How CFDs can shield your gains from the taxman

The approach of a new tax year is a reminder that it's time to protect the gains you may have accrued in the current year - from the disposal of assets such as shares, funds or perhaps a second property - that could be liable to capital gains tax (CGT).

CGT is payable on any gain of more than £10,600 (for the tax year 2011/12) made on asset disposals at the rate of 18 or 28% - depending on your tax band.

The CGT exemption is a 'use it or lose it' relief that cannot be carried forward to cover future gains. A practice known as bed and breakfasting, whereby assets are sold and bought back the next day to make maximum use of the annual exemption, is no longer allowed. You are permitted to buy the same shares back after 30 full days, but that does not always appeal to asset holders who want to stay in the market.

An alternative strategy involves taking out a contract for difference (CFD) position to crystallise your gains, or losses for offsetting purposes. Essentially, a CFD is an agreement to exchange the difference in the value of a particular asset between the opening and closing price. To bed and breakfast using a CFD, you simply sell a share, buy a corresponding CFD exposure and, after 31 days have elapsed, sell the CFD contract and repurchase the original shares.

The CFD position keeps you in the market regardless of its direction. If the share price rises during the 31-day interval, profits from the CFD trade will offset the cost of repurchasing the shares at a higher price. If the share price falls in the period, the CFD loss is compensated for by the cheaper price of the repurchased shares.

For example, Mr Oily owns 2,000 shares in BP worth 478p each, £9,560 in total.

He originally bought them at 450p per share, so he has made £560. He decides to bed and breakfast the shares by selling them at 478p and buying £9,560 worth of CFDs in BP at 478p, approximately the same level of exposure.

If the BP share price rises to 500p, he will lose £440 by being out of the market, but gain £440 from his CFD position.

You should be able to find a CFD spread that works for your portfolio, as thousands of underlying shares are represented, as well as foreign exchange, commodities and stock indices. Trades are conducted on a leveraged basis and the margin is based on a small percentage of the value of the trade, so you can open a position by putting up just 5 to 10% of its value.

If you sometimes spread bet, you may find your spread betting firm offers CFDs. One main benefit of spread trading is that profits are CGT exempt, but this means you cannot offset losses against capital gains for CGT purposes. The big attraction of CFDs over spread betting is that losses can be offset against your CGT liability.

The cost of financing CFDs is linked to Libor (the London interbank offered rate), and as Libor has been running at low levels in line with the Bank of England rate, the cost of holding CFDs for any length of time has fallen.

Chris Beauchamp, a market analyst at IG Group, says: "CFDs are the easiest to use as they are taxable - gains and losses can be offset in the same way as they can with normal shares. With spread bets, gains are not taxed, but it is not possible to offset losses against gains. From an individual's perspective, it is easier to use CFDs because they are directly applicable in CGT calculations."

Another advantage of a CFD is that you can use it to defer your capital gains liability to a subsequent tax year, when another annual exemption will apply or other losses may be available to offset a gain. A loss can also be deferred.

Returning to Mr Oily, imagine once again that he owns 2,000 shares in BP that are worth 478p each, £9,560 in total.

Again, he originally bought them at 450p per share, so he has made a £560 profit. He would like to lock in the gain while deferring the CGT chargeable on the gain until after 6 April 2012, so he takes a short (selling) position of £9,000 in CFDs in BP at 478p.

If BP then rises to 500p on or after 6 April, he has made £1,000 on his shares but lost £440 on his CFD position. He can then offset this £440 against his profit, reducing it to £560 and cutting his CGT liability in 2012/13.

How capital gains tax works

If a net gain from a sale is below £10,600 (in the tax year 2011/12), no CGT is due, even if the actual amount received exceeds that.

Until June 2010, CGT was charged at a single rate of 18%, but since then, two rates have been applied. Basic-rate taxpayers still pay CGT at 18%, but higher-rate taxpayers are charged CGT at 28%.

If you are a basic-rate taxpayer, because of your income level, but have made taxable capital gains that push you into the 40% income tax band - currently taxable income of £35,000 in 2011/12 (£42,475 including the personal allowance) - you will pay the higher rate of CGT on the portion that falls into the higher band.

Looking for more on trading tactics? Interactive Investor's Knowledge Centre offers a wealth of ideas, including: Getting to grips with short selling.