2018 marks the 40th anniversary of the introduction of legislation in the 1978 Finance Act to enable farmers (including market gardeners) to average their business profits for income tax purposes. Farming profits can fluctuate widely due to the weather and a range of other factors beyond the control of most farmers. The consequential variations in taxation liabilities contribute to uncertainty in planning cash flows and capital investment. It was the exceptional difficulties faced by farmers following the long drought in Summer 1976 which led to the introduction of averaging for 1977/78 and subsequent years.
The original scheme
The original system provided for the profits of two successive years to be added together and divided by two, provided that the lower profit figure did not exceed 70% of the higher. An alternative marginal relief, determined by a formula, was available if the profit gap fell between 70% and 75%. Profits could not be averaged if the lower figure exceeded 75% of the higher profit figure.
Initially, the profits to be averaged were the figures before the deduction of capital allowances and partnership profits could only be averaged if all partners agreed. Following the introduction of self-assessment, capital allowances were deducted before averaging and individual partners could elect to average their own profit shares independently of the other partners.
The current scheme: five-year averaging
As a result of concerns raised within the industry that two-year averaging did not provide adequately for profit volatility, new legislation was introduced in the 2016 Finance Act. A new five-year averaging was brought in alongside the existing two-year averaging, which was also simplified by raising the 70% threshold to 75% and abolishing the marginal relief.
For 2016/17 and subsequent years, farmers are now able to make an election to average their profits over five years as an alternative to, or in addition to, two years. This has the potential to be a very useful tool to take full advantage of lower tax rates and bands, especially in the current situation where many arable farmers made substantial profits in 2012/13 but are making much smaller profits or even losses now.
As with two-year averaging, five-year averaging can only be claimed by individuals who farm either as sole traders or through a partnership. A farming business which operates through a limited company does not qualify.
Five-year averaging is only available where a new volatility test is satisfied. This requires the difference between the profit for the fifth year and the average of the profits for the previous four years to be at least 25% of the higher figure. For the purposes of this calculation, the profit figures are after deduction of capital allowances and the result for a loss-making year is treated as a nil profit. Furthermore, irrespective of the result of the calculation, the volatility test is automatically deemed to have been satisfied if any of the five years results in a loss.
Claims for loss relief continue to be made separately from averaging claims.
Worked example
Farmer Adrian has made profits and losses as follows:
| 2016/17 | 2015/16 | 2014/15 | 2013/14 | 2012/13 | |
| Farming profit | £20,000 | £70,000 | £80,000 | £115,000 | |
| Farming loss | -£10,000 | ||||
| Other income | £25,000 | £20,000 | £15,000 | £16,000 | £13,000 |
A two-year averaging claim has already been made under the original rules for 2014/15 and 2015/16 as 20,000 is less than 70% of 70,000.
The total of profits for the first four years is £285,000 and the average is therefore £71,250. The difference between this figure and the fifth year figure (deemed to be nil) is clearly greater than 25% of the higher figure. In addition, one of the five years is loss-making. So, on both counts, the volatility test is satisfied. The average profit figure for each of the five years is thus £57,000.
Relief for the 2016/17 loss is claimed against the income for that year.
| 2016/17 | 2015/16 | 2014/15 | 2013/14 | 2012/13 | |
| Average profit | £57,000 | £57,000 | £57,000 | £57,000 | £57,000 |
| Farming loss | -£10,000 | ||||
| Other income | £25,000 | £20,000 | £15,000 | £16,000 | £13,000 |
| Previously averaged profit |
£45,000 |
£45,000 |
|||
| Change in profit | £57,000 | £12,000 | £12,000 | -£23,000 | -£58,000 |
| Change in tax | £17,000 | £5,000 | £5,000 | -£9,000 | -£26,000 |
The net saving in tax through making the five-year averaging claim is £8,000. This arises because income has been moved out of years when Adrian was a higher rate taxpayer into years when he was not fully utilising his basic rate band. Furthermore, his personal allowance, which was withdrawn in 2012/13 due to his total income exceeding £100,000, has now been reinstated.
Further considerations
In the example above, the 2016/17 loss has been used against total income in that year. It could have been carried back against total income in 2015/16 or carried forward to use against future farming income. The choice would depend on Adrian’s individual situation or the expectation of future income or profits.
A further tool for managing volatile farming profits is the ability to restrict a claim for capital allowances. With the annual investment allowance now at £200,000, many farms will show a loss for tax purposes in the year of a significant purchase, such as of a combine harvester. In some situations, it may be better to disclaim (wholly or partially) the annual investment allowance or the writing down allowances which may be available and carry them forward for use in later years.
In future years, Adrian could make further five-year or two-year averaging elections. These could include one or more of the years already included in the calculation above. For the purposes of such later calculations, the starting point for any revisited year would be the average of £57,000 rather than the original profit. If averaging elections are repeatedly made, the tax bill for any included year may be recalculated several times. Accordingly, it is essential that accurate records are kept for all years and for all averaging claims and that such records are all transferred whenever there is a change in a farmer’s tax adviser.
In family farming partnerships, profit sharing arrangements frequently change from year to year. Advice should be taken as to what impact any such changes may have on the availability of averaging claims so that the overall tax liability of the whole family can be minimised.
Planning for the payment of pension contributions also needs to take into account the effect of a subsequent averaging claim on a proposed payment of a large contribution in a year of high profit. An averaging reduction may result in a contribution already paid no longer qualifying for full tax relief.
Summary
The extension of famers’ averaging provides a lot of opportunities for minimising the income tax liabilities of a farming business but it is essential that proper advice is taken at each stage of what may be a complicated process. With our experience in tax and in advising farmers, BKL can help in arriving at the best result.
For more information, please get in touch with your usual BKL contact or use our enquiry form.