Averaging – a useful tax tool for managing volatile profits

Most farmers are all too familiar with how volatile profits can be in agriculture. Income can swing widely from year to year due to factors outside our control such as weather or disease, commodity prices we have little influence over (for example milk or grain), unpredictable input costs, and ongoing changes to agricultural policy and support. Farmers’ averaging is a useful tax tool designed to smooth taxable profits across years. Used correctly, it can save tax and help with cashflow.

Farmers’ averaging is only available to sole traders and partnerships. It is not available to companies. This is because companies pay corporation tax at more consistent effective rates (currently ranging from 19% to 26%), whereas effective personal tax rates for individuals can vary dramatically — from 0% up to an effective rate of 62%. Averaging applies only to farming taxable profits after capital allowances. Any non-farming income must be separated out first. It is entirely optional, and farmers can choose whether to: 

• Not average at all
• Average over two years
• Average over five years Eligibility requires profits in the current year to differ by more than 25% from the comparison year. 

Key Things to Consider When deciding whether averaging is worthwhile, the main factors are: 

• Whether profits are higher or lower this year
• What tax rates were paid in previous years
• The impact on payments on account for future tax years
• Future profitability of the business
• National insurance implications

Many dairy farms have experienced several strong years, but milk prices are now falling sharply. Averaging may already have been used to spread profits, but for some this still meant high profits pushing them into higher tax bands, including the 62% effective rate where the personal allowance is clawed back when income exceeds £100,000. If profitability has reduced, there may now be scope to pull profits from earlier high-tax years into a lower-tax year. For example, if a partner has £20,000 of spare basic rate band, moving income from a year taxed at over 40% into a year taxed at 20% could save around £4,000 in income tax per partner. When you also factor in National Insurance, the overall rate can fall from around 42% to about 26%, so the timing of income can make an even bigger difference. However, increasing taxable income in the current year can increase payments on account, meaning the cashflow benefit may be delayed unless further planning is done. You can elect to reduce your payments on account to help manage this where appropriate but if they are reduced too low there will be interest charged at 7.75%.

For farmers who have seen a spike in taxable profits — perhaps due to lower qualifying expenditure — averaging can be particularly valuable. Where previous years were taxed at the basic rate of 20%, profits can be pushed back into those years, saving income tax that would otherwise be paid at higher rates, such as 40%. This lower taxable profit in the current year will also automatically reduce upcoming payments on account, which can result in significant cashflow savings in January and July. If profits continue to rise in future years, these reduced payments on account will not attract interest, as they have not been manually reduced. A point Kate Hardy also refers to in her article

Farmers’ averaging is not a one-size-fits-all solution. Every business and individual’s circumstances are different, and finding the most tax-efficient approach can be something of a puzzle — sometimes involving amendments to earlier years’ tax returns. Extra care is needed where losses or pension contributions are involved. That said, when used correctly, farmers’ averaging can be a powerful way to manage volatile profits and reduce tax, making it well worth reviewing as part of your wider farm business planning.