Journal of Australian Taxation
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CHOOSING THE RIGHT JOINT VENTURE STRUCTURE FOR A FARMIN OR FARMOUT[*]
By Charles Birch[**]
This article concerns the compliance costs of the income taxation of farmouts as a determinant of the choice of the joint venture structure used by resident Australian taxpayers. The starting point is the nature of compliance costs and the farmout concept. The farmout arrangements under consideration are ones in the nature of option agreements.[1] Then the compliance costs of income tax and Capital Gains Tax aspects of these arrangements for farmors and farmees are examined in varying degrees. Relevant taxation factors, depending on whether a farmor is a participant or an equity participant, are identified. The author argues that this examination will reveal that a farmout structured as a disposal of assets bears more compliance costs than farmouts structured as options over shares. The typical farmout agreement raises important taxation questions in Australia.[2]
A fannout normally involves the farmee committing itself to carrying out certain tasks including expenditure in relation to the property held by a participant of an unincorporated joint venture in order to earn an interest in that property.[3] A farmee is either an aspirant holder of an exploration or prospecting entitlement or a holder seeking to increase its interest.[4] Farmouts are a fundamental and essential vehicle for the exploration and development of mining and petroleum areas and over the years they have evolved from short and simple letter agreements to voluminous and complex documents.[5] Farmouts in Australia can involve tens of millions of dollars, yet the application of Australian taxation laws to them is uncertain and complex, primarily because they have not been designed with farmouts in mind. Therefore, when a farmor is a participant of an unincorporated joint venture, characterisation risk[6] may be compounded.
Compliance costs are costs that are incurred, usually by taxpayers, but also by governments, in complying with tax laws. In this article, compliance costs will be referenced in terms of their causes: fiscal uncertainty, characterisation risk and fiscal complexity. Fiscal uncertainty arises from either the interpretation, operation or application of tax laws and could involve retrospective adverse tax consequences. Characterisation risk refers to the risk or probability that a particular joint venture structure is characterised as either a general law partnership or tax partnership. Characterisation risk is an example of fiscal uncertainty. Fiscal complexity may impose an onerous compliance burden and a cost disadvantage on a taxpayer. Fiscal complexity could be caused by fiscal uncertainty. Fiscal complexity is itself complex, as a substantial literature has shown;[7] it is "not a concept that can be easily defined, measured or agreed upon".[8] Its antithesis – fiscal simplicity – has been described as "simplicity of rules".[9] Fiscal complexity involves legal complexity and effective complexity.[10] Legal complexity describes the difficulty (ease) with which a particular tax law can be read and understood.[11] Effective simplicity is "the characteristic of a tax which makes the tax determinable for each taxpayer from a few readily ascertainable facts":[12] effective complexity (simplicity) can be measured by reference to the value of resources expended by the society in raising some amount of tax revenue.[13] The level of fiscal uncertainty, characterisation risk and fiscal complexity imposed on taxpayers will affect the compliance cost burden on taxpayers when they comply with tax laws. The extent of fiscal uncertainty, characterisation risk and fiscal complexity may vary between joint venture structures.
The expression "farmout" has its genesis in America. It has come to be used to describe a variety of arrangements but a definition is hard to find. Although the first judicial recognition given to the definition of farmout seems to appear in Petroleum Financial Corp v Cockburn,[14] the concept is said to have originated with the late Earl Brown, former general counsel of Magnolia Petroleum Company.[15]
As far as unincorporated joint ventures are concerned, farmout arrangements may involve a participant ("the farmor") agreeing to assign rights to all or part of its percentage interest under an exploration or prospecting entitlement ("a prospecting entitlement") to another participant of the same unincorporated joint venture or to some other party, in exchange for value. Provided the unincorporated joint venture is not characterised as a "partnership" for income tax purposes,[16] a participant would ordinarily hold an undivided percentage interest in the rights and obligations derived from the prospecting entitlement.[17] A participant "farms out" to the farmee; the farmee is said to "farm in".[18]
If equity participants farm out their interest in a prospecting entitlement, the structure of the farmout agreement will be different than for unincorporated joint ventures: equity participants only hold a shareholding in a Special Purpose Vehicle ("SPV") incorporated specifically for the venture whereas participants hold a direct interest in the assets of an unincorporated joint venture as a tenant in common. For example, in 1999 the unlisted Australian Power & Energy Corp ("APEC") entered into a farmout agreement of a percentage of its interest in the Esperance power and liquids project – a one billion tonne resource of lignite at Salmon Gums, 100km north of Esperance – to Hillcrest Resources on the following terms:
Hillcrest can earn 50% of APEC by providing $2.5 million toward feasibility costs. Hillcrest can move to 100% of APEC by issuing 50% of its issued capital or sell back its interest at cost.[19]
In general, farmouts occur in the exploratory, pre-discovery stage, when the commercia1 risks of the project failing to recover its costs are considerably greater than at the development stage. The underlying rationale of farmouts has, therefore, been said to be the reduction or sharing of risk to the farmor.[20] Debt financing is therefore either not available to the farmor or subject to a lending margin that incorporates the inherent riskiness of a project, thereby rendering debt finance uneconomic. Consequently, the potential future benefits assigned to the farmee are potentially greater than under normal financing arrangements; so that in the oil and gas industry at least, it is usual for the farmee to assume all of the farmor's obligations to complete the exploratory drilling programme (sometimes this involves reimbursement of the farmor's costs incurred to date) in consideration for the right to a percentage interest in all future production relating to the farmor's interest in the prospecting entitlement.[21]
There are a number of commercial reasons why participants and equity participants farm out their interests in prospecting entitlements, the most likely being that a farmor is threatened with prospecting entitlement expiration and must drill or lose a prospecting entitlement.[22] In addition, a prospecting entitlement may not meet a farmor's investment criteria, based on its perception of the geological prospectivity of the prospecting entitlement project area and its assessment of the probability of a positive financial outcome of future work on the project area, either because of its own work[23] or work conducted by the operator.[24] The farmor may be therefore unwilling to commit further funds to the project at that time. A farmor may, due to pre-existing capital commitments or ranking of opportunities, have cash flow constraints and, while still being optimistic as to the prospectivity of the area, be unable to fund, either in part or in full, its share of the work programme in the prospecting entitlement, but be unwilling to surrender or relinquish all of its interest in the prospecting entitlement or in the unincorporated joint venture or equity joint venture (as applicable).[25] A reluctance to relinquish or surrender can be caused by a desire to maintain good relations with the relevant prospecting entitlement issuing authority[26] concerning work commitment undertakings.
Additionally, as part of the normal management of prospecting entitlements, a farmor may receive an offer from other participants, equity participants or third parties to farm out all or part of is total acreage portfolio. Finally, there could be a desire to maintain the maximum number of prospective entitlements under its control or management if the farmor's perception of economic attractiveness is proved incorrect by subsequent exploration activities. Bratby has listed succinctly a considerable number of additional reasons why participants and equity participants may seek to alienate or vary their interests.[27]
It is useful to consider the commercial reasons why other participants or equity participants of the same joint venture and other parties would want to farm in to a prospecting entitlement. Many exploration and production companies monitor the progress of "like" companies and, where applicable, integrate competitors' work results into their own studies. By this process, an aspirant farmee may develop different technical rationales for conducting exploratory investigations in areas of land and seabed outside those governed by its own prospecting entitlements. An aspirant farmee wishing to participate in those other areas simply may not otherwise have an opportunity to acquire an interest in the unincorporated joint venture or equity joint venture. This would be so if the participants or equity participants do not wish to sell or are incapable of selling their interests.[28] Consequently, at a practical level, the only available form of entry may be for the farmee to farm in to the joint venture.
Farmouts may be structured in two ways: as a deferred transfer farmout, or an immediate transfer farmout.[29] Both these structures can be used by unincorporated and equity joint ventures. A person has an "interest" in a thing "when he has rights, titles, advantages, duties, liabilities, connected with it, whether present or future, ascertained or potential, provided they are not too remote".[30] With deferred transfer farmouts, the farmee agrees to undertake certain financial obligations or work commitments, following which it will be entitled to take an interest in the exploration entitlement. It is not unusual for deferred transfer farmout agreements to be drafted as an option (exercisable either immediately or after certain expenditure is incurred or work is performed).[31] A judicial definition of a deferred transfer farmout is that it is:
a contract to assign oil and gas lease rights in certain acreage upon the completion of drilling obligations and the performance of any other covenants and conditions therein contained. It is an executory contract. It is largely used in cases where the owner of a lease is unable or unwilling to drill on a lease which is nearing expiration, but is willing to assign an interest therein to another who will assume the drilling obligations and save the lease from expiring. Often the owner of the lease retains an overriding royalty of a carried interest as his consideration ...[32] [emphasis added]
It is clear from that definition that farmouts effect an assignment of an interest, and are executory contracts; that is, farmouts are conditional contracts which, conventional legal reasoning would suggest, create contingent or executory equitable interests in the property.[33] By way of illustration, a typical deferred farmout agreement might say:
I, the farmor, have a 30% interest in a Joint Venture Agreement for the exploration of the Exploration Entitlement. If you, the farmee, will pay for half my 30% share of the cost of 1,000 kms of seismic and the next four wells to be drilled, then I will assign to you one quarter of that 30% interest.[34]
An immediate transfer farmout involves an immediate transfer of an interest in the relevant prospecting entitlement, subject to an obligation to re-convey in the event of default in the performance of the farm in obligations.[35] It has been pointed out that the "assignment of a complete legal and beneficial interest up-front is not unusual for mineral joint ventures. It is less usual for petroleum joint ventures but far from being infrequent, and is a matter for negotiation".[36]
It should not be presumed that all definitions of a "farmout" have recognised the distinction between deferred and immediate transfers, because they have not. For example, one commentator has defined a farmout as "an assignment of all or part of an interest in all or part of a mining concession with the reservation to the assignor of an interest in the concession or in its production or the value thereof".[37] This definition lacks an appreciation of when the actual assignment of an interest takes place. Notice also the context is the mining industry and not the petroleum industry.[38] Absent from this definition is the requirement that the contract be an executory one.
The description attributed to farmouts in the Australian mining industry by the Commissioner of Taxation ("Commissioner") is broader still – he has ruled that farmouts are used to describe a wide variety of arrangements including any arrangement under which the holder of a prospecting or mining right assigns or disposes of a portion of that right to another person in return for any form of consideration.[39] It is noted that variations to this basic model include, for instance, stepped or incremental earning programmes, in which the farmor incrementally assigns a percentage of its interest to the farmee on the incremental completion of obligations under the farmout agreement.[40]
In the analysis so far, it should be evident that there are three recognised forms of "interests" relating to farmouts. First, the chose in action under the farmout agreement, which is the contractual right to acquire the prospecting entitlement.[41] Secondly, the contingent or executory equitable interest in the property the subject of the farmout;[42] this is not the underlying asset but rather the farmee's entitlement to call on equity to compel a conveyance of the property from the farmor to the farmee.[43] An equitable interest may be created by having the farmor acknowledge that the farmor holds the prospecting entitlement on trust for the farmee either during the entire period that the contract is executory, or, more usually, from the time that the farmee completes the earning obligations.[44] Where a farmout involves an immediate transfer, then the question of equitable interest will not arise.[45] And thirdly, the property the subject of the farmout, being the chose in action in the rights and obligations the farmee will acquire once it becomes a participant of the Joint Venture Agreement ("JVA") and a proprietary interest in the prospecting entitlement as a tenant in common or the chose in action in the rights and obligations of the farmee under the shareholders' agreement.[46] Therefore, the "interests" acquired by a farmee on execution of a farmout agreement will depend on whether the transfer is upfront or deferred.
By contrast, a participant of an unincorporated joint venture will normally have a proprietary interest in all the assets of the joint venture as a tenant in common.[47] Therefore, a farmee's interest may or may not be identical to the contractual and proprietary interests acquired by a participant in the assets of the joint venture as a tenant in common[48] on entry to a JVA.
That notwithstanding, a farmout will involve an assignment of property.[49] A farmout will be assignable by the farmee unless, by the terms of the farmout agreement, it is stipulated that the farmee's obligations are personal, so that they must be exercised by the farmee in person.[50] For example, in Shearer v Wilding,[51] Harvey J, referring to an option to purchase set out in a lease, stated:
[p]rima facie it is a right of property given to him under the lease ... The authorities show that the use of the word "assigns" is not necessary to render the option capable of assignment. It could have been assigned apart from the lease.[52]
Farmouts vary in type. The following grouping is not used as the basis of this article as generally speaking, the Australian taxation principles governing farmouts apply equally to all the groups. Where necessary, however, some distinction between the groups has been made.
A farmor could have its costs carried by the farmee.[53] The farmee is obligated to perform specific work, not limited or calculated by reference to dollars (eg drilling a well to a certain depth or acquiring a prescribed number of kilometres of seismic data). The prospecting entitlement is farmed out using a deferred transfer farmout agreement.[54] A carried interest arrangement is generally, but not always, between two participants of the same unincorporated joint venture.[55] The farmor's percentage interest of the costs are borne by the farmee for a defined period or until some defined event occurs. During the carrying period, the farmor may buy back its percentage interest of future benefits and commit itself to bear its share of future costs by reimbursing the farmee for its share of costs incurred to date, plus interest and perhaps with an additional sum to cover the risks borne by the farmee. The reimbursement may either take the form of an immediate cash payment or a percentage of the farmor's share of future production. If the farmor chooses not to exercise its option, it suffers no penalty and the farmee has the right to acquire an interest under the prospecting entitlement.[56]
A farmor and farmee could agree to unitise a proven field which straddles two or more blocks. All the parties concerned agree to operate the field as a unit and agree on their respective interests in the field as a whole. Costs will be then reallocated to each prospecting entitlement holder in accordance with their revised percentage interests, and balancing payments are made by those who have underpaid to those who have overpaid. During the production period, as further data become available as to the size and location of the reserves, the respective interests of each party are recalculated and further balancing payments made.
A farmee could earn a right to acquire an earning obligation in the prospecting entitlement. The earning obligation might involve the farmor agreeing to spend a certain percentage of future exploration costs up to a defined dollar limit at which time an undivided percentage interest in the prospecting entitlement and information will be farmed out to the farmee. Alternatively, the farmee could reimburse the farmor for all or part of its prior exploration costs. The parties would then bear future exploration costs in proportion to their percentage interests in the prospecting entitlement then owned by each. This would be an example of where the exploration expenditures are borne jointly.
Production payments describe a share of the oil produced from a described tract of land, free of the costs of production at the surface, terminating when a specified sum from the sale of such oil has been realised.[57] Oil payments may be reserved by a lessor, by an assignor of a lease, or carved out by the owner of a working interest or royalty interest.[58]
An overriding royalty is similar to a production payment in that a farmor grants to a farmee a right to acquire a percentage interest in future production for a fixed monetary amount. However, unlike a production payment, the future production assigned is not fixed in quantity or value terms, but is expressed as a fixed percentage of the gross production appropriate to the farmor's interest.[59] The specific wording of the provision in the farmout agreement, which establishes conversion of the overriding royalty into a working interest for record title purposes, will also be important.[60]
But there is a risk that the grant by a farmor of an overriding royalty could expose the farmor to characterisation risk. [61] Such a risk will exist if a farmee's rights under an overriding royalty agreement go beyond those appropriate in a financier and borrower relationship, then a court may treat the advance of funds by the farmee as a capital contribution and the farmee as a partner in the business.[62] In most cases, a farmee's rights under an overriding royalty agreement will not go beyond those appropriate in a financier and borrower relationship.
In John Bridge & Co Ltd v Magrath ("John Bridge"),[63] the plaintiff company, which ran a woolbrokers, stock and station agents business, entered into an agreement to finance the defendant's produce and skin dealer's business. The agreement provided that the plaintiff was entitled to be paid one-third of the profits of the defendant's business in reduction of the loan and a second one-third was to be paid to the plaintiff to be held as a "reserve fund" for the purposes of the defendant's business. The plaintiff reserved the right to end the agreement at any time after six months or to extend its operation and the defendant undertook to make his accounting statements and books available for inspection by the plaintiff at all times during the subsistence of the loan. The Court held that the rights vested in the plaintiff by this agreement were no more than was reasonable to preserve the security of the loan and did not constitute evidence of a partnership agreement to be submitted to a jury.
The decision in John Bridge is binding on all the courts of NSW except the Full Court. It is likely, in the author's view, that the Full Court would follow John Bridge and the author considers that it is not improbable that an inferior court would seek to follow John Bridge.
If a farmee's rights under an overriding royalty agreement go beyond what is reasonable to preserve the security of the loan and constitute evidence of a partnership agreement, then characterization risk may be more significant. For example, if a farmor could be forced to account for its share of the product of the joint venture activity as partner with the farmee, then it would be easier to draw the inference that there is a "joint profit". Partnership requires there to be an activity with a view of profit.
But farmees taking their minerals or other asset in kind as a fixed percentage of the gross production appropriate to the farmor's interest obtain no profit at that stage. However, it is not beyond argument that product sharing is mutually exclusive with general law partnerships. Whilst the better view is that Australian courts would probably not regard a fixed percentage of the gross production itself as constituting "profit" for the purposes of the Partnership Acts,[64] there remains some doubt about whether a "view to joint profit" is a necessary prerequisite for a finding of partnership.[65] If the resolution of the latter question depends on the method of interpretation of the statutory definition of partnership under the Partnership Acts and the definition of a partnership is viewed as three separate elements, the definition may be construed as requiring only that a farmor and farmee each have a (separate) view to profit.[66] But if the definition is treated as a composite expression, it leads to the conclusion that the profit motive must attach to the farmor and farmee as a group in the conduct of their common business.[67] On this approach, which is supported by Dawson J in United Dominions Corporation Ltd v Brian Pty Ltd,[68] the statutory definition of partnership under the Partnership Acts must be read as requiring profit to be gained jointly, which is not the case in a typical farmout structured as an overriding royalty.[69]
No Australian court has decided whether a farmout structured as an overriding royalty is a general law partnership and it is not possible to conclude with absolute certainty that it is not. Therefore, characterisation risk will be a feature of these farmouts. To a greater or lesser degree, prospective farmees and farmors would be likely to incur compliance costs to make an assessment of the level of characterisation risk in a given case. Assuming that a farmor will always seek the same after-tax return no matter which type of farmout agreement the farmor enters into with a farmee, the compliance cost disadvantage of overriding royalty agreements compared to other types of farmouts will make overriding royalty agreements less attractive than other types of farmout agreements.[70]
In addition, a farmee and farmor could structure the transaction so that the farmee is required to spend a specific sum of money until it has equalised that incurred by the farmor. If a farmor has incurred expenditure prior to the new arrangement, then the farmee will only acquire the right to a given percentage of the farmor's interest after it has incurred a given level of the exploration costs.
With farmouts of assets, a farmee acquires an interest in both a prospecting entitlement and the JVA from the farmor. The farmor will never be the unincorporated joint venture, because it does not enjoy a separate legal personality. The farmor will always be a participant. Therefore, the taxation factors of farmouts that are relevant to the farmor will always operate at the participant level. The only caveat on this is if the consolidation regime becomes law and a farmor participant is a member of a consolidated group.[71] For the convenience of discussion, it is assumed that the consolidated group proposals of the Review of Business Taxation ("Ralph Review"), will not be relevant.
It is argued that the compliance costs of farmouts of assets are higher than for farmouts of shares and the principal causes of this are the complexity and sheer volume of laws applicable to asset farmouts compared to share farmouts.[72] Other compliance burdens are imposed by characterising the profit from the farmout, the trading stock provisions of the tax law, depreciation and mining and petroleum balancing adjustments, resource rent tax payments and capital gains provisions. To some extent, these compliance costs are counter-balanced by the cash-flow benefits a farmor derives from being eligible for the genuine prospectors exemption.
A farmor will incur compliance costs to comply with obligations in the tax law to characterise the proceeds it receives from a farmout. These costs arise because of the distinction tax laws make about profit that is ordinary income,[73] profit made under a profit making undertaking or plan,[74] profit from the sale of trading stock[75] or a capital gain.[76]
When will a farmor derive a profit from farming out an interest in the prospecting entitlement? A "profit" will arise where a farmee pays the farmor a premium for the right to earn a percentage interest in that entitlement. The farmor's "profit" is the amount the farmee must pay in excess of the cost of the entitlement to the account of the farmor. But a farmor will not always derive a profit from entering into a farmout agreement; the farmee may merely recompense the farmor by satisfying the farmor's obligations under the prospecting entitlement or by performing certain work.
A farmor will incur compliance costs to assess whether its proceeds are characterised as revenue or capital in nature. If the proceeds are capital profits arising from the disposal of an asset acquired after 19 September 1985, they will be subject to tax as a capital gain. If the gain is characterised as one made in the course of the farmor's business activities or as a separate business activity altogether, then the profit will be income according to ordinary concepts.[77]
If the proceeds are part of a farmor's business, then they will be on revenue account. It is well established that whether or not activities constitute a business will depend on factors including commerciality,[78] scale, [79] frequency, [80] profit purpose[81] and commercial character of the activities.
In many cases, characterisation of the proceeds should be a relatively straightforward matter given the nature of a farmor's business activities. But from time to time there may be instances where a farmor must expend resources to properly characterise its proceeds. In theory, one such instance might be where a superannuation fund acquires, as part of its normal business activities, undivided fractional interests in unincorporated joint ventures specifically to farm out those interests for a profit.[82]
A farmor might expend resources to make a determination in the following example. Assume that company A, an insurance company, acquires all the shares in company B. Company B is mainly an insurance company, but it has a small ownership in an unincorporated joint venture. Shortly after company A acquired company B, the management of company B concluded a deal with company D to farm out a 40% share in a prospecting entitlement to company D. Company A is unsure how to treat the proceeds of the farmout.
If the circumstances are such that a farmor must characterise its proceeds as either revenue or capital, then a farmor will expend resources determining whether a business is carried on, and if so, the nature of the business.[83]
Whether or not a business is carried on is a matter to be determined having regard to the facts of the particular case.[84] The determination will involve some consideration of the definition of a “business” in the Income Tax Assessment Act 1997 (Cth) ("ITAA97").[85] Case law may also assist in appropriate circumstances,[86] but it has been said that "it is not possible exhaustively to enumerate the facts or circumstances which will support the inference that a course of activity is a business".[87]
An investigation into whether a taxpayer is carrying on business will involve considering whether any and how many of the indicia of business are present.[88] No single indicator will in itself be determinative.
A farmor may incur compliance costs to assess whether its proceeds are characterised as gains made from a profit-making undertaking or plan. If so, then s 15-15(1) of the ITAA97 provides that a farmor's profit includes profit arising from the carrying on (or carrying out) of a profit-making undertaking or plan. The provision does not, however, apply to a profit that is assessable as ordinary income under s 6-5[89] or which arises in respect of the sale of property acquired on or after 20 September 1985.[90] In FC of T v Myer Emporium Ltd ("Myer Emporium"),[91] the Full High Court found unanimously in a joint judgment that Myer was assessable as income under s 25(1) and also as profit from the carrying on or carrying out of a "profit-making undertaking or scheme" under s 26(a) of the Income Tax Assessment Act 1936 (Cth) ("ITAA36"). The High Court held that a gain:
made otherwise than in the ordinary course of carrying on the business that nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make profit or gain, the gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business.[92]
Myer Emporium highlights the traditional distinction between items on revenue account and items on capital account by emphasising a taxpayer's profit-making intention. Accordingly, if the circumstances of a farmout give rise to the inference that the farmor's intention or purpose in entering into the farmout was to make a profit or gain, then that profit or gain will be income, notwithstanding the transaction was an extraordinary one judged by reference to the ordinary course of the farmor's business.[93]
Even if a farmout is not an ordinary incident of a farmor's business activities, a farmor may nevertheless incur compliance costs to assess whether the proceeds of a one-off or isolated transaction constitute ordinary income. It is well settled that the proceeds of isolated ventures or one-off transactions can be characterised as assessable income.[94] FC of T v Whitfords Beach Pty Ltd[95] was decided on the basis that profit from an isolated transaction could constitute assessable income. In this case, the taxpayer company bought 1,584 acres of land. Over a decade later, the shares in the taxpayer company were sold to an insurance company and two land developers which companies proceeded to develop, subdivide and sell the land owned by the taxpayer company in order to realise a profit. The lots were subsequently sold at a substantial profit.[96] In that case, the change in purpose of the directors and shareholders of the taxpayer became the purpose of the company.
This Part of the article has shown that tax laws governing the characterisation of proceeds from a farmout are based on legal concepts of income, which have built up over time. The law involves concepts of ordinary income, statutory income including capital gains and expenses, and losses of either a revenue or capital nature. Consequently, the proceeds from a farmout of assets under a farmout agreement may be taxed in a variety of ways depending on the purpose for which the assets are held before they are disposed of.
The Ralph Review has proposed the cash flow/tax value approach to calculate taxable income. The approach involves a comparison of beginning and end of year balance sheets and will involve adjustments between the profit and loss account and taxable income.[97] If this reform is enacted, then it will affect all future farmouts.[98]
Under the cash flow/tax value approach, taxable income will be derived from receipts less payments plus or minus changes in the tax value of assets and liabilities.[99] All receipts and expenditures would be brought into the net income calculation. It would no longer be relevant to characterise proceeds in the same manner as is currently the case.[100]
A farmor may so frequently farm out its interests in prospecting entitlements that the trading stock provisions may apply. The difficulty is that there is no clear statement in the law that a prospecting entitlement can be an item of trading stock. The definition of trading stock in the ITAA97 is inclusive only,[101] and many of the words used are broad in scope and require interpretation; that is, legal complexity exists. Consequently, a farmor seeking to bring to account under the trading stock provisions its proceeds from a farmout will need to first incur a cost to determine whether its prospecting entitlement which is the subject of the farmout is capable of constituting an item of trading stock.
The High Court decision of St Hubert's Island Pty Ltd v FC of T ("St Hubert's Island")[102] is authority for the proposition that land will constitute trading stock if it is acquired for the purpose of sale. However, the question of whether a prospecting entitlement will constitute trading stock if it is acquired for the purpose of sale remains unreviewed by an Australian court. Accordingly, the author believes that St Hubert's Island is persuasive authority. In this connection, an Australian court would consider it significant that St Hubert's Island has been followed or cited favourably in at least two cases; namely, FC of T v Suttons Motors (Chullora) Wholesale Pty Ltd ("Suttons'')[103] and Parfew Nominees Pty Ltd v FC of T.[104]
In Suttons,[105] the Full High Court said:
the ordinary meaning of the term "trading stock" upon which section [ITAA97, s 70-20][106] builds is that which is attributed to it by legal and commercial people for accounting and other purposes ... . It is not necessary for present purposes however to explore the outer limits of the area covered by that ordinary meaning of the term. Its traditional and narrower denotation still lies at the centre of that meaning and is adequate for the present purposes. That denotation is of goods held by a trader in such goods for sale or exchange in the ordinary course of his trade.[107]
If prospecting entitlements are acquired "for exchange", then they are capable of constituting "trading stock". As trading stock, a farmor would be entitled to a deduction for the cost of the prospecting entitlement when it is assigned to the farmee. The nature of the transfer provision (ie upfront or deferred) contained in the farmout agreement will be determinative of the timing of the disposal.
When a prospecting entitlement is disposed of, a farmor must determine the value of each article of trading stock in accordance with any one of three methods:[108] the cost[109] price of the trading stock; the market selling value of the trading stock;[110] or the replacement price of the trading stock.[111] If a farmor elects to substitute market-selling value for cost, then the profit or loss arising on realisation of the item of trading stock must be brought to account. An election of market selling value where the market selling value of the item is less than cost will anticipate a loss. An election of cost at the end of the following year will reverse the anticipation of a loss. There will obviously be a compliance cost in complying with this provision.
Unless there are questions about the precise meaning of "cost price", it is hard to envisage a situation where a farmor's compliance burden in this area will be more onerous than for any other trader. "Cost price" generally means the cost of the trading stock to the taxpayer in getting the trading stock into its existing condition. For the corresponding provision of the ITAA36, Philip Morris Limited v FC of T[112] held that a number of remote expenses should enter the determination of cost. It is clear that if more remote expenses enter a farmor's determination of cost, then an increase in the deferral of outgoings will take place. This will result in a higher taxable income than otherwise if only direct costs entered the determination of cost.
The Ralph Review has recommended reforms to the trading stock provisions of the tax law as part of the change to the cash flow/tax value approach of calculating taxable income. In particular, the Ralph Review recommends limiting the definition of trading stock to tangible assets produced, manufactured or acquired and held for the purposes of manufacture, sale or exchange in the ordinary course of a business. Livestock will also be included. Intangibles like shares and other financial assets will no longer qualify as trading stock.[113] Trading stock will be valued at the lower of cost or net realisable value, as in accounting. Upward valuation to net realisable value will also be possible subject to constraints.[114]
The Government has not yet announced its position in relation to this measure. If a law is passed giving effect to the Ralph Review's recommendations, then the argument goes that the uncertainty inherent in the trading stock provisions of the tax laws will disappear. This remains to be seen. If the fiscal uncertainty disappears, farmors will no longer need to incur a compliance cost in relation to questions about trading stock.
Depreciation balancing adjustment complications may unexpectedly arise if the farmor and farmees' intentions are not sufficiently documented during the drafting phase of the farmout agreement. For instance, if a farmee incurs 100% of the expenditure on items of plant but pursuant to the farmout agreement is only entitled to an ownership interest of say, 35% of that plant, then it will be denied a depreciation deduction in excess of its ownership interest in the plant. This is because tax laws give taxpayers deductions for depreciation for plant and equipment when a taxpayer is the legal owner of the asset ("the legal ownership test").[115] Given that the participants own plant and equipment as tenants in common, deductions for depreciation are based on the ownership percentage interests in the plant and equipment and not just the amount of expenditure incurred.[116]
The legal ownership test does not cater well for farmouts of the type described in the preceding paragraph. The Ralph Review has recommended that a taxpayer's entitlement to a write-off in respect of depreciable assets for taxation purposes should be given to the taxpayer who incurs the loss in value of the asset, which is not necessarily the legal owner of the asset.[117] According to this measure, one of the persons who will be entitled to tax depreciation are persons who hold assets jointly such as co-owners or joint venture participants. Such taxpayers would be able to write off the cost of their share of depreciable assets regardless of how they paid for those shares.[118]
Although the Government has not yet announced its position in relation to this recommendation, a commitment by the Government to the core principle of this measure would be likely to produce a compliance cost saving for farmors and farmees.
If the parties enter into an agreement to transfer allowable capital expenditure, then a taxation clause could be included in the farmout agreement. Depending on the nomination of value of the property on the interests subject to the farmout, a tax clause may take the following form (or similar):
For the purpose of this Agreement, if section 330-235 of the Income Tax Assessment Act 1997 (Cth), as amended (the Act) is applied with respect to any change of ownership or interest brought about by or in relation to this Agreement:
(a) the value of the property subject to such change shall not exceed by more than $100.00 the total capital expenditure incurred by all parties in respect of the said property less the sum of all deductions allowed and allowable in respect of that expenditure under Div 330 of the Act; and
(b) the value to any one party of the said property shall not exceed by more than $100.00 the total capital expenditure incurred by that party in respect of the said property less the sum of all deductions allowed and allowable in respect of expenditure under Div 330 of the Act.
Where any two provisions of the Act referred to in clause 1.1 do not apply and analogous provisions do apply, clause 1.1 shall be read mutatis mutandis.
It could be argued that exploration or prospecting expenditure is never incurred in respect of a prospecting entitlement and therefore s 330-480 will never apply to such expenditure when a prospecting entitlement is disposed of. However, in Income Tax Ruling IT 2378 the Commissioner has expressed the opposite view. Whichever is correct, it is clear that where a farmor disposes of its undivided fractional interest in exploration plant, expenditure on such plant would be dealt with pursuant to s 330-480.
The provisions of the ITAA97 for taxing mining information are complex and add an unnecessary compliance burden on farmees and farmors. The law should be simplified to reduce the compliance burden.
From the perspective of a farmee, the issue is the lack of specificity in the tax law about the basis on which to apportion the farmin purchase price between the prospecting entitlement and the information. The framework created by Div 330 in the provisions of Subdiv 330-E entitles a farmee of a mining, quarrying or prospecting right or information (as defined by s 300-240(c)) to an allowable deduction for the farmin purchase price over a number of years.[119] The mechanism whereby a farmee becomes entitled to an allowable deduction does not specify the basis upon which the purchase price paid collectively for the prospecting entitlement and information is to be apportioned between the prospecting entitlement and the information. Such expenditure ought to be treated consistently with other expenditure and without a limit applying. For example, expenditure on information should be treated according to the benefit obtained from that information. If the information relates to exploration and prospecting activities, it should be immediately deductible to the farmee (consistent with retaining the current immediate write-off of the treatment of exploration and prospecting expenditure).[120] If it relates to an existing mine, it should be deductible over the effective life of that mine. Otherwise, it should be immediately deductible.[121]
From the perspective of a farmor, the issue is whether the balancing adjustment in s 330-480 will apply if there is an allocation of consideration. Arguably, because s 330-480 applies in respect of disposals of "property" and since it is debatable that information is not property at general law,[122] then if consideration supporting the farmout of a prospecting entitlement and information are wholly allocated to the information, it would be necessary to consider whether the conditions for the operation of s 330-480 would be satisfied.[123] On this analysis, a construction of Div 330 leads to the conclusion that mining or prospecting information comprises "property" for the purposes of the division, in which case the disposal of information would be covered by the provision.[124]
Similarly, Taxation Ruling TR 98/3 states that because prospecting information is not property, any consideration received for the disclosure of the information itself does not trigger the
operation of the balancing adjustment provisions in Subdiv 330-J and that in any transaction involving the disclosure of prospecting information it is necessary to examine the facts to see if any of the consideration relates to items of property.[125]
Although prospecting information is stored on a medium such as paper, computer memory (or similar) and this medium is property per se, it is accepted by the Commissioner that unless the facts indicate otherwise, the medium containing the information has a negligible value so that, as a practical matter, "no amount is to be accounted for under Subdiv 330-J in respect of the medium".[126]
It is noted that the Commissioner's position in TR 98/3 departs from his earlier view expressed in IT 2378 that exploration and prospecting expenditure is capital in nature incurred "in respect of" the prospecting entitlement. Information obtained by the farmor from exploration or prospecting is something separate from the prospecting entitlement. In the context of s 330-480, the Commissioner now considers that "in respect of" means expenditure incurred to acquire or improve the property and because information may be about a certain prospecting entitlement does not mean that it is in respect of a prospecting entitlement.[127]
The Ralph Review has recommended that all receipts from the sale of mining information be subject to taxation.[128] It is not intended that such receipts will be assessed under the balancing adjustment provisions. The balancing adjustment provisions must therefore be amended to make this expressly clear. This measure will be, in principle, consistent with the notion that all business receipts should be taxable with deductions being allowed for the costs of earning those receipts.[129]
The effect of TR 98/3 is relevant for the application of the balancing adjustment roll-over relief available under Subdiv 41 of the ITAA97. Subdivision 41 allows balancing adjustment roll-over relief for changes in ownership of property the subject of a farmout agreement between related companies or to a wholly owned company (for the purpose of Subdivs 122-A and 126-B of the ITAA97)[130] where the farmor and farmee jointly make an election for roll-over relief under s 330-520(4). The consequences of election are threefold: no balancing adjustment is required for the farmout; the farmee stands in the farmor's shoes with regard to the amount and timing of future allowable deductions, and the amount of potential balancing adjustment on a later disposal. If the farmor has undeducted exploration or prospecting expenditure in respect of information, then s 41-20 will not apply to allow roll-over relief in respect of such expenditure.[131]
A farmee would be entitled to an allowable deduction in respect of its exploration or prospecting expenditure incurred during an income year. Section 330-15 of the ITAA97 allows a deduction for expenditure (whether of a capital or revenue nature) incurred on exploration or prospecting.[132]
Farmouts are taxed under complex provisions of Pt 31 of the ITAA97.[133] It is unclear whether a farmee has an executory equitable interest in the property when the farmee is under no or only a limited obligation to earn an interest. A farrnor will incur compliance costs to determine whether a Capital Gains Tax ("CGT") event happens on the sale of prospecting information, and which CGT event to apply when an asset is disposed of, and the timing of the CGT event, its cost base or reduced cost base, disposal consideration and associated difficulties.
The legal structure of farmouts plays a determinative role in their classification as "assets" for capital gains purposes. In the end, their tax treatment is not always the same as for changes in the ownership of assets of participants or of shares of equity participants. CGT event D1 concerns the creation of contractual or other rights. The event happens if a taxpayer creates a contractual right or other legal or equitable right in another entity.[134] Under the tax reform proposals, it will no longer be relevant to consider whether a gain arising on an asset is on revenue or capital account.[135]
As far as asset farmouts are concerned, it is appropriate to consider what assets are disposed of. The most obvious asset is the property the subject of a farmout, being the chose in action in the rights and obligations a farmee will acquire once it becomes a party to the JVA and acquires a proprietary interest in a prospecting entitlement as a tenant in common.[136] Other assets would comprise the chose in action under the farmout agreement[137] and the contingent or executory equitable interest in the property the subject of the farmout.[138]
Assume that a farmee has a chose in action under the JVA and farmout agreement and a proprietary interest in a prospecting entitlement as a tenant in common, but not a contingent or executory equitable interest in a deferred transfer farmout. Participant A agrees to assign 50% of its undivided share of a prospecting entitlement to B if B pays all of Participant A's work obligations under the prospecting entitlement for the next three years and there is no obligation or only a limited obligation imposed on B to make those payments and hence earn an interest. In Amoco Minerals Australia Co v Commissioner of Stamp Duties (WA) ("Amoco"),[139] Jones J in the Western Australian Supreme Court held that such an arrangement, where Amoco had a right but not an obligation to earn an interest in statutory mining interests by making payments to the owners and incurring agreed exploration costs, was not dutiable as a conveyance on sale or as an agreement for the sale of property, since, quoting Channell J in West London Syndicate v IRC:
[s]ale is correlative with purchase: there is no contract for sale unless the purchaser agrees to buy whilst the vendor agrees to sell: if the vendor merely agrees to sell and the purchaser does not agree to buy, it is merely an offer and not a contract of sale.[140]
However, Jones J was prepared to hold that the right gained by Amoco upon execution of the agreement (ie the right to procure the rights of exploration and development and the right to perform and conduct related activities), was an "interest in any property" within the meaning of s 74(1) of the Stamp Act 1921 (WA), so that the sum which Amoco had to pay to the owners on executing the agreement was chargeable with ad valorem duty.
The decision in Allgas Energy Ltd v Commissioner for Stamp Duties (Qld) ("Allgas"),[141] however, suggests that the contingent or executory equitable interest in the property the subject of the farmout will be present in the above example if it involves an immediate transfer farmout and all the other facts remain unchanged. In this case, the court held that the agreement was of "an altogether different nature" from that in Amoco, stating that the former agreement "provides for an immediate assignment and creates an obligation on the part of the assignee to deposit certain sums subject to the forfeiture of its rights under the Agreement if it should fail to do so", and that "the real nature of the transaction effected by the instrument is one of the sale of the property concerned. This position is not altered by the fact that, if the payments provided for by the instrument are not made, the assignee forfeits its interest or that in certain events the payments made are refundable".[142]
At the time the agreement was made in Allgas, the vendor had been granted, by a previously executed deed with holders of certain leases and authorities to prospect ganted under the Petroleum Act 1923 (Qld), a right to earn a 50% working interest in parts of those titles and the right to assign part of the working interest it may earn. The working interest was to be earned by the vendor on the completion of an exploration well in the relevant area. While it could complete any well alone or in conjunction with the owners it was under no obligation to do so and could terminate the deed at any time. In the relevant agreement, the vendor purported to assign to the purchaser, subject to the vendor's earning the 50% interest in two specified blocks of a petroleum permit in accordance with the prior deed, a 47.5% working interest in those blocks being transferred to the vendor pursuant to the prior deed, the purchaser and vendor would execute such further documents as might be necessary to
transfer the 47.5% working interest in those blocks to the purchaser. The agreement provided that the purchaser had to deposit specified sums in accounts upon the Minister's approval of, and failure so to deposit would result in the purchaser forfeiting its rights under the agreement. If the wells reached the prescribed depth, those amounts would be paid to one of the holders of the titles in part satisfaction of payments that the vendor was obliged to make under the prior deed. If those wells did not reach the prescribed depth within a certain time after drilling had commenced, then the monies would be refunded to the purchaser.
The Commissioner assessed the agreement to ad valorem conveyance duty by reference to the amounts deposited and the court upheld this assessment. The Court held that the agreement effected an assignment of an equitable interest in property (ie the 47.5% working interest in the two blocks when that interest came into existence), with nothing further being required to be done by the parties in order to convey that interest to the assignee and there was consideration for the assignment. As well, the agreement assigned to the purchaser a percentage of the vendor's existing rights under the prior deed. The existing rights under the deed were held to be property under the Stamp Act.
It is difficult to accept the court's reasoning. The Court stated that the relevant clause of the agreement assigned a percentage of the working interest if and when it was earned by the vendor, but referred to the agreement as effecting an immediate assignment of that percentage of the working interest. It is not easy to see how the vendor could assign any interest greater than the interest it had at the date of execution of the agreement; that interest was only a right to obtain a working interest together with any other rights granted by the prior deed. The consideration upon which duty was calculated was calculated by reference to the monies deposited by the purchaser. These monies ostensibly represented the price payable by the purchaser to the vendor in the event the vendor earned its 50% interest and thereby enabled the assignment of 47.5% of that interest to the purchaser, and those sums were repayable if that event did not happen. It therefore seems inaccurate to describe those monies as
representing the sale of the interest assigned by the agreement, since what was assigned was something else; namely, the vendor's rights to earn the interest.
The court in Allgas distinguished the facts of Amoco without questioning the conclusion reached in that case. It is noted that the crucial factor in Allgas was the purchaser's obligation to pay over the relevant sums, notwithstanding they were refundable. It seems that while the vendor had the opportunity under the prior deed to decide whether or not to earn its interest, the purchaser was bound by the agreement to obtain its interest should the vendor decide to exercise its rights.
The other important issue to be considered here is prospecting information developed by the farmee on the prospecting entitlement area. If a CGT event happens in relation to the sale of prospecting information, then the sale of that information by a farmor to a farmee under a farmout agreement would attract Pt 3-1 consequences. If a CGT event does not happen in relation to the sale of prospecting information, then the sale of that information pursuant to a farmout agreement would not attract Pt 3-1 consequences. If a farmor must determine whether prospecting information is an asset each time it enters into a farmout agreement, then the compliance costs for farmors will also increase.
CGT events are at the centre of the operation of the provisions in Pt 3-1. It is only when a CGT event happens that a capital gain or capital loss can arise.[143] CGT assets are central to most CGT events, and most, but not all, CGT events arise as a result of something happening to a CGT asset.[144] If an asset is not a CGT asset, it will "not be affected by the event and no capital gain or capital loss will arise in respect of it".[145]
Whilst the basic definition of a CGT asset includes any kind of property, at general law, prospecting information is not property.[146] Prospecting information is not itself a CGT asset for the purposes of Pt 3-1.[147] Strictly speaking, the medium in which information is contained (eg paper, floppy disk etc,) is a CGT asset. However, the Commissioner considers that the value of the medium is usually negligible.[148]
The Commissioner's general administrative practice is to accept that no amount must be allocated to the medium in which information is contained by farmees and farmors under apportionment rule modification 2 pursuant to s 116-40(1) in farmout transactions[149] and that the amount of consideration received by the farmor does not give rise to a capital gain pursuant to the application of CGT events D1 and H2.[150]
The Ralph Review has proposed that all receipts from the sale of mining information will be subject to taxation on the basis that in principle, all business receipts should be taxable with deductions being allowed for the costs of earning those receipts.[151]
At the time of writing this article, the tax value method (option 2) is being researched by the Board of Taxation. If it proves workable, the earliest start date is 1 July 2005.
The legal structure of the farmout will determine which CGT event applies. This determination will not usually impose a particularly onerous compliance burden on a farmor, but the grant by a farmor of a right to income from a prospecting entitlement may impose a higher compliance obligation.
A number of different CGT events may apply to the one contract. The chose in action under a farmout agreement will attract CGT event D1 if the farmor creates a contractual right or other legal or equitable right in a farmee.[152] The contingent or executory equitable interest in the property the subject of a farmout will attract CGT event E1 if the farmor creates a trust over a CGT asset by declaration or settlement.[153] Property the subject of a farmout would attract CGT event A1 if the farmor disposes of a CGT asset.[154] Receipt of proceeds from a farmee might attract CGT event H2.[155] As an example, the Pt 3-1 consequences for the parties in farming out a percentage interest in a prospecting entitlement could be different than when a right to income is granted to the farmee but there is no underlying transfer of the prospecting entitlement.
If a farmor owns an interest in a "prospecting or mining entitlement"[156] and grants a farmee a right to receive any part of the future income from the operations permitted to be carried on by that prospecting entitlement,[157] then the farmor makes a capital gain if the proceeds from the grant of the right exceed the expenditure incurred by the farmor in granting it.[158] The disposal of a right to future income will not be treated as a disposal of the interest in the prospecting entitlement but rather a disposal of the right to receive future income.[159] The right to receive future income is created by a farmor immediately before entering into the farmout agreement. CGT event D3 happens if a farmor owns a prospecting entitlement or a mining entitlement, or an interest in one, and grants a farmee a right to receive ordinary or statutory income from operations permitted to be carried on by the entitlement.[160] The farmor makes a capital gain if the capital proceeds from the grant of the right are more than the expenditure the farmor incurred in granting it.[161] The expenditure can include giving property, but does not include amounts received as a recoupment of it (and that is not included in the farmor's assessable income), or amounts to the extent that the farmor has deducted or can deduct from it.[162]
The time of a disposal of an asset for capital gains purposes is generally the time that an agreement is made.[163] With deferred transfer farmout agreements, the relevant point in time is when the offer is accepted (ie upon exercise). But immediate transfer farmout agreements are made when the farmor grants the right to the farmee. Accordingly, the time of acquisition and disposal of the prospecting entitlement under a farmout agreement depends on the legal structure of the farmout agreement.
Capital Gains Tax Cell Determination No 16 provides that the date of acquisition or disposal is the date of the transaction entered into as a result of the exercise by the farmee of the right. Cell determinations provide taxpayers with answers to common but significant capital gains questions and do not have the force of law, but can be relied on as being the considered view of the Australian Taxation Office.
Further, IT 2378 consistently states that 'the time of disposal, ascertained in accordance with the provisions of [ITAA97, Divs 104 and 109],[164] would generally depend on the terms of the agreement between the parties".[165]
There are two elements to be taken into consideration in determining whether a capital gain or a capital loss has occurred on the disposal of a prospecting entitlement – the cost base and the consideration received. In general, the cost base of an asset consists of five elements (acquisition costs, incidental costs, assessable balancing adjustments, capital expenditure to increase value and capital expenditure to establish or defend title to or a right over an asset).[166] Cost base indexation was frozen on 30 September 1999. The ending of indexation means the Government is switching from taxing after-inflation gain to taxing the before inflation gain.
Exploration or prospecting expenditure "does not form part of the cost base of a mining, quarrying or prospecting right".[167] Whether or not it follows that expenditure on prospecting information forms part of the cost base of a mining, quarrying or prospecting right will depend on how expenditure on prospecting information is characterised by a farmor.
If expenditure on prospecting information were characterised as a form of exploration or prospecting expenditure, then it would be unlikely to form part of the cost base of a mining, quarrying or prospecting right. As a general business expense, the expenditure would be an allowable deduction to a farmor.[168] This characterisation may be easier to make when there is a temporal nexus between the incurring of the expenditure on prospecting information and the incurring of the exploration or prospecting expenditure.
The calculation of the market value of a farmout of a prospecting entitlement is fraught with difficulty. Tax laws require farmors to determine the "market value" of the asset disposed of at the time of disposal but do not prescribe a definition of "market value" or criteria to be used to assist in making a determination.[169] The law is legally and effectively complex. This increases the compliance burden on farmors. Before examining the causes of this compliance
burden, it is appropriate to outline the components comprising a farmor's disposal consideration.
A farmor's consideration will have one, possibly two components. The first component is comprised of the ongoing expenditure/work obligations of the farmee under the farmout agreement. The level of the farmee's expenditure/work obligations may be proportionate to the interest it will acquire in the prospecting entitlement or disproportionate (ie the farmor has a carried interest).[170] An example of the former would be where a farmor incurs 35% of the expenditure/work obligations to acquire a 35% interest in a prospecting entitlement, whilst an example of the latter would be where a farmor incurs 65% of the expenditure/work obligations to acquire a 35% interest in a prospecting entitlement. The second component is an upfront cash payment component.
The Commissioner encourages farmors and farmees to reach agreement on and specify either in the farmout agreement or in a separate written statement signed by them, the agreed fair and reasonable value (if any) of the prospecting entitlement disposed of at the time of the disposal.[171] It is clear that such an approach is not without risk to the revenue.[172] That is why the parties may be required to reconcile the valuation with the agreed work program commitments if the two appear inconsistent.[173] This reconciliation, if required, may need a supporting statement setting out the basis of valuation and assumptions used.[174] This approach seems overly-prescriptive given the uncertainty and cost of making a valuation. It could even be argued that this is an instance where the lawmaker's response to uncertainty by producing a new authority (ie a tax ruling) has complicated the law.[175] The difficulty in valuing exploration expenditure was recently put in these terms:
[a]pplying the recommended teatment of expenditure and assets without recognising the valuation difficulties associated with the results of exploration and prospecting expenditure would mean that the tax treatment of this expenditure would depend on the results of the exploration or prospecting activity.[176] [emphasis added]
The value of an asset must be determined in light of the circumstances that exist at the time of disposal. According to IT 2378, the value of a percentage interest in a prospecting entitlement disposed of at the "grass roots" or "wild cat" exploration stage would be low if not nil, but the value would be expected to be higher if the interest were disposed of after exploration indicated deposits or reserves that warranted development and production. A "grass roots" or "wild cat" well is "an exploratory well being drilled in unproven territory, that is, in a horizon from which there is no production in the general area".[177] Further, the discovery of minerals in neighbouring prospecting entitlement areas may have the effect of increasing the market value of the prospecting entitlement disposed of, notwithstanding the prospecting entitlement may or may not subsequently prove to be worth developing ("the recent commercial transactions valuation method").[178]
The author considers that the recent commercial transactions valuation method is unsustainable to the extent it is inconsistent with the principle laid down in Spencer v The Commonwealth ("Spencer").[179] In Spencer, the High Court held that, in assessing the value of land for the purposes of a resumption statute, the basis of valuation should be the price that a willing purchaser would at the
date in question have to pay to a willing but not anxious vendor. Isaacs J said that to arrive:
at the value of the land at that date, we have, as I conceive, to suppose it sold then, not by means of a forced sale, but by voluntary bargaining between the plaintiff and a purchaser, willing to trade, but neither of them so anxious to do so that he would overlook any ordinary business consideration. We must further suppose both to be perfectly acquainted with the land, and cognizant of all circumstances which might affect its value, either advantageously or prejudicially, including its situation, character, quality, proximity to conveniences or inconveniences, its surrounding features, the then present demand for land, and the likelihood, as then appearing to persons best capable of forming an opinion, of a rise or fall for what reason soever, in the amount which one would otherwise be willing to fix as the value of the property.[180]
It is apparent from IT 2378 that the Commissioner broadly adopts the principle expressed in Spencer. This is implicit from the authorities the Commissioner cited approvingly in the ruling. For example, in IT 2378, the Commissioner referred to Building and Civil Engineering Holidays Scheme Management Ltd v Post Office,[181] where Lord Denning MR stated that "market" in the expression "market value" in the statutory provision under consideration in that case:
[did] not connote a market where buyers and sellers congregate. The "market value" here means the price at which the goods could be expected to be bought and sold as between willing seller and willing buyer, even though there may be only one seller or one buyer, and even though one or both may be hypothetical rather than real.[182]
On the valuation question, some guidance is to be found in Waddell J's decision in Brisbane Water County Council v Commissioner of Stamp Duties (NSW),[183] which concerned the scope
of meaning of the expression market value in s 84G of the Stamp Duties Act 1920 (NSW). His Honour said that where the value of property is to be determined the value is to be calculated by reference to three factors. First, if there is no general market (eg shares in a proprietary company), then a general market is to be assumed. Secondly, all possible purchasers are to be taken into account; and thirdly, even a purchaser who is prepared for his own reasons to pay a fancy price and the value to be ascertained is the value to the vendor.
The basis of the Commissioner's approach in the ruling to the meaning of market value was stated originally by Dixon J in Commissioner of Succession Duties (SA) v Executor Trustee and Agency Co of South Australia Ltd'[184] in the following terms:
there is some difference of purpose in valuing property for revenue cases and in compensation cases. In the second the purpose is to ensure that the person to be compensated is given a full money equivalent to his loss, while in the first it is to ascertain what money value is plainly contained in the asset so as to afford a proper measure of liability to tax. While this difference cannot change the test of value, it is not without effect upon a court's attitude in the application of the test. In a case of compensation doubts are resolved in favour of a more liberal estimate, in a revenue case, of a more conservative estimate.[185]
Dixon J's approach in that case is not appropriate to farmouts of percentage interests in prospecting entitlements, since the adoption of a more conservative estimate in matters arising under Pt 3-1 would in many cases favour a farmor participant, and disadvantage a farmee. To illustrate, for a farmor, an immediate transfer farmout agreement has attraction because any added value as a result of the earn-in work may not be taken into account when determining the "market value" of the prospecting entitlement. Similarly, a deferred transfer farmout agreement is attractive to a farmee in that there is the possibility of no immediate CGT (subject to the quantum of premium paid), with the opportunity for tax planning to be implemented prior to the actual transfer some time later.
The value of an asset disposed of by a farmor once the participants of an unincorporated joint venture have determined the existence of an economic quantity of mineral would be likely to be significant. In this situation, the characterisation of the interest that is to be farmed out has shifted from what the Commissioner regards as the high risk to the low risk category.[186] The "Orthrus I wild cat well in Australian permit WA-267-P, which in 1999 had encountered a 53 metre net gas zone revealing a large gas field"[187] is an example of an interest that is in the low risk category.
A number of other observations can be made in relation to the operation of Pt 3-1 to farmouts. First, non-cash farmouts are not excluded from Pt 3-1. IT 2378 states that in the Commissioner's view it adequately addresses the technical issues of applying the capital gains provisions to non-cash farmouts.[188] The Ruling was issued on 24 December 1986 – over a decade ago.[189] It was issued to address a number of concerns as to how the capital gains legislation applied to farmout arrangements and particularly how the consideration for a non-cash transaction would be determined for the purposes of capital gains and losses provisions.
Secondly, IT 2378 does not attempt to canvass all the issues which may arise under the wide variety of farmout arrangements entered into by taxpayers but aims to illustrate, by way of basic examples, the common basis upon which the consideration for the disposal of an interest in a prospecting or mining right under a farmout arrangement has been determined for income tax purposes and will be determined for capital gains purposes.[190] No further Rulings have been issued to clarify other aspects of the application of the capital gains legislation to farmouts.[191]
Thirdly, the rules for valuing prospecting entitlements must deal with the problems of uncertainty and risk inherent in the very nature of the exploration sector of the mining or petroleum industry. The application of any particular methodology is dependent upon the particular circumstances. Despite its limitations, the Commissioner accepts the use of the recent commercial transactions valuation method, at the expense of other valuation methods, for example, the net present value method.
A net present value calculation is a determination of the current value of a future revenue stream.[192] For instance, the recent commercial transactions valuation method compares recent commercial transactions, ideally involving the property which is the subject of the valuation, or alternatively adjacent or nearby permits or prospects with similar prospectivity. Key assumptions are an arm's length transaction involving both a willing buyer and seller. Whilst such an approach is subject to prevailing market sentiment, it frequently provides the most realistic valuation available. Where recent transactions are not available or applicable the taxpayer may have recourse to a "hypothetical farmout agreement", which draws on the taxpayer's knowledge of the prevailing market to arrive at a "most likely" estimate of contract terms. If a farmout agreement has been executed at a time when the economy is depressed, then in this circumstance it is unlikely there will be any "active" market in prospecting entitlements. This renders the recent transactions method inappropriate.
Net present value is a valuation based on a financial model. The inputs are technical and economic assumptions that yield a series of cash flows: these are then discounted in order to recognise opportunity cost and the time value of money. The series of discounted cash flows are then summed in order to derive a net present value. This method is generally applicable when key variables have been determined in the lead up to a fully-fledged feasibility study. These variables include resource size, contract terms, including price, quantities, work commitments, transport costs, capital expenditure and operating expenses. Prior to this, it is necessary to discount the derived value in order to allow for the degree of risk in the estimates or assumptions.
A farmor will derive cash-flow advantages if it is eligible for the genuine prospectors exemption. These cash-flow benefits will reduce a farmor's compliance costs of entering into asset farmouts. Cash-flow benefits will ensue from the farmor having access to and use of funds that are ultimately exempt from income tax.
It is unlikely that these cash-flow benefits will exceed a farmor's compliance costs. Although it is too difficult to estimate the precise extent of the cash-flow benefits, the findings of the 1997 study by Evans into tax compliance costs of taxpayers in Australia in the 1994-95 year of income do give some indication of their likely extent in comparison to a taxpayer's social compliance costs. That study concluded that the social compliance cost of tax compliance for business taxpayers in Australia were estimated to be $8,874 million[193] and large taxpayers (ie annual turnover in excess of $10 million) were estimated to bear 11% of these costs (ie around $976 million). By comparison, the value of tax deductibility of compliance costs to business taxpayers was estimated for the 1994-95 year of income to be $2,446 million and cash flow benefits accruing to them were about $1,781 million; that is, cash-flow benefits amounted to 20% of social costs of tax compliance.
Taking into account these cash-flow benefits, it is reasonable to assume that the cash-flow benefits of the genuine prospectors exemption will reduce a farmor's compliance costs of entering into an asset farmout by around 20%.[194]
Thus far, this article has looked at the taxation factors of farmouts of assets by participants of unincorporated joint ventures. Now consideration is given to the taxation factors when the farmor is an equity participant of an equity joint venture. This will involve a consideration of farmees who are shareholders of the farmor when the farmout agreement is entered into and those that are not.
The capital gains provisions of the tax law are relevant to share farmouts. The contention is that the compliance costs of farmouts of shares are lower than for asset farmouts and the principal causes of this are the absence of complex provisions to interpret and relatively fewer laws applicable to share farmouts compared to asset farmouts.[195]
It is noted that share farmouts are available to both participants and equity participants. This contrasts with asset farmouts, which are not available to equity participants, as they do not hold a direct interest in the assets of the joint venture. If a participant chose to structure a farmout agreement as a share farmout, then it would likely take the form of an option over shares in the corporation that owns an interest in the assets of the unincorporated joint venture.[196] In fact, this will be fiscally simpler.
However, it is not axiomatic that a participant choosing to use a share farmout in lieu of an asset farmout will ultimately incur less compliance costs than if an asset farmout were used. The impact of the operation of the consolidation regime, for example, could negate all of a participant's compliance cost savings. For instance, the entry by a participant into a share farmout will mean that the company whose shares change ownership will not be 100% common owned. 100% common ownership is a condition that a company must satisfy to gain entry into a consolidated group. If a participant cannot consolidate its tax position into a consolidated group, then the participant will continue to incur high compliance costs and high tax revenue costs (and concomitant complex anti-avoidance provisions) associated with the current tax laws.[197]
Share farmouts could be structured in one of three ways. An equity participant ("the farmor") could grant to the farmee an option to acquire a percentage of the shares the equity participant holds in the SPV. Alternatively, a farmor could grant an option to acquire shares in the special purpose subsidiary or the Australian company holding all the shares in the equity participant.
If a farmee is an existing shareholder of the farmor when the farmout agreement is entered into, then the legal implications are straightforward. If a farmee is an existing shareholder of the farmor and the farmout agreement has been entered into for no consideration, then the option is acquired by the farmee at the time the farmee acquired the original shares[198] and for no consideration.[199] The exercise of the option by the farmee is not treated as a disposal of the option, so no capital gains tax liability should arise on its exercise.[200] The farmee is deemed to acquire the new shares at the time when the option is exercised.[201]
If the option is exercised by the farmee, the acquisition cost of the new share may be either the exercise price or the market value of the option at the time of the exercise plus any amount paid on their exercise.[202] The former applies if the option is acquired after 19 September 1985[203] and the latter applies if the option is deemed to be acquired before 20 September 1985.[204]
If the option is exercised by a person other than the farmee (ie a person who acquired the option from the farmee), then the acquisition cost of the new share is either the price of acquiring the option plus the price payable on its exercise[205] or the market value of the option at the date of exercise plus any amount paid on its exercise.[206]
An option will not be taken to have been disposed of by the farmee by the exercise of an option. The acquisition of an option and the exercise of the farmee's rights under the farmout agreement will be treated as a single transaction and therefore the consideration paid for the option forms part of the consideration paid by the farmee in respect of the acquisition of the shares.[207]
Since an option is an asset,[208] if the farmee disposes of the option then a capital gain may accrue or capital loss be incurred. Further, if the right is not exercised, then there is a disposal of the option by the farmee and in such a case a capital loss may be incurred by the farmee. The consideration paid will be the cost base of the option.
If a farmee is not an existing shareholder of the farmor when the farmout agreement is entered into, the legal implications are also straightforward. If a farmee is not an existing shareholder of the farmor, the option to acquire shares in the farmor is granted on or after 20 September 1985 and consideration is given for that right, neither the grant nor the exercise of the right is a disposal by the company.[209] No capital gains liability therefore arises at this time. If and when such a right expires without being exercised, or is cancelled, released or abandoned, then the grant of the right at that later time constitutes a disposal of the right by the equity participant.[210] The right is treated as having been owned by the SPV immediately before the disposal so that tax will be payable on the consideration received for the issue of the farmout (if any).[211]
If a farmee exercises its right to be issued shares, the grant of the right and the issue of shares by the farmor in fulfilment of its obligations under the farmout will be treated as a single transaction. The consideration for the farmout forms part of the consideration received by the farmor in respect of the issue of the shares.[212] That receipt does not attract CGT.
Compliance costs of the income taxation of farmouts act as a determinant of the choice of joint venture structure for resident Australian taxpayers. The definition of "compliance costs" and of the "farmout" concept, generally, are pivotal to understanding the role of compliance costs in this context. For the type of farmout arrangements considered in this article, compliance costs will vary depending on the structure of the farmout agreement, whether the taxpayer is a farmor or farmee, and whether the farmor and farmee is a participant or an equity participant. The examination undertaken in this article has revealed that a farmout structured as a disposal of assets bears more compliance costs than farmouts structured as options over shares.
[*] This article is Part I in a two-part series examining discrete aspects of the taxation of joint ventures. Part II will cover tolling companies and their income taxation features.
[**] Dr and Senior Lecturer, Faculty of Law, Monash University. The author gratefully acknowledges the enduring support of Associate Professor Dr John Glover.
[1] PH Martin, "Mineral Rights" (1992) 52 La Law Review 677, 688; H Alexander, "Tax Aspects of Joint Ventures" in WD Duncan (ed), Joint Ventures Law In Australia (1994) 236; and GS Pratt, "Disposal of Mining and Petroleum Interests and Current Revenue Considerations – Capital Gains Tax Aspect" 1988 AMPLA Yearbook 322, 325. M Roberts, "Contracts and the Legal Interests in the United Kingdom in the Context of Farm-ins" (1983) 2 OGLTR 21, 23, states that it is always possible for the parties to define a particular structure or formation and to provide that the farmee becomes entitled to whatever is produced from that structure alone. This is more common in the United States than in the North Sea and examples of this practice in the United Kingdom are not common. See, for instance, Moncrief v Martin Oil Service Inc [1981] USCA10 235; 658 F2d 768, 770 (10th Cir, 1981) ("Moncrief").
[2] Arguably, in the United States, notwithstanding that prima facie farmout agreements are covered by Revenue Ruling 77-176 see: M Wegher, "Taxation of Earned Interests – The Impact of Revenue Ruling 77-176" [1978] Rocky Mountain Law Institute Journal 521. The tax considerations are prima facie simpler than in Australia because of the popular technique of electing tax partnership treatment employed to avoid that Ruling's impact: HV Schaefer, "The Ins and Outs of Farmouts: a Practical Guide for the Landman and the Lawyer" (1986) 32 RMMLI 18-1, 18-29.
[3] P Fletcher, "Income Tax Implications of Mining" (1988) 5 Taxation in Australia 282, 291.
[4] AA Dawe, "Equitable Interests and Contractual Rights in Petroleum Titles" 1985 AMPLA Yearbook 309, 311; and WF Manning, "Assignment Clauses in Mining and Petroleum Joint Ventures" 1986 AMPLA Yearbook 119, 135.
[5] Schaefer, above n 2.
[6] Characterisation risk, is an expression coined by the author to describe the risk of a finding that the relationship between participants of an unincorporated joint venture is one of partnership.
[7] See generally W Blum, "Simplification of the Federal Income Tax Law" (1954) 10 Taxation Law Review 239; J Eustice, "Tax Complexity and the Tax Practitioner" (1989) 45 Taxation Law Review 7; P McDaniel, "Federal Income Tax Simplification: The Political Process" (1978) 34 Taxation Law Review 27; S Roberts, "Simplification Symposium Overview: The Viewpoint of the Tax Lawyer" (1978) 34 Taxation Law Review 5; A Sawyer, "Why Are Taxes So Complex, and Who Benefits?" (1996) 73 Tax Notes 1337; M White, "Why Are Taxes So Complex, and Who Benefits?" (1990) 47 Tax Notes 341; and E Zelinsky, "Another Look at Tax Law Simplicity" (1990) 47 Tax Notes 1225.
[8] B Tran-Nam, "Tax Reform and Tax Simplification: Some Conceptual Issues and a Preliminary Assessment" [1999] SydLawRw 20; (1999) 21 Sydney Law Review 500, 505.
[9] T Boucher, "Tax Simplification Debate: Too Simplistic" (1991) 26 Taxation in Australia 277, 278. Fiscal simplicity is understood by the Ralph Review to mean: "remov[ing] anomalies and inequities between the treatment of economically similar transactions ...", "drafting of the tax legislation on the basis of a set of consistent principles ...", "consolidation of company groups, while involving significant transitional costs..." and "a much clearer and shorter statement of the law": Review of Business Taxation, A Tax System Redesigned (1999) 16-17 ("A Tax System Redesigned").
[10] Tran-Nam, above n 8, 505.
[11] Ibid 506. This proposition raises two questions: how is readability of tax law to be determined, and who are the readers of the tax law? The degree of complexity in the tax law is a function of two factors.
[12] S Surrey and G Brannon, "Simplification and Equity as Goals of Tax Policy" (1968) 9 William & Mary Law Review 915.
[13] Tran-Nam, above n 8, 507. Tran-Nam argues, at 508, that there are five determinants of effective simplicity of a particular tax: (1) legal simplicity; (2) the number of taxpayers and tax administrators; (3) the size distribution of taxpayers (some components of operating costs such as tax compliance costs are known to be regressive in taxpayer size); (4) business cycle (changing macroeconomic conditions affect the tax base); and (5) the general level of tax avoidance and tax evasion in the economy and government's commitment to combat these.
[14] [1957] USCA5 35; 241 F2d 312, 313 (5th Cir, 1957).
[15] EM Cage, "Anatomy of a Farmout" (1970) 21 Oil and Gas Institute 153.
[16] Income Tax Assessment Act 1997 (Cth), s 6(1) ("ITAA97"); see also the detailed discussion contrasting unincorporated joint ventures from partnerships in article 2.
[17] See the definition of "Participating Interest" in Article 1, AIPN Model Form International Operating Agreement (1995).
[18] JC Norton and DA Rowe, Accounting and Auditing Guide for United Kingdom Oil and Gas Exploration and Production (1978) 78.
[19] M Weir, "Texaco Closes on $900m WA Deal", The West Australian, Business Section, 30 November 1999, 1.
[20] P Herd, "Capital Gains – Some Practical Problems" (1988) 5 Taxation in Australia 291, 293; and Industry Commission, Study into the Australian Gas Industry (1995) xxiv.
[21] Norton and Rowe, above n 18, 78-79.
[22] Schaefer, above n 2, 18-5.
[23] See, for instance, the sole risk provisions in Article 7, AIPN Model Form International Operating Agreement (1995).
[24] S Gibson, "Farm-Out Agreements" (1993) 2 OGLTR 45.
[25] Ibid. JB McArthur, "Coming of Age: Initiating the Oilfield into Performance Disclosure" (1997) 50 SMU Law Review 663, 666.
[26] The Department of Natural Resources & Energy, for instance.
[27] WH Bratby, "The Taxation Consequences of the Introduction and Retirement of Participants of Mining and Oil and Gas Ventures" (1984) 18 Taxation in Australia 950, 966: an outright sale by one participant to third parties, a sale by one participant to another of the whole or part of his interest in the particular venture; an agreed variation between participants as to their respective percentage interests for activities both present and future; a change in interest pursuant to provisions of an independent operations clause or because of provisions relating to expansion or other changes in scope where not all participants participate in the expansion; the desire of a group of companies to substitute another of its companies as a participant for that of another participant; progressive changes in percentage interests as between the participants resulting from different rates of contributions by them to the exploration or development activities; the purchase from a government or governmental instrumentality of its interest in an existing joint venture; the introduction of new Australian equity participants to a joint venture as required by the Foreign Investment Review Board; the variation in interests which can result from the completion of the obligations of a farmee under farmout arrangements; variations in interests caused by default or the merger of two or more companies or arising from the expiration of a period due to which one member has had a free carried interest.
[28] Due to pre-emptive rights or inflexible assignment and/or novation provisions in the Joint Venture Agreement or shareholders' agreement.
[29] DJ Gatcly, "Farmouts and Capital Gains: the Cost of Doing Business" (1987) 6 AMPLA Bulletin 58; AA Dawe, "Farmout Agreements – Problem Areas to be Addressed in Negotiation and Documentation" (1987) 5 AMPLA Bulletin 56; and Herd, above n 20, 293.
[30] R Bird, Osborn 's Concise Legal Dictionary (1983) 183.
[31] Gatcly, above n 29; and Herd, above n 20, 293.
[32] Petroleum Financial Corp v Cockburn [1957] USCA5 35; 241 F2d 312, 313 n 2 (5th Cir, 1957). For a simplified definition see Moncrief [1981] USCA10 235; 658 F2d 768 (10t6 Cir, 1981); Mengden v Peninsula Prod Co 544 SW2d 643, 645 n 1 (Tex) (1978); and Roberts, above n 1. Overriding royalties and carried interest farmouts are considered below.
[33] DJ Farrands, The Law of Option (1992) 16.
[34] Dawe, above n 4, 311.
[35] Ibid 314.
[36] Dawe, above n 29, 58.
[37] HP Williams, "Matters to be Taken into Consideration in the Negotiation of Farmout and Operating Agreements" (1978) 1 AMPLJ 509.
[38] Cf the Cockburn formulation and the Commissioner of Taxation's definition, both outlined above.
[39] Income Tax Ruling IT 2378, para 1.
[40] Herd, above n 20, 293.
[41] Farrands, above n 33, 115.
[42] Ibid 105.
[43] Ibid 115.
[44] Dawe, above n 4, 314.
[45] R Wilcocks, "Comment on Equitable Interests in Mining Titles" (AMPLA Conference, Sydney, 12 December 1980).
[46] Dawe, above n 4, 314.
[47] M Crommelin, "The Mineral and Petroleum Joint Venture in Australia" (1986) 1 JENRL 65, 70.
[48] Ibid.
[49] Dawe, above n 29, 58.
[50] Cf Carter v Hyde [1923] HCA 36; (1923) 33 CLR 115, 120-121 (per Knox CJ); and Griffin v Pelton [1958] Ch 205.
[51] [1915] NSWStRp 34; (1915) 15 SR (NSW) 283.
[52] Ibid 286.
[53] Bratby, above n 27, 966.
[54] There are at least three standard forms of carried interest: the "Manahan" interest, under which the farmor assigns all of its property but gets back half (or some other percentage) under a right of reversion after drilling costs are recouped; the "Herndon" type, in which the farmor assigns a portion of its mineral interest, plus a production payment (discussed below) covering the cost attributable to its retained interest, with the latter assigned back after the farmee recoups its costs; and the "Abercrombie" type, in which a farmor assigns part of its interest and gives a mortgage against development costs on the rest of its interest. See generally United States v Cocke [1968] USCA5 1015; 399 F2d 433, 436-437 (5th Cir, 1968), cert denied[1969] USSC 76; , 394 US 922 (1969); and Estate of Weinert v Commissioner [1961] USCA5 447; 294 F2d 750, 750 n 1 (5th Cir, 1961).
[55] Norton and Rowe, above n 18, 80.
[56] Pratt, above n 1, 331.
[57] PH Martin and BM Kramer, Williams & Meyers Manual of Oil and Gas Terms (10th ed, 1997) 847. Production payments are also known as oil payments.
[58] Ibid 712. Refer Tennant v Dunn 130 Tex 285, 110 SW2d 53 (1937); and State v Quintana Petroleum Corp 134 Tex 179, 133 SW2d 112 (1939).
[59] Pratt, above n 1, 331.
[60] Schaefer, above n 2, 18-25 and 18-26. See, for example, Div 5 ("Registration of Instruments") of the Petroleum (Submerged Lands) Act 1967 (Cth).
[61] Assuming the farmor is a participant of an unincorporated joint venture.
[62] See Re Butchart; Ex parte Jones (1865) 2 WW & AB (IE & M) 8 (per Molesworth J), where his Honour stated:
[t]here is nothing to prevent a person lending money to be used in trade, making any such stipulation as to not giving credit, and keeping accounts, and not carrying on any other business. All these stipulations are consistent with the mere relationship of borrower and lender.
[63] [1904] NSWStRp 82; (1904) 4 SR (NSW) 441 (per Owen, Cohen and Pring JJ).
[64] GLJ Ryan, "Joint Venture Agreements" (1982) 4 AMPLJ 101, 140-41; cf MC Chetwin, "Joint Ventures – a Branch of Partnership Law?" [1991] UQLawJl 5; (1991) 16 University of Queensland Law Journal 256, 263; and Crommelin, above n 47, 68.
[65] Chetwin, above n 64, 263; and Ryan, above n 64, 139-41.
[66] Chetwin, above n 64, 263:
It is not clear whether or not sharing of profits is essential for a partnership ... The implication of this approach is that the "in common" refers to the mode of conducting business and not with the disposal of the profit.
However, the definition of "partnership" in the ITAA97 is definitive as to the requirement of "in receipt of income jointly".
[67] See Crommelin, above n 47, 68.
[68] [1985] HCA 49; (1985) 157 CLR 1, 15-16 (per Dawson J).
[69] Crommelin, above n 47, 68.
[70] There are two reasons to support this. First, if a farmor entering into an overriding royalty agreement does not increase its overall rate of return by an amount equal to its compliance costs, then in aggregate terms, the farmor will be economically worse-off to the extent of those compliance costs. Secondly, if a farmor decides to pass-on its increased compliance costs to the farmee, then the farmee will be disinclined to enter into an overriding royalty agreement because this type of farmout is comparatively more expensive than other types of farmouts.
[71] In this instance, the taxation factors of farmouts which are relevant to the farmor will operate at the participant level, but will be consolidated into the group. The consolidation regime will not apply directly to unincorporated joint ventures, because this joint venture structure is not recognised by the ITAA97 as a taxpayer in its own right. Unincorporated joint ventures will not be eligible to join the consolidated regime: see A Tax System Redesigned, ch 15. Therefore, for unincorporated joint ventures, the consolidation regime will only ever operate at the participant level. Unless equity participants who are members of the same corporate group wholly own a Special Purpose Vehicle ("SPV"), the SPV will not be able to consolidate its tax position into that corporate group.
[72] This complexity also exists when there is a change in the ownership of participants of an unincorporated joint venture if it is an asset sale.
[73] ITAA97, s 6-5(1).
[74] ITAA97, s 15-15.
[75] ITAA97, s 70-20.
[76] See ITAA97, Pt 3-1. This assumes that a prospecting entitlement has been acquired severally by participants of an unincorporated joint venture on or after 20 September 1985.
[77] Case D67 72 ATC 400; see also Thorpe Nominees Pty Ltd v FC of T 88 ATC 4886, where the taxpayer was held assessable on the sale of the "nominee rights" held by it as grantee of certain options.
[78] Ferguson v FC of T [1979] FCA 29; (1979) 37 FLR 310.
[79] Fairway Estates Pty Ltd v FC of T[1970] HCA 29; (1970) 123 CLR 153 (per Barwick CJ).
[80] FC ofT v Radnor Pty Ltd (1991) 22 ATR 344, 357 (per Hill J).
[81] In Thomas v FC of T 72 ATC 4094, 4099, (per Walsh J). The High Court was prepared to infer a profit motive where the taxpayer aimed to produce quantities of the relevant item which were significantly greater than domestic needs.
[82] The author was unable to identify any authorities on this point.
[83] Whether or not a farmor is carrying on a business is a question of fact, not of law, depending upon a variety of circumstances: Werle & Co v Colquhoun [1888] UKLawRpKQB 46; (1888) 20 QBD 753, 761 (per Fry LJ); quoted with approval by Starke J in Blockey v FC of T [1923] HCA 2; (1923) 31 CLR 503, 511.
[84] Newton v Pyke (1908) 25 TLR 127.
[85] ITAA97, s 995-1 defines a "business" as including "any profession, trade, employment, vocation or calling, but does not include occupation as an employee".
[86] What may be extracted from the cases on this issue is that there is a "multitude of things" which together make up the carrying on of a business: Erichsen v Last [1881] UKLawRpKQB 165; (1881) 8 QBD 414 ("Erichsen").
[87] London Australia Investment Ltd v FC of T [1977] HCA 50; (1977) 138 CLR 106.
[88] See Erichsen [1881] UKLawRpKQB 165; (1881) 8 QBD 414.
[89] ITAA97, s 15-15(2)(a).
[90] ITAA97, s 15-15(2)(b).
[91] [1987] HCA 18; (1987) 163 CLR 199, 209.
[92] Ibid.
[93] Ibid.
[94] Ibid.
[95] [1982] HCA 8; (1982) 150 CLR 355.
[96] Ibid 384 (per Mason J). In finding that there was a business which commenced on 20 December 1967, Mason J said:
in deciding whether what the respondent did was the mere realisation of an asset or the carrying out of a profit -making undertaking or scheme, it is relevant to take into account that the company came under the ownership and control of new shareholders whose purpose was to use the company for the execution of what, judged from their point of view, was a profit-making undertaking or scheme. In deciding whether the company was carrying on the business of land development it is material that the new shareholders would have been carrying on such a business had they purchased the land from the company and carried out the development and sale on their own account.
[97] A Tax System Redesigned, Recommendation 4.1.
[98] In the Treasurer's response, "The New Business Tax System: Stage 2 Response", Press Release (No 74, 11 November 1999) 5, the Treasurer states:
The Government sees considerable merit in the high level reforms proposed by the Review and has given in principle support to their introduction. However, it recognises the importance of developing a workable system that can be implemented with minimum disruption.
[99] Ibid.
[100] G Cathro, "Capital Gains Tax – Report of the Review of Business Taxation" (1999) 28 Australian Tax Review 222, 224.
[101] "Trading stock" includes "anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business and livestock": ITAA97, s 70-10.
[102] [1912] HCA 78; (1978) 138 CLR 210.
[103] [1985] HCA 44; (1985) 59 ALJR 615.
[104] 86 ATC 4673.
[105] [1985] HCA 44; (1985) 157 CLR 277; appld FC of T v Brambles Holdings Ltd (1991) 28 FCR 451.
[106] ITAA36, s 31C; "trading stock" is defined in ITAA97, s 995-1.
[107] [1985] HCA 44; (1985) 157 CLR 277, 282 (per Gibbs CJ, Wilson, Deane and Dawson JJ).
[108] ITAA97, s 70–45(1).
[109] "Cost" as defined in the ITAA36 has been held to mean the actual cost of the taxpayer's stock up to the relevant time: see Phillip Morris Limited v FC of T (1979) 38 FLR 383; and Income Tax Rulings IT 2350 and IT 2402.
[110] See also Australasian Jam Co Pty Ltd v FC of T [1953] HCA 52; (1953) 88 CLR 23.
[111] See (regarding ITAA36) Parfew Nominees Pty Ltd v FC of T (1986) 85 FLR 370.
[112] (1979)38 FLR370.
[113] A Tax System Redesigned, 180.
[114] In addition, trading stock will continue to be excluded from capital gains treatment on the bases that such treatment would run counter to the objectives of encouraging investment in longer term capital assets and would be inconsistent with the existing concept of taxing income from trading activities. The inclusion of trading stock assets in loss quarantining would undermine the integrity of capital loss quarantining. Absorption cost will continue to apply and be extended to the valuation of assets for tax purposes generally. Similarly, trading stock conventions for the identification of cost with particular assets (actual cost, FIFO or weighted average cost) will extend to all assets other than capital assets. Current livestock valuation options will be retained: A Tax System Redesigned, 180.
[115] Ibid 309.
[116] ITAA97, s 42-15.
[117] A Tax System Redesigned, Recommendation 8.3.
[118] Ibid 309.
[119] See ITAA97, s 330-245.
[120] A Tax System Redesigned, Recommendation 4.3(v).
[121] Ibid Recommendation 8.15.
[122] Pancontinental Mining Ltd v Commissioner of Stamp Duties (Qld [1989] 1 QdR 310. See also JV (Crows Nest) v Commissioner of Stamp Duties (NSW) 85 ATC 4198; (see on appeal, (1986) 7 NSWLR 529); JE Stuckey, "The Equitable Action for Breach of Confidence: is Information Ever Property?" [1981] SydLawRw 6; (1981) 9 Sydney Law Review 402; N Palmer, "Information as Property" in L Clarke (ed), Confidentiality and the Law (1990) ch 5; F Gurry, Breach of Confidence (1984) 46-56; S Ricketson, "Confidential Information – a New Proprietary Interest? Pt I" [1977] MelbULawRw 14; (1977) 11 Melbourne University Law Review 223, 289; A Mitchell, "The Jurisdictional Basis of Trade Secrets Actions: Economic and Doctrinal Considerations" (1997) 8 AIPJ 134; and J McKeough and A Steward, Intellectual Property in Australia (1997) 69-74. See also M Pattison, "Using Intellectual Property as Security" (1996) 7 AIPJ 135, 142-143.
[123] P Green, "Selected Revenue Law Issues Concerning Prospecting or Mining Information" 1997 AMPLA Yearbook 159, 173.
[124] Ibid 174.
[125] TR 98/3, para 33.
[126] Ibid para 36.
[127] Ibid para 37.
[128] A Tax System Redesigned, Recommendation 8.16.
[129] Ibid.
[130] ITAA97, s 41-20(1)(b).
[131] TR 98/3, para 41.
[132] The expression "exploration or prospecting" is defined in ITAA97, s 330-20(1) in broad, inclusive terms.
[133] These provisions apply to disposals of assets acquired (see ITAA97, s 100-25(1)) or deemed to be acquired (see ITAA97, ss 149-30 and 104-230) on or after 20 September 1985 by a farmor.
[134] ITAA97, s 104-35(1).
[135] Cathro, above n 100, 224.
[136] Dawe, above n 4, 314.
[137] Farrands, above n 33, 115.
[138] Ibid 105.
[140] [1898] QB 228, 238.
[141] (1979) 10 ATR 593.
[142] Ibid 597.
[143] R Deutsch, Australian Tax Handbook (1999) [11 120].
[144] Ibid [11 130].
[145] Ibid.
[146] See ITAA97, s 108-5(1); and Pancontinental Mining Ltd v Commissioner of Stamp Duties (Qld) [1989] 1 QdR 310, 311-312, where de Jersey J said (on behalf of the Full Supreme Court of Queensland): "there is no definition of 'property' in the Act, but the ordinary meaning of the word does not encompass information. There is plenty of support for that view in the authorities". Gibbs J, in Brent v FC of T [1971] HCA 48; (1971) 125 CLR 418, 425, said
[i]t is not possible speaking strictly to say that in communicating the information to the agents of the company the appellant was parting with property. Neither knowledge nor information is property in a strictly legal sense, although they can be said to be property in a loose metaphorical sense and have been referred to as property in a number of cases.
See also Nischu Pty Ltd v Commissioner of State Taxation (WA) 90 ATC 4391; Csd Emerson v Custom Credit Corporation Ltd [1994] 1 QdR 516; appld Commissioner of State Taxation (WA) v Nischu Pty Ltd [1991] WASC 129; [1991] 4 WAR 437; and Green, above n 123, 161-162 for a discussion of Nischu.
[147] TR 98/3, para 8.
[148] Ibid.
[149] Ibid para 66.
[150] See ITAA97, ss 104-35(1) and 104-155(1).
[151] A Tax System Redesigned, Recommendation 8.16.
[152] ITAA97, s 104-35.
[153] ITAA97, s 104-55.
[154] ITAA97, s 104-10.
[155] Pursuant to ITAA97, s 104-155(1), CGT event H2 happens if an act, transaction or event occurs in relation to a CGT asset that is owned, and the act, transaction or event does not result in an adjustment being made to the asset's cost base or reduced cost base.
[156] "Prospecting or mining entitlement" is defined by ITAA97, ss 124-710(c) and (2).
[157] For example, an overriding royalty or production payment. These types of farmouts were discussed above.
[158] ITAA97, s 104-45(3) ("CGT event D3"). A farmor makes a capital loss if those capital proceeds are less than the expenditure incurred by the farmor in granting it.
[159] ITAA97, s 104-45. There seems to be little doubt that s 104-45 is capable of applying to farmout arrangements providing for production, overriding royalty or equalisation payments.
[160] ITAA97, s 104-45(1).
[161] ITAA97, s 104-45(3).
[162] ITAA97, s 104-45(4).
[163] Refer to the note at the foot of ITAA97, s 104-45(1). If CGT event D1 happens, the time of the event is when the farmor enters into the farmout agreement, or creates the other legal or equitable right in the farmee (ITAA97, s 104-35(2)). If CGT event E1 happens, the time of the event is when the trust over the asset is created (ITAA97, s 104-55(2)). If CGT event H2 happens, the time of the event is when the act, transaction or event occurs (ITAA97, s 104-155(2)).
[164] ITAA36, s 160U.
[165] IT 2378, para 8.
[166] See ITAA97, s 110-25(6).
[167] TR 98/3.
[168] Subject to satisfying the rules in ITAA97, s 8-1(1).
[169] The effect of market value substitution rule No 1 in ITAA97, s 116-30 is to deem the non-cash consideration to be the market value of the asset disposed of at the time of disposal. The ITAA97 does not define "market value".
[170] Gately, above n 29; and Herd, above n 20, 293.
[171] IT 2378, para 15. But the law changed in 1997, with the introduction of CGT events D1 and H2 - valuation exercises are not always needed.
[172] IT 2378, para 15. For instance, the Commissioner has ruled that a nil or very low valuation may not be consistent with very large work program commitments.
[173] Ibid.
[174] Ibid.
[175] In this context, a "lawmaker" is defined to mean the Commonwealth Parliament, the Australian Taxation Office which makes tax rulings on tax matters.
[176] A Tax System Redesigned, 167.
[177] Martin and Kramer, above n 57, 1185.
[178] IT 2378, para 11.
[179] (1907) 5 CLR 418.
[180] Ibid 441.
[182] Ibid 269.
[184] [1947] HCA 10; (1947) 74 CLR 358.
[185] Ibid 373-374 (per Dixon J).
[186] IT 2378, para 21.
[187] The WA-267-P joint venture participants include Mobil, Chevron Asiatic Ltd and Texaco Australia Pty Ltd, each with 25%, and Shell Development Australia Pty Ltd and BP Amoco Exploration (Alpha), each with 12.5%: I Howarth, "Shelf Yields New Huge Gas Field", The Australian Financial Review, 22 October 1999, 49.
[188] IT 2378, para 2. The market value substitution rule of ITAA97, s 112-20(1) will not necessarily help a farmor, either, because this provision is also predicated on the basis that a "market value" is ascertainable. This rule replaces the acquisition costs element of the (reduced) cost base of a CGT asset acquired from another entity with the asset's market value at the time of acquisition if either no expenditure was incurred to acquire it, some or all of the expenditure incurred cannot be valued, or the taxpayer did not deal at arm's length with the entity in connection with the acquisition.
[189] IT 2378, para 2.
[190] Ibid.
[191] Cf IT 2378, para 2.
[192] G Price, "Ratios, Forecasting and Modelling" (1999) 2 OGLTR 164.
[193] C Evans, K Ritchie, B Tran-Nam and M Walpole, A Report into Taxpayer Costs of Compliance (1997) vii.
[194] The author accepts that more rigorous financial modelling will be required to derive a more accurate estimation of the extent to which the cash-flow benefits of the genuine prospectors exemption reduce a farmor's compliance costs.
[195] This simplicity also exists when there is a change in the ownership of equity participants if it is a share sale.
[196] The word "likely" is used because in theory a share farmout could be structured so that an option is offered over shares in a parent company of the corporation which owns an interest in the assets of the unincorporated joint venture.
[197] A Tax System Redesigned, 517.
[198] ITAA97, s 130-45(1).
[199] ITAA97, s 112-20(3).
[200] ITAA97, s 130-40(7).
[201] ITAA97, s 130-45(2).
[202] ITAA97, s 130-40(6).
[203] Ibid.
[204] See ITAA36 s 160ZYT.
[205] ITAA97, s 130-40(6).
[206] Ibid.
[207] ITAA97, s 134-1.
[208 ]ITAA97, s 108-5.
[209] ITAA97, s 104-40(6).
[210] ITAA97, s 104-40(1).
[211] See ITAA97, s 104-30.
[212] ITAA97, s 104-40(5) and s 116-65.
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