This article is an introduction to income tax for primary producers.
A very important element of managing your farming business and wealth is your income tax affairs.
Tax and wealth are two sides of the same coin, you cannot have one without the other. If you grow your wealth, then taxation naturally follows, therefore it is imperative you effectively manage your tax affairs to not overpay your fair share.
Unfortunately, many primary producers are overpaying their fair share of tax due to many factors including, no strategic tax planning, lack of specialised knowledge by their advisor or reluctance to pay for advice.
There are numerous tax concessions available for primary producers which can be utilised with effective planning. This article seeks to provide some of the essentials to educate our readers for more advanced discussions.
Occasionally, tax planning can be neglected in lower income years when these years should be utilised to their full potential.
You might only conduct tax planning once towards the end of the financial year.
An effective tax plan should take a detailed approach with longer-term views of your tax affairs whilst seeking to achieve the best outcome over this time horizon. Don’t underestimate how much of a difference this can make to your bottom line and for future generations.
These plans don’t just happen and require appropriate structures and planning to be in place before it’s too late to implement them. Unfortunately, if you do not act, it can cost you dearly.
What is Assessable Income for Tax Purposes
A farmer or farming entity will derive different types of income as part of carrying on farming activities. The most obvious will be from carrying on a business, the income from that business is assessable to that farmer. Business income is normally derived in the ordinary course of farming operations.
Apart from the farming business income, a farmer may receive other amounts that may be assessable income as part of the business or on other grounds such as insurance, compensation payments, grants, and subsidies.
Your assessable income is the sum of your farming income, other sources of income including investments such as rental properties, interest, dividends, and capital gains to name a few.
Your farming income is known as primary production income. This is generally income such as wheat, barley, lupins, canola, or livestock.
Expenses related to your farming income are deductible against your primary production income. These are generally expenses such as fertilisers, sprays, chemicals, fuel and oil, freight, selling and other running costs.
Other sources of income are known as non-primary production income excluding capital gains. Expenses related to your other sources of income are generally deductible against your non-primary production income.
Your total net assessable income is your farming income combined with other sources of income and is normally calculated between 1 July and 30 June also known as the financial year.
You can recognise your income on an accruals or cash basis in any given year.
The accruals basis method is based on when the income is ‘earned’. Income is generally ‘earned’ when you issue an invoice, and it becomes a trade debtor or a customer issues you an invoice which requires you to make payment.
E.g you sell wheat in May 2022 but do not receive payment until July 2022, you pay tax in the financial year ended 30 June 2022.
The cash basis method recognises income when it is banked or when you physically pay your suppliers.
The distinction between accrual or cash accounting can be very important for tax planning and cash flow and depends on various factors.
There are both advantages and disadvantages for both methods and is only one piece of the overall picture. This comes back to having the appropriate structures in place to begin with and your advisor being pro-active to your circumstances.
Capital Gains Tax
Capital gains tax (CGT) is the tax you pay on profits from selling assets such as property or shares and is taxed differently to your ordinary income.
The ATO has data-matching systems in place which notifies them if assets such as property, shares, and other types of investments have been sold.
A common type of capital gains tax event is the disposal of land which is demonstrated below:
1. Farmer Jones (individual) bought land for $1,000,000 on 1 July 2005.
2. Farmer Jones decided to sell the land to his neighbour for $2,000,000 on 1 January 2022.
3. Farmer Jones made a capital gain of $1,000,000 which will be declared in his tax return.
4. As the land was held for more than 12 months, Farmer Jones is eligible for a 50% CGT discount
5. The $1,000,000 capital gain is reduced by the 50% discount.
6. Tax would be payable on $500,000 at marginal tax rates.
In a real-life scenario, there would be multiple other considerations including acquisition costs, incidental costs, costs of owning the asset, possibly capital costs to increase or preserve the assets value and costs to preserve the title which would change the calculation.
Please note this example has not considered, stamp duty, goods and services tax, foreign resident withholding tax, small business entities capital gains tax concessions, capital expenditure and capital works.
There may be circumstances for capital gains tax for certain capital assets to be completely disregarded or significantly reduced if using special concessions available to small business entities. These concessions are beyond the scope of this article.
There are 54 different types of capital gains tax events and many rules that may be relevant, suffice to say, this is a complex area of taxation law, and you should always seek professional advice before acting to ensure the best and correct outcome is achieved.
The Primary Production Averaging System
Primary production income is subject to primary production averaging unless you have opted out of the system. From 1 July 2017, you may re-instate your primary production averaging 10 years after opting out.
Primary production averaging is a mechanism which the tax system provides to primary producers to average out your income tax and is an important concession to help smooth out your cashflow.
Primary production averaging provides tax relief when your ‘primary production averaging income’ is lower than your ‘taxable income’. See diagrams and explanations below.
Primary production averaging results in additional tax when your ‘primary production averaging income’ is higher than your ‘taxable income’.
It only applies to individuals engaged in the business of primary production for two or more consecutive increasing years of primary production income and does not apply to corporate entities.
Your ‘taxable income’ is different to your ‘primary production averaging income’ and excludes capital gains, certain employment, and superannuation income.
Your ‘taxable income’ is calculated under the normal marginal tax rates plus the medicare levy where applicable. An example demonstrates how ‘taxable income’ is calculated in the diagram below.
E.g In Year 1, the taxable income is $150,000, in Year 2, the taxable income is $50,000. The income tax would be paid at marginal rates and would result in higher taxes in years 1, 3 and 5 due to the different tax brackets.
The following diagram demonstrates how primary production averaging is applied towards income tax.
The primary production averaging begins in year 3 in the example above as there have been two or more consecutive increasing years of primary production income.
The primary production averaging income is calculated on a 5-year running average of primary production income.
In Year 3, the primary production averaging offset (PPAO) is applied to reduce the amount of tax paid in the year.
This is due to the ‘primary production average income’ being less than the ‘taxable income’.
In Year 4, additional tax is payable due to the ‘primary production average income’ being higher than the ‘taxable income’.
The primary production averaging system seeks to account for the potentially cyclical nature of farming enterprises by averaging out excessive taxes in higher income years by spreading it across years in which income may be lower.
This can be an effective tool to manage your overall tax liability when combined with the right business structure and other strategies.
Traditional Tax Planning Strategies
You are well within your rights as a taxpayer to organise your financial affairs to minimise your income tax liabilities within the letter and spirit of the law and there are multiple strategies to achieve this goal.
The following strategies detailed in this article are some of the more traditional approaches tax accountants utilise for primary producers, I plan on releasing another article which deals with some more of the advanced tax strategies available such as appropriate structures, financing considerations, superannuation, diversification, and succession planning.
Farm Management Deposits
Farm Management Deposits are a very important wealth creation and risk management tool which should be essential in any farming business. There are advanced strategies for utilising them to their full potential which does not form part of this article.
A Farm Management Deposit (FMD) account allows primary producers to make tax deductible deposits into a bank account during years of good cash flow and withdraw them during bad years subject to having the right structure in place.
To be eligible to claim a deduction for a deposit to an FMD account, you must:
1. Be an individual (including a partner in a partnership, or beneficiary of a trust)
2. Be carrying on a primary production business in Australia when you make a deposit
3. Have no more than $100,000 in taxable non-primary production income in the income year you make the deposit
4. Hold no more than $800,000 in total FMDs
Companies and other entities are not eligible for FMD. You can’t make a deposit jointly with another person or people.
You must hold the deposit for at least 12 months (unless there is a severe drought or natural disaster) and continue to be a primary producer for the whole period you hold FMDs.
Once you withdraw FMDs after the 12-month period, the withdrawal is assessable income at marginal tax rates.
If you withdraw the FMDs before the 12-month period, the original tax return which claimed the deduction must be amended and corrected.
If the depositor dies or becomes bankrupt, the deposit must be withdrawn and becomes assessable income of the individual or deceased estate.
There are special rules that apply to beneficiaries of trusts. The requirements are that a beneficiary of a trust that engages in primary production is presently entitled to share of that income to be eligible to access FMDs.
This is fine when the business is profitable and a deduction can be obtained for a deposit, however the main disadvantage having your primary production business structured in a trust is that in loss years, you cannot distribute losses to beneficiaries, therefore losses are trapped in the trust. If you withdraw FMDs, then you are taxed at a higher rate than you would have if you were able to offset the losses against the FMD withdrawal, This is a more advanced topic, and another article will be written to touch on appropriate structuring for farming groups.
Timing of Income & Expenses
A strategy commonly used is timing your income and expenses via the cash method of accounting, allowing the income tax to be diverted or deferred to another period.
This can be done by prepaying expenses before the end of the financial year, a note of caution, I recommend that you take physical possession of goods in the off chance your supplier has financial issues.
Deferring income such as holding grain in a storage facility, on the farm, or selling on deferred contracts which raises some risk if the value of grain decreases.
This is a timing difference which may result in a favourable result due to seasonal events or legislation changes and requires careful monitoring of the trading results throughout each period.
Deferral & Write Offs
There is legislation specifically drafted for primary producers such as electing to exclude from your assessable income the profit on a forced disposal or death of livestock that you held as assets of a primary production business.
If you receive an insurance payment for the loss of livestock or trees, and you have claimed the cost of the insurance premiums as a tax deduction, the payment amount you receive will be treated as assessable income. You can elect to spread the payment over 5 years.
If you’re a wool grower and you had to shear your sheep earlier than usual because of drought, fire or flood, you can elect to defer the profit on the sale of the second clip to the next year to smooth out the income between the two years.
Primary producers can claim specific deductions for certain capital expenditure such as land care operations that is primarily and principally:
1. Eradicating or exterminating animal pests from the land
2. Eradicating, exterminating or destroying plant growth detrimental to the land
3. Preventing or combating land degradation (other than by using fences)
4. Erecting fences to keep animals out of areas affected by land degradation to prevent or limit the extension or worsening of land degradation in the area and to help reclaim the area
5. Constructing drainage works to control salinity or assist in drainage control.
6. Erecting fences to separate land classes in accordance with an approved land management plan
7. Constructing a levee or similar improvement
8. A structural improvement or altering, adding, extending or repairing a structural improvement that is reasonably incidental to the construction of a levee or drainage works incurred on or after 1 July 2004.
Primary producers can claim deductions for a shelterbelt of trees or shrubs planted to protect an area from weather, shelterbelts can be used to protect crops and livestock, improve biodiversity and prevent or fight land degradation.
Primary producers are entitled to claim an immediate deduction for capital expenses incurred on fencing and fodder storage assets subject to criteria.
The fodder storage asset must be primarily and principally for the purpose of storing fodder. Fodder refers to food for livestock, such as grain, hay or sileage. It can include liquid feed and supplements or any feed that could fit into the ordinary meaning of fodder.
Typical fodder storage assets include silos, liquid feed supplement storage tanks, bins for storing dried grain, hay sheds, grain storage sheds and above-ground bunkers.
Primary producers may claim a deduction for capital expenditure incurred on a water facility from 12 May 2015 onwards. You must have incurred the expenditure primarily and principally for the purpose of conserving or conveying water for use in primary production.
Primary producers can elect to become a Small Business Entity if your aggregated turnover is less than $10 million which provides generous provisions such as immediate tax write offs for items purchased subject to limits, accelerated depreciation for depreciable items via the pooling system, the small business income tax offset, and the ability to restructure your affairs without adverse tax consequences.
Conclusion
Having a highly skilled and experienced Chartered Accountant that understands primary production taxation is a worthy investment.
Thank you for taking the time to read our article. Contact us if you have any queries or if we can help.
Disclaimer
No person should rely on the contents of this publication without first obtaining advice from a qualified professional person. This publication is for discussion and education purposes only and the editor is not responsible for the results of actions taken on the basis of information in this publication, nor for any error or omission from this publication. This editor expressly disclaims all and any liability to any person, including reader for any part of this publication.