Capital expenditure
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 capital expenditure.
Example 1: fees paid
A horticultural scheme provides for fees to be paid to a responsible entity or manager to perform services to supervise or inspect the establishment of the agribusiness managed investment scheme.
Whether such fees are deductible under section 8-1 of the ITAA 1997 will depend on the specific facts such as the stage of the establishment of the agribusiness managed investment scheme the services were performed and the expenditure incurred by the participants.
The establishment of an agribusiness managed investment scheme typically includes capital infrastructure items such as irrigation, trellising and the establishment of horticultural plants. This type of expenditure itself is generally capital in nature, and as such is not deductible under section 8-1 of the ITAA 1997.
Generally, to the extent that services to supervise or inspect the establishment of the agribusiness infrastructure are provided prior to the full establishment of the business infrastructure, they would be regarded as part of that establishment and, as a result, capital in nature.
It must be clear or we must be satisfied that the capital structure required to conduct the business is expected to be fully established prior to the entry of the participant into the business. Only then, will such expenditure incurred by the participant be deductible.
If it is not certain (or we cannot satisfy ourselves sufficiently) that the capital structure required to conduct the business will be fully established at the time the participant enters the scheme, any expenditure incurred for supervision or inspection may be capital in nature, because it will be considered to be part of the establishment of the business.
In the latter case, it will be necessary to establish the component that is capital and apportion that amount from the deductible management fee. If we are unable to determine the amount of the capital component, we will refuse to rule, on the grounds that we cannot provide certainty to all participants.
End of example
Example 2: acquiring an interest
A participant acquires an interest in an established scheme where the olive grove was planted prior to the participant commencing in the scheme.
The cost for acquiring the interest in the scheme may include lease fees and management fees that would generally be deductible under section 8-1 of the ITAA 1997. However, it will be necessary to establish whether or not there is also a capital component for the cost of acquiring an interest in an established olive grove, and if so apportion that amount from the deductible fees.
End of exampleWe use benchmark information on the costs of establishing a plantation, vineyard or similar. We will examine an arrangement closely where the profit margin for a scheme appears to be very high relative to this benchmark information.
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, hide refunds to investors, or both; for example, via a 'round-robin' transaction or a commission rebate (see Rebates of commission from investment brokers).
Before issuing any product ruling, we will need to be satisfied that the profit margin represents nothing more than profit.
Establishing the proposed or anticipated profit margin 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.
Some managed investment schemes undergo 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.
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 (see Initial period fees).
We look closely at these 'excessive fee' situations. 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 this occurs, this may delay the provision of the ruling. 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
The level of the initial fee charged in some agribusiness managed investment schemes brings into question whether the full amount of the fee may be claimed as a deduction by participants in the initial year. We will look at the fee structure of these schemes to ensure that certainty can be provided to potential 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 (see 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
Established schemes are schemes where participants lease or 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.
With established schemes 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 (See also, Capital expenditure).
The concern about these schemes is with the date participants may be accepted into the scheme. If they are accepted late in the income year, it is uncertain that any significant services will be provided, and we can't be certain that the initial fee is paid for services within the same income year only.
We will look at such cases 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, we may not be able to rule.
If we can provide a product 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.
Unestablished schemes
Unestablished schemes are schemes where participants lease or licence an area of land, and contract with the responsible entity or manager to have a business established on their behalf, after they commence their participation in the scheme. We will look at the fee structure and the level of services to be provided by 30 June to ensure that we can provide certainty to participants about the application of the prepayment provisions (see also, Deductions for prepaid expenses). 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 than 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.
Initial period lease or licence fees
For many schemes, the level of the initial lease or 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 (see also, Deductions for prepaid expenses).
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.
Buy-back mechanisms
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. 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 we will look at 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 also look at the dominant purpose of the buy-back mechanism and whether it may trigger the anti-avoidance provisions of Part IVA of the ITAA 1936.
Management plans
Certain arrangements propose 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).
Such amounts are capital in nature and not deductible. A management plan sets out, in further detail, what the legal obligations of the manager are, as per the relevant agreement or agreements. Commonly, such an agreement also contains many of the participant's key rights in relation to the business they are said to be going to carry on. As a result, charging a fee for the preparation of such a plan is considered to be the same as charging for the preparation of the agreement itself.
Maintenance funds
Where 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, either this part of the fees is capital or, if it can be identified as being for work of a revenue nature, the prepayment rules will apply to allow deductions to be claimed over the period of time that the work will be carried out.
Availability of suitable land
We require detailed information about the land to be used in a scheme because:
- the manager's ability to gain access to suitable land is critical to their being able to get the scheme up and running and whether a product ruling should issue
- the suitability of the land for the scheme and how it is described will affect the accuracy of the product ruling, and accordingly, the level of protection it offers participants..
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
A product ruling does not consider the commerciality of your proposals from an investment perspective (see Non-commercial losses and product rulings).
However, 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 of the ITAA 1997. 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 the discretion to allow those losses in the year incurred.
To do this, 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, particularly if there are wide variations, for example, in the number of plants that are expected to be grown per hectare or expected yields. This should include copies of, or references to, established third-party material where available. We may seek to independently verify certain key assumptions underpinning these projections.
Electing growers
Some agribusiness schemes provide participants (growers) with the choice of either:
- harvesting or marketing the produce from their identifiable interest in the scheme themselves
- having the scheme manager harvest or market the produce on their behalf.
Growers who elect to harvest or market their own produce are commonly referred to as 'electing growers'.
Electing growers will be excluded from the class of persons ruled upon as we are unable to exercise our discretion under subsection 35-55(1) of the ITAA 1997 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
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, the extent to which the sum is of a capital nature will need to be established.
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.
In cases where the management agreement does not expressly impose identifiable fees or charges for the different components of work to be done, completion of the product ruling will be expedited if you anticipate the issue and provide 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, completion of the product ruling will also be expedited if you provide material (especially copies of, or references to, established third-party information) that evidences that those separate fees are commercial, arm's-length amounts.