We all know farm profits go up and down year on year with production and prices all highly subject to variations like weather, disease and market trends; farmers’ averaging is a tax relief that has been around for a long time now (the averaging legislation was introduced in 1977). In the simplest of terms it allows farmers to reduce volatility in their tax bills from one year to the next by adding two consecutive years’ profits together, dividing by two and calculating the tax on the average profit of the two years.
Hoops to jump through
As always, there are wrinkles, complications and limitations to claiming the relief, for example the ‘volatility test’ where the profits of the poorer year cannot exceed 70% of the profits of the better year. Unless of course the poorer year’s profits are between 70% and 75% of the better year, in which case a ‘marginal’ averaging applies. In the marginal cases, the tax relief is lower. Averaging isn’t allowed where one of the years being averaged is the first year of trade. Or the final year of trade. And the profits have to come from farming – if there are other activities such as contracting, catering or holiday lets included in the farm accounts these enterprises need to be excluded from the calculations. Averaging only applies to unincorporated businesses (sole traders and partnership) – if the farm is a limited company or a partnership that has a limited company as one of the partners averaging is not available.
How it works
Averaging is most beneficial when the profits of one year fall into higher rate tax but the other year falls into basic rate. The effect of averaging is to reduce the higher rate tax. Similarly, if there is a year of low profits where there is no tax to pay but the personal allowance is not fully utilised, an averaging claim can increase the profits of that year, and use up the personal allowance, but reduce the profits of the year it is averaged with, so saving tax.
When the annual investment allowance was introduced in 2008, averaging became even more useful, because farm profits could be drastically reduced in those years when there was significant investment in machinery.
Let’s look at an example
Say farmer Jo had farm profits of £28,000 in 2013-14 but only £6,000 in 2014-15. To keep things simple, we’ll assume Jo has no other sources of income. Personal allowances were £9,440 for 2013-14 and £10,000 for 2014-15. In 2013-14 Jo pays income tax on £18,560 (profit of £28,000 less personal allowance) – this is below the threshold for higher rate income tax so Jo pays basic rate tax at 20% – £3,712. There’s also Class 4 National Insurance but I’m not going to complicate the illustration with that. In 2014-15 there’s no income tax to pay, because profits are less than the personal allowance. In fact, £4,000 of the personal allowance is wasted – because it can’t be transferred to anyone else or carried forward to the next year. So for the two years Jo pays total tax of £3,712.
Could averaging help here? £6,000 is only 21% of £28,000, so Jo is entitled to make the claim. Taxable profits are now £17,000 for each year. Income tax is £1,512 for 2013-14 and £1,400 for 2014-15 – £2,912 in total. So Jo has paid £800 too much and gets a refund, with a little interest too. Well worth making the claim.
Changes in 2015 Budget
Averaging has always been based on the profits of two consecutive years (although the profits of the earlier year could already be the ‘averaged’ profits from a previous claim – and here the calculations can get harder to follow) but a very welcome extension to a five year averaging period was announced in the 2015 Budget. There was also a commitment to keeping the averaging rules as simple as possible to understand and operate. The exact mechanics of how this will work has been the subject of an HMRC consultation which closed last week.
When the details of how the the new five year averaging will work have been finalised, I’ll post an update, but in the meantime, if you have any questions about averaging, leave a comment below or drop me an e-mail at firstname.lastname@example.org
Farming is a unique industry with special tax and business rules. This publication is intended for general information and should not be relied on as a substitute for professional advice tailored to your precise needs and circumstances. No action should be taken without first taking professional advice and we do not take any responsibility for any loss to any person as a result of acting as a result of this material.