Australia: ATO calls for submissions on new treatment of transfer farm-out arrangements
Energy and resources update

A draft tax ruling issued on Wednesday, 24 August 2011 signals a new approach by the Australian Taxation Office (ATO) for the tax treatment of deferred transfer farm-out arrangements. The draft ruling follows an earlier draft ruling in relation to the less common immediate transfer farm-out arrangements.

The draft rulings refer to farm-out arrangements in relation to mining tenements. However, it affects mining, quarrying and prospecting rights under Australian laws and includes licences and permits in relation to minerals and petroleum.

The draft rulings propose to treat farm-out arrangements as barter transactions and this means there are income tax and GST implications for both the owner of the mining tenement (farminor) and the party to whom a percentage interest is transferred (farminee). While the draft ruling offers much needed clarification, the new approach is likely to increase compliance costs and could give rise to unexpected outcomes in some cases.

Background

The two draft rulings deal with:

• MT 2011/D1: immediate transfer farm-out arrangements – where there is an upfront transfer of a mining interest in return for a commitment to undertake exploration activities;
• MT 2011/D2: deferred transfer farm-out arrangements – where the mining interest is only transferred once exploration commitments are met.

The ATO's current view in relation to farm-out arrangements is set out in Taxation Ruling IT 2378, which normally allows a nil value for farm-out arrangements at the wildcat or grassroots exploration stage.

Valuation of interests and exploration benefits

The ATO appears to accept that the time for determining the market value of the interest in the mining tenement is when the parties enter into the farm-out arrangement. This is the case for both immediate and deferred transfer farm-out arrangements.

The ATO also accepts that tenements at a green-fields stage may only have minimal value.

The market value of the exploration services provided by the farminee (together with any cash payment) is generally equal to the market value of the interest in the mining tenement provided by the farminor. The value of the exploration benefit does not necessarily equate to the amount the farminee needs to spend on the exploration work.

Immediate transfer farm-out arrangement

Miscellaneous Tax Ruling MT 2011/D1 deals with the income tax and GST implications of arrangements under an immediate transfer farm-out arrangement. In summary, the draft ruling states:

• There is a sale of a percentage interest in a mining tenement by the farminor and, in return, the farminee commits to provide exploration services (exploration benefits).
• The farminor's interest is split into two depreciating assets – ie, the interest it retains and the interest it transfers to the farminee. A balancing adjustment event occurs for the farminor in relation to the interest it transfers to the farminee.
• The market value of the exploration services should form part of the termination value when calculating the farminor's balancing adjustment event from its disposal of a proportionate interest.
• The provision of exploration benefits are treated as services by the farminee on revenue account. The reward for those services is the interest in the mining tenement provided by the farminor.
• The market value of the exploration benefits provided to the farminor may be immediately deductible to the farminor.
• Since the arrangement is treated as a barter transaction, each party needs to account for GST in relation to their respective supplies and the other should be entitled to a corresponding input tax credit. The supply by the farmer may be treated as a GST-free supply of a going concern in certain circumstances.

Subject to industry consultation, the ATO's new approach will apply to immediate transfer farm-out agreements entered on or after 27 July 2011 and which relate to mining tenements entered into on or after 1 July 2001.

Deferred transfer farm-out arrangement

Miscellaneous Tax Ruling MT 2011/D2 deals with deferred transfer farm-out arrangements. The key points from the draft ruling are:

• The farminor grants the farminee a right to acquire an interest in a mining tenement subject to the farminee satisfying the earn-in requirements. The grant of that right results in a CGT event for the farminor.
• The farminee acquires a CGT asset in the form of a right to acquire an interest in a mining tenement. A CGT event happens when that right ends (eg, when the interest in the tenement is acquired) and the farminee may make a capital loss if the cost of the right was not deductible.
• The grant of the right to acquire the interest in the mining tenement is on capital account but the grant of an exclusive use and access to carry out exploration is treated as being on revenue account. The draft ruling suggests that cash payments will usually be treated as consideration for the use and access rights rather than the rights in relation to an interest in the mining tenement.
• The reward for the provision of the exploration benefits by the farminee is the interest in the mining tenement and the market value of the interest in the mining tenement will be assessable income to the farminee. The draft ruling assumes that the provision of the exploration benefits are on revenue account but that may depend on the particular circumstances.
• The market value of the exploration benefits should be immediately deductible to the farminor. The exploration benefits may still be received as non-cash business benefits for the farminor even if the earn-in requirements are not met.
• The farminor's interest in the mining tenement is split into two depreciating assets, the interest it retains and the interest it transfers to the farminee. A balancing adjustment event occurs for the farminor when the farminee exercises the right to acquire the mining tenement.
• The market value of the exploration benefit should form part of the termination value when calculating the farminor's balancing adjustment event from the disposal of its interest. The termination value will be the first element of the farminee's cost for the depreciating asset.
• The farminee may be entitled to an immediate deduction for the cost of the interest if its first use after it begins to hold that interest is for exploration or prospecting. The farminee may also be entitled to deductions for exploration expenditure that does not form part of the cost of the interest.
• Each party needs to account for GST in relation to their respective supplies and the other should be entitled to a corresponding input tax credit. The draft ruling proposes to include a legislative instrument to modify the timing of the farminor's GST liability (where the farminor accounts on an accruals basis) to align with the exercise of the option rather that the grant of the right.

Subject to industry consultation, the ATO's new approach will apply to immediate transfer farm-out agreements entered on or after 24 August 2011 and which relate to mining tenements entered into on or after 1 July 2001.

Consultation

The ATO has requested comments in relation to the tax treatment of immediate transfer farm-in arrangements by 9 September 2011. However, consultation in relation to the draft ruling on deferred transfer farm-out arrangements will be open until 8 October 2011.

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This report does not comprise legal advice and neither Gadens Lawyers nor the authors accept any responsibility for it.