In the course of our session of oral evidence to the Committee's enquiry on the future of the CAP, we were requested to supply some further information on the impact of exchange rate fluctuations on the agricultural sector, and on the effects of the proposed phasing out of the Agricultural Buildings Allowance.

EXCHANGE RATE FLUCTUATIONS

  1.  The impact of exchange rate fluctuations on the agricultural sector is multifaceted. As a trading sector, exchange rate fluctuations of the domestic currency with respect to the currencies of our competitors and/or the currencies most commonly used in international transactions impact the international competitiveness of the sector and add to the risk of the transaction, while the very existence of different currencies compounds the transaction costs associated with trade. As a recipient of payments originated in the EU budget (and, therefore, denominated in Euros), exchange rate fluctuations of sterling with respect to the Euro will lead to changing levels of agricultural support. The paragraphs below will develop these issues in further detail.

  2.  Given the importance of our economic and policy relation with the Euro zone, fluctuations between the Euro and sterling and resulting from the status of the UK as a non-Euro zone country merit special and separate consideration, especially as some of our main competitors will not be facing them.

  3.  UK agricultural trade is dominated by trade with the EU, as over ²/₃ of both agricultural imports and agricultural exports are conducted with EU-25 countries. [See Table 1 below]. In total, trade with the EU in agricultural goods represented over £22 million in 2005 (of which £15.5 million were imports and £6.5 million were exports). The majority of trade conducted with the EU-25 is conducted in Euros or Euro-pegged currencies (as the new member states prepare their markets for convergence in order to fulfil their ambition to be part of the Euro zone).[1]

  4.  The importance of EU trade is even more evident when focusing on (specific) indigenous products. Table 2, below, exemplifies the importance of EU imports and exports: for all the major indigenous products, except for sheep, EU imports and exports account for between 70% and 100% of all trade.

  5.  It should be noted that the impact of exchange rate fluctuations on trade flows will not be equal across all sectors, as those with more integrated and domestic supply chains will feel the impact less than those which are European or global markets. As an example, the cereals (wheat) market is considered a global commodity, with international performance varying depending on exchange rate fluctuations (especially as UK wheat is usually priced with reference to French wheat). This is demonstrated below by the relationship between the €/£ exchange rate and net trade in wheat, where an exportable surplus of more than £350 million in 1995 was reduced to a trade deficit of almost £50 million in 2002.

Source: NFU calculations

  6.  In addition to the impact of exchange rate fluctuations on international competitiveness, it should be noted that all transactions conducted in a foreign currency will be subject to transactions costs, with the EU Commission estimating that these transaction costs equal a "deadweight" of 1.2% of trade value. Over the period 2000-05 the deadweight loss on agri-food trade from the rest of the EU can be estimated to be in excess of £1.2 billion. This transaction cost is growing as trade increases, and represents a significant cost to the UK agri-food chain which could be reduced by entry to the Euro.[3]

  7.  Moreover, at the individual level and for small firms, transaction costs can be as much as 1-3% of any particular transaction. It should be noted, however, that only a portion of the transaction costs will accrue to farmers—more specifically, farmers stand to lose a share of the transaction costs related to exports. Over the six year period 2000 to 2005, this can be estimated to be in excess of £0.4 billion, roughly equal to the value of the annual barley crop. A portion of these transaction costs (dependent on the market power of the farmers respect to other economic agents in the supply chain) will accrue to farmers.

  8.  Transactions in a different currency involve a higher risk than that associated with transactions taking place in the same currency. Although in some cases it is possible to insure against the risk in a particular transaction, this involves an obvious cost that makes the product more expensive and, therefore, less attractive in international markets. Moreover, it is not always possible to insure against the risk in an ongoing trade relation, due to the several uncertainties involved (uncertain quantity, uncertain price, uncertain exchange rate). This might result in a discouragement to trade and a loss of potential markets for UK farmers when compared with their competitors in the Euro zone.

  9.  With market related payments, and more recently the single farm payment, priced in Euros and then converting to sterling at a predetermined exchange rate,[4] UK farmers and growers are also exposed to exchange rate risk on the support payments. This is demonstrated by the year-on-year variability in support payments and the losses over the period 1999-2007 can be estimated as being in excess of £1.5 billion, as the exchange rate used to convert farm support payments remains above that which it would have entered the Euro at its inception in 1999 (1€ = 0.705978 £).[5]

  10.  As a result of the factors highlighted above, the incomes of UK farmers are intrinsically linked to developments in the Euro-sterling exchange rate. The chart below shows the strength of this relationship over time.

Source: NFU calculations

  11.  Concerning our exchanges with non-EU countries, it should be noted that with the exception of the relation between exchange rate fluctuations and support payments (specific to the Euro), all the factors highlighted above apply also to the impact of changes in the value of sterling with respect to other currencies. Of these, special mention needs to be made of the $, given its status as currency of choice in a large percentage of the transactions with non-EU countries. For instance, transaction costs associated with agricultural exports during the 2000-06 period can be estimated (assuming 1-3% of transactions costs on exports, see above) to be in excess of £0.1 billion and as high as £0.3 billion.

  12.  As it would be expected, there is a certain degree of correlation between the competitiveness of specific agricultural commodities and the $/£ exchange rate, though the relation is weaker than in the case of the €/£ exchange rate (see Figure 3 below for wheat).

Source: NFU calculations

  13.  Given the lack of relation between the dollar exchange rate and support payments and the lower percentage of trade conducted in dollars, the relation between farming incomes and the $/£ exchange rate, though existent, is weaker than the one between farming incomes and the €/£ exchange rate.

Source: NFU calculations

THE EFFECT OF PHASING OUT AGRICULTURAL BUILDINGS ALLOWANCES

  1.  The 2007 Budget announced the phasing out of both industrial buildings allowances and agricultural buildings allowances. Agricultural buildings allowances give relief in tax computations for capital expenditure incurred on the construction of agricultural buildings, fences and certain "other works". The allowance is given at the rate of 4% per annum with the result that qualifying expenditure is written off against taxable profits over 25 years.

  2.  Agricultural buildings allowances will be phased out from 2008-09. The allowance will reduce to 3% in that year, 2% in 2009-10, 1% in 2010-11 and be abolished from April 2011.

  3.  Phasing out will apply to allowances on expenditure already incurred but not yet fully relieved as well as new, future investment. For example, a qualifying investment of £100,000 in 2005-06 will receive writing down allowances of £4,000 in 2005-06, £4,000 in 2006-07, £4,000 in 2007-08, £3,000 in 2008-09, £2,000 in 2009-10 and £1,000 in 2010-11. From April 2011, the balance of the original expenditure (£82,000) will become a "tax nothing" and will remain unrelieved for tax purposes.

  4.  On 5 June 2007, Stephen Timms MP replied to a Parliamentary question from Jim Paice MP that, for the 2010-2011 financial year, the receipts to the Treasury from the staged phasing-out of agricultural buildings allowances given to incorporated businesses are expected to be £5 million. The figures for unincorporated businesses could not be reliably estimated separately from industrial buildings allowances.

  5.  In order to calculate the full tax effect of the loss of agricultural buildings allowances for a particular business, it is necessary to have several pieces of information: the value of qualifying expenditure incurred to date in respect of which allowances have not yet been given; the value of allowances to be given in the course of 2007-11; the number of years remaining after 2011 over which the remaining qualifying expenditure would have been written down; and the business' marginal tax rate. Furthermore, if the business is intending to invest in additional or upgraded facilities rather than simply replacing existing facilities, the value of the allowances which will not be available on the future net investment in new buildings should also be taken into account.

  6.  The NFU does not have access to our members' accounting and tax records and cannot therefore extract this information. Having communicated with a number of accountants with agricultural clients, it is also clear that the information cannot be easily retrieved from their systems and databases. Consequently, we do not currently have sufficient data from which we can make reliable extrapolations regarding the overall value of the agricultural buildings allowance.

  7.  In the course of discussing the issue with members, we have however been given a number of specific examples of its effect and we have summarised some of these on the attached spreadsheet (not printed).

  8.  These examples illustrate that:

  9.  the impact of phasing-out on individual businesses is considerable. (A further large poultry business has estimated that it will lose agricultural buildings allowances worth £126K per annum in tax terms once these have been fully phased out);

  10.  significant balances of unrelieved expenditure can exist among unincorporated farming businesses as well as incorporated businesses; and

  11.  incorporated farming businesses do not necessarily pay tax at the full rate of corporation tax and cannot therefore be presumed to benefit from the proposed 2% rate cut. Those who pay tax at the small companies' rate will suffer a double "hit" because the small companies' tax rate is to be progressively increased, while the overall impact for those who pay tax at the marginal rate will depend on where their taxable profits lie within the marginal rate band.

November 2007

2   Butter import figures are distorted by New Zealand product which is imported via Denmark. Back

3   Of course, transactions costs apply to all international trade exchanges. The overall value of transaction costs for the agri-food sector the 2000-2005 period can then be estimated at £1.5 billion. Back

4   Currently payments are calculated on the exchange rate for last trading day of September, with a high associated level of risk. The NFU would like to see the exchange rate calculated on the average over a one-month period as under previous schemes. Back

5   The losses are calculated by comparing the actual rate applied to support payments as compared with the exchange rate of 1Euro = 0.705978 £. If the UK had become a member of the Euro zone at its inception, the entry rate would have been very close to the market rate at that time. Back