This is one of three articles in this FAQ about tax efficient schemes. The point of this article is to explain some of the things you should be looking for in legitimate tax efficient investments. Another article, part of the ripoffs FAQ, deals with dodgy investments and outright scams in the same sector. The third article appears in the tax FAQ and gives a some detail about non-commercial losses. Read all three to get the bigger picture.
Thanks to special rules that apply to various primary production schemes including agribusiness, film and television production, infrastructure etc, you can claim a tax deduction on investments into these sectors.
Subject to ATO confirmation, if you were to invest, say, $100,000 into a timber growing project, you could claim a $100,000 tax deduction. It wouldn't even matter if you borrowed the money to invest in this, so in theory if you wanted to you could reduce your income (and tax rate) to as low a level as you liked.
When people hear about the kinds of tax deductions that are possible they usually are amazed and quite keen to invest, but there is a flip side to these tax efficient investments: you get taxed on the entire return.
When you sell shares, you get back the original purchase cost and half of the capital gain tax free (if held for over one year). Fortunately, you don't pay tax on getting your own capital back. Tax deductible schemes only move income from one year to another, the deductions are not permanent because you'll only be increasing your income somewhere down the track.
Before I talk again about the tax deductions, I'll talk a bit about the performance of the asset class, which is how I prefer to look at these things.
According to data I have seen from Ibbotson, timber
woodlands have been one of the highest performing asset classes in
There are a number of research papers available for download from a US forestry consultant's web site, The Hancock Timber Resource Group, where actual and reconstructed returns have been gathered for timberland in a variety of areas in the US and overseas and made into a timberland index. The data there (and you can visit that site and download the papers yourself if you want to) also show returns quite competitive with share markets. Clearly timber does have a place in some portfolios.
In Australia there is limited data available. Most of the projects available today grow hardwood Eucalyptus for saw milling or pulping. These include the three largest managers in Australia; Gunns, Great Southern and Timbercorp.
This year (2003) is the first year that growers in a major hardwood plantation will get a return on their investment. Growers who invested in Timbercorp's first blue gum wood chip project in 1992 will receive a gross return on their initial investment of about 9%pa over the 10 year period. Timbercorp forecast a return in the prospectus of about 11% originally, so this was slightly below forecasts, but Timbercorp have spent millions of dollars on R&D including the science of soil analysis and site selection, seedling selection and tree management. It is likely (but not guaranteed of course) that future projects will give a return slightly higher than the 1992 project, perhaps 10% or more.
Recently I went on a tour with an agribusiness manager, going around looking at their plantations near Albany in WA. The forester drew our attention to the high degree of variability in earlier plantations. In a plantation that was nearly ten years old, there were a few "monster" blue gums that were much bigger (about twice the diameter) of the average tree (average being about 20cm), and a few "runts" that were very slim, only about 5cm in diameter. The big trees are cloned and taken to a seed orchard, the result being that (in the words of the forester) they have developed a kind of blue gum "master race" with a much higher pulp yield per hectare, as well as trying to develop trees with a high tolerance for salt and better drought resistance.
The difference was fairly obvious, I could see that there were far fewer runts in the newer plantations. This gives me a degree of confidence that the typical prospectus assumption of 9% made by most agribusiness managers and researchers should be relatively easily achieved.
Great Southern Plantations should have their first blue gum harvest in 2004, and Willmott Forests should have a first harvest of softwood (pine) timber in a few years. Indications are that the returns on each of these projects will be comparable to the Timbercorp result and 9 to 11%pa seems like a reasonable forecast return for most agribusiness projects.
Within timber you have an extensive array of crops. There are the old stalwarts, pine and eucalyptus timber, in addition to blue gums for wood chipping and more exotic stuff like sandalwood and paulownia. The former crops are lower risk, because cultivation techniques are well understood, markets well developed and practically insatiable, the latter, especially sandalwood, are higher risk because there are still significant challenges to horticulturalists who are still trying to figure out how to grow them successfully. There have been a couple of failures in growing sandalwood, the trees simply died.
If sandalwood is grown successfully, the return will probably be very high. This is because sandalwood is a fairly rare and very expensive scented timber used for fine wood carvings and luxury furniture, sandalwood oil production and ceremonial use (ie the Hindus burn it on their funeral pyres).
The trouble is that sandalwood plantations to date have had a nasty habit of dropping dead after a few years. There is still significant research going on to grow this crop, though there have recently been some successful experimental CSIRO plantations, so I have heard. The difficulty is that Sandalwood is one of those semi-parasitic plants that rely on relationships with other plants and soil organisms to survive. Getting the conditions right for growth depends on getting many variables right. Unlike blue gums which are virtually indestructible once established, sandalwood has a well deserved reputation for being a troublesome crop.
Paulownia is similar in some ways, this is a lightweight and fast growing
tropical timber that apparently grows like a weed in parts of
There are a huge variety of tree growing schemes that are not related to timber, including olives, almonds, stone fruit, citrus etc, not to mention vineyards and wild flower cultivation. I don't know much about the returns in this sector, though I have heard from some people that take an interest in these things that there is at present a glut of supply in some of these crops because too many plantations are in the ground, either now producing or going to produce in a couple of years.
While timber and wood chip production usually gives a return in a single year when harvested (woodchips about 7 years from planting, eucalypt timber about 15 years, pine about 20 years), these other fruit crops of course can produce for a long period of time. Olive trees and grape vines in particular are capable of producing crops for over a hundred years.
From the research reports I have seen prepared by Agribusiness Research, Lonsec and van Eyk Capital, the better agribusiness schemes should produce an after tax internal rate of return in line with or higher than long term stock market averages. Therefore agribusiness should be seen as just another asset class, one to give maybe 5-10% of your portfolio, to be added to your existing shares and property holdings.
There are a lot of film projects being promoted, but they are probably the most risky of all. It is a well known fact that most films lose money, only a few films make a huge profit. Therefore in terms of risk a film scheme can only be seen as quite speculative. You'll probably lose all of your money, you might make a killing. Either way I wouldn't want to put too much of my capital into a single film project.
Recently, Macquarie Bank in conjunction with Channel Nine and Hoyts released a film and television fund that is somewhat less speculative than the schemes that only apply to a single film. This fund is an investment in a wide variety of things, including a number of Channel Nine dramas and sitcoms as well as numerous film projects. There is even a minimum guaranteed return. As far as I know, the Macquarie/Channel Nine/Hoyts project is the only one of its kind, and although I still classify it as more risky than traditional timber growing, it is obviously considerably less risky than an undiversified project.
The main risks of these types of schemes are that the Tax Office will disallow the tax deduction (hence, you should only invest in the schemes that have a product ruling from the Australian Tax Office - the ruling will usually be advertised in large letters on the front cover of the prospectus, and enclosed with the information package you receive). If you have been following the newspapers you'll know that in the last couple of years there has been a tremendous stink around the "tax effective" industry because of the ATO retrospectively disallowing deductions going back many years for thousands of investors.
There are many that blame the ATO for this whole episode, and I agree that the ATO probably does have to share some of the blame. The schemes in question had a variety of contrived arrangements that enabled investors to claim a much larger tax deduction than the initial investment.
When a scheme is slapped together that has little or no prospect of producing an actual business return (and many of these schemes had very little possibility of producing a crop), but instead relies on a variety of contrived measures to enable an investor to get their money back only because for every dollar they invest they get three dollars tax deduction (and hence make a "tax profit" right from the initial investment), then the ATO is going to have a problem with it.
Most people anticipated that the ATO would have a problem with these schemes, so in their first year they invested a minimal amount to see what would happen. When they got back their refund cheque, substantially increased thanks to the tax deductions, the next year these people naturally invested very substantial amounts of money into these things, and continued to do so every year after that, often with borrowed money. It is thus understandable that there are a bunch of people right now who are very broke and very angry with the ATO because it took so many years for the ATO to get around to making a move against the tax dodge industry, and asking for all of these people to have to pay back all the taxes they owe now that the deductions have been limited only to the initial investment. An additional reason why people are mad at the ATO is that the ATO flatly refused at the time to make an announcement that the schemes were probably abusive. If you had called the ATO, as an accountant friend of mine did a few years ago when his client asked him if a scheme was kosher, you would have been told that the ATO can not say definitively if the scheme was ok or not, so the accountant had to go back to his client to tell him that the ATO could not categorically say the scheme was abusive.
While the ATO has been made out to be the villain in this case, really the blame should lie with the promoters of such abusive schemes. They tried to push the envelope and consciously knew that what they were doing was technically tax avoidance, yet they made a fortune in commissions selling these things to financially unsophisticated people with a high income (like miners and oil workers for example), many of whom have subsequently lost their homes and savings as a result.
Of course there is also the small matter that the people that buy these things should have done a bit more homework first or stopped to think that the ATO might eventually make a move on what was obviously "too good to be true", but I'd rather not rub salt into the wounds there.
Apart from the ATO moving in, there are also risks with the investments themselves. Obviously the agribusiness schemes involve agricultural risks, the usual stuff of fire, drought, disease, insects, weeds etc, in addition to financial risks should the promoter go out of business and not be around to look after the plantation properly.
Once the trees have reached a certain size it becomes very difficult to kill them through mismanagement, and their roots go deep enough that they can water themselves, but if the plantations are not well looked after the profits may be reduced, for example if the trees are not properly pruned the timber will not grow straight or will be full of knots, or if it is a fruit tree it is essential that pests be controlled and if the fruit is not properly thinned you'll end up with very small fruit that are mostly skin and seeds, which will not fetch a good price on the market.
With some schemes there are also difficulties in growing/farming. I've already mentioned sandalwood as an example of a crop where the horticultural science is not yet fully understood, so there is a risk of losing your money should the trees fail to thrive. The same applies to many of the more weird and wonderful animals such as ostriches, where entire flocks have had to be put down after the birds suffered terribly from disease and malnutrition, in addition to difficulties in getting them to breed.
Film funds are definitely high risk due to the low number of films that make
a profit, though I think the
Another major problem with these schemes is that liquidity is non existent and there may be a very substantial delay before any return is realised. There is no secondary market for woodlots or half mature orchards and vineyards, your only return comes in the form of income when the crop is sold. Obviously this makes this sector unsuitable for anyone needing immediate income or for anyone that may need access to their capital, for whatever reason.
One point that should be made is that provided you use a project with a valid tax ruling, you have a maximum downside of 51.5% of the initial investment because (if you are paying the top marginal tax rate) you get back 48.5% right at the start in tax rebates. From that point of view the absolute risk is about the same as a stock portfolio where losing half your money is not entirely unheard of if you buy at a really bad time or choose stocks poorly.
As I said earlier, although you claim a tax deduction with the initial investment, the return will be fully taxable as income. In the longer term there isn't much of a tax saving if you invest in one of these while on the top marginal tax rate and get your return down the track when you are still on the top marginal tax rate. For best results, buy an investment that will pay you after you retire, or at the very least in a year when you have lower income and hence are on a lower marginal tax rate.
I would advise that no more than 5-10% of a portfolio be invested in this sector, and since the minimum investments in agribusiness tend to be $5,000-$10,000 that obviously limits their application to higher net worth individuals only.
There are a number of strategies that have been developed for taking advantage of the tax deduction available from agribusiness investments. The key feature of many of these strategies is that one can claim a tax deduction while on a high marginal tax rate and receive the income later when one's income is lower (presumably, after retirement). This isn't a comprehensive list of strategies, nor am I suggesting that any of them would be useful to you.
See also the article in the ripoffs FAQ and the article in the tax FAQ.