House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 3 Regulation Impact Statement

Executive Summary

3.1 Despite good prospectivity in many commodities, Australia has not had a tier one (world-class) mineral discovery in more than twenty years. To ensure the future health of the Australian resources sector, it is vital that new mineral deposits are found to create a pipeline of projects to replace depleting mines. New deposits are more likely to be found in remote locations, may be of lower grade, deeper in the ground, mixed with greater impurities and/or require more difficult and costly exploration and extraction techniques.

3.2 Greenfields exploration activities target unexplored or incompletely explored areas, with the aim of discovering new resources. By contrast, brownfield exploration occurs in areas near established resources or in areas where resources have been previously mined, and is mainly focused on proving up or extending existing mining operations. ^[1]

3.3 Greenfields exploration activity in Australia is generally measured in two ways: expenditure and metres drilled. Over the past five years, greenfields minerals exploration in Australia declined by almost 70 per cent from $1.2 billion in 2011-12 to around $400 million in 2015-16. Over the same period, greenfields metres drilled declined by almost 60 per cent. ^[2]

3.4 Junior minerals exploration companies are a key driver of mineral exploration activity in Australia. Greenfields exploration is a high risk activity that involves large upfront costs, low rates of success, and can take 15-20 years before any return on investment is made. As such, companies undertaking these activities have an ongoing need to raise capital. The lack of certainty on exploration success makes it very difficult for prospective investors to adequately evaluate the risks and returns associated with investing in these companies, impeding their ability to raise capital.

3.5 The current tax system limits the refundability of losses, which reduces the incentive to undertake risky investments such as exploration. Junior explorers, with no production and therefore no (or little) assessable income, are unable to offset their exploration expenditure.

3.6 Given the importance of the resources sector to the Australian economy, particularly in regional and remote areas, there is a clear role for the Government to play in removing some of the obstacles to raising capital faced by the junior minerals exploration sector.

3.7 To support the junior minerals exploration sector, on 2 September 2017 the Government announced it would extend the existing Exploration Development Incentive (EDI) with some amendments to address issues that were affecting the uptake of the scheme. This scheme is referred to as the Junior Minerals Exploration Incentive tax offset (JMEI). This decision was made following consideration of an interim Regulatory Impact Statement (RIS). The Australian Taxation Office (ATO) has lead responsibility for the implementation of the JMEI.

3.8 This RIS considers two policy options for government intervention, in addition to the status quo: extending the existing EDI for another four years until 2020-21 and extending the EDI with some amendments to eligibility and credit allocation (JMEI). The RIS recommends that the Government pursues the JMEI. Each option was considered on its merits, as detailed from paragraph 3.28.

Policy Problem

3.9 The Australian junior minerals exploration industry has a number of characteristics that restrict its ability to attract capital to fund exploration activities compared with companies in other sectors at a similar stage of development. Without additional support, this has the potential to undermine the long term health of the resources sector, the jobs it creates and the contribution it makes to the economy as a whole.

3.10 There is a delay between the time an exploration company is created and exploration activity. This delay is exacerbated by the time it takes to earn revenue from a new discovery. Once a commercial resource has been discovered, it typically takes at least ten years to transform the deposit into a revenue producing mine. To the typical investor, these delays reflect poorly on junior minerals exploration companies and their ability to make a profit. By contrast, start-up businesses in other industries can sometimes go from concept to operation in the space of a year.

3.11 There is a considerable difference in the ability of junior minerals exploration companies to identify, develop and market a saleable product compared with start-up companies in other sectors. While market research by both junior explorers and other types of businesses can be undertaken to improve the prospect of selling a product, a junior explorer will not know with any great accuracy the quality or quantity of the product they will be able to provide for some time. Combined with the timeframes outlined above, this can potentially be decades into the future and significantly affect the risk profile of the company and its attractiveness to potential investors.

3.12 There is a high possibility that even after a new resource has been discovered it will ultimately prove to be of insufficient quantity or quality and uneconomic to produce given prevailing market prices and conditions.

3.13 The exploration sector is also exposed to other factors that arguably affect junior minerals exploration companies more than companies in other sectors, such as obtaining land access, approvals and gaining community acceptance.

3.14 Asymmetry in the treatment of tax losses compared with profits is a well-known issue in the tax system, which can impede risk taking and innovation in the economy. This is a particular issue for the exploration industry, where it is common for junior explorers to incur high expenditure and endure many years of losses. As a result, these companies typically have no taxable income and accumulate tax losses that they may not be able to recoup.

3.15 In combination, these factors introduce an unwelcome source of uncertainty to investor decisions, which inhibits their ability to evaluate the returns to minerals exploration activities.

3.16 In light of these issues, the Government committed to introduce an Exploration Development Incentive (EDI) in 2014 to encourage investment in small exploration companies undertaking greenfields minerals exploration in Australia. The EDI operated from 1 July 2014 until 30 June 2017.

3.17 In early 2017, participants in the scheme and other stakeholders were formally requested to provide feedback on the performance of the EDI. Through these discussions, two key issues were identified as adversely affecting the effectiveness of the scheme: the benefits to new investors were diluted and the modulation factor created uncertainty.

Diluted benefits to new investors

3.18 Companies participating in the EDI were able to pass on exploration credits to all shareholders, not just those associated with new capital raisings. This spread the eligible credits over a larger group of shareholders, which had the effect of diluting the benefits that any new investor was entitled to. Feedback indicated in some instances, the size of the credit was negligible.

Uncertainty around the modulation factor

3.19 To ensure the cost of the EDI was contained to the $100 million funding envelope, credits were allocated by the ATO using a post-modulation approach. Under this approach, companies that chose to participate had to notify the ATO of their estimated greenfields minerals expenditure and estimated tax loss for the previous income year by 30 September. After this information for all participating companies was received, the ATO would determine the modulation factor (between 0 and 1) that would be used to ensure that the credits issued did not exceed the capped amount of the incentive for that income year. If the scheme was oversubscribed, companies would not be entitled to get credits to the full value of their expenditure (i.e. a modulation factor of less than 1). After this was calculated, companies were informed of the value of the credits that could be passed on to their shareholders.

3.20 Since investors had to wait until this process was complete, they did not know the value of the credit that would be attached to their shares until well after their initial investment. From an investor perspective, this had the undesirable result of incorporating an additional source of uncertainty into their investment decision.

Government Intervention

3.21 A significant part of the Australian economy is based on the extraction and sale of its mineral resources. Investment in ongoing greenfields exploration and the discovery of new mineral resources is vital to the longer term future of the resources sector, and the economy as a whole.

3.22 Greenfields minerals exploration involves substantial expenditure and risks. Junior explorers are a critical driver of these activities as larger, established, mining companies generally prefer to acquire and develop proven discoveries. While larger mining companies are generally in a position to fund exploration from their own profits, smaller companies focused solely on exploration typically do not generate an income and are dependent on attracting investment to fund their activities.

3.23 Under the Australian tax system, expenditure incurred exploring or prospecting for minerals, petroleum and quarry materials can be deducted, subject to the tax payer passing certain tests. Expenditure on depreciating assets that are first used for exploration can also be written off. These tax concessions acknowledge the high-risk nature of exploration and the associated economic benefits that flow from these activities. However, deductibility of exploration expenditure is only beneficial to companies that generate a taxable income.

3.24 This is a source of non-neutrality in the tax system that favours companies with profits against which to offset expenses over companies that accumulate losses they are unable to utilise. Junior explorers, with no production and therefore no (or little) assessable income, are unable to offset their exploration expenditure. While a tax deduction allows a company with assessable income to reduce its tax liability, a company will not gain any immediate benefit from its deductions that exceed its assessable income.

3.25 Junior minerals exploration companies are acutely affected by non-neutrality in the tax system as they may need to wait many years before their losses can be utilised, and many will never generate sufficient income to utilise their losses. This effectively makes exploration more expensive for junior explorers, relative to companies with ongoing sources of income and is likely to adversely affect the level of greenfields exploration undertaken.

3.26 The delays in generating a profit, coupled with the lack of certainty on exploration success, makes it very difficult for prospective investors to adequately evaluate the risks and returns associated with investing in these companies, impeding their ability to raise capital.

3.27 Government intervention is required to enable junior minerals exploration companies to convert their otherwise unrecoverable tax losses into an asset that they can use to raise additional capital for their activities.

Policy Options

3.28 The Government identified the following options to improve the ability of junior minerals exploration companies to access capital, and encourage investment and risk taking to drive the next wave of mineral discoveries.

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Option 1: Status quo-Let the EDI expire

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Option 2: Extend the EDI in its original form

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Option 3: Extend the EDI with amendments

Status quo-Let the EDI expire

3.29 Under this option the Government would allow the EDI to expire and not extend it beyond its legislated lifespan of 2014-15 to 2016-17.

Extend the EDI in its original form

3.30 Under this option the Government would extend the EDI for a further four years with a similar funding envelope of $100 million from 2017-18 until 2020-21.

3.31 The EDI operated from 1 July 2014 until 30 June 2017. It provided an economic incentive to invest in the Australian mining sector by enabling eligible exploration companies to create exploration credits by giving up a portion of their tax losses from greenfields minerals expenditure, and distributing those credits to equity shareholders. Australian resident shareholders that were issued with an exploration credit were entitled to a refundable tax offset or additional franking credits. The exploration company's carry forward losses were reduced proportionately to reflect the amount of exploration credits created.

Extend the EDI with amendments

3.32 Under this option the Government would extend the EDI for a further four years from 2017-18 until 2020-21 with amendments. This updated scheme would have a funding envelope of $100 million and be called the Junior Minerals Exploration Incentive tax offset (JMEI).

3.33 The JMEI will operate in the same way as the EDI with two key improvements to address some of the issues that affected the take-up of the previous scheme:

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Only newly issued shares will be eligible for credits, i.e. only new investment

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Credits will be allocated on a first-in, first-served basis annually, subject to reasonableness and integrity rules which the ATO will consider in approving applications.

3.34 These changes will align the initiative more closely to the Canadian Flow-Through Shares (FTS) scheme. The FTS scheme is a long-standing feature of the Canadian tax system and is considered to provide significant assistance to junior explorers in Canada. According to the Canadian Finance Department, the scheme helped raise approximately C$1.4 billion in equity between 2007 and 2012. Around 20 per cent of Canadian exploration is financed by FTS. ^[3] However, funding for the Canadian scheme is not limited to a particular amount as it is with the JMEI.

Net Benefits

3.35 The purpose of this section is to provide an indication of the likely impacts arising from implementation of the options outlined in Section 4. It does this by analysing the costs and benefits of each option, and comparing the net benefit against the status quo.

Status quo-Let the EDI expire

Overview

3.36 If the Government lets the EDI expire, then the existing incentive to encourage investment in the junior minerals exploration sector will lapse.

Costs

3.37 By its nature, maintaining the status quo option of letting the EDI expire would not result in any additional regulatory or administrative costs for the junior minerals exploration industry or Government. However, given the disadvantages these companies face in raising capital, the removal of an incentive will detract from the amount of money they can raise through share issues to support greenfields minerals expenditure.

3.38 This could add to a situation where insufficient new, high quality mineral deposits are discovered to replace depleted mines. This would affect the investment pipeline, which is required to underpin the future health of the Australian resources sector.

Benefits

3.39 The main benefit from pursuing this option would be to reduce complexity in the tax system.

3.40 Maintaining the status quo of letting the EDI expire would provide certainty to investors and simplify investment decisions. Some stakeholders considered the modulation factor ^[4] introduced an additional source of uncertainty in the decision-making process that investors were adverse to.

Net Benefit

3.41 The cost of doing nothing outweighs the benefits as junior explorers would not have access to an incentive that addresses the treatment of losses for junior explorers and assists them to raise capital to fund exploration.

Option 2: Extend the EDI in its original form

Overview

3.42 The Government would not allow the EDI legislation to sunset, instead extending the scheme for another four years until 2020-21.

3.43 The EDI did not have a significant take-up and was undersubscribed (Table 3.1).

Table 3.1 : Take-up of the EDI

N/A: not available. Source: Australian Taxation Office.

Costs

3.44 This option is unlikely to create any additional regulatory costs for junior explorers than have been incurred over the last four years. These companies are typically familiar with the incentive and have set up the appropriate systems and processes to participate in the scheme.

Benefits

3.45 The EDI increases the efficiency by which junior minerals exploration companies are able to raise capital for exploration activities compared with the status quo. It achieves this through addressing some of the asymmetries that place junior minerals exploration companies at a disadvantage compared with larger profitable companies in the sector, and similar sized companies in other sectors.

3.46 Given that private sector investor behaviour reflects the costs and benefits of investment, the EDI should, in theory, increase investment in junior mineral explorers. It is possible that during the course of the EDI, investor behaviour may have been affected in part by uncertainties in the scheme such as the modulation factor.

3.47 If uptake in the scheme is as low as during the pilot, then any positive effects are unlikely to eventuate and are potentially small in magnitude.

Net Benefit

3.48 There were a number of issues that affected the EDI's ability to achieve the intended objective of stimulating greenfields minerals expenditure. If the EDI was to be extended without amendment then these issues would continue to limit the uptake and effectiveness of the scheme.

3.49 If this is the case, the likelihood of realising any benefit is small. The net benefit of this option is uncertain and potentially negligible.

Table 3.2 : Regulatory burden estimate (RBE) table (Option 2)

*Average annual impact (calculated over 10 years).

Option 3: Extend the EDI with amendments

Overview

3.50 This option would improve on the EDI by incorporating lessons and feedback from the pilot EDI program. These changes would have the effect of providing a more effective mechanism for both attracting new capital and the efficiency by which capital can be raised.

3.51 This option provides mechanisms for assisting junior explorers to raise capital for exploration activities: converting tax losses into credits and the ability for investors to earn a premium on newly issued shares. These mechanisms are widely understood and accepted by industry by virtue of the long-running Canadian FTS scheme. The modulation factor, which is a feature of the EDI, will also be removed.

Costs

3.52 The information required by a company to participate in the JMEI will be broadly similar to the type of information currently needed to complete its tax return and report to the ASX. As such, many eligible companies are likely to have systems already in place to facilitate reporting.

3.53 In this regard, it is anticipated that the compliance costs will be minor. Participating companies will be required to identify and provide some estimated information to the ATO, such as greenfields minerals expenditure prior to the commencement of the financial year.

3.54 Companies that choose to participate in the JMEI may require advice from accountants. For instance, tax advice may be required on the effect of a company relinquishing their entitlement to tax losses.

3.55 It is unlikely that all eligible exploration companies will participate in the new scheme, although it is not possible to know the extent of non-participation. Feedback from AMEC indicates that eligible companies would be more likely to participate in an improved version of the EDI such as the JMEI.

Benefits

3.56 The benefits of the enhanced scheme to the broader public will depend on its effectiveness in attracting additional investment into greenfields exploration. However, benefits to junior mineral explorers from the JMEI are expected to be more significant than the current EDI.

3.57 The proposed improvements are partly based on the Canadian FTS scheme that has operated successfully for many years. A Canadian Department of Finance study found that flow-through shares were issued at an average premium of between 18 and 26 percent. ^[5] While the magnitude of this premium is in part dependent on the size of the credit associated with this share it does some provide empirical evidence that such schemes can help exploration companies raise additional capital.

3.58 An effective scheme that attracts capital to the junior minerals exploration sector will secure additional private investment in greenfields minerals exploration to drive the next wave of mineral discoveries in the resources sector benefitting the Australian economy.

Net Benefit

3.59 The regulatory costs of the scheme are not expected to be large for individual participants, while the benefits of a healthy resources sector over the medium to longer term will be substantial and widespread. As a result, to the extent that this option is successful in attracting new investment, the net benefit of this proposal is greater than the net benefit of all other options, including the status quo. It is considered to have the strongest likelihood of improving access to capital for the junior minerals exploration sector.

Table 3.3 : Regulatory burden estimate (RBE) table (Option 3)

*Average annual impact (calculated over 10 years).

Consultations

3.60 The design of the scheme was shaped by discussions with the industry group representing junior minerals exploration companies, the Association of Mining and Exploration Companies (AMEC), the Australian Securities and Investments Commission, the Australian Taxation Office (ATO) and stakeholder feedback on the effectiveness of the EDI.

3.61 Given that the design of the revised scheme takes into account many of the features proposed by the industry, and brings the scheme more closely in line with the popular Canadian scheme, it is expected to obtain broad industry support.

Past consultations

3.62 In the Explanatory Memorandum to introduce the EDI legislation, the Government requested that the scheme be reviewed. In early 2017, participants in the scheme and other stakeholders were formally requested to provide feedback on the performance of the EDI, which formed the basis for consultation on improving the scheme.

3.63 As part of this process, the Government engaged with:

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Peak industry bodies

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Shareholder representative groups

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The Department of Industry, Innovation and Science, Treasury and the ATO

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The New South Wales, Queensland and South Australian governments

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Other interested parties.

3.64 This consultation included multiple face-to-face meetings, teleconferences and an AMEC roundtable discussion.

3.65 Industry identified a number of issues with the EDI that they believed discouraged participation in the scheme. These included:

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Diluted benefits to investors because EDI credits could be directed to all shareholders rather than just new investors

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The modulation factor creating considerable uncertainty within companies and their investors on the final value of the credit

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The long lag between initial investment and the investor obtaining a benefit.

3.66 Following the then Minister for Resources and Northern Australia's address to AMEC's 2017 convention, AMEC, the Minerals Council of Australia, the Western Australian Chamber of Mines and Energy, and the Queensland Resources Council developed a proposal that suggested changes to the EDI that may improve the outcomes of the EDI.

Recommendation

Recommendation and justification

3.67 This RIS considered three options to increase the ability of junior mineral exploration companies to raise capital to ensure the next wave of mineral discoveries.

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Option 1: Status quo-let the EDI expire. In the absence of government intervention, junior explorers will continue to struggle to raise sufficient capital to maintain or increase greenfields exploration activities. Without investment in greenfields exploration to ensure the development of new projects, the health of the Australian resources sector and the broader Australian economy will suffer.

•

Option 2: Extend the EDI in its original form. The net benefit of this option is negligible because the likelihood of increasing the capital available for junior minerals exploration companies is low. Under the EDI, the benefits to new investors were diluted and did not provide adequate incentive to invest in these companies. There was also a longer time lag before shareholders were able to claim the refundable credit. As in the first option, junior explorers will continue to struggle to raise capital. Uncertainties, such as the modulation factor, would also continue to be a burden to industry.

•

Option 3: Extend the EDI with amendments to the eligibility and how the credits are allocated to new investors to remain within the funding envelope. The net benefit of this scheme depends on its success in attracting additional investment into greenfields exploration by junior minerals exploration companies. Compared with the status quo, this option is more likely to meet the policy objective of increasing the ability of junior explorers to raise capital as it provides an incentive to invest in these companies. It will also be more effective than Option 2 because the amendments ensure investors have greater certainty on their entitlements and will receive the credits a year earlier than the previous EDI. The regulatory implications compared with the status quo are minor given that this scheme is based on improvements to the EDI. The EDI did not place significant impost on either junior explorers or their shareholders and the JMEI seeks to reduce that impost where possible.

3.68 After considering these options, the RIS recommended option is extending the EDI with amendments, the JMEI, as the most appropriate method to solve this policy problem. The JMEI takes into account the lessons learned from previous pilot programs, including the EDI. The proposed design provides greater certainty for stakeholders and will encourage the uptake of the scheme compared with the EDI. This will contribute to a better investment climate in the junior minerals exploration sector and an improved likelihood of mineral discovery.

Implementation

3.69 The JMEI will apply for greenfields minerals expenditure incurred from 1 July 2017. Amendments to the Income Tax Assessment Act 1997 will be required to implement the scheme.

3.70 The implementation process has been developed in consultation with the ATO. After the legislation has been passed, the ATO requires sufficient time to develop and implement the necessary administrative processes for the scheme. This risk is being managed by consulting early and regularly with the ATO on the administration of the incentive.

3.71 To the extent that the JMEI differs from the EDI, the ATO will be required to implement system changes and incur administrative costs.

3.72 A review of the scheme will be undertaken in 2019-20 to assess whether it is meeting its stated objectives. The key performance indicators will be identified during development to ensure appropriate data is collected to make a valid assessment.