Creative Fluctuation

ROBERT JAMIESON MA, FCA, FTII, partner in Mercer & Hole, examines the new régime for fluctuating profits for creative artists introduced by section 71 of, and Schedule 24 to, the Finance Act 2001.

CREATIVE ARTISTS SUFFER from the fact that they often make little or no profit while they are producing their work. During this period, they may be liable to tax at only the basic rate (or they may not even be liable to tax at all). If their work is in due course successful, it may give rise to substantial amounts of income which will attract higher rate tax. They may also dispose of their copyright instead of receiving royalties and thus find themselves with a lump sum taxable at the higher rate rather than lower annual amounts which might not be so heavily taxed.

In order to obviate these problems, creative artists have been entitled to spread specific items of income over more than one tax year. However, the rules were complex and it is understood that their take-up was low. The Government therefore decided to replace the rules currently found in the following sections of the Taxes Act 1988:

• section 534 (relief for copyright payments);
• section 535 (relief where copyright sold after ten years or more);
• section 537A (relief for payments in respect of designs); and
• section 538 (relief for painters, sculptors and other artists).

These have been replaced with a new system which will enable authors, painters and other creative artists to average their profits over a number of years in a manner similar to the one used by farmers since 1978.

The old régime does not apply to payments receivable on or after 6 April 2001, and the first pair of tax years which will be available for the new form of averaging are 2000-01 and 2001-02. Under this system, individual taxpayers (whether they are sole traders or partners) will be able to make a claim to average the profits of two consecutive tax years, provided that their profits:

• are derived wholly or mainly from qualifying creative works; and
• are chargeable to tax under Schedule D, Case I or II.

Qualifying creative works are literary, dramatic, musical or artistic works, or designs created by the taxpayer personally or, if the business is carried on by a partnership, by one or more of the partners.

Full averaging

A full averaging claim can be made if the profits for one of a consecutive pair of tax years is 70 per cent or less of the other, or if the profits for one of the years is nil, i.e. because there is a tax-adjusted loss.

Example 1

Couples is a reasonably successful author who has been making up his accounts to 31 March for several years. His recent adjusted results show:

The profit of £3,000 falls to be taxed in 2000-01, while the profit of £45,000 falls to be taxed in 2001-02. If Couples did not make an averaging claim for these two years, the likelihood is that he would have unused allowances for 2000-01, while he would be liable to higher rate tax in the following year.

Since the lower profit figure (£3,000) is well under the 70 per cent threshold, full averaging is permitted. Thus Couples' taxable Schedule D profits for 2000-01 and 2001-02 become:

(3,000 + 45,000) divided by 2 = £24,000

As a result, Couples' personal allowances for each of the two years would be fully used, and a 40 per cent tax charge for 2001-02 would be avoided.

Moreover, the averaged profit for 2001-02 could then be used in a claim with 2002-03. Given that Couples shows a loss for this latter year, his Schedule D figure is nil. Averaging £24,000 and nil produces a taxable profit of £12,000 for 2001-02; the assessment for this year has therefore been revised twice, and also for 2002-03. Couples' loss of £7,000 is still fully eligible for relief against his total income for 2002-03 and/or 2001-02 under section 380, Taxes Act 1988.

Ineligible claims

An averaging claim cannot be made for:

• a tax year in which the taxpayer begins to carry on his trade, profession or vocation;
• a tax year in which the taxpayer ceases to carry on his trade, profession or vocation;
• a tax year in which the taxpayer's business ceases to be a qualifying one, i.e. because his profits are no longer derived wholly or mainly from creative works; or
• a tax year preceding a year for which an averaging claim has already been made; for example, if the profits for 2001-02 and 2002-03 have already been averaged, the taxpayer cannot go back and try to average 2000-01 and the adjusted 2001-02.

The normal time limit for making an averaging claim is no later than 12 months after 31 January following the end of the second of the two years being averaged.

In Example 1, Couples would have to make his claim for 2000-01 and 2001-02 by 31 January 2004 at the latest. This time limit can, however, be extended if the taxpayer's profits are subject to an adjustment for some other reason.

Partial averaging

If the profits for one of the years are more than 70 per cent but less than 75 per cent of those of the other, a partial averaging procedure is available. Thus:

Step 1

Work out the adjustment given by the formula:

(D x 3) – (P x 0.75)

where:

D is the difference between the individual's profits for the two tax years; and
P is the individual's higher profit figure.

Step 2

Add the amount of the adjustment to the lower profit figure.

Step 3

Subtract the amount of the adjustment from the higher profit figure.

This method avoids a disproportionate change to the individual's tax bill near to the point where averaging is not allowable; if the lower profit figure is 75 per cent or more of the higher, averaging is not permitted.

Example 2

Duval is an established artist whose recent adjusted profits have been:

Because Duval's taxable profits for 2000-01 are 72 per cent of his taxable profits for 2001-02, he can make a partial averaging claim for these two years. The result of the partial averaging formula is:

(3 x 16,800) – (60,000 x 0.75) = £5,400

Duval's Schedule D figures are:

Under self assessment, an averaging claim is normally made in the tax return for the later of the two years in question, and it is the tax liability of the second year which is always appropriately adjusted.

A taxpayer who makes an averaging claim is specifically allowed to submit, amend or withdraw claims to other reliefs, e.g. capital allowances, at any time within the time limit for claiming averaging.

Summary

The main advantages claimed for averaging as compared with the old 'spreading' rules are that:

• there is no requirement for the claimant to have taken more than 12 months to create his work, so this should enable a greater number of people to claim;
• profits are averaged rather than individual items of income from particular works being spread, this is thought to be a simpler process; and
• people who are partners in creative businesses can claim, whereas this was not allowed under the old rules.

The changes have emerged from a substantial consultation, but it is not entirely clear that the new régime will be more straightforward than the system which it replaces. Even the Revenue has acknowledged that there was a significant minority of opinion which was against abolishing the spreading rules.

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