Two draft tax rulings have been released setting out the taxation and GST treatment for farm-out arrangements in the resources industry. The rulings are long and complex. They change the previous Tax Office position on the taxation outcomes of certain aspects.

State governments issue exploration permits and mining licences subject to conditions and work programmes. Farm-out arrangements are a common way for the holder of an exploration permit (“farmor”) to fund the required work program. Typically, the farmor will transfer (or agree to transfer in the future) a percentage interest in the exploration permit/ mining licence in return for the “farmee” undertaking some or all of the work program which might include drilling wells or taking core samples and undertaking geological analysis. Typically, the farmee might be a geologist or drill company.

The draft rulings set out the following taxation aspects for farm-out:

+ Deductibility of exploration expenditure for the farmor and farmee under the depreciation system;

+ Capital Gains Tax matters;

+ Assessability and deductibility of services provided by the farmee; and

+ GST aspects (which will be covered in a separate article).

The draft rulings treat an immediate transfer of the interest in the exploration permit as a sale. Where the transfer is to take place in the future, after certain conditions are met, the second draft ruling considers this to be akin to the granting of an option. The farmor receives the exploration services characterised as non-cash business benefits on revenue account as consideration for the transfer of the interest.

There are also rules set out for the sharing of mining information. Where the sharing is merely incidental to the exploration services or the transfer of the interest it has negligible effect. Where the farm-out agreement considers the information to be part of the consideration for the deal, then it too will be treated as a non-cash business benefit.

The Tax Act provides a generous tax incentive for undertaking exploration work under the depreciation rules. You can deduct capital expenditure on exploration or prospecting for minerals (which includes petroleum) or quarry materials immediately in the year that you incur the costs. You must have carried on a mining operation or propose to carry on such an operation or carry on a business of exploration or prospecting.

When the owner of the tenement transfers a portion of it to the geologist it is a balancing adjustment event for the owner as there has been the disposal of a depreciable asset. However, there is also a deduction available because the disposal of the percentage interest was in return for exploration services for which an immediate deduction is available.

The geologist can claim a deduction for their expenses in undertaking the exploration work.

The capital gains tax rules are generally disregarded in these circumstances because the disposal of the tenement interests are disposal of depreciable assets and there are provisions which exclude capital gains rules where depreciable assets are involved.

For the geologist the receipt of the percentage interest in the prospecting tenement represents ordinary income. It is considered a reward for providing the non-cash benefits of undertaking the prospecting work. This will be assessable income to the farmee!

Both the transfer of the percentage interest in the exploration permit by the farmor and the provision of the exploration services by the farmee are considered taxable supplies under the GST rules. The GST effects for both parties should however net each other out as … Assuming both the farmor and the farmee are registered for GST and account on a non-cash basis, each can claim any input tax credits as soon as they hold a tax invoice from the other party.

These draft rulings are complex and the holders of prospecting entitlements, geologists and drilling companies should take great care and seek advice on the correct income tax and GST treatment of their transactions.

MT 2011/D1, MT 2011/D2, IT 2378, WTB 1252, s 40-730 of 97 Tax Act

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