Product Ruling

PR 1999/44

Income tax: Ord River Sandalwood Project No 2

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FOI status:

May be releasedFOI number: I 1019700

Preamble

What this Product Ruling is about

1. This Ruling sets out the Commissioner's opinion on the way in which the 'tax law(s)' identified below apply to the defined class of persons, who take part in the arrangement to which this Ruling relates. In this Ruling this arrangement is sometimes referred to as the 'Ord River Sandalwood Project No 2', or just simply as 'the Project'.

Tax law(s)

2. The tax law(s) dealt with in this Ruling are:

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section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997');

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Part IVA of the Income Tax Assessment Act 1936 ('ITAA 1936');

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section 82KL of the ITAA 1936; and

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section 82KZM of the ITAA 1936.

Class of persons

3. The class of persons to whom this Ruling applies is those who enter into the arrangement described below on or after the date this Ruling is made. They will have a purpose of staying in the arrangement until it is completed (i.e., being a party to the relevant agreements until their term expires) and deriving assessable income from this involvement as set out in the description of the arrangement. In this Ruling these persons are referred to as 'Growers'.

4. The class of persons to whom this Ruling applies does not include persons who intend to terminate their involvement in the arrangement prior to its completion, or who otherwise do not intend to derive assessable income from it.

Qualifications

5. This Ruling provides this specified class of persons with a binding ruling as to the tax consequences of this project. The Commissioner accepts no responsibility in relation to the commercial viability of this project, and gives no assurance the prices charged for the project are reasonable, appropriate, or represent industry norms. A financial (or other) adviser should be consulted for such information.

6. The Commissioner rules on the precise arrangement identified in the Ruling.

7. The class of persons defined in the Ruling may rely on its contents, provided the arrangement (described below at paragraphs 12 to 25) is carried out in accordance with details described in the Ruling. If the arrangement described in the Ruling is materially different from the arrangement that is actually carried out:

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the Ruling has no binding effect on the Commissioner, as the arrangement entered into is not the arrangement ruled upon; and

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the Ruling will be withdrawn or modified.

8. A Product Ruling may only be reproduced in its entirety. Extracts may not be reproduced. As each Product Ruling is copyright, apart from any use as permitted under the Copyright Act 1968, no Product Ruling may be reproduced by any process without prior written permission from the Commonwealth. Requests and inquiries concerning reproduction and rights should be addressed to the Manager, Legislative Services, AusInfo, GPO Box 1920, Canberra ACT 2601.

Date of effect

9. This Ruling applies prospectively from 2 June 1999, the date this Ruling is made. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

10. If a taxpayer has a more favourable private ruling (which is legally binding), the taxpayer can rely on the private ruling if the income year to which the private ruling relates has ended, or has commenced but not yet ended. However, if the arrangement covered by the private ruling has not begun to be carried out, and the income year to which it relates has not yet commenced, the Product Ruling applies to the taxpayer to the extent of the inconsistency only (see Taxation Determination TD 93/34).

Withdrawal

11. This Product Ruling is withdrawn and ceases to have effect after 30 June 2002. The Ruling continues to apply, in respect of the tax law(s) ruled upon, to all persons within the specified class who enter into the specified arrangement during the term of the Ruling. Thus, the Ruling continues to apply to those persons, even following its withdrawal, for arrangements entered into prior to withdrawal of the Ruling. This is subject to there being no material difference in the arrangement or in the persons' involvement in the arrangement.

Arrangement

12. The arrangement that is the subject of this Ruling is described below. This description is based on the following documents. These documents, or relevant parts of them, as the case may be, form part of and are to be read with this description. The relevant documents or parts of documents incorporated into this description of the arrangement are:

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Product Ruling request dated 15 March 1999;

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Draft Ord River Sandalwood Project No 2 Constitution between Ord River Sandalwood Corporation Ltd ('Project Manager') and Ord River Land Corporation Pty Ltd ('Lessor'); which also incorporates a Draft Lease and Management Agreement between the Project Manager, the Lessor and the Grower;

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Ord River Sandalwood Project No 2 Prospectus;

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Draft Planting Agreement between the Project Manager and Lincfel Enterprises Pty Ltd; and

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additional correspondence from the Applicant dated 27 April, 6 May, 7 May, 11 May, 14 May, 17 May and 18 May 1999.

13. For the purposes of describing the arrangement to which this Ruling applies, there are no other agreements, whether formal or informal, and whether or not legally enforceable, which a Grower, or any associate of the Grower, will be a party to.

14. This arrangement is called the Ord River Sandalwood Project No 2. The Project is to carry out a forestry plantation, principally for the purpose of the production and sale of sandalwood trees. Income may also be derived by the Grower from the sale of host trees. Growers entering into the Project will lease the land located within the Ord River Scheme at Kununurra in Western Australia for a period of 15 years. The minimum individual holding is one Leased Area, being an allotment of 0.5 hectares of land planted with an average of 350 sandalwood trees, along with 90 ebony and 410 other host trees. Overall, it is proposed to plant 415 hectares with approximately 290,500 sandalwood trees, 74,700 ebony and 340,300 other host trees. The 830 Leased Areas that this represents are separately identified on the Schedule attached to the Lease and Management Agreement.

15. Under the Lease and Management Agreement, Growers contract with the Project Manager to manage the Leased Area and to establish the sandalwood plantation on the Grower's behalf. Once the seedlings are planted and the irrigation established, the Project Manager maintains the sandalwood trees and harvests the trees on the Grower's behalf. Growers have the option to take possession of their trees after the harvest. Where a Grower does not make this election, the Project Manager will act as the Grower's agent for the purpose of marketing and selling the trees.

Lease and Management Agreement

16. The Growers will make payments to the Project under the Lease and Management Agreement. The Agreement is to be executed no later than 30 June 1999. The payments will be for rent and management fees.

17. The Lessor grants to the Grower a lease of a Leased Area (set out in item 3 of the Schedule attached to the Lease and Management Agreement). Some of the conditions of the lease are that the Grower will not:

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use or permit any other person to use the Leased Area for any purpose other than that of commercial silviculture and the Project;

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erect any building or construction (whether temporary or permanent) on the Leased Area, except with the approval of the Lessor and for the purpose of commercial silviculture and the Project; and

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use or permit any other person to use the Leased Area for residential, recreational or tourism purposes.

18. In return the Grower may peaceably possess and enjoy the Leased Area during the term of the lease without any interruption or disturbance from the Lessor. The Grower and the Grower's invitees may use the common areas for the purposes incidental to the use of the Leased Area for the purpose of commercial silviculture.

19. At the expiration, or sooner determination of the term of the lease, the Grower will peaceably surrender and yield up to the Lessor the Leased Area and fixtures, free and clear from rubbish and in good and substantial repair, order and condition.

20. The Grower appoints the Project Manager to establish and maintain the trees on the Leased Area(s), and to arrange their harvest at such time or times as, in the opinion of the Project Manager, will maximise the price receivable for such trees. The Project Manager is required to perform these services according to good horticultural practices and may provide these services directly or through consultants or other specialists engaged. The Project Manager will have commenced these business operations on behalf of the Grower by 30 June 1999. The Project Manager will obtain insurance against public risk in respect of the plantation and, if requested by the Grower in writing, use its best efforts to arrange insurance of the Leased Area against destruction or damage by fire on behalf of the Grower.

21. Unless Growers have notified the Project Manager that they have elected to market their produce themselves, the Lease and Management Agreement authorises the Project Manager to market the trees of their Leased Area(s) as agent of the Growers.

22. The Lessor and Project Manager may waiver or reduce lease rental and management fees (at paragraphs 23.5 to 23.9). The Directors of the Project Manager have given an undertaking that this clause will only be invoked in the case of permanent damage or destruction of the trees.

Fees

23. The Growers will make the following advance payments per Leased Area for the first year of operation:

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an initial management fee of $11,800 to the Project Manager that has been allocated (item 3(a) of the Schedule) as $4,250 for the purchase and establishment of tree seedlings; and a manager's fee of $7,550 for management of the forestry Project from the date of commencement to 30 June 2000; and

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lease rental of $750 to the Lessor for the lease of the Grower's Leased Area of the plantation from the date of commencement to 30 June 2000.

24. The Growers will make the following advance payments per Leased Area in subsequent years for the remainder of the fifteen year project period:

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a management fee to the Project Manager set at $4,300 for the year ended 30 June 2001, $2,770 for the year ended 30 June 2002 and $1,150 for the year ended 30 June 2003. This last fee will be increased in subsequent years by the greater of three percent or the percentage increase in the Consumer Price Index (All Groups) Perth from the immediately preceding year; and

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a lease rental to the Lessor of $750 for the year ending 30 June 2001, and thereafter increased by Consumer Price Index (All Groups) Perth from the immediately preceding year.

Finance

25. Finance is not offered in the Prospectus. Growers can fund the investment themselves or borrow from an unassociated lending body. No entity involved in the Project is involved in the provision of financing for the Project. Nor are there any 'preferred lenders' being promoted by the Project Manager. Financing arrangements organised directly by a Grower with a lender are outside the arrangements to which this Ruling applies. There is no agreement, arrangement or understanding between any entity or party associated with the Project and any financial or other institution for the provision of any loan or finance for the Grower for any purpose under the Project.

Ruling

26. For a Grower who invests in the Ord River Sandalwood Project No 2 the following deductions will be available:

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lease rental paid by the Grower in relation to the Leased Area will be an allowable deduction in the year incurred (section 8-1 of the ITAA 1997); and

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management fees paid for the services outlined in the Lease and Management Agreement will be allowable deductions to the Grower in the year incurred (section 8-1 of the ITAA 1997).

Sections 82KZM and 82KL; Part IVA

27. For a Grower who invests in the Project the following provisions have application as indicated:

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the expenditure by Growers does not fall within the scope of section 82KZM;

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section 82KL does not apply to deny the deductions otherwise allowable to the Growers; and

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the relevant provisions in Part IVA will not be applied to cancel a tax benefit obtained under a tax law dealt with in this Ruling.

Explanations

Section 8-1: lease rental and management fees

28. Consideration of whether lease and management fees are deductible begins with the requirements under paragraph 8-1(1)(a). This consideration proceeds on the following basis:

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the outgoing in question must have a sufficient connection with the operations or activities that directly gain or produce the taxpayer's assessable income;

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the outgoing is not deductible under paragraph 8-1(1)(b) if it is incurred when the business has not commenced; and

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where a taxpayer contractually commits themselves to a venture that may not turn out to be a business, there can be doubt about whether the relevant business has commenced and, hence, whether paragraph 8-1(1)(b) applies. However, that does not preclude the application of paragraph 8-1(1)(a) in determining whether the outgoing in question would have a sufficient connection with activities to produce assessable income.

29. An afforestation scheme can constitute the carrying on of a business. Where there is a business, or a future business, the gross sale proceeds from the sale of timber from the scheme will constitute gross assessable income in their own right. The generation of 'business income' from such a business provides the backdrop against which to judge whether the outgoings in question have the requisite connection with the operations that more directly gain or produce this income. These operations will be the planting, tending, maintaining and harvesting of the trees.

30. Generally, a Grower will be carrying on a business of afforestation where:

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the Grower has an identifiable interest in specific growing of trees coupled with a right to harvest and sell the timber;

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the afforestation activities are carried out on the Grower's behalf; and

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the weight and influence of the general indicators of a business, as used by the Courts, point to the carrying on of a business.

31. The Lease and Management Agreement gives Growers an identifiable interest in specific trees and a legal interest in the leased land. Growers have the right personally to take possession and sell the trees attributed to their Leased Area or they may use the Project Manager to sell the trees on their behalf. Growers have a continuing interest in the trees from the time they are acquired until the end of the Project. There is a means to identify in which the trees the Growers have an interest.

32. Under the Lease and Management Agreement Growers appoint the Project Manager to provide services such as planting, cultivating, tending, fertilising, replanting, spraying, maintaining and otherwise caring for the trees according to good silvicultural practice. The Project Manager is also responsible for harvesting the trees.

33. Growers have an obligation to use the land in question for afforestation purposes and to have the Project Manager come onto the land to carry out its obligations under the Lease and Management Agreement. The Growers' degree of control over the Project Manager, as evidenced by the Agreement and supplemented by the Corporations Law, is sufficient. Under the Project, Growers are entitled to receive regular progress reports on the state of the tree crop and the Project Manager's activities. Growers are able to terminate arrangements with the Project Manager in certain instances, such as where the Project Manager fails to perform its services in a proper or efficient manner. The activities described in the Lease and Management Agreement are carried out on the Growers' behalf.

34. The general indicators of a business, as used by the Courts, are described in Taxation Ruling TR 97/11. Positive findings can be made from the arrangement's description for all the indicators. Growers to whom this Ruling applies intend to derive assessable income from the Project. This intention is related to projections contained in the Prospectus that suggest the Project should return a 'before-tax' profit to the Growers, i.e., a 'profit' in cash terms that does not depend in its calculation, on the fees in question being allowed as a deduction. The Independent Forester's assessment was that the silviculture systems to be used to grow sandalwood in this project are well thought out and are based on experience gained at Kununurra as well as overseas; plantation yields used in projections of the Prospectus are reasonable and consistent with expectations; and the knowledge and experience of the Project management team provides confidence for a successful venture.

35. Growers will engage the professional services of the Project Manager with appropriate credentials. There is means to identify which trees the Growers have an interest in. These services are based on accepted silvicultural practices and are of the type ordinarily found in afforestation ventures that would commonly be said to be businesses.

36. Growers have a continuing interest in the trees from the time they are acquired until harvest. The afforestation activities, and hence the fees associated with their procurement, are consistent with an intention to commence regular activities that have an 'air of permanence' about them. The Growers' afforestation activities will constitute the carrying on of a business.

37. The fees associated with the afforestation activities will relate to the gaining of income from this business and, hence, have a sufficient connection to the operations by which this income (from the sale of timber), is to be gained from this business. They will, thus, be deductible under the paragraph 8-1(1)(a). Further, no 'non-income producing' purpose in incurring the fee is identifiable from the arrangement. No capital component is identifiable. The tests of deductibility under paragraph 8-1(1)(a) are met. The exclusions of subsection 8-1(2) do not apply.

Section 82KZM

38. Section 82KZM operates to spread over more than one income year a deduction for prepaid expenditure that would otherwise be immediately deductible, in full, under section 8-1. The section applies if certain expenditure incurred under an agreement is in return for the doing of a thing under the agreement that is not wholly done within 13 months after the day on which the expenditure is incurred.

39. Under the Lease and Management Agreement, the rent and management fee of $12,550 per Leased Area will be incurred on execution of the Agreement. This fee is charged for providing 'initial services' to a Grower only for the period of 13 months from the execution of the Agreement. For this Ruling's purposes no explicit conclusion can be drawn from the arrangement's description, that the fee has been inflated to result in reduced fees being payable for subsequent years. The fee is expressly stated to be for a number of specified services. There is no evidence to suggest that the services covered by this fee could not be provided within 13 months of the fee being incurred. Therefore, it cannot be suggested that the 'thing' to be done cannot be done within 13 months of the fee being incurred.

40. The basic precondition for the operation of section 82KZM is not satisfied and the section will not apply to disallow a deduction for the rent and management fee.

Section 82KL

41. Section 82KL is a specific anti-avoidance provision that operates to deny an otherwise allowable deduction for certain expenditure incurred, but effectively recouped, by the taxpayer. Under 82KL(1) a deduction for certain expenditure is disallowed where the sum of the 'additional benefit' and the 'expected tax saving' in relation to that expenditure equals or exceeds the 'eligible relevant expenditure'.

42. 'Additional benefit' (see the definition of 'additional benefit' at subsection 82KH(1) and paragraph 82KH(1F)(b)) is, broadly speaking, a benefit received that is additional to the benefit for which the expenditure is ostensibly incurred. The 'expected tax saving' is essentially the tax saved if a deduction is allowed for the relevant expenditure.

43. Section 82KL's operation depends, among other things, on the identification of a certain quantum of 'additional benefit(s)'. Insufficient 'additional benefits' will be provided to trigger the application of section 82KL. It will not apply to deny the deduction otherwise allowable under section 8-1 of ITAA 1997.

Part IVA

44. For Part IVA to apply there must be a 'scheme' (section 177A); a 'tax benefit' (section 177C); and a dominant purpose of entering into or carrying out the scheme to enable the relevant taxpayer to obtain a tax benefit in connection with the scheme (section 177D).

45. The Ord River Sandalwood Project No 2 will be a 'scheme'. The Growers will obtain a 'tax benefit' from entering into the scheme, in the form of the tax deductions per Leased Area that would not have been obtained but for the scheme. However, it is not possible to conclude the scheme will be entered into or carried out with the dominant purpose of enabling the relevant taxpayer to obtain this tax benefit.

46. Growers to whom this Ruling applies intend to stay in the scheme for its full term and derive assessable income from the eventual harvesting of the trees. Further, there are no features of the Project, for example, such as the lease rental and management fees being 'excessive' and uncommercial, and non-recourse financing by related entities that might suggest that the Project was so 'tax driven', and so designed to produce a tax deduction of a certain magnitude that it would attract the operation of Part IVA.

Detailed contents list

47. Below is a detailed contents list for this Ruling:

Commissioner of Taxation
2 June 1999

No draft issued

References

ATO references:
NO 99/4043-0

Related Rulings/Determinations:

PR 98/1
TR 92/1
TR 97/11
TR 97/16
TD 93/34

Subject References:
carrying on a business
commencement of business
fee expenses
interest expenses
management fees expenses
primary production
primary production expenses
producing assessable income
product rulings
public rulings
schemes and shams
taxation administration
tax avoidance
tax benefits under tax avoidance schemes
tax shelters
tax shelters project

Legislative References:
ITAA1936 82KH(1)
ITAA1936 82KH(1F)(b)
ITAA1936 82KL
ITAA1936 82KZM
ITAA1936 Pt IVA
ITAA1936 177A
ITAA1936 177C
ITAA1936 177D
ITAA1997 8-1
ITAA1997 8-1(1)(a)
ITAA1997 8-1(1)(b)
ITAA1997 8-1(2)