Based on his experience and knowledge of other similar Indian sandalwood projects issued by EKS and an organisation he referred to as ITC, Mr Underwood considered that the fees charged to investors were similar across all projects. The project managers of the 2006 ITC sandalwood project charged investors a fee of $3,520 per 0.04 ha for establishment. This equated to $88,000 per hectare. On that comparison, he regarded the fees charged to investors in the project currently under consideration as not excessive.
58 Mr Underwood was cross-examined in relation to his report in the prospectus. He agreed that as of March 1998 there had not been any international sales of Indian sandalwood grown in Australia of which he knew. He was also cross-examined about the adequacy of the provision for replanting and infilling where planted trees had died. He said in his experience most forestry projects nearly always involved an expectation that there would be some need for replanting in the second year. He did not himself inquire as to whether there was such a provision in relation to the EKS project. He just naturally assumed that it would happen. He agreed that the EKS project had suffered early mortality among seedlings in the first wet season immediately after planting. As to the risks which he perceived associated with sandalwood plantations he said:
The tricky aspect with growing Indian sandalwood is that it requires hosts that cut in at different times of the rotation and until you've grown a plantation through to maturity and done everything, you're still basing your experience on the research plots rather than on actual plantations and I've made that clear in every report I've written, that this is a risk that investors need to know about.
He explained the concept of the host in the course of cross-examination. The sandalwood is a parasitic or semi-parasitic tree which attaches its roots to the roots of other trees. When a sandalwood plantation is grown from seedlings through to maturity it is necessary to establish a range of different host species during the 15 year period of the growth. The host trees are planted in amongst the sandalwood, adjacent to the sandalwood trees. Progressively the sandalwood kills the trees of the host species and sucks them dry so that other host species trees are needed to replace them.
59 I accept Mr Underwood's evidence that the set up and management of the EKS plantation project indicated that it was properly conceived and generally properly managed. The question whether fees charged to investors were "excessive" involves normative judgments the basis of which needs to be made clear in order to establish their relevance. In a case such as the present, if the level of entry fees paid is able to be characterised, on objective criteria, as inflated beyond what is relevant to the interests and services being acquired, and the costs, direct and indirect, of providing them, then that fact, in combination with others, may support the conclusion that a dominant purpose for entering the scheme was to acquire a tax benefit. In this case Mr Underwood's opinion about the fees was based upon the range of services provided and in that sense was properly based. Using a criterion of somewhat lesser reliability it invoked comparisons with other Indian sandalwood projects. I accept overall that Mr Underwood did have a proper basis for his opinion that the fees charged were reasonable. Such opinions however are necessarily more qualitative than quantitative in character.
60 Evidence was also called from Mr Anantha Padmanabha who, along with Mr Underwood, had prepared a report which was included in the prospectus. He has over 43 years experience in forestry in India predominantly dealing with sandalwood. There was no challenge to his qualifications or expertise.
61 Mr Padmanabha said the sale price of sandalwood in India over the period from 1990 to 2006 has increased from US$4,000 per ton to US$77,000 per ton. That represented an average increase of 23% per annum. In his opinion the increasing price trend will continue due to the rapid reduction in the supply of Indian sandalwood caused by dwindling production. Demand for the wood is increasing in the domestic market of India and in international markets. The gap between supply and demand is also dramatically increasing.
62 Mr Padmanabha referred to the projected 2014 price in the prospectus which was A$60,000 per ton. The annual percentage price increase for sandalwood over the past 15 years has averaged 23%. This exceeds the forecast 6% inflationary figure used in the prospectus projections. He anticipated that the final price to be achieved by investors in the project on harvest in 2013, based on continuing demand and the current price, may be at least double the prospectus forecast. In cross-examination he said that harvesting and sale of sandalwood is controlled by State governments in India. He agreed that it is a valuable export for that country but said that domestic demand is absorbing about 60% to 70% of production. Sandalwood in India is obtained from natural forests. There are no plantations because private landowners fear the "rigorous rules framed by the Forest Department". They are not willing to raise sandalwood and then just give it to the government. It appears from his evidence that sandalwood marketing in India is effectively controlled by State governments.
63 Mr Padmanabha's evidence can be accepted. As with the evidence of Mr Underwood, it largely went to the commercial viability of the plantation and its genuiness as a commercial operation. Having regard to the express acceptance by the Commissioner in the course of Mr Padmanabha's examination that the genuine commercial nature of the plantation project was not in issue, it is not necessary to say anything other than that the concession is supported by his evidence as well as that of Mr Underwood.
64 I also accept what Mr Padmanabha has had to say about the prospects of high returns from the plantation having regard to trends in the price of sandalwood. Given the trends which he identified and which existed at the time that the prospectus was issued, there was considerable cause for optimism about the future of Indian sandalwood as a commercial export product notwithstanding that the project itself had risks.
65 Evidence as to the soundness of the investment and the fee levels was called from Mr Martin Sammon, again subject to objection as to relevance. Mr Sammon is a chartered accountant who has been involved in the management and appraisal of regional agribusinesses for 25 years. He specialises in business strategy and business planning and has been intimately involved with the formation of a number of viticultural investment projects. From 2001 to 2005 he managed the establishment and development of Lonsdale Securities Ltd's (Lonsec) Alternative Research division. In that time he was engaged in the review of agricultural investments in the Managed Investment Scheme sector. Since 2005 he has worked with Thompson Partners to launch an institutional agribusiness fund, known as the Australian Rural Investment Fund. It is a joint venture aimed at attracting wholesale funds into regional agriculture, processing and infrastructure investment opportunities which meet predefined investment criteria. He was also a member of the Victorian Government Rural Land Stewardship Critical Reference Group. Mr Sammon is currently engaged as a consultant by the holding company for the TFS Group which, under its former name EKS, promoted the East Kimberley Sandalwood Project No 1.
66 Mr Sammon was asked by Mr Lenzo's solicitors to provide an opinion, for the purpose of these proceedings, on the investment offered under the EKS Project No 1 prospectus. He said that the project did not need to rely upon the tax benefits in order to provide a sufficient financial return to qualify as an investment grade product. He carried out his analysis of the project as an investment on a before tax basis. He reviewed the prospectus and applied factors he would normally consider in assessing an agribusiness project. During his employment with Lonsec he had reviewed a number of subsequent TFS Indian sandalwood projects similar to that proposed in this case. He produced reports on those projects. Through the process of reviewing those reports he had become familiar with the management of TFS, the Indian sandalwood market and Western Australian government research on growing Indian sandalwood in Kununurra which preceded the project.
67 In 1984 the Western Australian State Government had established experimental plantations of Indian sandalwood in Kununurra. These demonstrated that Indian sandalwood could be successfully grown in the Ord River Irrigation Area. The most suitable host species and soil type had been identified and the process for the propagation of seedlings from seed stock had been successfully established. There was sufficient evidence in 1998 to be satisfied that Indian sandalwood could be grown as a commercial forestry crop in the Ord. However, the plantation was a pioneering project as no large scale commercial Indian sandalwood plantations had been established in the Ord prior to 1998. Mr Sammon accepted that it is often the case that large scale operations in agriculture disclose problems not evident in smaller scale trial projects or not capable of efficient resolution in large scale operations. The risks of agricultural failure were therefore much higher for this project when compared to more established large scale forestry operations.
68 Mr Sammon considered the initial directors and managers of the project to be appropriately experienced. However he identified, as a major weakness in its early stages, the use of independent contractors located in Kununurra who had had no previous experience with Indian sandalwood and were not adequately trained foresters. He said that since that time EKS had corrected the problem.
69 Mr Sammon gave evidence about the market for Indian sandalwood. He described its outlook as "very bright today due to the dwindling supply and the growing demand from the two power house economies of the world in India and China where Indian sandalwood has been prized for its aromatic oil for centuries". Based on the prospectus forecasts, the project showed strong financial returns on a before tax and before finance basis. The forecast returns were very strong compared to other established forestry projects at the time which were projecting before tax and before finance returns of 6-8% per annum. In Mr Sammon's opinion the assumptions underlying the forecasts were reasonable. The forecast end price for the year 2013 as set out in the prospectus was US$43,132 per ton. At the most recent auction of Indian sandalwood held in Salem, India in March 2006, the average price obtained was US$75,260 per ton. Mr Sammon could not be confident that Kununurra Indian sandalwood would command the same price as Indian grown timber which usually has a higher oil content. However, even if the price obtained by Indian grown timber were to be discounted by 50%, which in his view was an excessive discount, the price projection in the prospectus was not only reasonable but understated.
70 The assumed survival rate of 90% was optimistic and a long term survival rate of 60% would have been more realistic. As to the forecast heartwood yield per tree, that was underpinned by State government research and Mr Underwood's report and was a reasonable assumption.
71 Mr Sammon was of the opinion that the fees charged were reasonable give the balanced management required in successfully establishing an irrigated Indian sandalwood plantation in a remote location of Australia. Although EKS had a significant profit margin on the actual costs of establishing and maintaining the plantation, the forecast financial return to the investors was, in his opinion, still reasonable.
72 Despite the experimental nature of the project in 1998, Mr Sammon considered that the compelling market outlook for Indian sandalwood at that time and the strong financial returns projected made it a project that was suitable as an "Investment Grade" project. The higher risks associated with it were commensurate with the higher returns expected. He described the project as suitable for an investor who was prepared to assume the higher risks in pursuance of the much higher returns that were possible from it compared to the lower returns expected from more traditional forestry projects.
73 It was put to Mr Sammon in cross-examination that out of the initial payment shown on Table 1 in the prospectus, $10,158 of it was not said to meet the initial costs that the manager had to meet. He said in response that he had not had an opportunity to form a detailed assessment of those costs. He didn't have enough information to make a statement of excessive charging but in the context of subsequent TFS projects the fees were reasonable. He said that the Table only showed "direct costs". He was asked in re-examination what indirect costs he had in mind. He said that, in answering that question one would need to know how the total operating costs of the promoter were allocated to the project. He said the promoter had to fund the creation of the underlying farm asset and the project itself. Under the structure of managed investment schemes, those costs get confusing accounting treatment. This seems to give an inflated view of the paper profits that are being made. The tables in the prospectus did not show the cost of land to the promoter or the cost of holding that land or any contingencies.
74 I accept Mr Sammon's evidence. In one respect it goes to the proposition, which is not in dispute, that the project was a genuine commercial project. However the significant issue which he and the other expert witnesses canvassed was whether the "upfront" payments were higher than reasonable for commercial purposes. The answer to that question would be relevant to whether the way in which the payments were structured could be said to have a dominant purpose of obtaining a tax benefit.
Expert evidence in relation to suitability of the investment
75 Mr Lenzo called evidence from Paul Begley, Director, Alliance Investment and Retirement Services Pty Ltd (AIRS). AIRS is the holder of an Australian Financial Services licence. Mr Begley said he is authorised, by that licence, to give advice in relation to listed securities, managed investments, master trusts, superannuation investments, property syndicates and income investments. AIRS specialises in servicing customers with $1 million or more in investment capital. He has himself been a grower of Indian sandalwood with TFS since June 2000 and a shareholder since that time. Mr Lenzo's solicitors had asked him to give evidence on the suitability of the investment in the EKS project number 1 based on the content of its prospectus focussing in particular on projected returns and taking into account the financial circumstances and goals of Mr Lenzo. His evidence was objected to by counsel for the Commissioner. The objection was on the basis that his opinion about the suitability of the investment was not a matter to which the provisions of Pt IVA were directed. The evidence was again received subject to relevance.
76 Mr Begley had been provided with an AIRS financial information questionnaire completed by Mr Lenzo and a worksheet detailing Mr Lenzo's financial position. He also had a copy of the prospectus. He set out his academic and other qualifications and experience in his affidavit. These were not in dispute. He stated his familiarity with pooled managed investment schemes which he described as providing an opportunity to invest in assets and industries that would otherwise be out of the reach of most investors. The pooling of funds provided economies of scale to investors enabling them to acquire interests in assets otherwise beyond their means, access management expertise and reduced management costs.
77 Mr Begley said he had reviewed Mr Lenzo's financial position as it was in June 1998. This was based on information provided in the AIRS financial information questionnaire which Mr Lenzo had completed. His opinion was shortly stated:
The applicant's investment in the Project was a higher risk investment, however projections indicated attractive financial returns on a pretax basis. Depending on the option chosen by the investor the projected returns ranged on a pretax and prefinance basis from 11.81% per annum for the annual fee option and 13.82% per annum for the prepaid option calculated on an internal rate of return basis. Given the applicant's high after tax income giving rise to excess cash flow at the time, his strong asset position which consisted mainly of property, equities and alternative investments, his age, his relatively high tolerance for risk in investing and his relatively low exposure to forestry as an asset class, in my opinion, the Project was a suitable (although relatively small) investment for the applicant to make at the time.
78 Mr Begley's affidavit did not refer to the projected internal rate of return of 16.91% shown in Table 1. He was asked why he didn't consider the rate of return based on the loan financed option which Mr Lenzo had chosen. He said that his objective was just to take a conservative approach. He said it was important in considering investment returns. Considering the returns without "gearing" he was able to compare them with the returns of a balance portfolio which over the medium to longer term he would expect to yield 4% to 6% ahead of inflation, that is to say about 7% to 9%. So he compared the 11.8% and the 13.82% returns shown in the non loan options for assessing suitability of the investment.
79 Mr Begley was aware that the project involved innovative technology. He was also aware that there was no history of the commercial production of Indian sandalwood in Australia and, in particular, in the Kununurra region. He was aware, however, that there had been some prior plantations in Kununurra.
80 I accept that Mr Begley's evidence was a reasonable assessment of the investment and that it is relevant to some of the factors to be considered under s 177D(b). Submissions as to the relevance of his evidence and that of Messrs Sammon and Padmanabha were made in closing by counsel for Mr Lenzo and I refer to those briefly.
Admissibility of the expert evidence
81 Counsel for Mr Lenzo made written closing submissions about the admissibility of the evidence of Messrs Sammon, Begley and Padmanabha. He relied upon the decision of the Full Court in Commissioner of Taxation v Sleight (2004) 136 FCR 211. The Court there upheld the Commissioner's application of Pt IVA. Both Hill and Carr JJ referred to the significance of poor projected financial returns from the particular scheme.
82 The case concerned an investment in a tea tree oil farming project. The Court held, having regard to the eight matters listed in s 177D(b) of the ITAA 1936, that the taxpayers had entered into and carried out the investment scheme for the purposes of obtaining a tax benefit. The Court had regard to the commercial uncertainty of the scheme in concluding that its tax purposes predominated over its commercial purposes.
83 In considering the manner in which the scheme was entered into or carried out for the purposes of s 177D(b)(i), Hill J observed that the commercial investment in tea trees was attendant with risk. Without the tax benefits which the prospectus predicted "the commercial returns were far from encouraging" (at [75]). Carr J, in considering the "form and substance of the scheme" for the purpose of s 177D(b)(ii) referred to "what can only be described as miniscule projected returns over a long period of time from a venture which on all the evidence involved significant risk so described in the Prospectus" (at [216]).
84 At first instance in Calder v Commissioner of Taxation (2005) 59 ATR 655, Nicholson J relied upon expert evidence of the poor projected returns (when properly calculated before tax and before finance) as a significant factor attracting the application of Pt IVA:
However as to factor (2) Mr Langridge's evidence was that the Project relied upon the tax deductibility and effect of the initial payments and the gearing up provided by the loan to show any rate of return. In those circumstances it cannot be objectively found that the dominant purpose of the applicant's entry into the scheme was to enable the applicant to make a commercial investment: the tax benefit was the key to the commerciality of the scheme.
85 Counsel for Mr Lenzo submitted that the evidence of Messrs Sammon and Begley confirmed that the internal rate of return forecast was 13.82% per annum before tax and before finance where the applicant pre-pays the maintenance and rent fees. Their unchallenged evidence was that the projected returns from the project were commensurate with the risks. Mr Sammon's unchallenged evidence was that the project was an "Investment Grade" investment without any reliance being placed on tax benefits and that the project showed strong financial returns on a before tax and before finance basis.
86 Counsel also pointed to Mr Padmanabha's evidence of an increase in demand for Indian sandalwood and the increase in average price. He also submitted evidence that the EKS project was suitable to Mr Lenzo's particular financial circumstances and that it did not rely on tax benefits and financing to show an acceptable return was relevant to whether Mr Lenzo could be regarded as having had a dominant tax purpose. Such evidence, it was submitted, was an objective fact to which regard must be had in considering whether Mr Lenzo had a dominant tax purpose and, in particular, in considering the manner in which the scheme was entered into or carried out, the form and substance of the scheme and the change in the financial position of Mr Lenzo that had resulted, would result, or might reasonably be expected to result, from the scheme.
87 The evidence of Messrs Sammon, Padmanabha and Begley was objected to on grounds of relevance only. In my opinion the evidence was relevant and therefore admissible.