then re-purchase the same shares within 30 days they are deemed not to have been sold at all with regards to the CGT obligations.

This article is timely because as the end of the tax year is approaching in the UK (5th April 2006) there is still a way to legally conduct the old style B&B trades using Contracts for Difference.

What Are Contracts for Difference (CFDs)

CFDs are basically leveraged stockmarket products which enable traders to buy or short sell shares by only depositing between 10%-20% of the nominal value. For example, if you wanted to buy £10,000 worth of Vodafone using a CFD the broker would only ask for a deposit of around £1,000 plus make you pay for any losses on a daily basis should the share price go down.

CFDs are primarily used for short term trading and day trading or trading. For a more detailed explanation of what CFDs are and how they can be used please visit the LearnMoney CFD section.

This Strategy Is Simple But You Must Understand The Basics

A lot of money has been lost and will continue to be lost in the markets by people not knowing exactly what they're doing and/or how the products they're trading really work. So if you're unsure of what CFDs are or how to correctly trade them you're strongly advised not to attempt this strategy until you've got sufficient experience. Experience can easily be gained by using a practice account that many of the CFD brokers offer.

By using CFDs to replicate an old style B&B trade it's easy to get around the 30 day limitation that the Treasury has implemented. And all of this is 100% legal, it's just another example of why investors should keep up to date with the different financial products that are available, and how to utilise them.

This Is How The Trade Would Work

• You've made a £10,000 realised profit on some shares in the current tax year
• You own 11,000 shares in Vodafone which were bought at £1.55, with the current price at £1.10 this shows an unrealised loss of around £5,000
• You don't want to sell the Vodafone stock to realise the loss because you feel there's a good chance that over the next 30 days they'll move strongly higher
• A 2 step simultaneous strategy is therefore needed to realise the loss but still own the shares so as to participate in any rise in the price

Step 1

1. On any day before the 5th April sell 11,000 Vodafone shares in the cash market
2. As soon as the shares are sold buy 11,000 Vodafone shares using CFDs

   By selling in the cash market the Vodafone loss has been realised

   The position though has been transferred into CFDs so you'll still participate 100% in any gains or losses of the share price

   For example, if you bought the Vodafone CFD at £1.10 and the shares moved to £1.20 over the following days your CFD account would be credited with £110 (11,000 CFDs x £0.10), losses will obviously be deducted if the shares move lower

1. After 31 days sell the Vodafone CFD position for either a profit or a loss
2. Immediately buy 11,000 Vodafone on the cash stockmarket

It doesn't matter if you've made a profit or loss on your CFD position because when you re-purchase the Vodafone shares it will be taken into account

So, if the shares have gone up 10% from where you originally sold them the CFD trade will have made a 10% profit so cancelling out the fact that you've paid a high price, and vice-versa

Points To Remember

• You must make sure you've got enough money in your CFD account to fund any losses should the shares move lower
• Perhaps it's a good idea to do business through a stockbroker that also allows clients to trade CFDs
• This trade shouldn't really be done with spread bets because although profits on spread bets are tax-free losses are not offsettable against tax so if the share price of Vodafone moves lower you'll be out of pocket

The Costs Involved

• There are 6 separate costs involved but these can vary greatly depending on the commissions scale of your two brokers, remember you'll be using your traditional stockbroker and a CFD broker. The 6 costs are -

• 2 commissions on each side of the two trades (cash stockmarket and CFDs)
• 0.5% Stamp duty on when you repurchase the Vodafone shares
• Interest which is charged on the CFD part of the trade, it's generally negligible though and works out to be around £2 per day per £10,000 worth of stock
• But as you only have to put up 10%-20% of the nominal amount when you trade CFDs the balance can be earning interest so perhaps the above costs are only £1.25 a day per £10,000

So although 6 separate costs seems a lot, one would have to pay all of these (apart from the interest cost) when carrying out B&B deals of yesteryear. Obviously though the whole cost of the trade has to be looked at in regards to the total amount of tax to be saved. If the costs are £250 but the tax saved is £1,000+ then that's one hell of a good investment.

Costs will also depend on what charges your two brokers (traditional stockbroker and CFD broker) levy. If you do business with an old style stockbroker they might try and rip you off charging up to 1% of the deal when selling the Vodafone shares. But if using a discount broker then expect to pay around £6-£12 for the trade.

Summary

This Bed & Breakfast trade looks complicated for those not familiar with CFDs, but it's not. In fact all the trading can be done in less than a few minutes and of course the paperwork is not your responsibility. If in doubt then try two things, firstly open a practice account and secondly talk to a CFD broker about what you're trying to achieve, chances are he or she will be only too happy to help.

Good luck in saving some tax.