In one sense, Australia's managed agribusiness industry should be riding high, poised to close a record-breaking year of capital raisings. Research house Adviser Edge expects a record $1.3 billion to be raised in agribusiness managed investment scheme (MIS) projects this year, spread across forestry, horticulture, viticulture, livestock and aquaculture - the highest investment amount since 1999 when $1.2 billion was raised. But the industry is not on a high, thanks to two factors out of its control: one, the continuing drought, and the other, the decision, announced in February, by the Australian Taxation Office (ATO) to remove the tax deductibility from non-forestry investment.
With just under two-fifths of the investment going into non-forestry, it is a worrying time for agribusiness managers. There is a transition period - non-forestry is allowed its tax deductions until June 30, 2008 - and in the meantime, the industry peak body, Agriculture Investment Managers Australia (AIMA), has declared it will mount a test case against the draft ruling by the commissioner of taxation on non-forestry investments (see box). The draft ruling has had two different effects on capital raising this year. "We've seen a bit of a swing back to forestry. Investors know that forestry will retain the current deductibility and the forestry market is still very strong," Adviser Edge managing director Shane Kelly says. The May budget also helped forestry, he says, with the announcement that from July 1 this year, secondary trading of timber investment lots will be allowed.
"Long-rotation (25 years or longer) sawlog plantation MIS vehicles have always been at a bit of a disadvantage in attracting investment, because cash flow takes a long time to come through. Horticulture has been able to offer much shorter periods until cash flow, and then an annuity-style cash flow thereafter, and investors have liked that." He says the secondary trading introduction removes a longstanding impediment to attracting more investment in long-rotation forestry, including pine, structural hardwoods, veneer and tropical timbers such as African mahogany, teak, red mahogany and sandalwood. "Some of the longer-rotation managers say that it is already making it easier for them than it has been in the past. We particularly expect the pine industry to benefit," he says.
"The challenge for the industry is that long-rotation products are not really conducive to a secondary market sale, because existing projects are encumbered by the agreements. Once they start to structure projects where it is actually intended that the product is sold before the end of the rotation, we think investment in long-rotation forestry has a bright future." But the uncertainty hanging over non-forestry has also brought forward investment into the projects, Great Southern corporate affairs manager David Ikin says. "If anything, the question mark hanging over non-forestry after July 2008 is encouraging investment into those products this year. There's a sense that there is a window closing for investors to invest in these annual-income-generating projects that can run for 20 years. Both the interest in and the demand for these projects has intensified," Ikin says.
Kelly says investors now view agribusiness as an investment class in its own right, one that is not correlated with the stock, property or bond markets, and can be expected to deliver strong returns over time. Most managed agribusiness schemes show pre-tax returns of between 6 and 12 per cent a year: forestry projects have delivered 6-8 per cent before tax, with horticulture schemes showing generally higher pre-tax returns, at 8-12 per cent a year, depending on the commodity, he says.
"The industry has met this increased sophistication by offering a far more diversified menu of product offerings than there was two or three years ago. This has enabled investors to diversify their portfolio across managers, forestry and non-forestry, regions, species, and also to have a spread of projects coming into positive cash flow at different times. They can do this because over the last two to three years we've seen a lot more short-term projects, in an agribusiness sense, which only take three to six years to achieve positive cash flow," he says. Research house Australian Agribusiness Group (AAG) director Tim Lee says investors can set up blended portfolios where the cash flows start in year one. "The Australian Bight Abalone project, for example, will harvest its first crop later this year ahead of schedule. One of the major changes we've seen in the last five years is the support for horticulture and viticulture projects because people want annuity-style income, starting in year three to six, to combine that with the lump-sum maturities they get from traditional timber projects to achieve diversification of cash flows," Lee says. "You could start with abalone, which is perhaps the shortest-term project, move into fruit and end up with timber, and you would have annual cash flow while your timber is growing."
This year, says Kelly, a new level of diversification has emerged. "Water security is a bigger issue than ever before, and it has effectively become another level of diversification within a managed agribusiness portfolio. We're focusing very strongly with our dealer group clients in making sure that they're very conscious of the risk of over-weighting to geographical areas where there is heightened risk, for example the Murray-Darling Basin," he says.
"It may be that their recommended list already has significant exposure to one of the systems that is at risk, and we're saying that they need to look at diversifying that risk away by having different types of products on their approved list. The spread of projects around the country helps this: there are agribusiness projects in every state and the Northern Territory, and every region has a different situation with regard to water availability. The dealer groups are all looking to establish greater diversification now to lessen clients' overall risk - either by investing in other regions or adding other crops to their portfolios.
"You could have a spread of projects that took in, say, high-value timber, macadamias and tropical fruit in Queensland; Rewards Group's groundwater-fed tropical fruit in south-western Western Australia; and the sandalwood projects of ITC and Tropical Forestry Services up on the Ord River. You're getting diversification across regions, managers and industries, but you're also getting water availability diversification." Water security has played a big part in the ratings that projects have been given, he says, and projects on secure groundwater systems have been rated higher than they may have been in previous years.
Ikin says there are several ways managers can demonstrate water security. "We have projects like our almonds project at Hillston, in New South Wales, for example, that is fed by bore water. Other projects, for example, our wine grape project, are spread geographically: the vineyards are spread across four states, not all of which are suffering dry conditions. We manage the risk through this diversification and it becomes another level of diversification for the investor," he says. Horticulture and viticulture managers also spend many millions of dollars on water harvesting infrastructure, he says. "We can capture and store rain on their properties so that we can irrigate the crops through the year. It's another way that agribusiness MIS managers, or more broadly corporate agriculture, can get around some of the problems that have a huge impact on a family farmer who doesn't have the capital to invest in that sort of infrastructure. We see it as another benefit of the business model," he says.
Macquarie Alternative Assets Management actually insured its almond crop against drought effect, striking a deal with insurer Swiss Re to cover investors in the Macquarie Almond Investment 2007 project for lost returns and the cost of replanting. It is the first agribusiness manager to insure against drought effect. "Investors are worried about water, and it's our role as project managers to give them comfort that we can deal with that issue. We've worked hard to conserve water and carry it forward into the current year, so we have more water than we need for the current year and we can withstand a partial allocation out of the Murray system down to fairly low levels; but people are still looking for the ultimate comfort - which is why we did the insurance policy. If rainfall falls below a certain level and we don't get water into the Murray, and our trees die, the insurance will pay out," Macquarie Alternative Assets Management director Anthony Abraham says.
Abraham says investors are torn over the idea that there may only be two years of horticulture left. "They don't want to miss out on it, but they're spooked by the drought. We think our insurance policy has put advisers in a position where they can make that investment, without exposing their clients to drought risk," he says. Another trend in the market this year, says Lee, is projects closing earlier, usually over-subscribed. "We see this as a very healthy development that the projects are not relying on money coming in at the end of the tax year, they're open all year round," Lee says.
"Great Southern's beef cattle project, for example, was a very popular project, and closed early. I think investors understand the beef industry - they're eating it often enough - and they also know that we've seen very good returns in the large pastoral sector over the last few years. I think that's had a lot to do with how that particular project was received." Some of the aquaculture projects - for example Australian Bight Abalone and Arafura Pearls - also closed early and fully subscribed. "They were very strongly supported. It might have had something to do with the fact that investors had concerns about water security in a lot of projects - but one thing that Australian Bight Abalone and Arafura Pearls certainly had going for them was water security." Lee says. Tax uncertainty hits MIS market
Managed agribusiness schemes (known as managed investment schemes (MIS)) are tax-effective investments because investments in them are fully tax deductible in the year in which they are made. This deduction has arisen because the Australian Taxation Office (ATO) considered the investors to be primary producers, carrying on an agricultural, forestry, horticultural, aquacultural or viticultural business to produce assessable income. Thus, the investment was tax deductible in the year in which it was made because the expenses were being incurred before the income was received. This was formalised by the ATO's system of product rulings, introduced in 1998, which gave a product ruling stating a particular project had been granted full deductibility.
But in February, Revenue Minister Peter Dutton dropped a bombshell on the managed agribusiness industry, informing it that the ATO had changed its mind, deciding instead that investors in non-forestry MIS investments would no longer be able to claim up-front deductions for their contributions on the basis that they were "carrying on a business".
Dutton's announcement was followed in April by the release by the tax commissioner of a draft taxation ruling (TR2007/D2) entitled "Income tax: registered agricultural managed investment schemes". In the draft ruling, the commissioner ruled that in a registered agricultural MIS: the investor's contributions are not expenses incurred in carrying on a business but are contributions of a capital nature; the investors are beneficiaries of a trust; and the investors are passive investors who do not carry on a business. The effect of the change of interpretation of the current law would mean that after July 1, 2008, a new investor in such a scheme would no longer be able to claim tax deductions for contributions on the basis that the investor was carrying on a business. (Agribusiness MIS with an existing product ruling would not be affected.)
"It is an understatement to say that the industry was surprised by the Minister's announcement and the subsequent draft ruling," Great Southern corporate affairs manager David Ikin says. "For more than a decade, the ATO has issued product rulings for the industry's products, and suddenly, without any court case that set a new precedent or any legislative change, the ATO had a complete change of heart." The ATO has proposed to expedite a test case through the Federal Court before the end of 2007/08. It called for submissions on the draft ruling from the industry, which closed on June 1. Members of Agriculture Investment Managers Australia (AIMA) - which comprises Macquarie, Great Southern, Timbercorp and Rewards Group - all lodged legal opinions. AIMA members believe the opinions support its contention that the draft ruling directly contradicts case law, and that if, after reading these opinions, the commissioner were to seek to test the draft ruling in court, the ATO - and by extension the Government - would be embarrassed in court.
"The emphatic advice that we have is that the industry would win a test case," Ikin says. "We have advice from seven top law firms that is unanimous in its condemnation of what the tax commissioner has done. We are quietly confident of the outcome of the test case, but in the meantime we have to face the fact that as things stand, from the middle of next year we will not be able to use the MIS structure for investments in non-forestry projects." In legal opinions received by AIMA members, law firm Piper Alderman says the commissioner has "misapplied the law" in making his three key rulings. The draft ruling, Piper Alderman says, "flies in the face of the case law including those cases quoted by the commissioner in support of his propositions". Former federal attorney-general Daryl Williams QC says in a legal opinion that the commissioner's three key contentions are "not consistent with current judicial authority".
In addition, Williams says that in his opinion it is "inappropriate and wrong for the commissioner to contemplate issuing a ruling which is not based on the existing law, as the courts have interpreted the legislation, but on what the commissioner would like the law to be". "It is even more inappropriate and even more wrong for the commissioner to be contemplating issuing such a ruling when most of the basis of his view of what he would like the law to be has been put in submissions to the Federal Court and its Full Court and been rejected by those courts. This involves the commissioner arrogating to himself the roles of both the Commonwealth Parliament and the federal judiciary," he says.
AIMA members believe there has not been a Federal Court decision that should allow the ATO to change its view: and the commissioner is obliged to heed the way the courts have interpreted the law. AIMA says it is confident its legal opinions would support a multi-million-dollar claim for compensation under the federal Compensation for Detriment Caused by Defective Administration rules. AIMA says its members' businesses have been affected financially by the uncertainty engendered by the draft ruling. In the case of members whose shares are listed on the Australian Securities Exchange, the loss of market value potentially runs into billions of dollars.
