I had a conversation recently with a friend whose hobby (making beautiful ceramic cups, bowls, vases etc.) is starting to develop into something more. She is starting to receive paid commissions and is setting-up a website to facilitate further sales. What once was a pastime is starting to look more like a business.
This situation is something you see regularly for musicians. A band might start as a bit of fun between friends, by playing covers in a garage, before they move to performing live at a local venue or busking. Or a young music producer might be playing around at home and uploading content to SoundCloud. In both cases, their expenses (instruments, travel, equipment, software etc.) are likely to heavily outweigh the income they generate. Accordingly, it is common for a musician not to realise when their hobby has become a bona fide business.
The distinction is important as it affects how HMRC views the income and the reporting requirements. It is therefore important to understand the “badges of trade” that HMRC consider when assessing if an activity is a trade:
- Profit-seeking motive
- The number of transactions
- The nature of the asset
- Existence of similar trading transactions or interests
- Changes to the asset
- The way the sale was carried out
- The source of finance
- Interval of time between purchase and sale
- Method of acquisition
You do not have to have all badges to be considered trading, but each should be considered to get an overall picture of the nature of the activity. Often the key badge is the profit-seeking motive. This means there is a clear intention to make profit from the activity and making a profit is realistic. Without profit, or a realistic prospect of making profit, there would be no trade.
The reason HMRC have this distinction is because they do not want to give tax relief to people who simply have a hobby. For example, I play guitar (not very well), which is one of my hobbies. I could record some songs and upload them online to be bought or streamed. It is very likely the cost of my guitar, recording equipment/studio costs, editing software etc. is going to vastly exceed the income I generate (let’s face it, the income will be zero), therefore I will generate a loss. Normally, trading losses can be offset against your other income, so in my case, the income from my accountancy business. HMRC therefore insist on the trade being viable otherwise they’d be contributing tax relief to people simply doing something they enjoy.
However, if you have talented musicians who have started to be paid to perform gigs, their music is receiving radio play and they have interest from record labels, the chances of them making a profit is viable. At this point, HMRC will accept a trade exists. The sooner you can identify the activity as a trade the better, as this allows you to claim more of your overheads (travel, telephone etc.). Furthermore, you can typically claim the costs of equipment you bought in the past as long as you still use them and it was within seven years.
To stress, you do not need to make a profit immediately in order to be treated as trading. You can make losses for several years while still being treated as trading (companies like Uber and Spotify have yet to make a profit despite trading for years). However, it would be useful to have a business plan that shows you expect to eventually make a profit and the forecast income is realistic.
Given there is a level of subjectivity and uncertainty, there are different approaches you can take depending on your attitude to risk:
- If you are risk adverse, I recommend not reporting the trade until you have made a profit. This will limit the historic expenses you will have claimed, but it is less likely HMRC will raise any enquiries, and if they do, they are not going to find any under-declared tax.
- If you are risk-taker, you can claim the losses once you are happy you have a viable business in the long-run. Since claiming these losses against your other income might result in a tax refund, it is more likely HMRC will investigate. It is therefore sensible to set aside the tax saving until HMRC’s enquiry window has closed.
- A middle ground would be to report the losses as they arise, but not to make a claim to offset the losses against your other income. This preserves the historic overhead expenses, although the losses can only be used against future income from the same trade. However, if you are not already preparing tax returns, the added cost of hiring an accountant, or the added stress of preparing returns yourself, might not be worth the expenses you are saving for future tax relief.
Whichever approach you take, I highly recommend you start keeping records of your income and expenses. This can be a basic spreadsheet, ideally supplemented by physical or digital copies of invoices and bank statements. However, HMRC are trying to push for businesses to keep digital records. This is not mandatory for non-VAT registered business right now, but should be expected in the near future.
If you think your hobby has become a trade, you will need to register with HMRC within six months of the first tax year-end (i.e. the 5 October following the 5 April). Your first tax return deadline will be subsequent 31 January. For example:
- Begin trading – 22 June 2020
- First tax year-end – 5 April 2021
- Deadline to register with HMRC – 5 October 2021
- Deadline to file online tax return – 31 January 2022
Finally, I should add there is a small exemption for hobbies that generate a small amount of profit. If your gross income (not the same as profits) from the hobby is less than £1,000, you do not have to report the profits to HMRC.
If you want to discuss any of the above, or any other tax matter, or even if you want to arrange a jam session, just give us a call on 020 7183 3383 or email info@kma-spotlight.com.
