House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon. P.J. Keating, M.P.)

Chapter Five: Calculation of Taxable Profit

1. Summary of Proposed Changes

The amendments proposed by this Bill will affect the calculation of the taxable profit of a petroleum project in two main ways. First, the classes of available deductible expenditure have increased as a result of -

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the two rates of compounding for augmented bond rate general expenditure; and

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the wider deductibility of exploration expenditure incurred on or after 1 July 1990 that is included in either augmented bond rate exploration expenditure or GDP factor expenditure.

There will now be two classes of augmented bond rate general expenditure. Broadly, general expenditure incurred not more than five years before the issue of the production licence in relation to the project and before 1 July 1990 is classified as class 1 augmented bond rate general expenditure. General expenditure incurred on or after 1 July 1990 and not more than five years before the issue of the production licence in relation to the project is class 2 augmented bond rate general expenditure.

There will also be two classes of augmented bond rate exploration expenditure. Expenditure incurred before 1 July 1990 (class 1) will not be transferable while expenditure incurred on or after that date (class 2) can be transferable to other projects.

GDP factor expenditure is also classified into non-transferable amounts (class 1) - exploration expenditure incurred before 1 July 1990 plus all general project expenditure - and transferable amounts (class 2) - exploration expenditure incurred on or after 1 July 1990.

Secondly, wider deductibility of exploration expenditure will mean that there may be transfers of exploration expenditure to a project that will have the effect of reducing its taxable profit. Transfers of exploration expenditure to a project may be from other petroleum projects held by a person or, in the case of a company, from other projects held by another company in the company group. Transfers may also occur from exploration permits and retention leases (exploration rights) to projects.

2. Background

PRRT is payable on the taxable profit in respect of a petroleum project and a year of tax. Taxable profit is the excess of assessable receipts over deductible expenditure.

Under the present law deductible expenditure is made up of the total of -

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augmented bond rate general expenditure which includes general project expenditure actually incurred in the year and that carried forward from earlier years;

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augmented bond rate exploration expenditure which includes exploration expenditure actually incurred in the year and that carried forward from earlier years;

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GDP factor expenditure which includes general project or exploration expenditure actually incurred and that carried forward from earlier years; and

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closing-down expenditure.

Where there is an excess of deductible expenditure (other than closing-down expenditure) over assessable receipts at the end of a financial year, that excess is compounded forward for deduction against future receipts from the project.

The classification of expenditures and the resultant rate of compounding will depend on the time at which the relevant expenditure was incurred. Broadly GDP factor expenditure is general project or exploration expenditure incurred more than five years before the production licence in relation to the project came into force and augmented bond rate expenditures are those general project or exploration expenditure incurred within the five years.

Augmented bond rate general expenditure is project-specific, in that it may only be deducted against the particular project, whereas augmented bond rate exploration expenditure and GDP factor expenditure is deductible against projects within project groups (broadly, projects involving production licences drawn from the same exploration permit).

3. Clauses involved in the Changes

Clause 5: inserts section 2A which defines the term "GDP factor" and will make it applicable for the entire Act.

Clause 8: amends section 22 to bring transferred exploration expenditure into the taxable profit calculation.

Clause 11: amends section 32 to take account of the new classes of expenditure.

Clause 13: amends section 34 so that the section will only apply to exploration expenditure incurred before 1 July 1990.

Clause 15: amends section 35 so that the section will only apply to exploration expenditure incurred before 1 July 1990 and to general project expenditure incurred in any financial year.

Clause 16: inserts sections 35A and 35B which will apply to transferable exploration expenditures either as augmented bond rate exploration expenditure or GDP factor expenditure.

Clause 17: makes consequential amendments to section 36.

Clause 19: inserts Division 3A which sets out the rules on transfers of exploration expenditure.

Clause 21: amends section 97 to ensure that the calculation of instalments is based on the new rules.

4. Explanation of the Amendments

How is taxable profit calculated?

Under wider deductibility undeducted exploration expenditure of petroleum projects and exploration rights will be transferable to other projects.

As a result, the taxable profit in relation to a person, a project and a year of tax will be the excess of total assessable receipts after deducting the following:

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the deductible expenditure of the project;

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the total of amounts transferred to the project from other projects and exploration rights held by that person; and

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if the person was a company in a company group, the total of the amounts transferred to the project from projects and exploration rights held by other companies in the group. [Clause 8, section 22]

It should be noted that under the transfer rules a transfer of expenditure to a project will only occur where, in relation to the receiving project, assessable receipts exceed deductible expenditure in the financial year. Also the amount of expenditure transferred to a project cannot be greater than that excess - in other words, the sum of transferred expenditure and deductible expenditure cannot exceed assessable receipts.

There are set rules on how a person calculates amounts of transferable expenditure (see Chapter 6) and how transfers of expenditure are to be made (see Chapter 7).

What is deductible expenditure?

The amendments in this Bill that give effect to wider deductibility of exploration expenditure and reduce the rate of compounding for augmented bond rate general expenditure will result in the classes of deductible expenditure increasing from four to seven. The classes of expenditure will now be -

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class 1 augmented bond rate general expenditure;

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class 1 augmented bond rate exploration expenditure;

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class 2 augmented bond rate general expenditure;

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class 1 GDP factor expenditure;

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class 2 augmented bond rate exploration expenditure;

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class 2 GDP factor expenditure; and

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closing down expenditure. [Clause 11]

The expenditures are deductible in the above order. This is important because in situations where there is an excess of deductible expenditure over assessable receipts for a financial year the order determines what expenditures remain undeducted and are able to be compounded forward against receipts of future years.

Two classes of augmented bond rate general expenditure

Class 1 augmented bond rate general expenditure is general expenditure incurred before 1 July 1990, while class 2 augmented bond rate general expenditure is expenditure incurred from that date (subject to the rule that augmented bond rate general expenditure can only be general expenditure incurred not more than five years before the issue of the production licence in relation to the project). The distinction is necessary because if the expenditures remain undeducted in relation to a financial year, they are compounded at different rates and carried forward for deduction against receipts of future years. This is discussed in detail in Chapter 4.

Two classes of augmented bond rate exploration expenditure

Broadly, under the existing law augmented bond rate exploration expenditure is exploration expenditure incurred by a person in relation to a project within 5 years of the projects production licence coming into force.

Only exploration expenditure of a project incurred on or after 1 July 1990 will be transferable to other projects that otherwise have a taxable profit. Therefore there is a need to distinguish transferable and non-transferable augmented bond rate exploration expenditure.

Class 1 augmented bond rate exploration expenditure

Expenditure incurred before 1 July 1990 (and therefore non-transferable) will be known as class 1 augmented bond rate exploration expenditure. The existing section 34 is being modified so that it properly identifies this expenditure. [Clause 13]

Section 34 will operate in exactly the same way as before in relation to petroleum projects and combined projects except that it will only relate to exploration expenditure actually incurred before 1 July 1990. As a result, for financial years commencing on or after 1 July 1990, class 1 augmented bond rate exploration expenditure will only be made up of amounts compounded and carried forward because in the project there were insufficient assessable receipts to offset the expenditure up to the financial year ended 30 June 1990.

None of this expenditure is transferable under the proposed wider deductibility rules.

Class 2 augmented bond rate exploration expenditure

Class 2 augmented bond rate exploration expenditure will be exploration expenditure that is incurred on or after 1 July 1990 and is therefore transferable under the proposed wider deductibility.

Broadly, exploration expenditure will be available for transfer in a financial year only after it has first been offset against assessable receipts of the project in relation to which it was incurred. Part 2 of the Schedule which will be inserted by this Bill contains rules on how to calculate, in relation to the deductible expenditure of a project, the amount of class 2 augmented bond rate exploration expenditure that is taken to be incurred in relation to a project - with the remainder being available for transfer to other projects. (This is dealt with in Chapter 6 - Calculation of Transferable Expenditure.)

Therefore the amount of Class 2 augmented bond rate exploration expenditure taken to be incurred in relation to a person, a project and a financial year is the amount worked out under the rules found in Part 2 of the Schedule. [Clause 16, subsection 35A(1)]

Compounding of non-transferable and transferable expenditure contrasted

The existing rules that will continue to apply to non-transferable expenditure are: deductible expenditure is offset against assessable receipts in a specific order; where assessable receipts are insufficient to cover the particular expenditure in a financial year, the undeducted expenditure is compounded (at either the augmented bond rate or GDP factor rate); and, the compounded amount is deemed to have been expenditure incurred on the first day of the following financial year.

In contrast, although subject to the specific order of deductibility, if assessable receipts are insufficient to cover post 1 July 1990 expenditure in the year it is actually incurred, the undeducted expenditure becomes available for transfer to other projects. If not transferred, it simply remains undeducted actual expenditure of that year. If in a later financial year there are assessable receipts available to offset some or all of the undeducted actual expenditure of the earlier year, then that actual expenditure is compounded and is carried forward and taken to be incurred in that later financial year.

There is no compounding forward of undeducted transferable expenditures until there are assessable receipts available to absorb that expenditure. Any remaining undeducted actual expenditure continues to be available to be offset against future years or for transfer to other projects.

The amount taken to be incurred

Where class 2 augmented bond rate exploration expenditure is deducted in the financial year it is actually incurred, the amount taken to be incurred under section 35A will be that amount. Where the expenditure is deducted in a financial year later than the year it is incurred, the amount taken to be incurred under section 35A will be the compounded amount.

Actual expenditure that is attributed to amounts taken to be incurred under section 35A cannot be counted again -

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as expenditure incurred or taken to be incurred by a person; or

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when working out whether there is transferable expenditure;

in a later financial year. [Clause 16, new subsection 35A(2)]

This provision prevents multiple deductions being generated by the one amount of actual expenditure.

Two classes of GDP factor expenditure

Broadly, under the existing law, GDP factor expenditure is any exploration or general expenditure incurred by a person in relation to a project more than 5 years before the project's production licence came into force.

GDP factor expenditure of a project that is exploration expenditure incurred on or after 1 July 1990 will be transferable to other projects in the same way as class 2 augmented bond rate exploration expenditure.

The amendments proposed by this Bill will distinguish transferable expenditure from other GDP factor expenditure by creating two classes of GDP factor expenditure

Class 1 GDP factor expenditure

Class 1 GDP factor expenditure will be general expenditure incurred in any financial year or exploration expenditure incurred before 1 July 1990. [Paragraph 15(f)]

This is subject to the rule that only expenditure incurred more than 5 years before the project's production licence came into force can be GDP factor expenditure. [Paragraph 15(f)]

Section 35 will be modified so that it properly refers to class 1 GDP factor expenditure. [Paragraphs 15(a), (c) and (e)]

While section 35 will now apply to a narrower class of expenditure, it will operate in exactly the same way as it did before these amendments. Thus class 1 GDP factor expenditure in relation to a person, a project and a financial year will be any amounts of class 1 GDP factor expenditure actually incurred in the year plus any amount taken to be incurred in the financial year by way of carry forward compounded amounts of undeducted expenditure. Similarly the amount of class 1 GDP factor expenditure in relation to a combined project will be calculated in exactly the same way as before.

Because there is a production licence in force in relation to the Bass Strait project from the date of application of PRRT to that project (1 July 1990) there cannot be any GDP factor expenditure in relation to the Bass Strait project. [Paragraph 15(b)]

Class 1 GDP factor expenditure will effectively be deducted from a person's assessable receipts after class 1 augmented bond rate general expenditure, class 1 augmented bond rate exploration expenditure and class 2 augmented bond rate general expenditure have been deducted.

Consequently - where in a financial year the sum of those expenditures and the GDP factor expenditure exceeds assessable receipts - so much of the excess that does not exceed the class 1 GDP factor expenditure is compounded forward by the GDP factor rate and taken to be class 1 GDP factor expenditure incurred on the first day of the next financial year. [Paragraph 15(d)]

GDP factor to be defined for the purposes of the entire Act

The provisions that define GDP factor are relevant to both section 35 and new section 35B (class 2 GDP factor expenditure). As amended, the term "GDP factor" will become part of the general interpretation provisions so that it will have application for the purposes of the whole the Principal Act. [Paragraph 15(f), clause 5, new section 2A]

Class 2 GDP factor expenditure

Class 2 GDP factor expenditure of a project will be exploration expenditure incurred on or after 1 July 1990 that is otherwise GDP factor expenditure and is therefore transferable to other projects under the new wider deductibility rules.

As with class 2 augmented bond rate exploration expenditure, before an amount of class 2 GDP factor expenditure becomes available for transfer it must first be offset against the assessable receipts of the petroleum project in relation to which it was incurred. Part 3 of the Schedule, that is being inserted by this Bill, contains rules to calculate:

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the amount taken to be incurred and, therefore, deductible in respect of the project; and

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the amount, if any, of the class 2 GDP factor expenditure available for transfer from the project.

Section 35B brings to account the amount of class 2 GDP factor expenditure taken to be incurred as deductible expenditure of the project. [Clause 16, new subsection 35B(1)]

Part 3 of the Schedule will operate in the same way as Part 2. Undeducted actual expenditure of a financial year is not automatically compounded forward and deemed to be incurred on the first day of the next financial year. It becomes available for transfer in the year it is incurred. If not transferred it simply remains expenditure of that year either to be compounded forward when there are receipts in later years or to be transferred in later years.

Actual class 2 GDP factor expenditure that is attributed to amounts taken to be incurred under section 35B cannot be brought to account again as expenditure incurred or taken to be incurred by a person in a later financial year or when working out any transferable expenditure in a later year. [Clause 16, new subsection 35B(2)]

This provision prevents multiple deductions being generated by the one amount of actual expenditure.

Project groups

There is a limited form of wider deductibility for projects involving production licences drawn from the same exploration permit already available under section 36 of the Principal Act. The amendments proposed by this Bill will mean that only class 1 augmented bond rate exploration expenditure and class 1 GDP factor expenditure will be deductible against projects in a project group. [Clause 17]

Class 2 augmented bond rate exploration expenditure and class 2 GDP factor expenditure will be deductible against all projects of a person. This will effectively replace section 36 as the means of offsetting excess expenditures of one project against assessable receipts of another with the much wider basis being introduced by the Bill.

Transfers of exploration expenditure generally

Where in relation to a project and a financial year a person has an excess of assessable receipts over deductible expenditure and that person has an interest in another project with transferable exploration expenditure, then this expenditure must be transferred to the first project. The same rule applies to an exploration right (where no project actually exists because a production licence has not been issued), so that if the person has an interest in an exploration right that has transferable exploration expenditure that expenditure must be transferred.

The amounts transferred to a project are taken into account in the taxable profit calculation under section 22 of the Principle Act. Parts 2, 3 and 4 of the Schedule inserted by this Bill will set out rules on how to calculate the amounts of transferable expenditure (see chapter 6). Where transferable expenditure is incurred in a financial year before the year the transfer takes place the expenditure will be compounded as it is carried forward to the transfer year. This is consistent with compounding forward of undeducted expenditure which is offset against receipts of the project in which the expenditure was actually incurred.

However, in the case of expenditure that is transferred, the rate of compounding is to be set according to the project to which the expenditure is transferred. This is dealt with in Part 7 of the Schedule. Where the transfer takes place in the year the expenditure was incurred only actual amounts are transferred.

Part 5 of the Schedule sets out rules for how transfers of transferable expenditure are to be made in the case of a person having interests in projects and/or exploration rights. The transfer must be notified to the Commissioner and a person who does not make a transfer in accordance with the rules is guilty of a punishable offence. [Clause 19, new section 45A]

Transfers are discussed in detail in Chapter 7

Transfers of expenditure between group companies

In the case of a company in a company group, the transfer rules will effectively apply on a group wide basis. A person is taken to include a company under the Principal Act by virtue of section 22 of the Acts Interpretation Act 1901. Therefore, the taxable profit otherwise calculated in relation to a person being a company, project and financial year may be reduced by transferable expenditure of projects or exploration rights held by other companies in the group. The definition of a group will follow that contained in section 80G of the Income Tax Assessment Act 1936.

The onus is on the company with the transferable exploration expenditure to make the transfer in accordance with the rules set out in Part 6 of the Schedule inserted by the Bill. Broadly, the company making the transfer must first make transfers in accordance with section 45A and Part 5 of the Schedule between its own projects. If after making transfers under Part 5 of the Schedule the company still has transferable expenditures it is obliged to comply with Part 6.

An inter-company transfer must be notified to the Commissioner and the transferring company that does not make a transfer in accordance with Part 6 is guilty of a punishable offence. [Clause 19, new section 45B]

Collection by instalments

Under the existing law, PRRT is collected by instalments. Instalments are cumulative, taking into account actual receipts and expenditure in the year of tax up to the end of the instalment period, a proportionate amount of previously undeducted expenditure and the amount of any prior instalments in that year of tax.

The scheme already in place for the collection of PRRT by instalments basically remains. The amendments to section 97 of the Principal Act by the Bill provide for the new section 34A (class 2 augmented bond rate general expenditure) and exploration expenditure amounts (that are not otherwise taken to be incurred and compounded forward) to be taken into account in determining the notional tax amount (the amount payable by a person as an instalment of tax in relation to an instalment period). [Clause 21]

PRRT instalments due and payable on or before 30 June 1991 will not be recalculated. [Clause 36]