Income averaging: Who is eligible, how it works

Australian tax legislation recognises that certain taxpayers, due to the nature of their work, can make inconsistent levels of income from year to year. In light of this, there is a concessionary tax treatment available that allows for a reduction of the otherwise unreasonable tax rates that would apply in higher income years, in effect smoothing out these income spikes to come to a fair level of tax overall.

The concession comes in the form of special tax rates applied, broadly, to a four year rolling average taxable income. It is available only to certain specified categories of income earners, known as “special professionals”. These are:

  • sportspeople
  • authors (literary, dramatic, musical, but also other artistic works and in some cases computer programmers)
  • inventors
  • performing artists, and
  • production associates (those who provide artistic support to performing artists).

The principle behind the income averaging provisions is that those working in these fields may spend a number of years working on a project that will only realise income at a future point in time. For example, a film-maker can spend years developing and producing a work that will only make any income once it is released, or a sportsperson may be limited to compete in their field on an occasional basis (for example, some major sporting events only happen once every four years). In each case, the income earned is characterised by peaks and troughs.

For the purposes of income averaging for special professionals however, what the legislation refers to as “special professional income” is that which is derived from the specific category of professional activity. For an artist for example, income from the sale of paintings counts, but income from running painting workshops does not.

The benefits to an eligible individual’s tax outcome by using such income averaging provisions will typically be mostly felt in the first few years of application, and can result in significant tax savings for those years. The benefit tends to reduce once income flattens out, which is of course the intent of the legislation. Note that all other income is taxed in the usual way and at normal rates.

The eligibility criteria for special professional income averaging includes that an individual:

  • earns income from one of the “special professional” categories
  • is an Australian resident at any time during the income year, and
  • satisfies the first year requirements (see below) in either the current income year or an earlier income year.

Note that assessable professional income includes:

  • rewards and prizes
  • income from endorsements, promotional activities, advertisements, interviews, commentating and any similar service
  • income from assigning copyright or granting a licence of a literary, dramatic, musical or artistic work
  • income from assigning a patent, or the right to apply for a patent, or granting a licence for an invention
  • income from providing professional services, and
  • other assessable income from a literary, dramatic, musical or artistic work, from copyright in such a work or for an invention.

To then calculate the “taxable professional income”, apply the formula given by the law:

Apportionable deductions x (assessable professional income ÷ {taxable income + apportionable deductions})

Broadly, to reduce the assessable professional income by deductions relating to it, and the relevant part of any apportionable deductions (for example, donations).

The first year a taxpayer becomes eligible for income averaging is the year in which they have more than $2,500 taxable professional income. This then becomes year one of a four-year period over which taxable professional income is averaged.

Over the ensuing years of the four-year phrase-in period, the Tax Office deems the average taxable professional income (TPI) to be:

  • year 2: one-third of the TPI in year 1
  • year 3: one-quarter of the sum of TPI of years 1 and 2, and
  • year 4: one-quarter of the sum of TPI of years 1, 2 and 3.

From the fifth year onwards, the average taxable professional income for each ensuing year is simply based on the rolling four-year averages — that is, the total of the past four year period is divided by four.

Note that the following are specifically excluded from assessable professional income:

  • a superannuation lump sum or an employment termination payment
  • payments for unused annual or long service leave on retirement or termination, and
  • a net capital gain.

To deal with the peaks of higher income that such special professionals encounter (or perhaps hope to) over their working lives, the law provides that the tax payable on “above average” income  — that is, the amount that exceeds the average taxable professional income — is calculated by applying a unique formula. This is set by applying, to 80% of the above average amount, four times the basic rate of tax that 20% of the above average amount would have borne had it been the top slice of the taxpayer’s taxable income in the relevant income year (the illustration below will hopefully make this more clear).

As you can see, the income averaging regime for special professionals is a complicated area, and can easily be misunderstood. Not only that, but the Tax Office tends to put applications to apply these income averaging provisions under the microscope — to ensure a taxpayer is legitimately eligible, but also to check that all the correct income is included and the correct tax rates are applied. It is essential that you seek clarification from this office should you believe you can make use of the special professional income averaging provisions.