Chapter 15 – Forestry
15.1 Overview
A number of events in the forest life cycle give rise to taxable forestry income. Clearly, this includes the net proceeds of sales, including felled timber and thinnings etc. In addition, sales or transfers of forestry or cutting rights are also taxable.
The forestry regime also contains special rules for deduction of forestry expenditure. Ordinarily, expenditure on long-term assets (such as forestry assets) would either be depreciable over the life of the assets, or perhaps (as in the case of trading stock), deducted when the asset was sold. To encourage the expansion of New Zealand forests, this industry is treated as an exception and much of the forestry expenditure is deductible up front when it is incurred rather than only being deductible at the end of the project. These immediate deductions are of benefit if they can be offset against other income you may have. This ability to offset deductions against other income will often depend upon the structure of the forestry activity. Some costs are required to be capitalised to the Cost of Timber Account and deducted from the proceeds of sale of the trees.
15.2.1 Taxation of Forestry Transactions
15.2.2 Forestry Expenditure
15.2.2.1 Expenditure Deductible in the Year Incurred
15.2.2.2 Expenditure to be Capitalised and Depreciated
15.2.2.3 Non-Deductible Expenditures
15.2.3 Structuring a Forestry Business
15.2.3.1 Sole Trader
15.2.3.2 Partnership
15.2.3.3 Forestry Joint Ventures
15.2.3.4 Corporate Structures
15.3.1 Business
15.3.2 Standing Timber
15.3.3 Structure of Investment
15.3.4 Spreading of Income from Timber Sales
15.2 Application
The Income Tax Act imposes tax on forestry transactions. The following transactions are subject to tax:
all profits or gains on the sale or transfer of cut or standing timber
all profits or gains on the sale or transfer of “Rights To Take Timber”
As a result a comprehensive range of forestry transactions is subject to tax. Income from the sale of timber may in some cases be spread over the current and 3 preceding income years. Specific provisions in the Income Tax Act also regulate the expenditure deductions.
Forestry expenditure is deductible for taxpayers who conduct a forestry business. This gives rise to a significant issue for passive forestry investors. The Department has issued a tentative guideline suggesting that a forestry activity of less than two hectares may not constitute a forestry business.
Taxation of forestry transactions and deductions for forestry expenditures are discussed below. In addition we briefly outline structures available for conducting a forestry business.
15.2.1 Taxation of Forestry Transactions
Sales of standing timber or harvested timber are subject to taxation. This applies whether the timber is mature or not.
Also subject to taxation is the sale or transfer of forestry rights.
This includes transfer of licences, easements or other rights to take timber. These concepts are rather technical but can be illustrated with a few examples:
Example
an owner of trees (let’s say a farmer with trees on the farm) grants a cutting right to a sawmill company for $200,000. The trees will not be cut for another 5 years. The original cost of the trees was $2,000. The profit on sale of the cutting right is fully taxable to the farmer
two years after purchasing the cutting right, the sawmiller decides that they no longer have the capacity to cut and mill the trees. The sawmiller sells the cutting right for say $350,000 to a local timber merchant. The sawmiller’s profit on transfer of cutting rights is also taxable
another common transaction concerns the transfer of land that includes standing timber. For example, a vendor sells a 20ha block of land. Approximately 2ha of this land contains 10-year-old pine trees. The sale and purchase contract does not allocate the purchase price between land and standing timber. Is the vendor liable for tax on this transaction?
In this example, the vendors believe they have derived a tax-free capital gain on the sale of land. The purchaser on the other hand argues that part of the purchase price was attributable to standing timber. The Department has the power to allocate the purchase price between the timber and the land and assess the vendor on the gain on selling the standing timber
Note, owners of forested land are able to grant themselves a forestry right without tax consequence.
Example
The owner of land may grant himself a forestry right and then sell the underlying land to a new purchaser. The creation and grant of the forestry right to the original owner should not be taxable. (As with all significant tax matters, take professional advice).
15.2.2 Forestry Expenditure
Forestry expenditure may be either:
deductible in the year incurred
capitalised and depreciated
entirely non-deductible
The tax treatment of typical forestry expenditure is outlined below.
15.2.2.1 Expenditure Deductible in the Year Incurred
Expenditure incurred in planting or maintaining of trees is deductible. These costs include:
the purchase price of seedlings
the costs incurred in planting the seedlings
the costs of sprays and granules
other maintenance costs including pruning and thinning
rents, rates, insurance premiums and most of the overheads relevant to the forestry operation
pest, disease and weed control, and fertiliser application undertaken subsequent to the planting of the forest
interest costs incurred in financing forestry operations
interest costs incurred in funding the purchase of partnership units or shares in a forestry company
the costs of constructing temporary access tracks. This assumes the track is to be used for no more than 12 months after construction
repair or maintenance of plant, machinery or equipment used for the purposes of the business
15.2.2.2 Expenditure to be Capitalised and Depreciated
The following expenditure on forestry operations is required to be capitalised and depreciated:
construction of roads lasting for more than 12 months
land preparation costs. These include destruction and removal of scrub and other vegetation in preparing the land for tree planting
eradication or extermination of animal and vegetable pests to enable tree planting to occur
draining of swamp and low lying lands in preparation of tree planting
the construction of metalled or sealed roads and associated culverts and bridges
the construction of dams, stop banks and irrigation works for the purpose of conserving or containing water or preventing soil erosion
the repair of flood or road damage
the sinking of bores or wells for the purpose of supplying water to the land
the construction of aeroplane landing strips to facilitate top dressing, disease and fire control
fences constructed on the land
electric power or telephone lines erected on the land
These items of expenditure are capitalised and generally depreciated. The depreciation rates range from 5% to 20%.
15.2.2.3 Non-Deductible Expenditures
The cost of acquiring land is non-deductible for the purchaser. The sale and purchase agreement should, however, allocate the purchase price between land and improvements of land. The purchaser may be able to depreciate certain improvements to land. See Chapter 6 “Depreciation” for a discussion on improvements to land.
Other non-deductible costs associated with the purchase of the land include legal costs, land lease costs, survey and valuation costs, feasibility studies and accounting fees.
15.2.3 Structuring a Forestry Business
The prime tax consideration for people involved in a forestry business is the ability to obtain tax deductions for expenditure incurred. In all cases, a deduction for forestry expenditures is only available where the activity constitutes a forestry business.
As referred in Chapter 4 “Assessable Income”, an activity will constitute a business if the taxpayer has the intention of making a taxable profit and conducts the activities in an organised manner. In addition, the scale and extent of those activities must demonstrate a reasonable commitment to the venture.
Many commentators suggest that a 40ha woodlet is a commercially viable forest. Such a forest activity is likely to constitute a business. At the other end of the spectrum, the activity associated with one or two hectares may not constitute a business as the scale and extent of the activities would not meet the criteria of a commercially viable forest. Passive investors who merely provide the equity to enter a forestry partnership or business generally do not satisfy the test “carries on a forestry business”.
15.2.3.1 Sole Trader
A sole trader may conduct a forestry business. Assuming that the requirements for a business are met, forestry expenditure can be readily offset against the sole trader’s other income. This other income may be income from personal services, rental income, interest or dividend income.
15.2.3.2 Partnership
A partnership is a business conducted for profit and carried on by or on behalf of its partners.
If the partnership forestry activity constitutes a business, the question can still arise as to whether the partners themselves are able to obtain forestry expenditure deductions. In most cases a deduction will be available, but you should seek professional assistance before entering into a forestry partnership.
Forestry partnerships are relatively common.
The primary disadvantage of a partnership is that individual partners may be liable for losses and liabilities exceeding their individual contribution to the partnership.
15.2.3.3 Forestry Joint Ventures
Forestry joint ventures are also relatively common in New Zealand. Forestry joint ventures are regulated by the Forestry Rights Registration Act 1993. Forestry joint ventures provide an effective practical method of combining the resources of landowners and investors. Specific legal advice and advice from a forestry consultant should be sought prior to entering into a forestry venture.
The investors in a forestry joint venture will generally invest as either an individual (sole trader) or in partnership with other investors. Refer to comments above on sole traders and partnerships.
15.2.3.4 Corporate Structures
Companies can undertake forestry businesses. Companies offer the advantage of limited liability.
However, because a company is a separate taxpayer for tax purposes, the individual investors in the company cannot deduct the forestry expenditure incurred by the company. See the comments on qualifying companies below.
15.3 Practical Hints
15.3.1 Business
When considering participation in a forestry activity, ensure that the activity constitutes a business (otherwise, a taxpayer may lose the ability to obtain deductions). In this regard, it would be helpful to:
maintain financial records
record decisions made on the management of the forest
operate it in an organised and business-like manner
operate with the intention of making a profit
15.3.2 Standing Timber
If you are involved in the sale and purchase of land containing standing timber, ensure that the sale and purchase contract identifies the value of standing timber. If you do not do this, or if the Department disagrees with your value, they will do their own valuation of standing timber and tax you accordingly. Certain requirements must be satisfied before this exemption applies so consult a tax advisor.
15.3.3 Structure of Investment
When considering participation in a forestry activity, ensure that you can obtain deductions for forestry expenditure. Generally deductions for forestry expenditure can be readily obtained if you conduct the forestry business as a sole trader, partnership or via an LTC or qualifying company. However, in the case of partnerships and qualifying companies, it would be wise to have your financial advisor confirm that expenditure deductions will flow through to the individual participants in the venture.
15.3.4 Spreading of Income from Timber Sales
An election can be made to have gross income from timber sale apportioned over the year of sale and three preceding years. The three preceding years return of income will be reassessed and the Commissioner will set a new date for the payment of increased tax. Generally there should be no use of money interest and late payment penalties (unless the increased tax is not paid by the new date).
Depending on your taxable income for the three preceding years and the amount that will be spread back, you may be in a position to take advantage of lower marginal tax rates. Also, by spreading income back, you will reduce your provisional tax liability for the subsequent year. In order to take advantage of these opportunities, a written notice of election must be filed with the Commissioner, within 12 months of the end of the income year in which the sale takes place.