Modernising the petroleum mining tax rules
Issue: Allow another method for amortising development expenditure
Submission
(16 – Petroleum Exploration and Production Association of NZ)
The bill should allow petroleum miners to adopt a diminishing value/double declining balance approach as a way of amortising development expenditure. This approach would be in addition to the current straight-line basis and the unit of production basis as contained in the bill.
Comment
Currently, development expenditure is amortised on a straight-line basis over seven years. The bill contains provisions that will allow petroleum miners to choose to amortise development expenditure on plant and equipment designed and constructed to operate for the life of the permit (called “petroleum mining assets”) on a unit of production basis or on the current straight-line basis.
The diminishing value method is generally accepted as being the method that more accurately reflects, when compared with straight-line amortisation, the actual decline in value of an asset over its useful life. Therefore, it is an appropriate method of calculating depreciation deductions for capital expenditure that has a finite useful life. The unit of production method provides an even more accurate method.
The unit of production method is a way of calculating depreciation deductions that uses a fixed cost per unit of production, based on an estimate of the total number of units the property will produce during its service life and the total cost of the asset. As each unit is produced, a deduction is allowed for the cost of that unit. Economically, the unit of production method is likely to be the most accurate way of amortising petroleum mining assets. In theory it would therefore be preferable to replace the straight-line method with the unit of production approach.
Economically, we see no reason to allow petroleum miners to amortise the cost of petroleum mining assets on a diminishing value basis. The diminishing value basis is a proxy for the decline in value for a given useful life. Amortising development expenditure over seven years is a concession where the capital spent to develop the field lasts for 20 years. Allowing a greater proportion of the capital expenditure to be taken earlier on in the asset’s life is more concessionary.
Given there is no strong economic case for allowing a double declining balance approach, we are of the view that allowing petroleum miners to amortise petroleum mining assets on this basis only increases tax compliance costs, as taxpayers will assess the tax results of each method and select the one that produces the most favourable result.
Recommendation
That the submission be declined.
Issue: Unit of production – formula
Clause 93
Submission
(16 – Petroleum Exploration and Production Association of NZ)
Probable reserves should be replaced with proved reserves in the unit of production formula that allocates expenditure on petroleum mining assets.
Comment
The basic difference between “proved” and “probable” reserves lies in the level of certainty about the quantities of commercially recoverable oil and gas. Reserve estimates are based on information at a given date looking forward, from known reservoirs and under current economic conditions, operating methods and government regulations. Proved reserves have more than a 90 percent probability of recovery, while probable reserves have a greater than 50 percent probability of recovery. Because proved reserves estimates are lower than estimates of probable reserves, the amount of development expenditure deductible per unit of production will be greatest using proved reserves.
So that tax does not interfere with investment decisions, it is important that amortisation rates accurately reflect an asset’s decline in value at the point at which the investment occurs. Overly generous rates encourage investment in what becomes a tax-preferred investment at the expense of other investment. Conversely, amortisation rates that are lower than the assets decline in value will discourage investment in what becomes a tax-disadvantaged investment. The question is whether oil companies’ investments are based upon proven or probable reserves estimates.
We consider that investment decisions are most likely based on estimates of probable reserves for the following reasons. First, probable reserve estimates are regularly reviewed for both accounting and regulatory purposes, and are frequently used in petroleum mining company annual reports. In addition, the International Accounting Standards Board, the standard-setting body responsible for the development of International Financial Reporting Standards, considered in September 2008 the categories of reserves to be disclosed. While a final decision is still pending, the Board’s current view seems to support the categories of reserves to be disclosed for accounting purposes ought to be “proven and probable”, as this is the best estimate of the economically recoverable resources. This supports the use of probable reserves as the basis for the unit of production method.
Recommendation
That the submission be declined.
Issue: Unit of production method – previous deductions
Submission
(16 – Petroleum Exploration and Production Association of NZ)
The definition of “previous deduction” should be amended as follows:
“The total amount of petroleum development expenditure to which this section applies that has been allocated in an earlier income year.”
Comment
The submission is concerned that deductions for pre-1 April 2008 reserves expenditure will be counted twice. If this is not corrected, the amount of reserve expenditure to be allocated under the units of production method would be incorrect.
Recommendation
That the submission be accepted.
Issue: Unit of production method – application date
Submission
(16 – Petroleum Exploration and Production Association of NZ, 21 – New Zealand Oil and Gas, 28 – Australian Worldwide Limited, 32 – KPMG, 35B – PricewaterhouseCoopers)
The unit of production method should apply to all expenditure and not just expenditure incurred on or after 1 April 2008.
A number of submissions are also concerned that the unit of production method is not available for development expenditure incurred on or after 1 April 2008 in relation to a permit area where there has been commercial petroleum production.
Comment
While we agree to some extent with the points made in these submissions, officials have at least two concerns.
First, officials are concerned that there are fiscal risks associated with the proposal. It is possible for a number of oil or gas reservoirs to co-exist within a single petroleum mining permit. Commercial practice suggests that where possible, development infrastructure will be used across a number of reservoirs to reduce production costs. By allowing different amortisation rules for development expenditure within the same permit area, petroleum miners would have incentives to elect the seven-year amortisation for some development expenditure – that is, when the seven-year period is concessionary, and to apply the unit of production method to shorter-lived development expenditure. Under this arrangement, a petroleum miner would have the flexibility and the incentives to undertake arrangements that produce the greatest tax benefits. Allowing taxpayers the flexibility to undertake such arrangements would increase fiscal costs. Allowing a one-off election that applies to the whole permit area, in the year of first production, addresses this concern.
The second concern relates to the compliance and administration costs associated with allowing petroleum miners to mix and match amortisation methods for development expenditure within the same permit area. Complex apportionment rules would be necessary to address concerns of accelerated deductions for longer-lived production assets, when these assets are used for both short-lived and longer-lived reserves. In addition, different calculations would need to be applied to development expenditure for the same petroleum mining development, depending on the amortisation method used.
For these reasons, officials prefer to have development expenditure within a permit area amortised on either the seven-year method or the unit of production method. However, we are still working on these matters.
Recommendation
That the submission be noted.
Issue: Aligning date of application with balance date
Submission
(16 – Petroleum Exploration and Production Association of NZ)
The rules should apply to expenditure, incurred on or after 1 April 2008, from the start of the petroleum miner’s income year (2009) to minimise compliance costs.
Comment
The application date is drafted to apply to expenditure incurred on or after 1 April 2008. This submission would, if accepted, defer the ability of taxpayers to apply the unit of production amortisation until the start of a later tax year. The problem is that some taxpayers are less sensitive to compliance costs than others. For those taxpayers that are less sensitive to compliance costs, they may prefer an earlier application date and bear the additional compliance costs. On balance, we think that compliance costs arising from the application date are unlikely to be large and that most taxpayers would prefer the current application date.
Recommendation
That the submission be declined.
Issue: Date of application
Submission
(35B – PricewaterhouseCoopers)
The words “on or” should be added before “after 1 April 2008”. As currently drafted, the proposed sections do not apply to expenditure incurred on 1 April 2008.
Comment
Officials agree with this submission.
Recommendation
That the submission be accepted.
Issue: Cap amortisation period
Submission
(16 – Petroleum Exploration and Production Association of NZ)
Irrespective of the choice of amortisation method, petroleum miners should be able to write off any remaining reserve value in the seventh year.
Comment
There is no basis for this approach as the seven-year period is arbitrary. In addition, capping the amortisation period for development expenditure would become a concession, under the unit of production method, and would have an additional fiscal cost. Consequently, officials do not support this submission.
Recommendation
That the submission be declined.
Issue: Transitional sections
Submission
(16 – Petroleum Exploration and Production Association of NZ)
A transition section is required for expenditure incurred before 1 April 2008 that has not yet been amortised.
Comment
The new sections apply to expenditure incurred on or after 1 April 2008. Officials will ensure that deductions can be taken for pre-1 April 2008 expenditure.
Recommendation
That the submission be noted.
Issue: Dry well and depleted production wells
Clause 95
Submission
(16 – Petroleum Exploration and Production Association of NZ)
The expenditure write-off provisions for dry and exhausted wells should apply from 1 April 2008, irrespective of the date when the expenditure was incurred.
Comment
The bill introduces a deduction for expenditure incurred on dry wells and the remaining book value of wells that stop producing, if the unit of production method is used. The provisions apply to expenditure incurred on or after 1 April 2008.
Allowing these provisions to apply to expenditure incurred before 1 April 2008 would produce a windfall gain for petroleum miners that incurred development expenditure earlier than 1 April 2008. It would also add fiscal costs. Petroleum miners undertake investment on the basis of the relevant economic and regulatory environment. For the investment to have occurred, they would have considered that the risks and returns made commercial sense.
Retrospectively altering the regulatory treatment of these sunken costs does nothing to alter investor behaviour. Instead, it produces windfall gains only for those who had investment before 1 April 2008.
Recommendation
That the submission be declined.
Submission
(35B – PricewaterhouseCoopers)
We support the proposal to allow a deduction for the cost of drilling a dry completed production well at the time the well is abandoned. However, this provision should be extended to apply also to wells which are only partly completed before being abandoned.
Comment
Officials agree with this submission.
Recommendation
That the submission be accepted.
Issue: Removing the onshore/offshore boundary
Submission
(68A – Corporate Taxpayers Group)
Taxpayers have had to historically determine whether or not any horizontal drilling operations were onshore or offshore, to determine when they could start amortising any petroleum development expenditure. Where such filing positions have been undertaken previously, these taxpayers should be grandparented and not subject to Inland Revenue audit, as there seems little point in seeking to clarify whether a boundary exists, when it is proposed to be removed.
Comment
Taxpayers are often required to make judgements that can have an effect on the tax treatment of certain transactions. Normally, previous decisions are safe-harboured if there is ambiguity about what the law means. This is not the case here.
The main concern that led to this provision was that horizontal drilling techniques meant that the current onshore/offshore boundary no longer served a policy purpose. For this reason we do not support the proposal.
Recommendation
That the submission be declined.
Issue: GST input deductions for restoration costs
Submission
(67 – New Zealand Institute of Chartered Accountants)
An amendment to the Goods and Services Act 1985 should be made that allows input tax credits to be claimed on the costs of restoration associated with past taxable activities.
Comment
The Commissioner’s view of the law that raised the concerns that input deductions might not be allowed for restoration costs associated with past taxable activity is currently being reviewed. Officials are waiting for the outcome of this review before recommending possible changes to the Goods and Services Act 1985.
Recommendation
That the submission be noted.
Issue: Extending section CW 57
Submission
(27 – Origin Energy, 68A – Corporate Taxpayers Group)
The current exemption for income earned by a non-resident company for certain exploration and development activities in an off-shore permit area should be extended beyond 31 December 2009, as part of this bill.
Comment
The current exemption ends on 31 December 2009. The exemption was introduced as part of a package of measures designed to enhance security of gas supply in 2005. This issue is currently under active consideration by the government.
Recommendation
That the submission be noted.
Issue: Claw-back provisions for exploration well expenditure
Submission
(16 – Petroleum Exploration and Production Association of NZ)
The current rules that recover deductions previously allowed for exploration well expenditure should be removed, because this treatment does not occur anywhere else in the tax legislation.
Comment
There is a distinction made between the treatment of exploration and development expenditures, where the former is treated as a revenue expense and the latter is treated as a capital expense. The current rules use a final purpose test to determine what type of expenditure has been incurred. This is to ensure that the boundary between exploration and production expenditure can be effectively policed.
While it is very unlikely that an exploration well will be re-entered after it is sealed and abandoned, it is technically possible to re-enter a well. Without the claw-back provision, however, there would be an opportunity for petroleum miners to seal and abandon an exploration well, claim the expenditure as a deduction, and then reopen the well some time later.
Recommendation
That the submission be declined.