Scrambling to make a profit
Julie Butler shares recent tax tribunal cases that reflect the difficult financial situation many farms now find themselves in.
The plethora of tax tribunal cases featuring sideways tax loss claims helps indicate the current troubles facing the farming industry with regard to reduced income and therefore increased tax loss claims and the need to prove commerciality.
The recent Upper Tribunal decision in B and R Scrambler v CRC Tribunal (Tax and Chancery Chamber) 10 January 2017 highlighted the harsh approach of HMRC towards the allowability of continued loss claims by farmers. While many of the diversified farm enterprises are producing overall profits, the pure farming element has seen reduced profitability, particularly if there are, for example, high loan interest payments (see N Erridge (TC4294)) or high overheads.
Mr and Mrs Scrambler ran a dairy farm in Devon which had achieved profits until 2005/06. From that date, the farm made farming losses. The losses were in part due to a drop in milk prices, but also an increase in their borrowings after installing a robotic milking parlour and the purchase of more land. Tax loss claims were made by Mr and Mrs Scrambler after the time allowed for hobby farming loss claims of 5 years (s 67 Income Tax Act 2007). Mr and Mrs Scrambler claimed sideways tax loss relief against their general income (ITA 2007, s 64). HMRC refused the tax loss claim on the ground that a competent farmer would not have had a reasonable expectation that the farm would not become profitable in the next five years (s 67 and s 68). The First-tier Tribunal had dismissed the appeal by Mr and Mrs Scrambler. The case proceeded to the Upper Tribunal.
The pragmatic approach
In order to be able to claim tax losses, farmers must be able to evidence expectation of profit. Business plans are essential to help demonstrate such expectation. Where there is a farm enterprise with different diversified activities it is key to correctly allocate the overheads as part of the accounts preparation. There can be a temptation for farming operations to incorrectly allocate overhead expenses against the farming trade only and not against the diversified activity, thus not presenting the correct tax loss position.
In the Scrambler case the Upper Tribunal judges agreed with the First-tier Tribunal’s conclusion that the taxpayers needed to show a specific reason why profits would not be made for the loss period, despite running the business competently. The case provides helpful analysis of the test to be applied in determining whether there is a reasonable expectation of profit for the purposes of section 68 Income Tax Act 2007. The Upper Tribunal stated it was not enough simply to say that the milk price was unpredictable. It was stated by the Tribunal that the price was as likely to increase as decrease. There should have been more explained reasoning.
‘Indefinite’ loss relief claims
The judge made it very clear that the farm tax loss relief could not be claimed ‘indefinitely’ The provisions of s 67 and s 68 have been in place a considerable number of decades and are there to prevent ’indefinite’ loss claims. For those tax advisers and entrepreneurs not brought up in a farming environment it must seem totally uncommercial that a farmer would want to be in a commercial position of more than one or two years’ losses, let alone the time cap of the hobby farming rules. Such advisers can be totally aghast at any form of prolonged loss claims and how these are funded. The Upper Tribunal judges explained their view:
"It follows from our analysis that we do not accept that the purpose of the legislation was to ensure that competent farmers doing everything they could within their control to address profitability were entitled to sideways loss relief indefinitely. We should stress that normal loss relief against future losses of the trading question are still available for farming trades in the same way as they are for any other trade…However, in our view, it is clear that the purpose of the legislation reflects a policy that, unless there is something in the nature of the farming activities concerned that means that they cannot reasonably be expected to become profitable except in the long-term, the period of sideways loss relief should be limited by time in normal circumstances.”
The sideways loss claim was denied as limited by time by the Upper Tribunal.
Proactive move to profitability
One question asked was: why would any farmer allow a continued loss? Why would the Scramblers not change or cease the structure of the farm trade that is losing money? The fact that milking ‘robots’ had been introduced showed a modern and commercial approach to the running of the business not ‘outdated’ methods etc. and competence was shown. The farm had been profitable up until 2005/06. At a general level farmers have seen pressures on the ability to achieve profit. At a practical level the last two to three years have seen the pure farm profits slip below the basic payment subsidy for a large number of the farming operation. How pure farming survives in the future when subsidies cease or reduce is an important question.
How to survive commercially
Many farmers have had no choice but to endure low farm profitability and survive on the sale of development land (see Henderson v HMRC TC04730) and/or letting income or some form of diversified income. It is also well known that farmers can spend very little in the way of drawings or money for themselves. In order to maximise future tax loss relief the farming community must embrace the review of trading activities in the form of the commerciality perspective as well as the disclosure/allocation approach. Management accounts must become a basic requirement. There has been much resistance to Making Tax Digital by the farming community. However, perhaps the digital reporting could be turned to a positive, with quarterly reporting being used in management terms to assess performance.
Section 68 ITA 2007 makes no allowance of the effect of supervening events that arise after the period of losses has commenced, even if those events are completely outside the farmer’s control, eg, milk prices. Interestingly, in looking at section 68 the FTT considered that it was necessary to look at the way farming was being carried on at the beginning of the period of the tax loss claims. However, in the Scrambler case the Upper Tribunal considered it was necessary to look at the way the farming was being carried on during the year being considered – the sixth year.
At para 72 the Upper Tribunal stressed that the losses could still be carried forward:
“It is clear that the purpose of the legislation reflects a policy that unless there is something in the nature of the farming activities concerned that means that they cannot be reasonably expected to become profitable except in the long-term, then the period of sideways loss relief should be limited in normal circumstances”.
The denial of the sideways tax loss relief by the Upper Tribunal in Scrambler highlights the need for a large consideration as to the protection of tax loss claims. All farm accounts should be forensically analysed to understand the detail of the operation and link to business plans. With diversification, lettings and pure farming operations running side by side, there must be an evidenced understanding of costings and the correct allocation of overheads. There must be evidence to show how tax losses can be made ’definite’ not ’indefinite’ and that there is reasonable expectation of profit.
Julie Butler F.C.A. Butler & Co
Farming and Rural Business Group, May 2017
© Julie Butler 2017