Part Two: Tax treatment of offshore petroleum decommissioning

Overview 8 min read

In Part One of this multi-part Insight series, we provided an overview of Australia's offshore petroleum decommissioning regime. In this second Insight, we examine the Australian tax treatment of decommissioning expenditure. The tax impact of decommissioning grows increasingly important for the industry, with a recent forecast estimating the total industry cost of decommissioning to be A$43.6 billion.¹

Key takeaways

• Income tax: decommissioning expenditure may be immediately deductible, including as a general deduction or as a specific deduction for mining site rehabilitation or environmental protection activities.
• PRRT: decommissioning expenditure may be deductible for Petroleum Resource Rent Tax (PRRT) as 'closing-down expenditure', which generates a refundable tax credit capped at the amount of PRRT previously paid by that taxpayer in relation to that petroleum project.  
• Timing matters: the ATO's view is that closing-down expenditure (and therefore the refundable tax credit) is generally only available where there has been a decision to imminently and permanently cease production throughout the entire project area. Under this view, the costs of partially decommissioning a project are likely to be considered 'general project expenditure'. As projects that are being partially decommissioned will have lower assessable receipts, such general project expenditure may be at risk of not being fully utilised by the end of the project.
• M&A and trailing liability: where a former titleholder is 'called back' pursuant to a direction under the Offshore Petroleum and Greenhouse Gas Storage Act 2006 (Cth) (OPGGSA), there is legal uncertainty regarding whether that former titleholder may be able to obtain a refundable tax credit for the decommissioning expenditure it incurs. Additionally, transactional structures such as indemnity payments or a decommissioning fund can manage trailing liability exposure, but taxpayers should carefully consider the tax consequences of those elements.  

Income tax deductions

Decommissioning expenditure may be deductible against the taxpayer's assessable income under a number of potentially applicable provisions. Where the same expenditure is deductible under multiple provisions of the Income Tax Assessment Act 1997 (Cth) (ITAA97), only the most appropriate provision applies.²

General deduction

A general deduction may be available under section 8-1 if the expenditure is not capital in nature. Whether or not expenditure is capital in nature requires a close examination of facts, having regard to the relevant case law.³ The expenditure must also be incurred in producing the taxpayer's assessable income or in carrying on a business for the purpose of producing its assessable income. Decommissioning expenditure incurred by a taxpayer may satisfy this requirement even if it is incurred after assessable income has ceased from that particular project.⁴

Immediate deductions

A specific deduction may be available for mining site rehabilitation or environmental protection activities, irrespective of whether the decommissioning expenditure is of a capital or revenue nature.

Section 40-735 allows an immediate deduction for expenditure incurred on mining site rehabilitation of a site on which the taxpayer has previously carried on mining and quarrying operations, which include the recovery of petroleum. 'Mining site rehabilitation' is the act of restoring or rehabilitating a site (or part of a site) to the condition it was in before mining operations were first started, or to a reasonable approximation of that condition. The ATO's view is that there must be a sufficient connection or close association between the expenditure and the acts of restoration or rehabilitation.⁵

Section 40-755 allows an immediate deduction for expenditure incurred for the sole or dominant purpose of carrying on environmental protection activities.⁶ Such activities, which can be carried on either by or for the taxpayer, include:

• cleaning up and removing waste on the site of the taxpayer's earning activity; and
• removing waste on a site where another entity carried on a business that the taxpayer subsequently acquired and continued to carry on substantially unchanged as its own earning activity.

'Earning activity' includes activities carried on for the purpose of producing assessable income, which could encompass the production of petroleum by the taxpayer in relation to a petroleum project.

Deductions over time

Alternatively, a deduction of the decline in value of a depreciating asset may be available under Division 40. In particular, the second element of the cost of a depreciating asset may include decommissioning expenditure if that expenditure is reasonably attributable to a balancing adjustment event for the asset, such as the asset's removal or destruction.⁷

As a last resort, a straight-line deduction over five years may be available as business-related capital expenditure.⁸

Issues in utilising end of project deductions

As decommissioning expenditure generally arises at the end of project life when there is unlikely to be significant assessable income from the project, there may be an issue of whether the deductions can be fully utilised to reduce income tax liability. This tends to be more of an issue for an incorporated joint venture, or a special purpose project entity, with a single project and which is not part of a tax consolidated group.

PRRT deductions

PRRT is a profit‑based tax levied on the 'taxable profit' of a petroleum project at a rate of 40%. It is calculated on a project‑by‑project basis, with deductions available under section 32 of the Petroleum Resource Rent Tax Assessment Act 1987 (Cth) (PRRT Act) for exploration expenditure, general project expenditure and closing‑down expenditure, whether of a capital or revenue nature. Except for transfers of exploration expenditure, these expenditures are only deductible from the taxpayer's assessable receipts in relation to the same petroleum project.

Closing‑down expenditure

'Closing-down expenditure' is defined in section 39 of the PRRT Act as payments that are made in carrying on operations involved in closing down the project, including in environmental restoration. Where expenditure falls within the scope of closing-down expenditure, the taxpayer may be entitled to a refundable tax credit equal to 40% of its closing-down expenditure, capped at the PRRT previously paid by the taxpayer.⁹ The intent of allowing a refundable tax credit for closing-down expenditure is to ensure that such expenditure is properly taken into account as a project cost for PRRT, as otherwise end of project expenditure would have no receipts to offset against and would therefore result in an economic cost that is effectively not taken into account in calculating PRRT liability.

The ATO has indicated in public ruling TR 2018/1 that closing-down expenditure does not encompass payments to partially decommission a project, such as when some wells are closed but production continues in another part of the same project (or in another licence area of the same combined project). Rather, there must be a decision to imminently and permanently cease production throughout the entire project area.

General project expenditure

Where decommissioning expenditure is not deductible as closing-down expenditure, it may instead be deductible as general project expenditure under section 38 of the PRRT Act. General project expenditure is deductible against the taxpayer's assessable receipts from that project in that financial year, thus reducing the amount of PRRT payable. Excess general project expenditure can be carried forward for deduction in future financial years, and is uplifted annually according to the legislated rate.

General project expenditure includes payments made in carrying on or providing the operations, facilities and other things comprising the project. Such operations include operations for an environmental purpose in relation to the petroleum project. A payment will not be general project expenditure unless there is a close and direct connection between the liability to make the payment and the carrying on of the physical activities involved in the petroleum project.¹⁰ The ATO considers that general project expenditure encompasses the cost of closing wells and removing property as part of the partial decommissioning of a project.¹¹

Implications of ATO's view on partial decommissioning expenditure

Commercially, for a project with many wells, or a combined project of many production licences, decommissioning may occur on a gradual basis while production winds down. Under the ATO's interpretation, such expenditure incurred to partially decommission the project would not constitute closing-down expenditure and gives rise to general project expenditure, which may not be able to be fully utilised given the limited receipts derived at the end of the project life. The impact of this view is that such partial decommissioning expenditure is effectively not recognised as a project cost for PRRT. This view may have implications for the economics of whether projects will decommission progressively or cease production across the project before undertaking decommissioning.

Tax considerations in M&A transactions

The project-based approach taken under the PRRT Act has tax relief implications for both buyers and sellers of petroleum assets. Where a buyer acquires a petroleum project towards the end of the project's life, tax credits for closing-down expenditure will be capped at the PRRT paid in relation to the project by the buyer alone. Conversely, sellers should be aware that if the buyer ultimately incurs the costs of decommissioning the project, tax credits are only available to the buyer, even though the seller may have paid most of the PRRT in relation to that project during its lifetime.

It should be noted that the tax position is different where a petroleum project is acquired by way of a share sale. In that situation, the PRRT history of the target company (that is, previous PRRT paid and deductible expenditure incurred) would be preserved alongside the company itself.

Remedial directions to decommission under the 'trailing liability' regime

As explained in Part One of this series, under the 'trailing liability' provisions of the OPGGSA, a former holder of a petroleum licence may be given a remedial direction to undertake decommissioning activities such as closing off wells and making good any damage to the seabed or subsoil. This means that even after a taxpayer sells its interests in the project, a 'clean-break' from statutory decommissioning liabilities may not be possible.

There is a lack of certainty as to whether a former licence holder would be entitled to a tax credit for PRRT on any decommissioning costs it incurs pursuant to a remedial direction. If a tax credit is unavailable, decommissioning undertaken by a former licence holder may produce a different economic outcome from the same work undertaken by a current licence holder.

Transactional structures

As discussed in Part One of this series, various funding mechanisms and structures are available to manage residual exposure to decommissioning liabilities following completion. Buyers and sellers should give careful consideration to the tax consequences of each potential structure, as the legislative framework is complex. For example, where a seller makes indemnity payments for decommissioning costs, the parties would need to consider whether these payments are tax deductible for the seller, whether they are assessable for the buyer (either for income tax or PRRT purposes), whether the indemnity carries capital gains tax consequences and the availability of refundable tax credits for PRRT. Complex tax issues also arise where a specific fund is set up as part of the transactional structure to manage post-completion decommissioning liabilities.

What should industry participants do?

Petroleum project participants should:

• consider whether decommissioning expenditure falls under general project expenditure under the ATO's view;
• model whether income tax and PRRT deductions are likely to be fully utilised;
• review the project's PRRT payment history before acquiring or disposing of a late-life asset; and
• examine the tax treatment of indemnities, decommissioning funds and other financial assurance arrangements to manage trailing liability exposure.

Please contact us if you would like to discuss the tax treatment of decommissioning expenditure or the allocation of decommissioning liabilities in a transaction.