This is one part of a three part article on tax efficient schemes. The point of this article is to warn you about dodgy tax schemes that are being flogged by promoters. The other articles in the managed funds FAQ and tax FAQ, deal with more reputable investments in the same sector. Read all three to get the bigger picture.

Tax efficiency is often the overwhelming criteria demanded by high income earners. With an almost pathological obsession with paying less tax, people are willing to invest in all sorts of things that promise to give a return by reducing your tax.

Many of these schemes involve making serious financial losses for many years, before a final profit is realised. At least that is the plan anyway.

"Tax efficient" schemes often come undone because they tend to be very good at the costing you money bit, but not so great at the final payoff bit. The ATO has a nasty habit of disallowing deductions on a variety of loss making schemes, various clauses in the tax act prohibit people from taking part in investment schemes that appear to be done primarily as a way of avoiding tax, so you end up paying the full amount straight out of your pocket with no deductions at all.

The sorts of schemes that frequently end up as "tax efficient" are frequently agricultural. They involve providing venture capital for plantations of various sorts, fish farms and an assortment of breeding programs. Now there is nothing at all wrong with agriculture, and it is true that it costs a lot of money to establish an orchard, and this orchard won't provide any income for many years.

The trouble is that the industry is full of people who do nothing but run around setting these schemes up for a living. The promoters are rarely farmers, they often don't know much about the industry they are setting up, simply looking for a vehicle to create short term negative cashflow, which is good, for someone who is totally obsessed with paying less tax.

(When I first wrote this article a couple of years ago, before the ATO crackdown, this was very true. It is still true today in that there are dodgy people in the industry, but the industry has now largely been purged of the more abusive schemes, though this does not guarantee that all the ones in existence will actually turn a profit.)

Commonly when the pine plantation, or blue-gum plantation, or fish farm or whatever finally does come on line to start producing money, the venture fails to produce the profits promised in the prospectus. When an entrepreneurial ex-MLM promoter wants to set up a pine plantation, rarely will this person bother with such details as making sure the underground water supply and rainfall are sufficient to maintain big pine trees. Rarely do they take the time to get a proper costing done as to how much it will cost to harvest the trees and get them milled. The extent of the analysis is usually to find a big block somewhere and plant a bunch of radiata saplings, write up an impressive looking puff piece based on the retail price of finished pine and get off to the printers to have a run of 10,000 glossy brochures printed.

The promoter then spends a few weeks telemarketing, inviting people to investment seminars or mailing out such information to doctors and resource miners (two groups famous for gullibility in falling for tax minimisation schemes). Cheques are cashed, more bills sent, another holding company is set up via a PO Box in Queensland and another promoter walks away with a 60% commission.

The trouble with these is that the projects were quite intentionally sloppily managed. Nobody particularly cared about the long term investment returns from the crop, investors just wanted a tax deduction. Some of the schemes gave tax deductions even larger than the initial investment. Their failures were virtually guaranteed right from the start, not that this bothered the promoters who charged enormously high fees, the advisers that sold them who were paid generous commissions, or indeed the investors themselves who often got more back in tax savings than they initially spent.

(Today, you often find that an independent forester's report is included with the prospectus. The forester will comment on such issues as rainfall, the profile of the soil, fertiliser requirements, likely growth rates etc. Insist on seeing such a document before you invest in any agribusiness scheme. Most particularly for the largest managers, there is a high degree of due diligence in site selection these days. I wouldn't be too worried about this kind of amateurishness with the big blue gum growers but I'd advise that you should be extremely cautious about investing with some of the smaller operators.)

If you want to invest in a tax efficient investment, there are a number of steps you can take to make sure that the venture is legitimate.

• Make sure that the investment adviser promoting it has an ASIC investment advisory license or is an authorised representative of a licensed securities dealer.

• Make sure that a prospectus has been lodged with ASIC for the scheme.

• The scheme has a specific and current ruling from the tax office. Don't be satisfied that they have a ruling for a similar product, for every single specific tax advantaged product the ATO must have issued a ruling, and make sure it is still valid.

• Independent research houses carry out reviews of different schemes, looking at fees, basic competency in areas like forestry and project management, market demand and other factors. Major research houses covering the sector include Lonsec Research, Agribusiness Research and van Eyk Capital. The number of schemes that get good marks each year tends to be very low, for example van Eyk Capital publishes a list of projects every year that it believes will offer superior returns, this list seldom has more than four projects, even though there are more than 80 in operation in 2002 (down substantially from the time before ATO came down on the industry). van Eyk Capital feel that many projects, while not "dodgy", probably will give inferior after tax returns for investors compared to standard managed funds.

• Avoid anything that promises unusually high returns. If the returns were really as terrific as promised then the thing would probably remain in private hands, not flogged to public investors. If they are trying to sell it to you and offering an extremely high yield then you have to ask yourself why bigger fish aren't biting. The better schemes are realistically promising to deliver returns maybe 2%pa higher than the stock market. You aren't going to get 25%pa out of this sector.

• High pressure sales tactics, or even subtle manipulative "low pressure" tactics like doing favours for you to make you feel obligated. Recently I heard of one operator who was taking a keg of beer to young client's houses and having the guy arrange an "investment party". On these nights the guy was signing up a dozen suitably enebriated young men for insurance and investment products, naturally the guys felt that this particular operator was something of a top sort since he is willing to bring the drinks. I suggest it would probably not be a good idea to go with any adviser that likes to get his clients totally sloshed before selling them something.

Some tips for "tax effective" investments

The majority of the tax dodge schemes that have failed and had the tax deductions subsequently disallowed by the tax office were schemes that made the profit only by tax deductions.

Some of these schemes were simply amazing, for every dollar you invested there were quite a few dollars tax deductible, and investors would get a tax rebate even larger than the initial investment. I have heard of several schemes that paid for themselves three or four times over in the first year because of tax rebates. Now these schemes have been retrospectively disallowed by the ATO, and investors are being forced to pay back all of the money they received as tax deductions beyond the initial investment.

Today, following the ATO crackdown, few projects give tax deductions beyond the initial investment and any ongoing fees you need to pay. The Australian Tax Office issues product rulings that guarantee that investors will be able to claim a full tax deduction, but bear in mind that these rulings are very specific.

If the manager changes anything, there is no guarantee that a deduction can be claimed. If you go for a slightly different finance scheme, if the manager runs out of units in the main scheme and offers you units in a similar project or one of many other changes then the ruling is worthless. Bear in mind also that a ruling implies only that the ATO will let you claim a tax deduction on your initial investment, it doesn't imply that you will actually make money in the end.

If you are on the top marginal tax rate, then the largest amount of money you usually stand to lose is your initial investment, and because of the tax deduction you would get half of that back in your next tax return so I guess one should presume in most cases the worst case return is to lose half of your money, which roughly corresponds to what the stock market can do to you in a couple of years in a really nasty bear market (though if you invest in a single stock you could lose a lot more in a shorter period of time). Sometimes there are other liabilities, so it is a good idea to investigate if you could be on the hook for more money later if the project goes bad.

Because of the high commissions involved in this sector of the industry, if you want to invest in tax effectives it could be more economical to go with a fee for service adviser so the commission is rebated to you.

Agribusiness and film schemes should usually be regarded as high risk. This is not just because the ATO knocks them on the head from time to time but also because they can be inherently high risk even without unfavourable ATO scrutiny.

Major film producers lose money on many of their films. The potential for profit is outstanding, and a good film can make vast profits, but the actual "hit rate" is poor. In this respect, films should usually be seen as a high risk/high return type of investment. This is particularly the case if the project only involves one film, though a diversified film fund is obviously somewhat lower risk.

Agribusiness is the same way, particularly with the more exotic produce. I tend to prefer the more mainstream crops, pine plantations, bluegum wood chips, vineyards, fruit and the more common timber species. These are far less likely to fail, as a group, than ostriches and the harder to grow trees.

The profits in the more exotic projects could well be very high, any project able to successfully grow these animals and crops could well make a significant amount of money. The trouble is that very few of these have succeeded to date. Ostriches are very hard to breed commercially, they suffer a variety of diseases farmers and vets have little experience in dealing with. Apart from the risks of the tax scheme from a legislative point of view there is also a very high chance of every bird dying. This has happened a number of times, with many animals having to be put down.

Not usually a source of ire to the RSPCA but nevertheless similarly risky from a commercial point of view are high value timbers like sandlewood and paulownia. While a few research programs are being conducted, the majority of projects to date have been dismal failures and the growers have gone out of business. Investors in these schemes should bear in mind that while profits are potentially high, the technology for growing these crops is unproven and in many cases highly experimental. They thus are highly risky, not unlike a biotech research stock.

A further risk lies in oversupply. So many olive plantations have been set up that the price of olive oil has fallen to the point where many crops are not worth harvesting. This is why I personally prefer to stay with your basic wood chip and timber type projects where demand is likely to remain constant or even increase well into the future. In addition, these crops are easier to grow and problems are well understood. If you have a "tax problem" this year and seek long term income (20 years from now, possibly after you retire when you are on a lower tax rate) then these projects might make sense.

If you want to invest in this sector, treat it as a high risk asset class. Tax deductions are a part of the total return, but I wouldn't feel comfortable with putting more than a small percentage of a portfolio (5% approx) into agribusiness schemes. If you invest $10,000 in one you'll get half of that back straight away as a tax deduction so you have effectively invested $5,000 into the agribusiness sector. This would be a reasonable investment for a very wealthy person that wants to cut tax but won't find the after tax cost of the initial investment to be a devastating loss.

You should be looking for managers with a good long term track record. This could mean buying off older companies, or only dealing with companies started by more experienced people. Of course you should not buy off anyone that previously presided over a failed scheme, any more than you should take the investment advice of a former bankrupt.

When examining schemes, think of the final payoff more than just the initial tax deduction. The better growers conduct very detailed surveys to check out the local climate, the soil and underground rocks, access to water, local pests, local infrastructure (like roads, railway, deep water harbours etc for transport), proximity to sawmills, depots etc. Ask to see these reports!

As a final point, check out the adviser's commission. The more reputable schemes pay a relatively modest commission that is only slightly higher than that paid by normal managed funds. Some shonky ones pay a lot more. Another thing to watch out for is soft dollar benefits to advisers, cumulative bonus schemes and prizes for selling the most units. All of these should be disclosed to investors in writing. It is always a good idea to seek the advice of only the most reputable advisers, preferably fee for service, and don't deal with guys that were flogging these things back in the bad old days.

This asset class is more mature in the United States, where investors see it as an important asset class alongside shares, property, fixed interest, cash, gold, hedge funds etc. Agribusiness and films actually have the potential to offer a significantly higher after tax return than many alternative investments in other asset classes. With timber type projects there is even a very good potential for "carbon credits" to add significantly to the long term return, though the exact details of how carbon credits are to work still are being discussed. The risk is obviously not one that can be measured as volatility, remember that these investments carry three major types of risk: agricultural risk, credit risk (for the management company itself) and legislative risk (ATO interference, or law changes).

See also the article in the managed funds FAQ and the article in the tax FAQ.