The Battle Continues

JOHN WARD FCA highlights some important tax issues for farmers following the Foot and Mouth epidemic.

ALTHOUGH SOME FARMERS have had their animals culled and been paid financial compensation, the future looks difficult and at this stage the tax implications are very important. Various reliefs are available for ordinary trading stock, but production stock warrants further attention. The following is the tax position where compensation is received in respect of production herds.

If not restocking

Where compensation has been received for more than 20 per cent of the animals in the production herd and restocking does not take place within the next five years, the profit on disposal of these animals is tax-free. In circumstances where an election has not been made in the past, where animals have been slaughtered from a notifiable disease, an election can be made at that time.

For example, if in a husband and wife partnership, £240,000 is received for 150 cows which have an historical cost of £50,000, a tax-free profit of £190,000 would exist if restocking does not take place within five years.

Restocking by existing partnership

If the same husband and wife partnership restocks the herd, there is a clawback of the tax-free profit.

For example, if 100 of the above cows are replaced at a cost of £80,000 the profit, which was tax free initially, will be taxed when restocking occurs:

	£
Compensation on 100 cows	160,000
Less: Cost of Replacement	80,000
Taxable Profit	£80,000

Restocking by new entity

If a new partnership is formed or an individual starts a new business in the quarantine period before restocking, a new herd basis election can be made.

In such cases the profit on the disposal of the herd by the old partnership could still be tax-free. The 100 cows bought by the new partnership in the above example, would have a base cost of £80,000.

The Inland Revenue's Tax Bulletin (29 June 1997) states:

'Under the new self assessment rules, section 113(2), Taxes Act 1988 disapplies section 113(1) so that a change in the membership of a partnership does not trigger a cessation and recommencement of the trade. But this does not alter the fact that the farmer carrying on the trade before the change is not the same as the farmer after the change. So the herd is no longer kept by the farmer making the election. It follows that fresh herd basis election by the new farmer is still required after a partnership change, if the new partnership wants the herd basis to apply.'

The Revenue's Tax Bulletin (October 2001) states:

'It is fairly well known that a herd basis election comes to an end when there is a change in the membership of a partnership. This is because the new partnership is a different farmer for the purpose of the herd basis from the old one. So a genuine partnership change between the compulsory slaughter of a herd and replacement may serve to crystallise a tax-free gain on the sale of the herd. But the cost of the new herd will not, of course, be allowable.'

The reference to a 'genuine partnership change' is important.

Various press reports have stated that an attack under anti-avoidance provisions or the Ramsay case could be made, by the Inland Revenue where changes are not made for 'genuine' reasons. In my view an attack could be upheld if the change is just a sham with no commercial justification. Examples could include a new partner having other full-time employment and living at the other end of the country, a very old parent or someone totally unconnected with the farm being introduced as a partner, or the new partnership only lasting a very short period of time.

However, there are many cases and situations where changes will be made for totally commercial reasons and any attack under Ramsay can be defended. Farmers are genuinely looking at the best way forward at present due to the emotional turmoil and state of farming; most farmers who have had their stock culled are taking the opportunity to plan ahead. Often this will involve retirements by parents, who can use compensation funds to retire and take it easier, and children or other relatives now wanting to set up or be introduced as partners. In family situations, another option being considered in some cases is for children to carry on farming activities with none of the existing partners being involved. On reviewing circumstances, some will also consider passing assets over to the next generation. Many decisions will also be made after consultation with a farm consultant under the FBAS-FMD scheme (Farm Business Advice Service: Foot and Mouth Disease) operated by Business Link.

It is important to obtain professional advice without delay and take advantage of the free Government funding available under that scheme.

Stock valuations

Only limited guidance has been given in the May 2001 Special Tax Bulletin relating to Foot and Mouth stating that:

'Where stocktaking valuations are based on deemed cost in accordance with paragraph 7 of Business Economic Notes 19 and markets are closed because of Foot and Mouth so market values on which to base deemed cost are not readily available, valuations should take into account:

• market value prevailing before the outbreak of foot and mouth disease;

• levels of compensation being paid in respect of animals slaughtered;

• prices being offered to farmers who are able to deliver animals to abattoirs.'

The Revenue's main booklet on stock valuations, BEN 19 (Business Economic Notes), states the following:

2.3 'For tax purposes we are looking for a figure (commonly referred to as a valuation) which represents the cost, or, if lower, the net realisable value of the stock'.

3.3.1 'If there is no reasonable expectation that the net realisable value of stock will cover costs incurred, then stock should be stated at net realisable value.

3.3.2 'Net realisable value consists of:

'The sale proceeds that it is anticipated will be received from the eventual disposal of the stock in the condition in which the farmer intended at his balance sheet date subsequently to market it. It is important to note that the valuation should be made on a normal commercial basis. For instance, it is not acceptable to value stock on the basis that it would have been sold in a forced sale on the balance sheet date in its then possibly immature state.

'Plus

'Grants and subsidies intended to augment the sale prices of stocks.

'For breeding/production animals the ancillary stream of income from the sale of their progeny and produce.

'Less

'The further costs to be incurred in getting the stock into marketable condition and then marketing, selling and distributing that stock. Where the proceeds from the sale of progeny/produce are brought in, then the costs relating to their production and marketing should also be deducted.

3.3.3 'It is not acceptable to treat cull value as the only future revenue from production animals as this does not recognise the value of the future income stream from the produce and/or progeny.'

Realisable value?

At 31 March 2001 many farms within 3 kilometre protected zones, Form C 8 kilometre zones or subject to Form A or D restrictions could not send or receive animals and at that date there was no likelihood that this would be lifted possibly for a long time. The fundamental accounting concept of the lower of cost and net realisable value and the anticipated sale proceeds under 3.3.2 needs consideration at the time the accounts are prepared. What is the anticipated sale price of stock now?

One possibility for final sale proceeds will be the Over 30 months Slaughter Scheme (OTMS). An example of the possible net realisable values using OTMS proceeds is as shown in Table 1.

Table 1: Over 30 months Slaughter Scheme Proceeds
Age at 31.3.2001		6 months		12 months		18 months		24 months
	Notes	Steer	Heifers	Steer	Heifers	Steer	Heifers	Steer	Heifers
Liveweight at 30 months	1	540	440	540	440	540	440	540	440
Income
Eventual Slaughter Price (47p x Liveweight)		254	207	258	207	254	207	254	207
Add: Slaughter Premium		32	32	32	32	32	32	32	32
Add: Beef Premium		174		87		87
Estimated Total Income		460	239	373	239	373	239	286	239
Less: Estimated Direct Cost to 30 Months of age	3	272	240	217	185	162	130	107	25
Estimated net realisable value		188	(1)	156	54	211	109	179	214
Notes:
1) The deadweights at 30 months are assumed to be an average of 52 per cent of average liveweights of 540 kgs for steers and 440 kgs for heifers.
(2) The eventual sale price is assumed to be 85 per cent of £1.57 kilo for steers and £1.50 for heifers at 26 August 2001.
(3) Estimated direct costs are taken at £9.18 per month (per the University of Exeter Farm Management Handbook 2000 excluding overheads) plus estimated finishing costs of £52 for steers and £20 for heifers.

 

Another option may be to use the current market value, but discounted to finishing at an average of 30 months to reflect the likely sale price. This discount would allow for the total uncertainty that exists now on possible sale values, haulage costs, the expected level of future market prices taking into account Foot and Mouth disease and an ongoing downward trend in sale prices with no current signs of an upturn. Since preparing this article, the market price of beef has continued falling to £1.40/£1,45 kilo! This last factor above all warrants a discount purely based on prudence and conservatism. Using this basis, and again adding in subsidies and slaughter premium and deducting estimated direct costs, could produce the result shown in Table 2.

Table 2: Discounted Market Value
Age at 31.3.2001			6 months		12 months				18 months			24 months
	Notes	Steers		Heifers		Steers	Heifers		Steers	Heifers		Steers	Heifers
Deadweight at 30 months	1	280		230		280	230		280	230		280	230
Income
Eventual Sale Price	2	373		293		373	293		373	293		373	293
Add: Slaughter Premium		32		32		32	32		32	32		32	32
Add: Beef Premium		174				87			87
Estimated Total Income		579		325		492	325		492	325		405	325
Less: Estimated Direct Cost to 30 Months of age	3	272		240		217	185	162		130	107		75
Estimated net realisable value		307		85		275	140	330		195	298		250
Notes as per Table 1.

 

Professional judgment

It is of course up to valuers or accountants to exercise professional judgment to make realistic assumptions and to use the 'best estimate' of eventual sale price at the date the accounts are prepared in calculating net realisable value. In some cases actual sale prices will be available at that time. In other cases a best estimate of eventual proceeds from animals will be needed. At the time of writing, my view is that the Over 30 months Slaughter Scheme values for animals over 18 months or a small discount on current values for under 18 months could be justified now in estimating eventual sale prices given future uncertainties. However, this needs to be judged individually on a case by case basis and for each category of stock. What is clear from the above is that net realisable value could easily be justified to be lower than cost in some cases.

Provisions

In the Tax Bulletin published in December 1999 an article regarding provisions stated:

'Whether provisions and other estimates included in accounts are sufficiently accurate is ultimately a question of fact for the Commissioners, to be determined by them after considering all relevant evidence. This means that it is in the first instance a matter for Inspectors, in the course of any enquiry they make into a return, to consider the accuracy of provisions and other estimates. Inspectors may wish to ask what factors the directors or business proprietors took into account in arriving at the figure, and what information was available to them.'

'We accept that sometimes absolute accuracy is impossible, so that there is no single "right" figure. Directors and business proprietors have a responsibility when preparing accounts to make judgments, and there will often be a range of possible answers within which their own business expertise will be the main factor affecting the final answer. What we expect them to do in arriving at an estimate is to exercise their judgment in a reasonable manner, taking into account the information reasonably available to them and other relevant factors including their own business expertise. If they have done this, and arrived at a result that accords with the requirement of UK Generally Accepted Accounting Practice, then Inspectors cannot substitute a different figure just because they might have exercised their own judgment differently.'

If net realisable value is used instead of cost, full disclosure on the tax return of the change to reflect the current situation is recommended. Many will understandably wish to avoid a reduction to net realisable value, but in some cases this will be unavoidable.

The choice

Clearly there are many arguments for leaving stock values at direct cost or a percentage of market value in accounts for consistency, especially where animals have been subsequently culled. Where, however, farmers are looking to include animals at the lower of net realisable value and cost, in accordance with Business Economic Notes 19, the above methods could be considered so that a 'best estimate' or calculation of the 'right' and correct valuation can be made without the risk of penalties at a later date.

Please note the figures shown are only examples and professional advice must be sought in all cases to reflect individual circumstances.

 

John Ward is a partner in Davisons, chartered accountants based in North Devon and a registered farm consultant under the Farm Business Advice Service: Foot and Mouth Disease Scheme operated by Business Link. He can be contacted on 01769 572404 or by e-mail at davisonssmo@sosi.net.