Chapter 5 - Sale of livestock and cessation of farming

Background

5.1 Sections EC 20 and EC 21 of the Income Tax Act 2007 allow an election to not make an opening herd scheme adjustment where a farmer who is using the herd scheme:

  • sells their livestock before 1 February of an income year and ceases to derive income from specified livestock in that income year and makes the election by 1 February in that income year; or
  • dies before 1 February of an income year where the tax return to date of death is filed before the NAMVs are announced.

5.2 This is called in this paper the “sale cease farming election”.

5.3 These provisions have not been substantially changed since their introduction from 1 April 1989.

5.4 This sale could be to an associated party. For example, in the 2008–09 income year there were a number of sales to associated persons in situations where a “2 years’ notice” election to exit the herd scheme had not been made with the 2006–07 tax return.[2] If the “sale cease farming election” was properly made in the 2008–09 income year, it had the same economic and tax result as a timely “2 years’ notice” election in that there was no opening herd scheme adjustment in the 2009 income year for the vendor.

Problem with the “sale cease farming election”

5.5 If that sale (and this also applies to all deemed sales upon death) was to an associated person in the 2008–09 income year, the tax outcome could be as illustrated in the example below [gain/(loss)].

Example 7: Sale to an associated person
Year Valuation election Opening stock Closing stock Tax account Capital account
2008 Herd 473,640 818,580 Nil 344,940
2009 Herd 818,580 489,240 (329,340) Nil
2010 Herd 489,240 521,220 Nil 31,98

5.6 The example presumes that the “new” farming entity makes an election to use the herd scheme. If the purchaser elected to use NSC, the purchaser and the vendor would still get very significant tax deductions over the next few years, but the precise timing and location of those deductions would depend on the sale and purchase price.

5.7 Note that this example presents the tax outcome of livestock valuation over both the vendor and the purchaser and ignores the actual sale and purchase of the livestock (which can be ignored using a “one economic entity” policy approach). The only effect of the sale price is to determine where the tax losses will arise – the higher the price the more the purchaser will derive the tax loss.

5.8 A similar outcome is achievable by selling the livestock to an associated person in the 2007–08 income year. The vendor would still get the large tax-free herd-scheme write-up in the 2007–08 income year. The purchaser could use the NSC scheme for the 2007–08 income year and revert to the herd scheme in the 2008–09 income year, thereby obtaining a large tax deduction, perhaps even, depending on the facts, an amount in the order of the $329,340 illustrated in Example 7.

5.9 There is a further more generic problem with this election even with genuine third party sales – it presents a choice that often results in farmers being able to make an election about which NAMVs to use depending on NAMV movements from year to year. Where NAMVs increase over the income year, the incentive is not to make the election to lock-in the opening values. Where NAMVs decrease over the income year, the incentive is to make the election. In seems likely that this situation will systemically advantage the farmer and therefore cost the Government. Therefore, this election seems to be inappropriate.

Suggested solutions

General cessation

5.10 The fact that ceasing farmers are allowed a choice puts them in a situation to take a tax advantage by making an election that most suits their perception of how NAMVs will move in the income year of the sale. Further, the nearer the disposal of the livestock is to 31 January, the more its market value is likely to be reflected in year-end NAMVs rather than in the previous year’s NAMVs. Similarly, where the sale is early in the income year, the more its market value is likely to be reflected in the previous year’s NAMVs.

5.11 Thus, while there is an argument to remove the “sale cease farming election” completely, if the disposal is early enough in the year, it seems reasonable to suggest that the opening NAMVs be used – that is, for there to be no herd scheme adjustment. This would reduce tax volatility.

5.12 We suggest that, where the disposal is on or before, say, 31 July of a year (and presuming the “vendor” has a balance date for this income year in the calendar year that is before this date), that it be compulsory for the vendor to use the opening NAMVs without adjustment in the year of disposal. Otherwise the opening herd scheme adjustment should be compulsory.

5.13 However, the associated person’s sale rule suggested below overrides this.

Sales to associated persons

5.14 As illustrated above, particular problems arise with transfers to associated persons, whether by way of ceasing farming and the sale of all livestock or as a result of the death of a farmer. Further, where there is any arrangement for the vendor to permanently and significantly reduce their livestock numbers by way of a sale, or a series of sales, to an associated person, similar problems can arise depending on the timing of the transaction and how market values actually move.

5.15 In this context “associated persons” means individuals within two degrees of association, spouses (including civil union and de facto) and the family’s trusts, and companies, whether owned by the trusts or by the family directly.

5.16 It is suggested that in respect of herd scheme livestock sold, or deemed to be sold, to associated persons:

  • the vendor must do the opening herd scheme adjustment (even if they sell all their livestock); and
  • the purchaser must value those livestock in the herd scheme at year-end if the vendor would have had to use the herd scheme for those livestock.

5.17 The purchaser would be able to use the AVO to the extent they have also acquired livestock that are not herd scheme livestock, or that they already owned livestock not valued in the herd scheme. For this to work properly, the vendor’s base herd scheme numbers for the year would, as necessary, be attributed to the purchaser.

5.18 The practical effect of this is to retain unchanged the herd scheme tax treatment when herd scheme livestock are sold to an associated purchaser. This has the effect of buttressing, for the family farming enterprise in all its potential combinations and entities, either of the two suggested reforms – a longer notice period, or the irrevocable nature of the herd scheme election. This is illustrated in Example 8 [gain/(loss)].

Year Valuation election Opening stock Closing stock Tax account Capital account
Example 8: Complete sale
2008 Herd 473,640 818,580 Nil 344,940
2009 Herd 818,580 489,240 Nil (329,340)
2010 Herd 489,240 521,220 Nil 31,980

5.19 Note that this example presents the tax outcome of livestock valuation over both the vendor and the purchaser and ignores the actual sale and purchase of the livestock (which again can be ignored under a “one economic entity” policy approach). The only consequence of the quantum of the sale price is where any taxable income positive or negative) will arise – the higher the price the more the purchaser will derive a tax loss, but the vendor will derive equivalent taxable income.

5.20 The result contrasts significantly with the outcome illustrated in Example 7.

5.21 If the purchaser already has dairy cattle valued in say, the NSC scheme, so long as at year-end the purchaser uses the vendor’s base herd-scheme numbers, the original cattle can continue to be valued in the NSC scheme under the AVO. This is illustrated in Example 9.

Year Herd numbers opening Total numbers closing Minimum closing herd numbers Maximum numbers in AVO
Example 9: The purchaser’s use of the AVO
2008 0 260 0 260
2009 300 540 300 240
2010 300 560 300 26

5.22 Officials acknowledge that getting the balance right in this area is important and they will be carefully considering points made in submissions. In particular, where there is a complete inter-generational change in the farming organisation as a result of an associated persons’ transaction, is there any need for this associated persons rule? This would potentially be on the basis that the vendor would have to totally cease to derive any income from the farming enterprise (except for interest on any loan to the purchaser) and could not be a current or potential beneficiary of any trust involved directly or indirectly in the farming enterprise. Officials welcome any submissions on this issue.

 

2 This policy paper makes no observations on whether these transactions comply with all aspects of the Income Tax Act.