Private ruling: Managed Investment Scheme - Forestry
Date of advice: 1 October 2015
Published: October 2015

Ruling: Q6: Does Part IVA of the ITAA 1936 apply to deny deductions for the expenditure incurred by the taxpayer under the project arrangements? Summary The relevant provisions in Part IVA of the ITAA 1936 will not be applied to cancel a 'tax benefit' obtained under a tax law dealt with in this Ruling. Detailed reasoning For Part IVA of the ITAA 1936 to apply there must be a 'scheme' (section 177A of the ITAA 1936), a 'tax benefit' (section 177C of the ITAA 1936) and a dominant purpose of entering into or carrying out the scheme to obtain a tax benefit (section 177D of the ITAA 1936). The project will be a 'scheme' and the taxpayer will obtain a 'tax benefit' from entering into the 'scheme', in the form of tax deductions for the amounts detailed in the table above. However, it is not possible to conclude the scheme will be entered into or carried out with the dominant purpose of obtaining this tax benefit. The taxpayer will derive assessable income from holding or disposing of their 'forestry interest' in the project. There are no facts that would suggest that the taxpayer have the opportunity of obtaining a tax advantage other than the tax advantages identified in this Ruling. There is no non-recourse financing and no indication that the parties are not dealing at arm's length or, if any parties are not dealing at arm's length, that any adverse tax consequences result. Further, having regard to the factors to be considered under paragraph 177D(b) of the ITAA 1936 it cannot be concluded, on the information available, that the taxpayer will enter into the scheme for the dominant purpose of obtaining a tax benefit.




Question 1: Will the establishment fee for the tree lots paid by the taxpayer on execution of the project agreement on or before 30 June be an allowable deduction under Division 394 of the Income Tax Assessment Act 1997 (ITAA 1997)? | The establishment fee for the tree lots paid by the taxpayer on execution of the project agreement on or before 30 June be an allowable deduction in that income year under Division 394 of the ITAA 1997 subject to: | • all of the trees under the project being established within 18 months of the execution of the project agreements, and | • a capital gains tax (CGT) event does not happen in relation to the taxpayer's forestry interest on or before 30 June within four years of the execution of the project agreement. | Question 2: Will the fees paid under the project agreements, be allowable deductions under Division 394 of the ITAA 1997 for the taxpayer? | The fees, paid under the project agreements, are an allowable deduction under Division 394 of the ITAA 1997 for the taxpayer as an initial participant in the project: | • the performance fee in the income year in which the taxpayer is entitled to gross proceeds of sale and the performance fee is paid from those proceeds, | • the selling and marketing fee in the income year in which the taxpayer is entitled to proceeds and the selling and marketing fees are paid from those proceeds, | • the property management fee in the income year in which it is paid, | • annual rent incurred under the lease agreement in the income year in which the annual rent is paid from the year after the execution of the project agreements, and | • amounts payable under the annual deferred investment options in the income year in which the taxpayer is entitled to proceeds and the deferred fee is paid from those proceeds. | Detailed reasoning for question 1 and 2: Section 8-5 of the ITAA 1997 (all subsequent legislative references are to this Act unless otherwise specified) allows certain specific deductions to be claimed against the assessable income of a taxpayer. The list of specific types of deductions are set out in a table in section 12-5 and includes payments under a 'forestry managed investment scheme' that meet the requirements of subsection 394-10(1). | Subsection 394-10(1) provides that the taxpayer can deduct an amount if: | (a) you hold a forestry interest in a forestry managed investment scheme; and | (b) you pay the amount under the scheme; and | (c) the scheme satisfies the 70% DFE rule (see section 394-35) on 30 June in the income year in which a participant in the scheme first pays an amount under the scheme; and | (d) you do not have day to day control over the operation of the scheme (whether or not you have the right to be consulted or give directions); and | (e) at least one of these conditions is satisfied: | (i) there is more than one participant in the scheme; | (ii) the forestry manager of the scheme, or an associate of the forestry manager, manages, arranges or promotes similar schemes; and | (f) the condition in subsection (4) is satisfied. | Subsection 394-15(2) provides that an entity that manages, arranges and promotes a forestry managed investment scheme is a forestry manager of the scheme. A scheme will be 'a forestry managed investment scheme if the purpose of the scheme is for establishing and tending trees for felling in Australia' (subsection 394-15(1)). A forestry interest is held in a forestry managed investment scheme where there is a right to benefits produced by the scheme (subsection 394-15(3)). | The deductibility of the establishment fee, under subsection 394-10(1), remains subject to the requirement that: | • the manager establishes all of the trees under the project within 18 months of the end of the income year in which the taxpayer becomes a participant in the scheme, and | • a CGT event does not happen in relation to the 'forestry interest' that the taxpayer holds as an initial participant before 1 July within four years of the execution of the project agreement. | The establishment fee is deductible in the income year in which it is paid, or it is paid on the taxpayer's behalf as an initial participant (subsection 394-10(2) and section 394-20). This requires cash to flow from the taxpayer, or from another entity on the taxpayer's behalf, to the manager's bank account in the year in which the deduction is claimed. Any form of payment that does not involve the movement of cash into the manager's bank account will not qualify for a deduction under subsection 394-10(2). | The taxpayer is a participant in the project, which meets the definition of a 'forestry managed investment scheme', and holds a 'forestry interest' in the Project. In consideration for payments the taxpayer makes, in respect of the taxpayer's forestry interest in the project, trees are intended to be established pursuant to the project agreement. As a result the taxpayer holds their forestry interest in the scheme as an initial participant in satisfaction of subsection 394-15(5). | Paragraph 394-10(1)(c) states that the scheme must satisfy the '70% DFE rule' on 30 June in the income year in which a participant pays an amount under the scheme. Under that rule it must be reasonable to expect that in the income year of the execution of the project agreement, the amount of 'direct forestry expenditure' (section 394-45) under the scheme will be no less than 70% of the amount of payments under the scheme (subsection 394-35(1) and section 394-40). | The amount of all 'direct forestry expenditure' is the amount of the net present value of all 'direct forestry expenditure' that the responsible entity, as 'forestry manager' (section 394-15(2)) of the project, has paid or will pay under the scheme (subsection 394-35(2)). | The taxpayer has contracted the manager to carry out the day to day operation of the project. The taxpayer is the only participant in the scheme; however, the manager, satisfies the definition of 'forestry manager' is subsection 394-15(2),. The condition is subparagraph 394-10(1)(e)(ii) is therefore satisfied. | Pursuant to the project agreement, the manager will cause the establishment services to be completed within 18 months of the execution of the project agreement, in satisfaction of the requirement in paragraph 394-10(1)(f) and subsection 394-10(4). | Accordingly, subject to the qualifications set out below, amounts paid by the taxpayer to the manager in relation to the taxpayer's 'forestry interests' satisfy all requirements of subsection 394-10(1). The amounts are allowable deductions in the income year in which they are paid (subsection 394-10(2)). However, whether registered for Goods and Services Tax (GST) or not, the taxpayer cannot treat GST payments as a payment under a forestry managed investment scheme (paragraph 394-40(d)). | Where the taxpayer does not fully pay an amount, or the amount is not fully paid on their behalf in an income year (see section 394-20), it is deductible only to the extent to which it has been paid. The unpaid balance is then deductible in the year or years in which it is actually paid. This may occur, for example, if all or part of the amount is borrowed and the financier fails to transfer the funds to the account of the 'forestry manager' on or before 30 June in an income year. | Loss of deductions previously allowed under subsection 394-10(1): Two situations may lead to a loss of deductions previously allowed to the taxpayer under subsection 394-10(1). | The first of these situations will occur if the condition in subsection 394-10(4) is not met in relation to the Project. That is, the manager fails to establish all the trees on the project land within 18 months of execution of the project agreements. Where this occurs the manager is required to notify the Commissioner within three months of the 18 month period (section 394-10 of Schedule 1 to the Tax Administration Act 1953 ). | The second situation where the taxpayer may have deductions disallowed is where a 'CGT event' happens to their 'forestry interest' within four years after 30 June of the income year they paid an amount under the scheme, for example, the establishment fee (subsection 394-10(5)). | For the purposes of giving effect to subsection 394-10(5), the Commissioner is able to amend the taxpayer's assessment within two years after the relevant 'CGT event'. Subsection 394-10(6) provides that the Commissioner's power to amend in these circumstances applies despite section 170 of the Income Tax Assessment Act 1936 (ITAA 1936). | Where a 'CGT event' happens to the 'forestry interest' held by the taxpayer within four years after the execution of the project agreements, the market value of the forestry interest at the time of the 'CGT event' or any decrease in the market value of the 'forestry interest' as a result of the 'CGT event' is still included in the taxpayer's assessable income pursuant to section 394-25. The amount must be included in the taxpayer's assessable income even where an amendment has disallowed or may disallow the deductions previously allowed under section 394-10. | However, subsection 394-10(5) will have no application where the 'CGT event' happens because of circumstances outside the taxpayer's control and the taxpayer could not reasonably have foreseen the 'CGT event' happening when they acquired the 'forestry interest' (subsection 394-10(5A)). | Under the terms of the project agreement, the establishment fee was payable by 30 June. | Therefore, ensuring all of the above requirements are met the taxpayer can claim deductions for the GST exclusive amount that is paid to the manager (sections 8-5 and 394-10). | Amounts that are allowable deductions under Division 394 cannot also be claimed as deductions under section 8-1 (section 8-10). | Question 3: Will the interest incurred on funds borrowed by the taxpayer as the initial participant to pay the establishment fee be an allowable deduction under section 8-1 of the ITAA 1997? | The interest incurred on funds the taxpayer borrowed as an initial participant to pay the establishment fee is an allowable deduction under section 8-1 in the year in which the interest is incurred. | For an amount to be deductible it must satisfy conditions set out in section 8-1. Section 8-1 states you can deduct from your assessable income any loss or outgoing to the extent that: | (a) it is incurred in gaining or producing your assessable income, or | (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. | Where the taxpayer, as an initial participant, borrows money to fund their investment in the project, the deductibility of the interest incurred on the loan monies falls for consideration under the general deduction provisions of section 8-1. If the interest incurred by the taxpayer is deductible under the first positive limb in paragraph 8-1(1)(a) there is no requirement to consider whether it is also deductible under the second positive limb in paragraph 8-1(1)(b). Court decisions show that the same basic test applies to both limbs of section 8-1 (see Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15). | Under the first positive limb in paragraph 8-1(1)(a), the interest incurred by the taxpayer will be deductible if it is incurred in gaining or producing the taxpayer's assessable income and is not excluded by one of the negative limbs in subsection 8-1(2). Whether an outgoing is deductible has been the subject of significant judicial consideration, some of which have relevantly noted: | The question of whether an outgoing [is] ... incurred in gaining or producing the assessable income is a question of characterisation' ( Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1 at 17; [1991] HCA 42 at paragraph 23 ( Fletcher) ). | To the extent that ... outgoings of interest ... can properly be characterised as of a kind referred to in the first limb of [section 8-1] they must draw their character from the use of the borrowed funds ( Fletcher , at CLR 19; HCA at paragraph 26). | [T]he characterisation of interest will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put ( Federal Commissioner of Taxation v. Roberts (1992) [1992] FCA 363 at paragraph 43; (1992) 37 FCR 246 at 257). | The taxpayer uses the borrowed funds to acquire a 'forestry interest' in a 'forestry managed investment scheme'. The holding of that 'forestry interest' is intended to produce assessable income for the taxpayer, as an initial participant, in the form of the proceeds of a full or part disposal of the 'forestry interest' or, as a proportionate share of the harvest proceeds. The tests for deductibility of interest under the first limb of subsection 8-1(1) are, therefore, met unless one of the exclusions in subsection 8-1(2) apply. | For the purposes of this project, only the capital exclusion in paragraph 8-1(2)(a) is relevant. The use of borrowed funds to purchase a capital asset, such as a 'forestry interest', does not mean that the interest outgoings are on capital account (see Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459 at 470; [1999] HCA 7 at paragraph 29): | Interest [is a] periodic payment for the use, but not the permanent acquisition of a capital item. Therefore, a consideration of the often-cited three matters identified by Dixon J in Sun Newspapers Ltd v. FC of T ... assigns interest ... to revenue ( Australian National Hotels Ltd v. Federal Commissioner of Taxation (1988) 19 FCR 234 at 241; 88 ATC 4627 at 4633-4634; (1988) 19 ATR 1575 at 1582). | Therefore, interest incurred on the loan between the taxpayer and a finance entity will be deductible in the year in which it is incurred pursuant to paragraph 8-1(1)(a) (Note: the meaning of 'incurred' is explained in Taxation Ruling TR 97/7 Income Tax : section 8-1 - meaning of ' incurred' - timing of deductions ). | This does not apply if the finance arrangement includes or has the following features: | • there are split loan features of a type referred to in Taxation Ruling TR 98/22 Income tax: the taxation consequences for taxpayers entering into certain linked or split loan facilities, | • there are indemnity arrangements or other collateral agreements in relation to the loan designed to limit the taxpayer's your risk, | • 'additional benefits' are or will be granted to the taxpayer for the purpose of section 82KL of the ITAA 1936 or the funding arrangements transform the project into a 'scheme' to which Part IVA of the ITAA 1936 may apply, | • the loan or rate of interest is non-arm's length, | • repayments of the principal and payment of interest are linked to the derivation of income from the project, | • the funds borrowed, or any part of them, will not be available for the conduct of the project but will be transferred by any mechanism back to the lender if an associate of the lender, | • lenders do not have the capacity under the loan agreement, or a genuine intention, to take legal action against taxpayer, | • entities associated with the project are involved or become involved in the provision of finance to the taxpayer for the project, or | • the funds are non-recourse or limited resource | Question 4: Will the Commissioner exercise his discretion under Division 35 of ITAA 1997 to allow losses from the project to be offset against other assessable income for the project duration? | The Commissioner will exercise his discretion under Division 35 to allow losses from the project to be offset against other assessable for the project duration. | As the relevant business activity, the project, has commenced, and the taxpayer is carrying on that activity as a business, it is subject to the provisions in Division 35. Information provided with the application for this Ruling, indicates that the taxpayer's business activity is not able to satisfy one of the tests or produce a taxation profit, and is unlikely to do so in the project duration. | Losses from activities that do not meet any of the four tests under Division 35, or the exception in subsection 35-10(4), will be subject to the loss deferral rule in subsection 35-10(2), unless the Commissioner exercises a discretion under paragraph 35-55(1)(b), for each income year in which losses are incurred, on 30 June of that specific income year that it would be unreasonable to defer the loss. | The discretion in paragraph 35-55(1)(b) applies only where you satisfy the income requirement in subsection 35-10(2E) which requires that, for an income year where the sum of their following amounts is less than $250,000: | • taxable income for that year (ignoring any loss arising from the taxpayer's participation in the Project or any other business activity), | • 'reportable fringe benefits total' for that year, | • 'reportable superannuation contributions' for that year, and | • 'total net investment losses' for that year. | The Commissioner will apply the principles set out in Taxation Ruling TR 2007/6 Income tax : non-commercial business losses : Commissioner's discretion when exercising the discretion. | The discretion in paragraph 35-55(1)(b) may be exercised where: | • the business activity has started to be carried on during those income years, | • because of its nature it has not met one of the tests set out in Division 35, and | • there is an expectation that the business activity of an individual taxpayer will either pass one of the tests or produce a taxation profit within a period that is commercially viable for the industry concerned. | The question of whether the taxpayer is carrying on a business is a question of fact and degree. The taxpayer stated that they are carrying on a business and that the business commenced in the year the project agreements were executed. | The taxpayer, as an initial participant, engages the manager to manage the project, plant trees on a commercial scale on the land and to perform maintenance. With the application for this Ruling, the taxpayer provided income projections indicating that the taxpayer's activity will become profitable. On that basis, the Commissioner accepts that the taxpayer demonstrated that they carry on their activity as a business. | It is accepted that it is in the nature of forestry activity that there will be a lead time before a profit can be expected or one of the tests satisfied, and that it is because of the nature of the taxpayer's activity that it will not be able to satisfy one of the tests during the project duration. | The information and the independent evidence the taxpayer provided demonstrates that there is an objective expectation that the taxpayer's business activity will make a profit at the end of the project duration. | In each income year where the Commissioner's discretion is exercised the taxpayer is able to offset a loss arising from their participation in the taxpayer's business activity against the taxpayer's other assessable income in circumstances where if the Commissioner did not exercise the discretion the taxpayer would be required to defer that loss until a later income year under section 35-10. | The Commissioner's discretion under paragraph 35-55(1)(b) has been conditionally exercised for the project duration. | Question 5: Do sections 82 KL and 82KZL to 82 KZMF of the Income Tax Assessment Act of 1936 (ITAA 1936) apply to deny the deductions otherwise allowable? | The following provisions of the ITAA 1936 have application as indicated: | • interest paid by the taxpayer, as an initial participant, to, does not fall within the scope of sections 82KZM, 82KZME and 82KZMF, | • rent paid as an initial participant, to the finance entity, does not fall within the scope of sections 82KZM, 82KZME and 82KZMF and | • section 82KL does not apply to deny the deductions otherwise allowable. | The prepayment provisions contained in Subdivision H of Division 3 of Part III of the ITAA 1936 affect the timing of deductions for certain prepaid expenditure. These provisions apply to certain expenditure incurred under an agreement in return for the doing of a thing under the agreement that will not be wholly done within the same year of income as the year in which the expenditure is incurred. For schemes such as this project, the main operative provisions are sections 82KZMD and 82KZMF of the ITAA 1936. | However, subsection 394-10(7) specifically provides that sections 82KZMD and 82KZMF of the ITAA 1936 do not affect the timing of amounts deductible under section 394-10. | Accordingly, under the scheme to which this Ruling applies, only deductions for interest payable under a loan with the finance entity will potentially fall within the prepayment provisions. However, the conditions applying to the loans to which this Ruling applies do not require any prepayment of interest over the term of the loan. | Deductions for rent under the scheme to which this Ruling applies may also potentially fall within the prepayment provisions. | The operation of section 82KL of the ITAA 1936 depends, among other things, on the identification of a certain quantum of 'additional benefit(s)'. Insufficient 'additional benefits' will be provided, or granted, to the taxpayer to trigger the application of section 82KL of the ITAA 1936. Section 82KL of the ITAA 1936 will not apply to deny deductions otherwise allowable to the taxpayer. | The following provisions of the ITAA 1936 therefore have application as indicated: | • interest paid by the taxpayer as an initial participant, to the finance entity, does not fall within the scope of sections 82KZM, 82KZME and 82KZMF, | • rent paid by the taxpayer as an initial participant, to the finance entity, does not fall within the scope of sections 82KZM, 82KZME and 82KZMF and