House of Representatives

Replacement Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 1 - Tax relief for certain mining arrangements

Outline of chapter

1.1 Schedule 1 to this Bill provides tax relief to taxpayers entering into certain arrangements in relation to mining, quarrying and prospecting rights and information. Relief will apply to farm-in farm-out (FIFO) arrangements, interest realignment arrangements and expenditure relating to the improvement of mining, quarrying and prospecting information.

1.2 The relief is provided in situations where recently enacted integrity rules would otherwise operate to disadvantage taxpayers who engage in genuine exploration activities, and other legitimate arrangements.

Context of amendments

1.3 The Tax and Superannuation Laws Amendment (2014 Measures No. 3) Act 2014 (the 2014 amendments) amended the uniform capital allowance (UCA) provisions in Division 40 of the Income Tax Assessment Act 1997 (ITAA 1997). The 2014 amendments limited the immediate deduction available for the cost of acquiring mining rights and mining information first used for exploration (see section 40-80 of the ITAA 1997). An immediate deduction is now only available where the mining rights or information are acquired from a specified source (for example a government authority).

1.4 The immediate deduction exists to support the exploration for resources. The explanatory memorandum to the 2014 amendments provides that the purpose of limiting the deduction was to address integrity concerns that deductions were being claimed for the acquisition of resources that had already been discovered.

1.5 As originally announced in the 2013-14 Budget, the amendments limiting the immediate deduction would have provided relief for taxpayers entering into FIFO arrangements. The enactment of this relief, however, was deferred.

1.6 In the 2014-15 Budget, the Government announced a further decision to provide relief to taxpayers who realign their interests in mining, quarrying and prospecting rights to facilitate common development projects. These realignments are known as interest realignment arrangements.

1.7 Following further consultation with industry, the Government has also decided to amend section 40-80 to overcome a technical issue that may have prevented some taxpayers from claiming immediate deductions for expenditure incurred in enhancing mining, quarrying or prospecting information.

Operation of the current law

Disposals of mining, quarrying and prospecting rights generally

1.8 Interest realignment and FIFO arrangements involve the disposal of mining, quarrying or prospecting rights. The current law applies differently depending on when the rights were acquired. Disposals of rights acquired between 20 September 1985 and 1 July 2001 (pre-UCA rights) are subject to the capital gains tax (CGT) rules. Disposals of rights acquired from 1 July 2001 (UCA Rights) are subject to the UCA regime, which commenced on that date (see section 40-77 of the Income Tax (Transitional Provisions) Act 1997).

1.9 Expenditure that was incurred in acquiring pre-UCA assets is included in the cost base of the asset for CGT purposes. The capital gain or capital loss on the disposal of the right is recognised under the CGT rules. Generally, a capital gain or capital loss is the difference between:

•

the capital proceeds received by a taxpayer when a CGT event happens to an asset; and

•

the cost base of the asset.

1.10 Generally, where an asset has been disposed of for non-cash consideration, the capital proceeds received are taken to include the market value of the property the taxpayer receives, or is entitled to receive, in respect of the CGT event happening (paragraph 116-20(1)(b) of the ITAA 1997).

1.11 For UCA rights, taxpayers may deduct an amount equal to the decline in value of the right (depreciating asset) they hold during an income year. The decline in value is generally worked out by reference to the effective life of the depreciating asset.

1.12 When a UCA right is disposed of, a balancing adjustment event is triggered (section 40-285 of the ITAA 1997). This adjustment brings to account any difference between the tax written-down value (adjustable value) of the asset and the amount received on disposal (termination value). If the termination value exceeds the adjustable value, the difference is included in assessable income. Deductions are generally available if the adjustable value exceeds the termination value.

1.13 Generally, where a UCA right is disposed of for non-cash consideration, the termination value of the right includes the market value of any benefits received (item 4 of the table in subsection 40-305(1) of the ITAA 1997). Similarly, where a depreciating asset has been acquired for non-cash consideration, the first element of the asset's cost includes the market value of that non-cash consideration (item 4 of the table in subsection 40-185(1) of the ITAA 1997).

Interest realignment arrangements

1.14 An interest realignment occurs where the parties to a joint venture exchange interests in mining, quarrying or prospecting rights to pursue a single development project, with a view to aligning the ownership of individual rights with the ownership of the overall venture.

Example 1.1 : Simple interest realignment example

Two mining companies own mining rights with respect to separate tenements, each worth $25 million. The two companies decide to form a joint venture as equal partners to develop the two tenements as a single project. As part of the joint venture, each company transfers 50 per cent of their original right to the other. Both companies now own 50 per cent of each right, collectively the common development project.

Each company's rights now reflect their interest in the common development project. This is an example of an interest realignment arrangement.

1.15 When parties enter into an interest realignment arrangement, a balancing adjustment event occurs to each party in relation to the rights disposed of. An amount is immediately brought to account reflecting the difference between the market value of the new right and the adjustable value of the original right. Prior to the 2014 amendments, each party would be entitled to an immediate deduction for each right acquired under the arrangement if they subsequently first used their new right for exploration or prospecting. This would result in a tax neutral outcome provided there was no other consideration involved.

1.16 The cost of the new right acquired, however, will not qualify for an immediate deduction under the amended section 40-80. The cost of the new right (that includes the market value of the original right) is deductible only over the lesser of the new right's effective life or 15 years. This outcome is not necessary to achieve the integrity objectives of the 2014 amendments and may have the effect of impeding interest realignment arrangements that encourage the joint development of resource discoveries.

Example 1.2 : Interest realignment tax outcomes

Further to Example 1.1, the termination value of each company's transferred right is $12.5 million (the market value of the new right received). Assuming the parties were previously entitled to an immediate deduction for the costs of the rights, $12.5 million will be included in each company's assessable income. The 2014 amendments apply to the companies and the companies are not entitled to an immediate deduction for the cost of the new rights. The cost of each new right ($12.5 million) is deductible to its acquirer over the lesser of the asset's effective life or 15 years. This produces a net income tax liability in the income year in which the realignment occurs.

Farm-in farm-out arrangements

1.17 A FIFO arrangement broadly involves the exchange of an interest in a mining, quarrying or prospecting right in return for an 'exploration benefit', usually an entitlement to receive exploration services or to have exploration expenditure funded by the other party. The initial owner of the right is known as the farmor. The person providing the exploration benefit in exchange for a part of the right is known as the farmee. The farmee may provide other consideration or commitments that do not relate to exploration benefits.

1.18 There are two broad types of FIFO arrangements - immediate transfers and deferred transfers. An immediate transfer occurs where the farmor transfers the right at the time the farm out agreement is entered into. A deferred transfer farm-out occurs where the farmor provides a right or option to the farmee to have right transferred to them after the agreed exploration or prospecting is carried out.

1.19 Under either type of arrangement, the farmee may agree to meet the expenses of the farmor in holding the farmor's right so the farmor is 'free carried' in respect of its retained right in the tenement. This free-carried commitment may include land tax payments and licence fees in addition to exploration commitments in relation to the farmor's retained right. This is in addition to any expenses the farmee meets for their own costs in owning, or potentially owning, a right in the tenement.

1.20 The tax treatment of FIFO arrangements, prior to the 2014 amendments, is outlined in the Australian Tax Office's Miscellaneous Tax Rulings MT 2012/1 and MT 2012/2 . Under these rulings, a FIFO arrangement will generally have tax neutral outcomes for the farmor and the farmee to the extent the arrangement involved exploration benefits. However, where the arrangement includes the payment of cash or other consideration for the farmor's original right, tax consequences may arise.

1.21 The rulings' broadly tax neutral outcome relied on the availability of an immediate deduction under section 40-80 for the farmee's cost of acquiring the right. This deduction would offset an amount that is included in the farmee's assessable income that reflected the value of the mining, quarrying or prospecting right received as a reward for services or as the capital proceeds of CGT event D1 (creating a contractual right in another entity).

1.22 In light of the 2014 amendments, an immediate deduction will be unavailable and the farmee's cost will only be deductible over the lesser of the right's effective life or 15 years. Further amendments are necessary to ensure that FIFO arrangements do not have these tax consequences where those consequences could impede genuine exploration activity.

Improvements to mining, quarrying or prospecting information

1.23 Paragraph 40-80(1)(e) of the ITAA 1997 outlines some of the limitations on when a taxpayer can claim an immediate deduction for the costs of acquiring mining, quarrying or prospecting information. The limitations relate to where the taxpayer sources the information.

1.24 Paragraph 40-80(1AB)(d) provides that a taxpayer will not be entitled to an immediate deduction for the cost of improving information (a second element cost) if the information does not satisfy paragraph 40-80(1)(e).

1.25 The operation of this criterion may mean that taxpayers are not entitled to immediate deductions for the expenditure incurred in improving mining information themselves. In those circumstances, providing an immediate deduction is appropriate and does not raise the integrity concern addressed through the 2014 amendments.

Summary of new law

1.26 Schedule 1 to this Bill provides tax relief for taxpayers entering into arrangements that support genuine exploration activity and other arrangements that do not raise integrity concerns.

1.27 Part 1 of Schedule 1 provides roll-over relief for taxpayers entering into interest realignment arrangements.

1.28 Part 2 provides a number of relief mechanisms for taxpayers entering into FIFO arrangements.

1.29 Part 3 amends section 40-80 to allow taxpayers to claim immediate deductions for expenditure that relates to certain improvements to mining, quarrying or prospecting information, regardless of how the original information was acquired.

Comparison of key features of new law and current law

Detailed explanation of new law

Part 1: Interest realignment arrangements

1.30 Roll-over relief is provided for taxpayers who enter into interest realignment arrangements. An interest realignment arrangement is an arrangement that involves two or more parties that each hold mining, quarrying or prospecting rights that relate to a common development project the parties propose to undertake jointly. The project must relate to mining or quarrying operations as defined in subsection 40-730(7) of the ITAA 1997. The project may already exist or it may be a proposed project. [Schedule 1, item 1, paragraph 40-363(5)(a) of the ITAA 1997]

1.31 The effect of the arrangement must be to align the interests that each party has in each right with their interest in the common development project. The interests of the parties in the common development project are to be determined by reference to the estimated resources and reserves underlying the relevant rights. The estimation of resources and reserves is to be conducted using an appropriate industry practice. [Schedule 1, item 1, subsections 40-363(6) and (7), and paragraph 40-363(5)(b) of the ITAA 1997]

1.32 The arrangement must not involve any other transfer of a mining, quarrying or prospecting right. [Schedule 1, item 1, paragraph 40-363(5)(c) of the ITAA 1997]

1.33 It is not necessary that the rights exchanged relate to tenements with close geographical proximity provided they form part of the same project or proposed project. [Schedule 1, item 1, paragraph 40-363(5)(a) of the ITAA 1997]

1.34 The exact form of roll-over relief will depend on the type of rights disposed of under the arrangement. Generally:

•

where the original rights were acquired after 1 July 2001 (UCA rights), balancing adjustment roll-over relief will be available;

•

where the original rights were acquired between 20 September 1985 and 1 July 2001 (post-CGT and pre-UCA rights), CGT roll-over relief will apply. Rights received under the arrangement will be deemed to have been acquired during that period; and

•

where the original rights were acquired prior to 20 September 1985 (pre-CGT rights), the rights received under the arrangement will have pre-CGT status.

Uniform capital allowance balancing adjustment relief

1.35 Balancing adjustment event roll-over relief applies to interest realignments where the taxpayer's original interest was acquired after 1 July 2001. [Schedule 1, item 1, subsection 40-363(1) of the ITAA 1997]

1.36 Taxpayers may choose to apply the roll-over. The choice must be made in writing when the taxpayer lodges their income tax return for the relevant income year. The Commissioner of Taxation may allow a longer period. [Schedule 1, item 1, subsection 40-363(2) of the ITAA 1997]

1.37 The effect of the roll-over is that a standard balancing adjustment (section 40-285) does not occur. [Schedule 1, item 1, paragraph 40-363(3)(a) of the ITAA 1997]

1.38 The adjustable value of the taxpayer's original right disposed of under the arrangement is transferred to the cost of the new right the same taxpayer received. [Schedule 1, item 1, paragraph 40-363(3)(c) of the ITAA 1997]

Other Proceeds

1.39 As part of an interest realignment, a taxpayer may also provide or receive consideration other than mining, quarrying and prospecting rights. Consideration in the form of money is a common example that is often exchanged when parties have rights that do not equate to their interest in the common development project.

1.40 For the party to an interest realignment that provides other consideration (the payer), the amount, or an equivalent amount, is added to the cost of the right received (see for example item 1 of the table in subsection 40-185(1) of the ITAA 1997).

1.41 For the party receiving the consideration (the payee), the amount of other consideration (and only that amount) is included in their assessable income in the income year in which the balancing adjustment event occurred. This is achieved by deeming the adjustable value of the right provided to be the market value of the right received and applying an otherwise standard balancing adjustment calculation (termination value less adjustable value). [Schedule 1, item 1, subsection 40-363(4) and paragraph 40-363(3)(b) of the ITAA 1997]

Example 1.3 : Interest realignment with additional consideration

Brian and Mark are partners in a mining operation and each owns mining rights relating to the project. Each partner acquired his right after 1 July 2001.

Brian and Mark agree to enter into an interest realignment such that they will each hold a 50 per cent interest in each of the original rights. This will align with their interests in the joint venture.

Brian's agrees to transfer 50 per cent of his right. That 50 per cent part has an adjustable value of $100 million. Mark agrees to transfer 50 per cent of his right. Mark's 50 per cent part has an adjustable value of $50 million.

Brian's right is expected to contain more resources than Mark's right and is more valuable to the joint venture. Mark, therefore, agrees to transfer $50 million to Brian in addition to providing the 50 per cent interest in his mining right.

The $50 million is included in Brian's assessable income and added to the cost of Mark's new right. This reflects that Brian is disposing of a significant portion of his right for cash, which is not subject to the roll-over relief offered for the exchange of rights.

Mark has not received any consideration other than a mining right so no amount will be included in his assessable income. The adjustable value of Mark's original right is transferred to the cost of Mark's new right. To this, Mark adds $50 million, being the amount of other consideration provided, for a total cost of $100 million.

The cost of Brian's new right is $100 million, being the adjustable value of Brian's original right.

Capital gains tax relief

1.42 CGT roll-over relief applies to interest realignments where the taxpayer's original right was acquired prior to 1 July 2001.

1.43 The consequences, generally, for the roll-over are that any capital gain or loss is disregarded and the cost base of the original right disposed of is transferred to the right acquired. The specific consequences are detailed in existing Subdivision 124-A and new Subdivision 124-S. [Schedule 1, item 2, sections 124-1220 and 124-1225 of the ITAA 1997]

1.44 Where more than one right is provided, or more than one new right is received, the cost base of each new right must be determined on a reasonable basis. This allocation of the original cost base or cost bases is by reference to the number, market value and character of the original and new rights. [Schedule 1, item 2, section 124-1235 of the ITAA 1997]

1.45 The character of the rights could refer to the estimated resources or reserves of the rights, provided this was a reliable comparator, or other features. The reference to market value does not require a professional valuation to be obtained but is included as a factor to be considered when selecting a particular characteristic, such as resources, on which to allocate cost bases to achieve the required reasonable allocation of cost bases.

Other proceeds

1.46 Consideration other than mining, quarrying and prospecting rights are not eligible for CGT roll-over relief (they are ineligible proceeds and are attributed to an ineligible part of the original right). A partial roll-over remains available for the eligible part of the transaction. [Schedule 1, item 2, section 124-1230 of the ITAA 1997]

1.47 For the party to an interest realignment that provides other consideration (the payer), the amount, or an equivalent amount, is added to the cost base of the right received. [Schedule 1, item 2, subsections 124-1225(2) and (3) of the ITAA 1997]

1.48 The mechanism for assessing the ineligible proceeds differs slightly from the mechanism that applies to UCA rights. Under the UCA roll-over, all of the proceeds other than the relevant rights are assessable and the entire adjustable value of the original right is transferred to the new right.

1.49 Under the CGT roll-over, the cost base is apportioned between the eligible and ineligible parts of the original right and only that part that relates to the eligible part is used in the roll-over. A standard CGT event applies in relation to both the ineligible proceeds and the ineligible part of the original cost base reasonably allocated to that part. As a result, some of the cost base may be applied to reduce the amount of any capital gain arising from the ineligible proceeds.

Example 1.4 : CGT interest realignment with additional consideration

Assume the same facts as in Example 1.3 except that both Mark and Brian acquired their interests between 20 September 1985 and 1 July 2001. Assume that the cost bases of their rights are equal to the adjustable value of those rights in Example 1.3.

Brian receives $50 million in cash that is an ineligible proceed. The cost base of his transferred right ($100 million) is apportioned between the eligible and ineligible parts of the right on a reasonable basis. Assume that this apportionment results in a $25 million cost base for the ineligible part and $75 million for the eligible part.

Brian makes a $25 million capital gain ($50 million cash proceeds less $25 million ineligible part cost base). Any capital gain or loss made on the eligible part of the interest is disregarded. The cost base and reduced cost base of Brian's new interest is $75 million, the cost base of the eligible part.

Mark receives a complete roll-over. He makes no capital gain or loss and the cost base of his original interest ($50 million) is transferred to the new interest he received. To this, Mark adds $50 million, being the amount of other consideration provided, for a total cost base of $100 million.

Preserving uniform capital allowance and capital gains tax status of rights

1.50 Where a taxpayer disposes of a right under an interest realignment arrangement, the replacement right should have the same status as if it was acquired at the same time as the original asset.

1.51 That is, if the original asset has a pre-CGT status because it was acquired prior to 20 September 1985, the right received under the arrangement will continue to have the same status. [Schedule 1, item 2, section 124-1240 of the ITAA 1997]

1.52 A similar outcome arises for assets acquired between 20 September 1985 and 1 July 2001. Such an asset is a post-CGT and pre-UCA asset. If disposed of under an interest realignment arrangement, the replacement right will have the same status as if it had been acquired during that period. [Schedule 1, item 4, subsection 40-77(1D) of the Income Tax (Transitional Provisions) Act 1997]

Disposals of multiple rights

1.53 There may be occasions where a party to an interest realignment arrangement is disposing of multiple rights. Some of those rights may have different CGT and UCA statuses. Indeed, it is possible that a taxpayer could dispose of a pre-CGT asset, a pre-UCA CGT asset and a UCA asset.

1.54 In these situations, each new right acquired will be split into two or three notional assets. This ensures that, following the roll-over, the taxpayer is in the same position in relation to the value of assets with specific tax characteristics. Different mechanisms apply depending on what combination of rights and asset statuses are disposed of under the arrangement.

1.55 Where a taxpayer disposes of both pre-CGT and post-CGT assets (but no UCA assets), each asset received under the arrangement is split into two assets, a pre-CGT asset and a post-CGT asset. The cost base of the post-CGT asset is determined by allocating the total cost bases of the original post-CGT assets between the new rights in proportion to the market values of each right received (disregarding the split). [Schedule 1, item 2, section 124-1245 of the ITAA 1997]

Example 1.5 : Pre-CGT and Post-CGT Right Roll-Over

Paul has three mining rights, parts of which he disposes of under an interest realignment arrangement. The parts disposed have the following characteristics:

Right	CGT Status	Market Value	Cost Base
Right A	Pre-CGT	$100 million	NA
Right B	Post-CGT	$180 million	$110 million
Right C	Post-CGT	$120 million	$90 million

Under the arrangement, Paul receives two new mining rights. The rights have market values of $150 million and $250 million respectively.

Each new right is split into two assets, a pre-CGT asset and a post-CGT asset.

Paul applies the statutory formula:

Total post-CGT cost base * [Market value of new right / Market value of all new rights]


The total of the cost bases of the original post-CGT rights is:

$110 million + $90 million = $200 million


The total of the market values of the new rights is:

$150 million + $250 million = $400 million


The cost base of the post-CGT asset split from the first new right (market value $150 million) is:

$200 million * [$150 million / $400 million] = $75 million


The cost base of the post-CGT asset split from the second new right (market value $250 million) is:

$200 million * [$250 million / $400 million] = $125 million


1.56 Where the assets disposed of include UCA assets and pre-UCA assets, the rights received will be split to include a notional new UCA asset. The other split asset will be either a pre-CGT asset or post-CGT asset according to the status of the pre-UCA assets disposed of. If assets of all three statuses are disposed of, the rights received are split into three notional assets and the rules outlined in paragraph 1.55 and Example 1.5 apply to the two pre-UCA assets. [Schedule 1, item 2, section 124-1250 of the ITAA 1997]

1.57 To the extent a taxpayer disposes of UCA rights, the new right will also be a UCA right. [Schedule 1, item 4, subsection 40-77(1E) of the Income Tax (Transitional Provisions) Act 1997]

Interest realignment adjustments

1.58 An interest realignment adjustment occurs where, pursuant to the interest realignment arrangement, additional payments are made between the parties because of changes in the perceived contributions of the parties to the common development project. This may arise where the estimates about the level of resources or reserves in each right are varied. The interest realignment arrangement may provide that the party that is now believed to have contributed less resources or reserves to the project should provide additional consideration to the other parties. [Schedule 1, item 1, subsection 40-364(7) of the ITAA 1997]

1.59 Where additional consideration is received under an interest realignment adjustment, a similar outcome will apply as if the consideration was made upfront. The only difference is that the tax outcome will arise in the income year in which the adjustment payment is made (it will not be necessary to reopen an earlier income tax assessment).

1.60 The amount of any adjustment payment will be included in the payee's assessable income and the payer's cost (or cost base) for their right received. The outcome will apply to any adjustment to the extent it included consideration other than a mining, quarrying or prospecting right. [Schedule 1, item 1, subsections 40-364(1) and (2) of the ITAA 1997]

1.61 If the interest realignment adjustment takes the form of a contribution of an additional mining right, the adjustment provisions will not apply. This transaction would be treated as a new interest realignment arrangement. [Schedule 1, item 1, subsection 40-364(7) of the ITAA 1997]

1.62 Further amendments are made to disregard the tax consequences of the contractual right that exists between the parties in relation to the adjustment:

•

The market value of the contractual right is not included in the termination value of the recipient's original mining, quarrying or prospecting right. [Schedule 1, item 1, subsection 40-364(3) of the ITAA 1997]

•

The market value of the contractual right is not included in the cost of a mining, quarrying or prospecting right acquired by the person providing the contractual right. [Schedule 1, item 1, subsection 40-364(4) of the ITAA 1997]

•

CGT events D1 and D3 do not occur to the person who provides the contractual right. [Schedule 1, item 1, subsection 40-364(5) of the ITAA 1997]

•

CGT event C2 does not occur to the person who receives an adjustment under a contractual right. [Schedule 1, item 1, subsection 40-364(6) of the ITAA 1997]

Example 1.6 : Interest realignment adjustments

Further to Example 1.3, 12 months after the interest realignment, additional estimates of the resources in the common development project are made. The estimates reveal that Brian's original right had even more resources than expected while the estimate of resources in Mark's original right remains unchanged.

Pursuant to the terms of the interest realignment arrangement, Mark provides an additional $10 million to Brian. Brian includes the $10 million in his assessable income. Mark includes the $10 million in the second element cost of the right he received from Brian. This inclusion increases the remaining adjustable value of the right (see section 40-85).

Part 2: Farm-in farm-out arrangements

1.63 Tax relief is provided to taxpayers entering into FIFO arrangements that support exploration and prospecting operations. A FIFO arrangement is eligible for tax relief if it is an arrangement where the farmor (or transferor):

•

transfers part of their mining, quarrying or prospecting right to the farmee (an immediate transfer); or

•

agrees to a future transfer or grants an option in relation to a future transfer (a deferred transfer),

in return for the farmee (or transferee) agreeing to provide exploration benefits to the farmor. Other consideration may be involved in the arrangement; however, this consideration will not be eligible for tax relief. [Schedule 1, item 10, subsection 40-1100(1)]

Exploration benefits

1.64 The concept of exploration benefits is critical to the existence of an eligible FIFO arrangement and the extent of tax relief provided. The relief is intended to support exploration activities. Benefits provided under a FIFO arrangement that are not exploration benefits are not eligible to receive tax relief.

1.65 Exploration benefits includes two types of activity undertaken by a farmee on the farmor's behalf:

•

The farmee may conduct the exploration activities itself or it may directly engage the service of a third party to undertake the activities. [Schedule 1, item 10, subparagraph 40-1100(2)(a)(i) of the ITAA 1997]

•

Alternatively, the farmee may free-carry the farmor in respect of exploration expenses. That is, the farmee may meet, on the farmor's behalf, the obligations that the farmor incurs during the term of the arrangement. The farmor may incur these expenses undertaking exploration activities itself or when another entity (an operator) issues cash-calls to the farmor with respect to exploration.

If the farmee provides reimbursements to the farmor for expenses paid by the farmor, the expenses must have been incurred, by the farmor, during the term of the arrangement. Reimbursement of expenses incurred prior to the FIFO arrangement is not an exploration benefit. [Schedule 1, item 10, subparagraph 40-1100(2)(a)(iii) of the ITAA 1997]

1.66 Two limitations apply to the concept of what may be an exploration benefit. These limitations ensure the benefits relate to exploration of the farmor's retained right and do not relate to the farmee's right or to expenditure on development or production.

•

Firstly, the benefit must be on the farmor's behalf and must relate to the part of the farmor's right not transferred under the arrangement. [Schedule 1, item 10, paragraph 40-1100(2)(b) of the ITAA 1997]

-

In an immediate transfer, the benefit must relate to the farmor's retained right.

-

In a deferred transfer arrangement, the benefit must relate to that part of the farmor's right that is not liable to be transferred.

If the farmee undertakes to explore the entire right originally owned by the farmor, only that portion of the exploration that relates to the farmor's ultimately retained right is an eligible exploration benefit. Exploration to the extent that the farmee has an option or other right to acquire the right is not an exploration benefit provided to the farmor.

•

Secondly, the expenditure must be of a kind that would be exploration expenditure deductible to the farmor if the farmor had undertaken the activity itself. That is, the expenditure must be of a kind referred to in section 40-730 or that would have been included the farmor's cost of its mining, quarrying or prospecting information or in the cost of another depreciating asset that satisfied section 40-80. [Schedule 1, item 10, paragraphs 40-1100(2)(c) and (d) of the ITAA 1997]

1.67 The references to section 40-730 in subparagraphs 40-1100(2)(c)(iii) and (d)(iii) are intended to apply to any payment that would be deductible to the farmor for the exploration activities referred to.

1.68 In some cases, an amount may be ineligible for a deduction under section 40-730 merely because it was eligible under another provision, such as section 8-1 (see section 8-10). Such amounts nevertheless satisfy the requirement in subparagraphs 40-1100(2)(c)(iii) and (d)(iii).

1.69 It is not sufficient that an amount satisfy subsection 40-730(1) if it is an amount to which subsections 40-730(2) or (3) applies. These include expenditure on development drilling for petroleum, expenditure on working a mining property and expenditure that is included in the cost of a depreciating asset. An amount also fails the requirements of the provision if the amount would be deductible under subsection 40-730(1) but is not deductible because of some other provision of the ITAA 1997. [Schedule 1, item 10, subsection 40-1100(3) and subparagraphs 40-1100(2)(c)(iii) and (d)(iii) of the ITAA 1997]

1.70 An exploration benefit includes the right to receive an exploration benefit. [Schedule 1, item 10, subparagraphs 40-1100(2)(a)(ii) and (iv) of the ITAA 1997]

Example 1.7 : Exploration benefits

A farmor and farmee are parties to a FIFO arrangement and are equal partners in a joint venture. The venturers establish a joint venture operator to manage exploration activities for the project. The operator is responsible for paying for exploration activities. The operator is funded by cash-calls on the venturers. Cash-call funds are placed in the joint venture's cash account and remain the property of the venturer who placed them there. When they are expended, they are expended on behalf of the venturers and the venturers incur that expenditure in proportion to their participating interest in the project.

Each time the venture operator calls for funds for exploration or prospecting, each venturer would normally contribute 50 per cent of the funds. The venture operator would then expend those funds on behalf of each of the venturers.

However, under the terms of the venturers' FIFO arrangement, the farmee has agreed to meet all of the cash calls made on the farmor. In return, the farmor has agreed to a deferred transfer of part of its mining right to the farmee. Following the potential transfer, each venturer would own 50 per cent of the mining right.

Following the establishment of the arrangement, the operator issues cash calls to meet a $10 million exploration expense. Each venturer incurs an expense of $5 million because they are equal partners in the venture. Under the terms of the FIFO arrangement, the farmee contributes $10 million to the joint venture account, which the operator then expends.

The farmee has provided an exploration benefit of $5 million being the amount that related to the right the farmor intends to retain.

Consequences for the farmor

Tax relief for the farmor

1.71 For the farmor, the value of any consideration received for disposing of a right under a FIFO arrangement is reduced, for tax purposes, to the extent the consideration is an exploration benefit.

1.72 For a UCA right disposed of, the termination value of the right is reduced by the market value of the exploration benefit. Because the termination value ordinarily includes the market value of any exploration benefits received, it is not necessary to calculate the market value of the exploration benefit. The amounts offset each other. [Schedule 1, item 10, section 40-1105 of the ITAA 1997]

1.73 If the right disposed of was a pre-UCA right, the capital proceeds of the CGT event are reduced by the same amount because the market value of the exploration benefits is deemed to be zero. [Schedule 1, item 16, subsection 116-115(1) of the ITAA 1997]

1.74 On entering into the FIFO arrangement, the farmor will ordinarily acquire a contractual right to receive exploration benefits. This right is a CGT asset. When the contractual right is satisfied or partially satisfied (eg because the farmor receives the promised exploration benefits), CGT event C2 occurs to the farmor. The cost base and reduced cost base of this contractual right is reduced by the market value of the entitlement to receive exploration benefits. [Schedule 1, item 10, section 40-1120 of the ITAA 1997]

1.75 To prevent any capital gain from arising in relation to exploration benefits received pursuant to the contractual right, the capital proceeds of the event are deemed to be zero to the extent they are exploration benefits. [Schedule 1, item 16, subsection 116-115(2) of the ITAA 1997]

Example 1.8 : Tax relief for the farmor

A farmor enters into a FIFO arrangement. The farmor immediately transfers a part of his mining right to the farmee. The part of the right has an adjustable value of nil.

In return, the farmor receives $2 million cash and a contractual right to receive exploration benefits. The termination value of the farmor's transferred mining right is $2 million, being the cash received. The market value of the contractual right would be included (item 4 of the table in subsection 40-305(1)) but the termination value is reduced by the same amount under the amendments (section 40-1105).

The farmor has a balancing adjustment event and includes $2 million in its assessable income ($2 million termination value less a nil adjustable value).

In the following year, the farmee provides a number of exploration benefits to the farmor pursuant to the arrangement. CGT event C2 occurs to the farmor, as the contractual right to receive exploration benefits is satisfied, in whole or in part. However, the cost base of the contractual right and capital proceeds of the CGT event are both nil (assuming no incidental costs). Therefore, no capital gain or loss arises.

Allocation of farmor's adjustable value

1.76 When the farmor transfers part of a right, the right is taken to have been split into two depreciating assets immediately before the disposal (section 40-115). The adjustable value of the entire asset is normally apportioned to become the cost of each split asset (section 40-205).

1.77 Under a FIFO arrangement, however, the entire adjustable value is allocated to the retained part. The farmor may still attribute a reasonable proportion of the incidental costs of splitting the mining, quarrying or prospecting right to the part disposed of under the arrangement. [Schedule 1, item 10, section 40-1110 of the ITAA 1997]

Example 1.9 : Allocation of farmor's adjustable value

A farmor acquires a mining right for a cost of $60 million. The farmor is not entitled to an immediate deduction under section 40-80. The farmor enters into a FIFO arrangement and agrees to an immediate transfer of half of the right. In return, the farmor receives exploration benefits and $10 million in cash. The farmor's cost incurred in splitting the mining right is $500,000.

The adjustable value of the mining right remained at $60 million immediately prior to the arrangement (no depreciation having been claimed). The right is split into two new assets, the retained part and the disposed part.

The cost of the retained part is $60.25 million, the adjustable value of the original right ($60 million) plus a reasonable proportion of the cost of splitting the asset (50 per cent of $500,000, or $250,000).

The cost of the disposed part is $250,000. This is the cost of the disposed part to the farmor immediately before the transfer. It is used only for the purposes of the farmor's balancing adjustment calculation and does not influence the farmee's cost of acquiring the right.

A balancing adjustment event occurs to the farmor. The termination value of the disposed part is $10 million. The adjustable value of the disposed part is its cost to the farmor, $250,000. The farmor will have $9.75 million included in its assessable income.

1.78 The allocation of the farmor's adjustable value in this way supports the integrity of the 2014 amendments. If a taxpayer acquires a mining right in circumstances that do not qualify the taxpayer to an immediate deduction under section 40-80, the mining right will have a significant adjustable value. If a taxpayer were eligible to claim, in effect, an immediate deduction by disposing of part of the right under a FIFO arrangement, the integrity introduced in the 2014 amendments would be reduced.

Limits to corresponding deductions of the farmor

1.79 To ensure tax neutral outcomes, some corresponding deductions and other benefits are reduced to the extent of the tax relief provided.

1.80 A farmor is not entitled to a deduction (generally a section 40-730 deduction) for expenditure that is the expenditure of a part of its original mining, quarrying or prospecting right. [Schedule 1, item 10, subsection 40-1115(1) of the ITAA 1997]

1.81 To the extent that a farmor incurs an exploration or prospecting expense that is met by the farmee under a free-carry commitment, the deductibility of that expense to the farmor is reduced (see Example 1.10). This applies to all deductions, including those that arise from exploration or prospecting expenditure and immediate deductions available because the expenditure is included in the cost of a depreciating asset first used for exploration or prospecting. [Schedule 1, item 10, subsection 40-1115(2) of the ITAA 1997]

1.82 Consistently, if the farmor improves mining, quarrying or prospecting information they hold because they have received an exploration benefit, the farmor is not entitled to include any expenditure in the cost of the information to the extent it relates to exploration benefits received. [Schedule 1, item 10, section 40-1125 of the ITAA 1997]

Consequences for the farmee

1.83 For the farmee, any tax outcome arising from entering into the FIFO arrangement is reduced to the extent the farmee agrees to provide exploration benefits. Any income that would be included in the farmee's assessable income because it was a reward for providing exploration benefits is treated as non-assessable non-exempt income. [Schedule 1, item 10, paragraph 40-1130(1)(b) of the ITAA 1997]

1.84 Similarly, CGT event D1 does not apply to bring about a capital gain for the farmee for creating a right in the farmor to receive exploration benefits. [Schedule 1, items 11 and 12, paragraphs 104-35(5)(f) and (g) of the ITAA 1997]

1.85 To ensure a tax neutral outcome, the depreciable cost of the transferred right in the hands of the farmee is reduced by the market value of the exploration benefits provided. Because the cost of the right ordinarily includes the market value of any exploration benefits provided, it is not necessary to calculate the market value of the exploration benefit. The amounts offset each other. [Schedule 1, item 10, paragraph 40-1130(1)(a) and subsection 40-1130(2) of the ITAA 1997]

1.86 Consideration other than the provision of exploration benefits is included in the cost of the farmee's received right under the general rule in section 40-185 and is not modified by these amendments.

Availability of section 40-730 deductions

1.87 A farmee is generally entitled to a deduction under section 40-730 for expenses incurred in conducting or funding exploration or prospecting on the farmor's behalf.

1.88 When the farmee undertakes to fund exploration, the amount of the farmee's commitment may be known and ascertainable or it may be contingent or other factors. It is intended that the same tax consequences should follow, regardless of whether the amount is known and ascertainable at the time of the FIFO arrangement. To achieve this, an amendment is required to deal with the interaction between known and ascertainable amounts and the availability of a section 40-730 deduction.

1.89 A known and ascertainable amount is included in the cost, to the farmee, of the mining, quarrying or prospecting right received under a FIFO arrangement (items 1 and 2 of the table in subsection 40-185(1) of the ITAA 1997). When the farmee incurs the expense of this amount, a deduction under section 40-730 is denied because the amount has been included in the cost of the mining right received (subsection 40-730(3)).

1.90 This denial is inappropriate in the context of exploration benefits; the inclusion of the amount in the farmee's cost is only notional because of the adjustment referred to in paragraph 1.85. An amendment is made to ensure that subsection 40-730(3) does not apply to such known and ascertainable amounts that are also exploration benefits. [Schedule 1, item 10, paragraph 40-1130(1)(c) of the ITAA 1997]

1.91 No amendment is required in the context of funding that is not known and ascertainable at the time of the FIFO arrangement. Such amounts are not included in the cost of the farmee's mining, quarrying or prospecting right directly. What is included in the farmee's cost is the market value of the undertaking, a non-cash benefit (item 4 of the table in subsection 40-185(1)). When the expenditure is incurred, subsection 40-730(3) does not apply to limit the availability of a section 40-730 deduction.

Example 1.10 : Exploration benefits and section 40-730

A farmee enters into a FIFO arrangement. In return for receiving part of the farmor's mining right, the farmee undertakes to free-carry the farmor in relation to all exploration of the farmor's retained part for the next two years.

At the time of entering into the arrangement, the parties are aware that the farmor will incur $1.5 million in exploration expenses in the first year. It is not known what expenses will be incurred in the second year as this will depend on a number of factors.

The farmee's cost is calculated under section 40-185. The farmee has incurred a liability to pay an amount ($1.5 million) and this is included at item 2 of the table in subsection 40-185(1). The farmee has provided a non-cash benefit in the form of a right to an unknown and unascertainable amount of money in year two. The market value ($ here because it is unnecessary to determine) of the non-cash benefit is included in cost at item 4.

Both the $1.5 million commitment and the unvalued commitment are exploration benefits. The cost, to the farmee, of the mining right received is therefore reduced to nil under paragraph 40-1130(1)(a):

Cost = $1.5 million + $x - ($1.5 million + $x)


In the first year, the farmee incurs the expense of providing the $1.5 million. Paragraph 40-1130(1)(c) applies to ensure that subsection 40-730(3) does not apply to deny a deduction under section 40-730 because the $1.5 million was notionally included in the calculation of the cost of the mining right.

In the second year, the farmor incurs exploration expenses of $2 million. The farmee funds this expense and incurs an expense of $2 million. Subsection 40-730(3) does not apply to the farmee's expense because the $2 million was never included in the cost of the farmee's mining right ($ was).

Note also that the farmor is not entitled to any deduction for either the $1.5 million or $2 million expenses it incurred because it was free-carried by the farmee (see paragraph 1.81).

1.92 It is not intended that these amendments alter the current availability, to a farmee, of section 40-730 deductions in any other way.

Changes to an exploration benefit

1.93 When an exploration benefit is first provided on entering a FIFO arrangement, the benefit is a contractual right or entitlement to receive exploration benefits over time. At this point, tax relief is provided to the farmor and farmee. If the farmor later receives non-exploration benefits in relation to the contractual right, it is necessary to claw back the tax relief provided.

1.94 The potential for the claw back is established at the time the FIFO arrangement is entered into. The first element of the cost base and reduced cost base of the CGT asset that is the contractual right to receive exploration benefits is reduced by the market value of that right. [Schedule 1, item 10, section 40-1120 of the ITAA 1997]

1.95 When the contractual right is satisfied (because the farmee fulfils the obligation or the parties renegotiate the arrangement), CGT event C2 occurs to the farmor. The capital proceeds of the event that are genuine exploration benefits are given a market value of zero. To the extent the proceeds include benefits that are not exploration benefits, there is likely to be a capital gain. The extent of the gain is increased because of the reduction in the cost base of the contractual right. The rules ensure that the gain is recognised in the later income year, avoiding the need to reopen any income tax assessments made for earlier income years.

1.96 If there is more than one payment (or other consideration provided) in relation to the contractual right, CGT event C2 occurs in relation to each payment. For each event, the cost base of the contractual right is reduced proportionately for the purposes of calculating the specific capital gain or loss on the part satisfied (subsection 112-30(2)).

Example 1.11 : Changes to an exploration benefit

A farmor disposed of a part of a mining right under a FIFO arrangement. The part has an adjustable value of nil per section 40-1110. In return, the farmor received an entitlement to exploration benefits. The entitlement commits the farmee to spend $100 million on exploration of the farmor's retained part.

The farmor receives no other consideration for the mining right and the termination value of the right is therefore zero. The farmor does not have any tax liability when disposing of the right.

In the following income year, the farmee provides exploration services to the farmor worth $50 million. The exploration is successful and substantial resource deposits are discovered.

CGT event C2 occurs to the farmor. The capital proceeds and the apportioned cost base are both nil because the event relates entirely to exploration benefits (it is assumed there were no incidental costs) (section 40-1120 and subsection 116-115(2)). No capital gain or loss arises.

In the third year, the parties agree to suspend further exploration and agree that the farmee can complete its obligations under the arrangement through contributions to development. The farmee provides $50 million worth of contributions to the development of the farmor's retained right and discharges its obligations.

CGT event C2 occurs again to the farmor in relation to the second half of the exploration benefit. The capital proceeds are $50 million. The apportioned cost base remains nil, resulting in a capital gain of $50 million. This reflects the amount that would not have received the original tax relief if it was known then that the contractual right would not be realised through the receipt of exploration benefits.

Part 3: Improvements to mining, quarrying or prospecting information

1.97 Part 3 of Schedule 1 amends paragraph 40-80(1AB)(d) to allow taxpayers to claim immediate deductions for certain expenditure that relates to making improvements to mining, quarrying or prospecting information.

1.98 The expenditure will be deductible if that taxpayer was entitled to a deduction for the original information when it was acquired. In addition, an immediate deduction will be available where the improvement would be immediately deductible if it were a new asset the taxpayer had just acquired. This outcome is achieved through the use of the concept of 'economic benefit' (see section 40-190 of the ITAA 1997) to refer to the improvement made to the original information. [Schedule 1, item 20, paragraph 40-80(1AB)(d) of the ITAA 1997]

1.99 As a result, the deductibility of improvements to mining, quarrying or prospecting information will not depend on whether an immediate deduction would be available for the unimproved information. This is appropriate because the improvement will often be the result of the taxpayer acquiring additional information through exploration or prospecting activities.

Consequential amendments

1.100 Rights and obligations that arise under a FIFO arrangement and relate to the provision of exploration benefits are exempted from the Taxation of Financial Arrangement regime contained in Division 230 of the ITAA 1997. While the rights and obligations may amount to a financial arrangement (section 230-45), it is intended that the UCA and CGT rules alone will provide the tax outcomes for these arrangements. [Schedule 1, item 17, subsection 230-460(17A) of the ITAA 1997]

1.101 Definitions of 'interest realignment arrangement', 'interest realignment adjustment', 'farm-in farm-out arrangement' and 'exploration benefit' are added to the ITAA 1997 dictionary. [Schedule 1, items 3 and 18, subsection 995-1(1) of the ITAA 1997]

1.102 Legislative signposts to the operative amendments made by Part 2 are inserted into the list of non-assessable non-exempt income provisions, the list of cost base modifications in section 112-97 and the list of capital proceeds modifications in section 116-25. [Schedule 1, items 6 and 13 to 15, sections 11-55, 112-97 and 116-25 of the ITAA 1997]

1.103 A guide is created to Subdivision 40-K, which outlines the consequences, under the UCA regime, for FIFO arrangements. [Schedule 1, item 10, section 40-1095 of the ITAA 1997]

1.104 Notes cross-referencing the operative amendments made by Part 2 are attached to the Division 40 rules for determining cost and termination value. [Schedule 1, items 7 to 9, notes to section 40-175 and subsections 40-180(4) and 40-300(3) of the ITAA 1997]

Application and transitional provisions

1.105 The amendments in Part 1 and 2 of Schedule 1 apply to interest realignment and FIFO arrangements, respectively, that are entered into after 7.30 pm on 14 May 2013. This aligns with the application of the 2014 amendments. This means that an arrangement entered into prior to that date is subject to neither these amendments nor the 2014 amendments. [Schedule 1, items 5 and 19]

1.106 The amendments in Part 3 are directly aligned to the application provisions of the 2014 amendments. Generally, the present amendments apply to mining, quarrying or prospecting information that a taxpayer starts to hold after 7.30 pm on 14 May 2013. [Schedule 1, item 21]

1.107 The amendments in Schedule 1 address issues that arose through the passage of the 2014 amendments. Remedying these issues will be favourable to the affected taxpayers. As such, it is appropriate that the present amendments apply retrospectively from the date of application of the 2014 amendments.

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

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

Tax relief for certain mining arrangements

1.108 This Schedule 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

1.109 Schedule 1 to this Bill provides tax relief to taxpayers entering into certain arrangements in relation to mining, quarrying and prospecting rights and information. Relief will apply to farm-in farm-out arrangements, interest realignment arrangements and expenditure relating to the improvement of mining, quarrying and prospecting information.

Human rights implications

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

Conclusion

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