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Farmers Weekly‘s Business Clinic experts offer free advice on legal, finance, tax, insurance, farm management and land issues. Pat Tomlinson of accountant Albert Goodman looks at under what circumstances it makes sense to use your annual investment allowance to reduce your tax bill.

Q. We have no spare cash to buy machinery, but we are worried about not using our annual investment allowance (AIA) to reduce our tax bill. What should we be doing?

A. The AIA can be a very effective way of reducing your tax bill. Until the latest budget, it was a temporary allowance set at wildly fluctuating levels, but George Osborne announced that with effect from 1 January 2016, it would be a set at a permanent level of £200,000/year.

One of the main benefits of this announcement is that it enables businesses to plan capital expenditure rather than make snap decisions to try to avoid a tax bill, for fear that the allowance might reduce in future or even disappear. 

See also: How to tell if your farm holiday let qualifies for tax relief

Pat Tomlinson
Pat Tomlinson
Albert Goodman

Over the past few years, it is inevitable that some machinery purchases will have been driven by theoretical tax benefits rather than the true commercial benefits. It has been very tempting (and frequently effective) to use the AIA to reduce the tax bill, but there are some health warnings:

If you make no profit, you do not pay tax. While not always the case, not having enough spare cash is frequently a symptom of no profit being made and so there is no tax bill to reduce.

The AIA is only an “accelerated” allowance which would otherwise be available in reducing amounts, usually at 18% of the residual balance a year.

Once the allowance has been used, the value of the asset(s) for tax purposes is nil. The result of this can be that there is very little capital allowance to be claimed against future profits. Worse still, when machines are swapped in future they are likely to be sold for more than their tax written-down value, creating a taxable profit.

To save £1 in tax, a basic-rate taxpayer would need to spend £3.45 on machinery, a higher-rate taxpayer £2.38 and a company £5.00.

The saving of £1 tax in each case looks tempting in isolation, but from a cash perspective the business has to spend up to £5 to achieve that saving and so the overall cash effect is entirely negative. 

In practice what has often happened is much worse in that the new machines are purchased on hire purchase and so the tax benefit comes in the year in which the profit is made, while the cash cost of buying the machine comes in subsequent years when profits may not be so good.

We are clearly in an era of very volatile profits from farming and one of the ways of coping with that volatility is to preserve cash from good years to sustain the business in poorer years – as opposed to spending it to prevent a tax bill. 

Good investment decisions on any farm should be based on the ability to increase the profit of the business and only then, having already justified the purchase decision, should thoughts turn to identify the best way and time to make the investment, to both minimise the tax burden and manage the cashflow effectively. 

If cashflow is tight, do not let the AIA tempt you into making a poor commercial decision – make sure the “tax tail” does not wag the “profit dog”.

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