What is averaging
Those individuals or partnerships whose profits are derived from qualifying creative works, are able to average their profits to help smooth out the peaks and troughs of their fluctuating income.
For these purposes, creative works are generally defined as literary, dramatic, musical or artistic works, or designs created by the individual or by one or more of the partners personally.
Who can claim averaging
You can claim averaging if your profits come from disposing of works or from royalties you get for allowing people to reproduce your works. So, for example, you can claim if you’re:
- an author whose income comes from the sale of your written work - even if a small part of your income comes from personal appearances
- a computer software writer whose income comes from royalties for reproducing the code you write, which is protected by copyright
Who can’t claim averaging
You can’t claim averaging if your profits come from the services you provide. So, for example, you can’t claim if you’re:
- an architect whose income comes mainly from your services – even if some of your income comes from selling material protected by copyright
- a computer programmer whose income comes from the service of writing scripts or programs, not the actual works
How is averaging calculated
A claim to averaging must be made no later than the first anniversary of 31 January following the second of the two consecutive years selected to be averaged.
This means, a claim for averaging the profits of the year 2015/16 with the profits of 2016/17 must be made by 31 January 2019. Full averaging is only available where the profit of one of the years is 70% or less than the profit of the other year.
John, an established artist has made profits of £60,000, and £20,000 for the years ended 31 March 2016, and 2017 respectively. John may claim for his taxable profit for each of these years to be adjusted to £40,000 per year.
The benefit here is that he is able to avoid higher rate tax on the taxable profits of £17,000 in excess of his personal allowance and the basic rate band for 2016/17 [i.e. £60,000 – (£11,000 + £32,000)] which is instead taxed at the basic rate for 2015/16.
Where the profit of one year is between 70% and 75% of the profit of the other year, a form of marginal relief is due, and the adjustment is calculated by applying the formula: (D x 3) – (P x 0.75)
D = the difference between the profits for the two years
P = the higher of the two year’s profits
The adjustment figure arrived at is then added to the lower year’s profit and deducted from the higher year’s profit.
An Averaging Claim would be effective to reduce a tax liability which would otherwise be chargeable at the top rate of 45%. This may be of particular relevance to authors who receive a large advance in year 1, followed by little, or no royalty income in the next year.
However, where the profit for one of the years is more than 75% of the profit of the other year, no averaging claim may be made.
Also, an Averaging Claim cannot be made for a tax year in which the individual begins, or permanently ceases to carry on the qualifying business, or the business begins, or ceases to be a qualifying activity.
How is the averaging adjustment processed?
Although an Averaging Claim affects the profit taxable for two years, the claim is actually given in the second year only.
This is done by adjusting the second year’s profit to the averaged profit, and then adjusting the tax liability to take into account the adjustment required for the earlier year. If the adjustment to the earlier year is a reduction in tax, this is treated as additional payments on account in the second year. If the tax for the earlier year increases, this increase is added to the tax payable for the second year.
In the case of a partnership, the claim is made by each individual partner with regard to his own share of the profits. It is not necessary for all partners to claim this treatment, and whether a claim is beneficial may well depend upon other factors outside of the partnership.
A claim to other reliefs, or a claim to have such reliefs amended or revoked, which would otherwise be out of date, may be included in an averaging claim at any time up to the latest date on which the averaging claim could be made.
The treatment for Class 4 Nic purposes follows the income tax treatment of the averaged profits
This provides a basic outline. If you require any further advice, please do contact us.
Roy Butcher is a Partner and heads up the Creative Client Sector at Raffingers LLP. Contact: firstname.lastname@example.org