Senate

Revised Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Petroleum Resource Rent Tax

Outline of chapter

4.1 Schedule 6 to the Bill amends the Petroleum Resource Rent Tax Assessment Act 1987 (PRRTAA) to address the unintended impacts arising from the decision of the Full Federal Court in Esso Australia Resources Pty Ltd v Commissioner of Taxation [2012] FCAFC 5 ( Esso ).

4.2 The amendments ensure that taxpayers can apportion payments for the purposes of determining deductible expenditure under the petroleum resource rent tax (PRRT) law. The amendments ensure that, where a taxpayer:

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incurs expenditure which was not solely incurred in relation to a petroleum project, the expenditure can be apportioned with that portion of expenditure incurred in relation to the project being deductible; or

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makes a payment to procure the carrying out of activities by a third party where that payment is not solely related to a petroleum project, the payment is able to be apportioned to determine the portion which is deductible.

4.3 The amendments also ensure that, where a PRRT taxpayer makes a payment to procure an unrelated third party to undertake project operations, activities or things on their behalf, they are not required to 'look-through' to the character and nature of the expenditure incurred by the third party to determine the extent to which the payment is deductible.

4.4 However, where the third party is related to the PRRT taxpayer, the amendments require that a look-through approach generally be applied, consistent with the decision of the Full Federal Court.

Context of amendments

Overview of the Petroleum Resource Rent Tax

4.5 The PRRT is a project-based resource profits tax of 40 per cent of certain taxable profits derived from the extraction and processing of petroleum recovered in Commonwealth waters. The PRRT was extended to apply to the North West Shelf project and onshore petroleum projects from 1 July 2012. The PRRT is imposed under the Petroleum Resource Rent Tax Assessment Act 1987 (PRRTAA). All legislative references in this Chapter are to the PRRTAA unless otherwise specified.

4.6 The PRRT is assessed on a petroleum project basis and is levied on the 'taxable profit' derived by a taxpayer in a financial year from a petroleum project. Taxable profit is calculated by deducting from project assessable receipts the person's eligible real expenditure, together with any expenditure transferred to the project from other projects.

4.7 Deductible expenditure broadly includes those expenditures, whether capital or revenue in nature, which are incurred in carrying on or providing the operations, facilities or other things related to the project ('project activities'). The deductible expenditure provisions of the PRRTAA cover three main expenditure types:

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exploration expenditure (section 37);

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general project expenditure (section 38); and

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closing down expenditure (section 39).

4.8 However, section 44 provides that certain types of expenditure, such as administrative costs or other work costs indirectly incurred, are not deductible, notwithstanding that they were incurred in relation to a petroleum project. Such costs are referred to as 'excluded expenditure'.

4.9 A taxpayer may carry on or provide operations, facilities or other things ('project activities related to their project themselves (including through their employees or agents), or alternatively pay a third party to carry on or provide those project activities on their behalf.

4.10 Where a PRRT taxpayer incurs a liability to make a payment to a third party to carry on or provide project activities, section 41 currently operates to treat:

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the PRRT taxpayer as having carried on those activities; and

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the liability to have been incurred by the PRRT taxpayer in undertaking those activities.

Application of the PRRT law prior to the Esso decision

Deductible expenditure provisions treated as self-apportioning

4.11 Prior to the decision in Esso , the Commissioner of Taxation (the Commissioner) applied the PRRT law on the basis that the deductible expenditure provisions of the PRRT were self-apportioning. That is, if a PRRT taxpayer incurred expenditure not solely related to a petroleum project ('mixed expenditure'), the mixed expenditure could be apportioned, with that portion incurred in relation to the project being deductible (provided it was not excluded expenditure).

4.12 Similarly, payments made to a third party to procure project activities in addition to non-project related activities could also be apportioned, with that portion related to the provision of project activities treated as having been incurred by the taxpayer under section 41 and deductible by the taxpayer, subject to the deductible expenditure provisions.

Deductibility of third party payments for project activities

4.13 Where a taxpayer had made a payment to procure project activities to be carried out by a third party, the taxpayer was generally not required to look-through to the nature of the expenditure incurred by a third party in undertaking the activities to determine the extent to which the payment was deductible. Rather, the deductibility of the payment was dependent on the nature and character of the activities procured and how they related to the project.

4.14 If the third party only carried out or provided project activities, then that expenditure (which would have been deductible had the activities procured been undertaken by the PRRT taxpayer) was taken to be of the same character and nature as the activities procured and the taxpayer's payment was treated as deductible in full. This was notwithstanding that the payment may have taken into account expenditure by the third party that would have been excluded expenditure had it been directly incurred by the PRRT taxpayer.

4.15 However, if the third party was contracted by the taxpayer to provide services which would constitute excluded expenditure under section 44 if incurred directly by the taxpayer (such as indirect administrative activities, for instance), then the payment for those services was excluded expenditure and was not therefore deductible under section 37, 38 or 39.

Impact of the decision in Esso

Deductibility of third party payments for project activities

4.16 The deductibility of third party payments under section 41 was considered by the Full Federal Court in Esso .

4.17 In its decision, the Court held that, under section 41, payments made by a PRRT taxpayer to a third party for project activities are taken to have the same characteristics as the actual expenditure incurred by the third party in undertaking or providing the activity. The Court noted that:

'...s 41 achieves the unsurprising result that the eligible person is in the same position to claim deductions from assessable receipts...as it would have been if it had carried on the activities comprising the project itself. Where an eligible person incurs a liability to make a payment to procure the carrying on or providing of operations, facilities or things of a kind referred to in s 37, 38 or 39 by another person, the deeming worked by paras (a) and (b) of s 41 makes the liability of the eligible person a liability to pay for those operations, facilities and things, including...things which are "excluded expenditure" as designated by s 44.'

4.18 The practical effect of applying this look-through interpretation is that, if part of the third party's expenditure is excluded expenditure under section 44, then it will also be excluded expenditure for the PRRT taxpayer and consequently not deductible.

4.19 Requiring PRRT taxpayers to apply a look-through approach to third party payments would require the third party to provide details of all the expenditure incurred in providing the service, including commercial-in-confidence information, in order for the taxpayer to determine the extent to which the payment was deductible.

4.20 A third party who is unrelated to the taxpayer is likely to be unwilling to provide the required information and, in its absence, the Commissioner will be unable to determine what proportion of the payment for services was deductible, potentially resulting in the entire payment being non-deductible.

4.21 In contrast, where parties are related there are not the same issues concerning providing information between the parties. Accordingly, requiring PRRT taxpayers to apply a look-through approach for payments made to related contractors protects the integrity of the PRRT. In these circumstances, the look-through requirement ensures that excluded costs and related party profit margins are not taken into account in working out the deduction available to the PRRT taxpayer.

Scope to apportion expenditure under the deductible expenditure provisions

4.22 In its decision, the Court also made the observation that the deductible expenditure provisions of the PRRTAA relating to exploration expenditure, general expenditure, and closing down expenditure (sections 37, 38 and 39 respectively) do not allow for payments to be apportioned.

4.23 The effect of this is that, where a taxpayer incurs mixed expenditure, none of the expenditure will be deductible. This is notwithstanding that a portion of it was legitimately incurred in relation to a petroleum project. The same outcome will also occur under section 41 where a payment was made to a third party which was not made solely to procure the carrying on or provision of project activities.

4.24 The Commissioner's longstanding administrative practice in relation to the PRRT has been to treat the relevant sections as self-apportioning.

Summary of new law

Scope to apportion expenditure

4.25 The amendments ensure that PRRT taxpayers can apportion 'mixed' expenditure that is only partly incurred in relation to a particular petroleum project for the purposes of determining deductible expenditure under sections 37, 38 and 39. To the extent a payment or part of a payment is made in relation to a project, it is able to be deducted provided it is not excluded expenditure.

4.26 Similarly, the amendments ensure that payments made to procure the carrying on of project activities, as well as other things, by a third party can be apportioned for the purposes of the PRRT law.

Look-through requirement limited to payments to related parties

4.27 Where a PRRT taxpayer makes a payment to an unrelated third party to procure project activities, the amendments ensure that the Commissioner's longstanding application of section 41 applies. That is, to the extent the payment is made to procure the carrying on or provision of project activities, it is treated as having been incurred by the taxpayer in carrying on or providing those things in determining its deductibility.

4.28 However, consistent with the decision of the Full Federal Court, where a PRRT taxpayer pays a related contractor to carry on or provide project activities (excluding those related to capital), the requirement that the taxpayer look-through the payment is preserved. That is, the character, nature and amount of the payment reflects that of the actual expenditure incurred by the related contractor in carrying on the project activities procured for the purposes of determining the extent to which it is deductible under sections 37, 38, 39 and 44.

4.29 Where a payment or part of a payment to a related contractor is made for the use of property (on which capital expenditure was incurred), the payment or part of the payment is not looked-through, but instead is deemed to have the same character and nature as the project activity procured.

Comparison of key features of new law and current law

Detailed explanation of new law

Scope to apportion expenditure

4.30 These amendments ensure that 'mixed' expenditure incurred by a taxpayer only partly in relation to a petroleum project can be apportioned to determine deductibility.

4.31 Where a PRRT taxpayer incurs expenditure in relation to both project activities (section 37, 38 or 39), as well as in relation to other things, the amendments confirm that expenditure can be apportioned to determine the amount and type of deductible expenditure under the PRRT law.

4.32 This is achieved by replacing the reference to payments 'liable to be made' and 'liable to be paid' in the deductible expenditure provisions relating to exploration, general project and closing-down expenditure, with the terms, 'to the extent that they are made', and 'paid by the person, to the extent that the payment relates to'. The words, 'to the extent' which are commonly used in the income tax law, support the apportionment of expenditure.

4.33 Only the part of the payment that was incurred in relation to project activities, and which does not constitute excluded expenditure is able to be deducted. [Schedule 6, items 1 and 2, subsection 37(1) of the PRRTAA, items 4 and 5, subsection 38(1) of the PRRTAA and Schedule 6, item 7, subsection 39(1) of the PRRTAA ]

Example 4.36 : Apportionment between types of deductible expenditure

Chan Resources holds an interest in a petroleum project and, on 1 July 2015, purchases a drill for $5 million to recover petroleum from the licence area as well as to carry on exploration for new petroleum pools in the licence area.

Drilling records confirm the drill was used in carrying on the recovery of petroleum and in carrying on the exploration for other petroleum pools in the production licence area.

Chan Resources incurs exploration expenditure to the extent the payment is made in carrying on the operations, facilities and other things required in section 34. Chan Resources also incurs an amount of general project expenditure to the extent the payment is made in carrying on the operations, facilities and other things in section 38.

The method of apportionment adopted by Chan Resources is a question of fact to be determined in the circumstances, and should be supported by business records sufficient to satisfy the substantiation requirements in section 112.

Example 4.37 : Apportionment of project related expenditure between multiple petroleum projects

Colour Enterprises holds an interest in both the Green petroleum project and the White petroleum project. Brian is employed by Colour Enterprises and is the site supervisor of both projects.

To determine the amount of general project expenditure incurred by Colour Enterprises in relation to each project, the salary paid to Brian in 2013-14 is apportioned to the extent that Brian is involved in carrying on the project activities for both the Green and White projects.

Colour Enterprises chooses to apportion the payment according to the time directly spent by Brian on the activities of each project. This method of apportionment is appropriate provided it is substantiated by the business records kept by Colour Enterprises.

Example 4.38 : Apportionment between deductible expenditure and excluded expenditure

JillCo holds an interest in an exploration permit and enters a hire purchase agreement on 1 July 2014 with LukeCo to acquire a drill in order to carry on exploration activities in the permit area.

Under the terms of the agreement, which separately discloses the interest charge, JillCo makes 12 monthly payments of $110,000. The total payment is $1.32 million ($1.20 million plus $0.12 million interest).

JillCo incurs exploration expenditure of $1.20 million for the payments made in carrying on the project activities. The $0.12 million interest charge is not deductible as exploration expenditure, as it constitutes excluded expenditure under paragraph 44(1)(b).

Example 4.39 : Apportionment between eligible real expenditure and non-project expenditure

Wetgasco holds an interest in an offshore petroleum project from which natural gas is recovered for use as feedstock for an integrated LNG plant. Wetgasco owns and operates the onshore processing and liquefaction plant.

The natural gas recovered from the project's offshore recovery platform is transported via pipeline to an onshore processing facility that removes impurities to produce the marketable petroleum commodity sales gas, before it then enters the downstream liquefaction plant to be further processed into LNG.

Grant is the operations manager for Wetgasco with responsibility for supervising the overall integrated gas to liquid (GTL) operation up until the point the LNG is produced and ready for sale.

In order to determine the amount of general project expenditure for the petroleum project, the salary paid to Grant by Wetgasco must be apportioned to reflect the extent to which the payment was made in carrying on or providing project activities, noting that the project ring fence occurs at the point sales gas is produced and becomes an excluded commodity.

Westgasco chooses to apportion Grant's salary payment according to the time directly spent by Grant on the project activities. The portion of Grant's salary related to time spent managing the downstream liquefaction activities is non-project expenditure and is not deductible. This method of apportionment is appropriate provided it is substantiated by the business records kept by Westgasco.

Apportionment of payments to third parties

4.34 The amendments also confirm that a PRRT taxpayer can apportion payments that are subject to section 41 where only part of the payment is to procure another person to carry on project activities. [Schedule 6, item 9, subsection 41(1) of the PRRTAA ]

4.35 Apportionment under section 41 effectively excludes the part of the payment made to the third party that was not to procure the carrying on or provision of project activities, but does not otherwise alter the operation of section 41 as a deeming provision, as confirmed by the Full Federal Court.

4.36 The deductibility of the part of the payment made to procure project activities, and which is taken to have been incurred by the taxpayer under subsection 41(1), is determined under sections 37, 38 and 39 of the PRRTAA.

Example 4.40 : Apportionment of a third party payment

Amartya Co holds an interest in an offshore petroleum project from which natural gas is recovered for use as feedstock for an integrated LNG plant. Amartya Co owns the onshore processing and liquefaction plant, but makes payments to Alpha Engineering to operate the processing and liquefaction plant on its behalf. As activities related to the liquefaction fall beyond the PRRT ring fence, Amartya Co apportions the payment made to Alpha Engineering to reflect that part of the payment relating to the provision of upstream project activities. Section 41 operates to deem that portion of the payment to have been incurred by Amartya Co in carrying on or providing project activities. Whether, and to what extent, the deemed payment is deductible is determined under the deductible expenditure provisions of the PRRTAA.

Deductibility of payments to third parties and the operation of section 41

4.37 The amendments repeal the current section 41, and replace it with a new section 41 which clarifies how payments made by a taxpayer to procure a third party to carry out or provide project activities are treated, depending on whether the third party is 'related' or 'unrelated' to the taxpayer. [Schedule 6, item 9, subsections 41(1) and 41(1A) of the PRRTAA ]

4.38 Where the third party is commercially or operationally related to the PRRT taxpayer, the Full Federal Court's interpretation of the operation of section 41 is largely preserved. That is, where a PRRT taxpayer makes a payment to procure project activities from another participant such as the operator, or a related contractor, the taxpayer is required to 'look-through' to the character, nature and amount of the related contractor's expenditure when determining how much of the payment is deductible under the PRRT law. [Schedule 6, item 9, paragraph 41(1)(d) of the PRRTAA ]

4.39 The amendments ensure that section 41 applies to payments made to third parties to procure project services or activities so that there is no requirement to look through to the character, nature and amount of the expenditure of the third party where the third party is not related to the PRRT taxpayer. [Schedule 6, item 9, paragraph 41(1)(b) of the PRRTAA ]

4.40 Not requiring PRRT taxpayers to look-through payments to an unrelated contractor's underlying expenditure reflects both that the parties are acting at arm's length as well as the practical difficulty of administering the arrangements under such circumstances.

When is a third party related to a PRRT taxpayer?

4.41 The amendments define what constitutes a related person for the purposes of the broader operation of section 41. [Schedule 6, item 9, subsection 41(1A) of the PRRTAA ]

4.42 A third party (referred to as the 'other person') that provides services to the PRRT taxpayer (referred to as the 'eligible person') is related to the taxpayer for the purposes of section 41 where they:

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hold an interest in the same petroleum project for which they are providing the operations, facilities or other things to the taxpayer; or

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are connected with the taxpayer to whom they are providing the project operations, facilities or other things.

4.43 Broadly, entities are 'connected' within the meaning of section 328-125 of the ITAA 1997 to one another if either entity controls the other, or both are controlled by the same third entity.

4.44 In addition, where the other person engages another party that is connected to the other person (referred to as the third person) to carry on or provide the activities procured on behalf of the eligible person, then the third person will be related for the purposes of section 41. [Schedule 6, item 9, subsection 41(1C) of the PRRTAA ]

Example 4.41 : Project service providers related to taxpayer RexCo holds an interest in a petroleum project and makes a payment to ProcessCo, a wholly owned subsidiary, to carry out project activities. ProcessCo contracts with ThreeCo, another wholly owned subsidiary of RexCo, to provide some of the activities in relation to the project. ProcessCo is connected to RexCo and so paragraph 41(1A)(b) applies in relation to that part of the payment relating to the project activities carried on by ProcessCo. Further, as ProcessCo and RexCo are connected and ProcessCo procured project activities from ThreeCo, which is a connected entity with ProcessCo, subsection 41(1C) will apply to that part of the payment relating to the project activities provided by ThreeCo. Example 4.42 : Third party related to taxpayer

BlackCo holds a 60 per cent interest in a petroleum project and is the joint venture operator responsible for project operations. The remaining project interest is held by RedCo. RedCo pays BlackCo for the project activities carried out in relation to its project interest.

BlackCo makes payments to WhiteCo, a wholly owned subsidiary, to carry on all the operations in relation to the project.

As BlackCo is procuring project operations from the connected entity WhiteCo on behalf of Redco; and as BlackCo holds an interest in the project, subsection 41(1C) applies in relation to the payment by RedCo to BlackCo.

Payments made to an unrelated contractor to procure project services

4.45 Where a PRRT taxpayer contracts with an unrelated contractor, to the extent the contract payments are to procure the carrying on or provision of project activities in relation to a project, the project activities procured are deemed to have been undertaken by the taxpayer and not the third party. Subsequently, the payment is deemed to have been incurred by the taxpayer in carrying on or providing those project activities. [Schedule 6, item 9, subsection 41(1) of the PRRTAA ]

4.46 For the purposes of determining the extent to which the payment constitutes deductible expenditure, the character and nature of the project activities procured is taken to be impressed upon the payment for the purposes of sections 37, 38, 39 and 44. That is, where a payment or part of a payment is solely for project activities which do not constitute excluded expenditure, that payment is taken to have been incurred in carrying on or providing those activities and is deductible in full. The taxpayer is not required to look-through the payment to what the contractor incurred expenditure on in providing the service. [Schedule 6, item 9, paragraph 41(1)(b) of the PRRTAA ]

Example 4.43 : Application of section 41 to an unrelated party - single operating expense PetroSarah holds an interest in an onshore petroleum project. PetroSarah enters into a service agreement with Lee Co to provide staff to operate a drill rig for the recovery of petroleum from the production licence area. The agreement is for a 12 month period for the fixed payment of $2 million. Lee Co incurs $1.9 million of expenditure in operating the drill rig. Lee Co does not hold an interest in the project and is not connected with PetroSarah and so subsection 41(1A) does not apply. Since subsection 41(1A) does not apply to Lee Co, the $2 million payment by PetroSarah is taken for the purposes of sections 37, 38, 39 and 44 to have the same character and nature as the operations, facilities or other things procured. The payment to Lee Co was incurred to procure a 'project activity' which is not itself an excluded expenditure type under section 44. Consequently, PetroSarah can deduct the full $2 million as general project expenditure (despite Lee Co only incurring $1.9 million of expenditure). Example 4.44 : Application of section 41 to an unrelated party - project activity procured is excluded expenditure

A PRRT taxpayer, Bayside Oil, incurs a liability to pay $100,000 to obtain office space for its administrative employees from an unrelated third party that does not hold an interest in the project. The office building is located at a site some distance from the project site which is not adjacent to the project operations.

Subsection 41(1A) does not apply as the person providing the office facilities to Bayside Oil is not a related party.

Therefore, the payment is deemed to have been incurred by Bayside Oil and is taken to have the same character and nature as the project activity procured.

Payments in respect of land and buildings for use in connection with administration, which are not adjacent to the project operations, are excluded expenditure under paragraph 44(1)(k). Consequently, the payment is an item of excluded expenditure when section 37, 38 or 39 is applied and is not deductible to Bayside Oil.

Payments made to a related contractor to procure project services: look-through

4.47 Where a PRRT taxpayer makes a payment to a related contractor to procure the carrying on or provision of project activities, the activities procured are treated as having been undertaken by the taxpayer. To the extent the payment relates to procuring those activities, it is deemed to have been made by the taxpayer in carrying on or providing those activities.

4.48 The PRRT taxpayer is required to look-through to the expenditure incurred by the related contractor in providing the service to determine the extent to which the payment constitutes deductible expenditure.

4.49 The payment deemed to have been made by the PRRT taxpayer under subparagraph 41(1)(a)(ii) is, except where it relates to the use of property (on which capital expenditure was incurred), taken to be of the same character, nature and amount as the expenditure incurred by the third party in providing the project activity. Where the third party incurs expenditure in providing the project activity that would be excluded expenditure had it been directly incurred by the PRRT taxpayer, then that expenditure is excluded expenditure when deemed to have been made by the PRRT taxpayer. [Schedule 6, item 9, paragraph 41(1)(d) of the PRRTAA ]

4.50 As the amount of the payment deemed to have been made by the PRRT taxpayer is also limited to the amount of expenditure incurred by the related party in providing this service, any mark-up is also effectively precluded from deduction by the PRRT taxpayer. This ensures that a PRRT taxpayer cannot artificially increase its deductible expenditure by establishing a related service company rather than undertaking project activities directly. [Schedule 6, item 9, subparagraph 41(1)(d) of the PRRTAA ]

Example 4.45 : Application of section 41 to related party - single expense

Nomis Co holds an interest in an offshore petroleum project. Nomis Co enters into a service agreement with Semaj Co, a wholly owned subsidiary, to provide maintenance services for the project's oil platform. The agreement is for a 12 month period for a fixed payment of $3 million.

Semaj Co incurs $2.75 million of expenditure in maintaining the platform.

Subsection 41(1A) applies as Semaj Co is connected to Nomis Co. Therefore, the payment that is deemed to have been made by Nomis Co under subparagraph 41(1)(a)(ii) is taken to be of the same character, nature and amount as the expenditure incurred by Semaj Co for the purposes of determining deductible expenditure under sections 37, 38, 39 and 44.

In this example, Nomis Co is taken to have incurred $2.75 million in expenditure, which is deductible as general project expenditure under section 38 of the PRRTAA.

Example 4.46 : Application of section 41 to related party - expenditure includes excluded expenditure

Assume the same facts as Example 6.10, except in this case, as well as incurring $2.75 million expenditure on maintaining the oil platform, Semaj Co also incurs an additional $10,000 in indirect head office administration expenses.

As subsection 41(1A) applies to Semaj Co, the payment deemed to have been incurred by Nomis Co is taken to be $2.76 million, being the same amount as the expenditure Semaj Co incurred in carrying on or providing the project service procured.

The payment is also taken to have the same character and nature as the $2.76 million expenditure incurred by Semaj Co for the purposes of determining its deductibility under sections 37, 38, 39 and 44. As indirect administrative or accounting costs are excluded expenditure under paragraph 44(1)(j) of the PRRTAA, Nomis Co is only able to deduct $2.75 million as general project expenditure under section 38.

Payments made to a related party concerning property

4.51 There is an exception to the look-through requirement where the payment or part of the payment relates to the use of property (on which the related party incurred capital expenditure) by the related party to provide the project activities procured by the PRRT taxpayer. To the extent the payment relates to the use of property on which the related party has incurred capital expenditure, that payment is treated like payments made to unrelated contractors for the purposes of determining the deductibility of the payment or part of the payment. [Schedule 6, item 9, paragraph 41(1)(c) of the PRRTAA ]

Example 4.47 : Payments to a related party in relation to property

LuckyLuke holds an interest in an onshore petroleum project and enters into an agreement with a wholly owned subsidiary, AnnaBella Co to provide and operate a drilling rig for the project. The agreement is for a 12 month period for a fixed payment of $10.15 million. The amount charged by AnnaBella Co includes an amount of $7 million which, consistent with normal commercial practice, takes into account a return of, and a return on, the capital cost of the drilling rig. The payment also includes $3 million to cover the operating expenses and labour costs incurred by AnnaBella Co to operate the rig, and a five per cent mark-up on the operating expenses to cover indirect costs, totalling $150,000.

As AnnaBella Co is wholly owned by LuckyLuke, they are connected and subsection 41(1A) applies. Paragraph 41(1)(c) applies to the part of the payment relating to the use of the drill rig (that is, $7 million) which is taken to have the same character and nature as the project activity procured for the purposes of sections 37, 38, 39 and 44. Paragraph 41(1)(d) applies to the extent the payment by LuckyLuke does not relate to the use of property, namely the operating costs and the mark-up. As this portion of the payment is taken to be of the same amount, character and nature as the expenditure incurred by AnnaBella Co, LuckyLuke is taken to have only made a payment of $3 million (subsection 41(1)). The $150,000 mark-up is not taken to have been made by LuckyLuke as it was not expenditure AnnaBella Co incurred in relation to the project.

Determining that part of the payment that relates to the use of property is a question of fact to be determined based on the circumstances. The method LuckyLuke uses to determine the extent the payment relates to the use of property is supported by the business records provided by AnnaBella Co.

A payment deemed under section 41 cannot exceed actual payment

4.52 As noted, where a PRRT taxpayer makes a payment to procure the carrying on or provision of project activities by a related contractor, the amount of the payment deemed under subparagraph 41(1)(a)(ii) to have been made by the taxpayer for the purposes of sections 37, 38, 39 and 44 is taken to be of the same character, nature and amount as the expenditure incurred by the related contractor in providing the activities procured.

4.53 Where the expenditure incurred by the related contractor in carrying on the project activities exceeds the payment made by the PRRT taxpayer, the related contractor's expenditure is taken to be proportionately reduced so as to ensure the taxpayer cannot deduct expenditure it did not incur. [Schedule 6, item 9, subsections 41(1B) and 41(1D) of the PRRTAA ]

Example 4.48 : Related party expenditure exceeds payment for project services

A related service provider, Company C, charges the eligible PRRT taxpayer $100,000 for the provision of project activities. However, the expenditure the related third party incurred in carrying on or providing the activities procured is $150,000 of which $50,000 is excluded expenditure. Under subsection 41(1B) the amount of the payment taken to be made by the eligible PRRT taxpayer is $100,000. Under subsection 41(1D), the character and nature of the payment reflects the proportionate reduction in the payment - that is, of the $100,000 one third (50,000/150,000) is excluded expenditure for the purposes of sections 37, 38, 39 and 44.

When deductible expenditure is taken to be incurred

4.54 The PRRT is intended to recognise expenditure at the time the liability for such expenditure arises, rather than when the amount is actually paid. This is consistent with the approach taken under the income tax law.

4.55 Amendments are made to exploration expenditure, general project expenditure and closing-down expenditure provisions to clarify the time at which the payment is taken to be incurred. This is when the taxpayer is liable to make the payment. [Schedule 6, items 3, 6, and 8, subsections 37(3 ), 38(3) and 39(5) of the PRRTAA ]

4.56 A similar amendment is made to section 41 in relation to payments made to a third party, which also provides that the payment is taken to have been incurred at the time it is liable to be paid. [Schedule 6, item 10, subsection 41(3) of the PRRTAA ]

4.57 When a person becomes liable to make a payment is determined by taking into consideration all the relevant facts surrounding the payment, including any contractual terms between the parties.

4.58 A contract that provides that payment is to be made on the issue of an invoice after delivery of the contract services, could give rise to a liability to make a payment when the invoice is issued. However, this depends on the terms of the arrangement.

Application of the PRRTAA anti-avoidance provisions

4.59 The anti-avoidance provisions in Part V of Division 6 continue to apply to arrangements, including those to which section 41 applies.

4.60 If a taxpayer enters into an arrangement, including transferring assets or restructures creating a tax benefit, the general anti-avoidance provisions contained in Division 6 of Part V may apply, if the requirements of the Division are satisfied.

4.61 If a payment made by a person is one to which deeming under section 41 applies, section 58 may apply so that the amount of the deemed expenditure may be reduced to what it would have been had the parties been dealing at arm's length in relation to the transaction.

4.62 Section 58 may also apply when apportioning the payment made by the eligible person between the part that relates to the use of property (on which the other person has incurred capital expenditure) and the other components.

Application provisions

4.63 The amendments generally apply from the applicable commencement date of the petroleum project. For projects located in Commonwealth waters (except the North West Shelf, and Bass Strait), the applicable commencement date is 1 July 1986. The applicable commencement date for the Bass Strait project is 1 July 1990. [Schedule 6, paragraph 11(1)(a)]

4.64 However, in relation to interests in onshore projects and the North West Shelf project, to which the PRRT was extended from 1 July 2012, the amendments apply from the relevant starting base date of the project interest, as outlined in section 45. For those petroleum project interests where the PRRT taxpayer has chosen the look-back approach to value its starting base, the relevant starting base date is 1 July 2002. Similarly, for project interests where the PRRT taxpayer has chosen the market or book value approach to value its starting base, these amendments will commence from the time the interim expenditure period relating to the interest commences. [Schedule 6, paragraphs 11(1)(b) and 11(1)(c)]

4.65 The retrospective application of the amendments benefits PRRT taxpayers. Without retrospective application, taxpayers would be denied deductions for past project expenditures where they were incurred as 'mixed expenditure' or alternatively where the taxpayer is unable to sufficiently substantiate the character and nature of expenditure incurred by contractors paid for undertaking past project activities.

4.66 The ability to apportion expenditure is consistent with the intended profits-based operation of the PRRT and with its administration since commencement. By providing that apportionment applies from the commencement date of projects, the amendments ensure that PRRT taxpayers holding interests in offshore petroleum projects, particularly those who are yet to submit a PRRT return, are able to deduct past expenditures legitimately incurred in relation to a project.

4.67 Similarly, in relation to onshore projects and the North West Shelf project, the application of these amendments from the relevant starting base date ensures that taxpayers are not denied the ability to take into account legitimate past project expenditure in determining the starting base amount for those project interests existing as at 2 May 2010, under the 'look-back', market value or book value approaches.

4.68 The amendments relating to the deductibility of contractor payments under section 41 apply to contractor payments made by PRRT taxpayers who have not been required to furnish an annual PRRT return in relation to their project interest prior to 14 December 2012 (the date the amendments were announced) as if the contractor was unrelated to the taxpayer for payments incurred prior to 1 July 2013. This ensures that past payments made by these PRRT taxpayers to contractors, and for which the taxpayer is unlikely to have sufficient records to apply a look-through approach, are treated consistently with the application of the PRRT law prior to the decision in Esso . [Schedule 6, subitem 11(3)]

4.69 The section 41 amendments will, however, apply from 1 July 2012 for those PRRT taxpayers who have been required to furnish an annual PRRT return prior to 14 December 2012. [Schedule 6, subitem 11(2)]

4.70 This recognises that, following the Esso decision, the Commissioner released a Decision Impact Statement acknowledging that the past administration of the PRRTAA differed from the Court's interpretation. The Statement advised that the ATO would not seek to disturb assessments for the 2011-12 and earlier years, provided the taxpayer self-assessed consistent with the ATO's general administrative practice in this area or where taxpayers choose to amend past assessments consistent with the ATO's general administrative practice.

4.71 Some taxpayers may not have the necessary records to substantiate their claims for payments made prior to the introduction of these amendments, particularly given the considered views expressed by the Full Federal Court in the Esso case on the application of section 41. It is expected that the Commissioner, in consultation with industry, will adopt a reasonable approach to substantiation and apportionment where a past assessment is amended, or found not to have complied with the past general administrative practice, in these circumstances.

4.72 The amendments also clarify for the purposes of the application provisions that a reference to payment takes the same meaning as that used in sections 37, 38, 39 and 41. This ensures consistency between the application provisions and the deductible expenditure provisions in the PRRTAA. [Schedule 6, subitem 11(4)]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Petroleum Resource Rent Tax (PRRT) - Esso

4.73 Schedule 6 to this Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

4.74 Schedule 6 to this Bill amends the Petroleum Resource Rent Tax 1987 to address issues arising out of the Full Federal Court decision in Esso Australia Resources Pty Ltd v Commissioner of Taxation [ 2012 ] FCAFC 5.

Human rights implications

4.75 This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

4.76 This Schedule is compatible with human rights as it does not raise any human rights issues.

Assistant Treasurer, the Hon David Bradbury