Separate decisions for tax and cash

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Advisers recommend keeping cash flow and business growth decisions, and tax decisions, on different sides of the fence.

PHOTO: Brad Collis

“That was a good profit … where did it go?” It is a question often heard as financial statements are reviewed at the end of the financial year. 

For Phil O’Callaghan, managing director at ORM, it illustrates why it is important for growers to understand clearly the difference between their taxable income and cash-flow surplus: “It’s the business’s annual cash-flow surplus, or lack thereof, that will impact on decisions about how and when to make discretionary allocations,” he says.

Being informed helps make timely and effective decisions, and gathering the necessary information is a constant process. Mr O’Callaghan reminds growers that decisions need to be made throughout the year in working towards achieving both business and personal goals. In other words: the important business decisions should be driven by tax planning.

“Understanding your individual circumstances and making decisions in line with what you want to achieve will help build your business’s overall resilience and financial success. You need an appropriately tailored strategy for achieving goals and for growing net worth.”

Cash-flow surplus is equal to a business’s taxable income less non-deductible expenses such as family drawings, capital purchases, the principal component of machinery finance repayment, principal repayment of bank debt and tax paid. 

Personal tax returns for individuals are in addition to business taxable income and include income from wages and personal assets as well as deductible items such as farm management deposits (FMDs) and superannuation.

Measuring the combined annual business and personal financial growth provides a check on whether cash flow has been allocated to business growth or contributed to lifestyle choices. Ideally, it is good to have a balance between both, Mr O’Callaghan says. The business’s financial value will increase with allocations to:

  • machinery purchases above current depreciation (this is typically 11 per cent of total machinery market value per year);
  • asset purchases such as land or off-farm investments;
  • principal repayments; and
  • FMDs or superannuation.

Mr O’Callaghan says that, typically, a two-family cropping farm increases in financial value (equity) by an average of $150,000 per year. However, he explains that this can vary by up to $1 million either way depending on favourable or poor seasons and prices. Therefore, it is important to monitor costs and to be wise about the allocation of profits in the profitable years.

The following scenarios illustrate how three fictional farm businesses with the same production income may end up having a different conversation with their accountant at tax time.

Each farm business has the following goals:

  • to consolidate financial position by having some funds available for redraw in future low-income years;
  • to ensure the older generation’s retirement in five to 10 years is financially independent of the farm business; and
  • to expand the scale of the business.

In these cases, each business has adequate machinery and labour, sound farming systems and production levels. The production year for each business resulted in equal income; however, the taxable income and cash-flow surpluses are different (Table 1).

“The different taxable incomes and cash-flow surpluses influence discussions at the end of the financial year,” Mr O’Callaghan says.

“The way each business invests profits will depend on its current position and future goals as well as personal choices. As always, what presents as the most suitable option for one business may not be practical or viable for another.”

TABLE 1 Financial positions of three farm businesses.
‘Alanvale’ ‘Baldock Hill’ ‘Chiltern Ag’
Debt level High Moderate Low
Financing costs to farm income ratio 20% 12% 5%
Five-year average tax rate < 10% 15% 22%
Level of off-farm assets Low
Superannuation and FMDs
Moderate
SMSF of $400,000
that includes $300,000 of farm land
High
A holiday house worth $500,000.
A SMSF of $1 million that includes $300,000
of farm land
‘Alanvale’ ‘Baldock Hill’ ‘Chiltern Ag’
Income $750,000 $750,000 $750,000
Expenses $500,000 $500,000 $500,000
Earnings before interest and taxes $250,000 $250,000 $250,000
Interest $150,000 $90,000 $30,000
Taxable income $100,000 $160,000 $220,000
Drawings $100,000 $100,000 $100,000
Cash-flow surplus (before tax and discretionary spending) Break-even $60,000 $120,000
FMDs – farm management deposits
SMSF – self-managed superannuation fund

Alanvale

Even though ‘Alanvale’ has a taxable income of $100,000, this is spent as drawings and therefore there are no surplus funds available. It requires another good income year just to pay the previous year’s tax, otherwise any tax payable will further increase debt.

In this situation, the business should not be distracted by tax-minimisation strategies such as FMDs or superannuation. Mr O’Callaghan suggests off-farm investment into superannuation would not be tax-effective because superannuation contributions are taxed at 15 per cent (within the superannuation fund) compared with the business’s five-year average tax rate of less than 10 per cent. Also any off-farm investment would effectively have to be funded by increased debt.

Mr O’Callaghan suggests that while ‘Alanvale’ may also want to make principal repayments on term-loan debt, it may not be beneficial as debt repayments would result in an increase to trading account peak debt later in the season. In addition, if the owners are looking to expand farm scale, Mr O’Callaghan says the best approach may be through leasing or share farming, rather than purchasing land.

Baldock Hill

The second farm business, ‘Baldock Hill’, may be able to reduce the amount of tax payable by investing in FMDs or superannuation. However, Mr O’Callaghan explains that because its current average tax rate of 15 per cent is similar to tax payable in superannuation, superannuation contributions may not be of any significant benefit for tax planning.

FMDs could be considered in this situation, although ‘Baldock Hill’ should bear in mind that the tax rate when the FMD is withdrawn may be higher than its current average tax rate. “If this is the case, the owners may be better paying the current tax rate at 15 per cent and using the after-tax profit to invest or grow the business,” Mr O’Callaghan explains. “A tax rate of 15 per cent is relatively favourable and puts ‘Baldock Hill’ in a strong position to make tax-effective debt-reduction decisions that create a financial buffer for the future.”

The financial position of ‘Baldock Hill’ means the owners could expand farm scale by purchasing land. In this case, Mr O’Callaghan recommends debt to income ratios should be assessed to determine the amount of land affordable.

Chiltern Ag

The five-year average tax rate for ‘Chiltern Ag’ will be increasing due to the good income year. Mr O’Callaghan explains that the business’s marginal rate is already moving into the higher tax bracket, more than 30 per cent, and so tax planning would be beneficial in this situation.

FMDs may be an effective financial planning tool for the younger generation and could also be used by the older generation after their maximum deductable superannuation contributions have been made. In addition, FMDs could be used to hold some profits over for future allocation to retirement planning.

“Off-farm assets such as superannuation are a good tool to develop financial independence for retirement and also for succession planning,” Mr O’Callaghan says.

Farm scale expansion by purchasing land would be a relatively safe option for ‘Chiltern Ag’. However, if farm scale is not a priority, then off-farm investments in real estate or the share market can provide an opportunity for capital growth without increasing the workload on the farm.

More information:

Phil O’Callaghan
03 5441 6176
phil@orm.com.au

Disclaimer: This article contains general information only and is not intended as financial advice. Individuals should seek professional advice from a financial adviser prior to making investment decisions.

A fact sheet on Farm Financial Tool: Cash Flow Budget is available at: www.grdc.com.au/GRDC-FS-FFT-CashFlowBudget

A fact sheet on Farm Business Costs is available at: www.grdc.com.au/FBM-FarmBusinessCosts

A fact sheet on What your tax return tells you is available at: www.grdc.com.au/GRDC-FS-TaxReturn

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