At the time of authoring this article Judy Sullivan was a Senior Associate at Mallesons Stephen Jaques, Canberra.
What is a hobby, and what is a business? Does it matter?
For tax purposes, it certainly does.
If you are not carrying on business as an artist, then you cannot offset losses from your art practice against other taxable income (such as teaching income, or income from other jobs or activities).
And even if you are carrying on business as an artist, you may still be caught by the 'non-commercial losses' rules in the Tax Act, with the same result.
The question of whether an artist is carrying on a business has been notoriously difficult to answer. The Australian Taxation Office (ATO) and arts bodies have been grappling with this question (and occasionally with each other) for many years. I have had the dubious honour of helping to lead the charge on behalf of the National Association for the Visual Arts (NAVA) and the Arts Law Centre of Australia (backed up by many other peak arts organisations across all art sectors – authors, dance, film, musicians, etc.) Thankfully, there is now some light at the end of this tunnel.
In January 2005, the ATO issued 'the Ruling' (public ruling TR 2005/1). It is called Income Tax: carrying on business as a professional artist. All artists should read it. It was the end result of much work on both sides. We talked at length to the ATO and the Rulings Panel to present an overview of life as an artist in Australia, how business as an artist contrasted to other types of business, and how to draw the line between an arts business and a hobby.
However, a fundamental 'lynchpin' of a business is a profit making intention. The ATO was concerned that an artist continually returning losses couldn't demonstrate the profit motive necessary to show that they were carrying on business as an artist. But how can an artist demonstrate this? As art depends upon unique ideas and originality, the concept of 'mass producing' a marketable product (the basis of commercial businesses) does not apply. The reality is that many artists return losses from their art activities. Australian studies conducted over many years have confirmed that most artists seek other sources of income in order to support their practice as an artist. However, most artists still hope for financial success as artists.
That said, the law applying to artists is no different to the law applying to any other business. The Ruling notes this, but discusses the legal tests of a business with particular reference to the circumstances of artists, and applies to artists practising across all art sectors. Importantly, it recognises that arts businesses typically have different characteristics to those found in other businesses. It also accepts that a large part of being in business as a professional artist may involve activities directed towards reputation building and audience/market creation. So if an artist genuinely intends to make a profit, they must be looking for relevant buyers, and positioning their arts practice to maximise the prospect of earning income. This can happen in a variety of ways – by developing contacts in the art world; offering art work for sale; actually selling works to the public; offering expert services through commission or consultancy; applying for grants, awards, patronage, commissions etc; making work accessible to the public through activities designed to raise your profile as an artist; entering art competitions, residencies and award events; undertaking business research and consulting with accountants or other experts; and generally documenting the future direction of the art activities.
The Pedley Case
The Administrative Appeals Tribunal (Tribunal) decided a test case (Pedley v Commissioner of Taxation) in February of this year, finding that an installation artist was carrying on a business, despite returning net losses over a number of years. The ATO did not appeal.
Mallesons Stephen Jaques agreed to represent the artist in this case pro bono, given the precedential importance of this case for other artists.
The taxpayer had been an artist for over twenty years. Her main focus was installation works. She also created small sculptures and 'cyanotypes' (photographs created by exposure to natural light). She had some minor sales of her art, but had failed to return a profit from her art activities in her tax returns.
Extensive evidence was led by us on the taxpayer's academic qualifications, her background and work as an artist, and the activities undertaken to build her reputation and bring her works to the attention of the relevant market in the hope of securing a commission for her works. She maintained a separate studio to produce her art, and exhibited her works consistently at major Australian galleries, with her works being offered for sale. She sought gallery representation, although that did not eventuate. She brought her work to the attention of the public through residencies, art competitions, media coverage and self promotion. The taxpayer had produced a colour booklet which contained photographs and critiques of her major works over many years, which she distributed to galleries or sold. Her main source of funding was through 'New Work' grants from the Australia Council.
The taxpayer said that she intended to carry on business as a professional, practising artist. However, it is important to understand that the test under the tax law was not what she thought, but what a reasonable person would objectively think – and in that regard the ATO said that it was impossible to predict when and if commercial success (and profits) would be achieved.
A previous case decided by the Tribunal after the Ruling was issued in 2005 (VBF v Commissioner of Taxation) found that an artist was carrying on a business once he had established his works in a format which could be commercially exploited. It was not fatal that the prospect of making a profit was very slim. Rather, the artist had an intention and expectation (viewed objectively) that he would eventually make a profit, which was sufficient for the profit motive necessary to be carrying on a business.
It is also clear (from other cases, and from the Ruling) that a taxpayer can be primarily motivated by excellence, rather than money, and still be carrying on a business. Further, a business can be carried on in conjunction with other income producing activities such as employment.
In the Pedley case, the ATO focussed upon a lack of sales, and noted that most of the artist's income came from grants. They argued that the artist would not be able to continue as an artist without grants funding. How then could that be a business?
The Tribunal found that installation art was an artistic area in which it was difficult, although not impossible, to achieve commercial success. The artist had the self-confidence and belief that she would eventually become successful. She had worked for many years as an artist. In commercial terms she had been unsuccessful; although this may always be so, it was not necessarily the case that it would always be so. Nearly all of the criteria in the Ruling relating to reputation building and bringing her work to public attention had been met. As such, the evidence demonstrated the relevant 'profit making intention' notwithstanding that no profits had eventuated to date, or could be forecasted with any precision or certainty.
Accordingly, the case was decided in the artist's favour, finding that the artist did carry on business as a professional artist in the relevant year.
The non-commercial losses rules
Even if an artist is carrying on a business, there is a risk that losses from that business may be caught under the non-commercial losses rules in Division 35 of the Tax Act.
Those rules were introduced to catch the so-called 'Pitt Street Farmers' – who ran elaborate farming businesses at a loss, and claimed the losses against their substantial CBD/Pitt Street income. If they apply, the losses cannot be used to offset other income, but are 'quarantined'. That means that they can only be offset against income from the art business which is earned in future years.
When first introduced, the farmers lobbied the Government to introduce a limited exception. We managed to have this same exception applied to artists. Accordingly, the rules do not generally apply if the income from other (ie. non-arts) sources is less than $40,000 in a particular year.
We are continuing to press for artists to be exempted from these rules, because of the increased certainty over the 'business' tests applying to artists (thanks to the Ruling and the new case law). However, this will is unlikely to occur in the near future.
The current state of play
The recent positive changes are a good start, but there is still more work to be done.
If you are making losses as an artist, you must be able to prove that you are carrying on a business, not indulging in a hobby. That will often be possible, but you must operate in a business-like way; creative passion and reputation are insufficient to convince the ATO. Rather, you must convey the perception and the actuality of being in business and plan, organise and undertake your activities in a business-like manner to bring your work or activity to relevant markets.
In particular, I urge you to read the Ruling, take the time to understand it, and make sure that you can meet the requirements.