Allens

Tax

Focus: Exploration deductions under s40-80

16 August 2012

In brief: The recent Full Federal Court decision in Mitsui v Commissioner of Taxation highlights the importance of identifying the particular asset acquired when seeking to obtain an upfront deduction for exploration expenditure under section 40-80 of the Tax Act. Partner Martin Fry (view CV) and Lawyer Jennifer Richards report.

How does it affect you?

  • As a result of the decision in Mitsui, it will be difficult to claim successfully an upfront deduction for expenditure incurred to acquire a tenement conferring a right to recover a resource, even though the tenement may also vest the holder with rights to explore within the relevant area.

Background

The heart of the problem for Mitsui was that it acquired an interest in a production licence and exploration permit from Woodside in circumstances where $264 million of the consideration was referable to a petroleum field within the production licence area that was still in the exploration phase.

Mitsui purchased a 40 per cent interest in a production licence and exploration permit from Woodside. There were three petroleum fields existing (in whole or part) within the area covered by the two tenements – being Einfield, Laverda and Vincent. Part of the purchase price was allocated to Enfield and was treated as deductible over 21 years (without ATO challenge), and part of the purchase price was allocated to Laverda and treated as an immediate deduction under section 40-80 of the Tax Act (without ATO challenge).

The dispute arose from the $264 million of the purchase price allocated to Vincent. The relevant part of the Vincent field was located within the boundaries of the production licence. At the time of Mitsui's purchase, it was not known whether or not exploitation of the Vincent field would be commercially viable, and further exploration work was required to ascertain the field's commercial viability.

The production licence was issued under the Petroleum (Submerged Lands) Act 1967 (Cth). The holder of such a production licence (or an interest therein) was authorised to recover petroleum and to explore for petroleum. Indeed, an express condition of the production licence required the holder to appraise and explore the licence area to determine the existence and commercial viability of additional petroleum within the area.

In the 2005 income year, exploration work was undertaken in relation to the Vincent field and operations occurred in the course of working the Einfield field.

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Issue in dispute

Mitsui claimed an immediate deduction under s40-80 in respect of the $264 million paid for the Vincent field.

Under s40-80 of the Tax Act, the immediate deduction would only be available if Mitsui first used the relevant depreciating asset for exploration, and did not use it for operations in the course of working the relevant property or field.

Mitsui pointed to the fact that under the Petroleum (Submerged Lands) Act, the holder of a production licence was authorised to recover petroleum and to explore for petroleum, and argued that it had acquired two separate depreciating assets – the right to recover and the right to explore. It argued that it had paid $264 million to acquire the right to explore and should be entitled to a s40-80 deduction on the basis that it first used the asset for exploration of the Vincent field.

The ATO argued that Mitsui had acquired a single depreciating asset being an interest in a production licence and that, as the licence had been used for operations in the course of working the Enfield field in the income year, the Mitsui claim failed the criteria under s40-80.

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The decision

The Full Federal Court held that the relevant depreciating asset acquired by Mitsui was an interest in the production licence and, as the licence had been used for operations in the course of working the Einfield field, Mitsui failed to satisfy the requirements of s40-80 for the $264m referable to the Vincent field. It also held that the production licence could not be viewed and treated as a composite asset under the capital allowance provisions.

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Comment

The dilemma presented by this case is that there was no apparent dispute that the Vincent field was still in the exploration phase. The fact that the Vincent field fell within the boundaries of the production licence, and that the production licence was found to be the depreciating asset acquired by Mitsui (rather than the right to explore conferred by the licence) has resulted in Mitsui being unable to obtain exploration tax recognition for acquisition costs relating to Vincent, despite the Vincent field still being in the exploration phase.

When the case came before Justice Siopis, at first instance, the ATO argued that a production licence will always fail the 'first use' requirement in s40-80, because under such a licence the right to explore and the right to recover will co-exist from the outset. This line of analysis opened up the question of what is meant by the 'first use' requirement in s40-80. Does 'first use' require that the tenement acquired by the taxpayer vest the taxpayer with the right to explore and nothing else? Or is the 'first use' requirement a 'first in time' requirement? Can a taxpayer satisfy the 'first use' requirement simply by demonstrating that the first act that was carried out under the authority of the tenement was an act of exploration (which might subsequently be followed by acts going to the recovery of the resource)? As the arguments in the Full Federal Court centred on identifying the relevant depreciating asset, and as it was accepted that the production licence had been used in the course of operations at the Enfield field, the decision of the Full Federal Court did not expand upon or develop these questions. The taxpayer failed because the relevant depreciating asset that it acquired was a production licence and that asset was used in the year of income in the course of working a field within the production licence area. Could a taxpayer succeed if it acquired a tenement that conferred both a right to recover and a right to explore, and the taxpayer was able to show that the first use in time was an act of exploration?

Further, at first instance Justice Siopis cited relevant Explanatory Memoranda and made it clear that the capital allowance provisions of the Tax Act proceed on the basis of there being a 'dividing line' between the exploration phase and the development/production phase of a project. Although the Full Federal Court decision did not directly discuss this issue, its approach tends to support the notion of the 'dividing line'.

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