CGT withholding and exploration farm-ins: don't assume…

Although the new CGT withholding rules (under Subdiv 14-D of Sch 1 to the TAA) rely on a large number of CGT concepts, it is dangerous to assume that the provisions apply in an identical fashion as the CGT rules do.  An example is in their application to exploration farm-ins [also called farm-outs in some cases and both terms are used on occasion in this article], where the result is that arguably the entirety of the "committed expenditure" can be treated as part of the "first element of the cost base" for withholding purposes.

"Farm-in farm-out" arrangements broadly involve the exchange of an interest in a mining, quarrying or prospecting right in return for an "exploration benefit" (with the initial owner of the right known as the "farmor" and the person providing the exploration benefit in exchange for the right known as the "farmee").

The basics

There are three elements to the application of the withholding in section 14-200(1)(a)-(c) of Sch 1 to the TAA:

1. you become the owner of a *CGT asset as a result of *acquiring it from one or more entities under one or more transactions; and
2. subsection 14-210(1) (about foreign residents) applies to at least one of those entities at the time one of those transactions is entered into; and
3. at that time, the CGT asset is:
   1. *taxable Australian real property; or
   2. an *indirect Australian real property interest; or
   3. an option or right to acquire such property or such an interest;

The elements can then be summarised as:

• acquiring a CGT asset (remembering that all assets whether or not subject to the CGT regime are strictly CGT assets);
• from a "foreign resident", which is defined to include any vendor of taxable Australia real property;
• where that CGT asset is, or is related to, Australian land.

Example 4 in LCG 2016/7 provides that the withholding rules apply irrespective of whether or not the vendor held the asset on revenue account (and thus no capital gain per se will arise for the vendor at all). 

Section 118-24 of the ITAA 1997 (relating to depreciable assets ‒ such as mining tenements) and 118-25 (trading stock) make it clear that although exemptions from CGT apply, what is dealt with is still a CGT asset. Although this is less clear in section 118-24, the exemption in section 118-25 refers to a gain made on a CGT asset being disregarded if held as trading stock.  For section 118-24, the road is not as clearly marked, since it refers only to a "CGT event" that is also a balancing adjustment event that happens to a depreciable asset.  The definition of depreciable asset in section 40-30 (via section 995-1) makes no reference to CGT asset, but the term is necessarily imported by the reference to CGT event in section 118-24, insofar as it relates to an asset.  Division 977 of the ITAA 1997 also deals with "revenue assets" on the basis that they are CGT assets.  

It would be curious if the regime could be circumvented simply by the purchaser acquiring the asset on revenue account.  It should be comparatively simple to establish the first element of the cost base even if the cost base per se will never be used for any other purpose.

A farm-in is not an earnout

Firstly, it should be noted that a farm-in is not an earnout as defined. 

An earnout arrangement occurs where the buyer and seller of a sale of business or business assets cannot agree on a fixed payment and instead agree that subsequent financial benefits may be provided based on the future economic performance of the business in which the assets are used.

To have a look-through earnout right (section 118-562(1) ITAA 1997):

• there must be a right to future financial benefits which are not reasonably ascertainable at the time the right is created
• the CGT asset subject to the transaction must be an active asset of the seller
• the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset.

From 24 April 2015, where you have a look-through earnout right:

• the value of the right is disregarded for the purposes of CGT (section 112-36(1)(a) ITAA 1997);  and
• the value of any financial benefits made or received under the right is included in either the capital proceeds arising from the sale of the relevant asset (for seller) or the cost base of the acquisition of the relevant asset (for the buyer) (sections 112-36(1)(a) and (b)).

Without this rule, arguably no withholding obligation in respect of the additional amounts payable for an earnout would apply ‒ as the Explanatory Memorandum notes [the earnout rules were introduced in the same Act as Subdiv 14-D of the TAA, the Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2016.  The earnout measures were found in Sch 1, while the withholding rules made up Sch 2.

However, under the general rules for look-through earnout arrangements any future financial benefits linked to the economic performance of the asset may well only be included in the capital proceeds of the underlying asset after the time the initial withholding tax is calculated and paid. Therefore, an additional rule is necessary to ensure a portion of the future financial benefit payment is paid to the Commissioner.

The withholding regime provides that if a purchaser is required to pay an amount to the Commissioner in respect of the original transaction (ie. because you have a foreign resident and the asset is subject to the regime), then the purchaser must also pay an amount to the Commissioner with respect to any financial benefits provided under look-through earnout rights at the time when the benefits are received (section 14-205(1) of Sch 1 to the TAA).

This contrasts nicely with the position in relation to mineral farm-in arrangements.

Some implications for farm-in arrangements

Mining, quarrying or prospecting rights in relation to minerals, petroleum or quarry materials situated in Australia with a market value of $2 million or more are deliberately caught by the regime (s 14-200). Options to acquire such rights are not subject to the $2 million exclusion.

Under the regime, a person exercising an option or right to acquire any of the property to which the regime applies may apply "the knowledge condition".  On application of this condition, if a purchaser does not know or have reason to believe a vendor is a foreign resident, the obligation to withhold 10% of the purchase price does not apply (EM to the Tax and Superannuation laws Amendment (2015 Measures No 6) Bill 2015, p 54).

The regime is clear, however, that the knowledge condition does not apply to acquisitions of TARP.

Accordingly, anyone acquiring a mining, quarrying or prospecting right under a farm-in arrangement ought to request a clearance certificate from the counterparty.

Piecing it all together

As a thought experiment, assuming that the counterparty had not obtained a certificate (or was a non-resident), what would happen on the acquisition of various mining tenements by BigMinCo?  Focus on an immediate transfer farm-out rather than an option arrangement for present purposes ‒  but note that the same issues will still arise in an option case, just at a different time, and also the grant of the option itself is a trigger point.

Clearly, BigMinCo has or will "*acquire" a TARP CGT asset from an entity.

Satisfaction of the second test in this case also leads to the satisfaction of the third, which again focuses on TARP.  Thus, the operation of any exceptions must be considered, which takes us to section 14-215(1).

BigMinCo's cost base

In the case of direct TARP, the primary exemption which might apply is that the market value must be "less than $2 million" ‒  this should then lead to a comparatively simple valuation exercise, except that such valuation exercises are never simple.

In addition, there is a special valuation rule which applies in such a case:

"For the purposes of paragraph (1)(a), if:

1. the *CGT asset is an interest in real property, or an interest in a *mining, quarrying or prospecting right; and
2. just after the transaction, there are one or more similar interests in the same real property or right;

treat the *market value of the CGT asset just after the transaction as including the market value of each of those similar interests."

Essentially, unlike other interests in land from the purchaser's perspective, all the acquisitions are aggregated together to look at the value of the tenement as a whole. 

Again, assume for the sake of argument that the tenement is valued in excess of $2 million.  Prima facie, the withholding liability now applies to BigMinCo in respect of its acquisition of an asset.

What is the liability applied to?

As pointed out in LCG 2016/6, contract value is irrelevant, and the provisions focus on the first element of the cost base to BigMinCo.

This is presumably not a case where the market value substitution rules in section 112-20 apply (on the basis that BigMinCo has incurred expenditure to acquire the asset.  It is a reasonably safe assumption in such a case that the parties are dealing at arm's length).  The first element of cost base of the acquirer is therefore simply the "money paid or required to be paid in respect of acquiring" the relevant property ‒ section 110-25(2)(a).  It also includes (in paragraph (b)) the value of any property given up to acquire the asset. Note that, in some cases of surrenders of one mining tenement to acquire another, this provision will also have operation (although not in a farm-in case per se).  For instance the condition to obtaining a CGT rollover under Subdiv 124-L is an example of potentially giving up property to acquire a new TARP asset.

BigMinCo's committed expenditure

The purchase price may or may not be a significant sum.  However, the question arises as to whether the commitment to expend moneys on an exploration program constitutes "money required to be paid" to acquire the asset. 

This requires taking a particular view of the provision ‒ but it should be noted this is not dissimilar to the approach taken by the High Court in Comr of State Revenue v Lend Lease Development Pty Ltd [2014] HCA 51 in relation to stamp duty ‒  focusing on what moved the transaction.  In turn, that is a development of the principles laid down in Chief Comr of State Revenue (NSW) v Dick Smith Electronics Holdings Pty Ltd (2005) 221 CLR 496, which related to whether a pre-sale dividend paid by a company to a shareholder formed part of the sale consideration.  The ATO considered how that might apply for CGT purposes in TR 2010/4, ultimately taking the view that while such an amount might form part of the capital proceeds of the vendor, it would not form part of the cost base of the purchaser, on the basis that, at paragraph 74:

"A dividend paid by the target company to its vendor shareholders is not money the purchaser paid, or property it gave, or is required to pay or give, in respect of acquiring the shares."

Clearly this rationale is of little help to BigMinCo in respect of undertakings it gives to carry out an exploration program.

Miscellaneous Tax Ruling MT 2012/1 states that committed expenditure amounts to "consideration" for the purposes of GST.  In a typical immediate transfer farm-out agreement, the farmor's transfer of the interest in the mining tenement is executed in return for exploration commitments and any cash payment commitments.

The exploration commitments undertaken by the farmee constitute a service (ie. an exploration benefit) to the farmor that is a non-cash benefit.  These commitments are, or are part of, the consideration that supports the existence of the contract between the farmor and farmee.

In relation to this exploration benefit, the farmee is entitled to a deduction for expenditure incurred on exploration or prospecting under section 40-730, and for GST purposes, a creditable acquisition of the exploration benefit results for the farmor and the exploration benefit is a taxable supply for the farmee.

While this relates to GST concepts of consideration rather than the CGT provisions, it shows at least a development of the topic in parallel with treating those amounts as a part of the first element of the cost base of the tenement acquired.

It might be thought that this is not really relevant, since presumably it will be claimed as an allowable deduction and excluded from the (notional) cost base of the asset in any event, remembering that it is likely such asset is subject to the UCA rules.

Section 110-37 provides:

SECTION 110-37  Expenditure forming part of cost base or element 

110-37(1)  If a later provision of this Subdivision says that:

1. certain expenditure does not form part of the *cost base of a *CGT asset; or
2. the cost base is reduced by certain expenditure;

the expenditure is initially included in the cost base, which is then reduced by the amount of the expenditure just before a *CGT event happens in relation to the asset.

Note: This has the effect of recognising in the cost base any indexed component relating to the expenditure.

110-37(2)  On the other hand, if such a provision says that:

1. certain expenditure does not form part of one or more elements of the *cost base of a *CGT asset; or
2. one or more elements of the cost base are reduced by certain expenditure;

the expenditure is never included in the relevant elements of the cost base.

Note: This has the effect of not recognising to any extent this expenditure in the cost base

This draws a very fine distinction indeed.

For present purposes, the language of section 110-40 applies so that deductable expenditure is excluded from the cost base rather than from elements of it.

It therefore appears that (in a purely notional sense) commitment to an exploration program could amount to a significant sum of money, which would then form part of the cost base of the asset, and create a liability to remit 10% of the amount to the ATO.

This may well occur at a time when (if BigMinCo is in fact SmallMinCo) it might not have suitable ready cash to fund a payment to the ATO.

So do the MT farm-out rulings provide any clarification?

MT 2012/1 and MT 2012/2, although purporting to deal with CGT, do not undertake any detail in relation to CGT issues related to "cost base" or otherwise ‒ refer para 50 of MT 2012/1:

"The farmee acquires a CGT asset (being the interest in the mining tenement). However, this is likely to be of no practical consequence for the farmee if the UCA provisions apply to any subsequent dealing by the farmee with that interest (see paragraph 46 of this Ruling as to the interaction of the UCA and CGT provisions in relation to the farmor)."

This is not particularly helpful.

At best, if this approach is in theory correct, then perhaps the exploration program falls to be valued under paragraph (b) of section 110-25(1) rather than paragraph (a) ‒ being property rather than money.

The importance of obtaining a certificate valid at the time of the event ‒ not one ex post facto ‒ from a counterparty in cases where it might not immediately be thought to be necessary should be all too clear.

Conclusion 

It is fair to say that some quirks and wrinkles remain in the withholding rules which may require some ironing out by sympathetic interpretation or Commissioner's variation. 

Importantly, a taxpayer who may have previously self-assessed that Division 855 applied to shield it from Australian tax liability now will only have that option where it gives a declaration to the purchaser that there is some basis on which the purchaser need not withhold.  Giving an incorrect declaration is a tax offence. 

Accordingly, there will now be additional levels of internal scrutiny applied to the characterisation of sale transactions involving potential Australian TARP interest.  This is, one assumes, a deliberate feature of the legislation, and one which will likely provide a significant quantum of work for tax advisers.

This article was first published in Thomson Reuters Weekly Tax Bulletin 45, 28 October 2016.