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Australia – Exploration Expenditure – No Bright Line Test.

20 June, 2013

 

Legal News & Analysis – Asia Pacific – Australia – Tax

 

ZZGN v Commissioner of Taxation [2013] AATA 351

 

WHAT YOU NEED TO KNOW

 

  • In the context of section 37 of the Petroleum Resource Rent Tax Assessment Act 1987 (Cth), the Administrative Appeals Tribunal has confirmed in ZZGN v Commissioner of Taxation that the term "exploration" should take its ordinary meaning understood in the context in which it appears.

 

  • For expenditure incurred in connection with exploration for petroleum to be deductible as "exploration expenditure", a reasonably direct connection between the operation and facilities being carried on and the activity of exploration is required. Such a connection would be established in circumstances where the work done or activity carried out is directed at benefiting, assisting, advantaging or facilitating the activity of exploration.

 

  • This decision has not been appealed. An ATO ruling on the scope of exploration activity is expected to be issued in the near future. As this case is the first direct authority on the important question of what is "exploration" in the context of PRRT, the approach taken in the ruling will likely be guided by this decision.


WHAT YOU NEED TO DO

 

  • Taxpayers should review the manner in which they currently classify expenditure and consider whether that criterion used appropriately classifies expenditure incurred as exploration expenditure, general project expenditure and excluded expenditure.

 

  • Further, such taxpayers should also review their record keeping processes in order to ensure the contemporaneous recording of the nature of the connection between the work done (or activity carried out) and the activity of exploration in order to ensure that they are in a position to prove the character of the expenditure at a later time, if required. This is particularly important for expenditure incurred after initial discovery and before a final investment decision is made.


Petroleum Resource Rent Tax – A profit based tax


Petroleum Resource Rent Tax (PRRT) is a project based tax imposed in respect of the taxable profit of a taxpayer in relation to a petroleum project. PRRT is imposed on those taxable profits at the rate of 40%.


The taxable profit of the taxpayer in relation to a project is the amount equal to the assessable receipts less any allowable amounts of deductible expenditure as well as amounts of expenditure transferred to a project from other projects. Deductible expenditure includes general project expenditure and exploration expenditure.


It is therefore necessary for taxpayers to work out the deductions they can claim for "exploration expenditure" in order for a taxpayer to determine their PRRT liability. In broad terms, a taxpayer can claim a deduction for exploration expenditure under section 37 of the Act for "payments liable to be made in carrying on or providing operations and facilities involved in or in connection with exploration for petroleum in relation to a petroleum project" [emphasis added].


Where a taxpayer's project does not have sufficient assessable receipts against which to apply exploration expenditure for the relevant project, a taxpayer must transfer exploration expenditure to another project held by the taxpayer or to another project held by a group company. The transferred exploration expenditure can then be applied against the assessable receipts of the other project.


In contrast, other kinds of deductible expenditure (such as general project expenditure) cannot be transferred between projects and group companies.


Application before the Tribunal


The Taxpayer sought a review of the Commissioner's objection decision which disallowed in part deductions in respect of certain expenditure incurred by Company A, another company in the same corporate group, in relation to that company's participation in the "Apple" joint venture.


There were three broad categories of expenditure at
issue:

 

  • "Company C Billed Expenditure", being costs incurred by the operator of the Apple joint venture and charged to Company A pursuant to cash calls made under a joint venture agreement;

 

  • "Company A Direct Expenditure", being expenditure incurred by Company A in respect of peer review work and other work carried out by Company A's parent company or by the Taxpayer and charged back to Company A under "back-to-back" service agreements between those companies and Company A; and

 

  • "Allocated expenditure"' comprising expenditure incurred by the Taxpayer in respect of staff costs allocated and charged by the Taxpayer to the Apple project carried on by Company A.


The issue for determination by the Tribunal was whether the expenditure falling within those three broad categories constituted "exploration expenditure" for the purposes of section 37 of the Act. If the expenditure concerned did constitute "exploration expenditure", and was therefore deductible, then, it was required to be transferred from Company A to the Taxpayer, pursuant to section 45B of the Act, and was deductible against the Taxpayer's assessable receipts from the Pear Project, for the purpose of calculating the Taxpayer's taxable profit under the Act.


What is "exploration"?


One of the key issues in the proceedings concerned the meaning of the word "exploration" as used in section 37 of the Act.


While it is clear that "exploration" extends to activities involved in searching for and drilling exploration wells to discover petroleum reserves, prior to the Tribunal’s decision, it was not clear whether the word "exploration" extended beyond the immediate discovery of petroleum. For example, if a taxpayer drilled an exploration well and discovered petroleum, does expenditure incurred subsequent to that point in time cease to have the character of exploration expenditure (even though the extent and quality of the reserve may be unknown)?


Further, it was unclear whether the term "exploration" extended to circumstances where a taxpayer did not yet know whether an identified reserve was commercially or technically viable to allow for the development and later production of a petroleum project (ie where the reserve is not a proven reserve). If activities of this nature were in connection with "exploration" then the costs of assessing the commercial or the technical feasibility of exploiting a reserve are likely to be referrable to "exploration" and therefore within section 37 of the Act.


A further step along the continuum is whether "exploration" continues until a final investment decision is made to proceed with a project in relation to a proven reserve. Again, it was not clear whether expenditure incurred on activities prior to a final investment decision being made are referrable to "exploration" and therefore within section 37 of the Act.


In its decision the Tribunal concluded, after considering the legislative history of the Act, that there is nothing in the legislative history or in the extensive case law referred to by either party to suggest that the term "exploration" should be read as meaning other than its ordinary everyday meaning understood in the context in which it appears.


The Tribunal found it useful to borrow from the language of a research report prepared by the Australian Bureau of Agricultural and Resource Economics in 1996 (ABARE report) in considering the nature of the activities which naturally fall within the meaning of the word "exploration", as the word would be understood by a user of ordinary English familiar with oil and gas mining.


The ABARE report refers to:


… oil and gas companies using a range of survey techniques to identify prospective fields. These may be geological, gravity, magnetic, seismic (2D and 3D) or geometrical surveys. In prospective areas, new field wildcat wells are drilled to discover the location of accumulations. In the event of a discovery, appraisal wells may also be drilled to provide a more accurate indication of the potential size and quality of the oil and gas resources.

 

The ABARE report then stated "[if] the discovery is significant, a feasibility study of the field for future development and production is undertaken".


The Tribunal took the view that although activities in the nature of feasibility studies were included by the ABARE report as falling within the "exploration phase" as opposed to the "production phase", activity of that kind is of a distinctly different nature to that included within the ordinary meaning of the term "exploration".


Accordingly, the Tribunal found at [322]:


… as a matter of fact, that in the context of section 37(1) of the PRRTA Act, the ordinary meaning of the word 'exploration' contemplates the use of any range of survey techniques to identify prospective oil or gas fields. Those survey techniques would include, but not be limited to, geological, gravity and magnetic, seismic (2D and 3D) and a geometric surveys together with any scientific or technical analysis necessarily associated with evaluating their results. 'Exploration' also includes the drilling of appraisal wells to provide a more accurate indication of the potential size and quality of the oil and gas reserves. However, the ordinary meaning of the word 'exploration' does not, in the Tribunal's view, extend to include feasibility studies of the field for future development and production. [emphasis added]


The meaning of "involved in or in connection with exploration"


The Tribunal then considered what is conveyed by the phrase "involved in or in connection with exploration" for the purposes of section 37(1) of the Act.


The Tribunal concluded that a "reasonably direct connection" is required for the purposes of section 37 of the Act. The Tribunal adopted the same approach as Keane CJ and Edmonds J in Esso Australia Resources Pty Limited v Federal Commissioner of Taxation (2012) 200 FCR 100 at [93], where their Honours stated the "vital question is whether there is a liability to make payments in the carrying on of the operations of the project" and "the connection required between the liability to make the payments on the carrying on of the project must be close and direct".


The Tribunal found that the first step was to identify the relevant "liability" for the purposes of section 37(1) of the Act. In the context of the Company C billed expenditure, the Tribunal found that the relevant liability arose under the joint venture agreement which created an obligation on the part of the group company to pay to the operator, cash advances under authorisations for expenditure.


Having identified the "cash advances" as the relevant specific liabilities, the Tribunal then sought to identify the relevant "operations and facilities" being carried on or provided and found that the relevant "operations" were the activities carried out by the operator, pursuant to the joint venture agreement, as agent for the joint venturers.


The Tribunal then focused its enquiry on whether the relevant operations and facilities being carried on or provided by the operator were "in connection with" exploration for petroleum in the eligible exploration or recovery area in relation to the project. Following the finding of the majority of the Full Federal Court in Esso (2012), at [98], the Tribunal found that this question is to be answered by reference to the objective circumstances in which the relevant liability was incurred (at the time the relevant liability was incurred), rather than upon any subjective "purpose" of the entity incurring the relevant liability.


The Tribunal agreed with the Taxpayer that the phrase "in connection with" is of potentially wide import but
found that it is not open to the Tribunal to conclude that all operations carried out up to the point when a commercial decision to proceed with a petroleum project (known in the industry as a Final Investment
Decision) was made is expenditure made "in connection with" exploration. Accordingly, not all the expenditure which the taxpayer was liable to pay in relation to those operations was deductible. In the Tribunal's view such an approach would be unacceptable as it would effectively substitute a particular commercial model for the words of this section.


In making that finding the Tribunal accepted the Commissioner's submission that in order for an operation to be in connection with exploration, the work done must be directed at benefiting, assisting, advantaging or facilitating the activity of exploration. In accepting such a criteria as a useful benchmark the Tribunal cautioned against the application of that criteria in substitution for the test as stated by the words enacted by the Parliament.


The Tribunal reiterated that, in its opinion, the starting point in each instance must remain the existence of a specific liability to make the payment in the carrying on of the operations of the project, and then the ultimate issue must be resolved on the basis of whether or not that operation is, or is not, sufficiently in connection with exploration. In expressing this opinion, the Tribunal observed that factual situations may exist where an operation is conducted not to benefit, assist, advantage or facilitate exploration, but simply to assess and determine whether exploration work or additional exploration will be undertaken at all. In the Tribunal's view, expenditure on operations involved in those assessments would be in connection with exploration, whether or not any further exploration was undertaken.


Further, the Tribunal formed the view, that there is nothing to prevent "feasibility and environmental studies" and other "preparatory" activities from constituting "exploration expenditure" for the purposes of section 37 of the Act, so long as they share the relevant "connection" with "exploration".


What does this decision mean for you?


The decision suggests that there is no bright line test – whether the particular expenditure incurred can be characterised as exploration expenditure requires a consideration of the nature of the operations and facilities carried on or provided and whether those operations or facilities were in fact involved in or in connection with exploration. This consideration needs to be made having regard to the objective circumstances in which the relevant liability was incurred (at the time the relevant liability was incurred), rather than upon any subjective "purpose" of the entity incurring the relevant liability.


The Tribunal's reasons for decision make it clear that exploration expenditure does not extend to expenditure incurred in respect of operations and facilities carried on or provided for the purpose of:

 

  • ascertaining the viability of developing a resource and commencing production; or
     
  • carrying out feasibility studies of a field for future development and production after a significant discovery has been made (unless those expenditures are "in connection with exploration").


The Tribunal's decision will have significant consequences for taxpayers in circumstances where they incur costs for feasibility studies undertaken for the purpose of ascertaining the viability of developing the field and their project does not ultimately proceed to production (resulting in assessable receipts against which they could deduct expenditure on feasibility studies as general project expenditure). In these circumstances, the expenditure relating to feasibility studies cannot be transferred and applied against other projects held by the taxpayer or related group companies as expenditure of this nature would be "general project expenditure" rather than "exploration expenditure", which is not transferable between projects. The expenditure therefore falls into a "black hole" and is not deductible for PRRT purposes. In these circumstances, there will be a mismatch between the income tax treatment and PRRT treatment of expenditure on feasibility studies (ie, the expenditure is likely to be deductible for income tax purposes but will not be deductible for PRRT purposes). Accordingly, taxpayers will need to be careful when characterising their expenditures for PRRT purposes and making sure that they separately consider how expenditure should be treated for income tax and PRRT purposes. The Tribunal's decision also demonstrates the need for taxpayers to keep clear, accurate and contemporaneous records to substantiate the character of expenditure in circumstances where the deductibility of that expenditure may be called into question.


While the decision concerns the meaning of "exploration" in the context of the PRRT and the definition and context differs from other legislation such as income tax law, this case offers a picture of how a court or tribunal will approach the meaning of "exploration" more generally in the context of current resource developments

 

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For further information, please contact:

 

Len Hertzman, Partner, Ashurst
len.hertzman@ashurst.com


Sarah Blakelock, Ashurst
sarah.blakelock@ashurst.com


Jared Clements, Ashurst
jared.clements@ashurst.com

 

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