How does tax averaging work for farmers?

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Farmers have the option of either using two or five year averaging rules to smooth out fluctuating profit levels and their annual tax bills. Previously farmers could only average profits over two consecutive years, but the longer option was introduced to give greater flexibility. 

 

 

Farmers have the option to average their profits for tax purposes over any two or five consecutive years with the averaged figure being used to work out their income tax liability. Alternatively, farmers can choose to simply pay the tax due on the taxable profits each year. 

 

Farming incomes can be significantly volatile between one year and the next. Averaging works to iron out these peaks and troughs. 

 

Averaging profits over the relevant number of years and treating the average profit as the taxable profit means farmers can off set good profits in one year against smaller profits or losses in another.

 

This reduces the risk of a business being hit by a high tax bill in a bad year, when cash flow might be tight, and in some cases they can even generate tax refunds.

 

Only unincorporated farming businesses have the option to average profits as the rules are only applicable for income tax and therefore cannot be used by companies. Averaging provisions only extend to farming profits (after capital allowances) and not to other income streams such as leisure, property rental or renewable energy production.

 

Averaging is also excluded for contract farming, or where a cash basis of accounting is used. New entrants may also be restricted on averaging as a full two or five year trading history is required. Averaging is also not allowed where trade is ceasing. 

 

Any farmers wanting to elect for averaging must pass a volatility test. This means:

  • For five-year averaging
    • The average of the previous four years' profits and the fifth year's profits must be more than 75% higher or lower than each other; or
    • The profits of any of the five years under consideration is nil or a loss. 
  • For two-year averaging
    • The current year and prior years' profits must not be within 75% of one another; or 
    • The profits of any of the two years under consideration is nil or a loss.

Where there is a loss, the result is treated as nil for averaging and losses are available for normal loss relief. 

 

If a farmer does take advantage of averaging, they are likely to face increased professional fees, as a number of additional calculations will need to be performed in order to determine whether averaging will benefit them. These calculations cannot be performed on standard tax return software, so they will need to be performed manually using spreadsheets.

 

Under the two-year averaging, there will be four calculations required, one for each of the two years where averaging is not applied, and one for each of the two years where the averaging provisions are applied. 

 

Under the five-year averaging, there will be 10 calculations required. Previously averaged years can then be averaged again too. 

 

Care should also be taken to ensure that averaging doesn't affect earlier pension contributions. Relevant earnings for pension purposes could be affected by averaging and mean that tax relief received on earlier pension contributions has to be repaid. 

 

Partners in a farming partnership can elect to average independently of one another, depending on their individual circumstances. 

 

Averaging claims must be made within 12 months of the normal self-assessment filing date for the latest year to which the claim relates. 

 

To find out more about tax averaging and if your farming business may benefit from it, please contact our specialist agricultural team