Mitsui v Commissioner of Taxation –Depreciating assets and section 40-80
Japanese conglomerate Mitsui & Co (Mitsui) recently lost a $264 million tax dispute relating to its acquisition of an interest in a petroleum field in Australia’s North-West Shelf.
In March 2004, Mitsui purchased from Woodside Energy Limited (Woodside) a 40% undivided interest in production licence WA-28-L and exploration permit WA-271-P. There were three petroleum fields covered by the two tenements:
- the Laverda field (within WA-271-P);
- the Enfield field (within WA-28-L); and
- the Vincent field (within WA-28-L).
The purchase price payable by Mitsui to Woodside for the acquisition of the two tenements was $624 million. The sale and purchase agreement made no provision for apportionment of the purchase price among the tenements or the petroleum fields.
For the purposes of completing its tax return for the 2005 year, Mitsui treated the purchase price paid under the sale and purchase agreement in the following way:
- $72 million was referable to the Laverda field;
- $288 million was referable to the Enfield field; and
- $264 million was referable to the Vincent field.
Both the Laverda and Vincent fields were at an exploration stage, whereas the Enfield field had proceeded to development at the time of the acquisition.
Issue in dispute
The cost of acquiring a depreciating asset (including a petroleum tenement) is generally deductible for income tax purposes over the effective life of that asset. However, special rules exist in section 40-80 of the Income Tax Assessment Act 1997 (Cth) which provide an immediate deduction for the cost of acquiring a depreciating asset which is first used for exploration purposes (and not used for operations in the course of working a petroleum field).
The treatment adopted by Mitsui in its 2005 tax return was as follows:
- $72 million referable to the Laverda field was treated as immediately deductible under section 40-80;
- $288 million referable to the Enfield field was treated as deductible over 21 years (being its effective life); and
- $264 million referable to the Vincent field was treated as immediately deductible under section 40-80.
The income tax treatment of the purchase price allocated to the Laverda and Enfields fields was accepted by the Australian Taxation Office (ATO) without challenge. Only the $264 million referable to the Vincent field was in dispute. The ATO asserted that this amount should have been treated in the same way as the Enfield field (i.e. deductible over 21 years) on the basis that they were both part of the same production licence.
They key issue which the dispute turned on was whether a production licence was a single depreciating asset or whether a production licence consisted of two separate depreciating assets (i.e. a right to recover and a right to explore) that could have different income tax treatments.
Mitsui’s argument relied on the fact that under the Petroleum (Submerged Lands) Act 1967 (Cth) (PSLA) the holder of a production licence was authorised to both recover petroleum and to explore for petroleum. Accordingly, Mitsui argued that it had acquired two separate depreciating assets (i.e. a right to recover and a right to explore). The $264 million referable to the Vincent field was said by Mitsui to be the cost of acquiring the right to explore and, as the right to explore was first used for exploration of the Vincent field, an immediate deduction should be allowed under section 40-80.
On the other hand, the ATO argued that a production licence was a single depreciating asset and, as the licence had been used for operations in the course of working the Enfield field, an immediate deduction was not available under section 40-80.
Mitsui lost in the Federal Court at first instance and in the Full Court of the Federal Court on appeal. The Courts held that a production licence is a single depreciating asset and it could not be separated into a right to recover and a right to explore. It followed that because the production licence had been used for operations in the course of working the Enfield field, an immediate deduction was not available under section 40-80.
Presumably, had there been two separate depreciating assets (either because a right to recover and a right to explore were separate depreciating assets or because the Vincent field was located on a separate tenement), then the amount allocated to the Vincent field would have been immediately deductible as it appears the ATO had accepted that the Vincent field was still in the exploration phase.
The decision in Mitsui relied heavily on the scheme created by the PSLA, in particular the use of graticular blocks to identify the production licence area. The issue in dispute would not have arisen if the production licence area had been marked out as commonly occurs under State mining acts (as none of the Vincent field would have fallen within the production licence area).
In addition, despite comments to the contrary by the Court, it is common practice for parties to deal separately, that is, contractually, with the rights granted under a production licence. It is possible that by separately acquiring the rights granted by a production licence, rather than acquiring the production licence itself, that a different tax outcome might have been reached. For example, had Mitsui acquired the right to explore in respect of production licence WA-28-L separately from the production licence there would be an argument that the cost of acquisition was deductible under section 40-80.
Esso Australia Resources Pty Ltd v CoT - PRRT deductibility case
The ATO has recently released a decision impact statement on the Esso Australia Resources Pty Ltd v Commissioner of Taxation  HCATrans 194;  FCAFC 5 ‘deductibility’ case. The position adopted by the ATO in the decision impact statement has significant implication for how agreements (especially service agreements) should be drafted to ensure the parties can obtain Petroleum Resource Rent Tax (PRRT) deductions for liabilities incurred under the agreements.
Esso Australia Resources Pty Ltd (EAR) was engaged in a petroleum project (the Project) involving exploring for, recovering, treating and selling petroleum and natural gas. The Project was conducted as a joint venture with BHP Billiton Petroleum (Bass Strait) Pty Ltd (BHP) pursuant to an Operating Agreement. As EAR had no employees or equipment, a Service Agreement between EAR and Esso Australia Ltd (EAL), a related company, provided that EAL make available to EAR trained personnel, equipment and facilities to enable EAR to conduct its petroleum exploration, production and marketing operations (i.e. upstream and downstream) in Australia and on the continental shelf (i.e. not just limited to the Project area).
Under the Service Agreement, EAR agreed to pay: (i) the direct costs EAL incurred in providing the agreed services to EAR; (ii) a share of EAL's overhead costs proportionate to the services performed; and (iii) a fee of 7.5% of EAR's share of the overhead costs.
The Commissioner disallowed deductibility of some of the claimed amounts relating to the Service Agreement that can be broadly described as relating to office facility, administrative and accounting expenditure (i.e. the costs falling under item (ii) of the Service Agreement).
The taxpayer was successful at first instance in the Federal Court (30 May 2011). The Commissioner’s appeal was upheld by the Full Court of the Federal Court (20 February 2012). The High Court refused an application for special leave to appeal against the decision of the Full Court of the Federal Court (17 August 2012).
Full Court of the Federal Court Judgment
The Full Court of the Federal Court held that the costs relating to office facility, administrative and accounting expenditure were not deductible. The deductibility of ‘indirect’ type costs has been an area of contention between the ATO and taxpayers for some time and therefore this aspect of the Full Court’s judgment was not entirely surprising.
The surprising (and concerning) part of the judgment was that the Full Court held that all expenditure incurred under the Service Agreement was not deductible, even though the ATO itself had accepted many of these costs as being deductible (such as the costs falling under item (i) of the Service Agreement). The basis for this finding by the Full Court appears to be that the Service Agreement created an indivisible liability that was not solely related to the Project (as defined under the PRRT Act) as it covered the provision of services to all of EAR’s projects in Australia and on the continental shelf (rather than just the Project) and it included both upstream and downstream operations (only upstream operations are relevant for PRRT). Although it is not clear, the Full Court appears to have formed the view that that apportionment of such a liability is not possible for the purposes of the PRRT Act and therefore none of the costs under the Service Agreement were deductible.
ATO Administrative Treatment
The ATO has acknowledged that the Full Court’s views on apportionment are inconsistent with its own previously stated views. Accordingly the ATO will not seek to disturb assessments for the 2012 financial year and earlier years where taxpayers have self-assessed in accordance with its previously stated views in draft taxation rulings TR 2010/D4, TR 2010/D5 & TR 2010/D6. Where taxpayers have not self-assessed in accordance with the draft taxation rulings the ATO is giving taxpayers an opportunity to comply with the draft taxation rulings before commencing further compliance activity. If a taxpayer’s position is found, as part of any subsequent ATO compliance activity, not to be in accordance with the draft taxation rulings the ATO have stated they will apply the law consistently with the views expressed in the Full Federal Court's decision. This is essentially ‘blackmailing’ taxpayers into adopting the ATO’s position on all issues covered in the draft taxation rulings.
For 2013 and later years the ATO will be applying the law in accordance with the Full Court’s judgment. The petroleum industry is lobbying treasury for the PRRT law to be changed so that apportionment of liabilities and expenditure will be permitted under the law.
If and until a legislative fix is implemented, consideration should be given to the Full Court’s judgment whenever drafting agreements (especially service agreements) that will give rise to deductible expenditure for PRRT purposes. Best practice will be to ensure the agreement is limited to the project (as defined for PRRT) and is only in respect of upstream operations. If this is not possible, at a minimum, the agreement should create separate and discrete liabilities – one of which relates solely to the upstream operations of the project.
A review and redrafting of existing agreements may be warranted in certain circumstances.
This article was written by Nick Heggart, Director, Greenwoods & Freehills, Perth.