House of Representatives

Taxation Laws Amendment Bill (No. 1) 2002

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation Definition
2020 Vision Plantations for Australia: The 2020 Vision
A Tax System Redesigned Review of Business Taxation: A Tax System Redesigned
ATO Australian Taxation Office
Commissioner Commissioner of Taxation
ITAA 1936 Income Tax Assessment Act 1936
ITAA 1997 Income Tax Assessment Act 1997
STS simplified tax system

General outline and financial impact

Amendments relating to certain prepayments and non-commercial losses

The purpose of this bill is to amend various parts of the ITAA 1936 and the ITAA 1997 which have particular impact on the plantation forestry sector.

The amendments contained in Part 1 of Schedule 1 to this bill introduce a new 12 month rule allowing an immediate deduction for certain prepaid expenditure when invested in a plantation forestry managed agreement.

The concession will apply to the component of the investment that relates to seasonally dependent agronomic activities that occur during the establishment period. The activities, expenditure for which is prepaid, will have to be completed within 12 months of the activity commencing and by the end of the following income year.

In order to maintain symmetry, managers of such agreements will include these amounts in assessable income in the year the deduction can be claimed by the investor, rather than when the work is done.

The amendments contained in Part 2 of Schedule 1 to this bill amend the non-commercial losses rules, specifically the Commissioners discretion. Previously the Commissioner could not exercise his discretion past a point in time at which a profit was made or one of the tests was passed, even if the profit was made or the test passed on a one-off basis even though the period that is commercially viable may still be in course. The amendments will allow the Commissioners discretion to be exercised for all relevant years where this is consistent with the nature of the business activity. This is of particular relevance to the plantation forestry sector where normal practices such as thinning may produce a one-off profit or passing of a test.

Date of effect: The amendments in Schedule 1, Part 1 will have effect from 2 October 2001. The amendments contained in Schedule 1, Part 2 will have effect from the 2000-2001 income year.

Proposal announced: 2 October 2001.

Financial impact: The cost to the revenue resulting from the prepayment measure is estimated to be $25 million in 2002-2003, $5 million in 2003-2004, nil in 2004-2005 and $25 million in 2005-2006 and each year thereafter. The amendments to the non-commercial losses rules will not have any revenue impact as they merely ensure the provision operates as intended.

Compliance cost impact: There will be no change in compliance costs for taxpayers in their capacity as investors. As the only change to be made by the managers of plantation forestry managed agreements is with respect to the year in which they include certain income, namely that attributable to seasonally dependent agronomic expenditure, it is expected that there will be little change to compliance costs.

Summary of regulation impact statement

Regulation impact on business

Impact: This bill will provide significant positive impacts for the forestry industry.

Main points:

The measures contained in this bill will provide investors in plantation forestry agreements a concession in the form of an immediate deduction for certain prepaid amounts. Plantation forestry investment companies will need to account for income in the year amounts received from investors are able to be claimed as a deduction by the investor.
There will be a significant initial impact and an ongoing impact on the ATO who will administer these changes. This will arise because of the initial need to review existing product rulings and rulings procedures in light of the change to the treatment of prepaid amounts. There will be an ongoing increase in the number and complexity of product rulings.
The measures will have a relatively neutral effect on the ecologically sustainable development criteria.

Chapter 1 - Amendments relating to certain prepayments and non-commercial losses

Outline of chapter

1.1 This chapter explains:

the new 12 month rule that is to apply to the timing of deductibility of certain expenditure incurred by investors in plantation forestry managed agreements; and
the associated rule requiring the bring-forward of the assessable income from this expenditure in the hands of the recipient.

1.2 This chapter also explains the technical amendments to the non-commercial losses rules in the ITAA 1997 that will ensure the Commissioners discretion (to allow a loss in the income year in which the loss arises) is able to be exercised as intended, particularly for the forestry plantation industry.

Context of amendments

Prepayments

1.3 Subdivision H of Division 3 of Part III of the ITAA 1936 permits an immediate deduction for a prepayment of expenditure that is deductible under the general deduction provision, section 8-1 of the ITAA 1997, where:

the prepayment is made by an STS taxpayer or is deductible non-business expenditure by an individual;
the eligible service period for the expenditure incurred is no longer than 12 months and ends no later than the last day of the income year following the year of expenditure (the 12 month rule); and
the prepayment is not under a tax shelter arrangement, or one of the exceptions to the tax shelter rules applies.

1.4 Where these requirements are not met and the expenditure is not excluded expenditure as described in subsection 82KZL(1) of the ITAA 1936, the prepayment deduction must be spread over the eligible service period, as provided for in section 82KZMF (tax shelter arrangements), section 82KZM (STS and non-business taxpayers) and sections 82KZMB and 82KZMD (other taxpayers).

Non-commercial losses

1.5 For individuals, Division 35 of the ITAA 1997 operates to defer losses from non-commercial business activities where the business activity does not satisfy any of the tests contained in this Division. In addition, the Commissioner has the discretion to allow the loss in the income year in which the loss arises where particular circumstances prevent the activity from satisfying one of the tests in that year.

1.6 In particular, paragraph 35-55(1)(b) allows for the exercise of the Commissioners discretion for those activities which:

because of their nature, are not able to meet a test in the income year in which the loss arises; and
are expected to meet a test or produce a profit after a period that is commercially viable for the particular industry.

1.7 Subsection 35-55(2) prevents the exercise of this arm of the discretion after the first occasion on which the business activity produces a profit or meets one of the tests, even for earlier income years, even though the period that is commercially viable may still be in course. This rule prevents the exercise of the discretion in income years in which losses arise following a one-off profit made from thinning out a plantation (a sound forestry management activity) and selling the cut timber.

Summary of new law

Prepayments

1.8 The amendments exclude certain prepaid expenditure from the application of the prepayment rules (thereby providing an immediate deduction). A prepayment is excluded from the operation of these rules where the following conditions are satisfied:

the expenditure is for seasonally dependent agronomic activities carried on under a plantation forestry managed agreement during the plantations establishment period;
the activities for which the expenditure is made are undertaken within 12 months of the prepayment being made or the activity commencing,whicheveris the later; and
the activities must be completed by the end of the income year following the income year in which the expenditure was incurred.

1.9 The amendments will also require that managers of plantation forestry managed agreements will need to include the relevant amounts in their assessable income in the year in which the investor is able to claim a deduction.

Non-commercial losses

1.10 The amendments ensure the Commissioners discretion can be appropriately exercised for any income year or years within the period that is commercially viable for the business activity.

Comparison of key features of new law and current law

Prepayments

New law Current law

A 12 month rule, similar to that applying to STS and non-business taxpayers, will apply where the expenditure is:

part of an investment in a plantation forestry managed investment agreement;
in relation to an activity that is undertaken in the course of establishing the plantation; and
for an activity which is seasonally dependent and agronomic in nature.

This new rule will apply to all taxpayers investing in plantation forestry managed agreements regardless of whether they are STS or non-STS business taxpayers.

The existing rules continue to apply to all other prepayments of expenditure.

Prepayments of expenditure by investors in plantation forestry managed agreements are subject to the rules in sections 82KZM to 82KZMF.

Where a tax shelter prepayment is made, any deductions are apportioned over the income years in which the goods or services are provided.

For STS and non-business taxpayers, where the expenditure is incurred after 25 May 1988 and the period over which the goods or services are to be provided:

is equal to or less than 12 months; and
ends before the last day of the income year after the income year in which the expenditure was incurred,

the 12 month rule will apply. That is, the whole deduction is claimable in the income year in which the expenditure is incurred.

Where these conditions are not met, the deduction must be apportioned across the income years in which the goods or services are provided.

For prepayments by non-STS business taxpayers, the deduction must be apportioned over the income years in which the goods or services are provided. Limited transitional arrangements apply, ending in the 2002-2003 income year.

A recipient of an amount which satisfies the new rule (i.e. the manager of the plantation forestry agreement) will be required to include that amount in their assessable income in the year in which the investor is first able to claim a deduction. The recipient would include the amounts in assessable income in the year when the service was provided.

Diagram 1.1: Prepayment rules after these amendments

Non-commercial losses

New law Current law
For an activity which, because of its nature, is not able to meet a test in the income year in which the loss arises, the Commissioner can, at any time, exercise his discretion for all relevant income years within the period that is commercially viable for the business activity. The Commissioner cannot exercise discretion at a time after the first time the business activity is expected to produce a profit or pass one of the tests.

Detailed explanation of new law

Prepayments

1.11 The amendments introduce section 82KZMG to Subdivision H of the ITAA 1936. The section explains how investors in plantation forestry managed agreements should determine the extent to which a prepaid deductible amount may be claimed in the year of expenditure or in a future income year.

1.12 Subsection 82KZMG(1) excludes prepaid expenditure from the prepayment rules provided in sections 82KZMB, 82KZMD and 82KZMF, to the extent that the prepaid amount satisfies the requirements of subsections 82KZMG(2) to (4). Where a part of a prepaid expenditure amount does not meet these requirements, the timing of the deductibility of this residual amount remains subject to the other prepayment provisions. [Schedule 1, item 1, subsection 82KZMG(1)]

Example 1.1 A large business investor makes a prepaid investment of $10,000 in a plantation forestry managed agreement on 30 June 2003. The prepaid activities are carried out within 12 months, and span into the next income year but not beyond the end of that year. $2,000 of the prepayment is for seasonally dependent agronomic activities that occur within the establishment period. This component of the prepayment meets the requirements of subsections 82KZMG(2) to (4), is excluded from the timing rules in sections 82KZMB, 82KZMD and 82KZMF and is fully deductible in the year ending 30 June 2003. As the agreement also satisfies section 82KZME, which relates to tax shelter arrangements, the remaining $8,000 continues to be subject to these provisions, and will need to be apportioned between the 2 years.

1.13 Subsection 82KZMG(2) sets out the requirements that must be satisfied for the relevant prepaid expenditure to be excluded under subsection 82KZMG(1). In particular:

the expenditure is in relation to an activity that is not wholly completed within the income year in which the expenditure was incurred [Schedule 1, item 1, paragraph 82KZMG(2)(c)] ;
the expenditure must be incurred on or after 2 October 2001, under an agreement [Schedule 1, item 1, paragraph 82KZMG(2)(a)] ; and
the eligible service period must be 12 months or less and the thing to be done under the agreement must be completed by the end of the income year following the income year in which the expenditure was incurred [Schedule 1, item 1, paragraph 82KZMG(2)(b)] .

1.14 Subsection 82KZMG(3) limits the application of the new provision to agreements satisfying the following requirements:

the agreement is for the planting and tending of trees for felling [Schedule 1, item 1, paragraph 82KZMG(3)(a)] . Work preparatory to the actual planting, such as ripping and mounding would be integral to the planting and would therefore satisfy this criterion;
the taxpayer must not have day to day control over the operations arising out of the agreement. However, the right to be consulted or give directions does not equate to having day to day control and will not result in this requirement not being satisfied [Schedule 1, item 1, paragraph 82KZMG(3)(b)] ; and
either:

-
there is more than one participant in the agreement in the same capacity as the taxpayer [Schedule 1, item 1, subparagraph 82KZMG(3)(c)(i)] . That is, there are 2 or more investors; or
-
the manager must manage, arrange or promote similar agreements for other taxpayers. Alternatively, an associate of the manager must provide these services, via similar agreements, to other taxpayers [Schedule 1, item 1, subparagraph 82KZMG(3)(c)(ii)] .

1.15 The expenditure must be paid for seasonally dependent agronomic activities that are carried out during the establishment period. Seasonally dependent agronomic activities include such activities as ripping and mounding a plantation site, applying fertiliser, tending the seedlings prior to planting and the actual planting. The amount charged to, and paid by, the investor would include a reasonable profit margin for carrying out such activities. The investor has paid the amount for the seasonally dependent agronomic activity and would obtain the deduction for that amount. A non-agronomic activity would include the administrative activities carried out by the manager of the agreement. [Schedule 1, item 1, subsection 82KZMG(4)]

1.16 The establishment period, for the purposes of section 82KZMG, is defined as commencing at the time that the first seasonally dependent agronomic activity is performed in relation to a specific planting of trees and concluding with the planting of the trees. If it is necessary to apply a fertiliser or herbicide to the trees at the same time as planting then those activities fall within the establishment period. Planting of trees refers to the main planting of the particular plantation and expressly excludes specific planting to replace existing seedlings that have not survived (i.e. infilling). [Schedule 1, item 1, subsection 82KZMG(5)]

1.17 A plantation manager may plan to undertake a herbicide spraying as soon as all the seedlings are planted. However, due to weather conditions that spraying may be postponed until the next practicable time, for example, one week. When that spraying is finally undertaken it is still in conjunction with that planting. However if, as part of a later infilling program, another herbicide spraying is undertaken that later spraying is clearly not in conjunction with the planting.

1.18 Section 15-45 of the ITAA 1997 explains that when a manager of an agreement receives an amount from an investor and all the requirements of section 82KZMG are satisfied, the amount must be included in the managers assessable income in the year in which the investor is first able to claim the corresponding deduction [Schedule 1, item 3, section 15-45] . A transitional arrangement allows the initial impact of this measure to be spread over 2 years (see paragraph 1.22).

Example 1.2 A manager of an agreement receives a payment of $3,000 for the ripping and mounding of a timber lot on 20 June 2005 and the activity is carried out in August 2005. The remaining requirements of section 82KZMG are met. The manager must account for this amount as income in the year ending 30 June 2005 because that is the year in which the taxpayer would first be able to claim the deduction.

Non-commercial losses

1.19 Paragraph 35-55(1)(b) of the ITAA 1997 is amended to ensure that the Commissioner is able to exercise the discretion for a number of income years. [Schedule 1, items 5 and 6]

1.20 Subsection 35-55(2) which prevents the exercise of the discretion after the first time a test is met or a profit produced, is repealed. This ensures that the discretion can be exercised where the requirements of paragraph 35-55(1)(b) are satisfied, for all the relevant income years, even though the business activity may, on a one-off basis, meet a test or produce a profit. This can occur, for example, as a consequence of a thinning operation in a forestry plantation. [Schedule 1, item 7]

Application and transitional provisions

Prepayments

1.21 The amendments will apply to expenditure incurred on or after 2 October 2001. [Schedule 1, item 9]

1.22 Where deductions are first able to be claimed under section 82KZMG in either the 2001-2002 or 2002-2003 income years (whichever is the first year of use) the manager receiving the payments has a choice to spread the assessment of that income from the first year of use equally between that year and the following year. [Schedule 1, item 4]

Example 1.3 The first income year of use is 2001-2002, and the manager receives eligible amounts of $2 million in the 2001-2002 income year and $3 million in the 2002-2003 income year. If the manager chooses to utilise the transitional arrangements, his assessable income for those years will be $1 million in 2001-2002 and $4 million in 2002-2003 (comprising $1 million deferred from 2001-2002 and $3 million received in 2002-2003). In this example, the deferral arrangement will not apply to income received in 2002-2003 as it is not the first year of use.

Example 1.4 The first income year of use is 2002-2003, and the manager receives eligible amounts of $4 million in the 2002-2003 income year and $5 million in the 2003-2004 income year. If the manager chooses to utilise the transitional arrangements, his assessable income for those years will be $2 million in 2002-2003 and $7 million in 2003-2004 (comprising $2 million deferred from 2002-2003 and $5 million received in 2003-2004). This deferral arrangement does not apply to payments received after 2002-2003.

Non-commercial losses

1.23 The amendments will have effect from the commencement of Division 35, being for the 2000-2001 income year. No transitional provisions are required. [Schedule 1, item 9]

Consequential amendments

1.24 Division 10 of the ITAA 1997 identifies particular types of assessable income. Section 10-5 is amended to include assessable income under a forestry agreement, specifically where section 82KZMG of the ITAA 1936 applies. [Schedule 1, item 2]

1.25 The amendments repeal references in section 82KZMG to section 82KZMB, effective as of the end of the income year which includes 21 September 2002. Section 82KZMB will be repealed from this time and will therefore not have to be affected by section 82KZMG. [Schedule 1, items 8 and 9]

Chapter 2 - Regulation impact statement

Policy objective

2.1 The policy objective of this measure is to stimulate investment in plantation forestry managed investment arrangements to meet the Governments 2020 Vision target initiative to have 3 million hectares under plantation by the year 2020. Without stimulating investment in these arrangements it is unlikely that the Governments 2020 Vision target initiative will be reached.

Background

2.2 Prior to 21 September 1999, the original 13 month rule allowed expenditure incurred on deductible goods or services that were wholly applied within 13 months to be deducted in the year of expenditure. Changes arising from recommendations in A Tax System Redesigned sought to limit, for certain taxpayers and arrangements, the tax advantages associated with immediate deductibility by requiring the deduction to be spread over the period when goods or services were provided. The forestry industry has submitted that the seasonally dependent nature of their operations requires them to raise funds in one income year for activities that will span more than one income year.

2.3 Industry sources estimate collected funds in managed investment companies in 2000 and 2001 were sufficient to support the establishment of 30,000 to 35,000 hectares of plantation, compared with 90,000 hectares in 1998 and 1999.

Implementation options

2.4 The measure in this bill arises from direct consultation with representatives from the plantation forestry managed agreement industry. It involves introducing a 12 month rule for certain expenditure, allowing an immediate deduction for some expenditure by taxpayers who invest in plantation forestry managed investment agreements (similar to that currently available to STS and non-business taxpayers). Expenditure in relation to a seasonally dependent agronomic activity, which is deductible under section 8-1 of ITAA 1997 and is undertaken in the establishment period of the plantation will be immediately deductible provided the services are provided within a period not exceeding 12 months and by the end of the next income year.

2.5 In order to maintain symmetry in the tax treatment of deductions compared to the treatment as income of the service provider, managers of such arrangements will include these amounts in assessable income in the year in which the investor is first able to claim a deduction for the prepayment, rather than when the work is done. Transitional treatment is provided for in the first year to alleviate any cashflow impacts on these managers. Rather than being required to bring forward the entire relevant income in the first year in which the concession is applied to a particular agreement, the manager can choose to defer half the relevant income to the following year. The manager only has this option if the first time they use the concession is in the 2002-2003 or 2003-2004 income year. Note that the option can not be exercised in both of these years.

2.6 The measure will take effect from 2 October 2001, which is the date it was announced by the then Minister for Forestry and Conservation.

Assessment of impact

Impact group identification

Investors

2.7 The measure will apply to all investors in the same way, whether they be individuals, STS taxpayers or medium or large business taxpayers. There will be no compliance cost to taxpayers in their capacity as investors.

ATO

2.8 The ATO will be required to administer the new arrangements.

Analysis of costs/benefits

Compliance costs

Investors

2.9 There will be no compliance cost to taxpayers in their capacity as investors. Investors will receive a benefit in that they will be able to claim certain deductions in the year the expenditure is incurred rather than having to apportion the deduction over the income years in which the goods or services are applied.

2.10 Investors will receive a benefit from the change because they will now be able to claim deductions earlier than would have been the case under the existing provisions. Therefore, investors will receive a cash flow benefit with less tax to be paid. This cash flow benefit is approximately double the negative cash flow incurred by the management companies.

Forestry Industry

2.11 Investment in plantation forestry managed agreements is expected to increase as taxpayers seek access to the tax concession. Managers will need to adjust their operations to account for income from seasonally dependent agronomic expenditure in the year the deduction is able to claimed, as opposed to the year in which services are provided. Representatives of the forestry industry have indicated that the industry is willing to make these adjustments in order to secure the concession.

2.12 Management companies will face a negative cash flow impact with the bring-forward of income tax payments but this is not likely to be significant. However, the cash flow effect could be significant for start-up companies that enter the market after the transitional years.

Transitional treatment

2.13 The cash flow impact of the transitional treatment, to allow half of the first year bring-forward amount to be delayed by one year is estimated to be $15 million. Therefore, this provides a benefit to the management companies equal to the cost of funds for that amount. For example, if the cost of funds was 5%, the benefit would be of the order of $0.75 million.

Administrative costs

2.14 There will be a significant initial increase in administrative workload resulting from the need to interpret the new law, then review and amend all existing product rulings to reflect the changed taxation treatment of these items of expenditure. This needs to be done in a timely manner and in consultation with managers of these arrangements. After this initial stage, there is likely to be an ongoing increase in the number of product ruling applications and the complexity of the information to be considered. This is because managers of these agreements seek product rulings to rely on information that can be placed in the prospectus on the application of the various tax laws. This proposal will not require any new systems support.

Government revenue

2.15 The cost to the revenue resulting from the prepayment measure is estimated to be $25 million in 2002-2003, $5 million in 2003-2004, nil in 2004-2005 and $25 million in 2005-2006 and each year thereafter. The fluctuation in revenue loss is due to transitional treatment of the bring-forward of income received by the manager of the investment arrangement.

Economic costs

2.16 Investors in plantation forestry managed agreements receive immediate, that is same year, deductions for certain amounts invested. As the new prepayments measure applies only to the plantation forestry managed agreement sector, there may be a shift in investment capital towards this area. This could result in a less than optimal allocation of capital, with investor decisions being influenced by offers of up-front tax deductions rather than by the commercial returns of an arrangement.

Ecologically sustainable development criteria

2.17 The measure supports the 2020 Vision target to treble the plantation estate to 3 million hectares by 2020. The 2020 Vision reflects a working partnership between Commonwealth, State and Territory governments and the plantation growing and processing industries. Non-market benefits of the 2020 Vision include reduction of the net of greenhouse gas emission (as growing trees take up CO2) and landcare benefits including reduced salinity and soil erosion.

2.18 The 2020 Vision is based on one of the national goals of the National Forestry Policy Statement of 1992, to expand Australias commercial plantations of softwoods and hardwoods so as to provide an additional, economical, reliable and high quality wood resource for industry. The National Forestry Policy Statement of 1992 is a strategy for the ecologically sustainable development of Australian forests in order to achieve the full range of benefits that forests can provide current and future generations.

Benefits of the measure

2.19 The prepayment rule plays a vital role in the success or otherwise of the 2020 Vision. Industry and independent estimates place the presence or absence of the prepayment rule at 50,000 to 60,000 hectares per annum - sufficient to the achievement or non-achievement of the 2020 Vision target of trebling plantations in Australia.

2.20 Independent estimates by the Bureau of Rural Sciences in 2001 place the value of the prepayment rule at about 50,000 hectares per annum of new plantations. Bureau of Rural Sciences estimated the total area of plantations established in Australia at about 139,000 hectares per annum with the prepayment rule and 89,000 without the prepayment rule.

Consultation

2.21 Consultation was undertaken with industry representatives prior to and following the announcement of this measure. The changes were initiated by industry, in response to a significant downturn in plantation sector investment in 2000 and 2001. Industry representatives were consulted in formulating the measure, developing the press release and drafting the legislation. The industry representatives fully support the measure in its current form.

2.22 Members of the Australian Forest Growers and National Association of Forest Industries participated in the consultative process, as well as representatives from Great Southern Plantations Ltd, Timbercorp Ltd and Willmott Forests Ltd.

Conclusion

2.23 This proposal will address the declining investment in forestry plantation managed agreements, by allowing certain deductions to be claimed in the year of expenditure to all investors in such arrangements. This will facilitate achievement of the Governments 2020 Vision target. By creating an environment which supports the achievement of the vision target this measure also has a positive influence on national environmental goals contained within the National Forestry Policy Statement of 1992.


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