Hobby farming rules and farmers’ averaging relief

While there is an understandable focus at the moment on farmers and inheritance tax following the significant 2024 Budget announcement, we turn below to a less well-known tax relief and also consider how you may be caught out by the ‘hobby’ farming rules.

In recognition of the fluctuating nature of the trade, farmers may average their profits over two or five years so as not to incur higher rates of tax in more profitable years.

It is not unusual for a farming business’ taxable profits to change from a substantial loss in one year to an equally significant profit in the consecutive year. For most other trades and virtually all employments, such a change would be unheard of. 

Various conditions must be met to qualify for the relief, including a time limit for making the claim. The key conditions relate to profits:

• For two-year averaging, the profits of one year are less than 75% of an adjacent year
• For five-year averaging, when the profits of the last tax year of the five and the mean average profits of the previous four tax years are compared, one of those profit figures is less than 75% of the other (or where one of the five tax years is a loss or zero profit)

If the farming activity qualifies, the average of the profits of the two or five years in question is used as the taxable trading profit for each year. For the years in which profits have been averaged, the tax on the new profit will be recalculated. The impact on Class 4 national insurance contributions should also be considered.

For example, a farmer’s taxable profit is nil in one year and £200,000 in the following year. Before an election for two-year averaging, the farmer would pay a proportion of tax at 45% and in total pay £76,203 of tax in the current year and no tax in the previous year. If two-year averaging were claimed, the farmer would have an effective taxable profit of £100,000 in each year: no profits would be taxed at 45% and the personal allowance would be fully reinstated in both years. This would result in £27,432 of tax due for each year, and so a total saving of £21,339 over the two-year period.

The farmer’s cashflow would still be more variable than that of someone in a more financially predictable trade, but this relief can alleviate the burden of the fluctuation.

Although provisions like farmers’ averaging and agricultural property relief (APR) provide tax advantages, farmers should be mindful of the hobby farming rules and the potential restriction on loss relief if ‘hobby’ farming criteria are met. A ‘hobby’ farm may also lose access to other valuable CGT and IHT reliefs.

If HMRC concludes in the first instance that the farming trade is not being run commercially or with a view to making a profit, it will be considered a ‘hobby’ farm. For the first part of this test, HMRC will look holistically at the farmer’s motivations for running the farm: in general, does it seem like a hobby? HMRC will then look at the business, its history and business plan, while judging whether or not there is a reasonable expectation that it will make a profit in the future.

Even if a farm is considered to be operating commercially and is expected to make a future profit, it can still be classified as a ‘hobby’ farm if it meets specific criteria. If the farmer makes a taxable loss, before the deduction of capital allowances, for five consecutive years (or six consecutive years from a commencement of the trade as the first year of trade is not included) a loss in the following year generally cannot be relieved against other income. In this situation, losses are only available to carry forward against a future profit. Once the cycle of losses is broken, the farmer may be eligible for sideways loss relief for future losses.

In particular circumstances, exceptions may be granted for failure to meet such conditions. For example, if the farming trade is subordinate to a larger business, rather than the main trade. Also, if a reasonably competent farmer would not have been expected to make a profit in any of the loss-making years, but would still expect a profit in the future, then five years of successive losses would not automatically deem a farm a ‘hobby’. This exception usually occurs if the farm is making an investment or changing the way it operates to such an extent that there will be a delay of more than five years before profits can be made again.

It is important for farmers to stay informed about their profit fluctuations and losses. By reviewing their financial position annually, they can minimise liabilities and ensure that losses are maximised for offsetting. If the ‘hobby’ farming rules are in effect, this practice prevents losses from being incorrectly offset, thereby avoiding penalties and substantial balancing payments.

Please do get in touch with your usual contact or the contact listed if you would like to discuss any of the above.