Tax planning around pure farming profit

With the continuing uncertainty in the farming industry, the profit goal becomes more of a problem. For the last few years most farms have made less profit than the farm subsidy in generic terms. Pure farm profit is very difficult to achieve in the current farming conditions. Achieving the all-important farming profit for tax purposes therefore continues to be a very significant tax planning point for any farm accountant to consider. The rules around ‘hobby farming’ are often considered relatively straightforward. However, advisers must be careful to ensure that the farm is not bearing the costs of the investment elements of the whole enterprise and this is very important when determining the true profit position of the farm. Advisers must review the practical steps and objective analysis of achieving a farming profit in a set of farm accounts. There has been increased attention on the commerciality of farm businesses over the past few years by HMRC with pressure being put on the importance of a farm profit. One of the most recent cases being Scambler v Revenue and Customs Commisioners [2016] UKFTT 47 (TC) which looked at the denial of a sideways loss relief claim as the six-year rule had been exceeded. However, the cases on farming losses focus on the commerciality after the fact and a reasonable expectation of profit, as advisers it is important to proactively review the farming accounts and the farming profit to try and avoid breaching the hobby farm rules.

Scambler is an Upper Tribunal decision and there have been many more recent farm loss cases passing through the Tribunals – Thorne, Silvester etc.

The six-year rule

A farm is required to make a profit every six years in order to satisfy the hobby farming rules, for these purposes the legislation references a loss ‘calculated without regard to capital allowances’ as per ITA 2007 s67. It is therefore the loss for the year adjusted for tax purposes and disregarding capital allowances, thus depreciation is added back and no account is taken for capital allowances in its place. It is also a necessity that the loss is calculated on a fiscal year basis and therefore the adviser will need to reapportion accounting years to the relevant tax year if the accounting date is not 31st March or 5th April. An interesting twist is that the year of commencement is not counted for these purposes.

For many farms and estates an integral source of income for the farming operation has been the investment properties, with less and less farm cottages being used for farm workers and instead let out to generate income. Quite regularly when the rental income is stripped out on the business tax computation the farms are showing a loss. It is often the case that expenses are not forensically analysed in the accounts, and although the rental income is being added back on the business tax computation, very few associated expenses are also being adjusted for as a mirror transaction. A lot of expenses such as overheads, wages and mortgage interest are overlooked when considering the full cost of the rental properties. A farm employee could be spending a proportion of their time carrying out the maintenance on the let properties, or it may be the case that the insurance paid for the property as a whole will cover the let properties, however such costs are not being allocated against the rental income. It is key that the significance of a farming profit and how this is determined for HMRC is explained to the farming client so that they can reflect this in their bookkeeping and the allocation of expenses.

All tax goals and risks must be looked at ‘in the round’ and the whole farming operation understood. It is not just let properties that need to be considered but also all forms of farm diversification. Are the core overhead costs being correctly allocated against the income that they generate? The impact on VAT partial exemption plus overall inheritance tax planning that will result from the correct analysis needs to be considered. As always there must be both the forensic and holistic approach.

The risks of lack of understanding

In a worst case scenario, if expenses are not being correctly allocated the accounts will show a false or misleading position, which can mean that the rental properties are generating large profits on which the taxpayer is suffering large tax bills due to farming losses being carried forward as they can no longer be offset sideways as a farming profit has not been achieved within the specified time limit. It is necessary that the farming and non-farming activities are reviewed and the running costs of the let properties are discussed with the client to try and avoid this scenario. Quality bookkeeping and understanding of the fundamental principles are key. Of course a farming profit cannot be manufactured and the treatment must be consistent but in a lot of scenarios there are genuine expenses not being allocated against the correct income source.

Any expenses that are allocated to the investment activities will need to be considered from a VAT perspective as rental income is an exempt supply, and therefore the input tax on these expenses could move to being either residual or exempt potentially resulting in a restriction of the amount of VAT that can be claimed via the partial exemption calculation.

Loan interest

Consideration will need to be given with regard to mortgage interest paid by farming businesses as from the 2017/18 tax year onwards, the way in which landlords of residential properties claim mortgage interest will change. Up to the 2016/17 tax year, mortgage interest for residential lets could be claimed as a deduction against the rental income in the same way that any other revenue expense could be claimed. The full tax relief will now be phased out over 4 tax years so that eventually there will be no deduction for mortgage interest against the rental income but instead tax relief is given at 20 per cent on the amount of mortgage interest paid for the year. It will therefore be critical that on farming estates that the mortgage interest arising from loans on let properties is correctly analysed and allocated against the rental profits so that the new rules can be correctly applied on the Tax Returns. Such allocation will again come down to forensic analysis and understanding, eg review of the purpose of the loan in the context of a total review considering all taxes.

Whilst carrying out the exercise of reviewing the whole farm operation including expenditure and the allocation thereof, it is also vital that the status of the income is considered as to what is trading and what is an investment activity. Review any farm business tenancy arrangements that are due for renewal in order to see if a contract farming arrangement can be put in place in order to maximize the trading income. If there are any planned diversification activities the advisers must consider their trading status and the impact on the farming profit/loss as well as IHT and CGT planning.

Every farming operation must be forensically understood on a case-by-case basis. The owners will have different goals as to what activity and what taxes have the greatest impact for the specific farming operation under review.

Contributed by Lucinda Knighton ACA MAAT, partner, Farming & Equine Department at Butler & Co, Email: lucy@butler-co.co.uk