FARM BUSINESSES restructure their borrowing for many reasons. Whether this is done to secure a cheaper rate, for family reasons, on retirement or to impose a repayment discipline, the tax implications should be examined before taking action, say advisors.
The potential IHT penalties or benefits of restructuring borrowings are substantial, according to Jonathan Ellis, agricultural specialist with Norfolk accountant Larking Gowen.
“Whatever the source or type of borrowing where there is a potential IHT liability, it is crucial that advice is sought and borrowing structured to achieve a favourable IHT impact,” says Mr Ellis. The rules differ for companies and the following examples apply to sole traders and partnerships only.
As farms diversify and an increasing proportion of income is earned off farm, valuable agricultural and business relief can be jeopardised simply by implementing a financial decision which may have no physical impact on the business on the ground.
From an IHT perspective, sole traders and partnerships should ensure that, if possible, borrowing is attached to assets where there is a risk or certainty that they will not qualify for APR or BPR, says Mr Ellis. The effect of this is to lower the value of those assets, as any loan outstanding against them will be deducted from their value on death or lifetime transfer.
Even where a farmhouse satisfies the Inland Revenue”s IHT relief tests as to whether it is of a character appropriate, the Revenue increasingly argues that the agricultural value (for which APR is available) may only represent a proportion of the market value, which would limit IHT relief to that portion, says Mr Ellis.
But, for example, a farmhouse or cottages worth 500,000 and attracting APR at 100% would incur no IHT liability, whether there is money borrowed against them or not. In contrast, property of the same value where the character of the house is not judged appropriate to the land area, or which fails to attract relief otherwise, would attract an IHT liability of 200,000.
However, if the same house were mortgaged for its whole value, this would have the effect of cancelling out the IHT liability, because its value would be reduced to zero for IHT purposes.
In certain circumstances, there are also income tax implications when borrowings are restructured, for example, when farm borrowings, traditionally secured against the value of land, are traded in for a cheaper residential mortgage borrowing secured against the house.
While this may be relatively easy to do, it must be arranged properly if the income tax advantages of farm borrowing are to be retained, warns Mr Ellis.
“Paying off your farm borrowings could reduce your interest costs but you could lose tax relief on the new interest payments. Some careful planning is required to ensure that finance costs (as opposed to capital repayments) continue to qualify for income tax relief. If you get this aspect wrong, it will more than cancel out any advantage from lower interest rates.”
Mark Ashbridge, a rural finance specialist at Savills Private Finance, has recently advised several landowners on restructuring borrowings. “In some cases, it has been prudent to shift loans away from land and on to houses to obtain the taxation advantages whilst achieving a lower interest rate on a domestic mortgage.”
“This movement of debt from land to residential property has been facilitated by the dramatic rise in property values and the flexibility and competitiveness of the residential mortgage market.
“The balance of asset value on farms has shifted radically in the past 10 years in favour of residential property. While average farmland prices have remained in a band between 1800 and 2200/acre, houses and cottages have increased in value by two to three times over the same period.”
“We are beginning to see debt shifting from commercial loans secured on land to residential and buy-to-let mortgages secured on main residences or farm cottages let on Assured Shorthold Tenancies. This can be beneficial in cases where the hardcore debt is long term and unlikely to require restructuring in the short to medium term.
“A residential mortgage secured against the farmhouse might be priced at 0.6% above base whereas the best commercial loan rates are around 1.25% above base on a 500,000 loan. Smaller commercial loans may well cost up to 2.5% above base. There are also discount mortgage products which might offer an initial rate of base plus 0.25% for the first two years.
“On this basis, switching a hard core debt of 500,000 could produce interest savings of between 0.5% and 1% per annum. This would mean annual interest savings of up to 5000.”
However, the initial move to a mortgage product will incur set-up costs and the saving on interest rate needs to be considered against the potential inflexibility of mortgage products when compared with a commercial loan, says Mr Ashbridge.
“A residential mortgage would not be managed on the same basis as a farming loan, where you would be likely to have a long-standing relationship with the manager and therefore your changing circumstances can be allowed for.”
So, before taking the residential mortgage route, important questions need to be considered, says Mr Ashbridge.
“How should the lending be arranged – do you need a staged drawdown facility rather than having all the cash available at once? This type of arrangement is possible with residential mortgages, although it greatly limits the number of product options and can be cumbersome.
“Is the structure or size of the loan likely to be changed in the short to medium term future? If so, this may require an ongoing banking relationship and access to a bank manager who understands your business. In these cases, I would be reluctant to suggest a shift to a residential mortgage, says Mr Ashbridge.
“Also, from an administration point of view, you are likely to have to split the title of the house from the rest of the farm if it is not already separate and this will incur solicitors” costs. These will vary according to how much work is involved, but it is advisable to get an estimate before proceeding.
AGREE TO RELEASE
“Your bank may hold the whole farm deeds and if so will have to agree to release the relevant residential property. There will also be valuation costs and arrangement fees in the same way as any new loan would require, however these costs should be absorbed by the savings achieved.”
Valuation costs can range from 250 to 1000 depending on the value of the property, while arrangement fees are usually based on a flat fee of several hundred pounds or occasionally on a percentage (maximum of 0.5%) of the facility.
Apart from the requirement for borrowings to fund farming activities or the expansion of a unit, Mr Ashbridge suggests that the residential mortgage approach may also be used to raise capital relatively cheaply and easily, perhaps to invest in a venture outside the main farming business, subject to an ability to service the debt and provide sufficient security.