If you don’t know already, here’s a short guide to help you understand the HMRC averaging adjustment. This is a special type of tax relief for certain sole traders, such as authors, writers and artists, who have a fluctuating income or receive lump sums of money up-front, to help them spread their tax bill over one or two years. Does this sound like you? If so, read on to find out how it works.
Friendly Disclaimer: Whilst I am an accountant, I’m not your accountant. The information in this article is legally correct but it is for guidance and information purposes only. Everyone’s situation is different and unique so you’ll need to use your own best judgement when applying the advice that I give to your situation. If you are unsure or have a question be sure to contact a qualified professional because mistakes can result in penalties.
Table of contents
1. How Does the HMRC Averaging Adjustment Work?
Certain self-employed individuals earn a fluctuating income. This means they may face high business profits in one tax year followed by lower profits in a subsequent year. That results in paying a higher tax bill, at higher income tax rates with the hassle of making a request for HMRC to carry back tax losses to get a tax repayment on tax returns.
The HMRC averaging adjustment lets individuals reduce the tax they pay in an unusually high-income tax year by using an average of two years profits. That way it evens out any fluctuations in income and the tax they have to pay.
2. An Example of the Author Averaging Rules
Eddie is a writer and receives an advance for a new book of £50,000 in the tax year 2019/2020 and knows that as a result of writing the book his profits will be lower in the next tax year 2020/2021. He estimates his profits for each of the tax years will look like this:
Without using the author averaging rules, Eddie would need to pay self-employed tax of £9,500 plus Class 2 and Class 4 National Insurance in 2019/2020, but no tax in the following tax year 2020/2021.
By apply the averaging adjustment, Eddie can use the average profit for both years when he filling in his tax return. The averaging amount would be £32,500 which is worked out as (£55,000 + £10,000 = £65,000) ÷ 2.
In his 2019/2020 tax return he will need to enter:
Net Business Profit £55,000
Less: averaging adjustment £32,500
Adjusted Profits £22,500
Eddies will now pay income tax of £2,000 for 2019/2020 plus class 2 and class 4 National Insurance instead of £9,500. In his next tax return for 2020/2021 he will need to enter the following:
Net Business Profit £10,000
Add: averaging adjustment £32,500
Adjusted Profits £42,500
Eddies will now pay income tax of £6,000 for 2020/2021 plus class 2 and class 4 National Insurance.
By using the averaging rules, Eddie will pay £8,000 in Income Tax rather than £9,500 by declaring it all in one tax year and paying higher rate income tax at 40%.
If you estimate a taxable loss this is treated as zero, it can’t be used to reduce the averaging adjustment.
3. Payments on Account
The averaging adjustment will help to reduce payments on account. In the example above, if Eddie didn’t adjust his profits he would have to pay tax on account of 50% in January and July based on his unadjusted profits of £55,000. By averaging his profits, this figure falls meaning his payment on account reduces too.
4. Who Can Claim the Averaging Adjustment?
Commonly the averaging adjustment is claimed by literary and artistic individuals because they have fluctuating profits and:
- It is not the first or last year of being self-employed;
- The cash basis is not used for calculating business profits;
- Profits of one year are less than 75% of the previous or subsequent tax year.
It is most commonly claimed by:
- Authors receiving an advance for a new book;
- Software developers whose income comes from royalties for reproducing the copyright-protected code they’ve written.
5. Who Cannot Claim the Averaging Adjustment?
You cannot claim the averaging adjustment if your profits come from services that you provide. For example, if you are a software developer who has income from writing code for others not code that you own and permit others to use.
6. How to Claim the Averaging Adjustment