House of Representatives

Explanatory Memorandum

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

Chapter 4 - Deductible expenditure

Outline of chapter

4.1 This chapter outlines the provisions in Schedule 3 to the Petroleum Resource Rent Tax Assessment Amendment Bill 2011 (Main Bill) which amends the Petroleum Resource Rent Tax Assessment Act 1987 (PRRTAA 1987) to:

•

clarify that environmental expenditure incurred in relation to a petroleum project is deductible for Petroleum Resource Rent Tax (PRRT) purposes;

•

allow existing Commonwealth, State and Territory resource taxes paid such as royalties and crude oil excise in relation to a project to be grossed up and deductible;

•

ensure that native title payments made under the Native Title Act 1993 are deductible under the PRRT and not treated as excluded expenditure;

•

provide the North West Shelf project and onshore projects with a notice day to apply the '5 year rule';

•

provide the North West Shelf project with the same deductible expenditure treatment as the Bass Strait Project; and

•

allow a functional currency election to be made by an onshore project or the North West Shelf project and to apply from 1 July 2012.

4.2 All legislative references throughout this chapter are to the Main Bill 2011 unless otherwise indicated.

Context of amendments

4.3 The extension of the PRRT recognises there are types of expenditure that are unique to onshore projects. It is important that these expenditures are prescribed the correct treatment under the PRRTAA 1987. The amendments to the deductible expenditure provisions achieve this.

4.4 Schedule 3 amends the existing deductibility provisions to include expenditure in relation to environmental expenditure, resource tax expenditure and native title payments.

Summary of new law

Environmental expenditure

4.5 Commonwealth, State and Territory governments have in place regulatory requirements in relation to the environment. Generally, environmental requirements must be carried out throughout the life of a petroleum project, but are particularly important during the exploration, planning and development stages when a project is seeking approval.

4.6 The amendments to the PRRT project definition and exploration expenditure definition make it explicit that these environmental expenditures are deductible.

Resource tax expenditure

4.7 Commonwealth, State and Territory resource tax expenditures are creditable against the liabilities of PRRT projects. This ensures that petroleum projects are not subject to double taxation. Such resource tax expenditures include State and Territory royalties and crude oil excise.

4.8 Payments of resource taxes are converted to a deduction equivalent and are able to be deducted against the assessable receipts of the project. Resource tax expenditures that are not used in a given year are uplifted at the long term bond rate plus 5 per cent (LTBR + 5 per cent).

4.9 A new deduction category is inserted in Division 3 of the PRRTAA 1987 to accommodate resource tax expenditures.

Private override royalties and native title payments

4.10 Private override royalty arrangements differ from State imposed royalties in that they are, in substance, a profit sharing agreement in respect of the exploitation of a resource, rather than the sale of the resource by the owner. Private override royalties can take a number of forms.

4.11 Private override royalties, are excluded expenditure and will remain so for petroleum projects transitioning into the PRRT. However, a carve out will apply to compensation payments made to native title holders, native title claimants and any persons who hold a right (under an Australian law dealing with the rights of Aboriginal persons or Torres Strait Islanders in relation to land and waters) that relates to an area where petroleum projects are operating. [Schedule 3, items 1, 2, 5 and 18]

Extending the PRRT to the North West Shelf project and onshore projects

4.12 The definition of 'relevant pre-commencement day' in the Schedule to the PRRTAA 1987 has been amended to include a notice day to accommodate onshore projects and the North West Shelf project [Schedule 3, item 20] . Section 34A Class 2 augmented bond rate general expenditure has also been amended to include a notice day to accommodate onshore projects and the North West Shelf project [Schedule 3, item 11] . Both these amendments ensure that a day can be used to apply the '5 year rule' to the North West Shelf project and onshore projects.

4.13 The North West Shelf project will now be subject to PRRT. To ensure consistent treatment of the North West Shelf project with the Bass Strait project, references to the North West Shelf project have been inserted into Division 3 of the PRRTAA 1987. [Schedule 3, items 8 to 10, 12 and 13]

Comparison of key features of new law and current law

Detailed explanation of new law

Environmental expenditure

4.14 Before, after and throughout the life of a petroleum project, certain environmental requirements must be complied with. These are outlined in the legislation and regulations of various jurisdictions.

4.15 Extending the PRRT to onshore petroleum projects means that the environmental expenditures of onshore projects will also be deductible. To address industry concern that some environmental expenditure, such as water treatment costs, may not meet the requirements of deductibility under the existing deductibility provisions, amendments have been made to ensure that various environmental expenditures are deductible. This may include such things as environmental impact statements and environmental compliance obligations prescribed by law.

4.16 Under the current law, these environmental expenditures (as they relate to the project operations of the petroleum project) are normally deductible. However, they are not separately identified.

4.17 For the avoidance of doubt, the Main Bill makes it explicit that certain environmental expenditures are deductible either as general project expenditure or exploration expenditure.

4.18 The existing definition of a petroleum project [section 19 of the PRRTAA 1987] is amended to also include 'operations and facilities, carried on or provided, for an environmental purpose, that are in relation to the carrying on or provision of the operations, facilities and services referred to in this section' [Schedule 3, item 6, paragraph 19(4)(b)] .

4.19 Similarly, the existing definition of exploration expenditure [section 37 of the PRRTAA 1987] is extended to include 'operations and facilities, carried on or provided, for an environmental purpose, that are in relation to the carrying on or provision of the operation, facilities and services referred to in this section' [Schedule 3, items 15 and 16, paragraph 37(1)(b)] .

4.20 The amendments to the PRRT make it explicit that environmental expenditures are deductible as either general project expenditure or exploration expenditure. Whether such expenditure is characterised as general or exploration expenditure will depend on the nature of the activity and the context in which they are undertaken.

4.21 These amendments ensure that water treatment and other environmental expenditures are deductible to the extent that they are incurred in relation to the petroleum project. Some examples of deducible environmental costs as they relate to the petroleum project would include but are not limited to: the cost of abating greenhouse gas emissions; the cost of acquiring carbon permits; and the costs of bio-sequestration activities. These environmental activities would generally be deductible as they are related to the petroleum project if they were undertaken by the taxpayer or if the taxpayer procures another entity to undertake the environmental activities.

4.22 In some cases, water or other products or carbon and capture services may be produced and sold as part of the petroleum project. A new incidental receipts provision is inserted in the PRRTAA 1987 to ensure only net project expenditure is deductible against project receipts. [Schedule 2, item 5]

Example 4.1: Deducting environmental expenditure

Sledgey Resources operates a coal seam gas project in Queensland. As part of the environmental licence and law, Sledgey is required to process and dispose of the water produced as part of the extraction of coal seam gas.

The costs incurred in treating and disposing of the water, and the costs of facilities associated with that treatment (such as the ponds and pipelines that transport the water), are deductible for PRRT purposes.

Example 4.2: Deducting expenditure incurred in purchasing carbon emission units

During the fiscal year 2013-14, Rincon liquefied natural gas (LNG) emits 20,000 tonnes of CO2 and is required to purchase and surrender 20,000 emission units to meet its obligations under the Clean Energy legislation. To the extent that a certain number of the emission units purchased can be reasonably linked to the upstream operations, the amount paid for those units will be recognised as environmental expenditure and deductible for PRRT purposes.

Example 4.3: Expenditure incurred in growing forests to generate carbon emission units

Pinder & Sons owns and operates a petroleum project and also runs a gold mine in WA. It acquires 1,000 hectares of land in Tasmania at a cost of $1 million to grow forests and generate emission units to meet its emissions liabilities.

Pinder & Sons will initially determine how much of the forests will be allocated to each of its coal and gold mining operation. Based on its initial estimates, it allocates 50 per cent or $500,000 to the coal mine. Pinder & Sons then allocates 30 per cent of this amount to its upstream PRRT project. It will include $150,000 in its environmental expenditure for the year, which will be deductible under the PRRT.

To the extent that the proportion of the forest allocated to the upstream operations generates any excess emission units that are then sold on the market, the resulting income will also be recognised an assessable incidental production receipt.

Resource tax expenditures

4.23 Onshore petroleum projects are subject to royalties imposed by State and Territory governments. Commonwealth crude oil excise also applies to crude oil and condensate produced onshore. The North West Shelf project is subject to Commonwealth royalties and crude oil excise, and the Resource Rent Royalty is applied to petroleum production from Barrow Island. Payments of these government taxes will be grossed up and deductible against the current and future PRRT liabilities of a petroleum project.

4.24 Resource tax expenditure will be deductible if it is incurred in relation to the petroleum project or any pre-combination petroleum project in the financial year and it relates to petroleum recovered after 1 July 2012. [Schedule 3, item 14, section 35C]

Example 4.4: Resource tax expenditure relating to petroleum production prior to 1 July 2012

High Octane pays a royalty to the Western Australian government after 1 July 2012 that relates to petroleum recovered before that date. The payment is not deductible resource tax expenditure as it relates to petroleum recovered before 1 July 2012.

4.25 The resource tax expenditure must be incurred in relation to petroleum recovered from the production licence area for the petroleum project for it to be deductible [Schedule 3, item 14, section 35C] . This is consistent with the PRRT being a project based tax.

4.26 The resource tax expenditure must be incurred under an Australian law and can either be a royalty, an excise, or an amount calculated by reference to the revenue, expenditure, value (at the wellhead), or profits made or incurred in relation to petroleum recovered from the production licence area of the project [Schedule 3, item 14, subparagraphs 35C(3)(c)(i) to (iv)] . It is intended that this would cover the range of resource taxes currently levied on projects transitioning to the PRRT.

Converting resource tax expenditures to a deduction equivalent

4.27 The resource tax expenditure is converted to a deduction equivalent by dividing the value of the expenditure by the PRRT rate. [Schedule 3, item 14, subsection 35C(4)]

Example 4.5: Converting resource tax credits to a deduction equivalent

Pentagon Petroleum Corporation pays a royalty of $2 million to a State government for petroleum recovered from a production licence area. This royalty payment is deductible against PRRT assessable revenue as a deduction equivalent.

Pentagon calculates its deduction equivalent by dividing the royalty payment by the prevailing PRRT rate (40 per cent).

Deduction Equivalent	=	$ 2m
		40%
	=	$5m

The value of Pentagon's resource tax expenditure deduction is $5,000,000.

4.28 The deduction for resource tax expenditure is included in the order of deductions. [Schedule 3, item 7]

4.29 In circumstances where resource tax expenditures cannot be deducted against a petroleum project's assessable receipts in a financial year, the excess is carried forward and uplifted by the LTBR + 5 per cent. [Schedule 3, item 14, subsection 35C(5)]

4.30 Undeducted amounts of resource tax expenditure are non-refundable and non-transferrable to other petroleum projects.

Example 4.6: Uplifting unused resource tax expenditures

Octagon Oil and Gas pays a royalty of $5 million to a State government for gas recovered from a production licence area for the financial year. It converts its royalty payment to a deduction equivalent, giving it a $12.5 million resource tax expenditure deduction.

Octagon receives $500 million in assessable receipts for the financial year. After deducting its available Class 2 expenditures, Octagon is able to deduct $6.5 million of its resource tax expenditures, leaving it with $6 million worth of undeducted expenditure (the available excess).

Octagon uplifts this available excess at the augmented bond rate and it is carried forward to the next financial year.

Carried forward deduction	=	$6m × 1.11
	=	$6.66m

Octagon has $6.66 million worth of carried forward resource tax expenditures to use in the next financial year.

4.31 Resource tax expenditures are included within the meaning of eligible real expenditure [Schedule 3, item 3] . In circumstances where a petroleum project with undeducted resource tax expenditures is sold, the unused expenditure related to the transferred interest will, like other eligible real expenditure, transfer to the new holder of the interest under Division 5 of the PRRTAA 1987 (sections 48 and 48A). The purchaser of the interest will step into the shoes of the vendor and be liable for any underpayment of resource tax expenditures but also be entitled to any refund of resource tax expenditure after the transfer date.

4.32 In some circumstances a petroleum project may be entitled to a refund of resource tax expenditure. Such a refund will be an assessable miscellaneous compensation receipt under subparagraph 28(b)(ii) of the PRRTAA 1987. The refund will be recognised as a miscellaneous assessable receipt in the period that it is received rather than in the period the resource tax expenditure was incurred.

Example 4.7: Refund of resource tax expenditure

Further to Example 4.6, Octagon Oil and Gas paid a royalty of $5 million to a State government for gas recovered from a production licence area in July 2015. Octagon Oil and Gas overpaid the royalty and received a refund of $1 million in September 2015. This refund would be considered an assessable miscellaneous compensation receipt under subparagraph 28(b)(ii) of the PRRTAA 1987, because it relates to eligible real expenditure incurred by the person in relation to the project. The refund would be recognised in September 2015 and converted to a deduction equivalent of $2.5 million by dividing the refund ($1 million) by the prevailing PRRT rate (40 per cent).

4.33 In some instances, a person (such as a joint venture operator) who incurs a liability to make a royalty or excise payment may have a separate agreement with another person (such as a joint venture participant) to be reimbursed with an amount equal to the payment (or part therefore). Where this happens, the second person, rather than the first person, will be taken to have incurred the amount of resource tax expenditure that relates to the reimbursement. [Schedule 3, item 14, subsection 35C(6)]

Example 4.8: Resource tax expenditure incurred on behalf of someone else.

Pegasus Co. (Pegasus) and Medusa Co. (Medusa) form a 50-50 joint venture to recover petroleum from a production license registered to Pegasus. As part of the joint venture agreement, Medusa is required to reimburse Pegasus for any royalty payments that Pegasus will be required to make on Medusa's 50 per cent share of the petroleum recovered from the production license within three business days of Pegasus making the payment. On 15 August 2013, Pegasus makes a royalty payment of $4 million and it receives a reimbursement of $2 million from Medusa three days later. In these circumstances, Pegasus and Medusa will each incur resource tax expenditure of $2 million.

Native title payments

4.34 Private override royalties are payments to a party other than under a State or Territory law. Private override royalties are excluded expenditure and not deductible under the PRRT. Payments to landowners associated with accessing production sites associated with onshore operations are generally deductible under sections 37 to 39 of the PRRTAA 1987 when they are incurred in carrying on operations in relation to the petroleum project.

4.35 To ensure that this exclusion does not prevent a deduction for eligible native title payments, a carve out has been included in the existing definition of excluded expenditure [section 44 of the PRRTAA 1987] . Under the carve out, payments that are made by way of compensation for carrying on or providing, in an area, the operations, facilities or other things comprising a petroleum project to:

•

a native title holder (within the meaning of the Native Title Act 1993 ) with an approved determination of native title relating to that area;

•

a native title claimant (within the meaning of the Native Title Act 1993 ) whose claimant application relates to that area; or

•

a person who holds a right that relates to that area and arises under another Australian law dealing with the right of Aboriginal persons or Torres Strait Islanders in relation to land or water,

are deductible against assessable receipts. [Schedule 3, items 17 and 18]

Example 4.9: Deductibility of native title payments

Triangle LNG negotiates an Indigenous Land Use Agreement with a native title group under the Native Title Act 1993 . The Indigenous Land Use Agreement is registered. In accordance with this Agreement, the native title group agrees to the granting of tenure over a part of their land, and to allow Triangle LNG to access and disturb that land to extract coal seam gas.

Triangle LNG pays a compensation payment to the native title holders. This compensation payment is deductible against the petroleum project's assessable receipts.

Example 4.10: Payment not amounting to a compensation payment

To celebrate the agreement reached in Example 4.9, Triangle LNG organises for a famous indigenous band to play at the local school. Since the agreement has already been reached, the cost incurred in providing the concert is not a compensation payment for carrying on the petroleum project.

Extending the PRRT to the North West Shelf project and onshore projects

4.36 The '5 year rule' alters the uplift rate that is applied to exploration expenditure. The PRRTAA 1987 applies the '5 year rule' by referring to the date specified in the notice issued under subsection 258(7) of the Offshore Petroleum and Greenhouse Gas Storage Act 2006 .

4.37 A new definition of 'production licence notice' has been inserted [Schedule 3, item 4] . The notice has been defined as either a notice issued under subsection 258(7) of the Offshore Petroleum and Greenhouse Gas Storage Act 2006 or a notice issued by a State or Territory authority that specifies the day that sufficient information has been provided to make a determination on the application for a production licence.

4.38 The 'production licence notice' definition is used in the 'relevant pre-commencement day' definition in Clause 1 of the Schedule and in section 34A of the PRRTAA 1987. Including the 'production licence notice' definition within the definition of 'relevant pre-commencement day' and within section 34A, sets the date for the application of the '5 year rule' and extends the application of the '5 year rule' to onshore projects and the North West Shelf project [Schedule 3, items 11 and 20] . To accommodate the scenario where a notice is not issued, the date that sets the '5 year rule' is the earliest day specified in the 'production licence notice' or the day the production licence is issued.

4.39 The North West Shelf project will now be subject to PRRT. To ensure consistent treatment of the North West Shelf project with the Bass Strait project, references to the North West Shelf project have been inserted into Division 3 of the PRRTAA 1987. [Schedule 3, items 8 to 10, 12 and 13]

4.40 The current functional currency rules (section 58B of the PRRTAA 1987) only allow a taxpayer to apply a functional currency election on a prospective basis, in the year after the year in which the election is made.

4.41 However, taxpayer's transitioning into the PRRT can apply the functional currency rules from 1 July 2012 if they make the election within 30 days of the commencement of Schedule 1 to the Main Bill. [Schedule 3, item 19]