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Focus: Unlocking the tax value of greenfield exploration expenditure

20 October 2014

In brief: Draft legislation has been released that contains details of the Exploration Development Incentive announced as part of the 2014-15 Federal Budget. The scheme is designed to encourage equity investment in greenfield explorers, by enabling explorers to issue 'exploration credits' to its investors. Partner Martin Fry (view CV) and Senior Associate Jennifer Richards report.

 
 

How does it affect you?

  • Small exploration companies often have high amounts of deductible exploration expenditure but little or no income and, as a result, accumulate tax losses they cannot utilise until many years later, if at all. Due to the time value of money, the present value of the tax deduction is diminished. By contrast, established mining companies that also undertake exploration often have income from mining operations and can therefore use exploration deductions in the year in which they are incurred. '
  • To address this imbalance, the Exploration Development Incentive enables greenfields exploration companies to transfer the tax value of eligible exploration expenditure to investors, by issuing 'exploration credits', which confer an entitlement to franking credits (for equity holders that are corporations) or tax offsets (for other equity investors). It is hoped that this acceleration in the utilisation of an explorers' tax losses will attract new equity investment to the explorer.
  • The scheme is only available to an entity if it qualifies as a 'greenfields minerals explorer'.
  • Companies will not qualify if they carry on mining operations (or have an affiliate or connected entity that has such operations); petroleum, oil shale and quarry material exploration is not eligible; and exploration expenditure will generally need to relate to establishing the existence (rather than the viability/feasibility of) a mineral resource or ore reserve.
  • Exploration credits must be distributed to equity holders in proportion to their equity interests and therefore, generally, cannot be streamed. As an exception, exploration companies can make an irrevocable election, before first issuing any credits, with the result that exploration credits will only be distributed to holders of equity interests issued on or after 1 July 2014. It is hoped that this will encourage new equity investment.
  • At this stage, the scheme will only apply to expenditure incurred in the 2014-15 through 2016-17 years. Exploration companies will therefore need to act quickly if they are to take full advantage of the scheme.
  • Comments or submissions on the exposure draft must be submitted by Friday, 24 October 2014.

Which entities, and what exploration, is eligible to generate exploration credits?

The tax incentive is designed to encourage equity investment in small mineral exploration companies undertaking greenfields mineral exploration in Australia. The draft legislation therefore contains prescriptive rules in relation to the type of entity that will qualify (a 'greenfields minerals explorer') and the type of expenditure that will qualify ('greenfields minerals expenditure'). Details are set out in the table below:

Eligible Not eligible
Type of entity The entity must be a 'greenfields minerals explorer', meaning it must:
  • be a 'disclosing entity' within the meaning of section 111AC of the Corporations Act 2001 (Cth);
  • be a corporation;1 and
  • have 'greenfields minerals expenditure' (see below).
An entity cannot be a 'greenfields minerals explorer' if it:
  • carries on mining operations; or
  • has an affiliate or connected entity that carries on mining operations.
Type of exploration 'Greenfields minerals expenditure' includes:
  • amounts deductible in accordance with s40-730 (exploration expenditure) or s40-80 (the cost of depreciating assets first used for exploration) of the Income Tax Assessment Act 1997; and
  • the exploration relates to an 'area':
    • in Australia; and
    • over which the entity holds a 'mining, quarrying or prospecting right'.
'Greenfields minerals expenditure' does not include exploration or prospecting relating to:
  • quarry materials, petroleum or oil shale;
  • feasibility studies and other activities undertaken to identify the viability of mineral resources, rather than its existence;
  • mineral resources/ore reserves that are at least inferred/probable, under the JORC Code, or an area in which such resources/ reserves are located; and
  • the coastal sea of Australia and certain other offshore areas.

 

 

How are credits created?

Under the scheme, exploration credits are able to be created based on the previous year's greenfields minerals expenditure. Therefore, an entity that was a greenfields minerals explorer in the 2014-15 year can issue credits referable to their 2014/15 greenfields minerals expenditure in the 2015-16 year. (There is no ability to carry forward unissued credits to later years).

A global cap has been imposed on the value of credits that can be issued under the scheme: namely, $25 million, $35 million and $40 million for expenditure in 2014-15, 2015-16 and 2016-17 respectively 2. To enable the cap to be enforced, entities that wish to create credits must report estimated greenfields minerals expenditure, and estimated tax losses for the previous income year, by 30 September the following income year. This is to enable the Commissioner of Taxation to calculate and publish a 'modulation factor', which operates as an effective cap on the total credits that can be issued by each participating entity. Credits can only be issued after the modulation factor has been published.

The maximum amount of exploration credits a company can create in an income year is calculated by applying the corporate tax rate to the smaller of its tax losses and its greenfields minerals expenditure for the previous year. This ensures that an entity cannot create credits where it has itself been able to utilise the tax deductions. Also, if estimated expenditure/losses is lower than actual expenditure/losses, estimated amounts must be used.

Example: Assume an entity has estimated tax losses of $1 million, actual tax losses of $1.1 million, and estimated and actual exploration expenditure of $1.2 million. Assume also that the published modulation factor is 0.20. The value of exploration credits an entity could issue would be $60,000 (ie $1 million x 30 per cent of the corporate tax rate x 0.2). If the entity creates credits of $60,000 (by issuing them to investors), it would reduce its tax losses by a corresponding amount ($1 million).  

How do equity investors benefit?

Equity investors who are issued with exploration credits may be eligible to receive either a tax offset or a franking credit, depending on their entity type. The following table summarises the consequences for the different entity types.

Entity to whom exploration credit is issued

Benefit

Qualifications

Corporate tax entity (a company, a corporate limited partnership, a corporate unit trust, or a public trading trust)

Franking credit

Australian residency requirement3

Entities other than corporate tax entities

Tax offset
(Refundable in accordance with the ordinary rules for individuals, superannuation fund, certain charities and not-for-profit entities.)

Australian residency requirement

Trusts and partnership

Flow through treatment is available, based on the beneficiary/partner's share of the exploration credit.
The beneficiary/partner must be issued with a statement detailing their entitlement.

Flow through treatment is only available if franking credits could flow through in equivalent circumstances.
There are integrity provisions to ensure the 'share' received does not exceed the entitlements under the trust/partnership terms and conditions.
Australian residency requirement for beneficiary/partner

Life insurers

Tax offset or franking credit4

Australian residency requirement

Integrity measures

The new rules also contain a number of specific integrity measures, including:

  • An 'excess exploration credit tax' that is imposed on the issuing entity, if they issue exploration credits in excess of the maximum number they are entitled to issue for a year. One circumstance where this could apply is where actual tax losses for a year are subsequently adjusted as a result of a tax audit. Where excess exploration tax is imposed, the Commissioner has a discretion to determine that the entity is no longer eligible to participate in the scheme.
  • Expansion of the general anti-avoidance rules in Part IVA to cover schemes with a dominant purpose of accessing exploration credits.
 

Conclusion

The proposed exploration incentive is a welcome measure, albeit limited. 

As the incentive is only proposed to apply to expenditure incurred in the 2014/15 to 2016-17 years, exploration companies will need to act quickly and ensure that they have the systems in place to take full advantage of the scheme.

Comments or submissions on the exposure draft must be submitted by Friday, 24 October 2014.

Footnotes
  1.  The entity must be a 'constitutional corporation', meaning a corporation to which paragraph 51(xx) of the Constitution applies (which includes a corporation incorporated under the Corporations Act and foreign corporations) or a body corporate that is incorporated in a Territory.
  2. At this stage, the scheme will not extend to expenditure incurred in the 2016-17 years onwards. However, a review will take place in 2016, and an extension of the scheme is possible.
  3. The recipient must be an Australian resident during the whole income year for which the exploration credit is issued.
  4. Life insurers' eligibility for refundable tax offsets is based on their eligibility to receive refundable tax offsets for franking credits under the imputation system . Otherwise, they are entitled to franking credits.

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