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When the last pyre has gone out and all the sheep are buried, will the politicians be aware that the ramifications of the foot and mouth epidemic will have a long-lasting effect on the businesses and lives of many in these rural communities? Certainly those with affected constituencies will, but what about their Cabinet masters? Will they, for example, even be aware that some of the farmers receiving their compensation in a few months time will have to pay tax on it?
This article is an attempt to outline some of the tax consequences and to clarify the tax implications of and possible planning options which might arise from, this appalling episode in the lives of so many in rural business communities. It inevitably begins with a look at the situation of farmers but also looks at some of the income and expense items which will arise for the many other businesses who are arguably even worse off than those in agriculture as the result of foot and mouth disease.
The tax helpline
To its credit, the Inland Revenue has at least moved with laudable speed in an effort to help and support businesses finding themselves in financial difficulties as the crisis rapidly deepened. The Revenue quickly announced a joint telephone helpline available for businesses to get in touch with it and Customs and Excise about deferral of tax, VAT and National Insurance contributions payments and possible speeding up of VAT refunds in repayment cases; call 0845 300 0157.
As a concrete practical measure, this was welcome in the early days of the spread of the disease and should be used speedily by anyone who believes they may be getting into financial difficulties. Experience to date suggests that the helpline staff offer a very sympathetic ear and practical advice as well as in most cases agreeing to delayed tax payments, etc.
Such help is, however, perhaps of little benefit to many small farmers in rural communities whose incomes over the last few years have been so low that in most cases they have not been achieving profits at a taxable level anyway. Of significantly more benefit will undoubtedly be the facility to speed up VAT refunds to which many farmers are entitled and to defer pay-as-you-earn liabilities, etc.
Other non-farming businesses might be forgiven for seeing these measures as something of a gift horse. When you have no outputs then your VAT bill is unlikely to be something which is currently causing you great concern. If, like many small guesthouses and hotels in the Lake District, you currently have no guests booked in from now until the start of July, due to cancellations because the popular (and accurate) perception is that the Lakeland fells are closed to tourists, then the blithe assurances that the countryside is 'open for business' have a rather hollow ring at the moment.
Some business rate relief is being offered via local authorities and will be welcome as a short term tax deferral measure, but the availability of such advice, which is of only marginal relevance to many businesses, is of only small comfort. Experience suggests that simply having an understanding person on the telephone to talk to has been of more real benefit to many. Indeed the two Government departments staffing the helpline must be commended for this alone.
Farmers averaging
Some commentators have pointed to the ability of farmers to average their profits under section 96, Taxes Act 1988 when they fluctuate considerably, (i.e. generally by more than 25 per cent from year to year). Unfortunately this ignores the problem that it is difficult to use averaging to your advantage when profits for the last two years have been almost non-existent or where losses have been arising.
Averaging should not, however, be ignored. Where a farmer does receive significant compensation for slaughtered animals there will be some cases where this compensation is included as taxable income in the financial accounts of the business (see below). Anecdotal experience already suggests that the levels of compensation which farmers are being offered as the result of stock valuations agreed prior to slaughter are quite generous and as such the receipt of such monies may well increase profits considerably for one financial year. In such cases the ability to average the profits remains a valuable tax planning facility and should probably be considered as a first option, especially for cases where profits have recently been very low.
For full details of the actual levels of compensation currently being offered to farmers under the Foot-And-Mouth Disease (Ascertainment of Value) (No. 4) Order 2001; readers should refer to the Ministry of Agriculture, Fisheries and Food website at www.maff.gov.uk/animalh/diseases/fmd/slaughter/instruments.asp.
Many farmers will use the existing tax spreading provisions under Inland Revenue Extra-statutory Concession B11 (see below), but in some cases averaging may provide a better alternative where prior year incomes have been very low and there are spare tax allowances available to offset taxable profits arising from the compensation.
Timing
The possibility of the farmer being able to determine when a compensation receipt is treated as an income item in the financial accounts of a business should be examined to ascertain whether any tax planning opportunities arise. Taxation of a compensation receipt which falls to be classed as trading income will generally fall to be considered under normal commercial accounting principles. As such the date on which the entitlement to the compensation is first firmly established will be when the receipt ought to be recognised for accounting purposes. But exactly when is this to be in the context of a compulsory slaughter for foot and mouth infection or dangerous contact?
As indicated above, the compensation must initially be regarded as a receipt of the business. Case law precedents have generally provided that where there is such an act of disturbance then the entitlement to the compensation is what triggers the recognition of the income for accounting purposes and the Revenue generally follows this line. See for example Johnson v W S Try 27 TC 167, Absalom v Talbot 26 TC 166, Isaac Holden and Sons v Commissioners of Inland Revenue 12 TC 768, and Commissioners of Inland Revenue v Newcastle Breweries Ltd 12 TC 927.
The Revenue's Capital Gains Manual contains the following entry at paragraph 15760:
'Foot-and-mouth disease
'Where compensation is paid by the Ministry of Agriculture, Fisheries and Food to farmers, or farming companies, whose livestock has been compulsorily slaughtered because of foot-and-mouth or some other major serious disease, see Inspector's Manual at paragraph IM2288, this compensation will normally be treated as a trading receipt or, where a 'herd basis' election is in force, see paragraph IM2321, as proceeds of sale.'
It is interesting to note that the reference to paragraph IM2288 in the above extract is generally of no use to practitioners as it is one of the few entries in the Inspector's Manual which appears to have been the subject of the departmental censor's red pen when the manuals were published.
However, a further and much more helpful comment can be found at paragraph IM2268a as follows:
'Compensation received for compulsory slaughter of animals
'The Ministry of Agriculture operates a slaughter policy with compensation for dealing with certain serious animal diseases. (In addition to the Ministry compensation, farmers may also receive compensation under an insurance policy – see paragraph IM2268d). Ministry compensation paid is normally treated for tax purposes as follows –
(i) Where the animals form part of the farmer's trading stock, as a trading receipt of the accounting period in which the slaughter takes place.'
The remainder of the extract deals with herd basis cases and this is discussed in more detail below. Thus the Revenue's view is that the entitlement to a compensation receipt is established at the point in time when slaughter occurs and that the compensation receipt should therefore initially be treated as an income receipt of that period.
Clearly then where the slaughter occurred in March 2001, as indeed was the case for many farmers, the compensation receipt is therefore a debtor at 31 March if this is the farmer's financial year end. The recognition of a single large income item will produce a potentially serious tax problem and this is recognized in the availability of some relief under Extra-statutory Concession B11 as discussed below. Alternatively, averaging may be another tax planning/relieving facility available to the farmer in such cases as mentioned above.
Farmers who have a 30 April accounting date may also need advice on the timing issue as their year-end approaches. Where a case of suspected foot and mouth is identified, then the date of slaughter clearly takes on extra importance as their year end draws closer. The provisions of Extra-statutory Concession B11 undoubtedly take some of the sting out of the tax bill but there may also be cases where slaughtering sooner rather than later might make sense not only from a disease control but also from a tax viewpoint.
Where the farmer has other income losses or other tax reliefs available, or where the amounts involved are small and can be set against personal allowances which might otherwise go unused, clearly the tax implications of slaughter before rather than after the year-end will need to be borne in mind. The resultant acceleration of the taxable profit could actually be of benefit in some cases if slaughter takes place before the year end rather than later.
Animals on the herd basis
As has already been indicated, the tax consequences of the receipt of compensation for compulsory slaughter of animals will depend heavily upon whether or not the farmer has already elected for the herd basis in respect of the farm animals. Not all farmers make use of this long-standing facility to have their trading stock treated as a capital asset, for a variety of reasons. Whatever choice they have made in the past, the availability of the herd basis will probably now have to be re-examined by many farmers.
The fresh election opportunity?
As a first point it is important to note that farmers who are not already on the herd basis may be eligible to make a herd basis election because of foot and mouth disease if they are affected by it.
A fresh opportunity to elect for the herd basis arises for such farmers if there is a substantial, (more than 20 per cent), compulsory slaughter of their production animals in a herd: paragraph 6 of Schedule 5 to the Taxes Act 1988. The Revenue's Inspector's Manual contains the following statement at IM 2268a:
'Farmers receiving compensation who have not previously elected for the herd basis and whose herds have been compulsorily slaughtered on account of disease are permitted under paragraph 6 of Schedule 5 to the Taxes Act 1988 to make a retrospective herd basis election to include the year of slaughter (see paragraph IM2316c).'
Thus where a farmer has previously decided not to make a herd basis election, for whatever reason, the legislation now provides an opportunity to make the election out of the normal time limits.
This late election must be made by an individual, not later than 12 months following 31 January after the end of the first year of assessment that was based on the profits of a period in which the compensation is 'relevant'. This means in a period in which the compensation is, or would be but for the election, taken into account as a trading receipt of that or an earlier period.
For a partnership the late election must be made no later than 12 months following 31 January after the end of the first year of assessment that was based on the profits of a period in which the compensation is relevant.
For a farming company the late election must be made no later than two years after the end of the company's accounting period to which the compensation is 'relevant'.
It would seem that such an election ought perhaps to be considered carefully in any cases where the farmer is actively considering ceasing farming home-reared animals or is perhaps intending to quit milk production as the result of the loss of his herd through the current foot and mouth crisis. The compensation would then be treated as effectively tax free as a compulsory slaughter of the whole herd.
The tax treatment of the animals where such a late election is made is as follows:
- Firstly the newly made herd basis election is deemed to have taken effect at the start of the farmer's period of account in which the compensation actually became due; i.e. the period in which the slaughter took place as outlined above.
- Any animals which are then to be treated as covered by the newly made election must be treated as if they have been physically transferred from the farmer's trading stock to a nominated production herd at that date. They could not, however, be treated as transferred to the herd if they were not mature at the start of the accounting period. In these circumstances they must be treated as transferred to the herd only once they reach maturity. This latter point arises because only mature production animals can be the subject of a herd-basis election as the herd basis is for herds kept for the sale of the 'produce or progeny'.
- The cost of such animals is then to be credited in the financial accounts of the transfer as a trading receipt of the farm under paragraph 3(3) of Schedule 5 to the Taxes Act 1988.
It is also important to note, however, that where at the previous accounting date animals were exceptionally valued at a net realisable value figure because this was less than their historic cost, then the Revenue will not normally object to the transfer to the herd being based on that value.
The new herd basis election continues in effect for all subsequent accounting periods, unless the farmer ceases to keep a herd of the specified class for a period of at least five years.
Finally where an opportunity to make such an election arises, the farmer is effectively prevented from taking advantage of profit spreading.
Compensation for a substantial herd disposal
There are special arrangements for the tax treatment of compulsorily slaughtered herd basis animals where compensation is received.
The compensation must be brought in to tax as sale proceeds on a pro-rata basis in the years in which the replacements for the slaughtered animals are purchased. If the replacements are of an inferior quality, the taxable receipt should not exceed the cost of the replacement. Thus:
- Where any culled herd basis animals are not replaced, any profit arising on their disposal which arises because of the receipt of the compensation payable to the farmer, or possibly other insurance monies as discussed below, is not taxable. Alternatively any loss arising in these circumstances is similarly not allowable.
- Where any culled herd basis animals are replaced then any compensation received must eventually be treated as taxable income. Where there takes place a substantial cull, i.e., more than 20 per cent of the herd is slaughtered, then this 'income' must be taxed when any replacements are added to the herd if this occurs within a five-year period. At this time any replacement costs incurred for these new beasts will be treated as allowable in full against the profits of that accounting period, although a disallowance must be made to account for any improvement element which is deemed to arise if better quality stock is bought.
Compensation for a non-substantial disposal
Where there is compulsory slaughter of herd basis animals and this accounts for less than the cut-off level of 20 per cent identified above then if those slaughtered animals are not replaced any profit which is deemed to arise on their 'disposal' must then be treated as representing taxable income of that accounting period. (This will be computed by reference to the compensation received less the animals' accounting historic cost.) Similarly any loss arising will be allowable as a tax deduction in the same accounting period.
However, if in such a case the animals which are compulsorily slaughtered are eventually replaced, then any compensation received must be treated as taxable income with any replacement costs also being classed as fully tax allowable, apart from a restriction which will again be necessary to take account of any improvement element in the quality of the animals treated as the replacements.
Herds with animals elsewhere?
Although it might be thought likely that the culling of animals will always be a total slaughter in the circumstances of the current foot and mouth epidemic this will by no means always be the case. In the modern farming environment, which has been so heavily criticised recently, many farmers over-winter animals away from their own farms and so may lose some or all of their beasts as the result of infection experienced elsewhere or indeed on their own farm. This may actually result in only a partial disposal of their herd. The exact circumstances will depend upon whether Ministry of Agriculture, Fisheries and Food as a matter of policy decides to treat animals located away from the farm, possibly even far away in another part of the United Kingdom, as 'dangerous contacts'.
Thus it is quite possible that a herd basis farmer may well only lose a non-substantial part of his herd to compulsory slaughter and then the under 20 per cent rules outlined above will apply.
Tax planning – herd basis cases?
The opportunity for a herd basis farmer to make a fresh election to the herd basis should also not be overlooked where the farm is currently run as a partnership. The Revenue normally insists that a partnership change brings about a fresh herd basis election requirement. As such it would seem that the Revenue accepts that the new partnership is not the same farmer as the old partnership notwithstanding the 'all farming one trade' provisions of section 53, Taxes Act 1988.
In these circumstances it would seem that a herd-basis farmer who receives a very substantial compensation sum on the compulsory slaughter of his entire herd should seriously consider a partnership change during the enforced six month quarantine period. Such a change would mean that any restocking of the herd after that six-month period would strictly be treated as being carried out by a different farmer for the purposes of the herd basis election. As such there should be no 'claw back' for tax purposes of the tax free capital profit arising on the slaughter of the herd under the previous herd basis elections since it took place during a period of farming by a different farmer. This would appear to be confirmed in the Revenue's own Tax Bulletin article on the subject in 29 June 1997 which reads as follows:
'Under the new self assessment rules, section 113(2), Taxes Act 1988 misapplies section 113(1), Taxes Act 1988 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 a 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'.
Would the proposed partnership change be subject to challenge on any other basis? Could a Ramsay challenge be mounted? It seems unlikely if the new partnership is real, with each partner having a proper legal status and entitlement to profits and losses stipulated in a properly drafted partnership agreement.
Similarly could the Revenue use the anti-avoidance provisions in paragraph 5 of Schedule 5 to the Taxes Act 1988 (transfers between connected persons) in these circumstances? Again this seems unlikely as it would surely be difficult for the Revenue to argue that the old partnership had control over the new or vice-versa as this would envisage that the two co-existed at some specific point in time and this seems a barely tenable view to say the least. However, the possibility can perhaps not be discounted and should be considered carefully where clients are seeking to make use of this planning device.
Animals not on the herd basis
Taxable compensation
Compensation received for the compulsory slaughter of non-herd basis animals will normally be treated as a taxable trading receipt with any excess of compensation over the value of the culled animals realising a taxable profit. Costs of replacements will be tax deductible and will be reflected in closing stock values.
Spreading treatment
Where compensation is received in respect of non-herd animals Extra-statutory Concession B11 applies to facilitate the spreading of the compensation money over three tax years. Extra-statutory Concession B11 will apply for the year of slaughter for an animal for which no herd basis election has been or could be made. This is an important qualification because where more than 20 per cent of a non-herd basis herd is culled, Extra-statutory Concession B11 will not be available because the fresh herd basis election could be made.
Where Extra-statutory Concession B11 is used, the profits from the compensation are excluded from the tax year in which the slaughter takes place and one-third of these profits is then to be included in the assessable profits for each tax year following the year of the slaughter. In this case profits attributable to the compensation are the excess of the compensation over opening stock values or 75 per cent of compensation for animals born in the year of slaughter; or the excess of compensation over the purchase price for any animals bought in the year of slaughter.
There are also special modifications to the rules applicable under Extra-statutory Concession B11 where the profits affected by the receipt of compensation are those for the year of cessation or commencement of a business or are affected by a change of accounting date. For a worked example of the application of Extra-statutory Concession B11 see Simons Taxes at B3.522.
In the past some farmers have been in the practice of insuring their herds against the impact of diseases which might lead to the compulsory slaughter of their animals. (There has even been at least one case reported nationally where a farmer who has been prudently paying insurance premiums to protect against foot and mouth since the 1967 outbreak has had the renewal of his policy refused by the insurance company in March 2001!)
Where a claim is made against the policy (and the insurance company actually pays up), the money received under the policy is effectively being received to fill the gap left in the farmer's profits as the result of the disease in the event that there is a shortfall between the amount of any Government compensation received and the market value of the animal. Some farmers' insurance premiums may also be made to provide them with cover for consequential losses of profits, although in the hard pressed farming communities this has become increasingly rare in recent years.
The Revenue's view is that insurance payments received to represent the value of the slaughtered animals must be treated as sales proceeds and then taxed or not as the case may be under the rules for compensation money as described above. Any further insurance payments received to compensate for consequential losses of profit should therefore be treated as trading receipts and subjected to tax accordingly.
RUSSELL COCKBURN practises as an independent taxation consultant based in Cumbria. He was formerly an Inspector of Taxes. Russell can be contacted by telephone or fax on 01900 824542 or via e-mail to Bluebellhouse@cs.com.
