Friday, 22 March 2013

The MIS phoenix

The MIS phoenix has risen.

AgriWealth’s 2012 Softwood Timber Project demonstrates memories are indeed short. The MIS industry pronounced dead after the disastrous insolvencies of Timbercorp, Great Southern, Willmott Forests, FEA and Gunns still has a pulse.

It is sometimes said we aren't predisposed to philanthropy but AgriWealth's latest offering suggests it too is alive and well. There is no other reason than philanthropy for becoming a AgriWealth grower. The massive upfront fees mean there is little chance of return on a before tax basis.

The tax driven Project differs from failed MISs in that it relies on Div 394 of the Tax Act which was enacted to overcome increasing problems with MISs prior to 2008.

But Div 394 has made it worse as prepaid expenses, some not due for 26 years are allowable deductions.

The upfront fees due to the loading of all prepaid expenses are ten times those charged by the old MIS projects.

Policy makers have taken their eyes of the ball probably thinking the MIS industry is dead.

Alas it’s not dead, as AgriWealth uses its cash to once again distort the pattern of agriculture in areas such as the beautiful Tallangatta Valley in northern Victoria as described in a recent Weekly Times article.

A closer look at the AgriWealth project follows but first a quick overview of how MISs used to operate, the issues and pitfalls.

Managed Investment Schemes MIS prior to 2008

Tax Ruling 2000/8 formalised the ATO approach to MIS schemes.

Deductions were allowable under ordinary precepts as per Div 8 of the Tax Act as necessarily incurred in carrying on a business.

Even tho’ it may only involve as little as 1/3 hectare of leased land and managers were contracted to plant, tend and harvest the crop, it was accepted as a ‘business’.

Non commercial loss provisions in Div 35 of the Tax Act would ordinarily preclude offsetting small scale business losses against other income but there was always a get out via Div 35-55 which allowed the ATO to exercise its discretion and allow losses in instances, for example, “an activity involving the planting of hardwood trees for harvest, where many years would pass before the activity could reasonably be expected to produce income.”

Product rulings for each MIS project always stated that the non commercial loss provisions would not apply.

Large upfront fees were attractive to some taxpayers if fully deductible. The fees became the life blood of MIS companies.

The MIS model varied between companies. The upfront fees vs ongoing fees vs commissions at harvest time all varied. Upfront fees say from $6,000 to $10,000 per hectare for establishment, some with ongoing annual fees for rent, maintenance etc, others with harvest commissions from 5% to 15% to cover rent and maintenance over the crop cycle etc.

In a lot of cases upfront fees contained ‘prepayments’, but they were hidden within a bulk amount. Prepayments usually are not deductible if they are in respect of services to be rendered more than 12 months hence.

Through the 2000’s MISs exploded. The open ended nature of the system propelled by taxpayers buying tax deductions rather than trees and the enormous cash flow advantages enjoyed by MIS companies as upfront fees flooded in each year meant that MIS companies were easily able to elbow aside other farmers in the grab for land.

MIS companies involved in non forestry such as horticulture were hugely disruptive not only competing for land and water but causing over supply of products.

Most forestry MIS projects offered by the big players (Timbercorp, Great Southern, Gunns and FEA) were short rotation hardwood plantations for pulpwood (10-12 years). Some involved thinning. A few projects were longer rotation hardwood projects with pruning and thinning with a peeler or possibly a sawlog as the final product. Of less significance were MIS softwood projects which included pulpwood and sawlog schemes (Willmott Forest were involved in the latter, Gunns to a very small extent)

The Government initiated a consultation process on the taxation aspects of plantation forestry in 2005 with a second round in 2006.

There was a widespread well founded belief that existing policy, supposedly designed to encourage investment in forestry, resulted in too much ending up in the pockets of promoters and other hangers-on via advertising, sales commission etc.

Furthermore being open ended meant that if demand for tax deductions exceeded the supply of suitable plantation sites, trees were being grown in less than ideal areas.

The ATO were growing weary of the non commercial nature of the rorting that was occurring and announced a change of interpretation of existing tax laws in early 2007 via Tax Ruling TR 2007/8.

TR 2007/8 contained damning criticisms of MISs as practiced. It was eventually withdrawn in 2009 following successful cases by taxpayers which were not appealed by the ATO partly because a new Div 394 had been inserted into the Tax Act as from 1st July 2007 to cover forestry MISs.

With disappointing yields, prices below expectation and the GFC, taxpayers no longer queued at the door of MIS companies. Cash flow dried up, there was no money to look after existing schemes and the whole show imploded.

The new div 394 of the Tax Act doesn’t require a ‘business’ to be conducted by a taxpayer. It will allow 100% deductibility provided at least 70% of the upfront fee is used to meet direct forestry expenditures (the DFE rule) which include costs re establishing, tending, felling, harvesting and other direct services provided by the Manager. Expenses can be prepaid expenses, an advantage not available to other taxpayers using the ordinary deductibility provisions.

Gunns 2006 Project offered as option 3 a softwood sawlog and pulpwood scheme with a similar end product to the AgriWealth project, thinning at 13 and 18 years and final harvest at 25 years with expected yields of 98, 108 and 345 cubic metres per hectare respectively (a total yield of 550 cubic metres with a mean annual increment MAI of 21.8 cubic metres per hectare per annum). The upfront fee was $6,200 plus GST of $620 (equals $6,820) with no ongoing rent or maintenance fees and 9.9% fee at harvest time. Harvest, freight and cartage to mill door costs are deducted from any harvest proceeds paid to growers.

AgriWealth 2012 Softwood Timber Project

The AgriWealth Project will involve 1,000 hectares to be planted in radiata pine (2,000 woodlots). It will be unpruned with 2 thinnings (at 12 and 18 years) with final harvest at 26 years.

AgriWealth’s upfront fees include harvest freight and cartage costs for the thinning and final harvest unlike ‘traditional’ MIS schemes like Gunns where these were deducted at harvest time.

The upfront fee for the project per hectare is $66,460 (incl GST). This includes $66,220 for establishment and future management services (fully deductible) $184 for a contribution to a sinking fund to pay rates etc (deductible when amounts paid) a put option fee of $22 (which if exercised after year 4 means the investor can sell out for $28,000 per hectare) and $34 to buy units in the trust which owns the land. Neither of the latter 2 amounts is deductible, as they are capital amounts. The units entitle the holder to a share of profits (NB profits not proceeds) if the land is sold after harvest.

Incorporating the harvest freight and cartage costs into the upfront fee causes the fee to increase from $6,000 to $66,000 compared to the 2006 Gunns project.

The breakup of total project funds from AgriWealth’s viewpoint is:

per woodlot
per hectare
per 1000 hectares
Road harvest Haulage
Sinking fund
Maintenance, overheads, profit
Total fees


Of the $66.46 million in fees paid by growers, $6 million will be spent on land to be owned by AgriWealth, $2 million to plant the growers’ trees, $44.5 million to be notionally set aside to pay for future harvest etc costs but meanwhile under the control of AgriWealth, a small amount into a sinking fund to pay rates etc and $13.8 million to cover maintenance, other expenses and profits to the managers over the life of the trees. Not a bad deal for AgriWealth, all cash up front. And it’s only 1,000 hectares, not much bigger than a farm.

The project is an unregistered MIS and as such is not regulated by the Corporations Act requirements that apply to registered schemes.

Most of the high profile MIS schemes with retail investors (Gunns, Timbercorp, Great Southern and FEA) came under the jurisdiction of ASIC which was responsible for regulation in accordance with the Corporations Act and the Managed Investment Act 1998.

Given that each grower was carrying on a business on a small plot of leased land, the overriding legal structure was quite complicated as has become evident when all the failed schemes have needed to be wound up.

Offers to retail investors involved the issue of a Product Disclosure Statement PDS approved by ASIC, deemed necessary to inform potential investors of all info needed to make an informed decision.

On the other hand the AgriWealth offer document is only an Information Memorandum IM, not a PDS approved by ASIC. The AgriWealth offer is not available to retail investors, only top end of town wholesale investors who have income greater than $250,000 pa or net assets in excess of $2.5 million, for whom the Corporations Act is not as onerous. As a quid pro quo there is no 14 day cooling off period, no waking up with a hangover the next day thinking what the hell have I done?

The information in the IM is offered on a voluntary basis to try to make a sale. It doesn’t need to satisfy any statutory or regulatory requirement.

There have always been unregulated forestry scheme, but as a rule, have never been available to retail investors.

In the eighties even, before prepayment rules were changed investors could pay all fees including management fees over the entire rotation up front and claim a tax deduction. Needless to say the promoter often had to lend funds to the grower to achieve this outcome. The latest AgriWealth scheme is a return to those days, although the lending term is only 12 months.

The second round of the Government’s consultation process referred to above invited comments on Treasury’s draft view at the time which included the 12 month prepayment rule for forestry MIS investors and its associated requirement that investors be carrying on a business should be replaced with new rules in the income tax law governing the deductibility of investments in MIS and forestry MIS investors would be able to deduct the full cost of their investment, subject to a cap of $6,500 per hectare in the year of expenditure, with the balance (if any) of the investor's contribution deductible in the following year;

The result was Div 394, however the $6,500 cap was not part of the div 394 provisions as enacted, instead the 70% DFE rule was dreamt up as a way of limiting amounts spent on non forestry expenses, advertising, overheads, sales commissions etc. No one seemed to envisage loading up upfront fees with harvesting freight and cartage expenses, which may not occur for 26 years, because traditionally these were deducted from receipts at harvest time.

The upfront fees are deductible under Div 394 if the 70% DFE rule is satisfied and DFE includes harvest and cartage costs.

Normally if an amount is deductible to a payer then the amount receivable is taxable to the payee. There are however exceptions to this general rule. It may well be that the amounts for roading harvest and haulage totalling $44.489 million (see above) to be placed in a trust and used to pay roading harvest and haulage expenses as required can be treated as prepayments in the hand of AgriWealth and only treated as income when the expenses is incurred regardless of the fact that the grower has claimed a deduction for that amount pursuant to Div 394.

Although $44.489 million is to be held in a Roading Harvest and Haulage Trust to meet future expenses, the trust appears to be in favour of AgriWealth both from a capital and an income viewpoint. Agriwealth will  presumably have access to the funds in the interim.

If the Roading Harvest and Haulage Trust was structured like the much smaller Sinking Fund contributions would only be tax deductible when expended, in other words in Years 13,18 and 26. Security for growers’ funds appears to be less important than tax deductibility.

Growers are only entitled to interest on the much smaller sinking fund used to pay rates and other statutory charges.

Whether those other charges include land tax is uncertain. In Tasmania the land tax law requires a business of primary production with a reasonable likelihood of profit to be carried on before a land tax exemption applies.

In this case it’s a Div 394 scheme, not a business. In addition there doesn’t appear to be a likelihood of profits.

Part of the fees paid will be used by a Land Trust to buy land worth $6 million, 1,000 hectares @ $6,000 per hectare. It appears as if AgriWealth will lend the trust the necessary amount to purchase the land from fees paid by growers and hence the Trust will always be indebted to AgriWealth for the amount lent. Growers will be allocated units in the Land Trust entitling them to profits after the land has been sold and AgriWealth repaid the amounts advanced to the Trust.

After harvest the stumps will remain. If pasture is worth $6,000 per hectare, then arguably a similar paddock following a crop of radiata with loss of fertility and stumps remaining may have a zero value ‘cos that is what it may cost to remove the stumps and restore a fertile pasture.

Hence the statement in the IM that investors “should receive land ownership benefits in respect of the Plantation Land” perhaps should read ... “may receive”. Most of the ownership benefit will remain with AgriWealth, just a few crumbs ending up with growers after it was their funds that financed the land purchase in the first instance.  Notwithstanding that the growers obtained a tax deduction for amounts used to buy the land, the land ownership benefits to growers are overstated.

The annual growth or MAI is predicted to be 18 which means the total yield will be 468 cubic metres per hectare (cf Gunns of 550 cubic metres) over the rotation. Even at a mill door delivered price of $100 per metre on an undiscounted basis that is only $46,800 per hectare, which is less than the purchases price.

All the risks lie with growers. None are borne by AgriWealth. The possibly upsides are difficult to spot. Insolvency will probably mean all funds in the Roading Harvest and Haulage Trust will disappear. After all the insolvency events of the past few years it’s amazing that any grower would contemplate such an adventure into the unknown with so little possibility of upside.

A window of opportunity is granted for a fortnight after 4 years for a grower to exercise a put option, which means an option to sell his/her forestry interest for $28,000 per hectare which considering $66,000 was stumped up four years earlier seems a bit light.

But there’s a sense of unreality about the whole charade. Recently in Tasmania 46,000 hectares of mixed age softwood plantations sold for $156 million or about $3,400 per hectare. The trees were of mixed ages from zero to harvestable age of 26 years, and were a more intensively managed plantation with thinning and pruning performed as required, so that the final product was arguably more valuable than the unpruned product contemplated by AgriWealth.

Actually what was sold was a forestry right with 57 years on the clock, the right to an existing crop of trees and the use of the land rent free for 57 years, and it was only valued at $3,400 per hectare.

When a MIS system creates values and amounts that bear little relationship to reality, which are only caused by the pathological desire of some to avoid tax at any cost, then the flow on effects are likely to cause distortions.

Creating distortions is bad public policy. An immediate tax subsidy to plant 1,000 hectares of pine trees at maybe 40% of $60 million, which equals say $24 million, is little short of certifiable madness.

The allowance of such massive tax deductions to grow what is in effect just a few trees worth $2,000 per hectare gives MIS companies a huge cash boost and again highlights how MIS companies are able to distort the market for land.

The problems with winding up failed MIS companies (Gunns, FEA Great Southern etc) has emphasised the urgent need for Government to finalise a simpler structure for pooled investments, one that is easily administered via ASIC and the Corporations Act, one which protects investors.

The Corporations and Markets Advisory Committee have produced a Discussion Paper but that’s about the extent of the progress so far.

The AgriWealth MIS confirms that Div 394 which only relates to forestry MIS and in effect allows such massive deductions for prepaid expenses most of which are not payable for 26 years gives forestry investment an enormous advantage over other industries.

Just when Div 394 by mandating a minimum of 70% of fees to be spent on direct forest expenditures, was hoped to limit the excesses of past MISs, the industry has upped its rorting by loading up forest expenditures with prepaid amounts not due until the distant future.

This comes at a time when the market is awash with MIS plantations for sale. Gunns has 107,000 hectares of its own MIS and a further 119,000 hectares ex Great Southern MIS plantation plus 50,000 hectares of its own trees all requiring new owners. FEA has a further 70,000 hectares of MIS desperate for a bit of TLC.

All existing MIS investors have lost between 80% to 90% of their investments and yet AgriWealth is able to pick up a further $24 million in tax assistance for another 1,000 hectares.

The world is crazy.

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