Farmers’ profit averaging and the herd basis

Despite the weather meaning a slow start to the 2021 harvest, yields have held up well and as the harvest season closes.

The Agriculture and Horticulture Development Board (AHDB) figures show 2021 average UK yields for winter wheat and winter barley up on last year: Winter wheat is up from 7.1-7.3 average tonnes per hectare to 8.1-8.3 average tonnes per hectare, and winter barley is up from 6.5-6.7 average tonnes per hectare to 6.9-7.1 average tonnes per hectare. Thoughts then turn to farm profitability and meeting the resulting tax liabilities.

Farmers’ profit averaging

Due to fluctuation in farm profitability from one year to the next, farmers have been able to use averaging in determining their taxable profits, to smooth out the effect of that fluctuation.

Farmers’ Profit Averaging was first introduced in the late 1970s, and allowed farm profits to be averaged over two consecutive financial years. In response to increasing volatility, resulting from climate change, extreme weather conditions and commodity prices, the permitted averaging was extended from two years to five consecutive years in 2016.

How does it work?

Under the current rules, farmers can choose whether to apply the old two-year averaging, the new five-year averaging, or indeed, to apply no averaging at all.

To qualify for the averaging, farmers must meet a volatility test – there must be a minimum level of fluctuation in profitability. The volatility test compares the profitability between years to be averaged as follows:

• To be able to apply the five-year profit averaging: The difference between the fifth year’s profits and the average of the previous four years’ profits must be at least 25% of whichever is the higher figure.
• To be able to apply the two-year profit averaging: The difference between the profits for the two consecutive years must be at least 25% of the profit figure for the better year.

Equally, the averaging can be applied where the result for one of the years to be averaged is nil or a loss. In that situation, for the purposes of the averaging, the result for any year with a loss is treated as nil, and the loss is available for normal loss relief.

Under the old rules, there was also a marginal relief band, but that has now been removed.

Where the volatility conditions are satisfied, the farmer can choose to average profits over the two or five years, as appropriate, or not at all. Where the averaging route is chosen, the profit figure averaged over the appropriate number of years is the figure that is then subject to tax in each of those averaged years. The averaging smooths tax cash outflow and can even generate an income tax refund in respect of some of the averaged years.

Claims for the relief must be made within 12 months of the self-assessment filing date for the latest year included within the claim.

Who can claim?

The averaging relief applies to income tax and income taxpayers only. Assuming the above volatility conditions are met, sole traders and members of farming partnerships can claim the relief. Partners in a farming partnership can make a claim for the relief independent of one another. All partners need not claim and whether a claim is appropriate or not will depend on the individual taxpayer’s personal tax position.

Are there any other restrictions?

As the relief applies only to income tax, it is only relevant to unincorporated businesses. Claims cannot be made in respect of limited companies and for corporation tax relief.

The averaging provisions apply to farming profits only (after capital allowances), and not to, for example, profits arising from diversified activities such as furnished holiday letting, leisure and tourism offerings or renewable energy production.

For new farmers without sufficient a trading history, the relief will be restricted. To claim the full two or five-year relief, there must be a full two or five-year trading history, as appropriate. It is not possible to make a claim for the relief where the trade is ceasing.

In addition to making greater use of the relief under the farmers’ Profit Averaging provisions, with continuing uncertainty around the impact of Brexit and reform of direct subsidy support on livestock farmers, we are also seeing clients increasingly looking to make use of herd basis elections. That is clients restructuring their farming businesses and adopting the herd basis as part of that restructuring, as well as clients rationalising their farming businesses to dispose of elected herds and looking towards sale and leaseback arrangements.

The herd basis

Under a herd basis election, qualifying production herds are treated as tangible fixed assets for tax purposes, rather than as trading stock.

Why would a farmer make a herd basis election?

The main advantage of a herd basis election, is that any profit (or loss) made on a disposal of the herd, or a significant number of the animals from the herd, is not taxable.

A significant disposal is more than 20% of the number of animals in the herd for this purpose.

The herd basis can therefore be used as an effective longer-term tax planning tool. Any costs incurred in maintaining the herd are tax-deductible.

What qualifies as an eligible production herd?

To be eligible, a herd must qualify as a ‘production unit’. To be a production unit, the herd must be kept for the products that it produces, so long as those products are not derived from the slaughter of the animal. Qualifying herds therefore include dairy herds, laying hens, sheep kept for fleece production and thoroughbred animals that are kept for breeding purposes.

Where animals are kept specifically for breeding purposes, the offspring are considered a product for the herd basis, as are single animals, so long as they meet the other requirements.

There are various classes that are excluded from the herd basis, including working animals, any animals kept for racing or public exhibition, animals kept for their resale potential, immature animals and animals kept for fattening and slaughter.

For a herd to qualify, the animals must be of the same species, but they do not need to be of the same breed.

Who can elect for the herd basis?

The election is available to farmers whether they are trading as a sole trader, in partnership or through a limited company.

The election must be made to HM Revenue & Customs (HMRC) in writing – there is no specific form for registering a herd basis election. That written election must disclose the nature and composition of the herd and the products for which the herd is kept.

In the case of a limited company election, the election must be made within two years of the end of the accounting period in which the herd is first kept. In the case of a sole trader or partnership election, the election must be made by 31 January falling two years after the end of the tax year in which the herd is first kept (a further year is allowed where the year in which the herd is first kept is also the first year in which any farming activities were undertaken).

Restructuring of a farming business could re-open the window for adopting the herd basis, where the herd is kept by a new entity.

Are there any downsides to making an election?

Once a herd basis election is made, it cannot be reversed.

There is additional complexity, due to the potential differing treatment of the animals for accounting and taxation purposes, and under a herd basis election, detailed records need to be maintained by the farmer.

Operation of the herd under a herd basis election can be complex, particularly in accounting for additions to, disposals from and replacement of animals in, the herd.

What other factors should I consider?

Clearly, the larger the qualifying production herd, the greater will be the impact of any decision to adopt the herd basis and the more important it will be to get the decision correct in the first instance. The election is irreversible.

The larger the difference between the initial cost of the herd and the ultimate value on disposal, the greater could be the tax advantage in adopting the herd basis.

If a farmer is approaching retirement or is considering cessation of the trade in which an eligible herd is used, if the herd basis adopted, the farmer could dispose of the herd and make a tax-free profit in the near future.

If the business could be transferred to a new individual or company, or a sole trader is considering forming a partnership, there can be complications where the herd basis has been adopted.

Specialist advice on adopting and operating under a herd basis election is strongly advised.