8. Impact of incentives on the development of forest plantation resources in Sabah, Malaysia - Chan Hing Hon^[96] and Chiang Wei Chia^[97]

INTRODUCTION

This paper presents a case study of a private enterprise involved in forest plantation development in Sabah, Malaysia. It is intended to provide a private sector perspective of the investment climate and environment in Sabah. The experience of this relatively large private company, with its ultimate objective of maximizing returns to its shareholders, is likely to be different from that of the public sector and smallholder investors in the forestry sector.

Malaysia

Malaysia is a federation of 13 states and two federal territories. With a total area of 330 113 km², it is made up of two distinct geographical regions: Peninsular Malaysia (131 566 km²) sharing borders with Thailand in the north and Singapore in the south, and the eastern states of Sabah and Sarawak and the Federal Territory of Labuan (198 547 km²) on Borneo Island. The two regions are about 540 km apart, separated by the South China Sea.

The economy of Malaysia has seen some rapid changes in the past two decades. The manufacturing sector, especially for electrical and electronic products, has overtaken agriculture as the engine of growth. However, the nation is still a major exporter of such natural products as oil-palm, rubber, timber, tin, petroleum and natural gas. Currently, Malaysia is moving rapidly from the industrial into the information age and it has targeted the year 2020 for achieving the status of a developed nation.

Sabah

Sabah, the most eastern state of Malaysia, is located on the northern tip of Borneo. Its immediate neighbours are Brunei, the Malaysian state of Sarawak, and Kalimantan (Indonesia) and the Philippines. Sabah has a total land area of 7.36 million ha. The population of Sabah stood at 2.72 million in 2001, with a density of 37 people/km². This represents almost a threefold increase from 1980 (Table 1).

Table 1: Population of Sabah, 1980-2001

Source: Department of Statistics (2002)
* provisional

The state is endowed with extensive forest land. Forests cover 4.45 million ha (about 61.81 percent) of its total land area. Six major vegetation types can be distinguished (Table 2).

Table 2: Vegetation types in Sabah in 2000

Source: Forestry Department (2002a)

Sabah’s economy is basically agrarian and natural resource-based. It depends on the production and export of several commodities, the main ones being timber, petroleum, oil-palm, cocoa and marine products. The agricultural sector consists of mainly oil-palm (one million ha), cocoa (52 000 ha), rubber (90 000 ha) and to a much smaller extent, coconut and paddy. Ownership of the oil-palm plantation is roughly divided equally between government-sponsored land development schemes and private owners of smallholdings and large estates. Cocoa plantations are principally privately owned, by smallholders mostly. Rubber plantations are almost entirely owned by smallholders.

Timber processing and exports have been important contributors to Sabah’s economic development. In fact, it was the leading foreign exchange earner until 1998. The timber industry was traditionally oriented towards the export of round logs, with minimal downstream processing. In the 1970s, the government started to promote downstream processing, and by the mid-1990s it decided to ban the export of round logs, which triggered unprecedented investments in the wood-based processing sector. This is clearly reflected in the significant increase in the export values of wood products, especially those of plywood and blockboard, when the log export ban took effect between 1994 and 1996 (Table 3).

Table 3: Export values of wood products of Sabah, 1990-2000 (RM million)⁺

Source: Forestry Department (2001)

+ exchange rates of US$1.00 = RM2.50 prior to the third quarter of 1998; subsequently, US$1.00 = RM3.80

* log export ban

The relative importance of the major export commodities in 2000 and 2001 is indicated in Table 4. The agriculture sector led in importance in 2001, followed closely by petroleum, while the wood-based sector ranked third.

Table 4: Exports of major commodities in Sabah, 2000 and 2001

Sources: Department of Statistics (2002); Forestry Department (2001)
* provisional

The State Development Planning Committee formulated the Land Capability Classification in Sabah in 1973. It was based on earlier work undertaken in Peninsular Malaysia, which classified the land according to economic uses. The various natural resource groups were split into the following five capability classes:

The land use in Sabah is thus committed to various end uses. The amount of land still uncommitted, which remains as state land, is about 6.5 percent or around 0.475 million ha. Slightly less than half of the total land area (48.8 percent) is classified as forest reserve (Table 5).

Table 5: Land-use classification in Sabah

Source: Sabah State Government (1998)

Under the Constitution of Malaysia, power to govern certain matters, for example land and forestry, is vested with the states. Thus all the states have control over their land and its development. The principal law governing land administration in Sabah is the Sabah Land Ordinance^[98] (Cap. 68) together with its subsidiary rules and regulations.

The aim of the Land Ordinance is to regulate the alienation and occupation of state lands. State land in Sabah may be alienated or leased by the state government to (i) an individual person or persons and (ii) a company, corporate body or registered society having power under its constitution to hold land. The right of any landowner is not absolute, as there are conditions attached to the land titles. A condition of issuance of a land title is normally for a specific duration (normally 99 years) and for a specific crop (such as rubber or oil-palm). A typical condition would read: “The said land is demised herein expressly and only for the purpose of the cultivation of coconut and trees bearing edible fruits.” This is further strengthened by a related condition that reads: “Only materials approved by the Director of Agriculture shall be planted or cultivated on the said land.”

Timber trees, with the exception of rubber, are not considered agricultural crops and specific approval has to be obtained from the Land and Survey Department to change this condition. Modification to this ruling is a matter of policy decision. Both the Land and Survey Department and the Agriculture Department are reportedly strict in upholding the policy to reserve alienated land for agricultural use. One argument against any change is that the ratio of agricultural land to non-agricultural land would be upset, as tree plantations are extensive. Moreover, some individuals argue that there are already sufficient forest reserves set aside for forestry use. Tree plantations are considered to be better confined to forest reserves.

FORESTRY

Forest reserves

Similar to land matters, forestry is fully controlled by the states as enshrined in the Federal Constitution. The principal law governing forestry in Sabah is the Forest Enactment (1968) and its subsidiary Forest Rules (1969). The Forestry Department of Sabah is the principal government agency in charge of the administration of all forest reserves in the state. It does not have any jurisdiction over private lands apart from the collection of royalty on timber from such land.

In 1984, the state government successfully regazetted 3.35 million ha of forests as Permanent Forest Estates or Forest Reserves. By 1997, the total area had been expanded and redesignated to 3.59 million ha. The forest reserves are classified into different categories, each serving a specific function (Table 6). Commercial forest harvesting is only allowed in Class II areas.

Table 6: Classes of forest reserves

Source: Forestry Department (1998)

Forest management units

In 1997, the Commercial Forest Reserves were divided into 27 Forest Management Units (FMUs), each approximately 100 000 ha in size. The FMUs are essentially forest administrative units for which long-term licenses are issued to corporate bodies. These agreements take two forms: Tree Plantation and Forest Management Agreement, and Sustainable Forest Management License Agreement. Both agreements are valid up to 100 years. Of the two types of licenses, the second is predominant.

Both license agreements provide long-term tenure security that is so vital in sustainable forest management. The significance of FMUs to Sabah cannot be overemphasized. In the past three decades or so, the forests of Sabah have been indiscriminately logged through a system of short-term annual licenses. Primary forests have dwindled from 2.7 million ha in 1970 to approximately 0.3 million ha in 2000, or a mere 11 percent of the Class II Forest Reserve (Mannan and Yahya Awang 1997). This represents an annual loss of 80 000 ha.

As a result of the initial overexploitation of natural forests in most of the FMUs, extensive rehabilitation activities are necessary. This requirement is also reflected in the strategic plan of the Sabah Forestry Department for forest resource development as follows (Forestry Department 1998):

• Encourage licensees to conduct forest rehabilitation in logged areas as required under the Sustainable Forest Management License Agreement;

• Intensify rehabilitation measures in forest reserves of low productivity through enrichment planting and appropriate silvicultural treatments. On poor and degraded forest areas, plantation forestry should be introduced;

• Promote forest plantation development through the active participation of the private sector; and

• Provide appropriate incentives to create a conducive investment environment to encourage developers to venture into forest plantation.

FOREST AND AGRICULTURE PLANTATIONS

Forest plantation

Forest plantation development in Sabah started in 1922 with a trial planting of teak (Tectona grandis) by a Dutch company for pole production. However, most research focused later on natural forests. Systemic research on forest plantation began only in 1965 when the Forestry Department created its Plantation Research Section. Its main objective was to identify suitable species for commercial plantation establishment in Sabah. To date, a total of 170 species, of which more than half are indigenous species, have been tested (Rahim Sulaiman 2001). From these trials, four hardwoods (Paraserianthes falcataria, Acacia mangium, Gmelina arborea and Eucalyptus deglupta) and four softwoods (Pinus merkusii, P. caribaea, Araucaria cunninghamii and A. hunsteinii) were identified as potential species for commercial forest plantation in Sabah. These species were adopted by the private sector in small-scale planting throughout Sabah. All the softwood species were later abandoned for various reasons (for example, seed availability problems and high establishment and maintenance costs). Over time, the species list was complemented by high-value timber species, such as mahogany and teak, and some indigenous species for forest rehabilitation.

Approach to tree planting

Traditionally, tree planting is similar to planting any agricultural crop. Land that is under private holding is usually first logged for commercial timber, then cleared of any remaining vegetation before planting takes place. In the case of forest reserves, policy dictates that the natural forest must be replenished and maintained as far as possible to conserve biological diversity. In this case, a good mix of indigenous species is planted to enrich the logged-over forests. Complete site clearing and planting can be used in a forest reserve only when either the forest is licensed specifically for large-scale tree planting or where the land is seriously denuded or devoid of trees. This type of planting is confined to the “forest reserve” category. Selected species are usually indigenous, principally dipterocarps.

A third method of planting is confined to private land when the owners opt to enhance the value of the land by introducing timber species on their agricultural holdings. Trees are either interplanted with agricultural crops or planted along perimeters. However, this method of planting, although common, covers only a small area.

Plantation species

Both indigenous and exotic species are being used in plantation development in Sabah. For forest rehabilitation, common species used are the four main genera of the Dipterocarpaceae family (that is, Shorea, Parashorea, Dipterocarpus, and Dryobalanops). For industrial tree plantations, popular species include exotics such as acacias (principally A. mangium, hybrids of A. mangium and A. auriculiformis, and A. crassicarpa), and teak, while local species consist principally of Octomeles sumatrana and Anthocephalus chinensis. Table 7 provides a breakdown of the species composition of the forest plantation in Sabah as of 2001. Over the years, some 146 311 ha of plantation have been established in Sabah (Tables 8 and 9).

Table 7: Forest plantation species’ composition in Sabah, December 2001

Source: Adapted from Anuar Mohamad (2002)
* mainly Calamus caesius, C. manan and C. subinermis
** mainly species of the dipterocarp family

Table 8: Forest plantation development in Sabah, 1980-2001

Sources: Anuar Mohamad, 2002, personal communication; Forestry Department (2002a)

Table 9: Forest plantation in Sabah, December 2001

Sources: Anuar Mohamad (2002) and adjustments from plantation companies
* SAFODA = Sabah Forest Development Authority
** Forest reserves where Sustainable Forest Management Licences Agreement are issued.
*** Sdn. Bhd. = Sendirian Berhad (Private Limited)
# adjusted from company records

Forest plantations were not considered important in the 1980s when natural forests were still abundant. It was only in the 1990s that the forest industry realized that the timber resource base was dwindling due to excessive logging. In response, interest in establishing plantations increased.

Main players in plantation forestry

Yayasan Sabah and Innoprise Corporation Sdn. Bhd.

Yayasan Sabah, or the Sabah Foundation, is a statutory body established in 1966 to improve the quality of life of Sabahans, particularly in education, welfare and social services.

In 1988, Innoprise Corporation Sdn. Bhd. (ICSB) was established as the investment arm of the Sabah Foundation and the holding management company in diverse business interests. In 1984, the already large concession of the Foundation was expanded to a single block of 972 804 ha - about one-seventh of the landmass of Sabah. This area was later divided into two main portions, the concession proper and Benta Wawasan Sdn. Bhd., a wholly-owned company of ICSB, which is to embark on a large-scale industrial tree plantation. These, together with Sabah Softwood Bhd., another ICSB majority-owned subsidiary, make ICSB Sabah’s biggest forest management company, with a total forest area of over one million ha.

ICSB is involved in the following planting activities:

• The Forests Absorbing Carbon Dioxide Emission (FACE) Foundation Project, which aims to plant sufficient trees to offset the equivalent of the carbon dioxide emissions from one large power station over 25 years (FACE 1991).

• The Inikea Project, which aims to restore around 14 000 ha of degraded forest in the Kalabakan Forest Reserve within the Sabah Foundation concession area.

• Luasong Forest Centre, which is located in the Sabah Foundation concession area, serving as a centre and an operating base for numerous forestry activities including a major rattan-planting programme.

• Benta Wawasan Sdn. Bhd., a wholly-owned subsidiary of ICSB, which is developing a forest plantation of up to 306 000 ha.

• Sabah Softwood Bhd. (SSB), a joint venture between the Sabah Foundation and the North Borneo Timbers Bhd.

Sabah Forest Development Authority (SAFODA)

SAFODA was established in 1976 as a semi-government body to:

• Convert wasteland and marginal agricultural land into productive forests;

• Supplement the production of natural forest products with products derived from man-made forests;

• Encourage and promote the active participation of the rural population in afforestation and reforestation; and

• Raise the living standard of the rural people through forest settlement and agroforestry development schemes.

A total of 108 243 ha of land parcels have been allotted to SAFODA through a gazette notification. Most of it is considered wasteland or lalang (Imperata cylindrica) grassland and non-commercial forest land, which have been classed as unsuitable or marginally suitable for agriculture (Stanley 1992). As of December 2001, 25 891 ha have been planted with tree species and 2 119 ha with rattan.

Sabah Forest Industries Sdn. Bhd.

The Sabah Forest Industries Sdn. Bhd. was established in June 1982, as a wholly-owned company of the state of Sabah, to expedite the industrialization programme (Sabah Forest Industry 1993). The coastal town of Sipitang in the southern part of Sabah was chosen as the mill site for a 150 000 tonne capacity pulp and paper mill. The Sabah Forest Industries was allocated 288 623 ha of natural forest to support the mill. The company is now privatized with the Lion Group of Malaysia holding the majority of the share while the state government holds a minor interest.

While the mill currently takes in residual timber from forest clearing, plantations of fast-growing tree species have been established to supply the mill in the future with raw materials. As of December 2001, more than 36 676 ha have been planted with acacias.

KTS Plantation Sdn. Bhd.

KTS Plantation is a member of the KTS Holdings Sdn. Bhd. It has entered into an agreement with the Sabah Government to manage a forest concession of 57 247 ha at Segaliud Lokan Forest Reserve in the Sandakan area. A major part of the area is being rehabilitated with dipterocarps, rubber (Hevea brasiliensis), and some other indigenous species.

Agricultural plantations

In the 1970s, Sabah experienced a steady expansion of cocoa and oil-palm plantations. The cocoa boom in the late 1970s saw the rapid development of cocoa plantations, both by smallholders and large estates. However, the collapse of the cocoa price in the mid-1980s, coupled with cocoa pod borer infestations, has dampened the interest in cocoa cultivation.

Unlike cocoa prices, crude palm oil (CPO) experienced continuous price increases. The CPO prices peaked at an average of RM2 377/tonne (US$625.50)^[99] in 1998 (PORLA 2002). The corresponding fresh fruit bunch (FFB) prices of oil-palm fruits reached a high of RM500/tonne (US$131.60) in Sabah. At this price level, oil-palm production is extremely lucrative. As a result, large areas of oil-palm have been developed, reaching more than one million ha in 2000 (Table 10). Some landowners have converted from cocoa to oil-palm. The current CPO prices have dropped to around RM1 400/tonne (US$368.42/tonne) with a corresponding FFB price of RM280/tonne (US$73.68/tonne).

Table 10: Oil-palm and cocoa plantations in Sabah (ha)

Sources: Malaysian Cocoa Board (2002); PORLA (2002)

Economics of plantation development

Comparative costs of establishment of forest and agricultural plantations

The main cost components of agricultural and forest plantations are similar, and include mainly:

• Administration: salary, wages, Employee Provident Fund, office expenses, vehicle maintenance;

• Direct planting cost: road and culvert construction, site preparation, seedlings, lining, holing for and planting seedlings, boundary survey, climber cutting, weeding;

• Maintenance: boundary, roads, weeding, shade adjustment;

• Capital expenditure: buildings, vehicles, nursery establishment; and

• Training, research and development.

The main differences relate to plantation management. For example, oil-palm plantations require higher labour inputs than forest plantations due to their intensive management. One labourer in an oil-palm plantation is able to take care of only four ha of land, while for a forest plantation this amounts to 30 to 50 ha. As a result, the cost (up to maturity) of establishing an oil-palm plantation is around RM7 200/ha for the first four years, whereas it is only RM3 500-4 000 for the first seven years for an Acacia mangium plantation.

The costs of marketing also differ. For example, there is no royalty and cess tax on timber produced from forest plantations. On the other hand, since 1999, the state government has put a levy of RM56/tonne on the production of CPO if the CPO price is above RM1 000/tonne. Similarly, the federal government also imposes a “windfall” levy when the CPO price exceeds RM2 000/tonne.

Economics of forest plantations

Various analyses have been carried out on the financial viability of large-scale industrial forest plantation in Sabah over the years. The studies are based on various assumptions related to, inter alia, the mean annual increment, length of rotation and prices of the end products. Invariably, results of financial analyses differ, although they all show a positive internal rate of return (IRR). Examples include:

• A weighted average IRR of 6.7 percent, based on planting of 50 percent Acacia mangium (eight-year rotation), 30 percent Paraserianthes (Albizia) falcataria (12-year rotation) and 20 percent Gmelina arborea (15-year rotation), excluding interest on capital (Golokin and Cassel 1987).

• IRRs of 5.9 and 5.1 percent for two scenarios. Scenario 1: 50 percent Acacia mangium and 50 percent Gmelina arborea, both for chip production with a rotation of eight years. Scenario 2: 40 percent Acacia mangium and 20 percent Gmelina arborea, both for chip production with a rotation of eight years, and 20 percent Paraserianthes falcataria with a rotation of ten years for sawlog production. Prices of RM80/m³ for logs of 20 cm diameter and above and RM50/m³ for logs of 14-19 cm diameter (Ti and Tangau 1991).

• IRR of 19.2 percent for the Compensatory Plantation Project in Peninsular Malaysia. Major assumptions are: average mean annual increment of 20 m³, non-commercial thinning at years 4 to 5, second commercial thinning at years 8 to 9 with a yield of 67 m³/ha (stumpage value of RM23/m³), production at final harvest at year 16 of 180 m³/ha (stumpage value of RM126/m³) (Johari Baharudin 1987).

• IRR of 13 percent with Paraserianthes falcataria (12-year rotation), Acacia mangium and Gmelina arborea (both 15-year rotation), all for sawlog production at prices of RM80/m³, RM90/m³ and RM100/m³, respectively (Rahim Sulaiman 1990).

• IRRs of 7.3 to 17.3 percent for four species: Tectona grandis, Azadirachta excelsa, Hevea brasiliensis and Acacia mangium under various assumptions such as rotation of 15 years for the monocrop and 20 years for Hevea with a latex production. Price assumptions are RM95/m³ at 15 years and RM115/m³ at 20 years for Hevea wood, RM600/m³ for teak, RM150/m³ for acacia and RM450/m³ for sentang (Azadirachta excelsa) at 15 years (Krishnapillay and Abdul Razak Mohd. Ali 1998).

• IRRs of 12.8 percent for rubberwood alone, and 13.7 percent for rubberwood with latex production commencing at year 8, on a rotation of 15 years (Mohamad Johari Mohd. Hassan 2002).

Economics of oil-palm plantations

Oil-palm is by far the most important economic agricultural (estate) crop in Sabah. In general, the returns on oil-palm are very sensitive to CPO prices (Table 11). Since 1994, CPO prices fell below RM1 000/tonne only in 2000 and 2001 (Table 12). At normal price levels, the IRR is expected to exceed 20 percent. High prices that exceeded RM1 500/tonne have brought considerable profits to the oil-palm industries.

Table 11: Internal rate of return of oil-palm production

Table 12: Crude oil-palm prices, 1991-2000

Source: PORLA (2004)
* Prior to the third quarter of 1998, US$1.00 = RM2.50; subsequently, US$1.00 = RM3.80

Note: In March 2004, the CPO price rose above RM2 000 again.

SABAH SOFTWOODS BERHAD (SSB)

SSB, incorporated in late 1973 under the Companies Act (1965) as a private limited company, was converted into a public limited company on 23 May 2000. It is a subsidiary of ICSB. It was originally established to plant logged-over areas with fast-growing commercial timber species and to develop commercial forest plantations. In 1977, SSB entered into a 60-year lease agreement with Sapangar Sdn. Bhd. for an area of 60 618 ha, which was partitioned into two main blocks of approximately 20 000 and 41 000 ha at Kalabakan and Brumas, respectively (Figure 1).

Figure 1: Location of SSB in Sabah

The principal activities of SSB are reforestation, planting and the operation of a woodchip mill. During 2000, SSB commenced contract reforestation for an associated company, Benta Wawasan Sdn. Bhd. Its wholly owned subsidiary company, Tawau Plywood Manufacturing Sdn. Bhd., is principally involved in manufacturing and sales of blockboards, laminated boards, veneer and plywood.

By December 2000, SSB had planted fast-growing forest trees on 34 024 ha of the leased land. Another 11 843 ha were planted with oil-palm and cocoa (95 percent and five percent of the land, respectively). Some of the forest plantations are in their third rotation. The oil-palm has not yet matured.

Since its incorporation, the shareholders of SSB have invested about RM200 million (US$52.6 million) in the company. To date, SSB has yet to declare a dividend or repay shareholder advances. By 2000, the retained profits of the company amounted to about RM85 million (US$22.4 million), which had been used to finance new plantations.

Plantation development expenditures have been the major cost of SSB, amounting to RM254 million in 2000 (that is, RM160 million for forest plantation and RM94 million for agricultural crops). The net profits after taxes were RM14.3 million (US$3.8 million) and RM18.7 million (US$4.9 million) in 1999 and 2000, respectively. Most profits can be attributed to the sales of plantation timber and woodchips.

Compared to the returns on alternative investments, SSB’s forest plantations have achieved limited success over the last 26 years. Since harvesting commenced in 1982, the accumulated retained profit of RM85 million (US$22.4 million) over a period of 18 years averaged RM4.7 million (US$1.2 million) per annum, or an internal rate of return of about 2.4 percent. The return on assets (profit/forest plantation assets) in 1999 and 2000 was only around 7.5 and 9.8 percent, respectively. This is considered low compared to other investments, especially taking into account the long investment period.

SSB is a pioneer in forest plantation development but it made some unfortunate mistakes in the early years of development (such as unsuitable species), which certainly depressed the company’s profits. To capitalize and increase SSB’s returns from the forest plantations, a woodchip mill using plantation-grown wood was established in 1998.

SSB’s forest plantations

SSB has identified Acacia mangium and acacia hybrids, Paraserianthes falcataria and, to a lesser extent, Gmelina arborea as species with the highest potential for Sabah’s climatic and topographic conditions. The three species are planted regularly, as their establishment costs are low, they grow faster and can be used for a wide range of end products. Species such as Eucalyptus deglupta and Pinus caribaea, which have poor growth characteristics and are commercially less economical, have not been used since 1986 and are currently being replaced by the other three species. In total, the five species have been planted (and replanted) on 73 300 ha between 1974 and 2001 (Table 13). SSB’s current objective is to fully plant the 40 000 ha designated for tree plantations with the three main species.

Table 13: Annual planting of Sabah Softwood Bhd., 1974-2001

Between 1982 (when harvesting commenced) and 2000, SSB harvested more than four million m³ of plantation-grown timber (Table 14). The current annual production is estimated at 400 000 m³.

Table 14: Production of plantation timbers from Sabah Softwoods Bhd., 1982-2001 (m³)

Source: Sabah Softwood Bhd. internal reports
* including 44 953 bone-dry tonnes (or 103 841 m³) for chipping
** including 85 271 bone-dry tonnes (or 196 976 m³) for chipping

SSB’s agricultural plantations

In response to high CPO prices in 1997 and 1998, SSB increased its oil-palm plantation from 2 300 ha in 1997 to 14 000 ha by 2001. Most of the new plantations are not yet productive and it is premature to comment on the actual return on investment. However, SSB envisages that oil-palm and oil-palm-related activities would contribute positively to its future income. The remaining agricultural cropping area of 560 ha is planted with cocoa. By December 2000, a total of 46 767 ha had been cultivated with different crops (Table 15).

In conjunction with the oil-palm plantation programme, SSB proposed to set up a CPO mill. The construction was expected to commence in 2002 and be completed by 2003.

Table 15: Tree and agricultural crops of SSB, December 2000

Source: Sabah Softwood Bhd. internal records

TAX INCENTIVES IN MALAYSIA

Historical development

During the 1970s, the potential long-term role of forest plantations in the forestry sector and the national economy was not recognized. As a result, no direct incentives were offered to encourage plantation development until the 1980s. As time progressed and the natural forest dwindled, the government introduced various incentives to promote forestry and forestry-related activities.

A chronological order of the changes to tax legislation and incentives, directly or indirectly affecting forest industry in Malaysia, is given hereunder:

Today, there is a wide range of tax incentives available to the plantation sector in Sabah. The forest plantations have been accorded more incentives than the traditional agro-crops such as oil-palm and rubber, as reforestation has been regarded as an industry of national and strategic importance since the Sixth Malaysia Plan (1991-1995). As a result, special tax incentives under Section 4A of the Promotion of Investments Act (PIA) are available to the forest plantation sector. The two principal incentives available to the forest plantation sector but not to the agricultural sector are Pioneer Status and Investment Tax Allowance.

In 2002, the government included forest plantations as an “Approved Agriculture Project” under Schedule 4A (see Annex 1 for details) of the Income Tax Act, in response to the disappointing impact of the previous tax incentives and requests by the private sector for additional support. Schedule 4A was originally formulated for food and fruit cultivation only. Under Schedule 4A certain capital expenditures, ordinarily claimable over a period of time, can be treated as current year deductions. Some people are hopeful that this change may provide a boost to forest plantation development.

As a result of the 1997/1998 regional financial crises in Asia and the surging value for imported food products - RM11 billion (US$2.9 billion) in 1998 - the government first introduced “group relief” as a further incentive to encourage investment in approved food production projects in 1999. As the cost of importing food products continues to increase, emphasis is placed on urging agro-based companies to diversify into food production. The government has since removed some of the rather restrictive definitions and conditions of “group relief”.

The current incentives available under Section 4A of PIA, the Income Tax Act and other support fall into two categories, that is, direct and indirect incentives:

Direct incentives

Direct incentives can be made available according to “Pioneer Status” or “Investment Tax Allowance” under Section 4A of the PIA. The latest inclusion of forest plantations under the “Approved Agriculture Project” also supports investments. The common feature of the first two incentives is that the untaxed profit can be transferred to an account from which tax-exempted dividends can be declared. In contrast, Schedule 4A of the Income Tax Act allows all the qualifying expenditures to be offset against the current year’s income from other sources, thus reducing the current year’s taxable income.

Pioneer Status

Forest plantation developers are granted a 100 percent tax exemption on statutory income for ten years (as compared to five years in the past), commencing from the “production day”, which has been set as the date of first harvest. Normally, a company that is granted Pioneer Status enjoys tax exemption of 70 percent on its statutory income for a period of five years. Effectively a company granted Pioneer Status would have an effective tax rate of 8.4 percent (30 percent [taxable income] x 28 percent [current tax rate]).

Investment Tax Allowance (ITA)

The ITA allows an eligible investor an additional deduction, over and above normal entitlement, for capital costs incurred on qualifying planting expenditures including roads and bridges, farm buildings, plant and equipment that are directly used in plantation development. The costs must be incurred within a period of five years commencing from the date of approval.

The ITA for forest plantation developers has been increased to 100 percent of the qualifying expenditures (instead of the normal rate of 60 percent) for other promoted sectors and enhanced to 100 percent deduction (instead of the normal 70 percent) from statutory income for each year of assessment. Effectively, the eligible company can claim up to 200 percent of its qualifying expenditures incurred during the initial five years.

Schedule 4A of Income Tax Act

Since a forest plantation is now recognized as an “Approved Agriculture Project” under Schedule 4A of the Income Tax Act, an investor who is currently deriving profits from other sources benefits from having all the qualifying forest plantation expenditures offset against current income. Previously, the planting costs could only be claimed under Schedule 3 of the Income Tax Act^[100] as annual capital cost allowance and not against other income.

As the Pioneer Status, ITA and Schedule 4A of the Income Tax Act are mutually exclusive, an investor has to decide on the most appropriate incentive. An investor who expects to profit soon after the commencement of harvesting will logically opt for Pioneer Status. However, becoming profitable soon after harvesting is unlikely to happen. The ITA, on the other hand, allows unutilized allowances to be carried forward indefinitely. This seems to favour forest plantation development, which incurs high initial capital costs and no returns in the first few years of operation. On the other hand, Schedule 4A of the Income Tax Act is suitable for a company that enjoys profits from various other sources as it reduces taxable income for the current year.

Indirect incentives

According to the ITA for approved in-house and other research activities, an additional 50 percent of capital expenditures incurred within ten years from the date of approval can be deducted. For approved research and development (R&D) activities, double deduction for expenses incurred and double deduction for cash contribution to approved research institutions or R&D companies are granted.

Other double deduction incentives are also accorded to expenditures such as approved training, freight charges for exporting rattan and wood-based products (excluding sawntimber and veneer), insurance (with a Malaysian incorporated company) on imported and exported cargo, export credit insurance premiums and cost of export promotion.

Experience of SSB

Tax incentives

SSB, as a pioneer in forest plantation since the early 1970s, does not qualify for Pioneer Status or ITA. Nevertheless, SSB has suffered from initial tax losses in its early years of operation. These losses and some unabsorbed plantation development allowances are being used to offset current taxable profit. It is estimated that SSB is unlikely to be taxable for another ten years.

Other incentives

Grants and subsidies in any form, soft loans, technical assistance, training and marketing assistance are not available to SSB. In addition, SSB develops its infrastructure without much governmental assistance. Water and electricity supply to the plantation area and the woodchip mill are also provided by the company without any external assistance.

Non-tax incentives for SSB

To facilitate the reforestation project, the Sabah Government alienated an area of about 60 618 ha to Sapangar Sdn. Bhd. This was alienated with minimum charge on land premium and low annual rental rates during the initial stage of plantation development. The land was subsequently subleased to SSB for 60 years. The allocation of land of such a size and the waiving of the normal terms and conditions of land alienation are the most significant government incentives provided to the joint-venture company.

Compared to other companies, SSB enjoyed a very low land premium and annual rent (Table 16). This has significantly reduced the initial costs of its plantation development. The Net Present Value (at five percent interest) of the land premium and annual rents over 30 years for SSB is only RM216 compared to RM1 403 for other companies. At ten percent interest, the respective figures are RM63 for SSB and RM1 230.

Table 16: Land costs of SSB compared to other companies (cost/ha)

The subsequent annual rent (US$7.16) may appear high. However, the amount is still considered reasonable because the state government imposes no other royalty or cess tax on the plantation-grown timber. This exemption improves the competitiveness of plantation-grown timber against the small-diameter logs from the natural forests in the market.

Discussion

Despite the government’s efforts to encourage forest plantation development through several tax incentives, investments in forest plantation development are being manifested only slowly. This is clearly reflected in the fact that the current ratio of oil-palm plantations to forest plantation is about 6:1. Between 1995 and 2000, oil-palm plantations have increased annually by 18.6 percent; forest plantations are a distant second at 7.5 percent. There are several reasons for this discrepancy.

Land availability

Land availability, though an age-old issue, is a fundamental constraint to forest plantation development (Rahim Sulaiman 2001). There is relatively little uncommitted state land and most is located in remote areas or is unsuitable for plantation development due to unfavourable terrain or soil conditions. Alienated land, on the other hand, is abundant. However, land can only be alienated for agricultural purpose. Also, land rents and premiums are too high, rendering forest plantations less competitive than alternative land uses.

Since 1997, forest land suitable either for rehabilitation or reforestation has been made available through Sustainable Forest Management Licence Agreements for 27 FMUs. More tree planting has taken place in some of the licensed areas, notably those of ICSB. Whether this will become a long-term development, remains to be seen.

Land-use competition

Aside from the question of land tenure, landowners generally prefer agricultural crops, especially oil-palm, for the following reasons:

• Shorter gestation period (oil-palm starts to produce four to five years after planting);

• Ease of marketing despite volatile CPO prices, because of an established market system;

• Higher returns due to high CPO prices in the past and currently (early 2003);

• Less risk (for example, less incidence of fire, pests and diseases);

• Single species, which improves the availability of high-quality planting stock and R&D information; and

• Potential additional income from residues, such as empty fruit bunches that can be used to generate energy or as raw material for industrial products (for example, paper and fibreboard).

In comparison with oil-palm, forest plantations are viewed as more complicated, especially if more than one species are selected. Marketing, technical and scientific support, and planting stock availability are also more problematic. The biggest disadvantage, or most significant impediment, is perhaps the long gestation period. Tree planting, especially over large areas, incurs substantial initial capital costs. This makes investments in forest plantations particularly unattractive. It is therefore not surprising that agricultural development in Sabah has outstripped forest plantations by a large margin over the past two decades.

Deficiencies of tax incentives

Even though direct and indirect incentives have been enhanced and much flexibility is provided, certain deficiencies remain, especially when the long-term nature of investing in forest plantations is considered. The Pioneer Status and ITA incentives are primarily designed for industrial and commercial projects with short gestation periods (Thorton 1987). Although these incentives have given extended periods, they do not adequately address the cash-flow problems of investors. Furthermore, Pioneer Status incentives are considered unattractive for the following reasons:

• Mandatory offset of pioneer losses against pioneer income;

• Inability to offset pioneer losses against non-exempted income of the pioneer company during the holiday and postholiday periods;

• Inability to carry forward unutilized pioneer losses to the postpioneer period;

• The ten-year holiday period is suitable only for fast-growing species, but does not suit high-value timber species that require longer rotations; and

• Unutilized plantation development allowances that are common in reforestation projects cannot be offset against income from another business source even if carried out by the same company.

In the case of the ITA, although the standard allowance rate of 60 percent has been enhanced to 100 percent, resulting effectively in a 200-percent claim for qualifying expenditures incurred, the qualifying period remains at the first five years. This suits industries where most capital expenditures are incurred early after commencement; forest plantations are subjected to costs for silvicultural treatment throughout the rotation until the final harvest.

However, the recent amendment of Schedule 4A of the Income Tax Act is an attempt to address the interim cash-flow problem of an investor in forest plantation. Of significance in this amendment is the inclusion of a list of tree species that qualify for an “Approved Agriculture Project”. This list comprises both exotic and indigenous species that are commonly used for planting including important dipterocarps for rehabilitating logged-over forest.

Possible improvements to the incentive schemes

Some incentives that may alleviate the cash-flow problem in the early years of planting are:

• Grants and subsidies

  Support should be provided in the form of replanting grants, cost refund grants (subsidy), grants for prescribed R&D and grants for a variety of capital costs incurred. Any form of grants and subsidies would enhance considerably an investor’s cash flow in the early years after plantation establishment.

• Special/soft loans

  It is not a common practice for most of the Malaysian financial institutions to extend any loan beyond ten years’ maturity. Access to long-term and inexpensive financing is important for forest plantation development. Special loan schemes for long-term investments should be arranged at preferential rates.

• Group relief

  Companies incorporated in Malaysia are limited by shares. The liability of the shareholders is limited to the amount of the paid-up capital of the companies. Corporate taxes are based on the annual return of each individual company. The company may not claim any relief that is accorded to its parent company or subsidiary company. Group relief is not permitted except for the food and fruit cultivation sector with certain conditions.

  As the initial planting costs are now treated as an operating cost and are fully deductible from current year revenue, they can be offset against any other company income immediately without having to wait until the final harvest. This may reduce profits or incur losses.

  Having allowed the offset of initial planting costs by transforming them into losses, the unabsorbed amounts of losses could be used immediately to offset them against the income of another company within the group if group relief is available. The group relief incentive, if permitted, would allow major investments in forest plantations.

• Non-taxation of income derived during land clearing

  Despite the ruling of the Privy Council on a controversial tax case (Makmor Sdn. Bhd. vs Director General of Inland Revenue, 1983), it is still uncertain whether indigenous timber cut during land clearing is taxable. The income from the sale of such timber, if non-taxable, would alleviate the negative cash flow during the first years after plantation establishment.

• Effect of unutilized Schedule 3 allowances

  According to the current system of granting tax exemption for ten years, statutory income is determined only after the accumulated Schedule 3 plantation development allowance has been offset. Considering that timber plantations would have accumulated substantial plantation development allowances, in view of its long gestation period, the tax holiday may be of academic interest if there is little or no statutory income after the mandatory offset of agricultural and other Schedule 3 allowances. It would be extremely advantageous if the tax exemption could revert to the old basis at adjusted income stage (before Schedule 3 allowances being offset), leaving the unutilized allowance untouched for future offsets and at the same time enhancing the tax exempt credits being created for franking dividends.

• Effect of unutilized pioneer losses

  Similarly, the current basis of treating companies with Pioneer Status is to offset pioneer income against pioneer losses. This diminishes and caps the extent of benefits otherwise available with a higher level of exempted income. Furthermore, should unrelieved pioneer losses remain unutilized, they are not carried forward to the postpioneer period, effectively making a pioneer company worse off than a company operating without such incentive. The inability to offset pioneer losses during the pioneer period against non-pioneer income also unduly punishes a pioneer company that incurs losses.

  The effect of the unutilized Schedule 3 allowances and pioneer losses, which were generated by the tax reform in 1991, severely punishes long-term and risky investments such as forest plantation development. If losses are incurred, a pioneer company is rendered weaker than a non-pioneer company.

CONCLUSIONS

Tax incentives alone had only a minor impact on forest plantation development in Sabah in the past. To effectively promote tree planting, incentives need to be more suitable and better targeted. They should take into account the cash-flow requirement of investments with long gestation periods. In addition, the forest plantation sector needs to be supported by non-tax incentives such as land at reasonable premiums and annual rents.

The amendment of Schedule 4A of the Income Tax Act in early 2002 is seen as a major step forward since 1994 when forest plantations were treated as an industry of national and strategic importance. It is designed to address the cash-flow problem that has been lamented by the industry for too long. Enrichment planting in logged-over forests is given appropriate attention, as most of the species commonly used in rehabilitation are included in the amendment.

Although the effect of the amendment is not known yet, it is hoped that it will encourage some of the major oil-palm companies to consider planting trees as an alternative to oil-palm and investors to rehabilitate the vast area of forest land made available under the Sustainable Forest Management Licence in Sabah.

LITERATURE CITED

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ANNEX 1: COMPARISON OF INCENTIVES

ANNEX 2: DERIVATION OF ADJUSTED AND STATUTORY INCOME