Draft taxation ruling TR 2015/D4 was released on 28 October 2015 in a significant milestone for the energy and mining industry. It will replace its 17 year old predecessor, ruling TR 98/23, and will hopefully provide more certainty to the industry by better reflecting current industry practices.
Our TaxTalk Alert of 28 October 2015 provided a summary of the key aspects of the draft ruling. Although the draft ruling should generally be welcomed by industry, some of the conclusions reached could have the impact of restricting the application of exploration provisions (including sections 40- 730 and 40-80 of the Income Tax Assessment Act 1997 and section 37 of the Petroleum Resource Rent Tax Assessment Act 1997).
This article considers the impact of some of the conclusions reached in the draft ruling in more detail highlighting where the draft ruling has ‘giveth’ but also where it ‘taketh away’.
The draft ruling extends to 68 pages including 41 paragraphs of proposed binding reasoning, 20 examples (also included in the binding section of the draft ruling) and over 33 pages of explanation and guidance. This level of detail, including the binding examples, should be of assistance to all taxpayers in the energy and mining industry by providing factual context to the application of the provisions.
The draft ruling also suggests that the ATO is working on a practical compliance approach to the provisions which should also be welcomed by an industry seeking certainty.
In terms of legal principle, the draft ruling provides conclusions in respect of broadly five topics. It is in expressing these principles that the ruling both gives and takes-away from taxpayers.
One of the most significant differences between this draft ruling and TR 98/23 (which is withdrawn and replaced by the new ruling) is the explicit consideration of the ordinary deduction provisions. As with many of the general principles expressed in this draft ruling and associated explanation, the ATO’s reasoning includes both positive and negative aspects for taxpayers.
The first significant conclusion expressed in the draft ruling is that Division 40 is not a code for deducting exploration expenditure and the ordinary deduction provisions can and should be considered at first instance. In a positive step forward, the draft ruling concludes (and echoed in the ATO’s guidance as to its compliance approach) that if section 40-730 and section 8-1 would potentially both provide a deduction for exploration expenditure, then the provision which provides the largest deduction should be preferred.
The draft ruling’s reasoning in respect of the negative limb of section 8-1 should generally be considered positively by taxpayers as the conclusions that:
- there is no presumption that exploration expenditure is capital (paragraph 17), and
- merely producing information does not imbue expenditure with the character of an enduring benefit (paragraph 19)
should facilitate deductions under ordinary principles.
However, the proposed binding part of the ruling, and the associated non-binding explanation, limits the operation of section 8-1 by more narrowly construing the positive limbs of section 8-1 to exclude expenditure where “a mining or exploration business has not yet commenced, or where a new source of income of an existing business is being investigated” citing Sundberg J’s reasoning in Esso Australia Resources vs Federal Commissioner of Taxation 97 ATC 4371. The non-binding explanation suggests that the positive limb may not be satisfied for activities including economic feasibility studies considering whether to commit to a business or new income activity may not be deductible under section 8-1 on this basis.
Whilst on balance, the draft ruling’s consideration of section 8-1 will likely be welcomed by taxpayers, the draft ruling’s comments (particularly within the explanation section of the draft ruling) regarding the positive limb are an example of the nuanced approach that must be taken to considering the draft ruling.
Exploration or prospecting
The draft ruling considers that the words ‘exploration or prospecting’ take their ordinary meaning and that this meaning is restricted to:
“the discovery and identification of the existence, extent and nature of the minerals and includes searching in order to discover the resources, as well as the process of ascertaining the size of the discovery and appraising its physical characteristics.”
This conclusion was perhaps not unexpected given the Administrative Appeals Tribunal’s reasoning in the case of ZZGN v Commissioner of Taxation  AATA 351 and the ATO’s endorsement of those views in TR 2014/9 (dealing with exploration under PRRT). The impact of this somewhat narrow definition is ameliorated for section 40-730 and section 40-80 matters by the statutory extensions to the exploration or prospecting definition within the income tax law.
Some taxpayers may still consider that this definition is unduly narrow by excluding the commercial context of exploration or prospecting activities from the ordinary meaning, but it appears that, at least in the ATO’s mind, this battle has been decided.
However, consistent with this article’s theme, the draft ruling does include some positive comments even in respect of the ordinary meaning of exploration. Paragraph 32 of the draft ruling confirms that activities which are incident to or closely connected with actual exploration or prospecting can ‘reasonably… be considered part of” actual exploration or prospecting.
This conclusion, whilst self-evidently sensible, is significant – particularly in respect of section 40-80 matters where the precise first use of an asset may be part of an integrated exploration process but not be pure exploration on a stand-alone basis. Under the reasoning in this draft ruling, those related activities may themselves be considered to be exploration.
The relevance of ‘FID’
One point on which the draft ruling may be said to ‘taketh’ is its very explicit statement that the ATO does not accept there is a ‘bright line test’ that all expenditure up to ‘FID’ is to be treated as exploration expenditure. However, the draft ruling also ‘giveth’ by noting that ‘whether an activity is carried out before or after a decision to mine has long been regarded as a guide for characterising activities’, and that ‘it may provide a useful indicator that can help ease compliance and administrative burdens and has been used by the Commissioner and by taxpayers for many years in this way.’ Thus FID may still be relevant to the practical compliance approach the Commissioner is developing.
Economic feasibility studies
The ATO’s views in respect of the ordinary meaning of exploration or prospecting mean that draft ruling’s interpretation of the statutory extensions to the definition are even more important. In this respect, the positions expressed in the draft ruling should generally be considered favourably by taxpayers.
In particular, the draft ruling confirms that the statutory extensions to the definition of exploration and prospecting in paragraphs 40-730(4)(a) to 40-730(4)(d) are express additions to the definition that are “expansive of the ordinary meaning and are not conditioned by it”. Accordingly, if an activity meets one of these legislative descriptions (e.g. economic feasibility studies) the activity will be considered to be exploration or prospecting regardless of whether it satisfies the ordinary meaning of those rules.
Furthermore, paragraphs 34 and 35 of the draft ruling consider economic feasibility studies in detail and generally take an expansive view of the meaning of paragraph 40-730(4)(c). This expansive approach is further contextualised by examples 2-8 which consider facts relevant to feasibility studies for offshore exploration, examples 10 and 11 which consider feasibility studies in a mining context and example 20 which considers feasibility studies in the context of unconventional gas.
The draft ruling’s consideration of this issue represents the most significant step forward by the ATO in this matter. The ATO’s historical positions (expressed primarily through audits or informal statements) that paragraph 40-730(4)(c) should be construed narrowly have been disavowed which means that the exploration provisions can be applied more practically by taxpayers.
The exclusions – operations in the course of…
The draft ruling’s reasoning in respect of the exclusions from the exploration provisions is likely to be the most underwhelming aspect of the draft ruling for taxpayers. In particular, the binding aspects of the ruling provide limited guidance in respect of the actual statutory text and instead consider, at length, factual considerations related to the application of the exclusions (in particular ‘operations in the course of working a mining property’) to mine extensions, expansions and augmentations.
The specific conclusion in paragraph 45 of the draft ruling that there is no presumption that activities will be operations in the course of working a mining property where they occur in relation to a mining property where there is an established mine is undermined by the heading ‘mine extensions, expansions and augmentations’ and the subsequent paragraphs.
The suggestions within paragraph 47 that commitments by the miner to extend or expand the mine are relevant to applying the exclusions appears to improperly imply into the exclusions a subjective test, when the exclusions should be more properly considered by reference to the objective purpose of the activity relevant to the expenditure.
Given the expansive views taken in respect of the extensions to the definition of exploration or prospecting, it appears likely that the new ‘battleground’ between taxpayers and the ATO in respect of exploration deductions (under either section 40-730 or section 40-80) will concern the application of the exclusions.
The draft exploration ruling represents a significant step forward in providing certainty to energy and resources taxpayers. However, the reasoning in the draft ruling is nuanced and taxpayers should carefully consider the application of these principles to their specific facts and circumstances. The ruling is still in draft and taxpayers are able to provide comments to the ATO by 11 December 2015.