Summary
The importance of the article is that it shows that the KG structure has some major flaws.
Analysis
In the past, many governments of traditional seafaring nations offered tax breaks to entice ship owners to operate their vessels under that nation’s flag. This led to investment vehicles for high income people living in countries with high tax rates; like in NW Europe. Most well-known are the German KG funds. Initially these investment funds were based on buying a ship; depreciate it in a fairly short time and pass tax savings on to its investors. Many ship owners are incorporated in tax-free havens and thus cannot take advantage of tax write-offs. Since KG-like funds recoup a substantial amount of the cost of the ship in the form of tax credits, they can lease the ship out at a lower rate. In essence the “regular” taxpayers in high-tax countries with KG type funds subsidize ship owners/operators, who probably don’t pay tax in the first place. Quoting legendary American soul singer Sam Cooke: “What a wonderful world this is!” That may be one of the reasons why governments scrapped this type of tax treatment and replaced it with a low tonnage tax, combined with provisions of virtually tax free dividends for investors. Let’s say investors deposit Euro 25,000 each for a total of 40% of the value of the vessel. The KG organization may invest some of their own money as well; but not always. Up till about a year ago the balance of the cost of the ship (usually 60%) was financed by a bank. Investors were promised an 8-10% annual dividend; virtually tax-free. Often the fancy brochures also dangled another carrot in the form of a 30% bonus upon sale of the ship after -let’s say- ten years. The KGs themselves earned hefty (often hard to reconstruct) management fees, and everybody was happy. However, for years I have warned investors about the flaws of KG-type investment vehicles. First of all, you won’t get your initial Euro 25,000 back, like when you buy a bond. Instead you get an unsubstantiated promise that you will recoup your investment in the form of annual dividends, plus perhaps a bonus upon sale of the ship. It may be hard to sell your KG participation share; especially when times are bad. The second major flaw is that KGs don’t take the time element of money into account. For example if there is 30% profit on the sale of the vessel after ten years, the KG adds 30%/10 years = 3%/year to the annual dividend rate and makes it look like a total annual RoR of 11-13%. Most ten year old ships are approaching midlife and may have lost a lot of their value. In ten years a lot can happen in shipping markets that have historically always been very cyclical. This makes it a pretty risky investment. Besides, the bonus after ten years is worth a lot less than in today’s money. Apparently investors are unfamiliar with the Present Value concept used by financial professionals all over the world. At the same time KGs themselves use the PV method to great advantage. As mentioned, a lot can happen in ten years of the average KG investment. The world certainly got a taste of that about a year ago when freight rates fell off the cliff. Since it has become very difficult to get additional bank financing, a lot of KGs have run into trouble. In fact some of them have asked their investors to put up additional funds to keep the KG on life support for the time being. The Norwegian Government really threw a monkey wrench in the gearbox when they passed legislation to reclaim all tax savings by ship owners for the last ten years; RETROACTIVELY! The moral of the story is: beware of KG type promoters with fancy brochures. Check with a shipping expert before you plunk down your money!
