The decision is significant because it represents a tightening of the Court’s approach to the deductibility of expenditure under the Petroleum Resource Rent Tax Act 1987 (“PRRT Act”).
Esso Australia Resources Pty Ltd (“EAR”) and BHP Billiton Petroleum (Bass Strait) Pty Ltd (“BHPBP”) are participants in a joint venture petroleum project located in Bass Strait.
As the operator of the Bass Strait project, EAR outsourced the performance of various project functions to a related company, Esso Australia Ltd (“EAL”), under a Services Agreement. The Services Agreement did not relate specifically to the Bass Strait project, but provided for EAL to perform services for EAR in furtherance of its Australian operations generally. Under the Services Agreement, EAR was required to pay EAL:
In calculating its taxable profit in relation to the Bass Strait project for the 2003 and 2004 income years, EAR claimed deductions for that portion of the fees paid by it under the Services Agreement which were allocated to the Bass Strait project. EAR’s claims were allowed in part by the Commissioner of Taxation (“Commissioner”), but were rejected to the extent that the Commissioner considered that the fees were excluded expenditure or were not incurred by EAR in carrying on the operations comprising the Bass Strait project.
As the operator of the Bass Strait project, EAR also entered into a contract with another related company, Exxon Mobile Upstream Research Company (“URC”), under which it was provided with technical information and other research in return for a Mutualised Research Charge (“MRC”). EAR claimed deductions for the payment of the MRC in calculating its taxable profit for the Bass Strait project for the relevant years. The Commissioner disallowed these claims in full.
On an appeal to the Federal Court, Ryan J held that the fees paid by EAR under the Services Agreement were deductible in full, but dismissed the appeal as it related to the MRC issue. Ryan J held that the Services Agreement fees were deductible even though they would have been disallowed in part as “excluded expenditure” had EAR incurred the costs directly (eg. the costs incurred in maintaining the office facilities and staff). EAR appealed Ryan J’s decision on the MRC issue to the Full Court, while the Commissioner cross-appealed in relation to the deductibility of the Services Agreement fees.
In allowing the Commissioner’s appeal on the Services Agreement issue, the Full Court (Keane CJ and Edmonds J, with Perram J in agreement) held that the fees paid by EAR to EAL were not incurred by EAR in carrying on the operations comprising the Bass Strait project. Rather, they were incurred by EAR in procuring EAL to carry on the relevant operations. On this basis, the Full Court held that the deductions were not allowable under the general deduction provisions, but were subject to s41 of the PRRT Act.
According to the Full Court, the effect of s41 was to deem a liability incurred by an eligible person (EAR) to a contractor (EAL) to have been incurred by the eligible person in carrying on the activities carried on by the contractor. Put another way, s41 was designed to put the eligible person in the position it would have been in had it carried on the operations comprising the project itself. The result of this was that the deductions were not allowable to the extent that they related to excluded expenditure (eg. the costs incurred in maintaining EAL’s offices and staff).
In the course of argument, EAR contended that the deductions were allowable in full on the basis that s41 does no more than deem the liability incurred by the eligible person to have been incurred in carrying on the operations comprising the relevant project. The Full Court rejected this construction on the basis that it would lead to the odd result that a taxpayer could secure the deductibility of excluded expenditure by interposing a services company between itself and the performance of the relevant activities.
The Full Court agreed with the Commissioner that EAR could not deduct the MRC. The Court held that the research and technology obtained from the URC was not sufficiently connected with or related to the Bass Strait project to be deductible.
The Full Court’s decision confirms that taxpayers will not be entitled to deductions for fees paid to service providers to the extent that the expenditure would have been excluded expenditure or otherwise not allowable had it been incurred on the relevant activities directly.
Observations made by the Court in their reasons also suggest that s41 has a fairly strict operation. In this respect, the Full Court noted that the Commissioner’s case at first instance and on appeal proceeded on the premise that the Services Agreement fees were in part deductible. Their Honours said that, had they been asked to decide the issue, they may have disallowed the deductions in full.
The Court reached this conclusion based on a narrow reading of s41. In order to engage the provision, the Court, in our view surprisingly, reasoned that a taxpayer must first incur a liability to make a payment to a service provider specifically to procure the carrying on of the activities comprising the particular project. In the present case, this condition was not satisfied because the Services Agreement did not relate specifically to the Bass Strait project, but provided for EAL to perform services for EAR in furtherance of its Australian operations generally. The Court reached this conclusion even though the Services Agreement effectively covered the Bass Strait project.
In view of the Full Court’s approach, businesses subject to the PRRT regime should consider whether the Court’s decision has any implications on how their service arrangements are structured and how their service agreements are drafted.
Who does this affect?
All businesses subject to the petroleum resource rent tax regime.
What do you need to do?
Review your services agreements with joint venture participants, operators and third party contractors to determine whether the Court’s decision has any implications on how your service arrangements are structured and how your service agreements are drafted. We can assist.