Income Tax 3: Herd Basis, Profit Averaging, and Loss Relief Notes

Income Tax 3: Herd Basis, Profit Averaging, and Loss Relief

• Lecturer: Dr Eric Osei, Harper Adams University.

• Core Topics covered:

  • Review of foundational income tax concepts.

  • Herd basis elections for livestock.

  • Farmers' profit averaging (2-year and 5-year basis).

  • Loss relief options and their applications.

Foundational Review and Tax Principles

• Essential Knowledge for Income Tax Assessment:

  • Identification of main sources of income.

  • Application of tax bands and their respective tax rates.

  • Correct treatment of dividend income.

  • Distinction between 'capital' and 'revenue' expenditure.

  • Calculating Capital Allowances on plant and machinery.

  • Calculating Capital Allowances on cars, including distinctions for the year of expenditure and subsequent years.

  • Knowledge of key forms of exempt income.

Valuation of Livestock and Profit Impact

• Financial Impact of Stock Valuation:

  • Profit figures can be heavily influenced by changes in stock valuation, even when physical sales and purchases remain constant. This can lead to increased tax liability on paper profits.

  • Fundamental Formula for Gross Profit:

    • $\text{Gross Profit} = \text{Sales} - \text{Cost of Sales}$

    • $\text{Cost of Sales} = \text{Opening Stock} + \text{Purchases} - \text{Closing Stock}$

• Numerical Case Study (Herd of 100 cows):

  • Scenario Parameters:

    • Opening Valuation (1 Jan): $\pounds 1,000/\text{head}$

    • Closing Valuation (31 Dec): $\pounds 1,100/\text{head}$

    • Sales: $\pounds 80,000$

    • Purchases: $\pounds 60,000$

  • Calculation 1: Unchanged Values (Opening and Closing both at $\pounds 1,000/\text{head}$):

    • Sales: $\pounds 80,000$

    • Opening Stock ($100 \times 1,000$): $\pounds 100,000$

    • Purchases: $\pounds 60,000$

    • Closing Stock ($100 \times 1,000$): $-\pounds 100,000$

    • Cost of Sales: $\pounds 60,000$

    • Gross Profit: $\pounds 20,000$

  • Calculation 2: Value Changed (Closing at $\pounds 1,100/\text{head}$):

    • Sales: $\pounds 80,000$

    • Opening Stock ($100 \times 1,000$): $\pounds 100,000$

    • Purchases: $\pounds 60,000$

    • Closing Stock ($100 \times 1,100$): $-\pounds 110,000$

    • Cost of Sales: $\pounds 50,000$

    • Gross Profit: $\pounds 30,000$

  • Conclusion: The $\pounds 10,000$ difference in profit is entirely due to stock valuation rather than actual cash inflow/outflow.

Herd Basis Election

• Purpose: To avoid 'false' profits generated by fluctuating valuations of production herds. The election removes production herds of mature animals from the Profit and Loss (P&L) Account.

• Scope of the Election:

  • Included: Mature production animals such as dairy herds, sheep flocks, suckler herds, sow herds, and poultry flocks.

  • Home-Reared Exceptions: Younger animals that must be reared at home (e.g., hill sheep) may be included.

  • Excluded: Working horses, dogs, and 'flying flocks' (livestock bought to be fattened and sold rather than kept for production).

• Rules and Irrevocability:

  • The election must be made within a 2-year time limit from the establishment of the herd.

  • The election is irrevocable.

  • It applies to all animals of the same species owned by the taxpayer (e.g., if a farmer has two separate dairy herds, both must be on the herd basis).

• Tax Benefits:

  • Disposal of the herd upon retirement is free from Income Tax and exempt from Capital Gains Tax (CGT).

Other Farm Stock Valuation Rules

• General Valuation Rule: Stock is valued at the lower of cost or net realisable value (NRV).

• HMRC Guidance (HS232): Taxpayers or the Revenue may depart from standard guidance where appropriate. This was formerly known as Business Economics Note BEN 19.

• Deemed Cost for Home-Bred Livestock:

  • Cattle: $60\%$ of market value.

  • Sheep and Pigs: $75\%$ of market value.

• Deadstock: Value at historic cost or $75\%$ of market value.

• Tenant Right: Generally valued at cost. HS232 is noted as being unclear regarding allowances for enhancement values.

Farm Profit Averaging

• Objective: To smooth the tax burden for farmers whose profits fluctuate dramatically due to external factors like weather and commodity prices. This prevents paying tax at excessively high rates in one year and low rates or losses in another.

• Mechanism: Average the relevant profits using the mean average over a 2-year or 5-year period.

2-Year Averaging Basis

• Eligibility: Available when the profits of one year are $75\%$ or less than the profits of the adjacent year (preceding or following).

• Calculation Logic:

  • Example A: Year 2 profit = $\pounds 50,000$; Year 1 profit = $\pounds 38,000$.

    • Test: $\frac{38,000}{50,000} = 76\%$

    • Result: No averaging available (fails the $75\%$ or less rule).

  • Example B: Year 2 profit = $\pounds 50,000$; Year 1 profit = $\pounds 34,000$.

    • Test: $\frac{34,000}{50,000} = 68\%$

    • Result: Averaging available.

    • Adjusted Profit: $\frac{34,000 + 50,000}{2} = \pounds 42,000$ for both Year 1 and Year 2.

• Note on Tax Due: Even with equalized profits, the actual tax due may differ between years due to changes in Personal Allowances, tax bands, or tax rates.

5-Year Averaging Basis

• Introduction: Established in the 2016 Budget.

• Volatility Condition: Must meet one of the following:

  1. The profits of years 1-4 differ by more than $25\%$ from the profits of year 5 (either higher or lower).

  2. A loss is made in any of the years 1-4.

• 5-Year Calculation Steps (Example 1: Y5 Lower than Y1-4 average):

  • Profits: Y1: $10,000$, Y2: $30,000$, Y3: $25,000$, Y4: $50,000$, Y5: $20,000$.

  • Step 1: Calculate Average for Y1-4: $\frac{10,000 + 30,000 + 25,000 + 50,000}{4} = 28,750$

  • Step 2: Check volatility: $\frac{28,750 - 20,000}{28,750} = 30.4\%$.

  • Result: Since 30.4\% > 25\%, averaging is possible.

  • Step 3: Final 5-year average: $\frac{135,000}{5} = 27,000$ per annum.

• 5-Year Calculation Steps (Example 2: Y5 Higher than Y1-4 average):

  • Profits: Y1-4 total: $115,000$ (Average: $28,750$); Y5: $45,000$.

  • Step 1: Check volatility: $\frac{45,000 - 28,750}{45,000} = 36.1\%$.

  • Result: Since 36.1\% > 25\%, averaging is possible.

  • Step 3: Final 5-year average: $\frac{160,000}{5} = 32,000$ per annum.

• Simpler Approach for Losses: If a loss is made in any of the 5 years, the volatility tests are not needed. The loss is restated as $0$ for the averaging calculation, but the total profit for the 5 years will rise as the negative figure is removed.

  • Example: Total profit with a $\pounds 10,000$ loss was $100,000$. Profit restated (loss to $0$) becomes $110,000$. 5-year average is $22,000$.

Loss Relief Options

• Factors influencing relief: The source/class of income (trading losses, different trades, property losses, agricultural property losses) dictates the rules.

• Four Primary Options:

1. Carry Forward

• Rule: Carry the loss forward to the next available year of profits from the same trade, profession, or vocation.

• Precedent Case: Gordon & Blair Ltd. v. IRC (1962) — brewing losses could not be offset against bottling profits after the nature of the business changed.

• Risks: May underutilise the Personal Allowance; delay in relief erodes value due to inflation.

2. Carry Across

• Rule: Carry the loss across to total income from other sources in the same year. Remaining balance can be carried forward one year.

• Requirement: Requires a specific election (default is carry forward).

• Hobby Farming Clause: Taxpayers must demonstrate that a competent farmer would have made a loss under the same circumstances to prevent abuse by non-commercial 'hobby' farms.

3. Carry Back (Initial Loss Relief)

• Rule: Available for losses incurred in the first 4 years of a business.

• Mechanism: Carry the loss backward and deduct it from income in the 3 years preceding the loss year. It is offset against earned income before unearned income.

• Benefits: Generates a tax refund; improves cash flow for reinvestment.

4. Offset Against Capital Gains (CGT)

• Rule: Offset trading losses against capital gains in the loss-making year and the following year.

• Condition: Only available if losses have already been carried across to other income first (Option 2).

• Risks: May underutilise the Personal Allowance and the annual CGT exemption.

Property Income Losses

• General Rule: Losses from property letting can usually only be carried forward against future rental income.

• Exceptions:

  • Capital Allowances: If a loss is created specifically by Capital Allowances claimed by a landlord, it can be carried across to other income in the same or following year.

  • Pooling: Income from all properties held by a taxpayer can be pooled to offset profits and losses within that pool.

  • Agricultural Land: If an estate is managed as one unit, losses due to maintenance, repairs, insurance, or management expenses (excluding loan interest) can be carried across to other income in the same or following year.