Changes to the tax treatment of petroleum mining

2009 amendments covering deductions for expenditure on petroleum mining, an update to the mining rules, and a change to the mining anti-avoidance provision.

Sections DT 1A, DT 2, DT 5, DT 9, EJ 12, EJ 12B, EJ 13, EJ 13B, EJ 13C, EJ 19, EJ 20 of the Income Tax Act 2007; sections DT 1A, DT 2, DT 5, DT 9, EJ 11, EJ 11B, EJ 12, EJ 12B, EJ 12C, EJ 13, EJ 17 and EJ 18 of the Income Tax Act 2004

There have been a number of changes made to the petroleum mining tax rules. Deductions for expenditure on petroleum mining undertaken through a branch in another country will only be allowed to be allocated against income from petroleum mining operations outside of New Zealand. The petroleum mining rules have also been updated to address a number of issues that apply to investment in oil and gas exploration and development in New Zealand. Lastly, a remedial amendment ensures that a petroleum mining anti-avoidance provision does not apply more broadly than intended.

Background

In November 2007, tax policy officials consulted on possible changes to the tax treatment of expenditure incurred on petroleum mining. The suggested changes were designed to remove the uncertainty and disincentives that currently exist with the current rules.

On 4 March 2008, the government announced that it would amend legislation to prevent New Zealand missing out on significant tax revenue from the petroleum mining industry. Tax legislation would be changed to ensure that expenditure on petroleum mining operations undertaken through a foreign branch cannot be offset against petroleum mining income from New Zealand.

Application dates

The application dates for the three sets of amendments to the petroleum mining rules are:

  • Petroleum mining expenditure incurred through a branch in another country applies to expenditure incurred on or after 4 March 2008.
  • The changes updating the petroleum mining rules apply to expenditure incurred on or after 1 April 2008.
  • The remedial amendment to the petroleum mining anti-avoidance provision applies from 1 December 2007.

Key features

  • Expenditure incurred on petroleum mining operations undertaken through a branch in another country cannot be deducted from income earned in New Zealand.
  • Changes to the petroleum mining tax rules remove disincentives that may affect investment in oil and gas exploration and development in New Zealand.
  • A change to the legislation ensures that the petroleum mining anti-avoidance rule does not apply more broadly than intended.

Detailed analysis

Expenditure on petroleum mining operations undertaken by a branch in another country

Section DT 1A of the Income Tax Act 2007 and the Income Tax 2004 provides that expenditure incurred on petroleum mining operations undertaken through a branch in another country cannot be deducted from income earned in New Zealand.

Petroleum mining expenditure not allocated in a current year is carried forward and is available for allocation in future income years. The amount that can be allocated in future years is capped to the amount of income that a petroleum miner earns from petroleum mining operations outside of New Zealand.

For example, if a petroleum miner incurs exploration expenditure through its branch operation in India, section DT 1A means that this expenditure cannot be offset against income from any petroleum mining in New Zealand. However, if the petroleum miner has income from the sale of oil or gas condensate from operations in Switzerland it will be able to offset this income against the exploration expenditure incurred in India.

Addressing existing impediments

A number of changes have been made to the petroleum mining tax rules to remove disincentives that may affect investment in oil and gas exploration and development in New Zealand.

Removing the onshore/offshore boundary

Section EJ 19 has been amended to remove the distinction between onshore and offshore petroleum mining development. Section EJ 12 has been changed so that a petroleum miner can start amortising development expenditure in the year that the expenditure is incurred, rather than having to work out whether the expenditure relates to an onshore or offshore development. Development expenditure incurred on or after 1 April 2008 can begin to be amortised during the income year in which it is incurred.

Reserve depletion method

New section DT 5 provides two methods for allocating deductions to an income year. A petroleum miner can elect to amortise development expenditure under either the current straight-line method (the default allocation rule) or the reserve depletion method. Section EJ 12 contains the default allocation rule. Section EJ 12B is the new reserve depletion method. This section allows petroleum development costs to be amortised in a manner that better reflects the allocation of development costs over the life of the field. The election to amortise development expenditure under the reserve depletion method must be made in the year that commercial production first begins. Once the election has been made, it applies to future development expenditure incurred in that permit area. The reserve depletion method is available for development expenditure incurred on or after 1 April 2008. Development expenditure incurred before this date must be amortised under the seven-year straight-line method.

Changes to probable reserves are counted in the year directly following the year that the estimate occurs. The following example illustrates the process:

Example

In December 2007, Slick Oil Ltd incurs $35 million on petroleum expenditure on an offshore development in New Zealand. Slick Oil incurs similar amounts of development expenditure in June 2008 and in December 2008. Commercial production begins in January 2009.

The first $35 million of development expenditure (incurred in December 2007) is amortised over seven years on a straight-line basis. A deduction of $5 million is allocated to each year until the expenditure is completely amortised at the end of 2014.

The remaining $70 million is allocated on a straight-line basis until commercial production begins in January 2009. Slick Oil then elects to allocate the remaining development expenditure under the reserve depletion method. As at January 2009, the balance of unamortised development expenditure incurred on or after 1 April 2008 is $67.5 million.

Applying section EJ 12B, the balance of reserve expenditure is $67.5 million. With probable reserves estimated at 100 million barrels and first-year production totalling 40 million barrels, a $27 million deduction for development expenditure is allocated to the 2009 income year.

At the end of 2009, the amount of probable reserves is revised down by 20 million barrels to 40 million barrels. The balance of reserve expenditure less previous expenditure is $40.5 million. Total production during 2010 is 20 million barrels. The deduction for development expenditure for 2010 is therefore $20.250 million.

Deduction for expenditure on a dry well

Section EJ 13B allows a deduction for the cost of a dry production well, if the cost of the well is incurred on or after 1 April 2008. A dry production well is a well that will never produce petroleum in commercial quantities, as opposed to a well that ceases to produce petroleum in commercial quantities. A deduction for the balance of the unamortised cost of the well is allowed in the year that drilling stops and the well is abandoned.

Well ceasing to produce petroleum in commercial quantities

Section EJ 13C provides a deduction for expenditure on a well if the well ceases producing petroleum in commercial quantities and is abandoned, and the petroleum miner is amortising development expenditure on the reserve depletion basis. Subject to these requirements, a deduction for the unamortised balance of the expenditure on the well is allowed in the income year that the well is abandoned. This rule applies to expenditure incurred on or after 1 April 2008.

Remedial amendment to petroleum mining anti-avoidance provision

Section DT 2 of the Income Tax Act 2004 and the Income Tax Act 2007 has been amended to ensure that the petroleum mining anti-avoidance rule does not apply more broadly than intended. The purpose of section DT 2 is to prevent double deductions for the same amount of expenditure. However, in some cases it could give the inappropriate result of reducing a taxpayer’s deductions from a single deduction to no deduction at all. As amended, section DT 2 prevents this result by excluding from the provision transactions involving the disposal of foreign petroleum mining assets. The amendment applies from 1 December 2007.