Agribusiness managed investment schemes (non-Division 394 schemes)

Capital expenditure

In the past, we have had concerns where amounts of expenditure incurred by the participants in an agribusiness managed investment scheme (MIS) were presented as deductible under section 8-1 of the ITAA 1997, when the true nature of the expenditure was capital.

Whether any expenditure incurred by a participant is deductible under section 8-1 of the ITAA 1997 or is capital expenditure will depend on the facts of each situation.

The following are examples of ATO concerns and capital expenditure.

 

See also:

• Established schemes

High profit margins

We use benchmark information on the costs of establishing a plantation, vineyard or similar. We often see proposals where the profit margin appears to be very high relative to this benchmark information.

We make no judgment about this issue, of itself. However, we are mindful that such profit margins may indicate the existence of an undisclosed collateral arrangement. Collateral arrangements are other transactions that a participant may enter into that are not presented as part of the facts of the arrangement that we are being asked to rule on. Collateral arrangements that raise concerns include arrangements that artificially inflate deductions and/or hide refunds to investors, for example via a 'round-robin' transaction or a commission rebate.

See also:

• Rebates of commission from investment brokers.

Before issuing any ruling, we will need to be satisfied that the profit margin represents nothing more than profit. That is, it is not associated with collateral agreements or mechanisms designed to artificially inflate any tax deductions.

Establishing just what the proposed or anticipated profit margin is commonly involves a full and true disclosure of the anticipated expenses, together with supporting documentation showing how those expenses have been arrived at. An application may be able to be expedited with such a disclosure.

If your proposed profit margin is above the benchmark, you should expect to be asked for an explanation of why this is so (assuming the answer is not already provided).

We have found that the structure of some managed investment schemes have undergone some variations. One of the most common variations is the lease or licence of an established agribusiness to participants in circumstances where the nature of services to be provided is substantially, if not totally, the same in the year of entry as it is in subsequent years.

See also:

• Initial period fees

Usually, with these schemes, the level of management fees charged in the first or initial period is very high relative to the level of services provided in that same period. Also, the initial period management fee is significantly higher than the fee charged for the same services in later years. These 'excessive fee' situations require thorough examination by us. This examination will include an analysis of cash flow, and comparisons of the fees to the services and to the cost of providing them in each year of the scheme, to determine whether the initial management fee contains a prepayment.

If we decide to conduct such an examination of your application, this may delay our final consideration of that application. In some instances, this may mean we will refuse to rule because the issue cannot be resolved to a point of providing certainty to potential participants.

Initial period fees

We have found that the level of the initial fee charged in some agribusiness managed investment schemes has brought into question whether the full amount of the fee may be claimed as a deduction by participants in the initial year. The fee structure of these schemes will be examined to ensure that the Commissioner can provide certainty to participants in relation to the application of the prepayment provisions.

The concerns about these schemes relate to the latest date on which participants are permitted to enter a scheme and the capacity for certain services to be provided within the specified period. This is discussed in further detail under Closing date to accept participants into a scheme. The schemes are categorised as either established schemes or unestablished schemes.

Closing date to accept participants into a scheme

Established schemes

These are schemes where participants lease/licence an area of land which already has an established agribusiness in place - for example, a participant leases an area of land which has an olive grove planted on it prior to the participant commencing in the scheme.

We have found with these schemes that the nature of the services to be provided is substantially, if not exactly, the same in the year of entry as it is in subsequent years. The level of management fees charged in the first or initial period is generally very high by comparison to the level of services provided in that same period. We have also found in those cases that the management fee for the initial period is significantly higher than the fee charged for the same services in later years.

The concern about these schemes arises as a result of the date to which participants may be accepted into the scheme. If this is late in the income year, there is substantial doubt as to whether any services of significance will be provided. In this case, we cannot be certain that the initial fee is paid for the provision of services within the same income year only.

Such cases will be thoroughly examined to ensure that we can provide certainty to participants about the application of the prepayment provisions. If we have concerns about the provision of services and the length of the service period it may not be possible to provide certainty to participants and, as a result, we may not be able to rule.

If we can provide a ruling, the closing date for applications into the scheme must be determined, having regard to the level of services to be provided and the quantum of fees paid. For established schemes, we may accept a closing date of 15 June or earlier, depending on the facts of the case and the level of services to be provided. A closing date after 15 June will generally not be accepted.

See also:

• Capital expenditure

Unestablished schemes

These are schemes where participants lease/licence an area of land, and contract with the responsible entity/manager to have a business established on their behalf, after they commence their participation in the scheme. The fee structure and the level of services to be provided by 30 June will be examined to ensure that we can provide certainty to participants about the application of the prepayment provisions. With regard to the comments made by Merkyl J in Carey v Field (2002) 122 FCR 538; 2002 ATC 4837; (2002) 51 ATR 40, we must be satisfied that the services in the initial period are capable of being performed by 30 June.

Consideration needs to be given not only to whether there is sufficient time to perform the services but also to whether the timing is right for performing the services. For example, depending on the type of tree and the location of where it is to be planted it may be recommended by the industry concerned that spring rather winter is the preferred time for planting.

In relation to these schemes, we will accept a closing date of 31 May. However, dependent on the facts of the case and the level of services to be provided, the closing date may be extended to 15 June. A closing date after 15 June will not be accepted.

See also:

• Deductions for prepaid expenses

Initial period lease/licence fees

For many schemes, the level of the initial lease/licence fee is the same as later years, even though it is for the lease or licence of land for a substantially shorter period of time - that is, the period to which the payment relates may be one month or less. In such cases, the amount of the initial lease fee may not be fully deductible by participants. In these cases, a portion of the fee will be treated as a premium which is capital in nature, or the prepayment provisions will apply to the expenditure, depending on the facts of the case.

In cases where the initial lease fee has been inflated to reduce the level of lease fees in subsequent years, the prepayment provisions will apply to apportion the initial lease fee over the term of the scheme or 10 years, whichever is the less.

Part of the initial lease fee will be considered to be a premium, and hence capital in nature, if there is evidence that the lease fees for subsequent years are commercially realistic and have not been reduced as a result of the higher initial lease fee. In such cases, participants will only be entitled to claim a deduction for that part of the fee which is not capital in nature.

These principles apply equally to other rights under contract (for example, licences) which provide participants with an interest in a scheme.

See also:

• Deductions for prepaid expenses

Buy-back mechanisms

Various buy-back mechanisms have been examined in connection with a number of primary production arrangements.

A buy-back mechanism refers to a means by which the participant's interest in the arrangement can be acquired from them under an agreement related to the operation of that arrangement. An example would be a put option offered to a participant in an agribusiness scheme to allow them to dispose of all or part of their interest, for consideration, to an entity associated with the promoter or manager, prior to the participant deriving income from the sale of the produce of the business.

If a buy-back is a feature of a scheme, we will consider it as part of the entire arrangement to determine whether there is any wider impact that will give us cause for concern.

The feature of a buy-back mechanism can significantly detract from finding that the arrangement will amount to the carrying on of a business (the argument typically put forward for the fees being deductible under the general deduction provisions).

Another aspect which will be examined is whether the buy-back price is based on the anticipated market value, or not, at the time of disposal. If the buy-back mechanism provides a guaranteed rate of return it can remove or significantly reduce investor risk.

We will examine whether there are any concerns about the dominant purpose of the buy-back mechanism and whether it may trigger the anti-avoidance provisions of Part IVA of the ITAA 1936.

We have declined to rule on the primary production arrangements that have been examined, if a buy-back mechanism was a feature of the scheme.

Guaranteed returns

If a promoter provides a guaranteed rate of return in a primary production arrangement we will consider it as part of the entire arrangement, to determine whether there is any wider impact that will give us cause for concern.

Management plans

Some applications have involved arrangements in which it was proposed to charge participants specific amounts for the preparation of a management plan. The management plan, as the name suggests, typically would set out what actions the manager had taken already in operating the arrangement (for example, site and seedling selection) and what action they proposed to take in the future (for example, in relation to future maintenance and harvesting and sale of the produce).

We have decided that such amounts are capital in nature, and so are not deductible under the general deduction provisions. The reason for this is that we consider that a management plan really sets out, in further detail, what the legal obligations of the manager are, as per the relevant agreement(s). As a result, charging a fee for the preparation of such a plan is seen as the same as charging for the preparation of the agreement itself.

Commonly, such an agreement contains many of the participant's key rights in relation to the business they are said to be going to carry on. Case law has usually regarded one-off expenditure on bringing such agreements into existence (that is, bringing one of the core structural assets of the business into being) as capital expenditure.

Maintenance funds

Some applications have raised the issue as to whether some part of the fees to be charged to a participant is not for a specific service, but is to be put aside into a maintenance fund. The question then arises as to whether that part of the fees would be an allowable deduction.

Our view is that either this part of the fees is capital or, if it could be identified as being for work of a revenue nature, the prepayment rules would apply to allow deductions to be claimed over the period of time that the work will be carried out.

Availability of suitable land

We have been asked why we require so much information about the land to be used in a scheme. The two main reasons for this are:

• The manager's ability to gain access to suitable land is relevant to their being able to get the scheme up and running and, therefore, whether we should issue a product ruling for the scheme.
• The suitability of the land for the scheme and how it is described will affect the accuracy of how closely the arrangement described in the product ruling matches the arrangement actually carried out and, therefore, whether or not the ruling is binding on the Commissioner. It is in the best interests of the participants, the manager and the ATO, that this description is as accurate as possible.

However, the fact that the promoter may not have acquired the land at the time of applying for the product ruling will not necessarily mean that we will decide against issuing a ruling.

Non-commercial business losses rules: Division 35, ITAA 1997

Commerciality of the product

We do not consider the commerciality of your proposals from an investment perspective. In every product ruling we issue, we state that the ruling is not an endorsement of the commerciality of a project.

However, this doesn't mean that we are entirely unconcerned about the commerciality of the product. Whether or not a product 'stacks up' commercially can be a clear indicator of the purposes associated with an outgoing to purchase the product, or whether a business is capable of being carried on.

Individuals, alone or in partnership, participating in arrangements like agribusiness schemes may be affected by Division 35. These provisions concern the deductibility of losses from the carrying on of a business activity.

In many schemes, losses will only be able to be offset against other income if we exercise our discretion to allow those losses in the year incurred.

To exercise our discretion, we need to ensure the arrangement to be ruled on will be profitable within a period that is commercially viable for the industry concerned, and that the income projections are credible and fully supported by appropriate expert independent evidence. We may seek to independently verify certain key assumptions underpinning these projections.

We have seen very wide variations – for example, in the number of plants that are expected to be grown per hectare, expected yields and so on - which on an initial reading appear inexplicable.

There may be valid commercial reasons for such variations. If your application involves such a variation, you should provide an explanation. Copies of, or references to, established third-party material, over and above any expert opinions otherwise provided, will assist us to understand why such variations occur, and how they can be commercially justified.

See also:

• Non-commercial losses and product rulings

Electing growers

Some agribusiness schemes provide participants (growers) with the choice of either:

• harvesting and/or marketing the produce from their identifiable interest in the scheme themselves
• having the scheme manager harvest and/or market the produce on their behalf.

Growers who elect to harvest and/or market their own produce are commonly referred to as 'electing growers'.

We have decided that we will exclude electing growers from the class of persons ruled upon. The reason for this is that we are unable to exercise our discretion under subsection 35-55(1) to allow losses from the activity to be offset against other income. Insufficient information is available at the time of considering the product ruling application to decide that the business activities of electing growers will eventually produce a tax profit.

Apportionment

The apportionment of expenses between capital and revenue is an issue arising in many cases. This applies to cases where the management agreement, or other relevant agreement, sets the one undissected sum for a mix of services of both a capital and a revenue nature. We believe, on the basis of long established authority, that we need to identify the extent to which the sum is of a capital nature.

We take the view that we may apportion undissected sums in accordance with the terms of the agreements entered into. Apportionment will be called for if a fee, or a portion of a fee, is directed to various objects - some of which are of a capital character, and some of which are of a revenue character.

Our view is that the terms and the circumstances surrounding execution of the management agreement in the Merchant case generally distinguish that case from the products now being considered (which as a rule are quite precise about what is being purchased).

In cases where the management agreement does not expressly impose identifiable fees or charges for the different components of work to be done you will save time by anticipating the issue, and providing an apportionment. If the management agreement does impose identifiable fees, but these amounts are directed to both capital and revenue expenditure, an apportionment of the fees should be provided. Overheads or indirect costs, such as marketing of the prospectus, should be apportioned between capital and revenue in the same proportions as capital and revenue items bear to each other.

If your application involves agreements where separate fees are set for the capital and for the revenue services, you may wish to expedite consideration of the application by providing material (especially copies of, or references to, established third-party information) that evidences that those separate fees are commercial, arm's-length amounts.