Whilst a number of articles have summarised some or all of the matters discussed in the Issues Paper, the purpose of this note is to highlight some of the more practical concerns associated with the new Minerals Resource Rent Tax (MRRT) and revised Petroleum Resource Rent Tax (PRRT), particularly from the perspective of financiers and investors in Australian resource projects, and ways in which these concerns may be able to be managed.
The new resource tax regimes are to apply from 1 July 2012.
The tax regimes will have important consequences for all industry participants including customers, investors and financiers of resource projects.
Although there is still some way to go before the scope and design of the taxes are finalised, the recent Issues Paper released to facilitate consultation on the taxes highlights a number of practical matters and concerns. These should be considered or addressed before the application of the taxes.
The taxes will raise different concerns depending on the affected group. Entities that expect to be subject to the taxes, or an acquirer of product from operations likely to be subject to the taxes, should review their contracts to ascertain the ability for the tax costs to be passed through.
Financiers may want to carefully consider:
possible impacts on financial models where restrictions are imposed in relation to the ability to deduct the starting base of a project and any losses of projects acquired by a financed entity;
how MRRT and PRRT losses in a group may affect the financial returns from a project;
how to value and allocate losses between projects;
the consequences for the return from a project in the event the scope of a project subject to MRRT or PRRT differs to the economic scope of the project;
the timing of commencement and cessation of the project from a PRRT or MRRT perspective; and
what obligations should be imposed on a financed entity in relation to the documentation they should prepare and retain.
Project entities may wish to consider whether there are any benefits for them in restructuring prior to the introduction of the new taxes.
The Policy Transition Group (PTG) charged by the Government with leading the technical design of the new MRRT and extended Petroleum Resource Rent Tax (PRRT) released its detailed Issues Paper earlier this month.
A copy of the Issues Paper can be found here.
The Issues Paper covers three main areas:
Considerations surrounding the technical design of the MRRT;
Issues for existing oil and gas projects transitioning into the PRRT; and
The need for and merits of policies to promote exploration in Australia.
The Issues Paper canvases a significant number of implementation issues and possible design options for the new MRRT and extended PRRT in accordance with the PTG’s terms of reference
Issues for consideration and possible actions
Check your contracts
Resource entities will want to ensure that their long term sales contracts provide them with the opportunity to pass on the cost of the taxes to their customers. Meanwhile, purchasers of products from the resource entities will want to ensure that they can increase their own charges for any costs passed on to them as a consequence of the taxes.
In many ways, the review process that should be undertaken is similar to that for the proposed carbon trading scheme or carbon tax. Of key importance will be clarifying what costs can be passed on under the contracts (and in what circumstances) and ensuring that taxes on profits relating to the sale of resources are specifically covered under any “pass-through” clause or other provisions in your contracts.
Although it will be many months until the final design and scope of the MRRT and extended PRRT is confirmed, it is important that the taxes arising from the regimes are taken into account when drafting your legal agreements. You may also want to revisit concluded long term agreements to see if they are broad enough to deal with the MRRT and the revised PRRT.
Additionally, it may be worthwhile for joint venture participants to check their agreements to ensure that they will get access to the joint venture documentation necessary for them to satisfy their obligations under the MRRT or PRRT.
Some issues for financiers
Financiers of resource projects will have a number of specific concerns in relation to the new taxes. Whilst the fundamental consequence is that the taxes will be an additional deduction from the cash flow waterfall of a resource project and therefore will be required to be included in any financial model for a project, there are a number of other important issues arising from the design of the taxes that may need to be carefully managed.
Allocation of losses between entities and resource projects
Financiers will want to ensure the costs incurred by a resource company are properly allocated to the financed project to ensure the project is subject to an appropriate tax burden.
Of key importance will be any grouping arrangements entered into by a resource group. Although yet to be confirmed, it is likely that MRRT project losses will be able to be allocated across entities within a group. Two proposals considered in the Issues Paper are:
to allow an irrevocable election to permit losses to be transferred between group companies with 100% common ownership; or
to effectively provide for an automatic transfer of losses between project companies that are members of a income tax consolidated group.
Financiers will require certainty in relation to the use of the tax shelter of a financed project by any non-financed project within the same group. Under the income tax consolidation regime, agreements (generally known as tax funding agreements) seek to ensure that consideration is received by members of the tax consolidated group in relation to the use of “their” losses by other group companies. However, such consideration can be restricted by accounting consequences. In such circumstances it may be necessary for the financier to require the project entity to enter into a side agreement to ensure it receives full consideration. It is expected that similar arrangements to ensure the project entity receives full consideration from the losses will need to be adopted for entity members of a “MRRT group”.
Losses may also be able to be transferred between different projects conducted by a single entity. Again, it is not clear whether this will be an automatic transfer or a transfer at the election of the resource company.
Particular concerns are raised by the PTG as to the consequences for revenue if losses are “stored” by a company rather than offset against other projects, because under the regime those losses would be subject to the long term bond rate +7% uplift (the “uplift”). The Issues Paper comments that the automatic transfer of losses between projects is consistent with the underlying policy rationale to ensure minimal flexibility in dealing with losses where it may be to the benefit of a project but not the tax revenue. Financiers may therefore wish to ensure appropriate arrangements are in place to ensure projects of a particular entity that are outside of the finance ring fence are not unduly benefited by the tax losses of a financed project in circumstances where there is an automatic transfer or utilisation of those losses. By way of example, would the project entity be in the same position where it receives full compensation for the loss (ie the value of tax saved) in year two given that it loses the benefit of the uplift on those losses for seven years (being the anticipated time before those losses started to serve as a tax shelter)?
Financiers will also want to consider whether the exploration expenditure is appropriately allocated to a project. It is expected that there will be significant restrictions imposed on the deductibility of exploration rights.
Restrictions on losses of acquired projects and utilisation of starting base
The PTG considers that allowing losses of a project acquired by an entity to be transferable in the hands of the acquirer would be inconsistent with the terms of reference and policy design of the MRRT. It is therefore likely that losses of an acquired project will be quarantined and subject to further restrictions on utilisation (the later restriction being similar to the provisions governing the utilisation of income tax losses). As a consequence, the value of these losses may need to be discounted when valuing the acquisition of a resource project or company.
Existing projects coming into the MRRT will be given a “starting base” that will be allocated against the revenues of a project. The “starting base” reflects capital expenditure incurred on a project prior to 1 July 2012 and taxpayers will have a choice of dealing with this expenditure in one of two ways:
the expenditure will be included at its market value (as at 1 May 2010), will receive no uplift (i.e. the LTBR +7%) and will be deductible over the lesser of its effective life and 25 years; or
the expenditure will be included at its book value, will be eligible for the uplift and will be deductible over five years if the expenditure is included in the starting base at book value.
The choice of method adopted by a resource entity will therefore have significant implications for the timing and treatment of the losses of a project. Financiers will need to understand how these restrictions will affect the modelling of a project and they may also wish to ensure that the method adopted in relation to existing projects provides them with the maximum benefit.
Another complication surrounding the treatment of the starting base will be whether deductions for the starting base are available to be offset between projects or quarantined to the particular project to which they relate. Although the terms of reference do not specifically address this point, the PTG indicates a preference for quarantining the starting base to the project to which it relates, although they have specifically asked for submissions on this point.
Timing of project expenditure
The timing of project commencement and capital expenditure outlays may need to be carefully considered. This is particularly so given the restrictions that will apply to starting base expenditure already discussed. Capital expenditure incurred prior to 1 July 2012 will be added to the starting base of a project and subject to the restrictions already discussed. This compares with expenditure incurred post 1 July 2012, which will be included at its market value, be eligible for the uplift and possibly transferrable between other projects.
This incentive for deferral of expenditure or commencement of a project is specifically acknowledged in the Issues Paper.
Determining the scope of a project
As the MRRT is a project based tax, the scope of the particular project, in particular what aspects of the project are within and outside of the tax, will be of fundamental concern to financiers.
The issues paper considers a number of possible approaches to determining the boundaries of a project that will be subject to MRRT. The following are considered to be two possible approaches to defining a project:
The Issues Paper also acknowledges that it is not necessary that the project align with the economic or operational features of a mining activity if those features can be aggregated (i.e. into a single economic project). The example provided in the Issues Paper is of three separate mines that involve centralised processing. The possible concern for financiers from such an arrangement is that the activities (including the expenses and revenues) of one particular operation may be co-mingled with another, so it may be necessary to impose ring-fencing arrangements to ensure that the equalisation payments are made to ensure that a financed project is subject to an appropriate burden of tax.
The Issues Paper acknowledges the concerns of combining individual projects and notes that specific provisions may be required to clarify how this will operate in practice.
Transfer of assets between projects
Assets may, at one time or another, be transferred between projects. The Issues Paper considers that any disposals of assets previously included in the starting base should, in principle, result in an adjustment to that starting base. The manner in which these adjustments are implemented may provide incentives for resource entities to structure acquisitions and disposals in a particular manner and it is likely that integrity provisions will be introduced to reduce or remove these incentives. Financiers will need to be aware of the consequences for the project of any such arrangements and may want to ensure that the transfer of assets between projects is appropriately managed.
Ascertaining commencement and cessation of a project
The commencement of a project will be the point at which the Project will fall within the MRRT. It is also important when ascertaining the extent to which exploration expenditure will be attributed to the project.
The Issues Paper acknowledges that exploration expenditure may not be readily attributable to the discovery of a particular resource and therefore may not be easily attributable to a MRRT project. It considers, however, that allowing an entity to deduct any onshore exploration expenditure against a PRRT or MRRT project would be least consistent with the narrow commodity focus of the taxes. Accordingly, it is to be expected that there will be restrictions placed on the utilisation of exploration expenditure, which is likely to be limited to tax shelter available for particular projects. These restrictions will need to be borne in mind when modelling the expected tax costs of a project.
Project documentation
Financiers may want to impose specific documentation requirements on project companies that are not within the scope of the MRRT due to the existence of the $50 million exemption threshold.
One of the proposals raised in the Issues Paper is that entities under this threshold would have the option of not maintaining MRRT accounts. However, such entities may not be entitled to benefit from a starting base or previous royalties paid by it if it subsequently exceeds the threshold and becomes subject to the tax. Whilst the administrative burden imposed on an entity undertaking the necessary MRRT calculations during the period not exceeding the threshold may be material, it would likely provide significant upside in the event that the threshold was later exceeded. Financiers may therefore consider imposing an obligation on small resource entities to ensure appropriate documentation is maintained so as to make certain that full benefit for project expenditure is available should the project subsequently become subject to the MRRT.
This would also have consequences if a project was acquired by another resource company that exceeded the relevant threshold and would be a factor taken into account in valuing the target project by a taxable acquirer.
Deductions for intangible assets
The terms of reference provide that the project assets that can be included in the starting base are to include tangible assets, improvements to land and mining rights (as already defined by the tax laws). The Issues Paper questions whether mining rights should be interpreted to include other intangible assets or whether such intangible assets should be excluded consistent with the availability of the 25 per cent extraction allowance.
Entities may need to consider the extent to which their rights would not be mining rights and whether there is any ability to restructure their holdings in order to ensure they are placed in an optimal position.
Multi-product mines
Some mining operations will involve the production of multiple products. Some of these products will be within the scope of the MRRT or PRRT (e.g. an iron ore mine may involve production of copper) and some operations may result in products that are within the scope of the MRRT and others within the scope of PRRT (e.g. a coal mine that produces coal seam gas).
This gives rise to important questions of apportionment as the effective rate of taxation differs between the MRRT and PRRT, and certain activities will not be within the scope of tax in the first place. There may therefore be a preference, for example, to allocate more profitable activities to the MRRT project (which has a lower effective tax rate) or to allocate more expenses to PRRT activities (where the benefit of the expenses will be greater).
The Issues Paper suggests that these allocation issues could be dealt with by either:
Determining the tax treatment based on the primary activity of a particular project. For example, if the main product of a mine is iron ore, all product from that mine would be subject to the MRRT (even if it would not otherwise be within the scope of the MRRT, e.g. copper, lead or zinc).
Direct apportionment of costs between each particular activity / operation. This could be based on a general rule (e.g. apportionment on a “fair and reasonable basis”) or based on a particular parameter (e.g. a volume or revenue basis).
Legislation could provide a prescriptive approach specifying the manner in which apportionment must be undertaken.
No matter what approach is adopted, the consequences will need to be appropriately modelled by financiers to ensure that the expected returns from the project are able to be achieved.
The taxing point and ascertaining resource value
The terms of reference provide that the taxing point is “the first saleable form (at mine gate)”. The Issues Paper interprets this as implying that at least some initial transportation and early stage processing would fall within the taxing point, although “beneficiation” processes would be beyond the taxing point.
Where there is no arm’s length sale of the resource at the taxing point, questions arise as to how the value of the resource is to be determined. Although only expenditures incurred in bringing the resource to the taxing point are intended to be deductible against MRRT receipts, where an arm’s length sale of the resource occurs downstream from the taxing point, the Issues Paper acknowledges that determining the resource’s assessable value will require the value added to the product through processes undertaken downstream to be netted off the sale price.
The Issues Paper considers a number of different methods that may be used to determine the resource’s value in these circumstances. It is acknowledged that where a direct open market price does not exist for particular activities within the production value chain, an appropriate methodology to determine market value will need to be ascertained. The PTG focuses on the use of the arm’s length principles developed for the purposes of transfer pricing and the various methods that may be adopted.
Although no specific recommendation is made in relation to how the value of the resource should be ascertained, a number of the transfer pricing methodologies considered provide a reasonable allowance for gross profit.
The calculation of the arm’s length price, which takes into account a gross margin allowance for downstream expenses, could be interpreted as a de facto form of profits tax on the ultimate sale of the resource. Of key concern will be whether or not the gross margin is applied by way of prescriptive rules or whether it will be left to the discretion of each resource entity as is the current approach in applying Australia’s transfer pricing provisions. Depending on how this margin compares with the statutory uplift, there may be incentive for allocation of expenditure up or downstream of the taxing point.
Under the existing PRRT, a residual price method is used for integrated enterprises that extract gas and liquefy it before transportation. Under this method, the methodology adopted to determine an appropriate price includes determination of the sales price of the resource (or an arm’s length equivalent) as reduced by post taxing point costs. These costs include an allocation of capital expenditure, which are eligible for an uplift (as specified by regulation). If a similar prescriptive approach is adopted for the MRRT, the rate of uplift will be important when considering how the capital costs of a project should be structured.
Equally, participants may want to restructure upstream capital costs into operating expenditure that reflect the entity’s real cost of capital. Such a conversion may occur through numerous means, the most obvious by a sale and lease back of capital costs upstream from the taxing point.
Industry participants will need to carefully consider how this add back approach to pricing will affect the expected application of the taxes to projects and whether or not any flexibility is provided in selecting a particular taxing point if that would provide them with more certainty in regards to pricing.
Some issues for investors
Investors will be concerned by many of the same issues as financiers.
For example, the scope of the project invested in will be relevant in determining the returns for an investor. Furthermore, the form of investment in a project may now become more important. For example, an equity investment in a project may result in a project being “degrouped” from a particular MRRT group and result in its losses being quarantined on a go forward basis and the removal of the ability to access losses of other group members. This may drive the nature of investment able to be offered by a resource entity and may, in some circumstances, provide an incentive for a synthetic investment.
The payment of MRRT and PRRT will not generate franking credits, and to the extent to which the taxes exceed state royalty payments, investors will receive reduced dividends. Furthermore, for international investors, it is not clear whether any credit would be available in their home jurisdiction for the taxes. Whilst many of Australia’s double tax treaties cover the existing, limited PRRT, there may be a need for these treaties to be amended to specifically cover the MRRT and extension to the PRRT to provide certainty for investors.
Consultation and time frame
Consultations are also being held by the PTG across Australia during October and November.
The PTG is required to provide its advice to the Government by the end of this year to enable the necessary legislation to be introduced into Parliament some time during 2011.
Further information and questions
If you would like further information on the Issues Paper or the MRRT and PPRT more broadly, or would like to discuss any of the matters raised in this paper, please do not hesitate to get in touch with one of our mining tax specialists or your usual Mallesons contact.