It is interesting to note that HMRC are relentless in their attempts to try to deny farming and equine sideways loss relief, especially where it is difficult to prove an expectation of profits as shown by the recent case of N Erridge (TC4294).
This case highlights the need for all tax advisers to, “sanity check” every tax loss before it is submitted to HMRC. There is a need to pay particular attention to the “loss memorandum" ie, the records of loss claims mindful of the need for justification and the detail around “hobby farming” rules. Farm tax is complicated and the loss rules are an example of this.
Large overheads and losses
Mr Erridge was a full-time dentist and claimed to set the farming tax losses against his other income after a history of losses. HMRC refused the claim on the grounds that sideways loss relief was not available because ITA 2007, s 68(3)(b) (reasonable expectation test) had not been satisfied. The taxpayer appealed against the HMRC decision and the debate led all the way to Tribunal.
The facts were that in 1982, Mr and Mrs Erridge bought a farm. They then bought the neighbouring farm in 2002. Both farm purchases were funded by bank loans. The farming business made a profit before capital allowances of £2,977 in 2004/05, but made tax losses for subsequent years until 2012/13. In 2006, Mr and Mrs Erridge bought a further farm, which was again funded by a bank loan. It is interesting to note that a profit was made in 2004/05. As a result of this, the tax loss “clock” started again in 2005/06 for the “hobby farming rules." However, the five-year rule had been exceeded by 2012/13. This was the problem facing HMRC.
The case was taken to the First-tier Tribunal (FTT) and the FTT explained that they had to consider the 2010/11 activities in the consideration of the beginning of the period of loss, ie 6 April 2005 (as a profit was made in 2004/05). The FTT decided that the losses of the farming business were in principle unchanged in the period. Mr Erridge had financing problems which prevented him achieving a profit as soon as he had hoped for. However, this reason was considered irrelevant for the purposes of justifying the loss claims in this particular case.
It must be remembered that all farming is one trade so there was no new clock starting with each farm acquisition. There have been many taxpayers acquiring land and farms over a period of time who have suffered from this particular ruling.
There are a few traps that the taxpayer and tax adviser can fall into when looking at these types of loss claims and trying to protect future loss claims.
Firstly, where there is outside funding there can be the overloading of costs and failure to look at the “financial roadmap” to ensure that there will be a reasonable expectation of profit after expenses. Where the loss and borrowings are funded from high earnings it is very attractive to continue farm expansion without regard for the tax loss claims.
Secondly, small losses can be claimed in early years which jeopardise the future possible larger loss claims. When any farm loss is claimed in the form of a sideways loss claim, the question must be asked – what is predicted for the next five years? Will this early small claim jeopardise future claims?
Foreseen profits by a competent person
For the purposes of s 68 ITA 2007, the FTT considered that the anticipation of profit could not have been foreseen by a “competent person” in 2005, ie it would not have been possible to make a profit. Mr Erridge’s appeal was therefore dismissed by the FTT. The problems appeared to be the high loan interest and the inability to overcome the detrimental cost structure of the farming operation, ie, in simple terms, too high costs. In 2010, the taxpayer commissioned a farm review from the Scottish Agricultural College which suggested the business would return to profit if certain measures were taken; however not all the suggestions were acted upon. It is essential to ensure that in order to achieve tax relief action is taken upon such suggested measures.
With the current HMRC vigorous attack on the income tax loss claims, there appear consistent threads of approach – a careful review of overheads (in this case including loan interest) by HMRC and showing that they always exceed potential income. Such a basic analysis might sound over-simplistic, however if the overheads are too high and profits cannot be reasonably expected, it is essential for the taxpayer and adviser to start to consider the rules around reasonable expectation of profit at an early stage. The purist adviser would argue that with the current HMRC attack the consideration of profitability should be on purchase.
The basic start point must be to produce business plans that show a realistic profit can be achieved and that a profit is achieved in reality. The consideration of s 68(3) and the reasonable expectation of profit by the taxpayer has to be reviewed. Such analysis comes back to the fundamental consideration of business plans as mentioned. How else can the potential for profit be proved at an early stage? Changes to the structure must be actioned if the farm roadmap does not lead to a sustainable profit.
The claim of tax relief on loan interest used to purchase a farm is in itself a complex and interesting subject. Some taxpayers and their advisers can overlook the right to claim genuine loan interest paid on the purchase. For example, where a loan is used to purchase part of the farmhouse it can be possible to not claim maximum income tax relief as the significance of the business use of the farmhouse is not appreciated by the adviser. The claim for loan interest can be made without jeopardising a future claim for principal private residence relief which some advisers are wary of.
At the other end of the scale is the excessive claiming of loan interest by advisers which does happen as such a claim makes the ability to show a future profit impossible. The correct restriction for private use should be considered on an interest paid loan and other areas of farm expenditure which will then show the correct reflection of allowable tax loss balanced with the correct ability to make a profit.
Whatever happens, the adjustment for private use must be consistent, based on fact and evidenced. This whole area of accountancy adjustment must be thought through at an early stage.
Another trap that the farmer can fall into is the letting out of the farm for a few years and still claiming the trading loss. The impact of this was shown by the French case as in the case the five year rule is extended (French v HMRC  UK FTT 940). Obviously during the periods of letting the farm losses cannot be shown as trading losses but property losses. The property losses will not count towards the “trading loss” clock for the hobby farming rules.
The key points when looking at any loss claims moving forward are that the tax adviser and client must be prepared for close scrutiny at every level by HMRC. There will be the need to be able to prove commerciality, demonstrate expectation of profit, provide an original business plan being checked to subsequent results, and evidence hours spent as appropriate. No tax loss claim can be made by a taxpayer without being able to argue justifiability.
Julie Butler FCA, Butler & Co
Farming and Rural Business Group, July 2015