Look at the product, not the tax

In recent years the capital markets in Australia have been usurped by the federal government. Canberra has created a low inflation environment – a laudable political ambition – which has in turn fed long term bullishness on the equities and capital raising markets.

Remember, though, that low inflation equals low yields, which means that as market capitalisation in many companies soars as a consequence of optimistic market sentiment, price earnings ratios begin to look a little ropey.

Then, just when you thought the conditions were near perfect for capital raisings, the government literally takes over the

capital markets by selling off large chunks of Telstra and other state-owned businesses.

These market conditions, and a genuine desire on behalf of the government to promote regional development through agri-business projects, have combined to make tax effective projects a low risk, potentially high yield investment.

Having said that, the Australian Taxation Office is ever vigilant about projects which are all about securing tax deductions rather than being a ‘real’ business, securing tax deductibility to attract investors.

Those projects which fail this simple test will not secure a product ruling.

A product ruling though, does not equate to a well-run, properly structured business and this is why some of the projects are now finding themselves in trouble.

At International Wine Marketing and Management Ltd, our Palandri Wines project flies in the face of traditional thinking about tax effective projects – traditional thinking which has played a considerable role in the downfall of some projects.

Traditionally, many tax effective projects have been based on the cultivation of exotic farm products like pecan nuts or something similar.

With the exception of blue gum plantations which have been a spectacular success, primarily as a consequence of changing political and community values about harvesting old growth forests for wood chipping, many of these exotic projects have failed to deliver to the investor.

Our answer was to take a traditional, known agribusiness – grape growing and wine production.

Rather than just grow grapes and sell them at the farm gate, the crucial difference with the Palandri project was to add value by making, bottling and then marketing the wine that comes from the grapes.

This was the first investment of its kind to move beyond solely primary production. Consequently, the ATO scrutinised our project long and hard before giving it a ruling.

In terms of return on capital, a value-added strategy makes great sense.

At the lower end of the ROC curve, where a product is grown and then sold – and where, incidently, the tax ruling has been traditionally applied – returns on investment are minimal.

At the top end of the ROC curve – where the primary product is turned from a mere commodity into a consumer product – we experience much high and more stable returns on capital.

So, why are some of the other products suffering, at best, low yields and, at worst, collapse?

We consider that such products sought to deliver tax deductions and make that their core business, rather than deliver a core business which attracts tax deductions.

There is a lesson in this for all investors. Look beyond the tax deduction.

While the immediate impact of a 100 per cent tax deduction is highly attractive, an investor has to ask: “What is the real yield?”