Taxation of authors - Literary Allusions - KEITH GORDON MA, ACA, ATII looks at the tax treatment of artists and writers.

JUST AS THERE are specific taxation issues relating to actors, sportsmen and farmers, such also exist in relation to writers and artists. The term 'writer' includes journalists, authors, playwrights, composers, etc. The term 'artist' covers painters, sculptors, etc. Clearly, where such a person is employed, the income from that employment will be taxed under the normal rules of Schedule E, but this article concentrates on the rules for income derived outside employment. Statutory references are to the Taxes Act 1988, unless otherwise specified.

Which case of Schedule D?

Although the dividing line may be hard to discern, it is necessary to decide whether a writer/artist should be classified as a professional writer or as a non-professional. Clearly, the profits of a professional author will be assessable under Schedule D, Case II, as would those of a professional artist. Others are assessed under Schedule D, Case VI.

Examples of works by non-professional writers would include autobiographies – even if the composition of them constitutes a full-time activity, perhaps in the early years of retirement. On the other hand, if a person writes regularly to complement another full-time activity, for example a politician or sportsman writing for a newspaper column, then the regularity of the income should mean that the author's income arises from a profession and would be assessable under Case II.

Case II treatment

Case II treatment can have its advantages and disadvantages. The principal advantages are that:

• Case II allows greater flexibility with respect to losses (in particular relief against other income under section 380); and
• Case II income qualifies as relevant earnings for pension contributions purposes.

The principal disadvantage concerns disposals of copyright or royalties. Normally, these disposals would be subject to capital gains tax, but it has been held in a number of cases that for professional writers and artists, these are revenue receipts relating to their profession. As a result, the individual is unable to take advantage of taper relief or the capital gains tax annual exemption.

Subject to the income spreading and averaging rules (see below), the calculation of Schedule D, Case II profits follows normal rules. The income will also be subject to the commencement and cessation rules of sections 61 to 63, so that overlap relief may be in point if an accounting year end is chosen other than 31 March or 5 April.

Case VI treatment

If a writing or artistic activity is being carried on as a hobby, it is more likely that the Revenue will seek assessment under Schedule D, Case VI. Such a treatment will restrict the availability of relief for losses and expenses incurred in connection with the activity.

Although the income would not qualify as relevant earnings for pension purposes, this kind of Case VI income counts as earned income, should there ever be another surcharge on investment income.

Pre-commencement expenses

As Case VI activities are not considered to be in the nature of a trade, profession or vocation, expenses incurred before the commencement of the activity do not fall within section 401(1). As a result, relief is not strictly available for these expenses. However, this problem can be partially overcome if the writer is able to secure an advance payment of royalties. This will be easier for certain writers and artists (for example, the writer of a political memoir) to negotiate than for others.

It is also important to realise that expenditure which puts the writer or artist in a position to generate income will constitute capital expenditure and will not attract relief.

Wholly and exclusively rule

While the 'wholly and exclusively' rule applies to Case II income, it would be anomalous if a similar test did not apply for Case VI. This reasoning was confirmed by the judgment in Curtis Brown Ltd v Jarvis 14 TC 744 and is reflected in the Inland Revenue Inspector's Manual at paragraph 1706.

However, when a writing or artistic activity is not being carried on as a profession, it may be harder to justify the deductibility of certain expenses. See Example 1.

Disposal of copyrights

As mentioned above, proceeds from the disposal of copyrights will be taxed as income in the hands of professional writers or artists. This treatment has been confirmed in a number of cases. These cases cover the scenarios:

• lump sums for the cancellation of publishing agreements (Glasson v Rougier 26 TC 86);
• sale of film rights (Howson v Monsell 31 TC 529);
• sale of copyright of works written whilst non-resident (Mackenzie v Arnold 33 TC 363);
• the sale by a writer of a collection of his manuscripts covering over 20 years (Wain's Executors v Cameron [1995] STC 555).

The comprehensiveness of these cases suggests that the proceeds from the sale of copyrights and other related receipts will in all cases be treated as income in the hands of a professional writer or artist.

However, professional writers and artists can gift such copyrights without incurring an income tax charge. This was confirmed in the Court of Appeal in Mason v Innes 44 TC 326, which held that the rule, i.e. that the private use of trading stock required a trader to bring into account a notional profit calculated at the market value of the stock, (in Sharkey v Wernher 36 TC 275) did not apply to Case II income. However, the Inspector's Manual at paragraph 2699 warns Inspectors to look out for cases where this is used for avoidance.

For non-professional writers/artists, it has been held that the gift of copyright constitutes a capital disposal. The decision in Earl Haig's Trustees 22 TC 725 was interesting, because it concerned a period before the introduction of capital gains tax. Finding the proceeds to be capital meant that they fell outside the scope of taxation. Further, the disposal by the trustees was of an intangible interest in the late Earl Haig's diaries; they were retaining the ownership of the diaries themselves. The Court of Session decided that even though the trustees were retaining the ownership of the diaries, the assignment of the publishing rights constituted 'a partial realisation of an asset' and therefore a capital disposal.

Disposals not treated as capital

There can be cases where non-professionals receive income on the disposal of their rights. Examples include the sale of one's 'story' to a newspaper: in such cases, there is no asset being disposed of which could give rise to a liability for capital gains tax. This will also apply, if there is within the disposal an implicit performance of services; for example, if the proceeds from the disposal of copyright are effectively the payment of a fee for the writing services performed. In such cases, the income should be assessed under Schedule D, Case VI.

Third party ownership

If the copyright is held by a person other than the writer or artist, for example a company, a relative or a trust, the rights will usually be considered to be an investment asset. In such cases, royalty income will be assessable under Schedule D, Case III and subject to the deduction of basic rate tax at source (sections 348 and 349).

There are cases where the income will be assessable under Schedule D Case VI; these cases will arise when expenses (for example literary agents' fees) need to be met from the royalty payments (Lawrence v Commissioners of Inland Revenue 23 TC 333).

If the payer of the income is overseas, the assessment will be under Case V.

If the copyright is held by a successor of the writer or artist or perhaps by a company whose trade is the exploitation of such rights, then income will be assessable under Case I or II.

Prize income, and other awards

Many writers and artists receive income from prizes or awards from benefactors. Sometimes the awards follow the entry into a competition by the individual; in other cases the prize is completely unsolicited. The courts have held that the award should be taxed under Case II if it is incidental to the writer's or artist's professional activities.

However, the Revenue's Inspector's Manual concedes at paragraph 2691a that some prizes may escape taxation:

'A prize which is unsolicited, and which is awarded as a mark of honour, distinction or public esteem in recognition of outstanding achievement in a particular field, including the field in which the recipient operates professionally, is not chargeable to tax. In 1979 the Special Commissioners found for the taxpayer in a case involving a literary award. The book was entered for the competition by the publisher without the author's consent. The decision turned very much upon its own facts and, in particular, a finding that the award was unsolicited and did not represent the proceeds of exploitation of the book by the author personally or by his publishers as agents on his behalf.'

Similarly, with grants and awards from the Arts Council, the Inspector's Manual provides a list of those that are subject to tax and those that are not. The list is shown in Table 1.

The Arts Council of Great Britain (and, it is expected, the other arts councils) will indicate to recipients the category into which particular awards fall for tax purposes. Taxpayers should keep documentary evidence of their awards in case they are asked to provide it to the Revenue.

No tax relief is available in respect of expenses incurred in respect of a non-taxable award. In cases where the Arts Council makes both a taxable grant and a non-taxable award to an individual, the Revenue has agreed with the Arts Council the following rules concerning related expenses:

• first allocate the expenditure against the taxable grant (so that relief is given up to the amount of the grant);
• then allocate any surplus against the non-taxable award; and
• if the expenditure exceeds the sum of both awards then the excess should be allowed as an expense subject to the normal Schedule D rules.

Spreading rules

Writers and artists have had the benefit of special rules in recognition of the fact that many of their works take more than a year to produce and therefore their annual taxable incomes may vary from year to year.

For new works, income arising from the grant or assignment of copyrights can be spread backwards over two or sometimes three years under section 534. For artists, the rules are extended in section 538 to cover the sale of works of art. For works that are more than ten years old, section 535 allows income to be spread forwards over up to six years.

These rules apply only to the creator of the work and not (for example) to a subsequent investor who may have acquired the interest in it. Similarly, they do not apply to companies or to partnerships.

The two different reliefs are mutually exclusive. So if a claim has been made under one provision in respect of a payment, a claim may not be made under the other in respect of the same payment. It is proposed, however, to repeal these rules in the forthcoming Finance Bill with effect for payments due after 5 April 2001. But since taxpayers still have time to make elections in respect of earlier receipts, the details have been included in this article.

Backwards spreading rules

The backwards spreading rules apply to an author of a literary, dramatic, musical or artistic work who assigns the copyright in the work wholly or partially, or grants any interest in the copyright by licence. The author must have been engaged on the work for more than a year. For the sale of works of art by an artist, section 538(1)(b) extends the rules to cover cases where a work took less than a year to produce, but was part of an exhibition that took more than a year to prepare.

What payments may be subject to the spreading rules?

The spreading rules apply to payments for the assignment or grant which would otherwise be included in computing the amount of the author's profits for a single year of assessment. To be covered by the rules, a payment must be either:

• a lump sum payment, including a non-returnable advance on account of royalties; or
• a payment of or on account of royalties or sums payable periodically, provided they fall due within two years of the work's first publication.

If a claim is made in respect of a payment of royalties, it has effect as if it covered all such payments in respect of the copyright in the same work receivable by the writer. It does not matter whether these other payments arise before or after the payment in respect of which the claim is actually made, and it can cover other years of assessment as well.

In the case of artwork under section 538, the income must relate to the sale or a commission or fee. Section 537A applies the rules to designers.

A claim must be made by 31 January in the second tax year after the one in which the qualifying payment is receivable. Where there is more than one such year, the latest year of assessment is used. So, providing the repeal of the rule occurs as proposed, the last election under these rules must be made by 31 January 2003.

Allocation of profits to earlier years

If a valid claim is made for spreading relief, only one half of the income is taxed as if it were received on the due date; the other half of the income is treated as if it were receivable 12 months earlier.

If, however, a work took more than two years to produce, the writer may divide the income into thirds and allocate each portion to the date the payment was receivable and the two preceding years.

The spreading of income will generally give rise to an additional tax liability in respect of the previous year(s). However, so as not to disturb assessments of earlier years, the spreading of income does not affect the taxable income of these years. Instead, the writer's additional tax liability is treated as a liability for the later year.

It should be noted that the spreading provision relates only to the income, not the related expenses that continue to be relieved in the year of assessment to which they relate. Example 2 shows how the spreading rules work.

Forward spreading over up to six years

The forward spreading rules apply to assignments of copyright or the grant of an interest in a work provided that:

• the work has been published for ten years;
• the interest in the copyright lasts for two years or more; and
• the consideration for the assignment (or grant) includes a lump sum.

There is no specific equivalent for sale of works of art after ten years.

The lump sum would normally be assessable in a single year of assessment: that relating to the date the lump sum became receivable. However, if a claim is made, it will be treated as receivable in equal annual instalments starting with the actual due date.

The number of instalments is equal to the number of whole years covered by the interest in the copyright assigned or granted up to a maximum of six.

There are provisions that deal with cases where the author permanently discontinues the vocation or profession (including on death). In such circumstances, any instalments deemed to be receivable after the date of discontinuance are accelerated and treated as receivable on the instalment date immediately before the date of discontinuance.

Until 1995-96, it was possible to elect for all earlier instalments to be recalculated so that the income could be spread evenly. Again these rules are to be repealed in respect of payments due after 5 April 2001.

A claim must be made by 31 January in the second tax year after the one in which the payment is receivable. Example 3 demonstrates how forward spreading works.

Deductions from income spread forwards

If the income is assessable under Schedule D, Case VI (and not in cases where Case II applies) and deductions are allowed against that income (e.g. agent's fees) then the spreading provision applies to the net income.

This rule only applies to casual authors (rather than those who are carrying on a vocation or profession). It ensures that relief for the deductions (which are likely to be fewer in such cases) are spread in the same way as the income.

Averaging rules

A technical note issued on Budget day confirmed that following consultation, the spreading rules would be replaced by the averaging rules as used for farmers. The draft legislation (dated 26 February 2001) was included in the technical note and is in Schedule 24 to the Finance Act. The rules are similar to those applying to farmers (see my article 'Down on the Farm', Taxation, 15 February 2001) in that two successive years' profits may be averaged for tax purposes provided that the profits in the less profitable year are 70 per cent or less than those in the other year and there is a restricted right to average profits if the ratio is between 70 per cent and 75 per cent.

The following points concerning the proposed changes are worth noting:

• the averaging rules apply to the profits rather than the gross income;
• there is no need for the creative work to have taken more than 12 months; and
• partnerships may now use the rules.

However, the averaging rules (as for farmers) do not apply for corporation tax purposes.

Interaction between spreading and averaging rules

The first years that may be subject to an averaging claim appear to be 2000-01 and 2001-02, whereas the last date of income for the spreading rules is 5 April 2001. So both the forward and backward spreading provisions could apply to assess income in a year also subject to the averaging rules. There does not appear to be any provision that deals with this situation (which is, to some extent, a relief since it would unnecessarily add to the complexity) so it is necessary to deal with both provisions in turn. See Example 4 for an illustration.

Keith Gordon is a director of ukTAXhelp Ltd and can be contacted by e-mail on keith.gordon@ukTAXhelp.co.uk. The views expressed in this article are those of the author.

Issue: 3809 / Categories: Comment & Analysis