III. Petroleum Mining

19.75. The special provisions of the Act in relation to prospecting and mining for petroleum are contained in an entirely new Division 10AA of the Act which was substituted for the previous Division 10AA by the Income Tax Assessment Act (No. 2) 1974 enacted in December 1974. The new Division 10AA preserves to a taxpayer entitlements to capital expenditures incurred prior to 18 September 1974 or incurred on or after that date and before 1 July 1976 in pursuance of contracts made prior to 18 September 1974.

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19.76. The provisions of Division 10AA apply to Australia, Papua New Guinea and the continental shelf as delineated in section 6AA of the Act, the word ‘minerals’ in section 6AA being defined in section 6 (1) as including petroleum.

Overseas Exploration and Prospecting

19.77. It has been submitted to the Committee that the availability of the deduction as allowable capital expenditure should be extended to expenditures made in exploration for petroleum overseas. Detailed arguments in support of this submission relate to Australia's future crude oil supply, the generation of overseas income with beneficial foreign exchange implications, the advantages of the export of Australian capital equipment and other products and support for Australian foreign-aid programmes. It is pointed out that the Governments of the United Kingdom, Canada, the United States, West Germany, France and Japan encourage the overseas activities of the private sectors of their economies by the provision of a range of financial incentives some of which are taxation concessions. Reference to the nature of these is made in the submission. It could not be denied that in these circumstances Australian companies engaged in overseas petroleum exploration would be placed at a considerable competitive disadvantage to the companies operating in this field from the major industrial companies but, as with the submission in relation to overseas mineral exploration (see paragraph 19.29), the Committee is of the opinion that the question whether a taxation concession of this kind should be granted upon these grounds does not depend upon matters within the purview of its terms of reference. Nevertheless, the Committee drews attention to the submission so that it may be considered in the appropriate quarters.

Exploration and Prospecting Expenditure

19.78. As with minerals in the earth's surface, deposits of petroleum in volume profitable to mine are difficult to find and the methods employed to discover these depend upon a variety of factors. A general survey of a wide area is first undertaken employing the techniques of photogeology, gravimetry and magnetometry. When sufficient and satisfactory general information has been obtained, the land search is pursued in the field by geological mapping and seismic work, and the offshore search is carried out by seismic work. The third stage is exploration by drilling, and offshore drilling is conducted by means of a floating rig. Only by means of drilling can the existence of a petroleum field be definitely established and the results obtained from this drilling be subjected to regular testing. If a field has been located by the exploration (or ‘wildcat’) well, it becomes necessary to mark out the field; for this purpose a number of other ‘step-out’ wells must be drilled. The field may be comprised by one large and profitable area or it may be distributed over a number of marginal or submarginal areas and questions will arise in relation to economic recoverability. Once it has been established that a viable field exists, a number of production wells are drilled to permit a flow of petroleum in profitable volume. A quantity of necessary equipment is then installed to separate the oil from the other constituents mixed with the mining product. When the production of petroleum is offshore, the installation of all this technical equipment must be effected upon a production platform. The petroleum must then be transported, whether from the land or offshore site, to a central storage facility. The expenses of the discovery of a profitable field and its subsequent development to the stage of commercial production need no emphasis.

19.79. Under section 124AH of the Act, expenditure incurred in ‘exploration or prospecting’ is an allowable deduction in the year in which it is incurred. The amount

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of the deduction is limited to the amount of net assessable income derived from petroleum operations in that year.

19.80. ‘Exploration or prospecting’ is defined in section 124AH (7) so as to include geological, geophysical and geochemical surveys, exploration drilling and appraisal drilling, but to exclude development drilling or operations in the course of working a petroleum field. The definition became necessary as a consequence of the distinction in treatment accorded exploration as distinct from development expenditure.

19.81. If the amount of exploration or prospecting expenditure exceeds the amount deductible in any year, the excess is carried forward for deduction against similar income of subsequent years until the entire amount is absorbed. The provisions therefore enable swift recoupment of exploration and prospecting expenditure against petroleum income but do not permit of such recoupment where the taxpayer does not derive assessable income from petroleum. The taxpayer may recoup his capital expenditure at an early stage without the need to match his prospecting and exploration expenditure with revenue derived from exploitation of reserves in that area (for example, on a life-of-field basis). However, allowance is made for the deduction of abortive or non-productive expenditure only where petroleum income is subsequently derived.

19.82. No distinction is seen by the Committee in the features of petroleum exploration vis-a-vis general mining exploration so far as taxation treatment is concerned. Hence the Committee confirms the comments and recommendations made in paragraphs 19.19–19.20 in relation to general mining: that is, such expenditure should be immediately deductible in full in the year in which it is incurred from income derived from any source.

19.83. Certain items of capital expenditure incurred in carrying on ‘prescribed petroleum operations’ are deductible over the life of the petroleum field on the same basis as for general mining. Some of these items are set out in section 124AA and include those costs incurred in providing light, power or water to the site, the cost of providing residential accommodation and amenities for employees. Refinery plant, ships and transport facilities of the nature described in section 124AA (2) (f), (g) and (h) are specifically excluded.

19.84. As with general mining, accrued undeducted allowable capital expenditure is translated into ‘residual capital expenditure’ under section 124AC and the balance is divided by the number of years of the estimated life of the field, or twenty-five, whichever is the less. The amount of the deduction in any one year is limited to the amount of assessable income from petroleum that remains after allowing all other deductions except in respect of development or exploration expenditure. This position is in contrast to that obtaining with respect to general mining, where the deduction for accrued residual capital expenditure is available against income derived from any source. Any amount excluded from the deduction allowed in any year falls into residual capital expenditure to be deducted in future years. Where the estimated life of the field exceeds twenty-five years, the upper limit of the deduction allowed in any year is 4 per cent of the undeducted expenditure on a reducing-balance basis. The Committee confirms the comments made in paragraph 19.21 with regard to the reducing-balance basis.

19.85. The treatment of all petroleum exploration and development expenditure prior to the 1974 amendments was characterised by immediate deductibility of such expenditure from income when derived from petroleum so that any such income

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when derived was exempt until all past expenditure had been recouped. This approach did not require that only expenditure incurred in the year of income should be deductible: it allowed a deduction for all such accrued undeducted expenditure, regardless of when it was incurred. These provisions constituted far more of an incentive than the general mining provisions of Division 10, except that recoupment was available only from profits generated by petroleum operations and associated activities, whereas the deductions available under section 122D or section 122E are available against income derived from any source. Under section 124AG a taxpayer who incurs allowable capital expenditure on plant may elect to have the normal depreciation provisions apply as an alternative to a life-of-field basis of deductibility. The depreciation deduction is, of course, available against income derived by a taxpayer from any source.

Development Expenditure

19.86. A number of difficulties arise with the life-of-field basis of deductibility in relation to petroleum development expenditure. The Committee has been assured that it is almost impossible to estimate with any accuracy the amount of recoverable reserves in, and hence the estimated life of, a field. This will depend upon the data available as a result of exploration and the adequacy of the production techniques employed to tap the field. A change in economic conditions may also affect the estimate, since an enterprise will undertake and continue extraction only where and when profitable.

19.87. As stated in paragraph 19.84, the deductions available to a petroleum mining enterprise in respect of its development expenditure are different from those accorded its general mining counterpart in two respects:

  • (a) the deduction for unrecouped capital expenditure is available only against income derived from petroleum operations; and
  • (b) the petroleum enterprise cannot elect to claim its entitlement to the full ‘unrecouped capital expenditure’ deduction to precipitate a loss which would provide access to the loss carry-forward provisions of section 80.

As to the latter, it has been suggested that this facility has been withheld because the petroleum enterprise will not, as a general rule, be able to recoup its losses within the period prescribed under section 80. This reason should not, however, stand in the way of granting the option. There does not appear to be any sound reason for according the differentiation in tax treatment in either of the two respects mentioned above.

19.88. The petroleum well or field, like the mine, is a wasting asset and the revenue it generates is partly income and partly capital in character. The process of exhaustion of the field necessitates an approach to taxation of the revenue which distinguishes and focuses upon the income element. Development costs are part of the asset subject to the process of waste and, for this reason, they should be recouped over the life of the field so that each barrel sold bears a proportionate share of the development cost. This treatment is framed towards the proper matching of expense with revenue derived from the field. The life-of-field method of amortisation embraces the time basis of amortisation so that development expenditure carried forward is allocated to each income tax year during the estimated life of the field. This method would be appropriate where time is the controlling factor in the consumption, or economic usefulness, of a reserve; but it may not be appropriate where rates of production or sale fluctuate according to changes in world market conditions or production techniques. This feature may be said to be more pronounced in petroleum mining than in general

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mining. Accordingly, the production basis of amortisation, whereby expenditure is amortised according to the ratio of production in a tax year to total estimated reserves, may be viewed as more appropriate. In addition, where the amortisation allowance is based upon actual production, it increases in periods of peak production and eases as mining operations near termination when income is correspondingly less. This achieves greater matching of costs and revenue. However, the time basis is more readily administrable and may be preferable from that point of view. The Committee makes no specific recommendation on this issue.

Depreciation Allowances

19.89. It remains to refer briefly to the question of accelerated depreciation allowances. The petroleum industry is faced with the same situation as was general mining in relation to section 122E, since the immediate write-off facility formerly enjoyed has now been extinguished. The practical difficulties attending this amendment are similar to those noted with regard to general mining in paragraphs 19.67–19.69. As with general mining, the Committee makes no recommendation regarding accelerated depreciation allowances. However, it reiterates the comment made with regard to general mining that consideration might be given to some form of investment allowance or accelerated depreciation to alleviate the practical difficulties that arise as a result of the unique character of this industry.

Acquisition of Prospecting Information or Mining Right

19.90. The costs of acquiring petroleum prospecting information or a petroleum mining right are deductible over the life of the field under section 124AB along lines identical with those applying in relation to general mining under section 122B. The vendor of such information or right may transfer to a purchaser his deduction entitlement in respect of accrued undeducted allowable capital expenditure and the purchase price is deductible up to a limit constituted by that deduction entitlement. As with general mining, expenditure by the vendor on buildings and improvements in the area the subject of the right is not transferable unless the purchaser acquires rights in respect of them. The notice procedure contemplated by section 122B is echoed in section 124AB.

19.91. The Committee sees no distinction between general mining and petroleum so far as this category of expenditure is concerned and confirms the recommendations made, and the reasons given, in paragraphs 19.42–19.45. The Committee therefore recommends that the total cost of acquiring a petroleum prospecting or mining right or information be deductible over the life of the field. These amendments will, of course, necessitate bringing to account as assessable income the proceeds of sale of such information or rights in the hands of the vendor in the year of sale. This recommendation accords with that made in paragraph 19.46 in relation to general mining.