Chapter 4 - Elections to exit the herd scheme

Background

4.1 The original March 1986 Consultative Document on Primary Sector Taxation discussed whether elections should be irrevocable and proposed at paragraph 2.7.2: “To avoid these problems [of taxpayers swapping from one valuation method to another to take advantage of movements in values] an election to use the herd scheme will be irrevocable”.

4.2 The Consultative Committee agreed with submitters that the proposed irrevocable nature of the election “would be an undue restriction on a taxpayer’s flexibility of choice” (at page 20 of the Report of the Consultative Committee on Primary Sector Taxation). It proposed 12 months clear notice. The Government did not accept this, and opted for 24 months before the commencement of the year in which the change was to apply.

4.3 At the Select Committee stages of the resultant tax bill later in 1986, this was then adjusted to the “2 years’ notice” which required the election to be made by 31 March of the tax year that was two years before the election was to apply. In practice this could be a minimum of a year and a day’s notice depending on the farmer’s balance date.

4.4 In the 1992 Report of the Consultative Committee on Livestock Valuation, a further change was proposed and accepted, for “administrative” reasons. This was a reference to the compliance cost savings that would result from the accountant not having to discuss livestock valuation election options with their farmer client other than as part of the annual financial statements and tax return review. This change provided that, instead of the notice being given by 31 March of a year, it could accompany the tax return for that year. This effectively reduced the period of notice by up to a year.

4.5 The current authority for the election is section EC 14(3) of the Income Tax Act 2007. Section EC 11(3) then requires that this notice be given with the tax return for “an income year that is at least two years before the income year in which the election is first to apply”.

4.6 So, for example, an election to exit the herd scheme for the 2008–09 income year could have been given with the 2006–07 tax return, which could have been filed as late as 31 March 2008. (Under the originally enacted “2 years’ notice” rule, for the notice to be effective for the 2008–09 year it would have to have been given by 31 March 2007.)

4.7 The effect of this election is that no opening herd scheme revaluation was completed in the 2008–09 income year and NSC could be used to value the closing livestock. Example 4 sets out what would have happened in the 2008–09 income year if appropriate notice had been given with the 2007 tax return.

  No. on Hand $ Value $ Tax free $
Example 4: Electing to leave the herd scheme
2007–08 income year
Revalued opening stock
MA Cows 300 2,150 645,000    
R 2 Heifers 60 1,856 111,360    
R 1 Heifers 60 1,037 62,220    
        818,580  
Closing stock – herd scheme
MA Cows 300 2,150 645,000    
R 2 Heifers 60 1,856 111,360    
R 1 Heifers 60 1,037 62,220    
        818,580  
Change in tax value       Nil  
Tax free gain/(non-deductible loss)         344,940
2008–09 income year
Opening stock
MA Cows 300 2,150 645,000    
R 2 Heifers 60 1,856 111,360    
R 1 Heifers 60 1,037 62,220    
        818,580  
Closing stock - NSC
MA Cows 300 2,091 627,360    
R 2 Heifers 60 1,180 70,776    
R 1 Heifers 60 788 47,256    
        745,392  
Change in tax value – income/(loss)       (73,188)  
Tax free gain/(non-deductible loss)         (Nil)

4.8 If the farmer had not elected to leave the herd scheme in the 2008–09 year, they would have had a capital (non-deductible) herd scheme loss of $329,340 (as is illustrated in Example 1) instead of a tax deduction of $73,188. However, as illustrated in Example 5 and the discussion immediately below it, this $73,188 deduction is just the start of further deductions as the NSC system applies over subsequent years.

Problem with the election

4.9 Example 4 sets out what would have happened in 2008–09 if the appropriate notice to exit the herd scheme and use NSC had been given with the 2006–07 tax return. This is summarised in Example 5 [gain/(loss)].

Year Valuation election Opening stock Closing stock Tax account Capital account
Example 5: Election to leave the herd scheme and to use NSC
2008 Herd 473,640 818,580 Nil 344,940
2009 NSC 818,580 745,392 (73,188) Nil
2010 NSC 745,392 647,532 (97,860) Nil

4.10 Over the next four years the NSC value of MA cows would continue to decrease until the effect of the herd values (using the FIFO method) has been “aged out” of the livestock and they would then have been valued at their underlying home-bred BRG (breeding, rearing and growing) cost. Over the 2008–09 and subsequent income years this would yield tax deductions in the order of $500,000 (being the difference between the 2007–08 NAMVs and the underlying BRG of homebred livestock.

4.11 If the farmer had elected back into the herd scheme in the 2009–10 income year (which election could be made with the filing of the tax return for that year) they would have derived a much quicker write-down because the NAMVs for the 2009–10 income year were much lower than the 2008–09 income year NSC values for the MA cows. We understand that a number of farmers did make this election. Example 6 illustrates the results [gain/(loss)].

Year Valuation election Opening stock Closing stock Tax account Capital account
Example 6: Election back into herd scheme
2008 Herd 473,640 818,580 Nil 344,940
2009 NSC 818,580 745,392 (73,188) Nil
2010 Herd 745,392 521,220 (224,172) Nil

4.12 Further, the analysis of the extract quoted in the previous chapter indicates a compliance and administration problem – that of some farmers deliberately delaying the filing of their tax returns to keep their election options open. This is undesirable from a tax administration perspective.

Potential responses

4.13 The Government’s continued emphasis upon fairness in the tax system requires a response to the problem outlined. There is a range of potential responses, varying from lengthening the notice period for the election to, at the other end of the spectrum, repealing the herd scheme.

4.14 Repealing the herd scheme is not justified. From an economic perspective, for a livestock farming operation based on a relatively stable number of mature livestock being used to produce progeny, milk or wool for sale, the mature livestock have significant capital characteristics. The herd scheme properly recognises these capital characteristics.

4.15 This leaves two potential solutions:

  • lengthen the notice period for the election; or
  • repeal the option to be able to elect to leave the herd scheme.

4.16 The question of a potential extension to the timeframe of the present notice is difficult. The following table summarises the above discussion on the history of the notice period:

  2005–06 year 2006–07 year 2007–08 year 2008–09 year
Original Consultative Document No election proposed
As introduced in 1986 Tax Bill Notice given by 31 March 2006     Election effective
As originally enacted in 1986   Notice given by 31 March 2007   Election effective
As amended in 1993     Notice given with 2007 tax return Election effective

4.17 Given the advent of the AVO in the 1992–93 tax year, the need for farmers to be able to elect out of the herd scheme because of changed circumstances seems to have largely, if not totally, fallen away. Any extra livestock can be valued at cost. Therefore the concerns raised in paragraph 4.2 are less valid.

4.18 Further, any period of notice that was long enough to make it a real gamble as to the taxation effects of leaving the herd scheme, would result in too long a period for any election to be effective to allow for a farmer’s change of circumstances.

4.19 Accordingly it is suggested that the original proposal that there be no election to leave the herd scheme be adopted. That is, the herd scheme election will be irrevocable. This is in the belief that the AVO will offer sufficient flexibility to deal with changes in farmers’ circumstances.

4.20 This will have the effect that, once a farmer has elected to treat their livestock as a capital asset, they cannot then change their mind and treat this livestock as if it were trading stock.

4.21 However, both of these options need buttressing to make them work. Presently, as discussed in the extract quoted in the previous chapter, and as is discussed in the next chapter, sales to associated persons can be used to circumvent the effect of repealing the ability to be able to elect out of the herd scheme.