Exploration defined in a PRRT context What are the potential ramifications for you? TaxTalk Alert September 2013 www.pwc.com.au
Introduction Participants in the Australian Oil & Gas industry continue to face considerable uncertainty regarding the operation of the Petroleum Resource Rent Tax (PRRT) regime. The recent decisions by the Australian Federal Court and the Administrative Appeals Tribunal (AAT) in Esso Australia Resources Pty Ltd v Commissioner of Taxation [2012] FCAFC 5 and ZZGN v Commissioner of Taxation [2013] AATA 351 (the ZZGN case) (respectively) have highlighted that there is an apparent disconnect between the way in which the Petroleum Resource Rent Tax Assessment Act 1987 (PRRTAA) is interpreted and the manner in which the Australian Taxation Office (ATO) have administered the PRRT. The practical implications of the recent amendments made to the PRRTAA by Tax Laws Amendment (2013 Measures No. 2) Act 2013 (the Esso amendments) are such that Joint Venture Participants (JVP) may have reduced reliance on the information provided in JV statements to work out what payments are deductible for PRRT purposes. This is because JVPs now have to look through payments made to JV operators to identify amounts of excluded expenditure for PRRT purposes. All taxpayers with an interest in a PRRT project, whether the operator or not, are now also required to identify amounts of excluded expenditure and apportion deductions accordingly. In the absence of a formal ATO view on the definition of exploration as it applies to the PRRT, taxpayers may in the past have sought to rely on their understanding of the ATO s interpretation of the meaning of exploration for PRRT purposes, applying either a bright line test such as a Final Investment Decision (FID) or the ATO s official view in TR 98/23 of the definition of exploration in the Income Tax Assessment Act 1997 (ITAA). However, following the decision in the ZZGN case taxpayers now have to consider analysing each item of expenditure to identify whether the item qualifies as exploration expenditure for PRRT purposes. Coupled with the tracing and apportionment requirements under the Esso amendments, there is consequently significant uncertainty for taxpayers seeking to comply with the law refer to PwC s TaxTalk Alert dated 21 June 2013 for an overview. In an effort to assist taxpayers and to remove some of the ambiguity, on 21 August 2013 the ATO issued a draft taxation ruling TR 2013/D4 which sets out the Commissioner of Taxation s (Commissioner) preliminary view in respect of the meaning of the phrase:... involved in or in connection with exploration for petroleum... [emphasis added] in paragraph 37(1)(a) of the PRRTAA. The preliminary view expressed by the Commissioner in respect of the definition of exploration is broadly consistent with the outcomes in the ZZGN case. This TaxTalk Alert provides an overview of the draft Ruling (including the associated papers issued with it) and considers how taxpayers might be impacted. A key issue to be addressed in finalising the Ruling is the date from which it will apply. It is currently proposed that once finalised, the draft Ruling will apply to payments made from the date of issue of the draft Ruling (i.e. effective 21 August 2013). The draft Ruling is however silent on what view the ATO will take in respect of payments made prior to 21 August 2013, but the ATO has indicated that in the interim (until the Ruling is finalised) they would apply the principles from the ZZGN case. Taxpayers have to consider analysing each item of expenditure to identify whether the item qualifies as exploration expenditure for PRRT purposes. PwC TaxTalk Alert Page 1
Overview TR 2013/D4 It is the Commissioner s preliminary view that the definition of 'exploration for petroleum' takes its ordinary meaning (for the purposes of s37 of the PRRTAA), consistent with the findings by the AAT in the ZZGN case. It is argued the meaning is therefore limited to the discovery and identification of the existence, extent and nature of petroleum. This includes searching in order to discover the resource, as well as the process of ascertaining the size of the discovery and appraising its physical characteristics. The drilling of an appraisal well to evaluate the physical extent and nature of a find is provided as an example of exploration expenditure within the ordinary meaning. The Commissioner is of the preliminary view that economic evaluation activities such as postdiscovery feasibility studies of a petroleum field (for future development and production) do not fall within the ordinary meaning of exploration. Furthermore the words involved in or in connection with exploration for petroleum do not extend the scope of s37 of the PRRTAA to include such activities. Accordingly, such expenditure could be classified as general project expenditure under s38 of the PRRTAA. As a result this expenditure will not be able to be transferred between PRRT projects and a less favourable augmentation rate may apply. However, in certain circumstances some preparatory activities (to the recovery of petroleum) may be in connection with exploration for petroleum in the context of s37 of the PRRTAA where there is shown to be a direct or reasonably direct relationship between those operations or facilities and exploration for petroleum for example, feasibility studies that address whether or not to continue exploring. Consistent with the outcomes of the ZZGN case, the Commissioner is of the view that there is no bright-line test in determining whether an amount constitutes exploration. For example, some taxpayers may have argued that all expenditure incurred prior to a certain decision gate, such as FID, occurs in the company s exploration phase and should consequently be classed as exploration expenditure (i.e. under s37 of the PRRTAA). Additionally, the Commissioner is of the view that regulatory regimes and industry resource classification systems do not alter or extend the ordinary meaning of exploration or its interpretation under s37 of the PRRTAA. The drilling of an appraisal well to evaluate the physical extent and nature of a find is provided as an example of exploration expenditure within the ordinary meaning. PwC TaxTalk Alert Page 2
Additional guidance released The ATO has also released the following documents with its issue of the draft Ruling: A Discussion paper on the date of effect of the draft Ruling; The QC opinion obtained by the ATO on various provisions in the tax law relating to the meaning of exploration; and A Compendium of alternative views in respect of the draft Ruling. It is evident that the QC opinion obtained by the ATO is largely consistent with the Commissioner s preliminary view as illustrated in the draft Ruling. In his opinion, R.V. Gyles QC states the ordinary meaning of exploration is a reference to activities involved in the searching for and appraisal of minerals, but not activities involved in evaluating the find in terms of technical feasibility of extraction and economic or commercial variability of mining [emphasis added]. Furthermore, the ordinary meaning of exploration does not, in his view, encompass all expenditure incurred prior to any decision to commence mining (i.e. FID), expressly disagreeing with the Commissioner s views expressed in TR 98/23 and IT-2642 and also Parliament s view as outlined in the Explanatory Memorandum (EM) to the New Business Tax System (Capital Allowances) Bill 2001. The Compendium of views contains the ATO s record of the views and issues raised in the consultation process with Industry, prior to the issue of the draft Ruling. It is unclear whether these alternative views were put forward to the QC (the brief to QC was not published with the QC opinion). In our view, some of the alternative arguments/issues outlined in the Compendium are compelling and may provide a basis for challenging the view put forward by the AAT in the ZZGN case, and now the ATO in its draft Ruling. In particular we consider below some of the ATO s arguments to address the alternative views/issues identified by Industry in the Compendium: There is no trade, technical or special meaning of exploration or exploration for petroleum which, rather than the ordinary meaning, applies in the PRRTAA (issue 1 Compendium of views). This is despite the fact that the PRRTAA only applies to taxpayers in a particular industry where the technical term exploration (and therefore arguably the ordinary meaning) carries a different meaning to the dictionary definition of the word and to what an ordinary person may consider to be exploration. Situations may exist where a significant amount of expenditure is black-holed (issue 4 Compendium of views). That is, taxpayers may not be able to utilise some expenditure under the PRRTAA. For example, where a taxpayer carries out post-discovery economic feasibility studies (i.e. front end engineering design or FEED) and determines to not proceed with a project development, the expenditure cannot be utilised by the taxpayer, nor is it transferable. In our view it is unlikely that the legislators intended for the situation to arise where significant amounts of expenditure, for instance FEED expenditure, is never deductible and/or utilised. This has the possibility of materially impacting project economics and the decision whether or not to proceed to the FEED stage for any project subject to PRRT. The meaning of exploration in both the PRRTAA and the ITAA is different as they appear in different statutory contexts (issue 7 Compendium of views). In our view, a strong argument exists that the ordinary meaning of the word exploration at the time the income tax definition was amended in 1997 (to expressly include feasibility studies) was already broad enough to include economic feasibility studies. It was for this reason, and to align the legislation with the ATO s administrative practice, that the income tax definition was amended (as per the EM to the Income Tax Assessment Bill 1996). There is no dividing line (e.g. a FID) between expenditure under s37 and s38 of the PRRTAA (issues 5 and 10 Compendium of views). The AAT and the ATO are in our view correct in concluding there is no bright-line test expressed in either the PRRTAA or in the ITAA. However the ATO s guidance as outlined in TR 98/23 and IT 2642 clearly states that in the Commissioner s view a bright-line test exists. In the absence of any official guidance in relation to the PRRT, taxpayers have had no other alternative than to refer to the ATO guidance issued in relation to income tax (and this is acknowledged by the ATO). PwC TaxTalk Alert Page 3
Key impacts for affected taxpayers Application date The Ruling (once finalised) will only be binding on the Commissioner and it will be up to taxpayers to decide whether or not to follow the ATO s guidance on this point. Taxpayers that choose not to follow the Commissioner s view may be subject to penalties and interest, if the ATO was to issue an amended assessment. Currently the final Ruling is proposed to have application to all payments made from the date of issue of the draft Ruling (i.e. effective 21 August 2013). In respect of payments made by taxpayers prior to the issue date of the draft Ruling, the ATO will conclude on its position upon finalisation of the Ruling, leaving prior periods with a significant degree of uncertainty. In the meantime, until this point is settled in the final Ruling, the ATO has stated that it will administer the law in respect of any income year (including prior periods) as set out in the ZZGN case and reflected in the draft Ruling. The ATO has invited comments in respect of the date of effect of the final Ruling. Arguably the view expressed in the draft Ruling is a change in administrative practice by the ATO. The ATO s views in respect of the PRRT definition of exploration were considered in the Inspector-General of Taxation s report to the Assistant Treasurer on U-turns ( Review into delayed or changed Australian Taxation Office views on significant issues dated March 2010). Given the above, it is our strong view that any nonconcessionary retrospective application of this Ruling to any payments made prior to the date of issue which is inconsistent with previous administrative practice is bad tax policy and should be avoided. Taxpayers have invested significant amounts in projects with, at least, a strong understanding of how the PRRTAA will be administered. Other key impacts Some of the key issues for the ATO and Industry to consider include: Where a taxpayer has previously sold or acquired an interest in a petroleum project, both the vendor and purchaser should consider their contractual rights and obligations under the relevant transaction agreement(s) and review Transfer Notices to ensure that the correct amounts of expenditure, and the classification thereof, have been transferred. Taxpayers that have transferred interests in PRRT projects may be challenged by the transferee (where a Transfer Notice has been prepared on the basis of prior administrative practice but not in line with the ZZGN case and the ATO s current view). Taxpayers who have adopted conservative positions and/or have been in dispute with the ATO may have conceded on the classification of certain amounts of exploration expenditure. However, should the final Ruling only apply prospectively and the ATO commits to not disturbing prior year assessments, this would make those taxpayers worse off compared to those who may have taken more aggressive positions. The ATO is suggesting that to address historic position, a mediation process may be undertaken with taxpayers. One approach suggests that the ATO develop a set of principles based on TR 2010/D4, a draft Ruling that expressed the Commissioner s preliminary view of the meaning of exploration for PRRT purposes (published on 30 June 2010; withdrawn on 5 October 2012). If not already done so, taxpayers need to form a view on the application of the ZZGN case to their circumstances and prepare their accounts accordingly. Taxpayers should monitor whether the ATO will apply its view prospectively or retrospectively. If the ATO determines that it will not be pursuing taxpayers positions retrospectively (i.e. payments made prior to 21 August 2013), taxpayers should re-evaluate any related provisions/positions previously booked. PwC TaxTalk Alert Page 4
Other key impacts (cont.) If the Commissioner upholds its narrow view of the ordinary meaning of exploration, an R&D benefit may arise for some taxpayers. Exploration is considered to be a non-core activity (i.e. a supporting activity) for R&D purposes and to be eligible must have been undertaken for the dominant purpose of supporting the core R&D activities. Accordingly, preparatory activities that are (in the Commissioner s view) considered to be outside the ordinary meaning of exploration such as feasibility studies could potentially be considered a core activity for R&D purposes (as opposed to being a support activity) in which case the dominant purpose test would not need to be met to claim these activities. What should you be doing now? Consider making a submission. PwC will be making a submission in consultation with Industry members. We welcome any contributions from Industry in relation to our submission. Consider revisiting the treatment of current exploration expenditure under s37 of the PRRTAA. Taxpayers should consider their current project economic assumptions included in any financial models to ensure that only eligible costs are carried forward and uplifted (or transferred) as exploration expenditure. Taxpayers should consider their ability to support historical PRRT deductions claimed and review their: PRRT assessments for years which remain open for amendment; Transfer Notices; The balance of un-deducted PRRT expenditures carried forward; Financial models used for investment decisions, tax accounting and impairment testing; Prior period exploration expenditure transfers (under s45a and s45b of the PRRTAA); and Starting base determinations. Taxpayers should consider the impact on project Residual Pricing Methodology (if applicable). What can we expect next? The ATO has communicated that they are currently working on the definition of exploration for income tax purposes. It is likely the Commissioner will leverage off the QC opinion obtained as it considers the ordinary meaning of exploration in an income tax context. As a result TR 98/23 could be withdrawn in its entirety (we note the ATO is currently reviewing this Ruling as a result of the ZZGN case). The ZZGN case is a decision of the AAT and should not be given the same weight as a judicial precedent such as a Federal Court decision. It remains open for another taxpayer to challenge the ATO and the views expressed by the AAT by taking a similar matter to the Federal Court. Until such time as that occurs, and as demonstrated in the draft Ruling, the AAT s interpretation is likely to be followed by the ATO. PwC TaxTalk Alert Page 5
pwc.com.au Let s talk For a deeper discussion of how this issue might affect your business or if you would like to contribute towards PwC s submission, please contact: David Lewis, Perth +61 (8) 9238 3336 david.r.lewis@au.pwc.com William Campbell, Perth +61 (8) 9238 3343 william.campbell@au.pwc.com Sara Mattsson, Perth +61 (8) 9238 3671 sara.e.mattsson@au.pwc.com James Strong, Melbourne + 61 (3) 8603 6599 james.r.strong@au.pwc.com James O Reilly, Brisbane +61 (7) 3257 8057 james.oreilly@au.pwc.com Scott Bryant, Adelaide +61 (8) 8218 7450 scott.a.bryant@au.pwc.com Ronen Vexler, Sydney +61 (2) 8266 0320 ronen.vexler@au.pwc.com Judy Sullivan, Tax Controversy + 61 (2) 8266 0197 judy.sullivan@au.pwc.com Amanda Gell, R&D +61 (8) 9238 3515 amanda.gell@au.pwc.com 2013 PricewaterhouseCoopers. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers a partnership formed in Australia, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. The information in this publication is provided for general guidance on matters of interest only. It should not be used as a substitute for consultation with professional accounting, tax, legal or other advisers. This document is not intended or written by PricewaterhouseCoopers to be used, and cannot be used, for the purpose of avoiding tax penalties that may be imposed on the tax payer. Before making any decision or taking any action, you should consult with your regular PricewaterhouseCoopers professional. No warranty is given to the correctness of the information contained in this publication and no liability is accepted by the firm for any statement or opinion, or for any error or omission.